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Wednesday, July 19, 2006

American Dairy (ADY) 10-K

ADY sec

10-K for period ending Dec 31, 2005.
Incorporated in Utah. Offices in Beijing, PRC.
14 million shares on March 29, 2006.


May 2003 acquired American Flying Crane Corporation ("AFC") (previously called American Dairy Holdings). Reverse merger with Gaslight, Inc., a shell company inactive since 1991.

AFC owns 100% of Heilongjian Feihe Dairy Co. ("Feihe Dairy") in PRC. Main activity is distribution of milk powder and other dairy stuff. Feihe Dairy has three subsidiaries:
1) 100% of Heilongjian Sanhao Dairy ("Sanhao Dairy") processed milk and soybean products
2) 100% of BaiQuan Feihe Dairy ("BaiQuan Dairy") processed milk and soybean products
3) 60% of Beijing Feihe Biotechnology Scientific and Commercial Co. which does marketing for Feihe Dairy.

Feihe Dairy started in 1962 with Heilongjiang Zhaoguang Hongguang Dairy Plants ("Hongguang Dairy Plant"), a state enterprise distributing powdered milk in China. Production was 5 tons per day, mainly sold in Shangdong Province.

1982, HeilongJiang Zhaoguang Diary Plants was established as a state enterprise. Merged into Hongguang Dairy Plant in 1984, still remained a state enterprise.

1997 re-org. Spun off as a private company in Feb 2000. $894K of registered capital.

March 2001, acquired all of the fixed assets (including land use rights, plants, equipment, buildings) of Kedong Gongmu Dairy Plants. 99% ownership (1% remains in trust by Fu Man Guo), but considered to be a wholely owned subsidiary.

Aug 2001, started new production facilities in Kedong County. Milk powder.

Sanhao Dairy incorporated in March 2001. $433K registered capital. Fu Man Guo holds 1% of this company in trust. Purchased (land use rights included) by Feihe Dairy from Kedong County Economic Committee for $364K. Feihe Dairy added all the fixed assets from Kedong Gongmu Dairy Plants (except for land use rights of 48K sq meters of land) plus an additional $69K. In 2004, ADY merged Sanhao Dairy into BaiQuan Feihe Dairy to consolidate.

April 2004, ADY established the 60% owned subsidiary Shanxi Feihesantai Biotechnology Scientific and Commercial Co ("Shanxi Feihesantai") in Shanxi Province. The 40% is owned by Licheng Shantia Technology Enterprises, unaffiliated. Shanxi Feihesantai makes walnut powder and other walnut products.

June 2005, ADY bought a milk powder processing facility from Nutricia Nutritionals of Hei Long Jiang for $7.3 million and $130K inventory. ADY also picked up 19 milk collection stations.

ADY has supply contracts with lots of small dairy farmers who have cattle grazing rights to about 800 square miles of land (about 2/3 the size of Rhode Island) in Kedong County [which is not far from Harbin]. This is 10 times bigger than the county itself. Here's a closeup map. Note that the grazing area would be about 1/4 of this entire map. The 10-K says about 27% of the acreage is arable pasture land and 30% is planted with beans and corn (ok, now that makes sense). The area below Kedong appears to be typical cattle grazing land similar to the land where my grandparents had their cattle ranch, but it's smaller than the 800 square miles they claim. And here's where it is on a big map relative to North Korea and northern Japan. This area has a subarctic climate. It's actually north of Harbin and Harbin is fricken cold!

ADY has a milk powder processing plant, Sanhao Dairy in Kedong County (bought in March 2001 for $461K), close to 12 acres of land, 59K square feet of factory space. About 8K square feet of office space. Building is 14 years old. 236 employees.

ADY has a milk powder packaging plant, BaiQuan Dairy, in Kedong County. Roughly similar dimensions and age. 62 employees. Acquired in Jan 2003 for $700K. Additional land aquired in March 2004 for $293K.

ADY has another milk powder packaging plant, Feihe Dairy, in Kedong County. Started up in Aug 2001. 134 employees.

ADY built another milk powder processing plant (started in 2004) near Sanhao Dairy. Land use cost $401K. Building cost $4.2 million. Equipment and machines cost $11 million.

Total of 578 employees.

Awarded ISO 9002 QA certificate in Oct 2000.

ADY processes raw mild within 24 to 36 hours vs large dairies which, ADY claims, are typically 3-4 days old. ADY doesn't homogenize the milk (they claim it tastes better that way) and pasteurizes at the lowest possible temp. They use cold separation for clarified milk.

The walnut powder operations started up Oct 2005.

Looking at the operating details, Ca+Zn series milk powder remained flat from 2004 to 2005 in terms of amount sold. CPP series milk powder increased. Soybean products decreased quite a bit. Rice cereal ramped up from zero to 4% of dollar sales.

No customer concentration. That's not true! In the notes, one customer is 15% of revenue during 2005 (however, no concentration during 2003 or 2004). No regional sales concentration.

They look to expand via joint ventures, licensing, or other arrangements.

They're doing lots of advertising in China ($3.4 million in 2005, $2.8 million in 2004, $1.6 million in 2003). The marketing focus is on the premium end. Their prices are higher than [many] competitors, which is good. ADY is less well-known than some competitors. The biggest competitors are state owned dairies (good). Big foreign companies have entered China.

April 2005, ADY issued a convertible note for $3 million. 6.5% interest, convertible at $8.00 per share, fixed. Term of 1 year.

Summer 2005, ADY issued two convertible notes for $5 million total. 7.5% interest, convertible at $10.00 per share, fixed. Term of 2 years. The cash was used for acquisitions.

Jan 2006, new agreement to build a milk processing plant in Gannan County, same general region. ADY gets some big perks with this, lots of government subsidies including the initial costs for farmers to buy up to 200K cows (hopefully bought from ETLT).

No legal proceedings.

3 million shares available for options, none issued. Some warrants were exercised.


Revenues increased 82% in 2005 due to "expanding market areas" (I don't know for sure if they mean that the total available market has expanded or that they have expanded into new markets) and due to new products. The specific reasons they give for increased revenue are:
COGS increased by 115%, more than revenues (i.e. gross margins dropped in 2005). The main factor seems to be a 49% increase in direct materials, due to using more nutritional supplements in higher end products (hey, I thought those had higher margins, not lower margins!!!). Other factors are a tiny fraction of this.

Distribution expenses went up 24% due to advertising, promotion, and the costs associated with adding new market areas (products or geography?).

G&A went up 89%. Depreciation (new buildings, plant, equipment), education, entertainment, office, union, transport, bad debts, salaries, top level consulting services.

Tax reversal of a 2003 actual tax on BiaQuan Dairy which was waived by tax authorities in 2004.

In 2004, revenues were up 40%, net income was up 207%. Much of the same story for that year as for 2005.

Liquidity section: Warrants exercised generated some cash. Negative working capital at the end of 2005.
Total obligations are $10 million, mostly long-term debt (most matures 1-3 years) and purchase obligations for advertising contracts (for one year). These don't seem to be a problem based on what I see in the financial statements.


Murrell, Hall, McIntosh & Co. in Oklahoma where the wind comes sweepin' down the plain.... They've been around since 1973. Two officies, both in OK. There's one Chinese person in their audit division: Zibing Pan (associated with the OK City office), email is zibingp at the company's domain name. According to this cached web page and this, Zibing Pan was working for the Oklahoma Employment Security Commission as recently as 2005. He apparently was associated with the University of Oklahoma in December 2003 and was holding onto a Sam's Club card while someone else (who themselves sold a microwave for $15) was out of town. :-)

They audited...

The Oklahoma Housing Finance Agency in 2000, 2001
Precis Smart Card Systems (sec). 2002 (Norman office), unqualified opinion, which was quite reasonable. Fees were $45K for the audit, $16K for tax services, $7K for misc. But they were soon dismissed by the company. BDO charged an audit fee of $107K and then $230K. I'm thinking the prior auditors were, um, lightweights maybe.

But they audited the Norman town public school system.

Also audited Third Millennium Industries, a real failure.

They audited Energas Resources. April 28, 2006, going concern qualifier. Seems like a good call.

Some art galleries and misc foundations. An oil company or two. They seem like a small-time operation. They might have a wonderful or terrible reputation, I don't know. But they're probably cheap and adequate from ADY's point of view.


Balance Sheet:
   * = $1 million
Current Assets
Cash *************
AR ****** $309K allowance
Inventories **********
pre-paid *
advances to suppliers *
total current assets *******************************

PP&E **************************************-
$3.4 million construction in progress

Total assets *********************************************************************

Liabilities and Equity
AP and accrued expenses ************
advances from related parties *
advances from employees *
deferred income ************
short term debt *******
total current liabil *********************************

Long term debt ******

Equity ******************************

Income Statement:
   * = $1 million
Revenues ********************************************************************
Cost of goods sold ***************************************
Distribution expense *****************
G&A **

Other income --

Net income ************

Cash Flow Statement:
   * = $1 million
Cash flows from Operations
Net income ++++++++++++
Depreciation +
stock issued as compensation +
AR -----
inventories -----
advances to suppliers -
AP +++
deferred income ++

Cash flows from Investing
capex ---------------
misc +

Cash flows from Financing
short term debt +++++++++
long term debt +++++
repaid short term debt -
sale of stock +

Net increase in cash ++++++

Depreciation schedule:
buildings: 33 years
plant and machinery: 20 years (seems a bit high)
motor vehicles: 9 years (actually less than what I often see from Chinese companies)
computers and equipment: 5 years

Revenue is recognized on the transfer of risk/reward, typically when delivered to customers.

Other income includes a state incentive to relocate from previous factory.

In 2003, 2004, 2005, Kendong County Government refunds 50% of the VAT tax as an economic incentive for the local economy. $1.5 million in 2005. $1.1 million in 2004. $943K in 2003.

Product display fees. ADY has agreements with resellers paying to display products. How quickly China adopts the finer details of capitalism.

There's all the usual issues, costs, etc. with Chinese companies.

$206K held in a US bank.

ADY owes Leng You-bin $858K (loan from officer/director)
ADY owes other officers/directors $75K
No interest, due on demand.

Fixed assets: $36 million with $1.4 million depreciation so far.
Buildings: $19.3 million
Plant and machinery: $16 million
Motor vehicles: $787K
Computers/equipment: $392K

Construction in progress: $3.4 million
Feihe Dairy processing facilities: $2.9 million
Shanxi walnut processing facilities: $506K

Note payable to a bank. 6.7% interest, secured by plant and machinery. $3 million
Convertible note. 6.5% interest. Due April 26, 2006. Convertible to common at $8.00. $3 million
Unsecured non-interest bearing note to unrelated company, payable on demand. $1 million
Unsecured non-interest bearing note to county finance dept. $247K
Convertible notes. 7.5% interest. convertible to common at $10.00. $5 million
Note to bank. 5.76% interest. Secured by P&E. 96 months. $635K
Car loan. 60 months. $10K

Minority interest is 40% of equity in Shanxi walnut stuff.

Expected tax expense for 2005 would be $4.4 million. All covered by foreign tax holiday. 7 years granted, expires in 2009. This is about 30 cents per share!

Outstanding warrants: 2.5 million shares (2.5 year life, $2.23 strike price)
3 million shares reserved for stock option plan. A small number were issued for services. No employee options granted.

Signficant future commitments mostly covered above. Nothing odd.

Q4 Results:
Revenue: $24.5 million
Gross profit: $8.2 million
Net income: $4.0 million

Quarter by quarter revenue: Q1=$14.1, Q2=$15.1, Q3=$14.3, Q4=$24.5
Quarter by quarter net income: Q1=$2.6, Q2=$2.8, Q3=$2.2, Q4=$4.0
Q1 2006 revenue is $25.9 million, net income is $4.8 million


Leng You-Bin, 36, Chairman/CEO.
13 years in the industry. 1989-1997 big shot at the predecessor to this company. Researched and patented "liver protection milk powder" (GanBao Milk Powder).

CEO owns 62.8% of the stock.

Liu Hua, 33, CFO
Was CEO of Shenzhen Cima Ltd. CEO of Zhengzhou Huacheng Ltd. CFO or FO in this company since 2000.

Liu Sheng-Hui, 35, Director since May 2003.
Financial guy within ADY. Joined in 1992. Current position since 1998.

Hui-Lan "Tracy" Lee, 56, Director
Assistant VP Taxation of Countrywide Home Loan since April 2003. Tax Manager of Watson Pharm from 1996 to 2003. Worked at Flying Tiger Line, Quotron Systems, Lear Siegler. MBA Indiana U.

Kevil L. Tseng, 42, Director since Feb 2005.
Advanced analyst with Boeing. Assistant prof at Perdue. Research Fellow at U of Mich. Etc.

Kirk G. Downing, 52, Director since Feb 2005.
Lawyer in LA. Also ranching, farming, logging, etc. Portland State, Loyola Law School.

Compensation is embarrassingly low. Highest salary listed in $9,000 per year and 33K restricted stock award.

Pike Capital Partners owns 821K shares (6.1% of the stock).

Related Party Stuff:
CEO and director Liu Sheng-Hui received shares during the reverse merger process. They also traded debt for shares at about $2 per share in 2002.
CEO sold ADY a dairy business.
Former President and director entered into a consulting agreement. $60K, 240K shares, also $12K. Not arm's length.

Audit fees for MHM auditors:
2003: $3.8K
2004: $19K
2005: $42.5K
small amount of audit related fees and tax fees.

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