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
1934




For
      the quarterly period ended
                    June
      30, 2010








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




For
      the transition period from
                      
                      to




Commission
      File Number:
                      000-52174







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     oNo





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).


oYes     oNo





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
the definitions of “large accelerated filer,” “accelerated filer” and “smaller
reporting company” in Rule 12b-2 of the Exchange Act:





Large
      accelerated filer o
            Accelerated
      filer oNon-accelerated
      filer o(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).


oYes     x No





The
registrant had 34,017,131 shares of common stock issued and outstanding as of
July 31, 2010 (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 JUNE 30, 2010





TABLE
OF CONTENTS





PAGEPART I
      -
            FINANCIAL
      INFORMATIONItem
      1.
            Financial
      Statements
            3Condensed
      Consolidated Balance Sheets as of June 30, 2010 (unaudited) and December
      31, 2009
            3Condensed
      Consolidated Statements of Income for the Three and Six Months Ended June
      30, 2010 and 2009 (unaudited)
            4Condensed
      Consolidated Statements of Cash Flows for the Six Months Ended June, 2010
      and 2009 (unaudited)
            5Notes
      to Condensed Consolidated Financial Statements (unaudited)
            6Item
      2.
            Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations
            26Item
      3.
            Quantitative
      and Qualitative Disclosures About Market Risk
            47Item
      4.
            Controls
      and Procedures
            47PART II
      -
            OTHER
      INFORMATIONItem
      1.
            Legal
      Proceedings
            49Item
      1A.
            Risk
      Factors
            49Item
      2.
            Unregistered
      Sales of Equity Securities and Use of Proceeds
            49Item
      3.
            Defaults
      Upon Senior Securities
            50Item
      4.
            (Removed
      and Reserved)
            50Item
      5.
            Other
      Information
            50Item
      6.
            Exhibits
            51Signatures
            52








2


PART
I. FINANCIAL INFORMATION





Item
1.  Financial Statements.





Emerald
Dairy Inc. and Subsidiaries


Condensed
Consolidated Balance Sheets


June
30, 2010 and December 31, 2009




ASSETSJune
      30,
                  
                  
                  December
      31,2010
                  
                  
                  2009(Unaudited)Current
      AssetsCash
      and cash equivalents
                  
                  $
                  11,328,951
                  
                  
                  $
                  13,486,429Trade
      accounts receivable, net
                  
                  
                  7,459,384
                  
                  
                  
                  7,223,016Inventory,
      net
                  
                  
                  1,567,638
                  
                  
                  
                  1,298,488Advances
      to equipment supplier
                  
                  
                  9,886,085
                  
                  
                  
                  3,710,707Other
      current assets
                  
                  
                  7,572,562
                  
                  
                  
                  1,292,749Total
      current assets
                  
                  
                  37,814,620
                  
                  
                  
                  27,011,389Property,
      plant and equipmentProperty,
      plant and equipment, net
                  
                  
                  5,767,393
                  
                  
                  
                  5,946,330Contruction
      in progress
                  
                  
                  9,409,890
                  
                  
                  
                  8,772,93115,177,283
                  
                  
                  
                  14,719,261Intangible
      assets, net
                  
                  
                  1,331,555
                  
                  
                  
                  1,341,534$
                  54,323,458
                  
                  
                  $
                  43,072,184LIABILITIES
      AND STOCKHOLDERS' EQUITYCurrent
      LiabilitiesAccounts
      payable and accrued expenses
                  
                  $
                  3,263,668
                  
                  
                  $
                  2,917,798Notes
      payable, net of debt discount of $357,780 and $729,830 at June 30,
      2010 and December 31, 2009, respectively
                  
                  
                  5,658,631
                  
                  
                  
                  5,843,472Other
      current liabilities
                  
                  
                  460,185
                  
                  
                  
                  704,056Current
      portion of long-term lease
                  
                  
                  997,084
                  
                  
                  
                  -Loan
      from shareholder
                  
                  
                  211,555
                  
                  
                  
                  210,142Total
      current liabilities
                  
                  
                  10,591,123
                  
                  
                  
                  9,675,468Long-term
      lease payable
                  
                  
                  3,012,383
                  
                  
                  
                  -Commitments
      and Contingencies (Note 18)Stockholders'
      EquityPreferred
      stock ($0.001 par value, 10,000,000 shares authorized, none issued
      and outstanding at June 30, 2010 and December 31, 2009)
                  
                  
                  -
                  
                  
                  
                  -Common
      stock ($0.001 par value, 100,000,000 shares authorized, 35,976,575
      and 34,890,267 issued and outstanding at June 30, 2010 December 31,
      2009, respectively)
                  
                  
                  35,977
                  
                  
                  
                  34,890Treasury
      Stock (1,944,444 shares at June 30, 2010 and December 31, 2009,
      respectively)
                  
                  
                  (1,944
                  )
                  
                  
                  (1,944
                  )Additional
      paid-in capital
                  
                  
                  25,037,259
                  
                  
                  
                  17,003,093Retained
      earnings (of which $3,191,614 and $1,834,742 are restricted at June
      30, 2010 and December 31, 2009, respectively, for common welfare
      reserves)
                  
                  
                  13,305,727
                  
                  
                  
                  14,318,425Accumulated
      other comprehensive income
                  
                  
                  2,342,933
                  
                  
                  
                  2,042,252Total
      stockholders' equity
                  
                  
                  40,719,952
                  
                  
                  
                  33,396,716$
                  54,323,458
                  
                  
                  $
                  43,072,184




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




3


Emerald
Dairy Inc. and Subsidiaries


Condensed
Consolidated Statements of Income


For
the Three and Six Months Ended June 30, 2010 and 2009


(Unaudited)




Three
      months ended
              
              
              Six
      months endedJune
      30,
              
              
              June
      30,
              
              
              June
      30,
              
              
              June
      30,2010
              
              
              2009
              
              
              2010
              
              
              2009Sales
              
              $
              13,309,502
              
              
              $
              10,246,935
              
              
              $
              27,562,358
              
              
              $
              21,103,487Cost
      of Goods Sold
              
              
              6,794,707
              
              
              
              5,639,310
              
              
              
              13,948,479
              
              
              
              11,487,985Gross
      Profit
              
              
              6,514,795
              
              
              
              4,607,625
              
              
              
              13,613,879
              
              
              
              9,615,502Operating
      ExpensesSelling
      expenses and administrative expenses
              
              
              4,004,280
              
              
              
              3,073,694
              
              
              
              7,906,670
              
              
              
              6,100,398Liquidated
      damages
              
              
              -
              
              
              
              -
              
              
              
              5,021,669
              
              
              
              -Depreciation
      and amortization
              
              
              51,724
              
              
              
              43,274
              
              
              
              102,952
              
              
              
              86,512Total
      operating expenses
              
              
              4,056,004
              
              
              
              3,116,968
              
              
              
              13,031,291
              
              
              
              6,186,910Other
      Income (Expense)Interest
      income
              
              
              1,077
              
              
              
              2,191
              
              
              
              2,135
              
              
              
              3,144Interest
      expense
              
              
              (784,679
              )
              
              
              48,352
              
              
              
              (784,679
              )
              
              
              -Total
      other income (expense)
              
              
              (783,602
              )
              
              
              50,543
              
              
              
              (782,544
              )
              
              
              3,144Net
      Income (Loss) Before Provision for Income Tax
              
              
              1,675,189
              
              
              
              1,541,200
              
              
              
              (199,956
              )
              
              
              3,431,736Provision
      for Income TaxesCurrent
              
              
              391,243
              
              
              
              278,064
              
              
              
              812,742
              
              
              
              615,894391,243
              
              
              
              278,064
              
              
              
              812,742
              
              
              
              615,894Net
      Income (Loss)
              
              $
              1,283,946
              
              
              $
              1,263,136
              
              
              $
              (1,012,698
              )
              
              $
              2,815,842Basic
      Earnings (Loss) Per Share
              
              $
              0.04
              
              
              $
              0.04
              
              
              $
              (0.03
              )
              
              $
              0.10Basic
      Weighted  Average Shares Outstanding
              
              
              33,941,295
              
              
              
              29,658,726
              
              
              
              33,446,310
              
              
              
              29,537,604Diluted
      Earnings (Loss) Per Share
              
              $
              0.04
              
              
              $
              0.04
              
              
              $
              (0.03
              )
              
              $
              0.09Diluted
      Weighted  Average Shares Outstanding
              
              
              34,660,893
              
              
              
              30,105,880
              
              
              
              33,446,310
              
              
              
              29,648,643The
      Components of Other Comprehensive Income (Loss)Net
      Income (Loss)
              
              $
              1,283,946
              
              
              $
              1,263,136
              
              
              $
              (1,012,698
              )
              
              $
              2,815,842Foreign
      currency translation adjustment
              
              
              444,016
              
              
              
              16,406
              
              
              
              454,311
              
              
              
              (39,420
              )Income
      tax related to other comprehensive income
              
              
              (150,966
              )
              
              
              (5,578
              )
              
              
              (154,466
              )
              
              
              13,403Comprehensive
      Income (Loss)
              
              $
              1,576,996
              
              
              $
              1,273,964
              
              
              $
              (712,853
              )
              
              $
              2,789,825




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


4


Emerald
Dairy Inc. and Subsidiaries


Condensed
Consolidated Statements of Cash Flows


For
the Six Months Ended June, 2010 and 2009


(Unaudited)




2010
              
              
              2009Cash
      flows from operating activitiesNet
      Income (Loss)
              
              $
              (1,012,698
              )
              
              $
              2,815,842Adjustments
      to reconcile net cash provided byoperating
      activitiesDepreciation
      and amortization
              
              
              283,526
              
              
              
              266,374Amortization
      of loan discount
              
              
              372,050
              
              
              
              43,944Capitalized
      interest
              
              
              (458,872
              )
              
              
              (220,727
              )Stock
      issued for services
              
              
              34,657
              
              
              
              33,475Warrants
      modified for liquidated damages
              
              
              5,021,669
              
              
              
              -Warrants
      modified for services
              
              
              -
              
              
              
              3,975Warrants
      issued for services
              
              
              90,137
              
              
              
              -Warrants
      issued for loan costs
              
              
              79,991
              
              
              
              -Incentive
      stock options
              
              
              385,891
              
              
              
              75,688Net
      change in assets and liabilitiesTrade
      accounts receivable
              
              
              (188,123
              )
              
              
              (563,653
              )Inventory
              
              
              (260,477
              )
              
              
              (747,598
              )Other
      current assets
              
              
              (877,809
              )
              
              
              (66,459
              )Accounts
      payable and accrued expenses
              
              
              576,581
              
              
              
              (483,663
              )Other
      current liabilities
              
              
              (248,574
              )
              
              
              (308,639
              )Net
      cash provided by operating activities
              
              
              3,797,949
              
              
              
              848,559Cash
      flows from investing activitiesDeposit
      on equipment and construction
              
              
              (11,543,962
              )
              
              
              -Construction
      in progress
              
              
              (119,489
              )
              
              
              -Purchases
      of fixed assets and intangibles
              
              
              (45,995
              )
              
              
              (4,189,873
              )Net
      cash used in investing activities
              
              
              (11,709,446
              )
              
              
              (4,189,873
              )Cash
      flows from financing activitiesAdvances
      on notes payable
              
              
              800,000
              
              
              
              -Repayments
      of notes payable
              
              
              (477,464
              )
              
              
              -Advances
      on sale-leaseback
              
              
              5,006,340
              
              
              
              -Exercise
      of warrants
              
              
              296,408
              
              
              
              758,231Net
      cash provided by financing activities
              
              
              5,625,284
              
              
              
              758,231Effect
      of exchange rate
              
              
              128,735
              
              
              
              (8,250
              )Net
      decrease in cash
              
              
              (2,157,478
              )
              
              
              (2,591,333
              )Cash
      and cash equivalents at beginning of period
              
              
              13,486,429
              
              
              
              7,343,588Cash
      and cash equivalents at end of period
              
              $
              11,328,951
              
              
              $
              4,752,255




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





5




Emerald Dairy, Inc. and
Subsidiaries


Footnotes
to Condensed Consolidated Financial Statements


June
30, 2010 and 2009





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. Through the Company’s network of over
1,100 salespeople, the Company’s products are distributed throughout 20
provinces in the PRC, and sold in over 6,000 retail outlets.





The
Company’s 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. XAL is a
dairy company engaged in manufacturing of milk powder, soybean powder and rice
powder. 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.




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 third
fiscal quarter of 2010. 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 for interim
financial information and with the instructions to Form 10-Q. Accordingly, they
do not include all of the information and footnotes required by generally
accepted accounting principles for complete financial statements and related
notes. The accompanying unaudited condensed consolidated financial statements
and related notes should be read in conjunction with the audited consolidated
financial statements of the Company and notes thereto for the year ended
December 31, 2009 which are included in the Company’s Form 10-K/A for the year
ended December 31, 2009, filed with the Securities and Exchange Commission
(“SEC”) on April 1, 2010.





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 consolidated balance
sheets of Emerald Dairy Inc. and subsidiaries as of June 30, 2010, and the
results of their operations for the three and six months ended June 30, 2010 and
2009, and cash flows for the six months ended June 30, 2010 and 2009. The
results of operations for the three and six months ended June 30, 2010 are not
necessarily indicative of the results to be expected for the entire
year.





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





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




6


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


3.
            Summary
      of Significant Accounting Policies





Use of estimates - The
preparation of these consolidated financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect 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 FDIC insurance
or any other similar insurance. Accounts held at United States financial
institutions are insured by the Federal Deposit Insurance Corporation up to
$250,000. As of June 30, 2010, no 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.





Trade 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 June
30, 2010 and December 31, 2009, 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 six months ended June 30, 2010 and 2009. 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 June 30, 2010, the
Company has incurred and capitalized into construction-in-progress $8,308,468 of
construction costs and $1,101,422 of capitalized interest for a balance of
$9,409,890.  As of December 31, 2009, the Company had incurred and
capitalized into construction-in-progress $8,130,380 of construction costs and
$642,551 of capitalized interest.  The estimated cost to be incurred
in 2010 to complete the project is approximately $499,897.




7
 Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009




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 and six months ended June 30, 2010 and 2009 is as
follows:





Three Months
              Ended June 30,
            
            Six Months
              Ended June 30,2010
            
            2009
            
            2010
            
            2009Interest
      cost capitalized
            
            $
            (172,046
            )
            
            $
            158,715
            
            
            $
            458,872
            
            
            $
            220,727Interest
      cost charged to income
            
            
            784,679
            
            
            
            (48,352
            )
            
            
            784,679
            
            
            
            -0-$
            612,633
            
            
            $
            110,363
            
            
            $
            1,243,551
            
            
            $
            220,727





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 the local currency,
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 the reporting currency (“U.S. Dollars”) are dealt with as a
separate component within stockholders’ equity. Translation adjustments net of
tax totaled $293,050 and $10,828, for the three months ended June 30, 2010 and
2009, respectively and $299,845 and $(26,017) for the six months ended June 30,
2010 and 2009, respectively.





As of
June 30, 2010 and 2009, the exchange rate was 6.7814 RMB and 6.8307 RMB per U.S.
Dollar, respectively.





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
June 30, 2010, the Company has no sales or contracts that included multiple
deliverables that would fall under the 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. 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.


8


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


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




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





Enterprise income
tax





Under the
Provisional Regulations of The People’s Republic of China Concerning Income Tax
on Enterprises promulgated by the State Council which came into effect on
January 1, 1994, income tax is payable by a Wholly Foreign Owned Enterprises at
a rate of 15% of their taxable income. Preferential tax treatment may, however,
be granted pursuant to any law or regulations from time to time promulgated by
the State Council. XAL enjoyed a 100% exemption from enterprise income taxes
starting on January 10, 2006 due to its classification as a “Wholly Foreign
Owned Enterprise.” On March 16, 2007, the 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
June 30, 2010 and December 31, 2009, the fair value of cash, trade 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.





Fair Value Measurements– On
January 1, 2008, the Company adopted accounting guidance that establishes a
framework for measuring fair value in generally accepted accounting principles,
clarifies the definition of fair value within that framework, and expands
disclosures about the use of fair value measurements. The accounting guidance
applies to fair value measurements required by existing accounting guidance and
does not require any new fair value measurements.




9
 Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009




3.
            Summary
      of Significant Accounting Policies
(Continued)





On
January 1, 2009, the Company adopted accounting guidance for non-financial
assets and non-financial liabilities that are recognized or disclosed at fair
value in the consolidated financial statements on a nonrecurring basis as
permitted by, which provided a deferral of such provisions until 2009. The
adoption of this guidance did not have a material impact on the Company’s
financial position, results of operations, or cash flows.





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 June 30, 2010.




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.





Recent accounting
pronouncements





In
October 2009, the FASB issued Accounting Standards Update, 2009-13, Revenue
Recognition (Topic 605): “Multiple Deliverable Revenue
Arrangements – A Consensus of the FASB Emerging Issues Task
Force.”  This update provides application guidance on whether
multiple deliverables exist, how the deliverables should be separated and how
the consideration should be allocated to one or more units of accounting. This
update establishes a selling price hierarchy for determining the selling price
of a deliverable. The selling price used for each deliverable will be based on
vendor-specific objective evidence, if available, third-party evidence if
vendor-specific objective evidence is not available, or estimated selling price
if neither vendor-specific or third-party evidence is available. On January 1,
2010 the Company adopted this amended accounting guidance, the adoption of this
guidance did not have a material impact on the Company’s financial
condition, results of operations or cash flows.





In June
2009, the FASB issued guidance related to accounting for transfers of financial
assets. This guidance improves the information that a reporting entity provides
in its financial reports about a transfer of financial assets; the effects of a
transfer on its financial position, financial performance and cash flows; and a
continuing interest in transferred financial assets. In addition, this guidance
amends various ASC concepts with respect to accounting for transfers and
servicing of financial assets and extinguishments of liabilities, including
removing the concept of qualified special purpose entities. This guidance must be
applied to transfers occurring on or after the effective date. On January 1,
2010, the Company adopted this amended accounting guidance, the adoption of this
guidance did not have a material impact on the Company’s financial
condition, results of operations or cash flows.





In June
2009, the FASB issued guidance which amends certain ASC concepts related to
consolidation of variable interest entities. Among other accounting and
disclosure requirements, this guidance replaces the quantitative-based risks and
rewards calculation for determining which enterprise has a controlling financial
interest in a variable interest entity with an approach focused on identifying
which enterprise has the power to direct the activities of a variable interest
entity and the obligation to absorb losses of the entity or the right to receive
benefits from the entity. On January 1, 2010, the Company adopted this amended
accounting guidance, the adoption of this guidance did not have a material
impact on the Company’s financial
condition, results of operations or cash flows.




10
 Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009





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 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 Federal Deposit Insurance Corporation up to $250,000. As of June 30, 2010
none of the U.S. cash balances are in excess of insured amounts.





Milk
powder is historically 75% to 95% of the Company’s total sales. Dairy product
consumption in China has historically been lower than in many other countries in
the world.  Growing interest in milk products in China 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 our 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 China, which may give rise to significant foreign currency
risks from fluctuations and the degree of volatility of foreign exchange rates
between US dollars and the Chinese currency RMB.





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





For the
three and six months ended June 30, 2010 and 2009, no single customer accounted
for 10% or more of sales.





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.


11




Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009





5.
            Inventory





As of
June 30, 2010 and December 31, 2009 inventory consists of the
following:






2010
            
            
            
            2009Raw
      materials
            
            $
            1,117,666
            
            
            $
            689,984Work-in-process
            
            
            372,753
            
            
            
            579,806Finished
      goods
            
            
            68,619
            
            
            
            20,365Repair
      parts
            
            
            8,600
            
            
            
            8,333$
            1,567,638
            
            
            $
            1,298,488




6.
            Other
      Current Assets





As of
June 30, 2010 and December 31, 2009, other current assets consist of the
following:





2010
            
            
            
            2009Advances
      to milk suppliers
            
            $
            320,253
            
            
            $
            368,566Advances
      to construction contractor
            
            
            5,464,949
            
            
            
            -Deposit
      on lease
            
            
            1,032,236
            
            
            
            -Advances
      to staff
            
            
            5,774
            
            
            
            15,496Deposit
      on contract
            
            
            195,948
            
            
            
            71,598Prepaid
      loan costs
            
            
            510,807
            
            
            
            828,725Prepaid
      expenses
            
            
            42,595
            
            
            
            8,364$
            7,572,562
            
            
            $
            1,292,749





7.
            Property,
      Plant, and Equipment





As of
June 30, 2010 and December 31, 2009, Property, Plant, and Equipment consist of
the following:





2010
            
            
            2009Building
            
            $
            3,793,321
            
            
            $
            3,767,984Plant
      and Machinery
            
            
            3,248,810
            
            
            
            3,227,110Motor
      vehicles
            
            
            571,243
            
            
            
            526,597Dairy
      cows
            
            
            258,593
            
            
            
            253,439Office
      equipment
            
            
            80,018
            
            
            
            76,6167,951,985
            
            
            
            7,851,746Less:
      Accumulated depreciation
            
            
            (2,184,592
            )
            
            
            (1,905,416
            )$
            5,767,393
            
            
            $
            5,946,330




Depreciation
expenses totaled $132,831 and $264,650 for the three and six months ended June
30, 2010, respectively, and $123,859 and $247,518 for the three and six months
ended June 30, 2009, respectively. $90,548 and $180,575 were included as a
component of cost of goods sold for the three and six months ended June 30,
2010, respectively, and $90,017 and 179,862 for the three and six months ended
June 30, 2009, respectively.


12




Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009





8.
            Construction-in-progress





June
      30,
              2010
            
            
            December 31,
              2009Construction
      in progress
            
            $
            9,409,890
            
            
            $
            8,772,931





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





9.
            Intangible
      Assets





June
      30,
              2010
            
            
            December 31,
              2009Land
      use rights
            
            $
            1,364,704
            
            
            $
            1,355,589Patents
            
            
            53,529
            
            
            
            53,1711,418,233
            
            
            
            1,408,760Less:
      Accumulated amortization
            
            
            (86,678
            )
            
            
            (67,226
            )$
            1,331,555
            
            
            $
            1,341,534




Amortization
expenses totaled $9,440 and $18,876 for the three and six months ended June 30,
2010, respectively and $9,432 and 18,856 for the three and six months ended June
30, 2009,respectively.





Amortization
expense is estimated to be $37,744 for each of the next five years.





10.
            Income
      Taxes





On May
30, 2005, American International Dairy Holdings, Inc. executed a Share Transfer
Agreement with Heilongjiang Xing An Ling Dairy Co., Ltd., a corporation
organized and existing under the laws of the PRC. XAL applied to be treated as a
foreign invested company right after the share transfer, and its business
license was approved as a foreign invested company on January 10, 2006.
According to Chinese taxation policy, a foreign invested company, Advanced
Technology Company or Software Development Company, receives a 100% income tax
exemption for the first 2 years and a 50% tax exemption for the next 3 years.
XAL is considered an Advanced Technology Company. Therefore the Company received
the benefit of this income tax exemption from January 10, 2006, the date XAL was
approved 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 from such date.





LvBao is
currently subject to the Enterprise income tax of 25%.





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 June 30,
            
            Six Months
              Ended June 30,2010
            
            2009
            
            2010
            
            2009U.S.
      Operations
            
            $
            (1,482,000
            )
            
            $
            (319,000
            )
            
            $
            (7,065,000
            )
            
            $
            (830,000
            )Chinese
      Operations
            
            
            3,157,000
            
            
            
            1,860,000
            
            
            
            6,865,000
            
            
            
            4,262,000$
            1,675,000
            
            
            $
            1,541,000
            
            
            $
            200,000
            
            
            $
            3,432,000




13




Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


10.
            Income
      Taxes (Continued)





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





Three Months
              Ended June 30,
            
            Six Months
              Ended June 30,2010
            
            2009
            
            2010
            
            2009Federal,
      State and Local
            
            $
            -
            
            
            $
            -
            
            
            $
            -
            
            
            $
            -Peoples
      Republic of China -Federal and Local
            
            
            391,200
            
            
            
            278,000
            
            
            
            812,700
            
            
            
            615,900$
            391,200
            
            
            $
            278,000
            
            
            $
            812,700
            
            
            $
            615,900





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 June 30,
            
            
            Six Months
              Ended June 30,2010
            
            
            2009
            
            
            2010
            
            
            2009Income
      tax provision at Federal statutory rate
            
            $
            569,600
            
            
            $
            524,000
            
            
            $
            (68,000
            )
            
            $
            1,166,800State
      income taxes, net of Federal benefit
            
            
            -0-
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            -0-U.S.
      tax rate in excess of foreign tax rate
            
            
            (284,100
            )
            
            
            (167,400
            )
            
            
            (617,800
            )
            
            
            (383,500
            )Abatement
      of foreign income taxes
            
            
            (398,000
            )
            
            
            (187,100
            )
            
            
            (903,500
            )
            
            
            (449,500
            )Increase
      in valuation allowance
            
            
            503,700
            
            
            
            108,500
            
            
            
            2,402,000
            
            
            
            282,100Tax
      provision
            
            $
            391,200
            
            
            $
            278,000
            
            
            $
            812,700
            
            
            $
            615,900




The
Company has a U.S. net operating loss carryforward of approximately $13,349,000
as of June 30, 2010 which expires in 2030. The deferred tax asset associated
with these net operating loss carryforwards was fully reserved as of June 30,
2010.





The
change in the valuation allowance as of June 30, 2010 and 2009 was $2,402,000
and $282,100, respectively.





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





Three
      Months
              Ended June 30,
            
            
            Six
      Months
              Ended June 30,2010
            
            
            2009
            
            
            2010
            
            
            2009Tax
      Saving
            
            $
            398,000
            
            
            $
            187,100
            
            
            $
            903,500
            
            
            $
            449,500Benefit
      per share:Basic
            
            $
            0.01
            
            
            $
            0.01
            
            
            $
            0.03
            
            
            $
            0.02Diluted
            
            $
            0.01
            
            
            $
            0.01
            
            
            $
            0.03
            
            
            $
            0.02




14


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009





10.
            Income
      Taxes (Continued)





Had the
tax exemption not been in place for the three and six months ended June 30, 2010
and 2009, the Company estimates the following proforma financial statement
impact:




Three Months
              Ended June 30,
            
            
            Six Months
              Ended June 30,2010
            
            
            2009
            
            
            2010
            
            
            2009Net
      income (loss) before tax provision, as reported
            
            $
            1,676,000
            
            
            $
            1,541,000
            
            
            $
            (200,000
            )
            
            $
            3,432,000Less
      Tax provision not exempted
            
            
            391,000
            
            
            
            278,000
            
            
            
            812,700
            
            
            
            615,900Less
      Tax provision exempted
            
            
            398,000
            
            
            
            187,100
            
            
            
            903,500
            
            
            
            449,500$
            887,000
            
            
            $
            1,075,900
            
            
            $
            (1,916,200
            )
            
            $
            2,366,600





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 six
months ended June 30, 2010, respectively, the Company contributed $27,353 and
$60,021 in pension contributions. During the three and six months ended June 30,
2009, respectively, the Company contributed $102,054 and $145,184 in pension
contributions.





12.
            Accounts
      Payable and accrued Expenses




At June
30, 2010 and December 31, 2009 accounts payable and accrued expenses consisted
of:





June
      30,
              2010
            
            
            December 31,
              2009Accounts
      payable
            
            $
            2,842,662
            
            
            $
            2,308,866Accrued
      payroll
            
            
            60,149
            
            
            
            306,011Accrued
      interest
            
            
            271,528
            
            
            
            71,570Economic
      development advance
            
            
            44,239
            
            
            
            43,943Accrued
      insurance
            
            
            45,090
            
            
            
            187,408$
            3,263,668
            
            
            $
            2,917,798




15


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


13.
            Notes
      payable




At June
30, 2010 and December 31, 2009 notes payable consisted of the
following:





June
      30,
              2010
            
            
            December 31,
              2009Notes
      dated June, 2008, due December 31, 2010 with a interest rate of
      10%,
            
            $
            1,716,411
            
            
            $
            2,573,301Notes
      dated November, 2008 due May 10, 2010 with a interest rate of
      10%
            
            
            -
            
            
            
            500,000Note
      dated November, 2009 due November 30, 2010 with a interest rate of
      10%
            
            
            1,750,000
            
            
            
            1,750,000Notes
      dated December, 2009 due December 24, 2010 with a interest rate of 10%,
      net of debt discount of $357,780  and $729,830 at June 30, 2010
      and December 31, 2009, respectively
            
            
            1,392,220
            
            
            
            1,020,171Note
      dated June, 2010 due June 2011 with a interest rate of 10%
            
            
            800,000
            
            
            
            -$
            5,658,631
            
            
            $
            5,843,472





14.
            Lease
      payable


On June
23, 2010, HXD entered into a sale and leaseback agreement pursuant to which, the
lessor purchased certain equipment from HXD located in HXD’s new milk powder
production facility, for a purchase price of $5,161,176, (RMB 35,000,000); the
lessor leased the equipment back to HXD for 36 monthly payments of $164,124,
(RMB 1,112,991), a commission fee of $154,835 (RMB 1,050,000), a refundable
deposit of $774,176 (RMB 5,250,000); and the Company issued to the lessor
three-year warrants to purchase 934,600 shares of the Company’s common stock at
an exercise price of $1.65 per share with a fair value of $996,873 (RMB
6,760,197). See note 15 regarding calculation of the fair value of the
warrants.





HXD
retained the benefits and risks incident to the ownership of the equipment, and
title to the equipment will transfer back to HXD at the completion of the lease.
Therefore the lease was treated as a financing with no recognition of gain or
loss on the sale.  Per accounting guidance the lease was recorded as a
capital lease at the present value of the minimum lease payments, including the
commission fee and the fair value of the warrants issued.





The
balances on the lease are as follows:





June
      30,
              2010
            
            
            December 31,
              2009Remaining
      lease payments
            
            $
            5,908,467
            
            
            $
            -Imputed
      interest
            
            
            (1,899,000
            )
            
            
            -Lease
      balance
            
            
            4,009,467
            
            
            
            -Less
      current portion
            
            
            (997,084
            )
            
            
            -Long-term
      lease payable
            
            $
            3,012,383
            
            
            $
            -





Future
principal payments over the next four years are as follows:


2010
              
              $
              465,0672011
              
              
              1,140,6242012
              
              
              1,492,6712013
              
              
              911,105


16


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009




15.
            Equity





Warrants





Information
with respect to stock warrants outstanding as of June 30, 2010 are as
follows:





Exercisable:




Exercise Price
            
            
            Outstanding
              December
              31, 2009
            
            
            Granted
              Modified
            
            
            Modified,
      Expired or
              Exercised
            
            
            Outstanding
              June
              30, 2010
            
            Expiration
              Date$
            0.75
            
            
            
            -0-
            
            
            
            373,334
            
            
            
            (373,334
            )
            
            
            -0-
            
            4/6/2010$
            0.94
            
            
            
            373,334
            
            
            
            -0-
            
            
            
            (373,334
            )
            
            
            -0-
            
            10/09/2010$
            1.20
            
            
            
            -0-
            
            
            
            499,522
            
            
            
            (499,522
            )
            
            
            -0-
            
            4/6/2010$
            1.50
            *
            
            
            -0-
            
            
            
            -0-
            
            
            
            833,811
            
            
            
            833,811
            
            8/02/2011$
            2.04
            *
            
            
            578,884
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            578,884
            
            8/01/2012$
            2.04
            *
            
            
            327,306
            
            
            
            -0-
            
            
            
            (30,675
            )
            
            
            296,631
            
            8/11/2012$
            1.63
            *
            
            
            235,583
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            235,583
            
            8/11/2012$
            1.63
            *
            
            
            195,000
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            195,000
            
            6/12/2013$
            1.63
            *
            
            
            75,000
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            75,000
            
            6/20/2013$
            1.63
            
            
            
            97,500
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            97,500
            
            12/31/2011$
            1.63
            
            
            
            100,000
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            100,000
            
            11/10/2012$
            1.63
            
            
            
            120,000
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            120,000
            
            11/30/2012$
            1.63
            
            
            
            536,809
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            536,809
            
            12/24/2012$
            1.63
            
            
            
            789,536
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            789,536
            
            12/31/2012$
            1.63
            
            
            
            -0-
            
            
            
            184,049
            
            
            
            -0-
            
            
            
            184,049
            
            4/6/2010$
            1.63
            
            
            
            -0-
            
            
            
            44,643
            
            
            
            -0-
            
            
            
            44,643
            
            9/2/2014$
            1.63
            
            
            
            -0-
            
            
            
            40,000
            
            
            
            -0-
            
            
            
            40,000
            
            6/25/2013$
            1.65
            
            
            
            -0-
            
            
            
            40,000
            
            
            
            -0-
            
            
            
            40,000
            
            3/31/2014$
            1.65
            
            
            
            -0-
            
            
            
            934,600
            
            
            
            -0-
            
            
            
            934,600
            
            6/24/2013$
            3.26
            *
            
            
            -0-
            
            
            
            -0-
            
            
            
            981,747
            
            
            
            981,747
            
            8/02/2011$
            3.26
            *
            
            
            -0-
            
            
            
            -0-
            
            
            
            1,423,372
            
            
            
            1,423,372
            
            8/11/2011$
            2.61
            
            
            
            75,000
            
            
            
            -0-
            
            
            
            -0-
            
            
            
            75,000
            
            11/10/2011





Not-exercisable:





Exercise Price
            
            
            Outstanding
              December
              31, 2009
            
            
            Granted
            
            
            Modified,
      Expired or
              Exercised
            
            
            Outstanding
              June
              30, 2010
            
            Expiration
              Date$
            1.65
            
            
            
            -0-
            
            
            
            120,000
            
            
            
            -0-
            
            
            
            120,000
            
            3/31/2014







*
            On
      January 28, 2010 the Company’s registration statement became effective
      which extended the expiration date of these
  warrants.





Extension
of Warrants





Pursuant
to the provisions of Section 10 of the respective common stock purchase warrants
(the “Warrants”) previously issued by the Company to the investors and certain
finders and placement agents in connection with private offerings the Company
consummated in October 2007, the original expiration dates of the Warrants were
to be extended beyond their initial stated termination dates for certain
specified periods until the Company satisfied certain registration rights
provisions relating to the shares of the Company’s common stock underlying the
Warrants. As a result of the Company’s satisfaction on January 28, 2010 of
certain registration rights provisions relating to the warrants, the expiration
dates of the Warrants were adjusted to provide as follows:




17


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009




15.
            Equity
      (Continued)





·
            373,334
      Warrants exercisable at $0.94 per share that would otherwise have expired
      on October 9, 2010 now expire on  August 1,
  2012;





·
            1,333,333
      Warrants exercisable at $1.50 per share that would otherwise have expired
      on October 9, 2009 now expire on August 2,
2011;





·
            190,245
      Warrants exercisable at $2.04 per share that would otherwise have expired
      on October 9, 2010 now expire on August 1,
2012;





·
            981,747
      Warrants exercisable at  $3.26 per share that would otherwise
      have expired on October 9, 2009 now expire on August 2,
    2011;





·
            235,583
      Warrants exercisable at $1.63 per share that would otherwise have expired
      on October 19, 2010 now expire on August 11,
  2012;





·
            715,945
      Warrants exercisable at  $2.04 per share that would otherwise
      have expired on October 19, 2010 now expire on August 11, 2012;
      and





·
            1,544,461
      Warrants exercisable at $3.26 per share that would otherwise have expired
      on October 19, 2009 now expire on August 12,
  2011.




The
extended expiration dates have been noted on the Company’s records and it is not
necessary for the holders to exchange their original Warrants for amended
warrants.  No other terms of the Warrants were
changed.





The fair
value of the warrants as of January 28, 2010, before modification of the terms,
was calculated to be $759,035. The fair value of the warrants as of January 28,
2010, after modification of the terms, was calculated to be
$5,780,704.  The incremental change in the value of the warrants is
$5,021,669, which was recorded to liquidated damages in the six months ended
June 30, 2010.





Warrant
Tender Offers





On
February 10, 2010, the Company commenced an offer (the “Third Offer”) to the
holders of 5,374,648 outstanding warrants to purchase shares of the Company’s
common stock originally issued in connection with the private offerings the
Company consummated in October 2007, having exercise prices of either $0.94,
$1.50, $1.63, $2.04 or $3.26 per share (the “Original Warrants”), to voluntarily
exchange any or all of the Original Warrants for amended warrants exercisable at
reduced exercise prices (“Amended Warrants”).  The reduced exercise
prices of the Amended Warrants will depend on the current exercise prices
applicable to the Original Warrants. As of February 10, 2010, the Original
Warrants included:





·
            373,334
      Original Warrants to purchase shares of Common Stock at an exercise price
      of $0.94 per share, which may be exchanged for Amended Warrants
      exercisable at a reduced price of $0.75 per
  share,





·
            1,333,333
      Original Warrants to purchase shares of Common Stock at an exercise price
      of $1.50 per share, which may be exchanged for Amended Warrants
      exercisable at a reduced price of $1.20 per
  share,





·
            235,583
      Original Warrants to purchase shares of Common Stock at an exercise price
      of $1.63 per share, which may be exchanged for Amended Warrants
      exercisable at a reduced price of $1.30 per
  share,





·
            906,190
      Original Warrants to purchase shares of Common Stock at an exercise price
      of $2.04 per share, which may be exchanged for Amended Warrants
      exercisable at a reduced price of $1.63 per share,
  and





·
            2,526,208
      Original Warrants to purchase shares of Common Stock at an exercise price
      of $3.26 per share, which may be exchanged for Amended Warrants
      exercisable at a reduced price of $1.63 per
    share.




18


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


15.
            Equity
      (Continued)





The only
differences between the Original Warrants and the Amended Warrants that were
offered, related to (i) the lower exercise prices, (ii) the shortening of the
exercise period to twenty (20) days following the expiration of the Third Offer,
(iii) the deletion of the provision that holders may not exercise their warrants
if the exercise will cause them and their affiliates to beneficially own an
aggregate of more than 9.9% of the outstanding shares of Common Stock of the
Company, and (iv) the requirement that the exercise price must be paid in cash,
as a cashless exercise of the Amended Warrants will not be
accepted.





On March
17, 2010 the Company closed the Third Offer with the following warrants
exchanged:





·
            a
      total of 373,334 Original Warrants with exercise prices of $0.94 per share
      were exchanged for Amended Warrants with reduced exercise prices of $0.75
      per share;





·
            a
      total of 499,522 Original Warrants with exercise prices of $1.50 per share
      were exchanged for Amended Warrants with reduced exercise prices of $1.20
      per share;





·
            no
      Original Warrants with exercise prices of $1.63 per share were exchanged
      for Amended Warrants with reduced exercise prices of $1.30 per
      share;





·
            a
      total of 30,675 Original Warrants with exercise prices of $2.04 per share
      were exchanged for Amended Warrants with reduced exercise prices of $1.63
      per share; and





·
            a
      total of 153,374 Original Warrants with exercise prices of $3.26 per share
      were exchanged for Amended Warrants with reduced exercise prices of $1.63
      per share.





On April
6, 2010, the holder of the Company’s 10% promissory notes in the principal
amount of $856,890, due on December 31, 2010 (the “Note”), requested that the
Company apply the $879,427 balance due to him under the Note (which balance
included $19,537 of accrued and unpaid interest) to the holder’s exercise of (a)
373,334 of his Amended Warrants, at an exercise price of $0.75 per share, and
(b) 499,522 of his Amended Warrants, at an exercise price of $1.20 per
share.  The Company’s Board approved the request and, accordingly, on
April 6, 2010 the holder exercised the Amended Warrants, the Company issued
872,856 shares of its common stock to the holder, and the Note was
cancelled.





On April
6, 2010 one holder of Amended Warrants exercised all 184,049 of his Amended
Warrants, at an exercise price of $1.63 per share, resulting in gross proceeds
to the Company of approximately $300,000.





Warrants
Issued for Loan Costs





In April
2010, the Company’s board of directors approved a November 23, 2009 amendment to
a financial consulting agreement with an advisor.  Pursuant to the
amended agreement, in connection with the Company’s December 2009 private
placement of priomissory notes, the Company issued to the advisor 44,643
warrants to purchase shares of the Company’s common stock, at an exercise price
of $1.63 per share, which expire on September 2, 2014.





The fair
value of the warrants as of November 23, 2009, the date of the amended
agreement, was calculated to be $79,991 and recorded as prepaid loan costs to be
amortized over the life of the notes.  The following assumptions were
used to calculate the fair value of the warrants:





Dividend
      yield
            
            
            0
            %Expected
      volatility
            
            
            177.42
            %Risk-free
      interest rate
            
            
            2.21
            %Expected
      life
            
            4.75
      yearsStock
      price
            
            $
            1.88Exercise
      price
            
            $
            1.63




19




Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


15.
            Equity
      (Continued)





Warrants
Issued for Services





In April
2010 the Company issued 4 year warrants to purchase 160,000 shares of common
stock for $1.65 per share.  The warrants vest 25% per quarter over the
one year life of the contract.  Pursuant to accounting guidance the
fair value of the warrants will be measured and recorded when
vested.  During the quarter ended June 30, 2010 the fair value of the
40,000 warrants vested was calculated to be $46,097 and was expensed to selling,
general and administrative expense.  The following assumptions were
used to calculate the fair value of the warrants:





Dividend
      yield
            
            
            0
            %Expected
      volatility
            
            
            146.93
            %Risk-free
      interest rate
            
            
            1.37
            %Expected
      life
            
            3.75
      yearsStock
      price
            
            $
            1.38Exercise
      price
            
            $
            1.65





In June
2010, the Company entered into a consulting services contract pursuant to which
the Company issued 3 year warrants to purchase 40,000 shares of common stock for
$1.63 per share.  The fair value of the warrants was calculated to be
$44,039 and was recorded as prepaid expense to be amortized over the life of the
contract.  The following assumptions were used to calculate the fair
value of the warrants:





Dividend
      yield
            
            
            0
            %Expected
      volatility
            
            
            147.62
            %Risk-free
      interest rate
            
            
            1.01
            %Expected
      life
            
            3.00
      yearsStock
      price
            
            $
            1.40Exercise
      price
            
            $
            1.63





Shares
Issued For Services





On March
18, 2010, the Company issued 180,000 shares of the Company’s common stock with a
fair value of $250,200 to an employee for services rendered in
2009.  The $250,200 was accrued as compensation expense for the year
ended December 31, 2009, and was included in accrued payroll at December 31,
2009.





Return
of Shares





On March
18, 2010, Yang Yong Shan, the Company’s Chairman, Chief Executive Officer and
President, returned 180,000 shares of the Company’s common stock to the Company
as a capital contribution.  The 180,000 shares have been returned to
the Company’s number of authorized but unissued shares of common stock. The $180
par value of the shares was transferred from common stock to additional paid-in
capital as of March 18, 2010.





Shares
Issued For Loan Extension





On May
10, 2010 the Company entered into an amendment of the note originally issued in
connection with a private placement consummated in November 2008 (the “November
2008 Note”), whereby the Company agreed:





(a)
            to
      pay the note holder $75,000 on May 11, 2010, which represented the
      full amount of accrued and unpaid interest on the November 2008 Note as of
      May 10, 2010;





(b)
            that
      within thirty (30) days of May 10, 2010, the Company would repay to the
      note holder the full $500,000 principal amount due under the November 2008
      Note, plus additional interest, at a rate of 15%, accrued from May 10,
      2010 through the date of repayment;
and


20




Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009





15.
            Equity
      (Continued)





(c)
            that,
      as additional consideration, the Company would issue to the note holder a
      total of





(i)
            5,000
      restricted shares of the Company’s common stock, if the full amount due
      under the November 2008 Note was repaid to the note holder on or before
      May 25, 2010; or





(ii)
            10,000
      restricted shares of the Company’s common stock, if the full amount due
      under the November 2008 Note was repaid to the note holder after May 25,
      2010, but on or before June 9,
2010.





On June
9, 2010, the Company entered into another letter agreement pursuant to which the
Company agreed that:





(a)
            within
      fifteen (15) days of June 9, 2010, the Company would
      repay the note holder the full $500,000 principal amount of
      the November 2008 Note, plus interest, at a rate of 15% per annum, accrued
      from May 11, 2010, through the date of repayment;
  and




(b)
            as
      additional consideration, the Company would issue to the
      note holder a total of 5,000 restricted shares of the
      Company's common stock.




The
Company repaid all remaining amounts of principal and interest
due to the note holder under his promissory note as of June 24,
2010.  The 15,000 shares of the Company’s common stock due the noteholder
under these agreements was valued at the closing price as of the date the stock
became due under the agreements as follows:




Date
              
              Number
      of Shares
              
              
              Closing
      Price
              
              
              Value5/10/10
              
              
              5,000
              
              
              $
              1.20
              
              
              $
              6,000.005/26/10
              
              
              5,000
              
              
              $
              1.25
              
              
              $
              6,250.006/9/10
              
              
              5,000
              
              
              $
              1.27
              
              
              $
              6,350.00


The total
value of $18,850 was recorded as loan costs and charged to interest expense in
the three and six months ended June 30, 2010.





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 Corporation 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
15, 2010 the Company issued 14,403 shares of common stock with a fair value of
$15,807 pursuant to the 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 to be issued is
determined.





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 June 30, 2010 and December 31, 2009, was
$3,191,614 and $1,834,742, 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.


21


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009





17.
            Earnings
      Per Share





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





For the
three months ended June 30, 2010 dilutive shares include stock options of
703,200 and outstanding warrants to purchase 833,811 of common stock at an
exercise price of $1.50. Stock options of 760,000 and warrants to purchase
6,564,125 shares of common stock were not included in dilutive shares as the
effect would have been anti-dilutive.





For the
six months ended June 30, 2010 stock options of 1,463,200 and outstanding
warrants to purchase 7,397,936 shares of common stock were not included in
dilutive shares as the effect would have been anti-dilutive.





For the
three and six months ended June 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 7,960,536 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 June 30, 2010:Net
      income
            
            $
            1,283,946Basic
      EPS income available to common shareholders
            
            $
            1,283,946
            
            
            
            33,941,295
            
            
            $
            0.04Effect
      of dilutive securities:Warrants
            
            
            
            
            
            
            240,036Stock
      options
            
            
            —
            
            
            
            479,562Diluted
      EPS income available to common shareholders
            
            $
            1,283,946
            
            
            
            34,660,893
            
            
            $
            0.04For
      the three months ended June 30, 2009:Net
      income
            
            $
            1,263,136Basic
      EPS income available to common shareholders
            
            $
            1,263,136
            
            
            
            29,658,726
            
            
            $
            0.04Effect
      of dilutive securities:Warrants
            
            
            
            
            
            
            109,474Stock
      options
            
            
            —
            
            
            
            337,680Diluted
      EPS income available to common shareholders
            
            $
            1,552,706
            
            
            
            30,105,880
            
            
            $
            0.04





Income
            
            
            Shares
            
            
            Per Share(Numerator)
            
            
            (Denominator)
            
            
            AmountFor
      the six months ended June 30, 2010:Net
      loss
            
            $
            (1,012,698
            )Basic
      EPS loss available to common shareholders
            
            $
            (1,012,698
            )
            
            
            33,446,310
            
            
            $
            (0.03
            )Effect
      of dilutive securities:Warrants
            
            
            
            
            
            
            --Stock
      options
            
            
            —
            
            
            
            --Diluted
      EPS loss available to common shareholders
            
            $
            (1,012,698
            )
            
            
            33,446,310
            
            
            $
            (0.03
            )For
      the six months ended June 30, 2009:Net
      income
            
            $
            2,815,842Basic
      EPS income available to common shareholders
            
            $
            2,815,842
            
            
            
            29,537,604
            
            
            $
            0.09Effect
      of dilutive securities:Warrants
            
            
            
            
            
            
            29,281Stock
      Options
            
            
            —
            
            
            
            81,758Diluted
      EPS income available to common shareholders
            
            $
            2,815,842
            
            
            
            29,648,643
            
            
            $
            0.09





22


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


18.
            Equity
      Incentive Plan





On March
2, 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 in the Condensed Consolidated Statements
of Income were $172,530 and $385,891 during the three and six months ended June
30, 2010, respectively, and $57,180 and $75,688 during the three and six months
ended June 30, 2009, 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.




No
options were granted during the three and six months ended June 30,
2010.


23


Emerald
Dairy, Inc. and Subsidiaries


Footnotes
to Condensed Consolidated Financial Statements


June
30, 2010 and 2009





18.
            Equity
      Incentive Plan (Continued)





Share
Options





A summary
of the Company’s outstanding share option award grants as of June 30, 2010 and
changes during the three months then ended are presented below:





Shares
            
            Weighted-Average
      Exercise Price
            
            Weighted-Average
              Remaining
              Contractual
      Term
            
            Aggregate
      Intrinsic ValueOutstanding
      at December 31, 2009
            
            1,463,200
            
            $
            1.14Granted
            
            -0-
            
            
            --Exercised
            
            -0-
            
            
            --Expired
            
            -0-
            
            
            --Forfeited
            
            -0-
            
            
            --Outstanding
      at June 30, 2010
            
            1,463,200
            
            $
            1.14
            
            8.92
            
            $
            675,072Vested
      and expected to vest at June 30, 2010
            
            1,463,200
            
            $
            1.14
            
            8.92
            
            $
            675,072Exercisable
      at June 30, 2010
            
            541,600
            
            $
            0.90
            
            8.92
            
            $
            337,536





As of
June 30, 2010, there was $436,063 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
0.96 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.





The
Company has contracted to purchase equipment from a supplier for the second
processing facility for $12,961,040 of which $10,321,689 has been
paid.  The remaining $2,639,351 will be paid on delivery and
completion of installation of the equipment in 2010.





The
Company has advances to milk suppliers of $320,253 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, an Infant & Baby Formula
Milk Powder Production Permit is required from the State General Administration
of Quality Supervision and Inspection and Quarantine of the People’s Republic of
China (the “Administration”). The Company’s current license will expire on April
25, 2013.  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 our business sectors in the
near future. Although management believes that the Company is in material
compliance with the statutes, laws, rules and regulations of every
jurisdiction in which it operates, no assurance can be given that the Company’s
compliance with the applicable statutes, laws, rules and regulations will
not be challenged by governing authorities or private parties, or that such
challenges will not lead to a material adverse effect on the Company’s financial
position, results of operations, or cash flows.


24


Emerald
Dairy, Inc. and Subsidiaries
 Footnotes
to Condensed Consolidated Financial Statements
 June
30, 2010 and 2009


19.
            Commitments
      and Contingencies (Continued)





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





20.
            Operating
      Leases





The
Company leases various distribution facilities. All leases are on an annual
basis and commence on January 1, of each year. The Company also leases office
space which expires September 2010.  For the three and six months
ended June 30, 2010, the Company incurred rental expense of $19,034 and $38,064,
respectively, and $39,116 and $78,409 for the three and six months ended June
30, 2009, respectively. As of June 30, 2010, the Company had outstanding lease
commitments totaling $972,982, $913,119 is due within the one year and $59,863
in the second year.





21.
            Subsequent
      events





Management
has evaluated subsequent events from July 1, 2010 to August 16, 2010, 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 August 16, 2010 have
not been evaluated in the financial statements as of June 30, 2010.





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.





For the
three and six months ended June 30, 2010 and 2009, the Company’s sales revenues
from various products are as follows:





Three Months
              Ended June 30,
            
            
            Six Months
              Ended June 30,2010
            
            
            2009
            
            
            2010
            
            
            2009Milk
      powder
            
            $
            11,517,627
            
            
            $
            9,126,262
            
            
            $
            23,941,820
            
            
            $
            18,395,943Soybean
      milk powder
            
            
            356,712
            
            
            
            267,662
            
            
            
            739,183
            
            
            
            554,823Rice
      powder
            
            
            408,453
            
            
            
            314,240
            
            
            
            853,040
            
            
            
            634,465Sub-contract
      processing
            
            
            1,026,710
            
            
            
            538,771
            
            
            
            2,028,315
            
            
            
            1,518,256$
            13,309,502
            
            
            $
            10,246,935
            
            
            $
            27,562,358
            
            
            $
            21,103,487




25





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 94.2%, 3.1% and 2.7%of our sales,
respectively. Through our network of over 1,100 salespeople, our products are
distributed throughout 20 provinces in the People’s Republic of China (“PRC”),
and sold in over 6,000 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 is one of
the fastest growing markets in the PRC. It has been growing at a rate of 16% per
year over the past six years, according to the National Bureau of Statistics of
China, 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, according
to the Dairy Association of China, has grown even faster in recent years, at a
rate of 20%-30% per year. 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. By adding a
third shift to the existing two shifts working schedule, we produced
approximately 9,000 tons of milk powder in each of fiscal 2008 and
2009.




26




We
believe that a lack of adequate production capacity has been a significant
impediment to our ability to increase our revenue in recent years. In July 2008,
through our wholly-owned subsidiary, Hailun Xinganling Dairy Co., Ltd., a PRC
company (“HXD”), we commenced construction of a new production facility in
Hailun City, Heilongjiang Province, PRC. Initially, this new facility will have
one production line, with the capacity to produce 9,000 tons of milk power
annually. A second production line can be added at this new facility, which,
when completed, would enable us to produce an additional 9,000 tons of milk
powder per year. 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.





We
anticipate that production at this new facility will commence on or around the
end of the third quarter of fiscal 2010. We expect the cost to add a second
production line to be approximately $15.0 million. We plan to fund the second
production line with a combination of retained earnings and, to the extent
necessary, funds raised from the capital market through private or public equity
offerings, private or public debt offerings and/or equipment lease transactions.
There can be no assurance that that any additional financing will become
available to us, and if available, on terms acceptable to us.





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





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


·
              Heilongjiang
      Be’ian Nongken Changxing Lvbao Dairy Limited Liability Company, a PRC
      company (“Lvbao”), which handles production of our products in Be’ian
      City, Heilongjiang Province, PRC;
and
  ·
              HXD,
      which, upon completion of the first production line of our new facility,
      will handle additional production of our products in Hailun City,
      Heilongjiang Province, PRC.




Our
products have become increasingly 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 $44.7 million in 2009, a
466% increase over four years. Net income increased from approximately $0.7
million in 2005 to approximately $4.2 million in 2009, a 500% increase over four
years.




Recent
Developments




Sale and Leaseback
Agreement





On June
24, 2010, our wholly-owned subsidiary, HXD, entered into a Sale and Leaseback
Agreement (the “Sale and Leaseback Agreement”) with Fenghui Leasing Co., Ltd.
(“Fenghui”), pursuant to which, among other things:





·
              Fenghui
      purchased certain milk powder processing equipment located at our new milk
      powder processing facility (the “Equipment”) from HXD, for a purchase
      price of aproximately
$5,161,176;




27




·
              Fenghui
      leased the Equipment back to HXD for 36 months in return for monthly
      payments of approximately $164,124 (a total of approximately $5,908,464),
      a commission fee of $154,835, and a refundable deposit of $774,176;
      and





·
              We
      issued to Fenghui three-year warrants to purchase 934,600 shares of the
      Company’s common stock, at an exercise price of $1.65 per share (the
      “Fenghui Warrants”).





See Note
14 of the Notes to our consolidated financial statements for additional
information concerning the sale and leaseback transaction (the “Sale and
Leaseback Transaction”).





June
2010 Term Loan





On June
24, 2010, we entered into a Loan Agreement with an unrelated third party (the
“June 2010 Lender”), pursuant to which we borrowed $800,000 from the June 2010
Lender (the “June 2010 Term Loan”), in consideration for which we issued the
June 2010 Lender a promissory note (the “June 2010 Term Loan Note”). We applied
the gross proceeds from the June 2010 Term Loan primarily toward the cost of
equipping the first production line of our newly-constructed milk powder
processing facility, the payment of expenses incurred in connection with the
June 2010 Term Loan, and general working capital purposes.





The
rights and obligations under the June 2010 Term Loan Note are further described
in “-- Liquidity and Capital Resources -- Promissory Notes” below.





Repayment
of November 2008 Promissory Note





On June
24, 2010, we repaid a promissory note in the principal amount of $500,000 (the
“Amended November 2008 Note”), which Amended November 2008 Note was originally
issued in connection with our November 2008 private placement, and amended as of
November 10, 2009, May 10, 2010 and June 9, 2010. We paid the noteholder accrued
interest of $75,000 and $9,247 on May 11, 2010 and June 24, 2010, respectively.
In addition, in connection with the amendments on May 10, 2010 and June 9, 2010,
we are required to issue the noteholder an aggregate of 15,000 restricted shares
of our common stock.





Trends
and Uncertainties





Economic
Downturn





The
worldwide economic downturn and market instability, which began in 2008, 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, as well as our results of operations and financial condition, may be
adversely affected by unpredictable and unstable market conditions. If the
current equity and credit markets deteriorate, or do not improve from current
levels, it may make it difficult, if not impossible, for us to obtain debt or
equity financing on acceptable terms at a time when we wish to do so. 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. We do
not expect this economic downturn to have a significant effect on our business
or operations in the near future.However, we cannot predict
the timing or duration of any economic slowdown or recession or the timing or
strength of a subsequent recovery, worldwide, or in the specific markets we
serve. If the markets for our products significantly deteriorate due to these
economic effects, our business, financial condition and results of operations
may be materially and adversely affected.




28




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. We believe this initiative will continue to provide us with
growth opportunities.





Industry
Growth





The dairy
market is one of the fastest growing markets in the PRC. It has been growing at
a rate of 16% per year over the past six years, according to the National Bureau
of Statistics of China, and is expected to grow at a rate of 15% per year for
the foreseeable future. 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;





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





·
              Increased
      popularity and acceptance of infant formula
  products.





Based on
these factors, we expect to see significant growth in our business and
operations when we commence production at our new production facility in Hailun
City. However, a slowdown in overall economic growth, an economic downturn or
recession or other adverse economic developments in the PRC may materially
reduce the demand for our products and materially and adversely affect our
business.





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 are equipping the first
production of our 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 by the end of the third quarter of 2010. 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.





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. In fiscal 2009,
the price of certain raw materials we use declined. We believe the prices of the
raw materials we use to produce our products will stay relatively stable for the
foreseeable future. To some extent, we believe we will be able to increase the
prices for our products to pass on any 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.




29




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. We plan to
continue to focus on penetrating less-competitive second and third tier
cities.





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 by the end of 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 insignificant. 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 become increasingly popular in the PRC. Over time, this should
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. The contraction in the Chinese milk powder industry
caused by this crisis has lead to increased demand for our products. However, 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.




30




Results
of Operations





Three-Month
Period Ended June 30, 2010 Compared to Three-Month Period Ended June 30,
2009





The
following summarizes changes in our operations for the three months ended June
30, 2010 and 2009.  Net income increased by $20,810, from $1,263,136
in the three months ended June 30, 2009, to $1,283,946 for the three months
ended June 30, 2010. The increase in net income during the three months ended
June 30, 2010, as compared to the same time period in the prior year, was due to
an increase in our gross profit as well as other factors further described
below.




Sales
and Cost of Goods Sold





For the Three
      Months
              Ended June
      30,2010
            
            2009Sales
            
            $
            13,309,502
            
            
            $
            10,246,935Cost of Goods
      Sold
            
            
            6,794,707
            
            
            
            5,639,310Gross
      Profit
            
            $
            6,514,795
            
            
            $
            4,607,625





Sales. Sales volume increased
by 592 metric tons, or 31.8%, period on period, to 2,453 metric tons for the
three months ended June 30, 2010, from 1,861 metric tons for the three months
ended June 30, 2009. Sales revenues increased by $3,062,567, or 29.9%, from
$10,246,935 in the three months ended June 30, 2009, to $13,309,502 for the
three months ended June 30, 2010. These increases were primarily due to
increased demand for our products, partially offset by a reduction in the
average selling price for all of our products, by $80 per metric ton, as
compared to the three months ended June 30, 2009, resulting from increased sales
of our middle and lower end products.





Sales by product
line.A break-down of our sales by product line for the three
months ended June 30, 2010 and 2009 is as follows:





Three
      Months Ended June 30,2010
            
            
            2009
            
            
            Period-on-periodProduct category
            
            Quantity
              (tons)
            
            
            $ Amount
            
            
            % of sales
            
            
            Quantity
              (tons)
            
            
            $ Amount
            
            
            % of
              sales
            
            
            Qty.
              VarianceMilk
      powder
            
            
            1,822
            
            
            
            11,517,627
            
            
            
            86.5
            
            
            
            1,433
            
            
            
            9,126,262
            
            
            
            89.0
            
            
            
            389Rice
      powder
            
            
            72
            
            
            
            408,453
            
            
            
            3.1
            
            
            
            55
            
            
            
            314,240
            
            
            
            3.1
            
            
            
            17Soybean
      powder
            
            
            218
            
            
            
            356,712
            
            
            
            2.7
            
            
            
            156
            
            
            
            267,662
            
            
            
            2.6
            
            
            
            62Subcontracting
            
            
            341
            
            
            
            1,026,710
            
            
            
            7.7
            
            
            
            217
            
            
            
            538,771
            
            
            
            5.3
            
            
            
            124Total
            
            
            2,453
            
            
            
            13,309,502
            
            
            
            100.0
            
            
            
            1,861
            
            
            
            10,246,935
            
            
            
            100.0
            
            
            
            592




There
were various changes to the break-down of sales among our product lines over the
three months ended June 30, 2010, as we increased production in most all
lines. Soybean powder accounted for 2.7% of our sales mix for the three
months ended June 30, 2010, at an average selling price of $1,636 per metric
ton, as compared to 2.6% of our sales mix in the three months ended June 30,
2009, at an average selling price of $1,716 per metric ton. Rice powder
accounted for 3.1% of our sales mix for the three months ended June 30, 2010, at
an average selling price of $5,673 per metric ton, as compared to 3.1% of our
sales mix in the three months ended June 30, 2009, at an average selling price
of $5,713 per metric ton. Milk powder accounted for 86.5% of second quarter 2010
sales mix, at an average selling price of $6,321 per metric ton, as compared to
89.0% of second quarter 2009, at an average selling price of $6,369 per metric
ton. We increased our subcontract production during the three months ended June
30, 2010 to 7.7% of the sales mix, at an average selling price of $3,011 per
metric ton, as compared to 5.3% of the sales mix in the three months ended June
30, 2009, at an average sales price of $2,483 per metric ton. The primary reason
for the increase in our sales from subcontracting was that we began extending
relationships with other companies for which we can subcontract to help absorb
the excess production capacity we will have when the first production line at
our new facility begins operating at the end of the third quarter.




31




A
breakdown of our average selling price by product line for the three months
ended June 30, 2010 and 2009 is as follows:




Three
      Months Ended
              June
      30,Average selling prices
            
            2010
            
            
            2009
            
            
            Variance$
            
            
            $
            
            
            $
            
            
            
            %Milk
      powder
            
            
            6,321
            
            
            
            6,369
            
            
            
            (48
            )
            
            
            (0.8
            )Rice
      powder
            
            
            5,673
            
            
            
            5,713
            
            
            
            (40
            )
            
            
            (0.7
            )Soybean
      powder
            
            
            1,636
            
            
            
            1,716
            
            
            
            (80
            )
            
            
            (4.7
            )Subcontracting
            
            
            3,011
            
            
            
            2,483
            
            
            
            528
            
            
            
            21.3All
      products
            
            
            5,426
            
            
            
            5,506
            
            
            
            (80
            )
            
            
            (1.5
            )




Cost of Goods
Sold.  Cost of goods sold increased by $1,155,397, or 20.5%,
from $5,639,310 in the three months ended June 30, 2009, to $6,794,707 for the
three months ended June 30, 2010. This increase was directly related to our
increased production during the three months ended June 30, 2010. Overall our
cost per metric ton decreased by $260, or 8.6%, to $2,770 per metric ton in the
three months ended June 30, 2010, as compared to $3,030 per metric ton in three
months ended June 30, 2009, due to decreases in the price of raw materials we
use to produce our products. We expect the prices of the raw materials we use to
produce our products to stay relatively stable for the foreseeable
future.




32


A
breakdown of cost of sales by product line for the three months ended June 30,
2010 and 2009 is as follows:




Three
      Months Ended June 30,2010
            
            
            2009
            
            
            Variance$
            
            
            $
            
            
            $
            
            
            
            %Cost of salesMilk
      powder
            
            
            5,471,288
            
            
            
            4,744,236
            
            
            
            727,052
            
            
            
            15.3Rice
      powder
            
            
            136,936
            
            
            
            123,231
            
            
            
            13,705
            
            
            
            11.1Soybean
      powder
            
            
            257,202
            
            
            
            215,192
            
            
            
            42,010
            
            
            
            19.5Subcontracting
            
            
            929,281
            
            
            
            556,651
            
            
            
            372,630
            
            
            
            66.9Total
            
            
            6,794,707
            
            
            
            5,639,310
            
            
            
            1,155,397
            
            
            
            20.5Cost per units sold(per
      ton)Milk
      powder
            
            
            3,003
            
            
            
            3,311
            
            
            
            (308
            )
            
            
            (9.3
            )Rice
      powder
            
            
            1,902
            
            
            
            2,241
            
            
            
            (339
            )
            
            
            (15.1
            )Soybean
      powder
            
            
            1,180
            
            
            
            1,379
            
            
            
            (199
            )
            
            
            (14.4
            )Subcontracting
            
            
            2,725
            
            
            
            2,565
            
            
            
            160
            
            
            
            6.2Average
      cost per unit sold
            
            
            2,770
            
            
            
            3,030
            
            
            
            (260
            )
            
            
            (8.6
            )




Gross Profit. Gross profit was
$6,514,795, or 48.9% of our sales for the three months ended June 30, 2010, as
compared to gross profit of $4,607,625, or 45.0% of sales, for the three months
ended June 30, 2009. During the three months ended June 30, 2010, our gross
margin on milk powder increased to 52.5%, from 48.0% in the same period of the
prior year, due to a 9.3% decrease in cost per metric ton of our products,
partially offset by a decerase in average selling price of 0.8%. The gross
margin for soybean powder increased 8.3% to 27.9% in the three months ended June
30, 2010, as compared to 19.6% in the three months ended June 30, 2009, due to a
decrease in the average cost per ton of 19.0% in the three months ended June 30,
2010 as compared to the same period in 2008.





A
breakdown of gross margin by product line for the three months ended June 30,
2010 and 2009 is as follows:




Three
      Months Ended June 30,2010
            
            
            2009
            
            
            Period-on-periodProduct category
            
            $ Amount
            
            
            Gross
              Margin %
            
            
            $ Amount
            
            
            Gross
              Margin %
            
            
            Margin
              VarianceMilk
      powder
            
            
            6,046,339
            
            
            
            52.5
            
            
            
            4,382,026
            
            
            
            48.0
            
            
            
            4.5Rice
      powder
            
            
            271,517
            
            
            
            66.5
            
            
            
            191,009
            
            
            
            60.8
            
            
            
            5.7Soybean
      powder
            
            
            99,510
            
            
            
            27.9
            
            
            
            52,470
            
            
            
            19.6
            
            
            
            8.3Subcontracting
            
            
            97,429
            
            
            
            9.5
            
            
            
            (17,880
            )
            
            
            (3.3
            )
            
            
            12.8Total
            
            
            6,514,795
            
            
            
            48.9
            
            
            
            4,607,625
            
            
            
            45.0
            
            
            
            3.9




Operating
Expenses





For the Three
      Months
              Ended June
      30,2010
            
            
            2009Operating ExpensesSelling
      and administrative expenses
            
            $
            4,004,280
            
            
            $
            3,073,694Depreciation
      and amortization
            
            
            51,724
            
            
            
            43,274Total
      operating expenses
            
            $
            4,056,004
            
            
            $
            3,116,968




33




Selling Expenses. Selling
expenses overall increased by $655,809, or 26.6%, from $2,463,710 in the three
months ended June 30, 2009, to $3,119,519 for the three months ended June 30,
2010. The major factors in the increase in selling expenses are as
follows:





·
              Advertising
      increased by $196,854, or 80.0%, to $442,820 in 2010, from $245,966 in
      2009, due to an increased marketing campaign in
  2010.





·
              Promotion
      expenses increased by $221,754, or 50.9%, to $657,375 in 2010, from
      $435,621 in 2009, as we increased our marketing as compared to
      2009.





·
              Outdoor
      promotion expenses increased by $27,907, or 12.2%, to $257,056 in 2010,
      from $229,149 in 2009, as a result of our increased marketing campaign in
      2010.





·
              Selling
      salary expenses increased by $93,997, or 17.6%, to $626,584 in 2010, from
      $532,587 in 2009, as a result of our increased marketing campaign in
      2010.





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





Administrative Expenses.
Administrative expenses increased by $274,778, or 45.0%, from $609,983 in three
months ended June 30, 2009, to $884,761 for the three months ended June 30,
2010. The major factors in the increase in administrative expenses are as
follows:





·
              Increase
      of salary and stock option expenses of $72,615, to $230,387 in 2010, from
      $157,773 in 2009, as a result of additional stock options granted in late
      2009.





·
              Increase
      in travel expenses of $16,188, to $70,019 in 2010, from $53,832 in 2009,
      as a result of increase in cost of travel during
  2010.





·
              Increase
      in legal and accounting expenses of $198,592, to $317,834 in 2010, from
      $119,242 in 2009, as a result of increased use of professional services
      during 2010.





These
increases were partially offset by a decrease of $42,712 in pension expense as
compared with 2009 and a decrease in consultation expenses of $36,361 as
compared with 2009. We required less time in preparation of our regulatory
filings in the current year and did not use the services of the consultant that
was used in the 2009.




Provision
for Income Taxes





For the Three
      Months
              Ended June
      30,2010
            
            
            2009Provision
      for Income TaxesCurrent
            
            $
            391,243
            
            
            $
            278,064Deferred
            
            
            —
            
            
            
            —$
            391,243
            
            
            $
            278,064





Provision for Income Taxes.
Income taxes increased by $113,179, or 40.7%, from $278,064 for the three months
ended June 30, 2009, to $391,243 for the three months ended June 30, 2010. This
increase was due to the increase in our taxable income in our operating
subsidiaries.




34




Six-Month
Period Ended June 30, 2010 Compared to Six-Month Period Ended June 30,
2009





The
following summarizes changes in our operations for the six months ended June 30,
2010 and 2009.  Net income decreased by $3,828,540, from $2,815,842 in
the six months ended June 30, 2009, to a loss of $1,012,698 for the six months
ended June 30, 2010. The decrease in net income during the six months ended June
30, 2010, as compared to the same time period in the prior year, was due to
liquidated damages we incurred during the current year in connection with the
extension of the expiration dates of certain of our issued and outstanding
warrants, which offset an increase in our gross profit as further described
below.




Sales
and Cost of Goods Sold





For the Six
      Months
              Ended June
      30,2010
            
            2009Sales
            
            $
            27,562,358
            
            
            $
            21,103,487Cost of Goods
      Sold
            
            
            13,948,479
            
            
            
            11,487,985Gross
      Profit
            
            $
            13,613,879
            
            
            $
            9,615,502





Sales. Sales volume increased
by 1,161 metric tons, or 29.8%, period on period, to 5,052 metric tons for the
six months ended June 30, 2010, from 3,891 metric tons for the six months ended
June 30, 2009. Sales revenues increased by $6,458,871, or 30.6%, from
$21,103,487 in the six months ended June 30, 2009, to $27,562,358 for the six
months ended June 30, 2010. This increase was due to an increase the quantity of
products we sold by 1,161 metric tons, as well as an increase in the average
selling price for all of our products, by $32 per metric ton, as compared to the
six months ended June 30, 2009, as a result producing more of our high end
product line in the first half of fiscal 2010 as a whole.





Sales by product
line.A break-down of our sales by product line for the six
months ended June 30, 2010 and 2009 is as follows:





Six
      Months Ended June 30,2010
            
            
            2009
            
            
            Period-on-periodProduct category
            
            Quantity
              (tons)
            
            
            $ Amount
            
            
            % of sales
            
            
            Quantity
              (tons)
            
            
            $ Amount
            
            
            % of
              sales
            
            
            Qty.
              VarianceMilk
      powder
            
            
            3,780
            
            
            
            23,941,820
            
            
            
            86.8
            
            
            
            2,891
            
            
            
            18,395,943
            
            
            
            87.2
            
            
            
            889Rice
      powder
            
            
            150
            
            
            
            853,040
            
            
            
            3.1
            
            
            
            112
            
            
            
            634,465
            
            
            
            3.0
            
            
            
            38Soybean
      powder
            
            
            451
            
            
            
            739,183
            
            
            
            2.7
            
            
            
            309
            
            
            
            554,823
            
            
            
            2.6
            
            
            
            142Subcontracting
            
            
            671
            
            
            
            2,028,315
            
            
            
            7.4
            
            
            
            579
            
            
            
            1,518,256
            
            
            
            7.2
            
            
            
            92Total
            
            
            5,052
            
            
            
            27,562,358
            
            
            
            100.0
            
            
            
            3,891
            
            
            
            21,103,487
            
            
            
            100.0
            
            
            
            1,161




There
were various changes to the break-down of sales among our product lines over the
six months ended June 30, 2010, as we increased production in all lines, but
attempted to adjust our sales mix to higher margin products. Rice powder
accounted for 3.1% of our sales mix for the six months ended June 30, 2010, at
an average selling price of $5,687 per metric ton, as compared to 3.0% of our
sales mix in the six months ended June 30, 2009, at an average selling price of
$5,665 per metric ton. Soybean powder accounted for 2.7% of our sales mix
for the six months ended June 30, 2010, at an average selling price of $1,639
per metric ton, as compared to 2.6% of our sales mix in the six months ended
June 30, 2009, at an average selling price of $1,796 per metric ton. Milk
powder accounted for 86.8% of the 2010 sales mix, at an average selling price of
$6,334 per metric ton, as compared to 87.2% in 2009, at an average selling price
of $6,363 per metric ton. We increased our subcontract production during the six
months ended June 30, 2010 to 7.4% of the sales mix, at an average selling price
of $3,023 per metric ton, as compared to 7.2% of the sales mix in the six months
ended June 30, 2009, at an average sales price of $2,622 per metric ton. The
primary reason for the increase in our sales from subcontracting was that we
began extending relationships with other companies for which we can subcontract
to help absorb the excess production capacity we will have when the first
production line at our new facility begins operating at the end of the third
quarter.




35




A
breakdown of our average selling price by product line for the six months ended
June 30, 2010 and 2009 is as follows:




Six
      Months Ended
              June
      30,Average selling prices
            
            2010
            
            
            2009
            
            
            Variance$
            
            
            $
            
            
            $
            
            
            
            %Milk
      powder
            
            
            6,334
            
            
            
            6,363
            
            
            
            (29
            )
            
            
            (0.5
            )Rice
      powder
            
            
            5,687
            
            
            
            5,665
            
            
            
            22
            
            
            
            0.4Soybean
      powder
            
            
            1,639
            
            
            
            1,796
            
            
            
            (157
            )
            
            
            (8.7
            )Subcontracting
            
            
            3,023
            
            
            
            2,622
            
            
            
            401
            
            
            
            15.3All
      products
            
            
            5,456
            
            
            
            5,424
            
            
            
            32
            
            
            
            0.6




Cost of Goods
Sold.  Cost of goods sold increased by $2,460,494, or 21.4%,
from $11,487,985 in the six months ended June 30, 2009, to $13,948,479 for the
six months ended June 30, 2010. This increase was directly related to our
increased production during the six months ended June 30, 2010. Overall our cost
per metric ton decreased by $191, or 6.5%, to $2,761 per metric ton in the six
months ended June 30, 2010, as compared to $2,952 per metric ton in six months
ended June 30, 2009, due to decreases in the price of raw materials we use to
produce our products We expect the prices of the raw materials we use to produce
our products to stay relatively stable for the foreseeable future.





A
breakdown of cost of sales by product line for the years ended June 30, 2010 and
2009 is as follows:




Six
      Months Ended June 30,2010
            
            
            2009
            
            
            Variance$
            
            
            $
            
            
            $
            
            
            
            %Cost of salesMilk
      powder
            
            
            11,293,235
            
            
            
            9,376,411
            
            
            
            1,916,724
            
            
            
            20.4Rice
      powder
            
            
            311,284
            
            
            
            248,810
            
            
            
            62,474
            
            
            
            25.1Soybean
      powder
            
            
            522,807
            
            
            
            430,563
            
            
            
            92,244
            
            
            
            21.4Subcontracting
            
            
            1,821,253
            
            
            
            1,432,201
            
            
            
            389,052
            
            
            
            27.2Total
            
            
            13,948,579
            
            
            
            11,487,985
            
            
            
            2,460,494
            
            
            
            21.4Cost per units sold(per
      ton)Milk
      powder
            
            
            2,988
            
            
            
            3,243
            
            
            
            (255
            )
            
            
            (7.9
            )Rice
      powder
            
            
            2,075
            
            
            
            2,222
            
            
            
            (147
            )
            
            
            (6.6
            )Soybean
      powder
            
            
            1,159
            
            
            
            1,393
            
            
            
            (234
            )
            
            
            (16.8
            )Subcontracting
            
            
            2,714
            
            
            
            2,474
            
            
            
            240
            
            
            
            9.7Average
      cost per unit sold
            
            
            2,761
            
            
            
            2,952
            
            
            
            (191
            )
            
            
            (6.5
            )




36




Gross Profit. Gross profit was
$13,613,879, or 49.4% of our sales for the six months ended June 30, 2010, as
compared to gross profit of $9,615,502, or 45.6%, for the six months ended June
30, 2009. During the six months ended June 30, 2010, our gross margin on milk
powder increased to 52.8%, from 49.0% in the same period of the prior year, due
to a decrease in the average sales price of 0.6%, while there was a 6.5%
decrease in the cost per metric ton from the six months ended June 30,
2009. The gross margin for soybean powder increased 6.9% to 29.3% in the
six months ended June 30, 2010, as compared to 22.4% in the six months ended
June 30, 2009, due to a decrease in the average cost per ton of 16.8% in the six
months ended June 30, 2010 as compared to the same period in 2009.





A
breakdown of gross margin by product line for the years June 30, 2010 and 2009
is as follows:




Six
      Months Ended June 30,2010
            
            
            2009
            
            
            Period-on-periodProduct category
            
            $ Amount
            
            
            Gross
              Margin %
            
            
            $ Amount
            
            
            Gross
              Margin %
            
            
            Margin
              VarianceMilk
      powder
            
            
            12,648,685
            
            
            
            52.8
            
            
            
            9,019,532
            
            
            
            49.0
            
            
            
            3.8Rice
      powder
            
            
            541,756
            
            
            
            63.5
            
            
            
            385,655
            
            
            
            60.8
            
            
            
            2.7Soybean
      powder
            
            
            216,376
            
            
            
            29.3
            
            
            
            124,260
            
            
            
            22.4
            
            
            
            6.9Subcontracting
            
            
            207,062
            
            
            
            10.2
            
            
            
            86,055
            
            
            
            5.7
            
            
            
            4.5Total
            
            
            13,613,879
            
            
            
            49.4
            
            
            
            9,615,502
            
            
            
            45.6
            
            
            
            3.8




Operating
Expenses





For the Six
      Months
              Ended June
      30,2010
            
            
            2009Operating ExpensesSelling
      and administrative expenses
            
            $
            7,906,670
            
            
            $
            6,100,398Liquidated
      damages
            
            
            5,021,669
            
            
            
            -Depreciation
      and amortization
            
            
            102,952
            
            
            
            86,512Total
      operating expenses
            
            $
            13,031,291
            
            
            $
            6,186,910





Selling Expenses. Selling
expenses overall increased by $1,461,192, or 30.4%, from $4,804,364 in the six
months ended June 30, 2009, to $6,265,556 for the six months ended June 30,
2010. The major factors in the decrease in selling expenses are as
follows:





·
              Advertising
      increased by $305,838, or 62.2%, to $797,562 in 2010, from $491,724 in
      2009, due to an increased marketing campaign in
  2010.





·
              Promotion
      expenses increased by $597,157, or 80.8%, to $1,336,645 in 2010, from
      $739,487 in 2009, as we increased our marketing as compared to
      2009.





·
              Outdoor
      promotion expenses increased by $140,972, or 36.1%, to $531,441 in 2010,
      from $390,469 in 2009, as a result of our increased marketing campaign in
      2010.





·
              Selling
      salary expenses increased by $209,523, or 19.4%, to $1,289,081 in 2010,
      from $1,079,558 in 2009, as a result of our increased marketing campaign
      in 2010.





These
increases were partially offset by a decrease in entertainment expenses of
$50,352, or 19.7%, to $205,004 in 2010, from $255,357 in 2009, as part of
readjusting our marketing campaign.




37




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





Administrative Expenses.
Administrative expenses increased by $345,080, or 26.6%, from $1,296,034 in six
months ended June 30, 2009, to $1,641,114 for the six months ended June 30,
2010. The major factors in the increase in administrative expenses are as
follows:





·
              Increase
      of salary and stock option expenses of $310,911, to $602,266 in 2010, from
      $291,355 in 2009, as a result of additional stock options granted in late
      2009.





·
              Increase
      in travel expenses of $26,384, to $130,137 in 2010, from $103,753 in 2009,
      as a result of increase in cost of travel during
  2010.





·
              Increase
      in legal and accounting expenses of $71,744, to $443,307 in 2010, from
      $371,564 in 2009, as a result of increase in cost of professional services
      related to compliance issues during
2010.





These
increases were partially offset by a decrease of $57,143 in pension expense as
compared with 2009 and a decrease in consultation expenses of $85,111 as
compared with 2009. We required less time in preparation of our regulatory
filings in the current year and did not use the services of the consultant that
was used in the 2009.





Liquidated Damages.We
recorded $5,021,669 in liquidated damages during the six months ended June 30,
2010, as a result of the extension of warrants previously issued by us to
satisfy certain registration rights provisions. See Note 15 of the Notes to
Condensed Consolidated Financial Statements for additional
information.




Provision
for Income Taxes





For the Six
      Months
              Ended June
      30,2010
            
            
            2009Provision
      for Income TaxesCurrent
            
            $
            812,742
            
            
            $
            615,894Deferred
            
            
            —
            
            
            
            —$
            812,742
            
            
            $
            615,894





Provision for Income Taxes.
Income taxes increased by $196,848, or 32.0%, from $615,894 for the six months
ended June 30, 2009, to $812,742 for the six months ended June 30, 2010. This
increase was due to the increase in our taxable income in our operating
subsidiaries.




38


Liquidity
and Capital Resources





Uses
of Capital





For the Six
      Months Ended
                  June
      30,2010
                
                
                2009Net
      cash provided by operating activities
                
                $
                3,797,949
                
                
                $
                848,559Net
      cash used in investing activities
                
                $
                (11,709,446
                )
                
                $
                (4,189,873
                )Net
      cash provided by financing activities
                
                $
                5,625,284
                
                
                $
                758,231





Net Cash Provided By Operating
Activities.For the six months ended June 30, 2010, $3,797,949
was provided by operating activities, compared with $848,559 provided by
operating activities for the six months ended June 30, 2009. Our net cash flows
provided from operating activities during 2010 increased due to the following
factors:





·
              Operations
      provided $4,796,351 of net cash during the six months ended June 30,
      2010.





·
              Trade
      accounts receivable increased by $188,123, due to the decreased
      collections during the
period.





·
              Inventory
      increased by $260,477, due to adjustments from increased sales of our
      products during the current
period.





·
              Other
      current assets increased by $877,809, due the increase in our level of
      production during 2010.





·
              Accounts
      payable and accrued expenses increased by $576,581 at June 30, 2010 due to
      increases in production of products and
  expenses.





Net Cash Used In Investing
Activities.For the six months ended June 30, 2010, we used
$11,709,446 in investing activities, compared with $4,189,873 used in investing
activities for the six months ended June 30, 2009. The $11,709,446 was primarily
for the construction and equipping of our new production facility.





Net Cash Provided By Financing
Activities.For the six months ended June 30, 2010 there was
$5,625,284 provided by financing activities, compared with $758,231 provided by
financing activities for the six months ended June 30, 2009. We raised $296,408
through the exercise of warrants during the six months ended June 30, 2010, in
connection with the consummation of warrant tender offers. We also completed the
Sale and Leaseback Transaction with regard to certain Equipment which provided
$5,006,340 during the six months ended June 30, 2010.





General





Cash and
cash equivalents at June 30, 2010 decreased by approximately 16.0% to
$11,328,951, from $13,486,429 at December 31, 2009. Working capital increased
from approximately $17.3 million at December 31, 2009, to approximately $27.2
million at June 30, 2010, which includes cash generated from operations, as well
as funds raised from private offerings of promissory notes and warrants we
consummated in fiscal 2009. 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.




39




We
believe that a lack of adequate production capacity has been a significant
impediment to our ability to increase our revenue in recent years. 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 through the opening of our
new production facility, and increasing both sales staff and advertising
expenditures.





In July
2008, we commenced construction of our new production facility. The first phase
of this project has cost an aggregate of approximately $22.0 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 on or around the end of the third
quarter of fiscal 2010.





The new
facility has the capacity to handle a second production line. Although there can
be no assurance will add a second production line to our new facility, we
currently intend to do so. If we were to add a second production line at this
new facility it 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 a second production line would be an
additional $15.0 million. Although there can be no assurance will add a second
production line to our new facility, we plan to fund the second production line
with a combination of retained earnings and, to the extent necessary, funds
raised from the capital market through private or public equity offerings,
private or public debt offerings and/or equipment lease transactions. We
currently have no sources for the additional financing we would need to add a
second production line at our new processing facility. There can be no assurance
that that any additional financing will become available to us, and if
available, on terms acceptable to us.





Historically
we have relied primarily 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 expect to
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.





In fiscal
2009, we raised approximately $7.7 million through the sale of promissory notes
and exercise of warrants. We used theses funds for the construction
and equipping of our new production facility and for general working capital
purposes.





In fiscal
2010, we:





·
              borrowed
      $800,000 through the June 2010 Term Loan from the June 2010 Lender;
      and





·
              consummated
      the Sale and Leaseback Transaction with Fenghui, pursuant to which, among
      other things Fenghui purchased certain Equipment from HXD, for a purchase
      price of approximately $5,161,176, and Fenghui leased the Equipment back
      to HXD for 36 monthly payments of approximately $164,124 (a total of
      approximately $5,908,464), a commission fee of $154,835, and a refundable
      deposit of $774,176.




40




We are
applying the proceeds we received from the June 2010 Term Loan and Sale and
Leaseback transaction to complete the equipping of the first production line of
our new production facility and for general working capital
purposes.





Currently,
we spend approximately 8%-12% of total revenues on advertising and promotional
efforts through out the year. We spent approximately $4.5 million on advertising
and promotion in fiscal 2009. We currently expect to spend an aggregate of
approximately $6.0 million on advertising and promotion in fiscal
2010.





Registration
Rights and Liquidated Damages





We
entered into Registration Rights Agreements with the investors (the “October
2007 Investors”) in the private placements we consummated in October 2007 (the
“October 2007 Private Placements”), 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
2007 Private Placements (the “Purchased Shares”), and (ii) the common stock
issuable upon exercise of the October 2007 Warrants (collectively (i) and (ii),
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 were required to pay liquidated
damages to the holders of the Purchased Shares if (i) we failed to file the
Registration Statement on or before the Filing Date, (ii) the SEC did 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 failed to request acceleration of
effectiveness within five (5) business days of a notice of no further review
from the SEC, (iv) we failed 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 accumulate
at the rate of one and one-half percent (1.5%) of the purchase price paid by the
October 2007 Investors for units of our securities purchase in the October 2007
Private Placements for each thirty (30) day period during which a registration
default is continuing; provided, however, that (i) we would not be liable for
liquidated damages with respect to any warrants or shares of common stock
underlying the warrants, and (ii) in no event would 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 of the October 2007 Investors shall
be 20% of the aggregate purchase price paid by such purchaser. The Registration
Rights Agreements further required that if we failed 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.





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.




41




On
January 28, 2010, a Registration Statement we filed to register the Registrable
Securities for resale was declared effective by the SEC.





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





The
Renminbi is currently not a freely convertible currency, and the restrictions on
currency exchange may limit our ability to use revenues generated in RMB to fund
our business activities outside the PRC, or to make dividends or other payments
in United States dollars. The PRC government strictly regulates conversion of
RMB into foreign currencies. Over the years, foreign exchange regulations in the
PRC have significantly reduced the government’s control over routine foreign
exchange transactions under current accounts. In the PRC, SAFE, regulates the
conversion of the RMB into foreign currencies. Pursuant to applicable PRC laws
and regulations, foreign invested enterprises incorporated in the PRC are
required to apply for “Foreign Exchange Registration Certificates.” Currently,
conversion within the scope of the “current account” (e.g. remittance of foreign
currencies for payment of dividends, etc.) can be effected without requiring the
approval of SAFE. However, conversion of currency in the “capital account” (e.g.
for capital items such as direct investments, loans, securities, etc.) still
requires the approval of SAFE.  See the discussion in Risk Factors
commencing on page 14 of Amendment No. 1 to our Annual Report on Form 10-K for
the fiscal year ended December 31, 2009 (the “Form 10-K/A”) for more
information.





Warrants





As of the
date hereof, we have outstanding exercisable warrants to purchase an aggregate
of 8,020,936 shares of our common stock, of which:




·
              833,811
      are exercisable at a price of $1.50 per
share;


·
              2,233,891
      are exercisable at a price of $1.63 per
share;


·
              1,597,600
      are exercisable at a price of $1.65 per share (and an additional 120,000
      to be exercisable at a price of $1.65 per share, whichvestas to one third of
      the underlying shares on each of September 30, 2010, December 31, 2010 and
      March 31, 2011);


·
              875,515
      are exercisable at a price of $2.04 per
share;


·
              75,000
      are exercisable at a price of $2.61 per share;
  and


·
              2,405,119
      are exercisable at a price of $3.26 per
share.


If all of
the warrants are exercised at their reduced exercise prices, we will receive
gross proceeds of approximately $17,350,000, although there can be no assurance
that any of these warrants will be exercised.




Promissory
Notes





The June 2010 Term Loan
Note





The June
2010 Term Loan Note has a principal balance of $800,000. The interest rate on
the June 2010 Term Loan Note is 10% per annum and is payable on maturity. The
June 2010 Term Loan Note has a stated maturity date of June 24, 2011. Upon the
maturity of the June 2010 Term Loan Note, by acceleration or otherwise, interest
on unpaid amounts shall thereafter be payable at the rate of 12% per annum,
until the obligation is paid in full. Any regular interest or default interest
not paid when due under the June 2010 Term Loan Note shall be added to the
principal of the June 2010 Term Loan Note. We may from time-to-time prepay any
amount due under the June 2010 Term Loan Note, in whole or in part, without
penalty. The entire unpaid principal balance, together with accrued interest,
shall become due and payable, without presentment, demand, protest, notice of
protest or other notice of dishonor of any kind upon the occurrence of an “Event
of Default,” as defined in our Loan Agreement with the lender.




42




The Amended June 2008
Note





A
promissory note we originally issued in connection with the private placement we
consummated in June 2008, as amended on December 31, 2008 and December 31, 2009
(the “Amended June 2008 Note”), which matures on December 31, 2010, has a
principal balance of $1,716,411 and bears interest at a rate of 10%, which is
also payable on December 31, 2010. 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 Amended June 2008 Note at any time without penalty, upon 15
days prior written notice. The holder of the Amended June 2008 Note has the
right to be prepaid any amounts due under the Amended June 2008 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 Amended June
2008 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) 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 the Amended June 2008 Note if: (a) we fail to
pay principal or interest when due on the Amended June 2008 Note; (b) we breach
any material covenant or other material term or condition contained in the
Amended June 2008 Note or securities purchase agreement entered into in
connection with the June 2008 Offering, as amended (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
Amended June 2008 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 NYSE Amex Equities. Upon the occurrence of any Event of
Default under the Amended June 2008 Note, unless such Event of Default shall
have been waived in writing by the holder, the holder may consider the Amended
June 2008 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 Amended June 2008 Note or any other right or
remedy afforded by law. Our repayment of amounts due under the Amended June 2008
Note is secured by a pledge of an aggregate of 2,104,950 shares of our common
stock beneficially owned by Yang Yong Shan, our Chairman, Chief Executive
Officer and President.





The November 2010 Term Loan
Note





The
promissory note we issued in connection with a loan transaction we consummated
in November 2009 (the “November 2009 Term Loan Note”), which matures on November
30, 2010, has a principal balance of $1,750,000 and bears interest at a rate of
10% per annum, which is also payable on maturity. The November 2009 Term Loan
Note has a stated maturity date of November 30, 2010. Upon the maturity of the
November 2009 Term Loan Note, by acceleration or otherwise, interest on unpaid
amounts shall thereafter be payable at the rate of 12% per annum default
interest, until the obligation is paid in full. Any regular interest or default
interest not paid when due under the November 2009 Term Loan Note shall be added
to the principal of the November 2009 Term Loan Note. We may from time-to-time
prepay any amount due under the November 2009 Term Loan Note, in whole or in
part, without penalty. The entire unpaid principal balance, together with
accrued interest, shall become due and payable, without presentment, demand,
protest, notice of protest or other notice of dishonor of any kind upon the
occurrence of an “Event of Default,” as defined in our Loan Agreement with the
lender.




43




The December 2009
Notes





The promissory notes we originally
issued in connection with the private placement we consummated in December 2009
(the “December 2009 Notes”), which mature on December 24, 2010, have an
aggregate principal balance of $1,750,000 and bear interest at a rate of 10%,
which is also payable on December 24, 2010. Any amount of principal or interest
which is not paid when due will bear interest at a rate of 15% per annum. We may
prepay the entire amount due under the December 2009 Notes at any time without
penalty, upon 15 days prior written notice; provided, however, in such event the
noteholders (the “December 2009 Noteholders”) will be entitled to retain an
amount of prepaid interest equal to the greater of (i) the amount accrued as of
the prepayment date, and (ii) an aggregate of $105,000. The December 2009
Noteholders have the right to be prepaid any amounts due under the December 2009
Notes should we consummate certain additional offerings of equity or debt
securities. So long as we have any obligation under the December 2009 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; (d) sell, lease or otherwise dispose of any significant portion of our
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. The entire unpaid principal balance,
together with accrued interest, shall become due and payable, without
presentment, demand, protest, notice of protest or other notice of dishonor of
any kind upon the occurrence of an “Event of Default,” as defined in the
December 2009 Notes. Our repayment of amounts due under the December 2009 Notes
is secured by a pledge of an aggregate of 5,883,329 shares of our common stock
beneficially owned by Yang Yong Shan, our Chairman, Chief Executive Officer and
President.





Dividends





We have
not paid any dividends. In all likelihood, we will use any earnings to develop
our business and do not intend to declare dividends for the foreseeable future.
Any decision to pay dividends on our common stock in the future will be made by
our board of directors on the basis of earnings, financial requirements and
other such conditions that may exist at that time. In addition, certain of our
outstanding promissory notes contain restrictive covenants on our payment of
dividends, as further described in “-- Promissory Notes” above.




44


Contractual
Obligations and Commercial Commitments





Our
contractual obligations, as of June 30, 2010, 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
              
              $
              2,639,351
              
              
              $
              2,639,351
              
              
              
              —
              
              
              
              —
              
              
              
              —Construction
      contract
              
              
              499,897
              
              
              
              499,897
              
              
              
              —
              
              
              
              —
              
              
              
              —Debt
      Obligations
              
              
              6,165,174
              
              
              
              6,165,174
              
              
              
              —
              
              
              
              —
              
              
              
              —Capital
      leases
              
              
              5,908,467
              
              
              
              1,969,489
              
              
              
              3,938,978Operating
      leases
              
              
              972,982
              
              
              
              853,255
              
              
              
              119,727
              
              
              
              —
              
              
              
              —Total:
              
              $
              16,185,871
              
              
              $
              12,127,166
              
              
              
              4,058,705
              
              
              
              —
              
              
              
              —





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





·
            Fair Value
      Measurements




45




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 2010, 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 Form 10-K/A for the fiscal year ended
December 31, 2009 for a more complete discussion of our critical accounting
policies and estimates.





Recently
Enacted Accounting Standards





Refer to
Note 3 to the Financial Statements included in Part I, Item 1 of this Quarterly
Report on Form 10-Q, which discusses new accounting pronouncements we recently
adopted, as well as accounting pronouncements recently issued or proposed but
not yet required to be adopted.





Off-Balance
Sheet Arrangements





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





46


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 (“Exchange Act”) and are not required to provide the information
under this item.





Item
4.  Controls and Procedures.





Disclosure
Controls and Procedures





Our
management maintains disclosure controls and procedures, as defined in Rules
13a-15(e) and 15d-15(e) of the Exchange Act that are designed to provide
reasonable assurance that the material information required to be disclosed by
us in our periodic reports filed or submitted under the Exchange Act is
recorded, processed, summarized, and reported within the time periods specified
in the SEC’s rules and forms. Disclosure controls and procedures include,
without limitation, controls and procedures designed to ensure that information
required to be disclosed by us in the reports that we file or submit under the
Exchange Act is accumulated and communicated our management, including our Chief
Executive Officer and Chief Financial Officer, to allow timely decisions
regarding required disclosure.





As of
June 30, 2010, our management, under the supervision of and with the
participation of our Chief Executive Officer and Chief Financial Officer,
evaluated the effectiveness of our disclosure controls and procedures as
required by Rules 13a-15(b) and 15d-15(b) under the Exchange Act. Based upon
this evaluation, our Chief Executive Officer and Chief Financial Officer
concluded that our disclosure controls and procedures were not effective as of
June 30, 2010 as a result of the material weaknesses identified in our internal
control over financial reporting. These material weaknesses are discussed in
“Management’s Report on Internal Control over Financial Reporting” contained in
our Form 10-K/A. Our management considers our internal control over financial
reporting to be an integral part of our disclosure controls and
procedures.





Our
management has taken and is continuing to take the following actions to improve
our internal controls over financial reporting, including actions to remediate
the identified material weaknesses:





·
              As
      financial conditions permit, our management will recruit an independent
      financial expert to the Board of Directors to chair the Audit Committee
      and formalize roles and responsibilities over our internal controls over
      financial reporting for the Board and our management. Our management also
      intends to develop and implement a formal corporate internal audit
      capability, eventually reporting directly to an independent Audit
      Committee, to provide more effective oversight of our internal control
      over financial reporting.





·
              Our
      management will implement a Code of Conduct specifically designed for
      public company applicability across all corporate entities. Company
      directors, management and staff will be required to certify receipt of the
      Code by signature. Thereafter, our management will periodically require
      employees to acknowledge that they understand the contents of the Code,
      and disclose whether they are aware of anyone in the Company that might
      have violated some part of the
Code.





·
              Our
      management will formalize finance-related job descriptions for all staff
      levels that specifically identify required financial reporting roles,
      responsibilities, and competencies, and clarify responsibility for
      maintaining our internal controls over financial reporting.  Our
      management will implement these revised policies and procedures across all
      of its corporate entities with appropriate staff training to ensure that
      financial reporting competencies are
  strengthened.




47




·
              Our
      management will hire additional, qualified accounting personnel at the
      Chinese operating unit level to enhance our financial reporting
      competencies. Our management will also continue to provide training to
      existing accounting personnel regarding our significant accounting
      policies and procedures.





·
              Our
      management will continue to engage the services of qualified consultants
      with China GAAP, U.S. GAAP and SEC reporting experience to assist with and
      support our financial reporting and SOX compliance requirements in 2010,
      including assistance with the
following:





o
            Remediating
      identified material weaknesses;





o
            Monitoring
      our internal controls over financial reporting on an ongoing
      basis;





o
            Managing
      our period-end financial closing and reporting processes;
    and





o
            Identifying
      and resolving non-routine or complex accounting
  matters.





·
              Our
      management will determine and hire the staff competencies required to
      ensure that essential IT general controls are maintained over our
      accounting system. In addition, our management will formalize its policies
      and procedures over core IT functions, including access, change, data, and
      security management, to ensure that all relevant financial information is
      secure, identified, captured, processed, and reported within the
      accounting system.





Our
management will continue to monitor and evaluate the effectiveness of its
disclosure controls and procedures, as well as its internal controls over
financial reporting, on an ongoing basis, and is committed to taking further
action and implementing additional improvements, as necessary and as funds
allow. However, our management cannot guarantee that the measures taken or any
future measures will remediate the material weaknesses identified or that any
additional material weaknesses or significant deficiencies will not arise in the
future due to a failure to implement and maintain adequate internal controls
over financial reporting.





Notwithstanding
the material weaknesses described above, our management believes that there are
no material inaccuracies or omissions of material fact and, to the best of its
knowledge, believes that the consolidated financial statements included in this
annual report present fairly, in all material respects, our financial position,
results of operations, and cash flows for the periods presented in conformity
with accounting principles generally accepted in the United States.





Changes
in Internal Control Over Financial Reporting





There
were no changes in our internal control over financial reporting (as defined in
Rules 13a-15(f) and 15d-15(f) under the Exchange Act) that occurred during the
interim period ended June 30, 2010, that have materially affected, or are
reasonably likely to materially affect, our internal control over financial
reporting.




48




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 Exchange Act and are not required to provide the
information under this item.





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





Issuance
of Warrants to an Investor Relations Firm





As of
April 1, 2010, we entered into an Investor Relations Agreement (the “IR
Agreement”) with a consultant. Pursuant to the IR Agreement, in consideration
for certain investor relations services to be provided to us by the consultant,
we agreed to (i) pay the consultant a monthly cash consulting and services fee
of $8,000, and (ii) issue to the consultant four-year warrants to purchase
160,000 shares of our common stock, at an exercise price of $1.65 per share,
which vested with respect to 40,000 of the underlying shares on June 30, 2010,
and will vest as to an additional 40,000 of the underlying shares on each of
September 30, 2010, December 31, 2010 and March 31, 2011 (the “IR
Warrants”).





We
believe the issuance of the 160,000 IR Warrants is exempt from registration
under the Securities Act of 1933, as amended (the “Act”), pursuant to Section
4(2) thereof, as a transaction by an issuer not involving a public
offering.





Issuance
of Shares to an Investor Relations Firm





As of
January 1, 2010, we entered into an Investor Relations Consulting Agreement (the
“IR Consulting Agreement”) with a consultant. Pursuant to the IR Consulting
Agreement, in consideration for investor relations services to be provided to us
by the consultant, we agreed to pay a monthly retainer of $9,500, consisting of
(i) $4,500 in cash, and (ii) such number of shares of our restricted stock to be
determined by dividing $4,500 by 85% of the average closing trading price of our
common stock for the first ten trading days of the applicable month, capped at
3,676 shares per month. On April 1, 2010, we terminated the IR Consulting
Agreement by written notice. As of April 30, 2010, we issued the consultant
14,403 shares of our common stock in consideration for services provided to us
between January 1, 2010 and April 30, 2010.





We
believe the issuance of the 14,403 shares pursuant to the IR Consulting
Agreement is exempt from registration under the Act, pursuant to Section 4(2)
thereof, as a transaction by an issuer not involving a public
offering.





Issuance
of Shares in Connection with Repayment of November 2008 Promissory
Note





On June
24, 2010, we repaid the Amended November 2008 Note in the principal amount of
$500,000, which was originally issued in connection with our November 2008
private placement, and amended as of November 10, 2009, May 10, 2010 and June 9,
2010. We paid the noteholder accrued interest of $75,000 and $9,247 on May 11,
2010 and June 24, 2010, respectively. In addition, in connection with the
amendments on May 10, 2010 and June 9, 2010, we are required to issue the
noteholder an aggregate of 15,000 restricted shares of our common
stock.





49





We
believe the issuance of these shares will be exempt from registration under the
Act, pursuant to Section 4(2) thereof, as transactions by an issuer not
involving a public offering.





Issuance
of Warrants to a Consultant





One June
24, 2010, we entered into a Consulting Agreement (the “Consulting Agreement”)
with a consultant. Pursuant to the Consulting Agreement, in consideration for
certain business consulting services to be provided to us by the consultant, we
issued to the consultant, and its designee, three-year warrants to purchase
40,000 shares of our common stock, exercisable at an exercise price of $1.63 per
share, and which may be exercised for cash or on a cashless basis (the
“Consultant Warrants”).





We
believe the issuance of the 40,000 Consultant Warrants is exempt from
registration under the Act, pursuant to Section 4(2) thereof, as a transaction
by an issuer not involving a public offering.





Item
3.  Defaults Upon Senior Securities.





Not
Applicable





Item
4.  (Removed and Reserved).





Item
5.  Other Information.





None




50


Item
6.  Exhibits





Exhibit No.
              
              Description of Exhibit4.1
              
              Promissory
      Note, dated June 24, 2010, Issued to the June 2010
  Lender4.2
              
              Warrants
      issued to Fenghui Leasing Co., Ltd., as of June 24,
201010.1
              
              Second
      Amendment, dated May 10, 2010, to a Securities Purchase Agreement between
      the Company and an investor in the Company’s November 2008 private
      placement (1)10.2
              
              Letter
      Agreement, dated June 9, 2010, between the Company and an Investor in the
      Company’s November 2008 Private Placement (2)10.3
              
              Loan
      Agreement, dated June 24, 2010, by and between the Company and the June
      2010 Lender10.4
              
              Sale
      and Leaseback Agreement, dated June 24, 2010, by and between the Company’s
      wholly-owned Subsidiary, HXD, and Fenghui Leasing Co.,
  Ltd.31.1
              
              Certification
      of principal executive officer pursuant to Exchange Act Rule
      13a-14(a)31.2
              
              Certification
      of principal financial and accounting officer pursuant to Section
      13a-14(a)32.1
              
              Certification
      of principal executive officer pursuant to 18 U.S.C. Section 135032.2
              
              Certification
      of principal financial and accounting officer pursuant to 18 U.S.C.
      Section 1350







(1)
              Incorporated
      by reference to the exhibit filed with the Company’s Current Report on
      Form 8-K for the event dated May 10,
2010


(2)
              Incorporated
      by reference to the exhibit filed with the Company’s Current Report on
      Form 8-K for the event dated June 9,
2010


51


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:
      August 16, 2010
              By:
              /s/
      Yang Yong ShanYang
      Yong ShanChairman,
      Chief Executive Officer andPresidentDated:
      August 16, 2010
              By:
              /s/
      Shu KanekoShu
      KanekoChief
      Financial Officer and Secretary




52