10

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NOTE 5 – PROPERTY, PLANT AND EQUIPMENT, NET

 

Property, plant and equipment, net, consist of:

 

		March 31,				December 31,
		2010				2009
		(Unaudited)
Building		$	263,727			$	263,727
Transportation equipment			227,644				222,986
Machinery and electronic equipment			345,408				50,697
Office equipment			3,506				3,506
			840,285				540,916
Less accumulated depreciation			(215,046	)			(202,921	)
Property, plant and equipment, net		$	625,239			$	337,995

 

In August 2009, Xinsheng acquired a building in Shannxi, China containing approximately 3,800 square feet of space for $244,073 (1,665,783 RMB). $126,873 (865,783 RMB) of the purchase price was paid in cash and the remaining $117,200 (800,000 RMB) was financed through a 10 year mortgage (see Note 10). For legal expediency reasons, the property and mortgage were acquired in the name of the Company’s Chairman of the Board of Directors.

In the first quarter of 2010, the Company acquired additional machinery and equipment from a vendor for $293,000 (2,000,000 RMB).

Depreciation expense was $12,125 and $10,262 for the three months ended March 31, 2010 and 2009, respectively. In the first quarter of 2009, the Company returned certain unused manufacturing equipment to the original vendor for $94,428, an amount equal to the net book value of the equipment.

 

NOTE 6 – INVESTMENT IN TIENWE TECHNOLOGY INC

On July 29, 2005, Xinsheng acquired a 13.95% equity interest in Tienwe Technology Inc. (“Tienwe”), a PRC company, for 6,000,000 RMB ($879,000 and $879,000 translated at the March 31, 2010 and December 31, 2009 exchange rate, respectively). The investment is carried at cost. Tienwe shares are not quoted or traded on any securities exchange or in any recognized over-the-counter market; accordingly, it is not practicable to estimate the fair value of the investment. Tienwe sells aerospace products to military industry customers.

 

NOTE 7 – DEFERRED FINANCING COSTS

Deferred financing costs, which are being amortized as interest expense over the two year term of the convertible notes payable due September 29, 2010, consist of:

 

		March 31,				December 31,
		2010				2009
		(Unaudited)
Placement Agent commissions		$	40,000			$	40,000
Placement Agent expense allowance			25,000				25,000
Fair value of Placement Agent warrants			19,920				19,920
Legal and other fees			122,362				122,362
Total			207,282				207,282
Less: accumulated amortization			(159,648	)			(134,550	)
Deferred Financing Costs, end of period		$	47,634			$	72,732

 

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NOTE 8 – INTANGIBLE ASSETS, NET

Intangible assets, net, consist of:

 

		March 31,				December 31,
		2010				2009
		(Unaudited)
Product rights		$	117,200			$	-
Patent			14,650				14,650
Trademark			2,189				2,189
Total			134,039				16,839
Less accumulated amortization			(13,536	)			(13,115	)
Intangible assets, net		$	120,503			$	3,724

 

The product rights which were acquired by Xinsheng in December 2006 from an unrelated third party for approximately $90,000 related to nine registered fertilizer products.  In the first quarter of 2009, the Company returned three of these products rights to the original vendor for $37,332, an amount equal to the net book value of the respective assets.  During the fourth quarter of 2009, the Company determined that the remaining six products rights were worthless. Accordingly, the Company wrote off products rights of $52,740 and related accumulated amortization of $43,950 and recognized a loss on impairment of product rights of $8,685 and a foreign exchange translation adjustment charge of $105.

In the first quarter of 2010, the Company acquired additional product rights for $117,200 (800,000 RMB). These rights will be amortized over their expected useful economic lives of 10 years.

The patent was acquired by Xinsheng in 2002 from three related parties (one of the parties was an officer, director and significant stockholder of the Company at the time of the exchange) in exchange for a total of 16.67% of the issued and outstanding shares of Xinsheng common stock. The patent (and contributed capital) at the date of the exchange on April 22, 2002 has been reflected at the transferors’ cost. The patent is for Zero-tillage Fertilizing Equipment (PRC Patent Number 330398), which is a type of seeding machine, the use of which reduces soil erosion.

Estimated amortization expense for each of the Company’s succeeding years ending March 31, 2011, 2012, 2013, 2014 and 2015 is $13,404, $12,996, $11,773, $11,773 and $11,773, respectively.

 

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NOTE 9 – CONVERTIBLE NOTES PAYABLE, NET

Convertible notes payable, net, consist of:

 

		March 31,				December 31,
		2010				2009
		(Unaudited)
Convertible notes - face amount		$	500,000			$	500,000
Less:
Debt discount attributable to the relative fair value of warrants			(149,615	)			(149,615	)
Debt discount attributable to the intrinsic value of the beneficial conversion feature			(49,615	)			(49,615	)
Add accumulated amortization of debt discounts			151,261				126,731
Convertible notes payable, net		$	452,031			$	427,501

 

On September 29, 2008, the Company completed the sale of 3% unsecured convertible notes in an aggregate principal amount of $500,000, and Series C warrants to purchase 500,000 shares of common stock, to two accredited investors. The Company received net proceeds of $431,500 after the deduction of Placement Agent commissions of $40,000, Placement Agent expense allowance of $25,000, and an escrow agent fee of $3,500.

 

The Notes mature two years from the date of issuance and bear interest at the rate of 3% per annum, payable annually in cash or in shares of common stock, subject to approval of the holder. Overdue interest shall bear interest at the rate of 15% per annum. Overdue principal shall bear interest at the rate of 8% per annum. The Notes are convertible at the option of the holder into the common stock of the Company at an initial conversion price of $0.50 per share. The conversion price is subject to adjustment upon the occurrence of stock splits, combinations, dividends and subsequent offerings.

The Series C warrants have a term of three years and are exercisable into shares of common stock at an exercise price of $1.50 per share. Upon exercise of a Series C warrant, in addition to receiving shares of common stock, each Series C warrant holder shall be issued a Series D warrant to purchase additional shares of common stock in an amount equal to the number of Series C warrants exercised. The Series D warrants, if issued shall have a term of three years and an exercise price of $2.00 per share. The exercise price of the warrants is subject to adjustment upon the occurrence of stock splits, combinations, dividends and subsequent offerings, as set forth in the warrants. No Series D warrants have been issued as of the date of this filing.

The Company shall have the right to prepay the Notes at 110% of the outstanding principal amount any time prior to the maturity date and upon 30 days prior written notice to the holders. The Company may call for the termination of any unexercised portion of the Series C warrants upon consummation of a subsequent offering by the Company of not less than $7,500,000 in gross proceeds and upon 30 days written notice to the holders. Upon termination of any unexercised Series C warrants, the warrant holders would not receive any Series D warrants, any shares underlying the Series C or Series D warrants, or any other securities.

 

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In connection with the transaction, the Company agreed to prepare and file a registration statement with the Securities and Exchange Commission (the “SEC”) within 60 days following the final closing date. In addition, if the registration statement was not declared effective within 120 days from the filing date, the Company was subject to monthly cash liquidated damages payments equal to 2% of the purchase price paid by each investor, subject to a maximum of 24%. On February 13, 2009, the Company filed a registration statement on Form S-1 to register the shares underlying the convertible notes and warrants. In response to SEC comment letters, the Company filed amendments to the registration statement on Form S-1. The Company and the investors entered into agreements extending the date that the Form S-1 was required to become effective to October 30, 2009. The registration statement on Form S-1 was declared effective on November 16, 2009. The Company accrued $734 in liquidated damages under the registration rights agreement payable to the investors as of March 31, 2010.

The Company recorded the $149,615 relative fair value of the warrants ($78,136 for the Series C warrants; $71,479 for the Series D warrants) and the $49,615 intrinsic value of the beneficial conversion feature as additional paid in capital.

The $149,615 fair value of the Series C and Series D warrants was calculated using a Black-Scholes option pricing model and the following assumptions: risk-free interest rate of 2.26%; expected stock price volatility of 130.69%; stock price of $0.40 per share; exercise price of $1.50 per share for the Series C warrants and $2.00 per share for the Series D warrants; and term of 3 years.

In connection with the private placement, the placement agent received warrants to purchase 80,000 shares of the Company’s common stock at an exercise price of $1.00 per share for a term of three years. The $19,920 fair value of these warrants (calculated using the same assumptions described above except for the exercise price) was charged to deferred financing costs and added to additional paid in capital. On October 9, 2009, the Company issued warrants to purchase 1,000 shares of the Company’s common stock at an exercise price of $1.00 per share for a term of three years for services rendered and waiving registration rights. The $426 fair value of these warrants (calculated using the same assumptions described above except for the exercise price) was charged to current financing cost and added to additional paid in capital.

Interest expense incurred on the convertible Notes Payable during the three months ended March 31, 2010 and 2009 was $3,750 and $3,750, respectively.

NOTE 10 – LONG-TERM DEBT

Long-term debt represents a mortgage payable to Xian Commerce Bank in connection with Xinsheng’s acquisition of a building in August 2009 (see Note 5). The mortgage, which had an initial balance of $117,200 (800,000 RMB) and is secured by the building, bears interest at an annual rate of 6.53% and is due in monthly installments of interest and principal of approximately $1,330 to August 6, 2019.

 

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At March 31, 2010, maturities of the Long-term Debt for the next five years and in total are as follows:

Year ending		Minimum
March 31,		Repayment
		(Unaudited)
2011		$	8,923
2012			9,524
2013			10,165
2014			10,849
2015			11,580
Thereafter			61,215
Total		$	112,256

 

Interest expense incurred on the Long-term Debt during the three months ended March 31, 2010 and 2009 was $1,857 and $0, respectively.

 

NOTE 11 – COMMON STOCK

 

On October 11, 2008, upon the completion of the public offering, China Agri sold 379,800 units at a price of $1.00 per unit to the public investors. Each Unit consisted of one share of Common Stock, one warrant to purchase one share of Common Stock at $1.50 per share exercisable for three years from the date of issuance, and one warrant to purchase one share of Common Stock at $2.00 per share exercisable for three years from the date of issuance only if the $1.50 Unit Warrant was exercised.

NOTE 12 - WARRANTS

The Company has issued warrants (exercisable into shares of common stock) to investors, the Underwriter, and the Placement Agent as part of its sale of Series A preferred stock, its public offering, and its private placement of convertible notes. Changes in the warrants outstanding are as follows:

		Three Months				Year Ended
		Ended March 31,				December 31,
		2010				2009
		(Unaudited)
Outstanding at beginning of period			1,378,580				1,387,580
Warrants issued - see Note 9			-				1,000
Warrants exercised			-				-
Warrants expired			-				(10,000	)
Outstanding at end of period			1,378,580				1,378,580
Exercisable at end of period			1,378,580				1,378,580

 

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Warrants outstanding at March 31, 2010 consist of:

 

Date Issued		Expiration Date		Number of Warrants				Weighted Average Exercise Price
October 11, 2007		October 10, 2010			379,800			$	1.50
October 11, 2007		October 10, 2010			379,800				2.00
October 11, 2007		October 10, 2012			37,980				1.00
September 29, 2008		September 29, 2011			80,000				1.00
September 29, 2008 (1)		September 29, 2011			500,000				1.50
October 9, 2009		October 9, 2012			1,000				1.00
Total					1,378,580			$	1.59

 

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(1)	Represents Series C warrants.

 

NOTE 13 – RESTRICTED NET ASSETS

Relevant PRC statutory laws and regulations permit payments of dividends by Meixin and Xinsheng only out of its retained earnings, if any, as determined in accordance with PRC accounting standards and regulations.  In addition, PRC laws and regulations require that annual appropriations of 10% of after-tax income should be set aside prior to payments of dividends as a reserve fund.  As a result of these PRC laws and regulations, the Company is restricted in its ability to transfer a portion of its net assets in the form of dividends, loans or advances. The restricted portion amounted to approximately $5,171,000 and $5,127,000 at March 31, 2010 and  December 31, 2009, respectively.

NOTE 14 – INCOME TAXES

Xinsheng is subject to a PRC 25% standard enterprise income tax.  However, due to its agricultural industry status, the National Tax Bureau in Xi’an High-Tech Development Zone has granted Xinsheng exemptions from this tax since 2006. The Company has to apply for exemption status on an annual basis.

At March 31, 2010 and December 31, 2009 the Company had an unrecognized deferred United States income tax liability relating to undistributed earnings of Xinsheng.  These earnings are considered to be permanently invested in operations outside the United States.  Generally, such earnings become subject to United States income tax upon the remittance of dividends and under certain other circumstances.  Determination of the amount of the unrecognized deferred United States income tax liability with respect to such earnings is not practicable.

Based on management’s present assessment, the Company has not yet determined it to be more likely than not that a deferred tax asset of approximately $262,500 ($245,000 at December 31, 2009) attributable to the future utilization of the approximately $750,000 net operating loss carryforward of China Agri as of March 31, 2010 will be realized. Accordingly, the Company has provided a 100% allowance against the deferred tax asset in the financial statements at March 31, 2010. The Company will continue to review this valuation allowance and make adjustments as appropriate. The net operating loss carryforward expires in varying amounts from year 2025 to year 2030.

Current United States income tax laws limit the amount of loss available to be offset against future taxable income when a substantial change in ownership occurs. Therefore, the amount available to offset future taxable income may be limited.

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The provisions for income taxes differ from the amounts computed by applying the statutory United States federal income tax rate to income (loss) before income taxes.  Reconciliations follow:

 

		Three Months Ended March 31,
		2010				2009
		(Unaudited)			(Unaudited)
Expected tax at 35%		$	116,133			$	37,421
Tax effect of unutilized losses of China Agri and Meixin			36,220				39,507
Effect of PRC income tax exemption granted to Xinsheng			(108,824	)			(54,949	)
Permanent difference relating to Xinsheng's earnings to be permanently invested in operations outside the United States			(43,529	)			(21,979	)
Actual provision for income taxes		$	-			$	-

 

NOTE 15 – SEGMENT INFORMATION

The Company operates in one industry segment – the manufacturing and sale of agricultural enhancement products.  Substantially all of the Company’s identifiable assets at March 31, 2010 and December 31, 2009 were located in the PRC.  Net sales for the periods presented were all derived from PRC customers.

From 2008, the Company launched a new sales and marketing initiative to establish a closer relationship with farmers through agricultural cooperatives located throughout the rural areas of China. One component of this initiative is called the “Super Chain Sales Partner Program”, which involves stores branded under the name of “Xinsheng Shiji” but owned and managed by third parties. The other is called “Direct Sales Stores”. The direct sales stores are controlled and managed directly by the Company.  As of April 30, 2010, the Company had established approximately 100 branded super chain stores, the majority of which are located in Shannxi Province (local province) and Hunan Province. In addition, the Company has established approximately 250 direct sales stores, which are located in the Shannxi Province.  For the three months ended March 31, 2010, approximately 81% of our revenues were generated from the super chain branded stores and direct sales stores.

		Three Months Ended
Sales by Sales Network		March 31, 2010								March 31, 2009
		(Unaudited)								(Unaudited)
Direct sales stores		$	1,062,461				68.95	%		$	-				0.00	%
Super chain branded stores			183,281				11.89	%			26,010				5.54	%
Traditional sales network			295,199				19.16	%			443,562				94.46	%
Total Sales		$	1,540,941				100.00	%		$	469,572				100.00	%

 

In addition to products manufactured by the Company, the Company also sells certain products manufactured by third parties in the direct sales stores. For the three months ended March 31, 2010, total sales of third party products was $870,754, or 57% of total sales.

 

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		Three Months Ended
		March 31, 2010 (Unaudited)
Sales of Products by Manufacturer		Total			Company Made  Products					Third Party Products				% of Third Party Products
Direct sales stores		$	1,062,461			$	191,707			$	870,754				81.96	%
Super chain branded stores			183,281				183,281				-				0.00	%
Traditional sales network			295,199				295,199				-				0.00	%
Total Sales		$	1,540,941			$	670,187			$	870,754				56.51	%

NOTE 16 – COMMITMENTS AND CONTINGENCIES

Lease Agreements

Xinsheng leased its office space (approximately 7300 square feet) at an annual rent of 366,390 RMB ($53,640 translated at the September 30, 2009 exchange rate) under a lease with a three year term expiring March 31, 2011. The Company terminated this lease on October 1, 2009 after relocating to its new purchased office building (see Note 5). On October 1, 2009, the Company signed a new lease with the same landlord for office space of 344 square feet at an annual rent of 12,000 RMB ($1,758). This one year lease expires on September 30, 2010.

Xinsheng leases its operating and testing space (approximately 2600 square feet) at an annual rent of 38,500 RMB ($5,640  translated at the March 31, 2010 exchange rate) under a lease which expired March 31, 2010. The Company is presently negotiating with the lessor to extend the lease.

Xinsheng leases its manufacturing space (approximately 22,600 square feet) at an annual rent of 90,000 RMB ($13,185) under a lease expiring December 21, 2011, with payment due in advance for each year.

China Agri utilizes office space provided by one of its directors at no cost.

For the three months ended March 31, 2010 and 2009, rental and related expenses for all operating leases amounted to $14,544 and $11,409, respectively.

The Company leases store space for direct sales stores from various individuals for terms of six months or one year. Each lease calls for rent payments ranging from $30 to $45 per month. For the three months ended March 31, 2010, such rent expense totaled $24,912.

At March 31, 2010, future minimum rental commitments under all non-cancellable operating leases were:

Year Ending		Minimum
March 31,		Rent
		(Unaudited)
2011		$	13,185
2012			-
Total		$	13,185

 

 

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Consulting Agreement

On March 31, 2010, the Company entered into an Investor and Media Relations Service Agreement (“the Agreement”) with Christensen International Limited (“Christensen”). Pursuant to the Agreement, Christensen is to provide investor relations services to the Company for a term of one year and the Company is to pay Christensen a total of $100,000 in fees, payable quarterly at the beginning of each quarter.

PRC Risks

Substantially all of the Company’s business operations are conducted in the PRC and governed by PRC laws and regulations.  Meixin and Xinsheng are generally subject to laws and regulations applicable to foreign investments and foreign-owned enterprises.  Because these laws and regulations are relatively new, the interpretation and enforcement of these laws and regulations involve uncertainties.

The PRC government imposes controls on the convertibility of RMB into foreign currencies and, in certain cases, the remittance of currency out of the PRC.  The Company receives substantially all of its revenues in RMB, which is currently not a freely convertible currency.  Under existing PRC foreign exchange regulations, payment of current account items, including profit distributions, interest payments and expenditures from the transaction, can be made in foreign currencies without prior approval from the PRC State Administration of Foreign Exchange by complying with certain procedural requirements.  However, approval from appropriate governmental authorities is required where RMB is to be converted into foreign currency and remitted out of the PRC to pay capital expenses, such as the repayment of bank loans denominated in foreign currencies.  The PRC government may also at its discretion restrict access in the future to foreign currencies for current account transactions.

 

NOTE 17 – CONCENTRATION OF CREDIT RISK

The Company maintains cash balances that are held in seven banks in China. Currently, no deposit insurance system has been set up in China. Therefore, the Company will bear a risk if any of these banks become insolvent. As of March 31, 2010 and December 31, 2009, the Company’s uninsured cash balances were approximately $9,327,000 and $9,597,000, respectively.

 

NOTE 18 – SUBSEQUENT EVENTS

On October 21, 2009, Xinsheng received an approval letter from the Bureau of Foreign Trade and Economic Cooperation of Lantian County of Xinsheng’s application to purchase land use rights in Lantian County to establish “Xinsheng Centennial Industrial Zone”.  Xinsheng intends to purchase the land use rights for 66 acres for a term of 30 years.  The land use right purchase cost is expected to be approximately $4.1 million (28,000,000 RMB).  In addition, the estimated cost for relocation of local dwellers is expected to be approximately $299,000 (2,040,000 RMB). As of the filing date of this Form 10-Q, the transaction has not yet been finalized due to the delay in processing by the local government.

 

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

 

The following is a discussion and analysis of our results of operations and should be read in conjunction with our financial statements and related notes contained in this Form 10-Q and our annual report on Form 10-K for the year ended December 31, 2009 filed with the SEC on April 15, 2010.

 

This Form 10-Q contains “forward-looking” statements that involve risks and uncertainties. You can identify these statements by the use of forward-looking words such as “may,” “will,” “expect,” “anticipate,” “estimate,” “believe,” “continue,” or other similar words.  You should read statements that contain these words carefully because they discuss our future expectations, contain projections of our future results of operations or financial condition or state other “forward-looking” information.  We believe that it is important to communicate our future expectations to our investors.  However, these forward-looking statements are not guarantees of future performance and actual results may differ materially from the expectations that are expressed, implied or forecasted in any such forward-looking statements.  There may be events in the future that we are unable to accurately predict or control, including weather conditions and other natural disasters which may affect demand for our products, and the product–development and marketing efforts of our competitors.  Examples of these events are more fully described in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009 under “ Item 1A. Risk Factors.”

 

Unless required by law, the Company undertakes no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.  However, readers should carefully review the reports and documents the Company files from time to time with the SEC, particularly its Quarterly Reports on Form 10-Q, Annual Report on Form 10-K, Current Reports on Form 8-K and all amendments to those reports.

 

References to the “PRC” or “China” are to the People’s Republic of China. Unless otherwise noted, all currency figures are in U.S. dollars. References to “yuan” or “RMB” are to the Chinese yuan, which is also known as the renminbi. Unless otherwise specified, the words “Company,” “China Agri” “we,” “us,” and “our,” refer collectively to China Agri-Business, Inc., Mei Xin Agri Technology (Shaanxi) Co., Ltd., and Shaanxi Xin Sheng Centennial Agricultural and Technology Co., Ltd., our operating company in the PRC.

 

 Results of Operations