Form 10KSB for SUNWIN INTERNATIONAL NEUTRACEUTICALS, INC.
ITEM 6. MANAGEMENT\'S DISCUSSION AND ANALYSIS OR PLAN OF OPERATIONS.
The following analysis of our consolidated financial condition and results of operations for the years ended April 30, 2006 and 2005 should be read in conjunction with the consolidated financial statements, including footnotes, and other information presented elsewhere in this annual report. When used in this section, "fiscal 2006" means our fiscal year ended April 30, 2006 and "fiscal 2005" means our fiscal year ended April 30, 2005.
Effective February 1, 2004, Sunwin Tech entered into a stock purchase agreement with Shandong Shengwang Pharmaceutical Group Corporation ("Group Corporation") and acquired 80% of the outstanding capital stock of Qufu Natural Green Engineering Company, Ltd. ("Qufu") in exchange for 100% of Sunwin Tech\'s capital stock which had a fair market value of $95,000. In April 2004, we acquired 100% of Sunwin Tech in exchange for approximately 17,000,004 shares of our common stock which resulted in a change of control of our company. The transaction has been accounted for as a reverse acquisition under the purchase method for business combinations. The combination of the two companies is recorded as a recapitalization of Qufu and we are treated as the continuing entity.
Prior to our acquisition of Sunwin Tech, effective February 1, 2004, Sunwin Tech acquired 80% of Qufu ("the Qufu Merger") from Shandong Shengwang Pharmaceutical Group Corporation ("Group Corporation"), a company controlled by Mr. Laiwang Zhang, our President and Chairman, in exchange for all the outstanding shares of Sunwin Tech\'s common stock. At the time of this merger the minority shareholders of Qufu included Shandong Shengwang Pharmaceutical Corporation Ltd. ("Corporation Ltd.") (17%) and Shandong Shengwang Group Corporation (2.5%) ("Shengwang Group"), both of which are controlled by Mr. Laiwang Zhang, our President and Chairman. The remaining minority shareholder, Qufu Veterinary Medicine Company, Ltd. ("Qufu Vet Ltd") (0.5%) was controlled by a Chinese state owned agency.
In July 2004 following the transaction with Sunwin Tech, we changed the name of our company from Network USA, Inc. to Sunwin International Neutraceuticals, Inc. ("Sunwin" or the "Company").
Subsequent to the Qufu Merger, the Shengwang Group acquired the 17% interest of Qufu owned by Corporation Ltd., and ultimately the Shengwang Group acquired the 0.5% Qufu interest owned by Qufu Vet Ltd,, after Qufu Vet Ltd. was dissolved. These events subsequent to the Qufu Merger, resulted in the Shengwang Group owning 20% of Qufu.
In February 2006, the Company acquired the remaining 20% of Qufu from Shandong Group in exchange for 5,000,000 shares of our common stock valued at $2,775,000. Our president and Chairman, Mr. Laiwang Zhang, is a control person of Shandong Group. Of the total purchase price, approximately $180,000 was allocated to consulting expenses paid to Mr. Zhang as it represented the difference between the purchase price and the valuation of the minority interest purchased.
Through our subsidiaries, we manufacture and sell neutraceutical products which can be classified into three main product groups including; stevioside, a 100% natural sweetener, veterinary medicines and animal feed additives, and traditional Chinese medicine formula extracts. All of our business and operations are located in the People\'s Republic of China.
The majority of our revenues are derived from our stevioside product, and our principal customers for this product are located in Asia, primarily China and Japan where stevioside is approved for use both as a food additive as well as a nutritional supplement.
This product group represented approximately 47% of our total revenues for fiscal 2006. China has grown into the world\'s largest exporting company of stevioside, with volume exceeding 80% of the world\'s supply. We believe that we are one of the top three companies in China manufacturing stevioside.
We also manufacture and sell a comprehensive line of veterinary medicines including seven series of more than 200 products. These veterinary medicines include traditional Chinese medicine as well as western medicines, feed additives, feeds and antibiotics.
We are an advocate of developing animal medicines from Chinese herbs, especially antivirus and feed additives. We are concentrating our efforts in this product category on developing and producing medicines which are relevant to the needs of the animal stock industry in the PRC, and developing special veterinary medicines made from pure traditional Chinese medicines or combining traditional Chinese medicine with Western medicine. This product group represented approximately 26% of our total revenues for fiscal 2006. Our last product group includes the manufacture and sale of traditional Chinese medicines formula extracts that are used in products made for use by both humans and animals. This product group represented approximately 27% of our total revenues for fiscal 2006.
Our ability to significantly increase our revenues in any of these groups faces a number of challenges. In addition to the existing laws which limit the sale of stevioside to Western countries, we face competition in the manufacture and sale of stevioside. There are approximately 30 stevioside manufacturers in China, with only approximately 10 companies operating on a continuing basis. Our other two product groups operate in highly competitive environments. We estimate that there are more than 5,000 companies in China selling animal medicines and more than 200 companies in China that produce Chinese traditional medicines and extracts and refined chemical products. The sale of our products in these two product groups are concentrated on domestic customers therefore our ability to expand our revenues in these product groups is limited to a certain extent by economic conditions in the PRC. In addition, since we are dependent upon raw materials which are harvested and farmed, our ability to produce our products and compete in our markets is also subject to risks including weather and similar events which may reduce the amount of raw materials we are able to purchase from farmers as well as increased competition or market pressure which may result in reduced prices for our products. Our ability, however, to expand our revenues from the sale of stevioside is limited as the product is not approved for use as a food additive in most Western countries, including the United States, Canada and the European Union. In these countries forms of stevioside can be marketed and sold as a nutritional supplement. In an effort to increase our competitive position within our market segment, we have built an additional stevioside manufacturing line in order to expand our stevioside production, upgraded our exiting manufacturing stevioside line, and relocated to a larger facility. In addition, during fiscal year 2005 and the first three quarters of fiscal year 2006 we were involved in reconstructing an additional veterinary production line into a new building which was put into full production in December 2005.
Through April 30, 2006, we have invested an aggregate of approximately $1,967,667 to be used for leasehold improvements and equipment towards the additional veterinary medicine manufacturing line and $1,214,777 towards the new stevioside facility.
Even though we are a U.S. company, because all of our operations are located in the PRC, we face certain risks associated with doing business in that country. These risks include risks associated with the ongoing transition from state business ownership to privatization, operating in a cash-based economy, various government policies, unexpected changes in regulatory requirements, export restrictions, tariffs and other trade barriers, challenges in staffing and managing operations in a communist country, differences in technology standards, employment laws and business practices, longer payment cycles and problems in collecting accounts receivable, changes in currency exchange rates and currency exchange controls. We are unable to control the vast majority of these risks associated both with our operations and the country in which they are located and these risks could result in significant declines in our revenues and adversely affect our ability to continue as a going concern.
Foreign Exchange Considerations
Since revenues from our operations in the PRC accounted for 100% of our net revenues for fiscal 2006 and fiscal 2005, how we report net revenues from our PRC-based operations is of particular importance to understanding our financial statements. Transactions and balances originally denominated in U.S. dollars are presented at their original amounts. Transactions and balances in other currencies are converted into U.S. dollars in accordance with Statement of Financial Accounting Standards (SFAS) No. 52,"Foreign Currency Translation," and are included in determining net income or loss. For foreign operations with the local currency as the functional currency, assets and liabilities are translated from the local currencies into U.S. dollars at the prevailing exchange rate on the respective balance sheet date.
Revenues and expenses are translated at weighted average exchange rates for the period to approximate translation at the exchange rates prevailing at the dates those elements are recognized in the financial statements. Translation adjustments resulting from the process of translating the local currency financial statements into U.S. dollars are included in determining comprehensive loss.
The functional currency of our Chinese subsidiaries is the local currency or the Chinese dollar called the Renminbi ("RMB"). The financial statements of our subsidiaries are translated to U.S. dollars using year-end rates of exchange for assets and liabilities, and average rates of exchange for the period for revenues, costs, and expenses. Net gains and losses resulting from foreign exchange transactions are included in the consolidated statements of operations and were not material during the periods presented. The cumulative translation adjustment and effect of exchange rate changes on cash at April 30, 2006 was $227,631. Until 1994, the Renminbi experienced a gradual but significant devaluation against most major currencies, including the U.S. dollar. There was a significant devaluation of the Renminbi on January 1, 1994 in connection with the replacement of the dual exchange rate system with a unified managed floating rate foreign exchange system. Since 1994, the value of the Renminbi relative to the U.S. dollar has remained stable; appreciating slightly against the U.S. dollar. Countries, including the United States, have historically argued that the Renminbi is artificially undervalued due to China\'s current monetary policies and have pressured China to allow the Renminbi to float freely in world markets. On July 21, 2005, the PRC announced that the Renminbi would be pegged to a basket of currencies rather than just tied to a fixed exchange rate to the U.S. dollar. It also increased the value of its currency 2% higher against the U.S. dollar, effective immediately
If any devaluation of the Renminbi were to occur in the future, returns on our operations in China, which are expected to be in the form of Renminbi, will be negatively impacted upon conversion to U.S. dollars. Although we attempt to have most future payments, mainly repayments of loans and capital contributions denominated in U.S. dollars, if any increase in the value of the Renminbi were to occur in the future, our product sales in China and in other countries may be negatively affected.
Critical Accounting Policies
The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates based on historical experience and on various other 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 from these estimates under different assumptions or conditions.
A summary of significant accounting policies is included in Note 1 to the audited consolidated financial statements included in this annual report. Management believes that the application of these policies on a consistent basis enables us to provide useful and reliable financial information about the company\'s operating results and financial condition.
We record property and equipment at cost. Depreciation and amortization are provided using the straight-line method over the estimated economic lives of the assets, which are from five to 20 years. Expenditures for major renewals and improvements which extend the useful lives of property and equipment are capitalized. Expenditures for maintenance and repairs are charged to expense as incurred. We review the carrying value of long-lived assets for impairment at least annually or whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. Recoverability of long-lived assets is measured by a comparison of its carrying amount to the undiscounted cash flows that the asset or asset group is expected to generate. If such assets are considered to be impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the property, if any, exceeds its fair market value.
We account for stock options issued to employees in accordance with the provisions of Accounting Principles Board ("APB") Opinion No. 25, "Accounting for Stock Issued to Employees", and related interpretations. As such, compensation cost is measured on the date of grant as the excess of the current market price of the underlying stock over the exercise price. Such compensation amounts, if any, are amortized over the respective vesting periods of the option grant. We adopted the disclosure provisions of SFAS No. 123, "Accounting for Stock-Based Compensation" and SFAS 148, "Accounting for Stock-Based Compensation- -Transition and Disclosure", which permits entities to provide pro forma net income (loss) and pro forma earnings (loss) per share disclosures for employee stock option grants as if the fair-valued based method defined in SFAS No. 123 had been applied. We account for stock options and stock issued to non-employees for goods or services in accordance with the fair value method of SFAS 123. In December 2004, the FASB issued FASB Statement No. 123R, "Share-Based Payment, an Amendment of FASB Statement No. 123" ("FAS No. 123R"). FAS No. 123R requires companies to recognize in the statement of operations the grant- date fair value of stock options and other equity-based compensation issued to employees. We adopted FAS No.123R in the second quarter of fiscal year 2006.
RESULTS OF OPERATIONS
YEAR ENDED APRIL 30, 2006 AS COMPARED TO YEAR ENDED APRIL 30, 2005
Internally we identify our products in three product groups, stevioside, traditional Chinese medicine formula extracts and veterinary medicines. For accounting purposes, we report two segments which include stevioside as one segment and traditional Chinese medicine extracts and veterinary medicine products as the second segment.
For the year ended April 30, 2006, our revenues were $15,490,013 as compared to $12,114,006 for the year ended April 30, 2005, an increase of $3,376,007 or approximately 27.9%. For fiscal 2006, revenues from our stevioside segment represented approximately 47% of our net revenues and revenues from our traditional Chinese medicine extracts and veterinary medicine segment represented approximately 53% of our total net revenues. We attribute our overall increase in net revenues to an increase in revenues from each of our product lines;
o revenues from the sale of our natural sweetener, stevioside increased $1,660,953,
o revenues from the manufacture and sale of our traditional Chinese medicine increased $796,425, and
o revenues from our veterinary medicine increased $918,629
The increase in the sale of our natural sweetener, stevioside, was due to the completion of our manufacturing equipment upgrade. Our revenues related to the manufacture and sale of stevioside increased from approximately $5,540,567 to $7,201,520, a 30% increase from April 30, 2005 to April 30, 2006. In September 2005 we commenced operations on our new manufacturing line; the facility became fully operational in November 2005. The new facility improves the quality of our stevioside and allows to acquire a larger market share. We manufactured 107 tons of stevioside and resold 123 tons during fiscal year 2006. We anticipate manufacturing 300 tons of stevioside during fiscal year 2007. We believe that the market for stevioside remains strong as we continue to witness growing demand for the product from consumers based in Japan resulting in increased exports to Japan. In order to ensure we have a sufficient supply of raw materials for production next year, we have prepaid farmers to harvest stevioside leaves, which increased our prepaid expenses by approximately $117,593 on our consolidated balance sheet as of April 30, 2006.
Our revenues related to traditional Chinese medicine increased from approximately $3,420,000 to $4,217,000, a 23% increase from April 30, 2005 to April 30, 2006. Our gross profit rate has grown from 39% to 41% from April 30, 2005 to April 30, 2006 on this product line due to the introduction of new products and improved sales. The Chinese central government issued a new rule for the Chinese Medicine industry that all manufactures should satisfy good manufacturing practices (GMP) standards in their production process before December 31, 2005. We completed our manufacturing equipment upgrade and as a result currently satisfy the GMP standards requirements in December 2005. As a result of these new regulations, we believe there was a significant market vacancy left by competitors who did not conform to the heightened standards. We believe that the new rules implemented by the central government of China helped us to establish a reputation within this field and acquire a larger market share. In December 2005, we completed the expansion and upgrade of our traditional Chinese medicine production facility and following this upgrade we launched five additional traditional Chinese medicine products. In January 2006, we introduced new products into the market and established a new products series, natural dietary health food. We expect to achieve growth in our traditional Chinese medicine division in our fiscal 2007.
Our revenues related to veterinary medicine increased from approximately $3,153,000 to $4,072,000, a 29% increase from April 30, 2005 to April 30, 2006. Furthermore our gross profit has grown from approximately $1,007,319 to $1,357,270, an approximate 35% increase from April 30,2005 to April 30, 2006 due to the introduction of new products and improved sales skills. Similar to the rules which effected our production of traditional Chinese medicine extracts described above, the Chinese central government also issued a new rule for the veterinary industry mandating that all manufacturers satisfy GMP standards in their production process on or before December 31, 2005. We completed the construction and finished the inspection process of our facilities in December 2005. As a result of these new regulations, we also believe a significant market vacancy was left by competitors who did not conform to the heightened standards and that this void enabled us to acquire a larger market share. From January 2006, we introduced five new products into the market. We expect to achieve growth in our veterinary medicine division in our fiscal 2007.
In December 2005, Sunwin has completed the expansion and upgrade of the veterinary medicine production facility. As a result, Sunwin launched 5 additional veterinary medicine products; Amoxicillin, Cephalosporium, Ampicillin, 4 mn iu sodium oxacillin, and penbritin. These five new products are employed as antiviral agents, to combat fever and treat respiratory tract infections. In fiscal 2006, these new products accounted for approximately 1.71% of revenue.
Cost of Sales and Gross Profit
For the year ended April 30, 2006, cost of sales amounted to $10,865,917 or 70% of net revenues as compared to cost of sales of $8,378,838 or 69% of net revenues for the year ended April 30, 2005, a percentage increase of 1%. Gross profit for the year ended April 30, 2006 was $4,624,096 or 30% of revenues, as compared to $3,735,168, or 31% of revenues for the year ended April 30, 2005.
Total Operating Expenses
Our total operating expenses increased for the year ended April 30, 2006 from the year ended April 30, 2005. Total operating expenses were $2,195,955 for the year ended April 30, 2006 while total operating expenses were $2,110,340 for the year ended April 30, 2005 an increase of $85,625, or approximately 4.1%. Included in this increase were:
o For the year ended April 30, 2006, we recorded non-cash compensation expense of $569,581 as compared to $220,000 for the year ended April 30, 2005, an increase of $349,581 or 159%. This amount represented the value of shares of our common stock we issued as compensation for consulting services and professional services being rendered to us. While we anticipate that we will enter into similar agreements during fiscal 2007, we cannot predict the amount of expense which will be attributable to such agreements;
o For the year ended April 30, 2006, selling expenses amounted to $615,348 compared to $923,114 for the year ended April 30, 2005 a decrease of $307,766 or 33%. For the year ended April 30, 2006 we experienced an increase in commission expenses of approximately $173,000, increased marketing expenses of approximately $53,000 increased shipping and freight costs of approximately $84,000 and an overall increase in other selling expenses of $22,300. These increases were offset by bad debt recovery of approximately $640,090 from the collection of previously reserved receivable balances; and
o For the year ended April 30, 2006, general and administrative expenses were $ 1,011,026 as compared to $967,226 for the year ended April 30, 2005, an increase of $43,800 or 4.5%. Travel related expenses included in the general and administrative costs increased from $25,000 for fiscal year 2005 to $110,000 for fiscal year 2006 which reflects expenses associated with our efforts to expand distribution of stevioside into North America. As well, we recognized increased general and administrative costs which are primarily due to the increase in our operations. As a result of our manufacturing upgrades, we realized a decrease in repairs, maintenance and retooling expenses. The repairs and maintenance expense amounted to $8,752 for the year ended April 30, 2006, a decrease from the $19,374 incurred for the year ending April 30, 2005. We expect expenditures for repairs, maintenance and facility upgrades to decrease in future periods as much of our upgrade and renovation projects was completed in December 2005. For the year ended April 30, 2006 we experienced an increase in management fees from approximately $44,000 in fiscal 2005 to approximately $123,000 in fiscal 2006, an increase of approximately $79,000. Shandong Shengwang Pharmaceutical Corporation, Limited, a company controlled by Mr. Zhang, our CEO, provides management services to us which includes costs and services related to housing provided to certain of our non-management employees, government mandatory insurance for our employees and rent for our principal offices and the research and development facilities we use. We do not have a contract with Shandong Shengwang Pharmaceutical Corporation, Limited and the amount of annual management fee is subject to increase at Mr. Zhang\'s discretion. We also reported an overall increase in other general and administrative expenses of approximately $20,700 associated with an increase in operations; this increase was offset by a decrease of approximately $56,200 in research and development expenses. Finally, we reported a decrease in advertising expenses for fiscal 2006 of approximately $41,000, from $212,865 in fiscal 2005 to $171,896 in fiscal 2006. This decrease is reflects a reduction in funds spent on advertising our veterinary medicines in fiscal 2006. Sunwin incurred a decrease in advertising costs related to its veterinary medicine division. Industry regulations adopted by the central government regarding good manufacturing process ("GMP") have limited competition in the industry. As such the Company has reduced their advertising expenditures in the veterinary medicine department.
o Legal and accounting fees increased to approximately $62,000 in Fiscal 2006 from approximately $53,000 in Fiscal 2005. This increase is primarily attributable to costs associated with our annual audit and a registration statement we filed during Fiscal 2006 with the SEC and other required filings with the SEC. During fiscal 2007 we anticipate further increases in legal and accounting fees associated with our continued compliance with provisions of the Sarbanes-Oxley Act of 2002, including new provisions which will phase in during fiscal 2007.
Total Other Income (Expense)
For fiscal 2006 we reported total other income of $68,337 as compared to total other expense of $2,960 for fiscal 2005. This change included:
o Other income amounted to $103,675 for the year ended April 30, 2006 as compared to other income of $59,094 for the year ended April 30, 2005. Other income for the year ended April 30, 2006 was associated with income recognized from the over accrual of value-added taxes on certain of our animal medicine products which had not been assessed to our customers. Certain of our animal medicine products are not subject to value added taxes. However until we received notification of such position from the respective tax authority, we had accrued additional value added taxes. Upon notification from the tax authority, the accrued taxes were recorded as other income for the period ending April 30, 2006.
o Interest expense was $35,338 in Fiscal 2006 as compared to $62,054 in Fiscal 2005. Interest expense for the year ended April 30, 2006 and 2005 was associated with our borrowings. The amount of loans payable was $255,487 and $592,541 and for Fiscal 2006 and Fiscal 2005 respectively, a decrease of $337,054, accordingly, the interest expense decreased. Given our current cash flow from our operations, we expect we are able to meet the obligation of the debt services from our existing working capital.
Our income before minority interest was $3,020,959 for the year ended April 30, 2006 as compared to $1,108,495 for the year ended April 30, 2005, an increase of $1,912,464 or 172.5%. On February 7, 2006, we acquired the remaining 20% of Qufu and, as a result, Qufu is now our wholly-owned subsidiary effective on February 1, 2006. The acquisition of the remaining 20% of Qufu was a non cash transaction, whereby we issued 5,000,000 shares of our common stock to acquire the remaining 20% of Qufu.
For the year ended April 30, 2006, we reported a minority interest in income of subsidiary (Qufu) of $591,145 as compared to $279,381 for the year ended April 30, 2005. The minority interest for Fiscal 2006 represents the minority interest\'s proportional share of Qufu\'s net income up until the date we acquired the minority interest ownership in Qufu.
As a result of these factors, we reported net income of $2,429,814 or $.05 per share for the year ended April 30, 2006 as compared to net income of $829,114 or $.02 per share for the year ended April 30, 2005.
LIQUIDITY AND CAPITAL RESOURCES
At April 30, 2005, we had working capital of $8,908,577 and cash and cash equivalents of $5,433,691. At April 30, 2006, our cash position by geographic area is as follow