U.S. Securities and Exchange Commission
Washington, D.C. 20549
Form 10-QSB
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
For the quarterly period ended June 30, 2005
OR
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES ACT
OF 1934
For the transition period from _____ to _____
Commission file number 0-27937
DRAGON PHARMACEUTICAL INC.
(Exact name of small business issuer as specified in its charter)
Florida 65-0142474
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
1055 West Hastings Street, Suite 1900
Vancouver, British Columbia
Canada V6E 2E9
(Address of principal executive offices)
(604) 669-8817
(Issuer's telephone number)
(Former address if changed since last report)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days. Yes [ X ] No [ ]
Number of shares of common stock outstanding as of June 30, 2005: 62,878,004
PART I - FINANCIAL INFORMATION
Item 1. Financial Statements
DRAGON PHARMACEUTICAL INC.
AND SUBSIDIARIES
CONSOLIDATED FINANCIAL STATEMENTS
FOR THE QUARTER ENDED JUNE 30, 2005
(UNAUDITED) Expressed in US Dollars
CONTENTS
PAGE 3 CONSOLIDATED BALANCE SHEETS AS AT JUNE 30, 2005 AND DECEMBER
31, 2004
PAGE 4 CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE
INCOME FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 AND
2004
PAGE 5 CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY FOR THE
PERIODS ENDED JUNE 30, 2005 AND DECEMBER 31, 2004
PAGE 6 CONSOLIDATED STATEMENTS OF CASH FLOWS FOR THE SIX MONTHS
ENDED JUNE 30, 2005 AND 2004
PAGES 7 - 31 NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - JUNE 30, 2005
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS AT JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
ASSETS
------ RESTATED
(NOTE 20)
December 31,
Note June 30, 2005 2004
---------- ------------------ -----------------
CURRENT ASSETS
Cash and cash equivalents 18 $ 1,355,481 $ 910,425
Accounts receivable, net of allowances 2 8,699,818 6,675,298
Inventories, net 3 17,600,990 16,623,906
Value added tax receivable - 162,443
Prepaid expenses 754,955 911,228
------------------ -----------------
Total Current Assets 28,411,244 25,283,300
------------------ -----------------
PROPERTY AND EQUIPMENT, NET 4 64,607,495 62,396,316
OTHER ASSETS
Intangible assets, net 6 2,497,682 432,769
Other receivables 1,868,305 2,213,842
Investments -cost 12,077 12,077
------------------ -----------------
Total Other Assets 4,378,064 2,658,688
------------------ -----------------
TOTAL ASSETS $ 97,396,803 $ 90,338,304
------------
================== =================
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES
Accounts payable $ 4,583,421 $ 3,047,485
Accrued retirement benefits 7 95,327 114,432
Other payables and accrued liabilities 8 18,613,368 17,705,163
Notes payable - short-term 9 6,845,410 12,884,057
Due to related companies 11 892,206 4,660,984
------------------ -----------------
Total Current Liabilities 31,029,732 38,412,121
------------------ -----------------
LONG-TERM LIABILITIES
Long term accounts payable 10 21,712,222 21,873,147
Long term retirement benefits 7 720,891 870,321
Notes payable - long-term 9 12,958,938 6,316,426
Due to related companies 11 - 1,328,502
------------------ -----------------
Total Long-Term Liabilities 35,392,051 30,388,396
------------------ -----------------
TOTAL LIABILITIES 66,421,783 68,800,517
------------------ -----------------
COMMITMENTS AND CONTINGENCIES (Note 14)
STOCKHOLDERS' EQUITY
Authorized: 200,000,000 common shares at par value of $0.001 each
Issued and outstanding: 62,878,004 (December 31, 2004: 44,502,004)
common shares 62,878 44,502
Additional paid-in capital 22,138,830 13,983,002
Retained earnings 1,237,416 -
Reserves 7,562,432 7,562,432
Accumulated other comprehensive (loss)
(911) -
Due from stockholder
(25,625) (52,149)
------------------ -----------------
Total Stockholders' Equity 30,975,020 21,537,787
------------------ -----------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 97,396,803 $ 90,338,304
------------------------------------------ ================== =================
The accompanying notes are an integral part of these consolidated financial statements.
3
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE INCOME
FOR THE THREE AND SIX MONTHS ENDED JUNE 30, 2005 AND 2004
(UNAUDITED) Expressed in US Dollars
RESTATED RESTATED RESTATED
(NOTE 20) (NOTE 20) (NOTE 20)
Three Months Three Months Six Six
Ended June Ended June 30, Months Ended Months Ended
Note 30, 2005 2004 June 30, 2005 June 30, 2004
------- --------------- ----------------- ---------------- --------------
NET SALES 12 $ 11,350,909 $ 7,320,949 $ 23,179,572 $ 14,475,985
COST OF SALES 8,169,143 3,284,181 16,788,627 7,241,284
--------------- ----------------- ---------------- --------------
GROSS PROFIT 3,181,766 4,036,768 6,390,945 7,234,701
--------------- ----------------- ---------------- --------------
OPERATING EXPENSES
Selling expense 1,285,282 1,109,338 2,429,249 1,918,241
General and administrative expenses 1,208,585 165,324 2,212,725 587,353
Depreciation and amortization 276,589 82,029 520,521 94,487
--------------- ----------------- ---------------- --------------
Total Operating Expenses 2,770,456 1,356,691 5,162,495 2,600,081
--------------- ----------------- ---------------- --------------
INCOME FROM OPERATIONS 411,310 2,680,077 1,228,450 4,634,620
OTHER INCOME (EXPENSE)
Interest expense
(315,568) (3,689) (556,619) (18,304)
Other income
28,416 50,627 39,500 50,627
Funds Released by Chinese Government
Liquidator 13 - - 885,864 -
Other expense 1,548 (36,231) (33,987) (36,231)
--------------- ----------------- ---------------- --------------
Total Other Income (Expenses) (285,604) 10,707 334,758 (3,908)
--------------- ----------------- ---------------- --------------
INCOME FROM OPERATIONS BEFORE TAXES 125,706 2,690,784 1,563,208 4,630,712
INCOME TAX EXPENSE 1(M) (129,046) (352,410) (325,792) (352,410)
--------------- ----------------- ---------------- --------------
NET INCOME (LOSS) (3,340) 2,338,374 1,237,416 4,278,302
OTHER COMPREHENSIVE INCOME
Foreign currency translation loss (911) - (911) -
--------------- ----------------- ---------------- --------------
COMPREHENSIVE INCOME (LOSS) $ (4,251) $ 2,338,374 $ 1,236,505 $ 4,278,302
=============== ================= ================ ==============
Earnings per share - basic and diluted $ 0.00 $ 0.05 $ 0.02 $ 0.10
=============== ================= ================ ==============
Weighted average number of shares
outstanding during the period - basic and
diluted 62,878,004 44,502,004 61,659,706 44,502,004
=============== ================= ================ ==============
The accompanying notes are an integral part of these consolidated financial statements.
4
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
FOR THE PERIODS ENDED JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
Common Stock Additional Accumulated
-------------------- Paid-In Retained other compre- Due from
Shares Amount Capital Earnings Reserves hensive loss Stockholder Total
---------- -------- ------------ ------------- ---------- ------------ ---------- ------------
Balance, December 31, 2003, 44,502,004 44,502 $ 7,841,363 $ 6,054,864 $1,286,784 $ - $(228,148) $ 14,999,365
adjusted for the effect of
recapitalization of reverse
acquisition (Note 5(B))
Registered capital appropriation - - 6,141,639 (6,141,639) - - - -
Notes receivable - stockholders - - - - - - 175,999 175,999
Net income for the year ended
December 31, 2004 - - - 6,362,423 - - - 6,362,423
Transfer from retained earnings
for appropriated statutory and
staff welfare reserves - - - (6,275,648) 6,275,648 - - -
---------- -------- ------------ ------------- ---------- ------------ ---------- ------------
Balance, December 31, 2004 44,502,004 $ 44,502 13,983,002 - 7,562,432 - (52,149) 21,537,787
Reverse acquisition (Note
5(B)) 18,376,000 18,376 5,740,370 - - - - 5,758,746
Related party debt exchanged
for equity - - 2,415,458 - - - - 2,415,458
Notes receivable -
stockholders - - - - - - 26,524 26,524
Comprehensive income (loss)
- foreign currency translation - - - - -
(911) - (911)
Net income for the six months
ended June 30, 2005 - - - 1,237,416 - - - 1,237,416
---------- -------- ------------ ------------ ---------- ----------- ---------- ------------
Balance, June 30, 2005 62,878,004 $ 62,878 $ 22,138,830 $ 1,237,416 $7,562,432 $ (911) $ (25,625) $30,975,020
========== ======== ============ ============ =========== =========== ========== ============
The accompanying notes are an integral part of these consolidated financial statements.
5
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE SIX MONTHS ENDED JUNE 30, 2005 AND 2004
(UNAUDITED) Expressed in US Dollars
RESTATED RESTATED
(NOTE 20) (NOTE 20)
2005 2004
------------------- -----------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,237,416 $ 4,278,302
Adjustments to reconcile net income to net cash provided by (used in) operating
activities:
Depreciation and amortization 2,870,284 881,627
Allowance for doubtful accounts 12,610 182,500
Provision for (recovery from) obsolete inventories (286,181) 274,219
Funds Released by Chinese Government Liquidator(Note 13) (745,828) -
Changes in operating assets and liabilities, net of effect of reverse acquisition
(Note 5(B)), (increase) decrease in:
Accounts receivable (655,011) (1,965,861)
Inventories (105,338) (3,047,576)
Value added tax receivable 162,443 -
Prepaid expenses 256,694 (663,388)
Other assets 345,537 -
Deposits - 993,474
Increase (decrease) in:
Accounts payable 981,036 1,988,828
Other payables and accrued expenses 277,817 5,331,009
------------------- ------------------
Net Cash Provided By (Used In) Operating Activities 4,351,479 8,253,134
------------------- ------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of property and equipment (3,977,853) (15,248,865)
Cash acquired in connection with reverse acquisition (Note 5(B)) 2,103,481
------------------- -----------------
Net Cash Provided By (Used In) Investing Activities (1,874,372) (15,248,865)
------------------- -----------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from notes payable 26,524 7,246,377
Due to related companies (2,681,821) (270,046)
Due from stockholder 603,865 183,365
------------------- -----------------
Net Cash Provided By (Used In) Financing Activities (2,051,432) 7,159,696
------------------- -----------------
(GAIN) LOSS ON CASH HELD IN FOREIGN CURRENCY 19,381 -
------------------- -----------------
NET INCREASE IN CASH AND CASH EQUIVALENTS 445,056 163,965
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 910,425 515,791
------------------- -----------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 1,355,481 $ 679,756
=================== =================
Cash paid during the period for interest expense $ 561,528 $ 18,304
=================== =================
Cash paid during the period for income taxes $ 366,563 $ -
=================== =================
SUPPLEMENTAL DISCLOSURE OF NON-CASH INVESTING AND FINANCING ACTIVITIES:
During March 2005, $2,415,458 of loans payable to an entity related to a
director of the Company was converted into equity of the Company.
The accompanying notes are an integral part of these consolidated financial statements.
6
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 1 SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES AND ORGANIZATION
(A) Organization and Basis of Presentation
Pursuant to a share purchase agreement, dated June 11, 2004, Dragon
Pharmaceutical Inc. (the "Company") acquired 100% of the issued and
outstanding shares of Oriental Wave Holding Limited ("Oriental Wave") by
issuing 44,502,004 common shares of the Company. This transaction was
completed on January 12, 2005 and has been accounted for as a reverse
acquisition (See Note 5(B)). Accounting principles applicable to reverse
acquisition has been applied to record the acquisition. Under this basis of
accounting, Oriental Wave is the acquirer and, accordingly, the
consolidated entity is considered to be a continuation of Oriental Wave
with the net assets of the Company deemed to have been acquired and
recorded at its fair market value. The Statement of operations includes the
results of Oriental Wave for the six months ended June 30, 2005 and those
of the Company from January 13 to June 30, 2005.
Oriental Wave was incorporated in the British Virgin Islands on January 7,
2003. Shanxi Weiqida Pharmaceutical Company Limited ("Shanxi Weiqida"), a
People's Republic of China limited liability company was incorporated on
January 22, 2002. Shanxi Weiqida is principally engaged in research and
development, manufacturing, and selling of pharmaceutical products in the
People's Republic of China ("PRC").
During 2003, Shanxi Weiqida's shareholders exchanged 100% of their
ownership of Shanxi Weiqida for 50,000 shares of Oriental Wave under a
reorganization plan. The transfer was accounted for as a reorganization of
entities under common control as the companies were beneficially owned by
identical shareholders and share common management. The financial
statements have been prepared as if the reorganization had occurred
retroactively.
The consolidated financial statements include the accounts of the Company
and its 100% owned subsidiaries: Oriental Wave, Shanxi Weiqida, Allwin
Newtech Ltd., Sanhe Kailong Bio-pharmaceutical Co., Ltd., Nanjing Huaxin
Bio-pharmaceutical Co. Ltd. ("Huaxin"), Allwin Biotrade Inc. and Dragon
Pharmaceuticals (Canada) Inc.. All significant intercompany balances and
transactions have been eliminated upon consolidation.
The accompanying unaudited consolidated financial statements have been
prepared in accordance with the instruction for Form 10-QSB pursuant to the
rules and regulations of Securities and Exchange Commission and, therefore,
do not include all information and notes normally provided in audited
financial statements and should be read in conjunction with the Company's
consolidated annual financial statements for the year ended December 31,
2004 included in the annual report previously filed on Form 10-KSB.
The results of operations for the interim periods presented are not
necessarily indicative of the results to be expected for the full year.
7
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
(B) Use of Estimates
In preparing consolidated financial statements in conformity with U.S.
generally accepted accounting principles, management is required to make
estimates and assumptions that affect the reported amounts of assets and
liabilities and the disclosure of contingent assets and liabilities at the
date of the financial statements and revenues and expenses during the
reported period. Actual results could differ from those estimates.
(C) Cash and Cash Equivalents
For purposes of the cash flow statements, the Company considers all highly
liquid investments with original maturities of three months or less at the
time of purchase to be cash equivalents.
(D) Accounts Receivable
The Company extends unsecured credit to its customers in the ordinary
course of business but mitigates the associated risks by performing credit
checks and actively pursuing past due accounts. An allowance for doubtful
accounts is established and recorded based on management's assessment of
the credit history with the customer and current relationships with them.
(E) Investments
During the twelve months ended December 31, 2004, the Company made an
investment in a private company of $12,077. The investment represents less
than 1% of the total equity outstanding of the private company outstanding
as of June 30, 2005. The private company investment is carried at cost and
written down to fair market value when indications exist that this
investment has other than temporarily declined in value. As of June 30,
2005, no impairment in the value of the investment has been recorded.
(F) Inventories
Inventories are stated at the lower of cost or market value, cost being
determined on a first-in, first-out method. The Company provides inventory
allowances based on excess and obsolete inventories determined principally
by customer demand and product expiration dates.
8
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
(G) Property and Equipment
Property and equipment are stated at cost, less accumulated depreciation.
Expenditures for additions, major renewals and betterments are capitalized
and expenditures for maintenance and repairs are charged to expense as
incurred.
Depreciation is provided on a straight-line basis, less estimated residual
value over the assets estimated useful lives. The estimated useful lives
are as follows:
Buildings 50 Years
Plant and machinery 10 Years
Motor vehicles 8 Years
Furniture, fixtures and
equipment 5 Years
Leasehold improvements Term of lease (5 -10 years)
Land use rights are stated at cost, less accumulated amortization. The land
use rights are amortized over the term of the relevant rights of 50 years
from the date of acquisition.
Depreciable assets are reviewed for impairment whenever events or changes
in circumstances indicate that the carrying amount may not be recoverable
based on projected undiscounted cash flows associated with the assets. A
loss is recognized for the difference between the fair value and the
carrying amount of the assets. Fair value is determined based upon market
quote, if available, or is based on valuation techniques.
(H) Fair Value of Financial Instruments
The carrying amount of the Company's cash and cash equivalents,
receivables, investments and notes and other payables approximates their
fair value. The fair value of the notes payables are estimated using
discounted cash flow analysis, based upon the Company's current borrowing
rates, and approximate their carrying value.
(I) Intangible Assets
Intangible assets represent licenses and permits for the production and
sales of pharmaceutical products in China and are amortized on a
straight-line basis over ten years.
Intangible assets are tested for impairment whenever events or
circumstances indicate that a carrying amount may not be recoverable. An
impairment loss would be recognized when the carrying amount of an asset
exceeds the estimated un-discounted cash flows used in determining the fair
value of the assets. The amount of the impairment loss to be recorded is
calculated by the excess of the assets carrying value over its fair value.
Fair value is generally determined using a discounted cash flow analysis.
9
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
(J) Revenue Recognition
The Company recognizes revenue from the sale of pharmaceutical products at
the time when title to the products transfers, the amount is fixed and
determinable, evidence of an agreement exists, and the customer bears the
risk of loss, net of estimated provisions for returns, rebates and sales
allowances. Revenues are recognized only when the Company has transferred
to the customer the significant risk and rewards of ownership of the goods.
(K) Advertising Costs
Advertising costs are expensed as incurred. Advertising expense totaled
$7,854 and $13,041 for the six months ended June 30, 2005 and 2004,
respectively and $6,873 and $11,882 for the three months ended June 30,
2005 and 2004, respectively.
(L) Research and Development
Research and development costs related to both present and future products
are expensed as incurred. Total expenditures on research and development
charged to selling, general and administrative expenses for the six months
ended June 30, 2005 and 2004 were $67,201 and $96,756, respectively and
$54,891 and $44,518 for the three months ended June 30, 2005 and 2004,
respectively.
(M) Income Taxes
The Company accounts for income taxes under the Statement of Financial
Accounting Standards No. 109, "Accounting for Income Taxes" ("Statement
109"). Under Statement 109, deferred tax assets and liabilities are
recognized for the future tax consequences attributable to differences
between the financial statement carrying amounts of existing assets and
liabilities and their respective tax bases. Deferred tax assets and
liabilities are measured using enacted tax rates expected to apply to
taxable income in the years in which those temporary differences are
expected to be recovered or settled. Under Statement 109, the effect on
deferred tax assets and liabilities of a change in tax rates is recognized
in income in the period that includes the enactment date. The Company
located its factories in a special economic region in China. This economic
region allows foreign enterprises a two-year income tax exemption from
central government tax beginning in the first year after they become
profitable, being the year commencing on January 1, 2003 to December 31,
2004 and a 50% income tax reduction for the following three years, being
2005 to 2007. The Company was approved as a wholly owned foreign enterprise
in October 2002.
10
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
(N) Foreign Currency Translation
The functional currency of the majority of the business of the Company is
the Chinese Renminbi ("RMB"), however, the Company reports in U.S. dollars.
The operating accounts of the Company which are maintained in RMB are
translated to U.S. dollars at US$1.00 = RMB 8.28 during the six month
period. Transactions denominated in currencies other than RMB are
translated into United States dollars using period end exchange rates as to
assets and liabilities and average exchange rates as to revenues and
expenses. Capital accounts are translated at their historical exchange
rates when the capital transaction occurred. Net gains and losses resulting
from foreign exchange translations are included in the statements of
operations and stockholder's equity as other comprehensive gain (loss).
(O) Other Comprehensive Income
The foreign currency translation gain or loss resulting from translation of
the financial statements expressed in RMB to United States Dollar is
reported as other comprehensive income in the statements of operations and
stockholders' equity.
(P) Segments
The Company operates in three reportable segments, Chemical Division,
Pharma Division and Biotech Division.
(Q) Earnings Per Share
Earnings per share are computed using the weighted average number of shares
outstanding during the period. Diluted earnings per share, as determined
using the treasury method, is equal to the basic income per share as common
stock equivalents consisting of options to acquire 3,128,000 common shares
that are outstanding at June 30, 2005 are not significantly dilutive,
however, they may be dilutive in future.
(R) Reclassifications
Certain 2004 balances have been reclassified to conform to the 2005
presentation.
(S) Stock Based Compensation
The Company adopted the disclosure-only provisions of Statement of
Financial Accounting Standards No. 123 (SFAS 123), "Accounting for
Stock-based Compensation", as amended by SFAS No. 148 "Accounting for
Stock-based Compensation - Transition and Disclosure - An amendment of SFAS
No. 123". SFAS 123 encourages, but does not require, companies to adopt a
fair value based method for determining expense related to stock-based
compensation. The Company continues to account for stock-based compensation
issued to employees and directors using the intrinsic value method as
11
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
prescribed under Accounting Principles Board Opinion (APB) No. 25,
"Accounting for Stock Issued to Employees" and related Interpretations.
(T) Recent Accounting Pronouncements
In November 2004, the FASB issued SFAS No. 151, "Inventory Costs--an
amendment of ARB No. 43, Chapter 4", which is the result of the FASB's
project to reduce differences between U.S. and international accounting
standards. SFAS No. 151 requires idle facility costs, abnormal freight,
handling costs, and amounts of wasted materials (spoilage) be treated as
current-period costs. Under this concept, if the costs associated with the
actual level of spoilage or production defects are greater than the costs
associated with the range of normal spoilage or defects, the difference
would be charged to current-period expense, not included in inventory
costs. SFAS No. 151 will be effective for inventory costs incurred during
fiscal years beginning after June 15, 2005. The adoption of SFAS No. 151
does not have an impact on the Company's consolidated financial statements.
In December 2004, the FASB issued SFAS No. 123(R), "Accounting for
Stock-Based Compensation". SFAS 123(R) establishes standards for the
accounting for transactions in which an entity exchanges its equity
instruments for goods or services. This Statement focuses primarily on
accounting for transactions in which an entity obtains employee services in
share-based payment transactions. SFAS 123(R) requires that the fair value
of such equity instruments be recognized as expense in the historical
financial statements as services are performed. Prior to SFAS 123(R), only
certain pro-forma disclosures of fair value were required. SFAS 123(R)
shall be effective for the Company as of the beginning of the first interim
or annual reporting period that begins after December 15, 2005. The
adoption of this new accounting pronouncement does not have a material
impact on the Company's consolidated financial statements.
In May 2005, the FASB issued Statement of Financial Accounting Standards
SFAS No. 154, "Accounting Changes and Error Corrections, a replacement of
APB Opinion No. 20 and FASB Statement No. 3." SFAS 154 requires
retrospective application to prior periods' financial statements for
changes in accounting principle, unless it is impracticable to determine
either the period-specific effects or the cumulative effect of the change.
SFAS 154 also requires that retrospective application of a change in
accounting principle be limited to the direct effects of the change.
Indirect effects of a change in accounting principle, such as a change in
non-discretionary profit-sharing payments resulting from an accounting
change, should be recognized in the period of the accounting change. SFAS
154 also requires that a change in depreciation, amortization, or depletion
method for long-lived, non-financial assets be accounted for as a change in
accounting estimate effected by a change in accounting principle. SFAS 154
is effective for accounting changes and corrections of errors made in
fiscal years beginning after December 15, 2005. Early adoption is permitted
for accounting changes and corrections of errors made in fiscal years
beginning after the date this Statement is issued. The adoption of this new
12
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
accounting pronouncement does not have a material impact on its
consolidated financial position, results of operations or cash flows.
NOTE 2 ACCOUNTS RECEIVABLE
Accounts receivable at June 30, 2005 and December 31, 2004 consisted of the
following:
RESTATED
(NOTE 20)
June 30, 2005 December 31, 2004
-------------- -----------------
Trade and other receivables $ 9,138,155 $ 6,799,872
Less: allowance for doubtful accounts 438,337 124,574
-------------- -----------------
Accounts receivable, net $ 8,699,818 $ 6,675,298
============== =================
For the six months ended June 30, 2005 and 2004, the Company recorded an
allowance for doubtful accounts of $12,610 and $182,500, respectively, in
the Consolidated Statement of Operations.
NOTE 3 INVENTORIES
Inventories at June 30, 2005 and December 31, 2004 consisted of the
following:
RESTATED
(NOTE 20)
June 30, 2005 December 31, 2004
-------------- -----------------
Raw materials $ 4,421,108 $ 4,287,604
Work-in-progress 11,301,810 10,994,088
Finished goods 3,123,854 2,302,073
-------------- -----------------
18,846,772 17,583,765
Less: provision for obsolescence
and impairment 1,245,782 959,859
-------------- -----------------
$ 17,600,990 $ 16,623,906
============== =================
For the three and six month periods ended June 30, 2005 , the Company
recorded a recovery from the provision for obsolete inventories of $762,764
and $286,181, respectively, in the Consolidated Statement of Operations
compared to provisions for obsolete inventories of $274,219 and $274,219
for the three and six month periods ended June 30, 2004.
13
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 4 PROPERTY AND EQUIPMENT
The following is a summary of property and equipment at June 30, 2005 and
December 31, 2004:
June 30, 2005
-----------------------------------------------------------
Accumulated Net Book
Cost Depreciation Value
---------------- ------------------ ---------------
Plant and equipment $ 44,766,348 $ 5,431,081 $ 39,335,267
Land and buildings 18,809,157 548,005 18,261,152
Motor vehicles 773,792 187,610 586,182
Furniture and office equipment 2,965,415 955,101 2,010,314
Leasehold improvements 1,083,534 1,058,355 25,179
Idle equipment 555,339 455,339 100,000
Construction in progress 4,289,401 - 4,289,401
---------------- ------------------ ---------------
$ 73,242,986 $ 8,635,491 $ 64,607,495
================ ================== ===============
December 31, 2004 RESTATED (NOTE 20)
---------------------------------------------------------
Accumulated Net Book
Cost Depreciation Value
--------------- ----------------- ---------------
Plant and equipment $ 41,154,014 $ 2,293,918 $ 38,860,096
Land and buildings 18,552,438 370,169 18,182,269
Motor vehicles 611,261 55,166 556,095
Furniture and office equipment 2,499,188 392,511 2,106,677
Construction in progress 2,691,179 - 2,691,179
--------------- ----------------- ---------------
$ 65,508,080 $ 3,111,764 $ 62,396,316
=============== ================= ===============
Depreciation expense for six month periods ended the June 30, 2005 and 2004
was $2,587,248 and $851,434 respectively. Depreciation expense for three
month periods ended the June 30, 2005 and 2004 was $1,280,980 and $488,649
respectively.
14
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 5 ACQUISITIONS
(A) Land Use Rights
During July 2003, the Company acquired Land Use Rights and buildings from a
government liquidator in exchange for assuming certain future employment,
healthcare and Land Use Rights acquisition costs of the factory and its
former employees. The agreement requires the Company to pay certain minimum
wages and health care costs until the date of their employment, retirement
or death, whichever occurs first. The maximum amount of the liabilities
assumed on the closing date was $8,897,685 which approximates the appraised
value of the Land Use Rights acquired. The Company has calculated the
related asset value by computing the estimated fair value of the future
expected payments to the remaining employees assuming an interest rate of
3% and has recorded the Land Use Rights at $3,332,907 (See Notes 7 and
14(D)). Subsequent to the acquisition the Company rehired a number of the
former employees, reducing the expected future payments required. The
Company has accounted for the reduction of the obligation by reducing the
amount of Land Use Rights recorded. The cost of Land Use Rights as at June
30, 2005 and December 31, 2004 is as follows:
RESTATED
(NOTE 20)
June 30, December
2005 31, 2004
---------------- -----------------
Original Cost recorded $ 3,332,907 $ 3,332,907
Less: reduction of future accrued
retirement benefit 1,163,387 1,135,238
---------------- -----------------
Cost of Land Use Rights $ 2,169,520 $ 2,197,669
================ =================
The Land Use Rights have been reduced by $28,149 during the period ended
June 30, 2005 and will be reduced in the future should payments be further
reduced due to additional former employees being rehired.
(B) Oriental Wave Holding Limited
The Company completed the acquisition of Oriental Wave on January 12, 2005
whereby the Company issued 44,502,004 common shares in exchange for all of
the issued and outstanding shares of Oriental Wave. The acquisition
represented an important strategic step in strengthening the competitive
position of the Company. The transaction has been approved by the Company's
shareholders and the regulatory authorities, who also approved an increase
in the authorized share capital to 200,000,000 common shares.
15
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
This transaction resulted in the former shareholders of Oriental Wave
owning 68.35% of the issued and outstanding shares of the combined entity
as of January 12, 2005. Accounting principles applicable to reverse
acquisition has been applied to record the acquisition. Under this basis of
accounting, Oriental Wave is the acquirer and, accordingly, the
consolidated entity is considered to be a continuation of Oriental Wave
with the net assets of the Company deemed to have been acquired and
recorded at its fair market value. The Statement of operations includes the
results of Oriental Wave for the six months ended June 30, 2005 and those
of the Company from January 13 to June 30, 2005.
The preliminary allocation of the net assets acquired is as follows:
Cash and short term securities $ 2,103,481
Accounts receivable 1,382,119
Inventories 585,565
Prepaid and deposits 100,421
--------------
Total Current Assets 4,171,586
Fixed Assets 867,742
Intangible and other assets, net 2,349,222
--------------
Total Assets 7,388,550
Less accounts payables and accrued liabilities (1,629,804)
---------------
Net assets acquired $ 5,758,746
===============
A summarized statement of operations for the Company for the twelve days
ended January 12, 2005 is as follows:
Sales $ 145,435
--------------
Gross Profit 109,059
--------------
Total operating expenses 166,881
--------------
Loss for the period $ (57,822)
==============
Pro-forma financial information, assuming the acquisition occurred January
1, 2004, are as follows:
For the six months ended June 30, RESTATED
(NOTE 20)
2005 2004
--------------------- --------------------
Sales 23,325,007 16,262,400
===================== ====================
Gross profit 6,500,003 8,579,619
===================== ====================
Net income 1,1982,934 3,640,875
===================== ====================
Earnings per share $ 0.02 $ 0.06
===================== ====================
16
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 6 INTANGIBLE ASSETS
The Company acquired $603,865 in licenses from a company related to a
director with the balance being recorded pursuant to the reverse
acquisition of Oriental Wave (Note 5(B)).
Intangible assets consist of the following as of June 30, 2005 and December
31, 2004:
RESTATED
(NOTE 20)
June 30, 2005 December 31, 2004
------------------ -----------------
Licenses $ 2,951,814 $ 603,865
Less: accumulated amortization 454,132 171,096
------------------ -----------------
$ 2,497,682 $ 432,769
================== =================
Amortization expense for the six month periods ended June 30, 2005 and 2004
was $283,036 and $30,193, respectively. For the three month periods ended
June 30, 2005 and 2004, amortization expense was $153,011 and $15,097,
respectively.
NOTE 7 ACCRUED RETIREMENT BENEFITS
During July 2003, the Company acquired land use rights and buildings from a
government liquidator. The present value of the accrued retirement benefits
assumed is recorded at June 30, 2005 and December 31, 2004 as follows:
RESTATED
(NOTE 20)
June 30, 2005 December 31, 2004
------------------- -------------------
Total liabilities assumed at closing date $ 8,897,685 $ 8,897,685
Less: reduction of liability due to re-employment (4 ,949,474) (4,949,474)
Less: net present value of liabilities not expected to be
paid (615,304) (615,304)
------------------- -------------------
Present value of expected liabilities 3,332,907 3,332,907
Less: amounts paid and liabilities not expected to be paid 2,516,689 2,348,154
------------------- -------------------
816,218 984,753
Less: current portion 95,327 114,432
------------------- -------------------
$ 720,891 $ 870,321
=================== ===================
17
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
Under the terms of the contract with the liquidator, the Company will
remain contingently liable for these liabilities until the date of
retirement or re-employment for each employee (See Notes 5(A) and 13.
NOTE 8 OTHER PAYABLES AND ACCRUED LIABILITIES
Other payables and accrued liabilities at June 30, 2005 and December 31,
2004 consist of the following:
RESTATED
(NOTE 20)
June 30, 2005 December 31, 2004
------------------- -------------------
Machinery and equipment payable $ 6,316,335 $ 7,050,243
Accrued expenses 7,826,102 6,360,198
Value added tax payables 279,178 -
Income taxes payable 170,321 166,495
Other taxes payable 108,471 121,054
Deposits received from customers 3,912,961 4,007,173
------------------ -------------------
$ 18,613,368 $ 17,705,163
================== ===================
18
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 9 NOTES PAYABLE
Balance at June 30, 2005 and December 31, 2004:
RESTATED
(NOTE 20)
June 30, 2005 December 31, 2004
------------------ --------------------
Note payable to a bank, interest rate of 6.372% per $ 420,290 $ 420,290
annum, guaranteed by a third party, due June 2005 (*)
Note payable to a bank, interest rate of 6.372% per
annum, guaranteed by a third party, due June 2005 (*) 386,473 386,473
Note payable to a bank, interest rate of 8.874% per
annum, guaranteed by a third party, due July 2005 (**) 603,865 -
Note payable to a bank, interest rate of 6.138% per
annum, secured by fixed assets of $5,047,038, due
November 2005 3,623,188 3,623,188
Note payable to a bank, interest rate of 6.039% per annum, secured by
leasehold land and fixed assets, due
April 2005 - 8,454,106
Note payable to a bank, interest rate of 6.039% per annum, secured by
leasehold land and fixed assets of
$3,192,237, due April 2006 1,811,594 -
Note payable to a bank, interest rate of 5.76% per annum,
secured by fixed assets of $9,996,803, due November 2006 6,316,426 6,316,426
Note payable to a bank, interest rate of 6.039% per annum, secured by
leasehold land and fixed assets of
$3,860,503, due April 2007 6,642,512 -
------------------ --------------------
19,804,348 19,200,483
Less current maturities 6,845,410 12,884,057
------------------ --------------------
$ 12,958,938 $ 6,316,426
================== ====================
19
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
* The Company is in the process of renegotiating and extending the
repayment term on the Notes Payable due in June 2005 but the process has
been extended due to additional information being required from the
guarantor of the Notes. In the meantime, the Company has subsequently
repaid $120,773 in July 2005 and $299,517 in August 2005 and intends to
further repay $386,473 in September 2005. The Company intends to re-borrow
the full amount of the Notes once the guarantor has been re-approved by the
bank.
** The Note payable due in July 2005 has been renegotiated and the
repayment term extended to October 2005.
Maturities are as follows:
Fiscal year ended December 31,
2005 $ 5,033,816
2006 8,128,020
2007 6,642,512
-------------------
$ 19,804,348
===================
NOTE 10 LONG TERM ACCOUNTS PAYABLE
Long term accounts payable balances at June 30, 2005 and December 31, 2004
is the final payment of construction contracts which had been finished as
of December 31, 2004. According to the contract terms, the final payments
on the contracts will be settled as follows:
RESTATED
(NOTE 20)
December 31,
June 30, 2005 2004
------------- ------------
Settlement Arrangement
Accounts payable due July to November, 2006 $ 21,712,222 $ 21,873,147
============= ============
20
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 11 DUE TO RELATED PARTIES
The amounts due to related party at June 30, 2005 and December 31, 2004 are
unsecured and non-interest bearing:
RESTATED
(NOTE 20)
June 30, 2005 December 31, 2004
------------------ -------------------
Due to a company owned by a stockholder and
director due March 2006 $ - $ 1,328,502
Due to a company owned by a stockholder and
director due March 2006 892,206 4,660,984
------------------ -------------------
892,206 5,989,486
Less: current maturities 892,206 4,660,984
------------------ -------------------
$ - $ 1,328,502
================== ===================
NOTE 12 SEGMENTS
The Company operates in three reportable segments, the Pharma Division,
Chemical Division and Biotech Division. The Pharma Division produces
chemical generic, mainly anti-infectious, drugs. The Chemical Division
produces the bulk intermediate or ingredient to sell to other
pharmaceutical companies for further processing and formulation into
finished products. The Biotech Division produces Erythropoietin or EPO, an
injection that stimulates red blood cell. Substantially all assets and
operations of the Company are located in China, which is considered as one
geographic location in an economic environment with similar risks and
returns. The accounting policies of the segments are the same as described
in the summary of significant accounting policies. The Company evaluates
segment performance based on income from operations. All intercompany
transactions between segments have been eliminated. As a result, the
components of operating income for one segment may not be comparable to
another segment. The following is a summary of the Company's segment
information for the periods ended June 30, 2005 and 2004 and as of June 30,
2005 and December 31, 2004.
21
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
Chemical Pharma Biotech
Division Division Division Total
--------------- --------------- -------------- -------------------
2005
Three months ended June 30, 2005
Sales $ 4,880,013 $ 5,686,800 $ 784,096 $ 11,350,909
Gross profit 184,473 2,410,184 587,109 3,181,766
Depreciation and amortization RESTATED
(NOTE 20)
1,059,381 184,907 215,011 1,459,299
Six months ended June 30, 2005
Sales 10,584,046 11,007,571 1,587,955 23,179,572
Gross profit 218,898 4,918,407 1,253,640 6,390,945
Depreciation and amortization RESTATED
(NOTE 20)
2,116,968 338,711 414,605 2,870,284
As at June 30, 2005
Total assets
RESTATED (NOTE 20)
69,819,365 22,129,522 5,447,916 97,396,803
Additions to long-lived assets 3,860,225 84,541 4,938 3,949,704
Intangible assets - 402,575 2,095,107 2,497,682
2004
Three months ended June 30, 2004
Sales 533,785 6,787,164 - 7,320,949
Gross profit 121,318 3,915,450 - 4,036,768
Depreciation and amortization 369,700 134,046 - 503,746
Six months ended June 30, 2004
Sales 1,383,570 13,092,415 - 14,475,985
Gross profit 449,491 6,785,210 - 7,234,701
Depreciation and amortization 604,481 277,146 - 881,627
As at December 31, 2004
Total assets
RESTATED (NOTE 20)
66,726,390 23,611,914 - 90,338,304
Additions to long-lived assets 27,295,156 852,773 - 28,147,929
Intangible assets - 432,769 - 432,769
22
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 13 OTHER INCOME - Funds Released by Chinese Government Liquidator
In July 2003, the Company, through Shanxi Weiqida, acquired out of
bankruptcy the land use rights of a state-owned enterprise. (Please also
refer to Note 5(A)) After entering into this transaction, the Company was
approached by an unrelated state agency to administer certain benefits
payable to former employees of the agency (the government liquidator) as
the Company had already established an infrastructure to make payments to
these employees for settlement of liabilities related to the transaction.
As a result, during 2004, the Company received $1,751,208 from the
government liquidator, for the settlement of human resources related
expenses of the bankrupt enterprise. As well, during the first quarter of
2005, a separate municipal agency, the Datong Municipal Government,
approved the transfer of a fund with a balance of $140,036 originally
reserved for the employee housing welfare as part of the liquidation
process of the state-owned enterprise. The two agencies, unrelated to the
acquisition, allowed the Company to retain the cash balance of $745,828 as
well as the reserve of $140,036 as payment for services provided by the
Company. As a result, the Company recorded other income of $885,864 during
the current period to reflect the above transactions.
NOTE 14 COMMITMENTS AND CONTINGENCIES
(A) Employee Benefits
The full time employees of Shanxi Weiqida are entitled to employee benefits
including medical care, welfare subsidies, unemployment insurance and
pension benefits through a Chinese government mandated multi-employer
defined contribution plan. The Company is required to accrue for those
benefits based on certain percentages of the employees' salaries. The total
provision for such employee benefits was $86,744 and $204,532 for the six
month periods ended June 30, 2005 and 2004, respectively and $29,473 and
$62,802 for the three month periods ended June 30, 2005 and 2004,
respectively . The Company is required to make contributions to the plans
out of the amounts accrued for medical and pension benefits. The Chinese
government is responsible for the medical benefits and the pension
liability to be paid to these employees.
23
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
(B) Loan Guarantee
The Company has guaranteed bank loans to two suppliers in the amount of
$181,000 (RMB1.5 million) due on August 11, 2005 (repaid subsequent to June
30, 2005) and $2,415,000 (RMB20 million) due on July 16, 2005 (extended to
July 16, 2005 subsequent to July 16, 2006). Interest on the loan due July
16, 2006 is charged at 7.905% and the bank has the right to seek settlement
from the Company for payment should the two supplier fail to repay the
loan. There is no recourse or possible recovery for the Company should the
suppliers default on their bank loans. The maximum potential amount of
future payments (undiscounted) that the Company could be required to make
is $2,614,274. The Company provided the guarantees to these suppliers to
maintain a good business relationship.
The Company has also issued a guarantee to a bank as security for loans to
a third party vendor of $2,415,000 (RMB20 million) due on September 26,
2007 and $3,623,000 (RMB30 million) due on October 27, 2007. Interest is
charged at the bank's base rate plus 5.9475 %. The bank has the right to
seek settlement from the Company for payment should the third party vendor
fail to repay the loan. The maximum potential amount of future payments
(undiscounted) that the Company could be required to make is $ 6,861,101.
This vendor has pledged assets totaling $8,484,000 (RMB70.2 million) to the
Company for this guarantee.
(C) Capital Commitments
According to the Articles of Association of Shanxi Weiqida, the Company has
to fulfill registered capital of $19,205,116 (RMB 159,018,360) within five
years from December 16, 2003. As of June 30, 2005, the Company has
fulfilled $14,656,174 (RMB 121,353,123) of registered capital requirement
and has registered capital commitments of $4,548,942 (See Note 15(A)).
(D) Contingent Employment Benefits
During July 2003, the Company acquired land and buildings from a government
liquidator in exchange for assuming certain future employment, healthcare
and land acquisition costs of the factory and its former employees. Under
the terms of the contract with the liquidator, the Company will remain
contingently liable for these liabilities until the earliest of date of
retirement, re-employment or death for each employee. As of June 30, 2005,
the Company has rehired 655 former employees, 236 employees have retired
and 163 former employees remain unemployed. If the Company is unable to
provide continued employment to these individuals, it will be liable to pay
each former employee approximately $49 per month until his or her date of
retirement, at age 60 or 50, respectively, or death, whichever comes first
(See Notes 5 & 7).
24
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
(E) Operating Leases
The Company has entered into operating lease agreements with respect to
Huaxin's production plant in Nanjing, China for an amount of RMB 2,700,000
(US$326,217) per annum until June 11, 2009 and the Company's administrative
offices in Vancouver for an amount escalating from CDN$200,000 to
CDN$230,000 (US$127,000 to US$146,000) per annum until March 31, 2007. The
Company decided to close the facility in Nanjing, effective July 31, 2005,
and build a new facility in Datong, China at the site of the manufacturing
facilities of Oriental Wave which is expected to be completed by September
30, 2005. The Company has renegotiated the termination of its lease,
without penalty, though the Company may be required to pay up to
approximately RMB 580,000 ($70,000) relating to severance and benefit costs
associated with the closure, of which RMB 500,000 (US$60,000) has been
accrued at June 30, 2005. Minimum payments required under the agreements
are as follows:
2005 $ 119,174
2006 188,202
2007 47,400
-----------------------------------------------------
Total $354,776
=====================================================
(F) Cell Line Development
The Company has contracted with a European Institute of Biotechnology to
develop a high yield proprietary cell line and production process
technology for the Company. Product from this advanced technology will be
used by the Company to enter the European market, once certain competitor's
patents expire. The total cost of development is $648,800 (EUROS 500,000)
of which $387,600 (EUROS 300,000) remains unpaid at June 30, 2005.
NOTE 15 STOCKHOLDERS' EQUITY
(A) Capital Contribution (See note 14(C))
On January 31, 2005 and on February 22, 2005 Oriental Wave paid Shanxi
Weiqida $479,988 and $198,682, respectively, towards its registered capital
requirement under Chinese law.
(B) Reserves
Pursuant to PRC regulations, Shanxi Weiqida is required to make
appropriations to reserves funds, comprising the statutory surplus reserve,
statutory public welfare fund and discretionary surplus reserve, based on
after-tax net income determined in accordance with generally accepted
accounting principles of the People's Republic of China (the "PRC GAAP").
Appropriation to the statutory surplus reserve should be at least 10% of
25
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
the after tax net income determined in accordance with the PRC GAAP until
the reserve is equal to 50% of the Company's registered capital. The
transfer to this reserve must be made before distribution of dividends to
shareholders. Except for the reduction for losses incurred, any other usage
should not result in this reserve balance falling below 25% of the
registered capital. Appropriations to the statutory public welfare fund are
at 5% to 10% of the after tax net income determined in accordance with the
PRC GAAP. The statutory public welfare fund is established for the purpose
of providing employee facilities and other collective benefits to the
employees and is non-distributable other than in liquidation.
Appropriations to the discretionary surplus reserve are made at the
discretion of the Board of Directors. These reserves are not available for
distribution to owners under general operating conditions.
(C) Stock Options
The Company has adopted the 2001 Stock Option Plan, effective December 17,
2001, which allows for the granting of options to Directors and Employees
for a period of up to ten years. The Company did not grant any options
during the year ended December 31, 2004. During the period ended June 30,
2005, the Company granted options to its directors and employees to
purchase 2,260,000 shares at a price of $1.18 per share (being the market
price at the time), expiring January 12, 2010. Options to purchase
1,460,000 shares were exercisable immediately with 400,000 options becoming
available January 12, 2006 and the balance of 400,000 options vesting on
January 12, 2007.
The following summarizes stock option information for the period ended June
30, 2005:
--------------------------------------------------------------- -------------------- ------------------------
Weighted Average
Shares Exercise Price
--------------------------------------------------------------- -------------------- ------------------------
Options outstanding at December 31, 2003 2,599,000 $ 2.04
Forfeited (705,000) $ 1.57
Exercised (145,000) $ 0.50
--------------------------------------------------------------- -------------------- ------------------------
Options outstanding at December 31, 2004 1,749,000 $ 2.36
Granted 2,260,000 $ 1.18
Forfeited (919,500) $ 2.88
--------------------------------------------------------------- -------------------- ------------------------
Options outstanding at June 30, 2005 3,089,500 $ 1.34
=============================================================== ==================== ========================
26
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
Options Outstanding Options Exercisable
----------------------------------------------------------------------------------- --------------------------------------
Weighted
Average Weighted Weighted
Range of Remaining Average Average
Exercise Number Contractual Exercise Number Exercise
Prices Outstanding Life Price Exercisable Price
----------------------- ------------------- -------------------- ------------------ ----------------- --------------------
$0.01 - $1.00 350,000 2.76 $0.68 337,500 $0.68
$1.01 - $2.00 2,439,500 4.34 $1.22 1,639,500 $1.24
$3.01 - $4.00 300,000 0.37 $3.13 300,000 $3.13
------- ---- ----- ------- -----
3,089,500 3.78 $1.34 2,277,000 $1.40
========= ==== ===== ========= =====
The Company accounts for its stock-based compensation plan in accordance
with APB Opinion No. 25, under which no compensation is recognized in
connection with options granted to employees and directors except if
options are granted with a strike price below fair value of the underlying
stock. The Company adopted the disclosure requirements SFAS No. 123,
Accounting for Stock-Based Compensation. Accordingly, the Company is
required to calculate and present the pro forma effect of all awards
granted. For disclosure purposes, the fair value of each option granted to
an employee has been estimated as of the date of grant using the
Black-Scholes option pricing model with the following assumptions:
risk-free interest rate of 5.5%, dividend yield 0%, volatility of 90%, and
expected lives of approximately 0 to 5 years. The weighted average fair
value of the options granted during the period was $0.69. Based on the
computed option values and the number of the options issued, had the
Company recognized compensation expense, the following would have been its
effect on the Company's net income:
------------------------------------------------ ------------------- ----------------
RESTATED
(NOTE 20)
For the six months ended June 30, 2005 2004
------------------------------------------------ ------------------- ----------------
Net income for the period:
- as reported $1,237,416 $4,278,302
- pro-forma $ 90,972 $4,278,302
------------------------------------------------ ------------------- ----------------
Basic and diluted income per share:
- as reported $0.02 $0.10
- pro-forma $0.00 $0.10
------------------------------------------------ ------------------- ----------------
27
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 16 INCOME TAXES
Shanxi Weiqida and Huaxin are subject to income taxes in China on their
taxable income as reported in their statutory accounts at a tax rate in
accordance with the relevant income tax laws.
Oriental Wave, Allwin Newtech Ltd. and Allwin Biotrade Inc are BVI
companies and are not subject to income taxes. Dragon Pharmaceutical Inc.
and Dragon Pharmaceutical (Canada) Inc. are U.S. and Canadian companies,
respectively, and are subject to taxes in those jurisdictions.
NOTE 17 RELATED PARTY TRANSACTIONS
See Notes 6 and 11.
NOTE 18 CONCENTRATIONS AND RISKS
92.5% and 89% of the Company's revenues for the three and six months ended
June 30, 2005, respectively, were derived from customers located in China
and 99% of its assets at June 30, 2005 are located in China. Comparatively,
100% of the Company's revenues during the three and six months ended June
30, 2004 were derived from customers located in China and 100% of its
assets were located in China.
The Company is exposed to the risk arising from changing interest rates. A
detailed analysis of the Company's Notes Payable, together with their
respective interest rates and maturity dates, are included in Note 9.
The majority of the Company's assets, liabilities, revenues and expenses
are denominated in Renminbi which is tied to the US Dollar and is not a
freely convertible currency. The deregulation of the Renminbi resulting in
an appreciation of the Renminbi against the US Dollar would result in an
increase in the assets, liabilities, revenues and expenses of the Company
and a foreign currency gain included in comprehensive income (See Note
19(A)). Conversely, the devaluation of the Renminbi against the US Dollar
would result in a decrease in the assets, liabilities, revenues and
expenses of the Company and a foreign currency loss included in
comprehensive income. At June 30, 2005, approximately US$1,148,000 of the
cash and cash equivalents (December 31, 2004: US$885,681) are held in
Renminbi.
28
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
NOTE 19 SUBSEQUENT EVENTS
(A) Renminbi Appreciation
On July 22, 2005, the Chinese government decided to no longer peg the value
of the Renminbi to the US dollar but rather to a basket of currencies of
its largest trading partners. The result was an appreciation of the
Renminbi of approximately 2% against the value of the US dollar. The effect
of the revaluation will be an increase in the assets, liabilities, revenues
and expenses of the Company and a foreign currency gain included in
comprehensive income.
(B) Notes payable extension
The Company has renegotiated, repaid and extended certain notes payable
subsequent to June 30, 2005 as described in Note 9.
NOTE 20 RESTATEMENT
As a result of a review of its accounting policies and applicable
accounting pronouncements, the Company has concluded that the reduction of
a future retirement benefit obligation related to the acquisition of a land
use right from a former state-owned enterprise in China by Oriental Wave
Holding Limited ("Oriental Wave") in July 2003, should have been accounted
for as a reduction to the recorded cost of the land use right instead of as
a non-operating gain from extinguishment of debt, as previously disclosed
in Oriental Wave's 2004 financial statements. As a result, Oriental Wave's
2004 financial statements have been restated retroactive to June 2004 to
reflect such change in accounting treatment.
29
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
The reduction of the future retirement benefit obligation during 2004,
totaling $1,135,238 million, which was recognized as a non-operating gain,
has been recorded as a reduction to the cost of the land use right. On a
going forward basis, any similar reduction of the retirement benefit
obligation will be treated as a reduction to the recorded cost of the land
use right. The effect on the financial statements is as follows:
As at December 31, 2004
-------------------------------------
Previously
Restated Reported
----------------- -----------------
Current assets $25,283,300 $25,283,300
Property and equipment 62,396,316 63,520,202
Other assets 2,658,688 2,658,688
----------------- -----------------
Total assets $ 90,338,304 $ 91,462,190
================= =================
Liabilities $ 68,800,517 $ 68,800,517
----------------- -----------------
Share capital 14,027,504 14,027,504
Retained earnings 7,562,432 8,686,318
Due from shareholder/comp loss (52,149) (52,149)
----------------- -----------------
Total equity 21,537,787 22,661,673
----------------- -----------------
Total liabilities and equity $ 90,338,304 $ 91,462,190
================= =================
Three months ended June 30, 2004 Six months ended June 30, 2004
------------------------------------- ---------------------------------------
Previously Previously
Restated Reported Restated Reported
------------------ --------------- ----------------- ------------------
Net Sales $ 7,320,949 $ 7,320,949 $ 14,475,985 $ 14,475,985
Cost of sales 3,284,181 3,284,181 7,241,284 7,241,284
------------------ --------------- ----------------- ------------------
Gross profit 4,036,768 4,036,768 7,234,701 7,234,701
Operating expenses 1,356,691 1,356,691 2,600,081 2,600,081
------------------ --------------- ----------------- ------------------
Income from operations 2,680,077 2,680,077 4,634,620 4,634,620
Other income (expense) 10,707 845,244 (3,908) 830,629
------------------ --------------- ----------------- ------------------
Income before taxes 2,690,784 3,525,321 4,630,712 5,465,249
Income tax expense 352,410 352,410 352,410 352,410
------------------ --------------- ----------------- ------------------
Net income $ 2,338,374 $ 3,172,911 $ 4,278,302 $ 5,112,839
================== =============== ================= ==================
Net Income per share $ 0.05 $ 0.07 $ 0.10 $ 0.11
================== =============== ================= ==================
30
DRAGON PHARMACEUTICAL INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
AS OF JUNE 30, 2005 AND DECEMBER 31, 2004
(UNAUDITED) Expressed in US Dollars
Three months ended March 31, 2005
----------------------------------------
Previously
Restated Reported
------------------ ------------------
Net Sales 11,828,663 11,828,663
Cost of sales 8,619,484 8,619,484
------------------ ------------------
Gross profit 3,209,179 3,209,179
Operating expenses 2,392,040 2,397,716
------------------ ------------------
Income from operations 817,139 811,463
Other income (expenses) 620,363 620,363
------------------ ------------------
Income before taxes 1,437,502 1,431,826
Income tax expense 196,746 196,746
------------------ ------------------
Net income 1,240,756 1,235,080
================= ==================
Net Income per share $ 0.02 $ 0.02
================= ==================
31
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
Overview
The following discusses the Company's financial condition and results of
operations for the three and six months ended June 30, 2005 based upon the
Company's interim unaudited consolidated financial statements which have been
prepared in accordance with the United States generally accepted accounting
principles. It should be read in conjunction with the Company's audited
financial statements and the notes thereto and other financial information
included in the Company's Form 10-KSB for the fiscal year ended December 31,
2004. Due to the fact that Dragon's acquisition of Oriental Wave Holding Limited
("Oriental Wave") on January 12, 2005 is deemed to be a reverse-take-over
transaction, the following discussion reflects the Company's results of
operations for the three and six months ended June 30, 2005, including the
results of Oriental Wave for the full six months and the results of Dragon's
biotech business for the period of January 12, 2005 to June 30, 2005.
Comparatively, the results of operations for the three and six months ended June
30, 2004 only reflected the Pharma and Chemical businesses of Oriental Wave.
Incorporated in Florida, USA and headquartered in Vancouver, B.C., Canada,
Dragon, prior to the acquisition of Oriental Wave, was formed for the purpose of
developing, marketing and selling biologics such as Erythropoietin ("EPO") in
China and international markets outside of China. Through its wholly-owned drug
manufacturing company Nanjing Huaxin Bio-pharmaceutical Co., Ltd. ("Nanjing
Huaxin") located in Nanjing City, China, Dragon manufactures and sells EPO.
Dragon's EPO has been approved and marketed in nine countries including China,
India, Egypt, Brazil, Ecuador, Dominican Republic, Trinidad-Tobago, Peru, and
Kosovo. In addition, we are preparing to enter the European market upon
obtaining product approval of our newly developed EPO products.
On January 12, 2005, the Company or ("Dragon") completed the acquisition of
Oriental Wave Holding Ltd. ("Oriental Wave") in a reverse take over transaction.
Oriental Wave, through its wholly owned subsidiary in China, Shanxi Weiqida
Pharmaceutical Ltd. ("Shanxi Weiqida"), currently has three production
facilities in China: two Chinese State Food and Drug Administration ("SFDA")
certified GMP production facilities consisting of a pharmaceutical facility with
a capacity of producing 1.6 billion tablets and capsules, 80 million injectables
and 10 million suppositories per year and a chemical plant producing clavulanic
acid. In addition, Oriental Wave has a third facility producing 7-ACA, an
intermediate for Cephalosporin antibiotics by a fermentation process. As an
intermediate, the 7-ACA facility doesn't require GMP certification. Oriental
Wave has a total of approximately 306 drug approvals from the SFDA of which
about 66, mainly anti-infectious drugs, were actively exploited in China in
2004. Dragon acquired all of the outstanding shares of Oriental Wave from Mr.
Yanlin Han, Mr. Zhanguo Weng and Ms. Xuemei Liu. As a result of the acquisition,
Mr. Han, Mr. Weng and Ms. Liu collectively owned 68.35% of Dragon's outstanding
shares of common stock at the date of the transaction.
As a result of the acquisition of Oriental Wave, Dragon has been
transformed into a diversified and growth oriented generic pharmaceutical
company with three key business units consisting of a Biotech division for
biologics products, such as Erythropoietin or EPO, a Chemical division for bulk
pharmaceutical chemical and intermediate such as Clavulanic Acid and 7-ACA and a
Pharma division for formulated drugs, including prescription and
over-the-counter drugs, and sterilized bulk drugs. Through the acquisition, the
Company has significantly increased the size of operations and now has four
manufacturing facilities in China (three in Datong city and one in Nanjing
city), approximately 1,800 employees, with over 1,200 contract sales
representatives in China, and approximately 58 key products in 90 different
32
dosages and presentations currently in the market. The Company now operates its
three business divisions: a Pharma Division, a Chemical Division, and a Biotech
Division, through two indirect wholly-owned subsidiaries in China, Shanxi
Weiqida Pharmaceutical Ltd. ("Shanxi Weiqida") and Nanjing Huaxin
Bio-pharmaceutical Co., Ltd. ("Nanjing Huaxin"). The Company maintains its sales
network through 63 sales offices and over 1,200 sales representatives throughout
China for Pharma products sales and marketing, while it uses a direct sales
model through the in-house sales department to sell Chemical products to other
domestic and international pharmaceutical companies. The Company's product
development department in China works on R&D of new generic products and
regulatory affaires of new products, presentations, and dosages approval, and
cooperates with external research institutes and companies to develop new
products as well. The Company's headquarters, located in Vancouver, has finance
department for financial reporting, SEC compliance, corporate finance and
investor relations, international sales department for international sales and
marketing, regulatory affairs department for international product approval, and
business development department for exploring new business opportunities. The
Company also operates a European office on product development of new EPO for
European market, Chemical bulk drugs and formulation drugs, technology
acquisition, and international sales.
Pharma Division
Pharma Division's operations are located in Datong Economic and Technology
Development Zone, Datong City, Shanxi Province, China. Pharma Division produces
chemical generic, mainly anti-infectious, drugs. Pharma Division currently holds
approximately 306 product approvals from the Chinese drug approval authority
(SFDA), with which only 52 prescription, Over-the-counter and sterilized bulk
products are currently commercialized in China. The Company plans to build a new
workshop for the freeze-drying of temperature sensitive pharmaceutical products.
(See liquidity section) Among these products is Levofloxacin, a product marketed
by the Company whose production is currently outsourced to a third party
contract manufacturer. The Pharma Division operates its business strategies to
focus on the expansion and development of the Chinese market by managing its
product portfolio and selecting potential products for commercialization,
strengthen R&D and introduce generic drugs with potential market through
cooperation and acquisition, and conduct market research and product development
for preparing the launching of OTC product branding strategy.
Chemical Division
The Chemical Division's operations are located in Datong Gongnong Road,
Datong City, Shanxi Province, China. Chemical Division produces the bulk
intermediate or ingredient to sell to other pharmaceutical companies for further
processing and formulation into finished products. The Chemical Division manages
the production of Clavulanic Acid, 7-ACA, and Abamectin for both the Chinese and
international markets. In January 2004, the Chemical Division began its
operation of a production facility for Clavulanic Acid, and in July 2004, the
second production facility of the Chemical Division to produce 7-ACA started its
operation. The third production facility for Abamectin with planned 120-ton
production capacity is currently under construction and is expected to be
completed in the fourth quarter of 2005. One of the key products in Chemical
Division is Clavulanic Acid, a drug that combines with antibiotics to fight drug
resistance. Dragon is currently the sole commercial producer in China. Two
Clavulanic Acid products were approved to export to India and initial quantities
of these two products to India has already started in 2004. Another key product
in the Chemical Division is 7-ACA, an intermediate for Cephalosporin
antibiotics. The 500-ton production capacity of 7-ACA makes Dragon among the
main produces in the world. 7-ACA's export to India has already started in 2004.
In 2004, Dragon's Chemical Division entered into a 3 year long term supply
agreement with Aurobindo Pharma Limited, an Indian pharmaceutical company, to
purchase 50% of the products from Chemical Division. The Chemical Division
33
operates its business strategies to upgrade its technology in order to improve
yields and lower production cost, to develop 7-ACA and Clavulanic Acid
downstream bulk products, and to apply for DMF approvals in US and EU to enter
into international market.
Biotech Division
The Biotech Division's operations are currently located in Nanjing City,
Jiangsu Province, China. The sole product of the Biotech Division is
Erythropoietin or EPO, an injection that stimulates red blood cell, the best
selling drug in the world with a market size of US$10 billion in 2004. Dragon's
EPO is the generic version of the originator's product. Dragon's Biotech
Division develops, manufactures and markets generic biotech products with China
(72% of the divisional revenues in 2004) and developing countries as the current
core markets, and has already been approved and sold in 9 countries: China,
India, Egypt, Brazil, Peru, Ecuador, Trinidad-Tobago, Dominican Republic and
Kosovo. Currently, Dragon's EPO only competes in countries where there is no
patent protection. Dragon is in preparation to enter the European market with a
new EPO product under development in Austria. The Company is also building a
brand new EPO production facility in Datong city, China and will relocate the
EPO production from its current facility in Nanjing city. The new EPO production
site adjacent to the campus of the Chemical division, which already includes the
entire basic infrastructure such as power, steam, purified water supply and
water treatment facilities, is under construction. The relocation of the EPO
production site to Datong will allow the Company to capitalize on the existing
production infrastructure and the efficiency of unified operational management.
In the new facility, it is anticipated that the capacity for bulk EPO will be
doubled and the capacity for sterile filing will be tripled. The Biotech
Division operates its business strategies to increase market share through
integration of sales network, to increase the sales in surgical usage as one of
the two approved surgical indication suppliers, and to enter into European and
other developed countries market with product developed in Europe.
Critical Accounting Policies and Estimates and Recent Accounting Pronouncements
The accompanying management's discussion and analysis of results of
operations and financial condition are based upon the Dragon's consolidated
financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States of America (GAAP). The
preparation of these financial statements requires management to make estimates
and judgments that affect the reported amounts of assets, liabilities, revenues,
and expenses and related disclosure of contingent assets and liabilities.
Management evaluates estimates on an ongoing basis. Management bases its
estimates on historical experiences and various other factors and assumptions
that are believed to be reasonable under the circumstances, the results of which
form the basis for making judgments about the carrying values of assets and
liabilities that are not readily apparent from other sources. Actual results may
differ materially from these estimates under different assumptions or
conditions.
A summary of significant accounting policies and a description of
accounting policies that are considered critical are described in Note 1 to the
Consolidated Financial Statements contained in this report and in Note 3 to the
Dragon's Annual Report on Form 10-KSB for the year ended December 31, 2004. In
addition, a description of Recent Accounting Pronouncements is contained in Note
1(T) to the Consolidated Financial Statements contained in this report and in
Note 3(r) to the Consolidated Financial Statements to the Corporation's Annual
Report on Form 10-KSB for the year ended December 31, 2004.
34
Results of Operations
Results of Operations for the Three and Six Months Ended June 30, 2005 and 2004
Sales.
Sales for the three months period ended June 30, 2005 increased 55% to
$11.35 million from $7.32 million for the same period in 2004. $10.50 million or
approximately 92% of the sales for the three months period ended June 30, 2005
were generated from the sales of products in the Chinese market, and the
remaining $0.85 million or approximately 8% were generated from the sales of
products in the international markets. All sales for the three months period
ended June 30, 2004 were generated from the sale of products in the Chinese
market. In the three months ended June 30, 2005, $5.69 million or approximately
50% of the sales were from the Pharma Division, $4.88 million or 43% of sales
were from the Chemical Division, and $0.78 million or 7% of sales were from the
Biotech Division. For the same period in 2004, 93% of sales were from the Pharma
Division and 7% of sales were from the Chemical Division which commenced
operation on January 1, 2004.
Sales for the six months period ended June 30, 2005 increased 60% to $23.18
million from $14.48 million for the same period in 2004. $20.61 million or
approximately 89% of the sales for the six months period ended June 30, 2005
were generated from the sales of products in the Chinese market, and the
remaining $2.57 million or approximately 11% were generated from the sales of
products in the international markets. All sales for the six months period ended
June 30, 2004 were generated from the sale of products in the Chinese market. In
the six months period ended June 30, 2005, $11.01 million or approximately 47%
of the sales were from the Pharma Division, $10.58 million or 46% of sales were
from the Chemical Division, and $1.59 million or 7% of sales were from the
Biotech Division. For the same period in 2004, 90% of sales were from the Pharma
Division and 10% of sales were from the Chemical Division which commenced
operation on January 1, 2004. The increase in sales during the three and six
months ended June 30, 2005 as compared to the same period for the prior year was
primarily due to increase in sales from the Chemical and Biotech Division.
Cost of sales for the three months ended June 30, 2005 was $8.17 million
compared to $3.28 million for the same period of 2004. The cost of sales is
attributed to the production costs of Dragon's pharmaceutical products with the
increase in the cost of sales related to the growth in products and sales in the
Chemical Division. Gross profit and gross margin for the three months ended June
30, 2005 were $3.18 million and 28% compared to $4.04 million and 55% for the
same period of 2004.
Cost of sales for the six months ended June 30, 2005 was $16.79 million
compared to $7.24 million for the same period of 2004. Gross profit and gross
margin for the six months ended June 30, 2005 were $6.39 million and 28%
compared to $7.23 million and 50% for the same period of 2004. The decrease in
gross margin was mainly due to a change in the product mix from the previous
year. The Chemical Division, whose facilities were brand new in 2004 and is
currently at the ramp up stage of the production which incurs higher production
and operation cost, especially depreciation expenses, increased the cost of
sales significantly during the three and six months ended June 30, 2005.
Divisional Revenues and Gross Margin Analysis
The Company's businesses are organized under three business divisions:
Pharma Division, Chemical Division and Biotech Division.
35
Pharma Division
Pharma Division's revenues for the three months ended June 30, 2005 were
$5.69 million, accounting for 50% of the total revenues of the Company.
Comparatively, Pharma Division's revenues were $6.79 million for the same period
in 2004, contributing 93% of the total revenues of the Company. Pharma
Division's revenues for the six months ended June 30, 2005 were $11.01 million,
accounting for 47% of the total revenues of the Company. Comparatively, Pharma
Division's revenues were $13.09 million for the same period in 2004,
contributing 90% of the total revenues of the Company. The lowering of
percentage of revenues from the Pharma division to the Company was due to the
tremendous growth of the brand new Chemical division achieved during the three
and six months ended June 30, 2005. The overall gross margin for the division
for the three months ended June 30, 2005 was 42% as compared to 58% for the same
period of 2004, and the overall gross margin for the division for the six months
ended June 30, 2005 was 45% as compared to 52% for the same period of 2004. The
lowering of revenues and gross profit was mainly due to a change in product mix
with more new products introduced in the market and the reduction in prices of
certain prescription drugs due to increasing competition. The Company introduced
a number of new prescription and over-the-counter drugs in the market at a more
competitive price initially in order to gain market awareness and market share.
Chemical Division
Chemical Division's revenues for the three months ended June 30, 2005 were
$4.88 million, representing a 814% increase from the revenues of 0.53 million
during the same period in 2004. Chemical Division's revenues for the six months
ended June 30, 2005 were $10.58 million, representing a 665% increase from the
revenues of $1.38 million during the same period in 2004. The increase is due to
the introduction of 7-ACA and the expansion of Clavulanic Acid sales outside
China. The Chemical division was new in 2004 as only the Clavulanic Acid
facility had started production and the sales during the first six months of
2004 were only made to Chinese customers. Since then, the Company started the
pilot production of the 7-ACA production facility and the Company has received
export permits to sell two Clavulanic Acid products to the Indian market.
Chemical Division's gross margin for the three and six months ended June
30, 2005 was 4% and 2%, respectively, compared to 23% and 32% for the three and
six months ended June 30, 2004, respectively. The gross margin for the division
was low as the Company has increased and expanded the infrastructure, and the
fixed manufacturing costs associated, but is still in the process of ramping up
production to cost efficient levels. The initial Chemical Division production in
2004 was limited to Clavulanic Acid and was produced with older, smaller scale
production infrastructure. The Company constructed the new production
infrastructure (power, steam, purified water supply and water treatment) during
2004 as the old production infrastructure was insufficient to produce the amount
of Clavulanic Acid and 7-ACA desired. The new facilities have greatly increased
production capacity but also have significantly higher fixed costs in the form
of depreciation cost ($1.06 million and $0.36 million for the three months ended
June 30, 2005 and 2004, respectively and $2.17 million and $0.60 million for the
six months ended June 30, 2005 and 2004, respectively) of the new facilities
constructed and overhead of the utilities costs to power the new facilities.
These fixed costs represent more than a third of the cost of sales at the
current production levels but are expected to fall significantly, on a
percentage basis, when the anticipated production levels are achieved.
Subsequent to the quarter end, the Company has increased the production of
7-ACA from approximately 30% to 80% of the full production capacity which will
increase the sales of the Chemical Division.
36
Biotech Division
Biotech Division's revenues for the three and six months ended June 30,
2005 were $0.78 million and $1.59 million, respectively, representing 7% of the
Company's revenues for these periods. Gross margin for the three and six months
ended June 30, 2005 was at 75% and 79%, respectively. The acquisition of
Oriental Wave by Dragon completed on January 12, 2005 was accounted for as a
reverse-take-over transaction. As a result, only revenues from the Biotech
Division from January 12, 2005 to June 30, 2005 were included in the Company's
revenues for the first six months of 2005 and no revenues from the Biotech
Division were included in the 2004 financials.
On a pro-forma basis (assuming the reverse-take-over had occurred at the
beginning of the year), for the three and six months ended June 30, 2005,
Biotech Division's revenues were $0.78 million and $1.73 million, respectively,
representing a 14% and 3% decrease, respectively, from the same period of 2004.
The decrease in total sales for the three months ended June 30, 2005 mainly came
from the decrease in international sales outside of China. However, the
international sales outside of China for the six month ended June 30, 2005 was
about the same as the same period of 2004, while the 3% decrease in total sales
for the six month ended June 30, 2005 was due to the decrease in China sales
compared to the same period of 2004.
Biotech Division's pro-forma gross margin for the three months ended June
30, 2005 was 75% compared to 79% for the same period of 2004. The decrease in
international sales at higher gross margin contributes to the decrease of gross
margin for the three months ended June 30, 2005. For the six months ended June
30, 2005, Biotech Division's pro-forma gross margin was 79% compared to 75% for
the same period of 2004. The improvement of the gross margin for the six months
ended June 30, 2005 was due to a combination of a larger percentage of sales to
overseas customers at a higher margin than the Chinese sales during the period
and no provision for inventory obsolescence as was recorded in the comparative
period.
Other Income / Expense During the three months ended June 30, 2005, the
Company recognized other expense of $0.29 million, consisting mainly of interest
expense of $0.32 million, compared to other income of $0.01 million for the same
period of 2004.
During the six months ended June 30, 2005, the Company recognized $0.33
million of other income. This amount primarily consisted of $0.89 million from
funds released by a Chinese Government Liquidator related to Datong
Pharmaceutical, which was offset in part by interest expense of $0.56 million.
The other expense for the six months ended June 30, 2004 was minimal.
Expenses. Total operating expenses were $2.77 million for the three months
ended June 30, 2005. The major category of operating expenses was General and
Administration expenses of $1.21 million, Selling expense of $1.29 million, and
Depreciation and Amortization expenses of 0.28 million. Total operating expenses
were $1.36 million for the three months ended June 30, 2004. The major category
of operating expenses was General and Administration expenses of $0.17 million,
Selling expense of $1.11 million, and Depreciation and Amortization expenses of
0.08 million. During the three months ended June 30, 2005, the General and
Administration expenses included $0.48 million for salaries, compensation and
benefits, $0.16 million for travel and entertainment expenses and $0.11 million
for rent compared to $0.02million for salaries, compensation and benefits and
$0.07 million for travel and entertainment expenses, and $0.01million for rent
for the same period of 2004.
37
Total operating expenses were $5.16 million for the six months ended June
30, 2005. The major category of operating expenses was General and
Administration expenses of $2.21 million, Selling expense of $2.43 million, and
Depreciation and Amortization expenses of $0.52 million. Total operating
expenses were $2.60 million for the six months ended June 30, 2004. The major
category of operating expenses was General and Administration expenses of $0.59
million, Selling expense of $1.92 million, and Depreciation and Amortization
expenses of 0.09 million. During the six months ended June 30, 2005, the General
and Administration expenses included $1.07 million for salaries, compensation
and benefits, $0.35 million for travel and entertainment expenses and $0.2
million for rent compared to $0.12 million for salaries, compensation and
benefits and $0.17 million for travel and entertainment expenses, and $0.03
million for rent for the same period of 2004.
The increase in operating expenses of $1.41 million and $256 million,
respectively, for the three and six months ended June 30, 2005 as compared to
the same period for the prior year reflects the increased overhead related to
the operations of both the Pharma and Chemical Divisions in 2005 (compared to
just the Pharma Division and one of the two facilities of the Chemical Division
in 2004) and the addition of the Biotech operations and the head office in
Vancouver. In addition, depreciation and amortization expense increased during
the three and six months ended June 30, 2005 due to the increase in fixed assets
of the Chemical Division in 2005.
Net Income. Dragon had a net loss of $0.003 million for the three months
ended June 30, 2005 compared to a net income of $2.34 million for the same
period in 2004. For the six months ended June 30, 2005, Dragon had a net income
of $1.24 million compared to $4.28 million for the same period in 2004.
Basic Net Income Per Share. Dragon's net income per share has been computed
by dividing the net income for the period by the weighted average number of
shares outstanding during the same period. Net income per share for the three
and six months ended June 30, 2005 was $0.00 and $0.02 per share, respectively,
and for the three and six months ended June 30, 2004 was $0.05 and $0.10 per
share, respectively. The weighted average number of shares outstanding during
three and six months ended June 30, 2005 was 62,878,004 and 61,659,706,
respectively, and was 44,502,004 shares during three and six months ended June
30, 2004. The outstanding common stock options have no significant dilutive
effect on the weighted average number of shares outstanding.
Dividends of the PRC subsidiary may only be distributed after allowance has
been made for i) recovery of losses, if any; ii) allocations to the statutory
common reserve fund; iii)allocations to the statutory common welfare fund; and
iv) allocations to a discretionary common reserve fund if approved by the
shareholders. Under current regulation, the minimum and maximum aggregate
allocations to the statutory funds are 15% and 20%, respectively, of our net
income determined in accordance with PRC accounting rules. However, once the
aggregated amount of statutory common reserve fund equals 50% of the Company's
registered capital, no further contributions to the fund need to be made. As at
June 30, 2005, the Company's statutory common reserve fund is $10.69 million,
44% of the Company's registered capital.
Liquidity and Capital Resources
As of June 30, 2005, Dragon had current liabilities of $31.03 million and
current assets of $28.41 million, including cash balance of $1.36 million and
accounts receivables of $8.70 million. Its working capital deficiency is mainly
due to the additional bank loan and payables incurred to finance its working
capital requirement for the Chemical Division and investment in the new EPO
workshop and Freeze-dry workshop.
38
As of June 30, 2005, Dragon had current liabilities of $31,029,733 as
follows:
Accounts Payable $4,583,421
Accrued Retirement Benefits - current potion $95,327
Other Payables and Accrued Expenses $18,613,368
Due to Related Companies $892,206
Notes Payable-Short Term:
Note payable to a bank, interest rate of 6.372% per annum,
due June 2005 $420,290
Note payable to a bank, interest rate of 6.372% per annum,
due June 2005 $386,473
Note payable to a bank, interest rate of 8.874% per annum,
due July 2005 $603,865
Note payable to a bank, interest rate of 6.138% per annum,
due November 2005 $3,623,188
Note payable to a bank, interest rate of 6.039% per annum,
due April 2006 $1,811,594
Notes Payable - Short Term Subtotal $6,845,410
Total Current Liabilities $31,029,732
The Accounts payable were incurred as part of the normal course of business
of Dragon while other payables and accrued expenses were incurred as part of the
investment in establishing the Chemical Division.
As of June 30, 2005, Dragon had outstanding short-term notes (less than one
year term) totaling $6.85 million. After $0.60 million originally due in July
2005 was renewed and extended for three months to October 2005, with a further
$0.81 million originally due in June 2005 in the process of renewing, Dragon
believes that it will be successful in the renegotiating other notes due based
on the assumption that the Company has enhanced its ability to generate
additional cash flow from its operation since the notes were originally entered
into. Since then, the Company's Chemical Division commenced production and began
generating revenues and cash flow. Further, it entered into a three-year long
term supply contract with Aurobindo Biopharma to supply specified amounts of
Clavulanic Acid and 7-ACA produced from its Chemical Division.
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Long-term Liabilities:
At June 30, 2005, Dragon had long-term liabilities of $35,392,050 as
follows:
Long-term accounts payable $21,712,222
Long-term retirement benefits $720,891
Note Payable - Long Term
Note payable to a bank, interest rate of 5.76% per
annum, due November 2006 $6,316,426
Note payable to a bank, interest rate of 6.039% per
annum, due April 2007 $6,642,512
Note Payable - Long Term $12,958,938
Total Long-term Liabilities $35,392,051
As of June 30, 2005, the Company had long-term retirement benefits of
$0.72million, which was incurred in July 2003 when Shanxi Weiqida acquired land
and buildings from a government liquidator in exchange for assuming certain
future employment, healthcare and land acquisition costs of the factory and its
former employees during July 2003. The Company is required to pay certain
minimum wages and health care costs until the date of their employment,
retirement or death, whichever occurs first. The total amount of the liabilities
assumed on the closing date was $8.90 million, which approximated the appraised
value of the land. As of June 30, 2005, Shanxi Weiqida had employed 633 former
employees, and 255 former employees have retired. Shanxi Weiqida has calculated
the related asset value by computing the net present value of the future
expected payments to the remaining approximately 160 employees assuming an
interest rate of 3%. As of June 30, 2005, approximately 160 former employees of
Datong Pharmaceutical remained as the obligation of Dragon.
Dragon had long-term notes payables (one to two years) totaling
approximately $12.96 million of which $6.32 million which will be due November
2006 and $6.64 million due April 2007, in addition to long-term account payables
of $21.71 million which will become due in 2006.
During the six months ended June 30, 2005, Dragon financed its operations,
development of its new EPO and freeze-dry injectable facilities, and increased
production level at its Chemical Division through operating revenues, accounts
payables and short-term loans. The Company had anticipated that it would
increase its production level through an equity financing. However, as discussed
below, the anticipated financing has taken longer than expected. As a result,
Dragon was not able to increase its production level as quickly as anticipated.
However, during July 2005, Dragon was able to increase its production level of
7-ACA, one of the key products of the Chemical Division, from 30% to 80% and
believes that its sales of the Chemical Division will increase. In addition,
certain vendors of Shanxi Weiqida have indicated that they intend to convert
their receivables into Dragon common stock. Finally, in August 2005, Dragon
received verbal approval of an approximately $3.6 million loan subject to
completion of loan agreements. Dragon intends to seek additional equity to
improve its financial position.
Further, as previously announced, Dragon intended to seek up to $25 million
through the sale of it equity securities to accredited investors on a private
basis. Dragon has engaged an investment bank in the U.S. to raise capital
through the sale of its equity securities which would enhance Dragon's financial
position. The process to raise additional capital has taken longer than
anticipated. However, Dragon is in discussions with certain institutional
investors who may be interested in investing in Dragon. No assurance can be
given that Dragon will be able to raise additional capital through the sale of
40
its equity securities The Company has taken steps to improve its negative
working capital and liquidity position and believes that it will be successful.
However, no assurance can be given that Dragon will be successful in completing
its plan. In the event the Company is not successful in improving its negative
working capital and liquidity position, the Company may required to reduce its
operations or take other alternatives. Accordingly, Dragon's business and
operations will be adversely affected.
Restatement
As a result of a review of its accounting policies and applicable
accounting pronouncements, the Company has concluded that the reduction of a
future retirement benefit obligation related to the acquisition of a land use
right from a former state-owned enterprise in China by Oriental Wave Holding
Limited ("Oriental Wave") in July 2003, should have been accounted for as a
reduction to the recorded cost of the land use right instead of as a
non-operating gain from extinguishment of debt, as previously disclosed in
Oriental Wave's 2004 financial statements. As a result, Oriental Wave's 2004
financial statements have been restated to reflect such change in accounting
treatment.
The reduction of the future retirement benefit obligation during 2004,
totaling $1,135,238 million, which was recognized as a non-operating gain, has
been recorded as a reduction to the cost of the land use right resulting in a
reduction of depreciation of expense of $11,352 during 2004. The Land Use Rights
have been further reduced by $28,149 during the period ended June 30, 2005 and,
on a going forward basis, any similar reduction of the retirement benefit
obligation will be treated as a reduction to the recorded cost of the land use
right.
Since Oriental Wave's 2004 financial results became the opening balance of
Dragon's 2005 financials due to the reverse merger in January 2005, the Company
has also restated its financial statements for the three months ended March 31,
2005 to reflect the impact from the restatement of Oriental Wave's 2004
financial statements. As a result of this restatement, Dragon's net income for
the three months ended March 31, 2005 increased by $5,676 to $1,240,756, and
total assets decreased by $1.12 million to $96.15 million at March 31, 2005,
equivalent to 1.15% of total assets prior to the restatement. Earnings per share
of $0.02 did not change for the three months ended March 31, 2005.
The restatement involved the accounting treatment of a non-cash transaction
during the year ended December 31, 2004 and the three months ended March 31,
2005. The restatement did not have an effect on the cash flow or liabilities of
the Company. As a result of the restatement, future amortization expense with
respect to the land use right will decrease accordingly over the 50 year
amortization period.
Item 3. Controls and Procedures
We carried out an evaluation, under the supervision and with the
participation of our management, including our Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operation of our
disclosure controls and procedures (as defined by Exchange Act Rule 13a-15(e))
as of the end of our second fiscal quarter pursuant to Exchange Act Rule
13a-15(b)), and concluded that Dragon's disclosure controls and procedures are
effective to ensure that information required to be disclosed in Dragon's
reports filed with the Securities and Exchange Commission pursuant to the
Exchange Act is accumulated and communicated to management, including Dragon's
Chief Executive Officer and Chief Financial Officer. Based upon that evaluation,
as of the end of the period covered by this report, the Chief Executive Officer
and Chief Financial Officer concluded that Dragon's disclosure controls and
procedures were effective in recording, processing, summarizing and reporting
information required to be disclosed by Dragon within the time periods specified
in the Securities and Exchange Commission's rules and forms.
41
There have been no changes in our internal control over financial reporting
that occurred during such quarter that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
The Company is not currently involved in any legal proceedings.
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds.
None
Item 3. Defaults Upon Senior Securities.
None
Item 4. Submission of Matters to a Vote of Security Holders.
None
Item 5. Other Information.
None
Item 6. Exhibits and Reports on Form 8-K.
(a) Exhibits.
Exhibit No.
31.1 Certification by the Principal Executive Officer Pursuant to
Section 302 of the Sarbanes-Oxley Act.
31.2 Certification by the Principal Accounting Officer Pursuant
to Section 302 of the Sarbanes-Oxley Act.
32 Certification by the Principal Executive and Financial
Officers Pursuant to Section 906 of the Sarbanes-Oxley Act.
(b) Reports on Form 8-K:
(1) Form 8-K for July 18, 2005 announcing the change of
auditors.
(2) Form 8-K for May 19, 2005 announcing first quarter results.
(3) Form 8-K for April 8, 18, 2005 announcing a business update
and pro-forma financial data.
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SIGNATURES
In accordance with 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.
DRAGON PHARMACEUTICAL INC.
(registrant)
Date: September 21, 2005 /s/ Yanlin Han
---------------------------
Yanlin Han
Chief Executive Officer
Dated: September 21, 2005 /s/ Garry Wong
---------------------------
Garry Wong
Chief Financial Officer
43