U.S.
SECURITIES AND EXCHANGE COMMISSION


Washington,
D.C. 20549










FORM
10-K







(Mark
One)


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




For the
transition period from ________________ to __________________





Commission
File Number 000-51379





China Medicine
Corporation


(Name of
small business issuer in its charter)




Delaware
            
            51-0539830(State
      or other jurisdiction of
            
            (IRS.
      Employerincorporation
      or organization)
            
            Identification
      No.)Room
      702, Guangri Mansion No. 9
              South
      Wuyang Xin Chengsi
              Guangzhou,
      China 510600(Address
      of principal executive offices)




Issuer’s
telephone number, including area code (8620) 8739-1718and (8620)
8737-8212




Securities
registered pursuant to Section 12(b) of the Act: None.




Securities
registered pursuant to Section 12(g) of the Act:   Common Stock $.0001 par
value.




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




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




Indicate
by check mark whether the registrant (1) has filed all reports required to
be filed by Section 13 or 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. Yes þNo
 ̈




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, a non-accelerated filer, or a smaller reporting company.
(as defined in Rule 12b-2 of
the Exchange Act). Check one:




Large accelerated filer
            o
            
            Non-accelerated
    filer
            oAccelerated
      Filer
            o
            
            Smaller reporting
company
            þ





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





The
aggregate market value of the voting and non-voting common equity held by
non-affiliates of the registrant (8,696,742 shares) based on the
closing price of the registrant’s common stock as quoted on the FINRA
Over-the-Counter Bulletin Board on March 25, 2009 of $0.74, was $6,435,589.08.
For purposes of this computation, all officers, directors, and 10% beneficial
owners of the registrant are deemed to be affiliates. Such determination should
not be deemed to be an admission that such officers, directors, or 10%
beneficial owners are, in fact, affiliates of the registrant.




As of
March 25, 2009, there were outstanding 15,226,742 shares of the
registrant’s common stock, par value $.0001 per share, and 0 shares of the
registrant’s Series A preferred stock, par value $.0001 per share.




Documents
incorporated by reference: None.









China
Medicine Corporation




Form
10-K




Table of
Contents




PagePART I
            
            
            
            2Item
      1.
            
            Description
      of Business
            
            2Item
      1A.
            
            Risk
      Factors
            
            20Item
      2.
            
            Description
      of Property
            
            39Item
      3.
            
            Legal
      Proceedings
            
            40Item
      4.
            
            Submission
      of Matters to a Vote of Security Holders
            
            40PART II
            
            
            
            40Item
      5.
            
            Market
      for Registrant’s Common Equity, Related Stockholder
Matters
            
            40Item
      7.
            
            Management's
      Discussion and Analysis of Financial Condition and Results of
      Operation
            
            43Item
      8.
            
            Financial
      Statements and Supplementary Data
            
            54Item
      9.
            
            Changes
      in and Disagreements with Accountants on Accounting and Financial
      Disclosure
            
            54Item
      9A(T).
            
            Controls
      and Procedures
            
            55Item
      9B.
            
            Other
      Information
            
            56PART III
            
            
            
            56Item
      10.
            
            Directors,
      Executive Officers and Corporate Governance
            
            56Item
      11.
            
            Executive
      Compensation
            
            59Item
      12.
            
            Security
      Ownership of Certain Beneficial Owners and Management and Related
      Stockholder Matters
            
            61Item
      13.
            
            Certain
      Relationships and Related Transactions, and Director
      Independence
            
            62Item
      14.
            
            Principal
      Accountant Fees and Services
            
            63PART IV
            
            
            
            63Item
      15.
            
            Exhibits
            
            63Signatures
            
            
            
            65Financial
      Statements
            
            F-1




i




PREDICTIVE
STATEMENTS AND ASSOCIATED RISK





Certain
statements in this Report, and the documents incorporated by reference herein,
constitute predictive statements. Such predictive statements involve known and
unknown risks, uncertainties and other factors which may cause deviations in
actual results, performance or achievements to be materially different from any
future results, performance or achievements expressed or implied. Such factors
include, but are not limited to: market and customer acceptance and demand for
our products; our ability to market our products; the impact of competitive
products and pricing; the ability to develop and launch new products on a timely
basis; the regulatory environment, including government regulation in the PRC;
our ability to obtain the requisite regulatory approvals to commercialize our
products; fluctuations in operating results, including spending for research and
development and sales and marketing activities; and other risks detailed from
time-to-time in our filings with the Securities and Exchange
Commission.





The words
"believe, expect, anticipate, intend and plan" and similar expressions identify
predictive statements. These statements are subject to risks and uncertainties
that cannot be known or quantified and, consequently, actual results may differ
materially from those expressed or implied by such predictive statements.
Readers are cautioned not to place undue reliance on these predictive
statements, which speak only as of the date they are made.





Unless
otherwise noted, all currency figures in this filing are in U.S. dollars.
References to "yuan" or "RMB" are to the Chinese yuan (also known as the
renminbi). According to the currency exchange website www.xe.com, as of December
31, 2008, US $1.00 = 6.8166 yuan.




1


PART I




ITEM 1. BUSINESS





Through
Guangzhou Konzern Medicine Co., Ltd. (“Konzern”), our wholly-owned subsidiary
organized under the laws of the PRC, we deal in approximately 2,400
pharmaceutical products in China. The products include prescription and
over-the-counter drugs, Chinese herbs, traditional Chinese medicines made from
Chinese herbs, nutritional supplements, dietary supplements and medical
instruments. We also sell improved drug formulas after purchasing the rights to
drug formulas at an early stage of development and improving those formulas
through our own research.





History
of the Company




We are a
Delaware corporation incorporated on February 10, 2005, under the name
Lounsberry Holdings III, Inc. (“Lounsberry”).




On
February 8, 2006, Lounsberry acquired an operating business by entering into a
reverse merger transaction under the terms of a share exchange agreement (the
“Exchange Agreement”) with the stockholders of Guangzhou Konzern Medicine Co.,
Ltd. (“Konzern”). In the reverse merger, we acquired all of the equity of
Konzern, which is a distributor of pharmaceutical products in the PRC organized
under the laws of the PRC, in exchange for issuing 6,530,000 shares of common
stock, representing approximately 88.5% of our outstanding common stock, to the
owners of Konzern.




As a
result of the reverse merger, beginning February 8, 2006, we have been engaged,
through our wholly-owned subsidiary Konzern, in pharmaceutical distribution in
the PRC. We serve as a holding company for Konzern.




Also on
February 8, 2006, we raised $3.9 million through the issuance and sale of (i)
3,120,000 shares of Series A Preferred Stock and (ii) warrants to purchase
7,389,476 shares of our common stock. Each share of our Series A preferred stock
is convertible into one share of common stock subject to adjustments. The
transaction was executed under a preferred stock purchase agreement with Barron
Partners L.P., Ray and Amy Rivers (as joint tenants with right of survivorship),
Steve Mazur and William Denkin.




On May
10, 2006, we changed our name to China Medicine Corporation.




History
and Operations of Konzern




Prior to
July 25, 2000, Konzern was a state-owned medicine distribution company located
in the City of Guangzhou, China. On July 25, 2000, Konzern was privatized
through a sale of all of its capital stock by a PRC government-owned holding
company.




2




On July
7, 2006, we formed a PRC joint-venture company with Guangzhou Ji'nan Science
& Technology Industrial Group ("JSIG") and Mr. Dongsheng Yao, to develop
applications for aflatoxin-detoxifizyme, or ADTZ, an enzyme designed to
eliminate a harmful toxin from food and animal feed. The new company is called
Co-Win Bio-Engineering Ltd. (“Co-Win”). It is still in development and has not
undertaken significant operating activities as of December 31, 2008. Co-Win has
received three patents related to ADTZ in China. In 2007, Co-Win applied for
international patents in 12 different countries including Australia, Canada,
Indonesia, Israel, Japan, South Korea, Mexico, Russia, South Africa, the U.S.,
Hong Kong and India and in the European Union. Co-Win plans to apply for patents
in single member states of the European Union after receiving the approval from
the European Union patent authorities. Co-Win obtained a patent for ADTZ from
the Australia Patent Office in July 2008 and a patent for ADTZ for South Africa
in October 2008. Patent application approval for ADTZ from South Korea was made
public in September 2008 and Co-Win received this patent in November 2008.
Patent application approval for ADTZ from Russia was made public in January 2009
and is currently pending. We expect to receive the official approval shortly.
The patent applications in other countries and regions are under review as of
the date of this report.




In
November 2006, we obtained approval from local government authorities for the
distribution of medical supplies and devices throughout Guangdong Province. We
began selling medical supplies in 2007 and generated sales of $331,610 in 2007.
In 2008 we generated sales of $878,904.





In
September 2007, Konzern US Holding Corporation, a New Jersey corporation
(“Konzern Holding”), became a wholly owned subsidiary of Konzern as a result of
an equity investment of $200,000. Konzern Holding engages in distribution and
marketing of drugs, medical supplies and medical equipment in the United
States.





In
December 2008, we obtained approval from the Guangdong Food & Drug
Administration to distribute dental equipment and instruments, including brushes
and drill bits, as well as oral surgery equipment, including scalpels, scissors,
and forceps, in Guangdong Province.





Beginning
in 2007, in an effort to help consolidate the provincial medicine acquisition
market and promote a transparent bidding process, the provincial government of
Guangdong Province established an on-line bidding system called the “Guangdong
Sunshine Medicine Public Internet Bidding System.” We believe the new system
provides us with greater opportunities to compete for distribution rights in
Guangdong Province. We obtained the rights to sell and distribute a total of 774
products through the new system in 2007. We obtained distribution rights for 516
products through the bidding system in 2008 as we renewed the distribution
rights for some of the products that we had in 2007 and have waived the bidding
for certain old products. We registered to participate in the 2009 Guangdong
Province On-Line Sunshine Bidding System and renewed our registration as a
distributor of pharmaceutical products to public medical facilities for the
period from September 1, 2008 to August 31, 2009. We expect the revenue from the
sale of these products to increase, and represent an important growth driver for
us in 2009.





On June
1, 2008, we entered into an agreement with Guangzhou Hongyuan Pharmaceutical
Company (“Hongyuan”) relating to the purchase of the ownership of BCG (Bacillus
Calmette-Guerin) vaccine for the prevention of infection in bladder cancer
patients post surgery, the ownership would include the new drug certificate,
manufacturing technology and the munufacturing certificate to be granted by the
SFDA. Hongyuan and the Drug Research Centre of Guangdong Province are carrying
out research and development for the approval of the BCG vaccine. Under the
agreement, we paid to Hongyuan a deposit of approximately $2.9 million towards
the purchase to secure our exclusivity in the negotiation with Hongyuan. The
deposit was paid to Hongyuan in three installments in June, July and September
2008. We expect that it will take approximately two years for Hongyuan to
complete clinical trials for the BCG vaccine.  Under the terms,
Hongyuan will refund the entire deposit to us if it fails to complete the
clinical trials within two years, or if the expenses for such trials exceed the
agreed amount.




3





In July
2008, we began to introduce to the U.S. market one of our products, a food
supplement called BeThin Tablets, which is designed for use as a weight-loss
aid. Bethin Tablets was developed by Konzern and manufactured by a Hong Kong
pharmaceutical manufacturer which has the certificate of Original Equipment
Manufacturer (OEM). In October 2008, we attended the Natural Food Expo East, a
trade show which was held in Boston, to explore resources and relationships that
may assist us in distribution of BeThin Tablets in the U.S. and in making sales
of the product in other countries. We made contacts with several dietary
supplements stores in Boston.We are also actively exploring the Hong
Kong market. We have obtained trademark protection from the Hong Kong government
for our Konzern and BeThin trademarks and have registered with the Hong Kong
Trade Development Council to search for potential distributors in Hong
Kong.





On
October 20, 2008, Co-Win entered into a technology development agreement with
Guangzhou Municipal Microbe Research Institute (the “Research Institute”). Under
the agreement which has a term of two years from October 20, 2008 to December
30, 2010, Co-Win engaged the Research Institute for the development of ADTZ in
consideration for a research fee of approximately $175,800 to be paid over the
term of the agreement. Co-Win is also providing the equipment necessary to
undertake this project. Co-Win shall be the owner of the intellectual property
rights on the technology to be developed.  In the third quarter of
2008, we purchased and installed equipment to conduct ADTZ research project with
the Research Institute for a total purchase price of $2.5 million.





In May
2008, we entered into agreements with Aohai Biotech Company Ltd. relating to
acquisition of distribution rights to a multivitamin pack and manufacturing of
the multivitamin pack and our self-developed products such as various types of
herbal tea. Pursuant to the agreements, we made the payment of approximately
$2.3 million as follows: $0.9 million as consideration for the 15-year exclusive
distribution rights to the multivitamin pack, $0.3 million as prepayment for its
manufacturing, and $1.1 million as prepayment for manufacturing of herbal
tea.





We have
communicated with a Pakistani importer for the export of Levocarnitine Powder
Injection to Pakistan and delivered documentation and samples of the product.
Currently, we are waiting for the official approval for the pricing of
Levocarnitine Powder Injection from the food and drug regulatory authority in
Pakistan. We expect that the export of Levocarnitine Powder Injection will help
to extend our overseas business.





During
the Beijing Olympic and Paralympic Games of 2008, for security reasons, the
government ceased all toxic tests and prohibited the delivery of all toxic raw
materials. Aflatoxin, a substance needed for tests of our ADTZ product, is a
highly toxic substance. Suppliers in Beijing ceased the supply of aflatoxin
throughout the third quarter, and our R&D staff called a halt to the tests
that we worked on together with the Feed Research Institute of the Chinese
Academy of Agriculture Sciences. We restarted the ADTZ tests in October and
focused on the improvement of zymosis technology and the enhancement of ADTZ’s
capacity to detoxify animal feeds. In addition, we expect to rent a larger
manufacturing facility for ADTZ and to apply for a production permit, which will
facilitate the commercialization of ADTZ.




4





The
national government has announced its intention to establish a national health
care system to cover over 90% of municipal and rural citizens by 2020, and the
government also encourages large public hospitals and medical service facilities
to provide citizens with safe, convenient and sufficient medical care. We
believe this policy will boost the sales of pharmaceutical products. The more
area the public medical care system covers, the larger demand for pharmaceutical
products will be.





In
addition, sales of daily health care and dietary supplements are growing rapidly
in China, and sales of products that address the daily health needs of
individuals with significant health issues population have been growing rapidly.
Currently, we are actively participating in the development of daily health care
products. We expect to launch a self-branded dietary supplement pack in the
first six months of 2009.





On
November 9, 2008, the State Council of the PRC announced a RMB 4 trillion ($586
billion) economic stimulus package aimed at bolstering the country's slowing
economy and helping fight the effects of any global economic slowdown. This
stimulus plan may facilitate our operation and development in the following
ways.


·
              The
      government is committed to increase the investment in medical care and
      financial support to hospitals, which we believe is likely to reduce the
      collection period of accounts receivable from
    hospitals.
 ·
                The
      State Council passed revised regulations on VAT (Value-Added Tax),
      consumption tax and business tax, a part of the stimulus package, which
      would enable companies to receive tax deductions on spending on fixed
      assets.
 ·
                  The
      government loosened restrictions on commercial credit and provided greater
      financial support to medium and small size enterprises. We believe this
      will improve the cash flow situation of our suppliers and clients, which
      in turn may reduce our accounts
  receivable.


Locations




Our
executive offices and Konzern’s executive offices are located at Room 702,
Guangri Mansion, No. 9, South Wuyang Xin Chengsi, Guangzhou, China 510600, and
the telephone numbers are (8620) 8739-1718 and (8620) 8737-8212. Konzern’s
website is located at www.konzern.com.cn. Information contained on Konzern’s
website, or any other website, is not part of this annual report on Form
10-K.




Our
Business




We are a
distributor of pharmaceutical and medical products in the PRC, including
prescription and over-the-counter drugs, Chinese herbs, traditional Chinese
medicines made from Chinese herbs, nutritional supplements, dietary supplements,
and medical instruments. We are also engaged in proprietary research and
development with the aim of creating new pharmaceutical products and
intellectual property that we may sell in the future. In 2008, 97.5% of our
total revenues of approximately $53 million came from product sales and 2.5%
came from sales of intellectual property.




5





Distribution




Products We
Distribute




As of
December 31, 2008, we dealt in approximately 2,400 pharmaceutical and medical
products, including: (i) western and traditional Chinese medicine (“TCM”) drugs
and supplements (including prescription and over the counter medicines), (ii)
medical equipment and substances including herbs, and (iii) dietary supplements.
In 2008, Western and TCM drugs and supplements accounted for $50.9 million, or
94.9%, of total revenues. In 2008 revenue from sales of medical equipment and
substances was $0.93 million or 1.8% of total revenues; revenue from sales of
dietary supplements was $0.45 million or 0.8% of total revenues. Our sales of
medical formula amounted to $1.34 million in 2008 or 2.5% of total
revenues.




We have
exclusive rights to nationwide distribution of seven products made by our
suppliers, which accounted for approximately 29.4% of our sales in fiscal year
2008 and 21.1% of our sales in fiscal year 2007. The most significant of these
products are Iopamidol Injection 370 and 300, prescription medicines that are
used for angiography and CT scanning. For the years ended December 31, 2008 and
2007, our total revenue from these products amounted to $6.1 million and $4.9
million respectively, which were 11.4% and 11.8% of our annual sales for the
years ended December 31, 2008 and 2007, respectively.




We
obtained the rights to sell and distribute a total of 774 products through the
new system in 2007. We obtained distribution rights for 516 products through the
bidding system in 2008, which accounted for approximately 32.6% of our sales in
fiscal year 2008 and 25% in 2007





Although
we face competition from large state-owned medicine distributors that are better
capitalized than we are, we believe that our unique competitive advantages
include our ownership of high-quality research and development facilities, our
after-sale customer service, and our sole nationwide or region-wide distribution
rights to certain medical products.  Our competitive pricing and our
ability to provide timely delivery are also important competitive features that
we use to attract and retain customers.





Prescription and Over the Counter
Medicines. Prescription and over the counter western medicines account
for majority of our sales, representing sales of approximately $34.93 million,
or 65.1%, of our revenues for the year ended December 30, 2008; $19.13 million,
or 45.4%, of our revenues for the fiscal year ended December 31, 2007, and
$15.32 million, or 63.2%, of our revenues for the fiscal year ended December 31,
2006.





Our
prescription and over the counter medicines are approved by the PRC State Food
and Drug Administration Bureau for treatment of various conditions and
illnesses. Our five best-selling pharmaceutical medicines for the year ended
December 31, 2008, together with the sales volume for the period,
are:





·
            Iopamidol
      Injection 370, a liquid preparation used for stomach radiography, which
      accounted for sales of approximately
$2,714,369.





·
            Iopamidol
      Injection 300, a liquid preparation used for stomach radiography, which
      accounted for sales of approximately
$2,283,208.





·
            Xintemie,
      an injectable liquid use in the treatment of infection, which accounted
      for sales of approximately
$1,654,446





·
            Levocarnitine,
      an injectable liquid used in the treatment of cardiac muscle disease, bone
      dysfunction, and high cholesterol, which accounted for sales of
      approximately $1,470,333.




6




·
            Fengduoxin
      Cefamandolenafate Injection, an injectable antibiotic, which accounted for
      sales of approximately $1,406,959.





Our five
best-selling pharmaceutical medicines for the year ended December 31, 2007,
together with the sales volume for the period, are:





·
            Iopamidol
      Injection 370, a liquid preparation used for stomach radiography, which
      accounted for sales of approximately
$2,713,697.





·
            Iopamidol
      Injection 300, a liquid preparation used for stomach radiography, which
      accounted for sales of approximately
$2,269,987.





·
            Levocarnitine,
      an injectable liquid used in the treatment of cardiac muscle disease, bone
      dysfunction, and high cholesterol, which accounted for sales of
      approximately $1,253,185.





·
            Fengduoxin
      Cefamandolenafate Injection, an injectable antibiotic, which accounted for
      sales of approximately $732,135.





·
            SonoVue,
      a topical gel used in ultrasound radiography, which accounted for sales of
      $538,384.





Traditional Chinese
Medicines. Our five best-selling traditional Chinese medicines for the
year ended December 31, 2008, together with the sales volume for the period,
were:





·
            Xue
      Shuan Tong, which is used for the treatment of strokes, accounted for
      approximately $3,242,061 in sales.





·
            Hongjin
      Xiaojie Capsule, which is used for the treatment of coughs, accounted for
      approximately $2,657,936 in sales.





·
            Xiasang
      Ju Granules, which are used for treatment of flu and various ailments,
      accounted for approximately $2,190,106 in
sales.





·
            Pingxuan
      Capsule, which is used for the treatment of vertigo, accounted for
      approximately $411,017 in sales.





·
            Chuanbei
      Piba Gao (Milian), which is used for treatment of coughs, accounted for
      approximately $329,692 in sales.





Our five
best-selling traditional Chinese medicines for the year ended December 31, 2007,
together with the sales volume for the period, were:





·
            Xiasang
      Ju Granules, which are used for treatment of flu and various ailments,
      accounted for approximately $7,701,423 in
sales.





·
            Hongjin
      Xiaojie Capsule, which is used for the treatment of coughs, accounted for
      approximately $2,404,292 in sales.




7




·
            Chuanbei
      Piba Gao (Milian), which is used for treatment of coughs, accounted for
      approximately $436,890 in sales.





·
            Tianhuang
      Houzao Powder, which is used for the treatment of strokes, accounted for
      approximately $386,568 in sales.





·
            Chuanbei
      Piba Gao (Shedan), which is used for treatment of coughs, accounted for
      approximately $374,884 in sales.





Process of
Distribution





Within
our home province of Guangzhou, we distribute products primarily using our own
trucks and other vehicles. Outside of Guangzhou, we distribute primarily through
delivery companies with whom we contract. The terms of our agreements with
delivery companies include storage temperature, insurance provisions, and
indemnification for loss among other provisions.





In the
US, we focus on food supplements. Currently, we are exploring opportunities to
launch BeThin Tablets, our weight control supplement, in several dietary
supplements stores in Boston. Within the US, we currently seek regional
distributors or an exclusive distributor able to promote the sales of our
supplement products in retail stores.





Principal
Suppliers





We
purchase most of the products we distribute from five PRC drug manufacturers.
These suppliers accounted for approximately 47.2%, and 56.2% of our purchases
for the fiscal years ended December 31, 2008 and 2007, respectively. In 2008,
our five largest suppliers were Shanghai Bracco Sino Pharmaceutical Corporation,
Guangzhou Pharmaceutical Holdings Limited, Guangdong Tianshili Pharmaceutical
Co., Ltd, Guangzhou Xingqun Pharmaceutical Co., Ltd and the Guangdong office of
Guangdong Jiuzhoutong Pharmaceutical Limited, which accounted for 15.1%, 14.6%,
9.3%, 4.8% and 3.3% of our purchases during 2008, respectively. Our agreements
with suppliers generally have a term of one year and provide for the shipments
of products on an order to order basis.





Neither
we nor Konzern has experienced any supply disruptions in the past. We believe
that we will be able to procure supplies for each of our major products from
alternative suppliers in the event that procurement from our regular suppliers
becomes unavailable. However, there is no guarantee that this will be the
case.





Principal
Customers





We have
approximately 800 customers. Our customers are primarily pharmaceutical product
wholesalers, hospitals and retail drug stores. Our five largest customers
accounted for approximately 37.9% of our revenues for the year ended December
31, 2008 and 39.5% of our revenues for the year ended December 31,
2007.




We
generally sell our products pursuant to one-year contracts, which do not include
any minimum purchase requirements. During fiscal 2008and 2007, we sold 81.4%
and 65.7% of our products to hospitals, and 16.1% and 27.5% to retail drug
stores, respectively. Although hospitals tend to consume a large portion of the
products we distribute, they usually require that their payment obligation begin
six months after delivery, which is longer than our other customers require and
leaves us with a long collection period that affects our accounts receivable,
cash flows, and financial condition generally. As a result, we are currently
focusing our efforts on large pharmaceutical wholesalers from whom we can
collect our accounts in a far shorter period of time.




8





Marketing





We have a
staff of approximately 70 marketing and sales employees. We do not sell to
individual patients or consumers. We advertise and participate in promotional
events with regard to over-the-counter products and supplements. We generate
business by marketing directly to wholesale pharmaceutical product companies,
hospitals and retail drug stores, which constitute substantially all of our
customers. Konzern had a distribution network in place when it was privatized in
2000, and we used this network as the basis of our current distribution network.
We also market our products to drug wholesalers and retail drug stores at two
national medicine trade shows. The marketing activities of our marketing
personnel consist primarily of phone calls, on-line marketing, the creation and
distribution of promotional materials, and visits to customer locations. During
2008, we spent approximately $536,674 on marketing, primarily as advertising and
promotion expense and expenses of extension of sales network. During 2007, we
spent approximately $411,300 on marketing.





We are
currently focusing our marketing and sales efforts on large pharmaceutical
wholesalers from whom we can collect our cash soon after delivery. Nonetheless,
we continue to allocate our marketing efforts on hospitals because the revenue
from hospital constitutes a large percentage of our total revenue.





After Sales Service
Network





We
contact individual patients and consumers directly to collect their feedback on
the quality of our products and distribution services. All of our 70 sales and
marketing personnel are responsible for providing after-sale services, including
on-site visits to the hospitals and follow up with customers. In addition, our
on-staff physician communicates with hospitals regarding dosages, side-effects
and patients’ feedback on particular products.




Seasonality of
Business





We
allocate considerable marketing resources to the negotiation with hospitals
during the bidding period of Guangdong Sunshine Bidding System, which affects
the sales during that time. Sales are usually highest during the last three
months of each calendar year because most of the pharmaceutical companies and
hospitals do more buying at this time. Sales in the first three months of the
calendar year are usually the lowest due to the occurrence of the Chinese New
Year holiday, when only patients with very serious conditions tend to seek
treatment. Our revenue and operating results have fluctuated from quarter to
quarter significantly in the past. For example, our sales revenue for the
quarters ended March 31, 2008 and 2007 amounted to $7.1 million and $5.1
million, respectively, about one third of sales revenue for the quarters ended
December 31, 2008 and 2007 amounted to $24.3 million and $16.2 million,
respectively.




Competition





Competition
in the sale of pharmaceutical products among distributors in the PRC is intense
because there is a large number of licensed distributors. We believe that our
major competitors are large, state-owned medicine distributors, such as
Guangzhou Medicine Company, Guangzhou Medicine Import and Export Corporation and
Guangdong Pharmaceutical Co., Ltd. These companies tend to be better
capitalized, which allows them to seek hospital customers that have a six-month
payment cycle. However, such state-owned companies do not have their own
research and development facilities, relevant technical support and customer
services, as Konzern does, and most of them do not provide after-sale customer
services. We believe these two aspects of our business are competitive
advantages.




9





In the
US, there is generally an intense competition in the sale of weight control
supplements. In 2008 we applied for a US patent for the formula of our product,
BeThin Tablets, which application is currently pending. The patent when approved
will give us an advantage over competition with regard to the pricing and safety
control. Our rights are reserved in the interim period while the application is
pending.





We have
the sole distribution rights to at least one medical product sold by each of our
five largest suppliers, which we believe assists us in marketing our products.
However, since other distributors offer comparable products, our ability to
compete successfully is also dependent upon other factors, such as price,
service and the ability to provide timely delivery. We believe that our ability
to develop proprietary products through our current research and development
efforts may provide further competitive advantages.




Product
Development and Technology Transfers





In
addition to the sale and distribution of our medical products, we engage in the
development of intellectual property relating to new pharmaceutical products
which we may use ourselves (which we refer to as product development) or may
sell to other pharmaceutical companies (which we refer to as technology
transfers). We generated approximately $1.3 million in sales from our technology
transfers in the year ended December 31, 2008.




Product
Development





On
October 8, 2003, we entered into an agreement (the “Agreement”) to establish a
cooperative relationship with the Pharmaceutical Research Institute of Nanhua
University. Under the Agreement, Konzern and Nanhua Univeristy jointly set up a
new pharmaceutical research facility, the New Medicine Research Center of
Konzern and Nanhua University (the “Center”). Konzern contributes the expenses
for research and development for new pharmaceutical products, including the
salaries of the research personnel who are principally professors at Nanhua
University, and, in return, we own the rights to any pharmaceutical products
that are developed. The Center is developing three products:





·
            Yutian
      Capsule for treatment of chronic obstructive pulmonary
      disease,





·
            Yutian
      frozen dry powder for treatment of lung
cancer,





·
            A
      multi-functional peptide derivative for treatment of intestinal
      cancers.




On July
7, 2006, we created a PRC joint-venture with Guangzhou Ji'nan Science &
Technology Industrial Group ("JSIG") and Professor Dongsheng Yao. The purpose of
the new company, Guangzhou Co-win Bioengineering Co., Ltd. (“Co-Win”), is to
develop applications for aflatoxin-detoxifizyme, or ADTZ, an enzyme that can
eliminate aflatoxin from food and animal feed. Aflatoxin, a toxic substance that
causes liver, stomach and lung cancers in animals and humans, is produced by the
common aspergillus fungus and frequently affects cereal grains, oilseeds,
spices, peanuts and acorns. Prof. Yao owns intellectual property rights, holding
four patents in the PRC, and JSIG is an agent for the entity that holds those
patents, Ji'nan University. Konzern owns a 70% equity interest in Co-Win, and
each of JSIG and Prof. Yao has a 15% equity interest. The agreement with JSIG
and Prof. Yao governing the creation of Co-Win, which was signed as of July 7,
2006, provides that (i) Konzern is to invest a total of approximately $2.2
million, which we have fully paid as of December 31, 2008, and (ii) Co-Win will
own the intellectual property rights to any products developed by the joint
venture pursuant to the agreement. The formation of Co-Win was approved and
licensed by the Guangzhou Industrial and Commerce Bureau on October 27, 2006.
Co-Win is still in the development stage and no sales activity has yet
occurred.




10





Technology
Transfers





Technology
transfers generated approximately $1.3 million or 2.5% of total sales for the
year ended December 31, 2008, and approximately $2.9 million, or 6.8% of our
total revenues for the year ended December 31, 2007. Our customers for
technology transfers are pharmaceutical manufacturers, research centers and
medicine distribution companies. We anticipate that our technology transfers,
which we began in 2003, will continue to be a significant segment of our
business in the foreseeable future.





Intellectual
Property





Patents





We have
obtained patents for the production methods we have developed or control for the
following four products. Patent certificates were issued on May 9, 2007 with
patents rights for 20 years from the issuance date:





·
            Xiao
      Shu Oral Liquid, an oral medication designed to reduce the effects of heat
      exhaustion;





·
            Jian
      Pi Xiao Ji Oral Liquid, an oral medication to treat
      indigestion;





·
            An
      unnamed oral medicine treatment for symptoms related to computer over-use;
      and





·
            An
      unnamed method of improving the effectiveness of oral
      medicines.





The table
below sets forth information relating to these four patents.




Name
            
            Inventor
            
            Application
      No.
            
            Filing
      date
            
            Publication
      date
            
            Patent
      No.
            
            Authorization
      date1
            
            Xiao
      Shu Oral Liquid
            
            Jinkun
      Xie,
              Minhua
      Liu
            
            20041005239600
            
            2004.11.26
            
            2005.8.10
            
            ZL200410052396.0
            
            2007.5.92
            
            Jian
      Pi Xiao Ji Oral Liquid
            
            Jinkun
      Xie,
              Minhua
      Liu
            
            200410052398
            
            2004.11.26
            
            2005.8.10
            
            ZL200410052398.X
            
            2007.5.93
            
            An
      oral medicine treatment for symptoms associated with over-use of
      computers
            
            Jinkun
      Xie,
              Minhua
      Liu
            
            200510032608.3
            
            2005.1.5
            
            2005.10.12
            
            ZL12005132607.9
            
            2007.10.034
            
            A
      method of improving oral medicines
            
            Jinkun
      Xie,
              Minhua
      Liu
            
            200510032607.9
            
            2005.1.5
            
            2005.10.12
            
            ZL200510032608.3
            
            2007.10.03




11




Co-Win
has obtained the following patents for ADTZ in China.





·
            Detoxification
      technology to remove AFT from the raw materials of
    condiments;





·
            Biosensor
      and its manufacturing method for the inspection of AFT and versicolorin;
      and





·
            Detoxifizyme
      with the function to convert the activity of AFT and the gene to code the
      aforesaid detoxifizyme.





The table
below sets forth the information relating to these three patents:





Name
            
            Filing
      date
            
            Publication
      date
            
            Patent
      No.
            
            Authorization
      date1
            
            Detoxification
      technology to remove AFT from the raw materials of
    condiments
            
            2001.1.12
            
            
            
            ZL01107435.3
            
            2005.11.162
            
            Biosensor
      and its manufacturing method for the inspection of AFT and
      versicolorin
            
            2004.7.9
            
            
            
            ZL200410028018.9
            
            2007.9.263
            
            Detoxifizyme
      with the function to convert the activity  of AFT and the gene
      to code the aforesaid detoxifizyme
            
            2004.8.17
            
            
            
            ZL200410051120.0
            
            2007.1.10





Furthermore,
Co-Win has obtained the following international patents for ADTZ.





·
            Patent
      in Australia: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme;





·
            Patent
      in South Africa: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme; and





·
            Patent
      in South Korea: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme.




12




The table
below sets forth the information relating to these three patents:





Name
            
            Filing
      date
            
            Publication
      date
            
            Patent
      No.
            
            Authorization
      date1
            
            Patent
      in Australia: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            
            
            2005274578
            
            2007.6.122
            
            Patent
      in South Africa: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme; and
            
            2004.8.17
            
            
            
            2007/0269
            
            2008.5.283
            
            Patent
      in South Korea: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            
            
            10-0850640
            
            2008.7.31




13




We have
patents pending for the production methods we have developed or control for
eleven medicines. These patent applications have been approved by the PRC State
Health Department, and approvals by the PRC National Intellectual Property
Bureau are pending. Except for the weight control component, we do not currently
manufacture or sell any of these medicines. Information relating to the products
and the pending patent applications is set forth below.





Name
            
            Inventor
            
            Application
      No.
            
            Filing
      date
            
            Publication
      date
            
            Patent
      No.
            
            Authorization
      date1
            
            Qu
      shi qing chang oral liquid, an oral medication to treat
      constipation
            
            Jinkun
      Xie,
              Minhua
      Liu
            
            2004.10052397.5
            
            2004.11.26
            
            2005.8.10
            
            —
            
            —2
            
            Radiation
      protection chewing gum, designed to reduce the effects of radiation
      emitted by computer monitors and relieve tired and strained
      eyes
            
            Jinkun
      Xie,
              Minhua
      Liu
            
            200510035432.7
            
            2005.6.27
            
            2008.6.4
            
            —
            
            —3
            
            Sihuan
      jiangzhi jianfei ji and its production formula to treat chronic lung
      disease
            
            Jinkun
      Xie,
              Minhua
      Liu
            
            200610036736.X
            
            2006.7.28
            
            2007.6.6
            
            —
            
            —4
            
            PCT
      international application of slug amylase and its production method to
      treat chronic lung disease
            
            Jinkun
      Xie
            
            PCT╱CN2006╱002813
            
            2006.10.23
            
            2007.11.8
            
            —
            
            —5
            
            A
      kind of glycoprotein used to treat chronic lung disease
            
            Jinkun
      Xie
            
            2007100267510
            
            2007.02
      07
            
            2007.8.8
            
            —
            
            —6
            
            PCT
      international application of a component of weight control
            
            Jinkun
      Xie Minhua Liu
            
            PCT/CN2008/070057
            
            2008.1.9
            
            2007.12.26




14




7
            
            PCT
      international application of a kind of glycoprotein used to treat chronic
      lung disease
            
            Jinkun
      Xie
            
            PCT/CN2008/070124
            
            2008.01.17
            
            2008.01.178
            
            Application
      in Hong Kong: a component of weight control
            
            Jinkun
      Xie Minhua Liu
            
            08113020.9
            
            2008.11.289
            
            Application
      in US: a component of weight control
            
            Jinkun
      Xie Minhua Liu
            
            CHINA200710032895.7
            
            2008-11-26
            
            2009.2.710
            
            A
      kind of glucan used to treat lung cancer
            
            Jinkun
      Xie
              Jianguo
      Cao
              Anqiang
      Zhang
            
            200810028974.5
            
            2008.6.23
            
            2008.11.511
            
            PCT
      international application of a kind of glucan used to treat lung
      cancer
            
            Jinkun
      Xie
              Jianguo
      Cao
              Anqiang
      Zhang
            
            PCT/CN2008/071414
            
            2008.6.23




15




Co-Win
has ten international patent applications pending for ADTZ. Information relating
to the pending patent applications is set forth below.





Name
            
            Filing
      date
            
            Publication
      date
            
            Patent
      No.
            
            Authorization
      date1
            
            Patent
      in US: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            
            
            —
            
            —2
            
            Patent
      in Japan: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —3
            
            Patent
      in Israel: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            
            
            —
            
            —4
            
            Patent
      in European Union: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —5
            
            Patent
      in Indonesia: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —6
            
            Patent
      in Canada: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —7
            
            Patent
      in Russia: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —8
            
            Patent
      in Mexico: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —9
            
            Patent
      in India: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —10
            
            Patent
      in Hong Kong: Detoxifizyme with the function to convert the
      activity  of AFT and the gene to code the aforesaid
      detoxifizyme
            
            2004.8.17
            
            —
            
            —
            
            —








Trademarks





Konzern
is the holder of the trademark “Konzem,” which was registered with the PRC
Trademark Office of the National Industrial and Commercial Administrative Bureau
(the “PRC Trademark Offices”). The discrepancy between the registered trademark
“Konzem” and the Company’s name resulted from a spelling error by the trademark
agent. Until the error is corrected, we may not be able to enforce any trademark
rights with respect to our company name. Konzern is also the holder of the
trademark (kefei) for nutritional supplements (product category 30 of the PRC
Trademark Offices) and medicine for external use (product category 3 of the PRC
Trademark Offices).




16





Trademarks
issued in the PRC have a term of 10 years; the term of our trademarks expires on
December 13, 2011. The registered scope of use of the trademark is for
pharmaceutical products, nutritional liquids, dietary supplements, original
materials, bio-chemical medicines, medicinal oils, medicines treating dandruff,
medicinal roots and vitamins. The PRC Trademark law, adopted in 1982 and revised
in 2001, protects registered trademarks. A registered trademark is protected for
a term of 10 years, renewable for another term of 10 years, so long as an
application for renewal is submitted to the PRC Trademark Offices within six
months prior to the expiration of the initial term.





Below is
a schedule of the trademarks held by Konzern and their effective
periods.





No.
            
            Name
            
            Application
      No.
            
            Status
            
            Effective
      period1
            
            Konzern
            
            1680414
            
            received
            
            2001.12.14
      - 2011.12.133
            
            kefei
            
            3564022
            
            received
            
            2005.09.28
      - 2015.09.276
            
            kefei
            
            3564020
            
            received
            
            2005.03.07
      - 2015.03.0615
            
            runxia
            
            4411469
            
            received
            
            2007.06.14
      - 2017.06.1320
            
            buzhong
            
            4411468
            
            received
            
            2007.06.21
      - 2017.06.2023
            
            qingshangqing
            
            4411471
            
            received
            
            2007.06.14
      - 2017.06.1328
            
            wangyou
            
            4519748
            
            received
            
            2007.10.07
      - 2017.10.06




In
addition, Konzern has applied for the registration of the following trademarks,
for which we are awaiting a disposition from the PRC Trademark
Offices:





Trademark
      applied for
            
            Application
      date
            
            Process
      acceptance date(shangqing)
            
            12/01/2004
            
            02/23/2005(buzhongbao)
            
            12/01/2004
            
            02/23/2005(erxianbaochun)
            
            12/01/2004
            
            02/23/2005(wangzeyou)
            
            03/02/2005
            
            05/25/2005(yutian)
            
            03/15/2005
            
            05/25/2005(qinghe)
            
            07/18/2005
            
            09/27/2005Co-win
            
            05/28/2006
            
            09/18/2006mushenghuo
            
            2006
            
            2006mushengtu
            
            2006
            
            2006jinshengshui
            
            2006
            
            2006tushengjin
            
            2006
            
            2006wubaohu
            
            06/20/2007
            
            09/17/2007Konzern
            
            01/13/2008
            
            01/24/2008BeThin
            
            01/13/2008
            
            01/24/2008





Below
is the schedule of the trademark held by China Medicine Corporation and their
effective period:





No.
            
            Name
            
            Registration
      No.
            
            Registration
      Date
            
            Effective
      period1
            
            Konzern
            
            3,550,633
            
            12/23/2008
            
            2008.12.23
      - 2018.12.223
            
            BeThin
            
            3,550,969
            
            12/23/2008
            
            2008.12.23
      - 2018.12.22




17




Government
Regulation





The
operation of any business in the PRC, including the manufacture or distribution
of pharmaceutical products, is subject to government regulations. These
regulations cover a wide range of products, from Chinese herbal products sold
over-the-counter to pharmaceutical products which require a
prescription.





The
manufacture and sale of pharmaceutical products in the PRC is governed by the
PRC Drug Administration Law. As of the date of this report, we do not
manufacture any products. Instead, all of the products we distribute are
manufactured at a facility which has received a permit to operate as a drug
manufacturing facility. As a distributor of pharmaceutical products, we are
required to obtain a permit from the drug regulatory department of the
government of the province, autonomous region or municipality directly under the
PRC Central Government, where we are located. We have obtained a permit to
operate as a distributor, a Certificate for Drug Distribution, from the
Guangdong Food and Drug Administration in the Province of Guangdong, China, with
a five-year term from December 28, 2004 to December 27, 2009. The certificate
allows for the purchase of raw materials; wholesaling of traditional Chinese
medicines, chemical medicines and the related medicines, antibiotics and related
medicines. In addition, we have a Certificate for Health issued by Guangzhou
Health Bureau with a term of four years, commencing on July 19, 2005, which
grants us the right to engage in wholesale marketing and distribution of
nutritional supplements. In the event that we expand our business scope to
manufacture our proprietary pharmaceutical products, we will require a
certificate for the manufacture of such products.





The Drug
Administration Law also governs other aspects of the drug manufacturing and
distribution business, including packaging, labeling, advertising and pricing.
The PRC Drug Administration Law and Pricing Law provide for the government to
determine and adjust prices of pharmaceutical products in order to ensure that
price is commensurate with quality, to eliminate excessively high prices, and
protect the legitimate interests of users. In general, the prices of our
products are determined by us and our customers through negotiation. We are
required to operate in accordance with Good Supply Practice (or “GSP”) for
Pharmaceutical Products, and we are subject to inspections organized by the
local drug regulatory department of the government of Guangdong Province. We
received a GSP Certificate from the Guangdong Province Administration Bureau for
Drugs with a term of five years beginning on October 27, 2008.





The Drug
Administration Law provides for penalties for manufacturing or distributing
drugs without obtaining the necessary certificate. If a distributor distributes
drugs without the certificate, the distributor is banned from the
industry.  If drugs are illegally produced or sold, all related
illegal gains may be confiscated, and the distributor may be fined not less than
two times but not more than five times the value of the drugs purchased or
sold.





In order
to market a new pharmaceutical product, we must first obtain government approval
for the clinical trial, as described in the preceding paragraph. The government
authority issues a list of hospitals which are qualified to conduct the clinical
trial, and we select one or more hospitals from such list. If the results of the
test are accepted by the PRC State Food and Drug Administration, we must then
apply for a production license so that the drug can be produced at a licensed
manufacturing facility. In accordance with relevant laws and regulations, the
Drug Certificate may be revoked if the pharmaceutical product is found to cause
adverse pharmacological effects or is found to be harmful to patients’ health,
or if it is found that other activities engaged in with respect to manufacturing
and marketing the drug are in violation of the laws. The Drug Certificate sets
forth the approved use of the pharmaceutical product. Four new products are
currently being developed by the research-center venture with Nanhua University.
After completion of laboratory testing, those products are subject to the
clinical trial process described above.




18




A typical
schedule for obtaining approval to manufacture or sell a new drug would require
one to one-and-a-half years for approval of clinical trials, an additional one
to three years for the completion of clinical trials, and an additional one to
one-and-a-half years for the issuance of a new medicine certificate and
production certificate.





The
effects on the Company of operating within the regulatory framework described
above are significant and comprehensive. We must employ medicine quality
controllers, managers, inspectors, receivers, verifiers, and warehouse managers,
all of whom must be appropriately trained and experienced and whose
qualifications are overseen by the SFDA; we must maintain a specialized
warehouse in compliance with regulatory standards, and we must maintain the
licenses and certificates described above. The direct costs of compliance with
these regulations during fiscal 2008 exceeded $200,000.





In 2008
we began to explore sales prospects in the U.S. of BeTin Tablets, a weight loss
dietary supplement. We currently seek U.S. distributors for BeThin Tablets and
made contact with several U.S. dietary supplements stores. Dietary supplements
in the U.S. are regulated by the U.S. Food and Drug Administration (“FDA”).
Under the Dietary Supplement Health and Education Act of 1994, the dietary
supplement manufacturer is responsible for ensuring that a dietary supplement is
safe before it is marketed. FDA is responsible for taking action against any
unsafe dietary supplement product after it reaches the market. Generally,
manufacturers do not need to register their products with FDA nor get FDA
approval before producing or selling dietary supplements. Manufacturers must
make sure that product label information is truthful and not misleading.
Pursuant to its post-marketing control responsibilities, FDA's monitors safety,
e.g. voluntary dietary supplement adverse event reporting, and product
information, such as labeling, claims, package inserts, and accompanying
literature. The U.S. Federal Trade Commission regulates dietary supplement
advertising in the U.S. We are in the initial stage of setting up distribution
of BeThin Tablets in the U.S. and as a result did not incur any costs of
compliance with these regulations during fiscal 2008. This may change, as we
continue in our efforts to begin sales of this product in the U.S.





Employees





As of
December 31, 2008, we had 105 employees, of whom 25 are executive and
administrative personnel, 10 are research and development staff and 70 are
marketing and sales personnel.




Risk of Loss and
Liability





The
standard contracts between Konzern and its customers do not specify risk of loss
allocation; however, the transportation company is generally responsible for
losses and damage which occur during transportation. In the event that a product
recall becomes necessary, any liability associated with the recall or use of the
product will be apportioned among the various parties involved in the production
and distribution of the product. Manufacturers are typically responsible for
problems arising from the quality of medicines, and distributors such as China
Medicine are typically responsible for problems related to incorrect packaging.
We mitigate these risks by providing for transportation insurance in our typical
delivery contracts with transportation companies.




19





Konzern
does not carry any product liability or other similar insurance. While product
liability lawsuits in the PRC are rare and we have never experienced significant
problems with any of our products, there can be no assurance that we would not
face liability in the event that any of our products is found to be ineffective,
harmful, unsafe, defective or tainted.





Our
subsidiary, Konzern US Holding Corporation carries general liability and product
liability insurance which covers our products distributed in the U.S. Currently,
only one of our products, a weight-loss dietary supplement, BeThin Tablets is
being distributed in the U.S.





ITEM
1A. RISK FACTORS





An
investment in our common stock involves a high degree of risk. You should
carefully consider all of the risks described below, together with the other
information contained in this report, before making a decision to purchase our
common stock. You should only purchase our common stock if you can afford to
lose your entire investment.




Risks
Associated with Our Business




Supply
interruptions could damage our core business.




Many of
the products we distribute are derived from plant products, whose availability
and price could be affected by any of the factors that affect crop growth and
availability, including weather, fire, insects, and disease. Most of the
products we distribute are produced through complex manufacturing processes that
must be designed and executed with precision. If our suppliers are not able to
acquire the raw materials or complete the manufacturing process needed to
produce the products that we purchase from them, our business will suffer. In
addition, we purchase most of our inventories from a small number of
suppliers. In 2008, our five largest suppliers accounted for approximately 47%
of our purchases. If any of these suppliers were to become unable or unwilling
to supply our inventories at reasonable prices, we would be forced to look
to other suppliers to meet our demand for materials. Although we believe that
alternative suppliers are available for each of the ingredients in our major
products, there is no guarantee that all of these ingredients are or will
continue to be available in the future, or that they will be available at prices
similar to those we are accustomed to paying. Although we have not experienced
any supply disruptions in the past, there is no guarantee they will not occur in
the future. As a result, the loss of a supplier could impair our ability to
operate profitably.




Interruptions
of deliveries to customers could damage our core business.




We
generate most of our revenues by delivering products to our customers. Our
performance therefore depends on the smooth and reliable functioning of all
aspects of the delivery process, including vehicles (primarily trucks),
availability of gasoline at historically typical prices, and infrastructure,
especially roads, bridges and tunnels. If we are not able to secure trucks and
delivery services at the rates to which we are accustomed; if gasoline prices
rise significantly; or if roads are damaged by weather or earthquakes or other
extraordinary events or are not repaired after ordinary wear, our ability to
make deliveries would suffer, and therefore our ability to generate revenue, our
financial results, and our competitive position would all suffer.




20




Because
a significant portion of our revenue comes from a small number of customers, the
failure of one of our customers could damage our financial
condition.





Our five
largest customers accounted for 37.9% of our revenue for 2008, and 39.5% of our
revenue for 2007. Our customers are not required to make minimum purchases from
us or to refrain from purchasing competing products from other
companies.




Because a substantial portion of our sales are made to a small
number of customers, our accounts receivable from a small number of customers
may represent a large percentage of our accounts receivable and assets. Our
largest account receivable at December 31, 2008 was $4,343,277, representing
9.7% of our total assets and 13.3% of our working capital, and accounts
receivable from our five largest customers at that time totaled approximately
$9.4million, representing 21% of our total assets and 28.8% of our working
capital. This concentration of accounts receivable represents a significant
credit risk. The failure of one or more of these customers to pay their
obligations to us in a timely manner could damage our liquidity and cash flows
and could impair our ability to continue to operate profitably or at
all.




If
the medicines we distribute are found to cause severe side effects or other
harm, or the drug formulas we own or develop are found to be defective, we could
suffer serious consequences.




The
products we distribute may be dangerous if taken in the wrong doses, if subject
to manufacturing process defects or tampering, or if badly designed or
inadequately tested prior to their release. As the distributor of drugs and
other medical products, we may be subject to liability in the event that claims
of harm resulting from the use of our products are made. In the case of drugs
that we are developing, we could face liability not only as a distributor but
also as the designer and formula owner of the drugs. Such a claim could lead
to:




·
            a
      withdrawal or modification of government approvals of such
      medicines;




·
            a
      government requirement that we recall or participate in the recall of one
      or more of our medicines;




·
            a
      decline or cessation of sales of the
medicine;




·
            damage
      to our reputation and competitive position, and reduced success in
      securing distribution rights from
manufacturers;




·
            claims
      against us by persons or entities claiming harm, including lawsuits
      against us by persons who may have experienced severe side effects or
      other harm; claims from customers that we have failed to fill orders to
      specifications; claims from purchasers of our formulas that we have failed
      to deliver the formulas as promised; and
claims




·
            the
      need for us to devote significant resources to improve a defective formula
      or create a new formula for an affected medicine, to change the way we
      market a formula or medicine, to conduct additional clinical trials or
      demand that they be conducted by a manufacturer, or to change the labeling
      of a medicine or demand that labeling be changed by a manufacturer;
      and




·
            the
      total or partial loss of the value of an affected
  formula.




21




The
occurrence of any of these events would harm our sales of the affected medicines
and substantially increase the costs of marketing these medicines, and could
cause serious harm to our revenues, profitability, and competitive
position.




We
have significant financial commitments under joint venture agreements with no
assurance that the ventures will ever be profitable.




We have
funding obligations with respect to the following projects that our management
has identified as potential sources of substantial future profits, but which may
never generate any profits at all:




·
            a
      joint-venture company called “Co-Win,” which we formed in 2006 together
      with Guangzhou Ji'nan Science & Technology Industrial Group (JSIG) and
      Prof. Dongsheng Yao, with the purpose of developing applications for
      aflatoxin-detoxifizyme, or ADTZ, an enzyme that can eliminate aflatoxin
      from food and animal feed. We have a total commitment to Co-Win of
      approximately $2.2 million, which we have fully paid as of December 31,
      2008.




·
            a
      research and development center at Nanhua University in Hengyang City,
      Hunan Province, China, which we established together with the
      Pharmaceutical Research Institute of Nanhua University in 2003. Under the
      agreement governing the creation of the center, Konzern contributed
      approximately $380,000, $270,000 and $100,000 in 2005, 2006 and 2007, in
      order to fund the center’s budget, including the salaries of research
      personnel, in return for ownership of the new medicines developed by the
      center. The center is developing three products, one of which is under
      review by the PRC State Food and Drug Administration. None of the products
      has yet been sold.




There is
no guarantee that any of these ventures will develop a marketable or profitable
product or intellectual property with a value equal to or greater than our
investment. We may enter into other research and development agreements in the
future in which we undertake funding obligations with no assurance that a
profitable product will be developed. There is no guarantee that future research
and development ventures pursued by management will succeed. Poor performance of
any of these ventures would limit our growth and could harm our profitability
and competitive position.




The
increased expenses resulting from our status as a public company may impair our
ability to operate profitably.




Our
status as a public company comes with obligations to file disclosure reports
with the SEC. As a result, our ongoing expenses have increased significantly.
Our increased expenses include (a) ongoing public company expenses such as (i)
increased legal and accounting expenses relating to our new reporting
requirements and our agreement with the initial investors that we would register
the shares of common stock issued or issuable to them upon conversion of Series
A preferred stock and exercise of the warrants, (ii) increased expenses relating
to investor relations activities, including activities to increase investors’
awareness of our common stock; (iii) expenses incurred in complying with the
internal-control requirements of the Sarbanes-Oxley Act, and (iv) obligations
incurred in connection with the reverse acquisition; (b) expenses related to
increased compensation to our officers as appropriate to the greater
responsibilities of managing a public company; and (c) additional expenses
relating to the search for a chief financial officer who is familiar with United
States GAAP. There is no guarantee that we will succeed in generating sufficient
income to grow or remain profitable given these increased expenses.




22




Because
we are dependent on our management, the loss of key executive officers or a key
consultant and the failure to hire additional qualified key personnel could harm
our business.




Our
business is largely dependent upon the continued efforts of our chief executive
officer, Senshan Yang, and our executive vice president, Minhua Liu, whose
managerial expertise would be difficult or impossible to replace. Both Mr. Yang
and Ms. Liu are also directors. We do not have a long-term contract with any of
our officers except other than Ms. Liu, whose employment agreement was renewed
at the end of December, 2007 and will expire on June 30, 2010. The loss of
either of these individuals could have a material adverse effect upon our
ability to operate profitably.




We
must make significant cash payments for our product supplies long before we
generate revenue from sales of those products. We may therefore require cash
from outside sources to purchase supplies and run our business, even if our
sales increase.




Our
suppliers require us to comply with strict payment terms that are written into
our supply contracts. The collection periods for our accounts receivable
typically range from three months to one year; we are required to pay our
suppliers in advance for a significant portion of the purchase price; and we
must maintain deposits with some of our suppliers. It generally takes our
supplies one to two months to deliver products once we place a purchase order.
In addition, some of our customers, especially hospitals, require payments terms
that allow them to pay for our deliveries months after they have been made. As a
result, we spend large amounts of cash for the products we distribute long
before we generate revenue from sales of those products. Our business is
therefore cash-intensive. We do not have an accounts-receivable or
inventory-based credit facility in place to provide liquidity when it is needed.
Therefore, sales of our products may not generate sufficient cash to enable us
to pay our suppliers while awaiting payment on our receivables, and we may be
forced to seek outside financing to continue operations. There is no guarantee
that we will obtain financing when needed, on beneficial terms or on any terms
at all. If we cannot obtain financing on reasonable terms to provide needed
liquidity, we may be forced to limit or halt operations, which could severely
damage our business, competitive position, and financial results.




The
terms on which we may raise additional capital may result in significant
dilution and may impair our stock price.




Because
of the limited extent of the public market for our common stock, the terms of
our February 2006 private placement, the number of outstanding warrants, and the
exercise price and other terms on which we may issue common stock upon exercise
of the warrants, it may be difficult for us to raise additional capital if
required for our present business and for any planned expansion. We cannot
assure you that we will be able to get additional financing on any terms, and,
if we are able to raise funds, it may be necessary for us to sell our securities
at a price which is at a significant discount from the market price and on other
terms which may be disadvantageous to us. In connection with any such financing,
we may be required to provide registration rights to investors and pay damages
in the event that a registration statement is not filed or declared effective by
specified dates. The price and terms of any financing which would be available
to us could result in both the issuance of a significant number of shares and
significant downward pressure on our stock price and could result in a reduction
of the exercise price of the warrants held by the investors in our February 2006
private placement, under the terms of the warrants. Under those terms, if we
issue common stock at a price which is less than the exercise price of the
warrants (currently $1.70 for Series A Warrants and $2.43 for Series B
Warrants), the exercise prices are to be proportionately reduced, which could
result in the holders of our warrants receiving substantially more shares of our
stock than initially anticipated.




23




Lack
of cash may prevent us from making identified acquisitions, and the financing of
successful acquisitions may have negative consequences.




An
important part of our growth strategy is to seek expansion by making strategic
acquisitions. If we have insufficient cash, due to our long collection cycle for
accounts receivable or for other reasons, and if we are unable to raise
financing on reasonable terms, we may miss opportunities to make acquisitions
that would benefit the Company. The loss of such opportunities could limit our
future growth, and the opportunities could be seized by our competitors to make
acquisitions and improve their competitive position relative to ours. In the
case where we are able to make a desired acquisition by borrowing funds or
issuing equity securities, there is no guarantee that the terms of the borrowing
or issuance will be justified by the ultimate value of the acquisition to the
Company. Any issuance of equity would result in dilution to our stockholders. As
of December 31, 2008, we do not have any agreement or understanding, either
formal or informal, as to any potential acquisition.




Acquisitions
may disrupt our operations.




If we
make acquisitions, we could have difficulties integrating the acquired
companies' personnel and operations with our own, including:




·
            difficulties
      integrating acquired products, services, operations and rights into our
      existing business;




·
            potential
      disruption of the ongoing businesses and distraction of our management and
      the management of acquired
companies;




·
            difficulties
      in disposing of the excess or idle facilities of an acquired company or
      business and expenses in maintaining such
  facilities;




·
            difficulties
      in maintaining uniform standards, controls, procedures and
      policies;




·
            potential
      impairment of relationships with employees and customers as a result of
      any integration of new management
personnel;




·
            potential
      inability or failure to achieve additional sales and enhance our customer
      base through cross-marketing of the products to new and existing
      customers;




·
            the
      effects of any government regulations which relate to the acquired
      business; and




·
            potential
      unknown liabilities associated with acquired businesses or product lines,
      or the need to spend significant amounts to retool, reposition or modify
      the marketing and sales of acquired products or the defense of any
      litigation, whether of not successful, resulting from actions of the
      acquired company prior to our acquisition.




Our
business could be severely impaired if and to the extent that we are unable to
succeed in addressing any of these risks or other problems encountered in
connection with these acquisitions, many of which cannot be presently
identified. These risks and problems could disrupt our ongoing business,
distract our management and employees, increase our expenses and adversely
affect our results of operations. Even if we manage these difficulties, there is
no guarantee that the increased revenue resulting from the acquisition will
outweigh the costs of the acquisition, the integration and the continuing
operations of our larger, consolidated company.




24




Our
operating results in future periods may vary from quarter to quarter and, as a
result, we may fail to meet the expectations of our investors and analysts,
which may cause our stock price to fluctuate or decline.




Our
revenue and operating results have fluctuated from quarter to quarter
significantly in the past. For example, in 2008, total revenue for the quarter
ended December 31, 2008 was approximately $24.3 million, over three times the
total revenue for the quarter ended March 31, 2008 of approximately $7.1
million. We expect that fluctuations in both revenue and net income will
continue due to a variety of factors, many of which are outside of our control,
including the needs of our customers, competitive products offered by others,
consumer preferences, the extent of our research and development activities, and
seasonal purchasing patterns of our customers. Due to such risks, you should not
rely on period-to-period financial comparisons as an indication of future
performance.




Efforts
to comply with recently enacted changes in securities laws and regulations will
increase our costs and require additional management resources, and we may fail
to comply in spite of those efforts.




As
directed by Section 404 of the Sarbanes-Oxley Act of 2002, the SEC adopted rules
requiring public companies to include a report of management on the company's
internal controls over financial reporting in their annual reports on Form 10-K.
In addition, the public accounting firm auditing the company's financial
statements must attest to and report the effectiveness of the company's internal
controls over financial reporting. These requirements will first apply to our
annual report on Form 10-K for the year ending December 31, 2009 with respect to
the filing of an auditor’s report. If and when these regulations become
applicable to us, and if we are unable to conclude that we have effective
internal controls over financial reporting or if our independent auditors are
unable to provide us with an unqualified report as to the effectiveness of our
internal controls over financial reporting as required by Section 404 of the
Sarbanes-Oxley Act of 2002, investors could lose confidence in the reliability
of our financial statements, which could result in a decrease in the value of
our securities.




25




We
may be required to pay liquidated damages if we do not satisfy our contractual
obligations to achieve and maintain the effectiveness of one or more
registration statements relating to the resale of some of our common stock by
private investors,  and to maintain a board consisting of a majority
of independent directors.




The
registration rights agreement which we executed in connection with our February
2006 private sale of securities required us to file a registration statement by
April 10, 2006 and to have the registration statement declared effective by the
SEC by August 8, 2006. Under the terms of the agreement, our failure to meet
either deadline obligates us to issue to the investors, as liquidated damages,
1,025 shares of Series A preferred stock for each day that we fail to meet
either of the scheduled dates or if we fail to keep the registration statement
effective thereafter, although no liquidated damages are payable if we fail to
meet the required filing date but meet the required effective date. We filed the
initial registration statement three days late. Thus, the terms of the
registration rights agreement would require us to issue 3,075 shares of Series A
preferred stock for our failure to file the registration statement by April 10,
2006 plus an additional 1,025 shares of Series A preferred stock for each of the
68 days between August 8, 2006 and October 17, 2006, the date on which the
registration statement was declared effective by the SEC. At that time, the
total number of shares to be issued as liquidated damages under the registration
rights agreement was 72,775.




We may
also be deemed to owe such liquidated damages for failure to maintain the
effectiveness of the registration statement from November 1, 2007 until our
amended registration statement was declared effective by the SEC on January 15,
2008. In connection with that period, we may be deemed to have an obligation to
issue up to approximately 46,125 shares of Series A preferred stock to the
investors. The investors have not requested that we issue any shares as
liquidated damages under the registration rights agreement, and we have not
issued any such shares.




Risks
Associated with Doing Business in the PRC





Changes
in the policies of the PRC government could have a significant impact upon the
business we may be able to conduct in the PRC and the profitability of that
business.





The PRC's
economy is in transition from a planned economy to a market oriented economy
subject to five-year and annual plans adopted by the government that set
national economic development goals. Policies of the PRC government can have
significant effects on the economic conditions of the PRC. The PRC government
has confirmed that economic development will follow the model of a market
economy. Under this direction, we believe that the PRC will continue to
strengthen its economic and trading relationships with foreign countries and
business development in the PRC will follow market forces. While we believe that
this trend will continue, there can be no assurance that this will be the
case.





A change
in policies by the PRC government could adversely affect our interests by, among
other factors: changes in laws, regulations or the interpretation thereof,
confiscatory taxation, restrictions on currency conversion, imports or sources
of supplies, or the expropriation or nationalization of private enterprises.
Although the PRC government has been pursuing economic reform policies for
several decades, there can be no assurance that the government will continue to
pursue such policies or that such policies may not be significantly altered,
especially in the event of a change in leadership, social or political
disruption, or other circumstances affecting the political, economic and social
situation of the PRC.




26




The laws and regulations of the PRC that govern our current
business operations are sometimes vague and uncertain. Any changes in such PRC
laws and regulations may harm our business.





The PRC
laws and regulations governing our current business operations are sometimes
vague and uncertain. There are substantial uncertainties regarding the
interpretation and application of PRC laws and regulations, including the laws
and regulations governing our business, or the enforcement and performance of
our arrangements with customers in the event of the imposition of statutory
liens, death, bankruptcy and criminal proceedings. We and any future
subsidiaries are considered foreign persons or foreign funded enterprises under
PRC laws, and as a result, we are required to comply with certain PRC laws and
regulations. These laws and regulations are sometimes vague and may be subject
to future changes, and their official interpretation and enforcement involves
substantial uncertainty.  New laws and regulations that affect existing and
proposed future businesses may also be applied retroactively. We cannot predict
what effect the interpretation of existing or new PRC laws or regulations may
have on our businesses.




At the
end of 2007, a comprehensive reform of China’s healthcare system was underway.
In March 2008, the National People’s Congress of the PRC and other legislative
entities began the initiative to draft a series of policies to broaden the
healthcare coverage for the population in the rural regions. Although the
details of the reform are still unclear, it is certain that the reform will
result in increased healthcare spending for the rural population and low income
families. Although the government has not enacted any detailed policy regarding
this issue, we expect that government will provide medical insurance subsidies
to rural areas and low income families. We will continue to improve the delivery
and network of our distribution.





As a
result of this healthcare reform, government may either subsidize hospitals or
healthcare institutions in rural areas, or subsidize drug manufacturers or
distributors if they can distribute their products to rural areas with fixed
profit margins. The management cannot guarantee that these new policies will
benefit the company or help to increase company’s revenues. The management
cannot guarantee that the company will be able to achieve the targeted profits
or maintain the current profit margin going forward.





We
could be affected by recent and continuing events affecting the drug industry in
the PRC.





In July
2007, representatives of the PRC’s leading food and drug regulatory bodies held
a joint news conference to emphasize their determination to crack down on the
production and export of fake and counterfeit food and medicine in China. During
the preceding several months, China’s food, drug, chemical and other industries
were the subject of many stories in the international press regarding the export
of dangerous and uncertified products from China, including industrial chemicals
found in pet food in the U.S., a toxic chemical substituted for glycerin in cold
medicine sold in Panama, and lead paint found in toys made in China and sold in
the U.S and Europe.





Also in
July 2007, the PRC government executed the former head of the State Food and
Drug Administration (the “SFDA”) for accepting bribes and failing to police the
marketplace. The new administrators of SFDA have emphasized the need to impose
stricter controls in pharmaceutical manufacturing and food processing in order
to regain public confidence in China-made food and medicines. While we cannot
know what further steps the government will take to police the pharmaceutical
market in China, those steps could include harsher sanctions for smaller
violations of law, regulation, or policy, reductions in the opportunities
available to companies to defend against accusations of violations, forced
closure of companies, and broad changes to the regulatory system in which
companies in the industry operate. Any such steps could have a significant
impact on our profitability or our ability to continue operations, which impact
cannot currently be predicted or quantified.




27





The
pharmaceutical distribution industry consolidation may impact our profitability
and operations.





The
pharmaceutical distribution industry in China is highly fragmented. The current
pharmaceutical distribution industry in China lacks the regulatory oversight.
The government has become more aware of the issue and started to tighten its
regulatory supervision over the pharmaceutical distribution
industry.





As the
industry consolidates, we need to distinguish ourselves with better products and
services. We intend to achieve this goal by focusing on distributing higher
quality pharmaceutical products with better efficacies and greater market
demand. In addition, we need to increase our efficiencies in product
distribution. We cannot guarantee that we will be able to meet this goal.
However, the, successful implementation of this strategy will provide upside
potential to our profitability.





Konzern
is subject to restrictions on paying dividends and making other payments to
us.




We are a
holding company incorporated in the State of Delaware and do not have any assets
or conduct any business operations other than our investments in our
subsidiaries. As a result of our holding company structure, we rely primarily on
dividends payments from Konzern, our subsidiary in China. However, PRC
regulations currently permit payment of dividends only out of accumulated
profits, as determined in accordance with PRC accounting standards and
regulations. Konzern is also required to set aside a portion of its after-tax
profits according to PRC accounting standards and regulations to fund certain
reserve funds. The PRC government also imposes controls on the conversion of RMB
into foreign currencies and the remittance of currencies out of China. We may
experience difficulties in completing the administrative procedures necessary to
obtain and remit foreign currency. See “Government control of currency
conversion may affect the value of your investment.” Furthermore, if
Konzern incurs debt on its own in the future, the instruments governing the debt
may restrict its ability to pay dividends or make other payments. If we or
Konzern are unable to receive all of the revenues from our operations through
these contractual or dividend arrangements, we may be unable to pay dividends on
our common stock.




Governmental control of currency conversion may affect the
value of your investment.





The PRC
government imposes controls on the convertibility of Renminbi into foreign
currencies and, in certain cases, the remittance of currency out of the PRC. We
receive substantially all of our revenues in Renminbi, which is currently not a
freely convertible currency. Shortages in the availability of foreign currency
may restrict our ability to remit sufficient foreign currency to pay dividends,
or otherwise satisfy foreign currency dominated obligations. Under existing PRC
foreign exchange regulations, payments of current account items, including
profit distributions, interest payments and expenditures from the transaction,
can be made in foreign currencies without prior approval from the PRC State
Administration of Foreign Exchange by complying with certain procedural
requirements. However, approval from appropriate governmental authorities is
required where Renminbi is to be converted into foreign currency and remitted
out of China to pay capital expenses such as the repayment of bank loans
denominated in foreign currencies.





The PRC
government may also in the future restrict access to foreign currencies for
current account transactions. If the foreign exchange control system prevents us
from obtaining sufficient foreign currency to satisfy our currency demands, we
may not be able to pay certain of our expenses as they come due.




28





The
fluctuation of the Renminbi may harm your investment.





The value
of the Renminbi against the U.S. dollar and other currencies may fluctuate and
is affected by, among other things, changes in the PRC's political and economic
conditions. As we rely entirely on revenues earned in the PRC, any significant
revaluation of the Renminbi may materially and adversely affect our cash flows,
revenues and financial condition. For example, to the extent that we need to
convert U.S. dollars we receive from an offering of our securities into Renminbi
for our operations, appreciation of the Renminbi against the U.S. dollar would
diminish the value of the proceeds of the offering and thereby diminish the
usefulness of the offering to us. Conversely, if we decide to convert our
Renminbi into U.S. dollars for the purpose of making payments for dividends on
our common shares or for other business purposes and the U.S. dollar appreciates
against the Renminbi, the U.S. dollar equivalent of the Renminbi we convert
would be reduced. In addition, the depreciation of significant U.S. dollar
denominated assets could result in a charge to our income statement and a
reduction in the value of these assets.





On July
21, 2005, the PRC government changed its decade-old policy of pegging the value
of the Renminbi to the U.S. dollar. Under the new policy, the Renminbi is
permitted to fluctuate within a narrow and managed band against a basket of
certain foreign currencies. This change in policy has resulted in significant
appreciation of the Renminbi against the U.S. dollar. While the international
reaction to the Renminbi revaluation has generally been positive, there remains
significant international pressure on the PRC government to adopt an even
more flexible currency policy, which could result in a further and more
significant appreciation of the Renminbi against the U.S. dollar.




PRC
regulations regarding offshore financing activities by PRC residents may
increase our administrative burdens and hinder the implementation of our
acquisition strategy, and a failure by our shareholders who are PRC residents to
make filings required by such regulations could make us ineligible to distribute
profits and could expose us and our PRC-resident shareholders to liability under
PRC law.





The PRC’s
State Administration of Foreign Exchange (“SAFE”), through the Notice of SAFE on
Relevant Issues concerning Foreign Exchange Administration for Domestic
Residents to Engage in Financing and Inbound Investment via Overseas Special
Purpose Vehicles (“SAFE Notice 75”), which became effective November 1, 2005,
requires registration with SAFE by the PRC-resident shareholders of any foreign
holding company (such as China Medicine) that owns a PRC entity (such as
Konzern). Without registration, the PRC company cannot remit any profits out of
the PRC as dividends or otherwise. Our major shareholders who are PRC residents
must comply with the registration and disclosure requirements provided in SAFE
Notice 75. Mr. Senshan Yang, our President and Chief Executive Officer and a
PRC-resident shareholder of the Company, has completed registration with SAFE
and was issued a SAFE certificate on January 28, 2006. Our minor PRC-resident
shareholders did not register with SAFE and we believe they are not required to
do so under SAFE Notice 75.





However,
in the event that the proper procedures are not followed under SAFE Notice 75,
we could lose the ability to remit funds outside of the PRC and would therefore
be unable to pay dividends or make other distributions. Our PRC-resident
shareholders could be subject to fines, other sanctions and even criminal
liabilities under the PRC Foreign Exchange Administrative Regulations
promulgated January 29, 1996, as amended.




29





In
connection with the same subject contemplated under SAFE Notice 75, SAFE issued
its Implementation Rules (“SAFE Notice 106”) on May 29, 2007 and the six
ministers in PRC promulgated the Provisions on Merger and Acquisition of
Domestic Enterprises by Foreign Investors effective from September 8, 2006 (the
“M&A Rules”).
Neither of SAFE Notice 106 nor M&A Rules, however, is applicable for us or
our PRC-resident shareholders because they both were effective after we
consummated a reverse merger with Konzern on February 8, 2006.





The
PRC’s legal and judicial system may not adequately protect our business and
operations and the rights of foreign investors.





The PRC
legal and judicial system may negatively impact foreign investors. In 1982, the
National People's Congress amended the Constitution of China to authorize
foreign investment and guarantee the "lawful rights and interests" of foreign
investors in the PRC. However, the PRC's system of laws is not yet
comprehensive. The legal and judicial systems in the PRC are still rudimentary,
and enforcement of existing laws is inconsistent. Many judges in the PRC lack
the depth of legal training and experience that would be expected of a judge in
a more developed country. Because the PRC judiciary is relatively inexperienced
in enforcing the laws that do exist, anticipation of judicial decision-making is
more uncertain than would be expected in a more developed country. It may be
impossible to obtain swift and equitable enforcement of laws that do exist, or
to obtain enforcement of the judgment of one court by a court of another
jurisdiction. The PRC's legal system is based on written statutes; a decision by
one judge does not set a legal precedent that judges in other cases are required
to follow. In addition, the interpretation of Chinese laws may be varied to
reflect domestic political changes.




The
promulgation of new laws, changes to existing laws and the pre-emption of local
regulations by national laws may adversely affect foreign investors. However,
the trend of legislation over the last 20 years has significantly enhanced the
protection of foreign investment and allowed for more control by foreign parties
of their investments in Chinese enterprises. There can be no assurance that a
change in leadership, social or political disruption, or unforeseen
circumstances affecting the PRC's political, economic or social life will not
affect the ability of the PRC government to continue to support and pursue these
reforms. Such a shift could have a material adverse effect on our business and
prospects.





A
slowdown or other adverse developments in the PRC economy may harm our
customers, demand for our services and our business.





As of
December 31, 2008, most of our operations were conducted in the PRC and all of
our revenues were generated from sales in the PRC. Although the PRC economy has
grown significantly in recent years, we cannot assure you that this growth will
continue. We do not know how sensitive we are to a slowdown in economic growth
or other adverse changes in the PRC economy. A slowdown in overall economic
growth, an economic downturn, a recession or other adverse economic developments
in the PRC could significantly reduce the demand for our products and harm our
business.





Because
our principal assets are located outside of the United States and nearly all of
our directors and officers reside outside of the United States, it may be
difficult for you to enforce your rights based on U.S. federal securities laws
against us and our officers and some directors in the U.S. or to enforce a
U.S. court judgment against us or them in the PRC.




Three of
our five directors and all of our officers reside outside of the United States.
In addition, our operating subsidiaries are and substantially all of our assets
are located in the PRC. It may therefore be difficult for investors in the
United States to enforce their legal rights based on the civil liability
provisions of the U.S. Federal securities laws against us in the courts of
either the U.S. or the PRC and, even if civil judgments are obtained in U.S.
courts, to enforce such judgments in PRC courts. Further, it is unclear if
extradition treaties now in effect between the United States and the PRC would
permit effective enforcement against us or our officers and directors of
criminal penalties, under the U.S. Federal securities laws or
otherwise.




30




Because
the scope of our business license is limited, we may need government approval to
expand our business.




We are a
wholly-owned foreign enterprise, commonly known as a WOFE. The scope of our
business is narrowly defined for all businesses in China and the WOFE can only
conduct business within its approved business scope, which ultimately appears on
the business license. Our license permits us to operate as a distributor of
drugs. Any amendment to the scope of our business requires further application
and government approval. Inevitably, there is a negotiation with the authorities
to approve as broad a business scope as is permitted, and we cannot assure you
that we will be able to obtain the necessary government approval for any change
or expansion of our business.




If we
were to seek to manufacture certain higher-value pharmaceutical products in the
future, we would need to have our manufacturing facilities certified with
certain licenses. For example, GMP, or Good Manufacturing Permit from the SFDA,
is mandatory for any facility to manufacture pharmaceutical products in China.
We may be unable to obtain this permit due to our limited qualifications and
experiences in this scope.





If
we are not able to protect our intellectual property rights, our business may be
impaired.




We have
developed proprietary products, which are based on formulation and know-how
developed by us, either by ourselves or pursuant to agreements with others. The
protection of intellectual property in the PRC remains weak, and we cannot give
any assurance that we will be able to protect our intellectual property rights
effectively. All of our products are manufactured by others. Manufacturers and
competitors could potentially copy or simulate our formulations if their
inherent complexity does not make such copying unlikely. If we are not able to
protect our intellectual property rights, the value of our intellectual
property, and our ability to generate revenue from it, would be severely
impaired.




If
the PRC enacts regulations which forbid or restrict foreign investment, our
ability to grow may be severely impaired.




We intend
to expand our business both by increasing our product range and making
acquisitions of companies primarily in the pharmaceutical and related
industries. In addition, we may seek to manufacture our own products. Many of
the rules and regulations that we would face are not explicitly communicated,
and we may be subject to rules that would affect our ability to grow, either
internally or through acquisition of other Chinese or foreign companies. There
are also substantial uncertainties regarding the proper interpretation of
current laws and regulations of the PRC. New laws or regulations that forbid
foreign investment could severely impair our businesses and prospects.
Additionally, if the relevant authorities find us in violation of PRC laws or
regulations, they would have broad discretion in dealing with such a violation,
including, without limitation:




·
            levying
      fines;




31




·
            revoking
      our business and other licenses;




·
            requiring
      that we restructure our ownership or operations;
  and




·
            requiring
      that we discontinue any portion or all of our Internet related
      business.




Any
deterioration of political relations between the United States and the PRC could
impair our operations.




The
relationship between the United States and the PRC is subject to sudden
fluctuation and periodic tension. Changes in political conditions in the PRC and
changes in the state of Sino-U.S. relations are difficult to predict and could
adversely affect our operations or cause potential acquisition candidates or
their goods and services to become less attractive. Such a change could lead to
a decline in our profitability. Any weakening of relations between the United
States and the PRC could have a material adverse effect on our
operations.




Our
operations and assets in the PRC are subject to significant political and
economic uncertainties.




Although
the government of the PRC has been pursuing economic reform policies, government
policies are subject to rapid change and the government may adopt policies which
have the effect of hindering private economic activity and greater economic
decentralization. There is no assurance that the government of the PRC will not
significantly alter its policies from time to time without notice in a manner
with reduces or eliminates any benefits from its present policies of economic
reform. In addition, a substantial portion of productive assets in the PRC
remains government-owned. For instance, all lands are state owned and leased to
business entities or individuals through governmental granting of State-owned
Land Use Rights. The granting process is typically based on government policies
at the time of granting, which could be lengthy and complex. This process may
adversely affect our future expansion, especially if we seek to commence
manufacturing operations. The government of the PRC also exercises significant
control over China's economic growth through the allocation of resources,
controlling payment of foreign currency and providing preferential treatment to
particular industries or companies. Uncertainties may arise with changing of
governmental policies and measures. In addition, changes in laws and
regulations, or their interpretation, or the imposition of confiscatory
taxation, restrictions on currency conversion, imports and sources of supply,
devaluations of currency or the nationalization or other expropriation of
private enterprises could have a material adverse effect on our business,
results of operations and financial condition.




Price
controls may affect both our revenues and net income.




The laws
of the PRC provide for the government to fix and adjust prices. For example, in
2006, some of our products became subject to price controls which subsequently
affected our gross profit, gross margin and net income. In the future, it is
possible that additional products may be subject to price control, especially
products tailored to the rural and low-income population. The government may use
price controls to encourage greater sales of these products in these
populations.





To the
extent that we are subject to price control, our revenue, gross profit, gross
margin and net income will be affected since the revenue we derive from our
sales will be limited and we may face no limitation on our costs. Further, if
price controls affect both our revenue and our costs, our ability to be
profitable and the extent of our profitability will be effectively subject to
determination by the applicable regulatory authorities in the PRC.




32




Our
operations may not develop in the same way or at the same rate as might be
expected if the PRC economy were similar to the market-oriented economies of
OECD member countries.




The
economy of the PRC has historically been a nationalistic, "planned economy,"
meaning it functions and produces according to governmental plans and pre-set
targets or quotas and price controls. We cannot predict the future direction of
these economic reforms or the effects these measures may have. The economy of
the PRC also differs from the economies of most countries belonging to the
Organization for Economic Cooperation and Development, an international group of
member countries sharing a commitment to democratic government and market
economy. For instance:




·
            the
      level of state-owned enterprises in the PRC, as well as the level of
      governmental control over the allocation of resources is greater than in
      most of the countries belonging to the
OECD;




·
            the
      level of capital reinvestment is lower in the PRC than in other countries
      that are members of the OECD;




·
            the
      government of the PRC has a greater involvement in general in the economy
      and the economic structure of industries within the PRC than other
      countries belonging to the OECD;




·
            the
      government of the PRC imposes price controls on certain products and our
      products may become subject to additional price controls;
    and




·
            the
      PRC has various impediments in place that make it difficult for foreign
      firms to obtain local currency, as opposed to other countries belonging to
      the OECD where exchange of currencies is generally free from
      restriction.




As a
result of these differences, our business may not develop in the same way or at
the same rate as might be expected if the economy of the PRC were similar to
those of the OECD member countries.




We
may have limited legal recourse under Chinese law if disputes arise under
contracts with third parties.




Almost
all of our agreements with our employees and third parties, including our
supplier and customers, are governed by the laws of the PRC. The legal system in
the PRC is a civil law system based on written statutes. Unlike common law
systems, such as we have in the United States, it is a system in which decided
legal cases have little precedential value. The government of the PRC has
enacted some laws and regulations dealing with matters such as corporate
organization and governance, foreign investment, commerce, taxation and trade.
However, their experience in implementing, interpreting and enforcing these laws
and regulations is limited, and our ability to enforce commercial claims or to
resolve commercial disputes is unpredictable. The resolution of these matters
may be subject to the exercise of considerable discretion by agencies of the
PRC, and forces unrelated to the legal merits of a particular matter or dispute
may influence their determination. Any rights we may have to specific
performance or to seek an injunction under Chinese law are severely limited, and
without a means of recourse by virtue of the Chinese legal system, we may be
unable to prevent these situations from occurring. The occurrence of any such
events could have a material adverse effect on our business, financial condition
and results of operations.




33




Because
we may not be able to obtain business insurance in the PRC, we may not be
protected from risks that are customarily covered by insurance in the United
States.




Business
insurance is not readily available in the PRC, especially for intangible assets
such as intellectual property. To the extent that we suffer a loss of a type
which would normally be covered by insurance in the United States, such as
product liability and general liability insurance, we would incur significant
expenses in both defending any action and in paying any claims that result from
a settlement or judgment. Since our products are taken as medicine, any damages
which we sustain could be material to our assets and earnings. If the nature or
amount of any uninsured loss is significant, we may be unable to continue in
business.




Because
our funds are held in banks which do not provide insurance, the failure of any
bank in which we deposit our funds could affect our ability to continue in
business.




Banks and
other financial institutions in the PRC do not provide insurance for funds held
on deposit. As a result, in the event of a bank failure, we may not have access
to funds on deposit. Depending upon the amount of money we maintain in a bank
that fails, our inability to have access to our cash could impair our
operations, and, if we are not able to access funds to pay our suppliers,
employees and other creditors, we may be unable to continue in
business.




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




We are
subject to the United States Foreign Corrupt Practices Act, which generally
prohibits United States companies from engaging in bribery or other prohibited
payments to foreign officials for the purpose of obtaining or retaining
business. Foreign companies, including some that may compete with us, are not
subject to these prohibitions. Corruption, extortion, bribery, pay-offs, theft
and other fraudulent practices occur from time-to-time in the PRC. We can make
no assurance, however, that our employees or other agents will not 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.




If
the United States imposes trade sanctions on the PRC due to its current
currency, export or other policies, our ability to succeed in the international
markets may be diminished.




The PRC
currently "pegs" its currency to a basket of currencies, including U.S. dollar.
This means that each unit of Chinese currency has a set ratio for which it may
be exchanged for United States currency, as opposed to having a floating value
like other countries' currencies. This policy is currently under review by
policy makers in the United States. Trade groups in the United States have
blamed the cheap value of the Chinese currency for causing job losses in
American factories, giving exporters an unfair advantage and making its imports
expensive. There is increasing pressure for the PRC to change its currency
policies to provide for its currency to float freely on international markets.
As a result, Congress is considering the enacting legislation which could result
in the imposition of quotas and tariffs. If the PRC changes its existing
currency policies or if the United States or other countries enact laws to
penalize the PRC for its existing currency policies, our business may be
adversely affected, even though we do not sell outside of the PRC. Further, we
cannot predict what action the PRC may take in the event that the United States
imposes tariffs, quotas or other sanctions on Chinese products. Even though we
do not sell products into the United States market, it is possible that such
action by the PRC may nonetheless affect our business since we are a United
States company, although we cannot predict the nature or extent
thereof.




34




Any
recurrence of a widespread public health problem, such as bird flu, could
adversely affect our business.




Any
widespread public health problem, including bird flu, in China, where a
substantial proportion of our revenues are derived, could have a negative effect
on both our revenues and our operations.  We will be able to increase
our revenue going forward due to the expected increase in public healthcare
spending. However, this increase in revenue may result in a lower profit margin
since over-the-counter products, which have lower profit margin, make up a
higher percentage of these sales





Our
operations may be impacted by a number of health-related factors, including the
following:




·
            quarantines
      or closures of some of our offices which would severely disrupt our
      operations,




·
            the
      sickness or death of our key officers and employees,
  and




·
            a
      general slowdown in the economy of the
PRC.




Any of
the foregoing events or other unforeseen consequences of public health problems
could adversely affect our business and results of operations.




If
certain tax exemptions within the PRC regarding withholding taxes are removed,
we may be required to deduct corporate withholding taxes from any dividends we
may pay in the future.




Under the
PRC's current tax laws, regulations and rulings, companies are exempt from
paying withholding taxes with respect dividends paid to stockholders outside of
the PRC. However, if the foregoing exemption is removed, we may be required to
deduct certain amounts from any dividends we pay to our
stockholders.




Risks
Associated with Our Common Stock




There
is a limited trading market for our common stock.




There is
currently a limited market for our common stock. There is no guarantee that
there will ever be a broader market for our common stock or that if such a
market develops, that it will continue. Our stock price may fluctuate
dramatically in the future in response to any of the following factors, some of
which are beyond our control:




·
            variations
      in our quarterly operating results;




·
            announcements
      that our revenue or income are below analysts'
    expectations;




·
            general
      economic slowdowns;




35




·
            matters
      affecting the economy of the PRC and the relationship between the United
      States and the PRC;




·
            changes
      in market valuations of both similar companies and companies whose
      business is primarily or exclusively in the
PRC;




·
            sales
      of large blocks of our common
stock;




·
            announcements
      by us or our competitors of significant contracts, acquisitions, strategic
      partnerships, joint ventures or capital
  commitments;




·
            fluctuations
      in stock market prices and volumes, which are particularly common among
      highly volatile securities of internationally-based companies;
      and




·
            concern
      by potential investors that the large number of shares of common stock may
      have a downward effect upon the market price of the
  stock.





The
rights of the holders of common stock may be impaired by the potential issuance
of preferred stock.




Our
certificate of incorporation gives our board of directors the right to create
new series of preferred stock. As a result, the board of directors has and in
the future may, without stockholder approval, issue preferred stock with voting,
dividend, conversion, liquidation or other rights which could adversely affect
the voting power and equity interest of the holders of common stock. Preferred
stock, which could be issued with the right to more than one vote per share,
could be utilized as a method of discouraging, delaying or preventing a change
of control. The possible impact on takeover attempts could adversely affect the
price of our common stock. Although we have no present intention to issue any
additional shares of preferred stock or to create any new series of preferred
stock and the certificate of designation relating to the Series A restricts our
ability to issue additional series of preferred stock, we may issue such shares
in the future.




Shares
may be issued pursuant to our stock plan which may affect the market price of
our common stock.




We may
issue stock upon the exercise of options or pursuant to stock grants covering a
total of 1,575,000 shares of common stock pursuant to our 2006 long-term
incentive plan, under which options to purchase 380,000shares of common stock at
$1.25 per share are currently outstanding. The total of 625,000 shares remains
reserved and available for distribution under the plan. The exercise of these
options and the sale of the underlying shares of common stock and the sale of
stock issued pursuant to stock grants may have an adverse effect upon the price
of our stock. If we issue all of the shares of common stock issuable pursuant to
the plan, these shares will represent approximately 6.2% of the outstanding
common stock, based on the presently outstanding shares of common stock and
approximately 5.1% of the outstanding common stock, based on the presently
outstanding common stock plus the shares issuable upon exercise of the
outstanding warrants, with a related dilution to the other holders of our common
stock.




36





Because
we are not subject to compliance with rules requiring the adoption of certain
corporate governance measures, our stockholders have limited protections against
interested director transactions, conflicts of interest and similar
matters.




The
Sarbanes-Oxley Act of 2002, as well as rule changes proposed and enacted by the
SEC, the New York Stock Exchange and the Nasdaq Stock Market as a result of
Sarbanes-Oxley requires the implementation of various measures relating to
corporate governance. These measures are designed to enhance the integrity of
corporate management and the securities markets and apply to securities which
are listed on those exchanges or the Nasdaq Stock Market. Because we are not
presently required to comply with many of the corporate governance provisions
and because we chose to avoid incurring the substantial additional costs
associated with such compliance any sooner than necessary, we have not yet
adopted all of these measures. We also are not in compliance with requirements
relating to the distribution of annual and interim reports, the holding of
stockholders meetings and solicitation of proxies for such meeting and
requirements for stockholder approval for certain corporate actions. Until we
comply with such corporate governance measures, regardless of whether such
compliance is required, the absence of such standards of corporate governance
may leave our stockholders without protections against interested director
transactions, conflicts of interest and similar matters and investors may be
reluctant to provide us with funds necessary to expand our
operations.




Failure
to achieve and maintain effective internal controls in accordance with Section
404 of the Sarbanes-Oxley Act could have a material adverse effect on our
business and operating results and stockholders could lose confidence in our
financial reporting.




Effective
internal controls are necessary for us to provide reliable financial reports and
effectively prevent fraud. If we cannot provide reliable financial reports or
prevent fraud, our operating results could be harmed. We are required to
document and test our internal control procedures in order to satisfy the
requirements of Section 404 of the Sarbanes-Oxley Act, which requires increased
control over financial reporting requirements, including attestation by the
company’s registered public accounting firm regarding internal control over
financial reporting. We do not have to comply with the attestation by a public
accounting firm requirement until our December 31, 2009 annual report. Failure
to achieve and maintain an effective internal control environment, regardless of
whether we are required to maintain such controls, could also cause investors to
lose confidence in our reported financial information, which could have a
material adverse effect on our stock price.




Because
of our cash requirements and restrictions in our preferred stock purchase
agreement we may be unable to pay dividends.




We expect
to retain any earnings to finance the growth of our business. Further, we are
prohibited from paying dividends on our common stock while the Series A
preferred stock is outstanding.




Because
we may be subject to the "penny stock" rules, you may have difficulty in selling
our common stock.




If a
public market develops for our common stock and if our stock price is less than
$5.00 per share, our stock may be subject to the SEC's penny stock rules, which
impose additional sales practice requirements and restrictions on broker-dealers
that sell our stock to persons other than established customers and
institutional accredited investors. The application of these rules may affect
the ability of broker-dealers to sell our common stock and may affect your
ability to sell any common stock you may own.




37




According
to the SEC, the market for penny stocks has suffered in recent years from
patterns of fraud and abuse. Such patterns include:




·
            control
      of the market for the security by one or a few broker-dealers that are
      often related to the promoter or
issuer;




·
            manipulation
      of prices through prearranged matching of purchases and sales and false
      and misleading press releases;




·
            "boiler
      room" practices involving high pressure sales tactics and unrealistic
      price projections by inexperienced sales
  persons;




·
            excessive
      and undisclosed bid-ask differentials and markups by selling
      broker-dealers; and




·
            the
      wholesale dumping of the same securities by promoters and broker-dealers
      after prices have been manipulated to a desired level, along with the
      inevitable collapse of those prices with consequent investor
      losses.




As
an issuer of "penny stock," we lack protections provided by federal securities
laws relating to forward-looking statements.




Although
the federal securities law provide a safe harbor for forward-looking statements
made by a public company that files reports under the federal securities laws,
this safe harbor is not available to issuers of penny stocks. As a result, if
our common stock is a “penny stock,” we will not have the benefit of this safe
harbor protection in the event of any claim based upon the material provided by
us contained a material misstatement of fact or was misleading in any material
respect because of our failure to include any statements necessary to make the
statements not misleading.




We
cannot predict when or whether an active market for our common stock will
develop.




In the
absence of an active trading market, you may have difficulty buying and selling
or obtaining market quotations; the market visibility for our stock may be
limited, and the lack of visibility for our common stock may have a depressive
effect on the market price for our common stock.




The
registration and potential sale by our stockholders of a significant number of
shares could encourage short sales by third parties.




Because
there is no public market for our stock, there may be significant downward
pressure on our stock price caused by the sale or potential sale of a
significant number of shares, which could allow short sellers of our stock an
opportunity to take advantage of any decrease in the value of our stock. The
presence of short sellers in our common stock may further depress the price of
our common stock.




If the
selling stockholders sell a significant number of shares of common stock, the
market price of our common stock may decline. Furthermore, the sale or potential
sale the offered shares and the depressive effect of such sales or potential
sales could make it difficult for us to raise funds from other
sources.





Because
the holders of our warrants have cashless exercise rights, we may not receive
proceeds from the exercise of the outstanding warrants if the underlying shares
are not registered.




The
holders of our warrants have cashless exercise rights, which provide them with
the ability to receive common stock with a value equal to the appreciation in
the stock price over the exercise price of the warrants being exercised. This
right is not exercisable during the first twelve months that the warrants are
outstanding and thereafter if the underlying shares are subject to an effective
registration statement. To the extent that the holders of the warrants exercise
this right, we will not receive proceeds from such exercise.




38




ITEM 2. DESCRIPTION OF
PROPERTY


We renewed our lease of approximately
4500 square feetof office
space at Room 702GuangriMansion No. 9, South
Wuyang Xin Chengsi,
Guangzhou, PRC from GuangzhouCarpentry Company for a term of eight
months which expires on August 31, 2009, pursuant to which the total rent is
approximately $22,064.


We
currently have a lease for Room 701 Guangri Mansion No. 9, South Wuyang Xin
Chengsi, Guangzhou, China from Guangzhou Carpentry Company which we extended for
four months from January 1, 2009 to April 30, 2009 for the total rent of
approximately $8,802. Upon its expiration, we will use a new space which we have
leased from Guangzhou Carpentry Company. The new lease is for the 2nd floor
Guangri Mansion No. 9, South Wuyang Xin Chengsi, Guangzhou, China and is valid
from March 1, 2009 to Feburary 28, 2012 for the total rent of approximately
$156,324.




We
currently have a lease for Room 803 Guangri Mansion No. 9, South Wuyang Xin
Chengsi, Guangzhou, China from Guangzhou Carpentry Company from January 1, 2009
to March 31, 2009 for the total rent of approximately $2,993.





We
renewed our one-year lease of approximately 9,688 square feet of warehouse space
at 67 Shahe Road, Tianhe District, Guangzhou City, for which we pay an annual
rent of approximately $30,807.




Co-Win
leased Room 901 Guangri Mansion No. 9, South Wuyang Xin Chengsi, Guangzhou,
China from Guangzhou Carpentry Company for thirty-two months from August 1, 2008
to April 30, 2011. The total rent is approximately $77,458.





Co-Win
also leased an office space of approximately 300 square feet from January 1,
2009 to November 30, 2013 for total of $6,751.





Co-Win
entered into a lease agreement with Guangzhou Municipal Microbe Research
Institute (the “Research Institute”), pursuant to which Co-Win an entire floor
in a industrial building located at No.1 Jiantashan Road, Luogang District in
Guangzhou with a total area of approximately 8000 square feet for the term of
five years from December 1, 2008 to November 30, 2013 for no consideration as
part of an arrangement relating to cooperation between the parties in
development of ADTZ. This cooperation is carried out pursuant to a technology
development entrustment agreement described in more detail under Item 1
“Business”.




39





We
believe that our facilities are adequate for the conduct of our business for the
foreseeable future.




ITEM 3. LEGAL PROCEEDINGS





Neither
the Company nor Konzern is currently a party to any pending or threatened legal
proceeding.





ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF
SECURITY HOLDERS





No
matters were submitted to a vote of shareholders during the fourth quarter
of  the fiscal year ended December 31, 2008.




PART II





ITEM 5. MARKET FOR REGISTRANT’S COMMON
EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY
SECURITIES





There is
a limited market for our common stock.




Dividends




We have
not paid dividends on our common stock. We plan to retain future earnings, if
any, for use in our business, and do not anticipate paying dividends on our
common stock in the foreseeable future. Prior to the reverse acquisition on
February 8, 2006, Konzern made distributions to its stockholders, including a
2006 cash distribution of $1.9 million and a distribution of $1.2 million of
inventory. At the time of the distribution, Konzern was a privately-owned
Chinese limited liability company, with income being taxed to stockholders. The
distributions by Konzern were made partly in inventory in order to maintain cash
in the business.




Market
for Our Common Stock




Our
common stock is traded in the over-the-counter market and quotations are
reported on the over-the-counter Bulletin Board overseen by FINRA under the
symbol CHME. The table below sets forth the high and low bid price for each
quarter since there has been a market for our common stock, as reported by the
Yahoo Finance website at http://finance.yahoo.com/q?s=CHME.OB.




These
quotations reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not represent actual transactions.




High
            
            
            LowFourth
      Quarter 2008
            
            $
            1.70
            
            
            $
            0.66Third
      Quarter 2008
            
            $
            2.65
            
            
            $
            1.55Second
      Quarter 2008
            
            $
            3.05
            
            
            $
            1.81First
      Quarter 2008
            
            $
            2.90
            
            
            $
            1.55Fourth
      Quarter 2007
            
            $
            4.48
            
            
            $
            2.90Third
      Quarter 2007
            
            $
            3.35
            
            
            $
            2.20Second
      Quarter 2007
            
            $
            4.45
            
            
            $
            2.70First
      Quarter 2007
            
            $
            3.75
            
            
            $
            2.70Fourth
      Quarter 2006
            
            $
            3.25
            
            
            $
            2.50




40




As of
March 25, 2009, there are approximately 33 holders of record of our common
stock.





Securities
Authorized for Issuance under Equity Compensation Plan





The
following table summarizes the equity compensation plans under which our
securities may be issued as of the date of this report.




Plan
      Category
            
            Number
      of securities 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 issuance under
      equity
              compensation
      plans (excluding securities reflected in column (a))Equity
      compensation plans approved by security holders
            
            380,000
            
            $
            1.35
            
            625,000Equity
      compensation plan not approved by security holders
            
            —
            
            
            —
            
            —Total
            
            380,000
            
            
            
            
            625,000




A 2006
long-term incentive plan and the outstanding options were approved by our board
of directors and stockholders.




41




Recent
Issuances of Securities





As of
March 25, 2009, we have issued an aggregate of 3,178,452 shares of common stock
upon the conversion of the Company’s series A preferred stock held by the
holders as stated in the following table:




Date
            
            Holders
            
            Common
      Stock Issued upon Conversion of Shares of Series A Preferred
      Stock11/16/2006
            
            Barron
      Partners, L.P.
            
            
            100,00011/20/2006
            
            Barron
      Partners, L.P.
            
            
            200,00012/06/2006
            
            Barron
      Partners, L.P.
            
            
            300,00012/19/2006
            
            Barron
      Partners, L.P.
            
            
            180,0001/10/2007
            
            Barron
      Partners, L.P.
            
            
            190,0002/08/2007
            
            Ray
      and Amy Rivers, JTROS
            
            
            100,0002/26/2007
            
            William
      Denkin
            
            
            160,0004/18/2007
            
            Barron
      Partners, L.P.
            
            
            458,5004/24/2007
            
            Barron
      Partners, L.P.
            
            
            300,0004/30/2007
            
            Steven
      Mazur
            
            
            164,9486/19/2007
            
            Barron
      Partners, L.P.
            
            
            100,0006/21/2007
            
            Barron
      Partners, L.P.
            
            
            300,00010/04/2007
            
            Barron
      Partners, L.P.
            
            
            309,90310/10/2007
            
            Barron
      Partners, L.P.
            
            
            200,00001/17/2008
            
            Barron
      Partners, L.P.
            
            
            1,59702/26/2008
            
            Barron
      Partners, L.P.
            
            
            51,64905/07/2008
            
            Ray
      and Amy Rivers, JTROS
            
            
            61,855Total:
            
            
            
            
            3,178,452




From
January to March 2007, we issued an aggregate of 1,621,750 shares of common
stock upon the exercise of warrants at $1.75 per share to Barron Partners,
L.P. for gross proceeds of $2,838,063.





From
April to May 2007, we issued an aggregate of 1,694,040 shares of common stock
upon the exercise of warrants at $1.70 per share to Barron Partners, L.P.
for gross proceeds of $2,879,869. From October to December 2007, we issued an
aggregate of 725,000 shares of common stock upon the exercise of warrants at
$2.43 per share to Barron Partners, L.P. for gross proceeds of
$1,761,750.





The
shares of common stock issued upon the conversion of series A preferred stock
and exercise of warrant were registered in the Registration Statement filed by
the Company on April 13, 2006 and declared effective by the SEC on October 17,
2006 for the resale by the holders.





As of
March 25, 2009, we had the following shares of common stock reserved for
issuance:





·
            3,348,686
      shares issuable upon exercise of the warrants issued to the investors in
      the February 2006 private
placement.





·
            625,000
      shares issuable upon exercise of stock options or other equity-based
      incentives pursuant to our 2006 long-term incentive plan, which is subject
      to stockholder approval.





Transfer
Agent





The
Company's stock transfer agent is Continental Stock Transfer & Trust
Company, located at 17 Battery Place, New York, New York 10004. Their telephone
number is 212-509-4000, and their facsimile is 212-509-5150.




42





Penny
Stock Regulations





The SEC
has adopted regulations which generally define a “penny stock” to be an equity
security that has a market price of less than $5.00 per share. Our common stock
falls within the definition of penny stock and is subject to rules that impose
additional sales practice requirements on broker-dealers who sell such
securities to persons other than established customers and accredited investors
(generally those with assets in excess of $1,000,000, or annual incomes
exceeding $200,000 or $300,000, together with their spouse).





For
transactions covered by these rules, the broker-dealer must make a special
suitability determination for the purchase of such securities and have received
the purchaser’s prior written consent to the transaction. Additionally, for any
transaction, other than exempt transactions, involving a penny stock, the rules
require the delivery, prior to the transaction, of a risk disclosure document
mandated by the Commission relating to the penny stock market. The broker-dealer
also must disclose the commissions payable to both the broker-dealer and the
registered representative, current quotations for the securities and, if the
broker-dealer is the sole market-maker, the broker-dealer must disclose this
fact and the broker-dealer’s presumed control over the market. Finally, monthly
statements must be sent disclosing recent price information for the penny stock
held in the account and information on the limited market in penny stocks.
Consequently, the “penny stock” rules may restrict the ability of broker-dealers
to sell our common stock and may affect the ability of investors to sell their
common stock in the secondary market.





ITEM 7.  MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND RESULTS OF OPERATION





The
following discussion and analysis of our financial condition and results of
operations should be read in conjunction with the financial statements and
accompanying notes and the other financial information appearing in Part I,
Item 1 and elsewhere in this report.





Statements
in this discussion that are not statements of historical fact could turn out to
be untrue and are subject to the risks and uncertainties described in the “Risk
Factors” and “Predictive Statements and Associated Risk” sections of this
report.





Overview





China
Medicine Corporation (“we,” “us” or the “Company”), through Guangzhou Konzern
Medicine Co., Ltd. (“Konzern”), our wholly owned subsidiary organized under the
laws of the People’s Republic of China (the “PRC” or “China”), is a distributor
of approximately 2,400 pharmaceutical products in China. Also as a developer of
innovative pharmaceutical products, currently the Company has four patents
registered with the State Food and Drug Administration of PRC (“SFDA”), and has
seven others pending for approval.





Most of
our revenues have derived from three sources, the distribution of pharmaceutical
products from suppliers, the distribution of self-developed pharmaceutical
products (including Bumetanide injection, Ozagrel Dried powder injection,
Levocarnitine dried powder injection), as well as the development and transfer
of intellectual property, including drug formulas and production techniques. In
particular, for the year ended December 31, 2008, the revenue from sales of
self-developed pharmaceutical products amounted $2,889,306, an increase of
$664,284 from $2,225,022 for 2007.




43





In
December of 2008 we obtained rights to distribute dental equipment and
instruments in Guangdong Province, but we did not generate any income from this
source in 2008.





The
pharmaceutical products we distribute, either from outside suppliers or
self-developed, include prescription and over-the-counter drugs, Chinese herbs,
traditional Chinese medicines made from Chinese herbs, nutritional supplements,
dietary supplements and medical instruments.





Although
we are competing with large state-owned medicine distributors that are better
capitalized than we are, we believe that our unique competitive advantages
include our ownership of good research and development facilities, our excellent
after-sale customer service, and the sole nationwide or region-wide distribution
rights to certain medical products. Our competitive pricing and our ability to
provide timely delivery are also important factors to attract and retain our
customers.





The
Chinese government has recently begun the initiative to draft a series of
policies to broaden the healthcare coverage for the population in the rural
region. Although the details of the reform are still unclear, it is certain that
the reform will result in increased healthcare spending from rural population
and low income families.





Government
may either subsidize hospitals or healthcare institutions in rural areas, or
subsidize medicine manufacturers or distributors if they can distribute their
products to rural areas with preset profit margins.





At the
same time, as the disposable income in these area increases, and the aging of
the rural population, the demand for healthcare products would potentially
become stronger in the years to come. Management would carefully analyze this
situation and try to catch up with new opportunities.





Our
distribution business greatly depends on our ability both to acquire our
products and to distribute our products in the Chinese markets. Typically,
exclusive rights to nationwide or to certain regions would contribute higher
profit margins than non-exclusive distribution. Besides our exclusive rights to
nationwide distribution of seven products made by our suppliers, we also have
distribution rights throughout Guangdong Province of 516 products made by our
suppliers.





We have
exclusive rights to nationwide distribution of seven products made by our
suppliers, which accounted for approximately 29.4% of our sales in fiscal year
2008 and 21.1% of our sales in fiscal year 2007. The most significant of these
products are Iopamidol Injection 370 and 300 prescription medicines that are
used for angiography & CT scanning. For the years ended December 31, 2008
and 2007, our total revenue from sales of these products amounted to $6,119,551
and $4,983,684, respectively, which were 11.4% and 11.8% of our annual sales for
the years ended December 31, 2008 and 2007, respectively.





Beginning
in 2007, in an effort to help consolidate the provincial medicine acquisition
market and promote a transparent bidding process, the provincial government of
Guangdong Province established an on-line bidding system called the “Guangdong
Sunshine Medicine Public Internet Bidding System.” We believe the new system
provides us with greater opportunities to compete for distribution rights in
Guangdong Province.





During
2008, we had an important breakthrough in regional exclusive distribution. Prior
to 2007, we had no exclusive regional sales rights from our suppliers. Thanks to
an on-line bidding system called the “Guangdong Sunshine Medicine Public
Internet Bidding System”, which will be described below in more detail, we
successfully obtained from our suppliers the exclusive regional sales rights in
Guangdong Province of the PRC for 774 products in 2007 and for 516 products in
2008. Revenue from sales generated from the distribution through the bidding
system was $17,466,987 or 32.6% of our total revenue during the year ended
December 31, 2008, and $5,508,551 or 13.1% of our total revenue during the year
ended December 31, 2007.




44





According
to the system’s policy, we can continue to possess the aforesaid distribution
rights and use them to generate revenues in 2009. We began the sales of these
products immediately after we obtained the rights, and expect a great increase
of sales from them would become an important driver of our growth in 2009.
Management also has an optimistic expectation to obtain rights to sale of more
products from this bidding system for the years ahead.





During
the fiscal year 2008, our reliance on certain suppliers has decreased. Our five
largest suppliers accounted for 47.2% of our total purchases for the year ended
December 31, 2008, compared to 56.2% for the year ended December 31, 2007. Our
agreements with our suppliers generally have a term of one year and provide that
the suppliers will provide us with the products we order.





However,
we are frequently required to make a significant down payment when we place an
order, in order to secure the lowest possible purchase price and broadest
possible distribution area. These down payments are made pursuant to contracts
with the suppliers, and to the extent that we reduce the size of the order, we
will receive a credit from the supplier. As of December 31, 2008, we had a total
balance of such advances to suppliers of $6,121,974.





At the same time, our reliance on certain customers was also
reduced. Our five largest customers accounted for 37.9% of total sales for the
year ended December 31, 2008, compared to 39.5% for the corresponding period of
2007. Currently we have approximately 800 customers.





Our
customers are typically wholesale medical product companies, hospitals and
retail drug stores. Our contracts with our customers do not provide for minimum
purchases, and our customers are not restricted from purchasing competitive
products from others.





Our
typical collection period ranges from three months to one year. In addition, it
generally takes one to two months to receive products from our suppliers after
we place an order. In order to have product available to meet anticipated
orders, we have been increasing our inventory in recent months, which has
required increased advance payments to our suppliers. In some cases, we must
maintain funds on deposit with a supplier. These factors require us to use
significant cash in our operations.





Because a
substantial portion of our sales were made to a small number of customers, our
accounts receivable from a small number of customers represented a large
percentage of our accounts receivable and assets. Our largest account receivable
as of December 31, 2008 was approximately $4,343,277, representing approximately
22.6% of our total accounts receivable, 9.7% of our total assets, 8.1% of total
sales and approximately 13.3% of our working capital. Our three largest accounts
receivable were approximately $8,383,477, representing approximately 43.6 % of
our total accounts receivable, or approximately 18.8% of our total assets, 15.6%
of total sales and approximately 25.7% of our working capital. This
concentration of accounts receivable represents a significant credit risk,
although the credit risk has been alleviated after the strong effort of the
management.




45





In 2008,
the revenue from sales of our core distribution increased stably. We will
continue to extend our distribution networking and product mix. We expect to add
at least one national distribution product in the coming year. Currently, we are
negotiating the distribution of a pharmaceutical product manufactured in Hong
Kong and used in the treatment of skin disease. Meanwhile, we are in the process
of launching a series of our self-developed products such as BeThin Tablets,
multivitamin pack and three types of herbal tea within the territory of China
and the US. In this regard, we will allocate more resources to the promotion of
self-developed products such as multivitamin pack and three types of herbal tea
in 2009.





In
nature, the pharmaceutical distribution industry in China is still very
fragmented, and therefore, inefficient. Distributors compete with each other
without sufficient regulatory control from the government, although Chinese
government has realized and has been trying to initiate new or remedial
regulations over this industry.





To
distinguish ourselves from peers, we have been striving to build up our
reputation as a better quality products provider with excellent services. We
have been aiming at distributing those pharmaceutical products which are more
effective in treatment, more stable in quality, and higher market
demand.





Although
the distribution of our suppliers’ pharmaceutical products has been the major
source of revenues, amounting to 92.1% and 87.9% of our total revenues in 2008
and 2007 respectively, management strongly believes that it is our long term
strategy to distribute our self-developed pharmaceutical products, and to
develop intellectual properties, including drug formulas and production
techniques.





Our
established reputation and marketing network as a distributor can be a valuable
asset for production outsourcing. We can make orders to certain manufacturers,
requiring them to produce some value-added pharmaceutical products with the
standards set by us. At the same time, if we assess that combining the
manufacturing of certain products with our distribution business would create
synergy, we may consider acquire some manufacturing assets. In doing so,
management, especially our financial team will carefully review our financial
position, reasonably price the acquisition target, and negotiate to minimize the
costs associated. We believe it is a good strategy to reap the most profitable
parts of medicines production, to minimize operational risks, and to reduce the
resources spent.





Typically
we purchase the intellectual rights of drug formulas at an early stage of
development from outside research institutes, then perform research and
determine how to make improvements. After our improvements, we may eventually
sell these improved drug formulas to our customers.





On July
7, 2006, we created a PRC joint-venture company together with Guangzhou Ji'nan
Science & Technology Industrial Group ("JSIG") and Prof. Dongsheng Yao.
Konzern owns a 70% equity interest in Co-Win. The purpose of the company,
Guangzhou Co-win Bioengineering Co., Ltd. (“Co-Win”), is to develop applications
for aflatoxin-detoxifizyme, or ADTZ, an enzyme that can eliminate aflatoxin from
food and animal feed. Aflatoxin, a toxic substance that causes liver, stomach
and lung cancers in animals and humans, is produced by the common aspergillus
fungus and frequently affects cereal grains, oilseeds, spices and acorns. During
the year 2007, JSIG worked hard to develop ADTZ. In 2008, we improved the
techniques of zymosis and relevant technologies. Furthermore, we purchased and
installed the equipment for the manufacturing of ADTZ, which had been examined
and approved by the Guangdong Feed Bureau. We expect to undertake the
commercialization of our development in 2009, including the grant of production
permit by Ministry of Agriculture of PRC and trial sales. With respect to the
technology transfer of ADTZ, we expect to obtain the premium for ADTZ patent
transfer from one country in 2009. Management believes that the
commercialization of ADTZ would be one of the most important drivers to our
future growth.




46





Considering
the current economic atmosphere as well as the development history of Chinese
economy, the management believes that we entered the era of high operating cost.
Given the character of our business operations, we should focus on the following
aspects in order to survive in this era:





Ÿ
              develop
      high-tech products and grasp the new
market;


Ÿ
              improve
      our service in order to maintain the friendly relationship with our
      clients; and




Ÿ
              promote
      brand recognition of both our company and
  products.





In order
to achieve the aforesaid goal, we have to take the following steps:





Ÿ
              speed
      up the commercialization of ADTZ and facilitate the entry into
      market;




Ÿ
              improve
      our service and expand our distribution line of products. In particular,
      we intend to obtain an exclusive national distribution rights for certain
      products which will increase our revenue from sales;
  and




Ÿ
              use
      to full extent market opportunities to expand our business in the current
      economic climate, e.g., by taking advantage of favorable pricing terms to
      acquire a business possessing rights to pharmaceutical products with a
      high degree of market recognition. We believe that this is essential for
      the establishment of a corporate
brand.





Because
most of our business is conducted in the PRC, our transactions are predominantly
accounted for in Chinese Renminbi (RMB). Our financial condition and the results
of our operations, expressed in terms of United States dollars (USD), is
dependent upon the applicable currency exchange rate, which can change
significantly from period to period and may be affected by the relationship
between the United States and the PRC. During the fiscal year 2007, US dollars
have been depreciating versus Chinese Yuan. The exchange rate of USD versus RMB
declined from 0.1371 as of January 1, 2008 to 0.1467 as of December 31, 2008. As
a result, we incurred a translation gain of $2,305,499, which is recognized as
other comprehensive income.





Results
of Operations





The
following table sets forth our statements of operations for years ended December
31, 2008 and 2007, in U.S. dollars:


Year
      Ended
              December
      31,2008
            
            2007Revenue
            
            
            53,647,806
            
            42,105,387Product
      sales
            
            
            52,307,211
            
            39,247,130Medical
      formula sales
            
            
            1,340,595
            
            2,858,257Costs
      of goods sold
            
            
            38,074,919
            
            29,708,088Gross
      profit
            
            
            15,572,887
            
            12,397,299R&D
      expenses
            
            
            840,437
            
            651,990Selling,
      general and administrative costs
            
            
            3,804,585
            
            3,330,907Income
      from operations
            
            
            10,927,865
            
            8,414,402Other
      income, net
            
            
            85,622
            
            15,423Income
      before income taxes & Minority interest
            
            
            11,013,487
            
            8,429,825Provision
      for income taxes
            
            
            2,006,137
            
            1,649,114Income
      before Minority interest
            
            
            9,007,350
            
            6,780,711Minority
      interest
            
            
            118,266
            
            94,658Net
      income
            
            
            9,125,616
            
            6,875,369Other
      comprehensive incomeForeign
      currency translation adjustment
            
            
            2,305,499
            
            1,621,672Comprehensive
      income
            
            
            11,431,115
            
            8,497,041




47




Our
revenue is derived primarily from the sale of prescription and over-the-counter
medicines, Chinese herbs, traditional Chinese medicines derived from Chinese
herbs, dietary supplements, and medical instruments (collectively “product
sales”) and the sale of medical formulas (“medical formula sales”). The
following table sets forth the revenues and percentage of revenues derived from
each of these types of products.




Years
      Ended December 31,2008
            
            2007Prescription
      and Over the Counter Western Medicine
            
            $
            34,929,442
            
            65.10%
            
            $
            19,125,485
            
            45.42%Traditional
      Chinese Medicine
            
            
            15,995,335
            
            29.82%
            
            
            19,419,435
            
            46.12%Herbs
      & Medicine materials
            
            
            0
            
            0%
            
            
            5,048
            
            0.01%Dietary
      Supplements
            
            
            450,776
            
            0.84%
            
            
            126,538
            
            0.30%Medical
      Instruments
            
            
            878,904
            
            1.64%
            
            
            331,610
            
            0.79%Others
            
            
            52,754
            
            0.10%
            
            
            239,014
            
            0.57%Medical
      Formula
            
            
            1,340,595
            
            2.50%
            
            
            2,858,257
            
            6.79%Total
            
            $
            53,647,806
            
            
            
            $
            42,105,387





Revenue





Total
revenue for the year ended December 31, 2008 was $53,647,806, an increase of
$11,542,419, or 27.4%, from total revenue of $42,105,387 for the year ended
December 31, 2007.





Revenue
from product sales for the year ended December 31, 2008 was $52,307,211, an
increase of $13,060,081, or 33.3%, from revenue of $39,247,130 for the year
ended December 31, 2007. Revenue from exclusive national distribution of seven
products as of December 31, 2008 increased by $6.9 million compared with that of
2007. As of December 31, 2008 we have obtained regional distribution rights in
Guangdong Province for 516 products, which generated $17,466,987 revenue
representing 32.6% of total revenue during the year ended December 31, 2008.
Revenue from products obtained through bidding system as of December 31, 2007
was $5,508,551, representing 13.1%. The increase of $11.96 million was due to
increase in product sales primarily driven by an increase in over-the-counter
products sales through our continued expansion of distribution network in
municipal and rural areas of Guangdong Province. In addition, an earlier Chinese
New Year resulted in many orders having been booked prior to December 31, 2008
which contributed to the sales growth.





Medical
formula sales were $1,340,595 or 2.5% of total sales, and $2,858,257 or 6.8% of
total sales, for the years ended December 31, 2008 and 2007, respectively. These
amounts represent proceeds from the sale of certain technology and know-how
relating to the production of medicines. We initially acquired the technology in
an undeveloped state from other companies, undertook research and development to
make improvements, and sold the improved technology to drug manufacturers. The
primary reason for the decrease in medical formula sales is that fewer new
customers have signed contracts for medical formula sales in 2007. We believe
this is due to regulatory action by the State Food and Drug Administration
(“SFDA”), which must approve every transfer of ownership of a medical formula in
the PRC, and which recently enhanced its approval procedures by setting higher
application criteria which requires more time for review.




48





The
decrease in technology transfer was due to: (i) the decrease in overall demand;
after the outbreak of Sichuan earthquake and milk-adulteration scandal, Chinese
government imposed stricter criteria on manufacturing of food and pharmaceutical
products; and (ii) lack of improvement of manufacturing technique. Since the
Chinese government does not provide a clear guideline on regulation of the
manufacturing and formulation technique, it is advisable for a pharmaceutical
company not to increase the R&D expense on technique improvement at this
stage. Considering the market demand and regulatory environment, we believe that
medical formula sales will decrease in the foreseeable future. Moreover, we see
that international transfer of ADTZ patent will be a considerable growth factor
in near future and therefore will boost the revenue generated by technology
transfers.





Cost
of revenue





Cost of
revenue for the year ended December 31, 2008 was $38,074,919, or 71% of total
revenue, compared to $29,708,088, or 70.6% of total revenue in 2007. The
increase in costs was due primarily to the increase in sales described above,
and to a lesser extent to the reasons described below that had impact on gross
margin.





Gross
Profit and Gross Margin





Gross
profit for the year ended December 31, 2008 was $15,572,887, an increase of
$3,175,588, or 25.6%, from $12,397,299 for the year ended December 31, 2007. Our
gross margin for the year ended December 31, 2008 was 29.0%, as compared with
29.4% for the year ended December 31, 2007.





The
slight decrease in our gross margin was due primarily to the setup of the
aforesaid distribution network and the introduction of new over-the-counter
products to satisfy this network. Although the over-the-counter product
distribution had lower margins than our average, we still strategically
allocated some resources to this market, since we anticipated that associated
market in the rural areas had great potential.





Because
we do not intend to continue introducing new products of this kind into our
product line to a significant degree in the coming years, we do not expect the
tendency of decreasing profit margins will continue.





Research
and Development Expenses





Research
and development expenses were $840,437 for the year ended December 31, 2008,
compared with $651,990 for the year ended December 31, 2007.Under the regulation on new
drug registration, experiment data in some application materials should be done
by the appointed laboratory. In this sense, additional experiments were required
which increased our research and development expense. In both periods, these
expenses were used primarily for the pre-clinical study of the Yutian capsule, a
traditional Chinese medicine designed for use in the treatment of lung cancer
that is being developed jointly by Konzern and the Pharmaceutical Research
Institute of Nanhua University. As of the date of this report, our patent
application for the Yutian capsule is pending before the PRC National
Intellectual Property Bureau and we expect to receive the patent in 2010. We
filed an application with SFDA for clinic research for Yutian
capsule.




49





Management
is committed to establishing a long term strategy in research and development.
Nevertheless, management also carefully evaluates the cash available, the
proportions of this expenditure to total revenues and net income, as well as the
potential contributions to our business.





Selling,
General and Administrative Expenses





Selling,
general and administrative expenses were $3,804,585 for the year ended December
31, 2008, an increase of $473,678 from $3,330,907 for the year ended December
31, 2007. The increase was mainly due to: (i) increased freight expenses, (ii)
an increase in depreciation expense, (iii) increased advertising, trade-show and
marketing expenses, and (iv) an increase in professional service fees to our
auditors, legal counsel and consultants. The freight expenses for the year ended
December 31, 2008 were $491,213, an increase of $208,322 from $282,891 for 2007.
Depreciation expense of fixed assets was $420,769 in 2008, an increase of
$116,512 from $303,957 for 2007. We participated in a series of activities to
promote our newly-developed products such as BeThin Tablets. As a result,
advertising, trade-show and marketing expenses accounted for $536,674 in 2008,
an increase of $125,374 from $411,300 for 2007. Professional service fees were
$519,799 in 2008, an increase of $60,516 from 459,283 in 2007.





Because
we do not expect significant increases in those categories of expenses over the
next several quarters, we do not expect the percentage of selling, general and
administrative expenses from total revenues to continue to
increase.





Income
Taxes





Provision
for income taxes was $2,006,137 for the year ended December 31, 2008, compared
with $1,649,114 for the year ended December 31, 2007. The increase was due to
the growth of sales revenue and operating income.





Net
Income





Net
income for the year ended December 31, 2008 was $9,125,616, an increase of
$2,250,247, or 32.7% from $6,875,369 for the year ended December 31, 2007. The
increase was mainly due to the increase of our core business, the distribution
of pharmaceutical products.




50





Liquidity
and Capital Resources





As of
December 31, 2008, we had $2.8 million in cash and cash equivalents. We have
historically funded our working capital needs from operations, advance payments
from customers, bank borrowings, and capital from shareholders. Our working
capital requirements are influenced by the level of our operations, the
numerical and dollar volume of our contracts, the progress of our contract
execution, and the timing of accounts receivable collections. During the year
ended December 31, 2008, as a result of the exercise of options, we received net
proceeds of approximately $362,500. We expect the holders of warrants and
options will continue to exercise their holdings in 2009, thus generating cash
proceeds for our business. However, the amount of cash proceeds is
uncertain.





Operating
Activities





Net cash
provided by operating activities was $4,209,084 for the year ended December 31,
2008, an increase of $6,519,197 or 282% from net cash of $2,310,113 used in our
operations for the year ended December 31, 2007. The increase in net cash
provided by operating activities was largely due to the increase in net income
because of the increased sales, and decrease of inventories and advances to
suppliers.





Investing
Activities





Net cash used in investing activities
was $7,863,267 during the fiscal year ended December 31, 2008, an increase of
$7,473,679 or 1,918%, from net cash of $389,588 used in investing activities
during the fiscal year ended December 31, 2007. Net cash used in investing
activities consisted primarily of payments for the acquisition of equipment and
rights to products. The increase of net cash used in investing activities is
attributable to the acquisition of ADTZ equipment, deposit for a patent for the
method of manufacturing BCG vaccine and payment for exclusive distribution
rights to special multivitamin pack.





Financing
Activities





Net cash
provided by financing activities was $362,500 during the fiscal year ended
December 31, 2008, a decrease of $7,467,181 or 95%, from net cash of $7,829,681
used in financing activities during the fiscal year ended December 31, 2007.
Such decrease in net cash provided by financing activities was primarily
attributable to a decrease in conversions of outstanding preferred stock,
warrants and options during the fiscal year ended December 31,
2008.





As of
December 31, 2008, we had working capital of $32,577,669, an increase of
$4,033,308 or 14.1%, from $28,544,361 as of December 31, 2007.




51





The
following table sets forth the changes in certain balance sheet items, in U.S.
dollars and percentages, from December 31, 2007 to 2008.





Balance Sheet Caption
            
            Change
      in US dollars
              12/31/07
      to 12/31/08
            
            Percentage
      Change
              12/31/07
      to
              12/31/08Accounts
      receivable
            
            5,598,744
            
            
            41.1
            %Inventories
            
            776,862
            
            
            19.7
            %Advances
      to suppliers
            
            138,697
            
            
            2.3
            %Accounts
      payable
            
            (15,664
            )
            
            (20.4
            )%Customer
      deposits
            
            (51,852
            )
            
            (25.5
            )%




The
change in these balance sheet captions reflects the nature of the cash
requirements of our business. Because it takes one to two months to receive
products we order, we have been increasing our inventories in order to meet
anticipated increases in sales, and to protect us from the inflationary
macroeconomic environment. From December 31, 2007 to December 31, 2008, our
inventories increased 19.7%.





In the
course of our business, we must make significant deposits to our suppliers when
we place an order. Our advances to suppliers increased 2.3% from December 31,
2007 to December 31, 2008 because of an increase in our purchases resulting from
increased sales and our payment policies, whereby we try to pay our suppliers
(other than required down payments) once or twice a year. As of December 31,
2008, our advance payments to our suppliers totaled approximately
$6,121,974.





In
addition, our customer deposits decreased 25.5% from December 31, 2007 to
December 31, 2008, which reflects that we had delivered goods to our customers
and then the customer deposits turned into the payment of sales. We require our
customers to pay a certain percentage of the sales price as a deposit before we
ship products to them. The percentage varies from customer to customer, under
management’s discretion. During the course of business, we may reduce the
deposit requirement for some customers with good credit.





During
2008, we purchased equipment to conduct ADTZ research project in cooperation
with the Guangzhou Municipal Microbe Research Institute for a total purchase
price of $2.5 million.





In May
2008, we entered into agreements with Aohai Biotech Company Ltd. relating to
acquisition of distribution rights to a multivitamin pack and manufacturing of
the multivitamin pack and our self-developed products such as various types of
herbal tea. Pursuant to the agreements, we made the payment of approximately
$2.3 million as follows: $0.9 million as consideration for the 15-year exclusive
distribution rights to the multivitamin pack, $0.3 million as prepayment for its
manufacturing, and $1.1 million as prepayment for manufacturing of herbal
tea.





In
addition, we paid $2,934,000 (RMB 20,000,000) as a deposit on an ownership for
BCG (Bacillus Calmette-Guerin) vaccine for the prevention of infection in
bladder cancer patients post surgery. Specifically, on June 1, 2008, we entered
into an agreement with Guangzhou Hongyuan Pharmaceutical Company (“Hongyuan”)
relating to the purchase of the ownerhip of BCG (Bacillus Calmette-Guerin)
vaccine for the prevention of infection in bladder cancer patients post surgery,
the ownership would include the new drug certificate, manufacturing technology
and the munufacturing certificate to be granted by the SFDA. Hongyuan and the
Drug Research Centre of Guangdong Province are carrying out research and
development for the approval of the BCG vaccine. Under the agreement, we paid to
Hongyuan a deposit of approximately $2.9 million towards the purchase to secure
our exclusivity in the negotiation with Hongyuan. The deposit was paid to
Hongyuan in three installments in June, July and September 2008. We expect that
it will take approximately two years for Hongyuan to complete clinical trials
for the BCG vaccine.  Under the terms, Hongyuan will refund the entire
deposit to us if it fails to complete the clinical trials within two years, or
if the expenses for such trials exceeds the agreed amount. As of December 31,
2008, $1,467,000 remains unpaid.




52





We intend
to use our available funds to accelerate the development and testing of new
drugs. We believe that our available funds will provide us with sufficient
capital for at least the next twelve months; however, we may acquire one or two
production facilities to manufacture our own products. To the extent that we
make acquisitions or establish our own production facilities, we may require
additional capital for the acquisition or for the operation of the combined
companies. However, we cannot assure that such funding will be
available.





Critical
Accounting Policies and Estimates





Management's
discussion and analysis of its financial condition and results of operations are
based upon our consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States.
Our financial statements reflect the selection and application of accounting
policies which require management to make significant estimates and judgments.
See note 2 to our consolidated financial statements, "Summary of Significant
Accounting Policies." Management bases its estimates on historical experience
and on various other assumptions that are believed to be reasonable under the
circumstances. Actual results may differ from these estimates under different
assumptions or conditions. We believe that the following reflect the more
critical accounting policies that currently affect our financial condition and
results of operations.





Revenue
recognition





We
recognize revenue when all four of the following criteria are met: (1)
persuasive evidence has been received that an arrangement exists; (2) delivery
of the products and/or services has occurred; (3) the selling price is fixed or
determinable; and (4) collectibility is reasonably assured. We follow the
provisions of the SEC’s Staff Accounting Bulleting No. 104, which sets forth
guidelines for the timing of revenue recognition based upon factors such as
passage of title, installation, payments and customer acceptance. Any amounts
received prior to satisfying our revenue recognition criteria are recorded as
deferred revenue.




Sales
revenue represents the invoiced value of goods, net of a value-added tax (VAT).
All of the Company’s products, which are sold exclusively in the PRC, are
subject to a Chinese value-added tax at a rate of 13% to 17% of the gross sales
price. This VAT may be offset by VAT paid by the Company on raw materials and
other materials included in the cost of producing their finished
product.





Research
and development costs




Research
and development costs are expensed as incurred. To the extent that research and
development services are performed for us by third parties, these costs are
expensed when the services are performed by the third party. The costs of
material and equipment that are acquired or constructed for research and
development activities, and have alternative future uses, either in research and
development, marketing, or sales, are classified as property and equipment or
depreciated over their estimated useful lives.


53


Use
of estimates





The
preparation of financial statements in conformity with generally accepted
accounting principles of the United States of America requires management to
make estimates and assumptions that affect the amounts reported in the combined
financial statements and accompanying notes. Management believes that the
estimates utilized in preparing its financial statements are reasonable and
prudent. Actual results could differ from these estimates.





Inventories





We record
reserves against our inventory to provide for estimated obsolete or unsalable
inventory based on assumptions about future demand for our products and market
conditions. If future demand and market conditions are less favorable than
management's assumptions, additional reserve could be required. Likewise,
favorable future demand and market conditions could positively impact future
operating results if previously reserved inventory is sold.




ITEM 8.  FINANCIAL STATEMENTS AND
SUPPLEMENTARY DATA





The
following table presents selected financial data for the Company on a
consolidated basis for the fiscal years ended December 31, 2008 and 2007,
respectively.





We
derived the selected financial data set forth below from the Company's
consolidated audited statements of operations for the fiscal years ended
December 31, 2008 and 2007 and the consolidated audited balance sheets as at
December 31, 2008 and 2007, each of which is included in this report. You should
read the following summary financial data in conjunction with the consolidated
financial statements and "Management's Discussion and Analysis of Financial
Condition and Results of Operations" appearing elsewhere in this
report.





For
      Year Ended
              December
      31,2008
            
            
            2007Gross
      revenues
            
            $
            53,647,806
            
            
            $
            42,105,387Income
      from operations
            
            
            10,927,865
            
            
            
            8,414,402Net
      income
            
            
            9,125,616
            
            
            
            6,875,369Total
      assets
            
            
            44,681,316
            
            
            
            32,640,238Total
      liabilities
            
            
            1,079,523
            
            
            
            862,718





The
Company's consolidated audited financial statements for the fiscal years ended
December 31, 2008 and 2007, together with the report of the independent
certified public accounting firm thereon and the notes thereto, are presented
beginning at page F-1.




ITEM 9.  CHANGES IN AND DISAGREEMENTS WITH
ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE




None.




54





ITEM
9A(T). CONTROLS AND PROCEDURES
 
 Disclosure
Controls and Procedures
 
 As
required by Rule 13a-15 under the Exchange Act, our management, including our
Chief Executive Officer and our Chief Financial Officer, evaluated the
effectiveness of the design and operation of our disclosure controls and
procedures as of December 31, 2008.
 
 Disclosure
controls and procedures refer to controls and other procedures designed to
ensure that information required to be disclosed in the reports we file or
submit under the Securities Exchange Act is recorded, processed, summarized and
reported within the time periods specified in the rules and forms of the SEC and
that such information is accumulated and communicated to our management,
including our chief executive officer and chief financial officer, as
appropriate, to allow timely decisions regarding required disclosure. In
designing and evaluating our disclosure controls and procedures, management
recognizes that any controls and procedures, no matter how well designed and
operated, can provide only reasonable assurance of achieving the desired control
objectives, and management is required to apply its judgment in evaluating and
implementing possible controls and procedures.
  Management
conducted its evaluation of disclosure controls and procedures under the
supervision of our chief executive officer and our chief financial officer.
Based on that evaluation, management concluded that because of the material
weakness in internal control over financial reporting described below, our
disclosure controls and procedures were not effective as of December 31,
2008.
 
 Management’s
Annual Report on Internal Control over Financial Reporting
 
 Our
management is responsible for establishing and maintaining adequate internal
control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f)
under the Securities Exchange Act.  Our internal control over
financial reporting is designed to provide reasonable assurance regarding the
(i) effectiveness and efficiency of operations, (ii) reliability of financial
reporting and the preparation of financial statements for external purposes in
accordance with generally accepted accounting principles, and (iii) compliance
with applicable laws and regulations.
 
 Because
of its inherent limitations, internal control over financial reporting may not
prevent or detect misstatements. Also, projections of any evaluation of
effectiveness to future periods are subject to the risk that controls may become
inadequate because of changes in conditions, or that the degree of compliance
with the policies and procedures may deteriorate.
 
 Management
assessed the effectiveness of our internal control over financial reporting as
of December 31, 2008. In making this assessment, we used the criteria set
forth by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO) in Internal Control - Integrated Framework. Based on our assessment,
we determined that, as of December 31, 2008, our internal control over
financial reporting was ineffective based on those criteria.
  During
our assessment of the effectiveness of internal control over financial reporting
as of December 31, 2008, management identified the following significant
deficiencies:
  1.
              Accounting
      and Finance Personnel Lack of US GAAP expertise. Our current accounting
      staff is relatively new and inexperienced, and needs substantial training
      to meet the higher demands of being a US public company. The accounting
      skills and understanding necessary to fulfill the requirements of US GAAP
      based reporting, including the skills of subsidiary financial statements
      consolidations, are inadequate and were inadequately supervised. The lack
      of sufficient and adequately trained accounting and finance personnel
      resulted in a material reclassification
      journal entries relative to key financial reporting
      functions.
  2.
                Lack
      of Internal Audit Function – We lack qualified resources to perform the
      internal audit functions properly. In addition, the scope and
      effectiveness of the internal audit function are yet to be
      developed.
  3.
                Lack
      of Segregation of Duties – We have relied heavily on our accounting
      department; we do not have segregation of duties between recording,
      authorizing and testing.


55




The
Company’s management determined that the number and nature of these significant
deficiencies, when aggregated, amounted to a material weakness.


Remediation
Initiative
  In 2008,
the Company took the following actions to remediate the foregoing weakness: (i)
engaged in modernization of inventories management and reporting system through
a number of measures such as warehouse hardware upgrade and improvement of
inventories control system, (ii) hired additional English speaking personnel in
the administrative division, (iii) continued to implement its written control
and accountability policies for administrative personnel, and (iv) started
search for US GAAP knowledgeable financial professionals. Additionally,
during the year of 2008 the Company’s staff in the accounting department gained
more expertise in internal audit functions. We plan to continue to take measures
to remediate the material weakness as soon as practicable including providing US
GAAP training to our staff in the accounting department.
  A material weakness (within the meaning
of PCAOB Auditing Standard No. 5) isa deficiency, or a combination of
deficiencies, in internal control over financial reporting, such that there is a
reasonable possibility that a material misstatement of our annual or interim
financial statements will not be prevented or detected on a timely basis. 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 company's financial reporting.
 
 Auditor
Attestation
 
 This
annual report does not include an attestation report of our registered public
accounting firm regarding internal control over financial
reporting.  Management’s report was not subject to attestation by our
registered public accounting firm pursuant to temporary rules of the Securities
and Exchange Commission that permit us to provide only management’s report in
this annual report.
 
 Changes
in Internal Controls over Financial Reporting
 
 Except as
described above, there were no changes in our internal controls over financial
reporting during the fourth quarter of the fiscal year 2008 that have materially
affected, or are reasonably likely to materially affect, our internal control
over financial reporting.




ITEM
9B. OTHER INFORMATION





None.





PART III





ITEM 10. DIRECTORS, EXECUTIVE OFFICERS AND
CORPORATE GOVERNANCE.





The
following are the officers and directors of the Company as of the date of this
report. Some of our officers and directors are residents of the PRC. As a
result, it may be difficult for investors to effect service of process within
the United States upon them or to enforce judgments obtained in the United
States courts against them in the PRC.




Name
            
            Age
            
            PositionSenshan
      Yang
            
            47
            
            Chief
      Executive Officer and DirectorMinhua
      Liu
            
            41
            
            Executive
      Vice President and DirectorHuizhen
      Yu
            
            36
            
            Chief
      Financial OfficerRobert
      Adler
            
            74
            
            Director,
      Chairman of the Audit Committee and member of the Compensation
      CommitteeDr.
      Rachel Gong
            
            41
            
            Director,
      Chairman of the Compensation Committee and member of the Audit
      CommitteeDr.
      Yanfang Chen
            
            45
            
            Director,
      member of Audit Committee and member of the Compensation
      Committee




56




Senshan Yang.Mr. Senshan
Yang has been our Chief Executive Officer since February 8, 2006 and a Director
since February 10, 2006. He has been Chairman and General Manager of Konzern
since July 2000. Prior to that, Mr. Yang had served as a Manager Associate for
Guangdong Maoming Petroleum Corporation, a state-owned company, for nearly 20
years. Mr. Yang obtained his bachelor’s degree from South China University of
Technology in 1981.





Minhua Liu. Ms. Minhua Liu
has been our Executive Vice President since February 8, 2006 and a Director
since February 10, 2006. She has been Vice General Manager of Konzern since July
2000. Prior to that, she had served as a company herbalist doctor for China
Military Science Qiming Research Center in Beijing, responsible for all the
health care of all staff of the research center. Ms. Liu obtained her bachelor’s
degree from Beijing College of Traditional Chinese Medicine in
1992.





Huizhen Yu.Ms. Huizhen Yu
has been our Chief Financial Officer since February 10, 2006. She has been Chief
Financial Officer of Konzern since October 2002. Ms. Yu was an accountant for
Shenzhen Liuge Bicycle Equipment Co., Ltd from 2000 until 2002, and an
accountant for Guangzhou JoinWin Consultancy Ltd. from 1997 to 2000. She
obtained her bachelor’s degree from Jinan University in Guangzhou and Middle
Level Accountant Certificate in China in 2002.





Robert Adler.Mr. Robert
Adler has been our Director and Chairman of the Audit Committee since May 9,
2006. He is a private investor. During the past five years, Mr. Adler was an
investment adviser with UBS Financial Services and most recently he taught
financial English for a semester in Shanghai University of Finance and
Economics. Mr. Adler's prior experience includes terms as a managing director
for ING Furman Selz Asset Management, Vice President and Senior Investment
Officer of BHF Securities Corp and DG Bank, New York Branch and Vice President
of Kuhn, Loeb & Co. Mr. Adler obtained a B.A. degree from Swarthmore College
and studied at NYU School of Business Administration. Mr. Adler is a member of
Institute of Chartered Financial Analysts and a member of the New York Society
of Security Analysts.





Dr. Rachel Gong.Dr. Gong has
been our Director, member of the Audit Committee and Chairman of the
Compensation Committee since May 9, 2006. Dr. Gong has both operating and
investment experiences in the biotechnology industry in China and the United
States. She joined Morningside Ventures in 2004 to focus on healthcare venture
investment and serves on the board of a number of its portfolio companies. Prior
to that, Dr. Gong held positions in biotech management at QIAGEN, public
accounting at PricewaterhouseCoopers, and investment banking at RBC Capital
Markets. Earlier in her career, she was a researcher at the Chinese Academy of
Medical Sciences in Beijing. Dr. Gong received her Ph.D. in Biochemistry and
Molecular Biology from the University Of South Florida College Of Medicine, her
M.B.A. from the Johnson Graduate School of Management of Cornell University, and
her B.S. in Plant Physiology and Biochemistry from Beijing
University.





Dr. Yanfang Chen. Dr. Chen
has been our Director, member of the Audit Committee and member of the
Compensation Committee since May 9, 2006. He is currently an assistant
professor, of Department of Pharmacology & Toxicology, Wright State
University Boonshoft School of Medicine. During the past five years, he has been
research associate, senior research associate and research assistant professor
at the Department of Pharmacology & Toxicology, Wright State University
Boonshoft School of Medicine. He obtained a Ph.D degree from Medical Science
Center, Peking University in China in 1995 and worked for Guangdong Provincial
People's Hospital from 1995 to 1999. Dr. Chen is a professional member of
American Heart Association and American Stroke Association, and a member of
American Society for Pharmacology and Experimental Therapeutics. He has numerous
publications in his field of research.




57




Family
Relationships





Minhua
Liu (our shareholder, Director and Executive Vice President) and Junhua Liu, a
shareholder, are siblings. There are no other family relationships among our
executive officers, directors and principal shareholders.




Audit Committee





The Board
of Directors created the audit committee in May 2006. The Audit Committee is to
oversee the Company's accounting and financial reporting processes, as well as
its financial statement audits. The committee recommends to the Board of
Directors the selection of the Company’s outside auditors and reviews their
procedures for ensuring their independence with respect to the services
performed for the Company.





The Audit
Committee is comprised of three directors: Dr. Rachel Gong, Dr. Yanfang Chen and
Mr. Robert Adler. Mr. Adler is the Chairman of the Audit Committee. In the
opinion of the Board of Directors, Dr. Gong, Dr. Yanfang Chen and Mr. Adler are
independent of management and free of any relationship that would interfere with
their exercise of independent judgment as members of this committee and they are
independent as defined by the rules of the Nasdaq Stock Market. The Board of
Directors has adopted a written charter for the Audit Committee.





Audit
Committee Financial Expert





The Board
of Directors has determined that we have an Audit Committee financial expert, as
defined under Item 407(d)(5)(i) of Regulation S-K, serving on our Audit
Committee. Robert Adler is our Audit Committee financial expert, and he is
independent as defined by the rules of the Nasdaq Stock Market.





Compensation
Committee





In May
2006, the Board of Directors established a Compensation Committee to oversee
executive compensation and related corporate governance matters. Dr. Yanfang
Chen , Mr Robert Adler and Dr. Rachel Gong currently serve on the Compensation
Committee. During the year ended December 31, 2008, the compensation committee
met one time.




Section
16(a) Beneficial Reporting Compliance




Section
16(a) of the Securities Exchange Act of 1934, as amended, requires the Company's
directors and executive officers, and persons who own more than 10% of a
registered class of our equity securities, to file with the SEC initial reports
of ownership and reports of changes in ownership of common stock and other of
our equity securities. These insiders are required by SEC regulations to furnish
us with copies of all Section 16(a) forms they file, including Forms 3, 4 and
5.




58





To our
knowledge, during the calendar year ended December 31, 2008:





·
              Dr.
      Rachel Gong, our director, failed to file on a timely basis one Form 4
      reporting grant of certain stock options on August 6, 2008. The required
      filing was made on November 21,
2008;





·
              as
      of the date of this report First Wilshire Securities Management, Inc.
      failed to file Form 3 reporting beneficial ownership of more than 10% of a
      registered class of our equity securities which ownership was acquired
      some time during the year of 2008 according to Schedule 13G/A filed by
      First Wilshire Securities Management, Inc. on February 13,
      2009.




Code
of Ethics




We have
not yet adopted a Code of Ethics for our executive officers. We intend to adopt
a Code of Ethics applying to such persons during the fiscal year
2009.




ITEM 11. EXECUTIVE
COMPENSATION




Summary
of Executive Compensation





The
following table reflects the compensation paid to our principal executive
officer and executive officers who have earned more than $100,000 in any of the
previous two fiscal years.





Summary
Compensation Table





Name
      and Principal Position
            
            Year
            
            Salary
              (cash
              or
      non-cash)
              ($)
            
            Bonus
              (cash
              or
      non-cash)
              ($)
            
            Stock
      Awards
              ($)
            
            Option
      Awards
              ($)
            
            Non-Equity
      Incentive Plan Compensation
              ($)
            
            Non-
              Qualified
      Deferred Compensation Earnings
              ($)
            
            All
      Other Compensation
              ($)
            
            Total
              ($)Senshan
      Yang,
              CEO
            
            
            2008
              2007
            
            50,214
              100,000
            
            
            —
              —
            
            ——
            
            
            —

                  —
            
            ——
            
            
            —

                  —
            
            ——
            
            
            50,214
              100,000Meiyi
      Xia,
            
            
            2008
            
            0
            
            
            —
            
            —
            
            
            0
            (1)
            —
            
            
            —
            
            —
            
            
            0former
      Vice
              President(2)
            
            
            2007
            
            58,500
            
            
            —
            
            —
            
            
            63,045
            (1)
            —
            
            
            —
            
            —
            
            
            121,545







(1)
            The
      amounts in this column represent the compensation cost of stock options
      awarded by the Compensation Committee granted in 2006, except that these
      amounts do not include any estimate of forfeitures. The grant date fair
      value of option awards granted were determined in accordance with
      Statement of Financial Accounting Standards No. 123R (SFAS123(R)) and are
      recognized as compensation cost over the requisite service period. The
      amount recognized for these awards was calculated using the Black Scholes
      option-pricing model, and our 2006 Long Term Incentive Plan is described
      under this Item 10.(2)
            Meiyi
      Xia has resigned from the Company effective September
  2007.




59




Compensation
Discussion and Analysis





Overview of Compensation
Program and Philosophy





We have
three executive officers, Senshan Yang, Minhua Liu,and Huizhen Yu. The Board of
Directors is comprised of Senshan Yang, Minhua Liu, Robert Adler, Dr. Rachel
Gong and Dr. Yanfang Chen. Dr. Rachel Gong, Mr. Robert Adler and Dr. Yanfang
Chen also serve as our Compensation Committee. No executive officer had total
compensation exceeding $100,000 for the fiscal year ended December 31,
2008.





The Board
of Director’s goal in determining compensation levels is to adequately reward
the efforts and achievements of executive officers for the management of the
Company. We have no pension plan, non-equity incentive plan or deferred
compensation arrangement. We do, however, have a long-term equity incentive
plan.





Long-Term Equity Incentive
Plan





In
January, 2006, we adopted the 2006 Long-Term Incentive Plan covering 1,575,000
shares of common stock. The plan provides for the grant of incentive and
non-qualified options, stock grants, stock appreciation rights and other
equity-based incentives to employees, including officers, and consultants. The
plan is administered by our Compensation Committee.




We have
not used a compensation consultant in any capacity but believe that our
executive officer compensation package is comparable to similar businesses in
our location of operations.





None of
our executive officers has an employment agreement. In the absence of an
employment agreement, the relevant PRC Labor Laws would apply and provide for
employment-related benefits and terms to the executive officers, including but
not limited to: the term of employment, the provision of labor-related
insurance, termination for cause, termination on 30 days’ notice and termination
without notice and benefits.





Director
Compensation




The
following table reflects the compensation of directors for the Company’s fiscal
year ended December 31, 2008:




Name
      of Director
            
            Fees
      Earned or Paid in Cash
              ($)
            
            Stock
      Awards
              ($)
            
            Option
      Awards
              ($)
            
            Non-Equity
      Incentive Plan Compensation
              ($)
            
            Change
      in Pension value and Nonqualified Deferred Compensation
      Earnings
            
            All
      Other Compensation
              ($)
            
            Total
              ($)Robert
      Adler*
            
            
            12,000
            
            —
            
            
            6,259
            (1)
            —
            
            
            —
            
            —
            
            
            18,259Rachel
      Gong*
            
            
            12,000
            
            —
            
            
            6,259
            (1)
            —
            
            
            —
            
            —
            
            
            18,259Yanfang
      Chen*
            
            
            12,000
            
            —
            
            
            6,259
            (1)
            —
            
            
            —
            
            —
            
            
            18,259







(1)
            The
      amounts in this column represent the compensation cost of stock options
      awarded by the Compensation Committee granted in 2008, except that these
      amounts do not include any estimate of forfeitures. The grant date fair
      value of option awards granted were determined in accordance with
      Statement of Financial Accounting Standards No. 123R (SFAS123(R)) and are
      recognized as compensation cost over the requisite service period. The
      amount recognized for these awards was calculated using the Black Scholes
      option-pricing model, and our 2006 Long Term Incentive Plan is described
      under this Item 10.*
            As
      of December 31, 2008, each of the three directors held options to purchase
      40,000 shares of our common stock, including options to purchase 30,000
      shares at an exercise price of $1.25 per share, 5,000 shares at an
      exercise price of $3.00 per share and 5,000 shares at an exercise price of
      $2.01 per share.




60


In
accordance with the 2006 Long Term Incentive Plan, independent directors are not
eligible for discretionary options. However, each newly elected independent
director receives, at the time of his or her election, a five-year option to
purchase 30,000 shares of common stock at the market price on the date of his or
her election. In addition, the plan provides for the annual grant of an option
to purchase 5,000 shares of common stock on April 1st of each
year, commencing April 1, 2007 to each independent director.





Also,
each independent director shall receive an annual retainer of $12,000. There is
no other specific compensatory arrangement for committee services, services as
chairman of the board or a committee and meeting attendance. All the directors
have the same compensation terms.




ITEM 12. SECURITY OWNERSHIP OF CERTAIN
BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER
MATTERS





The
following table sets forth as of the date of this report, certain information
with respect to the beneficial ownership of our voting securities by (i) each
person or group owning more than 5% of the Company’s securities, (ii) each
director, (iii) each executive officer, and (iv) all executive officers and
directors as a group. The information presented in the table is based on
15,226,742 shares of common stock outstanding as of the date of this
report.




Name
      and
            
            
            
            Amount
      andAddress
      of
            
            Title
      of
            
            Nature
      of Beneficial
            
            Percent
      ofBeneficial
      Owner
            
            Class
            
            Ownership
      (1)
            
            Class
      (1)Barron
      Partners L.P.
            
            
            Common
      Stock
            
            
            2,401,316
            (2)
            
            13.6
            %730
      Fifth Avenue, 9th FloorNew
      York, New York 10019First
      Wilshire Securities Management, Inc.
            
            
            Common
      Stock
            
            
            2,065,617
            (3)
            
            13.6
            %1224
      East Green Street, Suite 200Pasadena,
      California 91106Capital
      Ventures International
            
            
            Common
      Stock
            
            
            1,100,000
            (4)
            
            7.2
            %One
      Capitol Place, P.O. Box 1787 GTGrand
      Cayman, Cayman IslandsBritish
      West IndiesSenshan
      Yang
            
            
            Common
      Stock
            
            
            3,265,000
            
            
            21.5
            %Director
      and CEORoom
      702 Guangri Mansion No. 9South
      Wuyang Xincheng SiGuangzhouChinaMinhua
      Liu
            
            
            Common
      Stock
            
            
            2,612,000
            
            
            17.2
            %Director
      and Executive Vice PresidentRoom
      702 Guangri Mansion No. 9South
      Wuyang Xincheng SiGuangzhouChinaJunhua
      Liu
            
            
            Common
      Stock
            
            
            653,000
            
            
            4.3
            %Room
      702 Guangri Mansion No. 9South
      Wuyang Xincheng SiGuangzhouChinaHuizhen
      Yu
            
            
            Common
      Stock
            
            
            50,000
            (5)
            
            0.3
            %Chief
      Financial OfficerRoom
      702 Guangri Mansion No. 9South
      Wuyang Xincheng SiGuangzhouChinaRobert
      Adler
            
            
            Common
      Stock
            
            
            40,000
            (5)
            
            0.3
            %DirectorRoom
      702 Guangri Mansion No. 9South
      Wuyang Xincheng Si,Guangzhou,
      ChinaRachel
      Gong
            
            
            Common
      Stock
            
            
            40,000
            (5)
            
            0.3
            %DirectorRoom
      702 Guangri Mansion No. 9South
      Wuyang Xincheng Si,Guangzhou,
      ChinaYanfang
      Chen
            
            
            Common
      Stock
            
            
            40,000
            (5)
            
            0.3
            %DirectorRoom
      702 Guangri Mansion No. 9South
      Wuyang Xincheng Si,Guangzhou,
      ChinaAll
      Directors and Officers of the Company
            
            
            Common
      Stock
            
            
            6,700,000
            
            
            44.0
            %as
      a group








(1)
            In
      determining beneficial ownership of our common stock as of a given date,
      the number of shares shown includes shares of common stock which may be
      acquired on exercise of warrants or options within 60 days of that date.
      In determining the percent of common stock owned by a person or entity on
      March 25, 2009, (a) the numerator is the number of shares of common stock
      beneficially owned by such beneficial owner (including shares that he has
      the right to acquire within 60 days of March 25, 2009), and (b) the
      denominator is the sum of (i) the 15,226,742 shares outstanding on March
      25, 2009 and (ii) the number of shares of common stock which such
      beneficial owner has the right to acquire within 60 days of March 25, 2009
      upon exercise of warrants or options.Except
      as otherwise indicated each person has the sole power to vote and dispose
      of all shares of common stock listed opposite his
  name.


61




(2)
            This
      number includes 2,401,316 shares of common stock issuable upon exercise of
      our Series B warrants. However, the Series B warrants may not be exercised
      if such conversion or exercise would result in Barron Partners owning more
      than 4.9% of our outstanding common stock. This limitation may not be
      waived.(3)
            As
      disclosed by the beneficial owner on Schedule 13G/A filed on February 13,
      2009.(4)
            As
      disclosed by the beneficial owner on Schedule 13G filed on October 17,
      2007. Susquehanna Advisors Group, Inc. is the investment manager to
      Capital Ventures International and as such may exercise voting and
      dispositive power over these shares. The address of Susquehanna Advisors
      Group, Inc. is 401 City Avenue, Suite 220, Bala Cynwyd, PA
      19004.(5)
            Options
      to purchase our common stock with an exercise price of $1.25 per
      share.




ITEM
13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR
INDEPENDENCE





On
February 8, 2006, we purchased 928,000 shares of common stock from Capital
Markets, LLC for $200,000. The purchase price was funded from the sale of the
Series A Convertible Preferred Stock and Investor Warrants in the February 2006
private placement. At the time of the purchase, Capital Markets owned
approximately 97.3% of our outstanding common stock.





Contemporaneously
with the February 2006 private placement, we issued an aggregate of 750,000
shares for services, including 150,000 shares to Meiyi Xia and 37,500 shares to
Lin Li. In connection with the February 2006 private placement, we paid a
consulting fee of $100,000 to AiDi Financial Investment LLC. Ms. Xia was Chief
Executive Officer of AiDi Financial Investment, LLC.




As of
December 31, 2008, there were no cash advances outstanding to shareholders of
the company for cash advances for business expenses. Such amounts are unsecured,
non interest bearing and have no fixed terms of repayment.




Director
Independence





Mr.
Robert Adler, Dr. Rachel Gong and Dr. Yanfang Chen are independent directors
pursuant to the definition of “independent director” under the Rules of NASDAQ,
Marketplace Rule 4200(a)(15). Mr. Adler and Dr. Gong are members of our audit
committee. Dr. Chen and Dr. Gong are members of our compensation committee. They
are independent as defined under the rules above referenced.




62




ITEM 14. PRINCIPAL ACCOUNTANT FEES AND
SERVICES





The
following lists fees billed by Moore Stephens Wurth Frazer and Torbet, LLP
(“MSWFT”), current auditors for the Company, for the years ended December 31,
2008 and 2007:




2008
            
            
            2007Audit
      Fees
            
            $
            160,000
            
            
            $
            90,000Audit
      Related Fees
            
            
            —
            
            
            
            —Tax
      Fees
            
            
            8,000
            
            
            
            —All
      Other Fees
            
            
            —
            
            
            
            —




In the
event that we should require substantial non-audit services, the audit committee
would pre-approve such services and fees.




PART IV





ITEM 15. EXHIBITS





Number
                
                Description2.1
                
                Stock
      Exchange Agreement, dated as of February 8, 2006, among the Company and
      the former stockholders of Konzern (1);3.1
                
                The
      restated certificate of incorporation filed with the Delaware Secretary of
      State in July 2006 (2);3.2
                
                By-laws
      of the Company (3);4.1
                
                Specimen
      of Common Stock Certificate (5);4.2
                
                Specimen
      of Preferred Stock Certificate (4);4.3
                
                Certificate
      of Designation for the Series A Convertible Preferred Stock
      (1);4.4
                
                Form
      of warrant issued to investors in the February 2006 private placement
      (1);10.1
                
                Preferred
      stock purchase agreement dated February 8, 2006, between the Registrant
      and the investors in the February 2006 private placement
    (1);10.2
                
                Registration
      rights agreement dated February 8, 2006, between the Registrant and the
      investors in the February 2006 private placement (1);10.3
                
                Registration
      rights provisions pursuant to the stock exchange agreement
      (1);10.4
                
                BCG
      Vaccine Transfer Agreement between Guangzhou Konzern Pharmaceutical Co.,
      LTD and Hongyuan Pharmaceutical Technology Consulting Service Center of
      Yuexiu District of Guangzhou (6)10.5
                
                Memorandum
      between Guangzhou Konzern Pharmaceutical Co., LTD and Hongyuan
      Pharmaceutical Technology Consulting Service Center of Yuexiu District of
      Guangzhou (6)21.1
                
                List
      of Subsidiaries;




63




31.1
            
            Certification
      of Senshan Yang pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002;31.2
            
            Certification
      of Huizhen Yu pursuant to Exchange Act Rules 13a-14(a) and 15d-14(a), as
      adopted pursuant to Section 302 of the Sarbanes-Oxley Act of
      2002;32.1
            
            Certification
      pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of
      the Sarbanes-Oxley Act of 2002;99.4
            
            2006
      Long-term incentive plan (1).




Footnotes:





(1).
            Incorporated
      by reference from the exhibit to the Current Report on Form 8-K filed by
      the Company with the Commission on February 14,
  2006.




(2).
            Incorporated
      by reference from the appendix B to the Information Statement on 14C filed
      by the Company with the Commission on July,
  2006.





(3).
            Incorporated
      by reference from the exhibit to the Form 10-SB filed by the Company with
      the Commission on June 23, 2005.




(4).
            Incorporated
      by reference from the exhibit to the annual report on Form 10-KSB filed by
      the Company with the Commission on March 31,
  2006.




(5).
            Incorporated
      by reference from the exhibit to the annual report on Form 10-KSB filed by
      the Company with the Commission on April 3,
  2007.




(6).
            Incorporated by reference from
      the exhibit to the quarterly report on Form 10-Q filed by the Company with
      the Commission on November 11,
2008.




64




SIGNATURES





Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, the Registrant has duly caused this Report to be signed on its behalf by
the undersigned, thereunto duly authorized.




CHINA
      MEDICINE CORPORATIONDate:
      March 30, 2009
              By:
              /s/
      Senshan YangSenshan
      Yang, CEO(principal
      executive officer)




By:
              /s/
      Huizhen YuHuizhen
      Yu, CFO(principal
      financial officer and principal
                accounting
      officer)




Pursuant
to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
1934, this Report has been signed below by the following persons on behalf of
the Registrant in the capacities and on March 30, 2009.




/s/
      Minhua LiuMinhua
      Liu, Director





/s/
      Senshan YangSenshan
      Yang, Director





/s/
      Robert AdlerRobert
      Adler, Director





/s/
      Rachel GongRachael
      Gong, Director





/s/
      Yanfang ChenYanfang
      Chen, Director




65











REPORT
OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
   To the
Board of Directors and Stockholders of
 China
Medicine Corporation
  We have
audited the accompanying consolidated balance sheets of China Medicine
Corporation and subsidiaries as of December 31, 2008 and 2007, and the related
consolidated statements of income and other comprehensive income, stockholders’
equity, and cash flows for each of the years in the two-year period ended
December 31, 2008. China Medicine Corporation’s management is responsible for
these financial statements. 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 audit 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. Our audit included consideration of internal control over
financial reporting as a basis for designing audit procedures that are
appropriate in the circumstances, but not for the purpose of expressing an
opinion on the effectiveness of the company’s internal control over financial
reporting. Accordingly, we express no such opinion. An audit also includes
examining, on a test basis, evidence supporting the amounts and disclosures in
the financial statements, assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe our audits provide a reasonable
basis for our opinion.
  In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of China Medicine Corporation and
subsidiaries as of December 31, 2008 and 2007, and the results of its operations
and 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/ Moore
Stephens Wurth Frazer and Torbet, LLP
  Walnut,
California
 March 27,
2009




CHINA
      MEDICINE CORPORATION AND SUBSIDIARIESCONSOLIDATED
      BALANCE SHEETSAS
      OF DECEMBER 31, 2008 AND 20072008
                  
                  
                  2007ASSETSCURRENT
      ASSETSCash
                  
                  $
                  2,791,814
                  
                  
                  $
                  5,767,774Notes
      receivable
                  
                  
                  600,911
                  
                  
                  
                  -Accounts
      receivable, trade, net of allowance for doubtful accountsof
      $96,609 and $55,640 as of December 31, 2008 and
      2007, respectively
                  
                  
                  19,225,091
                  
                  
                  
                  13,626,347Inventories
                  
                  
                  4,725,322
                  
                  
                  
                  3,948,460Advances
      to suppliers
                  
                  
                  6,121,974
                  
                  
                  
                  5,983,277Other
      current assets
                  
                  
                  192,080
                  
                  
                  
                  81,221Total
      current assets
                  
                  
                  33,657,192
                  
                  
                  
                  29,407,079EQUIPMENT,
      net
                  
                  
                  3,761,637
                  
                  
                  
                  1,388,919OTHER
      ASSETSLong
      term prepayment
                  
                  
                  6,014,920
                  
                  
                  
                  678,237Intangible
      assets, net
                  
                  
                  1,247,567
                  
                  
                  
                  1,166,003Total
      other assets
                  
                  
                  7,262,487
                  
                  
                  
                  1,844,240Total
      assets
                  
                  $
                  44,681,316
                  
                  
                  $
                  32,640,238LIABILITIES AND
      SHAREHOLDERS' EQUITYCURRENT
      LIABILITIESAccounts
      payable, trade
                  
                  $
                  61,243
                  
                  
                  $
                  76,907Other
      payables and accrued liabilities
                  
                  
                  50,559
                  
                  
                  
                  70,343Customer
      deposits
                  
                  
                  151,429
                  
                  
                  
                  203,281Taxes
      payable
                  
                  
                  772,289
                  
                  
                  
                  468,184Liquidated
      damages payable
                  
                  
                  44,003
                  
                  
                  
                  44,003Total
      liabilities
                  
                  
                  1,079,523
                  
                  
                  
                  862,718MINORITY
      INTEREST
                  
                  
                  835,532
                  
                  
                  
                  893,337SHAREHOLDERS'
      EQUITYPreferred
      stock, $0.0001 par value; 10,000,000 shares authorized,0
      and 111,649 shares issued and outstanding at
      December 31, 2008 and 2007, respectively
                  
                  
                  -
                  
                  
                  
                  11Common
      stock, $0.0001 par value; 100,000,000 shares authorized,15,226,742
      and 14,821,641 shares issued and outstanding at
      December 31, 2008 and 2007, respectively
                  
                  
                  1,522
                  
                  
                  
                  1,482Paid-in
      capital
                  
                  
                  13,011,012
                  
                  
                  
                  12,560,078Statutory
      reserves
                  
                  
                  3,178,861
                  
                  
                  
                  2,191,230Retained
      earnings
                  
                  
                  22,146,572
                  
                  
                  
                  14,008,587Accumulated
      other comprehensive income
                  
                  
                  4,428,294
                  
                  
                  
                  2,122,795Total
      shareholders' equity
                  
                  
                  42,766,261
                  
                  
                  
                  30,884,183Total
      liabilities and shareholders' equity
                  
                  $
                  44,681,316
                  
                  
                  $
                  32,640,238


See
report of independent registered public accounting firm.
  The
accompanying notes are an integral part of these consolidated
statements.




F-1




CHINA
      MEDICINE CORPORATION AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF INCOME AND OTHER COMPREHENSIVE INCOMEFOR
      THE YEARS ENDED DECEMBER 31, 2008 AND 20072008
              
              
              2007REVENUESProduct
      sales
              
              $
              52,307,211
              
              
              $
              39,247,130Medical
      formula sales
              
              
              1,340,595
              
              
              
              2,858,257Total
      revenues
              
              
              53,647,806
              
              
              
              42,105,387COST
      OF GOODS SOLD
              
              
              38,074,919
              
              
              
              29,708,088GROSS
      PROFIT
              
              
              15,572,887
              
              
              
              12,397,299OPERATING
      EXPENSESResearch
      and development
              
              
              840,437
              
              
              
              651,990Selling,
      general and administrative
              
              
              3,804,585
              
              
              
              3,330,907Total
      operating expenses
              
              
              4,645,022
              
              
              
              3,982,897INCOME  FROM
      OPERATIONS
              
              
              10,927,865
              
              
              
              8,414,402OTHER
      INCOME, NET
              
              
              85,622
              
              
              
              15,423INCOME
      BEFORE INCOME TAXESAND
      MINORITY INTEREST
              
              
              11,013,487
              
              
              
              8,429,825PROVISION
      FOR INCOME TAXES
              
              
              2,006,137
              
              
              
              1,649,114INCOME
      BEFORE MINORITY INTEREST
              
              
              9,007,350
              
              
              
              6,780,711MINORITY
      INTEREST
              
              
              118,266
              
              
              
              94,658NET
      INCOME
              
              
              9,125,616
              
              
              
              6,875,369OTHER
      COMPREHENSIVE INCOMEForeign
      currency translation adjustment
              
              
              2,305,499
              
              
              
              1,621,672COMPREHENSIVE
      INCOME
              
              $
              11,431,115
              
              
              $
              8,497,041EARNINGS
      PER SHAREBasic
              
              $
              0.60
              
              
              $
              0.56Diluted
              
              $
              0.60
              
              
              $
              0.50WEIGHTED
      AVERAGE SHARES OUTSTANDINGBasic
              
              
              15,173,113
              
              
              
              12,346,208Diluted
              
              
              15,308,529
              
              
              
              13,658,007
  See
report of independent registered public accounting firm.
  The
accompanying notes are an integral part of these consolidated
statements.
  F-2
  CHINA
      MEDICINE CORPORATION AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF SHAREHOLDERS' EQUITYFOR
      THE YEARS ENDED DECEMBER 31, 2008 AND
2007
  AccumulatedPreferred
      Stock
              
              
              Common
      Stock
              
              
              
              
              
              
              
              
              Retained
      Earnings
              
              
              otherShares
              
              
              Par
      Value
              
              
              Shares
              
              
              Par
      Value
              
              
              Paid-incapital
              
              
              Contributionreceivable
              
              
              Statutoryreserves
              
              
              Unrestricted
              
              
              comprehensiveincome
              
              
              TotalBALANCE,
      December 31, 2006
              
              
              2,340,000
              
              
              $
              234
              
              
              
              8,160,000
              
              
              $
              816
              
              
              $
              4,396,971
              
              
              $
              (961,500
              )
              
              $
              1,345,206
              
              
              $
              7,979,242
              
              
              $
              501,123
              
              
              $
              13,262,092Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              6,875,369
              
              
              
              
              
              
              
              6,875,369Adjustment
      of statutory reserve
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              846,024
              
              
              
              (846,024
              )
              
              
              
              
              
              
              -Preferred
      stock converted to common stock
              
              
              (2,228,351
              )
              
              
              (223
              )
              
              
              2,283,351
              
              
              
              228
              
              
              
              (5
              )
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Warrants
      exercised for cash @ $1.70
              
              
              
              
              
              
              
              
              
              
              1,694,040
              
              
              
              169
              
              
              
              2,879,699
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,879,868Warrants
      exercised for cash @ $1.75
              
              
              
              
              
              
              
              
              
              
              1,621,750
              
              
              
              162
              
              
              
              2,837,900
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,838,062Warrants
      exercised for cash @ $2.43
              
              
              
              
              
              
              
              
              
              
              725,000
              
              
              
              73
              
              
              
              1,761,677
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,761,750Stock
      options exercised for cash @ $1.25
              
              
              
              
              
              
              
              
              
              
              280,000
              
              
              
              28
              
              
              
              349,972
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              350,000Stock
      option granted
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              154,470
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              154,470Common
      stock issued for services
              
              
              
              
              
              
              
              
              
              
              57,500
              
              
              
              6
              
              
              
              179,394
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              179,400Contribution
      receivable
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              961,500
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              961,500Foreign
      currency translation adjustments
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              1,621,672
              
              
              
              1,621,672BALANCE,
      December 31, 2007
              
              
              111,649
              
              
              $
              11
              
              
              
              14,821,641
              
              
              $
              1,482
              
              
              $
              12,560,078
              
              
              $
              -
              
              
              $
              2,191,230
              
              
              $
              14,008,587
              
              
              $
              2,122,795
              
              
              $
              30,884,183Net
      income
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              9,125,616
              
              
              
              
              
              
              
              9,125,616Adjustment
      of statutory reserve
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              987,631
              
              
              
              (987,631
              )
              
              
              
              
              
              
              -Preferred
      stock converted to common stock
              
              
              (111,649
              )
              
              
              (11
              )
              
              
              115,101
              
              
              
              11
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              -Stock
      option exercised for cash @ $1.25
              
              
              
              
              
              
              
              
              
              
              290,000
              
              
              
              29
              
              
              
              362,471
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              362,500Stock
      option granted
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              88,463
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              88,463Foreign
      currency translation adjustments
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              
              2,305,499
              
              
              
              2,305,499BALANCE,
      December 31, 2008
              
              
              -
              
              
              $
              -
              
              
              
              15,226,742
              
              
              $
              1,522
              
              
              $
              13,011,012
              
              
              $
              -
              
              
              $
              3,178,861
              
              
              $
              22,146,572
              
              
              $
              4,428,294
              
              
              $
              42,766,261
  See
report of independent registered public accounting firm.
  The
accompanying notes are an integral part of these consolidated
statements.
  F-3
  CHINA
      MEDICINE CORPORATION AND SUBSIDIARIESCONSOLIDATED
      STATEMENTS OF CASH FLOWSFOR
      THE YEARS ENDED DECEMBER 31, 2008 AND 20072008
              
              
              2007CASH
      FLOWS FROM OPERATING ACTIVITIES:Net
      income
              
              $
              9,125,616
              
              
              $
              6,875,369Adjustments
      to reconcile net income to cashused
      in operating activities:Minority
      interest
              
              
              (118,266
              )
              
              
              (94,658
              )Depreciation
      and amortization
              
              
              420,769
              
              
              
              303,957Bad
      debt expenses
              
              
              36,428
              
              
              
              18,495Loss
      on sale of assets
              
              
              9,416
              
              
              
              -Stock
      based compensation
              
              
              88,463
              
              
              
              333,870Amortization
      of deferred expenses
              
              
              -
              
              
              
              325,687Change
      in operating assets and liabilitiesNotes
      receivable
              
              
              (590,466
              )
              
              
              -Accounts
      receivable, trade
              
              
              (4,786,654
              )
              
              
              (5,879,829
              )Inventories
              
              
              (491,874
              )
              
              
              (1,840,170
              )Advances
      to suppliers
              
              
              461,695
              
              
              
              (2,535,589
              )Other
      current assets
              
              
              (105,081
              )
              
              
              (34,728
              )Accounts
      payable, trade
              
              
              (20,683
              )
              
              
              (120,129
              )Other
      payables - related parties
              
              
              -
              
              
              
              (30,000
              )Other
      payables and accrued liabilities
              
              
              (24,555
              )
              
              
              45,119Customer
      deposits
              
              
              (64,938
              )
              
              
              176,763Taxes
      payable
              
              
              266,606
              
              
              
              145,730Accrued
      Expenses
              
              
              2,608
              
              
              
              -Net
      cash provided by (used in) operating activities
              
              
              4,209,084
              
              
              
              (2,310,113
              )CASH
      FLOWS FROM INVESTING ACTIVITIES:Purchase
      of equipment
              
              
              (2,666,014
              )
              
              
              (389,588
              )Long
      term prepayment
              
              
              (5,197,253
              )
              
              
              -Net
      cash used in investing activities
              
              
              (7,863,267
              )
              
              
              (389,588
              )CASH
      FLOWS FROM FINANCING ACTIVITIES:Proceeds
      from exercise of warrants and options
              
              
              362,500
              
              
              
              7,829,681Net
      cash provided by financing activities
              
              
              362,500
              
              
              
              7,829,681EFFECT
      OF EXCHANGE RATE ON CASH
              
              
              315,723
              
              
              
              266,314(DECREASE)
      INCREASE IN CASH
              
              
              (2,975,960
              )
              
              
              5,396,294CASH,
      beginning of year
              
              
              5,767,774
              
              
              
              371,480CASH,
      end of year
              
              $
              2,791,814
              
              
              $
              5,767,774
  See
report of independent registered public accounting firm.
  The
accompanying notes are an integral part of these consolidated
statements.
  F-4




CHINA
MEDICINE CORPORATION AND SUBSIDIARIES





NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS


DECEMBER
31, 2008




Note
1 - Organization





China
Medicine Corporation (the "Company") is a Delaware corporation, incorporated on
February 10, 2005. The Company, through its subsidiaries in China, engages the
wholesale of prescription and over the counter medicines, traditional Chinese
medicines, which are medicines derived from Chinese herbs, dietary supplements,
medical instruments and the sale of medical formula in PRC.





Effective
February 8, 2006, the Company entered into a Stock Exchange Agreement (“Exchange
Agreement”) with Guangzhou Konzern Medicine Co., Ltd.
(“Konzern”).  Konzern was privatized from a state-owned medicine
company on July 25, 2000 in Guangzhou, People’s Republic of China
(“PRC”).  Konzern US Holding Corporation (“Konzern Holding”) was
registered in New Jersey on January 11, 2006 for the purpose of distributing and
marketing drugs, medical supplies and medical equipment. Konzern Holding is a
wholly owned subsidiary by Konzern with 100,000 shares of stock authorized.
Konzern Holding had no operating activities. As of December 31, 2008, Konzern
Holding received $200,000 from Konzern as an initial investment.





On July
7, 2006, Konzern formed a PRC joint-venture company with Guangzhou Ji’nan
Science & Technology Industrial Group (“JSIG”) and Mr. Dongsheng Yao, to
develop applications for aflatoxin-detoxifizyme, or ADTZ. Konzern has 70%
ownership in Co-Win. The joint venture’s name is Guangzhou Co-Win Bioengineering
Co., Ltd. (“Co-Win”), as of December 31, 2008; Co-Win is still in development
and has not undertaken significant operating activities.





Note
2 - Summary of significant accounting policies





Basis of
presentation





The
consolidated financial statements of the Company reflect its wholly-owned
subsidiary, Konzern, its 70% owned subsidiary, Co-win, both located in the PRC,
and its wholly-owned subsidiary Konzern US Holding. The accompanying financial
statements have been prepared in accordance with accounting principles generally
accepted in the United States of America. All material inter-company
transactions and balances have been eliminated in the
consolidation.





Use of
estimates





In
preparing financial statements in conformity with generally accepted accounting
principles, management is required to make estimates and assumptions that affect
the reported amounts of assets and liabilities, and the disclosure of contingent
assets and liabilities at the date of the financial statements, and revenues and
expenses during the reported period. For example, management estimates the
amount of potentially uncollectible accounts and estimates the fair value of
options and warrants granted. Actual results could differ from those
estimates.





Cash and concentration of
risk





For
purposes of the cash flow statements, the Company considers all highly liquid
investments with original maturities of three months or less at the time of
purchase to be cash equivalents. Cash includes cash on hand and demand deposits
in accounts maintained with PRC state owned banks and banks in the United
States.




F-5




CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


Financial
instruments, which subject the Company to concentration of credit risk, consist
of cash. The Company maintains balances at financial institutions which, from
time to time, may exceed Federal Deposit Insurance Corporation insured limits
for banks that are located in the Unites States, no deposits with the state
owned banks within the PRC are covered by insurance. As of December 31, 2008 and
2007, the Company had deposits in excess of federally insured limits total of
$2,613,220 and $4,987,180, respectively. The Company has not experienced any
losses in such accounts and believes it is not exposed to any significant risks
on its cash in bank accounts.





The
Company's operations may be adversely affected by significant political,
economic and social uncertainties in China. Although the Chinese government has
pursued economic reform policies in the past, there is no assurance that the
Chinese government will continue to pursue such policies or that such policies
may not be significantly altered, especially in the event of a change in
leadership, social or political disruption or unforeseen circumstances affect
China's political, economic and social conditions. There is also no guarantee
that the Chinese government's pursuit of economic reforms will be consistent or
effective.





For the
years ended December 31, 2008 and 2007, five suppliers accounted for
approximately 47% and 56%, respectively, of the Company's purchases. Advances to
these five suppliers represent 22% and 40% of the Company’s total advances to
suppliers as of December 31, 2008 and 2007, respectively. As of December 31,
2008 and 2007, no accounts payables were due to these suppliers.





For the
years ended December 31, 2008 and 2007, five customers accounted for
approximately 38% and 40%, respectively, of the Company's total sales. The
accounts receivable balance of these five customers amounted to $9,393,338 and
$3,219,275, representing 49% and 24% of the total accounts receivable as of
December 31, 2008 and 2007, respectively.





For the
years ended December 31, 2008 and 2007, the top three products accounted for
approximately 16% and 27% of the Company’s total sales,
respectively.





Accounts receivable,
trade





The
Company extends unsecured credit to its customers.  Management reviews
the composition of accounts receivable and analyzes historical bad debts,
customer concentrations, customer credit worthiness, current economic trends and
changes in customer payment patterns to determine if the allowance for doubtful
accounts is adequate.  An estimate for doubtful accounts is made when
collection of the full amount is no longer probable.  Account balances
are written-off after management has exhausted all efforts of
collection.




F-6




Notes
receivable





Notes
receivable represents trade accounts receivable due from various customers where
the customers’ banks have guaranteed the payment of the receivables. This amount
is non-interest bearing and is normally paid within three to six months. The
Company has the ability to submit a request for payment to the customer’s bank
earlier than the scheduled payment date, but will incur an interest charge and a
processing fee when it submits the early payment request





Inventories





Inventories
are stated at the lower of cost or market value, cost is determined using the
weighted average method. Management compares the cost of inventory with current
market values and if lower than cost, records an allowance writing down the
inventory to its market value,.





Equipment





Equipment
is stated at the actual cost of acquisition less accumulated depreciation and
amortization. Depreciation and amortization are provided in amounts sufficient
to relate the cost of depreciation of assets to operations over their estimated
service lives, principally on a straight-line basis. The estimated lives used in
determining depreciation are:





Leasehold
      improvements
            5
      yearsEquipment
            5
      yearsFurniture
            5
      yearsMotor
      vehicles
            5 -
      8 years





The
residual value is estimated to be 5% of the actual cost.





The cost
and related accumulated depreciation of assets sold or otherwise retired are
eliminated from the accounts and any gain or loss is included in the statement
of operations. Maintenance, repairs and minor renewals are expensed as
incurred.





Long term
prepayment





Long term
prepayment represents a deposit for the bidding of the BCG vaccine manufacturing
license, a prepayment for agency fees and prepayment for planned construction.
On June 1, 2008, the Company entered into an agreement with Guangzhou Hongyuan
Pharmaceutical Company (“Hongyuan”) relating to the purchase of the ownership of
BCG (Bacillus Calmette-Guerin) vaccine. As of December 31, 2008, the Company
paid $2.9 million to Hongyuan as deposit to secure the exclusivity in the
negotiation, the BCG vaccine bidding process had not started nor had the Company
received the BCG vaccine manufacturing license.




F-7




CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


Intangibles





Under the
Statement of Financial Accounting Standards ("SFAS") 142, "Goodwill and Other
Intangible Assets", all goodwill and certain intangible assets determined to
have indefinite lives will not be amortized but will be tested for impairment at
least annually. Intangible assets other than goodwill will be amortized over
their useful lives and reviewed for impairment at least annually or more often
whenever there is an indication that the carrying amount may not be
recovered.





The
Company acquired technology during 2007 and 2008 to manufacture
aflatoxin-detoxifizyme ("ADTZ"). The Company will begin amortizing costs once
manufacturing begins. As of December 31, 2008, the Company had not yet begun
operations.





The
future amortization for the years ended December 31, are as followings assuming
the Company will begin amortize the intangible from 2009:





December
      31,2009
            
            $
            91,7702010
            
            
            91,7702011
            
            
            91,7702012
            
            
            91,7702013
            
            
            55,095Thereafter
            
            
            825,311





Impairment of long-lived
assets





Per SFAS
144, long-lived assets are analyzed for impairment. The Company tests for
impairment of long-lived assets at least annually or more often whenever there
is an indication that the carrying amount of the asset may not be recovered.
Recoverability of these assets is determined by comparing the forecasted
undiscounted cash flows generated by those assets to the assets' net carrying
value. The amount of impairment loss, if any, is measured as the difference
between the net book value of the assets and the estimated fair value of the
related assets.





Management
evaluates the recoverability of long-lived assets by measuring the carrying
amount of the assets against the estimated undiscounted future cash flows
associated with them. At the time such flows of certain long-lived assets are
not sufficient to recover the carrying value of such assets, the assets are
adjusted to their fair values. As of December 31, 2008, the Company believes
that there were no significant impairments of long-lived assets.




Revenue
recognition





The
Company recognizes revenue when all four of the following criteria are met: (1)
persuasive evidence has been received that an arrangement exists; (2) delivery
of the products and/or services has occurred; (3) the selling price is fixed or
determinable; and (4) collectability is reasonably assured. The Company follows
the provisions of SAB No. 104 which sets forth guidelines in the timing of
revenue recognition based upon factors such as passage of title, installation,
payments and customer acceptance. Any amounts received prior to satisfying the
Company's revenue recognition criteria is recorded as deferred revenue. The
Company requires its customers to deposit monies with the Company when they
place an order. The Company does not pay interest on these amounts




F-8




CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


Sales
revenue represents the invoiced value of goods, net of a value-added tax (VAT).
All of the Company's products that are sold in the PRC are subject to a Chinese
value-added tax at a rate of 17% of the gross sales price. This VAT may be
offset by VAT paid by the Company on raw materials and other materials included
in the cost of producing their finished product.





VAT on
sales and VAT on purchases amounted to $9,048,561 and $6,740,512 for the year
ended December 31, 2008 and $6,315,142 and $5,243,211 for the year ended
December 31, 2007, respectively. Sales and purchases are recorded net of VAT
collected and paid as the Company acts as an agent for the government. VAT taxes
are not impacted by the income tax holiday.





Shipping and
handling




Shipping
and handling costs related to costs of goods sold are included in selling,
general and administrative costs and totaled $491,213 and $282,891 for the years
ended December 31, 2008 and 2007, respectively.





Advertising
costs





The
Company expenses the cost of advertising as incurred in selling, general and
administrative costs. For the years ended December 31, 2008 and 2007,
advertising expenses amounted to $536,674 and $411,300,
respectively.





Research and development
costs





Research
and development costs are expensed as incurred. The costs of material and
equipment that are acquired or constructed for research and development
activities, and have alternative future uses, either in research and
development, marketing, or sales, are classified as property and equipment or
depreciated over their estimated useful lives.





Foreign currency
translation




The
reporting currency of the Company is the US dollar. The Company uses their local
currency, Renminbi (RMB), as its functional currency. Results of operations and
cash flow are translated at average exchange rates during the period, and assets
and liabilities are translated at the unified exchange rate as quoted by the
People’s Bank of China at the end of the period. Translation adjustments
resulting from this process are included in accumulated other comprehensive
income in the statement of shareholders’ equity. Because cash flows are also
translated at average translation rates, amounts reported on the statement of
cash flows will not necessarily agree with changes in the corresponding balances
on the balance sheet.




F-9




CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


Asset and
liability accounts at December 31, 2008 were translated at 6.82 RMB to $1.00 as
compared to 7.29 RMB at December 31, 2007. Equity accounts were stated at their
historical rate. The average translation rates applied to income statements
accounts for the years ended December 31, 2008 and 2007 were 6.94 RMB and 7.59
RMB, respectively.





Transaction
gains and losses that arise from exchange rate fluctuations on transactions
denominated in a currency other than the functional currency are included in the
results of operations as incurred. No material transaction gains and losses for
the years ended December 31, 2008 and 2007. Historically, the Company has not
entered any currency trading or hedging transactions, although there is no
assurance that the Company will not enter into such transactions in the
future.





Income
taxes





The
Company records income taxes pursuant to SFAS 109, "Accounting for Income Taxes"
which requires the recognition of deferred income tax liabilities and assets for
the expected future tax consequences of temporary differences between income tax
basis and financial reporting basis of assets and liabilities. Provision for
income taxes consist of taxes currently due plus deferred taxes. There are no
deferred tax amounts at December 31, 2008 and 2007.





The
charge for taxation is based on the results for the year as adjusted for items,
which are non-assessable or disallowed. It is calculated using tax rates that
have been enacted or substantially enacted by the balance sheet
date.





Deferred
tax is accounted for using the balance sheet liability method in respect of
temporary differences arising from differences between the carrying amount of
assets and liabilities in the financial statements and the corresponding tax
basis used in the computation of assessable tax profit. In principle, deferred
tax liabilities are recognized for all taxable temporary differences, and
deferred tax assets are recognized to the extent that it is probable that
taxable profit will be available against which deductible temporary differences
can be utilized. Deferred tax is calculated at the tax rates that are expected
to apply to the period when the asset is realized or the liability is settled.
Deferred tax is charged or credited in the income statement, except when it is
related to items credited or charged directly to equity, in which case the
deferred tax is also dealt with in equity. Deferred tax assets and liabilities
are offset when they relate to income taxes levied by the same taxation
authority and the Company intends to settle its current tax assets and
liabilities on a net basis.




F-10


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008




The
Company adopted FASB Interpretation 48, “Accounting for Uncertainty in Income
Taxes” (“FIN 48”), as of January 1, 2007. A tax position is recognized as a
benefit only if it is “more likely than not” that the tax position would be
sustained in a tax examination, with a tax examination being presumed to occur.
The amount recognized is the largest amount of tax benefit that is greater than
50% likely of being realized on examination. For tax positions not meeting the
“more likely than not” test, no tax benefit is recorded. The adoption had no
affect on the Company’s financial statements.





China
Medicine Corporation was incorporated in the United States and has incurred net
operating losses for income tax purposes for the years ended December 31, 2008
and 2007, respectively. The net operating loss carry forwards for United States
income taxes amounted to $2,550,000 which may be available to reduce future
years’ taxable income. These carry forwards will expire, if not utilized,
through 2028. Management believes that the realization of the benefits from
these losses appears uncertain due to the Company’s limited operating history
and continuing losses for United States income tax purposes. Accordingly, the
Company has provided a 100% valuation allowance on the deferred tax asset
benefit to reduce the asset to zero. The valuation allowance at December 31,
2008 was $867,000. The net change in the valuation allowance for the years ended
December 31, 2008 and 2007 was an increase of $255,000 and $409,000,
respectively. Management will review this valuation allowance periodically and
make adjustments as warranted.





Fair value of financial
instruments





On
January 1, 2008, the Company adopted SFAS 157, “Fair Value Measurements,” which
defines fair value, establishes a three-level valuation hierarchy for
disclosures of fair value measurement and enhances disclosures requirements for
fair value measures. The carrying amounts reported in the balance sheets for
receivables and current liabilities each qualify as financial instruments and
are a reasonable estimate of fair value because of the short period of time
between the origination of such instruments and their expected realization. The
three levels are defined as follow:




●
            Level
      1 inputs to the valuation methodology are quoted prices (unadjusted) for
      identical assets or liabilities in active
  markets.





●
            Level
      2 inputs to the valuation methodology include quoted prices for similar
      assets and liabilities in active markets, and inputs that are observable
      for the asset or liability, either directly or indirectly, for
      substantially the full term of the financial
  instrument.




●
            Level
      3 inputs to the valuation methodology are unobservable and significant to
      the fair value measurement.




F-11


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


As of
December 31, 2008, the Company did not identify any assets and liabilities that
are required to be presented on the balance sheet at fair value.





Stock-based
compensation





The
Company records and reports stock-based compensation under FAS 123R,
“Share-Based Payments”. This Statement requires a public entity to measure the
cost of services received in exchange for an award of equity instruments based
on the grant-date fair value of the award. That cost is recognized over the
period during which services are received. Stock compensation for stock granted
to non-employees is determined in accordance with FAS 123R and the EITF 96-18,
"Accounting for Equity Instruments that are issued to Other than Employees for
Acquiring, or in Conjunction with Selling Goods or Services", as the fair value
of the consideration received or the fair value of equity instruments issued,
whichever is more reliably measured.





Earnings per
share





The
Company reports earnings per share in accordance with the provisions of SFAS
128, "Earnings Per Share," which requires presentation of basic and diluted
earnings per share in conjunction with the disclosure of the methodology used in
computing such earnings per share. Basic earnings per share are computed by
dividing income available to common stockholders by the weighted average common
shares outstanding during the period. Diluted earnings per share takes into
account the potential dilution that could occur if securities or other contracts
to issue common stock were exercised and converted into common
stock.




The
following is a reconciliation of the basic and diluted earnings per share
computations for the years ended December 31:





2008
            
            
            2007Net
      income
            
            $
            9,125,616
            
            
            $
            6,875,369Shares
      of common stock and common stock equivalents:Weighted
      average shares used in basic computation
            
            
            15,173,113
            
            
            
            12,346,208Diluted
      effect of stock options, warrants, and preferred stock
            
            
            135,416
            
            
            
            1,311,799Weighted
      average shares used in diluted computation
            
            
            15,308,529
            
            
            
            13,658,007Earnings
      per share:Basic
            
            $
            0.60
            
            
            $
            0.56Diluted
            
            $
            0.60
            
            
            $
            0.50




For the
year ended December 31, 2008, 2,969,738 warrants whose exercise price is $2.43
and 15,000 options whose exercise price is $3.00 and 70,000 options whose
exercise price is $2.26 and 15,000 options whose exercise price is $2.01 are
excluded from the calculation because of their anti-dilutive
nature.




F-12


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


For the
year ended December 31, 2007, 7,500 options whose exercise price is $3.00 are
excluded from the calculation because of their anti-dilutive
nature.





Minority
interest





Minority
interest consists of the 30% interest of minority shareholders in Guangzhou
Co-win Bioengineering Co., Ltd.





Recently issued accounting
pronouncements





In
February 2007, the FASB issued SFAS 159, “The Fair Value Option for Financial
Assets and Financial Liabilities—including an amendment of FASB Statement No.
115,” which permits companies to choose to measure many financial instruments
and certain other items at fair value that are not currently required to be
measured at fair value. The objective of SFAS 159 is to provide opportunities to
mitigate volatility in reported earnings caused by measuring related assets
and liabilities differently without having to apply hedge accounting provisions.
SFAS 159 also establishes presentation and disclosure requirements designed
to facilitate comparisons between companies that choose different measurement
attributes for similar types of assets and liabilities. SFAS 159 is effective as
of the beginning of an entity’s first fiscal year that begins after November 15,
2007. The Company adopted SFAS 159 on January 1, 2008, and chose not to elect
the option to measure the fair value of eligible financial assets and
liabilities.




In
September 2007, the FASB issued FASB Staff Position No. EITF 07-3, “Accounting
for Nonrefundable Advance Payments for Goods or Services Received for use in
Future Research and Development Activities” (“FSP EITF 07-3”), which addresses
whether nonrefundable advance payments for goods or services that used or
rendered for research and development activities should be expensed when the
advance payment is made or when the research and development activity has been
performed. The adoption of FSP EITF 07-3 did not materially impact the Company’s
consolidated financial statements.





In
December 2007, the FASB issued SFAS 160, “Noncontrolling Interests in
Consolidated Financial Statements - an amendment of Accounting Research Bulletin
No. 51,” which establishes accounting and reporting standards for ownership
interests in subsidiaries held by parties other than the parent, the amount of
consolidated net income attributable to the parent and to the noncontrolling
interest, changes in a parent’s ownership interest and the valuation of retained
non-controlling equity investments when a subsidiary is deconsolidated. The
Statement also establishes reporting requirements that provide sufficient
disclosures that clearly identify and distinguish between the interests of the
parent and the interests of the non-controlling owners. SFAS 160 is effective
for fiscal years beginning after December 15, 2008. The Company believes
adopting SFAS 160 will significantly impact its financial statements for
purchases of minority ownership completed after December 31, 2008.




F-13


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


In
December 2007, the FASB issued SFAS 141(R), “Business Combinations,” which
replaces SFAS 141, “Business Combinations”. SFAS 141R retains the fundamental
requirements in SFAS 141 that the acquisition method of accounting (which SFAS
141 called the purchase method) be used for all business combinations and for an
acquirer to be identified for each business combination. SFAS 141R requires an
acquirer to recognize the assets acquired, the liabilities assumed, and any
noncontrolling interest in the acquiree at the acquisition date, measured at
their fair values as of that date, with limited exceptions. This replaces SFAS
141’s cost-allocation process, which required the cost of an acquisition to be
allocated to the individual assets acquired and liabilities assumed based on
their estimated fair values. SFAS 141R also requires the acquirer in a business
combination achieved in stages (sometimes referred to as a step acquisition) to
recognize the identifiable assets and liabilities, as well as the noncontrolling
interest in the acquiree, at the full amounts of their fair values (or other
amounts determined in accordance with SFAS 141R). SFAS 141R applies
prospectively to business combinations for which the acquisition date is on or
after the beginning of the first annual reporting period beginning on or after
December 15, 2008. An entity may not apply it before that date. The Company
believes adopting SFAS 141R will significantly impact its financial statements
for any business combination completed after December 31, 2008.





In June
2008, the FASB issued EITF 07-5 “Determining whether an Instrument (or Embedded
Feature) is indexed to an Entity’s Own Stock”. This Issue is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years. Early application is not
permitted. Paragraph 11(a) of SFAS133 “Accounting for Derivatives and Hedging
Activities” specifies that a contract that would otherwise meet the definition
of a derivative but is both (a) indexed to the Company’s own stock and
(b) classified in stockholders’ equity in the statement of financial
position would not be considered a derivative financial instrument. EITF 07-5
provides a new two-step model to be applied in determining whether a financial
instrument or an embedded feature is indexed to an issuer’s own stock and thus
able to qualify for the SFAS 133 paragraph 11(a) scope exception. The Company
believes adopting this statement will have a material impact on the financial
statements because among other things, any option or warrant previously issued
and all new issuances denominated is US dollars will be required to be carried
as a liability and marked to market each reporting period.





In April
2008, the FASB issued FSP 142-3 “Determination of the useful life of Intangible
Assets” ,which amends the factors a company should consider when developing
renewal assumptions used to determine the useful life of an intangible asset
under SFAS 142. This Issue is effective for financial statements issued for
fiscal years beginning after December 15, 2008, and interim periods within those
fiscal years. SFAS 142 requires companies to consider whether renewal can be
completed without substantial cost or material modification of the existing
terms and conditions associated with the asset. FSP 142-3 replaces the previous
useful life criteria with a new requirement—that an entity consider its own
historical experience in renewing similar arrangements. If historical experience
does not exist, then the Company would consider market participant assumptions
regarding renewal including 1) highest and best use of the asset by a market
participant, and 2) adjustments for other entity-specific factors included in
SFAS 142. The Company is currently evaluating the impact that adopting FSP 142-3
will have on its financial statements.




F-14


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


In June
2008, FASB issued EITF 08-4, “Transition Guidance for Conforming Changes to
Issue No. 98-5,”  The objective of EITF 08-4 is to provide transition
guidance for conforming changes made to EITF 98-5, “Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios”, that result from EITF 00-27, “Application of Issue No. 98-5
to Certain Convertible Instruments”, and SFAS 150, “Accounting for Certain
Financial Instruments with Characteristics of both Liabilities and Equity”. This
Issue is effective for financial statements issued for fiscal years ending after
December 15, 2008. Early application is permitted.  EITF 08-4 had no impact
on the Company’s financial statements.





In
June 2008, the FASB issued FSP EITF 03-6-1, “Determining Whether
Instruments Granted in Share-Based Payment Transactions Are Participating
Securities.” The FSP addresses whether instruments granted in share-based
payment transactions are participating securities prior to vesting and therefore
need to be included in the earnings allocation in calculating earnings per share
under the two-class method described in SFAS 128. The FSP requires
companies to treat unvested share-based payment awards that have non-forfeitable
rights to dividend or dividend equivalents as a separate class of securities in
calculating earnings per share. The FSP is effective for fiscal years beginning
after December 15, 2008; earlier application is not permitted. The
Company does not expect adoption of FSP EITF 03-6-1 to have a material
effect on its results of operations or earnings per share.





In
September 2008, the FASB issued FSP  FAS 133-1 and
FIN 45-4, “Disclosures about Credit Derivatives and Certain Guarantees: An
Amendment of FASB Statement No. 133 and FASB Interpretation No. 45;
and Clarification of the Effective Date of FASB Statement No. 161.”
FSP FAS 133-1 and FIN 45-4 requires enhanced disclosures about
credit derivatives and guarantees and amends FIN 45, “Guarantor’s
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others” to exclude credit derivative instruments
accounted for at fair value under SFAS 133. The FSP is effective for
financial statements issued for reporting periods ending after
November 15, 2008. Since FSP FAS 133-1 and FIN 45-4
only requires additional disclosures concerning credit derivatives and
guarantees, adoption of FSP FAS 133-1 and FIN 45-4 did not have
an effect on the Company’s financial condition, results of operations or cash
flows.





On
October 10, 2008, the FASB issued FSP 157-3, “Determining the Fair Value of a
Financial Asset When the Market for That Asset Is Not Active,” which clarifies
the application of SFAS 157 in a market that is not active and provides an
example to illustrate key considerations in determining the fair value of a
financial asset when the market for that financial asset is not active. FSP
157-3 became effective on October 10, 2008, and its adoption did not have a
material impact on our financial position or results for the year ended December
31, 2008.




F-15


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


In
January 2009, the FASB issued FSP EITF 99-20-1, “Amendments to the Impairment
Guidance of EITF Issue No. 99-20, and EITF Issue No. 99-20, Recognition of
Interest Income and Impairment on Purchased and Retained Beneficial Interests in
Securitized Financial Assets”. FSP EITF 99-20-1 changes the impairment model
included within EITF 99-20 to be more consistent with the impairment model of
SFAS 115. FSP EITF 99-20-1 achieves this by amending the impairment model in
EITF 99-20 to remove its exclusive reliance on “market participant” estimates of
future cash flows used in determining fair value. Changing the cash flows used
to analyze other-than-temporary impairment from the “market participant” view to
a holder’s estimate of whether there has been a “probable” adverse change in
estimated cash flows allows companies to apply reasonable judgment in assessing
whether an other-than-temporary impairment has occurred. The FSP shall be
effective for annual reporting periods ending after December 15, 2008. The
adoption of FSP EITF 99-20-1 did not have a material impact on our consolidated
financial statements because all of our investments in debt securities are
classified as trading securities.




Note 3 – Accounts receivable





Accounts
receivable as of December 31 consisted of the following:





2008
            
            
            2007Trade
      accounts receivable
            
            $
            19,321,700
            
            
            $
            13,681,987Allowance
      for bad debts
            
            
            (96,609
            )
            
            
            (55,640
            )Trade
      accounts receivable, net
            
            $
            19,225,091
            
            
            $
            13,626,347





December 31,
            
            
            December 31,2008
            
            
            2007Beginning
      allowance for doubtful accounts
            
            $
            55,640
            
            
            $
            34,021Additions
      charged to bad debt expense
            
            
            36,428
            
            
            
            18,495Foreign
      currency translation adjustments
            
            
            4,541
            
            
            
            3,124Ending
      allowance for doubtful accounts
            
            $
            96,609
            
            
            $
            55,640





Note
4 – Inventories





Inventories
consisted of only finished goods as of December 31, as follows:





2008
            
            
            2007Pharmaceutical
      Medicine
            
            $
            4,725,322
            
            
            $
            3,948,460Totals
            
            $
            4,725,322
            
            
            $
            3,948,460




F-16


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008





Note
5 - Equipment





Equipment
consisted of the following:





December 31,
      2008
            
            
            December 31,
      2007Furniture
      and fixtures
            
            $
            169,305
            
            
            $
            174,086Equipment
            
            
            3,761,419
            
            
            
            1,259,434Motor
      vehicles
            
            
            433,768
            
            
            
            405,382Leasehold
      improvement
            
            
            318,398
            
            
            
            181,027Total
            
            
            4,682,890
            
            
            
            2,019,929Less
      accumulated depreciation
            
            
            (921,253
            )
            
            
            (631,010
            )Equipment,
      net
            
            $
            3,761,637
            
            
            $
            1,388,919




Depreciation
expense for the years ended December 31, 2008 and 2007 amounted to $420,769 and
$303,957 respectively.




Note 6 – Long term prepayment





Long term
prepayment as of December 31, consist of the following:




2008
            
            
            2007Prepayment
      for purchase of assets
            
            $
            362,864
            
            
            $
            678,237Prepayment
      for agency fee
            
            
            880,200
            
            
            
            —Long
      term deferred assets
            
            
            150,806
            
            
            
            —Long
      term deposit
            
            
            1,687,050
            
            
            
            —Deposit
      - technology know-how
            
            
            2,934,000
            
            
            
            —Total
      long term prepayment
            
            $
            6,014,920
            
            
            $
            678,237





Note
7 - Taxes





The
Company is organized in the United States and no tax benefit is expected from
tax credits in the future.  Beginning January 1, 2008, the new
Enterprise Income Tax (“EIT”) law replaced the existing laws for Domestic
Enterprises (“DES”) and Foreign Invested Enterprises (“FIEs”).





The key
changes are:





a.
            The
      new standard EIT rate of 25% replaced the 33% rate currently applicable to
      both DES and FIEs, except for High Tech companies who pays a reduced rate
      of 15%;





b.
            Companies
      established before March 16, 2007 will continue to enjoy tax holiday
      treatment approved by local government for a grace period of either for
      the next 5 years or until the tax holiday term is completed, whichever is
      sooner. These companies will pay the standard tax rate as defined in point
      “a” above when the grace period
expires.




F-17


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


The
Company and its subsidiaries were established before March 16, 2007 and
therefore are qualified to continue enjoying the reduced tax rate as described
above.





Under the
Income Tax Laws of PRC, the Company is generally subject to income tax at an
effective rate of 33% (30% state income taxes plus 3% local income taxes) on
income reported in the statutory financial statements after appropriate tax
adjustments, unless the enterprise is located in a specially designated region
where it allows foreign enterprises a two-year income tax exemption and a 50%
income tax reduction for the following three years.





The
Company’s two subsidiaries, Konzern and Co-win are located and are doing
business in China. Konzern was approved as a foreign Joint-venture enterprise in
2004 and as a wholly-owned foreign enterprise in 2006. Konzern has an income tax
exemption for 2004 and 2005 and a 50% reduction on the income tax rate for 2006,
2007 and 2008. Co-win has not obtained the approval for the tax exemption in
2006, and was subjected to an effective rate of 33%.





The
estimated tax savings for the years ended December 31, 2008 and 2007 amounted
$964,476 and $1,649,114, respectively. The net effect on earnings per share if
the income tax had been applied would decrease earnings per share from $0.60 to
$0.47 for the year ended December 31, 2008 and from $0.57 to $0.44 for the year
ended December 31, 2007, respectively.




The
provision for income taxes for the years ended December 31, 2008 and 2007
consisted of the following:




2008
            
            
            2007Provision
      for China income tax
            
            $
            1,823,761
            
            
            $
            1,499,195Provision
      for local tax
            
            
            182,376
            
            
            
            149,919Total
            
            $
            2,006,137
            
            
            $
            1,649,114





The
following table reconciles the U.S. statutory rates to the Company's effective
tax rate for the years ended December 31:





2008
            
            
            2007U.S.
      statutory rates
            
            
            34.0
            %
            
            
            34.0
            %Foreign
      income not recognized in USA
            
            
            (34.0
            )
            
            
            (34.0
            )China
      income taxes
            
            
            25.0
            
            
            
            33.0Income
      tax exemption
            
            
            (8.1
            )
            
            
            (16.5
            )Effective
      tax rate
            
            
            16.9
            %
            
            
            16.5
            %




F-18


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


Taxes
payable consisted of the following:





December 31,
      2008
            
            
            December 31,
      2007Income
      taxes payable
            
            $
            12,042
            
            
            $
            61,908Value
      added tax
            
            
            758,168
            
            
            
            405,264Other
      income tax
            
            
            2,079
            
            
            
            1,012Total
            
            $
            772,289
            
            
            $
            468,184




Note
8 - Commitments and contingencies





The
Company entered into non-cancelable purchase commitment with two vendors. As of
December 31, 2008, the Company was obligated under the non-cancelable commitment
to purchase products amounting to $1,907,100. The Company has experienced no
losses on these purchase commitments as of December 31, 2008.





On May 9,
2008, the Company signed a technology know-how transfer agreement for the amount
of $4,401,000 (RMB 30,000,000) as long term prepayment. As of December 31, 2008,
$1,467,000 remains unpaid.





The
Company leases its facilities under short-term and long-term, non-cancelable
operating lease agreements expiring through November 2013. The non-cancelable
operating lease agreement states for various lease periods that the Company pays
certain monthly operating expenses applicable to the leased
premises.




The future minimum annual lease payments required are as
follows:





Year Ending December 31,
            
            Amount2009
            
            $
            142,3222010
            
            
            86,9292011
            
            
            64,6302012
            
            
            10,0582013
            
            
            1,259Thereafter
            
            
            —





Total
rent expense for the years ended December 31, 2008 and 2007 amounted to $130,258
and $115,067, respectively.





Notes
9 - Supplemental disclosure of cash flows





The
Company paid no interest for the years ended December 31, 2008 and 2007,
respectively.




F-19


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


The
Company paid $2,059,396 and $1,573,872 income taxes for the years ended December
31, 2008 and 2007, respectively.





For the
year ended December 31, 2008, holders of Series A convertible preferred stock
converted 111,649 shares of Series A preferred stock into 115,101 shares of
common stock, par value $0.0001 per share.





Pursuant
to agreements with the parties, the Company offset certain accounts receivable
balances against advances to supplier totaling $186,358 and $0 for the years
ended December 31, 2008 and 2007, respectively.




Note
10 - Statutory reserves





The laws
and regulations of the People’s Republic of China require that before an
enterprise distributes profits to its partners, it must first satisfy all tax
liabilities, provide for losses in previous years, and make allocations, in
proportions determined at the discretion of the board of directors, after the
statutory reserve. The statutory reserves include surplus reserve fund and the
enterprise fund and represent restricted retained earnings.





Surplus reserve
fund





The
Company is required to transfer 10% of its net income, as determined in
accordance with the PRC accounting rules and regulations, to a statutory surplus
reserve fund until such reserve balance reaches 50% of the Company’s registered
capital, the Company has total registered capital approximately $6,205,694 (RMB
49,287,414). As of December 31, 2008 the Company is required to contribute an
additional $1,833,750 from future earnings.





The
transfer to this reserve must be made before distribution of any dividend to
shareholders. For the years ended December 31, 2008 and 2007, the Company did
not transfer any fund to this reserve. The surplus reserve fund is
non-distributable other than during liquidation and can be used to fund previous
years’ losses, if any, and may be utilized for business expansion or converted
into share capital by issuing new shares to existing shareholders in proportion
to their shareholding or by increasing the par value of the shares currently
held by them, provided that the remaining reserve balance after such issue is
not less than 25% of the registered capital.





Enterprise
fund





The
enterprise fund may be used to acquire plant and equipment or to increase the
working capital to expend on production and operation of the business. No
minimum contribution is required and the Company did not make any contribution
to this fund for the years ended December 31, 2008 and 2007,
respectively.


F-20
  CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008




Note
11 - Retirement benefit plans





Regulations
in the PRC require the Company to contribute to a defined contribution
retirement plan for all permanent employees. The contribution is based on a
percentage required by the local government and the employees' current
compensation. The Company contributed $69,211 and $50,529 for the years ended
December 31, 2008 and 2007, respectively.





Note
12 - Shareholders’ equity





Saleof preferred
stock





Contemporaneously
with the reverse acquisition, the Company entered into a Preferred Stock
Purchase Agreement (“PSPA”), dated February 8, 2006, with Barron Partners L.P.,
Ray and Amy Rivers, JTROS, Steve Mazur and William Denkin pursuant to which the
Company issued and sold 3,120,000 shares of its Series A convertible preferred
stock, a newly-created series of preferred stock, and warrants to purchase
3,694,738 shares of common stock at $1.75 per share and 3,694,738 shares of
common stock at $2.50 per share.





The
Series A convertible preferred stock is convertible at the option of the holder
at any time, into 3,120,000 shares of common stock, subject to adjustment set
forth in the PSPA. No dividends are payable on the preferred stock and dividends
may not be paid on the common stock while the preferred stock is outstanding.
The preferred stock is not redeemable but has a liquidation preference of $1.25
per share. Holders of the preferred stock are not entitled to vote, except on
matters that would adversely affect their rights.





The
warrants have a term of five years and are exercisable by the holder at any time
within the term. With certain exceptions, if the Company issues common stock at
a price, or warrants or other convertible securities with an exercise or
conversion price, which is less than the exercise price of the warrants, the
exercise price of the warrants will be reduced to the sales price, exercise
price or conversion price, as the case maybe, of such other securities. However,
in such circumstances, the number of shares obtainable on exercise of the
warrants is not changed.





The
conversion rate of the Series A convertible preferred stock and the
exercise price of the warrants (but not the number of shares obtainable on
exercise) are subject to adjustment in certain events, including the failure to
achieve specified levels of adjusted earnings before interest, taxes,
depreciation and amortization or fully diluted pre-tax income per share,
computed as set forth in the applicable agreements.  Because pre-tax
targets were not met, the conversion price of the preferred stock has been
reduced from $1.25 to $1.22 resulting in approximately 80,000 additional common
shares to be issued. The exercise price of the warrants has been reduced from
$1.75 to $1.70. There has been no effect on the financial statements for this
change.





On April
23, 2007, the Company and the holders of the preferred shares and warrants
executed a Waiver and Agreement that reduced the conversion price for preferred
stock and the exercise price of the warrants by 3% of the original conversion
amounts. The new agreement also requires the Company to redistribute the 750,000
shares issued to AiDi Financial Investment LLC, if recovered, as follows:
50% to the Company’s senior executives and 50% to the holders of preferred
shares.  Further, the Series A convertible preferred stock cannot be
converted and the warrants cannot be exercised if such conversion or exercise
would result in the holder and its affiliates owning more than 4.9% of the then
outstanding number of shares of common stock. The Company evaluated the
impact of this amendment and determined there is no effect on the financial
statements, given that both instruments were originally accounted for as equity
instruments and that a variation in the conversion and exercise prices was
contemplated under the original terms of the instruments, the implementation of
that condition does not require any separate accounting
recognition.




F-21


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


Under a Registration Rights Agreement with the investors, the
Company was required to file a registration statement registering the common
stock issuable upon conversion of the series A convertible preferred stock and
exercise of the warrants. The registration statement was filed on April 13,
2006, and was declared effective October 17, 2006. The Company incurred
liquidated damages under the Registration Rights Agreement of $44,003 for the
period from August 8, 2006 through October 17, 2006; these amounts are accrued
liabilities and were recorded as interest expense. Additionally, the Company is
required to maintain its effectiveness until the expiration of two years after
the date of the agreement or until the investors hold less than 10% of the
registerable securities or more liquidated damages of approximately $19,000 per
month will be incurred.





Common
stock




For the
year ended December 31, 2007, 1,621,750 shares of warrants were exercised at
$1.75 per share, 1,694,040 shares of warrants were exercised at $1.70 per share,
and 725,000 shares of warrants were exercised at 2.43 per share for the year
ended December 31, 2007. The Company received total of $7,479,681 cash from the
exercise of warrants as of December 31, 2007.





The
Company entered into Investor Relations Consulting Agreement with Hayden
Communication International, Inc. (“HC”) dated October 11, 2006, pursuant to
which HC is to provide the Company public relations consulting services for
certain consideration including the issuance of 43,125 shares of the Company’s
common stock. On July 19, 2007, these shares have been issued to HC. The
issuance of the shares is exempt from registration pursuant to Section 4(2) and
regulation D promulgated under the Securities Act of 1933, as amended (the ‘1933
Act”) and should contain a standard 1933 Act restrictive legend. Therefore, the
Company valued the common stock at $3.12 per share for a total of $179,400 for
the 43,125 shares issued; $179,400 was expensed for the year ended December 31,
2007.





During
the period ended December 31, 2008, holders of Series A convertible preferred
stock converted 111,649 shares into 115,101 shares of common stock, par value
$0.0001 per share. For the year ended December 31, 2007, holders converted
3,008,351 shares of Series A convertible preferred stock into 3,063,351 shares
of common stock, par value $0.0001 per share. As of December 31, 2008, all
convertible preferred stock had been converted into common stock.


F-22
  CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008




Stock options and
warrants





For the
year ended December 31, 2007, 280,000 shares of stock options were exercised at
$1.25 per share. The Company received a total of $350,000 cash from the stock
options that were exercised.





On April
2, 2007, the Company granted a total of 15,000 stock options to three of its
independent directors. The options become exercisable for 7,500 shares of common
stock six months from the grant date and the remaining 7,500 options, eighteen
months from the grant date. For the years ended December 31, 2008 and 2007, the
Company expensed $5,496 and $16,492 related to these stock options,
respectively.





On
November 22, 2007, the Company granted a total of 70,000 warrants to a third
party for investor relations services. The Company valued these warrants at
$71,753 using the Black Scholes model with the following factors: market price
of $2.37; volatility of 50%; risk free rate of 3.4%; exercise price of $2.26;
and an estimated life of 3.86 years. For the period ended December 31, 2008 and
2007, the Company expensed $61,503 and $10,250 related to these warrants,
respectively.




In July
31, 2008, the Company granted a total of 15,000 stock options to three of its
independent directors. The options become exercisable for 7,500 shares of common
stock six months from the grant date and the remaining 7,500 options, eighteen
months from the grant date. For the year ended December 31, 2008, the Company
expensed $9,992 related to these stock options.





For the
period ended December 31, 2008, 290,000 options were exercised at $1.25 per
share. The Company received a total of $362,500 cash from the exercise of stock
options.





SFAS 123R
requires that compensation expense related to the options granted be calculated
based on the fair value of the options as of the date of grant. The fair value
calculations take into account the exercise prices and expected lives of the
options, the current price of the underlying stock, its expected volatility, the
expected dividends on the stock, and the current risk-free interest rate for the
expected life of the option. Because there is no frequent trading market for the
Company's common stock, no historical data on which to base an estimate of
volatility. The Company has considered the volatility that might be expected to
occur for companies comparable to the Company and, selected three
publicly-traded companies whose business are similar to the Company's and who
are classified in the same SIC code as the Company, have assumed a volatility of
50% as being reasonably representative of the volatility that could be expected
to occur in the future over the relevant periods. The risk-free rates used are
based on Treasury Constant Maturity rates, published by the U.S. Federal
Reserve.




F-23


CHINA
MEDICINE CORPORATION AND SUBSIDIARIES
 
 NOTES TO
CONSOLIDATED FINANCIAL STATEMENTS
 DECEMBER
31, 2008


Since the
Company does not have a history of employee stock options, the estimated life is
based on one half of the sum of the vesting period and the contractual life of
the option. For the years ended December 31, 2008 and 2007, the Company had
stock-based compensation expense of $88,463 and $154,470,
respectively.





The
Company used the Cox-Ross-Rubinstein binomial model to value the options,
Warrants and the embedded conversion option of the Series A convertible
preferred stock. The following assumptions were used in the preparation of the
above valuations at inception:





Assumption
            
            Preferred Stock
            
            
            Warrants A
            
            
            Warrants B
            
            
            Stock optionsCommon
      stock -fair value
            
            $
            2,518,615
            
            
            $
            819,264
            
            
            $
            562,121
            
            
            $
            223,173Expected
      life
            
            Perpetual
            
            
            5
      years
            
            
            5
      years
            
            
            2.5
      yearsVolatility
            
            
            
            
            
            
            50
            %
            
            
            50
            %
            
            
            50
            %Risk-free
      rate
            
            
            
            
            
            
            4.55
            %
            
            
            4.55
            %
            
            
            4.65
            %





Summary of option
activity:




Outstanding
            
            
            Weighted-Average
      Exercise Price of outstanding options
            
            
            Exercisable
            
            
            Weighted-Average
      Exercise Price of excisable options
            
            
            Weighted-Average
      Remaining Contractual Term (years)
            
            
            Intrinsic
      Value12/31/2006
            
            
            1,370,000
            
            
            $
            1.25
            
            
            
            944,000
            
            
            $
            1.25
            
            
            
            1.48
            
            
            $
            2,479,700Granted
            
            
            15,000
            
            
            $
            3.00
            
            
            
            7,500
            
            
            $
            3
            
            
            
            5Exercised
            
            
            (280,000
            )
            
            $
            1.25
            
            
            
            (280,000
            )
            
            $
            1.25Forfeited
            
            
            —
            
            
            
            
            
            
            
            012/31/2007
            
            
            1,105,000
            
            
            $
            1.91
            
            
            
            671,500
            
            
            $
            1.91
            
            
            
            0.53
            
            
            $
            1,041,750Granted
            
            
            15,000
            
            
            $
            2.01
            
            
            
            7,500
            
            
            $
            2.01
            
            
            
            4.83Exercised
            
            
            (290,000
            )
            
            $
            1.25
            
            
            
            (290,000
            )
            
            $
            1.25Forfeited
            
            
            (450,000
            )
            
            
            
            
            
            
            -16,50012/31/2008
            
            
            380,000
            
            
            $
            1.35
            
            
            
            372,500
            
            
            $
            1.34
            
            
            
            2.48
            
            
            $
            —





Summary of
warrant activity:




WarrantsOutstanding
            
            Fair Market
      Value
            
            Weighted-Average Exercise
      Price
            
            Weighted-Average
              Remaining
              Contractual
              Term
      (years)December
      31, 2006
            
            
            7,389,476
            
            0.81
            
            
            2.13
            
            4.17Granted
            
            
            70,000
            
            2.37
            
            
            2.26
            
            3.86Exercised
            
            
            (4,040,790
            )
            3.18
            
            
            1.85Forfeited
            
            
            —December
      31, 2007
            
            
            3,418,686
            
            2.85
            
            
            2.35
            
            3.17Granted
            
            
            —Exercised
            
            
            —Forfeited
            
            
            —December
      31, 2008
            
            
            3,418,686
            
            2.85
            
            
            2.35
            
            2.17





F-24