UNITED
STATES


SECURITIES
AND EXCHANGE COMMISSION


WASHINGTON,
D.C. 20549





FORM 10-Q





(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, 2009OR ̈
            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.


xYes      ̈No





Indicate
by check mark whether the registrant has submitted electronically and posted on
its corporate Web site, if any, every Interactive Data File required to be
submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this
chapter) during the preceding 12 months (or for such shorter period that the
registrant was required to submit and post such files).


 ̈Yes      ̈No





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





Large
      accelerated filer  ̈
              Accelerated
      filer  ̈Non-accelerated
      filer  ̈(do not check if a smaller
      reporting company)
              Smaller
      reporting company x





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


 ̈Yes     x
No





The
registrant had 32,727,191 shares of common stock issued and outstanding as of
October 27, 2009 (not including an additional 1,944,444 shares of common stock
of the registrant currently being held in treasury).





QUARTERLY
REPORT ON FORM 10-Q


OF
EMERALD DAIRY INC. AND SUBSIDIARIES


FOR
THE PERIOD ENDED SEPTEMBER 30, 2009





TABLE
OF CONTENTS





PAGEPART I
                      -
                      FINANCIAL
      INFORMATIONItem
      1.
                      
                      Financial
      Statements
                      
                      1Condensed
      Consolidated Balance Sheets as of September 30, 2009 (unaudited) and
      December 31, 2008
                      
                      1Condensed
      Consolidated Statements of Income for the Three and Nine Months Ended
      September 30, 2009 and 2008 (unaudited)
                      
                      2Condensed
      Consolidated Statements of Cash Flows for the Nine Months Ended September
      30, 2009 and 2008 (unaudited)
                      
                      3Notes
      to Condensed Consolidated Financial Statements (unaudited)
                      
                      4Item
      2.
                      
                      Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
                      
                      25Item
      3.
                      
                      Quantitative
      and Qualitative Disclosures About Market Risk
                      
                      53Item
      4.
                      
                      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
                      
                      58Item
      4.
                      
                      Submission
      of Matters to a Vote of Security Holders
                      
                      58Item
      5.
                      
                      Other
      Information
                      
                      58Item
      6.
                      
                      Exhibits
                      
                      60Signatures
                      
                      61




i


PART
I. FINANCIAL INFORMATION





Item
1.  Financial Statements





Emerald
Dairy Inc. and Subsidiaries


Condensed
Consolidated Balance Sheets


September
30, 2009 and December 31, 2008





September 30,
                              
                              
                              December 31,2009
                              
                              
                              2008(Unaudited)
                              
                              
                              (Audited)ASSETSCurrent
      AssetsCash
      and cash equivalents
                              
                              $
                              9,681,007
                              
                              
                              $
                              7,343,588Trade
      accounts receivable,net
                              
                              
                              6,702,521
                              
                              
                              
                              6,146,228Inventory,
      net
                              
                              
                              1,719,833
                              
                              
                              
                              883,233Other
      current assets
                              
                              
                              4,194,359
                              
                              
                              
                              4,337,332Total
      current assets
                              
                              
                              22,297,720
                              
                              
                              
                              18,710,381Property, plant and equipmentProperty,
      plant and equipment, net
                              
                              
                              5,743,716
                              
                              
                              
                              6,101,566Contruction
      in progress
                              
                              
                              7,009,886
                              
                              
                              
                              2,482,33912,753,602
                              
                              
                              
                              8,583,905Intangible
      assets, net
                              
                              
                              1,351,110
                              
                              
                              
                              1,380,089$
                              36,402,432
                              
                              
                              $
                              28,674,375LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitiesAccounts
      payable and accrued expenses
                              
                              $
                              4,224,772
                              
                              
                              $
                              4,651,947Notes
      payable, net of debt discount of $21,972 and $87,888 atSeptember
      30, 2009 and December 31, 2008, respectively
                              
                              
                              2,728,028
                              
                              
                              
                              2,662,112Other
      current liabilites
                              
                              
                              414,561
                              
                              
                              
                              728,859Loan
      from shareholder
                              
                              
                              210,164
                              
                              
                              
                              210,265Total
      current liabilities
                              
                              
                              7,577,525
                              
                              
                              
                              8,253,183Commitments
      and Contingencies (Note 21)Stockholders'
      EquityPreferred
      stock ($0.001 par value, 10,000,000 shares authorized, none issued and
      outstanding at September 30, 2009 and December 31, 2008)
                              
                              
                              -
                              
                              
                              
                              -Common
      stock ($0.001 par value, 100,000,000 shares authorized, 33,895,802 and
      31,243,776 issued and outstanding at September 30, 2009 and December 31,
      2008, respectively)
                              
                              
                              33,896
                              
                              
                              
                              31,244Treasury
      Stock (1,944,444 shares at Septmeber 30, 2009 and December 31, 2008,
      respectively)
                              
                              
                              (1,944
                              )
                              
                              
                              (1,944
                              )Additional
      paid-in capital
                              
                              
                              12,936,917
                              
                              
                              
                              8,225,922Retained
      earnings (of which $1,834,742 and $1,314,861 are restricted at September
      30, 2009 and December 31, 2008, respectively, for common welfare
      reserves)
                              
                              
                              13,806,869
                              
                              
                              
                              10,106,402Accumulated
      other comprehensive income
                              
                              
                              2,049,169
                              
                              
                              
                              2,059,568Total
      stockholders' equity
                              
                              
                              28,824,907
                              
                              
                              
                              20,421,192$
                              36,402,432
                              
                              
                              $
                              28,674,375





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




1




Emerald
Dairy Inc. and Subsidiaries


Condensed
Consolidated Statements of Income


For
the Three and Nine Months Ended September 30, 2009 and 2008





Three months ended
                    
                    
                    Nine months endedSeptember 30,
                    
                    
                    September 30,
                    
                    
                    September 30,
                    
                    
                    September 30,2009
                    
                    
                    2008
                    
                    
                    2009
                    
                    
                    2008Sales
                    
                    $
                    10,158,004
                    
                    
                    $
                    11,221,019
                    
                    
                    $
                    31,261,491
                    
                    
                    $
                    32,560,256Cost
      of Goods Sold
                    
                    
                    5,569,598
                    
                    
                    
                    6,552,835
                    
                    
                    
                    17,057,583
                    
                    
                    
                    19,845,232Gross
      Profit
                    
                    
                    4,588,406
                    
                    
                    
                    4,668,184
                    
                    
                    
                    14,203,908
                    
                    
                    
                    12,715,024Operating
      ExpensesSelling
      expenses and adminstrative expenses
                    
                    
                    3,348,522
                    
                    
                    
                    3,319,484
                    
                    
                    
                    9,448,920
                    
                    
                    
                    10,283,634Depreciation
      and amortization
                    
                    
                    43,595
                    
                    
                    
                    41,905
                    
                    
                    
                    130,107
                    
                    
                    
                    72,336Total
      operating expenses
                    
                    
                    3,392,117
                    
                    
                    
                    3,361,389
                    
                    
                    
                    9,579,027
                    
                    
                    
                    10,355,970Other
      Income (Expense)Interest
      income
                    
                    
                    1,277
                    
                    
                    
                    2,455
                    
                    
                    
                    4,421
                    
                    
                    
                    12,061Interest
      expense
                    
                    
                    (67,887
                    )
                    
                    
                    (231,517
                    )
                    
                    
                    (67,887
                    )
                    
                    
                    (274,923
                    )Total
      other income (expense)
                    
                    
                    (66,610
                    )
                    
                    
                    (229,062
                    )
                    
                    
                    (63,466
                    )
                    
                    
                    (262,862
                    )Net
      Income Before Provision for Income Tax
                    
                    
                    1,129,679
                    
                    
                    
                    1,077,733
                    
                    
                    
                    4,561,415
                    
                    
                    
                    2,096,192Provision
      for Income TaxesCurrent
                    
                    
                    245,054
                    
                    
                    
                    269,666
                    
                    
                    
                    860,948
                    
                    
                    
                    586,957245,054
                    
                    
                    
                    269,666
                    
                    
                    
                    860,948
                    
                    
                    
                    586,957Net
      Income
                    
                    $
                    884,625
                    
                    
                    $
                    808,067
                    
                    
                    $
                    3,700,467
                    
                    
                    $
                    1,509,235Basic
      Earnings Per Share
                    
                    $
                    0.03
                    
                    
                    $
                    0.03
                    
                    
                    $
                    0.12
                    
                    
                    $
                    0.05Basic
      Weighted  Average Shares Outstanding
                    
                    
                    30,844,547
                    
                    
                    
                    29,299,332
                    
                    
                    
                    29,979,356
                    
                    
                    
                    29,299,332Diluted
      Earnings Per Share
                    
                    $
                    0.03
                    
                    
                    $
                    0.03
                    
                    
                    $
                    0.12
                    
                    
                    $
                    0.05Diluted
      Weighted  Average Shares Outstanding
                    
                    
                    31,631,381
                    
                    
                    
                    29,563,708
                    
                    
                    
                    30,429,024
                    
                    
                    
                    29,563,708The
      Components of Other Comprehensive IncomeNet
      Income
                    
                    $
                    884,625
                    
                    
                    $
                    808,067
                    
                    
                    $
                    3,700,467
                    
                    
                    $
                    1,509,235Foreign
      currency translation adjustment
                    
                    
                    24,487
                    
                    
                    
                    259,312
                    
                    
                    
                    (14,933
                    )
                    
                    
                    1,634,624Income
      tax related to other comprehensive income
                    
                    
                    (8,326
                    )
                    
                    
                    (88,166
                    )
                    
                    
                    5,077
                    
                    
                    
                    (555,772
                    )Comprehensive
      Income
                    
                    $
                    900,786
                    
                    
                    $
                    979,213
                    
                    
                    $
                    3,690,611
                    
                    
                    $
                    2,588,087





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





2


Emerald
Dairy Inc. and Subsidiaries


Condensed
Consolidated Statements of Cash Flows


For
the Nine Months Ended September 30, 2009 and 2008





2009
                
                
                2008Cash
      flows from operating activitiesNet
      Income
                
                $
                3,700,467
                
                
                $
                1,509,235Adjustments
      to reconcile net cash provided by operating activitiesDepreciation
      and amortization
                
                
                400,227
                
                
                
                309,749Amortization
      of loan discount
                
                
                65,916
                
                
                
                114,683Capitalized
      interest
                
                
                (351,071
                )
                
                
                -Stock
      issued for services
                
                
                33,475
                
                
                
                -Warrants
      modified for services
                
                
                3,975
                
                
                
                -Warrants
      issued for loan costs
                
                
                117,155
                
                
                
                -Incentive
      stock options
                
                
                125,452
                
                
                
                -Net
      change in assets and liabilitiesTrade
      accounts receivable
                
                
                (559,266
                )
                
                
                (1,290,662
                )Inventory
                
                
                (837,027
                )
                
                
                (251,318
                )Other
      current assets
                
                
                140,875
                
                
                
                2,480,834Accounts
      payable and accrued expenses
                
                
                (424,925
                )
                
                
                1,876,980Other
      current liabilities
                
                
                (313,945
                )
                
                
                206,295Net
      cash provided by operating activities
                
                
                2,101,308
                
                
                
                4,955,796Cash
      flows from investing activitiesDeposit
      on equipment purchase
                
                
                -
                
                
                
                (3,699,058
                )Purchases
      of fixed assets and intangibles including construction in
      progress
                
                
                (4,194,717
                )
                
                
                (6,489,860
                )Net
      cash used in investing activities
                
                
                (4,194,717
                )
                
                
                (10,188,918
                )Cash
      flows from financing activities-
                
                
                
                -Exercise
      of warrants
                
                
                4,433,590
                
                
                
                -Repayments
      of notes payable
                
                
                -
                
                
                
                (290,918
                )Advances
      on notes payable
                
                
                -
                
                
                
                2,250,000Net
      cash provided by financing activities
                
                
                4,433,590
                
                
                
                1,959,082Effect
      of exchange rate
                
                
                (2,762
                )
                
                
                461,855Net
      increase in cash
                
                
                2,337,419
                
                
                
                (2,812,185
                )Cash
      and cash equivalents at beginning of period
                
                
                7,343,588
                
                
                
                6,560,931Cash
      and cash equivalents at end of period
                
                $
                9,681,007
                
                
                $
                3,748,746





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


3


Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 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 (“PRC”)
through its wholly owned subsidiaries.
 
 The
Company’s wholly owned subsidiary, American International Dairy Holdings, Inc.
(“AIDH”), a Nevada corporation, was formed in 2005 for the purpose of acquiring
the stock in Heilongjiang Xing An Ling Dairy, Co. (“XAL”), a corporation formed
on September 8, 2003 in Heilongjiang Providence, pursuant to the laws of the
PRC. On May 30, 2005, AIDH acquired  XAL, pursuant to a Share Transfer
Agreement. 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 powder, soybean powder and rice
powder. Through the Company’s network of over 800 salespeople, the Company’s
products are distributed throughout 20 provinces in the PRC, and sold in over
5,800 retail outlets.
 
 Prior to
September 23, 2006, XAL owned 57.69% of Heilongjiang Be’ian 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”), pursuant to the laws of the
PRC. In July 2008, HXD commenced construction of a production facility in
Hailun City, Heilongjiang Province, PRC. It is expected that the
construction and equipping of this new facility will be completed in the fourth
fiscal quarter of 2009. Upon completion, it is anticipated that HXD will engage
in the manufacture of the Company's milk powder, soybean powder 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 (“GAAP”) in
the United States of America (“U.S.”) 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 GAAP 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, 2008, which are included in the Company’s Form 10-K for the
fiscal year ended December 31, 2008 filed with the Securities and Exchange
Commission (“SEC”) on April 9, 2009.
 
 In June
2009 the Financial Accounting Standards Board (“FASB”) established the
Accounting Standards Codification (“Codification” or “ASC”) as the source of
authoritative accounting principles recognized by the FASB to be applied by
nongovernmental entities in the preparation of financial statements in
accordance with GAAP. Rules and interpretive releases of the SEC issued under
authority of federal securities laws are also sources of GAAP for SEC
registrants. Existing GAAP was not intended to be changed as a result of the
Codification, and accordingly the change did not impact the Company’s financial
statements. The ASC does change the way the guidance is organized and
presented.
 
 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 the
Company and its subsidiaries as of September 30, 2009, the results of their
operations for the three and nine months ended September 30, 2009 and 2008, and
their cash flows for the nine months ended September 30, 2009 and
2008.
  4
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 
 3.
              Summary
      of Significant Accounting Policies
 
 The
results of operations for the nine months ended September 30, 2009 and 2008 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
GAAP and are expressed in terms of U.S. 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 have been eliminated in
consolidation.
 
 Use of estimates - The
preparation of these consolidated financial statements in conformity with GAAP
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 include, 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, deferred tax assets, property, plant and equipment, reserve
for employee benefit obligations, stock warrant valuation, income tax
uncertainties and other uncertainties. Actual results may differ from these
estimates.  The current economic environment has increased the degree
of uncertainty inherent in these estimates and assumptions.
 
 Cash and cash equivalents -Cash and cash equivalents represent cash on hand, demand deposits and all
highly liquid investments placed with banks or other financial institutions with
original maturities of three months or less. Substantially all of the Company’s
cash is held in bank accounts in the PRC and is not protected by the Federal
Deposit Insurance Corporation (“FDIC”) insurance or any other similar insurance.
Accounts held at U.S. financial institutions are insured by the FDIC up to
$250,000. As of September 30, 2009, $126,823 of the Company’s cash balances held
in U.S. balances are in excess of insured amounts. Given the current economic
environment and risks in the banking industry, there is a risk that the deposits
may not be readily available or covered by such insurance.
 
 Accounts receivable -Trade
accounts receivable are recorded at the invoiced amount and do not bear
interest. Amounts collected on trade accounts receivable are included in net
cash provided by operating activities in the consolidated statements of cash
flows. The Company maintains an allowance for doubtful accounts for estimated
losses inherent in its accounts receivable portfolio. In establishing the
required allowance, management considers historical losses, current receivables
aging, and existing industry and PRC economic data. The Company reviews its
allowance for doubtful accounts monthly. Past due balances over 90 days and over
a specified amount are reviewed individually for collectibility. Account
balances are charged off against the allowance after all means of collection
have been exhausted and the potential for recovery is considered remote. At
September 30, 2009 and December 31, 2008, there were no allowances for doubtful
accounts based on the review of the above factors. There were no write-off’s for
the three and nine months ended September 30, 2009 and 2008. The Company does
not have any off-balance sheet credit exposure related to its
customers.
 
 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, at which time depreciation will commence. As of September 30, 2009, the
Company has incurred and capitalized into construction-in-progress $6,568,948 of
construction costs from the construction contract and $440,938 of capitalized
interest for a balance of $7,009,886.  The estimated cost to be
incurred in 2009 to complete the project is approximately
$1,868,145.
  5
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 3.
              Summary
      of Significant Accounting Policies
(Continued)
 
 Capitalized Interest– The
Company’s policy is to capitalize interest costs on debt during the construction
of major projects exceeding one year.  A reconciliation of total
interest cost to interest expense as reported in the consolidated statements of
income for three months ended September 30, 2009 and 2008 is as
follows:
 
 Three Months
                          Ended September 30,
                        
                        Nine Months
                          Ended September 30,2009
                        
                        2008
                        
                        2009
                        
                        2008Interest
      cost capitalized
                        
                        $
                        130,343
                        
                        
                        $
                        —
                        
                        
                        $
                        351,070
                        
                        
                        $
                        —Interest
      cost charged to income
                        
                        
                        67,887
                        
                        
                        
                        231,517
                        
                        
                        
                        67,877
                        
                        
                        
                        274,923$
                        198,230
                        
                        
                        $
                        231,517
                        
                        
                        $
                        418,947
                        
                        
                        $
                        274,923
  Foreign Currency- The
Company’s principal country of operations is the PRC. The financial position and
results of operations of the Company are determined using RMB 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 U.S. dollars are dealt with as a separate component within
stockholders’ equity. Translation adjustments net of tax totaled $16,161 and
$171,146, for the three months ended September 30, 2009 and 2008, respectively
and ($9,856) and $1,078,852 for the nine months ended September 30, 2009 and
2008, respectively.
 
 As of
September 30, 2009 and 2008, the exchange rate was 6.8263 RMB and 6.8485 RMB per
U.S. Dollar, respectively.
 
 Revenue recognition - The
Company recognizes revenues in accordance with the guidelines of the SEC Staff
Accounting Bulletin (“SAB”) No. 104 “Revenue Recognition”.  Revenue is
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, 2009, the Company has no sales or contracts that included multiple
deliverables that would fall under accounting guidance.
 
 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. The FASB ASC Topic 260, “Earnings Per Share,” requires the
Company to include additional shares in the computation of earnings per share,
assuming dilution. 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.
  6
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 3.
              Summary
      of Significant Accounting Policies
(Continued)
 
 The
Company accounts for income tax under accounting guidance that requires
recognition of deferred tax assets and liabilities for the expected future tax
consequences of the events that have been included in the financial 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 the
PRC 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 U.S. 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
 
 The
Company is subject to income taxes in the U.S. and the PRC. Significant judgment
is required in evaluating the Company’s uncertain tax positions and determining
the Company’s provision for income taxes. In accordance with FASB ASC Topic 740,
“Income Taxes,” the Company provides for the recognition of deferred tax assets
if realization of such assets is more likely than not.
 
 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 PRC 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 qualified 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- 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.
 
 Stock Based Compensation –The
Company has adopted accounting guidance 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.
 
 Fair value of financial instruments -The Company applies the provisions accounting guidance that requires all
entities to disclose the fair value of financial instruments, both assets and
liabilities recognized and not recognized on the balance sheet, for which it is
practicable to estimate fair value.  The accounting guidance defines
fair value of a financial instrument as the amount at which the instrument could
be exchanged in a current transaction between willing parties.  As
of  September 30, 2009 and December 31, 2008 the fair value of cash,
accounts receivable, other receivables, accounts payable, commercial notes
payable, and accrued expenses approximated carrying value due to the short
maturity of the instruments, quoted market prices, or interest rates, which
fluctuate with market rates.
  7
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 3.
              Summary
      of Significant Accounting Policies
(Continued)
 
 Fair
Value Measurements
 
 Effective
April 1, 2009, the FASB ASC Topic 825, “Financial Instruments,” requires
disclosures about fair value of financial instruments in quarterly reports as
well as in annual reports.
  The FASB
ASC Topic 820, “Fair Value Measurements and Disclosures,” clarifies the
definition of fair value for financial reporting, establishes a framework for
measuring fair value and requires additional disclosures about the use of fair
value measurements.
 
 Various
inputs are considered when determining the fair value of the Company’s financial
instruments. The inputs or methodologies used for valuing securities are
not necessarily an indication of the risk associated with investing in these
securities.  These inputs are summarized in the three broad levels
listed below.
 
 ·
              Level
      1 – observable market inputs that are unadjusted quoted prices for
      identical assets or liabilities in active
  markets.
 
 ·
              Level
      2 – other significant observable inputs (including quoted prices for
      similar securities, interest rates, credit risk,
  etc...).
 
 ·
              Level
      3 – significant unobservable inputs (including the Company’s own
      assumptions in determining the fair value of financial
      instruments).
 
 The
Company’s adoption of FASB ASC Topic 825 did not have a material impact on the
Company’s consolidated financial statements.
 
 The
carrying value of financial assets and liabilities recorded at fair value is
measured on a recurring or nonrecurring basis. Financial assets and liabilities
measured on a non-recurring basis are those that are adjusted to fair value when
a significant event occurs. The Company had no financial assets or liabilities
carried and measured on a nonrecurring basis during the reporting periods.
Financial assets and liabilities measured on a recurring basis are those that
are adjusted to fair value each time a financial statement is prepared. The
Company’s had no financial assets and/or liabilities carried at fair value on a
recurring basis at September 30, 2009.
  The
availability of inputs observable in the market varies from instrument to
instrument and depends on a variety of factors including the type of instrument,
whether the instrument is actively traded, and other characteristics particular
to the transaction. For many financial instruments, pricing inputs are readily
observable in the market, the valuation methodology used is widely accepted by
market participants, and the valuation does not require significant management
discretion. For other financial instruments, pricing inputs are less observable
in the market and may require management judgment.
 
 Recently
Enacted Accounting Standards
 
 Accounting
Standards Update ("ASU") ASU No. 2009-05 (ASC Topic 820), which amends Fair
Value Measurements and Disclosures - Overall, ASU No. 2009-08, Earnings per
Share, ASU No. 2009-12 (ASC Topic 820), Investments in Certain Entities That
Calculate Net Asset Value per Share, and various other ASU's No. 2009-2 through
ASU No. 2009-15 which contain technical corrections to existing guidance or
affect guidance to specialized industries or entities were recently issued.
These updates have no current applicability to the Company, or their effect on
the financial statements would not have been significant.
  8
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 4.
              Concentrations
      of Business and Credit Risk
 
 The
Company conducts all of its primary trade in the PRC.  There can be no
assurance that the Company will be able to successfully conduct its trade, and
failure to do so would have a material adverse effect on the Company’s financial
position, results of operations and cash flows. Also, the success of the
Company’s operations is subject to numerous contingencies, some of which are
beyond management’s control. These contingencies include general economic
conditions, price of raw material, competition, governmental and political
conditions, and changes in regulations. Because the Company is dependant on
foreign trade in the PRC, the Company is subject to various additional
political, economic and other uncertainties. Among other risks, the Company’s
operations will be subject to risk of restrictions on transfer of funds,
domestic and international customs, changing taxation policies, foreign exchange
restrictions, and political and governmental regulations.
 
 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 FDIC up to $250,000. As of September 30, 2009 $126,823 of the cash balances
held in the U.S. are in excess of insured amounts.
 
 Milk
powder historically represents 75% to 95% of the Company’s total sales. Dairy
product consumption in the PRC has historically been lower than in many other
countries in the world. Growing interest in milk products in the PRC is a
relatively recent phenomenon which makes the market for the Company’s products
less predictable.  Consumers may lose interest in the
products.  As a result, achieving and maintaining market acceptance
for the Company’s products will require substantial marketing efforts and the
expenditure of significant funds to encourage dairy consumption in general, and
the purchase of the Company’s products in particular.  There is
substantial risk that the market may not accept or be receptive to the Company’s
products.  Market acceptance of the Company’s current and proposed
products will depend, in large part, upon its ability to inform potential
customers that the distinctive characteristics of the Company’s products make
them superior to competitive products and justify their pricing.  The
Company’s current and proposed products may not be accepted by consumers or able
to compete effectively against other premium or non-premium dairy
products.  Lack of market acceptance would limit the Company’s
revenues and profitability.
 
 The
Company operates in the PRC, 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 RMB.
 
 In
mid-2008, a number of milk powder products produced within the PRC were found to
contain unsafe levels of tripolycyanamide, also known as melamine, sickening
thousands of infants. This prompted the PRC’s 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 the PRC. On September 16,
2008, the PRC’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. The Company
passed the emergency inspection and were not included on AQSIQ’s list. Although
the Company believes that the inevitable contraction in the PRC’s milk powder
industry caused by this crisis will lead to increased demand for its products,
the Company can’t be certain that the illnesses caused by contamination in the
milk powder industry, whether or not related to the Company’s products, won’t
lead to decreased demand for milk powder products produced within the PRC,
thereby having a material adverse effect on its 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 the PRC. The Company does not require collateral or other
security to support financial instruments subject to credit risk.
 
 For the
three and nine months ended September 30, 2009 and 2008, no single customer
accounted for 10% or more of the Company’s sales revenues.
  9
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 4.
              Concentrations
      of Business and Credit Risk
(Continued)
 
 As of
September 30, 2009 and December 31, 2008, the Company had no insurance coverage
of any kind. Accrual for losses is not recognized by the Company until such time
as an uninsured loss has occurred.
 
 Payments
of dividends may be subject to some restrictions due to the fact that the
operating activities are conducted in subsidiaries residing in the
PRC.
 
 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, 2009 and December 31, 2008, inventory consists of the
following:
  2009
                        
                        
                        2008Raw
      materials
                        
                        $
                        1,094,471
                        
                        
                        $
                        557,128Work-in-process
                        
                        
                        546,613
                        
                        
                        
                        299,931Finished
      goods
                        
                        
                        69,906
                        
                        
                        
                        17,305Repair
      parts
                        
                        
                        8,843
                        
                        
                        
                        8,869$
                        1,719,833
                        
                        
                        $
                        883,233
  6.
              Other
      Current Assets
 
 As of
September 30, 2009 and December 31, 2008, other current assets consist of the
following:
 
 2009
                          
                          
                          2008Advances
      to milk suppliers
                          
                          $
                          332,783
                          
                          
                          $
                          388,406Advances
      to equipment supplier
                          
                          
                          3,711,088
                          
                          
                          
                          3,712,883Advances
      to staff
                          
                          
                          25,960
                          
                          
                          
                          76,712Deposit
      on contract
                          
                          
                          82,036
                          
                          
                          
                          74,614Prepaid
      expenses
                          
                          
                          42,492
                          
                          
                          
                          84,717$
                          4,194,359
                          
                          
                          $
                          4,337,332
 
 7.
              Property,
      Plant, and Equipment
 
 As of
September 30, 2009 and December 31, 2008, property, plant, and equipment consist
of the following:
 
 2009
                  
                  
                  2008Building
                  
                  $
                  3,703,182
                  
                  
                  $
                  3,704,971Plant
      and Machinery
                  
                  
                  2,971,446
                  
                  
                  
                  2,972,883Motor
      vehicles
                  
                  
                  526,651
                  
                  
                  
                  526,906Dairy
      cows
                  
                  
                  250,657
                  
                  
                  
                  242,102Office
      equipment
                  
                  
                  68,401
                  
                  
                  
                  59,7397,520,337
                  
                  
                  
                  7,506,601Less:
      Accumulated depreciation
                  
                  
                  (1,776,621
                  )
                  
                  
                  (1,405,035
                  )$
                  5,743,716
                  
                  
                  $
                  6,101,566
  10
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 7.
              Property,
      Plant, and Equipment (Continued)
 
 Depreciation
expenses totaled $124,421 and $371,939 for the three and nine months ended
September 30, 2009, respectively, and $106,862 and $290,164 for the three and
nine months ended September 30, 2008, respectively. $90,258 and $270,120 were
included as a component of cost of goods sold for the three and nine months
ended September 30, 2009, respectively, and $84,542 and $237,413 for the three
and nine months ended September 30, 2008, respectively.
 
 8.
              Construction-in-progress
 
 As of
September 30, 2009 and December 31, 2008, construction in progress was the
following:
 
 September 30,
                    2009
                  
                  
                  December 31,
                    2008Construction
      in progress
                  
                  $
                  7,009,886
                  
                  
                  $
                  2,482,339
 
 Construction-in-progress
represents construction and installations of the new plant and machinery for the
production facility in Hailun City.
 
 9.
              Intangible
      Assets
 
 As of
September 30, 2009 and December 31, 2008, intangible assets consisted of the
following:
 
 September 30,
                    2009
                  
                  
                  December 31,
                    2008Land
      use rights
                  
                  $
                  1,355,728
                  
                  
                  $
                  1,356,384Patents
                  
                  
                  53,177
                  
                  
                  
                  53,2021,408,905
                  
                  
                  
                  1,409,586Less:
      Accumulated amortization
                  
                  
                  (57,795
                  )
                  
                  
                  (29,497
                  )$
                  1,351,110
                  
                  
                  $
                  1,380,089
  Amortization
expense totaled $9,432 and $28,288 for the three and nine months ended September
30, 2009, respectively, and $11,398 and $19,585 the three and nine months ended
September 30, 2008, respectively.
 
 Amortization
expense is estimated to be $37,712 for each of the next five years.
 
 10.
              Income
      Taxes
 
 On May
30, 2005, AIDH executed a Share Transfer Agreement with XAL, a corporation
organized and existing under the laws of the PRC. 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 the
PRC’s 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 25%.
  11
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 10.
              Income
      Taxes (Continued)
 
 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 30,2009
                            
                            2008
                            
                            2009
                            
                            2008U.S.
      Operations
                            
                            $
                            (713,000
                            )
                            $
                            (874,000
                            )
                            $
                            (1,543,000
                            )
                            $
                            (2,065,000
                            )Chinese
      Operations
                            
                            
                            1,843,000
                            
                            
                            1,952,000
                            
                            
                            6,105,000
                            
                            
                            4,161,000$
                            1,130,000
                            
                            $
                            1,078,000
                            
                            $
                            4,562,000
                            
                            $
                            2,096,000
  The
components of the provision for income taxes are approximately as
follows:
  Three Months
                                            Ended September 30,
                                          
                                          Nine Months
                                            Ended September 30,2009
                                          
                                          2008
                                          
                                          2009
                                          
                                          2008Federal,
      State and Local
                                          
                                          $
                                          -
                                          
                                          $
                                          -
                                          
                                          $
                                          -
                                          
                                          $
                                          -Peoples
      Republic of China -Federal and Local
                                          
                                          
                                          245,000
                                          
                                          
                                          269,700
                                          
                                          
                                          861,000
                                          
                                          
                                          586,900$
                                          245,000
                                          
                                          $
                                          269,700
                                          
                                          $
                                          861,000
                                          
                                          $
                                          586,900
  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 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Income
      tax provision at Federal statutory rate
                  
                  $
                  384,100
                  
                  
                  $
                  366,400
                  
                  
                  $
                  1,550,900
                  
                  
                  $
                  712,700State
      income taxes, net of Federal benefit
                  
                  
                  -0-
                  
                  
                  
                  64,600
                  
                  
                  
                  -0-
                  
                  
                  
                  125,800U.S.
      tax rate in excess of foreign tax rate
                  
                  
                  (165,900
                  )
                  
                  
                  (136,700
                  )
                  
                  
                  (549,400
                  )
                  
                  
                  (291,300
                  )Abatement
      of foreign income taxes
                  
                  
                  (215,800
                  )
                  
                  
                  (370,900
                  )
                  
                  
                  (665,200
                  )
                  
                  
                  (778,000
                  )Increase
      in valuation allowance
                  
                  
                  242,600
                  
                  
                  
                  346,300
                  
                  
                  
                  524,700
                  
                  
                  
                  817,700Tax
      provision
                  
                  $
                  245,000
                  
                  
                  $
                  269,700
                  
                  
                  $
                  861,000
                  
                  
                  $
                  586,900
  The
Company has a U.S net operating loss carryforwards of approximately $3,779,000
as of December 31, 2008, which expires in 2027. The deferred tax asset
associated with these net operating loss carryforwards was fully reserved as of
September 30, 2009.
 
 The
change in the valuation allowance as of September 30, 2009 and 2008 was $524,700
and $817,700, respectively.
  12
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 10.
              Income
      Taxes (Continued)
 
 The
effects of the tax exemption per share were as follows:
 
 Three Months
                    Ended September 30,
                  
                  
                  Nine Months
                    Ended September 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Tax
      Saving
                  
                  $
                  215,800
                  
                  
                  $
                  370,900
                  
                  
                  $
                  665,200
                  
                  
                  $
                  778,000Benefit
      per share:Basic
                  
                  $
                  0.01
                  
                  
                  $
                  0.01
                  
                  
                  $
                  0.02
                  
                  
                  $
                  0.03Diluted
                  
                  $
                  0.01
                  
                  
                  $
                  0.01
                  
                  
                  $
                  0.02
                  
                  
                  $
                  0.03
  Had the
tax exemption not been in place for the three and nine months ended September
30, 2009 and 2008, the Company estimates the following proforma financial
statement impact:
 
 Three Months
                    Ended September 30,
                  
                  
                  Nine Months
                    Ended September 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Net
      income before tax provision, as reported
                  
                  $
                  1,130,000
                  
                  
                  $
                  1,078,000
                  
                  
                  $
                  4,562,000
                  
                  
                  $
                  2,096,000Less
      Tax provision not exempted
                  
                  
                  245,000
                  
                  
                  
                  269,700
                  
                  
                  
                  861,000
                  
                  
                  
                  586,900Less
      Tax provision exempted
                  
                  
                  215,800
                  
                  
                  
                  370,900
                  
                  
                  
                  665,200
                  
                  
                  
                  778,000$
                  669,200
                  
                  
                  $
                  437,400
                  
                  
                  $
                  3,035,800
                  
                  
                  $
                  731,100
  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, 2009, respectively, the Company contributed $59,264
and $204,448 in pension contributions. For the three and nine months ended
September 30, 2008 the Company contributed $28,883 and $83,970,
respectively.
 
 12.
              Accounts
      Payable and accrued Expenses
  At
September 30, 2009 and December 31, 2008 accrued expenses consisted
of:
 
 September 30,
                    2009
                  
                  
                  December 31,
                    2008Accounts
      payable
                  
                  $
                  2,630,458
                  
                  
                  $
                  3,264,066Liquidated
      damages
                  
                  
                  1,201,998
                  
                  
                  
                  1,201,998Accrued
      payroll
                  
                  
                  47,606
                  
                  
                  
                  56,404Accrued
      interest
                  
                  
                  311,537
                  
                  
                  
                  105,287Accrued
      insurance
                  
                  
                  33,173
                  
                  
                  
                  24,192$
                  4,224,772
                  
                  
                  $
                  4,651,947
  13
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 13.
              Notes
      payable
 
 At
September 30, 2009 and December 31, 2008 notes payable consisted of the
following:
 
 September 30,
                    2009
                  
                  
                  December 31,
                    2008Notes
      dated June 2008, due December 31, 2009 with a interest rate of 10%, net ofdebt
      discount of $10,028 and $40,113 at September 30, 2009 and December 31,2008,
      respectively
                  
                  $
                  2,239,972
                  
                  
                  $
                  2,209,887Note
      dated November 2008, due November 10, 2009 with a interest rate of 10%,
      net of debt discount of $11,944 and $47,775 at September 30, 2009 and
      December 31, 2008, respectively*
                  
                  $
                  488,056
                  
                  
                  
                  452,225$
                  2,728,028
                  
                  
                  $
                  2,662,112
 *As
of November 10, 2009, the maturity date of this Note was extended to May 10,
2010.
 
 14.
              Put/Call
      Liability
 
 On
October 9, 2007 (the “Closing Date”), 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 were met (the “Call
Option Conditions”):
 
 ·
                Either
      (i) a registration statement (“Registration Statement”) covering the
      resale of the Put/Call Shares was declared effective by the SEC, and has
      been kept continuously effective by the Company, or (B) all of the
      Put/Call Shares were available for sale without registration pursuant to
      Rule 144 promulgated under the Securities Act of 1933 (“Rule 144”);
      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) equaled or exceeded
      $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 of the closing) 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 was only permitted to 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 were met. The
Call Option was only exercisable for all, but not less than all, of the Put/Call
Shares. The repurchase was required to be consummated within ninety (90) days
following the date of the Call Option Exercise Notice.
 
 In
addition, the Put/Call Stockholders had 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 failed to exercise its Call Option within ten (10) days of a date
      on which all of the Call Option Conditions were met;
  or
 
 ·
              the
      Company consummated a private offering of not less than $5,000,000 of its
      securities (a “Qualified Offering”);
or
  14
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 14.
              Put/Call
      Liability
 
 ·
              the
      Company failed 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 SEC, 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;
      or
 
 ·
              the
      Company failed 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 were able to 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 were
only able to 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 was to be consummated within
ninety (90) days following the date of the Put Exercise Notice.
  In
accordance with accounting guidance regarding distinguishing liabilities from
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.
 
 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 failed to (i) file the Registration Statement within thirty (30)
      business days of the Filing Date, (B) have the Registration Statement
      declared effective within ninety (90) calendar days from the Filing Date,
      or, if reviewed by the SEC, 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.
 
 On March
3, 2009 the Company and the Put/Call Stockholders terminated the Put/Call
Agreement.
 
 The
termination of the Put/Call Agreements was considered a type 1 event due to the
culmination of events that started with the waiver executed on April, 9, 2008
and ending with the termination of the Put/Call Agreement on March 3,
2009.  As a type 1 event, the termination provided additional evidence
with respect to the valuation of the Put/Call agreement as of December 31, 2008.
As of December 31, 2008, the Company reclassified the $3,169,444 value previous
recorded from liabilities to additional paid-in capital.
  15.
              Equity
 
 Registration
Rights Agreement
 
 On
October 9, 2007 and October 19, 2007, the Company entered into Registration
Rights Agreements with certain accredited investors (“Investors”), in connection
with private offerings (the “Offerings”) it consummated on such dates. Pursuant
to the Registration Rights Agreements, the Company agreed to register the shares
of common stock, and shares underlying warrants, purchased in the
Offerings.  Further, if the Company did not satisfy its registration
requirements, liquidated damages would accumulate at the rate of 1.5% of the
purchase price paid by the Investors  for each thirty (30) day period
during which a registration default continued.
  15
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 15.
              Equity
      (Continued)
 
 The
Company did not satisfy the registration requirements.  However, as of
October 20, 2008, the liquidated damages stopped accruing because the shares
covered by the Registration Rights Agreements could then be sold under Rule
144.
 
 There are
accrued liquidated damages of $1,201,998 at September 30, 2009 and December 31,
2008,  Liquidated damages of $414,000 and $966,799 were accrued in the
three and nine months ended September 30, 2008, respectively.
 
 Per the
Registration Rights Agreements the Company can pay the $1,201,998 in liquidated
damages in cash or Company common stock.  The Company plans to issue
667,777 shares of the Company’s common stock in payment of the liquidated
damages based on the closing price of the Company’s common stock on October 20,
2008 of $1.80.
 
 Warrants
 
 Information
with respect to stock warrants outstanding as of September 30, 2009 is as
follows:
  Exercise Price
                  
                  Outstanding
                    December
                    31, 2008
                  
                  
                  Granted
                  
                  
                  Modified,
                    Expired or
                    Exercised
                  
                  
                  Outstanding
                    September
                    30, 2009
                  
                  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-
                  
                  
                  
                  (226,000
                  )
                  
                  
                  578,884
                  
                  10/09/2010$2.04
                  
                  
                  569,346
                  
                  
                  
                  -0-
                  
                  
                  
                  (242,040
                  )
                  
                  
                  327,306
                  
                  10/19/2010$1.63
                  
                  
                  195,000
                  
                  
                  
                  -0-
                  
                  
                  
                  -0-
                  
                  
                  
                  195,000
                  
                  6/12/2011$1.63
                  
                  
                  75,000
                  
                  
                  
                  -0-
                  
                  
                  
                  -0-
                  
                  
                  
                  75,000
                  
                  6/20/2011$1.63
                  
                  
                  -0-
                  
                  
                  
                  -0-
                  
                  
                  
                  235,583
                  
                  
                  
                  235,583
                  
                  10/19/2010$1.63
                  
                  
                  -0-
                  
                  
                  
                  97,500
                  
                  
                  
                  -0-
                  
                  
                  
                  97,500
                  
                  12/31/2011$3.26
                  
                  
                  2,061,227
                  
                  
                  
                  -0-
                  
                  
                  
                  (1,130,308
                  )
                  
                  
                  930,919
                  
                  10/09/2009$3.26
                  
                  
                  2,846,746
                  
                  
                  
                  -0-
                  
                  
                  
                  (1,256,457
                  )
                  
                  
                  1,590,289
                  
                  10/19/2009$2.61
                  
                  
                  75,000
                  
                  
                  
                  -0-
                  
                  
                  
                  -0-
                  
                  
                  
                  75,000
                  
                  11/10/2011
 
 As of
September 30, 2009 all outstanding warrants are exercisable.
 
 Modification
of Warrants
 
 On March
2, 2009, the Company entered into a Consulting Agreement with a placement agent
holding warrants to purchase 235,583 shares of the Company’s common stock at
$2.04 per share, pursuant to which, in consideration for certain consulting
services to be provided to the Company by the placement agent, the Company
agreed to (i) pay the placement agent a one-time consulting fee of $38,000, and
(ii) reduce the per share exercise price of the warrants received by the
placement agent and its designees  in connection with the private
offerings consummated by the Company in October 2007, from $2.04 to
$1.63.
 
 Pursuant
to accounting guidance regarding equity-based payments to non-employees,the Company evaluated the
value of the warrants before and after the modification to determine the
incremental change in the value of the warrants.
  16
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 15.
              Equity
      (Continued)
 
 The fair
value of the warrants as of March 2, 2009 before modification of the terms was
calculated to be $18,625.  The following assumptions were used to
calculate the fair value of the warrants:
 
 Dividend
      yield
                  
                  
                  0
                  %Expected
      volatility
                  
                  
                  114.83
                  %Risk-free
      interest rate
                  
                  
                  0.75
                  %Expected
      life
                  
                  1.58
      yearsStock
      price
                  
                  $
                  0.42Exercise
      price
                  
                  $
                  2.04
 
 The fair
value of the warrants as of March 2, 2009 after modification of the terms was
calculated to be $22,600.  The following assumptions were used to
calculate the fair value of the warrants:
 
 Dividend
      yield
                  
                  
                  0
                  %Expected
      volatility
                  
                  
                  114.83
                  %Risk-free
      interest rate
                  
                  
                  0.75
                  %Expected
      life
                  
                  1.58
      yearsStock
      price
                  
                  $
                  0.42Exercise
      price
                  
                  $
                  1.63
  The
incremental change in the value of the warrants is $22,600 less $18,625 or
$3,975, which was recorded to consulting expense.
  Warrant
Tender Offers
 
 As of
April 24, 2008, the Company commenced an offer (the “First Warrant Tender
Offer”) to the holders of the Company’s then outstanding warrants, pursuant to
which the warrant holders were entitled to tender their warrants for shares of
the Company’s 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 First Warrant Tender Offer was entitled to 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 First Warrant Tender Offer was entitled to 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 First Warrant Tender Offer was entitled to 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 First Warrant Tender Offer was entitled to exercise some or
      all of such warrants at $2.61 per share of common
  stock.
  On March
2, 2009, the Company closed on the First Warrant Tender Offer.  In
connection with the First Warrant Tender Offer:
  ·
                  A
      total of 183,457 warrants were tendered at the reduced exercise price of
      $1.63 per share (originally $2.04 per share), for an aggregate exercise
      price of $299,034; and
  ·
                A
      total of 175,937 warrants were tendered at the reduced exercise price of
      $2.61 per share (originally $3.26 per share), for an aggregate exercise
      price of $459,196.
  As a
result, (a) a total of 359,394 shares of the Company’s common stock were issued
in connection with the exercise of such warrants and (b) the Company received
gross proceeds of $758,230 as payment of the exercise prices.
  17
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 15.
              Equity
      (Continued)
 
 As of
June 19, 2009, the Company commenced an offer (the “Second Warrant Tender
Offer”) to the holders of its then outstanding warrants, pursuant to which they
may tender their warrants (“Original Warrants”) for warrants exercisable at
reduced exercise prices (“Amended Warrants”) as follows:
 
 ·
              With
      respect to warrants having an exercise price of $0.94 per share, a holder
      accepting the Second Warrant Tender Offer was entitled to exchange some or
      all of such warrants for Amended Warrants exercisable 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 Second Warrant Tender Offer was entitled to exchange some or
      all of such warrants for Amended Warrants exercisable at $1.20 per share
      of common stock;
 
 ·
              With
      respect to warrants having an exercise price of $1.63 per share, a holder
      accepting the Second Warrant Tender Offer was entitled to exchange some or
      all of such warrants for Amended Warrants exercisable at $1.30 per share
      of common stock;
  ·
              With
      respect to warrants having an exercise price of $2.04 per share, a holder
      accepting the Second Warrant Tender Offer was entitled to exchange some or
      all of such warrants for Amended Warrants exercisable 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 Second Warrant Tender Offer was entitled to exchange some or
      all of such warrants for Amended Warrants exercisable at $1.63 per share
      of common stock.
 
 On August
13, 2009, the Company closed the Second Warrant Tender Offer. In
connection with the Second Warrant Tender Offer:
 
 ·
                        a
      total of 49,000 Original Warrants with an exercise price of $2.04 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share;
and
 
 ·
                  a
      total of 2,210,828 Original Warrants with an exercise price of $3.26 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share.
 
 On August
14, 2009, the holders of the Amended Warrants exercised all 2,254,828 of the
warrants at $1.63 per share.  As a result the Company received gross
proceeds of $3,675,370.
 
 Stock
Issued for Consulting
 
 The
Company entered into an Investor Relations Consulting Agreement (the “IR
Agreement”) with an consultant, as of January 1, 2009.  Pursuant to
the IR Agreement, in consideration for investor relations services to be
provided to the Company by the consultant, the Company agreed to pay a monthly
retainer of $9,000, consisting of (i) $4,500 in cash, and (ii) such number of
shares of restricted stock of the Company to be determined by dividing $4,500 by
85% of the average closing trading price of the Company’s common stock for the
first ten trading days of the applicable month, capped at 10,588 shares per
month.
 
 On June
30, 2009, the Company issued 37,804 shares of common stock with a fair value of
$33,475 pursuant to the IR Agreement.  The fair value of the stock was
determined by the closing price of the stock on the 10th day of
each month, which is the day the number of shares is
determined.
  18
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 15.
              Equity
      (Continued)
 
 Placement
Agent Warrants
 
 On July
4, 2009, the Company agreed to issue 97,500 warrants to purchase the Company’s
common stock at $1.63 per share, expiring December 31, 2011, to a placement
agent for assistance in the extension of the June 2008 notes. The fair value of
the warrants as of July 4, 2009 was calculated to be $117,155.  The
following assumptions were used to calculate the fair value of the
warrants:
 
 Dividend
      yield
                  
                  
                  0
                  %Expected
      volatility
                  
                  
                  136.86
                  %Risk-free
      interest rate
                  
                  
                  1.68
                  %Expected
      life
                  
                  2.5
      yearsStock
      price
                  
                  $
                  1.65Exercise
      price
                  
                  $
                  1.63
 
 The
$117,155 fair value of the warrants were treated as loan costs to be amortized
over the life of the loan, therefore, $58,577 of the cost was recorded in
interest expense and the remaining $58,578 will be record in prepaid loan costs
to be amortized over the remaining life of the loan.
 
 Financial
Advisor Warrants
 
 On
September 2, 2009, the Company entered into an advisory agreement with a
financial advisor for a period commencing on September 2, 2009 and continuing
for six months.
 
 Pursuant
to the agreement, in consideration for the services to be provided to the
Company by the financial advisor, the Company agreed to (a) pay the advisor a
cash fee equal to $700,000, payable in 24 equal monthly installments, deferred
until the closing of a funding proposed financing; provided, however, that the
Company pay the advisor a non-refundable retainer of $15,000 (which was paid
9/15/09) to be deducted from the cash fee, (b) grant to the financial advisor
five-year warrants to purchase 714,286 shares of the Company’s common stock,
which are exercisable six months after September 2, 2009, subject to certain
conditions, (i) at an exercise price of $1.68 per share, or (ii) on a cashless
basis; provided, however, that all of the warrants will terminate if certain
conditions are not met, and (c) reimburse the advisor for up to an aggregate of
$35,000 of their accountable actual out-of-pocket reasonable
expenses.
 
 The
Company will record the fair value of the warrants as determined at the date of
the closing of the proposed financing when the warrants will become fully
vested.
 
 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 balance of these reserves at September 30, 2009 and December 31, 2008, was
$1,834,742 and $1,314,861, respectively. These amounts are restricted and are
included in retained earnings.
 
 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.
              Earnings
      Per Share
 
 FASB ASC
Topic 260, “Earnings Per Share,” requires a reconciliation of the numerator and
denominator of the basic and diluted earnings per share (“EPS”)
computations.
  19
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 17.
              Earnings
      Per Share (Continued)
 
 For the
three months ended September 30, 2009, dilutive shares include stock options of
703,200, outstanding warrants to purchase 373,334 shares of common stock at an
exercise price of $0.94 and outstanding warrants to purchase 1,333,333 shares of
common stock at an exercise price of $1.50. Warrants to purchase 4,105,481 share
of common stock were not included in dilutive shares as the effect would have
been anti-dilutive.
 
 For the
nine months ended September 30, 2009, dilutive shares include stock options of
703,200 and outstanding warrants to purchase 373,334 shares of common stock at
an exercise price of $0.94. Warrants to purchase 5,438,814 share of common stock
were not included in dilutive shares as the effect would have been
anti-dilutive.
 
 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.
 
 The
following reconciles the components of the EPS computation:
 
 Income
                  
                  
                  Shares
                  
                  
                  Per Share(Numerator)
                  
                  
                  (Denominator)
                  
                  
                  AmountFor
      the three months ended September 30, 2009:Net
      income
                  
                  $
                  884,625Basic
      EPS income available to common shareholders
                  
                  $
                  884,625
                  
                  
                  
                  30,844,547
                  
                  
                  $
                  0.03Effect
      of dilutive securities:Warrants
                  
                  
                  
                  
                  
                  
                  264,376Stock
      options
                  
                  
                  —
                  
                  
                  
                  522,458Diluted
      EPS income available to common shareholders
                  
                  $
                  884,625
                  
                  
                  
                  31,631,381
                  
                  
                  $
                  0.03For
      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
                  
                  
                  $
                  0.03
 
 Income
                  
                  
                  Shares
                  
                  
                  Per Share(Numerator)
                  
                  
                  (Denominator)
                  
                  
                  AmountFor
      the nine months ended September 30, 2009:Net
      income
                  
                  $
                  3,700,467Basic
      EPS income available to common shareholders
                  
                  $
                  3,700,467
                  
                  
                  
                  29,979,356
                  
                  
                  $
                  0.12Effect
      of dilutive securities:Warrants
                  
                  
                  
                  
                  
                  
                  88,022Stock
      options
                  
                  
                  —
                  
                  
                  
                  361,646Diluted
      EPS income available to common shareholders
                  
                  $
                  3,700,467
                  
                  
                  
                  30,429,024
                  
                  
                  $
                  0.12For
      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
                  
                  
                  $
                  0.05
  20
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 18.
              Equity
      Incentive Plan
 
 In March
2009, the Company’s board of directors and majority stockholders adopted the
Emerald Dairy Inc. 2009 Equity Incentive Plan (the “Plan”) to attract and retain
the best available personnel, provide additional incentives to employees,
directors and consultants and promote the success of the Company’s business.
1,500,000 shares of the Company’s common stock have been reserved for issuance
under the Plan.
 
 Eligibility
 
 The
Company may grant awards to its employees, directors and consultants, including
those of the Company’s subsidiaries. However, the Company may grant options that
are intended to qualify as incentive stock options (“ISOs”) only to its
employees and employees of its subsidiaries.
 
 Acceleration of Awards upon
Corporate Transactions.
 
 The
outstanding awards will terminate and/or accelerate upon occurrence of certain
significant corporate transactions, including amalgamations, consolidations,
liquidations or dissolutions, sales of substantially all or all of the Company’s
assets, reverse takeovers or acquisitions resulting in a change of
control.
 
 Exercise Price and Term of
Awards.
 
 In
general, the plan administrator will determine the exercise price of an option
in the award agreement. The exercise price may be a fixed price, or it may be a
variable price related to the fair market value of the Company’s ordinary
shares. If the Company grants an ISO to an employee, the exercise price may not
be less than 100% of the fair market value of its common stock on the date of
the grant, except that if the grantee, at the time of that grant, owns shares
representing more than 10% of the voting power of all classes of the Company’s
shares of common stock, the exercise price may not be less than 110% of the fair
market value of its common stock on the date of that grant. If the Company
grants a non-qualified share option to a grantee, the exercise price may not be
less than 100% of the fair market value of its common stock on the date of
grant.
 
 The term
of each award under the Plan will be specified in the award agreement, but may
not exceed ten years from the earlier of the adoption or the approval of the
plan, unless sooner terminated.
 
 Total
share-based compensation costs included on the Condensed Consolidated Statements
of Income were $49,764 and none during the three months ended September 30, 2009
and 2008, respectively, and $125,452 and none during the nine months ended
September 30, 2009 and 2008, respectively. All share-based compensation costs
are included in selling expenses and administrative expenses.
  The
Company estimates the fair value of stock options using a Black-Scholes option
pricing valuation model, consistent with accounting guidance. Key inputs and
assumptions used to estimate the fair value of stock options include the grant
price of the award, the expected option term, volatility of the Company’s stock,
the risk-free rate and the Company’s dividend yield. Estimates of fair value are
not intended to predict actual future events or the value ultimately realized by
grantees, and subsequent events are not indicative of the reasonableness of the
original estimates of fair value made by the Company.
  21
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 18.
              Equity
      Incentive Plan (Continued)
 
 The fair
value of each stock option is estimated on the date of the grant using the
Black-Scholes option pricing model. No dividends were assumed due to the nature
of the Company’s current business strategy. The following table presents the
weighted average assumptions used for options granted:
 
 Number
      of options
                      
                      
                      703,200Risk
      free interest rate
                      
                      
                      .67
                      %Expected
      life (year)
                      
                      
                      2Expected
      volatility
                      
                      
                      252.69
                      %Weighted
      average fair value per option
                      
                      $
                      0.34
 
 The risk
free interest rate was determined from the daily interest rate of United State
Treasury securities for the expected life on the date of grant.  The
expected volatility was based on the Company’s common stock past trading
history.
 
 Share
Options
 
 A summary
of the Company’s outstanding share option award grants as of September 30, 2009
and changes during the nine months then ended are presented below:
 
 Shares
                        
                        Weighted-Average
                          Exercise Price
                        
                        Weighted-Average
                          Remaining Contractual
                          Term
                        
                        Aggregate
                          Intrinsic Value(in years)
                        
                        (in millions)Outstanding
      at December 31,2008
                        
                        -0-
                        
                        $
                        —Granted
                        
                        703,200
                        
                        
                        0.42Exercised
                        
                        -0-
                        
                        
                        —Expired
                        
                        -0-
                        
                        
                        —Forfeited
                        
                        -0-
                        
                        
                        —Outstanding
      at September 30, 2009
                        
                        703,200
                        
                        $
                        0.42
                        
                        9.42
                        
                        $
                        794,616Non-vested
      and expected to vest at September 30, 2009
                        
                        527,400
                        
                        $
                        0.42
                        
                        9.42
                        
                        $
                        —Exercisable
      at September 30, 2009
                        
                        175,800
                        
                        $
                        0.42
                        
                        9.42
                        
                        $
                        —
 
 As of
September 30, 2009, there was $112,935 of total unrecognized compensation
costs related to non-vested Company share options granted under Company share
option plans. The cost is expected to be recognized over a weighted-average
period of 1.03 years.
 
 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.
  22
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 19.
              Commitments
      and Contingencies (Continued)
 
 The
Company has contracted for construction of a second production facility in
Hailun City, Heilongjiang Province, PRC.  The contract is for
$8,437,093 of which $6,568,948 has been paid.  The remaining
$1,868,145 is to be paid in 2009 for completion of the facility.
 
 The
Company has contracted to purchase equipment from a supplier for the second
processing facility for $5,301,554 of which $3,711,088 has been
paid.  The remaining $1,590,466 will be paid on delivery of the
equipment in 2009.
 
 The
Company has advances to milk suppliers of $332,783 which will be offset against
future milk purchases from those suppliers (see Note 6, Other current
assets).
 
 In order
for the Company to conduct its current operations, a milk powder production
license is required from the State General Administration of Quality Supervision
and Inspection and Quarantine of the PRC (the “Administration”). The Company’s
current license expires in May 2010. The Administration will inspect the quality
of the Company’s production process in 2010. Depending on the results of this
inspection, the State General Administration will either (i) grant the Company a
license renewal, or (ii) advise the Company of material deficiencies it has
discovered and schedule another inspection for 2011. The Company expects that it
will pass the inspection. If it does not, it will have an opportunity to cure
any deficiencies prior to the follow up inspection that would have been
scheduled for 2011. Other than the foregoing, no government approvals are
required to conduct the Company’s principal operations, and the Company is not
aware of any probable governmental regulation of its 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.
 
 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.
 
 The
Company’s employees were required to pay an employee deposit upon commencement
of employment, which was standard in the PRC. As of January 1, 2009, these
deposits are no longer allowed in the PRC and all amounts were returned to the
employees. As of December 31, 2008, the Company held employee deposits in the
aggregate amount of  $248,424 which were reflected in advances from
employees in the financials statements.
 
 20.
              Operating
      Leases
 
 The
Company leases various distribution facilities. All leases are on an annual
basis and commence on January 1, of each year. The Company also leases office
space which expires September 2010.  For the three months ended
September 30, 2009 and 2008, the Company incurred rental expense of $39,518 and
$30,811, respectively. For the nine months ended September 30, 2009 and 2008,
the Company incurred rental expense of $117,927 and $94,771, respectively. As of
September 30, 2009, the Company had outstanding lease commitments totaling
$39,335, all of which are due within the next year.
  23
  Emerald
Dairy Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 September
30, 2009 and 2008
 
 21.
              Subsequent
      Events
 
 In May
2009, the FASB issued accounting guidance now codified as FASB ASC Topic 855,
“Subsequent Events,” which establishes general standards of accounting for, and
disclosures of, events that occur after the balance sheet date but before
financial statements are issued or are available to be issued. FASB ASC Topic
855 is effective for interim or fiscal periods ending after June 15,
2009.
 
 Management
has evaluated subsequent events from September 30, 2009 to November 16, 2009,
the date which the Company’s financial statements have been issued and were
available to be issued, and has concluded the following events should be
reported during this period.  Subsequent events that may occur after
November 16, 2009 have not been evaluated in the financial statements as of
September 30, 2009.
 
 On
November 10, 2009, the Company amended the outstanding $500,000 note payable,
which was due to be paid on November 10, 2009, to extend its due date to May 10,
2010.  In connection with the amendment of the notes payable the
Company issued to the note holder warrants to purchase 100,000 shares of the
Company’s common stock, exercisable at $1.63 per share.  The fair
value of these warrants will be treated as additional loan discount an amortized
over the remaining life of the note.
 
 22.
              Segment
      Reporting
 
 The
Company operates in one operating segment in accordance with the provisions
accounting guidance regarding segment reporting. 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.The Company
determines its operating segments in accordance with FASB ASC Topic 280,
“Segment Reporting.”
 
 For the
three and nine months ended September 30, 2009 and 2008, the Company’s sales
revenue from various products are as follows:
 
 Three Months
                    Ended September 30,
                  
                  
                  Nine Months
                    Ended September 30,2009
                  
                  
                  2008
                  
                  
                  2009
                  
                  
                  2008Milk
      powder
                  
                  $
                  8,922,796
                  
                  
                  $
                  9,362,555
                  
                  
                  $
                  27,318,421
                  
                  
                  $
                  26,144,060Soybean
      milk powder
                  
                  
                  267,138
                  
                  
                  
                  221,124
                  
                  
                  
                  822,026
                  
                  
                  
                  644,233Rice
      powder
                  
                  
                  319,942
                  
                  
                  
                  275,722
                  
                  
                  
                  954,482
                  
                  
                  
                  813,645Sub-contract
      processing
                  
                  
                  648,128
                  
                  
                  
                  1,361,618
                  
                  
                  
                  2,166,562
                  
                  
                  
                  4,958,318$
                  10,158,004
                  
                  
                  $
                  11,221,019
                  
                  
                  $
                  31,261,491
                  
                  
                  $
                  32,560,256
  24


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 95%, 3% and 2%of our sales,
respectively. Through our network of over 800 salespeople, our products are
distributed throughout 20 provinces in the People’s Republic of China (“PRC”),
and sold in over 5,800 retail outlets.





Our
products are marketed under two brand names:





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




·
            “Yi
      Bai,” which is designed for middle and low-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 the
PRC 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 an annual rate of approximately 23%
through 2011. Currently, it is estimated that demand for infant formula in the
PRC 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 the PRC.





Because
of our close proximity to our sources of fresh milk, we are able to complete the
production process in approximately 30 – 35 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 produced
approximately 9,000 tons of milk powder.


25


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 we expect will enable us to
produce an additional 9,000 tons of milk powder in 2010 and a total of 18,000
tons of milk powder annually in 2011. As a result, between our existing
production facility in Be’ian City and our new production facility in Hailun
City, we believe we will have the capacity to produce approximately 27,000 tons
of milk powder per year by the end of fiscal 2011. It is expected that our
production of rice powder and soymilk powder will also increase in volume over
the same period, while continuing to comprise an aggregate of approximately 5%
of our overall sales.





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 Rule 405 of the
Securities Act of 1933 and Rule 12b-2 of the Securities Exchange Act of 1934,
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, (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 shares 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
Resource — Warrants” below.


26


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). Prior to
the termination of the Put/Call Agreements on March 3, 2009, we had the right to
repurchase an aggregate of 1,944,444 shares of our common stock from the
Put/Call Shareholders under certain circumstances, and the Put/Call Shareholders
had 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”).





As of
March 2, 2009, an aggregate of 183,457 of the Class A Warrants and 175,937 of
the Class B Warrants were tendered at reduced exercise prices, as further
described in “— Recent Developments — First Warrant Tender Offer” below. On
August 13, 2009, an aggregate of 49,000 Class A Warrants and 2,205,828 Class B
Warrants were exchanged for warrants with reduced exercise prices and, as of
August 14, 2009, all of the warrants were exercised, as further described in “—
Recent Developments — Second Warrant Tender Offer” below.





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 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
those of the Class A Warrants. On March 2, 2009, the exercise prices of 235,583
of these warrants were reduced from $2.04 to $1.63, as partial consideration for
services rendered in connection with a consulting agreement we entered into with
one of these parties.





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 of a production facility to be
located in Hailun City, Heilongjiang Province, PRC. Initially, the new facility
will have one production line, which will have the capacity to produce 9,000
tons of milk power annually. The new facility will have the capacity to
accommodate a second production line, which, if and when completed, would enable
us to produce an additional 9,000 tons of milk powder per year, giving us a
total annual production capacity at all of our production facilities of 27,000
tons of milk powder. We anticipate that production at this new facility will
commence in the fourth quarter of fiscal 2009, assuming we obtain the additional
$3.0 million we require to complete construction and equipping of the first
production line. We believe that the cost to add the second production line
would be approximately an additional $15.0 million. We plan to raise the funds
needed for the new facility from the capital market through private or public
equity and/or debt offerings. There can be no assurance that that any additional
financing will become available to us, and if available, on terms acceptable to
us.


27





Sale
of Notes and Warrants





June
Note Offering





In June
2008, we conducted a private offering of up to a maximum of (i) $3,000,000 of
our 8% promissory notes (the “June 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, a June 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, a June Note in the principal amount
of $750,000, and June Warrants to purchase 75,000 shares of our common stock. As
of December 31, 2008, certain of the terms of the June Notes and June Warrants
were amended. The rights and obligations under the June Notes, as amended, are
further described in “— Liquidity and Capital Resources — Promissory Notes”
below. The rights and obligations under the June Warrants, as amended, 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, as amended as of December 31, 2008. In addition, as of
July 4, 2009, we granted the same placement agent warrants to purchase an
additional 97,500 shares of our common stock in consideration for its services
in connection with the amendment of the June Notes and June Warrants as of
December 31, 2008. The rights and obligations under these additional warrants
are further described in “— Liquidity and Capital Resources — Warrants”
below.





November
Note Offering





On
November 10, 2008, we sold to one “accredited investor” (the “November
Noteholder”) for a purchase price of $500,000, a 10% promissory note (the
“November 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”). As of November 10, 2009,
certain of the terms of the November Note were amended. The rights and
obligations under the November Note, as amended, 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 addition, as of November
10, 2009, we granted the November Noteholder additional warrants to purchase
100,000 shares of our common stock in consideration for amending the November
Note. The rights and obligations under these additional 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 those of the November
Warrants.





First
Warrant Tender Offer





As of
April 24, 2008, we commenced an offer (the “First Warrant Tender Offer”) to the
holders of our then outstanding warrants, pursuant to which the holders had the
opportunity to exchange their existing warrants for amended warrants to be
exercised at reduced exercise prices as follows:


28








·
            with
      respect to eligible warrants having an exercise price of $0.94 per share,
      a holder accepting the First Warrant Tender Offer could exercise some or
      all of the amended warrants at $0.75 per share of common
      stock;




·
            with
      respect to eligible warrants having an exercise price of $1.50 per share,
      a holder accepting the First Warrant Tender Offer could exercise some or
      all of the amended warrants at $1.20 per share of common
      stock;




·
            with
      respect to eligible warrants having an exercise price of $2.04 per share,
      a holder accepting the First Warrant Tender Offer could exercise some or
      all of the amended warrants at $1.63 per share of common stock;
      and




·
            with
      respect to eligible warrants having an exercise price of $3.26 per share,
      a holder accepting the First Warrant Tender Offer could exercise some or
      all of the amended warrants at $2.61 per share of common
      stock.




On March
2, 2009, we closed the First Warrant Tender Offer. In connection with the First
Warrant Tender Offer:





·
            a
      total of 183,457 warrants were tendered at the reduced exercise price of
      $1.63 per share (originally $2.04 per share), for an aggregate exercise
      price of $299,035; and




·
            a
      total of 175,937 warrants were tendered at the reduced exercise price of
      $2.61 per share (originally $3.26 per share) for an aggregate exercise
      price of $459,196.




As a
result, we received gross proceeds of $758,231 and issued an aggregate of
359,394 shares of our common stock.





Second
Warrant Tender Offer





As of
June 19, 2009, we commenced an offer (the “Second Warrant Tender Offer”) to all
holders of warrants to purchase shares of our common stock, having exercise
prices of either $0.94, $1.50, $1.63, $2.04 or $3.26 per share, originally
issued in connection with the October Offerings (the “Original Warrants”), the
opportunity to voluntarily exchange any or all of the Original Warrants for
amended warrants exercisable at reduced exercise prices (“Amended Warrants”),
for a limited period of time.





The terms
of the Amended Warrants, included the following:





·
            with
      respect to the 373,344 warrants having an exercise price of $0.94 per
      share, a holder accepting the Second Warrant Tender Offer was entitled to
      exchange some or all of the warrants for amended warrants exercisable at
      $0.75 per share;




·
            with
      respect to the 1,333,333 warrants having an exercise price of $1.50 per
      share, a holder accepting the Second Warrant Tender Offer was entitled to
      exchange some or all of the warrants for amended warrants exercisable at
      $1.20 per share;




·
            with
      respect to the 235,583 warrants having an exercise price of $1.63 per
      share, a holder accepting the Second Warrant Tender Offer was entitled to
      exchange some or all of the warrants for amended warrants exercisable at
      $1.30 per share;




29




·
            with
      respect to the 955,190 warrants having an exercise price of $2.04 per
      share, a holder accepting the Second Warrant Tender Offer was entitled to
      exchange some or all of the warrants for amended warrants exercisable at
      $1.63 per share; and




·
            with
      respect to the 4,732,036 warrants having an exercise price of $3.26 per
      share, a holder accepting the Second Warrants Tender Offer was entitled to
      exchange some or all of the warrants for amended warrants exercisable at
      $1.63 per share.




On August
13, 2009, we closed the Second Warrant Tender Offer. In connection with the
Second Warrant Tender Offer:





·
            a
      total of 49,000 Original Warrants with an exercise price of $2.04 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share; and




·
            a
      total of 2,205,828 Original Warrants with an exercise price of $3.26 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share.




On August
14, 2009, the warrant holders that participated in the Second Warrant Tender
Offer exercised all of the 2,254,828 Amended Warrants they received in
connection therewith, at an exercise price of $1.63 per share. As a result, we
received gross proceeds of $3,675,370.





Adoption
of 2009 Equity Incentive Plan





On March
2, 2009, our board of directors adopted and our stockholders approved our 2009
Equity Incentive Plan (the “Plan”) to attract and retain the best available
personnel, provide additional incentives to employees, directors and consultants
and promote the success of our business. A total of 1,500,000 shares of our
common stock have been reserved for issuance under the Plan.





Following
the adoption of the Plan, we granted an aggregate of 703,200 non-qualified,
ten-year stock options to our executive officers and directors (the “March
Options”).Each
of the March Options has an exercise price of $0.42 per share, which was the
closing price of our common stock on the Over-the-Counter Bulletin Board
(“OTCBB”) on March 2, 2009, the date on which the March Options were
granted. The exercise price of the March Options may be exercised on a
“cashless” basis and are subject to such other provisions as are contained in
the Plan.





On
November 10, 2009, we granted non-qualified, ten-year stock options (the
“November Options”) to purchase 380,000 shares of our common stock to one of our
executive officers. The November Options have an exercise price of $1.80 per
share, which was the closing price of our common stock on the OTCBB on November
9, 2009. The November Options may be exercised on a “cashless” basis and are
subject to such other provisions as are contained in the Plan.





On
November 10, 2009, we also granted share appreciation rights (the “SARs”) with
respect to 380,000 shares of our common stock to one of our executive officers.
The SARs have an exercise price of $1.80 per share, which was the closing price
of our common stock on the OTCBB on November 9, 2009. The SARs have a term of
ten (10) years from the date of grant. The SARs are subject to such other
provisions as are contained in the Plan.


30


Payment
of 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 with the investors in the
October Offerings (the “Investors”). Pursuant to the Registration Rights
Agreements, we were required to pay liquidated damages to the Investors, if we
failed to satisfy certain registration requirements, as further described in “—
Liquidity and Capital Resources — Registration Rights and Liquidated Damages”
below. As a result of our failure to satisfy the registration requirements, we
accrued a total of $1,201,998 in liquidated damages through October 19, 2008,
the date the shares purchased in the October Offerings became eligible for sale
pursuant to Rule 144 under the Securities Act. Pursuant to the Registration
Rights Agreement, the liquidated damages were payable in cash or shares of our
common stock, at our discretion. As of October 5, 2009, in full payment of the
liquidated damages, we issued an aggregate of 667,777shares of our common
stock to the Investors, valued at $1.80 per share, the closing price on the
OTCBB on October 20, 2008. In addition, pursuant to the Registration Rights
Agreements, if we failed to pay any liquidated damages in full within seven days
after the date payable, we were required to pay interest thereon at a rate of
15% per annum until such amounts, plus all such interest thereon, are paid in
full. Therefore, as of October 5, 2009, we paid interest in the aggregate amount
of approximately $172,900, by issuing an aggregate of 108,056 additional shares
of our common stock, valued at $1.60 per share, the closing price of our common
stock on the OTCBB on October 2, 2009.





Trends
and Uncertainties





Economic
Downturn





The
recent worldwide economic downturn and market instability have made the business
climate more volatile and more costly. Although all of our business operations
are currently conducted in the PRC, our general business strategy may be
adversely affected by unpredictable and unstable market conditions. If the
current equity and credit markets deteriorate further, or do not improve, it may
make any necessary debt or equity financing more difficult, more costly, and
more dilutive. Failure to secure any necessary financing in a timely manner and
on favorable terms could have a material adverse effect on our growth strategy,
financial performance and stock price and could require us to delay or abandon
our expansion plans.





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 of its populous, the government views increased dairy production
as a means of improving employment in rural areas thus improving social
stability. The programs are designed to narrow the significant gap between the
PRC’s per capita milk consumption of 15 kg per person and the global average of
100 kg per person.





Industry
Growth





The dairy
market today in the PRC is over $13.0 billion. According to the website of China
National Bureau of Statistics, between 2000 and 2007 the dairy industry in the
PRC 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 the
PRC is projected to grow at rate of 15% per year from 2008 to 2012, to reach
$32.0 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 the
      PRC;


31


·
            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 the PRC outstrips supply by at
least 2-to-1. In recent years, our production capabilities have not been able to
keep up with demand for our products. We have commenced construction of a new
production facility in Hailun City with an initial annual production capacity of
9,000 tons of milk powder, which is expected to start production in the fourth
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. We have
applied 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 from the First Warrant Tender Offer, further described in
“— Recent Developments – First Warrant Tender Offer” above, and Second Warrant
Tender Offer, further described in “— Recent Developments – Second Warrant
Tender Offer” above toward the construction of this new production facility. We
have no additional commitments for the additional $3.0 million we expect to need
to complete the equipping of the first production line at our new production
facility. There can be no assurance that that any additional financing will
become available to us, and if available, on terms acceptable to
us.





Product
Pricing and Raw Material Supply





Historically
we have been able to obtain sufficient raw milk and other raw materials to meet
our production needs. The price of raw milk is affected by regional market in
Heilongjiang Province, PRC, 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 for the foreseeable future. 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 believe 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 the PRC. Most of our
international and larger competitors 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 in the industry, including us, have been focusing
on less developed second and third tier 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.


32


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 2010. 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 the PRC. 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.




Contamination
of Milk Powder Products Produced in the PRC





In
mid-2008, a number of milk powder products produced within the PRC 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 the PRC. 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 the PRC, thereby
having a material adverse effect on our business.


33


Results
of Operations





Three-Month
Period Ended September 30, 2009 Compared to Three-Month Period Ended September
30, 2008





Net
income increased by $76,558, from $808,067 in the three months ended September
30, 2008, to $884,625 for the three months ended September 30, 2009. The
increase in net income during the three months ended September 30, 2009, as
compared to the same time period in the prior year, was due to a decrease in
interest expense, which offset a decrease in our gross profit as further
described below.





Sales
and Cost of Goods Sold





For the Three Months
                    Ended September 30,2009
                  
                  
                  2008Sales
                  
                  $
                  10,158,004
                  
                  
                  $
                  11,221,019Cost
      of Goods Sold
                  
                  
                  5,569,598
                  
                  
                  
                  6,552,835Gross
      Profit
                  
                  $
                  4,588,406
                  
                  
                  $
                  4,668,184





Sales. Sales volume decreased
by 385 metric tons, or 16.4%, period on period, to 1,958 metric tons for the
three months ended September 30, 2009, from 2,343 metric tons for the three
months ended September 30, 2008. Sales revenues decreased by $1,063,015, or
9.5%, from $11,221,019 in the three months ended September 30, 2008, to
$10,158,004 for the three months ended September 30, 2009. This decrease was
primarily due to the decrease in subcontracting during three months ended
September 30, 2009, as we continued to adjust our sales mix to focus on higher
margin products in fiscal 2009.





Sales by product
line.A break-down of our sales by product line for the three
months ended September 30, 2009 and 2008 is as follows:





Three Months Ended September 30,2009
                    
                    
                    2008
                    
                    
                    Period-on-periodProduct category
                    
                    Quantity
                      (tons)
                    
                    
                    $ Amount
                    
                    
                    % of sales
                    
                    
                    Quantity
                      (tons)
                    
                    
                    $ Amount
                    
                    
                    % of
                      sales
                    
                    
                    Qty.
                      VarianceMilk
      powder
                    
                    
                    1,421
                    
                    
                    
                    8,922,796
                    
                    
                    
                    87.9
                    
                    
                    
                    1,621
                    
                    
                    
                    9,362,555
                    
                    
                    
                    83.4
                    
                    
                    
                    (200
                    )Rice
      powder
                    
                    
                    56
                    
                    
                    
                    319,942
                    
                    
                    
                    3.1
                    
                    
                    
                    50
                    
                    
                    
                    275,722
                    
                    
                    
                    2.5
                    
                    
                    
                    6Soybean
      powder
                    
                    
                    163
                    
                    
                    
                    267,138
                    
                    
                    
                    2.6
                    
                    
                    
                    120
                    
                    
                    
                    221,125
                    
                    
                    
                    2.0
                    
                    
                    
                    43Subcontracting
                    
                    
                    318
                    
                    
                    
                    648,128
                    
                    
                    
                    6.4
                    
                    
                    
                    552
                    
                    
                    
                    1,361,617
                    
                    
                    
                    12.1
                    
                    
                    
                    (234
                    )Total
                    
                    
                    1,958
                    
                    
                    
                    10,158,004
                    
                    
                    
                    100.0
                    
                    
                    
                    2,343
                    
                    
                    
                    11,221,019
                    
                    
                    
                    100.0
                    
                    
                    
                    (385
                    )





There
were various changes to the break-down of sales among our product lines over the
three months ended September 30, 2009, as we attempted to adjust our sales mix
to higher margin products, and away from subcontracting. Rice powder
accounted for 3.1% of our sales mix for the three months ended September 30,
2009, at an average selling price of $5,713 per metric ton, as compared to 2.5%
of our sales mix in the three months ended September 30, 2008, at an average
selling price of $5,546 per metric ton. Soybean powder accounted for 2.6%
of our sales mix for the three months ended September 30, 2009, at an average
selling price of $1,639 per metric ton, as compared to 2.0% of our sales mix in
the three months ended September 30, 2008, at an average selling price of $1,840
per metric ton. Milk powder accounted for 87.9% of the third quarter 2009 sales
mix, at an average selling price of $6,279 per metric ton, as compared to 83.4%
of third quarter 2008, at an average selling price of $5,778 per metric ton. We
decreased our subcontract production during the three months ended September 30,
2009 to 6.4% of the sales mix, at an average selling price of $2,038 per metric
ton, as compared to 12.1% of the sales mix in the three months ended September
30, 2008, at an average sales price of $2,465 per metric ton.


34


A
breakdown of our average selling price by product line for the three months
ended September 30, 2009 and 2008 is as follows:




Three Months Ended
                    September 30,Average selling prices
                  
                  2009
                  
                  
                  2008
                  
                  
                  Variance$
                  
                  
                  $
                  
                  
                  $
                  
                  
                  %Milk
      powder
                  
                  
                  6,279
                  
                  
                  
                  5,778
                  
                  
                  
                  501
                  
                  
                  
                  8.7Rice
      powder
                  
                  
                  5,713
                  
                  
                  
                  5,546
                  
                  
                  
                  167
                  
                  
                  
                  3.0Soybean
      powder
                  
                  
                  1,639
                  
                  
                  
                  1,840
                  
                  
                  
                  (201
                  )
                  
                  
                  (10.9
                  )Subcontracting
                  
                  
                  2,038
                  
                  
                  
                  2,465
                  
                  
                  
                  (427
                  )
                  
                  
                  (17.3
                  )Total
                  
                  
                  5,188
                  
                  
                  
                  4,790
                  
                  
                  
                  398
                  
                  
                  
                  8.3





Cost of Goods
Sold.  Cost of goods sold decreased by $983,237, or 15.0%, from
$6,552,835 in the three months ended September 30, 2008, to $5,569,598 for the
three months ended September 30, 2009. This decrease was directly related to our
reduction in subcontracting work during the three months ended September 30,
2009. Overall our cost per metric ton increased by $48, or 1.7%, to $2,845 per
metric ton in the three months ended September 30, 2009, as compared to $2,797
per metric ton in three months ended September 30, 2008, due to increases in the
prices of raw materials we use to produce our products.





A
breakdown of cost of sales by product line for the three months ended September
30, 2009 and 2008 is as follows:




Three Months Ended September
      30,2009
                  
                  
                  2008
                  
                  
                  Variance$
                  
                  
                  $
                  
                  
                  $
                  
                  
                  %Cost
      of salesMilk
      powder
                  
                  
                  4,511,008
                  
                  
                  
                  5,201,835
                  
                  
                  
                  (690,827
                  )
                  
                  
                  (13.3
                  )Rice
      powder
                  
                  
                  125,467
                  
                  
                  
                  89,718
                  
                  
                  
                  35,749
                  
                  
                  
                  39.8Soybean
      powder
                  
                  
                  185,513
                  
                  
                  
                  148,324
                  
                  
                  
                  37,189
                  
                  
                  
                  25.1Subcontracting
                  
                  
                  747,610
                  
                  
                  
                  1,112,958
                  
                  
                  
                  (365,348
                  )
                  
                  
                  (32.8
                  )Total
                  
                  
                  5,569,598
                  
                  
                  
                  6,552,835
                  
                  
                  
                  (983,237
                  )
                  
                  
                  (15.0
                  )Cost
      per units sold(per ton)Milk
      powder
                  
                  
                  3,175
                  
                  
                  
                  3,209
                  
                  
                  
                  (34
                  )
                  
                  
                  (1.1
                  )Rice
      powder
                  
                  
                  2,240
                  
                  
                  
                  1,794
                  
                  
                  
                  446
                  
                  
                  
                  24.9Soybean
      powder
                  
                  
                  1,138
                  
                  
                  
                  1,236
                  
                  
                  
                  (98
                  )
                  
                  
                  (7.9
                  )Subcontracting
                  
                  
                  2,351
                  
                  
                  
                  2,016
                  
                  
                  
                  335
                  
                  
                  
                  16.6Average
      cost per unit sold
                  
                  
                  2,845
                  
                  
                  
                  2,797
                  
                  
                  
                  48
                  
                  
                  
                  1.7





Gross Profit. Gross profit was
$4,588,406, or 45.2% of our sales for the three months ended September 30, 2009,
as compared to gross profit of $4,668,184, or 41.6%, for the three months ended
September 30, 2008. During the three months ended September 30, 2009, our gross
margin on milk powder increased to 49.4%, from 44.4% in the same period of the
prior year, due to an increase in the average sales price of 8.7%, while there
was a 1.1% decrease in the cost per metric ton from the three months ended
September 30, 2008. The gross margin for soybean powder decreased 2.3% to
30.6% in the three months ended September 30, 2009, as compared to 32.9% in the
three months ended September 30, 2008, primarily due to lower sales prices at
which we sold certain of our soybean products in the three months ended
September 30, 2009, as compared to the same period in 2008.


35


A
breakdown of gross margin by product line for the three months ended September
30, 2009 and 2008 is as follows:




Three Months Ended September
      30,2009
                  
                  
                  2008
                  
                  
                  Period-on-periodProduct category
                  
                  $ Amount
                  
                  
                  Gross
                    Margin %
                  
                  
                  $ Amount
                  
                  
                  Gross
                    Margin %
                  
                  
                  Margin
                    VarianceMilk
      powder
                  
                  
                  4,411,788
                  
                  
                  
                  49.4
                  
                  
                  
                  4,160,720
                  
                  
                  
                  44.4
                  
                  
                  
                  5.0Rice
      powder
                  
                  
                  194,475
                  
                  
                  
                  60.8
                  
                  
                  
                  186,004
                  
                  
                  
                  67.5
                  
                  
                  
                  (6.7
                  )Soybean
      powder
                  
                  
                  81,625
                  
                  
                  
                  30.6
                  
                  
                  
                  72,801
                  
                  
                  
                  32.9
                  
                  
                  
                  (2.3
                  )Subcontracting
                  
                  
                  (99,482
                  )
                  
                  
                  (15.3
                  )
                  
                  
                  248,659
                  
                  
                  
                  18.3
                  
                  
                  
                  (33.6
                  )Total
                  
                  
                  4,588,406
                  
                  
                  
                  45.2
                  
                  
                  
                  4,668,184
                  
                  
                  
                  41.6
                  
                  
                  
                  3.6





Operating
Expenses





For the Three Months
                    Ended September
      30,2009
                  
                  
                  2008Operating
      ExpensesSelling
      and administrative expenses
                  
                  $
                  3,348,522
                  
                  
                  $
                  3,319,484Depreciation
      and amortization
                  
                  
                  43,595
                  
                  
                  
                  41,905Total
      operating expenses
                  
                  $
                  3,392,117
                  
                  
                  $
                  3,361,389





Selling Expenses. Selling
expenses increased by $34,505, or 1.4%, from $2,452,994 in the three months
ended September 30, 2008, to $2,487,499 for the three months ended September 30,
2009. The major factors in the increase in selling expenses are:





·
            Promotion
      and advertising expenses increased by $155,460, or 16.4%, to $1,100,838 in
      2009, from $945,378 in 2008, as we slightly increased our marketing in
      2009 as compared to 2008.





·
            Product
      promoter salaries increased by $43,730, or 124.5%, to $78,844 in 2009,
      from $35,114 in 2008, as a result increased marketing efforts in 2009 as
      compared to 2008.





These
increases were partially offset by transportation costs decreasing by $39,535,
or 14.1%, to $240,265 in 2009, from $279,800 in 2008.





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





Administrative Expenses.
Administrative expenses decreased by $5,467, or 0.6%, from $866,490 in three
months ended September 30, 2008, to $861,023 for the three months ended
September 30, 2009. The primary reason for this decrease was that we incurred
liquidated damages of $414,000 in the three months ended September 30, 2008, as
a result of our failure to satisfy requirements to register shares of our common
stock, but did not incur liquidated damages in the comparable period in 2009.
The decrease in liquidated damages was partially offset by an increase in legal
and accounting expenses of $129,708, or 121.0%, to $236,921 in 2009, from
$107,213 in 2008, due to increased costs related to public company reporting
requirements as compared to 2008.


36


Provision
for Income Taxes





For the Three Months
                    Ended September
      30,2009
                  
                  
                  2008Provision
      for Income TaxesCurrent
                  
                  $
                  245,054
                  
                  
                  $
                  269,666Deferred
                  
                  
                  —
                  
                  
                  
                  —$
                  245,054
                  
                  
                  $
                  269,666





Provision for Income Taxes.
Income taxes decreased by $24,612, or 9.1%, from $269,666 for the three months
ended September 30, 2008, to $245,054 for the three months ended September 30,
2009. This increase was due to the increase in our taxable income in our
operating subsidiaries.





Nine-Month
Period Ended September 30, 2009 Compared to Nine-Month Period Ended September
30, 2008





The
following summarizes changes in our operations for the nine months ended
September 30, 2009 and 2008.  Net income increased by $2,191,232, from
$1,509,235 in the nine months ended September 30, 2008, to $3,700,467 for the
nine months ended September 30, 2009. The increase in net income during the nine
months ended September 30, 2009, as compared to the same time period in the
prior year, was due an increase in gross profit as further described
below.





Sales
and Cost of Goods Sold





For the Nine
      months
                    Ended September
      30,2009
                  
                  
                  2008Sales
                  
                  $
                  31,261,491
                  
                  
                  $
                  32,560,256Cost
      of Goods Sold
                  
                  
                  17,057,583
                  
                  
                  
                  19,845,232Gross
      Profit
                  
                  $
                  14,203,908
                  
                  
                  $
                  12,715,024





Sales. Sales volume decreased
by 774 metric tons, or 11.4%, period on period, to 5,987 metric tons for the
nine months ended September 30, 2009, from 6,761 metric tons for the nine months
ended September 30, 2008. Sales revenues decreased by $1,298,765, or 4.0%,
from $32,560,256 in the nine months ended September 30, 2008, to $31,261,491 for
the nine months ended September 30, 2009. This decrease was primarily due to a
decrease in subcontracting revenue, as compared to the nine months ended
September 30, 2008, as we shifted our sales mix to produce more of our higher
margin product line in fiscal 2009.


37


Sales by product
line.A break-down of our sales by product line for the nine
months ended September 30, 2009 and 2008 is as follows:





Nine months Ended September 30,2009
                    
                    
                    2008
                    
                    
                    Period-on-periodProduct category
                    
                    Quantity
                      (tons)
                    
                    
                    $ Amount
                    
                    
                    % of sales
                    
                    
                    Quantity
                      (tons)
                    
                    
                    $ Amount
                    
                    
                    % of
                      sales
                    
                    
                    Qty.
                      VarianceMilk
      powder
                    
                    
                    4,454
                    
                    
                    
                    27,318,421
                    
                    
                    
                    87.4
                    
                    
                    
                    4,543
                    
                    
                    
                    26,144,060
                    
                    
                    
                    80.3
                    
                    
                    
                    (89
                    )Rice
      powder
                    
                    
                    168
                    
                    
                    
                    954,482
                    
                    
                    
                    3.1
                    
                    
                    
                    147
                    
                    
                    
                    813,645
                    
                    
                    
                    2.5
                    
                    
                    
                    21Soybean
      powder
                    
                    
                    472
                    
                    
                    
                    822,026
                    
                    
                    
                    2.6
                    
                    
                    
                    350
                    
                    
                    
                    644,233
                    
                    
                    
                    2.0
                    
                    
                    
                    122Subcontracting
                    
                    
                    893
                    
                    
                    
                    2,166,562
                    
                    
                    
                    6.9
                    
                    
                    
                    1,721
                    
                    
                    
                    4,958,318
                    
                    
                    
                    15.2
                    
                    
                    
                    (828
                    )Total
                    
                    
                    5,987
                    
                    
                    
                    31,261,491
                    
                    
                    
                    100.0
                    
                    
                    
                    6,761
                    
                    
                    
                    32,560,256
                    
                    
                    
                    100.0
                    
                    
                    
                    (774
                    )





There
were various changes to the break-down of sales among our product lines over the
nine months ended September 30, 2009, as we increased production in most lines,
but attempted to adjust our sales mix to higher margin products, and away from
subcontracting. Rice powder accounted for 3.1% of our sales mix for the
nine months ended September 30, 2009, at an average selling price of $5,681 per
metric ton, as compared to 2.5% of our sales mix in the nine months ended
September 30, 2008, at an average selling price of $5,535 per metric
ton. Soybean powder accounted for 2.6% of our sales mix for the nine months
ended September 30, 2009, at an average selling price of $1,742 per metric ton,
as compared to 2.0% of our sales mix in the nine months ended September 30,
2008, at an average selling price of $1,841 per metric ton. Milk powder
accounted for 87.4% of nine months ended September 30, 2009 sales mix, at an
average selling price of $6,133 per metric ton, as compared to 80.3% of first
quarter 2008, at an average selling price of $5,755 per metric ton. We decreased
our subcontract production during the nine months ended September 30, 2009 to
6.9% of the sales mix, at an average selling price of $2,426 per metric ton, as
compared to 15.2% of the sales mix in the nine months ended September 30, 2008,
at an average sales price of $2,881 per metric ton.





A
breakdown of our average selling price by product line for the nine months ended
September 30, 2009 and 2008 is as follows:




Nine months Ended
                    September 30,Average selling prices
                  
                  2009
                  
                  
                  2008
                  
                  
                  Variance$
                  
                  
                  $
                  
                  
                  $
                  
                  
                  
                  %Milk
      powder
                  
                  
                  6,133
                  
                  
                  
                  5,755
                  
                  
                  
                  378
                  
                  
                  
                  6.6Rice
      powder
                  
                  
                  5,681
                  
                  
                  
                  5,535
                  
                  
                  
                  146
                  
                  
                  
                  2.6Soybean
      powder
                  
                  
                  1,742
                  
                  
                  
                  1,841
                  
                  
                  
                  (99
                  )
                  
                  
                  (5.4
                  )Subcontracting
                  
                  
                  2,426
                  
                  
                  
                  2,881
                  
                  
                  
                  (455
                  )
                  
                  
                  (15.8
                  )Total
                  
                  
                  5,222
                  
                  
                  
                  4,816
                  
                  
                  
                  406
                  
                  
                  
                  8.4





Cost of Goods
Sold.  Cost of goods sold decreased by $2,787,649, or 14.0%,
from $19,845,232 in the nine months ended September 30, 2008, to $17,057,583 for
the nine months ended September 30, 2009. This decrease was directly related to
our reduction in subcontracting work during the nine months ended September 30,
2009. Overall our cost per metric ton decreased by $86, or 2.9%, to $2,849 per
metric ton in the nine months ended September 30, 2009, as compared to $2,935
per metric ton in nine months ended September 30, 2008, due to increases in our
sales prices and the reductions in the price of raw materials we use to produce
our products.


38


A
breakdown of cost of sales by product line for the years ended September 30,
2009 and 2008 is as follows:




Nine months Ended September
      30,2009
                  
                  
                  2008
                  
                  
                  Variance$
                  
                  
                  $
                  
                  
                  $
                  
                  
                  
                  %Cost of salesMilk
      powder
                  
                  
                  13,887,172
                  
                  
                  
                  14,893,859
                  
                  
                  
                  (1,006,687
                  )
                  
                  
                  (6.8
                  )Rice
      powder
                  
                  
                  374,307
                  
                  
                  
                  262,169
                  
                  
                  
                  112,138
                  
                  
                  
                  42.8Soybean
      powder
                  
                  
                  616,126
                  
                  
                  
                  423,707
                  
                  
                  
                  192,419
                  
                  
                  
                  45.4Subcontracting
                  
                  
                  2,179,978
                  
                  
                  
                  4,265,497
                  
                  
                  
                  (2,085,519
                  )
                  
                  
                  (48.9
                  )Total
                  
                  
                  17,057,583
                  
                  
                  
                  19,845,232
                  
                  
                  
                  (2,787,649
                  )
                  
                  
                  (14.0
                  )Cost per units sold (per
      ton)Milk
      powder
                  
                  
                  3,118
                  
                  
                  
                  3,278
                  
                  
                  
                  (160
                  )
                  
                  
                  (4.9
                  )Rice
      powder
                  
                  
                  2,228
                  
                  
                  
                  1,783
                  
                  
                  
                  445
                  
                  
                  
                  25.0Soybean
      powder
                  
                  
                  1,305
                  
                  
                  
                  1,211
                  
                  
                  
                  94
                  
                  
                  
                  7.8Subcontracting
                  
                  
                  2,441
                  
                  
                  
                  2,478
                  
                  
                  
                  (37
                  )
                  
                  
                  (1.5
                  )Average
      cost per unit sold
                  
                  
                  2,849
                  
                  
                  
                  2,935
                  
                  
                  
                  (86
                  )
                  
                  
                  (2.9
                  )





Gross Profit. Gross profit was
$14,203,908, or 45.4% of our sales for the nine months ended September 30, 2009,
as compared to gross profit of $12,715,024, or 39.1%, for the nine months ended
September 30, 2008. During the nine months ended September 30, 2009, our gross
margin on milk powder increased to 49.2%, from 43.0% in the same period of the
prior year, due to an increase in the average sales price of 6.6%, while there
was a 4.9% decrease in the cost per metric ton from the nine months ended
September 30, 2008. The gross margin for soybean powder declined 9.2% to
25.0% in the nine months ended September 30, 2009, as compared to 34.2% in the
nine months ended September 30, 2008, due to an increase in the average cost per
ton of 7.8% in the nine months ended September 30, 2009 as compared to the same
period in 2008.





A
breakdown of gross margin by product line for the years September 30, 2009 and
2008 is as follows:




Nine months Ended September
      30,2009
                  
                  
                  2008
                  
                  
                  Period-on-periodProduct category
                  
                  $ Amount
                  
                  
                  Gross
                    Margin %
                  
                  
                  $ Amount
                  
                  
                  Gross
                    Margin %
                  
                  
                  Margin
                    VarianceMilk
      powder
                  
                  
                  13,431,249
                  
                  
                  
                  49.2
                  
                  
                  
                  11,250,201
                  
                  
                  
                  43.0
                  
                  
                  
                  6.2Rice
      powder
                  
                  
                  580,175
                  
                  
                  
                  60.8
                  
                  
                  
                  551,476
                  
                  
                  
                  67.8
                  
                  
                  
                  (7.0
                  )Soybean
      powder
                  
                  
                  205,900
                  
                  
                  
                  25.0
                  
                  
                  
                  220,526
                  
                  
                  
                  34.2
                  
                  
                  
                  (9.2
                  )Subcontracting
                  
                  
                  (13,416
                  )
                  
                  
                  (0.6
                  )
                  
                  
                  692,821
                  
                  
                  
                  14.0
                  
                  
                  
                  (14.6
                  )Total
                  
                  
                  14,203,908
                  
                  
                  
                  45.4
                  
                  
                  
                  12,715,024
                  
                  
                  
                  39.1
                  
                  
                  
                  6.3


39


Operating
Expenses





For the Nine
      months
                    Ended September
      30,2009
                  
                  
                  2008Operating ExpensesSelling
      and administrative expenses
                  
                  $
                  9,448,920
                  
                  
                  $
                  10,283,634Depreciation
      and amortization
                  
                  
                  130,107
                  
                  
                  
                  72,336Total
      operating expenses
                  
                  $
                  9,579,027
                  
                  
                  $
                  10,355,970





Selling Expenses. Selling
expenses overall decreased by $543,003, or 6.9%, from $7,834,865 in the nine
months ended September 30, 2008, to $7,291,862 for the nine months ended
September 30, 2009. The major factors in the decrease in selling expenses are as
follows:





·
            Advertising
      and promotion expenses decreased by $693,282, or 19.1%, to $2,940,297 in
      2009, from $3,633,579 in 2008, due to a less aggressive marketing campaign
      in 2009.





·
            Entertainment
      expenses decreased by $117,155, or 25.1%, to $350,155 in 2009, from
      $467,311 in 2008, as we reduced our marketing as compared to
      2008.





·
            Transportation
      expenses decreased by $69,367, or 8.7%, to $730,313 in 2009, from $799,680
      in 2008, as a result of our shipping costs decreasing in 2009 as compared
      to 2008.





These
decreases were partially offset by increases in:





·
            Traveling
      expenses, by $93,733, or 11.7%, to $897,992 in 2009, from $804,259 in 2008
      as cost for travel increased during
2009.





·
            Product
      promoter salaries, by $116,255, or 119.2%, to $213,816 in 2009, from
      $97,561 in 2008, as we increased the amount paid to
    promoters.





·
            Salaries
      of our salespersons, by $179,962, or 12.5%, to $1,615,054 in 2009, from
      $1,435,092 in 2008, as we increased our sales during
  2009.





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 decreased by $291,711, or 11.9%, from $2,448,769 in nine
months ended September 30, 2008, to $2,157,058 for the nine months ended
September 30, 2009. The primary factor in this decrease was that we incurred
liquidated damages of $901,199 in the nine months ended September 30, 2008, as a
result of our failure to satisfy requirements to register shares of our common
stock, but did not incur liquidated damages in the comparable period in
2009.





These
decreases were partially offset by:





·
            An
      increase in stock option expenses of $125,452 in 2009 from stock options
      granted in 2009 partially offset the decrease in liquidated
      damages.


40





·
            An
      increase in consulting expenses of $226,893 in 2009 from $83,430 in 2008
      to$310,323 in 2009 as we paid for assistance in locating potential
      financing options.





·
            An
      increase in legal and accounting expenses of $157,066 in 2009 from
      $451,419 in 2008 to $608,485 in 2009 due to increased costs related to
      public company reporting requirements as compared to
  2008.





Provision
for Income Taxes





For the Nine
      months
                    Ended September
      30,2009
                  
                  
                  2008Provision
      for Income TaxesCurrent
                  
                  $
                  860,948
                  
                  
                  $
                  586,957Deferred
                  
                  
                  —
                  
                  
                  
                  —$
                  860,948
                  
                  
                  $
                  586,957





Liquidity
and Capital Resources





Uses
of Capital





For the Nine
                    Months Ended
                    September
      30,2009
                  
                  
                  2008Net
      cash provided by operating activities
                  
                  $
                  2,101,308
                  
                  
                  $
                  4,955,796Net
      cash used in investing activities
                  
                  
                  (4,194,717
                  )
                  
                  
                  (10,188,918
                  )Net
      cash provided by financing activities
                  
                  $
                  4,433,590
                  
                  
                  $
                  1,959,082





Net Cash Provided By Operating
Activities.For the nine months ended September 30, 2009,
$2,101,308 was provided by operating activities, compared with $4,955,796
provided by operating activities for the nine months ended September 30, 2008.
Our decrease in net cash provided from operating activities during 2009 was due
to an increase in net income to $3,700,467 for the nine months ended September
30, 2009, from $1,509,235 for the same period in the prior year, which was
partially offset by the following:





·
            Trade
      accounts receivable increased by $559,266, due to the increased level of
      sales during 2009.





·
            Inventory
      increased by $837,027, due to seasonal summer build up in products as
      compared to December 2008.





·
            Accounts
      payable and accrued expenses increased by $424,925 at September 30, 2009,
      as compared to the same period in 2008, due to increases in production of
      products and expenses.


41





Net Cash Used In Investing
Activities.For the nine months ended September 30, 2009, we
used $4,194,717 in investing activities, compared with $10,188,918 used in
investing activities for the nine months ended September 30, 2008. The
$4,194,717 was for the construction of our new production facility.





Net Cash Provided By Financing
Activities.For the nine months ended September 30, 2009,
$4,433,590 was provided by financing activities, compared with $1,959,082
provided by financing activities for the nine months ended September 30, 2008.
We raised $4,433,590 through the exercise of warrants during the nine months
ended September 30, 2009, in connection with the consummation of the First
Warrant Tender Offer and Second Warrant Tender Offer as further described
in “- Recent Developments – First Warrant Tender Offer” and “- Recent
Developments – Second Warrant Tender Offer” above.





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 become 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 $44.3 million
in 2008, a 461% increase over three years. Net income increased from
approximately $0.7 million in 2005 to approximately $2.3 million in 2008, a 220%
increase over three years.





Cash and
cash equivalents at September 30, 2009 increased by 31.8% to $9,681,007, from
$7,343,588 at December 31, 2008. Working capital increased from approximately
$3.5 million in 2005 to approximately $14.7 million at September 30, 2009,
including cash generated from operations, as well as funds raised from private
offerings of promissory notes and warrants we consummated in fiscal 2008. 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.





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 with introduction of our new production
facility, sales staff, and advertising expenditures.





In July
2008, we commenced construction of a new production facility in Hailun City. The
first phase of this project is expected to cost an aggregate of approximately
$20.0 million, including land use rights, construction expenses and equipment
costs. Upon completion of the first phase, the new facility will have one
production line, which will have the capacity to produce 9,000 tons of milk
power annually. We anticipate that production at this new facility will commence
in the fourth quarter of fiscal 2009, assuming we obtain the remaining $3.0
million we require to complete construction and equipping of the first
production line. In the second phase, a second production line may be added at
this new facility, which, when completed, would enable us to produce an
additional 9,000 tons of milk powder per year, giving us a total annual
production capacity of 27,000 tons of milk powder. We believe the cost to add
the second production line would be an additional $15.0 million.





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
our capital expenditures increases, we will depend more on the capital markets
to raise funds through private and public offerings of equity and/or debt. There
can be no assurance that any future financing will be available to us when
needed, and on commercially reasonable terms.


42


In
connection with the October Offerings, we received aggregate gross proceeds of
$9,000,000. The gross proceeds from the October Offerings were used 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
gross proceeds of $2,250,000. In addition, on November 10, 2008, we closed the
November Note Offering, pursuant to which we received aggregate gross proceeds
of $500,000. We used the gross proceeds from the June Note Offering and the
November Note Offering primarily for the construction and equipping of our new
production facility, and to pay expenses related to these offerings. The June
Note Offering and November Note Offering are further described in “- Recent
Developments - Sale of Notes and Warrants” above.





As of
April 24, 2008, we commenced the First Warrant Tender Offer, pursuant to which
the holders of warrants received in connection with the October Offerings had
the opportunity to tender their warrants for shares of our common stock at a
reduced exercise prices. On March 2, 2009, we closed the First Warrant Tender
Offer. In connection with the First Warrant Tender Offer we received gross
proceeds of $758,231. We used the gross proceeds we received from the First
Warrant Tender Offer for the construction and equipping of our new production
facility, and to pay expenses related to the First Warrant Tender Offer. The
First Warrant Tender Offer is further described in “- Recent Developments –
First Warrant Tender Offer” above.





On August
13, 2009, we closed our Second Warrant Tender Offer, pursuant to
which:





·
            a
      total of 49,000 Original Warrants with an exercise price of $2.04 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share; and




·
            a
      total of 2,205,828 Original Warrants with an exercise price of $3.26 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share.




On August
14, 2009, the warrant holders that participated in the Second Warrant Tender
Offer exercised all of the 2,254,828 Amended Warrants they received in
connection therewith, at an exercise price of $1.63 per share. As a result, we
received gross proceeds of $3,675,370. We used the gross proceeds we received
from the Second Warrant Tender Offer for the construction and equipping of our
new production facility, and to pay expenses related to the Second Warrant
Tender Offer. The Second Warrant Tender Offer is further described in “- Recent
Developments – Second Warrant Tender Offer” above.





We have
no sources for the additional financing we may need to complete the construction
an equipping of our new processing facility, which we believe will cost $3.0
million. 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 purchase price of
this building was paid out of our retained earnings.


43


Currently,
we spend approximately 8% - 12% of total revenues on advertising and promotional
efforts through out the year. We spent approximately $3.0 million, $1.9 million
and $0.8 million on advertising and promotion in fiscal 2008, 2007 and 2006,
respectively. We currently expect to spend an aggregate of between $4.0 million
and $5.0 million on advertising and promotion in fiscal 2009, of which $2,940,297has
already been spent as of September 30, 2009. This will still fall within our
standard budget for advertising and promotion of 8% - 12% of total revenues, but
in 2009 we plan to spread the expense over the entire year rather than in the
first half of the year as we did in 2008. 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 SEC (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 SEC, 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, 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 SEC
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 SEC) (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 SEC, (iv) we fail to respond to the SEC 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.  The
Registration Rights Agreement further requires that if we fail to pay any
partial liquidated damages in full within seven days after the date payable, we
will pay interest thereon at a rate of 15% per annum, until such amounts, plus
all such interest thereon, are paid in full.


44


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.





We did
not satisfy these registration requirements and, as a result, accrued a total of
$1,201,998 in liquidated damages and $172,900 in interest. As of October 5,
2009, we issued an aggregate of 775,833 shares in full payment of the liquidated
damages and interest, as further described in “— Recent Developments — Reverse
Merger, Private Placements and Related Transactions” above.





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,
we had an option to repurchase an aggregate of 1,944,444 shares of our common
stock (the “Put/Call Shares”) from the Put/Call Shareholders (the “Call
Option”), for an exercise price of $1.63 per share (the “Call Option Price”), if
the following conditions were met (the “Call Option Conditions”):





·
            either
      (a) a registration statement (“Registration Statement”) covering the
      resale of the Put/Call Shares had been declared effective by the SEC, and
      had been kept continuously effective by us, or (b) all of the Put/Call
      Shares were available for sale without registration pursuant to Rule 144;
      and




·
            the
      closing price of a share of our common stock as traded on the Financial
      Industry Regulatory Authority’s Over-the-Counter Bulletin Board (or such
      other exchange or stock market on which the common stock may be listed or
      quoted) equaled or exceeded $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
      notice of exercise of a Call Option was given by
  us.




In
addition, pursuant to the Put/Call Agreements, the Put/Call Shareholders had the
right to cause us to repurchase the Put/Call Shares (the “Put Right”), for a
price of $1.63 per share (the “Put Purchase Price”), if:





·
            we
      failed to exercise our Call Option within ten (10) days of a date on which
      all of the Call Option Conditions had been met;
  or




·
            we
      consummated a private offering of our securities of $5,000,000 or greater
      (a “Qualified Offering”);




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




45


Initially,
our failure to (i) file the Registration Statement within thirty (30) business
days of October 9, 2007 (the “Filing Date”), (ii) have the Registration
Statement declared effective within ninety (90) calendar days from the Filing
Date, or, if reviewed by the SEC, 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” were available for sale
without registration pursuant to Rule 144, would also have served as a Put Right
Trigger. However, as of April 9, 2008, the Put/Call Shareholders agreed to amend
the Put/Call Agreements to delete this provision. We did not pay any
consideration to the Put/Call Shareholders in connection with their waiver of
this provision.





We had
recorded the value of the Put/Call Agreements as a liability in the aggregate
amount of $3,169,444 as of October 9, 2007, based on the fair market value of
the underlying common stock of $1.63 as of such date. The parties mutually
agreed that it was in our best interests, and the best interests of our
stockholders, for the Put/Call Agreements to be terminated. Therefore, as of
March 3, 2009, the Put/Call Agreements were terminated.





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 W-1 is scheduled to expire on the
three-year anniversary of its date of issuance; provided, however, that we need
to extend the expiration date in connection with our failure to satisfy our
requirement to register the shares underlying Warrant W-1. Warrant W-1 is
exercisable for cash only, provided a registration statement covering the shares
of common stock underlying Warrant W-1 is effective. Otherwise, Warrant W-1 is
exercisable on a cashless basis. 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 is scheduled to expire on the
two-year anniversary of its date of issuance; provided, however, that we need to
extend the expiration date in connection with our failure to satisfy our
requirement to register the shares underlying Warrant W-2. 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. Otherwise, Warrant W-2
is exercisable on a cashless basis. 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.


46


Prior to
the exercise of 183,457 of the Class A Warrants in our First Warrant Tender
Offer, as further described in “— Recent Developments — First Warrant Tender
Offer” above, and tender of 49,000 of the Class A Warrants in our Second Warrant
Tender Offer, as further described in “— Recent Developments – Second Warrant
Tender Offer” above, our Class A Warrants represented 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 are scheduled to expire on the three-year
anniversary of their date of issuance; provided, however, that we are
required to extend the expiration date as a result of our failure
to satisfy our requirement to register the shares underlying the Class A
Warrants. The Class A Warrants are exercisable for cash only, provided a
registration statement covering the shares of common stock underlying the Class
A Warrants is effective. Otherwise, the Class A Warrants are exercisable on a
cashless basis. 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; except that, as of March 2,
2009, the exercise price of 235,583 of these warrants was reduced from $2.04 to
$1.63, as partial consideration for services rendered in connection with a
consulting agreement we entered into with one of these parties.





Prior to
the exercise of 175,937 of the Class B Warrants in our First Warrant Tender
Offer, and tender of 2,205,828 of the Class B Warrants in our Second Warrant
Tender Offer, our Class B Warrants represented 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 are scheduled to expire on the two-year
anniversary of their date of issuance; provided, however, that we need to extend
the expiration date in connection with our failure to satisfy our requirement to
register the shares underlying the Class B Warrants. The Class B Warrants are
exercisable for cash only, provided a registration statement covering the shares
of common stock underlying the Class B Warrants is effective. Otherwise, the
Class B Warrants are exercisable on a cashless basis. 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.





Warrant
W-1, Warrant W-2, the Class A Warrants and the Class B Warrants (collectively,
the “2007 Warrants”) provide that in no event shall the holder be entitled to
exercise a number of 2007 Warrants (or portions thereof) in excess of the number
of 2007 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 2007 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 2007 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 2007 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.


47





If all of
the remaining 5,374,648 2007 Warrants (including warrants issued to finders and
placement agents) were exercised for cash pursuant to their terms, we would
receive $12,818,999 in proceeds, although there can be no assurance that any of
these 2007 Warrants will be exercised.





In June
2008 we closed the June Note Offering, pursuant to which we granted the June
Warrants. The June Note Offering is further described in “Recent Developments -
Sale of Notes and Warrants” above. As amended on December 31, 2008, the June
Warrants represent the right to purchase an aggregate of 225,000 shares of our
common stock, at an exercise price of $1.63 per share. The June Warrants will
expire five years after the date of issuance. The June Warrants may be exercised
for cash only. The number of shares of our common stock deliverable upon
exercise of the June 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 June Warrants will not be entitled to exercise
a number of June Warrants in excess of the number of June 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 sixty-one (61) days from the date of such waiver.





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, as amended.





If all of
the June Warrants, as amended (including warrants issued to a placement agent),
were exercised for cash pursuant to their terms, we would receive $440,000 in
proceeds, although there can be no assurance that any of these June Warrants
will be exercised.





In
addition, as of July 4, 2009, we granted the placement agent warrants to
purchase an additional 97,500 shares of our common stock in consideration for
its services in connection with the amendment of the June Notes and June
Warrants as of December 31, 2008. The terms and conditions of these additional
warrants are identical to the those of the June Warrants, as amended, except
that they will expire on December 31, 2011, and are exercisable either for cash,
at an exercise price of $1.63 per share, or on a cashless basis. If all of these
additional warrants were exercised for cash pursuant to their terms, we would
receive $158,925 in proceeds, although there can be no assurance that any of
these additional warrants will be exercised.





In
November 2008 we closed the November Note Offering, pursuant to which we issued
the November Warrants. The November Note Offering are further described in
“Recent Developments - Sale of Notes and Warrants” above. The November Warrants
represent the right to purchase an aggregate of 50,000 shares of our common
stock, at an exercise price of $2.61 per share. The November Warrants will
expire three years after the date of issuance. The November Warrants may be
exercised for cash only. The number of shares of our common stock deliverable
upon exercise of the November 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 November Warrants will not be entitled to
exercise a number of November Warrants in excess of the number of November
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 sixty-one (61) days from the date of
such waiver. On November 10, 2009, we granted the November Noteholder additional
three-year warrants to purchase 100,000 shares of our common stock, at an
exercise price of $1.63 per share (the “Additional November Warrants”). All of
the other terms of the Additional November Warrants are identical to the
November Warrants.


48





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.





If all of
the November Warrants and Additional November Warrants (including warrants
issued to a placement agent) were exercised for cash pursuant to their terms, we
would receive $358,750 in proceeds, although there can be no assurance that any
of these November Warrants will be exercised





We have
granted the holders of June Warrants and November Warrants “piggyback”
registration rights with respect to the shares underlying their
warrants.





Promissory
Notes





In the
June Note Offering, further described in “- Recent Developments - Sale of Notes
and Warrants” above, we also issued the June Notes. As amended on December 31,
2008, the June Notes bear interest at a rate of 10% until they become due and
payable on December 31, 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 June Notes at any time without penalty, upon 15 days prior
written notice. Each holder of the June Notes has the right to be prepaid any
amounts due under his, her or its June 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 June Notes, there are limitations on
our ability to: (a) pay dividends or make other distributions on our capital
stock; (b) redeem, repurchase or otherwise acquire any of our securities; (c)
create, incur or assume any liability for borrowed money (except as is related
to the completion of the construction of our new production facility); (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
June Note if: (a) we fail to pay principal or interest when due on the June
Note; (b) we breach any material covenant or other material term or condition
contained in the June 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 June 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 sixty (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 a June Note,
unless such Event of Default shall have been waived in writing by the holder,
the holder may consider the June 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 June
Note or any other right or remedy afforded by law.


49


In the
November Note Offering, further described in “— Recent Developments — Sale of
Notes and Warrants” above, we also issued the November Note. The November Note
bears interest at a rate of 10% until it becomes due and payable on May 10,
2010, as amended. 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 November Note at any time without penalty, upon 15 days prior written
notice. The holder of the November Note has the right to be prepaid any amounts
due under his November 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 November Note, there are limitations on our ability to:
(a) pay dividends or make other distributions on our capital stock; (b) redeem,
repurchase or otherwise acquire any of our 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 November Note if:
(a) we fail to pay principal or interest when due on the November Note; (b) we
breach any material covenant or other material term or condition contained in
the November 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 November 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 sixty (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
November Note, unless such Event of Default shall have been waived in writing by
the holder, the holder may consider the November 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.





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, the State
Administration of Foreign Exchange (“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.  See the discussion in “Risk Factors” in our Annual
Report on Form 10-K for our fiscal year ended December 31, 2008.





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.


50


Contractual
Obligations and Commercial Commitments





Our
contractual obligations, as of September 30, 2009, 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
                  
                  $
                  1,590,466
                  
                  
                  $
                  1,590,466
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Construction
      contract
                  
                  
                  1,868,145
                  
                  
                  
                  1,868,145
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Debt
      Obligations
                  
                  
                  3,199,038
                  
                  
                  
                  3,199,038
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Advertising
      contract
                  
                  
                  82,036
                  
                  
                  
                  82,036
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Operating
      leases
                  
                  
                  39,335
                  
                  
                  
                  39,335
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —Total:
                  
                  $
                  6,779,020
                  
                  
                  $
                  6,779,020
                  
                  
                  
                  —
                  
                  
                  
                  —
                  
                  
                  
                  —





Critical
Accounting Policies and Estimates





Our
consolidated financial statements are prepared in accordance with U.S. generally
accepted accounting principles (“GAAP”). These accounting principles require us
to make certain estimates, judgments and assumptions. We believe that the
estimates, judgments and assumptions upon which we rely are reasonable based
upon information available to us at the time that these estimates, judgments and
assumptions are made. These estimates, judgments and assumptions can affect the
reported amounts of assets and liabilities as of the date of the financial
statements as well as the reported amounts of revenues and expenses during the
periods presented. To the extent there are material differences between these
estimates, judgments or assumptions and actual results, our financial statements
will be affected. The accounting policies that reflect our more significant
estimates, judgments and assumptions and which we believe are the most critical
to aid in fully understanding and evaluating our reported financial results
include the following:





·
            Inventory





·
            Property
      and equipment





·
            Intangible
      Assets





·
            Revenue
      recognition





·
            Earnings
      per share





·
            Taxation





·
            Warrants





·
            Freestanding
      Financial Instruments with Characteristics of Both Liabilities and
      Equity





·
            Retirement
      benefit costs





·
            Stock
      Based Compensation





·
            Fair
      value of financial instruments


51





·
            Fair
      Value Measurements





In many
cases, the accounting treatment of a particular transaction is specifically
dictated by GAAP and does not require management’s judgment in its application.
There are also areas in which management’s judgment in selecting among available
alternatives would not produce a materially different result. Our senior
management has reviewed these critical accounting policies and related
disclosures with the Board of Directors.





During
the first six months of fiscal 2009, there were no significant changes in our
critical accounting policies and estimates. You should refer to Management’s
Discussion and Analysis of Financial Condition and Results of Operations
contained in Part II, Item 7 of our Annual Report on Form 10-K for our fiscal
year ended December 31, 2008 for a more complete discussion of our critical
accounting policies and estimates.





Recently
Enacted Accounting Standards





Accounting
Standards Update (“ASU”) ASU No. 2009-05 (ASC Topic 820), which amends “Fair
Value Measurements and Disclosures - Overall,” ASU No. 2009-08, “Earnings per
Share,” ASU No. 2009-12 (ASC Topic 820), “Investments in Certain Entities That
Calculate Net Asset Value per Share,” and various other ASU’s No. 2009-2 through
ASU No. 2009-15, which contain technical corrections to existing guidance or
affect guidance to specialized industries or entities, were recently issued.
These updates have either no current applicability to us, or their effect on our
financial statements would not have been significant.





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
4.  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. As a result of this
transaction, we became subject to the laws related to reporting companies,
including the Sarbanes-Oxley Act of 2002, as amended.





In
connection with the audit for the fiscal years ended December 31, 2008 and 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.


53





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
      U.S. GAAP standards.




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




In
addition, we retained an outside consultant to assist us with the
self-assessment required by Section 404 of the Sarbanes-Oxley Act of
2002.




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 the 2009 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.


54





Changes
in Internal Control Over Financial Report





In its Annual Report on Form 10-K for
the fiscal year ended December 31, 2008 (the “Annual Report”), our management
reported that, as of the date of such report, our internal control over
financial reporting was not effective. In the first quarter of fiscal 2009, an
outside consultant we retained to assist us with the self-assessment required by
Section 404 of the Sarbanes-Oxley Act of 2002, completed the documentation of
our internal controls and procedures. However, upon review of the work product,
our management determined that the prepared documentation did not contain
sufficient detail. Therefore, in the first quarter of 2009, we retained an
additional consultant to help management refine such documentation. That
consultant has not yet completed the documentation of our internal controls and
procedures.





Based
upon the foregoing, our management has determined that there were no 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, 2009, and subsequent period through the
date hereof, we did not consummate any sales of unregistered equity securities,
except as follows:





Issuance
of Additional Warrants to Placement Agent





As of
July 4, 2009, in partial consideration for its services in connection with the
Amendment, as further disclosed in “—  Item 5. Other Information — Issuance
of Additional Warrants to a Placement Agent” below, which disclosure is
incorporated herein by reference, we issued a placement agent warrants to
purchase 97,500 shares of common stock, exercisable either for cash, at an
exercise price of $1.63 per share, or on a cashless basis.





We
believe that the issuance of the warrants in this transaction is exempt from
registration under the Securities Act of 1933, as amended, pursuant to Section
4(2), and/or Regulation D promulgated thereunder, as transactions by an issuer
not involving a public offering.





Closing
of Second Warrant Tender Offer





As of
June 19, 2009, we commenced an offer (the “Second Warrant Tender Offer”) to all
holders of warrants to purchase shares of our common stock, having exercise
prices of either $0.94, $1.50, $1.63, $2.04 or $3.26 per share, originally
issued in connection with the October Offerings (the “Original Warrants”), the
opportunity to voluntarily exchange any or all of the Original Warrants for
amended warrants exercisable at reduced exercise prices (“Amended Warrants”),
for a limited period of time.





On August
13, 2009, we closed the Second Warrant Tender Offer. In connection with the
Second Warrant Tender Offer:





·
            a
      total of 49,000 Original Warrants with an exercise price of $2.04 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share; and




·
            a
      total of 2,205,828 Original Warrants with an exercise price of $3.26 per
      share were exchanged for Amended Warrants with a reduced exercise price of
      $1.63 per share.




We
believe that the issuance of the Amended Warrants in this transaction is exempt
from registration under the Securities Act of 1933, as amended, pursuant to
Section 3(a)(9) thereunder (and/or Section 4(2), as a transaction by an issuer
not involving a public offering).


56


Exercise
of Amended Warrants





On August
14, 2009, the twenty-two (22) warrant holders that participated in the Second
Warrant Tender Offer exercised all of the 2,254,828 Amended Warrants they
received in connection therewith, at an exercise price of $1.63 per
share.  As a result, we received gross proceeds of
$3,675,370.





We
believe that the issuance of the shares in this transaction is exempt from
registration under the Securities Act of 1933, as amended, pursuant to Section
4(2), and/or Regulation D promulgated thereunder, as a transaction by an issuer
not involving a public offering.





Grant
of Warrants to Advisor





On
September 2, 2009, as partial consideration for the services to be provided by
an advisor pursuant to an Advisory Agreement, as further disclosed in “— Item 5.
Other Information — Entry into Advisory Agreement” below, which disclosure is
incorporated herein by reference, we granted the advisor five-year warrants to
purchase 714,286 shares of our common stock (the “Advisor Warrants”), which are
exercisable six (6) months after the Execution Date, (i) at an exercise price of
$1.68 per share, or (ii) on a cashless basis; provided, however, that all of the
Advisor Warrants will terminate if certain conditions are not
met.





We
believe that the issuance of the Advisor Warrants in this transaction is exempt
from registration under the Securities Act of 1933, as amended, pursuant to
Section 4(2), and/or Regulation D promulgated thereunder, as a transaction by an
issuer not involving a public offering.





Issuance
of Shares in Payment of Liquidated Damages





As of
October 5, 2009, we issued an aggregate of 775,833 shares of common stock in
payment of Liquidated Damages and Interest, as further disclosed in “— Item 5.
Other Information — Payment of Liquidated Damages” below, which disclosure is
incorporated herein by reference.





We
believe that the issuance of the shares in this transaction is exempt from
registration under the Securities Act of 1933, as amended, pursuant to Section
4(2), and/or Regulation D promulgated thereunder, as a transaction by an issuer
not involving a public offering.





Extension
of Maturity Date of Note and Issuance of Warrants





In
connection with the November Amendment, as further disclosed in “— Item 5. Other
Information — Payment of Liquidated Damages” below, which disclosure is
incorporated herein by reference, we issued and delivered to the November
Investor a duly executed Amended and Restated Note and additional three-year
warrants to purchase 100,000 shares of our common stock at an exercise price of
$1.63 per share.





We
believe that the issuance of the warrants in this transaction is exempt from
registration under the Securities Act of 1933, as amended, pursuant to Section
4(2), and/or Regulation D promulgated thereunder, as a transaction by an issuer
not involving a public offering.


57


Grant
of Nonqualified Stock Options and Share Appreciation Rights under our 2009
Equity Incentive Plan





On
November 10, 2009, we granted non-qualified, ten-year stock options (the
“Options”) to purchase 380,000 shares of our common stock to Yang Yong Shan, our
Chairman, Chief Executive Officer and President. The Options have an exercise
price of $1.80 per share, which was the closing price of our common stock on the
OTCBB on November 9, 2009. The Options will vest with respect to 25% of the
underlying shares on each of May 10, 2010, November 10, 2010, May 10, 2011 and
November 10, 2011. The Options may be exercised on a “cashless” basis and are
subject to such other provisions as are contained in our 2009 Equity Incentive
Plan (“Plan”).





In
addition, on November 10, 2009, we granted share appreciation rights (the
“SARs”) with respect to 380,000 shares of our common stock to Shu Kaneko, our
Chief Financial Officer and Secretary. The SARs have an exercise price of $1.80
per share, which was the closing price of our common stock on the OTCBB on
November 9, 2009. The SARs have a term of ten (10) years from the date of grant.
The SARs will vest with respect to 25% of the shares on each of May 10, 2010,
November 10, 2010, May 10, 2011 and November 10, 2011. The SARs are subject to
such other provisions as are contained in the Plan.





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





Item
3.  Defaults Upon Senior Securities.





In the
three-month period ended September 30, 2009, and subsequent period through the
date hereof, we did not default upon any senior securities.





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





In the
three-month period ended September 30, 2009, and subsequent period through the
date hereof, we did not submit any matters to a vote of our security
holders.





Item
5.  Other Information.





Issuance
of Additional Warrants to Placement Agent





In June
2008, we sold to two investors (the “June Investors”) an aggregate of (i)
$2,250,000 of promissory notes (the “June Notes”) and (ii) warrants to purchase
225,000 shares of our common stock (the “June Warrants”). As of December 31,
2008, we entered into an agreement with the June Investors (the “Amendment”),
pursuant to which the Investors received Amended and Restated Notes in exchange
for the June Notes, and Amended and Restated Warrants in exchange for the June
Warrants. As of July 4, 2009, in partial consideration for its services in
connection with the Amendment, we issued a placement agent warrants to purchase
97,500 shares of our common stock, exercisable either for cash, at an exercise
price of $1.63 per share, or on a “cashless” basis. These warrants will expire
on December 31, 2011.





Entry
Into Advisory Agreement and Issuance of Advisor Warrants





On
September 2, 2009 (the “Execution Date”), we entered into a letter agreement
(the “Advisory Agreement”) with a financial advisor, pursuant to which the
advisor will provide us with certain financial advisory services for a period
commencing on September 2, 2009 and continuing for six (6) months, subject to
cancellation (i) by thirty (30) days written notice anytime after the six (6)
month anniversary of the Execution Date, or (ii) automatically, on June 30, 2010
in the event certain conditions are not met. As partial consideration for
the services to be provided by the advisor, we granted the advisor five-year
warrants to purchase 714,286 shares of our common stock (the “Advisor
Warrants”), which are exercisable six (6) months after the Execution Date, (i)
at an exercise price of $1.68 per share, or (ii) on a cashless basis; provided,
however, that all of the Advisor Warrants will terminate if certain
conditions are not met.


58





Payment
of Liquidated Damages





In
connection with private offerings we consummated in October 2007 (the “October
Offerings”) we entered into Registration Rights Agreements.  Pursuant
to the Registration Rights Agreements, we were required to pay liquidated
damages to the investors in the October Offerings (the “Investors”), if we
failed to satisfy certain registration requirements.  As a result, we
accrued a total of $1,201,998 in liquidated damages (“Liquidated Damages”)
through October 19, 2008, the date the shares purchased in the October Offerings
became eligible for sale pursuant to Rule 144 under the Securities Act of
1933.  Pursuant to the Registration Rights Agreements, the Liquidated
Damages were payable in cash or shares of our common stock, at our
discretion.  As of October 5, 2009, in full payment of the Liquidated
Damages, we issued an aggregate of 667,777shares of our common
stock to the Investors, valued at $1.80 per share, the closing price on the
OTCBB on October 20, 2008.  In addition, pursuant to the Registration
Rights Agreements, if we failed to pay any liquidated damages in full within
seven days after the date payable, we were required to pay interest thereon at a
rate of 15% per annum until such amounts, plus all such interest thereon, are
paid in full.  Therefore, as of October 5, 2009, we paid interest in
the aggregate amount of approximately $172,900, by issuing an aggregate of
108,056 additional shares of our common stock, valued at $1.60 per share, the
closing price of our common stock on the OTCBB on October 2, 2009. We
granted the recipients “piggyback” registration rights with respect to these
shares.





Extension
of Expiration Date of Class A Warrants and Class B Warrants





Our
2,526,208 Class B Warrants, exercisable at a price of $3.26 per share, were due
to expire in October 2009.  However, Section 10 of the Class B Warrants
provides for an extension of the expiration date due to our failure to
satisfy our obligation to register the shares underlying the Class B
Warrants (the “Warrant Shares”) for resale. As a result, the expiration date
extends one day for each day the registration default continues, subject to
certain limitations. On October 13, 2009, we filed a new Registration Statement
on Form S-1 to register for resale the Warrant Shares among other
securities. The expiration date of these warrants will continue to extend
one day for each day the registration default continues, until such time as the
Registration Statement is declared effective by the SEC. Since the Registration
Statement is not yet effective, we are unable to quantify what the extended term
of the warrants will be.





Grant
of Nonqualified Stock Options and Share Appreciation Rights





Reference
is made to the disclosure set forth under “— Item 2. Unregistered Sales of
Equity Securities and Use of Proceeds — Grant of Nonqualified Stock Options and
Share Appreciation Rights under our 2009 Equity Incentive Plan” above, which
disclosure is incorporated herein by reference.





Extension
of Maturity Date of Note and Issuance of Warrants





On
November 10, 2008, we entered into a Securities Purchase Agreement (the
“Purchase Agreement”) with an investor (the “Investor”), pursuant to which we
sold the Investor (a) a 10% promissory note in the principal amount of $500,000,
due November 10, 2009 (the “November Note”) and (b) three-year warrants to
purchase 50,000 shares of our common stock, at an exercise price of $2.61 per
share. On November 10, 2009, we entered into an amendment to the Purchase
Agreement (the “November Amendment”), pursuant to which: (a) the maturity date
of the November Note was extended from November 10, 2009 to May 10, 2010; (b) we
issued and delivered to the Investor a duly executed Amended and Restated Note
reflecting the change set forth in (a) above; and (c) we issued to the Investor
additional three-year warrants to purchase 100,000 shares of our common stock at
an exercise price of $1.63 per share.


59




Item
6.  Exhibits





Exhibit No.
            
            Description of Exhibit31.1
            
            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


60


SIGNATURES




Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly
authorized.




EMERALD
      DAIRY INC.Dated:
      November 16, 2009
                
                By:
                /s/ Yang Yong ShanYang
      Yong Shan
                  Chairman,
      Chief Executive Officer and
                  PresidentDated:
      November 16, 2009
                
                By:
                /s/ Shu KanekoShu
      Kaneko
                  Chief
      Financial Officer and
Secretary




61