14-Aug-2006
Quarterly Report Q2.........
ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion should be read in conjunction with the information contained in the condensed consolidated financial statements of the Company and the notes thereto appearing elsewhere herein and in conjunction with the Management's Discussion and Analysis set forth in (1) the Company's Annual Report on Form 10-KSB for the year ended December 31, 2005 and (2) the Company's Quarterly Report on Form 10-QSB for the quarter ended June 30, 2005. Readers should carefully review the risk factors disclosed in Form 10-KSB for the year ended December 31, 2005 and other documents filed by the Company with the SEC.
As used in this report, the terms "Company", "we", "our", "us" and "AOBO" refer to American Oriental Bioengineering, Inc., a Nevada corporation.
PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
This quarterly report contains forward-looking statements within the meaning of the federal securities laws. These include statements about our expectations, beliefs, intentions or strategies for the future, which we indicate by words or phrases such as "anticipate," "expect," "intend," "plan," "will," "we believe," "AOBO believes," "management believes" and similar language. The forward-looking statements are based on the current expectations of AOBO and are subject to certain risks, uncertainties and assumptions, including those set forth in the discussion under "Management's Discussion and Analysis of Financial Condition and Results of Operations" in this report. Actual results may differ materially from results anticipated in these forward-looking statements. We base the forward-looking statements on information currently available to us, and we assume no obligation to update them.
Investors are also advised to refer to the information in our previous filings with the Securities and Exchange Commission (SEC), especially on Forms 10-KSB, 10-Q and 8-K, in which we discuss in more detail various important factors that could cause actual results to differ from expected or historic results. It is not possible to foresee or identify all such factors. As such, investors should not consider any list of such factors to be an exhaustive statement of all risks and uncertainties or potentially inaccurate assumptions.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
This section should be read together with the Summary of Significant Accounting Policies included as Note 3 to the consolidated financial statements included in our annual report for 2005 filed with the SEC on Form 10-KSB.
ESTIMATES AFFECTING ACCOUNTS RECEIVABLE AND INVENTORIES
The preparation of our consolidated financial statements requires management to make estimates and assumptions that affect our reporting of assets and liabilities (and contingent assets and liabilities). These estimates are particularly significant where they affect the reported net realizable value of the Company's accounts receivable and inventories.
At June 30, 2006, the Company provided a $216,891 reserve against accounts receivable. Management's estimate of the appropriate reserve on accounts receivable at June 30, 2006 was based on the aged nature of some of these accounts receivable. In making its judgment, management assessed its customers' ability to continue to pay their outstanding invoices on a timely basis, and whether their financial position might deteriorate significantly in the future, which would result in their inability to pay their debts to the Company.
At June 30, 2006, the Company provided an allowance against its inventories amounting to $860,838. Management determination that this allowance is needed is based on potential impairments to the current carrying value of the inventories due to potential obsolescence of aged inventories. In making its estimate, management considered the probable demand for our products in the future and historical trends in the turnover of our inventories.
While the Company currently believes that there is little likelihood that actual results will differ materially from these current estimates, if customer demand for our products decreases significantly in the near future, or if the financial condition of our customers deteriorates in the near future, the Company could realize significant write downs for slow-moving inventories or uncollectible accounts receivable.
POLICY AFFECTING RECOGNITION OF REVENUE
Among the most important accounting policies affecting our consolidated financial statements is our policy of recognizing revenue in accordance with the SEC's Staff Accounting Bulletin ("SAB") No. 104. Under this policy, all of the following criteria must be met in order for us to recognize revenue:
1. Persuasive evidence of an arrangement exists;
2. Delivery has occurred or services have been rendered;
3. The seller's price to the buyer is fixed or determinable; and
4. Collectibility is reasonably assured.
The majority of the Company's revenue results from sales contracts with distributors and revenue is recorded upon the shipment of goods. Management conducts credit background checks for new customers as a means to reduce the subjectivity of assuring collectibility. Based on these factors, the Company believes that it can apply the provisions of SAB 104 with minimal subjectivity.
In August 2005, we established a subsidiary in Hong Kong with a specialty store to sell some of our products. Our subsidiary in Hong Kong also sells certain products to certain customers on consignment. We record revenue from consignment transactions when the consignee sells the product to the end user.
RESULTS OF OPERATIONS - THREE MONTHS ENDED JUNE 30, 2006 AS COMPARED TO THREE
-----------------------------------------------------------------------------
MONTHS ENDED JUNE 30, 2005
--------------------------
The following table sets forth the amounts and the percentage relationship to
revenues of certain items in our condensed consolidated statements of income for
the three months ended June 30, 2006 and 2005:
Three Months Three Months
Ended June 30, Ended June 30,
-------------------------- -------------------
2006 2005 2006 2005
----------- ----------- -------- --------
REVENUES $22,761,882 $11,902,470 100% 100%
COST OF GOODS SOLD 7,678,437 4,188,755 33.73 35.19
----------- ----------- -------- --------
GROSS PROFIT 15,083,445 7,713,715 66.27 64.81
Selling and marketing 1,956,629 550,446 8.60 4.62
Advertising 3,001,974 589,350 13.19 4.95
General and administrative 2,437,645 1,803,799 10.71 15.15
Depreciation and amortization 681,355 303,946 2.99 2.55
----------- ----------- -------- --------
INCOME FROM OPERATIONS 7,005,842 4,466,174 30.78 37.52
Interest income (expense), net 361,951 (65,401) 1.59 0.55
Other income(expenses), net 10,136 7,277 0.04 0.06
----------- ----------- -------- --------
INCOME BEFORE INCOME TAXES 7,377,929 4,393,496 32.41 36.91
Income taxes (1,550,708) (1,037,779) 6.81 8.72
----------- ----------- -------- --------
NET INCOME $ 5,827,221 $ 3,355,717 25.60% 28.19%
=========== =========== ======== ========
NET INCOME PER SHARE
BASIC $ 0.09 $ 0.08
=========== ===========
DILUTED $ 0.09 $ 0.08
=========== ===========
Revenue
Revenues for the second quarter of 2006 were $22,761,882, an increase of
$10,859,412 over revenues for the second quarter of 2005. Revenues by business
segment were as follows:
Product Three Months Ended June 30, Increase/
2006 2005 (Decrease)
-------------------------------------------------------------------------------
PBP products $ 15,845,371 $ 7,420,609 $ 8,424,762
PBN products 6,916,511 4,481,861 2,434,650
--------------- --------------- ---------------
TOTAL $ 22,761,882 $ 11,902,470 $ 10,859,412
=============== =============== ===============
Sales of our Plant Based Pharmaceutical (PBP) products increased by $8,424,762, or 114%, as compared to the same period during 2005 primarily due to the following factors:
o The increase in our sales of the Cease Enuresis Soft Gel by 119% from $1,919,802 in the second quarter of 2005 to $4,205,609 in the same period during 2006. The increase in sales of this product was due primarily to our continuous marketing efforts with respect to the Cease Enuresis Soft Gel together with the growing demand for the product in the Chinese market;
o The sales of our Shuanghuanglian Injection Powder increased from $3,909,917 in the three months ended June 30, 2005 to $5,734,186 in the corresponding period during 2006, or 47%. This increase is due to the full integration of HSPL into our company after the acquisition, including full access to our sales channels as well as our continuous marketing efforts since that time;
o The sales revenue from our UrinStopper Patch, a new product launched in 2005, also increased from $351,830 in the second quarter of 2005 to $1,219,783 in the same quarter during 2006, or 247%. This was attributable to improved recognition of our new product supported by our marketing campaigns;
o Sales revenues from other PBP products in the same period also increased by $432,722, or 35%, due primarily to the increased sales of our Double Ginseng Yishen Grain product; and
o Our newly acquired Guangxi Lingfeng Pharmaceutical Co. Ltd. (GLP) has also contributed $3,014,011 to our revenue for the three month ended June 30, 2006. GLP was not a subsidiary during the same period last year.
Sales from our Plant Based Nutraceutical (PBN) products increased to $6,916,511 in the second quarter of 2006 from $4,481,861 in the same period during 2005, representing a growth of 54% and it is primarily due to the following factors:
o Sales of our Protein Peptide series of products which increased by 84%, from $3,190,033 during the three months ended June 30, 2005 to $5,876,848 in the same period of 2006. This increase was mainly attributed to the increase in sales of peptide coffee and peptide powder;
o Increase in sales of PBN products was partially offset by the decrease in sales of our Compound Bio-functional beverage series from $935,020 in the second quarter of 2005 to $506,455 in the same quarter during 2006, representing an decrease of 46%. The decrease mainly resulted from reduced marketing efforts made for this product during the period; and
o Sales of other PBN products increased from $356,807 in the second quarter of 2005 to $533,208 in the same period during 2006, or an increase of 49%, due primarily to increased sales of our Vitamate nutritional oral liquid product.
Cost of Goods Sold and Gross Profit
Cost of goods sold was $7,678,437 for the three months ended June 30, 2006, compared to $4,188,755 for the three months ended June 30, 2005. Expressed as a percentage of revenues, cost of goods sold was 33.73% for the three months ended June 30, 2006, compared to 35.19% for the three months ended June 30, 2005. The reduction in cost of goods sold as a percentage of revenues reflected a continued focus on operating cost management, sourcing efficiencies and operation efficiencies.
Cost of goods sold for the quarters ended June 30, 2006 and 2005 by product categories were as follows:
Three Months Ended June 30, Increase/
Product 2006 2005 (Decrease)
------------------------ ------------ -------------- ---------------
PBP products $ 5,301,094 $ 2,647,978 $ 2,653,116
PBN products 2,377,343 1,540,777 836,566
------------ -------------- ---------------
TOTAL $ 7,678,437 $ 4,188,755 $ 3,489,682
============ ============== ===============
The cost of goods sold of PBP and PBN products increased by 100% and 54%, respectively, in the three months ended June 30, 2006 compared to the same quarter of 2005. These increases are attributed to our increase in sales.
Gross profit increased $7,369,730, or 96%, for the three months ended June 30, 2006 over the three months ended June 30, 2005. This increase reflected higher net sales, improved margins and operating efficiencies generally across our PBP and PBN businesses.
Gross profit as a percentage of net revenues increased from 64.81% in the comparable period of the prior year to 66.27% due to the reductions in cost of goods sold as a percentage of revenues discussed above and improved operational efficiency.
Selling and Marketing
---------------------
Selling and marketing expenses, including distribution expenses,
increased from $550,446 in the three months ended June 30, 2005 to $1,956,629 in
the same period of 2006, representing a 255% increase. The details of our sales
and marketing expenses were as follows:
Three Months Ended June 30, Increase/
2006 2005 (Decrease)
---------- ---------- ----------
Payroll $ 379,249 185,667 104%
Transportation 514,179 151,823 239%
Promotional materials and fees 502,194 35,431 1,317%
Offices and sundries 117,600 32,692 260%
AOBO Hong Kong marketing 53,313 5,308 905%
AOBO US marketing - 5,651 (100%)
Other 390,094 133,874 191%
---------- ----------
TOTAL $1,956,629 550,446 255%
========== ==========
Our increase in selling and marketing expenses in the quarter ended June 30, 2006 compared to the same quarter during 2005 was primarily due to the following factors:
o An increase in our payroll expenses for Harbin Bioengineering by 59%. Payroll expenses for HSPL increased by 137% compared with the same quarter during 2005 due to an increase in the number of employees and average salaries for people working in marketing and distribution. GLP, our newly acquired subsidiary, has also incurred $66,239 of payroll expenses during the second quarter of 2006.
o Transportation expenses for Harbin Bioengineering increased by 56% in the second quarter of 2006 compared to the same period during 2005. Transportation expenses for HSPL increased by $219,994. These increases resulted primarily from the growth in sales reflected in the increase in our sales revenue. GLP also added $57,806 of transportation expenses in the second quarter of 2006. GLP was not a subsidiary during the same period of 2005.
o Harbin Bioengineering increased its promotional materials and fees expenses by $329,745 in the quarter ended June 30, 2006 compared to the same quarter during 2005. This increase reflects increased spending in marketing communications to increase market awareness of our brand and products. We launched more marketing campaigns in more cities in the second quarter of 2006 compared to the same quarter of 2005. GLP spent $137,019 on its promotional materials and fees during the second quarter of 2006, which contributed 27% to this category of expenses.
o Harbin Bioengineering's office and sundries expenses increased by 135% in the second quarter of 2006 compared to the same period during 2005 due to increased support of our marketing activities. HSPL's office sundries expenses also increased by $35,679, or 416%, in the second quarter of 2006 as compared to the same period during 2005. The increase resulted primarily from the cost related to continued development and implementation of HSPL's branding and marketing campaigns. In addition, GLP incurred $16,566 in its office and sundries expenses.
o Marketing expenses increased also as a result of the opening of our AOBO Hong Kong specialty store in August 2005 and introducing products into many chain stores owned by chain pharmacies. To support the sales at these stores, as well as to increase our brand recognition, we engaged in substantial marketing activities during the second quarter of 2006.
o As a result of the increase in selling and distribution expenses by both HSPL and Harbin Bioengineering, as well as the integration of GLP, our overall selling and marketing expenses increased by 255% in the second quarter of 2006 as compared to the same quarter during 2005.
Advertising
Advertising expenses increased by $2,412,624, from $589,350 in the second quarter of 2005 to $3,001,974 in the same quarter of 2006. The increase in advertising expenses resulted from an increase in advertising and promotional efforts in the second quarter of 2006 to promote the Company's Shuanghuanlian Injection powder and Protein Peptide product series as well as our new products the Urinstopper Capsule and UrinStopper Patch. Our Hong Kong branch also increased advertisement on brand building and name recognition in the Hong Kong market in the second quarter of 2006 compared to the second quarter of 2005. GLP, our new acquired subsidiary, incurred $521,666 in advertising expenses during the second quarter of 2006. GLP was not a subsidiary in the second quarter of 2005.
General and Administrative
General and administrative expenses increased from $1,803,799 in the second quarter of 2005 to $2,437,645 in the same quarter of 2006, or a 35% increase. The details of general and administrative expenses were as follows:
Three Months Ended June 30, Increase/
2006 2005 Decrease)
---------- --------- ---------
Payroll $ 342,517 $ 247,141 39%
Directors' remuneration 114,250 91,750 25%
Stock compensation - directors 79,950 - 100%
Stock compensation - consultants 245,262 257,308 (5%)
Office rental 96,889 26,562 265%
Professional fees 368,243 288,902 27%
Office sundries 179,835 31,451 472%
Transportation 10,246 703 1,357%
Vehicles 21,642 10,313 110%
Utilities 55,478 42,437 31%
Research 198,097 125,209 58%
Business entertainment 132,302 4,638 2,753%
Provision for bad debts 38,033 562,620 (93%)
Miscellaneous 554,901 114,765 384%
---------- ----------
TOTAL $2,437,645 $1,803,799 35%
========== ==========
Our increase in general and administrative expenses in the three months ended June 30, 2006 compared to the same period during 2005 was primarily due to the following factors:
o An increase in general and administrative expenses incurred in the AOBO Hong Kong office of 160% as compared to the same period during 2005. The increase resulted primarily from additional personnel and facility expenses as well as fees paid for professional services.
o An increase in general and administrative expenses incurred in the AOBO US office of 28% as compared to the same period last year. In the second half of 2005, we increased the number of employees in AOB US from three to five, and we increased the number of offices occupied by AOBO US from one to two. As a result, there were increases in expenses in the payroll, office rental, office sundries and other expense categories in the second quarter of 2006 as compared to the same period during 2005. Director remuneration increased by 25% as a result of the appointment of a new independent director in the late second quarter of 2005, and stock-based compensation for directors was also initiated during that time. Stock-based compensation for consultants, however, decreased by 5% because some of the expenses for consultants were fully amortized earlier and as a result, such expenses did not recur in the second quarter of 2006. Professional fees for the second quarter of 2006 increased by 27% as compared to the same quarter during 2005 as a result of an increase in our use of audit and consultancy services in connection with the listing of our stock on the American Stock Exchange and a $60.0 million private placement in December 2005.
o Payroll expenses at Harbin Bioengineering increased by 6% compared with the second quarter during 2005, as a result of an increased number of employees. Our payroll expenses in HSPL decreased by 34% during that time, due to reduced number of employees in administrative departments of HSPL. Payroll expenses at GLP, our newly acquired subsidiary, were $56,934 for the second quarter of 2006.
o Research expenses at Harbin Bioengineering increased by 36% compared with the second quarter during2005, reflecting the devotion of additional resources to research on new product development. In the same period, research expenses at HSPL increased by 40%, due to investment in research of potential new products. GLP has also spent $28,021 in research expenses for the quarter ended June 30, 2006.
o Expenses for office sundries at Harbin Bioengineering increased by $109,318, or 447% compared with the same quarter of 2005, as a result of increased general and administrative activities to support our sales growth. In the same period, expenses for office sundries at HSPL increased by $5,656. This increase is due to the fact that during the second quarter of 2005, expenses for office sundries at HSPL were especially low because HSPL was then a newly-acquired subsidiary in the process of becoming integrated into our Company. The increased expenses for the second quarter of 2006 reflect HSPL's operation as a fully-integrated part of the Company. In addition, GLP contributed $29,787 in office sundries during the second quarter of 2006.
o In 2005, HSPL established a provision for bad debts in the amount of $266,248, based on the age of some of its accounts receivable. However, some of these bad debts have been recovered since then. Management does a reassessment at the end of each quarter and determines the appropriate amount of bad debt provision. For the second quarter of 2006, management reassessed and decided to increase the amount by $60,414. As of June 30, 2006, the provision for bad debts was $216,891 for HSPL.
o Other expenses at Harbin Bioengineering increased by $144,174, or 356% in the second quarter of 2006 compared with the same quarter during 2005. This increase was due to increases in maintenance expenses and telecommunication expenses of $55,184 and $21,390, respectively, as a result of increase in business activities to support our rapid growth. Other expenses at HSPL also increased by $34,225, or 152% in the second quarter of 2006 against the same quarter of 2005 due primarily to the $12,441 increase in repair and maintenance costs. Other expenses at GLP for the second quarter this year were $240,942, consisted mainly of insurance cost and quality control expenses. GLP's other expenses accounted for 43% of the total cost in this category.
Depreciation and Amortization
Depreciation and amortization expenses increased by $377,409, or 124%, in the quarter ended June 30, 2006 compared to the same quarter during 2005. The increase was mainly due to the integration of GLP with the net book value of $9,620,614 in fixed assets and $24,632,932 in intangible assets. The depreciation and amortization expenses at GLP amounted to $296,477 for the second quarter of 2006.
Interest Income (Expense), Net
Net interest income was $361,951 for the three months ended June 30, 2006, compared to net interest expense of $65,401 for the three months ended June 30, 2005. There were no significant fluctuations in interest expense incurred by us. The increase in interest income was the result of a higher level of excess cash reinvestment from the proceeds of our private placement in December 2005.
Other Income (Expense), Net
Other income (expense), net, was a net income of $10,136 for the three months ended June 30, 2006, compared to a net expense of $7,277 for the three months ended June 30, 2005. This was resulted primarily from our investment income of $5,315 and a government subsidy granted during the second quarter of 2006 that was not granted during the same quarter of 2005.
Income Taxes
Income tax expense for the quarter ended June 30, 2006 was $1,550,708 as compared to $1,037,779 for the quarter ended June 30, 2005. The increase was due to the increase in pre-tax income of Harbin Bioengineering and the contribution of profit from HSPL, which could not be offset against the losses of AOB Hong Kong and AOB US operations.
During the second quarter of 2006, income tax was provided for at 15% of pre-tax income for Harbin Bioengineering and 33% of pre-tax income for HSPL under applicable Chinese law. GLP enjoys a tax exemption according to applicable Chinese tax laws. The Company's effective tax rate during that period was 21%.
RESULTS OF OPERATIONS - SIX MONTHS ENDED JUNE 30, 2006 AS COMPARED TO SIX MONTHS
--------------------------------------------------------------------------------
ENDED JUNE 30, 2005
-------------------
The following table sets forth the amounts and the percentage relationship to
revenues of certain items in our condensed consolidated statements of income for
the six months ended June 30, 2006 and 2005:
Six Months Ended June 30, Six Months Ended June 30,
------------------------------
|
