UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


FORM 10-Q


(Mark One)


x
Quarterly report under Section 13 or 15(d) of the Securities Exchange Act of 1934





For the quarterly period ended March 31, 2010





 ̈
Transition report under Section 13 or 15(d) of the Securities Exchange Act of 1934





For the transition period from  to





COMMISSION FILE NO: 001-32569




AMERICAN ORIENTAL BIOENGINEERING, INC.


(Exact name of registrant as specified in its charter)





NEVADA
84-0605867(State or other jurisdiction of incorporation or organization)
(I.R.S. Employer Identification No.)





1 Liangshuihe First Ave, Beijing E-Town Economic and Technology Development Area, E-Town,


Beijing, 100176, People’s Republic of China


(Address of principal executive offices) (Zip Code)





86-10-5982-2039


(Registrant’s telephone number, including area code)





(Former name, former address and former fiscal year, if changed since last report)


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


Yes x    No  ̈





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


Yes  ̈   No  ̈





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


Large accelerated filer
 ̈
Accelerated filer
xNon-accelerated filer
 ̈  (Do not check if a smaller reporting company)
Smaller reporting company
 ̈





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





The number of shares outstanding of each class the issuer’s common stock as of the latest practicable date is stated below


Title of each class of common stock

Outstanding as of May 3, 2010Preferred Stock, $0.001 par value

1,000,000Common Stock, $0.001 par value

78,376,355












TABLE OF CONTENTS





PART I – FINANCIAL INFORMATION
3ITEM 1 – Financial Statements
3Unaudited condensed consolidated balance sheet as of March 31, 2010 and condensed consolidated balancesheet as of December 31, 2009Unaudited condensed consolidated statements of income for the three months ended March 31, 2010and 2009Unaudited condensed statements of cash flow for the three months ended March 31, 2010 and 2009Notes to unaudited condensed consolidated financial statements - March 31, 2010ITEM 2 – Management's Discussion and Analysis of Financial Condition and Results of Operations
23ITEM 3 – Quantitative and Qualitative Disclosures About Market Risk
30ITEM 4 – Controls and Procedures
30PART II – OTHER INFORMATION
30ITEM 1 – Legal Proceedings
30ITEM 1A – Risk Factors
30ITEM 2 – Unregistered Sales of Equity Securities and Use of Proceeds
30ITEM 3 – Defaults upon Senior Securities
30ITEM 4 – Other Information
30ITEM 5 – Exhibits
30





Signatures
31












PART I – FINANCIAL INFORMATION





ITEM 1 – FINANCIAL STATEMENTS





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)





ASSETS





MARCH 31,

2010


DECEMBER 31,

2009CURRENT ASSETSCash and cash equivalents

$
95,787,301


$
91,126,486Restricted cash


3,209,381



3,298,379Accounts and notes receivable, net


53,503,601



57,504,454Inventories, net


19,838,535



10,015,711Advances to suppliers and prepaid expenses


5,525,812



13,901,180Deferred tax assets


590,330



824,451Other current assets


1,494,931



1,246,647Total Current Assets


179,949,891



177,917,308LONG-TERM ASSETSProperty, plant and equipment, net


94,614,699



95,468,265Land use rights, net


152,805,027



153,604,196Other long term assets


7,930,112



7,909,086Construction in progress


30,111,567



28,975,386Other intangible assets, net


17,480,990



18,695,554Goodwill


33,164,121



33,164,121Investments in and advances to equity investments


57,461,382



57,325,887Deferred tax assets


138,746



134,268Unamortized financing cost


3,055,621



3,287,694Total Long-Term Assets


396,762,265



398,564,457TOTAL ASSETS

$
576,712,156


$
576,481,765





See accompanying notes to the condensed consolidated financial statements




3








AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)





LIABILITIES AND EQUITY





MARCH 31,

2010


DECEMBER 31,

2009CURRENT LIABILITIESAccounts payable

$
10,660,316


$
7,497,143Notes payable


3,297,568



3,392,575Other payables and accrued expenses


14,935,485



22,320,757Taxes payable


352,439



947,338Short-term bank loans


10,386,039



10,384,368Current portion of long-term bank loans


60,404



60,108Other liabilities


3,140,176



2,199,280Deferred tax liabilities


172,017



172,473Total Current Liabilities


43,004,444



46,974,042LONG-TERM LIABILITIESLong-term bank loans, net of current portion


727,731



743,957Deferred tax liabilities


15,737,755



15,961,465Unrecognized tax benefits


3,300,625



2,746,561Convertible notes


115,000,000



115,000,000Total Long-Term Liabilities


134,766,111



134,451,983TOTAL LIABILITIES


177,770,555



181,426,025COMMITMENTS AND CONTINGENCIESEQUITYSHAREHOLDERS’ EQUITYPreferred stock, $0.001 par value; 2,000,000 shares authorized; 1,000,000 shares issued and outstanding at March 31, 2010 and December 31, 2009, respectively


1,000



1,000Common stock, $0.001 par value; 150,000,000 shares authorized; 78,321,439 shares issued and outstanding at March 31, 2010 and December 31, 2009


78,321



78,321Common stock to be issued


485,000



388,000Prepaid forward repurchase contract


(29,998,616
)


(29,998,616
)Additional paid-in capital


200,408,156



199,829,921Retained earnings (the restricted portion of retained earnings is $23,757,901 at both March 31, 2010 and December 31, 2009)


194,296,931



191,173,754Accumulated other comprehensive income


33,143,073



33,050,224Total Shareholders’ Equity


398,413,865



394,522,604Non-controlling Interest


527,736



533,136TOTAL EQUITY


398,941,601



395,055,740TOTAL LIABILITIES AND EQUITY

$
576,712,156


$
576,481,765





See accompanying notes to the condensed consolidated financial statements







4


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME


(UNAUDITED)





THREE MONTHS ENDED MARCH 312010


2009Revenues

$
53,749,768


$
46,077,190Cost of sales


25,513,047



17,660,338GROSS PROFIT


28,236,721



28,416,852Selling and marketing expenses


5,976,226



5,211,502Advertising costs


6,748,470



5,567,357Research and development costs


2,778,809



749,798General and administrative expenses


4,766,486



4,390,701Depreciation and amortization expenses


1,596,958



1,632,586Total operating expenses


21,866,949



17,551,944INCOME FROM OPERATIONS


6,369,772



10,864,908Equity in earnings from unconsolidated entities


117,473



437,794Interest expense, net


(1,565,785
)


(1,579,269
)Other income (expenses)


12,247



(98,609
)INCOME BEFORE INCOME TAX


4,933,707



9,624,824Income tax


1,815,930



2,469,764NET INCOME


3,117,777



7,155,060Net loss (income) attributable to non-controlling interest


5,400



(3,551
)NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST


3,123,177



7,151,509OTHER COMPREHENSIVE INCOME


92,849



491,337COMPREHENSIVE INCOME

$
3,216,026


$
7,642,846EARNINGS PER COMMON SHAREBasic

$
0.04


$
0.10Diluted

$
0.04


$
0.10WEIGHTED AVERAGE SHARES OUTSTANDINGBasic


74,697,044



74,538,593Diluted


89,460,953



86,917,603





See accompanying notes to the condensed consolidated financial statements






5





AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)





THREE MONTHS ENDED MARCH 312010



2009CASH FLOWS FROM OPERATING ACTIVITIES:Net income

$
3,117,777


$
7,155,060Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


3,219,284



3,235,405Amortization of deferred issuance cost


232,072



232,072Loss on disposal of property, plant and equipment


370



1,993Amortization of deferred consulting expenses


20,200



104,000Reversal for doubtful accounts and slow moving inventories


(11,792
)


(149,978
)Deferred taxes


5,477



13,918Amortization of stock-based compensation expense


578,237



489,857Equity in (income) loss of unconsolidated entities


(117,473
)


(437,794
)Independent director stock compensation


97,000



97,000Changes in operating assets and liabilities, net of effects of acquisitions:(Increase) decrease in:Accounts and notes receivable


3,994,962



4,933,250Inventories


(9,805,226
)


(4,862,536
)Advances to suppliers and prepaid expenses


8,375,368



1,352,803Other current assets


(268,484
)


(142,651
)Increase (decrease) in:Accounts payable


3,163,172



(1,932,456
)Other payables and accrued expenses


(7,738,112
)


(6,188,301
)Taxes payable


(594,899
)


(1,244,408
)Other liabilities


940,896



484,673Unrecognized tax benefits


554,064



387,095Net cash provided by operating activities


5,762,893



3,529,002CASH FLOWS FROM INVESTING ACTIVITIES:Purchases of property, plant and equipment


(161,759
)


(51,512
)Purchases of construction in progress


(928,436
)


(343,238
)Deposit for long-term assets


(19,751
)


-Investments in and advances to equity investments


(12,101
)


(105,326
)Proceeds from disposal of property, plant and equipment


-



620Net cash provided by (used in) investing activities


(1,122,047
)


(499,456
)CASH FLOWS FROM FINANCING ACTIVITIES:Proceeds from bank loans


731,718



1,021,913Repayment of bank loans


(842,206
)


(1,004,311
)Net cash provided by (used in) financing activities


(110,488
)


17,602NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS


4,530,358



3,047,148Effect of exchange rate changes on cash and cash equivalents and restricted cash


41,459



215,944Cash and cash equivalents and restricted cash, beginning of period


94,424,865



70,636,510CASH AND CASH EQUIVALENTS AND RESTRICTED CASH, END OF PERIOD

$
98,996,682


$
73,899,602





See accompanying notes to the condensed consolidated financial statements




6


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)





NOTE 1 - BASIS OF PRESENTATION





The unaudited condensed consolidated financial statements of American Oriental Bioengineering, Inc. and subsidiaries (the “Company”) have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. However, the information included in these interim financial statements reflects all adjustments (consisting solely of normal recurring adjustments) which are, in the opinion of management, necessary for the fair presentation of the consolidated financial position and the consolidated results of operations. Results shown for interim periods are not necessarily indicative of the results to be obtained for a full year. The condensed consolidated balance sheet as of December 31, 2009 has been derived from the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K. These interim financial statements should be read in conjunction with that report.





Basis of Consolidation





The unaudited condensed consolidated financial statements include the financial statements of American Oriental Bioengineering, Inc. and its subsidiaries. All significant inter-company balances and transactions between the Company and its subsidiaries are eliminated upon consolidation. Results of acquired subsidiaries are consolidated from the date on which control is transferred to the Company and are no longer consolidated from the date that control ceases.





Investments





The Company applies Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) 323 “Investments - Equity Method and Joint Ventures” in accounting for its equity investments. Under FASB ASC 323 equity method is used for investments in entities in which the Company has the ability to exercise significant influence but does not own a majority equity interest or otherwise control. The cost method is used for investments over which the Company does not have the ability to exercise significant influence or control.





Use of Estimates





The preparation of financial statements in conformity with generally accepted accounting principles in the United States 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 date of the consolidated financial statements, and the reported amounts of revenue and expenses during the reporting period. Significant estimates reflected in the consolidated financial statements include, but are not limited to, the recoverability of the carrying amount and estimated useful lives of long-lived assets, allowance for accounts receivable, realizable values for inventories, valuation allowance of deferred tax assets, purchase price allocation of its acquisitions, valuation of derivative financial instruments, valuation of available for sale security, and share-based compensation expenses. Changes in facts and circumstances may result in revised estimates. Actual results could differ from these estimates.





Foreign Currency





The accompanying consolidated financial statements are presented in United States dollars (“US$”). The functional currency of the Company is US$, while that of the Company’ subsidiaries operating in the PRC is Renminbi (“RMB”), as determined based on the criteria of FASB ASC 830 “Foreign Currency Matters”.





Assets and liabilities of non-U.S. subsidiaries are translated into U.S. dollars at the noon buying rate certified by the Federal Reserve Bank of New York on March 31, 2010. Income and expense items are translated at average exchange rates prevailing during the quarter. The resulting translation adjustments are recorded as a component of shareholders’ equity. Gains and losses from foreign currency transactions are included in net income.





MARCH 31,2010


2009Quarter end RMB : US$ exchange rate


6.8361



6.8456Average quarterly RMB : US$ exchange rate


6.8367



6.8499





The RMB is not freely convertible into foreign currency and all foreign exchange transactions must take place through authorized institutions. No representation is made that the RMB amounts could have been, or could be, converted into US$ at the rates used in translation.




7


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)


NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES





Revenue Recognition





Revenues represent the invoiced value of goods sold and are recognized upon the shipment of goods to customers. The product sales price stated in the sales contract or purchase order is final and not subject to adjustment. Revenues are recognized pursuant to FASB ASC 605 “Revenue Recognition”, when all of the following criteria are met:





●
Persuasive evidence of an arrangement exists,





●
Delivery has occurred or services have been rendered,





●
The seller’s price to the buyer is fixed or determinable, and





●
Collectability is reasonably assured.





Revenue is recognized net of all value-added taxes imposed by governmental authorities and collected from customers concurrent with revenue-producing transactions.





Cost of Sales





Cost of revenue includes direct and indirect production costs, as well as freight in and handling costs for products sold.





Selling and Marketing Expenses





Selling and marketing expenses include the costs of selling merchandise, including preparing the merchandise for sale, such as picking, packing, warehousing and order charges. All shipping and handling are expensed as incurred and outbound freight is not billed to customers. Freight out and handling expenses included in selling expenses were $973,629 and $815,085 for the quarters ended March 31, 2010 and 2009, respectively.





Advertising Costs





The Company expenses advertising costs as incurred. Point of sale materials are accounted for as inventories and are charged to expense as utilized. Advertising costs were $6,748,470 and $5,567,357 for the quarters ended March 31, 2010 and 2009, respectively.





Research and Development Costs





Research and development costs are expensed as incurred.





FASB ASC 805 “Business combinations” requires the recognition of tangible and intangible assets that result from or are to be used in research and development activities as assets, irrespective of whether the acquired assets have an alternative future use. Acquired In-Progress Research & Development (IPR&D) assets are required to be measured at their acquisition-date fair value. Uncertainty about the outcome of an individual project does not affect the recognition of an IPR&D asset, but is reflected in its fair value.





Comprehensive Income





Comprehensive income is defined to include all changes in equity except those resulting from investments by owners and distributions to owners. Among other disclosures, items that are required to be recognized under current accounting standards as components of comprehensive income are required to be reported in a financial statement that is presented with the same prominence as other financial statements. The Company’s comprehensive income includes net income and foreign currency translation adjustments.





8


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)





Stock-Based Compensation





Stock-based compensation includes 1) stock options and common stock awards granted to employees and directors for services, and are accounted for under FASB ASC 718 “Compensation - Stock Compensation”, and 2) common stock awards granted to consultants which are accounted for under FASB ASC 505-50 “Equity – Equity-Based Payments to Non-Employees”.





All grants of common stock awards and stock options to employees and directors are recognized in the financial statements based on their grant date fair values. The Company has elected to recognize compensation expense using the straight-line method for all common stock awards and stock options granted with service conditions that have a graded vesting schedule, with a corresponding charge to additional paid-in capital.





Common stock awards are granted to directors for services provided. The vested portions of common stock awards granted but not yet issued are recorded in Common Stock to be Issued until issuance.





Common stock awards issued to consultants represent common stock granted to non-employees in exchange for services at fair value. The measurement date for such awards are set at dates that the contracts are entered into as the awards are non-forfeitable and vest immediately. The measurement date fair value is then recognized over the service period as if the Company has paid cash for such service. The Company does not have significant grants to consultants for any of the period presented.





The Company estimates fair value of common stock awards based on the number of shares granted and the quoted price of the Company’s common stock on the date of grant.





The fair value of stock options is estimated using the Black-Scholes model. The Company’s expected volatility assumption is based on the historical volatility of the Company’s stock. The expected life assumption is presumed to be the mid-point between the vesting date and the end of the contractual term, as is permitted for “plain vanilla” employee stock options. The risk-free interest rate for the expected term of the option is based on the U.S. Treasury yield curve in effect at the time of grant.





FASB ASC 718 requires forfeitures to be estimated at the time of grant and revised, if necessary, in the subsequent period if actual forfeitures differ from initial estimates. Forfeiture rate is estimated based on historical and future expectation of employee turnover rate and are adjusted to reflect future change in circumstances and facts, if any. Share-based compensation expense is recorded net of estimated forfeitures such that expense was recorded only for those stock options and common stock awards that are expected to vest.





Income Taxes





The Company accounts for income taxes following the liability method pursuant to FASB ASC 740, “Income Taxes”.  Under this method, deferred tax assets and liabilities are determined based on the difference between the financial reporting and tax bases of assets and liabilities using enacted tax rates that will be in effect in the period in which the differences are expected to reverse. The Company records a valuation allowance to offset deferred tax assets if, based on the weight of available evidence, it is more-likely-than-not that some portion, or all, of the deferred tax assets will not be realized.  The effect on deferred taxes of a change in tax rate is recognized in income in the period that includes the enactment date.





The Company accounts for uncertainty in income taxes in accordance with ASC 740-10, “Income Taxes-Overall”. The Company has elected to classify interest and penalties related to an uncertain position, if and when required, as part of interest expenses and other expenses, respectively, in the consolidated statements of income.





Value-Added Tax (“VAT”)





Enterprises or individuals, who sell commodities, engage in repair and maintenance or import or export goods in the PRC are subject to a value-added tax in accordance with the PRC laws. The value-added tax’s standard rate is 17% of the gross sales price and the Company records its revenue net of VAT. A credit is available whereby VAT paid on the purchases of semi-finished products or raw materials used in the production of the Company’s finished products can be used to offset the VAT due on the sales of the finished products.




9


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)





Segment Reporting





The Company has two operating segments based on its major lines of businesses: manufacturing and distribution. Each operating segment derives its revenues from the sale of products or services, respectively and each is the responsibility of a group of senior management of the Company who has knowledge of product and service specific operational risks and opportunities. The Company’s chief operating decision maker reviews and evaluates separate sets of financial information for decisions regarding resources allocation and performance assessments.





Cash and Cash Equivalents





Cash and cash equivalents consist of cash on hand and bank deposits with original maturities of three months or less, which are unrestricted as to withdrawal and use.





Restricted Cash





Restricted cash represents amounts held by a bank as security for bank acceptance notes and therefore is not available for the Company’s use. The restriction on cash is expected to be released within the next twelve months.





Accounts Receivable





Accounts receivable are carried at net realizable value. An allowance for doubtful accounts is recorded in the period when loss is probable based on an assessment of specific evidence indicating troubled collection, historical experience, accounts aging and other factors. An account receivable is written off after all collection effort has ceased.





Debt Issuance Costs





Debt issuance costs represent the incurred costs directly attributable to the issuance of the convertible notes. These costs, presented as non-current assets, are deferred and amortized ratably using the effective interest method from the debt issuance date over the earliest redemption date of the convertible notes. If the notes are converted prior to the debt maturity date, the unamortized debt issuance costs will be transferred to equity immediately upon occurrence of such an event.





Inventories





Inventories are stated at the lower of cost or market value. Cost is determined by the weighted average method. Costs of raw materials and consumables and packaging materials are based on purchase costs while costs of work-in-progress and finished goods comprise direct materials, direct labor and an allocation of manufacturing overhead costs.





Fair Value of Financial Instruments





FASB ASC 820 “Fair Value Measurements and Disclosures” establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value. The hierarchy prioritizes the inputs into three levels based on the extent to which inputs used in measuring fair value are observable in the market.





These tiers include:





●
Level 1 - defined as observable inputs such as quoted prices in active markets;





●
Level 2 - defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and





●
Level 3 - defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions.





The carrying amounts of financial assets and liabilities, such as cash and cash equivalents, accounts receivable, notes receivable, short-term and long-term bank loans, accounts payable, notes payable and other payables, approximate their fair values because of the short maturity of these instruments. The convertible notes are initially recognized at fair value upon issuance and subsequently accreted to the redemption value using the effective interest rate method, with any accrued and unpaid interest included under other payables and accrued expenses.







10


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)




Construction in Progress





Construction in progress represents direct costs of construction or acquisition, interest and design fees incurred. Capitalization of these costs ceases and the construction in progress is transferred to property, plant and equipment when substantially all the activities necessary to prepare the assets for their intended use are completed. No depreciation is provided until it is completed and ready for intended use.





The Company accounts for interest capitalization in accordance with FASB ASC 835, "Interest".  Interest costs are capitalized if they are incurred during the acquisition, construction or production of a qualifying asset and such costs could have been avoided if expenditures for the assets have not been made.  Capitalization of interest costs commences when the activities to prepare the asset are in progress and expenditures and borrowing costs are being incurred. Interest costs are capitalized until the assets are ready for their intended use.





Land Use Rights





According to the PRC laws, the government owns all the land in the PRC. Companies or individuals are authorized to possess and use the land only through land use rights granted by the PRC government. Land use rights are being amortized using the straight-line method over the lease term ranging from 40 to 50 years.





Property, Plant and Equipment





Property, plant and equipment are carried at cost less accumulated depreciation. Depreciation is provided over their estimated useful lives, using the straight-line method. Estimated useful lives of the property, plant and equipment are as follows:





Buildings
40 yearsMachinery and equipment
10 yearsMotor vehicles
5 yearsOffice equipment
5 yearsOther equipment
5 yearsLeasehold improvements
Shorter of 10 years or the lease term





The cost and related accumulated depreciation of assets sold or otherwise retired are eliminated from the accounts and any gain or loss is included in the statement of income. The cost of maintenance and repairs is charged to the statement of income as incurred, whereas significant renewals and betterments are capitalized.





Other Intangible Assets





Other intangible assets include product licenses, trademarks, patents and proprietary technologies, which are stated at acquisition cost less accumulated amortization. Amortization expense is recognized using the straight-line method over the estimated useful life. Proprietary technologies are recorded as an intangible asset only if regulatory approval from SFDA has been obtained and for which the re-registration of the proprietary technologies with the SFDA by the Company in its name is determined to be reasonably assured or perfunctory. The amortization of such intangible assets will not commence until the technology has been re-registered with the SFDA and hence ready for its intended use.  The cost of the product licenses are amortized over their licensed period of 2 to 12 years; the cost of trademarks are amortized over their registered period of 2 to 10 years; the cost of patents are amortized over their protection period of 7 to 20 years and the cost of proprietary technologies is amortized over its protection period of 10 years. The weighted-average amortization period of product licenses, trademarks, patents and proprietary technologies are 7.56 years, 6.40 years, 12.62 years and 9.42 years, respectively.





Goodwill





Goodwill and other intangible assets are accounted for in accordance with the provisions of FASB ASC 350 “Intangibles - Goodwill and Other”. Under FASB ASC 805, goodwill is measured as the excess of a over b below:





a.
The aggregate of the following:





1.
The consideration transferred measured in accordance ASC 805, which generally requires acquisition-date fair value.


2.
The fair value of any non-controlling interest in the acquiree.


3.
In a business combination achieved in stages, the acquisition-date fair value of the acquirer’s previously held equity interest in the acquiree.





b.
The net of the acquisition-date amounts of the identifiable assets acquired and the liabilities assumed measured in accordance with ASC 805.






11


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)


Other intangible assets are separately recognized from goodwill if the benefit of the intangible asset is obtained through contractual or other legal rights, or if the intangible asset can be sold, transferred, licensed, rented, or exchanged, regardless of an intent to do so.





Under FASB ASC 350, goodwill, including any goodwill included in the carrying value of investments accounted for using the equity method of accounting, and certain other intangible assets deemed to have indefinite useful lives are not amortized.





Impairment





Finite-lived intangible assets are amortized over their respective useful lives and, along with other long-lived assets, are evaluated for impairment periodically whenever events or changes in circumstances indicate that their related carrying amounts may not be recoverable in accordance with FASB ASC 360, “Property, Plant and Equipment”.





In evaluating long-lived assets for recoverability, including finite-lived intangibles and property and equipment, the Company uses its best estimate of future cash flows expected to result from the use of the asset and eventual disposition in accordance with FASB ASC 360-10-15. To the extent that estimated future, undiscounted cash inflows attributable to the asset, less estimated future, undiscounted cash outflows, are less than the carrying amount, an impairment loss is recognized in an amount equal to the difference between the carrying value of such asset and its fair value. Assets to be disposed of and for which there is a committed plan of disposal, whether through sale or abandonment, are reported at the lower of carrying value or fair value less costs to sell.





No impairment loss is subsequently reversed even if facts and circumstances indicate recovery. There was no impairment loss recognized for the periods presented.





Investments





The Company applies FASB ASC 323 “Investments—Equity Method and Joint Ventures” in accounting for its equity investments. Under FASB ASC 323, the equity method of accounting is used for investments in entities in which the Company has the ability to exercise significant influence but does not own a majority equity interest or otherwise control. Cost method is used for investments over which the Company does not have the ability to exercise significant influence or control.





The Company monitors its investments for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions, the operating performance of the investee companies including current earnings trends and other company-specific information. Any balance of equity method goodwill is not tested for impairment under the provisions of FASB ASC 350 “Intangibles - Goodwill and Other”. Instead, equity method goodwill is tested for impairment together with the related investment as they are not separable.





The Company monitors its investments for other-than-temporary impairment by considering factors including, but not limited to, current economic and market conditions, the operating performance of the investee companies including current earnings trends and other company-specific information. Any balance of equity method goodwill is not tested for impairment under the provisions of FASB ASC 350 “Intangibles - Goodwill and Other”. Instead, equity method goodwill is tested for impairment together with the related investment as they are not separable.





Economic and Political Risks





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





The Company’s operations in the PRC are subject to special considerations and significant risks not typically associated with companies in North America and Western Europe. These include risks associated with, among others, the political, economic and legal environment and foreign currency exchange. The Company’s results may be adversely affected by changes in the political and social conditions in the PRC, and by changes in governmental policies with respect to laws and regulations, anti-inflationary measures, currency conversion, remittances abroad, rates and methods of taxation and price controls, among other things.




12


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)





The Company’s products are subject to price control by the PRC government. The maximum prices of the products are published by the PRC price administration authorities from time to time. Any changes in product pricing announced by the PRC price administration authorities affect future sales transactions.





Recently Issued Accounting Standards





In January 2010, the FASB issued Accounting Standards Update 2010-05 (ASU 2010-05), “Compensation – Stock Compensation (Topic 718)”.  This standard codifies EITF Topic D-110 Escrowed Share Arrangements and the Presumption of Compensation and is effective immediately. The provisions of ASU 2010-05 did not have a material effect on the financial position, results of operations or cash flows of the Company and is effective immediately.





In January 2010, the FASB issued Accounting Standards Update 2010-06 (ASU 2010-06), “Fair Value Measurements and Disclosures (Topic 820)”: Improving Disclosures about Fair Value Measurements.  This amendment to Topic 820 has improved disclosures about fair value measurements on the basis of input received from the users of financial statements.  This is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements.  Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years.  Early adoption is permitted.  The provisions of ASU 2010-06 did not have a material effect on the financial position, results of operations or cash flows of the Company.





In February 2010, the FASB issued Accounting Standards Update 2010-09 (ASU 2010-09), "Subsequent Events (Topic 855)."  The amendments remove the requirements for an SEC filer to disclose a date, in both issued and revised financial statements, through which subsequent events have been reviewed.  Revised financial statements include financial statements revised as a result of either correction of an error or retrospective application of U.S. GAAP.  ASU 2010-09 is effective for interim or annual financial periods ending after June 15, 2010.  The provisions of ASU 2010-09 did not have a material effect on the financial position, results of operations or cash flows of the Company.





In February 2010, the FASB issued Accounting Standards Update 2010-10 (ASU 2010-10), "Consolidation (Topic 810)."  The amendments to the consolidation requirements of Topic 810 resulting from the issuance of Statement 167 are deferred for a reporting entity's interest in an entity (1) that has all the attributes of an investment company or (2) for which it is industry practice to apply measurement principles for financial reporting purposes that are consistent with those followed by investment companies.  An entity that qualifies for the deferral will continue to be assessed under the overall guidance on the consolidation of variable interest entities in Subtopic 810-10 (before the Statement 167 amendments) or other applicable consolidation guidance, such as the guidance for the consolidation of partnerships in Subtopic 810-20.  The deferral is primarily the result of differing consolidation conclusions reached by the International Accounting Standards Board ("IASB") for certain investment funds when compared with the conclusions reached under Statement 167.  The deferral is effective as of the beginning of a reporting entity's first annual period that begins after November 15, 2009, and for interim periods within that first annual reporting period, which coincides with the effective date of Statement 167.  Early application is not permitted.  The provisions of ASU 2010-10 are effective for the Company beginning in 2010. The adoption of ASU 2010-10 did not have a material impact on the financial position, results of operations or cash flows of the Company.





In March 2010, the FASB issued Accounting Standards Update 2010-11 (ASU 2010-11), "Derivative and Hedging (Topic 815)."  All entities that enter into contracts containing an embedded credit derivative feature related to the transfer of credit risk that is not only in the form of subordination of one financial instrument to another will be affected by the amendments in this Update because the amendments clarify that the embedded credit derivative scope exception in paragraph 815-15-15-8 through 15-9 does not apply to such contracts.  ASU 2010-11 is effective at the beginning of the reporting entity's first fiscal quarter beginning after June 15, 2010.  The provisions of ASU 2010-11 are not expected to have a material effect on the financial position, results of operations or cash flows of the Company.




13


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)


NOTE 3 - EARNINGS PER SHARE





Basic earnings per share is computed by dividing income available to common shareholders by the weighted average number of common shares outstanding, excluding common shares to be delivered under a prepaid forward repurchase contract (3,712,700 shares) during the period. Diluted earnings per share is computed similar to basic earnings per share except that the denominator is increased to include the number of additional common shares that would have been outstanding if the potential common shares had been issued and if the additional common shares were dilutive. The potential common stocks are stock options, common stock awards and convertible notes.





The following is a reconciliation of the numerator and denominator used in the calculation of basic and diluted earnings per share available to common shareholders.





Three Months Ended March 31,2010


2009Numerator:Net income attributable to controlling interest

$
3,123,177


$
7,151,509Interest expense on convertible securities, net of taxes


1,437,500



1,437,500Amortization of financing costs, net of taxes


232,072



232,072Less: capitalization of interest on convertible securities


(352,840
)


-Net income, as adjusted

$
4,439,909


$
8,821,081Denominator:Weighted average shares outstanding - Basic


74,697,044



74,538,593Effect of dilutive instruments:Stock options


-



-Convertible notes


14,232,673



12,379,010Common stock awards to be issued to employees


531,236



-Warrants


-



-Weighted average shares outstanding - Diluted


89,460,953



86,917,603





The calculation of weighted average common shares outstanding for the diluted earnings per share calculation excludes consideration of stock options for the three months ended March 31, 2010 and 2009, because the exercise of these options would not have been dilutive for those periods due to the fact that the exercise prices were greater than the weighted average market price of our common stock for each period.





As more fully discussed in Note 13, the Company had certain convertible notes outstanding during the periods presented. The aggregate number of shares of common stock that could be issued in the future to settle these notes is deemed outstanding for the purposes of the calculation of diluted earnings per share. This approach, referred to as the if-converted method, requires that such shares be deemed outstanding regardless of whether the notes are then contractually convertible into the Company’s common stock. For this if-converted calculation, the interest expense and issuance costs (net of tax) attributable to these notes are added back to Net Income, reflecting the assumption that the notes have been converted.




14


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)


NOTE 4 - SEGMENT REPORTING





For the three months ended March 31, 2010 and 2009 the Company’s segments were as follows:





Three Months Ended March 31,2010


2009Manufacturing SegmentRevenue from pharmaceutical products

$
40,865,081


$
34,679,469Revenue from nutraceutical products


9,665,703



8,912,393Total manufacturing revenue


50,530,784



43,591,862Total manufacturing costs


22,391,568



15,270,838Interest (expense) income, net


(84,189
)


3,039Depreciation, depletion and amortization expense


1,195,356



1,238,382Other operating expenses


17,966,221



13,657,870Income tax expense or benefit


1,439,556



2,467,135Operating income of manufacturing segment


7,453,894



10,960,676





Three Months Ended March 31,2010


2009Distribution SegmentDistribution revenue

$
3,218,984


$
2,485,328Distribution costs


3,121,479



2,389,500Interest income, net


13,570



74,943Depreciation, depletion and amortization expense


9,375



7,763Equity in earnings from unconsolidated entities


604,450



493,903Other operating expenses


274,078



153,011Income tax expense or benefit


-



2,629Operating income of distribution segment


432,072



501,271Reconciliation to Consolidated Net Income Available for Common Shareholders:Total net operating income, as defined, for reportable segments


7,885,966



11,461,947Unallocated


(4,762,789
)


(4,310,438
)Consolidated Net Income Available for Common Shareholders

$
3,123,177


$
7,151,509








NOTE 5 - INVENTORIES





Inventories are summarized as follows:





MARCH 31,

2010


DECEMBER 31, 2009Raw materials

$
7,937,620


$
4,599,700Work in progress


3,270,230



2,407,927Finished goods


8,648,930



3,043,926Total inventories


19,856,780



10,051,553Less: provision against slow-moving inventories


(18,245
)


(35,842
)Inventories, net

$
19,838,535


$
10,015,711






15


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)


NOTE 6 - LAND USE RIGHTS





Land use rights consist of the following:





MARCH 31,

2010


DECEMBER 31, 2009Cost of land use rights

$
160,191,317


$
160,165,545Less: Accumulated amortization


(7,386,290
)


(6,561,349
)Land use rights, net

$
152,805,027


$
153,604,196





As of March 31, 2010, the net book value of land use rights pledged as collateral was $47,839,272. See Note 12.





Amortization expense for the quarters ended March 31, 2010 and 2009 was $823,813 and $784,630, respectively.





NOTE 7 - CONSTRUCTION IN PROGRESS





Construction in progress as of March 31, 2010 and December 31, 2009 was $30,111,567 (inclusive of capitalized interest of $1,169,232) and $28,975,386 (inclusive of capitalized interest of $816,392), respectively. Construction in progress represents the construction for production lines and buildings. The Group capitalizes interest as a component of construction in progress in accordance with ASC 835. Total interest costs incurred for the three month periods ended March 31, 2010 and 2009 amounted to $1,996,625 and $1,784,556, respectively. Total interest costs capitalized as part of construction in progress for the three month period ended March 31, 2010 and 2009 amounted to $352,840 and $0, respectively.





NOTE 8 - PROPERTY, PLANT AND EQUIPMENT





Property, plant and equipment consist of the following:





MARCH 31,

2010


DECEMBER 31, 2009At cost:Buildings

$
91,578,317


$
91,565,622Machinery and equipment


21,134,808



21,016,658Motor vehicles


1,535,485



1,535,238Office equipment


2,191,222



2,157,528Other equipment


760,671



610,945117,200,503



116,885,991Less : Accumulated depreciationBuildings


(7,181,449
)


(6,600,971
)Machinery and equipment


(12,903,139
)


(12,483,002
)Motor vehicles


(1,181,852
)


(1,130,968
)Office equipment


(1,129,395
)


(1,037,234
)Other equipment


(189,969
)


(165,551
)(22,585,804
)


(21,417,726
)Property, plant and equipment, net

$
94,614,699


$
95,468,265





As of March 31, 2010 and December 31, 2009, the net book value of property, plant and equipment pledged as collateral for bank loans were $13,518,580 and $13,615,710. See Note 12.





Depreciation expense for the quarters ended March 31, 2010 and 2009 was $1,178,005 and $1,157,778, respectively.







16




AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)




NOTE 9 - OTHER INTANGIBLE ASSETS, NET





Other intangible assets are summarized as follows:





MARCH 31,

2010


DECEMBER 31, 2009At cost:Product licenses

$
15,526,940


$
15,524,443Trademarks


10,586,616



10,584,914Patents


4,808,878



4,808,103Proprietary technology


282,410



282,364Software


73,837



73,82231,278,681



31,273,646Less: Accumulated amortizationProduct licenses

$
(7,086,540
)

$
(6,396,185
)Trademarks


(4,579,625
)


(4,168,125
)Patents


(2,043,558
)


(1,935,171
)Proprietary technology


(74,976
)


(67,468
)Software


(12,992
)


(11,143
)(13,797,691
)


(12,578,092
)Other intangible assets, net

$
17,480,990


$
18,695,554





Amortization expense for the quarters ended March 31, 2010 and 2009 was $1,217,466 and $1,292,997, respectively.





NOTE 10 - INVESTMENTS IN AND ADVANCES TO UNCONSOLIDATED ENTITIES





Long-term investments and advances include our equity investment in Aoxing Pharmaceutical Company, Inc. (“CAXG”), Nuo Hua Affiliate and Hezhou Jinji Color Printing Co Ltd. (“Jinji”). CAXG is a PRC-based pharmaceutical company, listed on the U.S. OTCBB (CAXG was approved to be listed on the NYSE AMEX market and began trading under the ticker “AXN” on April 14, 2010), specializing in the research, development, manufacture and distribution of narcotic and pain-management products in the PRC. Nuo Hua Affiliate maintains a significant presence in pharmaceutical wholesale and retail distribution in the PRC. Jinji is a color printing company focusing on the printing of external packaging materials. Long-term investments are accounted for using the equity accounting method.





As of March 31, 2010, the Company owns a 36.16% equity interest in CAXG through an initial $18 million direct investment of its common stock in April 2008 and a subsequent conversion of a promissory note into additional common stock in August 2009. The promissory note represents an advance of RMB30 million to CAXG in May 2008. The note bears interest at a rate of 8% payable quarterly in arrears with an initial term of one year which was subsequently extended for additional three months. Upon conversion, the balance of such advance was reclassified to investment.





The Company owns a 30% equity interest in Nuo Hua Affiliate through the acquisition of Nuo Hua in October 2008 and the Company owns a 40% equity interest in Jinji through the acquisition of GLP in April 2006.





The cost of investments in excess of our estimate of the underlying equity in net assets at the time of the investments was goodwill of $1,369,799.








17


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)




The following table summarizes the long-term investments and advances as of March 31, 2010 and December 31, 2009:





MARCH 31,

2010


DECEMBER 31, 2009Cost of investments:CAXG

$
22,759,612


$
22,759,612Nuo Hua Affiliate


32,999,023



32,999,023Jinji


86,067



86,067Share of equity income (loss):CAXG


(2,397,093
)


(1,909,244
)Nuo Hua Affiliate


3,870,928



3,260,590Jinji


46,371



45,480Advances:CAXG


3,300



3,300Jinji


93,174



81,059Long-term investments and advances

$
57,461,382


$
57,325,887





The advances to CAXG and Jinji were unsecured, non-interest bearing and repayable on demand.





For the three months ended March 31, 2010 and 2009, the Company’s equity in earnings from above unconsolidated entities was as follows:





Three Months Ended March 31,2010

2009Equity income - Nuo Hua Affiliate

$
(604,450
)

$
(493,903
)Equity loss - CAXG


487,849



57,525Equity income - Jinji Printing


(872
)


(1,416
)Total equity in earnings from unconsolidated entities

$
(117,473
)

$
(437,794
)





As of March 31, 2010 and December 31, 2009, the value of investment in CAXG based on quoted market price is as follows:





March 31,

2010


December 31,

2009Investment in CAXG based on quoted market price

$
36,936,246


$
33,578,405





NOTE 11 - OTHER LONG-TERM ASSETS





MARCH 31,

2010


DECEMBER 31, 2009Payment for long-term supply contract

$
7,470,634


$
7,469,432Deposits for long-term assets


459,478



439,654Total other long-term assets

$
7,930,112


$
7,909,086





Payment of the long-term supply contract represents a payment for a long-term supply contract with a third party to secure the supply of Xanthoceras Sorbifolia Bge (“XSB”), a major raw material of a subsidiary of the Company. The Company expects such supply to start from year four of the contract as XSB is a fruit from certain plant which requires a three year period to mature. The contract expires after 10 years while the Company is entitled to renewal with terms to be negotiated. Under the contract, the Company is entitled to a supply price at fair value when delivered. The payment will be amortized to inventory upon delivery of the raw material. The Company assesses the impairment of the payment as of each balance date.





Deposits for long term assets are refundable deposits to acquire land use rights located in the PRC. The long-lived assets to be acquired will be for use in the expansion of some of the Company's current manufacturing facilities and are not intended for resale by the Company. The deposits will be reclassified to the respective accounts under the long-lived assets upon the transfers of legal title.





18


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)





NOTE 12 - DEBT





Short-term bank loans are obtained from local banks. All the short-term bank loans are repayable within one year and are secured by property, plant and equipment and land use rights owned by the Company. See Notes 6 and 8.





Long-term loans include a mortgage loan that bears interest on daily balances at 2.50% per annum below HSBC HKD best lending rate and is repayable over 15 years. The principal amount of long-term loans is not payable until the end of the term.





Interest expense for all outstanding debt excluding the convertible notes was $149,126 and $114,984 for the three months ended March 31, 2010 and 2009 respectively.





NOTE 13 - CONVERTIBLE NOTES





On July 15, 2008, the Company closed a private offering and issued $115 million aggregate principal amount of 5.00% Convertible Senior Notes due 2015 (the “Notes”). The Notes were sold to qualified institutional buyers in a private placement exempt from the registration requirements of the Securities Act of 1933, as amended. The net proceeds from the sale of the Notes were approximately $110.0 million, after deducting the placement agents’ commission and offering expenses payable by the Company.





The following is a brief summary of certain terms of this offering.





●
Total offering is $115,000,000 aggregate principal amount of 5.00% Convertible Senior Notes due on July 15, 2015.





●
Interest at 5.00% per year, payable semiannually in arrears in cash.





●
The notes are convertible, at the option of the holder, at any time prior to the close of business on the second business day preceding the maturity date based on an initial conversion rate of 107.6195 shares per $1,000 principal amount of notes, which represents an initial conversion price of approximately $9.29 per share. (See below)





●
The conversion rate is subject to certain adjustments. In particular, holders who convert their notes in connection with certain events of fundamental changes, as defined pursuant to the convertible notes agreement, may be entitled to a make whole premium in the form of additional shares of our common stock.





●
The initial conversion rate may also be adjusted on January 15, 2009 if the volume weighted average price (“VWAP”) of our common stock for each of the 30 consecutive trading days ended on January 15, 2009 is less than $8.08 per share. In such an event, the conversion rate will be increased as a one-time conversion price adjustment such that the conversion price as adjusted would represent the greater of (1) 115.0% of such arithmetic average of the daily VWAP and (2) $8.08.





●
Holders may require the Company to repurchase all or a portion of their notes on July 15, 2013 for cash at a price equal to 100% of the principal amount of the notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date.





●
If a fundamental change event occurs, holders will have the right to require the Company to repurchase for cash all or any portion of their notes. The fundamental change purchase price will be 100% of the principal amount of the notes to be purchased plus accrued and unpaid interest, if any, up to, but excluding, the fundamental change repurchase date.





●
The notes are unsecured, unsubordinated obligations and rank equal in right of payment to all of the Company’s existing and future unsecured and unsubordinated indebtedness. The notes will be effectively subordinated to all of the Company’s existing and future secured indebtedness.





Convertible notes issuance costs incurred by the Company that were directly attributable to the issuance of convertible notes were deferred and are charged to the consolidated statements of income using the effective interest rate method over the term of the convertible notes.





The Company has determined that the conversion feature embedded in the convertible notes is not required to be bifurcated and accounted for as a derivative pursuant to FASB ASC 815 “Derivatives and Hedging”, since the embedded conversion feature is indexed to the Company’s own stock and would be classified in shareholders’ equity if it was a free-standing instrument. The holder’s put rights qualify as an embedded derivative, but bifurcation of such is not required since it is considered to have economic characteristic and risks that are clearly and closely related to those of the debt host.





19


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)




On the date of issuance of the convertible notes, no portion of the proceeds was attributable to the beneficial conversion feature (“BCF”) since the conversion price of the convertible notes exceeded the market price of the Company’s ordinary shares. Furthermore, no contingent BCF exists from the one time conversion rate adjustment based on VWAP, as the adjustment is subject to a floor of $8.08, which equals market price of the Company’s common stock on the issuance date of the convertible notes.





The VWAP of our common stock for each of the 30 consecutive trading days ending on January 15, 2009 was $6.02 per share and as such, the initial conversion price of $9.29 per share was adjusted to $8.08 on January 15, 2009.





The effective interest rate on the convertible notes for the quarters ended March 31, 2010 and 2009 was 5.945%.





The amount of interest cost recognized for the quarters ended March 31, 2010 and 2009 was $1,437,500.





NOTE 14 - PREPAID FORWARD SHARES REPURCHASE TRANSACTION





In connection with the offering of the Notes, the Company entered into a prepaid forward repurchase contract with an affiliate of the lead placement agent (“Merrill affiliate”). Pursuant to the prepaid forward repurchase contract, the Company paid approximately $30 million to the Merrill affiliate to fund the purchase of 3.7 million shares of common stock for settlement at or about maturity of the Notes, which will occur on July 15, 2015. The forward shares purchase transaction was also intended to reduce the potential dilution of our common stock that would result from the conversion of the Notes into shares of our common stock.





The $30 million cost of the forward stock repurchase transaction qualifies as an equity transaction and was separately presented under shareholders’ equity in the balance sheet without subsequent recognition of changes in fair value. The prepaid forward repurchase contract contains an embedded equity forward derivative that is contingently cash settleable based on certain events.  The contingent cash settlement feature was bifurcated from the prepaid forward repurchase contract but its value was not significant for any of the periods presented.





The Company is potentially subject to significant concentration of credit risk with respect to the prepaid forward repurchase contract. The fact that the Merrill affiliate has merged with Bank of America reduced the bankruptcy and default risk. The Company will closely monitor the third depositary and may request early settlement of the contract prior to the maturity of the Notes.





NOTE 15 - SHAREHOLDERS’ EQUITY





Preferred Stock





The Company had 1,000,000 shares of Series A preferred stock (“Series A”) issued and outstanding. Pursuant to the terms of the Series A, the holder holds aggregate voting power equal to 25% of the combined voting power of our common stock and preferred stock. The percentage of voting power represented by the Series A cannot be diluted by the issuance of additional shares of common stock. The Series A has a liquidation preference equal to its initial issue price that will be paid to the holders of the Series A upon liquidation, dissolution or winding up and prior to any distributions being made to holders of our common stock.





Common Stock





Stock-Based Compensation





At the Annual Shareholders’ Meeting held on October 21, 2006, the shareholders of the Company approved the stock incentive plan (the “2006 Plan”), which allows the Company’s board of directors, at its discretion, to offer stock options and common stock awards to participants (employees, directors and consultants) of the Company.





The Company has reserved 5,000,000 shares of common stock for issuance upon the exercise of stock options and common stock awards granted under the 2006 Plan. The term of the options granted under the 2006 Plan should be no more than 10 years from the grant date. Options will be granted with an exercise price not less than the fair market value of a share of common stock on the date of the grant.




20


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)





Common Stock Awards issued to consultants and employee directors





Such awards are issued to consultants as partial payment in connection with the consulting services rendered or to be rendered, or to directors as compensation for participating in the Company’s board meetings. Number of shares granted and expenses recognized were insignificant during the periods presented.





In connection with common stocks awards described above, the Company recorded Common Stocks to be Issued for vested but yet to be issued shares. Number of shares to be issued was insignificant during the periods presented.





Stock Options and Common Stock Awards issued to Employees





Stock options and common stock awards granted to employees vest over a five year service period using a graded vesting schedule of 20% per fully completed year (based on each subsequent one-year anniversary of the date of grant). Compensation expense for all stock options and common stock awards granted is recognized over the awardee’s respective requisite service period.





Stock options





The Company calculated the estimated fair value of the options of the grant date using the Black-Scholes Option Pricing Model with the following assumptions:





Grant Date

April 10,

2009


November 25,

2008


April 9,

2008


August 20,

2007


April 20,

2007Risk-free interest rates


2.33
%



2.41
%



2.93
%



4.45
%



4.59
%Expected term


6.5




6.5




6.5




6.5




6.5Expected volatility


65.70
%



64.81
%



56.89
%



71.71
%



74.69
%Expected dividend yield


0.00
%



0.00
%



0.00
%



0.00
%



0.00
%Fair value of share option


2.64




3.34




4.81




5.87




7.44





The model requires the input of subjective assumptions including the expected stock price volatility, and the expected dividend yield. The Company uses historical experience of employee turnover and future expectation to estimate forfeiture rate. For expected volatilities, the Company has made reference to historical volatilities of the Company’s stock. The risk-free interest rate for periods within the contractual life of the option is based on the U.S. Treasury Bills yield in effect at the time of grant.





The Company recorded $474,638 and $489,857 compensation cost for the three months ended March 31, 2010 and 2009, respectively, with corresponding credits to additional paid-in capital. Compensation cost of all stock option awards are recorded in general and administrative expenses.





The expected forfeiture rate of the stock options granted as of March 31, 2010 is 0%.





Common Stock Awards





On April 10, 2009, the Compensation Committee of the Board of Directors of the Company approved the grant of common stock awards to the Company’s executive officer and certain senior management members. Common stocks awards granted vest over a five year service period. Compensation expense is recognized for the fair value of common stocks on the grant date on a straight-line basis over five years, the requisite service period of the awards.  The number of shares granted and the grant date market price of the Company’s common stock determines the fair value of the common stocks awards under the 2006 Plan.





The expected forfeiture rate of the common stock awards granted as of March 31, 2010 is 0%.





For the three months ended March 31, 2010, the Company recorded general and administrative expenses of $103,599 in connection with such awards.





21


AMERICAN ORIENTAL BIOENGINEERING, INC. AND SUBSIDIARIES
 NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
 AS OF MARCH 31, 2010
 (UNAUDITED)




Statutory Reserves





In accordance with the PRC Regulations on Enterprises with Foreign Investment, an enterprise established in the PRC with foreign investment is required to provide for certain statutory reserves, namely (i) General Reserve Fund, (ii) Enterprise Expansion Fund and (iii) Staff Welfare and Bonus Fund, which are appropriated from net profit as reported in the enterprise’s PRC statutory accounts. A wholly-owned foreign enterprise (“WOFE”) is required to allocate at least 10% of its annual after-tax profit to the General Reserve Fund until the balance of such fund has reached 50% of its respective registered capital.  A non- wholly-owned foreign invested enterprise is permitted to provide for the above allocation at the discretion of its board of directors. Appropriations to the Enterprise Expansion Fund and Staff Welfare and Bonus Fund are at the discretion of the board of directors for all foreign invested enterprises.





The aforementioned reserves can only be used for specific purposes and are not distributable as cash dividends.





As a result, $23,757,901 has been appropriated to the accumulated statutory reserves (included in the retained earnings) by the Company’s PRC subsidiaries as of March 31, 2010 and December 31, 2009.





NOTE 16 - COMMITMENTS AND CONTINGENCIES





As of March 31, 2010, the Company had entered into capital commitments for the manufacturing facilities under construction in the People’s Republic of China and purchase commitments for the purchase of raw materials. The Capital commitments and purchase commitments were $11,477,418 and $1,175,497 within one year and $8,580,916 and zero after one year but within five years, respectively. In addition, the Company had advertisement contract commitments of $22,375,482 for the next 12 months and R&D commitments of $6,284,425 for the next 24 months as of March 31, 2010.





Effective from January 1, 2007, the Company adopted FIN 48, which prescribes a more-likely-than-not threshold for financial statement recognition and measurement of a tax position taken in the tax return. As of March 31, 2010, the Company has recorded an unrecognized tax benefit of $3,300,625.





As of March 31, 2010, the Company has no significant litigation claims. Also, the Company does not have significant operating-lease commitments as of March 31, 2010.





NOTE 17 – TAXES





The Group's effective tax rates are 36.8% and 25.7% for the three months ended March 31, 2010 and 2009 respectively.  The increase in effective tax rate is mainly due to a decrease in profits before tax relative to permanent differences, unrecognized tax benefits and change in valuation allowance.  The Group has total income tax expense of $1,815,930 for the first quarter ended March 31, 2010.  The Group continues to conduct most of its business through its major PRC subsidiaries whose applicable income tax rate is 15%. A full valuation allowance is recorded for deferred tax assets of those entities within the group that continue to be in a cumulative loss position.  The Group recorded a current tax expense of $1,812,892 for the first quarter of which $376,374 is related to an increase in unrecognized tax benefits. The Company recorded cumulative interests of $177,567 and a penalty of $440,000 as of March 31, 2010.





NOTE 18 - EMPLOYEE DEFINED CONTRIBUTION PLAN





Full time employees of the Company’s subsidiaries in the PRC participate in a government-mandated defined contribution plan pursuant to which certain pension benefits, medical care, unemployment insurance, employee housing fund and other welfare benefits are provided to employees. Chinese labor regulations require that the PRC subsidiaries of the Company make contributions to the government for these benefits based on 41% of the employees’ salaries. The Company’s PRC subsidiaries have no legal obligation for the benefits beyond the contributions made. The total amounts for such employee benefits, which were expensed as incurred, were approximately $216,738 and $224,913 for the three months ended March 31, 2010 and 2009, respectively and are included in general and administrative expenses.





NOTE 19 - SUBSEQUENT EVENTS





We have evaluated all events or transactions that occurred after March 31, 2010 up through the date we issued the consolidated financial statements. There were no significant subsequent events occurred.




22




ITEM 2 – MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS





The following discussion should be read in conjunction with the information contained in the condensed consolidated financial statements of the Company and the notes thereto appearing elsewhere herein and in conjunction with the Management’s Discussion and Analysis set forth in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. Readers should carefully review the risk factors disclosed in the Company’s Form 10-K for the year ended December 31, 2009 filed by the Company with the Securities and Exchange Commission (SEC).





As used in this report, the terms “Company”, “we”, “our”, “us” and “AOB” refer to American Oriental Bioengineering, Inc., a Nevada corporation.





PRELIMINARY NOTE REGARDING FORWARD-LOOKING STATEMENTS





This quarterly report contains forward-looking statements within the meaning of the federal securities laws. These include statements about our expectations, beliefs, intentions or strategies for the future, which we indicate by words or phrases such as “anticipate,” “expect,” “intend,” “plan,” “will,” “we believe,” “AOB believes,” “management believes” and similar language. The forward-looking statements are based on the current expectations of AOB and are subject to certain risks, uncertainties and assumptions, including those set forth in the discussion under “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this report. Actual results may differ materially from results anticipated in these forward-looking statements. We base the forward-looking statements on information currently available to us, and we assume no obligation to update them.





Investors are also advised to refer to the information in our previous filings with the Securities and Exchange Commission (SEC), especially on Forms 10-K, 10-Q, and 8-K, in which we discuss in more detail various important factors that could cause actual results to differ from expected or historic results. It is not possible to foresee or identify all such factors. As such, investors should not consider any list of such factors to be an exhaustive statement of all risks and uncertainties or potentially inaccurate assumptions.





CRITICAL ACCOUNTING POLICIES AND ESTIMATES





This section should be read together with the Summary of Significant Accounting Policies included as Note 3 to the consolidated financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2009.





For a description of the Company’s critical accounting estimates, refer to “Item 7 — Management’s Discussion and Analysis of Financial Condition and Results of Operations — Critical Accounting Policies and Estimates” in the Company’s Annual Report on Form 10-K for the year ended December 31, 2009. There have been no material changes to the Company’s critical accounting estimates since December 31, 2009.





RECENT ACCOUNTING PRONOUNCEMENT





A description of recent accounting pronouncements is set forth under “Recently Issued Accounting Standards” in Note 2 of the Notes to the Condensed Consolidated Financial Statements contained in this Quarterly Report on Form 10-Q, and such description is incorporated herein by reference. Such description contains all of the information required with respect thereto.








23


RESULTS OF OPERATIONS – THREE MONTHS ENDED MARCH 31, 2010 AS COMPARED TO THREE MONTHS ENDED MARCH 31, 2009





The following table sets forth the amounts and the percentage relationship to revenues of certain items in our condensed consolidated statements of income for the quarters ended March 31, 2010 and 2009:





Three Months Ended

March 31,


Three Months Ended

March 31,2010


2009


2010


2009Revenues

$
53,749,768


$
46,077,190



100%



100%Cost of sales


25,513,047



17,660,338



47



38GROSS PROFIT


28,236,721



28,416,852



53



62Selling and marketing


5,976,226



5,211,502



11



11Advertising


6,748,470



5,567,357



13



12Research and development costs


2,778,809



749,798



5



2General and administrative


4,766,486



4,390,701



9



10Depreciation and amortization


1,596,958



1,632,586



3



3Total operating expenses


21,866,949



17,551,944



41



38INCOME FROM OPERATIONS


6,369,772



10,864,908



12



24Equity in earnings from unconsolidated entities


117,473



437,794



0



1Interest expense, net


(1,565,785)



(1,579,269)



(3)



(3
)Other income(expenses)


12,247



(98,609)



0



0INCOME BEFORE INCOME TAXES


4,933,707



9,624,824



9



22Income taxes


1,815,930



2,469,764



3



6NET INCOME


3,117,777



7,155,060



6



16Net loss (income) attributable to non-controlling interest


5,400



(3,551)



0



0NET INCOME ATTRIBUTABLE TO CONTROLLING INTEREST

$
3,123,177


$
7,151,509



6%



16%EARNINGS PER SHAREBasic

$
0.04


$
0.10Diluted

$
0.04


$
0.10





Revenues





Revenues for the first quarter of 2010 were $53,749,768, an increase of $7,672,578 over revenues in the same period of 2009. We classify our revenues in two segments: Manufacturing revenue, which comprises sales by our subsidiaries of our pharmaceutical and nutraceutical products, and Distribution revenue. Revenues by segments and product categories were as follows:





Three Months Ended

March 31,


Increase/


Increase/2010


2009


(Decrease)


(Decrease)Revenue from pharmaceutical products

$
40,865,081


$
34,679,469


$
6,185,612



18%Revenue from nutraceutical products


9,665,703



8,912,393



753,310



8Total manufacturing revenue


50,530,784



43,591,862



6,938,922



16Distribution revenue


3,218,984



2,485,328



733,656



30Total revenues

$
53,749,768


$
46,077,190


$
7,672,578



17%






24





Sales of our pharmaceutical products increased by $6,185,612, or 18%, as compared to the same period of 2009 primarily due to the following factors:





●
The sales of our prescription pharmaceutical products increased from $16,203,190 in the first quarter of 2009 to $20,946,430 in the same period of 2010, or a 29% increase. This is primarily due to the increase in sales of our prescription formulated Jinji capsule, SHL powder BOKE and CCXA prescription pharmaceutical products. The overall increase in sales was supported by our continuous marketing efforts, increase in new products offering, as well as expanding coverage in the rural market; and


●
The sales of our OTC pharmaceutical products increased from $18,476,279 to $19,918,651, or 8% increase. This was attributable to the increase sales of our Boke and CCXA products as a result of improved recognition of our product.





Sales from our nutraceutical products increased from $8,912,393 in the first quarter of 2009 to $9,665,703 in the same period of 2010, representing a growth of 8%. This increase was mainly attributed to new beverage products launched in the second quarter of 2009.





The distribution revenue from Nuo Hua's majority owned subsidiary increased from $2,485,328 in the first quarter of 2009 to $3,218,984 in the same period of 2010, representing a growth of 30%.  This increase was mainly attributed to Nuo Hua's expanding market coverage.





Cost of Sales and Gross Profit





Cost of sales was $25,513,047 in the first quarter of 2010, compared to $17,660,338 in the same period of 2009. Cost of sales in the first quarter of 2010 and 2009 by segments and product categories were as follows:





Three Months Ended

March 31,


Increase/


Increase/2010


2009


(Decrease)


(Decrease)Pharmaceutical products

$
17,624,204


$
11,717,925


$
5,906,279



50%Nutraceutical products


4,767,364



3,552,913



1,214,451



34Total manufacturing cost


22,391,568



15,270,838



7,120,730



47Distribution cost


3,121,479



2,389,500



731,979



31Total cost

$
25,513,047


$
17,660,338


$
7,852,709



44%





The cost of sales of pharmaceutical and nutraceutical products increased by 50% and 34%, respectively, in the first quarter of 2010 compared to the same period of 2009. These increases are mainly attributed to our increase in sales and the increase in production cost. The distribution cost increase in step with the distribution revenue.





Gross profit decreased by $180,131, or 1%, for the first quarter of 2010 over the same period of 2009. Gross profit as a percentage of net revenues decreased from 62% in prior year to 53% in the same quarter of 2009 due to a greater proportion of generic product sales in rural market. Further, the increased purchase prices of certain raw materials increased the cost of sales and lower margin distribution business from Nuo Hua also contributed to lower gross profit.





Selling and Marketing





Selling and marketing expenses, including distribution expenses, increased from $5,211,502 in the first quarter of 2009 to $5,976,226 in 2010, representing a 15% increase. The details of our sales and marketing expenses were as follows:





Three Months Ended

March 31,


Increase/


Increase/2010


2009


(Decrease)


(Decrease)Promotional materials and fees

$
2,040,494


$
1,885,432


$
155,062



8%Payroll


1,648,392



1,386,375



262,017



19Shipping


973,629



815,085



158,544



19Trips and traveling


741,350



619,680



121,670



20Sales conferences


170,789



259,923



(89,134)



(34)Office supplies


140,133



114,682



25,451



22Miscellaneous


261,439



130,325



131,114



101TOTAL

$
5,976,226


$
5,211,502


$
764,724



15%





The increase in selling and marketing expenses in the first quarter of 2010 compared to the same period in 2009 was primarily due to the following factors:





●
Payroll increased 19% from $1,386,375 to $1,648,392 in the first quarter of 2010 as compared to the same period of 2009. This was primarily due to the increase of the average salary and bonus for our sales people in view of our business expanding in the rural market; and





●
Shipping increased 19% from $815,085 to $973,629 in the first quarter of 2010 as compared to the same period of 2009. This was primarily due to the increase in net sales and the increase cost in logistics.







25




Advertising





Advertising expense increased by $1,181,113, from $5,567,357 in the first quarter of 2009 to $6,748,470 in the same period of 2010.  Advertising expenses as a percentage of revenue increased from 12% in the first quarter of 2009 to 13% in the same period of 2010. We increased the advertising expense to create a unified mega brand for AOBO so that  we can leverage on the establishment of all individual brands of ours to boost our chance of winning in the government sponsored competitive tendering processes for China's essential drug list products as well as those on the national insurance catalogs. We believe a reasonably priced product with a brand name will be more appealing to consumers, patients, and doctors.





Research and Development Costs





Research and development costs increased by $2,029,011, or 271%, from $749,798 in the first quarter of 2009 to $2,778,809 in the same period of 2010. Expressed as a percentage of revenue, research and development cost was 5% for the first quarter of 2010, compared to 2% for the same period of 2009.





The increase in research and development costs reflected our continuing effort in R&D activities including investment in the centralized R&D centre in Beijing, China. Our key research and development programs include the improvement of SHL Lyophilized Injection Powder, Cease Enuresis Soft Gel, Jinji series products and some acquired projects from GHK. The majority of research and development expenditures are on pharmaceutical products.





General and Administrative





General and administrative expenses remained stable in the first quarter of 2010 compared to the same period in 2009, even as our business expanded. General and administrative expenses expressed as a percentage of revenues decreased from 10% to 9%. The details of general and administrative expenses were as follows:





Three Months Ended

March 31,


Increase/


Increase/2010


2009


(Decrease)


(Decrease)Payroll

$
777,503


$
568,082


$
209,421



37%Staff welfare and insurance


409,247



307,481



101,766



33Professional fees


779,129



1,086,876



(307,747)



(28)Directors’ remuneration


190,000



235,230



(45,230)



(19)Stock based compensation


695,437



610,857



84,580



14Trip and traveling


205,667



227,826



(22,159)



(10)Maintenance and repair


170,918



20,445



150,473



736Office supplies


183,059



155,537



27,522



18Vehicles and utilities


316,156



147,497



168,659



114Conference fee


56,204



87,619



(31,415)



(36)Miscellaneous


983,166



943,251



39,915



4TOTAL

$
4,766,486


$
4,390,701


$
375,785



9%





The major changes in general and administrative expenses in the first quarter of 2010 as compared to the same period of 2009 were due to the following factors:





●
Payroll expenses increased by $209,421, or 37% and Staff welfare and insurance expenses increased by $101,766, or 33% as compared to the first quarter of 2009. These reflect the Company’s increased efforts in encouraging and optimizing management team in view of the changing market environment; and





●
Maintenance and repair fees increased by $150,473, or 736%, as compared to the first quarter of 2009. We continued upgrading our existing equipments and technologies in the first quarter of 2010, as a result of more stringent GMP manufacturing standards and to improve production efficiency.





The increase was partially offset by the decrease of Professional fees by $307,747, or 28%.





Depreciation and Amortization





Depreciation and amortization expenses decreased by $35,628, or 2%, in the first quarter of 2010 as compared to the same period of 2009.







26




Interest Expense, Net





Net interest expense was $ 1,565,785 for the first quarter of 2010, compared to net interest expense of $1,579,269 for the same period of 2009.





Income Taxes





Income tax expense for the first quarter of 2010 was $1,815,930, compared to $2,469,764 for the same period of 2009. The decrease of the income tax expense was mainly due to the decline of income before income taxes. The Company’s effective tax rate for the first quarter of 2010 was 36.8% which is an increase of 11.1% from prior year. The increase in effective tax rate is mainly due to a decrease in profits before tax relative to permanent differences, unrecognized tax benefits and change in valuation allowance.





LIQUIDITY AND CAPITAL RESOURCES





Cash





Our cash balance at March 31, 2010 was $98,996,682, representing an increase of $4,571,817, or 5%, compared with our cash balance of $94,424,865 at December 31, 2009. The increase was mainly attributable to the increase of operating activities for $5,762,893 and partially offset by the investing and financing activities of $1,122,047 and $110,488, respectively.





We plan to use our cash for acquisitions, research and development activities, sales and marketing of our products, and other general corporate purposes. We manage our cash based on thorough consideration of our corporate strategy as well as the macro economic situation. Factors we take into account when managing our cash include interest income, foreign currency fluctuation as well as the flexibility in executing our acquisition strategy.





Cash Flow





Our cash flows from operating, investing and financing activities, as reflected in the Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2010 and 2009, are summarized as follows:





THREE MONTHS ENDED MARCH 312010


2009Cash provided by (used in):Operating activities


5,762,893



3,529,002Investing activities


(1,122,047
)


(499,456
)Financing activities


(110,488
)


17,602Net increase (decrease) in cash and cash equivalents


4,530,358



3,047,148





Cash flows from operations during the first quarter of 2010 amounted to $5,762,893, representing an increase of $2,233,891, or 63% compared with cash flows from operations of $3,529,002  in the same period of 2009. The increase in net cash provided by operating activities was primarily attributable to the changes in operating assets and liabilities aggregated to a net cash outflow of $1,378,259, increase by $5,834,272  from a net cash outflow of $7,212,531during the same period of 2009. As reflected in our cash flow, the changes including:





●
Cash inflow from advances to suppliers and prepaid expenses amounted to $8,375,368 primarily attributed to the decrease in advances payment in purchasing certain raw materials at the year end of 2009. These advance payments was for a potential increase of raw materials’ future purchase prices and most of them were settled with inventories by our suppliers during the first quarter ended March 31, 2010;





●
Cash inflows from accounts payable amounted to $3,163,172 primarily attributed to the increased purchases of raw materials for planned inventory buildup; and





●
Cash outflows from inventories amounted to $9,805,226 mainly due to the increased purchases of rawmaterials for planned inventory buildup.





Our increased cash flows from operations was partially offset by the decrease in our net income by 56% to $3,117,777 in the first quarter of 2010, compared with net income of $7,155,060 in the same period of 2009.






27





Our net cash used in investing activities amounted to $1,122,047 during the first quarter of 2010, compared to net cash used in investing activities of $499,456 in the same period of 2009. The Changes in net cash provided by investing activities was primarily attributable to the capital expenditures of $1,090,195 in the first quarter of 2010 compared to $394,750 in the same period of 2009.





Our cash flows used in financing activities was $ 110,488 in the first quarter of 2010, compared to cash inflow of $ 17,602  in the same period of 2009.





Working Capital





Our working capital increased by $6,002,181 to $136,945,447 at March 31, 2010, as compared to $130,943,266 at December 31, 2009, primarily due to our increase in cash and cash equivalents by $4,660,815, increase in net inventories by $ 9,822,824, decrease in other payables and accrued expenses by $7,385,272.





We currently generate our cash flow through operations. We believe that our existing cash on hand and cash flow generated from operations will be sufficient to sustain operations for at least the next twelve months. From time to time, we may identify new expansion opportunities for which there will be a need to use cash.





Off -balance Sheet Arrangements





We do not have any off -balance sheet arrangements as of March 31, 2010.





Contractual Obligations





The following table summarizes the Company's estimated contractual obligations as of March 31, 2010:





Payments due by periodTotal


Less than 1

year


1-3 years


3-5 years


More than 5

yearsPurchase obligations


1,175,497



1,175,497



-



-



-Capital expenditure  commitments


20,058,334



11,477,418



8,580,916



-



-Advertising commitments


22,375,482



22,375,482



-



-



-R&D commitments


6,284,425



5,406,731



877,694



-



-Long-term loan


788,135



60,404



125,428



131,853



470,450Convertible notes


145,427,083



5,750,000



11,500,000



11,500,000



116,677,083Total


196,108,956



46,245,532



21,084,038



11,631,853



117,147,533





Holders of the convertible notes may require the Company to repurchase all or a portion of their notes on July 15, 2013 for cash at a price equal to 100% of the principal amount of the notes to be purchased, plus accrued and unpaid interest, if any, up to, but excluding, the repurchase date.





We rely largely on operating cash flow to fund our capital expenditure needs. Due to our significant operating cash flow, we believe we have the ability to meet our capital expenditure needs and foresee no delays to planned capital expenditures.





ISSUANCE OF COMMON STOCK





None.





INFLATION





Inflation has not had a material impact on our business.





CURRENCY EXCHANGE FLUCTUATIONS





The Company's operations are exposed to a variety of global market risks, including the effect of changes in foreign currency exchange rates. These exposures are managed, in part, with the use of a financial derivative. The Company does not use financial derivatives to hedge exposures in the ordinary course of business or for speculative purposes.





We currently conduct substantially all of our operations through our PRC subsidiaries. The functional currency of our PRC subsidiaries is the Chinese RMB. The financial statements of our PRC subsidiaries are translated to U.S. dollars using year-end exchange rates as to assets and liabilities and average exchange rates as to revenues, expenses, and cash flows. Capital accounts are translated at their historical exchange rates when the capital transaction occurred. Translation adjustments resulting from this process are included in accumulated other comprehensive income in the statement of shareholders’ equity. Transaction gains and losses that arise from exchange rate fluctuations on transactions denominated in a currency other than the functional currency are included in the results of operations as incurred.




28





As the majority of our net revenue, consolidated costs and expenses and substantially all of our assets are denominated in RMB, any significant revaluation of the RMB may materially and adversely affect our cash flows, revenues and financial condition. For example, if the RMB depreciates against the U.S. dollar, the value of our RMB revenues, earnings, and assets, as expressed in our U.S. dollar financial statements could decline. In addition, if we decide to convert our RMB into U.S. dollars for the purpose of making payments for business purposes, the U.S. dollar equivalent of the RMB we convert would be reduced. On the other hand, to the extent that we need to convert U.S. dollars we receive from an offering of our securities into RMB for our operations, appreciation of the RMB against the U.S. dollar could reduce the amount of the U.S. dollars available. In addition, the appreciation of the RMB could make our customers’ products more expensive to purchase, because some of our customers are involved in the export of goods, which may have an adverse impact on their sales. A decrease in sales by our customers could have an adverse effect on our operating results.





The local currencies in the countries in which we sell our products may fluctuate in value in relation to other currencies. Such fluctuations may affect the costs of our products sold and the value of our local currency profits. While we are not conducting any operations in countries other than China at the present time, we may expand to other countries and may then have an increased risk of exposure of our business to currency fluctuation.





The PRC government imposes control over the conversion of RMB, into foreign currencies. Under the current unified floating exchange rate system, the People’s Bank of China publishes an exchange rate, which we refer to as the PBOC exchange rate, based on the previous day’s dealings in the inter-bank foreign exchange market. Financial institutions authorized to deal in foreign currency may enter into foreign exchange transactions at exchange rates within an authorized range above or below the PBOC exchange rate according to market conditions.





Pursuant to the Foreign Exchange Control Regulations of the PRC issued by the State Council which came into effect on April 1, 1996, and the Regulations on the Administration of Foreign Exchange Settlement, Sale and Payment of the PRC which came into effect on July 1, 1996, regarding foreign exchange control, conversion of RMB into foreign exchange by Foreign Investment Enterprises, or FIEs, for use on current account items, including the distribution of dividends and profits to foreign investors, is permissible. FIEs are permitted to convert their after-tax dividends and profits to foreign exchange and remit such foreign exchange to their foreign exchange bank accounts in China. Conversion of RMB into foreign currencies for capital account items, including direct investment, loans, and security investment, is still under certain restrictions. On January 14, 1997, the State Council amended the Foreign Exchange Control Regulations and added, among other things, an important provision, which provides that the PRC government shall not impose restrictions on recurring international payments and transfers under current account items.





Enterprises in China, including FIEs, which require foreign exchange for transactions relating to current account items, if within a certain limited amount may, without approval of the State Administration of Foreign Exchange, or SAFE, effect payment from their foreign exchange account or convert and pay at the designated foreign exchange banks by providing valid receipts and proofs.





Convertibility of foreign exchange in respect of capital account items, such as direct investment and capital contribution, is still subject to certain restrictions, and prior approval from the SAFE or its relevant branches must be sought.





Between 1994 and 2004, the exchange rate for RMB against the U.S. dollar remained relatively stable, most of the time in the region of approximately RMB8.28 to US$1.00. However, in 2005, the Chinese government announced that it would begin pegging the exchange rate of the RMB against a number of currencies, rather than just the U.S. dollar.





Since a significant amount of our future revenues are expected to be denominated in RMB, any existing and future restrictions on currency exchange may limit our ability to utilize revenue generated in China to fund our business activities outside of China, if any, or expenditures denominated in foreign currencies, or our ability to meet our foreign currency obligations, which could have a material adverse effect on our business, financial condition and results of operations. We cannot be certain that the PRC regulatory authorities will not impose more stringent restrictions on the convertibility of RMB with respect to foreign exchange transactions.





We recognized a foreign currency translation adjustment of $92,849 and $491,337 for the three months ended March 31, 2010 and 2009, respectively. The balance sheet amounts with the exception of equity at March 31, 2010 were translated at 6.8361 RMB to $1.00 USD as compared to 6.8372 RMB at December 31, 2009. The equity accounts were stated at their historical rate. The average translation rates applied to the income and cash flow statement amounts for the three months ended March 31, 2010 and 2009 were 6.8367 RMB and 6.8499 RMB to $1.00 USD, respectively. We do not hedge our exposure to foreign exchange risk; as such, we may in the future experience economic loss as a result of any foreign currency exchange rate fluctuations.




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ITEM 3 – QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK





There were no material changes in the Company’s market risk components since December 31, 2009.





ITEM 4 – CONTROLS AND PROCEDURES





Evaluation of Disclosure Controls and Procedures





As of the end of the period covered by this report (the “Evaluation Date”), we carried out an evaluation in accordance with the requirements of auditing standards and applicable U.S. rules.  The Company’s internal audit group, which includes its Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of the design and operation of our disclosure controls and procedures, as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), with respect to this Quarterly Report on Form 10-Q before its filing with the Commission.  The internal audit group made its evaluation pursuant to Rule 13a-15 under the Exchange Act.





Based upon our evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that, as of the Evaluation Date, the Company's disclosure controls and procedures were effective.





Changes in Internal Control over Financial Reporting





There was no change in our internal control over financial reporting that occurred during the first quarter of 2010 covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.





PART II – OTHER INFORMATION





ITEM 1 – LEGAL PROCEEDINGS





We are not currently involved in any litigation that we believe could have a material adverse effect on our financial condition or results of operations. There is no action, suit, proceeding, inquiry or investigation before or by any court, public board, government agency, self-regulatory organization or body pending or, to the knowledge of our executive officers or any of our subsidiaries, threatened against or affecting our company, our common stock, or any of our subsidiaries, or against our Company’s or our Company’s subsidiaries’ officers or directors in their capacities as such, in which an adverse decision could have a material adverse effect.





ITEM 1A – RISK FACTORS





There have been no material changes or new risks since our Annual Report on Form 10-K for the year ended December 31, 2009.





ITEM 2 – UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS





None.





ITEM 3 – DEFAULTS UPON SENIOR SECURITIES





There have been no material defaults.





ITEM 4 – OTHER INFORMATION





Not applicable.





ITEM 5 – EXHIBITS





The following exhibits are filed as part of this Quarterly Report on Form 10-Q:





Exhibit No.
Description31.1
Certification of Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended31.2
Certification of Acting Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended32.1
Certification of Chief Executive Officer (Principal Executive Officer) and Chief Financial Officer (Principal Financial Officer) pursuant to 18 U.S.C. 1350, as adopted.








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SIGNATURES





In accordance with 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.





AMERICAN ORIENTAL BIOENGINEERING, INC.





/s/ Tony Liu


TONY LIU


CHAIRMAN AND CHIEF EXECUTIVE OFFICER


DATED: May 10, 2010








/s/ Yanchun Li


YANCHUN LI


CHIEF FINANCIAL OFFICER


DATED: May 10, 2010






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EXHIBIT INDEX








Exhibit No.
Description31.1
Certification of Chief Executive Officer (Principal Executive Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended31.2
Certification of Acting Chief Financial Officer (Principal Financial Officer) pursuant to Rule 13a – 14(a) of the Securities Exchange Act, as amended32.1
Certification of Chief Executive Officer (Principal Executive Officer) and Chief Financial Officer (Principal Financial Officer) pursuant to 18 U.S.C. 1350, as adopted.





























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