SEC Filings

Form 10-Q - Ended June 30, 2012
Author:Aoxin Tianli Date:Aug/10/2012



Quarterly Report


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

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited consolidated financial statements and the related notes included elsewhere in this report and with the consolidated financial statements and notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 2011. This discussion contains forward-looking statements that involve risks and uncertainties. Actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements.


Our Company is in the business of breeding, raising, and selling hogs in the Wuhan City area of the People's Republic of China ("PRC"). We control an affiliated entity, Wuhan Fengze Agricultural Science and Technology Development Co., Ltd. ("Fengze"), pursuant to a series of control agreements between Fengze and our wholly owned subsidiary, Wuhan Fengxin Agricultural Science and Technology Development Co., Ltd., a wholly foreign owned enterprise ("WFOE"). Fengze mainly produces and sells hogs for breeding stock and slaughter. As of June 30, 2012, Fengze owned and operated eleven commercial hog farms in the Wuhan City area with an annual production capacity of approximately 170,000 hogs when the most recently acquired tenth and eleventh farms reach full capacity.

On December 29, 2010, we completed the acquisition of the assets of the Hengdian Farm, located in Wuhan City, which represents our tenth farm and which will produce up to 20,000 hogs annually at full production. On May 12, 2011, we completed the acquisition from An Puluo Food, Inc. ("An Puluo") of our eleventh farm, which is located in Enshi Tujia and Miao Autonomous Prefecture of Hubei Province. This farm also will produce up to 20,000 hogs annually once it reaches full production. Our tenth farm had achieved full production by the fourth quarter of 2011 but now is operating slightly below capacity due to the use of contaminated food which impacted a number of our farms in late 2011.

In the last two years, our business has grown rapidly as a result of the expansion of our annual capacity levels through the acquisition of farms and we intend to take other measures to increase the size and profitability of our business. As one part of this effort, in August, 2011, we entered into a collaborative agreement to distribute processed pork products at major retail stores in greater Wuhan City. This collaborative agreement was canceled at June 15, 2012.

In an effort to significantly increase the scale of our operations, we concluded a series of agreements (the "Exclusivity Agreements") in 2011 with the Animal Husbandry and Veterinary Bureau of Enshi Tujia and Miao Autonomous Prefecture of Hubei Province, the Animal Husbandry and Veterinary Bureau of Xianfeng County of Hubei Province, the Xuwang Hog Farming Professional Cooperatives of Xianfeng County, and the Qiming Hog Farming Professional Cooperatives of Xianfeng County, whereby we were granted the exclusive right to breed and sell Enshi black hogs in Enshi Autonomous Prefecture in Hubei Province. Enshi black hog is one of the oldest hog species with a lineage that can be traced back to the year 1611. Enshi black hog originated in the Enshi Tujia and Miao Autonomous Prefecture in Hubei Province and the meat of the Enshi Black Hog is considered by many Chinese to be superior to that of many other breeds and for that reason, black hog meat generally sells for more than standard hog meat. The Company estimates that the price of Enshi black hog meat is currently approximately 35% above the price of typical lean pork meat. The agreements also call for the joint development, funding and operation of local cooperatives in the Enshi Autonomous Prefecture in Hubei Province whereby the Company, the relevant governmental agencies and the cooperatives will assist participating farmers to breed and raise Enshi black hogs which will be purchased by the Company for resale as meat hogs or retained or sold as breeders at the Company's discretion. By entering into this arrangement, we hope to be able to develop a widely recognized brand of black hog meat and to profit from the sale of black hogs grown by independent farmers as well as those grown by us. If successfully implemented, this program should allow us to profit from the black hogs grown by the participating farmers who will be obligated to purchase feed, vaccines and other supplies from us and then sell us their hogs at a price which is comparable to the costs at which we currently grow our own hogs.


The Exclusivity Agreements envision that we, acting through Fengze's wholly owned subsidiary, Tianzhili, will work with the Animal Husbandry and Veterinary Bureaus of Xianfeng County and Enshi Tujia and Miao Autonomous Prefecture, respectively, to develop a regional breeding and distribution program whereby local farmers will be trained and supervised by us, the relevant governmental agencies and their cooperatives in raising a breed of black hogs genetically developed and monitored by us with the approval of the local government agency. We will work with all of the farmers participating in the program to ensure that the quality of the breed is maintained and to develop standardized programs for the feed and care of the hogs. As part of this effort, we will develop an appropriate feed mix, which the farmers will purchase from us. To be eligible to participate in the program farmers will need to be able to maintain no less than 6 sows or produce at least 100 black hogs per year. It is envisioned that we will fund construction of up to 1,000 program farms by the end of this year, of which over 405 program farms have been completed and put into use as of June 30, 2012. The goal is to achieve a production capacity of 40,000 hogs during 2012 with a long run target of an annual capacity of 1 million hogs. Achievement of any of the program's goals and the need for financing are dependent upon the participation, cooperation and skills of local farmers which are currently being evaluated. The agreements are generally for a period of ten years.

As noted above, we should benefit from this program in a number of ways, principally by reselling the black hogs purchased from the participating farmers and by providing the farmers with necessary supplies. The price which we will pay the farmers is approximately the price at which typical lean white pork meat sells. The price at which black hog meat sells has certain percentage premium above the price of white hog meat and the premium prices vary in different areas. We believe this will provide sufficient margin to us even if the relative prices change.

We believe that because this program offers many advantages to the participating farmers and the local governments, the number of farmers wanting to join the program will be significant ensuring the success of the program and will result in a significant increase in the volume of pork we sell. Enshi Autonomous prefecture is a relatively poor area of China. By joining this program participating farmers will benefit from our expertise in breeding and caring for hogs, and will be producing a breed which is generally considered superior to the meat of standard hogs. To develop our strain of black hog we will apply internationally recognized advanced molecular breeding strategies. The project will be supported by the Animal Husbandry Research Institution of Hubei, which has significant experience in hog breeding research. Moreover, the Enshi Autonomous Prefecture government has determined to emphasize hog farming in China's current five-year development plan (2011-2015), which should cause it to cooperate with us to make the project a success. Significantly, the local governments have agreed that we are the only company with which it will undertake a project such as this.

In addition to the advantages of this program, we believe that some of the risks typical to hog farming will be minimized. For example, because individual farms will be relatively small and decentralized, and under strict supervision to employ disease control methods we determine are appropriate, the risk of disease should be lower than on traditional farms, Further, if a farm were to develop a problem, it should not spread since the farms are decentralized in the Prefecture's mountainous region. In addition, because of the emphasis being placed on this project by the local government, we anticipate a high level of cooperation from the farmers who are being given the opportunity to profit from what is otherwise communal land.

We have agreed to contribute to the financial needs of the project in various ways and the local governments have agreed to provide us and the participating farmers with various subsidies, incentives and insurance. The precise demands upon us will depend upon the rate at which the project grows which, in turn, will be impacted by the availability of financing that may be necessary to modernize and support the participating farmers. Given the long term of this project, it is likely that there will be continued negotiation of various issues that arise during the life of the project.

As of June 30, 2012, we had completed construction of 405 farms participating in our Black Hog Program at a cost of approximately $4.95 million. The annual production capacity of these farms is approximately 40,000 hogs per annum. In addition, as of June 30, 2012, we had spent an additional $1.27 million on another 92 farms that will become operational during the third quarter. Thus, as of June 30, 2012, we had spent in excess of $6 million constructing farms as part of our Black Hog Program. We anticipate that some of the completed farms will have hogs ready to be sold at market during the third quarter and thus, we will begin to receive a return on this significant investment.


Principal Factors Affecting our Results of Operations


We derive the bulk of our revenues from the sale of hogs to other hog farms for breeding purposes, to brokers who sell the hogs both to other hog farms for breeding purposes and to slaughterhouses, and directly to slaughterhouses. We breed and raise hogs that are eventually sold as either breeder or market hogs which will be sold to slaughter houses for conversion into pork products. Some of the hogs are bred and raised for the purpose of sale as market hogs, while others become market hogs because customers do not select them as breeder hogs. Also very few boars are required for breeding purposes, as compared with sows. As approximately half of a litter will be males, most of these males will be sold as market hogs. The average sales price for a breeder is significantly higher than that of a market hog, and since breeder hogs are sold at a younger age than market hogs and usually weigh about 110 pounds at the date sold, as compared to the average weight of about 220 pounds for a market hog on sale date, the direct cost of feeding and otherwise raising a breeder hog is less than a market hog. Thus the gross margin for breeder hogs is substantially higher than that of market hogs. Consequently, the Company has focused its operations to increase the proportion of its sales represented by breeder hogs, and its success in so doing has been a major contribution to its operating profit.

We receive some subsidies from the government for operating our farms. Some of these subsidies are non-recurring, such as the payment we receive when we reach specified annual production capacities, or for the acquisition of certain operating equipment. Others, such as subsidies for breeder hog insurance, are ongoing so long as we qualify. Of course, there is no assurance the government will continue any of its policies for granting subsidies.

Commencing in the third quarter of 2011, we began to derive revenue from our retail collaborative venture, Tianli An Puluo. In August 2011 Fengze and An Puluo signed a collaborative agreement to pursue a retail business, under which the venture had an exclusive right to sell An Puluo processed pork products at retail. We were the principal participant of this collaborative arrangement and accordingly the costs incurred and revenues generated from this business were recorded on a gross basis in our financial statements. According to the cooperative agreement, Fengzi and An Puluo shared the net profit (after tax) from this business on a ratio of 60% vs 40%. On June 15, 2012, Fengze and An Puluo terminated the collaborative arrangement at retail business.

Factors Affecting Revenues and Profitability

The following factors, among others, affect the revenues and profitability that we derive from our operations. For other factors affecting our revenues, see "Risk Factors-Risks Related to Our Business," as included in the Company's Annual Report on Form 10-K. for the fiscal year ended December 31, 2011 filed on March 15, 2012.

Consumer demand for pork products. Consumer demand for pork products is closely linked to the performance of the general Chinese economy and is sensitive to business and personal discretionary spending levels.

Declines in consumer demand may occur as a result of adverse general economic conditions. Lower consumer confidence and changes in consumer preferences for pork as compared with other meats can lower the revenues and profitability of our operations. As a result, changes in consumer demand and general business cycles can subject our revenues to volatility.

Revenues resulting from the sale of breeder hogs. A significant amount of our revenues and operating margin result from the sales of young breeder hogs for use by other hog farmers. Because these breeder hogs command a price significantly higher than market hogs, and are sold at a younger age, thus incurring less feed and related finishing expenses, the profitability of the sale of a breeder hog is higher than that for the sale of a market hog. A significant reduction in the proportion of our sales that are breeder hogs would very likely significantly reduce our overall profit margin.


Government action in our industry. Because pork occupies such a central role in the Chinese diet, the government has occasionally taken action to prevent the price of pork from dropping below specified levels and has provided subsidies to companies engaged in hog farming. We benefit from this protection and we could be harmed if the government terminated such practices. In addition, the government has taken actions to prevent the spread of diseases among livestock, including mandatory culls of affected animals. These actions have occasionally resulted in relative shortages, which tend to lead to higher prices for healthy animals, and could result in a reduction of our stock, thus reducing revenues and profit. Likewise it is possible that the government could implement some form of price controls that could adversely impact our ability to price our products high enough to recover increases in costs such as feed.

Competition and subsidies. While the hog farming industry in Hubei province and the Wuhan City area includes a large number of farms, many of those farms are smaller farms that sell relatively few hogs per year. We believe the incentives being given to farms that reach specified annual production capacities are likely to result in a consolidation of the industry. Our ability to increase our production capacity and thus to qualify for these incentives for our operations allows us to receive non-recurrent benefits from these subsidies, as well as to benefit from increased economies of scale in our operations.

Expansion. We believe we must continue to expand our production capacity to attain additional market share. Since 2006, we have acquired the assets of several hog farms including Hengdian farm (the Company's tenth farm), which was acquired in December 29, 2010, and the assets of the An Puluo farm (the Company's eleventh farm), which is located in Enshi Tujia and Miao Autonomous Prefecture of Hubei Province and was acquired in May 12, 2011. If we fail to make acquisitions or expand our production capacity, our revenue growth could slow down.

In an effort to increase our capacity we entered into the Exclusivity Agreements described above in "Overview." Pursuant to these agreements we will assist local farmers to upgrade their facilities and breed and grow hogs by providing both our capital and expertise. If the program progresses as planned, we should increase the volume of hogs we sell by more than we would if we were to limit ourselves to buying farms to be operated by us. We believe this is an efficient way to leverage upon our expertise in breeding and raising quality hogs. Moreover, the hogs to be raised under this program will be the Enshi black hogs, which generally sell at a price significantly above the price of typical lean pork meat.

Epidemic outbreaks. The outbreak of animal diseases could adversely affect our revenues. An occurrence of serious animal diseases, such as foot-and-mouth disease, or any outbreak of other epidemics in the PRC affecting animals or humans might result in material disruptions to our sales.

Taxes. We believe that the provisions of the PRC's Enterprise Income Tax law currently provide our hog breeding operations with an exemption from PRC income taxes, VAT taxes and business service taxes. If this understanding is incorrect or if the law or interpretations of the law change, this could significantly impact the Company's net operating results.

Contractual arrangements with Fengze. We conduct substantially all of our operations, and generate substantially all of our revenues, through contractual arrangements with Fengze that provide us with effective control over Fengze. We depend on Fengze to hold and maintain contracts with our customers. Fengze owns substantially all of our intellectual property, facilities and other assets relating to the operation of our business, and employs the personnel for substantially all of our business. Neither Tianli, nor HCS nor WFOE has any ownership interest in Fengze. Although WFOE's contractual arrangements with Fengze are valid, binding and enforceable under current PRC laws and regulations, these contractual arrangements may not be as effective in providing the Company with control over Fengze as direct ownership of Fengze would.

Costs and Expenses

We primarily incur the following costs and expenses:

Costs of goods sold. In raising hogs for sale, we incur a number of costs that represent the costs of goods sold. We must purchase hog feed, premix components, medicines and other supplies to grow our hogs and keep them healthy. In addition to these items, cost of goods sold includes expenses such as the amortization of the sows (referred to as biological assets), farm employee wages, water, electricity, equipment depreciation expense, maintenance expense, quarantine expense, equipment costs, insurance expense and sewage charges.

General and administrative expenses. General and administrative expenses consist primarily of compensation expense for our corporate staff, professional fees (including consulting, audit and legal fees), communication costs, research and development costs, gasoline, welfare expenses, education expenses, travel and business hospitality expenses, land rent, and other office administrative and related expenses.


Sales and marketing costs. Sales and marketing costs include advertisement and promotion expenses.

Factors Affecting Expenses

Supplies and commodity prices. The largest component of our expenses is the materials required to breed and raise hogs for sale. Specifically, while we ordinarily breed our own hogs, we periodically purchase breeding stock to continue to improve our genetic breeding pool. Similarly, the prices of corn and soybean husks in China are important to our operations, because corn and soybean husks are the primary components of our hogs' diet. To the extent the prices of these materials vary, our cost of goods will fluctuate, and we may not be able to recover increased costs resulting from higher prices by increasing the prices for our products. For this reason, we may be affected by droughts, floods, crop diseases and the like, which tend to make feed scarcer and thus more expensive.

Transition to public company. As we are now a public company, our administrative costs have increased materially, including audit, legal, travel to the United States, investor relations and advisor costs as well as the need to comply with detailed reporting requirements.

Number of customers. The more customers we have, the greater the likelihood that related selling expenses, travel expenses and other similar costs will increase. At present, we sell substantially all of our hogs to a relatively small number of customers. We believe this concentration of customers has allowed us to focus our marketing and selling efforts.

Number of farms. We have acquired or constructed a number of hog farms in the last several years. As we operate more farms, our administrative expenses tend to increase in dollars terms.

Retail expenses. As we pursue a strategy of providing our branded product to retail outlets, we expect that we will face additional costs such as promotion and advertising expenses to establish our brand image and retail recognition.

In connection with the Enshi Black Hog program described above, we have agreed to incur various costs and contribute various amounts to cover the costs of different aspects of the program. During 2011, we signed 7 joint development agreements, for periods of 10 years, with 7 local cooperatives in the Enshi Autonomous Prefecture in Hubei Province whereby the Company, the relevant governmental agencies and the cooperatives will assist participating farmers to breed and raise Enshi black hogs which will be purchased by us for resale as meat hogs or retained or sold as breeders at our discretion. Under these agreements, we provide funding to local independent farmers to construct small-scale hog farms or hog rearing facilities in which the farmers will grow the black hogs for sale to us. Pursuant to these joint development agreements, title to these small-scale hog farms and rearing facilities belongs to us and the local cooperatives (and the individual farmers) have the right to use them. As of June 30, 2012, we have paid a total of $6.22 million to build these hog rearing facilities, including hog rearing facilities for 3 local cooperatives of $1.19 million which had been completed and are in use and other hog rearing facilities for another 4 local cooperatives of $5.03 million which $3.76 million of rearing facilities had been completed and are in use and the remaining of $1.27 million of facilities were not yet completed or put into use.


Comparison of the Results of Operations for the Three Months Ended June 30, 2012 and 2011

All amounts, other than percentages, are in U.S. dollars


For Three Months Ended June 30,                           Percentage of
                                         2012                   2011            Net Change          Change
Sales                              $      6,391,343       $      7,670,429     $ (1,279,086 )        (16.68%)
Cost of goods sold                        5,589,803              4,452,623        1,137,180           25.54%
Gross profit                                801,540              3,217,806       (2,416,266 )        (75.09%)
Selling, general and
administrative expenses                     426,460                636,111         (209,651 )        (32.96%)
Income from operations                      375,080              2,581,695       (2,206,615 )        (85.47%)
Interest expense, net                       (85,692 )              (98,700 )         13,008          (13.18%)
Subsidy income                               27,339                 22,970            4,369           19.02%
Other expense                               (44,927 )              (26,814 )        (18,113 )         67.55%
Net other expense                          (103,280 )             (102,544 )           (736 )         0.72%
Income before income taxes                  271,800              2,479,151       (2,207,351 )        (89.04%)
Income taxes                                      -                      -                -             -
Net income from continuing
operations                                  271,800              2,479,151       (2,207,351 )        (89.04%)
Discontinued operations:
Gain from operations of
discontinued component, net of
taxes                                        43,836                      -           43,836            n/a
Net income                         $        315,636       $      2,479,151     $ (2,163,515 )        (87.27%)

The tables below illustrate the sales of breeder hogs, market hogs, and processed pork products for the quarters ended June 30, 2012 and 2011.


Sales by Products

                                                        Three Months Ended June 30,
                                       2012                                                     2011
               No. of Hogs                                              No. of Hogs
                   Sold          Average Price/Hog         Sales            Sold          Average Price/Hog         Sales
Breeder Hogs          6,883     $               307     $ 2,109,855            9,012     $               314     $ 2,833,352
Market Hogs          21,151     $               202       4,281,488           18,577     $               260       4,837,077
Total                28,034     $               228     $ 6,391,343           27,589     $               278     $ 7,670,429

Revenues. Our revenues decreased by $1,279,086 or approximately 17% for the three months ended June 30, 2012 as compared to the three months ended June 30, 2011. This decrease was mainly caused by the decrease in selling prices for breeder hogs and market hogs. The reduction in sales included an 11% decrease in sales of our market hogs and a 26% decrease in sales of our breeder hogs. We sold approximately 14% more market hogs in the second quarter of 2012 than in the same period of 2011, at an average price per hog that was 22% less than that in the comparable 2011 period. As a result, sales revenue attributable to market hogs decreased by approximately 11%. During the first half of 2012, market demand for breeder hogs was soft as farmers elected not to maintain their capacity as a result of rising feed prices. We sold approximately 24% fewer breeder hogs in the second quarter of 2012 than we sold in the same period of 2011, at an average price per hog 2% less than in the comparable 2011 period. As a result, sales revenue attributable to breeder hogs slipped by approximately 26%.


Our revenues from sales of market hogs declined because of reduced selling prices which resulted from a glut of pork in the market in the first half of 2012, exacerbated by the decision of the Chinese government to allow increased imports into the market during this period. Pork prices in China reached record high levels last winter which caused hog farmers to increase their hog headcount, eventually leading to an increase in the number of hog for sale. Additionally, because of the importance of pork in the diet of Chinese citizens, China's government allowed increased levels of imported pork to enter the market to release the price pressure on the price of pork. The oversupply of pork also resulted from rising feed prices, which caused farmers to send hogs to market that otherwise might have been kept as breeders. Our sales of breeder hogs decreased because while prices for hogs decreased, feeding costs increased . . .