U.S.
SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549





Form
10-K




x
            ANNUAL REPORT UNDER SECTION 13
      OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF
  1934





For the
fiscal year ended December 31, 2008




o
            TRANSITION REPORT UNDER SECTION
      13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF
  1934





For the
transition period from ______________ to ________________





Commission
File Number:001-32473




American
Dairy, Inc.


(Exact
name of registrant as specified in its charter)




Utah
            90-0208758(State
      or other jurisdiction of Incorporation
      or organization)
            (I.R.S.
      EmployerIdentification
      No.)




Star City
International Building, 10 Jiuqianxiao Road, C-16th Floor


Chaoyang
District, Beijing, China 100016


(Address
of principal executive offices)





Registrant’s
telephone number, including area code:1(626) 757-8885





Securities
registered under Section 12(b) of the Exchange Act:





Title
      of each class
              Name
      of each exchange on which registeredCommon
      Stock
              NYSE
      Arca





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  o Yes  x No





Indicate
by check mark if the registrant is not required to file reports pursuant to
Section 13 or Section 15(d) of the Act.  o Yes   x No





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed pursuant to Section 13 or Section 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.    x Yes   oNo





Indicate
by check mark if disclosure of delinquent filers pursuant to Item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K.  o





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, or a non-accelerated filer. See definition of“accelerated filer and
large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check
one):




Large
      accelerated filer   o
            Accelerated
      filer o
            Non-accelerated
      filer o
            Smaller Reporting Company x





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).  o Yes  x No





The
aggregate market value of the voting and non-voting common equity held by
non-affiliatesof the
registrant as of the last businessday of the registrant’s
most recently completed second fiscal quarter, based upon the closing sale price
of the registrant’s common stock on June 30, 2008 as reported on the
NYSE Arca, was $39,211,000.





As of
March31, 2009,17,253,907sharesof the registrant’s common
stock were outstanding.





DOCUMENTS
INCORPORATED BY REFERENCE





None







TABLE
OF CONTENTS




PART
      IItem
      1.
                    Business
                    1Item
      1A.
                    Risk
      Factors
                    11Item
      1B.
                    Unresolved
      Staff Comments
                    23Item
      2.
                    Properties
                    23Item
      3.
                    Legal
      Proceedings
                    23Item
      4.
                    Submission
      of Matters to a Vote of Security
      Holders
                    23PART
      IIItem
      5.
                    Market
      for the Registrant’s Common Stock, Related Stockholder
      Mattersand
      Issuer Repurchases of Equity
      Securities
                    24Item
      6.
                    Selected
      Financial Data
                    26Item
      7.
                    Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                    27Item
      7A.
                    Quantitative
      and Qualitative Disclosures About Market
      Risk
                    40Item
      8.
                    Financial
      Statements and Supplementary
    Data
                    40Item
      9.
                    Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
                    41Item
      9A.
                    Controls
      and Procedures
                    41Item
      9B
                    Other
      Information
                    43PART
      IIIItem
      10.
                    Directors,
      Executive Officers and Corporate
      Governance
                    44Item
      11.
                    Executive
      Compensation
                    46Item
      12.
                    Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
                    52Item
      13.
                    Certain
      Relationships and Related Transactions, and Director
      Independence
                    53Item
      14.
                    Principal
      Accountant Fees and Services
                    54PART
      IVItem
      15.
                    Exhibits
      and Financial Statement
    Schedules
                    55





In
this Annual Report on Form 10-K, references to “dollars” and “$” are to United
States dollars and, unless the context otherwise requires, references to “we,”
“us” and “our” refer to American Dairy, Inc. and its consolidated
subsidiaries.




ii




PART
I


Item
1. Business





Overview





We are a
leading producer and distributor of milk powder, soybean milk powder, and
related dairy products in the People’s Republic of China, or the
PRC.  Using proprietary processing techniques, we make products that
are specially formulated for particular ages, dietary needs and health
concerns.  We have over 200 company-owned milk collection stations,
six production facilities with an aggregate milk powder production capacity of
approximately 1,220 tons per day and an extensive distribution network that
reaches over 50,000 retail outlets throughout China.





Corporate
History and Structure





We were
incorporated in the State of Utah on December 31, 1985, originally under the
corporate name of Gaslight, Inc. We were inactive until March 30, 1988, when we
changed our corporate name to Lazarus Industries, Inc. and engaged in the
business of manufacturing and marketing medical devices.  We
discontinued this business in 1991 and became a non-operating public company
shell.  Effective May 7, 2003, we acquired 100% of the issued and
outstanding capital stock of American Flying Crane Corporation, or AFC, a
Delaware corporation that operates a dairy business in China through various
subsidiaries.  In connection with that acquisition, we changed our
name to American Dairy, Inc.


1




Today, we
own various subsidiaries in the PRC that operate our business,
including:





·
            Heilongjiang
      Feihe Dairy Co., Limited, or Feihe Dairy, which produces, packages and
      distributes milk powder and other dairy
  products;





·
            Gannan
      Flying Crane Dairy Products Co., Limited, or Gannan Feihe, which produces
      milk products;





·
            Langfang
      Flying Crane Dairy Products Co., Limited, or Langfang Feihe, which
      packages and distributes finished
products;





·
            Shanxi
      Feihesantai Biotechnology Scientific and Commercial Co., Limited, or
      Shanxi Feihe, which produces walnut and soybean
  products;





·
            Baiquan
      Feihe Dairy Co., Limited, or Baiquan Dairy, which produces milk
      products;





·
            Heilongjiang
      Feihe Kedong Feedlots Co., Limited, or Kedong Farms, which operates dairy
      farms the construction of which is partially complete;
  and





·
            Heilongjiang
      Feihe Gannan Feedlots Co., Limited, or Gannan Farms, which operates dairy
      farms the construction of which is partially
  complete.


2





The
following chart reflects the current corporate structure of the American Dairy
entities:








*  Indicates
a nominee shareholder who, pursuant to a former requirement under the PRC
Company Law that certain PRC companies have at least two shareholders, holds its
equity interest for the benefit of the majority shareholder.




3




Principal
Products





Our
products fall into four main product categories: milk powder, soybean
powder, rice cereal and walnut products.





Milk
Powder


Milk
powder is our primary product and is divided into several
sub-categories.  We produce milk powder for infants and young children
formulated for zero to six months, six months to one year, one to three years
and three to six years of age.  We also produce milk powder for
expectant mothers, students and for the middle-aged and elderly
populations.  In addition, we purchase semi-finished milk powder, or
raw milk powder, from third parties, process it, and then distribute it to
beverage manufacturers and other wholesalers for use in their blended drink
products.





Soybean
Powder


Soybean
powder is an auxiliary product to our milk powders and represents a low fat,
high calcium alternative to milk powder, particularly for seniors.





Rice
Cereal


Rice
cereal is an auxiliary product to our milk powders and represents a low fat,
high calcium alternative to milk powder, particularly for young children,
teenagers, and seniors.  We purchase semi-finished rice cereal from
third parties, process it, and then distribute it to wholesalers and
retailers.





Walnut
and Other Products


We
produce other auxiliary products that we market in conjunction with our infant
milk powder, as well as to health-conscious adults.  Walnut products
include walnut powder and walnut oil.  Other products include cream,
skim milk powder, full milk powder, butter, and other related milk powder
products.





Product
Sales





The
following table reflects the sales of our principal products during the fiscal
years ended December 31, 2008 and 2007:





2008
                
                2007
                
                2008
      over 2007Product name
                
                Quantity
                  (Kg’000)
                
                Amount
                  ($’000)
                
                % of
                  Sales
                
                Quantity
                  (Kg’000)
                
                Amount
                  ($’000)
                
                % of
                  Sales
                
                Quantity
                  (Kg’000)
                
                Amount
                  ($’000)
                
                % of SalesMilk
      powder
                
                
                16,311
                
                
                
                121,255
                
                
                
                62.8
                
                
                
                17,100
                
                
                
                118,349
                
                
                
                72.2
                
                
                
                (789)
                
                
                
                2,906
                
                
                
                2.5Raw
      milk powder
                
                
                16,572
                
                
                
                60,753
                
                
                
                31.4
                
                
                
                12,899
                
                
                
                35,566
                
                
                
                21.7
                
                
                
                3,673
                
                
                
                25,187
                
                
                
                70.8Soybean
      powder
                
                
                2,153
                
                
                
                4,400
                
                
                
                2.3
                
                
                
                1,785
                
                
                
                3,253
                
                
                
                2.0
                
                
                
                368
                
                
                
                1,147
                
                
                
                35.3Rice
      cereal
                
                
                816
                
                
                
                4,631
                
                
                
                2.4
                
                
                
                1,292
                
                
                
                5,332
                
                
                
                3.3
                
                
                
                (476)
                
                
                
                (701)
                
                
                
                (13.1)Walnut
      products
                
                
                327
                
                
                
                1,663
                
                
                
                0.9
                
                
                
                241
                
                
                
                1,212
                
                
                
                0.7
                
                
                
                86
                
                
                
                451
                
                
                
                37.2Other
                
                
                727
                
                
                
                490
                
                
                
                0.2
                
                
                
                97
                
                
                
                187
                
                
                
                0.1
                
                
                
                630
                
                
                
                303
                
                
                
                162.0Total
                
                
                36,906
                
                
                
                193,192
                
                
                
                100
                
                
                
                33,414
                
                
                
                163,899
                
                
                
                100
                
                
                
                3,492
                
                
                
                27,224
                
                
                
                16.6





Sources
of Milk





We have
entered into supply contracts with numerous small dairy farmers that have
provided us access to over 200,000 cows that provide milk to our over 200
company-owned milk collection stations.  On average, each cow provides
four tons of milk per year, which farmers deliver to our milk collection
stations.  In addition, we commenced construction in 2007 of two
company-owned dairy farms, Gannan Farms and Kedong Farms, which we expect to be
complete in the fourth quarter of 2009.  When construction is
complete, each of these dairy farms will have the capacity to house
10,000-12,000 dairy cows.  Gannan Farms and Kedong Farms currently
house a total of approximately 8,000 Australian Holstein cows, each of which, on
average, provides us with 8-10 tons of milk per year.  We expect
that each of our dairy farms will have annual capacity to source up to 70,000
tons of fresh milk per year.




4





Raw
Milk Processing





We
believe that, through purchasing raw milk locally and employing minimal
processing techniques, we are able to preserve the fresh taste of
milk.  The industry standard for the time it takes for raw milk to be
converted to milk powder is approximately 48 hours.  Most large
regional dairies, we believe, process raw milk that may be three to four days
old.  Milk processed by conventional farms for sale to regional
dairies is typically stored at the farm for a minimum of two days, commonly
spends a full day in transit to the dairy facility, and is only processed the
following day.





However,
our standard is to process the raw milk within 6-24 hours after milking,
depending upon the time of day the raw milk is delivered to
us.  Within this time, the milk is chilled, transported, separated,
sterilized and spray-dried.  The raw milk is first received from milk
collection centers.  Fully enclosed, stainless-steel vacuum milking
machines are used to receive the raw milk.  Once received, the raw
milk will no longer have any contact with air and is immediately processed with
refrigeration equipment that cools the raw milk within four seconds to
approximately four degrees Celsius.  The raw milk is then stored in
air-tight tanks in preparation for advanced processes, which include milk fat
separation, sterilization and spray-drying.





Our milk
is not homogenized.  During homogenization, pressurized milk is forced
through openings smaller than the size of the fat globules present in milk,
breaking them into smaller particles.  Thus treated, the milk fat
remains suspended and does not separate out in the form of cream.  We
believe that this process adversely affects the taste and feel of
milk.  In addition, our milk is pasteurized at the lowest temperatures
allowed by law to avoid imparting a cooked flavor to the milk.  When
the milk is clarified and the butterfat removed to yield cream and skim milk, a
process of cold separation is used, rather than the more commonly employed hot
separation, which we believe adversely affects the flavor of the
milk.





Dairy
Product Processing





Our
products are made in small batches using minimal processing techniques to
maintain freshness and allow maximum flavor and nutrition retention.  They
are made with wholesome ingredients.  No chemicals or additives are
employed.  Because they are produced locally, our dairy products
arrive to consumers in our marketing area sooner after production than most
other dairy products.  To assure product quality, the beginning of
each production run is sampled for flavor, aroma, texture and appearance. 
In addition, inspectors conduct spot-checks for bacteria and butterfat content
in our products, as well as sanitary conditions in our facilities.





Quality
Assurance





We are
committed to delivering high-quality dairy products.  We apply a
25-step quality control process that involves over a hundred points of testing
from the feed for the dairy cows, throughout our manufacturing process, and
extending to semi-finished products, which we purchase from third parties for
further processing, and finished products.





The
production facilities we have constructed comply with pharmaceutical good
manufacturing practice, or GMP, standards, a higher level of quality control
than required for consumer goods manufacturing facilities.  Since
2000, our production facilities have obtained ISO 9002 and HACCP quality
assurance certifications, as well as quality certifications from the PRC
regulatory authorities.  Our processing equipment is manufactured by
well-known European manufacturing companies.  We use whole-sealing and
mechanized vacuum milk-pressing devices with freezing equipment for each milk
station, which allows us to reduce the temperature of raw milk to four degrees
Celsius within seconds for storage.  Our equipment also eliminates
external air contact from the time milk is collected through the time that it is
fully processed.  We employ automated processes and scientific
parameters throughout the manufacturing process that are designed to ensure that
all products meet our quality requirements.  We have in-house
laboratories that utilize proprietary in-line sampling techniques to ensure the
quality and safety of the entire production process, from raw materials to
semi-finished products to finished products.  We believe that our
rigorous testing and inspection procedures have been critical in ensuring that
our products are free from melamine and other contaminants, are premium quality
products and are safe and healthy for customers.




5





Production
and Packaging Facilities





We own
and operate six production and packaging facilities.  The production
facilities we have constructed comply with pharmaceutical GMP standards, a
higher level of quality control than required for consumer goods manufacturing
facilities.  Since 2000, our production facilities have obtained ISO
9002 and HACCP quality assurance certifications, as well as quality
certifications from the PRC regulatory authorities.  We believe that
our design standards help us assure our product quality.  We believe
that we are one of the few PRC milk producers that has processing areas that
meet a 300,000 cleanliness purification standard, which means that there are
less than 300,000 dust particles per cubic centimeter of air.  In a
standard room, dust particles can reach over two million dust particles per
cubic centimeter of air.  Continuing our commitment to quality, we
have also added testing equipment and other quality control procedures to our
processing equipment manufactured by known European and American manufacturing
companies.





Feihe
Dairy


Located
in Heilongjiang Province, China, in Kedong, the Feihe Dairy premises
comprise approximately 88,221 square meters.  The plant is
approximately 8 years old, although it was completely remodeled in
2005.  Feihe Dairy principally produces infant milk formula and has a
production capacity of 550 tons per day of milk powder.  In addition,
Feihe Dairy serves as a packaging facility and packages approximately 22,000
tons of products per year.





Gannan
Feihe


Located
in Heilongjiang Province, China, the Gannan Feihe premises comprise
approximately 300,000 square meters.  The plant is approximately 3
years old and commenced milk powder production in 2008.  Gannan Feihe
principally produces infant milk formula and has a production capacity of
approximately 300 tons per day of milk powder.





Langfang
Feihe


Located
in Hebei Province, China, the Langfang Feihe premises comprise approximately
80,243 square meters.  The plant is approximately 3 years old and
commenced operations in 2007.  Langfang Feihe primarily serves as a
packaging and distribution facility and packages approximately 50,000 tons of
products per year.





Shanxi
Feihe


Located
in Shanxi Province, China, the Shanxi Feihe premises comprise approximately
40,000 square meters.  The plant is approximately 5 years
old.  Shanxi Feihe principally produces soybean powder, walnut powder
and walnut oil and has a production capacity of approximately 5,000 tons per
year of soybean powder and walnut powder combined, and 1,000 tons per year of
walnut oil.





Baiquan
Dairy


Located
in Heilongjiang Province, China, the Baiquan Dairy premises comprise
approximately 36,000 square meters.  The plant is approximately 17
years old, although it was completely remodeled in 2004.  Baiquan
Dairy principally produces infant milk formula and has a production capacity of
approximately 100 tons per day of milk powder.


6





Qiqihaer
Feihe


Feihe
Dairy operates a production facility we refer to as Qiqihaer Feihe, which we
acquired in 2006.  Located in Heilongjiang Province, China, the
Qiqihaer Feihe premises comprise approximately 90,000 square
meters.  The plant is approximately four years
old.  Qiqihaer Feihe principally produces infant milk formula and
adult milk formula and has a production capacity of approximately 270 tons per
day of milk powder.  Qiqihaer Feihe also produces butter and has a
production capacity of approximately 15 tons per day.





The table
below summarizes key information regarding our production and packaging
plants.




Facility
                  
                  Province/
                    Region
                  
                  Products
                  
                  Production
                    Capacity
                  
                  Packaging Capacity
                    (tons/year)Feihe Dairy
                  
                  Heilongjiang
                  
                  Infant milk formula
                  
                  550 (tons/day)
                  
                  
                  22,000Gannan Feihe
                  
                  Heilongjiang
                  
                  Infant milk formula
                  
                  300 (tons/day)
                  
                  
                  N/ALangfang Feihe
                  
                  Hebei
                  
                  N/A
                  
                  N/A
                  
                  
                  50,000Shanxi Feihe
                  
                  Shanxi
                  
                  Walnut powder;
                    Walnut oil;
                    Soybean powder
                  
                  5,000 (tons/year)
                    1,000 (tons/year)
                  
                  
                  N/ABaiquan Dairy
                  
                  Heilongjiang
                  
                  Infant milk formula
                  
                  100 (tons/day)
                  
                  
                  N/AQiqihaer Feihe
                  
                  Heilongjiang
                  
                  Infant milk formula and adult milk powder;
                    Butter
                  
                  270 (tons/day)
                    15 (tons/day)
                  
                  
                  N/A





Sources
of Walnut and Soybeans





We order
walnuts and soybeans from local farmers for delivery to the Feihe
Dairy.  We then distribute these raw materials to our facilities as
necessary.





Product
Distribution





Currently,
our products are sold in stores nationwide throughout China, except in Hong Kong
SAR, Macau SAR and Taiwan.  Prior to distribution, we route our
products to our Feihe Dairy and Langfang Feihe for final
packaging.  Feihe Dairy then distributes our finished products
primarily in northeastern China, including Heilongjiang, Jilin and Liaoning
Provinces, and Langfang Feihe distributes our finished products throughout the
rest of China.  We have a distribution team working out of our
headquarters and coordinating a network of over 450 dealers or representatives
in key provinces across China.  The dealers, in turn, each typically
hire one or two secondary agents who assist in the distribution process,
including inventory management, product sales and service and
payments.  Dealer agents display and sell our products in specially
designated areas in stores.  In addition, in 2008 we began
distributing our raw milk powder to beverage manufacturers and other wholesalers
for use in their blended drink products.





Generally,
we deliver our products only after receipt of payment from the
dealer.  We typically enter into new agreements with our dealers each
year that specify sales targets and territories, among other
provisions.  We seek to expand the number of key provinces served by
our dealer network as part of our growth strategy and ultimately to establish a
distribution system based upon local production at local dairies.  We
currently distribute our products to 26 provinces in China and to over 50,000
retail outlets.





Customers





No single
customer equaled or exceeded 10% of our sales during the years ended December
31, 2008 or 2007.




7





Intellectual
Property





We rely
principally on trade secrets and confidentiality agreements to protect our
proprietary product formulations and production processes.  We have
obtained trademark registrations for the use of our trade name “Feihe” as well
as our “Fei Fan” and “Fei Rui” brands, which have been registered with the PRC
Trademark Bureau of the State Administration for Industry and Commerce with
respect to our milk products.  We believe our trademarks are important
to the establishment of consumer recognition of our
products.  However, due to uncertainties in PRC trademark law, the
protection afforded by our trademarks may be less than we currently expect and
may, in fact, be insufficient.  Moreover, even if it is sufficient, in
the event any of our trademarks are challenged or infringed, we may not have the
financial resources to defend it against any challenge or infringement and such
defense could in any event be unsuccessful.  Moreover, any events or
conditions that negatively impact our trademark could have a material adverse
effect on our business, operations and finances.





Research
and Development





As of
March 31, 2009, we have six technicians engaged in research and development
activities.  These technicians monitor quality control at our
production facilities to ensure that the processing, packaging and distribution
of our milk products result in high quality premium milk products that are safe
and healthy for customers.  These technicians also pursue methods and
techniques to improve the taste and quality of our milk products and to evaluate
new milk products for further production based upon changes in consumer tastes,
trends and the introduction of competitive products by other milk
producers.





During
the fiscal years ended December 31, 2007 and 2008, we spent approximately
$117,000 and $137,000, respectively, per year on research and development,
representing amounts paid in compensation to our six quality control technicians
described above.





Growth
Strategy





We
believe the market for dairy products in China is growing rapidly, including the
market for high quality dairy products.  Our growth strategy involves
increasing market share during this rapid growth phase.  To implement
this strategy, we plan to:




·
            Expand
      production capabilities by investing in world-class production
      processes.  We believe we can significantly increase our
      production of high quality dairy products by continuing to enter exclusive
      contracts with dairy farmers who can deliver quality milk, constructing
      company-owned large-scale dairy farms, expanding our company-owned
      collection stations and production facilities, and employing comprehensive
      testing and quality control
measures.




·
            Enhance
      distribution capabilities in first-tier PRC markets.  We
      plan to expand our distribution network in first-tier markets in the PRC,
      including Beijing, Shanghai, Guangzhou, Shenzhen and other major cities in
      the Pearl River Delta.  In addition, we plan to further increase our
      sales points across China, focusing on southern and western China. 
      Our currently extensive distribution network, which reaches many
      provincial capital and sub-provincial cities, has special channels into
      first-tier markets that we plan to expand.  We believe that
      positioning our brand as a high-quality line of products in these markets
      will facilitate our expansion.




·
            Strengthen
      our premium quality brand awareness. We
      believe that our products enjoy a reputation for high quality among those
      familiar with them, and our products routinely pass government and
      internal quality inspections.  We intend to increase our advertising
      expenses and continue advertising on China Central Television, or CCTV, as
      well as provincial stations in China, in order to market our products as
      premium and super-premium products.  We also intend to adopt a
      corresponding pricing model.  We believe many consumers in China tend
      to regard higher prices as indicative of higher quality and higher
      nutritional value, and as a result consumers with higher disposable
      incomes are increasingly inclined to purchase higher priced products,
      particularly in the areas of infant formula and nutritional
      products.




·
            Align
      sourcing, production and distribution by region.  We believe
      that we can increase our efficiency and decrease our costs if our products
      are produced from local sources and sold in local markets.  We plan
      to select strategic locations for our company-owned collection stations
      and production facilities that will enhance this
    efficiency.




8





Competition





The dairy
industry in China is highly competitive.  We face significant
competition from large multinational producers, such as Dumex, Mead Johnson, and
Wyeth, and large national milk companies, such as Synutra, Yashili and Yili,
particularly in more affluent major urban areas.  Many of our
competitors have greater resources and sell more products than we
do.  We believe that our competitive position has improved following
the melamine crisis in 2008, which did not involve any of our
products.  Our products are positioned as premium products and,
accordingly, are generally priced higher than many similar competitive
products.  We believe that the principal competitive factors in
marketing our products are quality, taste, freshness, price and product
recognition.  While we believe that we compete favorably in terms of
quality, taste and freshness, our products are more expensive and less well
known than certain other established brands.  Our premium products may
also be considered in competition with non-premium quality dairy products for
discretionary food dollars.





Government
Regulation





We are
regulated under national, provincial and local laws in China.  The
following information summarizes aspects of those regulations that apply to us
and is qualified in its entirety by reference to all particular statutory or
regulatory provisions.  Regulations at the national, provincial and
local levels in China are subject to change.  To date, compliance with
governmental regulations has not had a material impact on our level of capital
expenditures, earnings or competitive position, but, because of the evolving
nature of such regulations, we are unable to predict the impact such regulations
may have in the foreseeable future.





As a
producer and distributor of nutritional products, and particularly dairy-based
food products in China, we are subject to the regulations of China’s
Agricultural Ministry.  This regulatory scheme governs the manufacture
(including composition and ingredients), labeling, packaging and safety of
food.  Specific PRC laws and regulations we face include:


·
              the
      PRC Product Quality Law;
  ·
              the
      PRC Food Hygiene Law;
  ·
              the
      Access Conditions for Dairy Products Processing
  Industry;
  ·
              the
      Implementation Rules on the Administration and Supervision of Quality and
      Safety in Food Producing and Processing
  enterprises;
  ·
              the
      Regulation on the Administration of Production Licenses for Industrial
      Products;
  ·
              the
      General Measure on Food Quality Safety Market Access
      Examination;
  ·
              the
      General Standards for the Labeling of Prepackaged
  foods;
  ·
              the
      Implementation Measures on Examination of Dairy Product Production
      Permits;
  ·
              the
      Standardization Law;
  ·
              the
      Raw Milk Collection Standard;
  ·
              the
      Whole Milk Powder, Skimmed Milk Powder, Sweetened Whole Milk Powder and
      Flavored Milk Powder Standards; and
  ·
              the
      General Technical Requirements for Infant Formula Powder and Supplementary
      Cereal for Infants and
Children.


9


We and
our products are also subject to provincial and local regulations through such
measures as the licensing of dairy manufacturing facilities, enforcement of
standards for our products, inspection of our facilities and regulation of our
trade practices in connection with the sale of dairy products.





In March
2008, the PRC National Development and Reform Commission, or the NDRC,
promulgated the Access Conditions for Dairy Products Processing Industry, or the
Access Conditions.  The Access Conditions set forth the conditions an
entity must satisfy in order to engage, or continue to engage, in the dairy
products processing business in China, including technique and equipment,
product quality, energy and water consumption, sanitation and environmental
protection, as well as production safety.  Any new or continuing dairy
products processing projects or enterprises will be required to meet all the
conditions and requirements set forth in the Access Conditions.  For
projects or enterprises that already commenced operations before the
promulgation of the Access Conditions, improvements or rectification actions may
need to be taken in order to have such projects or enterprises meet the
conditions within two years of the effective date of the Access Conditions on
April 1, 2010.





The
Access Conditions also set forth requirements relating to the location,
processing capacity and raw milk source for any new or continuing dairy products
processing project or enterprise.  Any new or continuing dairy
processing projects or enterprises that fail to meet the requirements will not
be able to procure land, license, permits, loan facilities and electricity
necessary for the processing of dairy products, and those projects or
enterprises already in operation before the promulgation of the Access
Conditions will be deregistered and ordered to shut down if they fail to meet
the conditions within a two-year rectification period.





In May
2008, the NDRC issued the Dairy Industry Policies, or the
Policies.  According to the PRC government, the Policies are the first
set of comprehensive government policies on the dairy industry in China,
covering a broad range of matters such as industry planning, closure of
inefficient capacity, milk supply, quality control and product safety,
environmental protection and promotion of milk consumption.  Moreover,
the Policies provide conditions that new entrants to the dairy industry must
meet in addition to the conditions set forth in the Access
Conditions.





As a
result of the melamine crisis, PRC governmental authorities have conducted
several dairy industry inspections.  In addition to the initial 22
companies implicated in the melamine crisis, these subsequent government
inspections have identified other companies with unacceptable contaminants in
dairy products.  The melamine crisis did not involve any of our
products, and we have passed all of these government inspections.  In
addition, we are working with the PRC government and attended several emergency
meetings to discuss ways to improve the dairy and overall food industry in
China.





Environmental
Matters





Our
manufacturing facilities are subject to various pollution control regulations
with respect to noise, water and air pollution and the disposal of waste and
hazardous materials.  We are also subject to periodic inspections by
local environmental protection authorities.  Our operating
subsidiaries have received certifications from the relevant PRC government
agencies in charge of environmental protection indicating that their business
operations are in material compliance with the relevant PRC environmental laws
and regulations.  We are not currently subject to any pending actions
alleging any violations of applicable PRC environmental laws.





Employees





As of
March 31, 2009, we had approximately 2,847 employees on our
payroll.  We had nine group administrators, approximately 992
employees were in marketing and sales, approximately 36 employees provided
marketing support, approximately 175 people were working in our Nutrition
Department as consultants and managers, approximately 139 employees were
performing administrative functions, including financing, auditing and human
resources, and approximately 1,496 employees were in production, storage and
distribution.  Our employees are not represented by a labor union or
covered by a collective bargaining agreement.  We have not experienced
any work stoppages.  We believe that our relations with our employees
are good.




10




Financial
Information about Segments and Geographic Areas





Although
we have historically operated and managed our business as a single
reportable segment, in 2008, with the initial operations of our dairy farms, we
have two reportable segments:  dairy products and dairy
farm. Our dairy
products segment produces and sells dairy products, such as wholesale and retail
milk powders, as well as soybean powder, rice cereal, walnut powder and walnut
oil.  Our dairy farm segment operates our two company-owned dairy
farms, Gannon Farms and Kedong Farms, construction of which we commenced in 2007
and expect to be complete in the fourth quarter of 2009.  Our dairy
farms provide milk to us and not to external customers.Please see Note
29 to our audited financial statements included elsewhere in this report for
further discussion about segments. As we primarily generate our revenues
from customers in the PRC, we do not present geographical segments.





Available
Information





Our
website is www.americandairyinc.com.  We
provide free access to various reports that we file with, or furnish to, the
U.S. Securities and Exchange Commission, or the SEC, through our website, as
soon as reasonably practicable after they have been filed or
furnished.  These reports include, but are not limited to, our annual
reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form
8-K, and any amendments to those reports.  Also available on our
website are printable versions of our Code of Business Conduct and Ethics and
charters of our Audit Committee, Compensation Committee, Nominating/Corporate
Governance Committee and other committees of our board of
directors.  Information on our website does not constitute part of and
is not incorporated by reference into this Annual Report on Form 10-K or any
other report we file or furnish with the SEC.  Our SEC reports can
also be accessed through the SEC’s website at www.sec.gov and may
be read or copied at the SEC’s Public Reference Room located at 100 F Street,
NE, Washington, D.C., 20549.  Information regarding the Public
Reference Room may be obtained by calling the SEC at
1-800-SEC-0330.





Item
1A. Risk Factors





Any
negative public perception regarding our products or industry, or any ill
effects or product liability claims, could harm our reputation, damage our
brand, result in costly and damaging recalls, and expose us to government
investigations and sanctions, which would materially and adversely affect our
results of operations.





We sell
products for human consumption, which involves risks such as product
contamination, spoilage and tampering. In 2008, sales in China of substandard
milk formula contaminated with a substance known as melamine caused the death of
six infants as well as illness of nearly 300,000 others.  Although
this incident did not involve any of our products, China’s Administration of
Quality Supervision, Inspection and Quarantine found that the products of 22
Chinese milk and formula producers were contaminated by melamine, a substance
not approved for use in food, which caused significant negative publicity for
the entire dairy industry in China.  The mere publication of
information asserting that our milk powder, infant formula or other products
contain melamine or other contaminants could have a material adverse effect on
us, regardless of whether these reports are scientifically supported or concern
our products or the raw materials used in our products.  In addition,
if the consumption of any of our products causes injury, illness or death, we
may face product liability claims, product recalls, temporary or permanent
suspensions of operations, government investigations or sanctions, any of which
could be extremely expensive and damaging to our business.





Prior to
the 2008 melamine crisis, there have also been widely publicized occurrences of
counterfeit, substandard milk products in China.  For example, in
April 2004, such sales of counterfeit and substandard infant formula in Anhui
Province, China caused the deaths of 13 infants and harmed many
others.  Counterfeiting or imitation of our products may occur in the
future, and we may not be able to detect it and deal with it effectively. Any
occurrence of counterfeiting or imitation could negatively impact our corporate
brand and image or consumers’ perception of our products or similar nutritional
products generally, particularly if the counterfeit or imitation products cause
injury or death to consumers.


11





We
expect to incur costs related to our planned acquisitions and expansion into new
plants and ventures, which may not prove to be profitable. Moreover, any delays
in our expansion plans could cause our profits to decline and jeopardize our
business.





We
anticipate that our proposed expansion of our milk production facilities may
include the acquisition and construction of new or additional facilities. Our
cost estimates and projected completion dates for construction of new production
facilities may change significantly as the projects progress. In addition, our
projects will entail significant construction risks, including shortages of
materials or skilled labor, unforeseen environmental or engineering problems,
weather interferences and unanticipated cost increases, any of which could have
a material adverse effect on the projects and could delay their scheduled
openings. A delay in scheduled openings of production facilities will delay our
receipt of sales revenues from such facilities, which, when coupled with the
increased costs and expenses of our expansion, could cause a decline in our
profits.





Our plans
to finance, develop, and expand our production facilities will be subject to the
many risks inherent in the rapid expansion of a high growth business enterprise,
including unanticipated design, construction, regulatory and operating problems,
and the significant risks commonly associated with implementing a marketing
strategy in changing and expanding markets. These projects may not become
operational within their estimated time frames and budgets as projected at the
time we enter into a particular agreement, or at all. In addition, we may
develop projects as joint ventures in an effort to reduce our financial
commitment to individual projects. The significant expenditures required to
expand our production plants may not ultimately result in increased
profits.





When our
future expansion projects become operational, we will be required to add and
train personnel, expand our management information systems and control expenses.
If we do not successfully address our increased management needs or are
otherwise unable to manage our growth effectively, our operating results could
be materially and adversely affected.





As we increase the
scale of our operations, we may be unable to maintain the level of quality we
currently attain by producing our products in small batches.





Our
products are manufactured in small batches with milk from the farms of local
farmers. We may be unable to maintain the quality of our dairy products at
increased levels of production. Increased production levels may cause us to
modify our current manufacturing methods and will necessitate the use of milk
from other additional sources. A decline in the quality of our products could
damage our business, operations and finances.





Our
products may not achieve market acceptance.





We are
currently selling our products principally in northern, central, and eastern
China.  Achieving market acceptance for our products, particularly in
new markets, will require substantial marketing efforts and the expenditure of
significant funds.  There is substantial risk that any new markets may
not accept or be as receptive to our products.  In addition, we intend
to market our products as premium and super-premium products and to adopt a
corresponding pricing model, which may not be accepted in new or existing
markets.  Market acceptance of our current and proposed products will
depend, in large part, upon our ability to inform potential customers that the
distinctive characteristics of our products make them superior to competitive
products and justify their pricing.  Our current and proposed products
may not be accepted by consumers or able to compete effectively against other
premium or non-premium dairy products. Lack of market acceptance would limit our
revenues and profitability.





Our
planned growth may require more raw milk than is available and could diminish
the quality of our dairy products.





Our
business requires a supply of raw milk. Our growth will be limited if the supply
of raw milk is insufficient to meet demand. Moreover, as we attempt to implement
our growth strategy, it may become difficult to maintain current levels of
quality control. Inadequate quality control could harm our reputation and the
demand for our products, which would also limit our growth. The raw milk used in
our products is supplied to us by numerous local farms under output contracts.
We believe that our farmers can increase their production of raw milk. We
further believe, however, that this supply may not be sufficient to meet
increased demand for our products associated with our proposed marketing efforts
and that such increase may compromise quality. Though we believe that additional
raw milk is available locally, if needed, we may not be able to enter into
arrangements with the producers of such milk on terms acceptable to us, if at
all. An inadequate supply of raw milk, coupled with concern over quality
control, could increase costs for raw milk or decrease the sales price for our
products, which could limit our ability to grow, cause our earnings to decline
and make our business less profitable.




12




The
recent global economic and financial market crisis could significantly impact
our financial condition.





Current
global economic conditions could have a negative effect on our business and
results of operations. Economic activity in China, United States and throughout
much of the world has undergone a sudden, sharp economic downturn following the
recent housing downturn and subprime lending collapse in both the United States
and Europe.  Market disruptions have included extreme volatility in
securities prices, as well as severely diminished liquidity and credit
availability.  The economic crisis may adversely affect us in a
variety of ways. Access to lines of credit or the capital markets may be
severely restricted, which may preclude us from raising funds required for
operations and to fund continued expansion.  It may be more difficult
for us to complete strategic transactions with third parties. The financial and
credit market turmoil could also negatively impact our suppliers and customers,
which could decrease our ability to source, produce and distribute our products
and could decrease demand for our products. While it is not possible to predict
with certainty the duration or severity of the current disruption in financial
and credit markets, if economic conditions continue to worsen, it is possible
these factors could significantly impact our financial condition.





Our
results of operations may be affected by fluctuations in availability and price
of raw materials.





The raw
materials we use are subject to price fluctuations due to various factors beyond
our control, including, among other pertinent factors:




·
            increasing
      market demand;




·
            inflation;




·
            severe
      climatic and environmental
conditions;





·
            seasonal
      factors, with dairy cows generally producing more milk in temperate
      weather as opposed to cold or hot weather and extended unseasonably cold
      or hot weather potentially leading to lower than expected
      production;





·
            commodity
      price fluctuations;





·
            currency
      fluctuations; and




·
            changes
      in governmental and agricultural regulations and
  programs.





For
example, our raw milk cost increased by approximately 45% in 2008 due to various
factors, including, we believe, general economic conditions, such as inflation
and fuel prices, and rising production costs.  We also expect that our
raw material prices will continue to fluctuate and be affected by these factors
in the future.  Changes to our raw materials prices may result in
increases in production and packaging costs, and we may be unable to raise the
prices of our products to offset such increases in the short term or at all. As
a result, our results of operations may be materially and adversely
affected.





We
are subject to public company reporting and other requirements for which we will
incur substantial costs and our accounting and other management systems and
resources may not be adequately prepared.





We incur
significant legal, accounting, insurance and other expenses as a result of being
a public company.  For example, laws and regulations affecting public
companies, including the provisions of the Sarbanes-Oxley Act of 2002, or SOX,
and rules related to corporate governance and other matters subsequently adopted
by the SEC and the NYSE Arca, result in substantial costs to us, including legal
and accounting costs, and may divert our management’s attention from other
matters that are important to our business.  Compliance with Section
404 of SOX requires that our management annually assess the effectiveness of our
internal control over financial reporting and that our independent auditors
report on management’s assessment.  During our review of our financial
statements and results for the years ended December 31, 2008 and 2007, and
following our termination of our prior auditors and the re-audit of our
financial statements for the years ended December 31, 2006 and 2005, our
management identified several internal control matters that constitute material
weaknesses and significant deficiencies and, consequently, has concluded that
our internal control over financial reporting was not effective at
December 31, 2007 or December 31, 2008.  In addition,
management has concluded, based primarily on the identification of the material
weaknesses and significant deficiencies, that our disclosure controls and
procedures were not effective at December 31, 2008.  See “Part II—Item 9A—Controls
and Procedures” below. Material weaknesses in our internal controls
over financial reporting related to financial statement review procedures,
accounting treatment for routine and non-routine transactions, our internal
audit function, and our untimely assessment of our internal controls over
financial reporting.  Significant deficiencies in our internal
controls over financial reporting related to period-end closing procedures,
access to administrative and accounting systems, documentation of accounts
receivable transfers and promoters expenses, and division of treasury and
accounting duties.




13




A
“material weakness” is a deficiency, or a combination of deficiencies, in
internal control over financial reporting such that there is a reasonable
possibility that a material misstatement of the registrant’s annual or interim
financial statements will not be prevented or detected on a timely basis by the
company’s internal controls.  A “significant deficiency” is a
deficiency, or a combination of deficiencies, in internal control over financial
reporting that is less severe than a material weakness, yet important enough to
merit attention by those responsible for oversight of the registrant’s financial
reporting.  A “deficiency” in internal control over financial
reporting exists when the design or operation of a control does not allow
management or employees, in the normal course of performing their assigned
functions, to prevent or detect misstatements on a timely basis.  We
are devoting significant resources to remediating and improving our internal
controls, including hiring additional accounting, internal audit and finance
staff, engaging consultants to assist with these functions, upgrading our
systems, and implementing additional financial and management controls,
reporting systems and procedures.  These measures may not ensure the
adequacy of our internal controls over our financial processes and reporting in
the future.  If we are unable to remediate successfully these material
weaknesses and significant deficiencies in a timely manner, investors may lose
confidence in our reported financial information, which could lead to a decline
in our stock price, limit our ability to access the capital markets in the
future, and require us to incur additional costs to improve our internal control
systems and procedures.





We
significantly depend on our management team.





Each of
our executive officers is responsible for an important aspect of our
operations.  In addition, we rely on management and senior personnel
to ensure that our sourcing, production, sales, distribution and other business
functions are effective.  Losing the services of our executive
officers or key personnel could be detrimental to our operations.  We
do not have key-man life insurance for any of our executive officers or other
employees.





Investors
may not be able to enforce judgments entered by United States courts against
certain of our officers and directors.





We are
incorporated in the State of Utah.  However, a majority of our
directors and executive officers, and certain of our principal shareholders,
live outside of the U.S., principally in China. As a result, you may not be able
to effect service of process upon those persons within the U.S. or enforce
against those persons judgments obtained in U.S. courts.





We
face substantial competition in connection with the marketing and sale of our
products.





Our
products compete with other premium quality dairy brands as well as less
expensive, non-premium brands. Our products face competition from non-premium
producers distributing in our marketing area and other producers packaging their
products in our marketing area. Most of our competitors are well established,
have greater financial, marketing, personnel and other resources and have
products that have gained wide customer acceptance in the marketplace. Our
largest competitors are state-owned dairies owned by the government of China.
Large foreign companies have also entered the dairy industry in China. The
greater financial resources of such competitors will permit them to procure
retail store shelf space and to implement extensive marketing and promotional
programs, both generally and in direct response to advertising efforts by us.
The dairy industry is also characterized by the frequent introduction of new
products, accompanied by substantial promotional campaigns. We may be unable to
compete successfully or our competitors may develop products which have superior
qualities or gain wider market acceptance than ours.




14




We
face the potential risk of product liability associated with food
products.





We face
the risk of liability in connection with the sale and consumption of dairy
products and soybean products should the consumption of such products cause
injury, illness or death. Such risks may be particularly great in a company
undergoing rapid and significant growth. The successful assertion of product
liability claims against us could result in potentially significant monetary
damages, diversion of management resources and require us to make significant
payments and incur substantial legal expenses. We do not currently maintain
product liability insurance. Any insurance that we may obtain in the future may
be insufficient to cover potential claims or the level of insurance coverage
needed may be unavailable at a reasonable cost. Even if a product liability
claim is not successfully pursued to judgment by a claimant, we may still incur
substantial legal expenses defending against such a claim and our brand image
and reputation would suffer. Finally, serious product quality concerns could
result in governmental action against us, which, among other things, could
result in the suspension of production or distribution of our products, loss of
certain licenses, or other governmental penalties, including possible criminal
liability.





Doing
business in China involves various political and economic risks.





We
conduct substantially all of our operations and generate most of our revenue in
China. Accordingly, our business, financial condition, results of operations and
prospects are affected significantly by economic, political and legal
developments in China. China’s economy differs from the economies of most
developed countries in many respects, including:





·
            the
      higher level of government involvement and
  regulation;





·
            the
      early stage of development of the market-oriented sector of the
      economy;





·
            the
      rapid growth rate;





·
            the
      higher level of control over foreign exchange;
  and





·
            government
      control over the allocation of many
resources.





As
China’s economy has been transitioning from a planned economy to a more
market-oriented economy, the government of China has implemented various
measures to encourage economic growth and guide the allocation of resources.
While these measures may benefit the overall economy of China, they may also
have a negative effect on us.





Although
the government of China has in recent years implemented measures emphasizing the
utilization of market forces for economic reform, the PRC government continues
to exercise significant control over economic growth in China through the
allocation of resources, controlling payment of foreign currency-denominated
obligations, setting monetary policy and imposing policies that impact
particular industries or companies in different ways.  Any adverse
change in the economic conditions or government conditions or government
policies in China could have a material adverse effect on the overall economic
growth and the level of consumer spending in China, which in turn could lead to
a reduction in demand for our products and consequently have a material adverse
effect on our business and prospects.




15




Regulations
affecting acquisitions of PRC companies by foreign entities may make it more
difficult for us to complete acquisitions and grow our business.





In 2005,
the PRC State Administration of Foreign Exchange, or SAFE, issued a public
notice, known as “Circular 75,” concerning the application of foreign exchange
regulations to mergers and acquisitions involving foreign investment in
China.  Among other things, the public notice provides that if an
offshore company controlled by PRC residents intends to acquire a PRC company,
such acquisition will be subject to strict examination by the relevant foreign
exchange authorities.  Under Circular 75, if an acquisition of a PRC
company by an offshore company controlled by PRC residents occurred prior to the
issuance of Circular 75, certain PRC residents were required to submit a
registration form to the local SAFE branch to register their ownership interests
in the offshore company before March 31, 2006.  Such PRC
residents must also amend the registration form if there is a material event
affecting the offshore company, such as, among other things, a change to the
company’s share capital, a transfer of shares, or if the company is involved in
a merger, an acquisition or a spin-off transaction or uses its assets in China
to guarantee offshore obligations.





As there
is still significant uncertainty in China regarding the interpretation and
implementation of Circular 75, we cannot predict how these regulations will
affect our future acquisition strategy and business operations. For example, if
we decide to acquire additional PRC companies, we or the owners of such
companies may not be able to complete the filings and registrations, if any,
required by the SAFE notices. This may restrict our ability to implement our
acquisition strategy and could adversely affect our business and
prospects.





In
addition, in 2006 six PRC regulatory authorities, including the PRC Ministry of
Commerce and the PRC Securities Regulatory Commission, jointly promulgated a
rule entitled “Provisions regarding Mergers and Acquisitions of Domestic
Enterprises by Foreign Investors,” or the New M&A Rules, in
September 2006. The New M&A Rules establish additional procedures and
requirements that could make merger and acquisition activities by foreign
investors more time-consuming and complex, including, in some circumstances,
advance notice to the Ministry of Commerce of any change-of-control transaction
in which a foreign investor takes control of a PRC domestic enterprise.
Compliance with the New M&A Rules, and any related approval processes,
including obtaining approval from the Ministry of Commerce, may delay or inhibit
our ability to complete such transactions, which could affect our ability to
expand our business or maintain our market share.





Extensive
regulation of the food processing and distribution industry in China could
increase our expenses resulting in reduced profits.





We are
subject to extensive regulation by China’s Agricultural Ministry, and by other
provincial and local authorities in jurisdictions in which our products are
processed or sold, regarding the processing, packaging, storage, distribution
and labeling of our products. Applicable laws and regulations governing our
products may include nutritional labeling and serving size requirements. Our
processing facilities and products are subject to periodic inspection by
national, provincial and local authorities. We believe that we are currently in
substantial compliance with all material governmental laws and regulations and
maintain all material permits and licenses relating to our operations.
Nevertheless, we may fall out of substantial compliance with current laws and
regulations or may be unable to comply with any future laws and regulations. To
the extent that new regulations are adopted, we will be required, possibly at
considerable expense, to adjust our activities in order to comply with such
regulations. Our failure to comply with applicable laws and regulations could
subject us to civil remedies, including fines, injunctions, recalls or seizures,
as well as potential criminal sanctions, which could have a material adverse
effect on our business, operations and finances.




16




The
PRC government’s recent measures to curb inflation rates could adversely affect
future results of operations.





China has
faced rising inflation in recent years. In April 2008, the change in China’s
Consumer Price Index increased to 8.5% according to the National Bureau of
Statistics of China, or the NBS. Recently, the government of China undertook
various measures to alleviate the effects of inflation, especially with respect
to key commodities. On January 16, 2008, the PRC National Development and Reform
Commission announced national price controls on various products, including
milk. Similarly, the government of China may conclude that the prices of infant
formula or other of our products are too high and may institute price controls
that would limit our ability to set prices for our products as we might wish.
The government of China has also encouraged local governments to institute price
controls on similar products. Such price controls could adversely affect our
future results of operations and, accordingly, the price of our common
stock.





The
PRC currency is not a freely convertible currency, which could limit our ability
to obtain sufficient foreign currency to support our business operations in the
future.





The PRC
currency, the “Renminbi” or “RMB,” is not a freely convertible currency. We rely
on the PRC government’s foreign currency conversion policies, which may change
at any time, in regard to our currency exchange needs. We receive substantially
all of our revenues in Renminbi, which is not freely convertible into other
foreign currencies. In China, the government has control over Renminbi reserves
through, among other things, direct regulation of the conversion of Renminbi
into other foreign currencies and restrictions on foreign imports. Although
foreign currencies that are required for current account transactions can be
bought freely at authorized PRC banks, the proper procedural requirements
prescribed by PRC law must be met. At the same time, PRC companies are also
required to sell their foreign exchange earnings to authorized PRC banks and the
purchase of foreign currencies for capital account transactions still requires
prior approval of the PRC government. This substantial regulation by the PRC
government of foreign currency exchange may restrict our business operations and
a change in any of these government policies could negatively impact our
operations, which could result in a loss of profits.





In order
for our China subsidiaries to pay dividends to us, a conversion of Renminbi into
U.S. dollars is required, which, if not permitted by the PRC government, would
cause an interruption in our operating cash flow. Under current PRC law, the
conversion of Renminbi into foreign currency for capital account transactions
generally requires approval from SAFE and, in some cases, other government
agencies. Government authorities may impose restrictions that could have a
negative impact in the future on the conversion process and upon our ability to
meet our cash needs and to pay dividends to our shareholders. Although, our
subsidiaries’ classification as wholly foreign-owned enterprises, or WFOEs,
under PRC law permits them to declare dividends and repatriate their funds to us
in the United States, any change in this status or the regulations permitting
such repatriation could prevent them from doing so. Any inability to repatriate
funds to us would in turn prevent payments of dividends to our
shareholders.





Fluctuations
in the exchange rate between the PRC currency and the U.S. dollar could
adversely affect our operating results.





The
functional currency of our operations in China is the Renminbi. However, results
of our operations are translated at average exchange rates into U.S. dollars for
purposes of reporting results. As a result, fluctuations in exchange rates may
adversely affect our expenses and results of operations as well as the value of
our assets and liabilities. Fluctuations may adversely affect the comparability
of period-to-period results. We do not currently use hedging techniques, and any
hedging techniques which we may use in the future, may not be able to eliminate
and may exacerbate the effects of currency fluctuations. Thus, exchange rate
fluctuations could cause our profits, and therefore our stock prices, to
decline.




17





Under
the New EIT Law, we may be classified as a “resident enterprise” of China, which
would likely result in unfavorable tax consequences to us and our non-PRC
shareholders.





Under
China’s Enterprise Income Tax Law, or the New EIT Law, and its implementing
rules, which became effective in 2008, an enterprise established outside of
China with “de facto management bodies” within China is considered a “resident
enterprise,” meaning that it can be treated in a manner similar to a Chinese
enterprise for enterprise income tax purposes.  Under the implementing
rules of the New EIT Law, de facto management means substantial and overall
management and control over the production and operations, personnel,
accounting, and properties of the enterprise.  Because the New EIT Law
and its implementing rules are new, no official interpretation or application of
this new “resident enterprise” classification is available. Therefore, it is
unclear how tax authorities will determine tax residency based on the facts of
each case.





If the
PRC tax authorities determine that American Dairy, Inc. is a “resident
enterprise” for PRC enterprise income tax purposes, unfavorable PRC tax
consequences could follow. First, we may be subject to enterprise income tax at
a rate of 25% on our worldwide taxable income as well as PRC enterprise income
tax reporting obligations. Second, although under the New EIT Law and its
implementing rules dividends paid to us from our PRC subsidiaries would qualify
as “tax-exempt income,” such dividends may be subject to a 10% withholding tax,
as the PRC foreign exchange control authorities, which enforce the withholding
tax, have not yet issued guidance with respect to the processing of outbound
remittances to entities that are treated as resident enterprises for PRC
enterprise income tax purposes. Finally, it is possible that future guidance
issued with respect to the new “resident enterprise” classification could result
in a situation in which a 10% withholding tax is imposed on dividends we pay to
our non-PRC shareholders and with respect to gains derived by our non-PRC
shareholders from transferring our shares. We are actively monitoring the
possibility of “resident enterprise” treatment for the 2008 and 2009 tax
years and are evaluating appropriate organizational changes to avoid this
treatment, to the extent possible.




“resident
enterprise ”
for purposes of the New EIT Law and believe that we are not. However, given the
uncertainty regarding these new tax rules, our assessment may be incorrect. If we
were treated as a “resident enterprise” by PRC tax authorities, we would be
subject to tax in both the U.S. and China, and our PRC tax may not be creditable
against our U.S. tax.  In addition, we have not accrued any tax
liability associated with the possible payment of dividends to our U.S. parent
company. Such a tax would be an added expense appearing on our income statement,
which would reduce our net income.





We
do not intend to pay and may be restricted from paying dividends on our common
stock.





We have
never declared or paid dividends on our capital stock and we do not intend to
declare dividends in the foreseeable future. We currently intend to retain
future earnings to fund our continued growth. Furthermore, if we decide to pay
dividends, foreign exchange and other regulations in China may restrict our
ability to distribute retained earnings from China or convert those payments
from Renminbi into foreign currencies.





Lack
of bank deposit insurance puts our funds at risk of loss from bank foreclosures
or insolvencies.





We
maintain certain bank accounts in China that are not protected by FDIC insurance
or other insurance. As of December 31, 2008, we held approximately $11.6 million
in bank accounts in China.  If a PRC bank holding our funds
experienced insolvency, it may not permit us to withdraw our funds, which would
result in a loss of such funds and reduction of our net assets.




18





Limited
and uncertain trademark protection in China makes the ownership and use of our
trademark uncertain.





We have
obtained trademark registrations for the use of our trade name “Feihe” as well
as our “Fei Fan” and “Fei Rui” brands, which have been registered with the PRC
Trademark Bureau of the State Administration for Industry and Commerce with
respect to our milk products.  We believe our trademark is important
to the establishment of consumer recognition of our
products.  However, due to uncertainties in PRC trademark law, the
protection afforded by our trademark may be less than we currently expect and
may, in fact, be insufficient. Moreover, even if it is sufficient, in the event
it is challenged or infringed, we may not have the financial resources to defend
it against any challenge or infringement and such defense could in any event be
unsuccessful. Moreover, any events or conditions that negatively impact our
trademark could have a material adverse effect on our business, operations and
finances.





Our
lack of patent protection could permit our competitors to copy our trade secrets
and formula and thus gain a competitive advantage.





We have
no patents covering our products or production processes, and we expect to rely
principally on know-how and the confidentiality of our formula and production
processes for our products and our flavoring formula in producing competitive
product lines. Any breach of confidentiality by our executives or employees
having access to our formula could result in our competitors gaining access to
such formula. The ensuing competitive disadvantage could reduce our revenues and
our profits.





One
of our shareholders owns a significant percentage of our stock and will be able
to exercise significant influence over our affairs.





Leng
You-Bin, our Chairman, Chief Executive Officer, President, and General Manager,
beneficially owned approximately 51.6% of our common stock as of March 31,
2009.  Our executive officers and directors as a group beneficially
owned approximately 53.9% of our common stock as of March 31,
2009.  Consequently, these individuals will likely be able to
determine the composition of our board of directors, retain the voting power to
approve certain matters requiring shareholder approval and continue to have
significant influence over our operations.  The interests of these
shareholders may be different than the interests of other shareholders on these
matters.  This concentration of ownership could also have the effect
of delaying or preventing a change in our control or otherwise discouraging a
potential acquirer from attempting to obtain control of us, which in turn could
reduce the price of our common stock.





Failure
to comply with the US Foreign Corrupt Practices Act could subject us to
penalties and other adverse consequences.





Since we
are a Utah corporation and a public company in the United States, we are subject
to the U.S. Foreign Corrupt Practices Act, which generally prohibits U.S.
companies from engaging in bribery or other prohibited payments to foreign
officials for the purpose of obtaining or retaining business. Non-U.S.
companies, including some that may compete with our company, are not subject to
these prohibitions. Corruption, extortion, bribery, pay-offs, theft and other
fraudulent practices may occur in China. Although such practices are prohibited
at our company, our employees or other agents may engage in such conduct for
which we might be held responsible.  If our employees or other agents
are found to have engaged in such practices, we could suffer severe penalties
and other consequences that may have a material adverse effect on our business,
financial condition and results of operations.




19





We
have a significant amount of indebtedness, which may limit our operating
flexibility.





As of
December 31, 2008 we had approximately $242.1 million of total liabilities,
which included approximately $99.2 million of outstanding principal on our 7.75%
Convertible Notes due 2009, or the 2009 Notes, and our 1.00% Guaranteed Senior
Secured Convertible Notes due 2012, or the 2012 Notes.  Our high level
of indebtedness could have important consequences, including the
following:




·
            it
      may be difficult for us to satisfy our obligations with respect to our
      indebtedness;




·
            our
      ability to obtain additional financing for working capital, capital
      expenditures, or general corporate or other purposes may be
      impaired;




·
            a
      substantial portion of our cash flow from operations must be dedicated to
      the payment of principal and interest on our indebtedness, reducing the
      funds available to us for other
purposes;




·
            it
      may cause our trade creditors to change their terms for payment on goods
      and services provided to us, thereby negatively impacting our ability to
      receive products and services on acceptable
  terms;




·
            it
      may place us at a competitive disadvantage compared to our competitors
      that have less debt or are less leveraged;
and




·
            we
      may be more vulnerable to economic downturns, may be limited in our
      ability to respond to competitive pressures and may have reduced
      flexibility in responding to changing business, regulatory and economic
      conditions.





Our
ability to pay interest on and to satisfy our debt obligations will depend upon,
among other things, our future operating performance and our ability to
refinance indebtedness when necessary.  Each of these factors is, to a
large extent, dependent upon economic, financial, competitive and other factors
beyond our control.  If, in the future, we cannot generate sufficient
cash from operations to meet our debt obligations, we will need to refinance our
existing debt, obtain additional financing or sell assets.  Our
business may not generate sufficient cash flows to satisfy our existing
indebtedness and funding sufficient to satisfy our debt service requirements may
not be available on satisfactory terms, if at all.





The
covenants in the indentures governing our 2012 Notes restrict our ability to
operate our business and our failure to comply with them could adversely affect
our business and financial condition.





We have
issued an aggregate principal amount of $80.0 million in 2012
Notes.  The indentures under which the 2012 Notes were issued contain
covenants restricting our operations, including restrictions on:




·
            our
      use and maintenance of our
properties;




·
            incurrence
      of indebtedness;




·
            declaring
      or paying dividends or other
distributions;




·
            repurchasing
      our capital stock or subordinated
obligations;




·
            making
      investments;




·
            incurring
      liens;




·
            selling
      assets;




·
            our
      use of the proceeds from the sale of the 2012 Notes;
  and




·
            our
      engaging in business unrelated to dairy and related food
      products.


20




The
indentures also require us to maintain tangible net worth ratios, to complete a
qualifying initial public offering of our common stock by December 1, 2008, to
repurchase some or all of our 2012 Notes from electing holders upon certain
assets sales, upon certain change of control transactions or if our common stock
ceases to trade on a qualifying U.S. stock exchange, and to file reports under
the Securities Exchange Act of 1934, as amended, or the Exchange Act, with the
SEC.  In addition, the outstanding 2012 Notes will accrue additional
interest at an annual rate of 5.0% if a qualifying initial public offering has
not occurred by December 1, 2008, and we will also be obligated to pay an
additional amount equal to 3.0% of the principal amount of the outstanding 2012
Notes if a qualifying initial public offering has not occurred by December 1,
2008 and an additional amount equal to 1.0% of the principal amount of the
outstanding 2012 Notes if we fail to retain a qualified auditor at any time
after May 1, 2008.  Although we have entered into a supplemental
indenture pursuant to which we have obtained waivers and consents from the
holders of the 2012 Notes, those waivers and consents are limited in scope and
are conditioned on events, including our timely making required repurchase
payments, that we may not be able to satisfy.  Our failure to comply
with the restrictions on our operations and other requirements under our
indentures could constitute an event of default, subject us to litigation, and
have an adverse effect on our business and financial condition.  See
“Item
7.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations—Outstanding Indebtedness—1.00% Senior Secured Convertible Notes Due 2012”
below and “Item
7.  Management’s Discussion and Analysis of Financial Condition and
Results of Operations—Outstanding Indebtedness—Restructuring of 2012
Notes” below.





Our
failure to repurchase the 2012 Notes pursuant to the supplemental indenture
could adversely affect our business and financial condition.





Pursuant
to the supplemental indenture with respect to the 2012 Notes, holders of 100% of
the outstanding 2012 Notes elected to exercise the early repurchase option with
respect to all of the outstanding 2012 Notes, which obligates us to repurchase
the 2012 Notes for an aggregate amount of $92.0 million in accordance with the
terms and conditions of the supplemental indenture.  Accordingly, we
have paid $15,333,333 to the holders of the 2012 Notes, of which $11,000,000 was
paid in November 2008 and $4,333,333 was paid in January 2009, and we are
obligated to pay an additional $15,333,333 by each of April 15 and July 15, 2009
and to pay the remaining $46.0 million by October 15, 2009.  We may
not have adequate cash on hand or generate sufficient cash flows to make the
repurchase payments and, even if we do, making such payments could substantially
impair our liquidity and capital resources.  Additional financing
sufficient to make the repurchase payments may not be available on satisfactory
terms, if at all.  If we do not make the required repurchase payments
on April 15, 2009, July 15, 2009 or October 15, 2009, the waivers
granted to us under the supplemental indenture will terminate, which will
restrict our business operations, the 2012 Notes will recommence accruing
interest, which will adversely affect our business and financial condition, and
the holders of the 2012 Notes could exercise their conversion rights under the
indentures, which may result in substantial dilution.  See “Item 7.  Management’s
Discussion and Analysis of Financial Condition and Results of
Operations—Outstanding Indebtedness—Restructuring of 2012 Notes”
below.





We
may face significant penalties if we are unable to file and maintain
registration statements in compliance with our agreements.





In
connection the issuances of with our 2009 Notes, we have granted demand,
piggy-back and S-3 registration rights.  The amended registration
rights agreement requires us to pay additional interest, accruing at 1.0% of the
principal amount of each holder’s 2009 Notes per month, if:




·
            we
      fail to file a registration statement by January 3,
  2007,




·
            we
      fail to file a registration statement by the three month anniversary of
      any demand registration notice,




·
            sales
      of all registrable securities cannot be made pursuant to the registration
      statement,




·
            our
      common stock ceases to be listed or traded in qualifying exchanges or
      markets,




·
            a
      qualifying initial public offering has not occurred on or before June 30,
      2009,




·
            we
      fail to keep public information
available,




·
            we
      fail to file in a timely manner all reports and other documents we are
      required to file with the SEC, or




·
            we
      fail to maintain our Exchange Act
registration.




21





Although
the holders of our 2009 Notes have agreed that we will only be obligated to make
additional interest payments to them if a registration statement is not
effective by June 30, 2009 or if we are unable to timely comply with our
reporting and filing obligation under the Exchange Act by April 15, 2009, we may
be unable to meet these deadlines, which would expose us to substantial future
penalties.





Furthermore,
under the indentures governing our 2012 Notes, we are required to
pay:




·
              an
      additional amount equal to 3.0% of the principal amount of the outstanding
      2012 Notes if a qualifying initial public offering has not occurred by
      December 1, 2008, and
 
 ·
              additional
      interest accruing at an annual rate of 0.25% for the first 90 days, and
      thereafter at an annual rate of 0.5%, if, within 90 days of our
      eligibility to do so, we fail to file a shelf registration statement for
      the 2012 Notes, the guarantees of the 2012 Notes, and any shares of our
      common stock issuable upon conversion of the 2012 Notes, or if such a
      shelf registration statements does not become effective within 180 days
      our eligibility to make such a
filing.





Although
the holders of our 2012 Notes have waived these additional payment and interest
obligations, the waiver provides that these obligations will recommence if we do
not make the required 2012 Note repurchase payments pursuant to the supplemental
indenture.  If we are unable to make the repurchase payments and to
comply with the public offering and registration statement requirements, our
business and financial condition will be adversely affected.  See
“Item 7. Management’s
Discussion and Analysis of Financial Condition and Results of
Operations—Outstanding Indebtedness—Restructuring of 2009 Notes”
below and “Item 7.
Management’s Discussion and Analysis of Financial Condition and Results of
Operations—Outstanding Indebtedness—Restructuring of 2012 Notes”
below.





We
are at risk of securities litigation.





We are at
risk of being subject to securities litigation, including possible enforcement
action or class action lawsuits.  The SEC has notified us of an
informal investigation related to our former independent registered public
accountants.  While we believe that the primary focus of the
investigation is not related to our business or management, but rather to the
independence of our former auditors, the SEC may expand the focus of its
investigation or pursue action against us.  Following notification of
the investigation, we dismissed our former auditors, sued our former auditors,
engaged new independent registered public accountants, commenced a re-audit of
historical financial statements, and restated our financial statements as of and
for our fiscal years ended December 31, 2005 and 2006.  Accordingly,
we were unable to file Exchange Act reports for 2007 and 2008 in a timely
manner.  Securities class action litigation has often been brought
against companies who have been unable to provide current public information or
who have restated previously filed financial statements.  Such
litigation is complex and could result in substantial costs, divert management’s
attention and resources, and seriously harm our business, financial condition
and results of operations.





FORWARD-LOOKING
STATEMENTS





The
statements included in this report that are not purely historical are
forward-looking statements within the meaning of Section 21E of the
Exchange Act, and Section 27A of the Securities Act of 1933, as amended, or
the Securities Act. These statements include, but are not limited to, statements
about our plans, objectives, expectations, strategies, intentions or other
characterizations of future events or circumstances and are generally identified
by the words “may,” “expects,” “anticipates,” “intends,” “plans,” “believes,”
“seeks,” “estimates,” “could,” “would,” and similar expressions. Because these
forward-looking statements are subject to a number of risks and uncertainties,
our actual results could differ materially from those expressed or implied by
these forward-looking statements. Factors that could cause or contribute to such
differences include, but are not limited to, those discussed under the heading
“Risk Factors” and in other documents we file from time to time with the
Securities and Exchange Commission. All forward-looking statements included in
this report are based on information available to us on the date hereof. Our
business and the associated risks may have changed since the date this report
was originally filed with the SEC. We assume no obligation to update any such
forward-looking statements.




22





Item
1B. Unresolved Staff Comments





None.





Item
2. Properties





Our
principal executives are located at Star City International Building, 10
Jiuqianxiao Road, C-16th Floor, Chaoyang District, Beijing, China
100016.  We have six production and packaging facilities, which have
an aggregate milk powder production capacity of 1,220 tons per day, encompass an
aggregate of approximately 634,464 square meters of office, plant, and warehouse
space, and are located in the Heilongjiang, Shanxi and Hebei Provinces in
China.  For additional information on our production and packaging
facilities, see “Item 1.
Business—Production
and Packaging
Facilities” above.





There is
no private ownership of land in China.  All land is owned by the
government of China, its agencies and collectives. Land use rights are obtained
from the government for period ranging from 50 to 70 years, and are typically
renewable. Land use rights can be transferred upon approval by the land
administrative authorities of China (such as the State Land Administration
Bureau) upon payment of the required land transfer fee.





We
believe that our facilities are suitable for our current
operations.  As part of our growth strategy, we plan to expand our
production capacity at our current facilities and to acquire and construct new
facilities in the future.





Item
3. Legal Proceedings





From time
to time, we may become involved in various claims and lawsuits incidental to our
business.  Other than as disclosed below, we know of no material
existing or pending legal proceedings against us, nor are we involved as a
plaintiff in any material proceeding or pending litigation.





We are a
plaintiff in a lawsuit entitled American Dairy, Inc. v. Murrell, Hall, McIntosh
& Co. PLLP et al., filed on April 15, 2008 in the United States District
Court for the Western District of Oklahoma. This suit alleges that our previous
independent auditor, Murrel, Hall, McIntosh & Co. PLLP, or MHM, breached its
duties of due care and professional competence by failing to perform its audits
in accordance with professional standards of care in that MHM improperly and
negligently (i) accepted Henny Wee & Co.’s representation that it was
independent and otherwise failed to make sufficient inquiries concerning Henny
Wee & Co.’s independence, and (ii) permitted Henny Wee & Co. to perform
such a significant and material part of the audit work that MHM should have
evaluated whether it could act as principal auditor and report on our financial
statements. We are seeking compensatory damages of not less than $10.0 million
in connection with this suit.





Item
4. Submission of Matters to a Vote of Security Holders





There
were no matters submitted to a vote of our security holders in the fourth
quarter of the fiscal year ended December 31, 2008.




23





PART
II





Item
5.  Market for the Registrant’s Common Stock, Related Stockholder
Matters and Issuer Repurchases of Equity Securities





Price
Range of Our Common Stock





American
Dairy common stock trades on the NYSE Arca Exchange under the symbol
“ADY.”  At March 31, 2009 there were 17,253,907 shares of common stock
issued and outstanding that were held by approximately 440 stockholders of
record.  The table below lists the high and low closing prices per
share of our common stock for each quarterly period during the past two fiscal
years as reported on the NYSE Arca Exchange.





Closing Price Range of Common StockHigh
                  
                  
                  LowYear
      Ended December 31, 2007:1st
      Quarter
                  
                  $
                  25.20
                  
                  
                  $
                  18.762nd
      Quarter
                  
                  $
                  22.01
                  
                  
                  $
                  16.803rd
      Quarter
                  
                  $
                  21.69
                  
                  
                  $
                  16.804th
      Quarter
                  
                  $
                  23.94
                  
                  
                  $
                  11.15Year
      Ended December 31, 2008:1st
      Quarter
                  
                  $
                  12.91
                  
                  
                  $
                  7.002nd
      Quarter
                  
                  $
                  13.91
                  
                  
                  $
                  7.883rd
      Quarter
                  
                  $
                  11.34
                  
                  
                  $
                  6.744th
      Quarter
                  
                  $
                  17.02
                  
                  
                  $
                  8.32





Dividend
Policy





We have
not declared or paid any dividends on our common stock and presently do not
expect to declare or pay any such dividends in the foreseeable
future.  Payment of dividends to our shareholders would require
payment of dividends by our PRC subsidiaries to us.  This, in turn,
would require a conversion of Renminbi into US dollars and repatriation of funds
to the US.  Under current PRC law, the conversion of Renminbi into
foreign currency for capital account transactions generally requires approval
from SAFE and, in some cases, other government agencies.  Government
authorities may impose restrictions that could have a negative impact in the
future on the conversion process and upon our ability to meet our cash needs,
and to pay dividends to our shareholders.  Although our subsidiaries’
classification as WFOEs under PRC law permits them to declare dividends and
repatriate their funds to us in the United States, any change in this status or
the regulations permitting such repatriation could prevent them from doing
so.  Any inability to repatriate funds to us would in turn prevent
payments of dividends to our shareholders.





Transfer
Agent and Registrar





Our
transfer agent and registrar is Interwest Stock Transfer Company, 1981 Murray
Holladay Road, Suite 100, Salt Lake City, Utah 84117-5148; telephone 1 (801)
272-9294.




24




Performance
Graph





The
following graph compares the annual cumulative total shareholder return on an
investment on December 31, 2003 of $100 in our common stock with the annual
cumulative total return on the same investment in the S&P 500 Index and the
S&P Packaged Foods and Meats Index for the five subsequent fiscal
years.











Recent
Sales of Unregistered Securities





In June
2007, we issued an aggregate of $80.0 million in principal amount of our 2012
Notes, accruing interest at an annual rate of 1.0% and maturing in June 2012, to
accredited investors in offshore transactions not requiring registration under
the Securities Act pursuant to Regulation S, and pursuant to the exemptions
from registration under Section 4(2) of the Securities Act for transactions by
an issuer not involving any public offering.





In July
and August 2007, we issued an aggregate of 575,000 shares of our common stock
upon conversion of $5.0 million in principal amount plus $750,000 in accrued and
unpaid interest of our 7.50% Series B Convertible Notes due 2007, or the Series
B Notes, at a conversion price of $10.00 per share, to accredited investors
pursuant to the exemptions from registration under Section 3(a)(9) of the
Securities Act for certain exchange offers and Section 4(2) of the Securities
Act for transactions by an issuer not involving any public
offering.





In
November 2008, pursuant to an agreement regarding our 2009 Notes, we issued to
holders of our 2009 Notes an aggregate amount of 216,639 shares of our common
stock.  In connection with the agreement, we amended and restated the
2009 Notes and the warrants issued therewith.  The amended and
restated 2009 Notes have an aggregate principal amount of $18.2 million, accrue
interest at an annual rate of 7.75%, mature in October 2009, and may be
converted at the option of the holder into shares of our common stock at a
conversion price of $14.50 per share.  The warrants issued with the
amended and restated 2009 Notes permit the holders to acquire approximately
251,000 shares of our common stock at an exercise price of $14.50 per share at
any time prior to October 2012.  We issued these securities pursuant
to the exemptions from registration under Section 3(a)(9) of the Securities Act
for certain exchange offers and Section 4(2) of the Securities Act for
transactions by an issuer not involving any public offering.




25




In
November 2008, we entered into a supplemental indenture with respect to the 2012
Notes, which amended the terms of the 2012 Notes to provide for our early
repurchase of the 2012 Notes and to provide certain waivers and consents to us,
in offshore transactions not requiring registration under the Securities Act
pursuant to Regulation S, and pursuant the exemptions from registration under
Section 3(a)(9) of the Securities Act for certain exchange offers and under
Section 4(2) of the Securities Act for transactions by an issuer not involving
any public offering.





From
January 2008 to the present, we have issued 8,000 restricted shares of our
common stock to each of our directors in consideration for their services to us,
and an additional 2,000 restricted shares of our common stock to Hui-Lan Lee, a
director and the chairperson of our Audit Committee.  In addition,
from January 2008 to the present, we have issued 22,500 shares of our common
stock, and options to purchase up to an aggregate of 270,000 shares of our
common stock at exercise prices ranging from $ 12.00 to $30.00 per share, to
employees in consideration for their services to us.  We issued these
securities pursuant to the exemption from registration under Section 4(2) of the
Securities Act for transactions by an issuer not involving any public
offering.





Item
6. Selected Financial Data





Not
applicable.


26




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





In
December 2007, we dismissed MHM as our independent registered public accountant
following notification of an informal SEC investigation related to individuals
and entities that provided accounting or certain advisory services to us,
including MHM and Henny Wee & Co.  We believe that the primary
focus of the investigation is not related to our business or management, but
rather to the independence of MHM and Henny Wee & Co.  In April
2008, we filed a lawsuit against MHM in the United States District Court for the
Western District of Oklahoma alleging that MHM breached its duties of due care
and professional competence when serving as our independent registered public
accountant.  In January 2008, we engaged Grant Thornton, the Hong Kong
member firm of Grant Thornton International Ltd., as our new independent
registered public accountants.  In addition, we initiated a voluntary
re-audit of certain historical financial statements.  During the
course of the re-audit, we identified items that require reclassification and
errors that require correction in certain financial statements line items in our
financial statements as of and for the 2006 and 2005 fiscal years.  On
March 26, 2009, our management, in consultation with our Audit Committee,
concluded that our previously filed financial statements as of and for the
fiscal years ended December 31, 2006 and 2005 should be restated and should no
longer be relied upon, and on March 31, 2009 we filed our Annual Report on Form
10-K for the fiscal year ended December 31, 2007, which included audited,
restated financial statements as of and for these years.





This
Annual Report contains our audited financial statements for the years ended
December 31, 2008 and 2007 and data derived therefrom. Data for the fiscal year
ended 2007 have been revised to present certain components as discontinuing
operations.  See Note 11 to our audited financial statements included
elsewhere in this report.





The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with our audited financial statements
and related notes appearing elsewhere in this Annual Report.  In
addition to historical financial information, the following discussion contains
forward-looking statements that reflect our plans, estimates and
beliefs.  Our actual results could differ materially from those
discussed in the forward-looking statements.  Factors that could cause
or contribute to these differences include those discussed below and elsewhere
in this Annual Report, particularly in “Item 1A. Risk Factors”
above.





Overview





We are a
leading producer and distributor of milk powder, soybean milk powder, and
related dairy products in the PRC.  Using proprietary processing
techniques, we make products that are specially formulated for particular ages,
dietary needs and health concerns.  We have over 200 company-owned
milk collection stations, six production and distribution facilities with an
aggregate milk powder production capacity of 1,220 tons per day, and an
extensive distribution network that reaches over 50,000 retail outlets
throughout China.


27




Factors
Affecting our Results of Operations





Our
operating results are primarily affected by the following factors:




·
            Dairy
      Industry Growth.We believe the market for dairy
      products in China is growing rapidly, driven by China’s economic growth,
      increased penetration of infant formula, and a growing female working
      population.  We expect these factors to continue to drive
      industry growth. We believe that the increasing affordability of infant
      formula in our primary markets has become an increasingly important driver
      of growth.




·
                Production
      Capacity.We
      believe much of the dairy market in China is still underserved,
      particularly with respect to infant formula.  In addition, since
      the melamine crisis in 2008, which did not involve any of our products, we
      have been able to operate our milk production facilities at maximum
      capacity.  Accordingly, we believe that the ability to increase
      production of high quality dairy products will allow well positioned
      companies to significantly increase revenues and market
    share.·
                Perceptions
      of Product Quality and Safety. We believe that rising consumer
      wealth in China has contributed to a greater demand for higher-priced
      products with perceived quality advantages.  We believe many
      consumers in China tend to regard higher prices as indicative of higher
      quality and higher nutritional value, particularly in the areas of infant
      formula and nutritional products.  Accordingly, we believe our
      reputation for quality and safety allows us to command higher average
      selling prices and generate higher gross margins than competitors who do
      not possess the same reputation.  Conversely, any decrease in
      consumer perceptions of quality and safety could adversely impact
      us.


·
              Raw
      Material Supply and Prices.  The per unit costs of
      producing our infant formula are subject to the supply and price
      volatility of raw milk and other raw materials, which are affected by the
      PRC and global markets. For example, in 2008 our raw milk prices increased
      by approximately 45% and we expect they will continue to be affected by
      factors such as geographic location, rising feed prices, general economic
      conditions such as inflation and fuel prices, and fluctuations in
      production, rising production costs and
  competition.





·
            Expenses
      Associated with Expansion.In
      implementing our plan to expand our business, we face corresponding
      increases in expenses in order to attract and retain qualified talent,
      implement strategic advertising campaigns, and finance our
      expansion.  In addition, we face various one-time, non-cash
      charges associated with the convertible notes we have issued to finance
      our business plans.





As
further explained below under “—Ausnutria Transaction,” due
to a letter of intent we entered into in December 2008, accounts relating to our
subsidiary Heilongjiang Moveup Co., Limited, or Moveup, are reflected in our
financial statements as discontinuing operations.  In addition, in
2008, with the initial operations of our dairy farms, we have two reportable
segments:  dairy products and dairy farm. Our dairy
products segment produces and sells dairy products, such as wholesale and retail
milk powders, as well as soybean powder, rice cereal, walnut powder and walnut
oil.  Our dairy farm segment operates our two company-owned dairy
farms, Gannon Farms and Kedong Farms, construction of which we commenced in 2007
and expect to be complete in the fourth quarter of 2009.  Our dairy
farms provide milk to us and not to external customers.





Results
of Operations





The
following table sets forth certain information regarding our results of
operation.





Years Ended December 312008
                
                
                2007($ in thousands)Statements
      of Operations DataSales
                
                
                193,192
                
                
                
                163,899Cost
      of goods sold
                
                
                117,181
                
                
                
                91,430Gross
      profit
                
                
                76,011
                
                
                
                72,469Operating
      and administrative expensesSales
      and marketing
                
                
                50,686
                
                
                
                40,739General
      and administrative
                
                
                19,047
                
                
                
                13,836Income
      from continuing operations
                
                
                6,278
                
                
                
                17,893Other
      income (expenses)
                
                
                7,849
                
                
                
                (4,389
                )Income
      tax expenses
                
                
                3,567
                
                
                
                5,662Net
      income from discontinuing operations
                
                
                6,463
                
                
                
                442Net
      income attributable to ordinary shareholders
                
                
                17,023
                
                
                
                8,284Other
      comprehensive income:Cumulative
      currency translation adjustments
                
                
                13,065
                
                
                
                9,315Total
      comprehensive income
                
                
                30,088
                
                
                
                17,599




28





Comparison
of Years Ended December 31, 2008 and 2007





Total
Comprehensive Income


Total
comprehensive income increased by approximately $12.5 million, or 71.0%, from
approximately $17.6 million in 2007 to approximately $30.1 million in
2008.  This increase was primarily attributable to an increase of
approximately $29.3 million, or 17.9%, in sales, an increase of approximately
$12.2 million, or 279.2% in other income (expenses), a decrease of approximately
$2.1 million, or 37.0%, in income tax expenses, an increase of approximately
$6.0 million, or 1,361.8%, in net income from discontinuing operations, and an
increase of approximately $3.9 million, or 41.3%, in cumulative currency
translation adjustments, offset in part by an increase of approximately $25.8
million, or 28.2%, in cost of goods sold and an increase of approximately $15.2
million, or 27.8%, in total operating expenses.  Our gross profit
margin decreased from 44.2% in 2007 to 39.3% in 2008.





Sales


Our sales
consist primarily of revenues generated from sales of milk powder, raw milk
powder, soybean powder, rice cereal, and walnut products.  Sales
increased by approximately $29.3 million, or 17.9%, from approximately $163.9
million in 2007 to approximately $193.2 million in 2008.  This
increase was primarily attributable to expanding our market areas and
distribution network throughout China, increased demand for high quality
products and strong market acceptance of these products, and increased sales
quantities of several high profit margin products.





The
following table sets forth information regarding the sales of our principal
products during the fiscal years ended December 31, 2008 and 2007:





2008
                    
                    2007
                    
                    2008 over 2007Product name
                    
                    Quantity
                      (Kg’000)
                    
                    Amount
                      ($’000)
                    
                    % of
                      Sales
                    
                    Quantity
                      (Kg’000)
                    
                    Amount
                      ($’000)
                    
                    % of
                      Sales
                    
                    Quantity
                      (Kg’000)
                    
                    Amount
                      ($’000)
                    
                    % of SalesMilk
      powder
                    
                    
                    16,311
                    
                    
                    
                    121,255
                    
                    
                    
                    62.8
                    
                    
                    
                    17,100
                    
                    
                    
                    118,349
                    
                    
                    
                    72.2
                    
                    
                    
                    (789)
                    
                    
                    
                    2,906
                    
                    
                    
                    2.5Raw
      milk powder
                    
                    
                    16,572
                    
                    
                    
                    60,753
                    
                    
                    
                    31.4
                    
                    
                    
                    12,899
                    
                    
                    
                    35,566
                    
                    
                    
                    21.7
                    
                    
                    
                    3,673
                    
                    
                    
                    25,187
                    
                    
                    
                    70.8Soybean
      powder
                    
                    
                    2,153
                    
                    
                    
                    4,400
                    
                    
                    
                    2.3
                    
                    
                    
                    1,785
                    
                    
                    
                    3,253
                    
                    
                    
                    2.0
                    
                    
                    
                    368
                    
                    
                    
                    1,147
                    
                    
                    
                    35.3Rice
      cereal
                    
                    
                    816
                    
                    
                    
                    4,631
                    
                    
                    
                    2.4
                    
                    
                    
                    1,292
                    
                    
                    
                    5,332
                    
                    
                    
                    3.3
                    
                    
                    
                    (476)
                    
                    
                    
                    (701)
                    
                    
                    
                    (13.1)Walnut
      products
                    
                    
                    327
                    
                    
                    
                    1,663
                    
                    
                    
                    0.9
                    
                    
                    
                    241
                    
                    
                    
                    1,212
                    
                    
                    
                    0.7
                    
                    
                    
                    86
                    
                    
                    
                    451
                    
                    
                    
                    37.2Other
                    
                    
                    727
                    
                    
                    
                    490
                    
                    
                    
                    0.2
                    
                    
                    
                    97
                    
                    
                    
                    187
                    
                    
                    
                    0.1
                    
                    
                    
                    630
                    
                    
                    
                    303
                    
                    
                    
                    162.0Total
                    
                    
                    36,906
                    
                    
                    
                    193,192
                    
                    
                    
                    100
                    
                    
                    
                    33,414
                    
                    
                    
                    163,899
                    
                    
                    
                    100
                    
                    
                    
                    3,492
                    
                    
                    
                    27,224
                    
                    
                    
                    16.6





In 2008,
we also experienced an increase in the average sales price per kilogram of our
products, as demonstrated in the table below:




2008
                  
                  
                  2007Sales
      revenues (in thousands)
                  
                  $
                  193,192
                  
                  
                  $
                  163,899Total
      sales volume (kilograms in thousands)
                  
                  
                  36,906
                  
                  
                  
                  33,414Average
      selling prices/kilogram (in thousands)
                  
                  $
                  5.23
                  
                  
                  $
                  4.91




The
increase in average sales price per kilogram, as reflected in the table, is
relatively small and primarily attributable to the shift in product mix to
higher end products rather than an increase in the sales price of individual
products.  Prices per kilogram actually increased in the two most
significant product lines as demonstrated in the following table, which reflects
the average sales price per kilogram by product for 2008 and 2007 and the
percentage change in the sales price per kilogram.




29




Average Price Per KilogramProduct
                  
                  2008
                  
                  
                  2007
                  
                  
                  Percentage
                    ChangeMilk
      powder
                  
                  $
                  7.43
                  
                  
                  $
                  6.92
                  
                  
                  
                  7.4Raw
      milk powder
                  
                  
                  3.67
                  
                  
                  
                  2.76
                  
                  
                  
                  33.0Soybean
      powder
                  
                  
                  2.04
                  
                  
                  
                  1.82
                  
                  
                  
                  12.1Rice
      cereal
                  
                  
                  5.68
                  
                  
                  
                  4.13
                  
                  
                  
                  37.5Walnut
      products
                  
                  
                  5.09
                  
                  
                  
                  5.03
                  
                  
                  
                  1.1Other
                  
                  
                  0.67
                  
                  
                  
                  1.93
                  
                  
                  
                  (65.3)Total
                  
                  $
                  5.23
                  
                  
                  $
                  4.91
                  
                  
                  
                  6.5





Cost
of Goods Sold


Our costs
of goods sold consist primarily of direct and indirect manufacturing costs,
including production overhead costs shipping and handling costs for the products
sold.  Cost of goods sold increased approximately $25.8 million, or
28.2%, from approximately $91.4 million in 2007 to approximately $117.2 million
in 2008.  This increase was primarily attributable to an increase of
approximately $32.9 million, or 81.2%, in raw milk powder purchased from third
parties for processing and distribution, as well as a general increases in costs
resulting from economic conditions.





Operating
and Administrative Expenses


Our total
operating expenses consist primarily of sales and marketing expenses and general
and administrative expenses.  Our total operating expenses increased
by approximately $15.2 million, or 27.8%, from approximately $54.6 million in
2007 to approximately $69.7 million in 2008.





Sales and
Marketing.  Our sales and marketing expenses consist primarily
of advertising and market promotion expenses, and other overhead expenses
incurred by the Company’s sales and marketing personnel.  Sales and
marketing expenses increased approximately $9.9 million, or 24.4%, from
approximately $40.7 million for 2007 to approximately $50.7 million for
2008.  This increase was primarily attributable to an increase of
approximately $2.1 million, or 17.7%, in salary and an increase of approximately
$2.4 million, or 87.0%, in transportation expenses.  Sales and
marketing expenses are likely to increase as we continue expanding our
distribution network throughout China and seek to increase our market share and
awareness of our premium quality products.





General and Administrative.
Our general and administrative expenses consist primarily of salary, travel,
entertainment expenses, benefits, share-based compensation, and professional
service fees.  General and administrative expenses increased
approximately $5.2 million, or 37.7%, from approximately $13.8 million for 2007
to approximately $19.0 million for 2008.  This increase was primarily
attributable to an increase of approximately $2.7 million, or 120.2%, in legal
and accounting fees and an increase of approximately $0.6 million, or 13.7%, in
allowance for receivables.  General and administrative expenses are
likely to increase as we continue to expand our production, sourcing capacity,
and distribution capacity throughout China.





Income
from Continuing Operations


As a
result of the foregoing, our income from continuing operations decreased by
approximately $11.6 million, or 64.9%, from approximately $17.9 million in 2007
to approximately $6.3 million in 2008.





Other Income
(Expenses)


Our other
income (expenses) consists primarily of interest income, interest and finance
costs, amortization of deferred charges, registration rights penalty, gain on
extinguishment of debt, gain (loss) on derivatives, government subsidized tax
refunds, and other income and expense accounts.  Other income
(expenses) increased approximately $12.2 million, or 279.2%, from other expense
of approximately $4.4 million for 2007 to other income of approximately $7.9
million for 2008.  This increase was primarily attributable to a gain
on extinguishment of notes of approximately $30.5 million, offset in part by a
decrease in gain (loss) on derivatives of approximately $11.6 million, or
353.8%, an increase in interest and finance costs of approximately $5.4 million,
or 40.6%, and a decrease in government subsidized tax refunds of approximately
$1.3 million, or 16.3%.  The gain on extinguishment of notes and the
loss on derivatives primarily relate to our agreement to repurchase all of our
2012 Notes, which we expect to be non-recurring.


30





Income
Tax Expenses


We are
subject to U.S. federal and state income taxes, and our subsidiaries
incorporated in the PRC are subject to enterprise income taxes in the
PRC.  Our income tax expenses decreased by approximately $2.1 million,
or 37.0%, from approximately $5.7 million in 2007 to approximately $3.6 million
in 2008.  The decrease was primarily attributable to decreases in our
PRC tax expenses resulting from a decrease in our income subject to PRC
tax.





Net
Income from Discontinuing Operations


As
further explained below under “—Ausnutria Transaction,” due
to a letter of intent we entered into in December 2008, accounts relating to our
subsidiary Moveup are reflected in our financial statements as discontinuing
operations.  Our net income from discontinuing operations increased by
approximately $6.0 million, or 1,361.8%, from approximately $442,000 in 2007 to
approximately $6.5 million in 2008.





Cumulative
Currency Translation Adjustments


Our
principal country of operations is the PRC and our functional currency is the
Renminbi, but our reporting currency is the U.S. dollar.  All
translation adjustments resulting from the translation of our financial
statements into U.S. dollars are reported as cumulative currency translation
adjustments.  Our cumulative currency translation adjustments
increased by approximately $3.9 million, or 41.4%, from approximately $9.3
million in 2007 to approximately $13.2 million in 2008.





Liquidity
and Capital Resources





We had
retained earnings of approximately $54.1 million and $37.9 million as of
December 31, 2008 and 2007, respectively.  As of December 31,
2008, we had cash and cash equivalents of approximately $11.8 million and total
current assets of approximately $151.9 million.  As of December 31,
2008, we had a working capital deficit of approximately $69.5 million, primarily
attributable to our agreement to repurchase our 2012 Notes.  We have
financed our activities to date principally from cash generated from operations
and the sale of debt securities.





Our
summary cash flow information is as follows:




Year ended December 31Net cash provided by (used in):
                
                2008
                
                
                2007($ in thousands)Operating
      activities
                
                
                29,899
                
                
                
                (4,398
                )Investing
      activities
                
                
                (32,259
                )
                
                
                (101,661
                )Financing
      activities
                
                
                713
                
                
                
                73,931





Net
Cash Provided by (Used in) Operating Activities


Net cash
provided by (used in) operating activities increased approximately $25.5
million, from net cash used in operating activities of approximately $4.4
million in 2007 to net cash provided by operating activities of approximately
$29.9 million in 2008.  This increase was primarily attributable to an
increase in net income from continuing operations of approximately $2.7 million,
an increase in depreciation of property and equipment of approximately $1.9
million, a decrease in prepayments and other assets of approximately $4.6
million, an increase in accounts payable and accrued expenses of approximately
$20.8 million, an increase in income taxes payable of approximately $2.0
million, an increase in advances from customers of approximately $2.5 million,
an increase in accrued employee benefits of approximately $1.3 million, and an
increase in other payables of approximately $5.6 million.  This
increase was offset in part by various non-cash charges associated with our
convertible notes aggregating to approximately $6.5 million, a decrease in
provision for losses on receivables of approximately $3.7 million, an increase
in trade receivables of approximately $9.1 million, an increase in net
inventories of approximately $466,000, and an increase in refundable taxes of
approximately $1.1 million.


31




Net
Cash Used in Investing Activities


Net cash
used in investing activities decreased approximately $69.4 million, from
approximately $101.7 million in 2007 to approximately $32.3 million in
2008.  This decrease was primarily attributable to a reduction of
approximately $13.0 million in purchases of property and equipment, a reduction
of approximately $16.5 million in purchases of leases, a reduction of
approximately $6.8 million in prepayments for land use rights, an increase in
time deposits of approximately $16.4 million, an increase in note and loan
receivable accounts aggregating to approximately $7.8 million, and a deposit of
approximately $4.4 million associated with our sale of Moveup.  This
decrease was offset in part by a purchase of dairy cows of approximately $3.7
million.  Net cash used in investing activities primarily relates to
our bank account and other cash management vehicles and expenditures associated
with our construction and acquisition of new facilities.





Net
Cash Provided by Financing Activities


Net cash
provided by financing activities decreased approximately $73.2 million, from
approximately $73.9 million in 2007 to approximately $713,000 in
2008.  This decrease was primarily attributable to our sale of
convertible notes in 2007, netting proceeds to us of approximately $76.3
million, our 2008 repayment of $11.0 million to holders of our 2012 Notes, and
approximately $1.1 million less in cash received from warrant
exercises.  This decrease was offset in part by increases in proceeds
from sales of notes, loans and long term debt aggregating to approximately $8.6
million and reductions in the amounts we repaid for notes, loans and long term
debts aggregating to approximately $7.6 million.





Outstanding
Indebtedness





Series
B Convertible Notes


On June
30, 2005 and August 14, 2005, we issued two Series B Notes, in the aggregate
principal amount of $5.0 million.  The Series B Notes accrued interest
at 7.50% per annum, matured one year from their dates of issuance, and were
convertible into shares of our common stock at an initial conversion price of
$10.00 per share subject to adjustments for stock splits, dividends,
reorganization and similar events.  The Series B Notes were issued to
Pike Capital Partners L.P.  In July and August 2007, the $5.0 million
principal amount plus $750,000 in accrued and unpaid interest was converted in
accordance with the terms of the Series B Notes into 575,000 shares of our
common stock, which were allocated between Pike Capital Partners, L.P. and its
affiliate Pike Capital Partners (QP) LP, or collectively the Pike
Entities.  During the fiscal years ended December 31, 2008 and 2007,
the Pike Entities beneficially owned in excess of 5% of our issued and
outstanding common stock.




32




7.75%
Convertible Notes Due 2009


On
October 3, 2006, pursuant to a subscription agreement, we issued an aggregate
principal amount of $18.2 million in 2009 Notes and warrants to purchase up to
an aggregate of 251,000 shares of our common stock.  The value of the
warrants of $1,871,859 was recorded as a discount to the value of the 2009 Notes
and was to be amortized to interest expense over the term of the 2009
Notes.  The 2009 Notes mature on October 2, 2009, accrue interest at
an annual rate of 7.75% compounded annually and payable in shares of our common
stock at maturity, and contain customary representations, warranties, and events
of default, including failure to pay amounts due under the 2009 Notes, failure
to comply with certain covenants, and the occurrence of certain insolvency
events.  The principal and accrued and unpaid interest due under the
2009 Notes may be converted at the option of the holder into shares of common
stock at an initial conversion price of $14.50 per share.  The
conversion price is subject to adjustments for dividends, subdivisions,
combinations, and other events.  Subject to the same adjustments, the
warrants permit the holders to acquire, at any time prior to October 2, 2012, an
aggregate of approximately 251,000 shares of our common stock at an initial
exercise price of $14.50 per share.  As of December 31, 2008, the
conversion price of the 2009 Notes and the exercise price for the warrants was
$14.50 per share.





The
subscription agreement contains customary representations, warranties,
indemnities and covenants, including covenants by us to maintain our securities
exchange listing and to comply with our reporting and filing obligations under
the Exchange Act.  The subscription agreement also grants holders of
the 2009 Notes a right of first refusal to purchase an aggregate amount of up to
25.0% of any securities we may propose to sell.





In
connection with the issuance of the 2009 Notes, we entered into a registration
rights agreement pursuant to which we agreed to file, by January 3, 2007, a
registration statement covering the resale of the shares of our common stock
issuable upon conversion of the 2009 Notes and upon exercise of the
warrants.  We also agreed to register, on one occasion and prior to
October 3, 2011, shares issued on conversion of interest payable on the
2009 Notes if such shares have not been included in a prior registration
statement.  If we fail to meet these registration obligations, or if
the SEC does not declare such registration statements effective within 120 days
of the filing thereof, we agreed to pay an additional amount equal to 2.0% of
the principal amount of each holder’s 2009 Notes per month, payable monthly in
cash or, at the option of the holder, in shares of our common stock at the
then-applicable conversion price per share.  The registration rights
agreement also grants piggy-back, demand and S-3 registration rights to the
holders of shares of our common stock issuable upon conversion of the 2009
Notes.  We were not in compliance with the requirement under the
registration rights agreement to file a registration statement by January 3,
2007 and to cause it to become effective within 120 days.  As all of
the holders of the 2009 Notes have waived the 2.0% payment for the periods in
2007 prior to May 3 and after September 30, we made the 2.0% payment for
the period from May 3, 2007 through September 30, 2007, equal to
approximately $1.8 million, which was charged to earnings for the year ended
December 31, 2007.




33




In
November 2008, we restructured the 2009 Notes and related
agreements.  See “—Restructuring of 2009 Notes”
below for a discussion of certain changes to the terms and conditions of the
2009 Notes and related agreements.





1.00%
Guaranteed Senior Secured Convertible Notes Due 2012


On June
1, 2007 and June 27, 2007, pursuant to a notes purchase agreement and related
agreements, we issued an aggregate principal amount of $60.0 million and $20.0
million, respectively, in 2012 Notes.  The 2012 Notes accrue interest
at an annual rate of 1.00%, payable in cash on June 1 and December 1
of each year, and mature on the five-year anniversary of their
issuance.  The 2012 Notes have been guaranteed by certain of our
subsidiaries and secured by a pledge of all of our equity interest in AFC and a
pledge of 2,664,340 shares of our common stock held by Leng You-Bin, our
Chairman, Chief Executive Officer, President, and General
Manager.  Costs of $3,697,934 associated with the 2012 Notes were
capitalized as a deferred charge and are shown as an other asset as of December
31, 2007.  These costs were to be amortized over the term of the 2012
Notes.  Amortization of $657,258 and $369,794 was charged to expense
during the years ended December 31, 2008 and 2007, respectively.





The
principal amount of the 2012 Notes is convertible into shares of our common
stock at the option of the holder at an initial conversion price of $24.00 per
share.  On March 1, 2008, pursuant to a semi-annual reset provision
based on the volume-weighted 30-day average trading price of our common stock,
the conversion price of the 2012 Notes was reset to $12.00 per
share.  The conversion price is also subject to adjustments for
dividends, subdivisions, issuances of our common stock or warrants below current
market prices, and other events.   If not previously converted or
repurchased, upon maturity we must redeem the 2012 Notes at a price equal to
$228,776 per each $100,000 in principal amount of 2012 Notes.  As of
December 31, 2007, we accrued $8,151,867 of the redemption amount related to the
2012 Notes.





The notes
purchase agreement contains representations, warranties, indemnities and
covenants, including covenants by us and our controlling shareholders to use
best efforts to effect a qualifying initial public offering by December 1, 2008,
to provide certain additional security for the 2012 Notes, to file timely all
required reports under the Exchange Act, and not to take certain other actions
regarding any potential acquisition of our equity securities or any tender
offer, exchange offer, merger, consolidation, or sale of all or substantially of
our assets.





The
indentures under which the 2012 Notes were issued contain covenants restricting
our operations, including restrictions on our use and maintenance of our
properties, incurrence of indebtedness, declaration or payment of dividends or
other distributions, repurchase of capital stock or subordinated obligations,
making investments, incurrence of liens, sale of assets, use of proceeds from
the sale of the 2012 Notes, and engaging in business unrelated to dairy and
related food products.  The indentures also require us to maintain
tangible net worth ratios, to complete a qualifying initial public offering of
our common stock by December 1, 2008, to repurchase some or all of our 2012
Notes from electing holders upon certain assets sales, upon certain change of
control transactions or if our common stock ceases to trade on a qualifying U.S.
stock exchange, and to file reports under the Exchange Act with the
SEC.  In addition, the outstanding 2012 Notes will accrue additional
interest at an annual rate of 5% if a qualifying initial public offering has not
occurred by December 1, 2008.  We will also be obligated to pay an
additional amount equal to 3.0% of the principal amount of the outstanding 2012
Notes if a qualifying initial public offering has not occurred by December 1,
2008 and an additional amount equal to 1.0% of the principal amount of the
outstanding 2012 Notes if we fail to retain a qualified auditor at any time
after May 1, 2008.  The indentures also contain customary events of
default, including any failure to pay any interest, principal, or premium on the
2012 Notes, failure to comply with certain covenants, the occurrence of certain
insolvency events, defaults under or failure to pay when due any other
indebtedness exceeding $2.0 million and certain events regarding the security
interests.




34




In
connection with the issuance of the 2012 Notes, we entered into a registration
rights agreement and an investor rights agreement with holders of the 2012
Notes.  The registration rights agreement requires us to file certain
registration statements and provides that our failure to do so will result in
additional interest accruing at an annual rate of 0.25% for the first 90 days
and thereafter at an annual rate of 0.50%.





Pursuant
to the investor rights agreement, we granted Citadel Equity Fund Ltd, or
Citadel, a right of first refusal to purchase any securities we may propose to
issue or sell until June 1, 2012.  We sold and issued a principal
amount of $60.0 million of the 2012 Notes to Citadel.  During the
fiscal year ended December 31, 2008, Citadel beneficially owned in excess of 5%
of our issued and outstanding common stock.





At the
date of issuance of the 2012 Notes, we determined that the convertible note
instrument contained embedded derivatives.  The fair value of the
embedded derivatives was determined to be $53,298,331 and was recorded as a
derivative liability at inception.  That amount was accreted through
charges to the statements of operations and comprehensive income using the
effective interest method over the period of the 2012 Note
obligations.  At December 31, 2007, the fair value of the derivatives
was $50,019,300.  The reduction in the fair value of the derivative
was also recorded in the statements of operations and comprehensive income as
gain on derivatives during the year ended December 31, 2007.





In
November 2008, we restructured the 2012 Notes and related
agreements.  See “—Restructuring of 2012 Notes”
below for a discussion of certain changes to the terms and conditions of
the 2012 Notes and related agreements.





Restructuring
of 2009 Notes


On
November 12, 2008, we entered into an agreement with the holders of the 2009
Notes pursuant to which we agreed to issue to such holders an aggregate amount
of 216,639 shares of our common stock and such holders waived claims to
additional payments under the registration rights agreement relating to the 2009
Notes.  The agreement contains customary representations and
warranties, as well as security and inter-creditor provisions.  In
connection with the agreement, we amended and restated the 2009 Notes, or the
New 2009 Notes, amended and restated the warrants issued therewith, and amended
the prior registration rights agreement.





The New
2009 Notes were issued in an aggregate principal amount of $18.2 million, mature
on October 2, 2009, accrue interest at an annual rate of 7.75% compounded
annually and payable in shares of our common stock at maturity.  The
New 2009 Notes contain representations, warranties, and events of default,
including default for failure to pay amounts due under the New 2009 Notes,
failure to comply with certain covenants, the occurrence of certain insolvency
events, certain events regarding the security interests, and cross-defaults
under the 2012 Notes or any other indebtedness exceeding $2.0
million.  The principal and accrued and unpaid interest due under the
New 2009 Notes may be converted at the option of the holder into shares of our
common stock at an initial conversion price of $14.50 per share.  The
conversion price is subject to adjustments for dividends, subdivisions,
combinations, or issuances of our common stock, warrants or similar rights at a
price per share less than the conversion price then in
effect.  Subject to the same adjustments, the amended and restated
warrants permit the holders to acquire, at any time prior to October 2, 2012, an
aggregate of approximately 251,000 shares of our common stock at an initial
exercise price of $14.50.





The New
2009 Notes are guaranteed by AFC and secured by a pledge of all of our equity
interest in AFC and a pledge of 2,664,340 shares of our common stock held by
Leng You-Bin, our Chairman, Chief Executive Officer, President, and General
Manager.  The guarantees and security interests are subordinate to
those securing the 2012 Notes.




35




The
amendments to the registration rights agreement extend the existing demand,
piggy-back and S-3 registration rights to the holders of shares of our common
stock issued in connection with the release of claims to additional payments
under the prior registration rights agreement.  In addition, the
amendments restate the penalties for our failure to comply with registration and
other covenants.  In particular, we agreed to pay additional interest,
accruing at 1.00% of the principal amount of each holder’s New 2009 Notes per
month and payable monthly in cash or, at the option of the holder, shares of our
common stock at the then-applicable conversion price per share, upon the
occurrence of certain events.  These events include our failure to
file a registration statement by January 3, 2007, our failure to file a
registration statement by the three month anniversary of any demand registration
notice, if sales of all registrable securities cannot be made pursuant to the
registration statement, if our common stock ceases to be listed or traded in
qualifying exchanges or markets, if a qualifying initial public offering has not
occurred on or before June 30, 2009, if we fail to keep public information
available, if we fail to file in a timely manner all reports and other documents
we are required to file with the SEC, or if we fail to maintain our Exchange Act
registration.  In connection with the amended registration rights
agreement, the holders of the New 2009 Notes agreed that we will only be
obligated to make additional interest payments to them if a resale registration
statement is not effective by June 30, 2009 or if we are unable to timely comply
with our reporting and filing obligation under the Exchange Act by
April 15, 2009.





Restructuring
of 2012 Notes


On
November 12, 2008, we entered into a supplemental indenture with respect to the
2012 Notes.  The supplemental indenture grants each holder of the 2012
Notes the option to elect that we repurchase all or any portion of such holder’s
2012 Notes, at a repurchase price of 115% of the principal amount of 2012 Notes
for which such holder elected early repurchase.  On November 13, 2008,
the holders of 100% of the outstanding 2012 Notes elected to exercise the early
repurchase option with respect to all of the outstanding 2012 Notes, which
obligates us to repurchase the 2012 Notes for an aggregate amount of $92.0
million in accordance with the terms and conditions of the supplemental
indenture.  Accordingly, we have paid $15,333,333 to the holders of
the 2012 Notes, of which $11,000,000 was paid in November 2008, and $4,333,333
was paid in January 2009, and we are obligated to pay an additional $15,333,333
by each of April 15 and July 15, 2009 and to pay the remaining $46.0 million by
October 15, 2009.  As part of the first repurchase payment, we
also paid $407,000 in accrued and unpaid interest and accrued registration
rights penalty to holders of the 2012 Notes.  As a result of the
repurchase election, interest on all 2012 Notes ceased to accrue after November
13, 2008 and the 2012 Notes may not be converted into shares of our common
stock, subject to our making the required repurchase
payments.  Holders of the 2012 Notes are entitled to all other rights
and privileges as holders of the 2012 Notes until the required repurchase
payments are paid in full.  Costs of $123,354 associated with the
2012 Notes restructuring were capitalized as a deferred charge and are shown as
an other asset as of December 31, 2008.  These costs are amortized
over the term of the restructured Notes.  Amortization of $16,957 was
charged to expense during the year ended December 31, 2008.





Our
failure to make the required repurchase payments on April 15, 2009, July 15,
2009 or October 15, 2009 will not constitute an event of default under the
indentures, although certain waivers granted to us under the supplemental
indenture, described below, would terminate, interest would recommence accruing
on the 2012 Notes, and the holders of the 2012 Notes could exercise their
conversion rights under the indentures.





In the
supplemental indenture, we obtained waivers and consents from the holders of the
2012 Notes.  These waivers and consents allow us to incur additional
debt and liens in connection with funding the repurchase of the 2012 Notes and
for certain operating purposes, waive our compliance with tangible net worth and
leverage ratio requirements, waive the requirement that we repurchase 2012 Notes
from electing holders if our common stock ceases to trade on a qualifying U.S.
stock exchange, and waive the requirement that we file Exchange Act reports to
the extent our non-compliance is due to or results from the previously announced
re-audit of our financial statements.





Since the
terms of the 2012 Notes entered into on November 12, 2008 were substantially
different than the previous terms of the 2012 Notes, the transaction was
accounted for as an extinguishment of debt.  This resulted in
$30,497,268 of gain recognized in our consolidated statements of operations and
comprehensive income in the year ended December 31, 2008.  The
embedded derivatives contained in the original terms of the 2012 Notes were also
extinguished on November 12, 2008.  However, prior to extinguishment,
the fair value of the derivatives measured using the using the Monte Carlo
simulation approach was increased to $58,340,781, resulting in a loss of
$8,321,481 recorded in the statements of operations and comprehensive income
during the year ended December 31, 2008.




Other Factors Affecting our Liquidity and Capital
Resources




Expansion
Strategy


We
believe the market for dairy products in China is growing rapidly, including the
market for high quality dairy products.  Our growth strategy involves
capturing as much of this market as possible during this rapid growth
phase.  To implement this strategy we plan to expand our production
capabilities by investing in world-class production processes, to enhance our
distribution capabilities into first-tier PRC markets, to strengthen our premium
quality brand awareness, and to strategically align sourcing, production and
distribution by region.  Our expansion strategy will require the
continued retention and investment of our earnings from operations and, we
believe, additional funding from private debt and equity
financing.  In general, the commitment of funds to the acquisition or
construction of plant and equipment tends to impair
liquidity.  However, we believe that because of the upward trend in
our revenues in recent years, even if this trend levels off, our income from
continuing operations coupled with such additional financing should provide
sufficient liquidity to meet our needs.  Based upon our short term
liabilities, we believe our cash and cash equivalents are adequate to satisfy
our working capital needs and sustain our ongoing operations for the next twelve
months.  In the event of an unanticipated shortfall, we have access to
a line of credit with the Construction Bank of China and other Chinese banks to
fund our operations.  We have credit facilities in place with an
aggregate limit of approximately $9.0 million provided by three branches of the
China Construction Bank.




36




Ausnutria
Transaction


In August
2007, we made an advance payment to Ausnutria Dairy (Hunan) Company Ltd., or
Ausnutria, a distributor of milk powder and rice products in China, in
connection with a proposed acquisition of 100% of the equity interest in
Ausnutria.  The transaction did not close and we entered into
renegotiations with the sellers.





In
October 2007, we entered into an equity purchase agreement pursuant to which we
agreed to purchase, through our subsidiary Moveup, 75% of the outstanding equity
interests of Ausnutria, for consideration that included the amount of the
advance payment we previously made.  The transaction did not close
because the sellers failed to comply with certain closing conditions under the
equity purchase agreement, and we entered into renegotiations with the sellers,
including discussions regarding our proposed acquisition (directly or
indirectly) of the other 25% of the outstanding equity interests of
Ausnutria.  In connection with this transaction, we recorded a deposit
for investment of $28,269,857 as of the year ended December 31,
2007.





In
February 2008, we made a deposit payment of approximately $1.4 million to
Ausnutria Holding Co., Ltd., which indirectly owns Ausnutria, in connection with
our efforts to resolve the incomplete transactions in 2007.  The
transaction did not close and we entered into renegotiations.  In
connection with this transaction, we recorded a total deposit for investment of
$31,586,473 as of the year ended December 31, 2008, of which $1,925,852 of
the increase related to changes in exchange rates.





To
resolve the incomplete transactions regarding Ausnutria, on December 16, 2008,
we signed a letter of intent to sell all of the business activities and
operations of Moveup.  Accordingly, Moveup is reflected in our
consolidated financial statements as discontinuing operations.  On
February 18, 2009, we, through our subsidiary Feihe Dairy, entered into a new
equity purchase agreement pursuant to which Feihe Dairy and the minority
shareholder of Moveup, Liu Sheng-Hui, one of our directors and Vice President of
Finance of Feihe Dairy, each agreed to sell to Hunan Xindaxin Co., Ltd. 100% of
their equity interests in Moveup for an aggregate consideration of approximately
$43.3 million.  The agreement is subject to customary representations,
warranties, covenants and indemnities.  The purchase price is payable
in two tranches.  We have received approximately $11.0 million from
the purchasers, and the second tranche of approximately $32.3 million has been
deposited into an escrow account and will be released to Feihe Dairy and Mr. Liu
upon satisfaction of the closing conditions under the agreement, including
completion of the application for amendment of shareholders with the local
counterpart of the State Administration of Industry and Commence in Kedong
County, Heilongjiang Province, China.




37




Critical
Accounting Policies





The
consolidated financial statements include the financial statements of us and our
subsidiaries.  All transactions and balances among us and our
subsidiaries have been eliminated upon consolidation. Certain
amounts included in or affecting our consolidated financial statements and
related disclosures must be estimated, requiring us to make certain assumptions
with respect to values or conditions that cannot be known with certainty at the
time the financial statements are prepared. These estimates and assumptions
affect the amounts we report for assets and liabilities and our disclosure of
contingent assets and liabilities at the date of our financial statements. We
routinely evaluate these estimates, utilizing historical experience, consulting
with experts and other methods we consider reasonable in the particular
circumstances. Nevertheless, actual results may differ significantly from our
estimates. Any effects on our business, financial position or results of
operations resulting from revisions to these estimates are recorded in the
period in which the facts that give rise to the revision become
known.





We
believe that certain accounting policies are of more significance in our
consolidated financial statement preparation process than others, which policies
are discussed below. See also Note 2 to the consolidated financial
statements for a summary of our principal accounting policies.





Estimates of allowances for bad
debts – We must periodically review our trade and other receivables to
determine if all are collectible or whether an allowance is required for
possible uncollectible balances.





Estimate of the useful lives of
property and equipment and biological assets – We must estimate the
useful lives and proper salvage values of our property and equipment and
biological assets. We must also review property and equipment and biological
assets for possible impairment.





Inventory – We must determine
whether we have any obsolete or impaired inventory.





Goodwill – We must test
goodwill annually for impairment or more frequently if events or changes in
circumstances indicate that it might be impaired.





Revenue recognition – Revenue
from the sale of goods is recognized on the transfer of risks and rewards of
ownership, which generally coincides with the time when the goods are shipped to
customers and the title has passed.





Please
refer to the notes to the financial statements included elsewhere in this filing
for a more complete listing of all of our critical accounting
policies.


38





New
Accounting Pronouncements





In
December 2007, the Financial Accounting Standards Board, or the FASB, issued
Statement of Financial Accounting Standard, or SFAS, No. 160, “Noncontrolling Interests in
Consolidated Financial Statements – An Amendment of ARB No. 51,”or SFAS 160.SFAS 160 establishes
new accounting and reporting standards for the noncontrolling interest in a
subsidiary and for the deconsolidation of a subsidiary.  Specifically,
SFAS 160 requires the recognition of a noncontrolling interest (minority
interest) as equity in the consolidated financial statements that is presented
separate from the parent’s equity.  The amount of net income
attributable to the noncontrolling interest will be included in consolidated net
income on the face of the income statement.  SFAS 160 clarifies that
changes in a parent’s ownership interest in a subsidiary that do not result in
deconsolidation are equity transactions if the parent retains its controlling
financial interest.  In addition, SFAS 160 requires that a parent
recognize a gain or loss in net income when a subsidiary is
deconsolidated.  Such gain or loss will be measured using the fair
value of the noncontrolling equity investment on the deconsolidation date. SFAS
160 also includes expanded disclosure requirements regarding the interests of
the parent and its noncontrolling interest.  SFAS 160 is effective for
fiscal years, and interim periods within those fiscal years, beginning on or
after December 15, 2008.  Earlier adoption is
prohibited.  The adoption of SFAS 160 is not expected to have a
significant impact on our financial statements.





In
December 2007, the FASB issued SFAS No. 141 (revised),“Business Combinations,” or
SFAS 141(R).  SFAS 141(R) changes the accounting for business
combinations including the measurement of acquirer shares issued in
consideration for a business combination, the recognition of contingent
consideration, the accounting for pre-acquisition gain and loss contingencies,
the recognition of capitalized in-process research and development, the
accounting for acquisition-related restructuring cost accruals, the treatment of
acquisition related transaction costs and the recognition of changes in the
acquirer’s income tax valuation allowance. SFAS 141(R) is effective for fiscal
years beginning after December 15, 2008.  The adoption of SFAS
141(R) is not expected to have a significant impact on our financial
statements.





In
March 2008, the FASB issued SFAS, No. 161, “Disclosures about Derivative
Instruments and Hedging Activities - an Amendment of FASB Statement 133,”
or SFAS 161.  SFAS 161 provides new disclosure requirements for an
entity’s derivative and hedging activities.  SFAS 161 is effective for
periods beginning after November 15, 2008. We have not yet determined the
impact the adoption of SFAS 161 will have on our consolidated financial
statements.





In
April 2008, the FASB issued FASB Staff Position, or FSP, No. FAS
142-3, “Determination of the
Useful Life of Intangible Assets,” or
FSP FAS 142-3.  FSP FAS 142-3 amends the factors an entity
should consider when developing renewal or extension assumptions used in
determining the useful life over which to amortize the cost of a recognized
intangible asset under SFAS No. 142, “Goodwill and Other Intangible
Assets.”  FSP FAS 142-3 requires an entity to consider its
own historical experience in renewing or extending similar arrangements in
determining the amortizable useful life and requires expanded disclosures
related to the determination of intangible asset useful
lives.  FSP FAS 142-3 is effective for fiscal years beginning
after December 15, 2008, and may impact any intangible assets we acquire in
future transactions.  The guidance for determining the useful life of
a recognized intangible asset must be applied prospectively to intangible assets
acquired after the effective date.  The disclosure requirements,
though, must be applied prospectively to all intangible assets recognized as of
the effective date. Early adoption is prohibited.  The adoption of FSP
FAS 142-3 is not expected to have a significant impact on our financial
statements.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles,” or FAS 162.  FAS 162 identifies the
sources of accounting principles and the framework for selecting the principles
used in the preparation of financial statements.  FAS 162 is effective
60 days following SEC approval.





In June
2008, the FASB issued Staff Position No. Emerging Issues Task Force, or EITF,
03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities,” or FSP EITF 03-6-1.  FSP EITF 03-6-1 requires
entities to apply the two-class method of computing basic and diluted earnings
per share for participating securities that include awards that accrue cash
dividends (whether paid or unpaid) any time common shareholders receive
dividends and those dividends will not be returned to the entity if the employee
forfeits the award.  FSP EITF 03-6-1 is effective for fiscal years
beginning after December 15, 2008, and the interim periods within those
years.  Early adoption is prohibited and retroactive disclosure is
required.  We are currently evaluating the effect that the adoption of
FSP EITF 03-6-1 will have on our financial statements.





In June
2008, the FASB ratified EITF Issue 07-5,“Determining Whether an Instrument (or Embedded
Feature) Is Indexed to an Entity’s Own Stock,” or EITF
07-5.  EITF 07-5 addresses the determination of whether an instrument
(or an embedded feature) is indexed to an entity’s own stock.  EITF 07-5
will be effective for years beginning after December 15, 2008.  We are
currently evaluating the effect that the adoption of EITF 07-5 will have on our
financial statements.





In
December 2008, the FASB issued FSP No. FAS 132R-1, “Employers’ Disclosures about
Postretirement Benefit Plan Assets,” or FSP FAS 132R-1, to require
employers to provide more transparency about the assets in their post-retirement
benefit plans.  The disclosures are required for the fiscal years
ending after December 15, 2009.  We intend to adopt FSP FAS 132R-1
effective December 31, 2009.




39





In
February 2008, the FASB issued FSP No. SFAS 157-2, “Effective Date of FASB Statement No.
157,” or FSP SFAS 157-2.  This statement defers
fair value requirements for non-financial assets and liabilities not required to
be stated at fair value on a recurring basis (at least annually) until fiscal
years beginning after November 15, 2008. This deferral primarily impacts assets
such as property, plant and equipment, intangible assets and goodwill upon
non-recurring events such as business combinations, asset impairments and
goodwill impairment, among others.  The adoption of FSP SFAS 157-2 did
not have a material impact on our financial position, results of operations or
cash flows.





Item
7A. Quantitative and Qualitative Disclosures About Market Risk





We
conduct all of our operations in the PRC, and the Renminbi is the national
currency in which our operations are conducted. We have not utilized any
derivative financial instruments or any other financial instruments, nor do we
utilize any derivative commodity instruments in our operations, nor any similar
market sensitive instruments.





The
exchange rate between the Renminbi and the U.S. dollar is subject to the PRC
government’s foreign currency conversion policies, which may change at any
time.  The exchange rate at December 31, 2007 was approximately 7.3
Renminbi to 1 U.S. dollar.  The exchange rate at December 31, 2008 was
approximately 6.8 Renminbi to 1 U.S. dollar.  The exchange rate is
currently permitted to float within a very limited range.





Item
8. Financial Statements and Supplementary Data





Financial
Statements





Please
see the accompanying Financial Statements attached hereto beginning on page
F-1.




40




Item
9. Changes in and Disagreements with Accountants on Accounting and Financial
Disclosure





On
December 7, 2007, we dismissed MHM as our independent auditor following
notification of an informal SEC investigation related to individuals and
entities that provided accounting or certain advisory services to us, including
MHM and Henny Wee & Co.  The report of MHM on our financial
statements for the two most recent fiscal years did not contain an adverse
opinion or disclaimer of opinion, nor was it qualified or modified as to
uncertainty, audit scope or accounting principles. The decision to dismiss MHM
was approved by our Audit Committee.  During the Company’s two most
recent fiscal years and the subsequent interim period through the date of
dismissal, there were no reportable events as the term is described in Item
304(a)(1)(iv) or (v) of Regulation S-K.  Effective January 25, 2008,
we engaged Grant Thornton, the Hong Kong member firm of Grant Thornton
International Ltd., as our new independent registered public
accountants.





Item
9A. Controls and Procedures





Evaluation
of Disclosure Controls and Procedures





Disclosure
controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under
the Exchange Act) are designed to ensure that information required to be
disclosed in reports filed or submitted under the Exchange Act is recorded,
processed, summarized, and reported within the time periods specified in SEC
rules and forms and that such information is accumulated and communicated to
management, including our Chief Executive Officer and Chief Financial Officer,
to allow timely decisions regarding required disclosures.





During
our review of our financial statements and results for the year ended December
31, 2008 and 2007, and following our termination of our prior auditors and the
re-audit of our financial statements for the years ended December 31, 2006 and
2005, our management, under the supervision and with the participation of our
Chief Executive Officer and Chief Financial Officer, identified several internal
control matters that constitute material weaknesses and significant
deficiencies, which we view as an integral part of our disclosure controls and
procedures.  Consequently, our Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures
were not effective at December 31, 2007 or December 31, 2008.  These
weaknesses and deficiencies are discussed below under “— Management’s Report on Internal
Control Over Financial Reporting.”





Because
of these weaknesses and deficiencies, management has taken additional steps to
ensure the reliability of our financial reporting.  These steps have
included our internal review that identified revisions to our previously issued
financial statements, additional Audit Committee review, efforts to remediate
the material weaknesses and significant deficiencies in internal control over
financial reporting described below, and the performance of additional
procedures by management with respect to the financial statements contained in
this report.





Management’s
Report on Internal Control Over Financial Reporting





Management,
under the supervision of our Chief Executive Officer and Chief Financial
Officer, is responsible for establishing and maintaining adequate internal
control over financial reporting.  Internal control over financial
reporting (as defined in Rules 13a-15(f) and 15d(f) under the Exchange Act)
is a process designed to provide reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external
purposes in accordance with generally accepted accounting principles in the
United States, or GAAP.  Internal control over financial reporting
includes those policies and procedures that (a) pertain to the maintenance
of records that, in reasonable detail, accurately and fairly reflect the
transactions and dispositions of assets, (b) provide reasonable assurance
that transactions are recorded as necessary to permit preparation of financial
statements in accordance with GAAP, (c) provide reasonable assurance that
receipts and expenditures are being made only in accordance with appropriate
authorization of management and the board of directors, and (d) provide
reasonable assurance regarding prevention or timely detection of unauthorized
acquisition, use or disposition of assets that could have a material effect on
the financial statements.  A “material weakness” is a deficiency, or a
combination of deficiencies, in internal control over financial reporting such
that there is a reasonable possibility that a material misstatement of the
registrant’s annual or interim financial statements will not be prevented or
detected on a timely basis by the company’s internal controls.  A
“significant deficiency” is a deficiency, or a combination of deficiencies, in
internal control over financial reporting that is less severe than a material
weakness, yet important enough to merit attention by those responsible for
oversight of the registrant’s financial reporting.  A “deficiency” in
internal control over financial reporting exists when the design or operation of
a control does not allow management or employees, in the normal course of
performing their assigned functions, to prevent or detect misstatements on a
timely basis.




41




During
our review of our financial statements and results for the years ended December
31, 2008 and 2007, and following our termination of our prior auditors and the
re-audit of our financial statements for the years ended December 31, 2006 and
2005, our management, under the supervision and with the participation of our
Chief Executive Officer and Chief Financial Officer, assessed the effectiveness
of our internal control over financial reporting based on criteria established
in Internal Control –
Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway Commission,
or COSO, and concluded that these controls were not effective at December 31,
2007 or December 31, 2008.  As a result of that assessment, we
identified the following internal control matters that constitute material
weaknesses or significant deficiencies:




·
            Material weaknesses in our
      internal controls over financial
  reporting:




o
            Financial
      statement review procedures – We did not establish review procedures and
      retain qualified personnel to ensure the financial statements were
      prepared in compliance with GAAP and SEC disclosure
      requirements.  In addition, we did not adequately review GAAP
      adjustment procedures, our disclosure reporting process and our
      consolidated financial statements preparation
  processes.




o
            Accounting
      treatment for routine and non-routine transactions – We did not
      effectively and timely assess the accounting treatment for transactions,
      including sales, purchases, inventory, taxation, acquisition of assets,
      asset valuations and capital
assets.




o
            Internal
      audit function – We did not maintain effective oversight of our internal
      control over financial reporting, including ineffective communication and
      understanding of our Code of Business Conduct and Ethics, lack of an
      appointed chief officer of internal audit functions, lack of selection
      criteria for a chief officer of internal audit functions, lack of an
      established reporting channel between our internal audit function and our
      Audit Committee, a lack of documented review or approval by our Audit
      Committee of our risk assessment, lack of effective and documented
      procedures that ensured relevant and sufficient financial-related
      information was provided to the Audit Committee in the course of its
      review of financial statements, and lack of documented evidence that the
      Audit Committee accomplished its tasks under its
  charter.




o
            Timing
      of management’s assessment – We did not timely perform and document our
      management assessment of our internal controls over financial
      reporting as of December 31,
2008.




42




·
              Significant deficiencies in
      our internal controls over financial
  reporting:




o
            Period-end
      closing procedures – We did not have formal period-end closing procedures
      in place, which did not allow effective identification, approval and
      detection of routine and non-routine accounting journal
      entries.




o
            Access
      to administrative and accounting systems – We did not adequately control
      the accountants and financial controllers who were assigned system
      administrator rights on our accounting systems while also preparing or
      reviewing journal entries.




o
            Documentation
      of accounts receivable transfers and promoters expenses – We did not have
      adequate documentation of approval by our management or confirmation from
      our customers for transfers of certain accounts receivable
      amounts.  In addition, we did not have adequate documentation of
      the incurrence, authorization or recordation of promoters
      expenses.




o
            Division
      of treasury and accounting duties – We did not adequately assess the
      compatibility of treasury and accounting duties, including the use of
      payment authorization stamps by accounting personnel who also acted as
      preparers or reviewers of journal entries or as accounting system
      administrators and the performance or review of bank
      reconciliations.





In
addition, management, under the supervision and with the participation of our
Chief Executive Officer and Chief Financial Officer, identified several control
deficiencies that it believes do not rise to the level of significant
deficiencies.





This
Annual Report does not include an attestation report of our independent
registered public accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
independent registered public accounting firm pursuant to temporary rules of the
SEC that permit us to provide only management’s report in this Annual
Report.





Remediation
Plan





We are
devoting significant resources to remediating and improving our internal
controls, including hiring additional accounting, internal audit and finance
staff, engaging consultants to assist with these functions, upgrading our
systems, and implementing additional financial and management controls,
reporting systems and procedures.  These measures may not ensure the
adequacy of our internal controls over our financial processes and reporting in
the future.  If we are unable to remediate successfully these material
weaknesses and significant deficiencies in a timely manner, investors may lose
confidence in our reported financial information, which could lead to a decline
in our stock price, limit our ability to access the capital markets in the
future, and require us to incur additional costs to improve our internal control
systems and procedures.





Changes
in Internal Controls





During
the third and fourth quarters of our 2007 fiscal year, since the end of our 2007
fiscal year, and since the end of our 2008 fiscal year, we have begun the
implementation of some of the remedial measures described above, including
hiring additional staff, engaging consultants, training our staff, implementing
more rigorous policies and procedures relating to period-end financial
reporting, journal-entry approval, supporting documentation, account
reconciliations, and management representation letters, and increasing our
corporate audit focus on key accounting controls and processes, including
documentation requirements.  We expect to continue to implement
additional financial and management controls, reporting systems and
procedures.





Item
9B. Other Information





Not
applicable.


43




PART
III





Item
10.  Directors, Executive Officers and Corporate
Governance





Directors





The
following table sets forth the name and age of each member of our board of
directors, the positions and offices held by each director with us, and the
period during which the director has served as one of our
directors.  Directors serve until the election and qualification of
their successors.




Name
            
            Age
            
            Position
            
            Director SinceLeng You-Bin
            
            44
            
            Chairman, Chief Executive Officer, President, and General Manager
            
            2003Liu Hua
            
            36
            
            Vice Chairman, Secretary, Treasurer, and Director
            
            2003Liu Sheng-Hui
            
            38
            
            Vice President of Finance, Feihe Dairy, and Director
            
            2003Hui-Lan Lee
            
            59
            
            Director
            
            2003Kirk G. Downing, Esq.
            
            56
            
            Director
            
            2005James C. Lewis, Esq.
            
            56
            
            Director
            
            2006





Leng
You-Bin has been our Chairman, Chief Executive Officer, President, and
General Manager since May 2003.  From January 2002 to May 2003, Mr.
Leng served as the Chief Executive Officer and President of American Flying
Crane Corporation. From 1997 to 2002, Mr. Leng served as the General Manager of
Feihe Dairy, and he became the Chairman and General Manager in
2000.  From 1989 to 1997, Mr. Leng served as a technician, deputy
director and director of Zhaoguang Dairy Plants, the predecessor of Feihe
Dairy.  Mr. Leng received a bachelor’s degree in food engineering from
Northeast Agriculture University, China. and Shanghai Light Industrial college
and studied business administration at Beijing University.





Liu Hua
has been our Vice Chairman since April 2008, and he has also served as
Secretary, Treasurer, and a director since May 2003.  From May 2003 to
April 2008, Mr. Liu served as our Chief Financial Officer, Secretary, and
Treasurer.  From November 2000 to May 2003, Mr. Liu served as the
Financial Officer of Feihe Dairy.  From June 1998 to November 2000,
Mr. Liu served as the Chief Executive Officer of Shenzhen Cima Limited, a
financial consulting company.  From January 1996 to June 1998, Mr. Liu
served as Chief Executive Officer of Shensheng Jiajing Inc., a trading
company.  From September 1993 to January 1996, Mr. Liu served as the
Chief Executive Officer of Zhengzhou Huacheng Limited, a trading
company.  Mr. Liu received a bachelor’s degree in finance and
economics from Xian Jiaotong University and from Shenzhen
University.





Liu
Sheng-Hui has been a director since May 2003, and he has also served as
Vice President of Finance of Feihe Dairy since August 2001.  From
January 2000 to May 2003, Mr. Liu served as Chief Financial Officer and a
director of American Flying Crane Corporation.  From September 1998 to
January 2000, Mr. Liu served as Chief Financial Officer at Feihe Dairy, where he
also served in a variety of business positions from July 1992 to September
1998.  Mr. Liu received a bachelor’s degree in economics from
Northeast Agriculture University, China, and an associate degree in accounting
from Country Cadre Institute under the Supervision of Ministry of Agriculture in
China.





Hui-Lan (“Tracy”)
Lee has been a director since June 2003.  From April 2006 to
November 2008, Ms. Lee served as Vice President of Financial Reporting of
Countrywide Home Loans, Inc., a residential mortgage company, where she also
served as Vice President and Director of Income Tax Compliance from April 2003
to April 2006.  From October 1996 to March 2003, Ms. Lee served as Tax
Manager at Watson Pharmaceuticals, Inc., a specialty pharmaceutical
company.  From 1979 to 1996, Ms. Lee held a variety of management
positions with companies such as The Flying Tiger Line Inc., a large air cargo
company, Quotron Systems, Inc., a large supplier of equity data to the financial
community, and Lear Siegler, Inc., a conglomerate company in aerospace,
automotive, agriculture and other industries.  Ms. Lee holds a
bachelor’s degree in business administration from National Cheng-Kung
University, Taiwan, a Master of Science degree in Taxation from Golden Gate
University, and a Master of Business Administration from Indiana
University.


44




Kirk G.
Downing has been a director since February 2005.  From December
1980 to the present, he has been practicing law in Los Angeles, California. From
January 1989 to June 1997, Mr. Downing also engaged in ranching, farming,
logging and property development.  Mr. Downing received a
bachelor’s degree in liberal arts from Portland State University and a Juris
Doctorate degree from Loyola Law School.





James C.
Lewis has been a director since December 2006.  From 2006 to
the present, Mr. Lewis has been a partner in the law firm of Lewis, Hansen,
Waldo & Pleshe, in Salt Lake City, Utah.  From July 2002 to
September 2006, Mr. Lewis was involved in a number of private business ventures
and practiced law under the name James C. Lewis, L.C. in Salt Lake City,
Utah.  From 2000 to June 2002, Mr. Lewis was a member of the firm of
Jones, Waldo, Holbrook & McDonough, Salt Lake City, Utah.  From
1997 to 2000, Mr. Lewis was a partner in the firm of Lewis Law
Offices.  From 1993 to 1997, Mr. Lewis was a partner in the firm of
Diumenti & Lewis. From 1987 to 1992, he was a partner in the firm of Lewis
& Lehman. From 1979 to 1985, Mr. Lewis was an attorney with Kruse, Landa
& Maycock.  Mr. Lewis received a bachelor’s degree in psychology
from the University of Utah and a Juris Doctorate from the University of San
Diego.





Director
Independence





The board
of directors has determined that Hui-Lan Lee, Kirk G. Downing and James C. Lewis
are each an independent director as defined by the listing standards of the NYSE
Arca and SEC rules.





Board
Committees





Our board
of directors has established the following committees:  the Audit
Committee, the Compensation Committee, the Nominating/Corporate Governance
Committee, the Executive Committee and the Finance Committee.  Our
Audit Committee, Compensation Committee and Nominating/Corporate Governance
Committee each operate under a written charter adopted by the board of
directors, copies of which is available on our website at www.americandairyinc.com.  Our
board of directors and its committees set schedules to meet throughout the year
and also can hold special meetings and act by written consent from time to time,
as appropriate.  The committees report on their activities and actions
to the board of directors.





Audit
Committee


Our Audit
Committee consists of Kirk G. Downing, James C. Lewis and Hui-Lan Lee, each of
whom is an independent director as defined by the listing standards of the NYSE
Arca and SEC rules.  The board of directors has determined that Ms.
Lee is an “Audit Committee Financial Expert,” as defined in Item 407(d)(5)
of Regulation S-K.  Our Audit Committee appoints, retains, compensates
and oversees our independent public accountants and reviews the scope and
results of the annual audits, receives reports from our independent public
accountants, and reports the committee’s findings to the board of
directors.





Compensation
Committee Interlocks and Insider Participation





The
current members of our Compensation Committee are Leng You-Bin, Lee Hui-Lan, and
James C. Lewis.  Except for Leng You-Bin, our Chairman, Chief
Executive Officer, President, and General Manager, none of the members of our
compensation committee is an officer or employee of our company.  None
of our executive officers serve, or in the past year has served, as a member of
the board of directors or Compensation Committee of any entity that has one or
more executive officers serving on our board of directors or Compensation
Committee.  See “Item 13. Certain Relationships and
Related Transactions, and Director Independence—Transactions with Related
Persons” below for a
summary of related party transactions involving Mr. Leng.




45




Executive
Officers





The
following table sets forth the name and age of each of our executive officers,
the positions and offices held by each executive officer with us, and the period
during which the executive officers has served as one of our executive
officers.  All officers serve at the pleasure of the board of
directors.




Name
            
            Age
            
            Position
            Officer SinceLeng You-Bin
            
            
            44
            
            Chairman, Chief Executive Officer, President, and General Manager
            2003Liu Hua
            
            
            36
            
            Vice Chairman, Secretary, Treasurer, and Director
            2000Jonathan H. Chou
            
            
            44
            
            Chief Financial Officer
            2008Liu Sheng-Hui
            
            
            39
            
            Vice President of Finance, Feihe Dairy, and Director
            2001Nie Bo
            
            
            37
            
            Head of Sales and Marketing
            2007





Leng
You-Bin’s biographical summary is included under “—Directors.”





Liu Hua’s
biographical summary is included under “—Directors.”





Jonathan
H.
Chou
has been our Chief Financial Officer since April 2008.  From February
2007 to June 2007, Mr. Chou served as the Asia Pacific Corporate Chief Financial
Officer and Vice President of Mergers & Acquisitions for Honeywell
International. From September 2003 to June 2006, Mr. Chou served as the Asia
Regional Chief Financial Officer of Tyco Fire & Security (ADT), a division
of Tyco International. From May 2000 to September 2003, Mr. Chou served the Asia
Pacific Chief Financial Officer of Lucent Technologies, where he oversaw
regional Sarbanes-Oxley compliance and restructuring efforts during the downturn
of the telecommunication sector. Mr. Chou received a bachelor’s degree in arts
from the State University of New York at Buffalo and a Masters of Business
Administration degree from Fuqua School of Business at Duke
University.





Liu
Sheng-Hui’s biographical summary is included under“—Directors.”





Nie Bo has
been our Head of Sales and Marketing since July 2007.  From November
2006 to July 2007, Mr. Nie served as Vice General Manager and National Sales
Director for Anlijia Dairy (Beijing) Limited, a dairy company.  From
February 2003 to November 2006, Mr. Nie served as National Sales Director for
Inner Mongolia Yili Industrial Group Co., Ltd., a large dairy company in
China.  From October 2001 to February 2003, Mr. Nie served as Manager
of North China Region for Anyi Dairy, a large New Zealand dairy enterprise. From
October 1998 to September 2001, Mr. Nie served as Manager Assistant and Regional
Sales Manager for Meadow Gold Investment Co., Ltd., a multinational dairy
products company.  Mr. Nie received a bachelor’s degree in thermal
engineering from Central South University of Technology in Hunan Province,
China.





Item
11. Executive Compensation





Compensation
Discussion and Analysis





Our
Compensation Committee assists our board of directors in reviewing and approving
the compensation structure of our directors and executive officers, including
all forms of compensation to be provided to our directors and executive
officers.  With the responsibility of establishing, implementing and
monitoring our executive compensation program philosophy and practices, our
Compensation Committee seeks to ensure that the total compensation paid to our
directors and executive officers is fair and competitive.




46




Compensation
Philosophy and Objectives





Our
Compensation Committee’s goals regarding executive compensation are primarily to
recruit, hire, retain, motivate and reward.  In determining what
constitutes a fair and competitive compensation for each executive, our
Compensation Committee evaluates individual executive performance with a goal of
setting compensation at levels based on the executive’s general business and
industry knowledge and experience and comparable to executives in other
companies of similar size and stage of development, while taking into account
our relative performance and our strategic goals.





We
conduct an annual review of the aggregate level of our executive
compensation as part of the annual budget review and annual performance review
processes.  During our review of an individual executive’s
compensation, our Compensation Committee primarily considers individual
performance of that executive and internal review of the executive’s
compensation, both individually and relative to other executive
officers.  Our Compensation Committee also considers factors of
corporate performance including the stock prices, sales, revenue and the current
overall economic situation.  Adjustments to salary levels are
typically made annually as part of the company’s performance review process, as
well as upon a change in job responsibility.  Merit-based increases to
salaries are based on our Compensation Committee’s assessment of the
individual’s performance.





While we
do not currently have performance-based compensation arrangements in place, we
intend to implement such arrangements as we believe such arrangements can better
align the interests of the key executives with our
shareholders.  After implementing such arrangements, our Compensation
Committee intends to grant equity awards to our executives if certain
performance goals are met, such as those based on specified increases in cash
flow, net profits, stock price, sales, market shares or earnings per
share.





Setting
Executive Compensation





Historically,
our executive compensation has consisted of base salary and equity
incentives:





Base Salary:  Our
Compensation Committee determines executive salaries based on job
responsibilities and individual experience, and also compares the amounts we pay
against comparable competitive market compensation for similar positions within
similar industries.  In making such a comparison, we review
compensation information made available to us through recruiting or investors
relations firms as well as public data of a peer group comprised of at least
twenty companies, which include Chinese dairy companies listed on stock
exchanges in countries other than China (including, for example, companies such
as China Mengniu Dairy Company Limited and Synutra International, Inc.), U.S.
listed companies with substantial if not all operations in China (including, for
example, companies such as American Oriental Bioengineering Inc. and New
Oriental Education and Technology Group Inc.), and American companies in the
food and/or dairy industries (including, for example, companies such as
Dean Foods Company and Kraft Foods, Inc.).  We expect to continue
to provide competitive salaries to our executive officers by reviewing the
salaries of our executives annually and, if appropriate, recommending increases
in salaries based on individual performance during the prior calendar year and
cost of living adjustments.





Equity Awards:  Our
Compensation Committee determines stock, options and other awards after
consulting with recruiting firms that provide market information concerning
equity awards to executives of similar positions in the peer group of companies
described above.  We have adopted a 401(k) plan and intend to adopt
formal programs for time off allocation and performance bonuses in the
future.


47




Monitoring
Executive Compensation Program





Our
Compensation Committee monitors our executive compensation program by routinely
comparing it to the compensation programs of similarly situated companies and
considering other factors such as performance, length of service, peer
evaluations, subjective and objective reviews.  As a result of its
examination in 2008, our Compensation Committee recommended, and our board of
directors approved, a cash compensation package of $200,000 for each of
Leng You-Bin, our Chairman, Chief Executive Officer, President, and General
Manager, and Liu Hua, who served as our Chief Financial Officer until April
15, 2008 and who continues to serve as our Vice Chairman, Secretary, Treasurer,
and a director, for services rendered in 2008.





Summary
Compensation Table




Name and Principal Position
      (1)
                                                  
                                                  Fiscal Year
                                                  
                                                  Bonus
                                                  
                                                  Salary
                                                  
                                                  Equity Awards
      (2)
                                                  
                                                  
                                                  TotalLeng
      You-Bin, Chairman, Chief Executive Officer,
                                                  
                                                  2007
                                                  
                                                  0
                                                  
                                                  200,000
                                                  
                                                  
                                                  68,250
                                                  
                                                  
                                                  
                                                  268,250President,
      and General Manager
                                                  
                                                  2008
                                                  
                                                  0
                                                  
                                                  200,000
                                                  
                                                  
                                                  120,560
                                                  
                                                  
                                                  
                                                  320,560Liu
      Hua, Vice Chairman, Secretary, Treasurer, and
                                                  
                                                  2007
                                                  
                                                  0
                                                  
                                                  200,000
                                                  
                                                  
                                                  68,250
                                                  
                                                  
                                                  
                                                  268,250Director 
      (3)
                                                  
                                                  2008
                                                  
                                                  0
                                                  
                                                  200,000
                                                  
                                                  
                                                  120,560
                                                  
                                                  
                                                  
                                                  320,560Jonathan
      H. Chou, Chief Financial Officer
                                                  
                                                  2007
                                                  
                                                  0
                                                  
                                                  0
                                                  
                                                  
                                                  0
                                                  
                                                  
                                                  
                                                  02008 (4)
                                                  
                                                  55,000
                                                  
                                                  116,667
                                                  
                                                  
                                                  140,689
                                                  
                                                  
                                                  
                                                  312,356





(1)
            Identifies
      our principal executive and principal financial officers during the
      specified periods.




(2)
            Represents
      the dollar amount of expense recognized for financial statement reporting
      purposes with respect to awards of common stock or options to acquire
      common stock issued under our 2003 Stock Incentive Plan, in accordance to
      SFAS 123(R).  See the notes to our financial statements
      contained herein for an explanation of all assumptions made by us in
      determining the SFAS 123(R) values of our equity
  awards.




(3)
              Liu
      Hua served as our Chief Financial Officer until April 15, 2008, and
      thereafter has continued to serve as our Vice Chairman, Secretary,
      Treasurer and a director. Amounts indicated include full year compensation
      Mr. Liu received.


(4)
            Includes
      a signing bonus of approximately $55,000 and a proration of Mr. Chou’s
      annual salary of $175,000 based on an April 15, 2008 employment
      commencement date.





Employment
Agreements





On April
15, 2008, we entered into an employment agreement with Jonathan H. Chou, who
became our Chief Financial Officer on that date.  The agreement has a
four-year term and provides that Mr. Chou will receive a base salary of
$175,000, a signing bonus of approximately $55,000, and options to acquire up to
270,000 shares of our common stock according to a 48-month vesting
schedule.  Mr. Chou is also eligible to receive discretionary bonuses
at times and in amounts determined by our Compensation Committee and to
participate in medical, health, dental, disability, liability insurance and life
insurance benefits, and certain other fringe benefits available to executive
officers.  We plan to enter into similar employment agreements with
other executive officers in the future.


48


Benefit
Plans





We do not
have any profit sharing plan or similar plans for the benefit of our officers,
directors or employees. However, we may establish such plans in the
future.  Certain employees of our subsidiaries, including Leng
You-Bin, our Chairman, Chief Executive Officer, President, and General Manager,
have pension and healthcare benefits through plans offered by such subsidiaries,
as required by local Chinese laws.





Incentive
Stock Plan





Effective
April 1, 2003, we adopted and approved our 2003 Incentive Stock Plan, which
reserves 3,000,000 shares of common stock for issuance under the plan. The plan
allows us to issue awards of incentive or non-qualified stock options, stock
appreciation rights, and stock bonuses which may be subject to
restrictions.  We granted to directors, employees, and management a
total of 72,500 shares of common stock during 2008.





Our 2003
Incentive Stock Plan is administered by our Compensation Committee, which
consists of Leng You-Bin, our Chairman, our Chief Executive Officer, President,
and General Manager, Lee Hui-Lan, and James C. Lewis.  For the fiscal
year ended December 31, 2008, no plan-based awards were granted to our named
executive officers for services rendered in their executive
positions.  Our named executive officers do not have any unexercised
stock options, stock that has not yet vested or equity incentive awards
outstanding as of the fiscal year ended December 31, 2008, except as
follows:





Name and Principal Position (1)
                              
                              Grant Date
                              
                              Shares
                                Underlying
                                Options
                              
                              Exercise
                                Price Per
                                Share
                              
                              Vesting Date
                              
                              Expiration DateJonathan H. Chou, Chief Financial Officer
                              
                              October 15, 2008
                              
                              80,000
                              
                              $
                              12.00
                              
                              October 15, 2009
                              
                              October 15, 2012





Compliance with Section 16(a) of the Exchange
Act





Section
16(a) of the Exchange Act requires our executive officers and directors, and
persons who beneficially own more than 10% of our equity securities, to file
reports of ownership and changes in ownership with the
SEC.  Officers, directors and greater than 10% shareholders are
required by SEC regulation to furnish us with copies of all Section 16(a) forms
they file.





Based on
our review of the copies of such forms we have received, we believe that during
the year ended December 31, 2008, filing requirements applicable to our
officers, directors and 10% owners of our common stock were complied
with.





49





Board
Compensation





Our
directors received compensation during the year ended December 31, 2008, as
follows:




Name
                  
                  Stock Awards (1)Leng
      You-Bin
                  
                  $
                  120,560
                  (2)Liu
      Hua
                  
                  $
                  120,560
                  (2)Liu
      Sheng-Hui
                  
                  $
                  120,560Hui-Lan
      Lee
                  
                  $
                  150,700Kirk
      G. Downing
                  
                  $
                  120,560James
      C. Lewis
                  
                  $
                  120,560




(1)
            Represents
      the dollar amount of expense recognized for financial statement reporting
      purposes with respect to awards of common stock under our 2003 Stock
      Incentive Plan, in accordance to SFAS 123(R).  All directors
      received an award of 4,000 restricted shares of our common stock for their
      2008 board service, with an additional 1,000 shares issued to the
      chairperson of our Audit Committee, Hui-Lan Lee.  See the notes
      to our financial statements contained herein for an explanation of all
      assumptions made by us in determining the SFAS 123(R) values of our stock
      awards.




(2)
            Reflected
      in the Summary Compensation Table above under the caption “Stock
      Awards.”





Severance
and Change of Control Agreement





As of
December 31, 2008, we had no agreements or arrangements providing for payments
to a named executive officer in connection with any termination.





Limited
Liability and Indemnification





Section
16-10a-840 of the Utah Revised Business Corporation Act, or the URBC, requires
directors and officers to perform their duties in good faith and with the care
that an ordinary person would exercise under similar circumstances in a manner
reasonably believed to be in the best interest of the corporation. A director or
officer of a corporation is not liable to the corporation, its shareholders or
others for any action taken or any failure to act as an officer or director
unless he has breached or failed or failed to perform his duties as described
above and the breach or failure to perform constitutes gross negligence, willful
misconduct, or intentional infliction of harm on the corporation or its
shareholders.





Section
16-10a-841 of the URBC provides that the articles of incorporation of a Utah
corporation may eliminate or limit the liability of a director to the
corporation or its shareholders for monetary damages, except for (i) a financial
benefit to which is not entitled; (ii) an intentional infliction of harm; (iii)
unlawful distributions of the corporation constituting a violation of Section
16-10a-842 of the URBC; or (iv) an intentional violation of criminal
law.





Section
16-10a-902 of the URBC permits a Utah corporation to indemnify directors made a
party to a proceeding because he is or was a director if (i) his conduct was in,
or not opposed to, the corporation’s best interest; and (ii) he reasonably
believed his conduct was in, or not opposed to, the corporation’s best
interests; and (iii) in the case of a criminal proceeding, he had no reasonable
cause to believe his conduct was unlawful. However, a Utah corporation may not
indemnify a director if he was adjudged liable to the corporation, or if he was
adjudged liable on the basis that he derived an improper personal benefit; and
such indemnification in any action brought by the corporation is limited to
reasonable expenses incurred in connection with the proceedings.





50





Article
VI of our Articles of Incorporation and Article VIII of our Bylaws provide for
the indemnification of our directors and officers. Indemnification is mandatory
regarding reasonable expenses incurred in connection with proceedings or claims
with respect to which the director or officer has been successful. Officers,
employees, fiduciaries and agents of a Utah corporation may be entitled to
indemnification to a greater extent, if not inconsistent with public policy or
if provided for in a company's articles of incorporation, bylaws, general or
specific action of its board of directors or contract.





Consultants





We may
retain compensation consultants to the extent we deem it necessary and
appropriate.  We will not delegate our authority and responsibility to
make management decisions to consultants or any other persons, nor shall any
consultant have any discretionary authority or the authority to bind us in any
material respect.





Compensation
Committee Report





We, the
Compensation Committee of the Board, have reviewed and discussed the
Compensation Discussion and Analysis contained in this proxy statement with
management.  Based on such review and discussion, we have recommended
to the Board that the Compensation Discussion and Analysis be included in this
Annual Report on Form 10-K for the fiscal year ended December 31,
2008.




Compensation
      CommitteeLeng
      You-BinJames
      C. LewisHui-Lan
      Lee




51





Item 12. Security
Ownership of Certain Beneficial Owners and Management and Related Stockholder
Matters





The
following table sets forth, as of March 31, 2009, information concerning the
beneficial ownership of shares of our common stock held by our directors, our
executive officers, our directors and executive officers as a group, and each
person known by us to be a beneficial owner of 5% or more of our outstanding
common stock.





Beneficial
ownership is determined according to the rules of the SEC.  Beneficial
ownership means that a person has or shares voting or investment power of a
security and includes any securities that person has the right to acquire within
60 days after the measurement date, such as pursuant to options, warrants or
convertible notes.  Except as otherwise indicated, we believe that
each of the beneficial owners of our common stock listed below, based on
information each of them has given to us, has sole investment and voting power
with respect to such beneficial owner’s shares, except where community property
or similar laws may apply.  For purposes of the column for shares
underlying convertible securities, in accordance with rules of the SEC, shares
of our common stock underlying securities that a person has the right to acquire
within 60 days of March 31, 2009 are deemed to be beneficially owned by such
person for the purpose of computing the percentage ownership of that person, but
we do not treat them as outstanding for the purpose of computing the ownership
percentage of any other person.




Common Stock Beneficially OwnedName and Address of Beneficial Owner
                                  
                                  Total
                                    Outstanding
                                  
                                  
                                  Shares
                                    Underlying
                                    Convertible
                                    Securities (1)
                                  
                                  
                                  Total
                                  
                                  
                                  Percent (2)Directors
      and Executive OfficersLeng
      You-Bin (3)
                                  
                                  
                                  8,900,135
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  8,900,135
                                  
                                  
                                  
                                  51.6
                                  %Liu
      Hua (3)
                                  
                                  
                                  27,200
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  27,200
                                  
                                  
                                  
                                  
                                  *Jonathan
      H. Chou (3)
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  %Liu
      Sheng-Hui (3)
                                  
                                  
                                  287,774
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  287,774
                                  
                                  
                                  
                                  1.7
                                  %Hui-Lan
      Lee (3)
                                  
                                  
                                  39,500
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  39,500
                                  
                                  
                                  
                                  
                                  *Kirk
      Downing (3)
                                  
                                  
                                  14,500
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  14,500
                                  
                                  
                                  
                                  
                                  *James
      C. Lewis (3)(4)
                                  
                                  
                                  35,000
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  35,000
                                  
                                  
                                  
                                  
                                  *Nie
      Bo (3)
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  0
                                  %Directors
      and executive officers as a group
                                    (8
      persons)
                                  
                                  
                                  9,304,109
                                  
                                  
                                  
                                  
                                  
                                  
                                  
                                  9,304,109
                                  
                                  
                                  
                                  53.9
                                  %5%
      Beneficial OwnersEntities
      associated Pike Capital Partners (5)
                                  
                                  
                                  1,881,519
                                  
                                  
                                  
                                  250,000
                                  
                                  
                                  
                                  2,131,519
                                  
                                  
                                  
                                  12.2
                                  %275
      Madison Avenue, Suite 418New
      York, NY 10016River
      Road Asset Management (6)
                                  
                                  
                                  1,092,294
                                  
                                  
                                  
                                  0
                                  
                                  
                                  
                                  1,092,294
                                  
                                  
                                  
                                  6.3
                                  %462
      S. 4th Street, Suite 1600Louisville,
      KY 40202*Less
      than 1%




(1)
              Includes
      shares of our common stock issuable upon exercise of options or upon
      conversion of warrants or convertible notes, if the person has the right
      to acquire such shares within 60 days of March 30,
  2009.
 (2)
              Based
      on 17,253,907 shares of our common stock outstanding as of March 31,
      2009.
 (3)
              The
      address for this beneficial owner is c/o American Dairy, Star City
      International Building, 10 Jiuqianxiao Road, C-16th Floor, Chaoyang
      District, Beijing, China 100016.
 (4)
              James
      C. Lewis holds such shares jointly with his
  spouse.
 (5)
              Consists
      of 1,686,196 shares of our common and warrants to purchase 219,514 shares
      of our common stock held by Pike Capital Partners (QP) LP (“PCPQP”), and
      195,323 shares of our common stock and warrants to purchase 30,486 shares
      of our common stock held by Pike Capital Partners LP
      (“PCP”).  Pike Capital Management LLC (“PCM”) is the general
      partner of PCPQP and of PCP.  Daniel W. Pike is the managing
      member of PCM and, in such capacity, has voting and dispositive power over
      such shares.
 (6)
              Thomas
      D. Mueller is the Chief Operating officer and Chief Compliance Officer of
      River Road Asset Management, LLC, and, in such capacity, has voting and
      dispositive power over such
shares.




52





The
following table sets forth information issuances of securities pursuant to
equity compensation plans as of December 31, 2008:




Plan Category
                    
                    Number of
                      securities issued
                      and to be issued
                      upon exercise of
                      outstanding
                      options, warrants
                      and rights
                    
                    
                    Weighted-average
                      exercise price of
                      outstanding options,
                      warrants and rights
                    
                    
                    Number of
                      securities
                      remaining
                      available for
                      future issuanceEquity compensation plans approved by security holders
                    
                    
                    454,020
                    
                    
                    $
                    20.30
                    
                    
                    
                    2,545,980Total
                    
                    
                    454,020
                    
                    
                    $
                    20.30
                    
                    
                    
                    2,545,980





Item
13. Certain Relationships and Related Transactions, and Director
Independence





Transactions
with Related Persons





Leng
You-Bin, our Chairman, Chief Executive Officer, President, and General Manager,
is also the founder of a Heilongjiang Feihe Dairy Educational Charitable
Foundation, or HFDECF, charitable organization for under-privileged children in
the Heilongjiang Province of the PRC.  We have an outstanding loan
payable to HFDECF, which is unsecured, accrues interest at an annual rate of
5.85%, and is payable on demand.  In 2008, the largest aggregate
amount of the indebtedness outstanding, including accrued interest, was
approximately $253,000.





Review,
Approval or Ratification of Transactions with Related Persons





Although
we have not adopted formal procedures for the review, approval or ratification
of transactions with related persons, we adhere to a general policy that such
transactions should only be entered into if they are on terms that, on the
whole, are no more favorable, or no less favorable, than those available from
unaffiliated third parties and their approval is in accordance with applicable
law.  Such transactions require the approval of our board of
directors.





Corporate
Governance





The board
of directors has determined that Hui-Lan Lee, Kirk Downing and James C. Lewis,
are each an independent director under the general guidelines for determining
director independence of the NYSE Arca and the rules of the SEC.





53





Item
14. Principal Accountant Fees and Services





The
following table sets forth the professional service aggregate fees of our
principal accountants for the services and periods indicated:





Name
                        
                        Audit Fees (1)Murrell,
      Hall, McIntosh & Co., PLLP for fiscal year ended (2):December
      31, 2007
                        
                        
                        0December
      31, 2008
                        
                        
                        0Grant
      Thornton, for fiscal year ended:December
      31, 2007
                        
                        
                        1,109,448December
      31, 2008
                        
                        
                        100,000
                        (3)





(1)
              This
      category includes the audit of our annual financial statements, the audit
      of our internal control over financial reporting, review of unaudited
      quarterly financial statements included in our Form 10-Q quarterly
      reports, and services that are normally provided by the independent
      registered public accounting firm in connection with regulatory filings or
      engagements, for those fiscal years.  This category also
      includes advice on accounting matters that arose during, or as a result
      of, the audit or the review of interim financial statements. These fees
      represent all fees paid to our principle accountants for the periods
      indicated.




(2)
                In
      December 2007, we dismissed Murrell, Hall, McIntosh & Co., PLLP, or
      MHM, as our independent registered public accountant following
      notification of our informal SEC investigation related to individuals and
      entities that provided certain advisory services to us. In April 2008, we filed a lawsuit against MHM
      in the United States District Court for the Western District of Oklahoma
      alleging that MHM breached its duties of due care and professional
      competence when serving as our independent registered public
      accountant.


(3)
              Represents
      initial amounts billed to date for 2008 audit fees; additional amounts
      expected.





Our Audit
Committee’s policy is to pre-approve all audit and permissible non-audit
services provided by our independent registered public accounting
firm.  These services may include audit services, audit-related
services, tax services and other services.  Pre-approval is generally
provided for up to one year and any pre-approval is detailed as to the
particular service or category of services.  The independent
registered public accounting firm and management are required to periodically
report to our Audit Committee regarding the extent of services provided by the
independent registered public accounting firm in accordance with this
pre-approval.  None of the services related to Audit-Related Fees, Tax
Fees or All Other Fees described above were approved by our Audit Committee
pursuant to a waiver of pre-approval provisions set forth in applicable rules of
the SEC.





54





PART
IV





Item
15. Exhibits and Financial Statement Schedules





Financial
Statements


The
financial statements required by this item are included herein:




Report
      of Independent Registered Public Accounting FirmAudited
      Financial StatementsConsolidated
      Balance Sheets
                                    F-1Consolidated
      Statements of Operations and Comprehensive Income
                                    F-2Consolidated
      Statements of Changes in Shareholders’ Equity
                                    F-3Consolidated
      Statements of Cash Flows
                                    F-4Notes
      to the Consolidated Financial Statements
                                    F-5





Exhibits


The
following exhibits are filed as a part of this Annual Report.




Incorporated by ReferenceExhibit No.
                                                    
                                                    Exhibit Title
                                                    
                                                    Filed
                                                      Herewith
                                                    
                                                    Form
                                                    
                                                    Exhibit No.
                                                    
                                                    File No.
                                                    
                                                    Filing Date2
                                                    
                                                    Stock
      Exchange Agreement, dated as of January 15, 2003, by andamong
      the registrant, the registrant’s shareholders and LazarusIndustries,
      Inc.
                                                    
                                                    
                                                    
                                                    8-K
                                                    
                                                    2.1
                                                    
                                                    000-27351
                                                    
                                                    1/21/032.1
                                                    
                                                    Amendment
      to Stock Exchange Agreement, dated as of March 5, 2003, by and among the
      registrant, the registrant’s shareholders and Lazarus Industries,
      Inc
                                                    
                                                    
                                                    
                                                    8-K/A
                                                    
                                                    2.2
                                                    
                                                    000-27351
                                                    
                                                    3/5/033.1
                                                    
                                                    Articles
      of Incorporation
                                                    
                                                    
                                                    
                                                    10-SB
                                                    
                                                    1
                                                    
                                                    000-27351
                                                    
                                                    9/16/993.2
                                                    
                                                    Amendment
      to Articles of Incorporation
                                                    
                                                    
                                                    
                                                    10-KSB/A
                                                    
                                                    3.2
                                                    
                                                    000-27351
                                                    
                                                    5/25/043.3
                                                    
                                                    Bylaws
                                                    
                                                    
                                                    
                                                    10-SB
                                                    
                                                    2
                                                    
                                                    000-27351
                                                    
                                                    9/16/994.1
                                                    
                                                    Private
      Placement Memorandum, together with subscription documents, dated as of
      June 30, 2003
                                                    
                                                    
                                                    
                                                    S-1/A
                                                    
                                                    4.1
                                                    
                                                    333-128075
                                                    
                                                    10/6/064.2
                                                    
                                                    Private
      Placement Memorandum, together with subscription documents, dated as of
      April 26, 2004
                                                    
                                                    
                                                    
                                                    S-1/A
                                                    
                                                    4.2
                                                    
                                                    333-128075
                                                    
                                                    10/6/064.3
                                                    
                                                    Private
      Placement Memorandum, together with subscription documents, dated as of
      June 30, 2004
                                                    
                                                    
                                                    
                                                    S-1/A
                                                    
                                                    4.3
                                                    
                                                    333-128075
                                                    
                                                    10/6/064.4
                                                    
                                                    Series
      A Convertible Note, maturity date April 26, 2006
                                                    
                                                    
                                                    
                                                    10-QSB
                                                    
                                                    10.1
                                                    
                                                    001-32473
                                                    
                                                    8/15/054.5
                                                    
                                                    Series
      B Convertible Note, maturity date June 30, 2007
                                                    
                                                    
                                                    
                                                    10-QSB
                                                    
                                                    10.2
                                                    
                                                    001-32473
                                                    
                                                    8/15/054.6
                                                    
                                                    Series
      B Convertible Note, maturity date August 13, 2007
                                                    
                                                    
                                                    
                                                    10-Q
                                                    
                                                    10.5
                                                    
                                                    001-32473
                                                    
                                                    11/14/054.7
                                                    
                                                    Form
      of 7.75% Convertible Note
                                                    
                                                    
                                                    
                                                    8-K/A
                                                    
                                                    4.1
                                                    
                                                    001-32473
                                                    
                                                    10/6/064.8
                                                    
                                                    Form
      of Common Stock Purchase Warrant
                                                    
                                                    
                                                    
                                                    8-K/A
                                                    
                                                    4.2
                                                    
                                                    001-32473
                                                    
                                                    10/6/0610.1
                                                    
                                                    Consulting
      Agreement, dated as of March 28, 2003, by and between the registrant and
      Danbury Properties, L.L.C.
                                                    
                                                    
                                                    
                                                    10-KSB
                                                    
                                                    10.3
                                                    
                                                    000-27351
                                                    
                                                    4/05/0410.2
                                                    
                                                    Stock
      Purchase Agreement, dated as of March 28, 2003, by and among the
      registrant, the registrant’s shareholders and Lazarus Industries,
      Inc
                                                    
                                                    
                                                    
                                                    10-KSB
                                                    
                                                    10.4
                                                    
                                                    000-27351
                                                    
                                                    4/15/0410.3
                                                    
                                                    Joint
      Venture Agreement to organize Beijing Feihe
                                                    
                                                    
                                                    
                                                    10-QSB
                                                    
                                                    10.1
                                                    
                                                    000-27351
                                                    
                                                    5/17/0410.4
                                                    
                                                    2003
      Stock Incentive Plan
                                                    
                                                    
                                                    
                                                    S-8
                                                    
                                                    10
                                                    
                                                    333-123932
                                                    
                                                    4/7/0510.5
                                                    
                                                    Asset
      Purchase Agreement, dated as of May 20, 2005, by and between the
      registrant and Nutricia Nutritionals Col, Ltd.
                                                    
                                                    
                                                    
                                                    8-K
                                                    
                                                    10.1
                                                    
                                                    001-32473
                                                    
                                                    5/26/05





55




Incorporated by ReferenceExhibit
                                    No
                                  
                                  Exhibit Title
                                  
                                  Filed
                                    Herewith
                                  
                                  Form
                                  
                                  Exhibit
                                    No.
                                  
                                  File No.
                                  
                                  Filing
                                    Date10.6
                                  
                                  RMB
      Loan Contract, dated as of June 24th, 2005, by and between Feihe Dairy and
      Qiqihaer Branch of China Construction Bank Co., Ltd.
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.9
                                  
                                  333-128075
                                  
                                  7/19/0610.7
                                  
                                  Construction
      Contract by and between Shanxi Feihe and Changzhi subsidiary company of
      Henan Construction Project Company
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.10
                                  
                                  333-128075
                                  
                                  7/19/0610.8
                                  
                                  Form
      of Subscription Agreement, dated as of October 3, 2006, by and between the
      registrant and investors listed therein
                                  
                                  
                                  
                                  8-K/A
                                  
                                  10.1
                                  
                                  333-128075
                                  
                                  10/6/0610.9
                                  
                                  Form
      of Registration Rights Agreement, dated as of October 3, 2006, by and
      between the registrant and investors listed therein
                                  
                                  
                                  
                                  8-K/A
                                  
                                  10.2
                                  
                                  333-128075
                                  
                                  10/6/0610.10
                                  
                                  Loan
      Contract of Current Capital, by and between Heilong Jiang Flying Crane
      Dairy Co., Ltd and Kedong County branch of Agricultural Development Bank
      of China
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.13
                                  
                                  333-128075
                                  
                                  12/6/0610.11
                                  
                                  RMB
      Loan Contract, by and between Feihe Dairy and Qiqihaer Branch of China
      Construction Bank Co., Ltd.
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.11
                                  
                                  333-128075
                                  
                                  12/6/0610.12
                                  
                                  RMB
      Loan Contract, by and between Feihe Dairy and Qiqihaer Branch of China
      Construction Bank Co., Ltd.
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.12
                                  
                                  333-128075
                                  
                                  12/6/0610.13
                                  
                                  Form
      of Dairy Contract
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.14
                                  
                                  333-128075
                                  
                                  12/6/0610.14
                                  
                                  Product
      Purchase and Sale Contract, dated as of December 26, 2005, by and between
      Feihe Dairy and Changxing Dairy
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.14
                                  
                                  333-128075
                                  
                                  3/19/0710.15
                                  
                                  Product
      Purchase and Sale Contract, dated as of April 26, 2004, by and between
      Feihe Dairy and Changxing Dairy
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.15
                                  
                                  333-128075
                                  
                                  3/19/0710.16
                                  
                                  Share
      Transference Agreement, dated as of July 1, 2006, by and between the
      registrant and Shanxi Li Santai Science and Technology Co.,
      Ltd.
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.16
                                  
                                  333-128075
                                  
                                  4/17/0710.17
                                  
                                  Amended
      and Restated Notes Purchase Agreement, dated as of June 1, 2007, by and
      among the registrant, Leng You-Bin, Liu Hua and Citadel Equity
      Fund
                                  
                                  
                                  
                                  8-K
                                  
                                  10.1
                                  
                                  001-32473
                                  
                                  6/4/0710.18
                                  
                                  Indenture,
      dated as of June 1, 2007, by and between the registrant and The Bank of
      New York.
                                  
                                  
                                  
                                  8-K
                                  
                                  10.2
                                  
                                  001-32473
                                  
                                  6/4/0710.19
                                  
                                  Form
      of Note (attached as exhibit to the Indenture filed as Exhibit
      10.19)
                                  
                                  
                                  
                                  8-K
                                  
                                  10.2
                                  
                                  001-32473
                                  
                                  6/4/0710.20
                                  
                                  Registration
      Rights Agreement
                                  
                                  
                                  
                                  8-K
                                  
                                  10.3
                                  
                                  001-32473
                                  
                                  6/4/0710.21
                                  
                                  Investor
      Rights Agreement
                                  
                                  
                                  
                                  8-K
                                  
                                  10.4
                                  
                                  001-32473
                                  
                                  6/4/0710.22
                                  
                                  Share
      Pledge Agreement
                                  
                                  
                                  
                                  8-K
                                  
                                  10.5
                                  
                                  001-32473
                                  
                                  6/4/0710.23
                                  
                                  Indenture,
      dated as of June 27, 2007, by and among the registrant, the holders listed
      therein and The Bank of New York
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.25
                                  
                                  333-128075
                                  
                                  6/28/0710.24
                                  
                                  Form
      of 1% Guaranteed Senior Secured Convertible Note (attached as an exhibit
      to the Indenture filed as exhibit 10.25)
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.25
                                  
                                  333-128075
                                  
                                  6/28/0710.25
                                  
                                  Form
      of Accession Letter
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.26
                                  
                                  333-128075
                                  
                                  6/28/0710.26
                                  
                                  Form
      of Non-Competition Agreement, by and between the registrant and each of
      Mr. Leng You-Bin and Roger Liu
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.27
                                  
                                  333-128075
                                  
                                  6/28/0710.27
                                  
                                  Joinder
      Agreement
                                  
                                  
                                  
                                  S-1/A
                                  
                                  10.28
                                  
                                  333-128075
                                  
                                  6/28/0710.28
                                  
                                  Loan
      Agreement, dated as of June 27, 2007, by and between the registrant and
      Moveup
                                  
                                  
                                  
                                  10-Q/A
                                  
                                  10.1
                                  
                                  001-32473
                                  
                                  8/22/0710.29
                                  
                                  Equity
      Purchase Agreement, dated as of August 2, 2007, by and among Moveup, Hunan
      Mulin Modern Food Company, Ltd., Australia Ausnutria Dairy Pty., Chen
      Yuanrong and Ausnutria
                                  
                                  
                                  
                                  10-Q/A
                                  
                                  10.2
                                  
                                  001-32473
                                  
                                  8/22/07




56




Incorporated by ReferenceExhibit
                                  No.
                                
                                Exhibit Title
                                
                                Filed
                                  Herewith
                                
                                Form
                                
                                Exhibit
                                  No.
                                
                                File No.
                                
                                Filing
                                  Date10.30
                                
                                Share
      Subscription Agreement, dated as of August 12, 2007, by and between Moveup
      and Ausnutria
                                
                                
                                
                                10-Q/A
                                
                                10.3
                                
                                001-32473
                                
                                8/22/0710.31
                                
                                Share
      Subscription Agreement, by and between the registrant and
      Ausnutria
                                
                                
                                
                                10-Q/A
                                
                                10.4
                                
                                001-32473
                                
                                8/22/0710.32
                                
                                Equity
      Purchase Agreement, dated as of October 25, 2007, by and among Moveup,
      Hunan Mulin Modern Food Company, Ltd Chen Yuanrong and
      Ausnutria
                                
                                
                                
                                8-K
                                
                                10.1
                                
                                001-32473
                                
                                10/31/0710.33
                                
                                Employment
      Agreement, dated as of April 15, 2008 by and between the registrant and
      Jonathan H. Chou
                                
                                
                                
                                8-K
                                
                                10.1
                                
                                001-32473
                                
                                4/18/0810.34
                                
                                Supplemental
      Indenture, dated as of November 12, 2008, by and between the registrant
      and The Bank of New York Mellon, as Trustee, as amended
                                
                                
                                
                                8-K/A
                                
                                10.1
                                
                                001-32473
                                
                                11/21/0810.35
                                
                                Agreement
      Regarding 2009 Notes, dated as of November 12, 2008, by and among the
      registrant, Leng You-Bin and the investors named therein
                                
                                
                                
                                8-K/A
                                
                                10.2
                                
                                001-32473
                                
                                11/21/0810.36
                                
                                Share
      Pledge Agreement, dated as of November 12, 2008, by and among the
      registrant, Leng You-Bin and The Bank of New York, Mellon, as collateral
      agent
                                
                                
                                
                                8-K/A
                                
                                10.3
                                
                                001-32473
                                
                                11/21/0810.37
                                
                                First
      Amendment to Registration Rights Agreement, dated as of November 12, 2008,
      by and between the registrant and the investors named
    therein.
                                
                                
                                
                                8-K/A
                                
                                10.4
                                
                                001-32473
                                
                                11/21/0810.38
                                
                                Waiver
      Letter to Registration Rights Agreement, dated as of November 12, 2008, by
      and between the registrant and the investors named therein
                                
                                
                                
                                8-K/A
                                
                                10.5
                                
                                001-32473
                                
                                11/21/0810.39
                                
                                Form
      of Amended and Restated 7.75% Convertible Note due October 2,
      2009
                                
                                
                                
                                8-K/A
                                
                                10.6
                                
                                001-32473
                                
                                11/21/0810.40
                                
                                Form
      of Amended and Restated Common Stock Purchase Warrant
                                
                                
                                
                                8-K/A
                                
                                10.7
                                
                                001-32473
                                
                                11/21/0814.1
                                
                                Code
      of Business Conduct and Ethics
                                
                                
                                
                                10-KSB
                                
                                14
                                
                                000-27351
                                
                                3/31/0514.2
                                
                                Amended
      and Restated Code of Business Conduct and Ethics
                                
                                
                                
                                8-K
                                
                                14
                                
                                001-32473
                                
                                5/12/0816.1
                                
                                Letter
      of HJ & Associates, L.L.C. regarding change in certifying
      accountant
                                
                                
                                
                                8-K
                                
                                16
                                
                                000-27351
                                
                                8/6/0316.2
                                
                                Letter
      of Weinberg & Company, regarding change in certifying
      accountant
                                
                                
                                
                                8-K
                                
                                16
                                
                                000-27351
                                
                                11/17/0316.3
                                
                                Letter
      of Murrell, Hall, McIntosh & Co., PLLP, regarding change in certifying
      accountant
                                
                                
                                
                                8-K
                                
                                16.1
                                
                                001-32473
                                
                                12/13/0721.1
                                
                                Subsidiaries
      of the registrant
                                
                                
                                
                                10-K
                                
                                21.1
                                
                                001-32473
                                
                                3/31/0923.1
                                
                                Consent
      of Grant Thornton
                                
                                X31.1
                                
                                Certification
      of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14(a), as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002
                                
                                X31.2
                                
                                Certification
      of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14(a), as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002
                                
                                X32
                                
                                Certification
      of Principal Executive Officer and Principal Financial Officer pursuant to
      18 U.S.C. § 1350, as adopted pursuant to Section 906 of the
      Sarbanes-Oxley Act of 2002
                                
                                X




57




SIGNATURES





POWER
OF ATTORNEY





KNOW BY
ALL MEN BY THESE PRESENTS, that each person whose signature appears below
constitutes and appoints Leng You-Bin as his or her true and lawful
attorney-in-fact and agent, with full power of substitution and resubstitution,
for him or her and in his or her name, place and stead, in any and all
capacities, to sign any and all Amendments hereto, and to file the same, with
all exhibits thereto, and other documents in connection therewith, with the
Securities and Exchange Commission, granting unto said attorney-in-fact and
agent full power and authority to do and perform each and every act and thing
requisite and necessary to be done in and about the premises, as fully to all
intents and purposes as he or she might or could do in person, hereby ratifying
and confirming all that said attorney-in-fact and agent, or his substitute or
substitutes, may lawfully do or cause to be done by virtue thereof.





Pursuant
to the requirements of the Securities Exchange Act of 1934, as amended, this
Report has been signed by the following persons in the capacities and on the
dates indicated.





In
accordance with Section 13 or 15(d) of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.




April
      15, 2009
                  AMERICAN
      DAIRY, INC.By:
                  /s/
      Leng You-BinLeng
      You-Bin, Chief ExecutiveOfficer
      and President (Principal Executive Officer)By:
                  /s/
      Jonathan H. ChouJonathan
      H. Chou, Chief Financial Officer(Principal
      Accounting and Financial Officer)





In
accordance with the Exchange Act, this report has been signed below by the
following persons on behalf of the registrant and in the capacities and on the
dates indicated.




/s/
      Leng You-Bin
                            April
      15, 2009Leng
      You-Bin, Director, Chief ExecutiveOfficer
      and President (Principal Executive Officer)/s/
      Liu Hua
                            April
      15, 2009Liu
      Hua, Director, Vice Chairman, Secretary and Treasurer/s/
      Liu Sheng-Hui
                            April
      15, 2009Liu
      Sheng-Hui, Director/s/
      Hui-Lan Lee
                            April
      15, 2009Hui-Lan
      Lee, Director/s/
      Kirk Downing
                            April
      15, 2009Kirk
      Downing, Director/s/
      James Lewis
                            April
      15, 2009James
      Lewis, Director





58





REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM





Board of
Directors and


Shareholders
of American Dairy, Inc.





We have
audited the accompanying consolidated balance sheets of American Dairy, Inc. (a
Utah Corporation) and subsidiaries (the “Company”) as of December 31, 2008 and
December 31, 2007 and the related consolidated statements of operations and
comprehensive income, changes in shareholders' equity, and cash flows for each
of the years in the two year period ended December 31, 2008.  These
financial statements are the responsibility of the Company's
management.  Our responsibility is to express an opinion on these
financial statements based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audits to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, nor were we engaged to perform an audit of its
internal control over financial reporting.  An audit includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements.  An audit also includes assessing the
accounting principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation.  We believe
that our audits provide a reasonable basis for our opinion.





In our
opinion, the consolidated financial statements referred to above present fairly,
in all material respects, the financial position of the Company as of December
31, 2008 and December 31, 2007 and the results of their operations and their
cash flows for each of the years in the two year period ended December 31, 2008
in conformity with accounting principles generally accepted in the United States
of America.





/s/  GRANT
THORNTON





Hong
Kong


April 14,
2009











AMERICAN
DAIRY, INC.


CONSOLIDATED
BALANCE SHEETS




Note
                                        
                                        
                                        December 31,
                                          2008
                                        
                                        
                                        December 31,
                                          2007US$
                                        
                                        
                                        US$ASSETSCurrent
      assets:Cash
      and cash equivalents
                                        
                                        
                                        
                                        
                                        
                                        11,785,408
                                        
                                        
                                        
                                        11,057,874Time
      deposit
                                        
                                        
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        8,214,002Notes
      and loans receivable, net
                                        
                                        
                                        7
                                        
                                        
                                        
                                        1,493,245
                                        
                                        
                                        
                                        1,285,382Trade
      receivables, net
                                        
                                        
                                        8
                                        
                                        
                                        
                                        12,275,497
                                        
                                        
                                        
                                        4,518,647Due
      from related parties
                                        
                                        
                                        18
                                        
                                        
                                        
                                        265,479
                                        
                                        
                                        
                                        115,477Employee
      receivable
                                        
                                        
                                        
                                        
                                        
                                        
                                        307,249
                                        
                                        
                                        
                                        105,662Advances
      to suppliers
                                        
                                        
                                        
                                        
                                        
                                        
                                        24,943,046
                                        
                                        
                                        
                                        28,051,487Receivable
      from discontinuing operations
                                        
                                        
                                        11
                                        
                                        
                                        
                                        31,002,897
                                        
                                        
                                        
                                        25,949,410Inventories,
      net
                                        
                                        
                                        9
                                        
                                        
                                        
                                        52,330,333
                                        
                                        
                                        
                                        24,696,034Prepayments
      and other current assets
                                        
                                        
                                        
                                        
                                        
                                        
                                        63,711
                                        
                                        
                                        
                                        2,567,262Refundable
      taxes
                                        
                                        
                                        
                                        
                                        
                                        
                                        488,938
                                        
                                        
                                        
                                        143,703Deposit
      for land use right
                                        
                                        
                                        
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        6,889,251Other
      receivables
                                        
                                        
                                        
                                        
                                        
                                        
                                        4,598,359
                                        
                                        
                                        
                                        3,853,267Current
      assets of discontinuing operations
                                        
                                        
                                        11
                                        
                                        
                                        
                                        12,392,384
                                        
                                        
                                        
                                        1,346,657Total
      current assets
                                        
                                        
                                        
                                        
                                        
                                        
                                        151,946,546
                                        
                                        
                                        
                                        118,794,115Investments:Investment
      in mutual funds – available for sale
                                        
                                        
                                        10
                                        
                                        
                                        
                                        77,504
                                        
                                        
                                        
                                        171,125Investment
      at cost
                                        
                                        
                                        
                                        
                                        
                                        
                                        262,611
                                        
                                        
                                        
                                        246,420340,115
                                        
                                        
                                        
                                        417,545Property
      and equipment:Property
      and equipment, net
                                        
                                        
                                        12
                                        
                                        
                                        
                                        88,289,858
                                        
                                        
                                        
                                        52,279,168Construction
      in progress
                                        
                                        
                                        13
                                        
                                        
                                        
                                        28,847,959
                                        
                                        
                                        
                                        33,009,992117,137,817
                                        
                                        
                                        
                                        85,289,160Biological
      assets:Immature
      biological assets
                                        
                                        
                                        14
                                        
                                        
                                        
                                        23,784,479
                                        
                                        
                                        
                                        -Mature
      biological assets, net
                                        
                                        
                                        14
                                        
                                        
                                        
                                        1,483,355
                                        
                                        
                                        
                                        -25,267,834
                                        
                                        
                                        
                                        -Other
      assets:Deferred
      tax assets
                                        
                                        
                                        5
                                        
                                        
                                        
                                        730,490
                                        
                                        
                                        
                                        -Long
      term notes and loans receivable
                                        
                                        
                                        7
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,368,999Prepaid
      leases
                                        
                                        
                                        
                                        
                                        
                                        
                                        29,146,748
                                        
                                        
                                        
                                        20,967,898Goodwill
                                        
                                        
                                        15
                                        
                                        
                                        
                                        2,282,838
                                        
                                        
                                        
                                        2,142,079Deferred
      charges, net
                                        
                                        
                                        16
                                        
                                        
                                        
                                        107,396
                                        
                                        
                                        
                                        3,328,140Long
      term assets of discontinuing operations
                                        
                                        
                                        11
                                        
                                        
                                        
                                        31,587,018
                                        
                                        
                                        
                                        28,270,501Total
      assets
                                        
                                        
                                        
                                        
                                        
                                        
                                        358,546,802
                                        
                                        
                                        
                                        260,578,437LIABILITIES
      AND SHAREHOLDERS’ EQUITYLiabilitiesCurrent
      liabilities:Current
      maturities of long term debt
                                        
                                        
                                        21
                                        
                                        
                                        
                                        4,018,704
                                        
                                        
                                        
                                        101,990Convertible
      debt redeemable within one year
                                        
                                        
                                        22
                                        
                                        
                                        
                                        91,541,926
                                        
                                        
                                        
                                        -Notes
      and loans payable
                                        
                                        
                                        17
                                        
                                        
                                        
                                        8,055,450
                                        
                                        
                                        
                                        8,512,446Accounts
      payable
                                        
                                        
                                        
                                        
                                        
                                        
                                        36,643,041
                                        
                                        
                                        
                                        9,970,688Accrued
      expenses
                                        
                                        
                                        23
                                        
                                        
                                        
                                        10,620,393
                                        
                                        
                                        
                                        5,830,658Income
      tax payable
                                        
                                        
                                        
                                        
                                        
                                        
                                        1,185,528
                                        
                                        
                                        
                                        18,267Advances
      from customers
                                        
                                        
                                        
                                        
                                        
                                        
                                        9,864,080
                                        
                                        
                                        
                                        4,738,848Due
      to related parties
                                        
                                        
                                        18
                                        
                                        
                                        
                                        1,017,399
                                        
                                        
                                        
                                        401,560Advances
      from employees
                                        
                                        
                                        19
                                        
                                        
                                        
                                        1,016,173
                                        
                                        
                                        
                                        574,579Accrued
      employee benefits
                                        
                                        
                                        20
                                        
                                        
                                        
                                        2,873,889
                                        
                                        
                                        
                                        1,088,171Other
      payable
                                        
                                        
                                        24
                                        
                                        
                                        
                                        19,513,681
                                        
                                        
                                        
                                        10,413,156Current
      liabilities of discontinuing operations
                                        
                                        
                                        11
                                        
                                        
                                        
                                        35,063,603
                                        
                                        
                                        
                                        27,787,737Total
      current liabilities
                                        
                                        
                                        
                                        
                                        
                                        
                                        221,413,867
                                        
                                        
                                        
                                        69,438,100Long
      term debt, net of current portion
                                        
                                        
                                        21
                                        
                                        
                                        
                                        9,146,034
                                        
                                        
                                        
                                        382,465Long
      term tax payable
                                        
                                        
                                        5
                                        
                                        
                                        
                                        2,750,887
                                        
                                        
                                        
                                        1,714,429Convertible
      debt, net
                                        
                                        
                                        22
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        55,237,771Derivatives
                                        
                                        
                                        22
                                        
                                        
                                        
                                        -
                                        
                                        
                                        
                                        50,019,300Deferred
      income
                                        
                                        
                                        
                                        
                                        
                                        
                                        8,416,492
                                        
                                        
                                        
                                        1,580,508Long
      term liability of discontinuing operations
                                        
                                        
                                        11
                                        
                                        
                                        
                                        395,176
                                        
                                        
                                        
                                        -Total
      liabilities
                                        
                                        
                                        
                                        
                                        
                                        
                                        242,122,456
                                        
                                        
                                        
                                        178,372,573Minority
      interests
                                        
                                        
                                        
                                        
                                        
                                        
                                        546,447
                                        
                                        
                                        
                                        536,977Shareholders’
      equityOrdinary
      shares (US$0.001 par value, 50,000,000 sharesauthorized;
      17,253,907 and 16,961,768 issued andoutstanding
      as of December 31, 2008 and 2007, respectively)
                                        
                                        
                                        25
                                        
                                        
                                        
                                        17,254
                                        
                                        
                                        
                                        16,961Additional
      paid-in capital
                                        
                                        
                                        25
                                        
                                        
                                        
                                        26,758,425
                                        
                                        
                                        
                                        22,629,333Ordinary
      share warrants
                                        
                                        
                                        26
                                        
                                        
                                        
                                        3,003,448
                                        
                                        
                                        
                                        3,011,444Statutory
      reserves
                                        
                                        
                                        27
                                        
                                        
                                        
                                        6,861,224
                                        
                                        
                                        
                                        6,040,382Accumulated
      other comprehensive income
                                        
                                        
                                        
                                        
                                        
                                        
                                        25,146,055
                                        
                                        
                                        
                                        12,081,467Retained
      earnings
                                        
                                        
                                        
                                        
                                        
                                        
                                        54,091,493
                                        
                                        
                                        
                                        37,889,300Total
      shareholders’ equity
                                        
                                        
                                        
                                        
                                        
                                        
                                        115,877,899
                                        
                                        
                                        
                                        81,668,887Total
      liabilities and shareholders’ equity
                                        
                                        
                                        
                                        
                                        
                                        
                                        358,546,802
                                        
                                        
                                        
                                        260,578,437





The
accompanying notes are an integral part of these financial
statements.




F-1




AMERICAN
DAIRY, INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS AND COMPREHENSIVE INCOME




For the years ended December 31,Note
                                
                                
                                2008
                                
                                
                                2007US$
                                
                                
                                US$Sales
                                
                                
                                
                                
                                
                                193,191,710
                                
                                
                                
                                163,898,555Cost
      of goods sold
                                
                                
                                
                                
                                
                                117,180,986
                                
                                
                                
                                91,429,949Gross
      profit
                                
                                
                                
                                
                                
                                76,010,724
                                
                                
                                
                                72,468,606Operating
      and administrative expenses:Sales
      and marketing
                                
                                
                                
                                
                                
                                50,685,804
                                
                                
                                
                                40,739,403General
      and administrative
                                
                                
                                
                                
                                
                                19,046,939
                                
                                
                                
                                13,836,171Total
      operating expenses
                                
                                
                                
                                
                                
                                69,732,743
                                
                                
                                
                                54,575,574Income
      from continuing operations
                                
                                
                                
                                
                                
                                6,277,981
                                
                                
                                
                                17,893,032Other
      income (expenses):Interest
      income
                                
                                
                                
                                
                                
                                579,724
                                
                                
                                
                                374,386Interest
      and finance costs
                                
                                
                                
                                
                                
                                (18,843,032
                                )
                                
                                
                                (13,404,841
                                )Amortization
      of deferred charges
                                
                                
                                16
                                
                                
                                
                                (657,258
                                )
                                
                                
                                (369,794
                                )Registration
      rights penalty
                                
                                
                                22
                                
                                
                                
                                (2,389,077
                                )
                                
                                
                                (2,540,000
                                )Gain
      on extinguishment of debt
                                
                                
                                22
                                
                                
                                
                                30,497,268
                                
                                
                                
                                -Gain
      (loss) on derivatives
                                
                                
                                
                                
                                
                                
                                (8,321,481
                                )
                                
                                
                                3,279,031Government
      subsidy-tax refund
                                
                                
                                5
                                
                                
                                
                                6,810,231
                                
                                
                                
                                8,140,145Other
      income, net
                                
                                
                                
                                
                                
                                
                                182,406
                                
                                
                                
                                135,168Income
      from continuing operations before income tax expenses and minority
      interests
                                
                                
                                
                                
                                
                                
                                14,136,762
                                
                                
                                
                                13,507,127Income
      tax expenses
                                
                                
                                5
                                
                                
                                
                                3,567,135
                                
                                
                                
                                5,661,779Net
      income from continuing operations before minority
interests
                                
                                
                                
                                
                                
                                
                                10,569,627
                                
                                
                                
                                7,845,348Minority
      interests
                                
                                
                                
                                
                                
                                
                                (9,470
                                )
                                
                                
                                (3,066
                                )Net
      income from continuing operations
                                
                                
                                
                                
                                
                                
                                10,560,157
                                
                                
                                
                                7,842,282Net
      income from discontinuing operations
                                
                                
                                11
                                
                                
                                
                                6,462,878
                                
                                
                                
                                442,111Net
      income attributable to ordinary shareholders
                                
                                
                                
                                
                                
                                
                                17,023,035
                                
                                
                                
                                8,284,393Other
      comprehensive income:Cumulative
      currency translation adjustments
                                
                                
                                
                                
                                
                                
                                13,169,453
                                
                                
                                
                                9,314,690Change
      in fair value of available for sale investments
                                
                                
                                10
                                
                                
                                
                                (104,865
                                )
                                
                                
                                -Total
      comprehensive income
                                
                                
                                
                                
                                
                                
                                30,087,623
                                
                                
                                
                                17,599,083Earnings
      per ordinary share - BasicIncome
      from continuing operations
                                
                                
                                
                                
                                
                                $
                                0.62
                                
                                
                                $
                                0.48Income
      from discontinuing operations, net of tax
                                
                                
                                
                                
                                
                                $
                                0.38
                                
                                
                                $
                                0.03Net
      income
                                
                                
                                
                                
                                
                                $
                                1.00
                                
                                
                                $
                                0.51Earnings
      per ordinary share - DilutedIncome
      from continuing operations
                                
                                
                                
                                
                                
                                $
                                0.60
                                
                                
                                $
                                0.46Income
      from discontinuing operations, net of tax
                                
                                
                                
                                
                                
                                $
                                0.37
                                
                                
                                $
                                0.02Net
      income
                                
                                
                                
                                
                                
                                $
                                0.97
                                
                                
                                $
                                0.48Weighted
      average ordinary shares outstandingBasic
                                
                                
                                
                                
                                
                                
                                16,993,390
                                
                                
                                
                                16,327,616Diluted
                                
                                
                                
                                
                                
                                
                                17,636,862
                                
                                
                                
                                17,696,997





The
accompanying notes are an integral part of these financial
statements.




F-2




AMERICAN
DAIRY, INC.


CONSOLIDATED
STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY





Ordinary shares
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          
                          Accumulated(US$0.001 par value)
                          
                          
                          Additional
                          
                          
                          Ordinary
                          
                          
                          
                          
                          
                          Other
                          
                          
                          
                          
                          
                          TotalNumber of
                          
                          
                          Par
                          
                          
                          Paid-in
                          
                          
                          Share
                          
                          
                          Statutory
                          
                          
                          Comprehensive
                          
                          
                          Retained
                          
                          
                          Shareholders’Shares
                          
                          
                          Value
                          
                          
                          Capital
                          
                          
                          Warrants
                          
                          
                          Reserves
                          
                          
                          Income
                          
                          
                          Earnings
                          
                          
                          EquityUS$
                          
                          
                          US$
                          
                          
                          US$
                          
                          
                          US$
                          
                          
                          US$
                          
                          
                          US$
                          
                          
                          US$Balance
      as of January 1, 2007
                          
                          
                          15,831,820
                          
                          
                          
                          15,831
                          
                          
                          
                          14,120,275
                          
                          
                          
                          3,610,835
                          
                          
                          
                          3,053,906
                          
                          
                          
                          2,766,777
                          
                          
                          
                          32,591,383
                          
                          
                          
                          56,159,007Warrant
      exercise
                          
                          
                          505,698
                          
                          
                          
                          506
                          
                          
                          
                          1,698,932
                          
                          
                          
                          (599,391
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          1,100,047Shares
      issued for services
                          
                          
                          49,250
                          
                          
                          
                          49
                          
                          
                          
                          1,060,701
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          1,060,750Shares
      issued for notes conversion
                          
                          
                          575,000
                          
                          
                          
                          575
                          
                          
                          
                          5,749,425
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          5,750,000Net
      income
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          8,284,393
                          
                          
                          
                          8,284,393Appropriation
      to statutory reserves
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          2,986,476
                          
                          
                          
                          -
                          
                          
                          
                          (2,986,476
                          )
                          
                          
                          -Currency
      translation adjustments
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          9,314,690
                          
                          
                          
                          -
                          
                          
                          
                          9,314,690Balance
      as of December 31, 2007
                          
                          
                          16,961,768
                          
                          
                          
                          16,961
                          
                          
                          
                          22,629,333
                          
                          
                          
                          3,011,444
                          
                          
                          
                          6,040,382
                          
                          
                          
                          12,081,467
                          
                          
                          
                          37,889,300
                          
                          
                          
                          81,668,887Warrant
      exercise
                          
                          
                          3,000
                          
                          
                          
                          3
                          
                          
                          
                          14,743
                          
                          
                          
                          (7,996
                          )
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          6,750Shares
      issued for services
                          
                          
                          72,500
                          
                          
                          
                          73
                          
                          
                          
                          1,092,578
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          1,092,651Shares
      issued to note holders
                          
                          
                          216,639
                          
                          
                          
                          217
                          
                          
                          
                          2,881,082
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          2,881,299Stock
      compensation
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          140,689
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          140,689Net
      income
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          17,023,035
                          
                          
                          
                          18,698,833Appropriation
      to statutory reserves
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          820,842
                          
                          
                          
                          -
                          
                          
                          
                          (820,842
                          )
                          
                          
                          -Currency
      translation adjustments
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          13,169,453
                          
                          
                          
                          -
                          
                          
                          
                          13,169,453Change
      in fair value of available for sale investments
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          -
                          
                          
                          
                          (104,865
                          )
                          
                          
                          -
                          
                          
                          
                          (104,865
                          )Balance
      as of December 31, 2008
                          
                          
                          17,253,907
                          
                          
                          
                          17,254
                          
                          
                          
                          26,758,425
                          
                          
                          
                          3,003,448
                          
                          
                          
                          6,861,224
                          
                          
                          
                          25,146,055
                          
                          
                          
                          54,091,493
                          
                          
                          
                          115,877,899





The
accompanying notes are an integral part of these financial
statements.




F-3


AMERICAN
DAIRY, INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS





For the years ended December 31,2008
                              
                              
                              2007US$
                              
                              
                              US$Cash
      flows from operating activities:Net
      income before minority interests
                              
                              
                              17,032,505
                              
                              
                              
                              8,287,459Less:  Net
      income from discontinuing operations
                              
                              
                              6,462,878
                              
                              
                              
                              442,111Net
      income from continuing operations
                              
                              
                              10,569,627
                              
                              
                              
                              7,845,348Adjustments
      to reconcile net income to operating activities:Depreciation
      of property and equipment
                              
                              
                              4,840,402
                              
                              
                              
                              2,941,122Depreciation
      of biological assets
                              
                              
                              6,816
                              
                              
                              
                              -Amortization
      of prepaid leases
                              
                              
                              473,601
                              
                              
                              
                              180,496Amortization
      of deferred income
                              
                              
                              (13,524
                              )
                              
                              
                              (24,756
                              )Loss
      on disposal of property and equipment
                              
                              
                              5,397
                              
                              
                              
                              6,574Loss
      on disposal of biological assets
                              
                              
                              286,727
                              
                              
                              
                              -Provision
      for losses on receivables
                              
                              
                              641,218
                              
                              
                              
                              4,377,606Provision
      for losses on inventories
                              
                              
                              (217,045
                              )
                              
                              
                              586,162Gain
      on debt extinguishment
                              
                              
                              (30,497,268
                              )
                              
                              
                              -Compensation
      expenses for stock issued
                              
                              
                              1,092,650
                              
                              
                              
                              1,060,750Compensation
      expenses for option awards
                              
                              
                              140,689
                              
                              
                              
                              -Registration
      rights penalty paid in shares
                              
                              
                              2,881,299
                              
                              
                              
                              -Interest
      expense from accrual of guaranteed redemption value
                              
                              
                              13,584,533
                              
                              
                              
                              8,151,867Interest
      expense from amortization of note discounts
                              
                              
                              8,028,585
                              
                              
                              
                              3,900,106Loss
      (gain) on derivatives
                              
                              
                              8,321,481
                              
                              
                              
                              (3,279,031
                              )Amortization
      of deferred charges
                              
                              
                              657,258
                              
                              
                              
                              369,794Changes
      in assets and liabilities:(Increase)
      decrease in trade receivable, net
                              
                              
                              (8,398,068
                              )
                              
                              
                              670,212Increase
      in due from related parties
                              
                              
                              (150,002
                              )
                              
                              
                              (12,061
                              )(Increase)
      decrease in employee receivable
                              
                              
                              (201,587
                              )
                              
                              
                              108,488Increase
      in inventories, net
                              
                              
                              (27,334,926
                              )
                              
                              
                              (26,868,400
                              )Decrease
      (increase) in advances to suppliers
                              
                              
                              3,108,442
                              
                              
                              
                              (10,543,305
                              )Decrease
      (increase) in prepayments and other assets
                              
                              
                              2,306,151
                              
                              
                              
                              (2,274,160
                              )(Increase)
      decrease in refundable taxes
                              
                              
                              (345,235
                              )
                              
                              
                              732,641Increase
      in other receivable
                              
                              
                              (745,087
                              )
                              
                              
                              (1,639,269
                              )Increase
      in deferred tax assets
                              
                              
                              (730,491
                              )
                              
                              
                              -Increase
      in accounts payable and accrued expenses
                              
                              
                              25,220,827
                              
                              
                              
                              4,449,377Increase
      (decrease) in income taxes payable
                              
                              
                              1,167,261
                              
                              
                              
                              (786,947
                              )Increase
      in advances from customers
                              
                              
                              5,125,231
                              
                              
                              
                              2,597,299Increase
      (decrease) in due to related parties
                              
                              
                              615,839
                              
                              
                              
                              (126,750
                              )Increase
      (decrease) in advances from employees
                              
                              
                              441,594
                              
                              
                              
                              (163,974
                              )Increase
      in accrued employee benefits
                              
                              
                              1,785,718
                              
                              
                              
                              499,129Increase
      in other payable
                              
                              
                              8,160,185
                              
                              
                              
                              2,563,139(Decrease)
      increase in long term tax payable
                              
                              
                              1,036,458
                              
                              
                              
                              708,862Net
      cash provided by (used in) continuing operations
                              
                              
                              31,864,756
                              
                              
                              
                              (3,969,681
                              )Discontinuing
      operations
                              
                              
                              (1,965,294
                              )
                              
                              
                              (428,374
                              )Net
      cash provided by (used in) operating activities
                              
                              
                              29,899,462
                              
                              
                              
                              (4,398,055
                              )Cash
      flows from investing activities:Purchase
      of property and equipment
                              
                              
                              (23,154,636
                              )
                              
                              
                              (36,155,611
                              )Purchase
      of leases
                              
                              
                              -
                              
                              
                              
                              (16,454,106
                              )Purchase
      of biological assets
                              
                              
                              (21,944,621
                              )
                              
                              
                              -Prepayment
      for land use right
                              
                              
                              -
                              
                              
                              
                              (6,840,823
                              )Increase
      in short term notes and loans receivable
                              
                              
                              (8,699,813
                              )
                              
                              
                              (1,054,908
                              )Decrease
      in short term notes and loans receivable
                              
                              
                              10,131,885
                              
                              
                              
                              -Increase
      in long term notes receivable
                              
                              
                              -
                              
                              
                              
                              (5,321,860
                              )Decrease
      (increase) in time deposit
                              
                              
                              8,446,778
                              
                              
                              
                              (7,988,497
                              )Purchase
      of mutual funds
                              
                              
                              -
                              
                              
                              
                              (167,296
                              )Purchase
      of equity investment
                              
                              
                              -
                              
                              
                              
                              (243,253
                              )Deposit
      for disposal of a subsidiary
                              
                              
                              4,352,033
                              
                              
                              
                              -Proceeds
      from disposal of fixed assets
                              
                              
                              -
                              
                              
                              
                              25,053Net
      cash used in continuing operations
                              
                              
                              (30,868,374
                              )
                              
                              
                              (74,201,301
                              )Discontinuing
      operations
                              
                              
                              (1,390,763
                              )
                              
                              
                              (27,459,982
                              )Net
      cash used in investing activities
                              
                              
                              (32,259,137
                              )
                              
                              
                              (101,661,283
                              )Cash
      flows from financing activities:Proceeds
      from short term notes and loans payable
                              
                              
                              7,844,115
                              
                              
                              
                              12,036,970Repayment
      of short term notes and loans payable
                              
                              
                              (8,777,630
                              )
                              
                              
                              (15,299,909
                              )Proceeds
      from long term debt
                              
                              
                              12,747,806
                              
                              
                              
                              -Repayment
      of long term debt
                              
                              
                              (108,369
                              )
                              
                              
                              (1,141,317
                              )Proceeds
      from convertible debt, net of issuance costs
                              
                              
                              -
                              
                              
                              
                              76,302,066Repayment
      of convertible debt
                              
                              
                              (11,000,000
                              )
                              
                              
                              -Contribution
      from minority shareholders
                              
                              
                              -
                              
                              
                              
                              533,910Minority
      interest acquisition
                              
                              
                              -
                              
                              
                              
                              (945,295
                              )Warrant
      exercise
                              
                              
                              6,750
                              
                              
                              
                              1,100,047Net
      cash provided by (used in) continuing operations
                              
                              
                              712,672
                              
                              
                              
                              72,586,472Discontinuing
      operations
                              
                              
                              -
                              
                              
                              
                              1,344,648Net
      cash provided by financing activities
                              
                              
                              712,672
                              
                              
                              
                              73,931,120Effect
      of exchange rate changes on cash
                              
                              
                              2,374,537
                              
                              
                              
                              3,664,644Net
      increase/(decrease) in cash of discontinuing operations
                              
                              
                              3,106,821
                              
                              
                              
                              (26,101,597
                              )Net
      increase (decrease) in cash and cash equivalents
                              
                              
                              727,534
                              
                              
                              
                              (28,463,574
                              )Cash
      and cash equivalents, beginning of year
                              
                              
                              11,057,874
                              
                              
                              
                              39,521,448Cash
      and cash equivalents, end of year
                              
                              
                              11,785,408
                              
                              
                              
                              11,057,874Supplemental
      disclosure of cash flow information:Cash
      paid during the year for income tax
                              
                              
                              (3,084,582
                              )
                              
                              
                              (4,578,511
                              )Cash
      received during the year for tax refund
                              
                              
                              6,715,872
                              
                              
                              
                              3,179,204Cash
      paid during the year for registration rights penalty
                              
                              
                              -
                              
                              
                              
                              (1,820,000
                              )Interest
      paid during the year
                              
                              
                              (1,498,952
                              )
                              
                              
                              (701,216
                              )Supplemental
      disclosure of non-cash investing and financing activities:Conversion
      of convertible debt to ordinary shares
                              
                              
                              -
                              
                              
                              
                              5,750,000Registration
      rights penalty paid in shares
                              
                              
                              2,881,299
                              
                              
                              
                              -





The
accompanying notes are an integral part of these financial
statements.





F-4





AMERICAN
DAIRY, INC


NOTES
TO THE CONSOLIDATED FINANCIAL STATEMENTS





1.
              ORGANIZATION
      AND NATURE OF OPERATION





The
accompanying consolidated financial statements include the financial statements
of American Dairy, Inc (the “Company” or “American Dairy”) and its
subsidiaries.  The Company and its subsidiaries are collectively
referred to as the “Group.”





The
Company was incorporated in the State of Utah on December 31, 1985, originally
with the name of Gaslight Inc. It was inactive until March 30, 1988 when it
changed its corporate name to Lazarus Industries, Inc. and engaged in the
business of manufacturing and marketing medical devices. This line of business
was discontinued in 1991, and it became a non-operating public company shell.
During 2003, the Company changed its name to American Dairy, Inc.





Effective
May 7, 2003, the Company completed the acquisition of 100% of the issued and
outstanding capital stock of American Flying Crane Corporation (“AFC”), a
Delaware corporation. As a result, AFC became a wholly owned subsidiary of
American Dairy.





AFC was
incorporated in Delaware, with 50,000,000 authorized ordinary shares at a par
value of $0.001 per share. AFC owns 100% of the registered capital of
Heilongjiang Feihe Dairy Co., Limited (“Feihe Dairy”).  Feihe Dairy in
turn owns 100% of the registered shares of BaiQuan Feihe Dairy Co. Limited
(“Baiquan Dairy”), and Heilongjiang Sanhao Dairy Co., Limited (“Sanhao Dairy”)
which was liquidated into Feihe Dairy in 2004, and 95% of Beijing Feihe
Biotechnology Scientific and Commercial Co., Limited (“Beijing Feihe”) and
Qiqihaer Feihe Soybean Co., Limited (“Feihe Soybean”), with the other 5% being
held in trust for the Company.  Feihe Dairy also owns 95% of the
registered capital of Heilongjiang Feihe Kedong Feedlots Co., Limited (“Kedong
Feedlots”), Heilongjiang Feihe GanNan Feedlots Co., Limited (“Gannan Feedlots”),
and 99% of the registered capital of Heilongjiang Moveup Co., Limited
(“Moveup”).





From 2006
onwards, the Company also own 100% of the registered capital of Shanxi
Feihesantai Biotechnology Scientific and Commercial Co., Limited (“Shanxi”),
Langfang Flying Crane Dairy Products Co., Limited (“Langfang Feihe”) and GanNan
Flying Crane Dairy Products Co., Limited (“Gannan”).





The core
activities of subsidiaries included in the consolidated financial statements are
as follow:


·
            American
      Flying Crane Corporation – Investment
holding


·
            Langfang
      Flying Crane Dairy Products Co., Limited – Packaging and distribution of
      Flying Crane branded products


·
            GanNan
      Flying Crane Dairy Products Co., Limited – Manufacturing and distribution
      of Flying Crane branded products


·
            Heilongjiang
      Feihe Dairy Co., Limited – Manufacturing and distribution of dairy
      products under Feihe Trademarks


·
            BaiQuan
      Feihe Dairy Co., Limited – Manufacturing and distribution of dairy
      products under Feihe Trademarks


·
            Beijing
      Feihe Biotechnology Scientific and Commercial Co., Limited – Marketing and
      distribution of products under Feihe Trademarks and the Flying Crane
      brand


·
            Shanxi
      Feihesantai Biotechnology Scientific and Commercial Co., Limited –
      Manufacturing and distribution of Walnut
  products


·
            Heilongjiang
      Feihe Kedong Feedlots Co., Limited – The intended activities are breeding
      and rearing of dairy cows, and distribution of fresh
  milk


·
            Heilongjiang
      Feihe Gannan Feedlots Co., Limited – The intended activities are breeding
      and rearing of dairy cows, and distribution of fresh
  milk


·
            Qiqihaer
      Feihe Soybean Co., Limited – The intended activities are manufacturing and
      distribution of soybean products


·
            Heilongjiang
      Moveup Co., Limited – Marketing and distribution of third party dairy
      products





Apart
from AFC, the subsidiaries’ principal country of operations is the People’s
Republic of China (the “PRC”).





2.
            PRINCIPAL
      ACCOUNTING POLICIES





Basis
of presentation





The
accompanying consolidated financial statements have been prepared in accordance
with generally accepted accounting principles in the United States of America
(“US GAAP”).





Principles
of consolidation





The
consolidated financial statements include the financial statements of the
Company and its subsidiaries.





Subsidiaries
are all entities over which the Group has the power to govern the financial and
operating policies generally accompanying a shareholding of more than one half
of the voting rights. The existence and effect of potential voting rights that
are currently exercisable or convertible are considered when assessing whether
the Group controls another entity. Subsidiaries are fully consolidated from the
date on which control is transferred to the Group. They are de-consolidated from
the date that control ceases.





Inter-company
transactions, balances and unrealized gains on transactions between Group
companies are eliminated. Unrealized losses are also eliminated.




F-5




Acquisitions





The
purchase method of accounting is used to account for the acquisition of
subsidiaries by the Group. The cost of an acquisition is measured as the fair
value of the assets given, equity instruments issued and liabilities incurred or
assumed at the date of exchange, plus costs directly attributable to the
acquisition. Identifiable assets acquired and liabilities and contingent
liabilities assumed in a business combination are measured initially at their
fair values at the acquisition date, irrespective of the extent of any minority
interest. The excess of the cost of acquisition over the fair value of the
Group’s share of the identifiable net assets acquired is recorded as goodwill.
If the cost of acquisition is less than the fair value of the net assets of the
subsidiary acquired, the difference is allocated as a pro rata reduction of the
amounts of the acquired assets, except for financial assets and current
assets.  The residual amount, if any, is recognized directly in the
consolidated statements of operations and comprehensive income.


Acquisition
of companies under common control is recorded at the book value of the acquired
companies.





Foreign
currency translation





The
Group’s principal country of operations is in the PRC. The financial position
and results of operations of the subsidiaries are determined using the local
currency (“Renminbi” or “RMB”) as the functional currency.





Translation
of amounts from RMB into United States dollars (“US$” or “$”) for reporting
purposes is performed by translating the results of operations denominated in
foreign currency at the weighted average rate of exchange during the reporting
period. Assets and liabilities denominated in foreign currencies at the balance
sheet date are translated at the market rate of exchange ruling at that date.
The registered equity capital denominated in the functional currency is
translated at the historical rate of exchange at the time of capital
contribution. All translation adjustments resulting from the translation of the
financial statements into the reporting currency US$ are reported as a component
of accumulated other comprehensive income in shareholders’ equity.





As of
December 31, 2008 and 2007 the year end exchange rates applied for balances were
RMB6.85 and RMB7.30 per US$, respectively, and the average exchange rates
applied for transactions were RMB6.96 and RMB7.61 per US$,
respectively.





Cash
and cash equivalents





Cash and
cash equivalents represent cash on hand, demand deposits and highly liquid
investments placed with banks or other financial institutions, which have
original maturities less than three months.  The carrying amounts
reported approximate their fair value.





Time
deposits





Time
deposits represent investments placed with banks or other financial
institutions, which have maturities less than 1 year.  The carrying
amounts reported approximate their fair value.





Investments





Investment
in securities classified as available-for-sale are carried at fair market value,
with the unrealized gains and losses, net of tax, included in the determination
of comprehensive income and reported in shareholders’ equity.





The fair
value of substantially all securities is determined by quoted market prices. The
estimated fair value of securities for which there are no quoted market prices
is based on similar types of securities that are traded in the
market.





Investment
at cost represents an investment in a non-marketable equity
interest.  Fair value is not estimated unless impairment is
indicated.  The Group considers that there is no impairment in the
investment value as of December 31, 2008 and 2007.





Trade
receivables, net, and notes and loans receivables, net





The
Group’s trade receivables are due from trade customers. Credit is extended based
on evaluation of customers’ financial condition. Trade receivable payment terms
vary and amounts due from customers are stated in the financial statements net
of an allowance for doubtful accounts. Receivables outstanding longer than the
payment terms are considered past due. The Group determines its allowance by
considering a number of factors, including the length of time the receivable is
past due, the Group’s previous loss history, the counter party’s current ability
to pay its obligation to the Group, and the condition of the general economy and
the industry as a whole. The Group writes off receivables when they are deemed
uncollectible, and payments subsequently received on such receivables are
credited to the allowance for doubtful accounts.





Interest
income from notes and loans receivables is recognized when earned, taking into
account the principal amounts outstanding and the interest rates
applicable.





Inventories,
net





Inventories
are comprised of raw materials, work-in-progress and finished goods and are
valued at the lower of cost or market value. The value of inventories is
determined using the weighted average cost method and includes any related
production overhead costs incurred in bringing the inventories to their present
location and condition. Overhead costs included in finished goods include,
direct labor cost and other costs directly applicable to the manufacturing
process.





The Group
estimates an inventory allowance for excessive, slow moving and obsolete
inventories as well as inventory whose carrying value is in excess of net
realizable value.  Inventory amounts are reported net of such
allowances




F-6


Construction
in progress





All
facilities purchased for installation, self-made or subcontracted are accounted
for as construction in progress. Construction in progress is recorded at
acquisition cost, including cost of facilities, installation expenses and
interest. Upon completion and readiness for use of the project, the cost of
construction in progress is transferred to property and equipment.





Interest
costs associated with construction in progress are capitalized in the period
they are incurred.  Interest is no longer capitalized when the asset
is completed and ready for use.





Property
and equipment, net





Property
and equipment are recorded at cost. Expenditures for major additions and
improvements are capitalized and minor replacements, maintenance, and repairs
are charged to expense as incurred. When property and equipment are retired or
otherwise disposed of, the cost and accumulated depreciation are removed from
the accounts and any resulting gain or loss is included in the results of
operations for the respective period.





Depreciation
is provided over the estimated useful lives of the related assets using the
straight-line method.  The estimated useful lives for significant
property, plant and equipment categories are as follows:





Buildings
      and plant
                20-33
      yearsMachinery
      and equipment
                10-14
      yearsOffice
      equipment
                5
      yearsMotor
      vehicles
                5-8
      years





The Group
reviews the carrying value of property, plant, and equipment for impairment
whenever events and circumstances indicate that the carrying value of an asset
may not be recoverable from the estimated future cash flows expected to result
from its use and eventual disposition. In cases where undiscounted expected
future cash flows are less than the carrying value, an impairment loss is
recognized equal to an amount by which the carrying value exceeds the fair value
of assets. The factors considered by management in performing this assessment
include current operating results, trends and prospects, the manner in which the
property is used, and the effects of obsolescence, demand, competition, and
other economic factors.  There were no impairments recorded in the
years ended December 31, 2008 and 2007.





Biological
assets





Immature
biological assets





Biological
assets consist of dairy cows held in the Group’s pastures for milking
purposes.  Immature biological assets are recorded at cost, including
acquisition costs, transportation costs, insurance expenses, interest costs and
feeding costs, incurred in bringing the asset to its intended productive
state.  Once the asset reaches productive state, the cost of the
immature biological asset is transferred to mature biological assets using the
weight average cost method.





Interest
costs associated with immature biological assets are capitalized in the period
they are incurred.  Interest is no longer capitalized when the asset
reaches its productive state.





Mature
biological assets





Mature
biological assets are recorded at cost. When mature biological assets are
retired or otherwise disposed of, the cost and accumulated depreciation are
removed from the accounts and any resulting gain or loss is included in the
results of operations for the respective period.





Depreciation
is provided over the estimated useful live of the mature biological assets of 5
years using the straight-line method.  The estimated residual value of
mature biological assets is 10%.





Feeding
and management costs incurred on mature biological assets are included as costs
of goods sold on the consolidated statements of operations and comprehensive
income.





The Group
reviews the carrying value of biological assets for impairment whenever events
and circumstances indicate that the carrying value of an asset may not be
recoverable from the estimated future cash flows expected to result from its use
and eventual disposition. In cases where undiscounted expected future cash flows
are less than the carrying value, an impairment loss is recognized equal to an
amount by which the carrying value exceeds the fair value of assets. The factors
considered by management in performing this assessment include current health
status of the asset and production capacity.  There were no
impairments recorded in the year ended December 31, 2008.





Prepaid
leases





All lands
in the PRC are state-owned and no individual land ownership right exists. The
Group acquired the rights to use certain lands and the premiums paid for such
rights are recorded as prepaid leases and amortized over the use terms of 40 to
50 years in the statements of operations using the straight-line
method.





Certain
of the land use rights can only be used by the Group to which the right was
granted and cannot be transferred or sold to others.




F-7




Goodwill





In
accordance with SFAS No. 141 “Business Combination” (“SFAS
No. 141”), goodwill represents the excess of the cost of an acquisition over the
fair value of the group’s share of the net identifiable tangible and intangible
assets acquired at the date of acquisition.





Goodwill
is not amortized and is tested for impairment annually or more frequently if
events or changes in circumstances indicate that it might be impaired. In the
end of each year, the Group tests impairment of goodwill at the reporting unit
level and recognizes impairment in the event that the carrying value exceeds the
fair value of each reporting unit.





Deferred
charges, net





Deferred
charges represent issuance costs of convertible debt, which are deferred and
amortized on a straight-line basis over the life of the associated debt from the
date of issuance.  Such amortization is included as a separate item of
expenses in ‘Other income (expenses) on the consolidated statements of
operations and comprehensive income.





Convertible
debt and embedded derivatives





The
Company applies APB No. 14 “Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants” to determine the classification
of its convertible debt.  In accordance with APB No 14, when
convertible debt is issued and the conversion price is greater than the market
value of the stock on issuance date, no value is apportioned to the conversion
feature.  Therefore, convertible debt is entirely recorded in
liabilities.





The
Company identifies any embedded derivative instruments that may be contained
within its convertible debt instruments in accordance with the provisions of
SFAS No. 133 and records the fair value of such derivatives separately from the
value of the host instrument. Changes in the fair value of the derivative
instruments are recorded in the statements of operations and comprehensive
income each reporting period. The fair value of the derivative at inception is
also recorded as a discount to the face value of the convertible debt and is
amortized as additional finance cost over the period of the debt.





Deferred
income





From time
to time, the Group receives funding from local authorities in the PRC to support
their development of the production facilities; these funds are recorded as
deferred income when received.





Deferred
income is amortized to the consolidated statements of operations and
comprehensive income, when the facilities are completed and commenced
depreciation, on a straight line basis over the life of the facilities, which is
generally 20-33 years.





Financial
instruments





Financial
instruments of the Company primarily comprise of cash and cash equivalents,
notes and loans receivable, trade receivables, other receivables, time deposits,
investment in mutual funds, notes and loans payable, debt securities such as
convertible debt and long term debt, accounts payable, payable for property and
equipment, payable for prepaid leases and other payables.  As of
December 31, 2008 and 2007, their carrying values approximated their fair
values.





Revenue
recognition





Sales
Revenue





Revenue
from the sale of goods is recognized on the transfer of risks and rewards of
ownership, which generally coincides with the time when the goods are shipped to
customers and the title has passed.





Revenue
is shown net of sales returns, which amounted to less than 0.02% of total sales
in each of the years ended December 31, 2008 and 2007.





Any
shipping, handling or other costs incurred by the Group associated with the
sale, are expensed as sales and marketing expenses in the period when the sale
occurs. Such costs amounted to $5,056,821 and $2,704,171 during the years ended
December 31, 2008 and 2007, respectively.





During
2007, the Group provided annual sales rebates to its distributors based upon
sales volumes.  Sales rebates were recorded as a current liability at the
time of the sale based upon the Group’s estimates of whether each customer would
be entitled to rebates for the year.  At year end, the accrued rebate
amount was adjusted to the actual amount earned.  Sales rebates were
deducted from sales in the accompanying consolidated statements of operations
and comprehensive income.





Government
subsidy – tax refund





Sales
revenues represent amounts invoiced, net of a value-added tax (“VAT”).  All
of the Group’s products sold in the PRC are subject to Chinese VAT at a rate of
17% of the gross sales price or at a rate approved by the Chinese local
government.  This VAT may be offset by VAT paid by the Group on raw
materials and other materials included in the cost of producing its finished
products.  The VAT amounts paid and available for offset are maintained in
other payables.




F-8


The
Group’s entities that operate production facilities in the Kedong County in the
PRC, namely Feihe Dairy and BaiQuan Dairy, receive 50% of the value added tax
paid on inventory refunded as local County incentive to support local economy
through employment of local residents. Such refunds are included in the
consolidated statements of operations and comprehensive income as refunds of
income tax and VAT taxes.





Feihe
Dairy and Baiquan Dairy also benefit from the Business Promotion Policy
Concerning Income Tax on Foreign Enterprises promulgated by the QiQiHaEr City
Municipal Government, which provides foreign owned enterprises registered in
QiQiHaEr City, tax holiday of seven years for full Enterprise Income Tax (“EIT”)
exemption. The preferential tax treatment commenced in 2003 and expires in
2009.





Advances
from customers





Revenue
from the sale of goods is recognized when goods are shipped. Receipts in advance
for goods to be shipped in the future are recorded as advances from
customers.





Cost
of goods sold





Cost of
goods sold primarily consists of direct and indirect manufacturing costs,
including production overhead costs, shipping and handling costs for the
products sold.





Sales
and marketing





Sales and
marketing costs consist primarily of advertising and market promotion expenses,
and other overhead expenses incurred by the Group’s sales and marketing
personnel. Advertising expenses amounted to $11,116,857 and $14,813,976 during
the years ended December 31, 2008 and 2007, respectively.





Advertising
expenses are expensed as incurred.





Product
display fees





The
Company has entered into a number of agreements with their resellers, whereby
the Company pays the reseller an agreed upon amount to display its products. As
prescribed by the Emerging Issues Task Force Issue 01-09, “Accounting for Consideration given
by a Vendor to a Customer ̧” the
Company has reduced sales by the amount paid under these agreements. For the
years ended December 31, 2008 and 2007 these amounts were $7,025,104 and
$5,854,451, respectively.





Employee
benefit costs





According
to the People’s Republic of China regulations on pension, a company contributes
to a defined contribution retirement plan organized by municipal government in
the province in which the Company was registered and all qualified employees are
eligible to participate in the plan. Contributions to the plan are calculated at
20% of the employees’ salaries above a fixed threshold amount, employees
contribute 4% and the Company contributes the balance of 16%.





Share-based
compensation





The
Company adopted the fair value recognition provisions of Statement of Financial
Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS
123(R)”), which supersedes SFAS No. 123, “Accounting-Based
Compensation” (“SFAS 123”) and Accounting Principles Board (“APB”)
Opinion No. 25, “Accounting for Stock Issued to
Employees” (“APB 25”). Under the fair value recognition provisions of
SFAS 123(R), the Company is required to measure the cost of employee services
received in exchange for share-based compensation measured at the grant date
fair value, or minimal value, of the award.





Leases





Leases
where substantially all the rewards and risks of ownership of assets remain with
the leasing company are accounted for as operating leases. Other leases are
accounted for as capital leases.





Taxation





We must
make certain estimates and judgments in determining income tax expense for
financial reporting purposes. These estimates and judgments occur in the
calculation of certain deferred tax assets and liabilities, which arise from
differences in the timing of recognition of revenue and expense for tax and
financial reporting purposes pursuant to FAS No. 109, Accounting for Income
Taxes.





Refer to
Note 5 in our notes to Consolidated Financial Statements for further information
regarding the components of our income tax expense.





Earnings
per ordinary share





In
accordance with SFAS No. 128, “Computation of Earnings Per
Share” (“SFAS No. 128”), basic earnings per share is computed by dividing
net income attributable to ordinary shareholders by the weighted average number
of ordinary shares outstanding during the year.  Diluted earnings per
share is calculated by dividing net income attributable to ordinary shareholders
as adjusted for the effect of dilutive ordinary equivalent shares, if any, by
the weighted average number of ordinary and dilutive ordinary equivalent shares
outstanding during the year. Ordinary equivalent shares consist of the ordinary
shares issuable upon the conversion of the convertible debt (using the
as-converted method).




F-9




Segment
reporting





The Group
has two reportable segments:  dairy products and dairy
farm.  The dairy products segment produces and sells dairy products,
such as wholesale and retail milk powders as well as soybean powder, rice
cereal, walnut powder and walnut oil. The dairy farm segment operates the
Group’s two dairy farms in the PRC, construction of which was commenced in 2007
and is expected to be complete in the fourth quarter of 2009.  As the
Group primarily generates its revenues from customers in the PRC, no
geographical segments are presented.





Use
of estimates





The
preparation of financial statements in conformity with US GAAP requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities, disclosures of contingent assets and liabilities at the
balance sheet dates and the reported amounts of revenues and expenses during the
reporting periods. Actual results could materially differ from those
estimates.





The
estimates and assumptions that have a significant risk of causing a material
adjustment to the carrying amounts of assets and liabilities are reserves for
losses on trade receivables, notes and loans receivable, other receivables and
deposits receivable; reserves for inventory; estimated useful lives of property
and equipment and biological assets; and impairment of goodwill.





3.  ACCOUNTING
PRONOUNCEMENTS





In
February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial
Assets and Financial Liabilities,” (“SFAS 159”). SFAS 159 permits
entities to choose to measure many financial instruments and certain other items
at fair value. SFAS 159 is effective for fiscal years beginning after November
15, 2007.  The adoption of SFAS 159 had no impact on the Company’s
financial statements.





In
December 2007, the FASB issued SFAS No. 160, “Non controlling Interests in
Consolidated Financial Statements – An Amendment of ARB No. 51,”(“SFAS 160”).SFAS 160 establishes new
accounting and reporting standards for the non controlling interest in a
subsidiary and for the deconsolidation of a subsidiary. Specifically, SFAS 160
requires the recognition of a non controlling interest (minority interest) as
equity in the consolidated financial statements that is presented separate from
the parent’s equity. The amount of net income attributable to the non
controlling interest will be included in consolidated net income on the face of
the income statement. SFAS 160 clarifies that changes in a parent’s ownership
interest in a subsidiary that do not result in deconsolidation are equity
transactions if the parent retains its controlling financial interest. In
addition, SFAS 160 requires that a parent recognize a gain or loss in net income
when a subsidiary is deconsolidated. Such gain or loss will be measured using
the fair value of the non controlling equity investment on the deconsolidation
date. SFAS 160 also includes expanded disclosure requirements regarding the
interests of the parent and its non controlling interest. SFAS 160 is effective
for fiscal years, and interim periods within those fiscal years, beginning on or
after December 15, 2008.  The adoption of SFAS 160 is not expected to
have impact on the Company’s financial statements.





In
December 2007, FASB issued SFAS No. 141 (revised),“Business Combinations” (“SFAS
141(R)”). SFAS 141(R) changes the accounting for business combinations including
the measurement of acquirer shares issued in consideration for a business
combination, the recognition of contingent consideration, the accounting for
pre-acquisition gain and loss contingencies, the recognition of capitalized
in-process research and development, the accounting for acquisition-related
restructuring cost accruals, the treatment of acquisition related transaction
costs and the recognition of changes in the acquirer’s income tax valuation
allowance. SFAS 141(R) is effective for fiscal years beginning after
December 15, 2008.  The adoption of SFAS 141(R) is not expected
to have impact on the Company’s financial statements.





In
September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements”(“SFAS 157”). SFAS 157
simplifies and codifies guidance on fair value measurements under generally
accepted accounting principles. This standard defines fair value, establishes a
framework for measuring fair value and prescribes expanded disclosures about
fair value measurements. SFAS 157 is effective for the Company starting
January 1, 2008, and interim periods within those fiscal years, with early
adoption permitted. The adoption of SFAS 157 resulted in additional disclosures
being presented on assets recorded at fair value (Note 11).





In
March 2008, the FASB issued SFAS No. 161, “Disclosures about Derivative
Instruments and Hedging Activities - an Amendment of FASB Statement 133”
(“SFAS 161”).  SFAS 161 provides new disclosure requirements for an
entity’s derivative and hedging activities. SFAS No. 161 is effective for
periods beginning after November 15, 2008. The Company has not yet
determined the impact on its consolidated financial statements of adopting
SFAS No. 161.





In
April 2008, the FASB issued Staff Position No. FAS 142-3, “Determination of the Useful Life of
Intangible Assets” (“FSP FAS 142-3”). This position amends the factors an
entity should consider when developing renewal or extension assumptions used in
determining the useful life over which to amortize the cost of a recognized
intangible asset under SFAS No. 142, “Goodwill and Other Intangible
Assets.” FSP FAS 142-3 requires an entity to consider its own historical
experience in renewing or extending similar arrangements in determining the
amortizable useful life. Additionally, this position requires expanded
disclosures related to the determination of intangible asset useful lives. FSP
FAS 142-3 is effective for fiscal years beginning after December 15, 2008,
and may impact any intangible assets the Company acquires in future
transactions. The guidance for determining the useful life of a recognized
intangible asset must be applied prospectively to intangible assets acquired
after the effective date. The disclosure requirements, though, shall be applied
prospectively to all intangible assets recognized as of the effective date.
Early adoption is prohibited.  The adoption of FSP FAS 142-3 is not
expected to have impact on the Company’s financial statements.





In May
2008, the FASB issued SFAS No. 162, “The Hierarchy of Generally Accepted
Accounting Principles” (“FAS 162”). FAS 162 identifies the sources of
accounting principles and the framework for selecting the principles used in the
preparation of financial statements.  FAS 162 is effective 60 days
following SEC approval.




F-10




In June
2008, the FASB issued Staff Position No. Emerging Issue Task Force (“EITF”)
03-6-1, "Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities" (“FSP EITF 03-6-1”), which requires entities to apply the
two-class method of computing basic and diluted earnings per share for
participating securities that include awards that accrue cash dividends (whether
paid or unpaid) any time common shareholders receive dividends and those
dividends will not be returned to the entity if the employee forfeits the award.
FSP EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008,
and the interim periods within those years. Early adoption is prohibited and
retroactive disclosure is required. The Company is currently evaluating the
effect its adoption will have on the Company’s financial
statements.





In June
2008, the FASB ratified EITF Issue 07-5,“Determining Whether an Instrument (or Embedded
Feature) Is Indexed to an Entity’s Own Stock” (“EITF 07-5”). This Issue
addresses the determination of whether an instrument (or an embedded feature) is
indexed to an entity’s own stock. The EITF will be effective for years
beginning after December 15, 2008.  The Company is evaluating the
impact of adopting the provisions of this EITF.





In
December 2008, the FASB issued FASB Staff Position (“FSP”) FAS 132R-1, “Employers’ Disclosures about
Postretirement Benefit Plan Assets” (“FSP FAS 132R-1”), to require
employers to provide more transparency about the assets in their postretirement
benefit plans.  The disclosures are required for the fiscal years
ending after December 15, 2009.  The Company intends to adopt FSP FAS
132R-1 effective December 31, 2009.





In
February 2008, the FASB issued FSP SFAS 157-2, “Effective Date of FASB Statement No.
157” (“FSP SFAS
157-2”). 
This statement defers fair value requirements for non-financial assets and
liabilities not required to be stated at fair value on a recurring basis (at
least annually) until fiscal years beginning after November 15, 2008. This
deferral primarily impacts assets such as property, plant and equipment,
intangible assets and goodwill upon non-recurring events such as business
combinations, asset impairments and goodwill impairment, among others. The
adoption of FSP SFAS 157-2 did not have a material impact on the Company’s
financial position, results of operations or cash flows.





4.
            CONCENTRATIONS
      OF BUSINESS AND CREDIT RISK





Financial
instruments that potentially subject the Group to significant concentrations of
credit risk consist primarily of cash and cash equivalents, trade receivables,
time deposits, deposit for equity investments and notes and loans
receivable.





(1)
Cash and cash equivalents and time deposits





The
Company maintains certain bank accounts in the PRC which are not protected by
FDIC insurance or other insurance.  Cash balance held in PRC bank
accounts to $11,623,649 and $11,004,954 as of December 31, 2008 and 2007,
respectively.  As of December 31, 2008 and 2007, the Company held
$161,759 and $176,530 of cash balances within the United States of which $0 and
$76,530 was in excess of FDIC insurance limits, respectively.





As of
December 31, 2008 and 2007 substantially all of the Group’s cash and cash
equivalents, time deposits, investment in mutual funds and short term notes
receivable were held by major financial institutions located in the PRC and
United States which management believes are of high credit quality.





(2)
Sales and trade receivables





Nearly
all of the Group’s sales are concentrated in the PRC and substantially all of
the Group’s profits are generated from the operation
there.  Accordingly, the Group is susceptible to fluctuations in its
business caused by adverse economic conditions in the PRC.





The Group
provides credit in the normal course of business and substantially all customers
are located in the PRC.  The Group
performs ongoing credit evaluations of its customers and maintains allowances
for doubtful accounts based on factors surrounding the credit risk of specific
customers, historical trends, and other information.  No individual
customer accounted for more than 10% of net revenues during the years ended
December 31, 2008 and 2007.





(3)
Short term notes and loans receivable





Short
term notes and loans receivable include a promissory note in the principal
amount of $4,000,000 (the “Note”) issued by Huge Power Int’l S.A., a company
organized in Samoa (“Huge Power”).  On June 27, 2007, the Company
loaned a principal amount of $4,000,000 to Huge Power and Huge Power issued the
Note.  The Note accrues interest at an annual rate of 8%, payable in
cash semi-annually.  The Note matures on June 27,
2009.  Huge Power has made payments of interest under the Note;
however, the Company has been unable to obtain the collateral that is required
to be pledged according to the Note agreement.  As a result, the
Company has provided an allowance for doubtful collection of the Note as a
result of not receiving collateral.





5.
            TAXATION





The
components of income (loss) before income taxes from continuing operations
consisted of the following:





2008
                  
                  
                  2007US$
                  
                  
                  US$Income
      (loss) subject to domestic income taxes only
                  
                  
                  7,208,685
                  
                  
                  
                  (21,479,394
                  )Income
      (loss) subject to foreign income taxes only
                  
                  
                  19,931,453
                  
                  
                  
                  33,251,659Intercompany
      elimination
                  
                  
                  (13,003,376
                  )
                  
                  
                  1,734,86014,136,762
                  
                  
                  
                  13,507,125




F-11




The
Company is subject to U.S. federal and state income taxes.  The
Company’s subsidiaries incorporated in the PRC are subject to enterprise income
taxes.  The provision for income taxes from continuing operations
consisted of the following:





2008
                  
                  
                  2007US$
                  
                  
                  US$Current:Federal
                  
                  
                  -
                  
                  
                  
                  -State
                  
                  
                  5,823
                  
                  
                  
                  12,505PRC
                  
                  
                  4,291,802
                  
                  
                  
                  5,649,2744,297,625
                  
                  
                  
                  5,661,779Deferred:Federal
                  
                  
                  -
                  
                  
                  
                  -State
                  
                  
                  -
                  
                  
                  
                  -PRC
                  
                  
                  (730,490
                  )
                  
                  
                  -3,567,135
                  
                  
                  
                  5,661,779





The
following is a reconciliation of the difference between the actual provision for
income taxes and the provision computed by applying the federal statutory rate
on income from continuing operations before income taxes:





2008
                    
                    
                    2007US$
                    
                    
                    US$Tax
      at Federal statutory rate
                    
                    
                    4,806,499
                    
                    
                    
                    4,592,423U.S.
      Permanent differences
                    
                    
                    (7,674,514
                    )
                    
                    
                    4,745,468State
      tax expenses
                    
                    
                    5,823
                    
                    
                    
                    12,505Current
      year State tax deduction
                    
                    
                    (4,252
                    )
                    
                    
                    (34
                    )Change
      in valuation allowance
                    
                    
                    671,485
                    
                    
                    
                    2,728,994Foreign
      permanent differences
                    
                    
                    5,947,745
                    
                    
                    
                    (1,984,778
                    )Foreign
      rate differential
                    
                    
                    (2,197,930
                    )
                    
                    
                    (287,295
                    )Foreign
      tax holiday
                    
                    
                    (3,397,666
                    )
                    
                    
                    (5,232,905
                    )Foreign
      tax reserve
                    
                    
                    968,871
                    
                    
                    
                    1,285,128Embedded
      derivatives
                    
                    
                    4,317,964
                    
                    
                    
                    -Others
                    
                    
                    123,110
                    
                    
                    
                    (197,727
                    )3,567,135
                    
                    
                    
                    5,661,779





Deferred
tax assets and liabilities are recognized for the expected future tax
consequences of differences between the carrying amounts of assets and
liabilities and their respective tax bases using enacted tax rates in effect for
the year in which the differences are expected to reverse. Deferred taxes are
comprised of the following:





2008
                  
                  
                  2007US$
                  
                  
                  US$Net
      operating loss carryforward
                  
                  
                  5,223,638
                  
                  
                  
                  1,819,767Accrued
      liabilities and allowances
                  
                  
                  1,545,318
                  
                  
                  
                  1,612,898Debt
      restructuring costs
                  
                  
                  369,701
                  
                  
                  
                  279,220Others
                  
                  
                  (9,953
                  )
                  
                  
                  (7,877
                  )PRC
      deferred tax assets
                  
                  
                  980,981
                  
                  
                  
                  418,794Gross
      deferred tax assets
                  
                  
                  8,109,685
                  
                  
                  
                  4,122,802Deferred
      tax liabilities
                  
                  
                  -
                  
                  
                  
                  -Total
      deferred tax assets
                  
                  
                  8,109,685
                  
                  
                  
                  4,122,802Valuation
      allowance
                  
                  
                  (7,379,195
                  )
                  
                  
                  (4,122,802
                  )Net
      deferred tax assets
                  
                  
                  730,490
                  
                  
                  
                  -





The
company has recorded a valuation allowance against all of its U.S. federal and
state and PRC deferred tax assets at December 31, 2008 except for Feihe
Dairy.  In accordance with FAS 109 and based on all available
evidence, including our historical results and the uncertainty of predicting its
future income, the valuation allowance reduces our deferred tax assets to an
amount that is more likely than not to be realized.





For U.S.
federal income tax purposes, the Company has net operating loss, or NOL
carryforwards of approximately $15.3 million and $5.3 million, at December 31,
2008 and 2007, respectively. The 2008 net operating loss carryforwards will
expire between 2022 and 2028 and the 2007 net operating loss carryforwards will
expire between 2022 and 2027, if not utilized.  The company also has
approximately $0.4 million and $0.4 million of net operating loss carryforwards
for PRC enterprise income tax purposes, at December 31, 2008 and 2007,
respectively.




F-12




On March
16, 2007, the PRC National People’s Congress passed the PRC Enterprise Income
Tax Law (“New EIT Law”) which became effective on January 1,
2008.  Pursuant to the New EIT Law, a unified enterprise income tax
rate of 25 percent and unified tax deduction standards will be applied
consistently to both domestic-invested enterprises and foreign-invested
enterprises.  However, the New EIT Law repealed most of the existing
preferential tax rates and tax holidays.  A five-year transition
period is allowed for enterprises that obtained preferential tax treatment under
the prior tax regime.  Under the prior tax regime, foreign-invested
enterprises were generally subject to a 30 percent federal tax rate plus a 3
percent local tax rate for a total tax rate of 33 percent.





Prior to
the effective date of the New EIT Law, Feihe Dairy and Baiquan Dairy secured a
combination of preferential tax treatment and government incentives in their
respective jurisdiction where they conducted their manufacturing
activities.  Pursuant to Article 8 of the Income Tax Law of the PRC on
Enterprises with Foreign Investment and Foreign Enterprises, a manufacturing
enterprise that operate for at least 10 years shall receive certain preferential
tax treatment.  Feihe Dairy qualifies for an 18 percent tax exemption
for tax years 2005 through 2007.  In addition to the preferential tax
treatment, Feihe Dairy received a tax subsidy from the local government for 100
percent of the enterprise income tax liability paid for tax years 2005 through
2009.  Baiquan Dairy received a tax subsidy from the local government
for 100 percent of the enterprise income tax liability paid for tax years 2004
through 2010.  The tax subsidies granted by the local government for
Feihe Dairy and Baiquan Dairy may be modified or challenged by the central
government or the tax authority.  If these incentives are modified,
the Company may lose or significantly reduce the tax subsidy received from the
local government, and will adversely affect the financial
statements.  Feihe Dairy received tax subsidies totaling $3.3 million
and $4.4 million for the periods ended December 31, 2008 and 2007,
respectively.  The tax subsidies received are recorded in “Other
Income” on the Consolidated Statements of Operations and Comprehensive
Income.





Undistributed
earnings of the PRC subsidiaries amounted to approximately $88 million as of
December 31, 2008.  Those earnings are considered to be permanently
reinvested and accordingly, no deferred tax expense is recorded for U.S. federal
and state income tax or applicable withholding taxes.  The PRC tax
authorities have clarified that dividend distributions made out of pre-January
1, 2008 retained earnings will not be subject to withholding taxes.





The
Company adopted the provisions of FIN 48 on January 1, 2007. As a result of the
implementation of FIN 48, there were no material changes to the liability for
unrecognized tax benefits.  Upon adoption, we had recorded $1.7
million of unrecognized tax benefits (excluding interest & penalty) with an
offsetting receivable for $0.9 million of which $0.8 million, when recognized,
will impact the effective tax rate. At December 31, 2007, we had $2.8 million of
unrecognized tax benefits (excluding interest & penalty) with an offsetting
receivable for $1.5 million of which $1.3 million, when recognized, will impact
the effective tax rate. These non-current income tax liabilities are recorded in
other long term liabilities in its consolidated balance sheet.





A
reconciliation of the January 1, 2007 through December 31, 2008 amount of
unrecognized tax benefits (excluding interest and penalties) is as
follows:





Beginning
      balance at January 1, 2007
                  
                  $
                  1,701,010Increase
      in unrecorded tax benefits taken in current year
                  
                  $
                  1,113,603Ending
      balance at December 31, 2007
                  
                  $
                  2,814,613Increase
      in unrecorded tax benefits taken in current year
                  
                  $
                  651,027Ending
      balance at December 31, 2008
                  
                  $
                  3,465,640





At
December 31, 2008, of the total $3.5 million in unrecognized tax benefits, $1.8
million represents the amount that if recognized, would favorably affect the
effective income tax rate in any future periods.  At December 31,
2007, of the total $2.8 million in unrecognized tax benefits, $1.3 million
represents the amount that if recognized, would favorably affect the effective
income tax rate in any future periods.





The
Company record interest and penalties related to unrecognized tax benefits in
income tax expense. We had cumulatively accrued approximately $0.6 million and
$0.3 million for estimated interest and penalties related to uncertain tax
positions at December 31, 2008 and 2007, respectively.  For the twelve
months ended December 31, 2008 and 2007, the Company recorded estimated interest
and penalties of approximately $0.3 million and $0.2 million,
respectively.





The
Company and its subsidiaries are subject to taxation in the U.S. and the PRC.
Our U.S. federal and state income tax returns are generally not subject to
examination by the tax authorities for tax years before 2004. With a few
exceptions, the tax years 2004-2008 remain open to examination by tax
authorities in the PRC.





6.
            EARNINGS
      PER ORDINARY SHARE





The
following table sets forth the computation of net income attributable to
shareholders for calculating basic and diluted earnings per ordinary share for
the fiscal years ended:





December 31,2008
                                    
                                    
                                    2007US$
                                    
                                    
                                    US$Net
      income attributable to shareholders – Basic
                                    
                                    
                                    17,023,035
                                    
                                    
                                    
                                    8,284,393Effect
      of dilutive securitiesConvertible
      notes
                                    
                                    
                                    -
                                    
                                    
                                    
                                    218,322Net
      income attributable to shareholders – Diluted
                                    
                                    
                                    17,023,035
                                    
                                    
                                    
                                    8,502,715





The
following table sets forth the computation of weighted-average shares
outstanding for calculating basic and diluted earnings per share for the fiscal
years ended:




F-13




2008
                      
                      
                      2007Weighted-average
      shares – Basic
                      
                      
                      16,993,390
                      
                      
                      
                      16,327,616Effect
      of dilutive securitiesConvertible
      notes
                      
                      
                      -
                      
                      
                      
                      335,287Warrants
                      
                      
                      643,472
                      
                      
                      
                      1,034,094Weighted-average
      shares – Diluted
                      
                      
                      17,636,862
                      
                      
                      
                      17,696,997





For the
year ended December 31, 2008, 1,473,437 shares of the Company’s ordinary shares
attributable to the potential conversion of the 7.75% Convertible Notes due 2009
and 251,040 warrants were excluded from the calculation of diluted income per
share because the conversion price or exercise price exceeded the average price
of the Company’s ordinary shares.





For the
year ended December 31, 2007, 1,376,168 shares of the Company’s ordinary shares
attributable to the potential conversion of the 7.75% Convertible Notes due 2009
were excluded from the calculation of diluted income per share because the
conversion price of the 7.75% Convertible Notes due 2009 exceeded the average
price of the Company’s ordinary shares.





For the
year ended December 31, 2007 a total of 1,950,549 shares of the Company’s
ordinary shares attributable to the potential conversion of the 1% Guaranteed
Senior Secured Convertible Notes due 2012 were excluded from the calculation of
diluted income per share because the conversion price of the 1% Guaranteed
Senior Secure Convertible Notes due 2012 exceeded the average price of the
Company’s ordinary shares.





7.
            NOTES
      AND LOANS RECEIVABLE





The notes
and loans receivable amount included in the consolidated balance sheets for the
years ended December 31, 2008 and 2007 were as follows:





(1)
Short term notes and loans receivable





2008
                  
                  
                  2007US$
                  
                  
                  US$Bills
      receivable from banks in the PRC, due within three months
                  
                  
                  34,286
                  
                  
                  
                  190,182Loans
      receivable from an unrelated party, bearing interest at 5.85%, due on
      October 1, 2008
                  
                  
                  -
                  
                  
                  
                  1,095,200Promissory
      note, bearing interest at 8%, due on June 27, 2009 (See Note
      4(3))
                  
                  
                  4,000,000
                  
                  
                  
                  -Loans
      receivable from an unrelated party, bearing interest at 10%, due on
      January 17, 2009
                  
                  
                  1,458,959
                  
                  
                  
                  -5,493,245
                  
                  
                  
                  1,285,382Less:
      Allowance for doubtful note receivable
                  
                  
                  (4,000,000
                  )
                  
                  
                  -1,493,245
                  
                  
                  
                  1,285,382





(2)
Long term notes and loans receivable





2008
                  
                  
                  2007US$
                  
                  
                  US$Loans
      receivable from an unrelated party, bearing interest at 10%, due on
      January 17, 2009
                  
                  
                  -
                  
                  
                  
                  1,368,999Promissory
      note, bearing interest at 8%, due on June 27, 2009 (See Note
      4(3))
                  
                  
                  -
                  
                  
                  
                  4,000,000-
                  
                  
                  
                  5,368,999Less:
      Allowance for doubtful note receivable
                  
                  
                  -
                  
                  
                  
                  (4,000,000
                  )-
                  
                  
                  
                  1,368,999





8.
            TRADE
      RECEIVABLES, NET





The trade
receivables amount included in the consolidated balance sheets for the years
ended December 31, 2008 and 2007 were as follows:





2008
                    
                    
                    2007US$
                    
                    
                    US$Trade
      receivables
                    
                    
                    13,586,828
                    
                    
                    
                    5,188,760Less:
      Allowance for doubtful accounts
                    
                    
                    (1,311,331
                    )
                    
                    
                    (670,113
                    )Trade
      receivables, net
                    
                    
                    12,275,497
                    
                    
                    
                    4,518,647




F-14




The
movement of the allowance for doubtful notes and loans and trade receivables
during the years was as follow:





2008
                          
                          
                          2007US$
                          
                          
                          US$Balance
      as at January 1
                          
                          
                          4,670,113
                          
                          
                          
                          292,507Add:
      Current year additions
                          
                          
                          641,218
                          
                          
                          
                          4,377,606Less:
      Current year deletions
                          
                          
                          -
                          
                          
                          
                          -Less:
      Current year charge offs
                          
                          
                          -
                          
                          
                          
                          -Balance
      as at December 31
                          
                          
                          5,311,331
                          
                          
                          
                          4,670,113





9.
            INVENTORIES,
      NET





The
inventory amounts included in the consolidated balance sheets for the years
ended December 31, 2008 and 2007 comprised of:





2008
                          
                          
                          2007US$
                          
                          
                          US$Raw
      materials
                          
                          
                          16,193,783
                          
                          
                          
                          9,420,116Work-in-progress
                          
                          
                          14,667,279
                          
                          
                          
                          9,459,614Finished
      goods
                          
                          
                          21,469,271
                          
                          
                          
                          5,816,304Total
      inventories, net
                          
                          
                          52,330,333
                          
                          
                          
                          24,696,034





The
movement of provision for inventory reserves during the years was as
follow:




2008
              
              
              2007US$
              
              
              US$Balance
      as at January 1
              
              
              744,067
              
              
              
              147,687Add:
      Current year additions
              
              
              214,635
              
              
              
              586,162Less:
      Current year deletions
              
              
              -
              
              
              
              -Less:
      Current year charge offs
              
              
              (431,680
              )
              
              
              -Foreign
      exchange fluctuation
              
              
              48,894
              
              
              
              10,218Balance
      as at December 31
              
              
              575,916
              
              
              
              744,067


10.
            INVESTMENT
      IN MUTUAL FUNDS – Available for
sale





Investment
in mutual funds is carried at fair value based on the quoted market prices of
the underlying fund at December 31, 2008 and 2007.  Unrealized loss
recorded for the years ended December 31, 2008 and 2007 was $104,865 and $0,
respectively.





Fair value measurementDescription
                  
                  December 31,
                  
                  
                  Quoted prices
                    in active
                    markets of
                    identical assets
                    (Level 1)
                  
                  
                  Significant
                    other
                    observable
                    inputs
                    (Level 2)
                  
                  
                  Significant
                    unobservable
                    inputs
                    (Level 3)US$
                  
                  
                  US$
                  
                  
                  US$
                  
                  
                  US$Investment
      in mutual funds – 2008
                  
                  
                  77,504
                  
                  
                  
                  77,504
                  
                  
                  
                  -
                  
                  
                  
                  -Investment
      in mutual funds – 2007
                  
                  
                  171,125
                  
                  
                  
                  171,125
                  
                  
                  
                  -
                  
                  
                  
                  -





11.
            DISCONTINUING
      OPERATIONS





In August
2007, an advance payment was made to Ausnutria Dairy (Hunan) Company Ltd.
(“Ausnutria”), a distributor of milk powder and rice products in China, in
connection with a proposed acquisition of 100% of the equity interest in
Ausnutria.  The transaction did not close and the parties entered into
renegotiations.




In
October 2007, the Company entered into an equity purchase agreement (the “2007
EPA”) pursuant to which the Company agreed to purchase, through its subsidiary
Moveup, 75% of the outstanding equity interests of Ausnutria, for consideration
that included the amount of the advance payment previously made by the Company
(the “2007 Transaction”).  The 2007 Transaction did not close because
the sellers failed to comply with certain closing conditions under the equity
purchase agreement, and the parties entered into renegotiations, including
discussions regarding the Company’s proposed acquisition (directly or
indirectly) of the other 25% of the outstanding equity interests of
Ausnutria.  In connection with the 2007 Transaction, a deposit for
investment of $28,269,857 was recorded in the financial records of
Moveup.




In
February 2008, a further deposit payment of US$1,390,763 was made to
Ausnutria Holding Co., Ltd., which indirectly owns Ausnutria, in connection with
the efforts to resolve the incomplete transactions under the 2007
EPA.  At the end of December 31, 2008, a total deposit for investment
of $31,586,473 was recorded in the financial records of Moveup, of which
$1,925,852 of the increase was related to changes in exchange
rates.




F-15




To
resolve the incomplete transactions regarding Ausnutria, on December 16, 2008,
the Group signed a letter of intent to sell all of the business activities and
operations of Moveup.  Accordingly, Moveup is reflected in the
Company’s consolidated financial statements as a discontinuing
operations.  And on February 18, 2009, the Company, through its
subsidiary Feihe Dairy, entered into a new equity purchase agreement pursuant to
which Feihe Dairy and the minority shareholder of Moveup, Liu Sheng-Hui, each
agreed to sell to Hunan Xindaxin Co., Ltd. 100% of their equity interests in
Moveup for an aggregate consideration of RMB 296,500,000 (the “2009
Transaction”).  The agreement is subject to customary representations,
warranties, covenants and indemnities.  The purchase price is payable
in two tranches.  The Company received RMB75,000,000 from the
purchasers, and the second tranche of RMB 221,500,000 has been deposited into an
escrow account and will be released to Feihe Dairy and Mr. Liu upon satisfaction
of the closing conditions under the agreement, including completion of the
application for amendment of shareholders with the local counterpart of the
State Administration of Industry and Commence in Kedong County, Heilongjiang
Province, China.





Moveup
received advances from the Group of $31,002,897 and $25,949,410 as of December
31, 2008 and 2007, respectively. The advance will be settled from the Moveup
sales proceeds.




The
following table presents the components of discontinuing operations reported in
the consolidated statements of operations and comprehensive income:





For the years ended December
                            31,2008
                          
                          
                          2007US$
                          
                          
                          US$Sales
                          
                          
                          38,979,045
                          
                          
                          
                          2,069,595Income
      from operations
                          
                          
                          8,593,564
                          
                          
                          
                          659,868Income
      tax expenses
                          
                          
                          2,130,686
                          
                          
                          
                          217,757Net
      income from discontinuing operations
                          
                          
                          6,462,878
                          
                          
                          
                          442,111





The
following table presents the major classes of assets and liabilities of
discontinuing operations reported in the consolidated balance
sheets:




December 31,
                                2008
                              
                              
                              December
                                31,
                                2007US$
                              
                              
                              US$Cash
      and cash equivalents
                              
                              
                              2,108,739
                              
                              
                              
                              123,610Trade
      receivables, net
                              
                              
                              4,376,878
                              
                              
                              
                              -Advances
      to suppliers
                              
                              
                              3,394,526
                              
                              
                              
                              1,115,396Inventories,
      net
                              
                              
                              1,573,374
                              
                              
                              
                              -Other
      receivables
                              
                              
                              938,867
                              
                              
                              
                              107,651Current
      assets of discontinuing
      operations
                              
                              
                              12,392,384
                              
                              
                              
                              1,346,657Deposit
      for equity investment
                              
                              
                              31,586,473
                              
                              
                              
                              28,269,857Other
      long term assets
                              
                              
                              545
                              
                              
                              
                              644Long
      term assets of discontinuing operations
                              
                              
                              31,587,018
                              
                              
                              
                              28,270,501Current
      maturities of long term debt
                              
                              
                              -
                              
                              
                              
                              1,362,155Accounts
      payable and accrued expenses
                              
                              
                              1,742,699
                              
                              
                              
                              -Payable
      to the Group
                              
                              
                              31,002,897
                              
                              
                              
                              25,949,410Other
      taxes payable
                              
                              
                              1,012,860
                              
                              
                              
                              220,479Advances
      from customers
                              
                              
                              429,580
                              
                              
                              
                              231,493Accrued
      employee benefits
                              
                              
                              433,355
                              
                              
                              
                              429Other
      payable
                              
                              
                              442,212
                              
                              
                              
                              23,771Current
      liabilities of discontinuing operations
                              
                              
                              35,063,603
                              
                              
                              
                              27,787,737Long
      term tax payable
                              
                              
                              395,176
                              
                              
                              
                              -Long
      term liability of discontinuing operations
                              
                              
                              395,176
                              
                              
                              
                              -


12.
            PROPERTY
      AND EQUIPMENT, NET





Property
and equipment and related accumulated depreciation as of December 31 2008 and
2007 were as follows:




2008
                
                
                2007US$
                
                
                US$Buildings
      and plant
                
                
                50,745,361
                
                
                
                30,752,574Machinery
      and equipment
                
                
                47,680,884
                
                
                
                27,054,642Office
      equipment
                
                
                797,562
                
                
                
                432,969Motor
      vehicles
                
                
                1,183,861
                
                
                
                805,299100,407,668
                
                
                
                59,045,484Less:
      Accumulated depreciation
                
                
                (12,117,810
                )
                
                
                (6,766,316
                )Net
      book value
                
                
                88,289,858
                
                
                
                52,279,168




F-16




(1)
Depreciation expenses





Depreciation
expense for the years ended December 31 2008 and 2007 was $4,840,402 and
$2,941,122, respectively, of which $3,700,632 and $2,426,182 were included as a
component of cost of goods sold in the respective years.





(2)
Pledged property and equipment





The net
book value of buildings and equipment pledged for borrowings were $8,008,238 and
$10,063,236 as at December 31, 2008 and 2007.





13.
            CONSTRUCTION
      IN PROGRESS





The major
construction projects under construction at December 31, 2008 and 2007 were as
follow:





2008
                          
                          
                          2007US$
                          
                          
                          US$Feihe
      Dairy processing facilities
                          
                          
                          -
                          
                          
                          
                          498,876Langfang
      Feihe production factory facilities
                          
                          
                          9,950
                          
                          
                          
                          4,994Gannan
      production factory facilities
                          
                          
                          179,937
                          
                          
                          
                          16,313,727Shanxi
      walnut processing facilities
                          
                          
                          38,622
                          
                          
                          
                          58,979Gannan
      Pasture facilities
                          
                          
                          13,381,175
                          
                          
                          
                          7,409,610Kedong
      Pasture facilities
                          
                          
                          13,745,720
                          
                          
                          
                          7,546,838Soybean
      processing facilities
                          
                          
                          1,479,131
                          
                          
                          
                          1,161,209Others
                          
                          
                          13,424
                          
                          
                          
                          15,759Total
                          
                          
                          28,847,959
                          
                          
                          
                          33,009,992





$4,149,543
and $1,158,912 of interest expense was capitalized in construction in progress
for the years ended December 31, 2008 and 2007.





14.
            BIOLOGICAL
      ASSETS




2008US$Immature
      biological assets
              
              
              23,784,479Mature
      biological assets
              
              
              1,490,171Less:
      Accumulated depreciation
              
              
              (6,816
              )Net
      book value
              
              
              25,267,834


(1)
Depreciation expenses





Depreciation
expense for the year ended December 31 2008 was $6,816, all of which was
recorded in cost of goods sold.





(2)
Pledged property and equipment





The net
book value of biological assets pledged for borrowings was $19,995,659 at
December 31, 2008.





(3)
Capitalized interest





$1,999,630
of interest expense was capitalized in immature biological assets for the year
ended December 31, 2008.





15.
            GOODWILL





Goodwill
represents excess of the purchase price over the estimated fair value of the net
tangible and identifiable intangible assets acquired from the Shanxi minority
interest acquisition in 2006.  Such amount is not tax
deductible.





The
Company has performed goodwill impairment tests relating to goodwill arising
from its acquisition and concluded that there was no impairment as to the
carrying value of goodwill as of December 31, 2008 and 2007.





16.
            DEFERRED
      CHARGES, NET





Deferred
charges represent direct issuance costs incurred in connection with the 1%
Guaranteed Senior Secured Convertible Notes due 2012 that were issued in 2007
and costs incurred in connection with the note restructuring in 2008 (Note
22(2)).  During the years ended December 31, 2008 and 2007,
amortization expense was $657,258 and $369,794, respectively.




F-17




Amortization
expense is estimated to be $107,396 for 2009 and $0 thereafter.





17.
            NOTES
      AND LOANS PAYABLE





Notes and
loans payable included in the consolidated balance sheets for the years ended
December 31, 2008 and 2007 comprised of:





2008
                                        
                                        
                                        2007US$
                                        
                                        
                                        US$Note
      payable to a bank in the PRC, bearing interest at 7.29% per annum, secured
      by plant and machinery and prepaid leases, payable with interest on
      maturity, due on October 29, 2008
                                        
                                        
                                        -
                                        
                                        
                                        
                                        3,422,501Note
      payable to a bank in the PRC, bearing interest at 7.47% per annum,
      unsecured, payable with interest on maturity, due on December 25,
      2008
                                        
                                        
                                        -
                                        
                                        
                                        
                                        3,422,502Note
      payable to a bank in the PRC, bearing interest at 8.019% per annum,
      unsecured, payable with interest on maturity, due on December 5,
      2008
                                        
                                        
                                        -
                                        
                                        
                                        
                                        1,369,000Note
      payable to a bank in the PRC, bearing interest at 7.47% per annum,
      unsecured, payable with interest on maturity, due on May 11,
      2009
                                        
                                        
                                        4,522,774
                                        
                                        
                                        
                                        -Note
      payable to a bank in the PRC, bearing interest at 7.47% per annum, secured
      by plant and machinery, payable with interest on maturity, due on May 11,
      2009
                                        
                                        
                                        2,772,023
                                        
                                        
                                        
                                        -Unsecured,
      non-interest bearing loan payable to an unrelated party, due on
      demand.
                                        
                                        
                                        442,600Unsecured,
      non-interest bearing loan payable to County Finance Department, due on
      demand. (i)
                                        
                                        
                                        318,053
                                        
                                        
                                        
                                        298,443Total
                                        
                                        
                                        8,055,450
                                        
                                        
                                        
                                        8,512,446





(i)  Shanxi
received funding from the local County Finance Department for its construction
of the production facilities in the region.  Although, no repayment
terms were attached with the funds, the Company considers them to be unsecured,
non-interest bearing loans from the County Finance Department that are repayable
on demand.





None of
the notes and loans payables have restrictions or covenants
attached.





18.
            RELATED
      PARTY TRANSACTIONS





Due
from/to related parties included in the consolidated balance sheets for the
years ended December 31, 2008 and 2007 comprised of:





2008
                            
                            
                            2007US$
                            
                            
                            US$Due
      from related parties:Due
      from Directors of the Group
                            
                            
                            33,011
                            
                            
                            
                            50,855Due
      from related companies
                            
                            
                            232,468
                            
                            
                            
                            64,622Total
                            
                            
                            265,479
                            
                            
                            
                            115,477





2008
                  
                  
                  2007US$
                  
                  
                  US$Due
      to related parties:Due
      to Directors of the Group
                  
                  
                  33,156
                  
                  
                  
                  129,222Due
      to related companies
                  
                  
                  730,833
                  
                  
                  
                  20,788Loan
      payable to a related party
                  
                  
                  253,410
                  
                  
                  
                  251,550Total
                  
                  
                  1,017,399
                  
                  
                  
                  401,560





F-18


(1)
Due from/to Directors of the Group





As part
of normal business operation, Directors of the Group will from time to time
incur expenses on behalf of the Group, or receive advances from the Group for
settlement of Group expenses.  The amounts outstanding at year end are
of short term nature and due on demand.





As of
December 31, 2008 and 2007, the Group had the following balances due from its
Directors:





2008
                  
                  
                  2007US$
                  
                  
                  US$Liu
      Hua
                  
                  
                  28,483
                  
                  
                  
                  47,208Directors
      of subsidiaries in the PRC
                  
                  
                  4,528
                  
                  
                  
                  3,647Total
                  
                  
                  33,011
                  
                  
                  
                  50,855





As of
December 31, 2008 and 2007, the Group had the following balances due to its
Directors:





2008
                  
                  
                  2007US$
                  
                  
                  US$Leng
      You-Bin
                  
                  
                  32,608
                  
                  
                  
                  41,606Liu
      Sheng-Hui
                  
                  
                  -
                  
                  
                  
                  87,616Directors
      of subsidiaries in the PRC
                  
                  
                  548
                  
                  
                  
                  -Total
                  
                  
                  33,156
                  
                  
                  
                  129,222





(2)
Due from/to related companies





Mr. Leng
You-Bin is the Chairman, Chief Executive Officer, President, and General Manager
of the Group.  During the years ended December 31, 2008 and 2007, the
Group sold goods to companies owned by close family members of Mr. Leng You-Bin,
including one company, Heilongjiang Feihe Yuanshengtai Co., Ltd directly owned
by Mr. Leng You-Bin, on an arm’s length basis.





For the
years ended December 31, 2008 and 2007, the Group made sales of goods to the
following related companies:





2008
                  
                  
                  2007US$
                  
                  
                  US$Tangshan
      Feihe Trading Company
                  
                  
                  1,216,948
                  
                  
                  
                  790,331Qinhuangdao
      Feihe Trading Company
                  
                  
                  476,397
                  
                  
                  
                  107,421Dalian
      Hewang Trading Company
                  
                  
                  90,629
                  
                  
                  
                  25,400Total
                  
                  
                  1,783,974
                  
                  
                  
                  923,152





As of
December 31, 2008 and 2007, the Group had the following balances due from its
related companies:





2008
                  
                  
                  2007US$
                  
                  
                  US$Tangshan
      Feihe Trading Company
                  
                  
                  177,524
                  
                  
                  
                  64,622Qinhuangdao
      Feihe Trading Company
                  
                  
                  54,944
                  
                  
                  
                  -Total
                  
                  
                  232,468
                  
                  
                  
                  64,622





As of
December 31, 2008 and 2007, the Group had the following balances due to its
related companies for payments for goods received in advance:





2008
                  
                  
                  2007US$
                  
                  
                  US$Heilongjiang
      Feihe Yuanshengtai Co., Ltd
                  
                  
                  729,480
                  
                  
                  
                  -Qianhuangdao
      Feihe Trading Company
                  
                  
                  -
                  
                  
                  
                  16,412Dalian
      Hewang Trading Company
                  
                  
                  1,353
                  
                  
                  
                  4,376Total
                  
                  
                  730,833
                  
                  
                  
                  20,788




F-19




(3)  Loan
payable to related parties





The Group
has an outstanding loan payable to a charitable organization set up by Leng
You-Bin for under privileged children in the Heilongjiang province of the PRC,
of $253,410 and $251,550 at December 31, 2008 and 2007,
respectively.  The loan is unsecured and bears interest at 5.85% per
annum and is payable on demand.





19.
            ADVANCES
      FROM EMPLOYEES





Advances
from employees represent temporary funding by employees to improve cash flow and
working capital of the Company. The advances were unsecured, interest free and
repayable within one year.





20.
            EMPLOYEE
      BENEFITS





The
full-time employees of the Company’s subsidiaries that are incorporated in the
PRC are entitled to staff welfare benefits, including medical care, welfare
subsidies, unemployment insurance and pension benefits. These companies are
required to accrue for these benefits based on certain percentages of the
employees’ salaries in accordance with the relevant regulations, and to make
contributions to the state-sponsored pension and medical plans out of the
amounts accrued for medical and pension benefits. The total amounts charged to
the consolidated statements of operations and comprehensive income for such
employee benefits amounted to approximately $1,893,632 and $714,055 for the
years ended December 31, 2008 and 2007, respectively. The PRC government is
responsible for the medical benefits and ultimate pension liability to these
employees.





Effective
January 1, 2007, the Company established the American Dairy Inc
401(k) Profit Sharing Plan and Trust (the “Plan”).  The Plan is a
discretionary defined contribution plan and covers substantially all employees
who have attained the age of 21, have completed at least six months of service,
and have worked a minimum of 1,000 hours in the past Plan or anniversary
year.





Under
provisions of the Plan, the Company, for any plan year, has contributed an
amount equal to 100% of the participant’s contribution or 5% of the
participant’s eligible compensation, whichever is less.  The Company may,
at its own discretion, make additional matching contributions to
participants.  Company contributions, net of forfeitures, amounted to
$12,545 and $2,016 in the years ended December 31, 2008 and 2007,
respectively.





21.
            LONG
      TERM DEBT





Long term
debt comprised of the following as of December 31, 2008 and 2007:





2008
                                
                                
                                2007US$
                                
                                
                                US$Loan
      payable to a bank in the PRC, bearing interest at 5.76%, secured by
      buildings and payable in monthly installments of $9,058, including
      interest. The Loan commenced in 2004 and matures on September 30,
      2012
                                
                                
                                407,597
                                
                                
                                
                                484,455Loan
      payable to a bank in the PRC, bearing interest at 7.47%, unsecured,
      guaranteed by Feihe Dairy (i), and payable in installments of $2,917,919
      on October 28, 2009 and $933,734 on October 28, 2010. The Loan commenced
      in October 29, 2008
                                
                                
                                3,851,653
                                
                                
                                
                                -Loan
      payable to a bank in the PRC, bearing interest at 7.47%, secured by
      biological assets, guaranteed by Feihe Dairy (i), and payable on October
      20, 2011. The Loan commenced on October 29, 2008
                                
                                
                                3,918,765
                                
                                
                                
                                -Loan
      payable to a bank in the PRC, bearing interest at 7.47%, secured by
      biological assets, guaranteed by Feihe Dairy (i), and payable in
      installments of $3,443,144 on October 28, 2010 and $551,487 on October 28,
      2011. The Loan commenced in October 29, 2008
                                
                                
                                3,994,631
                                
                                
                                
                                -Loan
      payable to local government, bearing no interest, unsecured and payable on
      maturity.  The Loan commenced on January 29, 2008 and matures on
      December 31, 2009
                                
                                
                                992,092
                                
                                
                                
                                -13,164,738
                                
                                
                                
                                484,455Less:
      current portion of long term debt
                                
                                
                                (4,018,704
                                )
                                
                                
                                (101,990
                                )9,146,034
                                
                                
                                
                                382,465





(i) In
connection with the purchase of long-lived fixed assets of Kedong Farms, Feihe
Dairy guaranteed the loans payable to a bank in the PRC for a period of one
year, beginning on October 29, 2008 and ending on October 28,
2009.  The maximum potential future amount under the terms of the
guarantee is RMB 251,510,000.





F-20





Principal
payments due by year for the next five years and thereafter on long term debt
are as follows:





Year ended December 31,
                      
                      Future repaymentsUS$2009
                      
                      
                      4,018,7042010
                      
                      
                      4,485,5702011
                      
                      
                      4,578,9452012
                      
                      
                      81,51913,164,738





None of
the long term debt has restrictions or covenants attached.





22.
            CONVERTIBLE
      DEBT, NET





Convertible
debt consisted of the following as of December 31, 2008 and
2007:





2008
                          
                          
                          2007US$
                          
                          
                          US$7.75%
      Convertible Notes due 2009, net of discount of $467,967 and $1,091,919 at
      December 31, 2008 and 2007, respectively
                          
                          
                          17,732,033
                          
                          
                          
                          17,108,0811.00%
      Guaranteed Senior Secured Convertible, including guaranteed redemption
      accrual of $0 and $8,151,867, and note discount of $7,190,107 and
      $50,022,177 at December 31, 2008 and 2007, respectively
                          
                          
                          73,809,893
                          
                          
                          
                          38,129,69091,541,926
                          
                          
                          
                          55,237,771Less:
      current portion
                          
                          
                          (91,541,926
                          )
                          
                          
                          --
                          
                          
                          
                          55,237,771





(1)   7.75%
Convertible Notes Due 2009





On
October 3, 2006, pursuant to a subscription agreement, the Company issued an
aggregate principal amount of $18,200,000 in 7.75% Convertible Notes due 2009
(the “2009 Notes”) and warrants to purchase up to an aggregate of 251,000 shares
of Common Stock (the “Warrants”).  The value of the warrants of
$1,871,859 was recorded as a discount to the value of the 2009 Notes and was to
be amortized to interest expense over the term of the 2009 Notes.





The 2009
Notes mature on October 2, 2009, accrue interest at an annual rate of 7.75%
compounded annually and payable in ordinary shares at maturity, and contain
customary representations, warranties, and events of default, including failure
to pay amounts due under the 2009 Notes, failure to comply with certain
covenants, and the occurrence of certain insolvency events.  The
principal and accrued and unpaid interest due under the 2009 Notes may be
converted at the option of the holder into ordinary shares at an initial
conversion price of $14.50 per share.  The conversion price is subject
to adjustments for dividends, subdivisions, combinations, and other
events.  Subject to the same adjustments, the Warrants permit the
holders to acquire, at any time prior to October 2, 2012, an aggregate of
approximately 251,000 ordinary shares at an initial exercise price of $14.50 per
share.  As of December 31, 2008, the conversion price of the 2009
Notes and the exercise price for the Warrants was $14.50 per share.





The
subscription agreement contains customary representations, warranties,
indemnities and covenants, including covenants by the Company to maintain its
securities exchange listing and to comply with its reporting and filing
obligations under the Securities Exchange Act of 1934, as amended (the “Exchange
Act”).  The subscription agreement also grants holders of the 2009
Notes a right of first refusal to purchase an aggregate amount of up to 25.00%
of any securities the Company may propose to sell.





In
connection with the issuance of the 2009 Notes, the Company entered into a
registration rights agreement pursuant to which Company agreed to file, by
January 3, 2007, a registration statement covering the resale of the ordinary
shares issuable upon conversion of the 2009 Notes and upon exercise of the
Warrants.  The Company also agreed to register, on one occasion and
prior to October 3, 2011, shares issued on conversion of interest payable on the
2009 Notes if such shares have not been included in a prior registration
statement.  If the Company failed to meet these registration
obligations, or if the SEC did not declare such registration statements
effective within 120 days of the filing thereof, the Company agreed to pay an
additional amount equal to 2.00% of the principal amount of each holder’s 2009
Notes per month, payable monthly in cash or, at the option of the holder, in
ordinary shares at the then-applicable conversion price per share (the “2%
Payment”).  The registration rights agreement also grants piggy-back,
demand and S-3 registration rights to the holders of ordinary shares issuable
upon conversion of the 2009 Notes.  The Company was not in compliance
with the requirement under the registration rights agreement to file a
registration statement by January 3, 2007 and to cause it to become effective
within 120 days.  As all of the holders of the 2009 Notes have waived
the 2% Payment for the periods in 2007 prior to May 3 and after September
30, the Company made the 2% Payment for the period from May 3, 2007 through
September 30, 2007, equal to $1,820,000, which was charged to earnings for the
year ended December 31, 2007.




F-21




On
November 12, 2008, the Company entered into an agreement with the holders of the
2009 Notes pursuant to which the Company agreed to issue to such holders an
aggregate amount of 216,639 ordinary shares ($2,881,299, excluding $720,000
accrued at December 31, 2007) and such holders waived claims to additional
payments under the registration rights agreement relating to the 2009
Notes.  The agreement contains customary representations and
warranties, as well as security and inter-creditor provisions.  In
connection with the agreement, the Company amended and restated the 2009 Notes
(the “New 2009 Notes”), amended and restated the warrants issued therewith (the
“New Warrants”), and amended the prior registration rights
agreement.





The New
2009 Notes were issued in an aggregate principal amount of $18,200,000, mature
on October 2, 2009, accrue interest at an annual rate of 7.75% compounded
annually and payable in ordinary shares at maturity.  The New 2009
Notes contain representations, warranties, and events of default, including
default for failure to pay amounts due under the New 2009 Notes, failure to
comply with certain covenants, the occurrence of certain insolvency events,
certain events regarding the security interests, and cross-defaults under the
2012 Notes or any other indebtedness exceeding $2,000,000.  The
principal and accrued and unpaid interest due under the New 2009 Notes may be
converted at the option of the holder into ordinary shares at an initial
conversion price of $14.50 per share.  The conversion price is subject
to adjustments for dividends, subdivisions, combinations, or issuances of
ordinary shares, warrants or similar rights at a price per share less than the
conversion price then in effect.  Subject to the same adjustments, the
New Warrants permit the holders to acquire, at any time prior to October 2,
2012, an aggregate of approximately 251,000 ordinary shares at an initial
exercise price of $14.50.





The New
2009 Notes are guaranteed by AFC and secured by a pledge of all of the Company’s
equity interest in AFC and a pledge of 2,664,340 shares of ordinary shares held
by Leng You-Bin, the Chairman, Chief Executive Officer, President, and General
Manager of the Company.  The guarantees and security interests are
subordinate to those securing the 2012 Notes.





The
amendments to the registration rights agreement extend the existing demand,
piggy-back and S-3 registration rights to the holders of ordinary shares issued
in connection with the release of claims to additional payments under the prior
registration rights agreement.  In addition, the amendments restate
the penalties for the Company’s failure to comply with registration and other
covenants.  In particular, the Company agreed to pay additional
interest, accruing at 1.00% of the principal amount of each holder’s New 2009
Notes per month and payable monthly in cash or, at the option of the holder,
ordinary shares at the then-applicable conversion price per share, upon the
occurrence of certain events.  These events include the Company’s
failure to file a registration statement by January 3, 2007, the Company’s
failure to file a registration statement by the three month anniversary of any
demand registration notice, if sales of all registrable securities cannot be
made pursuant to the registration statement, if the ordinary shares ceases to be
listed or traded in qualifying exchanges or markets, if a qualifying initial
public offering has not occurred on or before June 30, 2009, if the Company
fails to keep public information available, if the Company fails to file in a
timely manner all reports and other documents it is required to file with the
SEC, or if the Company fails to maintain its Exchange Act
registration.  In connection with the amended registration rights
agreement, the holders of the 2009 Notes agreed that the Company will only be
obligated to make additional interest payments to them if a resale registration
statement is not effective by June 30, 2009 or if the Company is unable to
timely comply with its reporting and filing obligation under the Exchange Act by
April 15, 2009.





(2)   1.00%
Guaranteed Senior Secured Convertible Notes Due 2012





On June
1, 2007 and June 27, 2007, pursuant to a notes purchase agreement and related
agreements, the Company issued an aggregate principal amount of $60,000,000 and
$20,000,000, respectively, in 1% Guaranteed Senior Secured Convertible Notes due
2012 (the “2012 Notes”).  The 2012 Notes accrue interest at an annual
rate of 1.00%, payable in cash on June 1 and December 1 of each year,
and mature on the five-year anniversary of their issuance.  The 2012
Notes have been guaranteed by certain of the Company’s subsidiaries and secured
by a pledge of all of the Company’s equity interest in AFC and a pledge of
2,664,340 ordinary shares held by Leng You-Bin, the Chairman, Chief Executive
Officer, President, and General Manager of the Company.  Costs of
$3,697,934 associated with the 2012 Notes were capitalized as a deferred charge
and are shown as an other asset as of December 31, 2007.  These costs
were to be amortized over the term of the 2012 Notes.  Amortization of
$657,258 and $369,794 was charged to expense during the years ended December 31,
2008 and 2007, respectively.





The
principal amount of the 2012 Notes is convertible into ordinary shares at the
option of the holder at an initial conversion price of $24.00 per share. On
March 1, 2008, pursuant to a semi-annual reset provision based on the
volume-weighted 30-day average trading price of the ordinary shares, the
conversion price of the 2012 Notes was reset to $12.00 per share. The conversion
price is also subject to adjustments for dividends, subdivisions, issuances of
ordinary shares or warrants below current market prices, and other events. If
not previously converted or repurchased, upon maturity the Company must redeem
the 2012 Notes at a price equal to $228,776 per each $100,000 in principal
amount of 2012 Notes.  As of December 31, 2007, the Company had
accrued $8,151,867 of the redemption amount related to the 2012
Notes.





The notes
purchase agreement contains representations, warranties, indemnities and
covenants, including covenants by the Company and controlling shareholders to
use best efforts to effect a qualifying initial public offering by December 1,
2008, to provide certain additional security for the 2012 Notes, to file timely
all required reports under the Exchange Act, and not to take certain other
actions regarding any potential acquisition of equity securities of the Company
or any tender offer, exchange offer, merger, consolidation, or sale of all or
substantially of the Company’s assets.





The
indentures under which the 2012 Notes were issued contain covenants restricting
the Company’s operations, including restrictions on its use and maintenance of
its properties, incurrence of indebtedness, declaration or payment of dividends
or other distributions, repurchase of capital stock or subordinated obligations,
making investments, incurrence of liens, sale of assets, use of proceeds from
the sale of the 2012 Notes, and engaging in business unrelated to dairy and
related food products.  The indentures also require the Company to
maintain tangible net worth ratios, to complete a qualifying initial public
offering of Common Stock by December 1, 2008, to repurchase some or all of its
2012 Notes from electing holders upon certain assets sales, upon certain change
of control transactions or if the ordinary shares cease to trade on a qualifying
U.S. stock exchange, and to file reports under the Exchange Act with the
SEC.  In addition, the outstanding 2012 Notes would accrue additional
interest at an annual rate of 5% if a qualifying initial public offering had not
occurred by December 1, 2008.  The Company would also be obligated to
pay an additional amount equal to 3.0% of the principal amount of the
outstanding 2012 Notes if a qualifying initial public offering had not occurred
by December 1, 2008 and an additional amount equal to 1.0% of the principal
amount of the outstanding 2012 Notes if the Company fails to retain a qualified
auditor at any time after May 1, 2008.  The indentures also contain
customary events of default, including any failure to pay any interest,
principal, or premium on the 2012 Notes, failure to comply with certain
covenants, the occurrence of certain insolvency events, defaults under or
failure to pay when due any other indebtedness exceeding $2,000,000, and certain
events regarding the security interests.




F-22




In
connection with the issuance of the 2012 Notes, the Company entered into a
registration rights agreement and an investor rights agreement with holders of
the 2012 Notes.  The registration rights agreement requires the
Company to file certain registration statements and provides that the Company’s
failure to do so will result in additional interest accruing at an annual rate
of 0.25% for the first 90 days and thereafter at an annual rate of 0.50% (the
“Registration Rights Penalty”).





Pursuant
to the investor rights agreement, the Company granted Citadel Equity Fund Ltd,
one of the holders of the 2012 Notes, a right of first refusal to purchase any
securities the Company may propose to issue or sell until June 1, 2012. During
the fiscal year ended December 31, 2007, Citadel beneficially owned in excess of
5% of the Company’s issued and outstanding ordinary shares.





At the
date of issuance of the 2012 Notes, the Company determined that the convertible
note instrument contained embedded derivatives. The fair value of the embedded
derivatives was determined to be $53,298,331 and was recorded as a derivative
liability at inception. That amount was accreted through charges to the
statements of operations and comprehensive income using the effective interest
method over the period of the 2012 Note obligations. At December 31, 2007, the
fair value of the derivatives was $50,019,300. The reduction in the fair value
of the derivative was also recorded in the statements of operations and
comprehensive income as gain on derivatives during the year ended December 31,
2007.





On March
1, 2008, pursuant to the indentures governing the 2012 Notes, the conversion
price of the 2012 Notes was reset to $12.00 per share.





On
November 12, 2008, the Company entered into a supplemental indenture with
respect to the 2012 Notes.  The supplemental indenture grants each
holder of the 2012 Notes the option to elect that the Company repurchase all or
any portion of such holder’s 2012 Notes, at a repurchase price of 115% of the
principal amount of 2012 Notes for which such holder elected early
repurchase.  On November 13, 2008, the holders of 100% of the
outstanding 2012 Notes elected to exercise the early repurchase option with
respect to all of the outstanding 2012 Notes, which obligates the Company to
repurchase the 2012 Notes for an aggregate amount of $92,000,000 in accordance
with the terms and conditions of the supplemental
indenture.  Accordingly, the Company has paid $15,333,333 to the
holders of the 2012 Notes, of which $11,000,000 was paid in November 2008, and
$4,333,333 was paid in January 2009, and the Company is obligated to pay an
additional $15,333,333 by each of April 15 and July 15, 2009 and to pay the
remaining $46,000,000 by October 15, 2009.  As part of the first
repurchase payment, the Company also paid $407,000 in accrued and unpaid
interest and accrued registration rights penalty to holders of the 2012
Notes.  As a result of the repurchase election, interest on all 2012
Notes ceased to accrue after November 13, 2008 and the 2012 Notes may not be
converted into ordinary shares of Common Stock, subject to the Company’s making
the required repurchase payments.  Holders of the 2012 Notes are
entitled to all other rights and privileges as holders of the 2012 Notes until
the required repurchase payments are paid in full.  Costs of $123,354
associated with the 2012 Notes restructuring were capitalized as a deferred
charge and are shown as an other asset as of December 31, 2008.  These
costs are amortized over the term of the restructured
Notes.  Amortization of $16,957 was charged to expense during the year
ended December 31, 2008.





The
Company’s failure to make the required repurchase payments on April 15, 2009,
July 15, 2009 or October 15, 2009 will not constitute an event of default under
the indentures, although certain waivers granted to the Company under the
supplemental indenture, described below, would terminate, interest would
recommence accruing on the 2012 Notes, and the holders of the 2012 Notes could
exercise their conversion rights under the indentures.





In the
supplemental indenture, the Company obtained waivers and consents from the
holders of the 2012 Notes.  These waivers and consents allow the
Company to incur additional debt and liens in connection with funding the
repurchase of the 2012 Notes and for certain operating purposes, waive its
compliance with tangible net worth and leverage ratio requirements, waive the
requirement that the Company repurchase 2012 Notes from electing holders if the
ordinary shares cease to trade on a qualifying U.S. stock exchange, and waive
the requirement that the Company file Exchange Act reports to the extent its
non-compliance is due to or results from the previously announced re-audit of
its financial statements.





In
accordance with EITF 96-19, “Debtor’s Accounting for a
Modification or Exchange of Debt Instruments,” the terms of the 2012
Notes entered into on November 12, 2008 were substantially different to the
previous terms of the 2012 Notes. Therefore, this transaction was accounted for
as an extinguishment of debt as set forth in SFAS 140, “Accounting for Transfers and
Servicing of Financial Assets and Extinguishments of Liabilities.” This
resulted in $30,497,268 of gain recognized in the consolidated statements of
operations and comprehensive income in the year ended December 31,
2008.





The
embedded derivatives contained in the original terms of the 2012 Notes were also
extinguished on November 12, 2008.  However, prior to extinguishment,
the fair value of the derivatives measured using the using the Monte Carlo
simulation approach was increased to $58,340,781, resulting in a loss of
$8,321,481 recorded in the statements of operations and comprehensive income
during the year ended December 31, 2008.





Principal
payments due are $99,200,000 in 2009 and $0 thereafter.




F-23


23.
            ACCRUED
      EXPENSES





Accrued
expenses as of December 31, 2008 and 2007 consist of the following:





2008
                        
                        
                        2007US$
                        
                        
                        US$Accrued
      selling expenses
                        
                        
                        6,802,837
                        
                        
                        
                        2,889,739Other
      payable
                        
                        
                        3,817,556
                        
                        
                        
                        2,940,91910,620,393
                        
                        
                        
                        5,830,658





24.
            OTHER
      PAYABLE





Other
payable as of December 31, 2008 and 2007 consists of the following:





2008
                          
                          
                          2007US$
                          
                          
                          US$Payable
      for property and equipment
                          
                          
                          6,358,939
                          
                          
                          
                          4,883,238Payable
      for leases
                          
                          
                          2,054,553
                          
                          
                          
                          1,945,519Other
      tax payable
                          
                          
                          4,454,081
                          
                          
                          
                          55,428Others
                          
                          
                          6,646,108
                          
                          
                          
                          3,528,97119,513,681
                          
                          
                          
                          10,413,156





25.
            ORDINARY
      SHARES AND EQUITY TRANSACTIONS





The
Company has 50,000,000 shares of authorized ordinary shares with a par value
$0.001 per share.





(1)
During 2007, the Company had the following stock transactions:





The
Company issued 505,698 shares of its ordinary shares pursuant to the exercise of
warrants at various exercise prices for a total consideration of
$1,100,047.





The
Company issued 49,250 shares of restricted ordinary shares valued at $1,060,750,
of which $409,500 was for bonuses to directors and $651,250 was for consulting
services to independent consultants.  The expense related to the
consulting services is recorded in general and administrative expenses in the
consolidated statements of operations and comprehensive income.





The
Company issued 575,000 shares of its ordinary shares pursuant to the conversion
of $5,000,000 of Series B convertible notes with accrued interest of $750,000,
at a conversion price of $10.00 per share.





(2)
During 2008, the Company had the following stock transactions:





The
Company issued 3,000 shares of its ordinary shares pursuant to the exercise of
warrants at an exercise price of $2.25 for a total consideration of
$6,750.





The
Company issued 72,500 shares of restricted ordinary shares valued at $1,092,651
of which $753,500 was for bonuses to directors and $339,150 was for bonuses to
employees.





On
October 15, 2008, pursuant to the Company’s 2003 Incentive Stock Plan (the
“Plan”), an option to purchase 80,000 shares valued at $562,758 was granted to
an employee.  As the option vests one year from date of grant,
$140,689 was allocated to the year ended December 31, 2008 using the straight
line method as described in Note 26(1).





On
November 12, 2008, the Company issued to holders of the 2009 Notes 216,639
ordinary shares valued at $2,881,299, in connection with an agreement reached
with the holders to waive claims to additional payments under the registration
rights agreement relating to the 2009 Notes as described in Note
22(1).





26.
            OPTION
      PLAN AND WARRANTS





(1)  2003
Share Incentive Plan





Effective
May 7, 2003, the Company adopted and approved its 2003 Incentive Stock Plan (the
“Plan”), which reserved 3,000,000 ordinary shares for issuance under the Plan.
The Plan allows the Company to issue awards of incentive non-qualified stock
options, stock appreciation rights, and stock bonuses to directors, officers,
employees and consultants of the Company which may be subject to restrictions.
The Company applies FASB 123(R) and related interpretations in accounting for
the Plan. Compensation for services that a corporation receives under FASB
123(R) through share-based compensation plans should be measured by the quoted
market price of the stock at the measurement date less the amount, if any, that
the individual is required to pay.  Compensation expense for
share-based compensation of $1,233,339 and $1,060,750 were recorded during the
years ended December 31, 2008 and 2007 related to the Plan.





F-24




No stock
appreciation rights have been issued under the Plan.





On
October 15, 2008, an option to purchase 80,000 shares was granted to an employee
that vests on the 12-month anniversary of the date of grant, conditioned upon
continued employment on such date, and have a contractual life of 4
years.  The fair value of the option award is estimated on the date of
grant using the Black-Scholes option valuation model to be $562,758, of which
$140,689 was recorded as compensation cost in the year ended December 31,
2008.  The valuation was based on the assumptions noted in the
following table.





Expected volatility
                    
                    
                    90.7
                    %Expected dividends
                    
                    
                    0
                    %Expected term (in years)
                    
                    4 yearsRisk-free rate
                    
                    
                    2.7
                    %





A summary
of option activity under the Plan as of December 31, 2008 and movement during
the year then ended are as follow:





Options
                              
                              
                              Weighted
                                average
                                exercise price
                              
                              
                              Aggregate
                                intrinsic
                                value
                              
                              
                              Weighted
                                average
                                remaining
                                contractual
                                termUS$
                              
                              
                              US$Outstanding
      at January 1, 2008
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Granted
                              
                              
                              80,000
                              
                              
                              
                              12.00
                              
                              
                              
                              317,600
                              
                              
                              
                              3.8Exercised
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Forfeited
      or expired
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -
                              
                              
                              
                              -Outstanding
      at December 31, 2008
                              
                              
                              80,000
                              
                              
                              
                              12.00
                              
                              
                              
                              317,600
                              
                              
                              
                              3.8





The
weighted average grant date fair value per options granted during the years
ended December 31, 2008 was $7.03.





A summary
of the status of the Company’s non-vested options as of December 31, 2008 and
movements during the year then ended are as follow:





Options
                          
                          
                          Weighted average
                            granted date fair
                            valueUS$Non-vested
      at January 1, 2008
                          
                          
                          -
                          
                          
                          
                          -Granted
                          
                          
                          80,000
                          
                          
                          
                          7.03Vested
                          
                          
                          -
                          
                          
                          
                          -Forfeited
      or expired
                          
                          
                          -
                          
                          
                          
                          -Non-vested
      at December 31, 2008
                          
                          
                          80,000
                          
                          
                          
                          7.03





As of
December 31, 2008, there was $422,069 of unrecognized compensation cost related
to non-vested share-based compensation granted under the Plan.  The
cost is expected to be recognized over a period of 10 months.





(2)  Warrants





As of
December 31, 2008, the Company had 1,045,983, warrants outstanding at an average
exercise price of $5.06 per warrant. The warrants will expire at various dates,
with 794,943 expiring in 2009 and 251,040 expiring in 2012.





During
the years ended December 31, 2008 and 2007, 3,000 and 505,698 warrants,
respectively, were exercised at various exercise prices, resulting in proceeds
of $6,750 and $1,100,047, respectively, to the Company.





Warrants
                                  
                                  
                                  Average exercise
                                    priceUS$Outstanding
      warrants at January 1, 2007
                                  
                                  
                                  1,554,681
                                  
                                  
                                  
                                  4.11Warrants
      granted
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Exercised
                                  
                                  
                                  (505,698
                                  )
                                  
                                  
                                  2.17Expired
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Outstanding
      warrants at December 31, 2007
                                  
                                  
                                  1,048,983
                                  
                                  
                                  
                                  5.05Warrants
      granted
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Exercised
                                  
                                  
                                  (3,000
                                  )
                                  
                                  
                                  2.25Expired
                                  
                                  
                                  -
                                  
                                  
                                  
                                  -Outstanding
      warrants at December 31, 2008
                                  
                                  
                                  1,045,983
                                  
                                  
                                  
                                  5.06




F-25




Information
regarding the warrants outstanding at December 31, 2008 is summarized as
below:





Warrants outstanding atDecember 31, 2008WeightedAverage
                        
                        
                        WeightedRemaining
                        
                        
                        AverageExercise Prices
                        
                        Warrants
                        
                        
                        Contractual
                        
                        
                        ExerciseUS$
                        
                        Outstanding
                        
                        
                        Life (years)
                        
                        
                        Price US$1.50
                        
                        
                        184,543
                        
                        
                        
                        0.8
                        
                        
                        
                        1.502.25
                        
                        
                        610,400
                        
                        
                        
                        0.7
                        
                        
                        
                        2.2514.50
                        
                        
                        251,040
                        
                        
                        
                        3.8
                        
                        
                        
                        14.501,045,983





27.
            STATUTORY
      RESERVES





Relevant
PRC laws and regulations permit payments of dividends by our PRC subsidiaries
and affiliates only out of their retained earnings, if any, as determined in
accordance with PRC accounting standards and regulations. In addition, the
statutory general reserve fund requires annual appropriations of 10% of net
after-tax income should be set aside prior to payment of any
dividends.  As a result of these and other restrictions under PRC laws
and regulations, the PRC subsidiaries and affiliates are restricted in their
ability to transfer a portion of their net assets to the Company either in the
form of dividends, loans or advances.





28.
            COMMITMENTS
      AND CONTINGENCIES





(1)  Operating
lease arrangements





The Group
has entered into leasing arrangements relating to office premises and computer
equipment that are classified as operating leases. There were no minimum future
rental payments under non-cancellable operating leases having remaining terms in
excess of one year.





Rent
expenses incurred and expensed to consolidated statements of operations and
comprehensive income during the years ended December 2008 and 2007 amounted to
$120,704 and $12,000, respectively.





(2)  Capital
commitments





Capital
commitments for purchase of property and equipment and biological assets as of
December 31, 2008 were approximately $16,472,057.





(3)  Land
use rights





All lands
in the PRC are state-owned and no individual land ownership rights
exist.  The Group has obtained land use rights certificates for the
land on which its facilities are located, except that Langfang Feihe is in the
process of obtaining such a certificate.





Feihe
Dairy entered into a land use right contract on January 13, 2006 with the Bureau
of Land and Real Estate of Langfang Economic and Technology Development Zone in
Hebei Province, China, as amended by a supplementary contract dated January 13,
2006, which sets forth rights to use the land on which Langfang Feihe’s
facilities are located.  Feihe Dairy is applying to assign its rights
under the contract to Langfang Feihe.  Management believes that this
contract adequately evidences Langfang Feihe’s right to use the land, and that
there should be no legal obstacle to Langfang Feihe’s use of the land or
obtaining a certificate of land use right.  However, in the event that
Langfang Feihe fails to obtain such a certificate, there is a risk that the PRC
government may deem Langfang Feihe’s operations illegitimate or impose penalties
and fines.  While present, however, management believes that this
possibility is remote.





(4)
Other assets





Substantially
all of the Group’s assets and operations are located in the PRC.  The
Company is self-insured for all risks and carries no liability or property
insurance coverage of any kind.





F-26





29.
            SEGMENTS







In accordance with
SFAS No. 131, “Disclosures about Segments of an Enterprise and
Related Information,” based upon the
manner in which internal financial information is produced and evaluated by the
Group’s chief operating decision maker, the Group has determined that it has two
reportable segments: dairy products and dairy farm. The dairy products segment
produces and sells dairy products, such as wholesale and retail milk powders, as
well as soybean powder, rice cereal, walnut powder and walnut
oil.  The dairy farm segment operates the Group’s two dairy farms in
the PRC, construction of which was commenced in 2007 and is expected to be
complete in the fourth quarter of 2009.  The Group’s two dairy farms
provide milk to the Group.  As the Group primarily generates its
revenues from customers in the PRC, no geographical segments are
presented.







The
segment information for the reportable segments for the year ended December 31,
2008 is as follows:




Dairy products
                    
                    
                    Dairy farms
                    
                    
                    Corporate
                    
                    
                    TotalUS$
                    
                    
                    US$
                    
                    
                    US$
                    
                    
                    US$Revenues
      from external customers
                    
                    
                    193,191,710
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    193,191,710Intersegment
      revenues
                    
                    
                    -
                    
                    
                    
                    91,299
                    
                    
                    
                    -
                    
                    
                    
                    91,299Interest
      revenue
                    
                    
                    254,457
                    
                    
                    
                    5,242
                    
                    
                    
                    320,025
                    
                    
                    
                    579,724Interest
      expenses
                    
                    
                    1,041,447
                    
                    
                    
                    183
                    
                    
                    
                    18,401,184
                    
                    
                    
                    19,442,814Depreciation
      and amortization
                    
                    
                    4,936,788
                    
                    
                    
                    384,031
                    
                    
                    
                    -
                    
                    
                    
                    5,320,819Income
      tax
                    
                    
                    3,536,373
                    
                    
                    
                    24,939
                    
                    
                    
                    5,823
                    
                    
                    
                    3,567,135Segment
      profit (loss)
                    
                    
                    21,266,451
                    
                    
                    
                    (1,182,203
                    )
                    
                    
                    7,208,685
                    
                    
                    
                    27,292,933Segment
      assets
                    
                    
                    385,536,806
                    
                    
                    
                    89,175,716
                    
                    
                    
                    188,428,520
                    
                    
                    
                    663,141,042Goodwill
                    
                    
                    2,282,838
                    
                    
                    
                    -
                    
                    
                    
                    -
                    
                    
                    
                    2,282,838Expenditures
      for segment assets
                    
                    
                    32,632,030
                    
                    
                    
                    27,602,841
                    
                    
                    
                    -
                    
                    
                    
                    60,234,871





The
segment information for the reportable segments for the year ended December 31,
2007 is as follows:





Dairy products
                            
                            
                            Dairy farms
                            
                            
                            Corporate
                            
                            
                            TotalUS$
                            
                            
                            US$
                            
                            
                            US$
                            
                            
                            US$Revenues
      from external customers
                            
                            
                            163,898,555
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            163,898,555Interest
      revenue
                            
                            
                            202,248
                            
                            
                            
                            -
                            
                            
                            
                            172,138
                            
                            
                            
                            374,386Interest
      expenses
                            
                            
                            315,520
                            
                            
                            
                            -
                            
                            
                            
                            13,361,843
                            
                            
                            
                            13,677,363Depreciation
      and amortization
                            
                            
                            3,093,704
                            
                            
                            
                            27,914
                            
                            
                            
                            -
                            
                            
                            
                            3,121,618Income
      tax
                            
                            
                            5,661,779
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            5,661,779Segment
      profit (loss)
                            
                            
                            35,037,161
                            
                            
                            
                            (27,101
                            )
                            
                            
                            (21,479,394
                            )
                            
                            
                            13,530,666Segment
      assets
                            
                            
                            309,060,917
                            
                            
                            
                            31,167,333
                            
                            
                            
                            185,816,284
                            
                            
                            
                            526,044,534Goodwill
                            
                            
                            2,142,079
                            
                            
                            
                            -
                            
                            
                            
                            -
                            
                            
                            
                            2,142,079Expenditures
      for segment assets
                            
                            
                            17,407,781
                            
                            
                            
                            15,331,367
                            
                            
                            
                            -
                            
                            
                            
                            32,739,148





A
reconciliation of reportable segment revenues, profit, and assets, to the
Group’s totals is as follows:





2008
                    
                    
                    2007US$
                    
                    
                    US$RevenuesTotal
      revenues for reportable segments
                    
                    
                    193,283,009
                    
                    
                    
                    163,898,555Elimination
      of intersegment revenues
                    
                    
                    (91,299
                    )
                    
                    
                    -Total
      consolidated revenues
                    
                    
                    193,191,710
                    
                    
                    
                    163,898,555





2008
                    
                    
                    2007US$
                    
                    
                    US$ProfitTotal
      profit for reportable segments
                    
                    
                    27,292,933
                    
                    
                    
                    13,530,666Elimination
                    
                    
                    (13,156,172
                    )
                    
                    
                    (23,541
                    )Income
      from continuing operations before income taxes and minority
      interest
                    
                    
                    14,136,761
                    
                    
                    
                    13,507,125




2008
                        
                        
                        2007US$
                        
                        
                        US$AssetsTotal
      assets for reportable segments
                        
                        
                        663,141,042
                        
                        
                        
                        526,044,534Elimination
                        
                        
                        (348,573,642
                        )
                        
                        
                        (295,083,255
                        )Total
      assets
                        
                        
                        314,567,400
                        
                        
                        
                        230,961,279




F-27




30.
            QUARTERLY
      OPERATING RESULTS





For the
fiscal year 2008 and 2007, quarterly operating results are summarized as
follows:





Three Months Ended (Unaudited)Fiscal 2008
                                            
                                            December 31
                                            
                                            September 30
                                            
                                            June 30
                                            
                                            March 31US$
                                            
                                            US$
                                            
                                            US$
                                            
                                            US$Sales
                                            
                                            54,487,873
                                            
                                            
                                            49,632,365
                                            
                                            47,633,550
                                            
                                            41,437,922Gross
      profit
                                            
                                            29,943,570
                                            
                                            
                                            15,649,833
                                            
                                            15,268,241
                                            
                                            15,149,080Net
      income (loss) from continuing operations
                                            
                                            23,361,684
                                            
                                            
                                            (23,222,183)
                                            
                                            3,147,375
                                            
                                            7,273,281Net
      income (loss) from discontinuing operations
                                            
                                            2,629,513
                                            
                                            
                                            2,199,207
                                            
                                            1,635,934
                                            
                                            (1,776)Net
      income (loss)
                                            
                                            25,991,197
                                            
                                            
                                            (21,022,976)
                                            
                                            4,783,309
                                            
                                            7,271,505Earnings
      per share - BasicNet
      income (loss) from continuing operations
                                            
                                            1.37
                                            
                                            
                                            (1.37)
                                            
                                            0.19
                                            
                                            0.43Net
      income from discontinuing operations
                                            
                                            0.15
                                            
                                            
                                            0.13
                                            
                                            0.10
                                            
                                            0.00Net
      income (loss)
                                            
                                            1.52
                                            
                                            
                                            (1.24)
                                            
                                            0.29
                                            
                                            0.43Earnings
      per share - DilutedNet
      income (loss) from continuing operations
                                            
                                            1.32
                                            
                                            
                                            (1.37)
                                            
                                            0.18
                                            
                                            0.41Net
      income from discontinuing operations
                                            
                                            0.15
                                            
                                            
                                            0.13
                                            
                                            0.09
                                            
                                            0.00Net
      income (loss)
                                            
                                            1.47
                                            
                                            
                                            (1.24)
                                            
                                            0.27
                                            
                                            0.41





Three Months Ended (Unaudited)Fiscal 2007
                                            
                                            December 31
                                            
                                            September 30
                                            
                                            June 30
                                            
                                            March 31US$
                                            
                                            
                                            US$
                                            
                                            US$
                                            
                                            US$Sales
                                            
                                            43,666,743
                                            
                                            
                                            44,113,426
                                            
                                            39,746,028
                                            
                                            36,372,358Gross
      profit
                                            
                                            15,513,386
                                            
                                            
                                            18,906,012
                                            
                                            18,577,977
                                            
                                            19,471,231Net
      (loss) income from continuing operations
                                            
                                            1,357,520
                                            
                                            
                                            (6,874,506)
                                            
                                            6,849,802
                                            
                                            6,509,466Net
      income from discontinuing operations
                                            
                                            442,111
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            -Net
      income (loss)
                                            
                                            1,799,631
                                            
                                            
                                            (6,874,506)
                                            
                                            6,849,802
                                            
                                            6,509,466Earnings
      per share - BasicNet
      income (loss) from continuing operations
                                            
                                            0.08
                                            
                                            
                                            (0.42)
                                            
                                            0.43
                                            
                                            0.41Net
      income from discontinuing operations
                                            
                                            0.03
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            -Net
      income (loss)
                                            
                                            0.11
                                            
                                            
                                            (0.42)
                                            
                                            0.43
                                            
                                            0.41Earnings
      per share - DilutedNet
      income (loss) from continuing operations
                                            
                                            0.08
                                            
                                            
                                            (0.42)
                                            
                                            0.39
                                            
                                            0.37Net
      income from discontinuing operations
                                            
                                            0.02
                                            
                                            
                                            -
                                            
                                            -
                                            
                                            -Net
      income (loss)
                                            
                                            0.10
                                            
                                            
                                            (0.42)
                                            
                                            0.39
                                            
                                            0.37




F-28