UNITED STATES


SECURITIES AND EXCHANGE
COMMISSION


WASHINGTON, D.C.
20549







FORM 10-Q/A


(Amendment
No. 1)





(Mark
      One)x
            QUARTERLY
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934For
      the quarterly period ended:September
      30, 2008ORo
            TRANSITION
      REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
      EXCHANGE ACT OF 1934For
      the transition period from _______________ to ______________Commission
      file number:000-52174







EMERALD DAIRY
      INC.(Exact
      Name of Registrant as Specified in its
Charter)




Nevada
            80-0137632(State
      or Other Jurisdiction of Incorporation or
              Organization)
            (I.R.S.
      Employer Identification No.)




11990
      Market Street, Suite 205
              Reston,
      Virginia
            20190(Address
      of Principal Executive Offices)
            (Zip
      Code)(703)
      867-9247(Registrant’s
      Telephone Number, Including Area Code)___________________________________________________________(Former
      Name, Former Address and Former Fiscal Year, if Changed Since Last
      Report)




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 x No o








Indicate
by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange
Act).


Yes o No x




As of
November 14, 2008, the issuer had 29,299,332 shares of Common Stock issued and
outstanding (not including an additional 1,944,444 shares of Common Stock of the
issuer currently being held in treasury).





Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company:





Large
      accelerated filero
            Accelerated
      fileroNon-accelerated
      filerx
            Smaller
      reporting companyx








AMENDMENT
NO. 1 TO QUARTERLY REPORT ON FORM 10-Q


OF EMERALD DAIRY INC. AND
SUBSIDIARIES


FOR THE PERIOD ENDED SEPTEMBER 30,
2008





TABLE OF CONTENTS





PAGEPART I
            -
            FINANCIAL
      INFORMATIONItem
      1.
            
            Financial
      Statements
            
            1Condensed
      Consolidated Balance Sheets as of September 30, 2008 (Unaudited) and
      December 31, 2007
            
            1Condensed
      Consolidated Statements of Income for the Three and Nine Months Ended
      September 30, 2008 and 2007 (Unaudited)
            
            2Condensed
      Consolidated Statements of Cash Flows for the Nine Months Ended September
      30, 2008 and 2007 (Unaudited)
            
            3Footnotes
      to Condensed Consolidated Financial Statements (Unaudited)
            
            4Item
      2.
            
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            
            23Item
      3
            
            Quantitative
      and Qualitative Disclosures About Market Risk
            
            53Item
      4T.
            
            Controls
      and Procedures
            
            53PART II
            -
            OTHER
      INFORMATIONItem
      1.
            
            Legal
      Proceedings
            
            56Item
      1A.
            
            Risk
      Factors
            
            56Item
      2.
            
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            
            56Item
      3.
            
            Defaults
      Upon Senior Securities
            
            56Item
      4.
            
            Submission
      of Matters to a Vote of Security Holders
            
            57Item
      5.
            
            Other
      Information
            
            57Item
      6.
            
            Exhibits
            
            58Signatures
            
            59







EXPLANATORY
NOTE
 
 This Amendment No. 1 to the Quarterly
Report on Form 10-Q (“10-Q/A”), for the fiscal quarter ended September 30, 2008,
of Emerald Dairy Inc. (as originally filed on November 14, 2008, the "Form
10-Q"), is being filed in response to comments from the Staff of the Securities
and Exchange Commission (“Commission”).  The Form 10-Q is restated
herein in its entirety. The disclosures in this amendment continue to speak as
of the date of the Form 10-Q, and do not reflect events occurring after the
filing of the Form 10-Q. Accordingly, this Form 10-Q/A should be read in
conjunction with our other filings made with the Commission subsequent to the
filing of the Form 10-Q, including any amendments to those filings. The filing
of this Form 10-Q/A shall not be deemed an admission that the Form 10-Q filed
included any untrue statement of material fact or omitted to state a material
fact necessary to make a statement not misleading.
  The Company has attached to this 10-Q/A
updated certifications executed as of the date of this Form 10-Q/A by the
principal executive officer and principal financial and accounting officer, as
required by Sections 302 and 906 of the Sarbanes Oxley Act of 2002. These
updated certifications are attached as Exhibits 31.1, 31.2, 32.1 and 32.2 to
this 10-Q/A.




i


PART I. FINANCIAL
INFORMATION





Item 1. Financial
Statements


Emerald Dairy Inc. and
      SubsidiariesCondensed Consolidated Balance
      SheetSeptember 30, 2008 and December
      31, 2007
  2008
              
              2007(Unaudited)
              
              (Audited)ASSETSCurrent
      AssetsCash
      and cash equivalents
              
              $
              3,748,746
              
              $
              6,560,931Trade
      accounts receivable
              
              
              6,702,729
              
              
              5,096,828Inventory
              
              
              1,313,621
              
              
              1,000,427Other
      current assets
              
              
              5,444,970
              
              
              3,936,751Total current
      assets
              
              
              17,210,066
              
              
              16,594,937Property, plant and
      equipmentProperty,
      plant and equipment, net
              
              
              5,700,404
              
              
              3,320,081Construction
      in progress
              
              
              2,743,133
              
              
              -8,443,537
              
              
              3,320,081Intangible assets,
      net
              
              
              1,384,357
              
              
              115,228$
              27,037,960
              
              $
              20,030,246LIABILITIES AND STOCKHOLDERS'
      EQUITYCurrent
      LiabilitiesAccounts
      and accrued expenses
              
              $
              4,420,313
              
              $
              2,395,190Notes
      payable, net of debt discount of $95,917 at September 30,
    2008
              
              
              2,154,083
              
              
              273,973Other
      current liabilities
              
              
              859,308
              
              
              614,977Loan
      from shareholder
              
              
              209,482
              
              
              196,526Total current
      liabilities
              
              
              7,643,186
              
              
              3,480,666Put/Call
      Liability
              
              
              3,169,444
              
              
              3,169,444Stockholders'
      EquityPreferred
      stock ($0.001 par value, 10,000,000 shares authorized,
noneissued
      and outstanding at September 30, 2008 and December 31,
      2007)
              
              
              -
              
              
              -Common
      stock ($0.001 par value, 100,000,000 shares authorized,31,243,776
      issued and outstanding at September 30, 2008 andDecember
      31, 2007)
              
              
              31,244
              
              
              31,241Treasury
      Stock (1,944,444 shares at September 30, 2008 andDecember
      31, 2007)
              
              
              (1,944
              )
              
              (1,944
              )Additional
      paid-in capital
              
              
              4,923,348
              
              
              4,666,244Retained
      earnings (of which $1,340,713 and $659,903 are restricted
    atSeptember
      30, 2008 and December 31, 2007 for common welfare
      reserves)
              
              
              9,301,130
              
              
              7,791,895Accumulated
      other comprehensive income
              
              
              1,971,552
              
              
              892,700Total stockholders'
      equity
              
              
              16,225,330
              
              
              13,380,136$
              27,037,960
              
              $
              20,030,246
  The
accompanying notes are an integral part of these consolidated financial
statements.
  1


Emerald Dairy Inc. and
      SubsidiariesCondensed Consolidated
      Statements of IncomeFor the Three and Nine Months
      Ended September 30, 2008 and 2007(Unaudited)


Three months
      ended
              
              Nine months
      endedSeptember
      30,
              
              September
      30,
              
              September
      30,
              
              September
      30,2008
              
              2007
              
              2008
              
              2007Sales
              
              $
              11,221,019
              
              $
              8,443,361
              
              $
              32,560,256
              
              $
              20,971,555Cost of Goods
      Sold
              
              
              6,552,835
              
              
              5,422,899
              
              
              19,845,232
              
              
              13,853,290Gross
    Profit
              
              
              4,668,184
              
              
              3,020,462
              
              
              12,715,024
              
              
              7,118,265Operating
      ExpensesSelling
      and administrative expenses
              
              
              3,319,484
              
              
              1,561,700
              
              
              10,283,634
              
              
              3,985,432Depreciation
      and amortization
              
              
              41,905
              
              
              12,999
              
              
              72,336
              
              
              36,844Total operating
      expenses
              
              
              3,361,389
              
              
              1,574,699
              
              
              10,355,970
              
              
              4,022,276Other Income
      (Expense)Interest
      income
              
              
              2,455
              
              
              965
              
              
              12,061
              
              
              3,597Interest
      expense
              
              
              (231,517
              )
              
              (5,460
              )
              
              (274,923
              )
              
              (14,050
              )Total
      other income (expense)
              
              
              (229,062
              )
              
              (4,495
              )
              
              (262,862
              )
              
              (10,453
              )Net Income Before Provision for
      Income Tax
              
              
              1,077,733
              
              
              1,441,268
              
              
              2,096,192
              
              
              3,085,536Provision for Income
      TaxesCurrent
              
              
              269,666
              
              
              65,942
              
              
              586,957
              
              
              148,594269,666
              
              
              65,942
              
              
              586,957
              
              
              148,594Net
    Income
              
              $
              808,067
              
              $
              1,375,326
              
              $
              1,509,235
              
              $
              2,936,942Basic Earnings Per
      Share
              
              $
              0.03
              
              $
              0.06
              
              $
              0.05
              
              $
              0.12Basic Weighted Average Shares
      Outstanding
              
              
              29,299,332
              
              
              24,305,546
              
              
              29,299,332
              
              
              24,305,546Diluted Earnings Per
      Share
              
              $
              0.03
              
              $
              0.06
              
              $
              0.05
              
              $
              0.12Diluted Weighted Average Shares
      Outstanding
              
              
              29,563,708
              
              
              24,305,546
              
              
              29,563,708
              
              
              24,305,546The Components of Other
      Comprehensive IncomeNet
      Income
              
              $
              808,067
              
              $
              1,375,326
              
              $
              1,509,235
              
              $
              2,936,942Foreign
      currency translation adjustment
              
              
              259,312
              
              
              165,260
              
              
              1,634,624
              
              
              321,927Income
      tax related to other comprehensive income
              
              
              (88,166
              )
              
              (56,188
              )
              
              (555,772
              )
              
              (109,455
              )Comprehensive
      Income
              
              $
              979,213
              
              $
              1,484,398
              
              $
              2,588,087
              
              $
              3,149,414




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




2


Emerald Dairy Inc. and
      SubsidiariesCondensed Consolidated
      Statements of Cash FlowsFor the Nine Months Ended
      September 30, 2008 and
2007


2008
              
              2007Cash flows from operating
      activitiesNet
    Income
              
              $
              1,509,235
              
              $
              2,936,942Adjustments to reconcile net
      cash provided byoperating
      activitiesDepreciation
      and amortization
              
              
              309,749
              
              
              166,973Amortization
      of loan discount
              
              
              114,683Net change in assets and
      liabilitiesTrade
      accounts receivable
              
              
              (1,290,662
              )
              
              (749,786
              )Inventory
              
              
              (251,318
              )
              
              (810,073
              )Other
      current assets
              
              
              2,480,834
              
              
              (248,040
              )Accounts
      payable and accrued expenses
              
              
              1,876,980
              
              
              212,269Advances
      from employees
              
              
              206,295
              
              
              14,452Taxes
      payable
              
              
              -
              
              
              39,728Net cash used in operating
      activities
              
              
              4,955,796
              
              
              1,562,465Cash flows from investing
      activitiesDeposit
      on equipment purchase
              
              
              (3,699,058
              )
              
              -Construction
      in progress
              
              
              (2,743,133
              )
              
              -Purchases
      of fixed assets and intangibles
              
              
              (3,746,727
              )
              
              (689,983
              )Net cash used in investing
      activities
              
              
              (10,188,918
              )
              
              (689,983
              )Cash flows from financing
      activitiesSale
      of stock for cash
              
              
              -
              
              
              2,000,000Repayments
      of notes payable
              
              
              (290,918
              )
              
              -Advances
      on notes payable
              
              
              2,250,000
              
              
              266,667Loans
      from shareholders
              
              
              -
              
              
              -Net cash provided by financing
      activities
              
              
              1,959,082
              
              
              2,266,667Effect of exchange
      rate
              
              
              461,855
              
              
              14,690Net increase (decrease) in
      cash
              
              
              (2,812,185
              )
              
              3,153,839Cash and cash equivalents at
      beginning of period
              
              
              6,560,931
              
              
              641,164Cash and cash equivalents at
      end of period
              
              $
              3,748,746
              
              $
              3,795,003




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




3




Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007


1.
            Description of
      Business





Emerald
Dairy, Inc. (the Company), a Nevada corporation, is a producer of milk powder,
rice powder and soybean milk powder in the People’s Republic of China through
its wholly owned subsidiaries.





American
International Dairy Holdings, Inc., a Nevada corporation, was formed in 2005 for
the purpose of acquiring the stock in Heilongjiang Xing An Ling Dairy, Co. On
May 30, 2005, AIDH, pursuant to the Share Transfer Agreement acquired
Heilongjiang Xing An Ling Dairy Co. Limited, (XAL) a corporation formed on
September 8, 2003 in Heilongjiang Providence, The People’s Republic of China,
(PRC). This transaction was treated as a recapitalization of XAL for financial
reporting purposes. The effect of this recapitalization was rolled back to the
inception of XAL for financial reporting purposes.





XAL is a
dairy company engaged in manufacturing of milk, soybean and rice powder. Through
the Company’s network of over 600 salespeople, the Company’s products are
distributed throughout 20 provinces in the People’s Republic of China, and sold
in over 5,600 retail outlets.





Prior to
September 23, 2006, XAL owned 57.69% of Heilongjiang Beian Nongken Changxing
LvBao Dairy Limited Liability Company (“LvBao”) with the remaining balance being
held by the Company’s sole shareholder. On September 23, 2006, the remaining
42.31% ownership in LvBao was transferred to XAL and was treated as an
additional capital contribution. The effect of this contribution by the sole
shareholder was rolled back to September 8, 2003 for financial reporting
purposes. LvBao was formed on January 20, 2000 and is engaged in manufacturing
and sales of dairy products.





On May
22, 2008, the Company formed a new wholly-owned subsidiary,
Hailun Xinganling Dairy Co., Ltd. (“HXD”), under the laws of the PRC. In July
2008, HXD commenced construction of a production facility in Hailun City,
Heilongjiang Province, PRC. It is anticipated that HXD will engage in the
manufacture of the Company's milk, soybean and rice powder products at this new
facility





2.
            Basis of Preparation of
      Financial Statements





XAL,
LvBao and HXD maintain their books and accounting records in Renminbi (“RMB”).





The
accompanying unaudited condensed consolidated financial statements have been
prepared in accordance with generally accepted accounting principles for interim
financial information and with the instructions to Form 10-Q. Accordingly, they
do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements and related
notes. The accompanying unaudited condensed consolidated financial statements
and related notes should be read in conjunction with the audited consolidated
financial statements of the Company and notes thereto for the year ended
December 31, 2007.





In the
opinion of management, the accompanying unaudited condensed consolidated
financial statements contain all adjustments (which include only normal
recurring adjustments) necessary to present fairly the balance sheets of Emerald
Dairy Inc. and subsidiaries as of September 30, 2008 and the results of their
operations for the three and nine months ended September 30, 2008 and 2007, and
cash flows for the nine months ended September 30, 2008 and 2007. The results of
operations for the three and nine months ended September 30, 2008 and 2007 are
not necessarily indicative of the results to be expected for the entire
year.





The
financial statements have been prepared in order to present the consolidated
financial position and consolidated results of operations in accordance with
accounting principles generally accepted in the United States of America (“US
GAAP”) and are expressed in terms of US dollars (see paragraph “Foreign
Currency” below).





The
consolidated financial statements include the accounts of the Company and its
wholly owned subsidiaries, XAL, LvBao and HXD. All inter-company transactions
and balances were eliminated.




4


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





3.
            Summary of Significant
      Accounting Policies





Use of estimates - The
preparation of these consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affected the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the dates of the consolidated financial statements and the
reported amounts of net sales and expenses during the reported periods.





Significant
estimates and assumptions by management including, among others, values and
lives assigned to acquired intangible assets, reserves for customer returns and
allowances, uncollectible accounts receivable, slow moving, obsolete and/or
damaged inventory and stock warrant valuation. Actual results may differ from
these estimates.





Cash and cash equivalents - The  Company
considers all highly liquid debt instruments purchased with maturity period of
three months or less to be cash equivalents. Substantially all of the Company’s
cash is held in bank accounts in The Peoples Republic of China and is not
protected by FDIC insurance or any other similar insurance. Accounts held at
United States financial institutions are insured by the Federal Deposit
Insurance Corporation up to $250,000. As of September 30, 2008, no U.S. balances
are in excess of insured amounts.





Construction-in-Progress - Plant
and production lines currently under development are accounted for as
construction-in-progress. Construction-in-progress is recorded at acquisition
cost, including land rights cost, development expenditure, professional fees and
the interest expenses capitalized during the course of construction for the
purpose of financing the project. Upon completion and readiness for use of the
project, the cost of construction-in-progress is to be transferred to fixed
assets.





Foreign Currency - The
Company’s principal country of operations is The People’s Republic of China. The
financial position and results of operations of the Company are determined using
the local currency (“Renminbi” or “Yuan”) as the functional currency. The
results of operations denominated in foreign currency are translated at the
average rate of exchange during the reporting period.




Assets
and liabilities denominated in foreign currencies at the balance sheet date are
translated at the exchange rates prevailing at the balance sheet date. The
registered equity capital denominated in the functional currency is translated
at the historical rate of exchange at the time of capital contribution. All
translation adjustments resulting from the translation of the financial
statements into the reporting currency (“US Dollars”) are dealt with as a
separate component within stockholders’ equity. Translation adjustments net of
tax totaled $171,146 and $1,078,852, for the three and nine months ended
September 30, 2008, respectively. Translation adjustments totaled $109,072 and
$212,472 for the three and nine months ended September 30, 2007,
respectively.





As of
September 30, 2008 and 2007, the exchange rate was 6.8485 Yuan and 7.3 Yuan per
U.S. Dollar, respectively.





Revenue
recognition -
Revenue is recognized in accordance with Staff Accounting Bulletin No. 104,
Revenue Recognition, which states that revenue should be recognized when the
following criteria are met: (1) persuasive evidence of an arrangement
exists; (2) the service has been rendered; (3) the selling price is
fixed or determinable; and (4) collection of the resulting receivable is
reasonably assured.





Interest
income is recognized when earned, taking into account the average principal
amounts outstanding and the interest rates applicable.





As of
September 30, 2008, the Company has no sales or contracts that included multiple
deliverables that would fall under the scope of EITF 00-21, “Revenue
Arrangements with Multiple Deliverables.”




5


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





3.
            Summary of Significant
      Accounting Policies
(Continued)





Shipping and handling costs
- Shipping
and handling costs are billed to the customer in sales transactions and are
reported in sales. Costs incurred by the Company for shipping and handling are
included in costs of goods sold.





Earnings per share - Basic net
earnings per common share is computed by dividing net earnings applicable to
common shareholders by the weighted-average number of common shares outstanding
during the period. Diluted net earnings per common share is determined using the
weighted-average number of common share shares outstanding during the period,
adjusted for the dilutive effect of common stock equivalents, using the treasury
stock method, consisting of shares that might be issued upon exercise of common
stock warrants. In periods where losses are reported, the weighted-average
number of common shares outstanding excludes common stock equivalents, because
their inclusion would be anti-dilutive.





Taxation - Taxation
on profits earned in the PRC has been calculated on the estimated assessable
profits for the year at the rates of taxation prevailing in the PRC in which the
Company operates after taking into effect the benefits from any special tax
credits or “tax holidays” allowed in the country of operations.





The
Company accounts for income tax under the provisions of SFAS 109 Accounting for Income
Taxes, which
requires recognition of deferred tax assets and liabilities for the expected
future tax consequences of the events that have been included in the financials
statements or tax returns. Deferred income taxes are recognized for all
significant temporary differences between tax and financial statements bases of
assets and liabilities. Valuation allowances are established against net
deferred tax assets when it is more likely than not that some portion or all of
the deferred tax asset will not be realized.





The
Company does not have any long-term deferred tax assets or liabilities in China
that will exist once the tax holiday (See Note 10) expires. The Company does not
have any significant deferred tax asset or liabilities that relate to tax
jurisdictions not covered by the tax holiday.





The
Company does not accrue United States income tax on unremitted earnings from
foreign operations, as it is the Company’s intention to invest these earnings in
the foreign operations indefinitely.





Enterprise income
tax





Under the
Provisional Regulations of The People’s Republic of China Concerning Income Tax
on Enterprises promulgated by the State Council which came into effect on
January 1, 1994, income tax is payable by a Wholly Foreign Owned Enterprises at
a rate of 15% of their taxable income. Preferential tax treatment may, however,
be granted pursuant to any law or regulations from time to time promulgated by
the State Council. XAL enjoyed a 100% exemption from enterprise income taxes
starting on January 10, 2006 due to its classification as a “Wholly Foreign
Owned Enterprise.” On March 16, 2007, The People’s Republic of China enacted a
new Enterprise Income Tax Law for the purpose of unifying the tax treatment of
domestic and foreign enterprises. This new law eliminates the preferential tax
treatment for new Wholly Foreign Owned Enterprises but allows previously granted
exemptions to stay in place through 2012, with the exception that the statutory
tax rate will increase by 2% per year from 15% in 2006 to 25% by 2012. This
exemption ended on January 10, 2008, at which time XAL will qualify under the
current tax structure for a 50% reduction in the statutory enterprise income tax
rates for an additional three years.





Freestanding Financial Instruments
with Characteristics of Both Liabilities and Equity - In
accordance with SFAS 150, Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and Equity, the
Company accounts for financial instruments as a liability if it embodies an
obligation to repurchase the issuer’s equity shares, or is indexed to such an
obligation, and that requires or may require the issuer to settle the obligation
by transferring assets. Freestanding financial instruments are financial
instruments that are entered into separately and apart from any of the entity's
other financial instruments or equity transactions, or that is entered into in
conjunction with some other transaction and is legally detachable and separately
exercisable. The liability recorded is the per share price to be paid and is
offset to equity.




6


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





3.
            Summary of Significant
      Accounting Policies
(Continued)





Stock Based Compensation - On
December 16, 2004, the FASB issued SFAS No. 123R, Share-Based Payment (“SFAS
No. 123R”) , which requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the financial statements
based on the grant date fair value of the award. Under SFAS No. 123R, the
Company must determine the appropriate fair value model to be used for valuing
share-based payments, the amortization method for compensation cost and the
transition method to be used at date of adoption. The transition methods include
prospective and retroactive adoption options. Under the retroactive option,
prior periods may be restated either as of the beginning of the year of adoption
or for all periods presented. The prospective method requires that compensation
expense be recorded for all unvested stock options and restricted stock at the
beginning of the first quarter of adoption of SFAS No. 123R, while the
retroactive methods would record compensation expense for all unvested stock
options and restricted stock beginning with the first period restated. The
Company has adopted the requirements of SFAS No. 123R for the fiscal year
beginning on January 1, 2006





Fair value of financial instruments - The
carrying amounts of certain financial instruments, including cash, accounts
receivable, other receivables, accounts payable, commercial notes payable, and
accrued expenses approximate their fair values as of September 30, 2008 and
December 31, 2007 because of the relatively short-term maturity of these
instruments.





Recent accounting
pronouncements





In
September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements (SFAS
157). SFAS No. 157 defines fair value, establishes a framework for
measuring fair value in accordance with generally accepted accounting
principles, and expands disclosures about fair value measurements. This
statement does not require any new fair value measurements; rather, it applies
under other accounting pronouncements that require or permit fair value
measurements. The provisions of this statement are to be applied prospectively
as of the beginning of the fiscal year in which this statement is initially
applied, with any transition adjustment recognized as a cumulative-effect
adjustment to the opening balance of retained earnings. The provisions of SFAS
157 are effective for the fiscal years beginning after November 15, 2007.
The adoption of this standard did not have a material impact on our financial
condition, results of operations or cash flows.





In
September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans (SFAS No. 158), an amendment of FASB Statements No. 87, 88, 106
and 132(R). SFAS No. 158 requires (a) recognition of the funded
status (measured as the difference between the fair value of the plan assets and
the benefit obligation) of a benefit plan as an asset or liability in the
employer’s statement of financial position, (b) measurement of the funded
status as of the employer’s fiscal year-end with limited exceptions, and
(c) recognition of changes in the funded status in the year in which the
changes occur through comprehensive income. The requirement to recognize the
funded status of a benefit plan and the disclosure requirements are effective as
of the end of the fiscal year ending after December 15, 2006. The
requirement to measure the plan assets and benefit obligations as of the date of
the employer’s fiscal year-end statement of financial position is effective for
fiscal years ending after December 15, 2008. This Statement has no current
applicability to the Company’s financial statements. Management adopted this
Statement on December 31, 2006 and the adoption of SFAS No. 158
did not have a material impact to the Company’s financial position, results of
operations, or cash flows.





In
February 2007, the FASB issued Statement No. 159 The Fair Value Option for Financial
Assets and Financial Liabilities (SFAS
159). This statement permits companies to choose to measure many financial
assets and liabilities at fair value. Unrealized gains and losses on items for
which the fair value option has been elected are reported in earnings. SFAS 159
is effective for fiscal years beginning after November 15, 2007. The adoption of
this standard did not have a material impact on our financial condition, results
of operations or cash flows.





7


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





3.
            Summary of Significant
      Accounting Policies
(Continued)





In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business
Combinations (SFAS
141(R)). SFAS 141(R) will change the accounting for business combinations. Under
SFAS No. 141(R), an acquiring entity will be required to recognize all the
assets acquired and liabilities assumed in a transaction at the acquisition-date
fair value with limited exceptions. SFAS No. 141(R) will change the
accounting treatment and disclosure for certain specific items in a business
combination. SFAS No. 141(R) 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. SFAS 141(R) will
impact the Company in the event of any future acquisition.




In
December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51 (SFAS
160). SFAS 160 establishes new accounting and reporting standards for the
non-controlling interest in a subsidiary and for the deconsolidation of a
subsidiary. SFAS No. 160 is effective for fiscal years beginning on or
after December 15, 2008. The Company does not believe that SFAS 160 will
have a material impact on its consolidated financial statements.




In
March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement
No. 133 (SFAS
161). FAS 161 changes the disclosure requirements for derivative instruments and
hedging activities. Entities are required to provide enhanced disclosures about
(a) how and why an entity uses derivative instruments, (b) how
derivative instruments and related hedged items are accounted for under
Statement 133 and its related interpretations, and (c) how derivative
instruments and related hedged items affect an entity’s financial position,
financial performance, and cash flows. The guidance in SFAS 161 is effective for
financial statements issued for fiscal years and interim periods beginning after
November 15, 2008, with early application encouraged. This Statement
encourages, but does not require, comparative disclosures for earlier periods at
initial adoption. The Company is currently assessing the impact of SFAS
161.





In May
2008, the FASB issued SFAS 162,The Hierarchy of Generally Accepted
Accounting Principles(SFAS
162). SFAS 162 is intended to improve financial reporting by identifying a
consistent framework, or hierarchy, for selecting accounting principles to be
used in the preparation of financial statements of nongovernmental entities that
are presented in conformity with U.S. generally accepted accounting principles
(GAAP). SFAS 162 directs the GAAP hierarchy to the entity, not the independent
auditors, as the entity is responsible for selecting accounting principles for
financial statements that are presented in conformity with GAAP. SFAS 162 is
effective 60 days following the Securities and Exchange Commission's approval of
the Public Company Accounting Oversight Board amendments to remove the GAAP
hierarchy from the auditing standards. The Company does not expect SFAS 162 to
have a material impact on its future consolidated results of operations or its
financial position.





In June
2008, the Emerging Issues Task Force (EITF) reached final consensuses on EITF
Issue 08-4, Transition
Guidance for Conforming Changes to Issue No. 98-5 . Certain
conclusions reached in EITF
Issue No. 98-5, “Accounting for Convertible Securities with Beneficial
Conversion Features or Contingently Adjustable Conversion Ratios,”were
nullified in EITF
Issue No. 00-27, “Application of Issue No. 98-5 to Certain Convertible
Instruments.”Moreover, some of the conclusions in Issue No. 98-5 and Issue No. 00-27 were
superseded by SFAS No.
150,
Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. While the conclusions reached in Issue No. 98-5 were
subsequently updated to reflect the issuance of Issue No. 00-27 and SFAS No.
150, the transition guidance in Issue No. 98-5 was not revised. The EITF reached
a consensus on Issue No. 08- 4, which
provides such guidance and requires that (1) conforming changes made to Issue
No. 98-5 resulting from Issue No. 00-27 and SFAS No. 150 be effective for
financial statements of fiscal years ending after December 15, 2008, with early
application allowed, and (2) the effect of applying the conforming changes be
presented retrospectively (with the cumulative effect of the change reported in
retained earnings as of the beginning of the first period presented). The
Company is currently assessing the impact of EITF Issue 08-4.




8


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





3.
            Summary of Significant
      Accounting Policies
(Continued)





In June
2008, the Emerging Issues Task Force (EITF) reached final consensuses on EITF
Issue 07-5, Determining Whether an Instrument (or Embedded Feature) Is Indexed
to an Entity's Own Stock. In EITF
Issue 07-5 , the
EITF reached the consensus that evaluation of whether an equity-linked financial
instrument (or embedded feature) is indexed to the company's own stock should be
based on a two-step approach. Under the two-step approach, an equity-linked
financial instrument (or embedded feature) is not deemed indexed to the entity's
own stock if the strike price is denominated in a currency other than the
issuer's functional currency (but the determination of whether the instrument is
indexed to the company's own stock is not affected by the currency in which the
underlying shares are traded). Also, market-based employee stock valuation
instruments are not considered to be indexed to the entity's own stock
(presumably because they are influenced by, among other factors, employee
behavior, which is not an input used to estimate the fair value of the forward
contract or option). An exercise contingency is a provision entitling the entity
(or the counterparty) to exercise an equity-linked financial instrument or
embedded feature based on changes in an underlying, which includes the
occurrence (or nonoccurrence) of a specified event. Provisions that accelerate
the timing of the entity's (or counterparty's) ability to exercise an instrument
or that extend the length of time that an instrument is exercisable are exercise
contingencies. EITF 07-5 is effective for financial statements issued for fiscal
years beginning after December 15, 2008, and interim periods within those fiscal
years. The Company is currently assessing the impact of EITF
07-5.





In July
2008, the FASB issued FASB Staff Position (FSP) No. EITF 03-6-1, Unvested Share-Based Awards as
Participating Securities for EPS Purposes (FSP No.
EITF 03-6-1). FSP No. EITF 03-6-1 clarifies the circumstances under which
unvested share-based payment awards should be considered participating
securities for purposes of determining basic earnings per share (EPS). FSP No.
EITF 03-6-1is
effective for fiscal years beginning after December 15, 2008 (and for interim
periods within such years). The Company is currently assessing the impact of FSP
No. FAS 157-3.





In
October 2008, the FASB issued FASB Staff Position (FSP) No.
FAS 157-3,Determining the Fair Value of a
Financial Asset in a Market That Is Not Active.The FSP
amends Statement of Financial Accounting Standards (SFAS)
No. 157,Fair Value
Measurements, by
clarifying the application of SFAS No.
157when the
market for a financial asset is inactive. Specifically, the FSP clarifies how
(1) management's internal assumptions should be considered in measuring fair
value when observable data are not present, (2) observable market information
from an inactive market should be taken into account, and (3) the use of broker
quotes or pricing services should be considered in assessing the relevance of
observable and unobservable data to measure fair value. The
guidance in FSP No. FAS 157-3 is effective immediately and applies as well to
prior periods for which financial statements have not been issued. The Company
is currently assessing the impact of FSP No. FAS 157-3.





4.
            Concentrations of Business and
      Credit Risk





Substantially
all of the Company’s bank accounts are in banks located in the PRC and are not
covered by any type of protection similar to that provided by the FDIC on funds
held in U.S. banks. Accounts held at U.S. financial institutions are insured by
the Federal Deposit Insurance Corporation up to $250,000. As of September 30,
2008 none of the U.S. cash balances are in excess of insured amounts.





The
Company operates in China, which may give rise to significant foreign currency
risks from fluctuations and the degree of volatility of foreign exchange rates
between U.S. dollars and the Chinese currency RMB.




9


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





4.
            Concentrations of Business and
      Credit Risk (Continued)





Recently,
a number of milk powder products produced within China were found to contain
unsafe levels of tripolycyanamide, also known as melamine, sickening thousands
of infants. This prompted the Chinese government to conduct a nationwide
investigation into how the milk powder was contaminated, and caused a worldwide
recall of certain milk powder products produced within China. On September 16,
2008, China’s Administration of Quality Supervision, Inspection and Quarantine
(AQSIQ) revealed that it had tested samples from 175 dairy manufacturers, and
published a list of 22 companies whose products contained melamine. We passed
the emergency inspection and were not included on AQSIQ’s list. Although we
believe that the inevitable contraction in the Chinese milk powder industry
caused by this crisis will lead to increased demand for our products, we can not
be certain that the illnesses caused by contamination in the milk powder
industry, whether or not related to our products, will not lead to decreased
demand for milk powder products produced within China, thereby having a material
adverse effect on our business.





Financial
instruments that potentially subject the Company to concentration of credit risk
consist principally of cash and trade receivables, the balances of which are
stated on the balance sheet. Concentration of credit risk with respect to trade
receivables is limited due to the Company's large number of diverse customers in
different locations in China. The Company does not require collateral or other
security to support financial instruments subject to credit risk.





For the
nine months ended September 30, 2008 and 2007, no single customer accounted for
10% or more of sales revenues.





As of
September 30, 2008, the Company had no insurance coverage of any kind. Accrual
for losses is not recognized until such time as an uninsured loss has
occurred.





Payments
of dividends from foreign subsidiaries may be subject to some restrictions.





The
operations of the Company are located in the PRC. Accordingly, the Company’s
business, financial condition, and results of operations may be influenced by
the political, economic, and legal environments in the PRC, as well as by the
general state of the PRC economy.





5.
            Inventory





As of
September 30, 2008 and December 31, 2007 inventory consists of the
following:





2008
            
            2007Raw
      materials
            
            $
            956,077
            
            $
            634,018Work-in-process
            
            
            312,994
            
            
            349,334Finished
      goods
            
            
            35,385
            
            
            8,490Repair
      parts
            
            
            9,165
            
            
            8,585$
            1,313,621
            
            $
            1,000,427




10


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





6.
            Other current
      assets





As of
September 30, 2008 and December 31, 2007, other current assets consist of the
following:





2008
            
            2007Advances
      to milk suppliers
            
            $
            340,298
            
            $
            652,398Advances
      to equipment suppliers
            
            
            3,699,058
            
            
            -Deposit
      on building purchase
            
            
            -
            
            
            1,101,370Deposit
      on new facility site
            
            
            574,821
            
            
            539,725Deposit
      on contract
            
            
            675,247
            
            
            1,534,247Other
      Receivables
            
            
            50,000
            
            
            50,000Advances
      to staff
            
            
            10,478
            
            
            18,924Prepaid
      expenses
            
            
            95,068
            
            
            40,087$
            5,444,970
            
            $
            3,936,751




7.
            Property, Plant, and
      Equipment





As of
September 30, 2008 and December 31, 2007, Property, Plant, and Equipment consist
of the following:





2008
            
            2007Building
            
            $
            3,223,921
            
            $
            1,007,475Plant
      and Machinery
            
            
            2,941,371
            
            
            2,512,451Motor
      vehicles
            
            
            524,944
            
            
            459,547Dairy
      cows
            
            
            236,622
            
            
            211,220Office
      equipment
            
            
            54,062
            
            
            52,6966,980,920
            
            
            4,243,389Less:
      Accumulated depreciation
            
            
            (1,280,516
            )
            
            (923,308
            )$
            5,700,404
            
            $
            3,320,081




Depreciation
expenses totaled $106,862 and $290,164 for the three and nine months ended
September 30, 2008, respectively, and $61,561 and $166,973 for the three and
nine months ended September 30, 2007, respectively. $84,542 and $237,413 were
included as a component of cost of goods sold for the three and nine months
ended September 30, 2008, respectively, and $48,562 and $130,129 for the three
and nine months ended September 30, 2007, respectively.





8.
            Intangible
      Assets





September
      30,
              2008
            
            December
      31,
              2007Land
      use rights
            
            $
            1,351,333
            
            $
            66,839Patents
            
            
            53,004
            
            
            49,7271,404,337
            
            
            116,566Less:
      Accumulated amortization
            
            
            (19,980
            )
            
            (1,338
            )$
            1,384,357
            
            $
            115,228




11


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





8.
            Intangible Assets
      (Continued)





For the
three and nine months ended September 30, 2008, amortization expenses totaled
$11,398 and $19,58, respectively. There was no amortization for the nine months
ended September 30, 2007.





9.
            Construction in
      progress




September
      30,
              2008
            
            December
      31,
              2007Construction
      in progress
            
            $
            2,743,133
            
            $
            -





Construction-in-progress
represents construction and installations of the new plant and machinery for the
production facility in Hailun City.





10.
            Income
    Taxes





On May
30, 2005, American International Dairy Holdings, Inc. executed a Share Transfer
Agreement with Heilongjiang Xing An Ling Dairy Co., Ltd., a corporation
organized and existing under the laws of People’s Republic of China. XAL applied
to be as a foreign invested company right after the share transfer, which
business license has been approved as a foreign invested company on January 10,
2006. According to Chinese taxation policy, there is income tax exemption for 2
years and half for 3 years suitable to foreign invested company, advanced
Technology Company or software Development Company. XAL is considered an
Advanced Technology Company. Therefore the Company receives this income tax
exemption policy from January 10, 2006 the date approval as a foreign invested
company. The Company received a 100% tax holiday as of January 10, 2006. On
January 10, 2008 the Company’s tax exemption was reduced to 50% of the
prevailing tax rate and will continue at this reduced rate for three additional
years.





LvBao is
currently subject to the Enterprise income tax of 33%.





A
reconciliation of the provision for income taxes with amounts determined by the
U.S. federal income tax rate to income before income taxes is as
follows.





The
components of net income (loss) before provision for income tax consist of
following:





Three
      Months
              Ended September 30,
            
            Nine
      Months
              Ended September 30,2008
            
            2007
            
            2008
            
            2007U.S.
      Operations
            
            $
            (874,000
            )
            $
            (39,000
            )
            $
            (2,065,000
            )
            $
            (92,000
            )Chinese
      Operations
            
            
            1,952,000
            
            
            1,480,000
            
            
            4,161,000
            
            
            3,178,000$
            1,078,000
            
            $
            1,441,000
            
            $
            2,096,000
            
            $
            3,086,000




12


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





10.
            Income Taxes
      (Continued)





The
components of the provision for income taxes are approximately as
follows:




Three
      Months
              Ended September 30,
            
            Nine
      Months
              Ended September 30,2008
            
            2007
            
            2008
            
            2007Federal,
      State and Local
            
            $
            -
            
            $
            -
            
            $
            -
            
            $
            -Peoples
      Republic of China -Federal and Local
            
            
            269,700
            
            
            65,900
            
            
            586,900
            
            
            148,600$
            269,700
            
            $
            65,900
            
            $
            586,900
            
            $
            148,600




The table
below approximately summarizes the reconciliation of the Company’s income tax
provision (benefit) computed at the statutory U.S. Federal rate and the actual
tax provision:





Three
      Months
              Ended September 30,
            
            Nine
      Months
              Ended September 30,2008
            
            2007
            
            2008
            
            2007Income
      tax provision at Federal statutory rate
            
            $
            366,400
            
            $
            490,000
            
            $
            712,700
            
            $
            1,049,100State
      income taxes, net of Federal benefit
            
            
            64,600
            
            
            86,500
            
            
            125,800
            
            
            185,200U.S.
      tax rate in excess of foreign tax rate
            
            
            (136,700
            )
            
            (103,600
            )
            
            (291,300
            )
            
            (222,400
            )Abatement
      of foreign income taxes
            
            
            (370,900
            )
            
            (422,000
            )
            
            (778,000
            )
            
            (899,700
            )Increase
      in valuation allowance
            
            
            346,300
            
            
            15,000
            
            
            817,700
            
            
            36,400$
            269,700
            
            $
            65,900
            
            $
            586,900
            
            $
            148,600




The
Company has a U.S. net operating loss carryforwards of approximately $792,000 as
of December 31, 2007 which expires in 2027. The deferred tax asset associated
with these net operating loss carryforwards was fully reserved as of September
30, 2008.





The
change in the valuation allowance as of September 30, 2008 and 2007 was $817,700
and $36,400, respectively.





The
effects of the tax exemption per share were as follows:




Three
      Months
              Ended September 30,
            
            Nine
      Months
              Ended September 30,2008
            
            2007
            
            2008
            
            2007Tax
      Saving
            
            $
            370,900
            
            $
            422,000
            
            $
            778,000
            
            $
            899,700Benefit
      per share:Basic
            
            $
            0.01
            
            $
            0.02
            
            $
            0.03
            
            $
            0.04Diluted
            
            $
            0.01
            
            $
            0.02
            
            $
            0.03
            
            $
            0.04




13


Emerald Dairy, Inc. and
Subsidiaries
 Footnotes to Condensed Consolidated
Financial Statements
 September 30, 2008 and
2007




Had the
tax exemption not been in place for the three and nine months ended June 30,
2008 and 2007, the Company estimates the following pro forma financial statement
impact.





Three
      Months
              Ended September 30,
            
            Nine
      Months
              Ended September 30,2008
            
            2007
            
            2008
            
            2007Net
      income before tax provision, as reported
            
            $
            1,078,000
            
            $
            1,441,000
            
            $
            2,096,000
            
            $
            3,086,000Less
      Tax provision not exempted
            
            
            269,700
            
            
            65,900
            
            
            586,900
            
            
            148,600Less
      Tax provision exempted
            
            
            370,900
            
            
            422,000
            
            
            778,000
            
            
            899,700$
            437,400
            
            $
            953,100
            
            $
            731,100
            
            $
            2,037,700




11.
            Employee Retirement Benefits
      and Post Retirement Benefits





According
to the Heilongjiang Provincial regulations on state pension program, both
employees and employers have to contribute toward pensions. The pension
contributions range from 2% to 8% that was contributed by individuals
(employees), and the Company is required to make contributions to the state
retirement plan based on 20% of the employees’ monthly basic salaries. Employees
in the PRC are entitled to retirement benefits calculated with reference to
their basic salaries on retirement and their length of service in accordance
with a government managed benefits plan. The PRC government is responsible for
the benefit liability to these retired employees. During the three and nine
months ended September 30, 2008 and 2007, respectively, the Company contributed
$28,883, $83,970, $24,335 and $69,378 in pension contributions.





12.
            Notes
      payable




In June,
2008 the Company sold 8% promissory notes maturing December 31, 2008 and
three-year warrants to purchase 225,000 shares of common stock at an exercise
price of $2.61 for $2,250,000. Any amount of principal or interest outstanding
after December 31, 2008 will bear interest at a rate of 12%. In accordance with
Accounting Principles Board Opinion No. 14, "Accounting for Convertible Debt and
Debt Issued with Stock Purchase Warrants", the proceeds from issuance of the
notes were allocated to the notes and warrants based upon their relative fair
values. This allocation resulted in allocating $210,600 to the warrants to be
treated as loan discount to be amortized over the life of the notes. During the
three and nine months ended September 30, 2008, $95,917 and $114,683,
respectively, of the loan discount was amortized to interest expense. The
following assumptions were used to calculate the fair value of the warrants
using the Black - Scholes Model:





Dividend
      yield
            
            
            0
            %Expected
      volatility
            
            
            118.01
            %Risk-free
      interest rate
            
            
            3.35
      - 3.17
            %Expected
      life
            
            
            3
      yearsStock
      price
            
            $
            1.63Exercise
      price
            
            $
            2.61





The notes
may be prepaid in their entirety without penalty upon 15 day notice. So long as
the Company has any obligation under the notes, there are limitations on its
ability to: (a) pay dividends or make other distributions on its capital stock;
(b) redeem, repurchase or otherwise acquire any of its securities; (c) create,
incur or assume any liability for borrowed money; (d) sell, lease or otherwise
dispose of any significant portion of its assets; (e) lend money, give credit or
make advances; or (f) assume, guarantee, endorse, contingently agree to purchase
or otherwise become liable upon the obligation of any other person or
entity.





14


Emerald Dairy, Inc. and
Subsidiaries
 Footnotes to Condensed Consolidated
Financial Statements
 September 30, 2008 and
2007


12.
            Notes payable
      (Continued)




In
connection with the sale of the notes the Company paid a placement agent
$122,500 in fees and delivered 45,000 three- year warrants to purchase 45,000
shares of common stock at an exercise price of $2.61. The warrants were valued
at $46,507 using a Black-Scholes Model and together with the fee were treated as
deferred issuance costs to be amortized over the life of the notes. Amortization
of the deferred issuance costs for the three and nine months ended September 30,
2008 was $82,718 and 97,367, respectively. The following assumptions were used
to calculate the fair value of the warrants:





Dividend
      yield
            
            
            0
            %Expected
      volatility
            
            
            118.01
            %Risk-free
      interest rate
            
            
            3.35
            %Expected
      life
            
            
            3
      yearsStock
      price
            
            $
            1.63Exercise
      price
            
            $
            2.61





In
connection with the sale of the June 20, 2008 notes the Company paid legal fees
of $15,000 that were treated as deferred issuance costs and are being amortized
over the life of the notes.





13.
            Related-Party
      Transactions




On May
28, 2006, the Company purchased and obtained legal titles to machinery,
facilities, housing and 100 cows from a stockholder of the Company for a note of
$209,305, which approximated historical cost of these assets. The note does not
bear interest and is due on demand. Since the note does not have a set repayment
date, interest is not being imputed on the principal amount under the
note.





14.
            Put/Call
      Liability





On
October 9, 2007, the Company entered into Put/Call Agreements with two (2) of
its stockholders (the “Put/Call Stockholders”), pursuant to which the Put/Call
Shareholders granted the Company an option to repurchase an aggregate of
1,944,444 shares (the “Put/Call Shares”) from the Put/Call Stockholders (the
“Call Option”), for an exercise price of $1.63 per share (the “Call Option
Price”), if the following conditions have been met (the “Call Option
Conditions”):





·
            Either
      (i) a registration statement (“Registration Statement”) covering the
      resale of the Put/Call Shares has been declared effective by the
      Commission, and has been kept continuously effective by the Company, or
      (B) all of the Put/Call Shares are available for sale without registration
      pursuant to Rule 144(k); and




·
            The
      closing price of a share of Common Stock of the Company as traded on the
      Over-the-Counter Bulletin Board (or such other exchange or stock market on
      which the Common Stock may then be listed or quoted) equals or exceeds
      $4.08 (appropriately adjusted for any stock split, reverse stock split,
      stock dividend or other reclassification or combination of the Common
      Stock occurring after the date hereof) for at least ten (10) consecutive
      trading days immediately preceding the date that the Call Option Exercise
      Notice is given by the Company.





Term of the Call
Option , the
Company may only exercise its Call Option by delivering a written notice (a
“Call Option Exercise Notice”) to the Put/Call Stockholders within thirty (30)
days of such time as all of the Call Option Conditions have been met. The Call
Option may be exercised for all, but not less than all, of the Put/Call Shares.
The repurchase shall be consummated within ninety (90) days following the date
of the Call Option Exercise Notice.




15


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





14.
            Put/Call Liability
      (Continued)





In
addition, the Put/Call Stockholders shall have the right to cause the Company to
repurchase the Put/Call Shares from the Put/Call Stockholders (the “Put Right”),
for a price of $1.63 per share (the “Put Purchase Price”), if:





·
            the
      Company fails to exercise its Call Option within ten (10) days of a date
      on which all of the Call Option Conditions have been met;
    or





·
            the
      Company consummates a private offering of not less than $5,000,000 of its
      securities (a “Qualified Offering”); or





·
            the
      Company fails to (i) file the Registration Statement within thirty (30)
      business days of the Closing Date (the “Filing Date”), (B) have the
      Registration Statement declared effective within ninety (90) calendar days
      from the Filing Date, or, if reviewed by the Commission, within one
      hundred eighty (180) calendar days after the Filing Date, or (C) keep the
      Registration Statement continuously effective until all of the Shares are
      available for sale without registration pursuant to Rule 144(k);
      or




·
            the
      Company fails to consummate a Qualified Offering within two (2) years of
      the date hereof (each of the aforementioned conditions, a “Put Right
      Trigger”).




Term of the Put
option , the
Put/Call Stockholders shall exercise their Put Right by giving written notice
(“Put Exercise Notice”) of their exercise of the Put Right to the Company within
thirty (30) days of a Put Right Trigger. The Put/Call Stockholders may only
exercise their Put Right as to all, but not less than all, of the Put/Call
Shares. Upon exercise of the Put Right by the Shareholder, the repurchase of the
Put/Call Shares by the Company shall be consummated within ninety (90) days
following the date of the Put Exercise Notice.




In
accordance with SFAS 150 Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and
Equity the
Company recorded the value of the Put/Call agreement of $3,169,444 as a
liability as of October 9, 2007. The value of the Put/Call agreement was based
on the fair market value of the underlying common stock of $1.63 at October 9,
2007. As of September 30, 2008 there has been no change in the Put/Call
liability as the fair market value of the underlying common stock has not
changed.





On April
9, 2008 the company and the Put/Call Stockholders executed a waiver and
amendment to the Put/Call Agreement reaffirming that the Put/Call Agreement is
still in full force and removing the following provision as a Put Right
Trigger:





·
            The
      Company fails to (i) file the Registration Statement within thirty (30)
      business days of the Closing Date (the “Filing Date”), (B) have the
      Registration Statement declared effective within ninety (90) calendar days
      from the Filing Date, or, if reviewed by the Commission, within one
      hundred eighty (180) calendar days after the Filing Date, or (C) keep the
      Registration Statement continuously effective until all of the Shares are
      available for sale without registration pursuant to Rule
      144(k).




16


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





15.
            Equity





Registration Rights
Agreement





On
October 9, 2007 and October 19, 2007, the Company entered into Registration
Rights Agreements (each, a “Registration Rights Agreement,” and collectively the
“Registration Rights Agreements”) with the accredited investors,( the
“Investors”), pursuant to which it agreed that within thirty (30) business days
of the Closing Date (the Filing Date), the Company will file a registration
statement (the Registration Statement) with the Securities and Exchange
Commission (the “Commission”) covering the resale of (i) the shares of Common
Stock purchased in the above placements (collectively, the “Offerings”) (the
“Purchased Shares”), (ii) the Common Stock issuable upon exercise of the
warrants issued in the Offerings (the “Registrable Securities”). Further, the
Company agreed to use its best efforts to (i) cause the Registration Statement
to be declared effective within ninety (90) calendar days from the Filing Date,
or, if reviewed by the Commission, within one hundred eighty (180) calendar days
after the Filing Date, and (ii) keep the Registration Statement continuously
effective until all of the Registrable Securities have been sold, or may be sold
without volume restrictions, pursuant to Rule 144.




Pursuant
to the Registration Rights Agreements, the Company will be required to pay
liquidated damages (payable in cash in arrears at the end of each month during
which a registration default occurs and is continuing) to the holders of the
Purchased Shares, the First Investor Warrants, the Class A Warrants, the Class B
Warrants, or the Common Stock issued upon exercise of the First Investor
Warrants, Class A Warrants and Class B Warrant (collectively, the “Securities”)
if (i) the Company fails to file the Registration Statement within thirty (30)
business days from the Closing Date, (ii) the Commission does not declare the
Registration Statement effective within ninety (90) days of the Filing Date (or
one hundred eighty (180) days in the event of a review by the Commission) (the
“Effectiveness Date”), (iii) the Company fails to request acceleration of
effectiveness within five (5) business days of a notice of no further review
from the Commission, (iv) the Company fails to respond to the Commission within
ten (10) business days of receipt by the Company of any comments on the
Registration Statement, or (v) after it has been declared effective, the
Registration Statement ceases to be effective or available or if the Company
suspends the use of the prospectus forming a part of the Registration Statement
(A) for more than thirty (30) days in any period of 365 consecutive days if the
Company suspends in reliance on its ability to do so due to the existence of a
development that, in the good faith discretion of its board of directors, makes
it appropriate to so suspend or which renders the Company unable to comply with
SEC requirements, or (B) for more than sixty (60) days in any period of 365
consecutive days for any reason. The liquidated damages will accumulate at the
rate of one and one-half percent (1.5%) of the purchase price paid by the
Investors for the Securities offered for each thirty (30) day period during
which a registration default is continuing;
provided, however, that (i) the Company shall not be liable for
liquidated damages with respect to any warrants or shares of common stock
underlying the warrants, and (ii) in no event will the Company be
liable for liquidated damages in excess of 1.5% of the aggregate purchase price
of the securities purchased in the Offerings in any 30 day period, and (iii) the
maximum aggregate liquidated damages payable to any Investor in the Offerings
shall be 20% of the aggregate purchase price paid by such
Investor.





Notwithstanding
anything to the contrary stated in the Registration Rights Agreements, the
Company shall be entitled to limit the Registrable Securities to the extent
necessary to avoid any issues arising from the recent interpretations by the SEC
of Rule 415 of the Securities Act of 1933, as amended.





As of
September 30, 2008 there were accrued liquidated damages of $1,116,498.
Additional liquidated damages of $414,000 and $966,799 were accrued in the three
and nine months ended September 30, 2008. The Company has
not paid out any of the accrued liquidated damages, which are payable in
cash or shares of its common stock, or a combination thereof, at its
sole discretion.  Additionally, the Company will accrue $4,500 per day in
liquidated damages until such time as the requirements described above have been
satisfied.





17


Emerald Dairy, Inc. and
Subsidiaries
 Footnotes to Condensed Consolidated
Financial Statements
 September 30, 2008 and
2007


15.
            Equity
      (Continued)





Warrants





Information
with respect to stock warrants outstanding as of September 30, 2008 are as
follows:




Exercise
      Price
            
            
            Outstanding
              December
      31, 2007
            
            
            Granted
            
            
            Expired
      or Exercised
            
            
            Outstanding
      September 30, 2008
            
            
            Expiration
      Date$0.94
            
            
            373,334
            
            
            -0-
            
            
            -0-
            
            
            373,334
            
            
            10/09/2010$1.50
            
            
            1,333,333
            
            
            -0-
            
            
            -0-
            
            
            1,333,333
            
            
            10/09/2009$2.04
            
            
            804,884
            
            
            -0-
            
            
            -0-
            
            
            804,884
            
            
            10/09/2010$2.04
            
            
            569,346
            
            
            -0-
            
            
            -0-
            
            
            569,346
            
            
            10/19/2010$2.61
            
            
            -0-
            
            
            195,000
            
            
            -0-
            
            
            195,000
            
            
            6/12/2011$2.61
            
            
            -0-
            
            
            75,000
            
            
            -0-
            
            
            75,000
            
            
            6/20/2011$3.26
            
            
            2,061,227
            
            
            -0-
            
            
            -0-
            
            
            2,061,227
            
            
            10/09/2009$3.26
            
            
            2,846,746
            
            
            -0-
            
            
            -0-
            
            
            2,846,746
            
            
            10/19/2009





Warrant Tender
Offer





As of
April 24, 2008, we commenced an offer (“Offer”) to the holders
(“Warrantholders”) of our then outstanding warrants, pursuant to which the
Warrantholders may tender their Warrants for shares of our Common Stock at a
reduced exercise price as follows:





·
            With
      respect to warrants having an exercise price of $0.94 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $0.75 per
      share of Common Stock;




·
            With
      respect to warrants having an exercise price of $1.50 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $1.20 per
      share of Common Stock;




·
            With
      respect to warrants having an exercise price of $2.04 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $1.63 per
      share of Common Stock; and




·
            With
      respect to warrants having an exercise price of $3.26 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $2.61 per
      share of Common Stock.




A
Warrantholder may tender less than the full number of its warrants. If a
Warrantholder tenders less than all of its warrants, the remaining warrants not
tendered will remain outstanding until they expire by their current terms or are
exercised.  In
addition, a Warrantholder may change its election and withdraw from the Offer. If a
Warrantholder accepts our Offer, the exercise price for the tendered warrants
must be paid in cash.  The Offer
will expire on November 21, 2008, as extended, unless we sooner extend or
terminate the period of time during which the offer is open, by giving oral or
written notice of such extension or termination.





16.
            Common Welfare
      Reserves





The
Company is required to transfer 10% of its net income, as determined in
accordance with PRC accounting rules and regulations, to the general reserve.
The Company voluntarily contributed an additional 5% in the nine months ended
September 30, 2008. The balance of these reserves at September 30, 2008 and
December 31, 2007, was $1,340,713 and $659,903, respectively. These amounts are
restricted and are included in retained earnings.





18


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





16.
            Common Welfare Reserves
      (Continued)





This fund
can only be utilized on capital items for the collective benefit of the
Company’s employees, such as construction of dormitories, cafeteria facilities,
and other staff welfare facilities. The fund is non-distributable other than
upon liquidation.




17.
            Other Comprehensive
      Income





SFAS No.
130, Reporting Comprehensive
Income ,
requires the reporting of comprehensive income in addition to net income from
operations. Comprehensive income is a more inclusive financial reporting
methodology that includes disclosure of certain financial information that
historically has not been recognized in the calculation of net
income.





The
Company reports comprehensive income (loss) in its consolidated statements of
stockholders’ equity. Comprehensive income (loss) represents changes in
stockholders’ equity from non-owner sources. The components of other
comprehensive income included adjustments from foreign currency
translation.





18.
            Earnings Per
      Share





SFAS 128
requires a reconciliation of the numerator and denominator of the basic and
diluted earnings per share (EPS) computations.





For the
three and nine months ended September 30, 2008, dilutive shares include
outstanding warrants to purchase 373,334 shares of common stock at an exercise
price of $0.94 and warrants to purchase 1,333,333 shares at an exercise price of
$1.50. Warrants to purchase 6,552,193 share of common stock were not included in
dilutive shares as the effect would have been anti-dilutive.





There
were no dilutive shares for the three and nine months ended September 30,
2007.





The
following reconciles the components of the EPS computation:





Income
            
            Shares
            
            Per
      Share(Numerator)
            
            (Denominator)
            
            AmountFor
      the three months ended September 30, 2008:Net
      income
            
            $
            808,067Basic
      EPS income available to common shareholders
            
            $
            808,067
            
            
            29,299,332
            
            $
            0.03Effect
      of dilutive securities:Warrants
            
            
            —
            
            
            264,376Diluted
      EPS income available to common shareholders
            
            $
            808,067
            
            
            29,563,708
            
            $
            0.03For
      the three months ended September 30, 2007:Net
      income
            
            $
            1,375,326Basic
      EPS income available to common shareholders
            
            $
            1,375,326
            
            
            24,305,546
            
            $
            0.06Effect
      of dilutive securities:Warrants
            
            
            —
            
            
            —Diluted
      EPS income available to common shareholders
            
            $
            1,375,326
            
            
            24,305,546
            
            $
            0.06




19


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





18.
            Earnings Per Share
      (Continued)





Income
            
            Shares
            
            Per
      Share(Numerator)
            
            (Denominator)
            
            AmountFor
      the nine months ended September 30, 2008:Net
      income
            
            $
            1,509,235Basic
      EPS income available to common shareholders
            
            $
            1,509,235
            
            
            29,299,332
            
            $
            0.05Effect
      of dilutive securities:Warrants
            
            
            —
            
            
            264,376Diluted
      EPS income available to common shareholders
            
            $
            1,509,235
            
            
            29,563,708
            
            $
            0.05For
      the nine months ended September 30, 2007:Net
      income
            
            $
            2,936,942Basic
      EPS income available to common shareholders
            
            $
            2,936,942
            
            
            24,305,546
            
            $
            0.12Effect
      of dilutive securities:Warrants
            
            
            —
            
            
            —Diluted
      EPS income available to common shareholders
            
            $
            2,936,942
            
            
            24,305,546
            
            $
            0.12





19.
            Commitments and
      Contingencies





The
Company has various purchase commitments for materials, supplies and services
incident to the ordinary conduct of business, generally for quantities required
for the Company’s business and at prevailing market prices. No material annual
loss is expected from these commitments.





In 2007
the Company placed a deposit of $574,821 with a governmental agency allowing the
Company to negotiate a possible purchase of an additional processing facility.
No agreement as to the purchase of the facility has been reached.





The
Company has contracted to purchase equipment from a supplier for a second
processing facility for $5,284,369 of which $3,699,058 has been
advanced.





The
Company has advances to milk suppliers of $340,298 which will be offset against
future milk purchases from those suppliers.





No
government approvals are required to conduct the Company’s principal operations,
and the Company is not aware of any probable governmental regulation of our
business sectors in the near future. Although management believes that the
Company is in material compliance with the statutes, laws, rules and
regulations of every jurisdiction in which it operates, no assurance can be
given that the Company’s compliance with the applicable statutes, laws,
rules and regulations will not be challenged by governing authorities or
private parties, or that such challenges will not lead to a material adverse
effect on the Company’s financial position, results of operations, or cash
flows.





The
Company and its subsidiaries are self-insured, and they do not carry any
property insurance, general liability insurance, or any other insurance that
covers the risks of their business operations. As a result any material loss or
damage to its properties or other assets, or personal injuries arising from its
business operations would have a material adverse effect on the Company’s
financial condition and operations.




20


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





19.
            Commitments and Contingencies
      (Continued)





The
Company is not involved in any legal matters arising in the normal course of
business. While incapable of estimation, in the opinion of the management, the
individual regulatory and legal matters in which it might involve in the future
are not expected to have a material adverse effect on the Company’s financial
position, results of operations, or cash flows.





20.
            Operating
      Leases





The
Company leases various distribution facilities. All leases are on an annual
basis and commence on January 1, of each year. For the three and nine months
ended September 30, 2008 and 2007, the Company incurred rental expense of
$30,811, $94,771, $6,138 and $62,883, respectively. As of September 30, 2008,
the Company had outstanding lease commitments totaling $29,052, all of which are
due within the next year.





21.
            Subsequent
      events





On
November 10, 2008, we sold to one “accredited investor,” for a
purchase price of $500,000, a 10%
promissory note (the “10% Note”) in the principal amount of $500,000,
and warrants to purchase 50,000 shares of our Common Stock, at an exercise price
of $2.61 per share (the “November Warrants”) (the “November Note Offering”). The 10%
Note will bear interest at a rate of 10% until they become due and payable on
November 10, 2009. Any amount of principal or interest which is not paid when
due will bear interest at a rate of 12%. We may prepay the entire amount due
under the 10% Note at any time without penalty, upon 15 days prior written
notice. The holder of the 10% Note has the right to be prepaid any amounts due
under his 10% Note from the proceeds of any future offering we consummate
resulting in gross proceeds of $6,500,000 or more. So long as we have any
obligation under the 10% Note, there are limitations on our ability to: (a) pay
dividends or make other distributions on its capital stock; (b) redeem,
repurchase or otherwise acquire any of its securities; (c) sell, lease or
otherwise dispose of any significant portion of its assets; (d) lend money, give
credit or make advances; or (e) assume, guarantee, endorse, contingently agree
to purchase or otherwise become liable upon the obligation of any other person
or entity. It shall be deemed an “Event of Default” under the 10% Note if: (a)
we fail to pay principal or interest when due on the 10% Note; (b) we breach any
material covenant or other material term or condition contained in the 10% Note
or securities purchase agreement entered into in connection with the November
Note Offering (the “November Purchase Agreement”), and such breach continues for
a period of thirty (30) days after written notice thereof; (c) any
representation or warranty we made under the 10% Note or the November Purchase
Agreement shall be false or misleading in any material respect; (d) we, or any
subsidiary of ours, shall make an assignment for the benefit of creditors, or
apply for or consent to the appointment of a receiver or trustee, or such a
receiver or trustee shall otherwise be appointed; (e) a money judgment shall be
entered against us, or any subsidiary of ours, for more than $250,000, that
remains in effect for a period of twenty (20) days; (f) bankruptcy, insolvency,
reorganization or liquidation proceedings or other similar proceedings shall be
instituted by or against us, or any subsidiary of ours, which are not dismissed
within ninety (60) days; or (g) we fail to maintain the listing of our Common
Stock on at least one of the OTCBB, the Nasdaq National Market, the Nasdaq
SmallCap Market, the New York Stock Exchange, or the American Stock Exchange.
Upon the occurrence of any Event of Default under the 10% Note, unless such
Event of Default shall have been waived in writing by the holder, the holder may
consider the 10% Note immediately due and payable, without presentment, demand,
protest or notice of any kind, and the holder may immediately enforce any and
all of its rights and remedies provided in the Note or any other right or remedy
afforded by law.





In
connection with the November Note Offering, we engaged a placement agent to whom
we paid a placement fee in the amount of $40,000, and granted warrants to
purchase an aggregate of 25,000 shares of our Common Stock, the terms and
conditions of which are identical to the those of the November
Warrants.




21


Emerald Dairy, Inc. and
Subsidiaries


Footnotes to Condensed Consolidated
Financial Statements


September 30, 2008 and
2007





22.
            Segment
      reporting





The
Company operates in one operating segment in accordance with the provisions of
SFAS No. 131, “Disclosures about Segments of an Enterprise and Related
Information”. Although the Company has key product lines of milk, soybean milk,
and rice powder, the Company’s chief operating decision maker reviews and
evaluates one set of combined financial information deciding how to allocate
resources and in assessing performance.





For the
three and nine months ended September 30, 2008, the Company’s sales revenue from
various products are as follows:





Three
      Months
              Ended September 30,
            
            Nine
      Months
              Ended September 30,2008
            
            2007
            
            2008
            
            2007Milk
      powder
            
            $
            9,362,555
            
            $
            6,514,022
            
            $
            26,144,060
            
            $
            15,898,010Soybean
      milk powder
            
            
            221,124
            
            
            177,986
            
            
            644,233
            
            
            495,204Rice
      powder
            
            
            275,722
            
            
            303,290
            
            
            813,645
            
            
            785,162Sub-contract
      processing
            
            
            1,361,618
            
            
            1,448,063
            
            
            4,958,318
            
            
            3,793,179$
            11,221,019
            
            $
            8,443,361
            
            $
            32,560,256
            
            $
            20,971,555




22


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





Forward Looking
Statements





This
Quarterly Report on Form 10-Q contains “forward-looking statements” that involve
substantial risks and uncertainties. You can identify such statements by forward
looking words such as “may,” “expect,” “plans,” “intends,” “anticipate,”
“believe,” “estimate,” and “continue” or similar words. Such statements involve
known and unknown risks, uncertainties and other factors that may cause our
actual results, performance or achievements to be materially different from any
future results, performance or achievements expressed or implied by such
forward-looking statements. The forward-looking statements included herein are
based on current expectations that involve numerous risks and uncertainties. Our
plans and objectives are based, in part, on assumptions involving the continued
growth and expansion of our business. Assumptions relating to the foregoing
involve judgments with respect to, among other things, future economic,
competitive and market conditions and future business decisions, all of which
are difficult or impossible to predict accurately and many of which are beyond
our control. Although we believe the assumptions underlying the forward-looking
statements are reasonable, any of the assumptions could prove inaccurate and,
therefore, there can be no assurance the forward-looking statements included in
this Report will prove to be accurate. In light of the significant uncertainties
inherent in the forward-looking statements included herein, the inclusion of
such information should not be regarded as a representation by us or any other
person that our objectives and plans will be achieved.





Overview





We are a
producer of milk powder, rice powder and soybean milk powder, which currently
comprise approximately 96%, 2% and 2% of our sales, respectively. Through our
network of over 600 salespeople, our products are distributed throughout 20
provinces in the People’s Republic of China (“PRC”), and sold in over 5,600
retail outlets.





Our
products are marketed under two brand names:





·
            “Xing
      An Ling,” which is designed for low-end customers;
  and




·
            “Yi
      Bai,” which is designed for middle and high-end
  customers.




The
Chinese government has initiated programs to promote milk consumption and is
providing incentives to increase dairy production. The dairy market today in
China is over $13.0 billion and is expected to grow at a rate of 15% per year
for the foreseeable future. We focus on the infant formula segment of the
market, which is expected to grow even faster, at a rate of approximately 23%
through 2011. Currently, it is estimated that demand for infant formula in China
outstrips supply by at least 2-to-1.





We have
received an Infant & Baby Formula Milk Powder Production Permit from the
State General Administration of Quality Supervision and Inspection and
Quarantine of the PRC. Only current license holders are permitted to produce
formula milk powder in China. In addition, we have received a Product Exemption
from Quality Surveillance Inspection waiver from the State General
Administration. Only companies that have passed their product quality
inspections for five consecutive years are awarded this certificate of
waiver.





Because
of our close proximity to its sources of fresh milk, we are able to complete the
production process in approximately 30 hours, which is faster than competitors
of ours that are not similarly situated. We produced approximately 7,000 tons of
milk powder at our facility in Be’ian City, Heilongjiang Province, PRC in fiscal
2007, up from approximately 5,000 tons in fiscal 2006. In 2008, by adding a
third shift to the existing two shifts working schedule, we plan on producing
approximately 9,000 tons of milk powder. In addition, in July 2008, through our
wholly-owned subsidiary, Hailun Xinganling Dairy Co., Ltd. (“HXD”), we commenced
construction of a new production facility in Hailun City, Heilongjiang Province,
PRC, which will enable us to produce an additional 9,000 tons of milk powder
annually, beginning in fiscal 2009. As a result, we believe we will have the
capacity to produce almost 20,000 tons of milk powder per year by fiscal 2010.
It is expected that our production of rice powder and soymilk powder will also
increase in volume, while continuing to comprise approximately 2% and 2% of our
overall sales, respectively.





23


All of
our business is conducted through our wholly-owned Chinese
subsidiaries:





·
            Heilongjiang
      Xing An Ling Dairy Co. Limited (“XAL”), which handles our promotion, sales
      and administrative functions;




·
            Heilongjiang
      Be’ian Nongken Changxing Lvbao Dairy Limited Liability Company (“Lvbao”),
      which handles production of our products in Be’ian City, Heilongjiang
      Province, PRC; and




·
            HXD,
      which will handle additional production of our products in Hailun City,
      Heilongjiang Province, PRC.




Recent
Developments




Reverse Merger, Private Placements
and Related Transactions





Prior to
October 9, 2007, we were a public shell company, as defined by Securities Act
Rule 405 and Exchange Act Rule 12b-2, without material assets or activities. On
October 9, 2007, we completed a reverse merger (the “Reverse Merger”), pursuant
to which our wholly-owned subsidiary merged with and into a private company,
American International Dairy Holding Co., Inc. (“AIDH”), with such private
company being the surviving company. In connection with this Reverse Merger, we
discontinued our former business and succeeded to the business of AIDH as our
sole line of business. For financial reporting purposes, AIDH is considered to
be the accounting acquirer. Accordingly, the historical financial statements
presented and the discussion of financial condition and results of operations
herein are those of AIDH and do not include our historical financial
results.





Simultaneously
with the Reverse Merger, we sold 1,333,333 units of our securities to John V.
Winfield, consisting of: (i) 1,333,333 shares of our common stock, $.001 par
value per share (“Common Stock”), (ii) warrants to purchase 266,667 shares of
our Common Stock, at an exercise price of $0.94 per share (“Warrant W-1”), and
(iii) warrants to purchase 1,333,333 shares of our Common Stock, at an exercise
price of $1.50 per share (“Warrant W-2”), for an aggregate purchase price of
$1,000,000 (the “First Offering”). In addition, we sold 2,061,227 units of our
securities to certain additional “accredited investors” (the “Initial
Purchasers”), consisting of (i) 2,061,227 shares of our Common Stock,
(ii) warrants to purchase 412,245 of our Common Stock, at an exercise price
of $2.04 per share (the “Class A Warrants”), and (iii) warrants to purchase
2,061,227 of our common stock, at an exercise price of $3.26 per share (the
“Class B Warrants”), for an aggregate purchase price of $3,359,800 (the “Initial
Placement of the Second Offering”). The rights and obligations under Warrant
W-1, Warrant W-2, the Class A Warrants, and the Class B Warrants are further
described in “- Liquidity and Capital Resources - Warrants” below.





24


Upon the
consummation of the Reverse Merger, and the closing of the First Offering and
Initial Placement of the Second Offering, we entered into a Share Repurchase
Agreement with Grand Orient Fortune Investment, Ltd. (“Grand Orient”), a PRC
company controlled by Mingwen Song, pursuant to which we repurchased 1,944,444
shares (the “Repurchased Shares”) of our issued and outstanding Common Stock
from Grand Orient for an aggregate purchase price of $3,169,444 (the “Repurchase
Transaction”). We determined to repurchase these shares, to reduce the overall
dilution created by the First Offering and Second Offering. The Repurchased
Shares are currently being held in treasury.





Immediately
following the closing of the Repurchase Transaction, we entered into Put/Call
Agreements with each of Grand Orient and Fortune Land Holding, Ltd., a PRC
company controlled by Dexuan Yu (jointly, the “Put/Call Shareholders). Pursuant
to the Put/Call Agreements we have the right to repurchase an aggregate of
1,944,444 shares of our Common Stock from the Put/Call Shareholders under
certain circumstances. In addition, the Put/Call Shareholders have the right to
cause us to repurchase such shares at $1.63 per share if certain events occur.
The Put/Call Agreements are further described in “- Liquidity and Capital
Resources - Put/Call Agreements” below.





On
October 19, 2007, we sold 2,846,746 units of our securities to additional
“accredited investors” (the “Additional Purchasers”), consisting of
(i) 2,846,746 shares of our Common Stock, (ii) 569,346 Class A Warrants,
and (iii) 2,846,746 Class B Warrants, for an aggregate purchase price of
$4,640,200 (the “Additional Placement of the Second Offering,” and together with
the Initial Placement of the Second Offering, the “Second
Offering”).





In
connection with the First Offering and Second Offering (collectively, the
“October Offerings”), we engaged finders and placement agents to whom we paid
fees in the aggregate of $700,452, and granted (i) warrants to purchase an
aggregate of 106,667 shares of our Common Stock, at an exercise price of $0.94
per share, the terms and conditions of which are identical to the those of
Warrant W-1, and (ii) warrants to purchase 392,639 shares of our Common Stock,
at an exercise price of $2.04, the terms and conditions of which are identical
to the those of the Class A Warrants.





Warrant Tender
Offer





As of
April 24, 2008, we commenced an offer (“Offer”) to the holders
(“Warrantholders”) of our then outstanding warrants, pursuant to which the
Warrantholders may tender their Warrants for shares of our Common Stock at a
reduced exercise price as follows:





·
                With
      respect to warrants having an exercise price of $0.94 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $0.75 per
      share of Common Stock;




·
                With
      respect to warrants having an exercise price of $1.50 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $1.20 per
      share of Common Stock;




·
            With
      respect to warrants having an exercise price of $2.04 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $1.63 per
      share of Common Stock; and




·
            With
      respect to warrants having an exercise price of $3.26 per share, a holder
      accepting the Offer may exercise some or all of such warrants at $2.61 per
      share of Common Stock.




A
Warrantholder may tender less than the full number of its warrants. If a
Warrantholder tenders less than all of its warrants, the remaining warrants not
tendered will remain outstanding until they expire by their current terms or are
exercised.  In
addition, a Warrantholder may change its election and withdraw from the Offer. If a
Warrantholder accepts our Offer, the exercise price for the tendered warrants
must be paid in cash.  The Offer
will expire on November 21, 2008, as extended, unless we sooner extend or
terminate the period of time during which the Offer is open, by giving oral or
written notice of such extension or termination.





25


As of the
date hereof, a limited number of Warrantholders have elected to tender their
warrants. However, since any Warrantholder
may change its election and withdraw from the Offer , the
funds related to such transactions are being held in escrow, and will not be
released to us until the Offer expires.





Sale of Notes and
Warrants





In June
2008, we conducted a private offering of up to a maximum of (i) $3,000,000 of
our 8% promissory notes (the “8% Notes”) and (ii) warrants to purchase 300,000
shares of our Common Stock, at an exercise price of $2.61 per share (the
“June Warrants”) (the
“June Note Offering”).  On June
12, 2008, one “accredited investor” purchased, for a
purchase price of $1,500,000, an 8%
Note in the principal amount of $1,500,000,
and June Warrants to purchase 150,000 shares of our Common Stock. On June 20,
2008, an additional “accredited investor” purchased, for a purchase price of
$750,000, an 8% Note in the principal amount of $750,000, and June Warrants to
purchase 75,000 shares of our Common Stock. The rights and obligations under the
8% Notes are further described in “- Liquidity and Capital Resources -
Promissory Notes” below. The rights and obligations under the June Warrants are
further described in “- Liquidity and Capital Resources - Warrants”
below.





In
connection with the June Note Offering, we engaged a placement agent to whom we
paid a non-refundable retainer of $25,000, and a placement fee in the amount of
$97,500, and granted warrants to purchase an aggregate of 45,000 shares of our
Common Stock, the terms and conditions of which are identical to the those of
the June Warrants.





On
November 10, 2008, we sold to one “accredited investor,” for a
purchase price of $500,000, a 10%
promissory note (the “10% Note”) in the principal amount of $500,000,
and warrants to purchase 50,000 shares of our Common Stock, at an exercise price
of $2.61 per share (the “November Warrants”) (the “November Note Offering”). The
rights and obligations under the 10% Note are further described in “- Liquidity
and Capital Resources - Promissory Notes” below. The rights and obligations
under the November Warrants are further described in “- Liquidity and Capital
Resources - Warrants” below.





In
connection with the November Note Offering, we engaged a placement agent to whom
we paid a placement fee in the amount of $40,000, and granted warrants to
purchase an aggregate of 25,000 shares of our Common Stock, the terms and
conditions of which are identical to the those of the November
Warrants.





Construction of New Production
Facility





On May
22, 2008, we organized our wholly-owned subsidiary, HXD, under the laws of the
PRC. In July 2008, HXD commenced construction on a production facility to be
located in Hailun City, Heilongjiang Province, PRC. When completed, the new
facility will have the capacity to produce approximately 9,000 tons of infant
formula milk powder annually, expandable to 18,000 tons annually. We anticipate
that production will begin at this facility in the second quarter of
2009.





26


Trends and
Uncertainties





Narrowing of Gap in Milk
Consumption





The
Chinese government has initiated programs to promote milk consumption and is
providing incentives to increase dairy production. In addition to improving the
overall health the populous, the government views increased dairy production as
a solution to improve employment in rural areas thus improving social stability.
It is expected that there will be a steady narrowing of the significant gap
between China’s per capita milk consumption of 15kg per person and the global
average of 100 kg per person.




Industry
Growth





The dairy
market today in China is over $13.0 billion. According to the website
of China National Bureau of Statistics, between 2000 to 2005 the dairy
industry in China experienced an average growth of 16% per year.
English-language copies of the reports of the China National Bureau of
Statistics are available on its website, free of charge, at www.stats.gov.cn/english.
The dairy industry in China is projected to grow at rate of 15% per year from
2006 to 2012, to reach $32 billion by 2012.




On its
website, the Dairy Association of China estimates that the infant formula market
segment, which is the market segment we target, has grown even faster in recent
years, at a rate of 20%-30% per year. We believe the following three factors are
the main drivers of the infant formula market:





·
            Increased
      household income made infant formula more affordable in
    China;





·
            Increased
      number of working mothers or busy mothers created more demands for infant
      formula products; and





·
            Increased
      popularity and acceptance of infant formula
  products.





Supply of Infant
Formula





It is
estimated that the demand for infant formula in China outstrips supply by at
least 2-to-1. Production capacity has been the bottle neck for our growth in
recent years, because production has not been able to keep up with demand. We
have commenced construction of a new production facility with annual production
capacity of 9,000 tons of milk powder, which is expected to start production in
the second quarter of 2009. We expect that this increase in production capacity
of approximately 100% will result in the doubling of our sales revenues, with a
corresponding increase in cost of goods sold and sales and administrative
expenses.





This
project is expected to cost an aggregate of approximately $20.0 million,
including land use rights, construction expenses and equipment costs. Management
will need to raise $10.0 million to $15.0 million to fund the construction of
new production facility. We plan to apply the net proceeds we received from the
June Note Offering and November Note Offering, further described in “— Recent
Developments—Sale of Notes and Warrants” above, and any proceeds we receive from
the Offer, further described in “—Recent Developments—Warrant Tender Offer”
above, toward the construction of this new production facility. Other than that,
we have no additional commitments for additional financing we may need to
complete the construction of our new processing facility. There can be no
assurance that that any additional financing will become available to us, and if
available, on terms acceptable to us.




27


Product Pricing and Raw Material
Supply





Historically
we have been able to obtain raw milk and other raw materials to meet our
production needs. The price of raw milk is affected by regional market in
Heilongjiang China while other raw materials are affected by global markets. We
expect that the raw materials we require to produce our products will continue
to be available to us we grow. However, we believe the recent worldwide
increases in the cost and availability of commodities, such as rice and oil,
will lead to increases in prices for such commodities. To some extent, we will
be able to increase the prices for our products to pass on higher raw material
costs to consumers. However, there is no guarantee that we will be able to raise
prices to the full extent necessary to cover rises in costs for raw materials,
which could have a negative material impact on our financial condition and
results of operations.





Brand Name and Product
Quality





There are
more than 30 brand names of infant formula products sold in China. Most of the
International and larger players have been concentrating in the first tier
cities, or well-known urban centers such as Beijing and Shanghai. The rest of
the Chinese domestic companies have been focusing on less developed second and
third cities where competition is less severe than the top tier cities. As
consumers have many options for infant formula products, infant formula
producers with better quality and safety images have the advantages to sell
their product at higher price. Brand image and recognition are increasingly
important in gaining customer loyalty.





Organic Label Milk
Products





Currently,
there are no organic label milk powder products in the mainland China market. In
February 2008, we obtained organic label certification from Guangdong Zhongjian
Certification Co., Ltd. We plan to create an organic label product line
beginning in fiscal 2009. We will need to test the market to determine demand
for organic milk products. Initially, we expect sales of organic milk powder to
be minor. However, over the long term, we believe that, similar to the growth of
the organic milk market in the U.S., organic milk products will be very popular
in China. Over time, this will help increase our revenues.





Factors Affecting Raw Milk
Production





Raw milk
production is influenced by a number of factors that are beyond our control
including, but not limited to, the following:





·
            Seasonal
      factors:
      dairy cows generally produce more milk in temperate weather than in cold
      or hot weather and extended unseasonably cold or hot weather could lead to
      lower than expected production;




·
            Environmental
      factors:
      the volume and quality of milk produced by dairy cows is closely linked to
      the quality of the nourishment provided by the environment around them, if
      environmental factors cause the quality of nourishment to decline, milk
      production could decline and we may have difficulty finding sufficient raw
      milk; and




·
            Governmental agricultural and
      environmental policy:
      declines in government grants, subsidies, provision of land, technical
      assistance and other changes in agricultural and environmental policies
      may have a negative effect on the viability of individual dairy farms, and
      the numbers of dairy cows and quantities of milk they are able to
      produce.




28


Contamination of Milk Powder
Products Produced in China





Recently,
a number of milk powder products produced within China were found to contain
unsafe levels of tripolycyanamide, also known as melamine, sickening thousands
of infants. This prompted the Chinese government to conduct a nationwide
investigation into how the milk powder was contaminated, and caused a worldwide
recall of certain milk powder products produced within China. On September 16,
2008, China’s Administration of Quality Supervision, Inspection and Quarantine
(AQSIQ) revealed that it had tested samples from 175 dairy manufacturers, and
published a list of 22 companies whose products contained melamine. We passed
the emergency inspection and were not included on AQSIQ’s list. Although we
believe that the inevitable contraction in the Chinese milk powder industry
caused by this crisis will lead to increased demand for our products, we can not
be certain that the illnesses caused by contamination in the milk powder
industry, whether or not related to our products, will not lead to decreased
demand for milk powder products produced within China, thereby having a material
adverse effect on our business.




Results of
Operations





Three Months Ended September 30,
2008 Compared to Three Months Ended September 30,
2007





The
following summarizes changes in our operations for the three months ended
September 30, 2008 and 2007. Net income decreased by $567,259, or 41.2%, from
$1,375,326 in the three months ended September 30, 2007 to $808,067 for the
three months ended September 30, 2008. The decrease in net income during the
three months ended September 30, 2008, as compared to the same time period in
the prior year, was due to an increase in our operating expenses, which offset
an increase in our gross profit as further described below.





Sales and Cost of Goods
Sold





For the Three
      Months
              Ended September
      30,2008
            
            2007Sales
            
            $
            11,221,019
            
            $
            8,443,361Cost of Goods
      Sold
            
            
            6,552,835
            
            
            5,422,899Gross Profit
            
            $
            4,668,184
            
            $
            3,020,462





Sales. Sales
volume increased by 211 metric tons, or 9.9%, period on period, to 2,343
metric tons for the three months ended September 30, 2008, from 2,132 metric
tons for the three months ended September 30, 2007. As a result, sales revenues
increased by $2,777,658, or 32.9%, from $8,443,361 in the three months ended
September 30, 2007, to $11,221,019 for the three months ended September 30,
2008. This increase was due to the following factors:




·
              We
      expanded the market areas in the twenty provinces in which we sell our
      products and our products are now sold in over 5,600 retail
      outlets;
  ·
              Our
      products have became increasing popular in mainland China due to our
      continued sales and marketing efforts;
and
  ·
              The
      average selling price for all products has increased by $829 per metric
      ton, or 20.9%, as compared to the three months ended September 30,
      2007.
  29


Sales by product line. A
break-down of our sales by product line for the three months ended September 30,
2008 and 2007 is as follows:




Three
      Months Ended September 30,2008
            
            2007
            
            Period-on-periodProduct category
            
            Quantity
                (tons)
            
            $  Amount
            
            % of sales
            
            Quantity
                (tons)
            
            $ Amount
            
            % of sales
            
            Quantity
                VarianceMilk
      powder
            
            
            1,621
            
            
            9,362,555
            
            
            83.4
            
            
            1,442
            
            
            6,514,022
            
            
            77.2
            
            
            179Rice
      powder
            
            
            50
            
            
            275,722
            
            
            2.5
            
            
            57
            
            
            303,290
            
            
            3.6
            
            
            (7
            )Soybean
      powder
            
            
            120
            
            
            221,125
            
            
            2.0
            
            
            104
            
            
            177,986
            
            
            2.1
            
            
            16Subcontracting
            
            
            552
            
            
            1,361,617
            
            
            12.1
            
            
            529
            
            
            1,448,0631
            
            
            17.1
            
            
            23Total
            
            
            2,343
            
            
            11,221,019
            
            
            100.0
            
            
            2,132
            
            
            8,443,361
            
            
            100.0
            
            
            211





There
were very few changes to the break-down of sales among our products over the
three months ended September 30, 2008, as compared to the three months ended
September 30, 2007. Soybean powder only accounted for 2.0% of our sales mix for
the three months ended September 30, 2008, at an average selling price of $1,840
per metric ton, as compared to 2.1% of our sales mix in the three months ended
September 30, 2007, at an average selling price of $1,717 per metric ton. Milk
powder accounted for 83.4% of the sales mix for the quarter ended September 30,
2008, at an average selling price of $5,778 per metric ton, as compared to 77.2%
of the quarter ended September 2007, at an average selling price of $4,516 per
metric ton. We decreased our subcontract production during the quarter ended
September 30, 2008 to 12.1% of the sales mix, at an average selling price of
$2,465 per metric ton, as compared to 17.1% of the sales mix in the same quarter
in 2007, at an average sales price of $2,737 per metric ton.





A
breakdown of our average selling price by product line for the three months
ended September 30, 2008 and 2007 is as follows:




Three Months
       Ended
              September 30,Average selling prices
      (per ton)
            
            
            2008
            
            
            2007
            
            
            Variance$
            
            
            $
            
            
            $
            
            
            %Milk
      powder
            
            
            5,778
            
            
            4,516
            
            
            1,262
            
            
            27.9Rice
      powder
            
            
            5,546
            
            
            5,334
            
            
            212
            
            
            4.0Soybean
      powder
            
            
            1,840
            
            
            1,717
            
            
            123
            
            
            7.2Subcontracting
            
            
            2,465
            
            
            2,737
            
            
            (272
            )
            
            (9.9
            )Average
      total selling price
            
            
            4,790
            
            
            3,960
            
            
            830
            
            
            20.9





Cost of Goods
Sold. Cost of
goods sold increased by $1,129,936, or 20.8%, from $5,422,899 in the three
months ended September 30, 2007, to $6,552,835 for the three months ended
September 30, 2008. In addition, our cost per metric ton increased by $253, or
10.0%, to $2,797 per metric ton in the quarter ended September 30, 2008, as
compared to $2,554 per metric ton in quarter ended September 30, 2007. This
increase in cost per metric ton was the result of an increase in the price of
raw materials we use to produce our products.




30


A
breakdown of cost of sales by product line for the three months ended September
30, 2008 and 2007 is as follows:





Three
      Months Ended September 30,2008
            
            2007
            
            Variance$
            
            $
            
            $
            
            %Cost of
      salesMilk
      powder
            
            
            5,201,835
            
            
            4,007,782
            
            
            1,194,053
            
            
            29.8Rice
      powder
            
            
            89,718
            
            
            100,880
            
            
            (11,162
            )
            
            (11.1
            )Soybean
      powder
            
            
            148,324
            
            
            112,160
            
            
            36,164
            
            
            32.2Subcontracting
            
            
            1,112,958
            
            
            1,202,077
            
            
            (89,119
            )
            
            (7.4
            )Total
            
            
            6,552,835
            
            
            5,422,899
            
            
            1,129,936
            
            
            20.8Cost per units sold (per
      ton)Milk
      powder
            
            
            3,209
            
            
            2,779
            
            
            430
            
            
            15.5Rice
      powder
            
            
            1,794
            
            
            1,770
            
            
            24
            
            
            1.4Soybean
      powder
            
            
            1,236
            
            
            1,078
            
            
            158
            
            
            14.7Subcontracting
            
            
            2,016
            
            
            2,272
            
            
            (256
            )
            
            (11.3
            )Average
      cost per unit sold
            
            
            2,797
            
            
            2,544
            
            
            253
            
            
            10.0





Gross Profit. Gross
profit was $4,668,184, or 41.6% of our sales for the three months ended
September 30, 2008, compared to gross profit of $3,020,462, or 35.8% for the
three months ended September 30, 2007. During the quarter ended September 30,
2008 our gross margin on milk powder increased 5.9% due to an increase in the
average sales price of 27.9% from quarter ended September 30, 2007, partially
offset by a 15.5% increase in the cost per metric ton from the quarter ended
September 30, 2007. The gross margin for soybean powder decreased 4.1% to 32.9%
in quarter ended September 30, 2008, as compared from 37.0% in quarter ended
September 30, 2007 due to increase in the average sales price of 7.2% in quarter
ended September 30, 2008, as compared to 2007, offset by an increase of 32.2% in
the cost per metric ton from the quarter ended September 30, 2008 to the quarter
ended September 30, 2007.





A
breakdown of gross margin by product line for the three months ended September
30, 2008 and 2007 is as follows:





Three
      Months Ended September 30,2008
            
            2007
            
            Period-on-periodProduct category
            
            $  Amount
            
            Gross
              Margin %
            
            $ Amount
            
            Gross
              Margin %
            
            Margin
              VarianceMilk
      powder
            
            
            4,160,720
            
            
            44.4
            
            
            2,506,240
            
            
            38.5
            
            
            5.9Rice
      powder
            
            
            186,004
            
            
            67.5
            
            
            202,410
            
            
            66.7
            
            
            0.8Soybean
      powder
            
            
            72,801
            
            
            32.9
            
            
            65,826
            
            
            37.0
            
            
            (4.1
            )Subcontracting
            
            
            248,659
            
            
            18.3
            
            
            245,986
            
            
            17.0
            
            
            1.3Total
            
            
            4,668,184
            
            
            41.6
            
            
            3,020,462
            
            
            35.8
            
            
            5.8




31


Operating
Expenses





For the Three Months
              Ended September
      30,2008
            
            2007Operating
      ExpensesSelling
      expenses
            
            $
            2,452,994
            
            $
            1,355,483Administrative
      expenses
            
            
            866,490
            
            
            206,217Depreciation
      and amortization
            
            
            41,905
            
            
            12,999Total
      operating expenses
            
            $
            3,361,389
            
            $
            1,574,699





Selling Expenses . Selling
expenses overall increased by $1,097,511, or 210.4%, from $1,355,483 in the
quarter ended September 30, 2007, to $2,452,994 for the quarter ended September
30, 2008. The major factors in the increase in selling expenses are as
follows:


·
              Advertising
      increased by $532,271, or 2,193.2%, to $556,540 in 2008, from $24,269 in
      2007, due to our marketing campaign to increase brand awareness and
      sales.
 
 ·
              Selling
      salaries increased by $139,368, or 38.2%, to $504,465 in 2008, from
      $365,096 in 2007, as the amounts we paid to our sales staff rose due to
      increased sales.
 
 ·
              Travelling
      expenses incurred by the sales staff increased by $95,852, or 50.0%, to
      $287,516 in 2008, from $191,663 in 2007, due to the expansion of our sales
      network.
 
 ·
              Transportation
      expenses increased by $71,660, or 34.4%, to $279,800 in 2008, from
      $208,140 in 2007, as a result of shipping more product in 2008 as compared
      to 2007.
 
 ·
              Entertainment
      expenses increased by $52,244, or 45.4%, to $167,260 in 2008, from
      $115,016 in 2007, as a result of the increase in the sales staff and
      network.




Rather
than using a wholesaler, our sales people deal directly with the retail
outlets.  This business model has higher sales expenses compared to
the traditional business model, but creates better profit margins for
us.




Administrative
Expenses .
Administrative expenses increased by $660,273, or 320.2%, from $206,217 in the
quarter ended September 30, 2007, to $866,490 for the quarter ended September
30, 2008. The major factors in the increase in administrative expenses are as
follows:


·
              Liquidated
      damages incurred in 2008 of $414,000 related to registration rights
      agreements we entered into, which were not similarly incurred in
      2007.
 
 ·
              Increase
      in legal and accounting fees in 2008 of $68,707, or 178.4%, to $107,213,
      as compared to $38,506 in 2007, due to costs associated with audits and
      SEC filings not required prior to the reverse merger we consummated in
      October 2007.
 
 ·
              Consultant
      expenses incurred of $26,243, which were not similarly incurred in
      2007.
 
 ·
              Increase
      of administrative salaries of $20,784, or 49.4%, to 62,886 in 2008, from
      $42,102 in 2007, related to 6 additional administrative personnel hired
      during 2008.
  ·
              Increase
      in entertainment expenses of $22,565, or 66.7%, to $56,418 in 2008, from
      $33,853 in 2007, due to increased travel and entertainment by
      administrative personnel to develop financing and funding for our
      growth.
  32
 ·
              Increase
      of travel expenses of $24,430, or 85.5%, to $53,000 in 2008, from $28,569
      in 2007, due to the increase in travel by administrative personnel to
      develop financing and funding for our
growth.




Provision for Income
Taxes





For the Three
      Months
              Ended September
      30,2008
            
            2007Provision for Income
      TaxesCurrent
            
            $
            269,666
            
            $
            65,942Deferred
            
            
            —
            
            
            —$
            269,666
            
            $
            65,942





Provision for Income
Taxes . Income
taxes increased by $203,724, or 308.9%, from $65,942 in the three months ended
September 30, 2007, to $269,666 for the three months ended September 30, 2008.
This increase was due to the increase in our pre-tax income and the reduction in
the tax exemption for XAL to 50% of the statutory enterprise income tax rate
from 100% as of January 1, 2008.





Nine Months Ended September 30, 2008
Compared to Nine Months Ended September 30, 2007





The
following summarizes changes in our operations for the nine months ended
September 30, 2008 and 2007. Net income decreased by $1,427,707, or 48.6%, from
$2,936,942 in the nine months ended September 30, 2007, to $1,509,235 for the
nine months ended September 30, 2008. The decrease in net income during the nine
months ended September 30, 2008, as compared to the same time period in the
prior year, was due to an increase in our operating expenses, which offset an
increase in our gross profit as further described below.





Sales and Cost of Goods
Sold





For the Nine
      Months
              Ended September
      30,2008
            
            2007Sales
            
            $
            32,560,256
            
            $
            20,971,555Cost of Goods
      Sold
            
            
            19,845,232
            
            
            13,853,290Gross Profit
            
            $
            12,715,024
            
            $
            7,118,265





Sales. Sales
volume increased by 917 metric tons, or 15.7%, period on period to 6,761 metric
tons for the nine months ended September 30, 2008, from 5,844 metric tons for
the nine months ended September 30, 2007. As a result, sales revenues increased
by $11,588,701, or 55.3%, from $20,971,555 in the nine months ended September
30, 2007, to $32,560,256 for the nine months ended September 30, 2008. This
increase was due to the following factors:


·
              We
      expanded the market areas in the twenty provinces in which we sell our
      products and our products are now sold in over 5,600 retail
      outlets;
 
 33
  ·
              Our
      products have became increasing popular in mainland China due to our
      continued sales and marketing efforts;
and
  ·
              The
      average selling price for all products has increased by $1,227 per metric
      ton, or 34.2%, as compared to the nine months ended September 30,
      2007.


Sales by product line. A
break-down of our sales by product line for the nine months ended September 30,
2008 and 2007 is as follows:





Nine
      Months Ended September 30,2008
            
            2007
            
            Period-on-periodProduct category
            
            Quantity
              (tons)
            
            $  Amount
            
            % of sales
            
            Quantity
              (tons)
            
            $ Amount
            
            % of
              sales
            
            Qty.
              VarianceMilk
      powder
            
            
            4,543
            
            
            26,144,060
            
            
            80.3
            
            
            3,936
            
            
            15,898,010
            
            
            75.8
            
            
            607Rice
      powder
            
            
            147
            
            
            813,645
            
            
            2.5
            
            
            1492
            
            
            785,162
            
            
            3.7
            
            
            (2
            )Soybean
      powder
            
            
            350
            
            
            644,233
            
            
            2.0
            
            
            295
            
            
            495,204
            
            
            2.4
            
            
            55Subcontracting
            
            
            1,721
            
            
            4,958,318
            
            
            15.2
            
            
            1,464
            
            
            3,793,1791
            
            
            18.1
            
            
            257Total
            
            
            6,761
            
            
            32,560,256
            
            
            100.0
            
            
            5,844
            
            
            20,971,555
            
            
            100.0
            
            
            917





There
were very few changes to the break-down of sales among our products over the
nine months ended September 30, 2008, as compared to the nine months ended
September 30, 2007. Soybean powder only accounted for 2.0% of our sales mix for
the nine months ended September 30, 2008, at an average selling price of $1,840
per metric ton, as compared to 2.4% of our sales mix in the nine months ended
September 30, 2007, at an average selling price of $1,677 per metric ton. Milk
powder accounted for 80.3% of sales mix in the nine months ended September 30,
2008, at an average selling price of $5,755 per metric ton, as compared to 75.8%
of the sales mix in nine months ended September 30, 2007, at an average selling
price of $4,040 per metric ton. Our subcontract production during the nine
months ended September 30, 2008 decreased to 15.2% of the sales mix, at an
average selling price of $2,880 per metric ton, as compared to 18.1% of the
sales mix in the nine months ended September 30, 2007, at an average sales price
of $2,591 per metric ton.





A
breakdown of our average selling price by product line for the nine months ended
September 30, 2008 and 2007 is as follows:





Nine Months
       Ended
              September 30,Average selling prices
      (per ton)
            
            2008
            
            2007
            
            Variance$
            
            $
            
            $
            
            %Milk
      powder
            
            
            5,755
            
            
            4,039
            
            
            1,715
            
            
            42.5Rice
      powder
            
            
            5,535
            
            
            5,270
            
            
            265
            
            
            5.0Soybean
      powder
            
            
            1,841
            
            
            1,679
            
            
            162
            
            
            9.6Subcontracting
            
            
            2,881
            
            
            2,591
            
            
            290
            
            
            11.2Average
      total selling price
            
            
            4,816
            
            
            3,589
            
            
            1,227
            
            
            34.2





34


Cost of Goods
Sold. Cost of
goods sold increased by $5,991,942, or 43.3%, from $13,853,290 in the nine
months ended September 30, 2007, to $19,845,232 for the nine months ended
September 30, 2008. This increase was related to an increase in sales during
quarter of 55.3%. In addition, our cost per metric ton increased by $564, or
23.8%, to $2,935 per metric ton in the quarter ended September 30, 2008, as
compared to $2,371 per metric ton in quarter ended September 30,
2007.





A
breakdown of cost of sales by product line for the nine months ended September
30, 2008 and 2007 is as follows:





Nine
      Months Ended September 30,2008
            
            2007
            
            Variance$
            
            $
            
            $
            
            %Cost of
      salesMilk
      powder
            
            
            14,893,859
            
            
            10,124,336
            
            
            4,769,523
            
            
            47.1Rice
      powder
            
            
            262,169
            
            
            256,957
            
            
            5,212
            
            
            2.0Soybean
      powder
            
            
            423,707
            
            
            303,566
            
            
            120,141
            
            
            39.6Subcontracting
            
            
            4,265,497
            
            
            3,168,431
            
            
            1,097,066
            
            
            34.6Total
            
            
            19,845,232
            
            
            13,853,290
            
            
            5,991,942
            
            
            43.3Cost per units sold(per
      ton)Milk
      powder
            
            
            3,278
            
            
            2,572
            
            
            706
            
            
            27.4Rice
      powder
            
            
            1,783
            
            
            1,725
            
            
            58
            
            
            3.4Soybean
      powder
            
            
            1,211
            
            
            1,029
            
            
            182
            
            
            17.7Subcontracting
            
            
            2,478
            
            
            2,164
            
            
            314
            
            
            14.5Average
      cost per unit sold
            
            
            2,935
            
            
            2,371
            
            
            564
            
            
            23.8





Gross Profit. Gross
profit was $12,715,024, or 39.1%, of our sales for the nine months ended
September 30, 2008, compared to gross profit of $7,118,265, or 33.9%, for the
nine months ended September 30, 2007. During the nine months ended September 30,
2008 our gross margin on milk powder increased 6.7%, due to an increase in the
average sales price of 42.5% from nine months ended September 30, 2007,
partially offset by a 27.4% increase in the cost per metric ton from the nine
months ended September 30, 2007. The gross margin for soybean powder decreased
4.5%, to 34.2% in the nine months ended September 30, 2008, as compared to 38.7%
in nine months ended September 30, 2007. This decrease was due to a 9.7%
increase in the average sales price in nine months ended September 30, 2008, as
compared to 2007, offset by an increase of 17.7% in the cost per metric ton in
nine months ended September 30, 2008, as compared to 2007.





A
breakdown of gross margin by product line for the nine months ended September
30, 2008 and 2007 is as follows:





Nine Months Ended September 30,2008
            
            2007
            
            Period-on-periodProduct category
            
            $  Amount
            
            Gross
              Margin %
            
            $ Amount
            
            Gross
              Margin %
            
            Margin
              VarianceMilk
      powder
            
            
            11,250,201
            
            
            43.0
            
            
            5,773,674
            
            
            36.3
            
            
            6.7Rice
      powder
            
            
            551,476
            
            
            67.8
            
            
            528,205
            
            
            67.3
            
            
            0.5Soybean
      powder
            
            
            220,526
            
            
            34.2
            
            
            191,638
            
            
            38.7
            
            
            (4.5
            )Subcontracting
            
            
            692,821
            
            
            14.0
            
            
            624,748
            
            
            116.5
            
            
            (2.5
            )Total
            
            
            12,715,024
            
            
            39.1
            
            
            7,118,265
            
            
            33.9
            
            
            5.1





35


Operating
Expenses





For the Nine Months Ended
              September 30,2008
            
            2007Operating
      ExpensesSelling
      expenses
            
            $
            7,834,865
            
            $
            3,427,327Administrative
      expenses
            
            
            2,448,769
            
            
            558,105Depreciation
      and amortization
            
            
            72,336
            
            
            36,844Total
      operating expenses
            
            $
            10,355,970
            
            $
            4,022,276





Selling Expenses . Selling
expenses overall increased by $4,407,538, or 128.6%, from $3,427,327 in the nine
months ended September 30, 2007, to $7,834,865 for the nine months ended
September 30, 2008. The major factors in the increase in selling expenses are as
follows:





·
            Advertising
      increased by $2,593,060, or 3,295.6%, to $2,671,743 in 2008, from $78,683
      in 2007, due to our marketing campaign to increase brand awareness and
      sales.





·
            Selling
      salaries increased by $461,354, or 47.4%, to $1,435,092 in 2008, from
      $973,738 in 2007, the amounts we paid to our sales staff rose due to
      increased sales.





·
            Travelling
      expenses incurred by the sales staff increased by $355,948, or 79.4%, to
      $804,259 in 2008, from $448,311 in 2007, due to the expansion of our sales
      network.





·
            Transportation
      expenses increased by $199,137 or 33.2%, to $799,680, in 2008 from
      $600,543 in 2007, as a result of shipping more product in 2008 as compared
      to 2007.





·
            Entertainment
      expenses increased by $190,235, or 68.7%, to $467,311 in 2008, from
      $277,076 in 2007, as a result of the increase in the sales staff and
      network.




Rather
than using a wholesaler, our sales people deal directly with the retail
outlets.  This business model has higher sales expenses compared to
the traditional business model, but creates better profit margins for
us.




Administrative
Expenses .
Administrative expenses increased by $1,890,664, or 338.8%, from $558,105 in the
nine months ended September 30, 2007, to $2,448,769 for the nine months ended
September 30, 2008. The major factors in the increase in administrative expenses
are as follows:





·
            Liquidated
      damages incurred in 2008 of $901,199 related to registration rights
      agreements we entered into, which were not similarly incurred in
      2007.





·
            Increase
      in legal and accounting fees in 2008 of $365,414, or 424.9%, to $451,419,
      as compared to $86,006 in 2007, due to costs associated with audits and
      SEC filings not required prior to the reverse merger we consummated in
      October 2007.





·
            Increase
      in consultant expenses of $76,015, or 1,025.1%, to $83,430 in 2008, as
      compared to $7,415 in 2007, for services related to possible financing and
      funding.





·
            Increase
      of administrative salaries of $162,022, or 147.1%, to $272,138 in 2008,
      from $110,116 in 2007, related to 10 additional administrative personnel
      hired during 2008.





·
            Increase
      in entertainment expenses of $76,150, or 89.9%, to $160,880 in 2008, from
      $84,731 in 2007, due to increased travel and entertainment by
      administrative personnel to develop financing and funding for our
      growth.





36


·
            Increase
      of travel expenses of $75,010, or 98.2%, to $151,417 in 2008, from $76,407
      in 2007, due to the increase in travel by administrative personnel to
      develop financing and funding for our
growth.





Provision for Income
Taxes





For the Nine Months Ended
              September 30,2008
            
            2007Provision for Income
      TaxesCurrent
            
            $
            586,957
            
            $
            148,594Deferred
            
            
            —
            
            
            —$
            586,957
            
            $
            148,594





Provision for Income
Taxes . Income
taxes increased by $438,363, or 295.0%, from $148,594 in the nine months ended
September 30, 2007, to $586,957 for the nine months ended September 30, 2008.
This increase was due to the increase in our pre-tax income and the reduction in
the tax exemption for XAL to 50% of the statutory enterprise income tax rate
from 100% as of January 1, 2008.





Liquidity and Capital
Resources





Uses of
Capital





For the Nine Months Ended
              September 30,2008
            
            2007Net cash provided by operating
      activities
            
            $
            4,955,796
            
            $
            1,562,465Net cash used in investing
      activities
            
            
            (10,188,918
            )
            
            (689,983
            )Net cash provided by (used in)
      financing activities
            
            $
            1,959,082
            
            $
            2,266,667





Net Cash Provided By Operating
Activities. For the
nine months ended September 30, 2008, $4,955,796 was provided by operating
activities, compared with $1,562,465 provided by operating activities for the
nine months ended September 30, 2007. Our net cash flows used in operating
activities increased during 2008 due to the following factors:





·
            Deposits
      on contracts and other current assets decreased by $2,480,834 due to
      completion of the contracts.





·
            Trade
      accounts receivable increased by $1,290,662, due to the increase level of
      sales during the year.





37


·
            We
      increased inventory at September 30, 2008 by $251,318, due to better
      management of the production
process.




·
            Accounts
      payable and accrued expenses increased by $1,867,980 at September 30,
      2008, as compared to 2007, due to increases in production of products and
      expenses.





38


Net Cash Used In Investing
Activities. For the
nine months ended September 30, 2008, we used $10,188,918 in investing
activities, compared with $689,983 used in investing activities for the nine
months ended September 30, 2007. Our increase in net cash flows used in
investing activities during 2008 was due to our purchase of land use rights for
a new production facility in the amount of $1,280,574, our purchase of fixed
assets of $6,165,211 and construction in process of $2,743,133.




Net Cash Provided By (Used In)
Financing Activities. For the
nine months ended September 30, 2008, $1,959,082 was provided by financing
activities, compared with approximately $2,266,667 provided by financing
activities for the nine months ended September 30, 2007. We raised $2,250,000
with the sale of 8% promissory notes payable due on December 31, 2008 and
warrants in September 2008. We also paid off notes payable of $290,918 in the
nine months ended September 30, 2008.





General




In recent
years, the Chinese government has initiated programs to promote milk consumption
and is providing incentives to increase dairy production. Over the same period,
our products have became increasing popular in mainland China due to our
continued sales and marketing efforts. As a result, we have experienced
tremendous growth well above the industry average during recent years. Sales
increased from approximately $7.9 million in 2005 to approximately $29.6 million
in 2007, a 275% increase over two years, or a compound annual growth rate of
66%. Net income increased from approximately $0.8 million in 2005 to
approximately $4.2 million in 2007, a 425% increase over two years, or a
compound annual growth rate of 100%. Following the same trend, working capital
increased from approximately $1.4 million in 2005 to approximately $13.1 million
in 2007, including cash generated from operations as well as funds raised from
private offering we consummated in October 2007.





Cash and
cash equivalents at September 30, 2008 decreased by 42.9%, to $3,748,746, from
$6,560,931 at December 31, 2007. Based upon our short term liabilities, we
believe our cash and cash equivalents are adequate to satisfy our working
capital needs and sustain our ongoing operations for the next twelve months. We
are expecting the cash flows to fluctuate in the future as we try to raise funds
from the capital markets to implement our growth strategy.





Production
capacity has been the bottle neck for our growth in recent years, because
production has not been able to keep up with demand. Our growth strategy for the
next three years will be primarily focused on expanding production capacity and
strengthening sales efforts. Management plans to achieve this strategy by
increasing our production capacity, sales staff and advertising
expenditures.





In July
2008, we commenced construction of a new facility that will have annual
production capacity of 9,000 tons of milk powder, which is expected to commence
production in the second quarter of 2009. This project is expected to cost an
aggregate of approximately $20.0 million, including land use rights,
construction expenses and equipment costs. Management will need to raise $10.0
million to $15.0 million to fund the construction of the new production
facility .





Historically
we relied on investments by our Chief Executive Officer and shareholders, and
bank loans, to meet our cash and capital expenditures. However, as the amount of
capital expenditures increases, we will depend more on the capital markets to
raise funds through private and public offerings of equity and/or debt.





39


In
connection with the October Offerings, we received aggregate net proceeds of
$4,395,104. The net proceeds from the October Offerings were used to in
connection with the Repurchase Transaction, to pay expenses related to our
Reverse Merger and October Offerings, and for general working capital purposes.
The Repurchase Transaction, Reverse Merger and October Offerings are further
described in “- Recent Developments - Reverse Merger, Private Placements and
Related Transactions” above.





In June
2008, we closed the June Note Offering, pursuant to which we received aggregate
net proceeds of $2,003,742. In addition, on November 10, 2008, we closed the
November Note Offering, pursuant to which we received aggregate net proceeds of
$260,000. We plan to use the net proceeds from the June Note Offering and
November Note Offering offerings primarily for the construction and equipping of
our new production facility in Hailun City, Heilongjiang Province, PRC. The June
Note Offering and November Note Offering are further described in “- Recent
Developments - Sale of Notes and Warrants” above.





One
additional way we expect to raise funds in the short term, is through the Offer
we have made to our Warrantholders, as further described in “Recent Developments
- Warrant Tender Offer” above. As of the date hereof, a limited number of
Warrantholders have elected to tender their warrants. However, since any
Warrantholder may change its election and withdraw from the Offer, the funds
related to such transactions are being held in escrow, and will not be released
to us until November 21, 2008, the expiration date of the Offer, unless we
sooner extend or terminate the period of time during which the Offer is open. If
all of the Warrantholders exercise their warrants in connection with the Offer,
we will raise an aggregate of $16,929,805.





We have
no additional commitments for additional financing we may need to complete the
construction of our new processing facility. There can be no assurance that that
any additional financing will become available to us, and if available, on terms
acceptable to us.





In
addition to constructing our new production facility, we have purchased an
office building located in Heilongjiang Province, PRC, for approximately $1.8
million, which will serve as our corporate headquarters. The balance of
approximately $0.7 million was paid in the third quarter out of our retained
earnings.





Currently,
we spend about 8% - 12% of total revenues on advertising and promotional plans
through out the year. We spent approximately $3.0 million, $1.9 million and $0.8
million on advertising and promotion in fiscal 2007, 2006 and 2005,
respectively. We plan to increase spending on advertising and promotion to an
aggregate of between $4.0 million and $5.0 million in fiscal 2008. This will
still fall within our standard budget for advertising and promotion of 8% - 12%
of total revenues. The funds for advertising and promotion will generally come
out of our earnings.





Management
will also consider making strategic acquisitions if there are good opportunities
in the marketplace. However, revenue from acquisitions has not been included in
our planned growth.





Registration Rights and Liquidated
Damages





In
connection with the October Offerings, as further described in “- Recent
Developments - Reverse Merger, Private Placements and Related Transactions”
above, we entered into Registration Rights Agreements (each, a “Registration
Rights Agreement,” and collectively the “Registration Rights Agreements”) with
Mr. Winfield, the Initial Purchasers and the Additional Purchasers
(collectively, the “Investors”), pursuant to which we agreed that within thirty
(30) business days of the respective closing date (the “Filing Date”), we would
file a registration statement with the Securities and Exchange Commission (the
“Commission”) (the “Registration Statement”) covering the resale of (i) the
shares of Common Stock purchased in the October Offerings (the “Purchased
Shares”), and (ii) the Common Stock issuable upon exercise of Warrant W-1,
Warrant W-2, the Class A Warrants, and the Class B Warrants (collectively (i),
(ii), (iii) and (iv), the “Registrable Securities”). Further, we agreed to use
our best efforts to (i) cause the Registration Statement to be declared
effective within ninety (90) calendar days from the Filing Date, or, if reviewed
by the Commission, within one hundred eighty (180) calendar days after the
Filing Date, and (ii) keep the Registration Statement continuously effective
until all of the Registrable Securities have been sold, or may be sold without
volume restrictions pursuant to Rule 144.





40


Pursuant
to the Registration Rights Agreements, we are required to pay liquidated damages
to the holders of the Purchased Shares if (i) we fail to file the Registration
Statement within thirty (30) business days from the Closing Date, (ii) the
Commission does not declare the Registration Statement effective within ninety
(90) days of the Filing Date (or one hundred eighty (180) days in the event of a
review by the Commission) (the “Effectiveness Date”), (iii) we fail to request
acceleration of effectiveness within five (5) business days of a notice of no
further review from the Commission, (iv) we fail to respond to the Commission
within ten (10) business days of receipt by us of any comments on the
Registration Statement, or (v) after it has been declared effective, the
Registration Statement ceases to be effective or available or if we suspend the
use of the prospectus forming a part of the Registration Statement (A) for more
than thirty (30) days in any period of 365 consecutive days if we suspend in
reliance on its ability to do so due to the existence of a development that, in
the good faith discretion of its board of directors, makes it appropriate to so
suspend or which renders us unable to comply with SEC requirements, or (B) for
more than ninety (60) days in any period of 365 consecutive days for any reason.
The liquidated damages will accumulate at the rate of one and one-half percent
(1.5%) of the purchase price paid by the Investors for units of our securities
purchase in the October Offerings for each thirty (30) day period during which a
registration default is continuing; provided, however, that (i) we shall not be
liable for liquidated damages with respect to any warrants or shares of common
stock underlying the warrants, and (ii) in no event will we be liable for
liquidated damages in excess of 1.5% of the aggregate purchase price of the
securities purchased in the October Offerings in any 30 day period, and (iii)
the maximum aggregate liquidated damages payable to any purchaser in the October
Offerings shall be 20% of the aggregate purchase price paid by such
purchaser.





Notwithstanding
anything to the contrary stated in the Registration Rights Agreements, we are
entitled to limit the Registrable Securities to the extent necessary to avoid
any issues arising from the recent interpretations by the SEC of Rule 415 of the
Securities Act of 1933, as amended.





As of
September 30, 2008, there were accrued liquidated damages of $1,116,498. We have
not yet paid out any of the accrued liquidated damages, which are payable in
cash or shares of our common stock, or a combination thereof, at our sole
discretion. Additionally, we will accrue $4,500 per day in liquidated damages
until such time as the requirements described above have been
satisfied.





Share Repurchase and Put/Call
Agreements





On
October 9, 2007, we consummated the Repurchase Transaction with a shareholder,
as further described in “- Recent Developments - Reverse Merger, Private
Placements and Related Transactions” above. We repurchased the Repurchased
Shares, to reduce the overall dilution created by the October Offerings. The
Repurchased Shares are currently being held in treasury.





Immediately
following the closing of the Repurchase Transaction, we entered into Put/Call
Agreements with the Put/Call Shareholders. Pursuant to the Put/Call Agreements
the Put/Call Shareholders granted us an option to repurchase an aggregate of
1,944,444 shares (the “Put/Call Shares”) from the Put/Call Shareholders (the
“Call Option”), for a price of $1.63 per share (the “Call Option Price”), if the
following conditions have been met (the “Call Option Conditions”):





·
            Either
      (i) a registration statement (“Registration Statement”) covering the
      resale of the Put/Call Shares has been declared effective by the
      Commission, and has been kept continuously effective by us, or (ii) all of
      the Put/Call Shares are freely tradable without registration pursuant to
      Rule 144; and




41


·
            The
      closing price of a share of our Common Stock as traded on the
      Over-the-Counter Bulletin Board (or such other exchange or stock market on
      which the Common Stock may then be listed or quoted) equals or exceeds
      $4.08 (appropriately adjusted for any stock split, reverse stock split,
      stock dividend or other reclassification or combination of the Common
      Stock occurring after the date hereof) for at least ten (10) consecutive
      trading days immediately preceding the date that the Call Option Exercise
      Notice is given by us.




We may
only exercise our Call Option by delivering a written notice (a “Call Option
Exercise Notice”) to the Put/Call Shareholders within thirty (30) days of such
time as all of the Call Option Conditions have been met. The Call Option may be
exercised for all, but not less than all, of the Put/Call Shares. The repurchase
shall be consummated within ninety (90) days following the date of the Call
Option Exercise Notice.




In
addition, the Put/Call Shareholders shall have the right to cause us to
repurchase the Put/Call Shares from the Put/Call Shareholders (the “Put Right”),
for a price shall be $1.63 per share (the “Put Purchase Price”),
if:





·
            We
      fail to exercise its Call Option within ten (10) days of a date on which
      all of the Call Option Conditions have been met;
  or




·
            We
      consummate a private offering of not less than $5,000,000 of its
      securities (a “Qualified Offering”);
or




·
            We
      fail to consummate a Qualified Offering on or before October 9, 2009 (each
      of the aforementioned conditions, a “Put Right
  Trigger”).




Initially,
our failure to (i) file the Registration Statement within thirty (30) business
days of the Closing Date (the “Filing Date”), (ii) have the Registration
Statement declared effective within ninety (90) calendar days from the Filing
Date, or, if reviewed by the Commission, within one hundred eighty (180)
calendar days after the Filing Date, or (iii) keep the Registration Statement
continuously effective until all of the Registrable Securities are available for
sale without registration pursuant to Rule 144, would have served as a Put Right
Trigger as well. However, as of April 9, 2008, the Put/Call Shareholders agreed
to amend the Put/Call Agreements to delete this clause. We did not pay any
consideration to the Put/Call Shareholders in connection with their waiver of
this provision.





The
Put/Call Shareholders shall exercise their Put Right by giving written notice
(“Put Exercise Notice”) of their exercise of the Put Right to us within thirty
(30) days of a Put Right Trigger. The Put/Call Shareholders may only exercise
their Put Right as to all, but not less than all, of the Put/Call Shares. Upon
exercise of the Put Right by the Put/Call Shareholders, our repurchase of the
Put/Call Shares shall be consummated within ninety (90) days following the date
of the Put Exercise Notice.





42


If the
Put/Call Shareholders exercised their Put Rights we would be forced to
repurchase the Put/Call Shares for an aggregate of $3,169,444.





Warrants





In
connection with the October Offerings, as further described in “- Recent
Developments - Reverse Merger, Private Placements and Related Transactions”
above, we issued warrants to purchase an aggregate of 7,988,870 shares of Common
Stock, of which (i) 373,334 are exercisable at a price of $0.94 per share; (ii)
1,333,333 are exercisable at a price of $1.50 per share; (iii) 1,374,230 are
exercisable at a price of $2.04 per share; and (iv) 4,907,973 are exercisable at
a price of $3.26 per share.





Warrant
W-1 represents the right to purchase 266,667 shares of our Common Stock, at an
exercise price of $0.94 per share. Warrant No. W-1 will expire on October 9,
2010. Warrant W-1 is exercisable for cash only, provided a registration
statement covering the shares of Common Stock underlying Warrant W-1 is
effective. The number of shares of our Common Stock to be deliverable upon
exercise of Warrant W-1 will be subject to adjustment for, among other things,
subdivision or consolidation of shares, rights or warrants issues, dividend
distributions, stock dividends, bonus issues, asset distributions, and other
standard dilutive events. Warrants to purchase an aggregate of 106,667 shares of
our Common Stock issued to a finder, have terms and conditions identical to the
those of Warrant W-1.





Warrant
W-2 represents the right to purchase 1,333,333 shares of our Common Stock, at an
exercise price of $1.50 per share. Warrant W-2 will expire on October 9, 2009.
Warrant W-2 is exercisable for cash only, provided a registration statement
covering the shares of Common Stock underlying the Warrant W-2 is effective. The
number of shares of our Common Stock to be deliverable upon exercise of Warrant
W-2 will be subject to adjustment for, among other things, subdivision or
consolidation of shares, rights or warrants issues, dividend distributions,
stock dividends, bonus issues, asset distributions, and other standard dilutive
events. At anytime one year following the date a registration statement covering
the shares of Common Stock underlying the Warrant W-2 is declared effective, we
will have the ability to call the Warrant W-2 at a price of $0.01 per warrant,
upon thirty (30) days prior written notice to the holders of the warrants, if
the closing price of the Common Stock exceeded $1.88 for each of the ten (10)
consecutive trading days immediately preceding the date that the call notice is
given by us.





Our Class
A Warrants represent the right to purchase an aggregate of 981,591 shares of our
Common Stock, at an exercise price of $2.04 per share. The Class A Warrants will
expire on the three-year anniversary of their date of issuance. The Class A
Warrants will be exercisable for cash only, provided a registration statement
covering the shares of Common Stock underlying the Class A Warrants is
effective. The number of shares of Common Stock to be deliverable upon exercise
of the Class A Warrants will be subject to adjustment for, among other things,
subdivision or consolidation of shares, rights or warrants issues, dividend
distributions, stock dividends, bonus issues, asset distributions, and other
standard dilutive events. Warrants to purchase 392,639 shares of our Common
Stock issued to finders and placement agents, have terms and conditions
identical to the those of the Class A Warrants.





The Class
B Warrants represent the right to purchase an aggregate of 4,907,973 shares of
our Common Stock, at an exercise price of $3.26 per share. The Class B Warrants
will expire on the two-year anniversary of their date of issuance. The Class B
Warrants will be exercisable for cash only, provided a registration statement
covering the shares of Common Stock underlying the Class B Warrants is
effective. The number of shares of Common Stock to be deliverable upon exercise
of the Class B Warrants will be subject to adjustment for, among other things,
subdivision or consolidation of shares, rights or warrants issues, dividend
distributions, stock dividends, bonus issues, asset distributions, and other
standard dilutive events. At anytime one year following the date a registration
statement covering the shares of Common Stock underlying the Class B Warrants is
declared effective, we will have the ability to call the Class B Warrants at a
price of $0.01 per Class B Warrant, upon thirty (30) days prior written notice
to the holders of the Class B Warrants, if the closing price of the Common Stock
exceeded $4.08 for each of the ten (10) consecutive trading days immediately
preceding the date that the call notice is given by us.





43


Warrant
W-1, Warrant W-2, the Class A Warrants and the Class B Warrants (collectively,
the “October Warrants”) provide that in no event shall the holder be entitled to
exercise a number of October Warrants (or portions thereof) in excess of the
number of October Warrants (or portions thereof) upon exercise of which the sum
of (i) the number of shares of Common Stock beneficially owned by the holder and
its affiliates (other than shares of Common Stock which may be deemed
beneficially owned through the ownership of the unexercised October Warrants and
the unexercised or unconverted portion of any of our other securities (subject
to a limitation on conversion or exercise analogous to the limitation contained
herein) and (ii) the number of shares of Common Stock issuable upon exercise of
the October Warrants (or portions thereof) with respect to which the
determination described herein is being made, would result in beneficial
ownership by the holder and its affiliates of more than 9.9% of the outstanding
shares of Common Stock. For purposes of the immediately preceding sentence,
beneficial ownership shall be determined in accordance with Section 13(d) of the
Securities Exchange Act of 1934, as amended, and Regulation 13D-G thereunder,
except as otherwise provided in clause (i) of the preceding sentence.
Notwithstanding anything to the contrary contained herein, the limitation on
exercise of the October Warrants may be waived by written agreement between us
and the holder; provided, however, such waiver may not be effective less than
ninety-one (61) days from the date thereof.





If all of
the October Warrants were exercised for cash pursuant to their terms, we would
receive $21,154,354 in proceeds. However, as of April 24, 2008, we commenced the
Offer to the holders of the October Warrants, pursuant to which they may tender
their October Warrants for shares of our Common Stock at a reduced exercise
prices. The Offer is further described in “Recent Developments - Warrant Tender
Offer” above. The purpose of this Offer is to encourage the exercise of the
October Warrants in order to raise additional capital. We intend to apply the
proceeds toward costs related to constructing and equipping our new production
facility, which we believe will enable us to produce an additional 9,000 tons of
milk powder in fiscal 2009. In addition, by reducing the number of outstanding
warrants, we can provide greater certainty to investors and potential investors
regarding the number of shares of Common Stock which are, and may become,
outstanding. If all of October Warrants are exercised pursuant to the Offer, we
will raise $16,929,805 in proceeds.





In June
2008 we closed the June Note Offering, pursuant to which we granted the June
Warrants. In November 2008 we closed the November Note Offering, pursuant to
which we granted the November Warrants. The June Note Offering and November Note
Offering are further described in “Recent Developments - Sale of Notes and
Warrants” above. The June Warrants and November Warrants (collectively, the New
Warrants”) represent the right to purchase an aggregate of 275,000 shares of our
Common Stock, at an exercise price of $2.61 per share. The New Warrants will
expire three years after the date of issuance. The New Warrants may be exercised
for cash only. The number of shares of our Common Stock deliverable upon
exercise of the New Warrants will be subject to adjustment for, among other
things, subdivision or consolidation of shares, and certain other standard
dilutive events. A holder of the New Warrants will not be entitled to exercise a
number of New Warrants in excess of the number of New Warrants upon exercise of
which would result in beneficial ownership by such holder and his, her or its
affiliates of more than 9.9% of the outstanding shares of our Common Stock,
unless this provision is waived by written agreement between us and the holder
not less than ninety-one (61) days from the date of such waiver. Warrants to
purchase an aggregate of 70,000 shares of our Common Stock issued to a placement
agent in connection with the June Note Offering and November Note Offering, have
terms and conditions identical to the those of the New Warrants.





44


Promissory
Notes





In the
June Note Offering, further described in “- Recent Developments - Sale of Notes
and Warrants” above, we also issued the 8% Notes. The 8% Notes will bear
interest at a rate of 8% until they become due and payable on December 31, 2008.
Any amount of principal or interest which is not paid when due will bear
interest at a rate of 12%. We may prepay the entire amount due under the 8%
Notes at any time without penalty, upon 15 days prior written notice. Each
holder of the 8% Notes has the right to be prepaid any amounts due under his,
her or its 8% Note from the proceeds of any future offering we consummate
resulting in gross proceeds of $4,500,000 or more. So long as we have any
obligation under the 8% Notes, there are limitations on our ability to: (a) pay
dividends or make other distributions on its capital stock; (b) redeem,
repurchase or otherwise acquire any of its securities; (c) create, incur or
assume any liability for borrowed money; (d) sell, lease or otherwise dispose of
any significant portion of its assets; (e) lend money, give credit or make
advances; or (f) assume, guarantee, endorse, contingently agree to purchase or
otherwise become liable upon the obligation of any other person or entity. It
shall be deemed an “Event of Default” under each 8% Note if: (a) we fail to pay
principal or interest when due on the 8% Note; (b) we breach any material
covenant or other material term or condition contained in the 8% Note or
securities purchase agreement entered into in connection with the June Note
Offering (the “June Purchase Agreement”), and such breach continues for a period
of thirty (30) days after written notice thereof; (c) any representation or
warranty we made under the 8% Note or the June Purchase Agreement shall be false
or misleading in any material respect; (d) we, or any subsidiary of ours, shall
make an assignment for the benefit of creditors, or apply for or consent to the
appointment of a receiver or trustee, or such a receiver or trustee shall
otherwise be appointed; (e) a money judgment shall be entered against us, or any
subsidiary of ours, for more than $250,000, that remains in effect for a period
of twenty (20) days; (f) bankruptcy, insolvency, reorganization or liquidation
proceedings or other similar proceedings shall be instituted by or against us,
or any subsidiary of ours, which are not dismissed within ninety (60) days; or
(g) we fail to maintain the listing of our Common Stock on at least one of the
OTCBB, the Nasdaq National Market, the Nasdaq SmallCap Market, the New York
Stock Exchange, or the American Stock Exchange. Upon the occurrence of any Event
of Default under an 8% Note, unless such Event of Default shall have been waived
in writing by the holder, the holder may consider the 8% Note immediately due
and payable, without presentment, demand, protest or notice of any kind, and the
holder may immediately enforce any and all of its rights and remedies provided
in the 8% Note or any other right or remedy afforded by law.





In the
November Note Offering, further described in “- Recent Developments - Sale of
Notes and Warrants” above, we also issued the 10% Note. The 10% Note will bear
interest at a rate of 10% until they become due and payable on November 10,
2009. Any amount of principal or interest which is not paid when due will bear
interest at a rate of 12%. We may prepay the entire amount due under the 10%
Note at any time without penalty, upon 15 days prior written notice. The holder
of the 10% Note has the right to be prepaid any amounts due under his 10% Note
from the proceeds of any future offering we consummate resulting in gross
proceeds of $6,500,000 or more. So long as we have any obligation under the 10%
Note, there are limitations on our ability to: (a) pay dividends or make other
distributions on its capital stock; (b) redeem, repurchase or otherwise acquire
any of its securities; (c) sell, lease or otherwise dispose of any significant
portion of its assets; (d) lend money, give credit or make advances; or (e)
assume, guarantee, endorse, contingently agree to purchase or otherwise become
liable upon the obligation of any other person or entity. It shall be deemed an
“Event of Default” under the 10% Note if: (a) we fail to pay principal or
interest when due on the 10% Note; (b) we breach any material covenant or other
material term or condition contained in the 10% Note or securities purchase
agreement entered into in connection with the November Note Offering (the
“November Purchase Agreement”), and such breach continues for a period of thirty
(30) days after written notice thereof; (c) any representation or warranty we
made under the 10% Note or the November Purchase Agreement shall be false or
misleading in any material respect; (d) we, or any subsidiary of ours, shall
make an assignment for the benefit of creditors, or apply for or consent to the
appointment of a receiver or trustee, or such a receiver or trustee shall
otherwise be appointed; (e) a money judgment shall be entered against us, or any
subsidiary of ours, for more than $250,000, that remains in effect for a period
of twenty (20) days; (f) bankruptcy, insolvency, reorganization or liquidation
proceedings or other similar proceedings shall be instituted by or against us,
or any subsidiary of ours, which are not dismissed within ninety (60) days; or
(g) we fail to maintain the listing of our Common Stock on at least one of the
OTCBB, the Nasdaq National Market, the Nasdaq SmallCap Market, the New York
Stock Exchange, or the American Stock Exchange. Upon the occurrence of any Event
of Default under the 10% Note, unless such Event of Default shall have been
waived in writing by the holder, the holder may consider the 10% Note
immediately due and payable, without presentment, demand, protest or notice of
any kind, and the holder may immediately enforce any and all of its rights and
remedies provided in the Note or any other right or remedy afforded by
law.





45


Changes in foreign exchange
regulations in the PRC and ability to pay dividends in foreign currency or
conduct other foreign exchange business





The
Renminbi is currently not a freely convertible currency, and the restrictions on
currency exchange may limit our ability to use revenues generated in RMB to fund
our business activities outside the PRC, or to make dividends or other payments
in United States dollars. The PRC government strictly regulates conversion of
RMB into foreign currencies. Over the years, foreign exchange regulations in the
PRC have significantly reduced the government’s control over routine foreign
exchange transactions under current accounts. In the PRC, SAFE, regulates the
conversion of the RMB into foreign currencies. Pursuant to applicable PRC laws
and regulations, foreign invested enterprises incorporated in the PRC are
required to apply for “Foreign Exchange Registration Certificates.” Currently,
conversion within the scope of the “current account” (e.g. remittance of foreign
currencies for payment of dividends, etc.) can be effected without requiring the
approval of SAFE. However, conversion of currency in the “capital account” (e.g.
for capital items such as direct investments, loans, securities, etc.) still
requires the approval of SAFE. For more information, see the discussion in the
Risk Factors included in our Annual Report on Form 10-KSB for the fiscal year
ended December 31, 2007.





Transactions with Related
Parties





Purchase of Assets from Chief
Executive Officer





On May
28, 2006, American International Dairy Holding Co., Inc. (“AIDH”), our
wholly-owned subsidiary, purchased and obtained legal title to machinery,
facilities, housing and 100 cows from Yang Yong Shan, our President, Chief
Executive Officer and director, in exchange for a promissory note in the amount
of $209,305, which was still outstanding as of the date hereof. The note does
not bear interest and is due on demand.  Since the note does not have
a set repayment date, interest is not being imputed on the principal amount
under the note.  We believe this was an arms-length transaction, since
the price paid for this property and equipment was approximately the same as the
seller’s cost in these assets, and was approximately the same amount we would
have had to pay to purchase similar assets from a third
party.


Dividends





We have
not paid any dividends. In all likelihood, we will use our earnings to develop
our business and do not intend to declare dividends for the foreseeable future.
Any decision to pay dividends on our Common Stock in the future will be made by
our board of directors on the basis of earnings, financial requirements and
other such conditions that may exist at that time. In addition, the 8% Notes we
issued in the June Note Offering, further described in “- Recent Developments -
Sale of Notes and Warrants” above, contain restrictive covenants on our payment
of dividends, as further described in “- Liquidity and Capital Resources -
Promissory Notes” above.





46


Contractual Obligations and
Commercial Commitments





Our
contractual obligations, as of September 30, 2008, were as follows:





Payments Due By
      PeriodContractual
      obligations
            
            Total
            
            Less than
              1 year
            
            1-3 years
            
            After
              3-5 years
            
            More than
              5 yearsEquipment
      purchase
            
            $
            1,585,311
            
            $
            1,585,311Operating
      leases
            
            $
            29,052
            
            $
            29,052
            
            
            —
            
            
            —
            
            
            —Total:
            
            $
            1,614,363
            
            $
            1,614,363
            
            
            —
            
            
            —
            
            
            —





Critical Accounting Policies and
Estimates





Our
consolidated financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America which require use
to make estimates and assumptions that affect the reported amounts of assets and
liabilities at the date of our financial statements and the reported amounts of
revenues and expenses during the reporting periods. The consolidated financial
statements include the our accounts and those of our wholly owned subsidiaries.
All significant intercompany balances and transactions have been eliminated in
consolidation. In our opinion, the condensed consolidated financial statements
contain all the adjustments necessary (consisting only of normal recurring
accruals) to make our financial position and the results of operations and cash
flows not misleading. Critical accounting policies are those that require the
application of management’s most difficult, subjective, or complex judgments,
often because of the need to make estimates about the effect of matters that are
inherently uncertain and that may change in subsequent periods. In preparing the
financial statements, we utilized available information, including our past
history, industry standards and the current economic environment, among other
factors, in forming our estimates and judgments, giving due consideration to
materiality. Actual results may differ from these estimates. In addition, other
companies may utilize different estimates, which may impact the comparability of
our results of operations to those of companies in similar businesses. We
believe that of our significant accounting policies, the following may involve a
higher degree of judgment and estimation.





Use of
estimates





The
preparation of these consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affected the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the dates of the consolidated financial statements and the
reported amounts of net sales and expenses during the reported periods.





Significant
estimates and assumptions by management including, among others, values and
lives assigned to acquired intangible assets, reserves for customer returns and
allowances, uncollectible accounts receivable, slow moving, obsolete and/or
damaged inventory and stock warrant valuation. Actual results may differ from
these estimates





Cash and cash
equivalents





We
consider all highly liquid debt instruments purchased with maturity period of
three months or less to be cash equivalents. Substantially all of our cash is
held in bank accounts in The Peoples Republic of China and is not protected by
FDIC insurance or any other similar insurance. Accounts held at United States
financial institutions are insured by the Federal Deposit Insurance Corporation
up to $250,000. As of September 30, 2008, no U.S. balances are in excess of
insured amounts.





47


Construction-in-Progress





Plant and
production lines currently under development are accounted for as
construction-in-progress. Construction-in-progress is recorded at acquisition
cost, including land rights cost, development expenditure, professional fees and
the interest expenses capitalized during the course of construction for the
purpose of financing the project. Upon completion and readiness for use of the
project, the cost of construction-in-progress is to be transferred to fixed
assets.





Foreign
Currency





Our
principal country of operations is The People’s Republic of China. Our financial
position and results of operations are determined using the local currency
(“Renminbi” or “Yuan”) as the functional currency. The results of operations
denominated in foreign currency are translated at the average rate of exchange
during the reporting period.




Assets
and liabilities denominated in foreign currencies at the balance sheet date are
translated at the exchange rates prevailing at the balance sheet date. The
registered equity capital denominated in the functional currency is translated
at the historical rate of exchange at the time of capital contribution. All
translation adjustments resulting from the translation of the financial
statements into the reporting currency (“US Dollars”) are dealt with as a
separate component within stockholders’ equity. Translation adjustments net of
tax totaled $171,146 and $1,078,852, for the three and nine months ended
September 30, 2008, respectively. Translation adjustments totaled $109,072 and
$212,472 for the three and nine months ended September 30, 2007,
respectively.





As of
September 30, 2008 and 2007, the exchange rate was 6.8485 Yuan and 7.3 Yuan per
U.S. Dollar, respectively.





Revenue
recognition





Revenue
is recognized in accordance with Staff Accounting Bulletin No. 104, Revenue
Recognition, which states that revenue should be recognized when the following
criteria are met: (1) persuasive evidence of an arrangement exists; (2) the
service has been rendered; (3) the selling price is fixed or determinable; and
(4) collection of the resulting receivable is reasonably assured.





Interest
income is recognized when earned, taking into account the average principal
amounts outstanding and the interest rates applicable.





As of
September 30, 2008, we had no sales or contracts that included multiple
deliverables that would fall under the scope of EITF 00-21, “Revenue
Arrangements with Multiple Deliverables.”





Shipping and handling
costs





Shipping
and handling costs are billed to the customer in sales transactions and are
reported in sales. Costs incurred by us for shipping and handling are included
in costs of goods sold.





Earnings per
share





Basic net
earnings per common share is computed by dividing net earnings applicable to
common shareholders by the weighted-average number of common shares outstanding
during the period. Diluted net earnings per common share is determined using the
weighted-average number of common share shares outstanding during the period,
adjusted for the dilutive effect of common stock equivalents, using the treasury
stock method, consisting of shares that might be issued upon exercise of common
stock warrants. In periods where losses are reported, the weighted-average
number of common shares outstanding excludes common stock equivalents, because
their inclusion would be anti-dilutive.





48


Taxation





Taxation
on profits earned in the PRC has been calculated on the estimated assessable
profits for the year at the rates of taxation prevailing in the PRC in which we
operate after taking into effect the benefits from any special tax credits or
“tax holidays” allowed in the country of operations.




We
account for income tax under the provisions of SFAS 109 Accounting for Income
Taxes, which requires recognition of deferred tax assets and liabilities for the
expected future tax consequences of the events that have been included in the
financials statements or tax returns. Deferred income taxes are recognized for
all significant temporary differences between tax and financial statements bases
of assets and liabilities. Valuation allowances are established against net
deferred tax assets when it is more likely than not that some portion or all of
the deferred tax asset will not be realized.





We do not
have any long-term deferred tax assets or liabilities in China that will exist
once the tax holiday our subsidiary has been receiving expires. We do not have
any significant deferred tax asset or liabilities that relate to tax
jurisdictions not covered by the tax holiday.





We do not
accrue United States income tax on unremitted earnings from foreign operations,
as it is our intention to invest these earnings in the foreign operations
indefinitely.





Enterprise income
tax





Under the
“ Provisional Regulations of The
People’s Republic of China Concerning Income Tax on
Enterprises ”
promulgated by the State Council, which came into effect on January 1, 1994,
income tax is payable by a Wholly Foreign Owned Enterprises at a rate of 15% of
their taxable income. Preferential tax treatment may, however, be granted
pursuant to any law or regulations from time to time promulgated by the State
Council. XAL enjoyed a 100% exemption from enterprise income taxes starting on
January 10, 2006 due to its classification as a “Wholly Foreign Owned
Enterprise.” On March 16, 2007, The People’s Republic of China enacted a new
Enterprise Income Tax Law for the purpose of unifying the tax treatment of
domestic and foreign enterprises. This new law eliminates the preferential tax
treatment for new Wholly Foreign Owned Enterprises but allows previously granted
exemptions to stay in place through 2012, with the exception that the statutory
tax rate will increase by 2% per year from 15% in 2006 to 25% by 2012. This
exemption ended on January 10, 2008, at which time XAL will qualify under the
current tax structure for a 50% reduction in the statutory enterprise income tax
rates for an additional three years.





Freestanding Financial Instruments
with Characteristics of Both Liabilities and Equity





In
accordance with SFAS 150, “ Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and
Equity ,” we
account for financial instruments as a liability if it embodies an obligation to
repurchase the issuer’s equity shares, or is indexed to such an obligation, and
that requires or may require the issuer to settle the obligation by transferring
assets. Freestanding financial instruments are financial instruments that are
entered into separately and apart from any of the entity's other financial
instruments or equity transactions, or that is entered into in conjunction with
some other transaction and is legally detachable and separately exercisable. The
liability recorded is the per share price to be paid and is offset to
equity.





49


Stock Based
Compensation





On
December 16, 2004, the FASB issued SFAS No. 123R, Share-Based
Payment (“SFAS
No. 123R”), which requires all share-based payments to employees, including
grants of employee stock options, to be recognized in the financial statements
based on the grant date fair value of the award. Under SFAS No. 123R, we must
determine the appropriate fair value model to be used for valuing share-based
payments, the amortization method for compensation cost and the transition
method to be used at date of adoption. The transition methods include
prospective and retroactive adoption options. Under the retroactive option,
prior periods may be restated either as of the beginning of the year of adoption
or for all periods presented. The prospective method requires that compensation
expense be recorded for all unvested stock options and restricted stock at the
beginning of the first quarter of adoption of SFAS No. 123R, while the
retroactive methods would record compensation expense for all unvested stock
options and restricted stock beginning with the first period restated. We have
adopted the requirements of SFAS No. 123R for the fiscal year beginning on
January 1, 2006.





Fair value of financial
instruments





The
carrying amounts of certain financial instruments, including cash, accounts
receivable, other receivables, accounts payable, commercial notes payable, and
accrued expenses approximate their fair values as of September 30, 2008 and
December 31, 2007 because of the relatively short-term maturity of these
instruments.




Recently Issued Accounting
Pronouncements





In
September 2006, the FASB issued SFAS No. 157, Fair Value
Measurements (SFAS
157). SFAS No. 157 defines fair value, establishes a framework for measuring
fair value in accordance with generally accepted accounting principles, and
expands disclosures about fair value measurements. This Statement does not
require any new fair value measurements; rather, it applies under other
accounting pronouncements that require or permit fair value measurements. The
provisions of this Statement are to be applied prospectively as of the beginning
of the fiscal year in which this statement is initially applied, with any
transition adjustment recognized as a cumulative-effect adjustment to the
opening balance of retained earnings. The provisions of SFAS 157 are effective
for the fiscal years beginning after November 15, 2007. The adoption of this
standard did not have a material impact on our financial condition, results of
operations or cash flows.





In
September 2006, the FASB issued Statement No. 158, Employers’ Accounting for Defined
Benefit Pension and Other Postretirement Plans (SFAS
No. 158), an amendment of FASB Statements No. 87, 88, 106 and 132(R). SFAS No.
158 requires (a) recognition of the funded status (measured as the difference
between the fair value of the plan assets and the benefit obligation) of a
benefit plan as an asset or liability in the employer’s statement of financial
position, (b) measurement of the funded status as of the employer’s fiscal
year-end with limited exceptions, and (c) recognition of changes in the funded
status in the year in which the changes occur through comprehensive income. The
requirement to recognize the funded status of a benefit plan and the disclosure
requirements are effective as of the end of the fiscal year ending after
December 15, 2006. The requirement to measure the plan assets and benefit
obligations as of the date of the employer’s fiscal year-end statement of
financial position is effective for fiscal years ending after December 15, 2008.
This Statement has no current applicability to our financial statements.
Management adopted this Statement on December 31, 2006 and the adoption of SFAS
No. 158 did not have a material impact on our financial position, results of
operations, or cash flows.





50


In
February 2007, the FASB issued Statement No. 159 The Fair Value Option for Financial
Assets and Financial Liabilities (SFAS
159). This Statement permits companies to choose to measure many financial
assets and liabilities at fair value. Unrealized gains and losses on items for
which the fair value option has been elected are reported in earnings. SFAS 159
is effective for fiscal years beginning after November 15, 2007. The adoption of
this standard did not have a material impact on our financial condition, results
of operations or cash flows.





In
December 2007, the FASB issued SFAS No. 141 (revised 2007), Business
Combinations (SFAS
141(R)). SFAS 141(R) will change the accounting for business combinations. Under
SFAS No. 141(R), an acquiring entity will be required to recognize all the
assets acquired and liabilities assumed in a transaction at the acquisition-date
fair value with limited exceptions. SFAS No. 141(R) will change the accounting
treatment and disclosure for certain specific items in a business combination.
SFAS No. 141(R) 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. SFAS 141(R) will impact us in
the event of any future acquisition.




In
December 2007, the FASB issued SFAS No. 160, Non-controlling Interests in
Consolidated Financial Statements—an amendment of Accounting Research Bulletin
No. 51 (SFAS
160). SFAS 160 establishes new accounting and reporting standards for the
non-controlling interest in a subsidiary and for the deconsolidation of a
subsidiary. SFAS No. 160 is effective for fiscal years beginning on or after
December 15, 2008. We do not believe that SFAS 160 will have a material impact
on its consolidated financial statements.




In March
2008, the FASB issued SFAS No. 161, Disclosures about Derivative
Instruments and Hedging Activities—an amendment of FASB Statement No.
133 (SFAS
161). FAS 161 changes the disclosure requirements for derivative instruments and
hedging activities. Entities are required to provide enhanced disclosures about
(a) how and why an entity uses derivative instruments, (b) how derivative
instruments and related hedged items are accounted for under Statement 133 and
its related interpretations, and (c) how derivative instruments and related
hedged items affect an entity’s financial position, financial performance, and
cash flows. The guidance in SFAS 161 is effective for financial statements
issued for fiscal years and interim periods beginning after November 15, 2008,
with early application encouraged. This Statement encourages, but does not
require, comparative disclosures for earlier periods at initial adoption. We are
currently assessing the impact of SFAS 161.





In May
2008, the FASB issued SFAS 162, The Hierarchy of Generally Accepted
Accounting Principles (SFAS
162). SFAS 162 is intended to improve financial reporting by identifying a
consistent framework, or hierarchy, for selecting accounting principles to be
used in the preparation of financial statements of nongovernmental entities that
are presented in conformity with U.S. generally accepted accounting principles
(GAAP). SFAS 162 directs the GAAP hierarchy to the entity, not the independent
auditors, as the entity is responsible for selecting accounting principles for
financial statements that are presented in conformity with GAAP. SFAS 162 is
effective 60 days following the Securities and Exchange Commission's approval of
the Public Company Accounting Oversight Board amendments to remove the GAAP
hierarchy from the auditing standards. We do not expect SFAS 162 to have a
material impact on its future consolidated results of operations or its
financial position.




In June
2008, the Emerging Issues Task Force (EITF) reached a final consensus on EITF
Issue 08-4, Transition Guidance for Conforming
Changes to Issue No. 98-5 . Certain
conclusions reached in EITF Issue No. 98-5, “Accounting for Convertible
Securities with Beneficial Conversion Features or Contingently Adjustable
Conversion Ratios,” were nullified in EITF Issue No. 00-27, “Application of
Issue No. 98-5 to Certain Convertible Instruments.” Moreover, some of the
conclusions in Issue No. 98-5 and Issue No. 00-27 were superseded by SFAS No.
150 , Accounting for Certain Financial
Instruments with Characteristics of both Liabilities and
Equity . While
the conclusions reached in Issue No. 98-5 were subsequently updated to reflect
the issuance of Issue No. 00-27 and SFAS No. 150, the transition guidance in
Issue No. 98-5 was not revised. The EITF reached a consensus on Issue No. 08-4,
which provides such guidance and requires that (1) conforming changes made to
Issue No. 98-5 resulting from Issue No. 00-27 and SFAS No. 150 be effective for
financial statements of fiscal years ending after December 15, 2008, with early
application allowed, and (2) the effect of applying the conforming changes be
presented retrospectively (with the cumulative effect of the change reported in
retained earnings as of the beginning of the first period presented). We are
currently assessing the impact of EITF Issue 08-4.





51


In June
2008, the Emerging Issues Task Force (EITF) reached final consensuses on EITF
Issue 07-5, Determining Whether an Instrument
(or Embedded Feature) Is Indexed to an Entity's Own Stock . In EITF
Issue 07-5, the EITF reached the consensus that evaluation of whether an
equity-linked financial instrument (or embedded feature) is indexed to the
company's own stock should be based on a two-step approach. Under the two-step
approach, an equity-linked financial instrument (or embedded feature) is not
deemed indexed to the entity's own stock if the strike price is denominated in a
currency other than the issuer's functional currency (but the determination of
whether the instrument is indexed to the company's own stock is not affected by
the currency in which the underlying shares are traded). Also, market-based
employee stock valuation instruments are not considered to be indexed to the
entity's own stock (presumably because they are influenced by, among other
factors, employee behavior, which is not an input used to estimate the fair
value of the forward contract or option). An exercise contingency is a provision
entitling the entity (or the counterparty) to exercise an equity-linked
financial instrument or embedded feature based on changes in an underlying,
which includes the occurrence (or nonoccurrence) of a specified event.
Provisions that accelerate the timing of the entity's (or counterparty's)
ability to exercise an instrument or that extend the length of time that an
instrument is exercisable are exercise contingencies. EITF 07-5 is effective for
financial statements issued for fiscal years beginning after December 15, 2008,
and interim periods within those fiscal years. We are currently assessing the
impact of EITF 07-5.





In July
2008, the FASB issued FASB Staff Position (FSP) No. EITF 03-6-1, Unvested Share-Based Awards as
Participating Securities for EPS Purposes (FSP No.
EITF 03-6-1). FSP No. EITF 03-6-1 clarifies the circumstances under which
unvested share-based payment awards should be considered participating
securities for purposes of determining basic earnings per share (EPS). FSP No.
EITF 03-6-1 is effective for fiscal years beginning after December 15, 2008 (and
for interim periods within such years). We are currently assessing the impact of
FSP No. FAS 157-3.





In
October 2008, the FASB issued FASB Staff Position (FSP) No. FAS 157-3 , Determining the Fair Value of a
Financial Asset in a Market That Is Not Active . The FSP
amends Statement of Financial Accounting Standards (SFAS) No. 157 , Fair Value
Measurements, by clarifying the application of SFAS No. 157 when the market for
a financial asset is inactive. Specifically, the FSP clarifies how (1)
management's internal assumptions should be considered in measuring fair value
when observable data are not present, (2) observable market information from an
inactive market should be taken into account, and (3) the use of broker quotes
or pricing services should be considered in assessing the relevance of
observable and unobservable data to measure fair value. The guidance in FSP No.
FAS 157-3 is effective immediately and applies as well to prior periods for
which financial statements have not been issued. We are currently assessing the
impact of FSP No. FAS 157-3.





Off-Balance Sheet
Arrangements





We are
not a party to any off-balance sheet arrangements.





52


Item 3. Quantitative and Qualitative
Disclosures about Market Risk





We are a
smaller reporting company as defined by Rule 12b-2 of the Securities Exchange
Act of 1934 and are not required to provide the information under this
item.





Item 4T. Controls and
Procedures.





Disclosure Controls and
Procedures





We are
required to maintain disclosure controls and procedures that are designed to
ensure that information required to be disclosed in our reports filed under the
Securities Exchange Act of 1934, as amended, is recorded, processed, summarized
and reported within the time periods specified in the Securities and Exchange
Commission's rules and forms, and that such information is accumulated and
communicated to our management, including our president (also our principal
executive officer) and our chief financial officer (also our principal financial
and accounting officer) to allow for timely decisions regarding required
disclosure.





On
October 9, 2007, American International Dairy Holding Co. Inc. (“AIDH”) entered
into an Agreement and Plan of Reorganization and Merger (the “Merger Agreement”)
with our predecessor filer, Micro-Tech Identification Systems, Inc.
(“Micro-Tech”), AIDH Acquisition, Inc., Micro-Tech’s newly formed, wholly owned
Nevada subsidiary (“Acquisition Sub”), and Tryant, LLC, Micro-Tech’s majority
shareholder, pursuant to which:





·
            Acquisition
      Sub merged with and into AIDH, and AIDH, as the surviving corporation,
      became a wholly owned subsidiary of Micro-Tech (the
    “Merger”);




·
            Each
      share of AIDH’s capital stock issued and outstanding immediately prior to
      the closing of the Merger was converted into the right to receive 1.020833
      shares of Micro-Tech’s Common Stock (an aggregate of 24,305,546 shares of
      Micro-Tech’s Common Stock, par value $0.001 per share, were issued to the
      holders of AIDH’s capital stock);




·
            AIDH’s
      officers and directors replaced Micro-Tech’s officers and directors as
      officers and directors of the filing company;
  and




·
            The
      filing company succeeded to the business of AIDH as its sole line of
      business.




As a
result of the transactions, there was a change in control of the filing company,
as the stockholders of AIDH became the majority stockholders the filing
company.  For accounting purposes, the transaction was accounted for
as a reverse acquisition under the purchase method.  Accordingly, AIDH
and its subsidiary are treated as the continuing entity for accounting
purposes.  Therefore, we only became subject to the laws related to
reporting companies, including the Sarbanes-Oxley Act of 2002, as amended, less
than a year ago.





53


In
connection with the audit for the fiscal year ended December 31, 2007, Windes
& McClaughry Accountancy Corporation (“Windes”), our independent registered
public accounting firm, noted matters involving our internal controls that it
considered to be significant deficiencies, and taken together constitute a
material weakness, under the standards of the Public Company Accounting
Oversight Board, or PCAOB. Under the PCAOB standards, a significant deficiency
is a control deficiency, or combination of control deficiencies, that, in
Windes’s judgment, would adversely affect the ability to initiate, authorize,
record, process, or report external financial data reliably in accordance with
generally accepted accounting principles such that there is more than a remote
likelihood that a misstatement of the annual or interim financial statements
that is more than inconsequential will not be prevented or
detected.  A material weakness is a significant deficiency, or
combination of significant deficiencies, that, in Windes’s judgment, results in
more than a remote likelihood that a material misstatement of the annual or
interim financial statements will not be prevented or
detected.




The
material weaknesses identified by Windes were as follows:




·
            Improper
      treatment of the effects of exchange rate changes on cash balances held in
      foreign currencies in the 2006 statements of cash flows;
    and




·
            Inadequate
      or incomplete review and analysis of certain contractual and other
      liabilities.




Our
management has discussed these material weaknesses with our board of directors
and has engaged in the following remediation efforts to ensure that the
significant deficiencies do not reoccur:





·
            We
      hired an outside consultant to assist with the preparation of our
      financial statements;




·
            We
      implemented new review and analysis processes for all significant
      contractual and other liabilities, including, without
      limitation:




(a)           the
requirement that white papers be prepared to document all material
transactions;
  (b)           the
establishment of checklists and timelines to insure timely reporting of
financial information;
  (c)           the
utilization of comparison review of Chinese accounting standards versus GAAP
standards; and




·
            We
      purchased, and are in the process of employing, new revenue accounting
      software.




54


These
remediation efforts are designed to address the material weakness identified by
Windes and to improve and strengthen our overall control environment. We believe
these actions will prevent the significant deficiencies from reoccurring. Our
management, including our principal executive officer and principal financial
officer, does not expect that disclosure controls or internal controls over
financial reporting will prevent all errors, even as the aforementioned
remediation measures are implemented and further improved to address all
deficiencies. The design of any system of controls is based in part upon certain
assumptions about the likelihood of future events, and there can be no assurance
that any design will succeed in achieving its stated goals under all potential
future conditions.





The
implementation of our remediation plan will require substantial expenditures,
could take a significant period of time to complete, and could distract our
officers and employees from the operation of our business.  However,
our management believes that these remediation efforts will be complete by the
end of this fiscal year.


Our
management has evaluated the effectiveness of the design and operation of our
disclosure controls and procedures as of the date of this report, under the
supervision and with the participation of our president (also our principal
executive officer) and chief financial officer (also our principal financial and
accounting officer), in order to conclude if our disclosure controls and
procedures are effective.  Based on the information set forth above,
our management has determined that, as of the date of this report, we do not
have effective disclosure controls and procedures.




Changes
in Internal Control Over Financial Report




In its
Annual Report on Form 10-KSB for the fiscal year ended December 31, 2007 (the
“Annual Report”), our management reported that, as of the date of such report,
our internal control over financial reporting was not
effective.  Since filing the Annual Report, we have:
 
 ·
                Hired
      an outside consultant to assist with the preparation of our financial
      statements;
  ·
                Implemented
      new review and analysis processes for all significant contractual and
      other liabilities;
  ·
                Purchased
      new revenue accounting system software, which we will begin to employ in
      the near future; and
  ·
                Retained
      a consultant to assist us with the self-assessment required by Section 404
      of the Sarbanes-Oxley Act of
2002.
  Based in the foregoing, our management
has determined that there were changes in our internalcontrol over financial
reporting, identified in connection with the evaluation that occurredduring our last fiscal
quarter, under the supervision and with the participation of our president (also
our principal executive officer) and chief financial officer (also our principal
financial and accounting officer), that materially affected, or are reasonable
likely tomaterially affect, our
internal control over financial reporting.


55


PART II - OTHER
INFORMATION





Item 1. Legal
Proceedings.





We are
not a party to any pending legal proceedings.





Item 1A. Risk
Factors.





We are a
smaller reporting company as defined by Rule 12b-2 of the Securities Exchange
Act of 1934 and are not required to provide the information under this
item.





Item 2. Unregistered Sales of Equity
Securities and Use of Proceeds.





In the
three-month period ended September 30, 2008, and subsequent period through the
date hereof, we did not consummate any unregistered sales of equity securities,
except as follows:





Sales of Notes and
Warrants





On
November 10, 2008, we sold to one “accredited investor” (the “Purchaser”) for a
purchase price of $500,000, a 10%
promissory note (the “10% Note”) in the principal amount of $500,000,
and warrants to purchase 50,000 shares of our Common Stock, at an exercise price
of $2.61 per share (the “November Warrants”) (the “November Note Offering”). The
rights and obligations under the 10% Note are further described in “Part I. Item
2. Management’s Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources - Promissory Notes” above. The
rights and obligations under the November Warrants are further described in
“Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources - Warrants”
above.





In
connection with the November Note Offering, we engaged a placement agent (the
“Placement Agent”) to whom we paid a placement fee in the amount of $40,000, and
granted warrants to purchase an aggregate of 25,000 shares of our Common Stock,
the terms and conditions of which are identical to the those of the November
Warrants.





We have
granted the Purchaser and Placement Agent “piggyback” registration rights with
respect to the shares of Common Stock underlying the warrants they received in
connection with the November Note Offering.





We
believe that these transactions are exempt from registration under the
Securities Act of 1933, as amended, pursuant to Section 4(2), or Regulation D
promulgated thereunder, as transactions by an issuer not involving a public
offering.





Item 3. Defaults Upon Senior
Securities.





In the
three-month period ended September 30, 2008, and subsequent period through the
date hereof, we did not default upon any senior securities.





56


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





In the
three-month period ended September 30, 2008, and subsequent period through the
date hereof, the we did not submit any matters to a vote of our security
holders, except as follows:





Written Consent to
Borrowing





Our
outstanding 8% promissory notes (the “8% Notes”), in the aggregate principal
amount of $2,250,000, contain a restrictive covenant requiring that, so long as
we have any obligation under the 8% Notes, we need to obtain written consent of
the holders (the “8% Note Holders”) to, among other things, incur any additional
liability for borrowed money, with certain exceptions. Therefore, as of November
10, 2008, we obtained the written consent of both of the 8% Note Holders to sell
and issue a 10% promissory note to one purchaser, in the principal amount of
$500,000.





Reference
is made to the disclosure set forth under “Part II, Item 2. Unregistered Sales
of Equity Securities and Use of Proceeds - Sales of Notes and Warrants” above,
which disclosure is incorporated herein by reference.





Item 5. Other Information.





There was
no information we were required to disclose in a report on Form 8-K during the
three-month period ended September 30, 2008, or subsequent period through the
date hereof, which was not so reported, except as follows:





Sale of Notes and
Warrants





On
November 10, 2008, we sold to one “accredited investor” (the “Purchaser”) for a
purchase price of $500,000, a 10%
promissory note (the “10% Note”) in the principal amount of $500,000,
and warrants to purchase 50,000 shares of our Common Stock, at an exercise price
of $2.61 per share (the “November Warrants”) (the “November Note Offering”). The
rights and obligations under the 10% Note are further described in “Part I. Item
2. Management’s Discussion and Analysis of Financial Condition and Results of
Operations - Liquidity and Capital Resources - Promissory Notes” above. The
rights and obligations under the November Warrants are further described in
“Part I. Item 2. Management’s Discussion and Analysis of Financial Condition and
Results of Operations - Liquidity and Capital Resources - Warrants”
above.





In
connection with the November Note Offering, we engaged a placement agent (the
“Placement Agent”) to whom we paid a placement fee in the amount of $40,000, and
granted warrants to purchase an aggregate of 25,000 shares of our Common Stock,
the terms and conditions of which are identical to the those of the November
Warrants.





We have
granted the Purchaser and Placement Agent “piggyback” registration rights with
respect to the shares of Common Stock underlying the warrants they received in
connection with the November Note Offering.





57


Item 6.  Exhibits





Exhibit No.
            
            Description of
      Exhibit4.1
            
            Form
      of 10% Promissory Note — Incorporated by reference from our Quarterly
      Report on Form 10-Q, filed on November 14, 20084.2
            
            Form
      of Warrant —  Incorporated by reference from our Quarterly
      Report on Form 10-Q, filed on November 14, 200810.1
            
            Form
      of Securities Purchase Agreement —  Incorporated by
      reference from our Quarterly Report on Form 10-Q, filed on November 14,
      200831.1
            
            Certification
      of principal executive officer pursuant to Section 13a-14(a) — filed
      herewith31.2
            
            Certification
      of principal financial and accounting officer pursuant to Section
      13a-14(a) — filed
      herewith32.1
            
            Certification
      of principal executive officer pursuant to Section 1350 — filed
      herewith32.2
            
            Certification
      of principal financial and accounting officer pursuant to Section 1350
      — filed
      herewith




58


SIGNATURES




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




EMERALD DAIRY
      INC.Dated:
      January
      30, 2009
            By:
            /s/ Yang Yong ShanYang
      Yong Shan
              Chairman,
      Chief Executive Officer andPresident




Dated:
      January
      30, 2009
                By:
                /s/ Shu KanekoShu
      Kaneko
                  Chief
      Financial Officer and
Secretary




59