SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-KSB/A
Amendment No. 1
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the Fiscal Year Ended December 31, 1996
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to .
--------- ---------
Commission File No. 1-12293
NATURAL WAY TECHNOLOGIES, INC.
----------------------------------------------
(Name of small business issuer in its charter)
Nevada 87-0394313
- ------------------------------- ------------------------------------
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
One World Trade Center, Suite 7865
New York, New York 10048
---------------------------------------------------
(Address of Principal Executive Offices) (Zip Code)
Registrant's Telephone Number, Include Area Code: (212) 938-0574
Securities Registered Pursuant to Section 12(b) of the Act:
Title of Each Class Name of Each Exchange on Which Registered
------------------- -----------------------------------------
None None
Securities Registered Pursuant to Section 12(g) of the Act:
Common Stock, $.001 par value
-----------------------------
(Title of Class)
Check whether the issuer (1) filed all reports required to be filed by
Section 13 or 15(d) of the Exchange Act during the past twelve (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 ninety (90)
days. Yes X No
----- -----
Check if disclosure of delinquent filers in response to Item 405 of
Regulation S-B is not contained in this form, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-KSB or any amendment to
this Form 10-KSB. [ ]
The issuer's revenues for its most recent fiscal year were $9,655,000.
As of April 18, 1997, 10,200,000 shares of common stock of the Registrant
were outstanding. As of such date, the aggregate market value of the common
stock held by non-affiliates, based on the closing bid price on the NASD
Bulletin Board, was approximately $9,900,000.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrant's definitive annual information statement to be
filed within 120 days of the Registrant's fiscal year ended December 31, 1996
are incorporated by reference into Part III.
Transitional Small Business Disclosure Format: Yes No X
----- -----
<PAGE>
TABLE OF CONTENTS
Page
----
PART I
ITEM 1. DESCRIPTION OF BUSINESS............................... 1
ITEM 2. DESCRIPTION OF PROPERTIES............................. 8
ITEM 3. LEGAL PROCEEDINGS..................................... 8
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS... 9
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS............................................... 9
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS.................. 9
ITEM 7. FINANCIAL STATEMENTS.................................. 13
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS
ON ACCOUNTING AND FINANCIAL DISCLOSURE................ 13
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND
CONTROL PERSONS; COMPLIANCE WITH SECTION 16(a)
OF THE EXCHANGE ACT................................... 14
ITEM 10. EXECUTIVE COMPENSATION................................ 14
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS
AND MANAGEMENT........................................ 14
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS........ 14
ITEM 13. EXHIBITS AND REPORTS OF FORM 8-K...................... 15
SIGNATURES............................................ 16
FINANCIAL STATEMENTS.................................. F-1
<PAGE>
PART I
This Form 10-KSB contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. The Company's actual results could differ materially from
those set forth in the forward-looking statements. Certain factors that might
cause such a difference are discussed in the section entitled "Certain Factors
Affecting Future Operating Results" beginning on page 13 of this Form 10-KSB.
ITEM 1. DESCRIPTION OF BUSINESS
General and Development of Business
Natural Way Technologies, Inc. (the "Company"), a Nevada corporation,
through its subsidiaries and a sino-foreign joint venture, is engaged in the
manufacture of formulated Chinese medicines. The Company's manufacturing
facility is located in Dunhua, Jilin Province, the People's Republic of China
("PRC").
The Company's operations began in 1990 as a state-owned enterprise known as
Dunhua Huakang Pharmaceutical Plant ("DHPP") which was formed to develop and
produce a number of medical products. In 1993, DHPP management decided to
concentrate on the production of its two most profitable and widely accepted
products, Xue Shuan Xin Mai Ning ("XMN"), a medication used in the treatment of
cerebral thrombosis, coronary arteriosclerosis and cardiac neuralgia, and Guan
Mai Ning ("GMN"), a medication used in the treatment of coronary heart disease,
cardiac neuralgia and blood deficiency in coronary arteries. Management of DHPP
ultimately determined that, to fully develop its business, it would need greater
resources and larger pools of capital. In March, 1996, DHPP contracted with
China Medical Development Co., Ltd. ("China Medical"), a British Virgin Islands
company, to form a Sino-Foreign joint venture known as Dunhua Huakang
Pharmaceutical Co., Ltd. (the "Pharmaceutical Joint Venture"). The joint venture
term is thirty years from March 1996 to March 2026. Under the terms of the joint
venture agreement, DHPP contributed to the Pharmaceutical Joint Venture the
plant and equipment valued at $1,800,000 and China Medical contributed
$4,200,000 in cash for working capital. In addition, DHPP transferred to the
Pharmaceutical Joint Venture additional operating assets and liabilities with an
estimated valuation of approximately $4,261,000 in return for an unsecured
receivable from the Pharmaceutical Joint Venture which bears interest at 5.5%
per annum. All earnings of the Pharmaceutical Joint Venture are to be divided
based on the parties respective capital contributions, or 70% to China Medical
and 30% to DHPP. DHPP has delivered a guarantee to China Medical that the annual
net income after tax of the Pharmaceutical Joint Venture for each of its first
four years of operations will not be less than 25% of the net assets employed by
the Pharmaceutical Joint Venture. In the event that the net income of the
Pharmaceutical Joint Venture is below the guaranteed amount, DHPP has agreed to
reallocate to China Medical all or a portion of its share of net income of the
Pharmaceutical Joint Venture or to make payments to China Medical so as to cover
any shortfall with respect to China Medical's share of the net income.
Additionally, receivables of DHPP transferred to the Pharmaceutical Joint
Venture which are not collected by June 30, 1997 are subject to transfer back to
DHPP with a corresponding reduction in the receivable from the Pharmaceutical
Joint Venture relating to the transferred operating assets.
On June 30, 1996, China Medical completed a "reverse acquisition" (the
"Exchange") of Energy Systems, Inc. ("ESI"), a U.S. public company. ESI had no
operations prior to the Exchange but was a publicly held shell which was seeking
an operating business to acquire. Pursuant to the terms of the Exchange, ESI
acquired 100% of the outstanding shares of China Medical in exchange for
7,000,000 shares of common stock and 100,000 shares of Series B preferred stock
of ESI. As a condition of the Exchange, ESI agreed to contribute $4,200,000 to
China Medical. ESI issued a total of 6,000 shares of Series A convertible
preferred stock for $6,000,000 and contributed a portion of the proceeds of such
offering to China Medical in order to meet such funding requirements. Following
the Exchange, ESI changed its name to Natural Way Technologies, Inc. and
management of China Medical assumed control of the Company. As used herein,
references to the Company include Natural Way Technologies, Inc., its
wholly-owned subsidiary, China Medical, and China Medical's 70% interest in the
Pharmaceutical Joint Venture.
1
<PAGE>
Company Strategy
Management has set as the Company's overriding goal to become the
recognized leader in the production and distribution of pharmaceutical products
in the PRC. To achieve its objectives, the Company plans to (1) acquire and/or
develop a line of leading or niche market pharmaceutical products aimed
specifically at the PRC market, and (2) establish a nationwide distribution
network through the acquisition and/or construction of distribution centers and
retail drug stores throughout the PRC. The Company's plans in that regard
include (1) the opening of drug stores in 40 large urban areas, principally
along the Pacific Coast, (2) the opening of stores in the 2,860 counties
throughout China, and (3) the establishment of dispensary or distribution
centers in rural areas. The pharmaceutical industry is highly fragmented in the
PRC because pharmaceutical products cannot be freely distributed from one
province to another. By setting up a nationwide distribution system and outlets
to operate within each of the provinces, cross-province distribution
difficulties can be eliminated. Management believes that, through the
establishment of such a distribution network, an opportunity exists for the
Company to capture substantial market share and to establish brand name
recognition for its products. To facilitate its growth plans, the Company has
signed a letter of intent to acquire a controlling interest in a joint venture
to be established with Shanghai First Pharmacy Company ("SFP") to open, own and
operate retail drug stores throughout the PRC. SFP is a PRC company which
presently operates eighteen stores which sell in excess of 10,000 medical
products and has annual sales exceeding $75 million in Shanghai. The Company
plans to execute its business plan through this joint venture and through
similar acquisitions.
In conjunction with its efforts to establish its position as the leading
provider and distributor of Chinese natural medicines within the PRC, the
Company is establishing relationships with major international pharmaceutical
companies whereby the Company will distribute western medicines through its
distribution network in the PRC and license and distribute the Company's Chinese
medicines outside of the PRC.
Overview of PRC Medical Products and Services Market
The market for medical services and products in the PRC over the past
several decades has been greatly influenced by the diverse affects of two
distinct forces, (1) an ancient tradition of reliance on Chinese natural
medicines and (2) the proliferation and subsequent downsizing of a state
controlled health care delivery and finance system. These influences have had
dramatically different effects when viewed in rural areas of China as compared
to urban areas.
State influence over socialized health care, until recent years, was the
single dominant force in influencing the delivery of health care products and
services in urban areas. Such influence was largely the result of the
concentration of hospitals and health care providers in urban areas. Under the
state system, state-funded insurance plans provided free medical care for most
of the PRC's 1.2 billion population. Under this system, an employee or worker
was reimbursed for medical expenses by his/her employer, which in virtually all
instances were state owned. That system made cost a non-factor in seeking
medical services and created incentives for frequent hospital visits and
physician consultations. While PRC pharmaceutical regulations provide that all
pharmaceuticals, whether prescription or over-the-counter, can be sold through
either licensed pharmacies or hospitals, given the absence of cost factors which
would otherwise tend to deter excessive use of medical products and services,
the urban dwelling Chinese would routinely visit hospitals in order to seek
medical consultations and medicine in lieu of simply visiting a retail pharmacy.
The state financed system of health care created a growing financial burden
for the PRC government. With the advent of market reform in the PRC during the
late 1970's and the accompanying economic growth and increase in the living
standard of the Chinese people, the state began to implement reform in the
health care system to shift a greater portion of the financial responsibility
for health care to the consumers of such services, the Chinese people. As a
result of such shift and a growing emphasis on financial accountability of
hospitals, patient charges have increased. To deal with the increased cost and
time associated with routine doctor visits, a growing percentage of the Chinese
urban population has elected to forego what were previously routine doctor
visits and instead have elected to purchase medicine directly from retail
pharmacies without first visiting a hospital.
2
<PAGE>
Throughout the rise and subsequent decline of the state financed health
care system, the health care market in rural areas of China continued to be
influenced primarily by the reliance on traditional and local Chinese natural
medicines. Because of the relative scarcity of both hospitals and physicians in
the rural areas of China, the rural population has historically relied upon the
advice of "medicine doctors" who, though not trained or licensed as physicians,
routinely diagnose illness, formulate medicines based on ancient Chinese
formulas or periodically purchased medicine from a dispensary located in the
local county seat.
With traditional Chinese natural medicine continuing to be popular among
the Chinese people, as well as enjoying growing popularity outside of the PRC,
and with continuing growth in the PRC economy and a continuing shift toward
greater individual responsibility for the payment of health care costs, the
Company expects the market for health care products and services, and
particularly pharmaceutical products, within the PRC to grow at a rate
substantially higher than the U.S. rate of growth in the delivery of such
products and services. According to published reports, it was estimated that the
market for medicines in the PRC was already in excess of $5 billion during 1996,
of which approximately 70% was produced domestically and approximately 30% was
imported.
In addition to the foregoing factors, the Company believes that the
pharmaceutical market in the PRC, and the Company's position within that market,
will benefit from the following factors: (1) the requirement that all medicines
be sold through either licensed pharmacies or hospitals and the lack of
distinction between over-the-counter medications and prescription medications in
the PRC which results in common medications (e.g., aspirin and cough syrup)
being unavailable at supermarkets or other non-licensed outlets; (2) significant
regulatory barriers to entry into the PRC pharmaceutical market by foreign
competitors which is expected to benefit domestic companies such as the
Company's Pharmaceutical Joint Venture in establishing market share and in
negotiating joint marketing and distribution arrangements with large
multi-national pharmaceutical companies; (3) the existing position of the
Company's proposed joint venture partner, China National Pharmaceutical Foreign
Trade Corporation, which has strong ties to the Ministry of Health; and (4) the
selection of SFP which acts as chairman of the National Medical Retailing
Enterprises Association.
Initial Products
The Company's predecessor, DHPP, initially produced a broad variety of
products. However, because of limited capital resources and the difficulties
associated with managing and marketing a large number of products, DHPP, and the
Company, emphasized and concentrated on its two most profitable and widely
accepted products, XMN and GMN. XMN is a Chinese Patent Medicine used in the
treatment of cerebral thrombosis, coronary arteriosclerosis and cardiac
neuralgia. XMN is made from an abstract and mixture of chanxiong rhizome, musk
kernel, bezoar, toad venom, and leech. GMN is a Chinese Patent Medicine used in
the treatment of coronary heart disease, cardiac neuralgia and blood deficiency
in coronary arteries. GMN is made from the extract and mixture of red sage root,
angelic root and salflower. At present, these two products constitute 99% of the
Company's production and sales.
Product Development
Although the Company plans to gradually introduce new products, its primary
production for the coming year will be XMN and GMN. The Company's initial
product development strategy involves the development and acquisition of various
medications which address common medical concerns and have significant market
potential, if properly distributed. The Company presently conducts no product
development activities on its own behalf, but has established relationships with
various research laboratories and will attempt to acquire new products from
those laboratories as they are developed. As a supplement to such efforts, where
the efficacy and market potential meet the Company's criteria, the Company will
attempt to acquire the exclusive rights to manufacture and market existing
products assuming that a satisfactory price can be agreed upon. In addition to
the Company's existing practice of acquiring new products from research
laboratories and acquiring existing products and manufacturing facilities, the
Company is presently engaged in discussions with respect to the potential
formation of a joint venture with Asia First Pharmaceutical Investments Ltd
("Asia First Pharmaceutical") which manufactures traditional Chinese medicine
used in the treatment of rheumatic arthritis. If such acquisition is
consummated, the Company will add Asia First Pharmaceutical's arthritis medicine
to its product line and may carry on in-house the research and product
3
<PAGE>
development activities of Asia First Pharmaceutical as well as expand the
funding and scope of such research. The Company may also pursue other joint
ventures and acquisitions in the future pursuant to which the Company may
acquire and carry on existing product development activities presently carried
conducted by prospective joint venture or acquisition candidates.
The Company has identified nine out of eighteen new products which it hopes
to add during the next five years. Of these products, four are currently being
manufactured in the PRC by other pharmaceutical firms, three are newly
formulated medications which have not previously been produced, and the
remaining two are derivatives of existing products. In addition to the eighteen
new products, the Company may add up to twenty other niche products.
The requirements for the addition of any new product is that it meet what
the Company has termed as its "three/six/nine plan". Under this plan, three of
the new products must produce annual sales of Rmb 100 million (US$12 million),
six of the new products must produce annual sales of Rmb 50 million (US$6
million), and nine of the new products must produce annual sales of Rmb 10
million or greater (US$1.2 million). If a new product cannot reach this minimum
sales level, it will be discontinued from production or sold. The three new
products which are expected to generate the highest sale are anticipated to be
(1) an anti-blood clotting agent, (2) an arthritic pain reliever, and (3) a
treatment for skin fungus. The other six products which have been identified
consist of or will be used in treatment of: (1) the common cold, (2) hepatitis,
(3) urinary tract infections, (4) respiratory ailments, (5) coughs and (6) a
general antibiotic. All eighteen of the new products are expected to be in
production by the end of calendar year 2000. As noted above, the potential joint
venture with Asia First Pharmaceutical would provide the first addition to the
Company's product line with the addition of Asia First Pharmaceutical's
rheumatic arthritis medicine. No assurance, however, can be given that the
Company will be successful in acquiring, developing or marketing any of the
products presently proposed to be introduced.
Manufacturing
The Company currently manufactures XMN and GMN at its production facilities
in Dunhua, Jilin Province, PRC. The Company's production facilities are operated
under the supervision of a team of six physicians, pharmacists and chemists. The
production management team sets production volumes and schedules based on
projected product demand as determined in conjunction with the Company's
marketing staff. The production management team arranges for the purchase of raw
materials, consisting generally of herbs, roots, bark, seeds, fossils, bones,
minerals, animal organs and other natural products. The Company generally
maintains a thirty day supply of raw materials in inventory but has no long-term
contractual arrangements for the purchase of raw materials because these raw
materials are widely available in the PRC from numerous suppliers.
After securing the appropriate raw materials for production of its
products, the Company's production staff produces medicinal products based on
formulas for the products being manufactured. The production process varies
depending upon the nature and form of product being produced. Production of dry
products generally involves crushing, mixing and compressing ingredients to
produce powders or pills. Production of wet products typically involves mixing,
stirring, cooking, brewing, boiling and, in some cases, extracting ingredients.
The Company employs two separate processes, utilizing water or steam, to extract
various medical bases from raw materials. Wet products are then bottled, encased
in gel caps or hardened and cut as appropriate.
Pharmaceutical manufacturing operations are currently conducted in a single
eight hour shift five days per week. The Company has adequate facilities,
equipment and personnel to support current operations and to increase production
by approximately 50% from existing levels without adding production shifts. The
Company can further increase production capacity by adding production shifts or
by acquiring additional equipment and hiring additional production employees.
In addition to the Company's production management team, the Company
employs approximately 140 persons in the manufacturing process. Production
employees receive approximately four weeks of training upon being hired before
joining the production line. Employees are readily available in the community
surrounding the Company's plant.
4
<PAGE>
Marketing
Under PRC law, pharmaceutical manufacturers are not generally allowed to
export their products. Permitted exports must be carried out through certain
import/export corporations licensed by the PRC. Because of the restriction on
exports and greater customer acceptance of the Company's products by the Chinese
people, the Company's products are marketed almost exclusively in the PRC at
this time.
Senior management oversees the marketing process and sets goals and policy
for the Company's marketing team. The Company's sales and marketing efforts are
conducted through an in-house marketing staff, consisting of approximately 150
persons, and a network of approximately 100 independent sales representatives.
Additional marketing personnel and sales representatives will be added as
management deems necessary to support the Company's marketing and production
plans. While the Company's products are sold throughout the PRC, the majority of
such sales are presently concentrated in large metropolitan areas. Among the
factors which have contributed to the concentration of sales in the larger
metropolitan areas are (1) the concentration of marketing personnel and sales
representatives in those markets, (2) the emphasis of the Company on sales to
wholesalers, clinics and hospitals which are also primarily located in the
larger metropolitan areas, and (3) the poor distribution system of the PRC which
makes shipment to outlying areas more difficult.
With the Company's proposed expansion into retail drug store operations,
discussed below, the Company plans to expand its marketing efforts both within
and outside of the major metropolitan areas of the PRC. The Company expects to
establish retail stores in the large urban areas principally along the Pacific
Coast and in the various county seats throughout China. Given the relative lack
of medical facilities and access to pharmaceuticals outside of the major
metropolitan areas, the Company believes that the rural areas of China will be
very receptive to the increased availability of medicines.
Planned Retail Drug Stores and Distribution Operations
The pharmaceutical distribution system within the PRC is very poorly
developed and is virtually non-existent in many rural regions. In order to
capitalize on the perceived need for a well established distribution system for
pharmaceuticals in the PRC, the Company has determined that, as a compliment to
its manufacturing operations, it should be involved in the distribution and
retailing of both traditional Chinese medicines and Western style medicines
throughout the PRC. In furtherance of this objective, the Company has developed
a business plan to establish 3,000 drug stores in the PRC within five years,
including the opening of stores in each of the 2,860 counties within the PRC and
stores in 40 large urban areas, primarily along the Pacific coast. The Company
plans to establish wholesale distribution facilities in each of the twenty-seven
provinces of China which would distribute medical products to the Company's
retail drug stores and to various commercial establishments in each province. By
the end of 1997, a minimum of ten stores are planned to be established, provided
sufficient funds can be raised in the equity market. Concurrent therewith, the
Company also plans to begin acquiring existing retail outlets as well as opening
new pharmaceutical facilities. All of the stores will be designed using the
modern Hong Kong or western style drug store as a model, will carry identical
inventory and will be staffed by the same number of people and work under the
same management concept, including the use of electronic cash registers,
infra-red bar code scanners and sophisticated inventory control systems. The
Company plans to develop a program to train management and employees of the
planned stores and distribution centers. The establishment of the planned
national distribution network is expected to facilitate the sale of products
manufactured by the Company as well as the distribution of products of other
pharmaceutical manufacturers and will serve as an additional source of revenue.
It is estimated that the cost of each retail facility, excluding inventory and
training, will approximate $30,000 for rural stores and up to $60,000 in the
major urban cities. No cost has been factored in for inventory as the standard
payment terms in the PRC are net 180 days and required downpayments for imported
drugs generally range from 10% to 20%. A significant portion of the cost of this
project is expected to be financed by third party lending sources and funds
raised in the equity market. Failure to successfully carry out the Company's
planned development of a national distribution network, whether through a lack
of adequate financing or otherwise, could have a material adverse effect on the
Company's business, financial condition or results of operations.
Initial efforts with regard to the establishment of the proposed retail
distribution system include the proposed joint venture with SFP which presently
operates 18 retail drug stores. The Company has formed Beijing Heng Jia Long
5
<PAGE>
Medical Development Company Ltd. ("Heng Jia Long"), a joint venture with China
National Pharmaceutical Foreign Trade Corporation ("China National"), to
facilitate the transaction with SFP. Pursuant to the terms of the Heng Jia Long
joint venture, the Company is required to inject cash and China National is
required to contribute certain intangible assets to Heng Jia Long. The Company,
in turn, is entitled to 92% of the net income or loss of Heng Jia Long and China
National is entitled to 8% of the net income or loss. Pursuant to the proposed
joint venture with SFP, Heng Jia Long is obligated to contribute $843,000 to the
capital of a newly formed joint venture to be known as "Shanghai First Pharmacy
(Heng Jia Long) Medical Investment Company (the "SFP Joint Venture"). SFP, in
turn, is obligated to contribute one retail outlet and headquarter facilities
with an estimated value of $362,000 to the SFP Joint Venture. The Company,
through Heng Jia Long, is responsible for securing funding for the establishment
of the 3,000 store retail drug store chain which is proposed to be operated by
the SFP Joint Venture. Heng Jia Long will also be responsible for securing
distribution rights relating to brand pharmaceutical products and implementing
modern management techniques. SFP will be responsible for personnel and resource
management. Profit and loss of the SFP Joint Venture will be allocated 70% to
Heng Jia Long and 30% to SFP.
Facilities
The Company's production facilities are located on approximately seven
acres in Dunhua City, Jilin Province, and consist of eleven separate buildings
in a campus like setting. Seven of the buildings are older single level
structures. These buildings constituted the DHPP facility prior to the
formulation of the Pharmaceutical Joint Venture, but have now been converted to
storage. In addition to these facilities, there are two newly constructed
buildings used for manufacturing, a new power plant and an office building which
was acquired from a third party and completely renovated. The total square
footage of all of the buildings is approximately 120,890 square feet.
The two manufacturing buildings were completed in June of 1996 and are
constructed of re-enforced concrete with a tile facade. One of the buildings has
three floors, while the second building has only two floors although it is as
tall as the three storied structure. The three story facility has in excess of
47,000 square feet and is used for mixing, assembly and packaging. The two story
facility has approximately 22,000 square feet and is used for extraction of
medical bases from raw materials. Because of the volume of water used in the
extraction and manufacturing process and to avoid the costs of purchasing water
from the municipal district, the facility has its own well on the property and
draws all of its water from this source.
The other structure on the property is a newly constructed power plant
which contains three coal fueled generating facilities. This one story building
has over 9,000 square feet of space and supplies all of the steam and power to
the facility.
The existing space is sufficient to manufacture and produce the Company's
existing products and those which they intend to introduce over the next several
years.
Government Regulation
In the PRC, the pharmaceutical industry is regulated by the Ministry of
Health and the States Administration of Medicine. Before pharmaceutical products
may be produced and marketed, a manufacturing license and qualification
certificate must be obtained from each agency. To obtain any license or
certificate, the product must comply with the "Testing Criteria for Issuance of
the Pharmaceutical Manufacturer License" promulgated by the Ministry of Health
on July 15, 1989. This promulgation specifies the minimum standards for
pharmaceutical products; the qualification required of persons involved in their
production; the equipment standards of machinery used in production; and the
hygiene requirements to be maintained throughout the production process. Each
license or certificate runs for five years. Renewals are granted only after a
satisfactory demonstration that the standards set out in the promulgation have
been and are being maintained.
The approval process of new pharmaceutical products for distribution in the
PRC generally requires approximately eighteen months to complete (six to eight
months for products which have received approval from the United States Food &
Drug Administration ("FDA")) and is applied to both domestic products and
6
<PAGE>
imported products. The lengthy approval process has historically favored
domestic producers and served as an impediment to the import of products. While
the approval process in the PRC is intended to serve a purpose similar to the
FDA approval process for drugs in the United States and tests cases similar to
FDA standards, the process consists of less testing over a shorter time period.
Medicines developed outside of the PRC are also subject to stringent
government imposed price controls which are intended to ensure the affordability
of such products.
In addition to regulations applying specifically to the production and
distribution of pharmaceuticals, the Company's operations are subject to various
PRC environmental regulations. Those regulations generally regulate the
discharge of hazardous materials in the manufacturing process as well as the use
of natural resources.
The Company believes that its operations comply with all applicable PRC
regulations governing the manufacture and distribution of pharmaceuticals and
governing various environmental matters.
Proprietary Rights
The Company's current products are designated as Chinese Patent medicine
and as such carry certain proprietary rights under Chinese law in the nature of
a patent. While the PRC has implemented various laws and regulations intended to
protect the rights of owners of proprietary technologies and formulas such as
those relating to the production of the Company's current pharmaceutical
products, and signed international conventions relating to patent protection,
such protections should not be considered the equivalent of patents granted in
more developed nations. Current patent protection for the Company's products is
five years and consideration is being given to extending such protection to ten
years. Because intellectual property protection laws in the PRC do not afford
the level of protection and are not as strictly enforced as similar laws in
western countries, and because many of the Company's existing products are based
on ancient formulas or derivatives of such formulas, the Company undertakes all
steps it may deem reasonable to assure that its formulas are kept secret.
Accordingly, most Chinese natural medicines should be considered to be of a
generic nature and it is possible that other manufacturers could produce
products based on similar formulas in which case the Company will likely have
little recourse to prevent such manufacturing.
Competition
There are many companies which produce and distribute formulated Chinese
and western medicines. In addition, although the licensing approval of foreign
entities is difficult and stringent price controls apply to medical products
developed outside of the PRC, large foreign pharmaceutical corporations are also
establishing facilities in the PRC. A number of competing facilities may offer
greater amenities and broader product lines and may be operated by companies
having greater resources than the Company. Further, it can be expected that
competition will intensify as large foreign pharmaceutical companies enter the
PRC market and other smaller pharmaceutical companies are acquired by, enter
into joint ventures with or receive funding from new entrants in the PRC
pharmaceutical market. The Company believes that it is competitive, and will be
competitive, with such companies and facilities based on the quality of the
Company's products, pricing and distribution channels. At present, in most areas
of the country, the company has no direct competition and none is initially
expected in most areas where is plans to opens its retail outlets.
Employees
At April 18, 1997, the Company employed approximately 374 people; 12 in
management, 38 in administration, 173 in production and 151 in sales and
marketing. With the exception of some of the sales personnel, all of the
employees are located in Dunhua. The Company and its subsidiaries are not
parties to any traditional labor contracts. The Company has not suffered any
labor stoppages and believes that it has good relations with its employees.
7
<PAGE>
Potential Acquisitions
On June 28,1996, the Company entered into a Conditional Acquisition
Agreement with China Food and Beverage Industrial Company Limited ("China Food
and Beverage") and its shareholders pursuant to which the Company would have the
right to acquire not less than 50% of China Food and Beverage for a price not to
exceed eight times earnings. Pursuant to this agreement, the Company has until
June 30, 1997 to conduct due diligence with respect to the potential acquisition
of China Food and Beverage. The Company deposited $1,400,000 with China Food and
Beverage which shall be refundable in full with interest at 8% commencing on
January 1, 1997 if the Company elects not to consummate such acquisition. If the
Company elects to pursue the acquisition of China Food and Beverage the deposit
will be applied toward the purchase price.
China Food and Beverage is involved in efforts to form a sino-foreign joint
venture which will own and operate an almond juice and health products
manufacturing business presently operated by a PRC government controlled entity.
China Food and Beverage is owned and controlled by Yiu Yat Hung, a director of
the Company.
On April 2, 1997, the Company signed a Letter of Intent for the acquisition
of 70% of a proposed joint venture with Shanghai First Pharmacy Co. ("SFP").
Under the Letter of Intent, SFP would contribute one retail outlet and
headquarter facilities with an estimated value of $362,000 and the Company would
contribute $843,000. The joint venture would open, own and operate the proposed
network of 3,000 retail pharmacies throughout the PRC. SFP operates eighteen
stores in the PRC, selling over 10,000 medical products. Its current annual
sales exceed $75 million.
On May 15, 1996, the Company executed a letter of intent with Simple Win
Investment Ltd. ("Simple Win") for the potential acquisition of Asia First
Pharmaceutical Investment Ltd. ("Asia First Pharmaceutical") and its 90% equity
interest in Jilin Huajia Pharmaceutical Company Limited ("Jilin Huajia
Pharmaceutical"). Subject to due diligence and market conditions, the Company
will pay the fair market value of the assets acquired, not to exceed $5 million
for this acquisition, should it be consummated. The Company deposited $2.392
million with Simple Win which shall be refundable in full without interest if
the Company elects not to consummate such acquisition. If the Company elects to
pursue the acquisition, the deposit will be applied toward the purchase price.
The Company's option to acquire Asia First Pharmaceutical expires June 30, 1997.
Jilin Huajia Pharmaceutical is engaged in the manufacture and sale in the
PRC of formulated Chinese medicine to treat rheumatic arthritis.
ITEM 2. DESCRIPTION OF PROPERTIES
The Company's executive offices consist of 3,315 square feet located at One
World Trade Center, Suite 7865, New York, New York. Such space is provided to
the Company, free of charge, by an entity controlled by Yiu Yat Hung, an
affiliate of the Company.
The Company's production facilities located in Dunhua City, Jilin Province,
PRC are owned by the Pharmaceutical Joint Venture. The site on which such
production facilities are located is held pursuant to a grant of land use rights
from the PRC government expiring in 2046. See "Item 1. Description of Business.
Facilities."
The Company believes that its properties are adequate to support its
current operations.
ITEM 3. LEGAL PROCEEDINGS
The Company is from time to time a party to litigation arising in the
routine course of business. Management is not aware of any pending or threatened
litigation which is material to the Company.
8
<PAGE>
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of the Company's stockholders through
the solicitation of proxies, or otherwise, during the fourth quarter of the
Company's fiscal year ended December 31, 1996.
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Market Information
The Company's Common Stock is traded in the over-the counter on the NASD
Electronic Bulletin Board. Trading in the Company's Common Stock is extremely
limited and sporadic.
The Company has applied for listing of its Common Stock on the Nasdaq
Small-Cap Market under the symbol "NWYT". There can be no assurance, however,
that the Company's Common Stock will in fact be listed on Nasdaq or that a
sustained trading market will develop.
At April 18, 1997, the bid price of the Common Stock was $3.00. For the
fourth quarter of calendar year 1996, the price of the Common Stock ranged from
a high of $6.50 to a low of $3.75.
Record Holders
As of April 18, 1997, there were approximately 293 record owners of the
Common Stock of the Company.
Dividends
The Company has never declared or paid any cash dividend on its Common
Stock and does not expect to declare or pay any such dividend in the foreseeable
future.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS
This Form 10-KSB contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. The Company's actual results could differ materially from
those set forth in the forward-looking statements. Certain factors that might
cause such a difference are discussed in the section entitled "Certain Factors
Affecting Future Operating Results" beginning on page 13 of this Form 10-KSB.
Natural Way Technologies, Inc. (the "Company"), through its subsidiaries
and a sino-foreign joint venture, is engaged in the manufacture of formulated
Chinese medicines.
The Company is the successor to the operations of Dunhua Huakang
Pharmaceutical Plant ("DHPP"), a state-owned enterprise, which began in 1990 to
develop and produce a number of medical products. In 1993, DHPP management
decided to concentrate on the production of its two most profitable and widely
accepted products, Xue Shuan Xin Mai Ning ("XMN") and Guan Mai Ning ("GMN"). In
March, 1996, DHPP contracted with China Medical Development Co., Ltd. ("China
Medical") a British Virgin Islands company, to form a Sino-Foreign joint venture
known as Dunhua Huakang Pharmaceutical Co., Ltd. (the "Pharmaceutical Joint
Venture"). Under the terms of the joint venture agreement, DHPP contributed to
the Pharmaceutical Joint Venture the plant and equipment valued at $1,800,000
and China Medical contributed $4,200,000 in cash for working capital. All
earnings of the Pharmaceutical Joint Venture are to be divided based on the
parties respective capital contributions, or 70% to China Medical and 30% to
DHPP. See "Description of Business General and Development of Business."
9
<PAGE>
On June 30, 1996, China Medical completed a "reverse acquisition" (the
"Exchange") of Energy Systems, Inc. ("ESI"), a U.S. public company. ESI had no
operations prior to the Exchange but was a publicly held shell which was seeking
an operating business to acquire. Pursuant to the terms of the Exchange, ESI
acquired 100% of the outstanding shares of China Medical in exchange for
7,000,000 shares of common stock and 100,000 shares of Series B preferred stock
of ESI. As a condition of the Exchange, ESI infused $4,200,000 into China
Medical and ESI issued a total of 6,000 shares of Series A convertible preferred
stock for $6,000,000 in order to meet such funding requirements. Following the
Exchange, ESI changed its name to Natural Way Technologies, Inc. and management
of China Medical assumed control of the Company. As used herein, references to
the Company include Natural Way Technologies, Inc., its wholly-owned subsidiary,
China Medical, and China Medical's 70% interest in the Pharmaceutical Joint
Venture.
The acquisition of China Medical by ESI on June 30, 1996 was treated as a
recapitalization of China Medical with China Medical as the acquirer (reverse
acquisition). On this basis, the historical consolidated financial statements of
the Company prior to June 30, 1996 are those of China Medical and the historical
shareholders' equity amounts of China Medical as of December 31, 1993, 1994 and
1995 have been retroactively restated to reflect the equivalent number of shares
of common stock of the Company issued for this acquisition.
The acquisition of China Medical's interest in the Pharmaceutical Joint
Venture on March 6, 1996 has been accounted for using the purchase method of
accounting. Accordingly, the assets acquired and liabilities assumed have been
recorded at their estimated fair values, and the operations of the
Pharmaceutical Joint Venture are included in the consolidated financial
statements of the Company from the date of acquisition.
Results of Operations
The following table sets forth certain items from the Consolidated
Statements of Income, and expressed as a percentage of net sales, for the year
ended December 31, 1996 and pro forma information reflecting the operations of
DHPP for the year ended December 31, 1995:
Pro Forma
1996 1995
----------------- ------------------
Amount Percent Amount Percent
$'000 $'000
Net sales............................ 9,655 100.0% 10,348 100.0%
Cost of sales........................ 2,194 22.7 2,683 25.9
------ ----- ------ -----
Gross profit......................... 7,461 77.3 7,665 74.1
Selling expense...................... 2,085 21.6 1,710 16.5
General and administrative expense... 2,259 23.4 2,654 25.6
Other expenses, net.................. 206 2.1 (13) 0.0
------ ----- ----- -----
Income before taxes and
minority interest................... 2,911 30.2 3,314 32.0
Provision for income taxes........... - - 120 1.2
------ ----- ----- -----
Income before minority interest...... 2,911 30.2 3,194 30.8
Minority interest.................... 903 9.4 - -
------ ----- ----- -----
Net income........................... 2,008 20.8% 3,194 30.8%
====== ===== ===== =====
Fiscal Year 1996 Compared to Fiscal Year 1995
As noted above, the Company's actual operating results for 1996 reflect the
operations of the Pharmaceutical Joint Venture from the date of its formation on
March 6, 1996 through December 31, 1996. Pro forma operating results for 1995
reflect the operations of DHPP for the entire twelve month period ended December
31, 1995. Accordingly, comparisons of operating results during fiscal 1995 and
1996 should be made in light of the shorter period during which pharmaceutical
operations were undertaken during 1996 and any such comparisons may not be
meaningful.
10
<PAGE>
Net Sales. Net sales during 1996 totaled $9.7 million compared to pro forma
net sales of $10.3 million during 1995. On a pro forma basis, assuming formation
of the Pharmaceutical Joint Venture on January 1, 1996, sales were up slightly
to $10.4 million during 1996. Growth in pro forma sales during 1996 was
restrained by increased competition in several provinces which resulted in lower
unit pricing and lower unit sales in those provinces. Management believes that
the competitive situation in those provinces has since returned to normal and
that, with the addition of capital during June of 1996 from the formation of the
Pharmaceutical Joint Venture, the Company will be able to increase its marketing
and distribution efforts and increase sales during 1997.
Cost of Goods Sold and Gross Profit. Cost of goods sold during 1996 totaled
$2.2 million (22.7% of net sales) compared to $2.7 million (25.9% of pro forma
net sales) during 1995. The decrease in cost of goods sold was attributable to
the implementation during 1996 of tighter cost controls and re-engineering of
the production process to improve efficiency. Gross profits during 1996 totaled
$7.5 million as compared to $7.7 million of pro forma gross profits during 1995.
On a full year basis, gross profit for 1996 would have been $8.0 million, an
increase of 4%.
Selling Expense. Selling expense during 1996 totalled $2.1 million as
compared to $1.7 million for 1995. The increase was principally attributable to
increased advertising costs undertaken during 1996 and the hiring of additional
sales representatives.
General and Administrative Expense. General and administrative expenses
("G&A") during 1996 totaled $2.3 million (23.4% of net sales) as compared to
$2.7 million (25.6% of pro forma net sales) during 1995. The decrease in G&A was
attributable to a reduction in the number of employees which was partially
offset by higher per employee salaries and wages resulting from conversion from
a state-owned enterprise to a sino-foreign joint venture
Other Expense, Net. Other expense, net, during 1996 totaled $206,000 as
compared to net other income of $13,000 during 1995. Other expense during 1996
consisted primarily of net interest expense of $196,000 which was attributable
to amounts payable to DHPP pursuant to the joint venture agreement in exchange
for certain assets contributed to the Pharmaceutical Joint Venture.
Income Taxes. The Company had no income tax provision for 1996 as compared
to $120,000 during 1995. The decrease in income tax provision for 1996 was
attributable to a tax holiday granted by the PRC government for the first two
years of profitable operations of the Pharmaceutical Joint Venture.
If the tax holiday for the Pharmaceutical Joint Venture did not exist, the
Company's income tax expense (net of minority interest) would have been
increased by approximately Rmb 5,782,000 (US$695,000) for the year ended
December 31, 1996.
Minority Interests. Minority interest, totaling $0.9 million in 1996,
represents the allocable share of income or loss attributable to the 30% share
of the Pharmaceutical Joint Venture not owned by the Company. On a pro forma
basis, the minority interest would have been $0.96 million for 1995.
Earnings Per Share. Primary and fully diluted earnings per common share, as
reported in the financial statements, of $0.16 and $0.15, respectively, reflect
the effects of certain common stock equivalents, including 21,000,000 warrants
originally issued in connection with the Exchange. Subsequent to the date of the
Company's financial statements, the Company retroactively cancelled the
21,000,000 warrants issued in connection with the Exchange. Had those warrants
been cancelled prior to the date of the Company's financial statements, the
weighted average shares outstanding for both primary and fully diluted earnings
per common share purposes would have decreased to 11,133,880 and primary and
fully diluted earnings per share would have increased to $0.18.
11
<PAGE>
Liquidity and Capital Resources
At December 31, 1996, the Company had a working capital balance of $7.5
million and a cash balance of $1.2 million as compared to working capital of
$3.8 million and a cash balance of $0.4 million at December 31, 1995. The change
in working capital and cash balances was attributable to a combination of (i)
cash flows from profitable operations, (ii) the receipt of $5.0 million of net
proceeds from the sale of convertible preferred stock during 1996 and (iii) the
use of such funds for the acquisition of property, plant and equipment, the
establishment of the Pharmaceutical Joint Venture and deposits on two proposed
acquisitions.
At December 31, 1996, the primary obligations of the Company consisted of a
payable of the Pharmaceutical Joint Venture to DHPP of $4.3 million for certain
excess operating assets transferred by DHPP to, and utilized by, the
Pharmaceutical Joint Venture. The payable provides for interest at 5.5%. DHPP
forgave accrued interest on the payable in the amount of $218,000 during 1996
and has agreed not to demand repayment at this time. Included in the operating
assets transferred by DHPP to the Pharmaceutical Joint Venture are accounts
receivable of DHPP, $7.0 million of which remained outstanding at December 31,
1996. Pursuant to the terms governing the formation of the Pharmaceutical Joint
Venture, if such receivables have not been collected by June 30, 1997, such
receivables may be transferred back to DHPP in which case the note from the
Pharmaceutical Joint Venture to DHPP will be reduced by the amount of such
receivables actually transferred back to DHPP.
During 1996, the Company issued 6,000 shares of Series A convertible
preferred stock raising approximately $5.0 million net of offering costs of
approximately $978,000, all of which shares remained outstanding and convertible
into Common Stock at December 31, 1996. Each share of Series A convertible
preferred stock is convertible into common stock with the number of shares of
common stock determined by dividing 1,000 by a conversion factor equal to the
lesser of the average closing market price of the Company's common stock for the
five days immediately preceding the date of notice of conversion or $1.00. The
Series A convertible preferred stock is redeemable at the option of the Company
at any time after December 31, 1997 on ten days notice at $1,000 per share plus
any accrued dividends.
The proceeds from the sale of securities during 1996 were used to fund the
acquisition of property, plant and equipment ($0.99 million) and for deposits
relating to two proposed acquisitions ($3.8 million). Pursuant to two separate
letters of intent relating to the proposed acquisitions of China Food and
Beverage and Asia First Pharmaceutical, the Company made deposits of $1.4
million and $2.4 million, respectively. Each of those letters of intent expire
June 30, 1997. Pursuant to the China Food and Beverage letter of intent, the
purchase price for not less than 50% of China Food and Beverage will be fixed at
not more than eight times earnings. The Asia First Pharmaceutical letter of
intent provides for a purchase price for 100% of Asia First Pharmaceutical equal
to the fair market value of the assets acquired but not more than $5 million. If
the Company elects to pursue those acquisitions, the deposits will be applied
toward the purchase price. Should the Company pursue either or both of the
potential acquisitions discussed, the Company will be required to pay the
balance of the purchase price at closing. Should the Company elect not to pursue
the acquisitions, the deposit with respect to China Food and Beverage shall be
refundable in full with interest at 8% from January 1, 1997 and the deposit with
respect to Asia First Pharmaceutical shall be refundable in full without
interest. See "Business - Potential Acquisitions."
In addition to amounts which may become payable should the Company pursue
the acquisitions of China Food and Beverage and Asia First Pharmaceutical, the
Company's only other known potential material capital requirement relates to the
proposed opening of multiple retail pharmacies. Pursuant to the terms of the
proposed SFP Joint Venture, the Company, through Heng Jai Long, is obligated to
contribute $843,000 to the capital of SFP. Additionally, Heng Jai Long is
obligated to secure the necessary funding for the establishment of a retail drug
store chain throughout the PRC. The Company, through SFP, plans to open up to
3,000 retail drug stores in the PRC within five years with not less than ten
stores planned to open during 1997. The Company has estimated the cost of
opening retail drug stores at $30,000 to $60,000 each. Additionally, over such
five year period, the Company plans to establish distribution centers in each of
the twenty-seven provinces of the PRC.
12
<PAGE>
The Company presently is actively seeking funding to consummate the
acquisitions of China Food and Beverage and Asia First Pharmaceutical and to
fund the anticipated costs, both in 1997 and for future years, of opening retail
drug stores and distribution centers.
The Company is presently evaluating various options, including the sale of
convertible debt or equity securities to fund the Company's acquisition and
expansion plans. The Company has executed letters of intent in that regard at
this time.
Other than the foregoing, the Company has no sources of available capital
or commitments to provide additional capital. Management believes that the
Company has sufficient capital resources to fund its current operations for the
foreseeable future.
Certain Factors Affecting Future Operating Results
This Form 10-KSB contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933 and Section 21E of the Securities
Exchange Act of 1934. The Company's actual results could differ materially from
those set forth in the forward-looking statements. Certain factors that might
cause such a difference include the following: fluctuations in economic and
other conditions within the PRC which could adversely effect the demand for
pharmaceutical products; the entry into the PRC pharmaceutical market of new
domestic or foreign competition or the introduction of new products which
compete with the Company's products; changes in government policies which may
adversely effect the Company's ability to acquire, produce and distribute
pharmaceuticals in the PRC; the availability and timing of, and terms on which
the Company can secure, funding in order to carry out its proposed acquisitions
and entry into the retail drug market; and, inefficiencies in the distribution
system, regulations and other conditions which generally make operations in the
PRC unpredictable when compared to operations in more developed economies.
As the Company's plan of operations revolves around its ability to make
certain strategic acquisitions and to open retail drug stores and distribution
centers throughout the PRC, the Company's future revenues and profitability will
be largely dependent upon the Company's ability to secure necessary financing to
carry out such plans and its ability to manage such operations. If the Company
experiences delays in commencing such operations or is unable to manage the same
as planned, the Company's prospects and operating results could be materially
adversely effected.
Inflation and Exchange Rates
The Company does not believe that inflation has had a material impact on
the results of its operations. However, high levels of inflation and exchange
rate fluctuations have characterized the PRC economy in recent years. Because
the operations of the Pharmaceutical Joint Venture are conducted exclusively
within the PRC, management believes that any price fluctuations attributable to
inflation or changes in exchange rates can be passed through to its customers.
There can be no assurance, however, that continued inflation and exchange rate
fluctuations will not adversely impact the Company in the future. In particular,
as the Company's revenues are primarily received in Renminbi, the Company's
ability to pay dividends and make other payments denominated in other currencies
may be adversely impacted by exchange rate fluctuations.
ITEM 7. FINANCIAL STATEMENTS
The consolidated financial statements of the Company, together with the
independent auditors' report thereon of Arthur Andersen & Co., appears on pages
F-2 through F-24 of this report. See Index to Financial Statements on page F-1
of this report.
13
<PAGE>
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
Following the acquisition of China Medical by the Company, on July 31,
1996, the Company's Board of Directors selected Arthur Andersen & Co. to serve
as its new independent accountants and dismissed D. Brian Macbeth, Certified
Public Accountant, of Spring, Texas who previously served as the independent
accountant for the Company.
D. Brian Macbeth's reports on the financial statements of the Company for
the fiscal years ended December 31, 1994 and 1995 contain no adverse opinion or
disclaimer of opinion and were not qualified or modified as to uncertainty,
audit scope, or accounting principles. In connection with its audits for fiscal
years 1994 and 1995 and through July 31, 1996, there were no disagreements with
D. Brian Macbeth on any matter of accounting principles or practices, financial
statement disclosure, or auditing scope or procedure, which disagreements if not
resolved to the satisfaction of D. Brian Macbeth would have caused him to make
reference thereto in his reports on the financial statements for such years.
Arthur Andersen & Co. served as the principal accounting firm for DHPP with
respect to the financial statements of such company for fiscal years 1994 and
1995.
The information described above regarding the Company's decision to dismiss
D. Brian Macbeth as its independent accountant and select Arthur Andersen & Co.
as its new independent accountants, along with a letter from D. Brian Macbeth
stating that he agrees with the above information regarding the Company's change
of accountants, was fully disclosed in a Form 8-K filed with the SEC.
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
WITH SECTION 16(a) OF THE EXCHANGE ACT
The information required by this Item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after the close of the Company's fiscal year. Such information is incorporated
herein by reference.
ITEM 10. EXECUTIVE COMPENSATION
The information required by this Item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after the close of the Company's fiscal year. Such information is incorporated
herein by reference.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this Item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after the close of the Company's fiscal year. Such information is incorporated
herein by reference.
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this Item will be included in a definitive
proxy statement, pursuant to Regulation 14A, to be filed not later than 120 days
after the close of the Company's fiscal year. Such information is incorporated
herein by reference.
14
<PAGE>
PART IV
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
Exhibit
Number Description of Exhibit
------- ----------------------
2.1 Acquisition Agreement dated June 3, 1996 between Energy Systems, Inc.
and China Medical Development Co. Ltd. (1)
2.2* Amendment to Acquisition Agreement
3.1 Amended and Restated Articles of Incorporation (2)
3.2 Bylaws, as amended to date (2)
4.1 Certificate of Designation for Series A Convertible Preferred Shares
(2)
4.2 Certificate of Designation for Series B Convertible Preferred Shares
(2)
4.3 Certificate of Designation for Series C Convertible Preferred Shares
(2)
10.1 Conditional Acquisition Agreement between Natural Way Technologies,
Inc. and China Food and Beverage Industrial Company Limited (2)
10.2*Letter of Intent dated May 15, 1996 between Natural Way Technologies,
Inc. and Simple Win Investment Ltd.
16.1 Letter from D. Brian Macbeth relating to change of independent
accountants (1)
21.1* Subsidiaries of Registrant
27.1* Financial Data Schedules
- ------------------------
* Previously filed
(1) Incorporated by reference to the respective exhibits filed with the
Company's Current Report on Form 8-K/A dated June 30, 1996.
(2) Incorporated by reference to the respective exhibits filed with the
Company's Quarterly Report on Form 10-QSB for the quarter ended September
30, 1996.
(b) Reports on Form 8-K
None
15
<PAGE>
SIGNATURES
In accordance with Section 13 or 15(d) of the Exchange Act, the registrant
caused this amended report to be signed on its behalf by the undersigned,
thereunto duly authorized.
NATURAL WAY TECHNOLOGIES, INC.
By: /s/ Yiu Yat Hung
-----------------------------------------
Yiu Yat Hung
Chief Executive Officer
Dated: April 30, 1997
In accordance with the Exchange Act, this report has been signed below by
the following persons on behalf of the registrant and in the capacities and on
the dates indicated.
Signature Title Date
---------
/s/ Yiu Yat Hung Chief Executive Officer and Chairman April 30, 1997
- --------------------- of the Board of Directors (Principal
Yiu Yat Hung Executive Officer)
/s/ Yiu Yat On Vice Chairman, Vice President and April 30, 1997
- --------------------- Director
Yiu Yat On
/s/ Yao Yi Le Treasurer and Director April 30, 1997
- ---------------------
Yao Yi Le
/s/ Yao Su Zhen Director April 30, 1997
- ---------------------
Yao Su Zhen
/s/ Yao Yi Ming Chief Operating Officer and Director April 30, 1997
- ---------------------
Yao Yi Ming
/s/ Ken Kangmao Wang Chief Financial Officer (Principal April 30, 1997
- --------------------- Financial and Accounting Officer)
Ken Kangmao Wang
16
<PAGE>
NATURAL WAY TECHNOLOGIES, INC. AND SUBSIDIARIES
Index to Consolidated Financial Statements
Page
Report of Independent Public Accountants............................. F-2
Consolidated Balance Sheets as of December 31, 1996 and 1995......... F-3
Consolidated Statements of Operations for the Years Ended
December 31, 1996, 1995 and 1994.................................... F-4
Consolidated Statements of Cash Flows for the Years Ended
December 31, 1996, 1995 and 1994.................................... F-5
Statements of Changes in Shareholders' Equity for the Years
Ended December 31, 1996, 1995 and 1994.............................. F-7
Notes to Financial Statements........................................ F-8
F-1
<PAGE>
REPORT OF INDEPENDENT PUBLIC ACCOUNTANTS
To the Shareholders and the Board of Directors of Natural Way Technologies,
Inc.:
We have audited the accompanying consolidated balance sheets of Natural Way
Technologies, Inc. (a company incorporated in the State of Nevada; "the
Company") and Subsidiaries ("the Group") as of December 31, 1995 and 1996, and
the related consolidated statements of operations, cash flows and changes in
shareholders' equity for the years ended December 31, 1994, 1995 and 1996. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing standards
in the United States of America. Those standards require that we plan and
perform the audits to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the financial position of Natural Way
Technologies, Inc. and Subsidiaries as of December 31, 1995 and 1996, and the
results of their operations and their cash flows for the years ended December
31, 1994, 1995 and 1996, in conformity with generally accepted accounting
principles in the United States of America.
As indicated in Note 8 to the accompanying consolidated financial statements, as
of December 31, 1996, the Group has made deposits of approximately
Rmb31,548,000, including a deposit of approximately Rmb11,648,000 placed with a
related company, in connection with the proposed acquisition of two companies.
The Company's directors consider that the Group could realise such deposits
either by completing the acquisition or by refund if the Group decides to
withdraw from the acquisitions.
/s/ Arthur Andersen & Co.
- -------------------------------
ARTHUR ANDERSEN & CO.
Certified Public Accountants
Hong Kong
Hong Kong,
April 11, 1997.
F-2
<PAGE>
NATURAL WAY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
AS OF DECEMBER 31, 1995 AND 1996
1995 1996
------- -------------------
Rmb'000 Rmb'000 US$'000
ASSETS
Current assets:
Cash - 10,017 1,204
Accounts receivable, net - 73,533 8,838
Due from a related company - 4,159 500
Due from shareholders 84 - -
Due from a director - 75 9
Prepayments and deposits - 2,607 313
Inventories, net - 5,618 675
---- -------- ------
Total current assets 84 96,009 11,539
Investment deposits - 31,548 3,792
Deferred value added tax recoverable - 1,011 122
Property, plant and equipment, net - 23,526 2,828
---- -------- ------
Total assets 84 152,094 18,281
==== ======== ======
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable - 9,016 1,084
Accrued expenses and other payables 66 7,762 933
Due to a related company - 3,412 410
Taxation payable - 13,648 1,640
---- -------- ------
Total current liabilities 66 33,838 4,067
Payable to a joint venture partner - 35,450 4,261
---- -------- ------
Total liabilities 66 69,288 8,328
---- -------- ------
Minority interest - 22,450 2,698
---- -------- ------
Shareholders' equity:
Preferred stock, Series A convertible
and redeemable, par value US$0.001;
issued and outstanding - nil as of
December 31, 1995 and 6,000 shares
as of December 31, 1996 - - -
Preferred stock, Series B
supervoting, par value US$0.001;
issued and outstanding - 100,000
shares as of December 31, 1995 and 1996 - - -
Common stock, par value US$0.001;
issued and outstanding - 8,000,000
shares as of December 31, 1995 and
8,200,000 shares as of December 31, 1996 66 68 8
Additional paid-in capital 8 43,611 5,242
Dedicated capital - 1,752 211
(Accumulated deficit) Retained earnings (56) 14,901 1,791
Cumulative translation adjustments - 24 3
---- ------- ------
Total shareholders' equity 18 60,356 7,255
---- ------- ------
Total liabilities, minority interest
and shareholders' equity 84 152,094 18,281
---- ------- ------
The accompanying notes are an integral part of these financial statements.
- ------------------------
Translation of amounts from Renminbi ("Rmb") into United States dollars ("US$")
is for the convenience of the readers, which has been made at the noon buying
rate in New York City for cable transfers in foreign currencies as certified for
customs purposes by the Federal Reserve Bank of New York on March 31, 1997 of
US$1.00=Rmb8.32. No representation is made that the Renminbi amounts could have
been, or could be, converted into United States dollars at that rate or at any
other rate.
F-3
<PAGE>
NATURAL WAY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
<TABLE>
<CAPTION>
1994 1995 1996
---------- --------- --------------------------
Rmb'000 Rmb'000 Rmb'000 US$'000
---------- --------- ----------- -----------
<S> <C> <C> <C> <C>
Net sales - - 80,333 9,655
Cost of goods sold - - (18,252) (2,194)
--------- --------- ---------- ----------
Gross profit - - 62,081 7,461
Selling expenses - - (17,350) (2,085)
General and administrative expenses - (66) (18,795) (2,259)
Interest expenses - - (2,162) (260)
Interest income 536 64
Other expenses, net - - (91) (10)
--------- --------- ---------- ----------
Income (loss) before income
taxes and minority interest - (66) 24,219 2,911
Provision for income taxes - - - -
--------- --------- ---------- ----------
Income (loss) before minority
interest - (66) 24,219 2,911
Minority interest - - (7,510) (903)
--------- --------- ---------- ----------
Net income (loss) - (66) 16,709 2,008
========= ========= ========== ==========
Primary earnings per common share
Net income per common share - - 1.30 $ 0.16
--------- --------- ---------- ----------
Weighted average number of
shares outstanding used in
primary calculation 8,000,000 8,000,000 12,872,848 12,872,848
========= ========= ========== ==========
Fully dilutive earnings
per common share
Net income per common share - - 1.22 $ 0.15
--------- --------- ---------- ----------
Weighted average number of
shares outstanding used in
fully dilutive calculation 8,000,000 8,000,000 13,661,202 13,661,202
========= ========= ========== ==========
Supplementary earnings per
common share (see Note 4.h)
Net income per common share - - 2.04 $ 0.25
--------- --------- ---------- ----------
Weighted average number of
common shares used in the
supplementary calculation 8,000,0000 8,000,000 8,200,000 8,200,000
========== ========= ========== ==========
</TABLE>
The accompanying notes are an integral part of these financial statements.
- ------------------------
Translation of amounts from Renminbi ("Rmb") into United States dollars ("US$")
is for the convenience of the readers, which has been made at the noon buying
rate in New York City for cable transfers in foreign currencies as certified for
customs purposes by the Federal Reserve Bank of New York on March 31, 1997 of
US$1.00=Rmb8.32. No representation is made that the Renminbi amounts could have
been, or could be, converted into United States dollars at that rate or at any
other rate.
F-4
<PAGE>
NATURAL WAY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
<TABLE>
<CAPTION>
1994 1995 1996
------- ------- -------------------
Rmb'000 Rmb'000 Rmb'000 US$'000
<S> <C> <C> <C> <C>
Cash flows from operating activities:
Net income (loss) - (66) 16,709 2,008
Adjustments to reconcile net
income (loss) to net cash
provided by operating activities -
Provision for doubtful debts - - 947 114
Write-back of allowance for
obsolete and slow-moving inventory - - (527) (63)
Depreciation of property, plant
and equipment - - 965 116
Minority interest - - 7,510 903
(Increase) Decrease in operating assets-
Accounts receivable, net - - (18,293) (2,199)
Due from a related company - - 4,593 552
Due from shareholders - - 84 10
Due from a director - - (75) (9)
Prepayments and deposits - - 930 112
Inventories, net - - 399 48
Deferred value added tax recoverable - - 338 40
Increase (Decrease) in operating
liabilities-
Accounts payable - - 2,240 269
Accrued expenses and other payables - 66 (17,241) (2,071)
Due to a related company - - 3,032 364
Taxation payable - - 1,432 172
---- ---- ------- ------
Net cash provided by operating
activities - - 3,043 366
---- ---- ------- ------
Cash flows from investing activities:
Investment deposits - - (31,548) (3,792)
Acquisition of property, plant and
equipment - - (8,218) (988)
Establishment of a joint venture
(Note 19) - - 3,111 375
Effect of translation adjustments - - 24 3
---- ---- ------ -----
Net cash used in investing
activities - - (36,631) (4,402)
---- ----- ------ -----
</TABLE>
(To be continued)
F-5
<PAGE>
NATURAL WAY TECHNOLOGIES, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONT'D)
FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
<TABLE>
<CAPTION>
1994 1995 1996
Rmb'000 Rmb'000 Rmb'000 US$'000
<S> <C> <C> <C> <C>
Cash flows from financing activities:
Issuance of common stock - - 2 -
Loan, subsequently capitalized
by issuance of preferred stock
(Note 18) - - 49,920 6,000
Cost for issuance of stock - - (8,131) (978)
Forgiveness of interest by a
joint venture partner - - 1,814 218
---- ---- ------ -----
Net cash provided by financing
activities - - 43,605 5,240
---- ---- ------ -----
Net increase in cash - - 10,017 1,204
Cash as of beginning of year - - - -
---- ---- ------ -----
Cash as of end of year - - 10,017 1,204
==== ==== ====== =====
</TABLE>
The accompanying notes are an integral part of these financial statements.
- ------------------------
Translation of amounts from Renminbi ("Rmb") into United States dollars ("US$")
for the convenience of the readers, which has been made at the noon buying rate
in New York City for cable transfers in foreign currencies as certified for
customs purposes by the Federal Reserve Bank of New York on March 31, 1997 of
US$1.00=Rmb8.32. No representation is made that the Renminbi amounts could have
been, or could be, converted into United States dollars at that rate or at any
other rate.
F-6
<PAGE>
NATURAL WAY TECHNOLOGIES, INC. AND SUBSIDIARIES
STATEMENTS OF CHANGES IN SHAREHOLDERS' EQUITY
FOR THE YEARS ENDED DECEMBER 31, 1994, 1995 AND 1996
<TABLE>
<CAPTION>
Series A
convertible Series B
and redeemable supervoting Accumu- Cumula-
preferred stock preferred stock Common stock lated tive
--------------- ---------------- ------------------ Additional deficit transla-
Number of Number of Number of paid-in Dedicated Retained tion ad-
shares Amount shares Amount shares Amount capital capital earnings justments
------- ------ -------- ------ --------- ------ ---------- --------- ------- ---------
Rmb Rmb Rmb Rmb'000 Rmb'000 Rmb'000 Rmb'000
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance as of December
31, 1993 and 1994 - - 100,000 832 8,000,000 66,560 8 - 10 -
Net loss - - - - - - - - (66) -
----- -- ------- --- --------- ------ ------ ------ ------ ---
Balance as of
December 31, 1995 - - 100,000 832 8,000,000 66,560 8 - (56) -
Issuance of Series A
preferred stock 6,000 50 - - - - 49,920 - - -
Issuance of common
stock - - - - 200,000 1,664 - - - -
Issuance costs - - - - - - (8,131) - - -
Forgiveness of interest
by a joint venture partner - - - - - - 1,814 - - -
Net income - - - - - - - - 16,709 -
Transfer from retained
earnings to dedicated
capital - - - - - - - 1,752 (1,752) -
Translation adjustments - - - - - - - - - 24
----- -- ------- --- --------- ------ ------ ----- ------ --
Balance as of December
31, 1996 6,000 50 100,000 832 8,200,000 68,224 43,611 1,752 14,901 24
===== == ======= === ========= ====== ====== ===== ====== ==
</TABLE>
The accompanying notes are an integral part of these financial statements.
F-7
<PAGE>
NATURAL WAY TECHNOLOGIES, INC. AND SUBSIDIARIES
NOTES TO FINANCIAL STATEMENTS
I. ORGANIZATION AND PRINCIPAL ACTIVITIES
Natural Way Technologies, Inc. ("the Company") was incorporated in the State of
Nevada, United States of America on May 4, 1988 under the name of Energy
Systems, Inc. It changed its name to Natural Way Technologies, Inc. with effect
from June 26, 1996.
Acquisition of subsidiary
On June 30, 1996, the Company entered into an agreement with Beautimate Group
Limited ("BGL"; a company incorporated in the British Virgin Islands) and
Ongoing Limited ("OL"; a company incorporated the British Virgin Islands) to
acquire from them 100% interest in China Medical Development Company Limited
("CMDC"; a company incorporated in the British Virgin Islands) by issuing to (i)
BGL 6,900,000 shares of common stock, 100,000 shares of Series B supervoting
preferred stock, 7,000,000 Class A warrants, 7,000,000 Class B warrants and
7,000,000 Class C warrants, and (ii) OL 100,000 shares of common stock. BGL is
owned by New Silver Eagles Holdings Limited (a company incorporated in the
British Virgin Islands), which is beneficially owned by Yat-hung Yiu and Yat-on
Yiu, directors of the Company, and certain family members of Yat-hung Yiu. OL is
owned by Wu Guan, a director of CMDC.
CMDC and its joint venture
On March 6, 1996, CMDC entered into a joint venture agreement with Dunhua
Huakang Pharmaceutical Plant ("DHPP"; a PRC state-owned company under the Dunhua
Municipal Government) to establish a sino-foreign joint venture in Dunhua, Jilin
Province, the People's Republic of China ("the PRC") - Dunhua Huakang
Pharmaceutical Co. Ltd. ("DHPC"). Pursuant to this joint venture agreement, CMDC
is required to contribute into DHPC cash of US$4,200,000 (equivalent to
approximately Rmb34,860,000, determined at an exchange rate of US$1 for Rmb8.30)
as its capital contribution for 70% equity interest in DHPC, while DHPP is
required to contribute into DHPC production plant, including buildings and
machinery, with a valuation of US$1,800,000 (equivalent to approximately
Rmb14,940,000, determined at an exchange rate of US$1 for Rmb8.30) as its
capital contribution for 30% equity interest in DHPC. As of December 31, 1996,
CMDC and DHPP had fully paid up all of their capital contributions - CMDC's
contribution in cash of US$4,200,000 has been verified by a certified public
accountant in the PRC according to PRC regulations whereas DHPC's contribution
has yet to be subject to such a verification.
F-8
<PAGE>
1. ORGANIZATION AND PRINCIPAL ACTIVITIES (Cont'd)
CMDC and its joint venture (Cont'd)
DHPC has succeeded to certain business of manufacturing and sales of formulated
Chinese medicine in the PRC previously undertaken by DHPP. In connection with
the establishment of DHPC, DHPP has delivered to CMDC a guarantee that the
annual net income after tax (as determined under generally accepted accounting
principles in the United States of America) of DHPC for each of its first four
years of operations will not be less than 25% of the net assets employed by
DHPC. In the event that the net income of DHPC is below the guaranteed amount,
DHPP has agreed to reallocate all or a portion of its entitlement to the net
income of DHPC to CMDC or make payments to CMDC so as to cover any shortfall
with respect to CMDC's share of the net income. In addition, DHPP has
transferred into DHPC additional operating assets and liabilities with an
estimated valuation of approximately Rmb35,450,000 in return for an unsecured
receivable from DHPC, which bears interest at 5.5% per annum. DHPP has also
given a guarantee to CMDC to transfer DHPP's accounts receivable as of December
31, 1995 back to DHPP if such accounts receivable are not realized in cash by
June 30, 1997.
The other key provisions of the joint venture agreement include:
the joint venture period is 30 years from March 1996 to March 2026; and
the Board of Directors of DHPC consists of seven members, with four
designated by CMDC and three designated by DHPP.
2. SUBSIDIARIES
Details of the Company's subsidiaries (which together with the Company are
collectively referred to as "the Group") as of December 31, 1996 were as
follows:
Percentage of
Place of equity interest
Name Incorporation held Principle activities
- -------------------- --------------- --------------- --------------------
China Medical'
Development Company
Limited ("CMDC") The British
Virgin Islands 100% Investment holding
Dunhua Huakang
Pharmaceutical Co.
Ltd. ("DHPC") The PRC 70% Manufacturing and
sales of formulated
Chinese medicine in
the PRC
F-9
<PAGE>
3. BASIS OF PRESENTATION
The acquisition of CMDC by the Company on June 30, 1996 was treated as a
recapitalization of CMDC with CMDC as the acquirer (reverse acquisition). On
this basis, the historical consolidated financial statements of the Company
prior to June 30, 1996 are those of CMDC and the historical shareholders' equity
amounts of CMDC as of December 31, 1993, 1994 and 1995 have been retroactively
restated to reflect the equivalent number of shares of common stock of the
Company issued for this acquisition.
The acquisition of DHPC by CMDC on March 6, 1996 has been accounted for using
the purchase method of accounting. Accordingly, the assets acquired and
liabilities assumed have been recorded at their estimated fair values, and the
operations of DHPC are included in the consolidated financial statements of the
Company from the date of acquisition. The following is an unaudited pro forma
summary of the combined results of the Company and CMDC for the year ended
December 31, 1996 as if the acquisition had occurred as of January 1, 1996. The
unaudited pro forma summary is not necessarily indicative either of the results
of operations that would have occured had the acquisition been made as of
January 1, 1996, or of the future results of operations of the combined
companies.
Year ended December 31, 1996
----------------------------
Rmb'000 US$'000
Pro forma net sales 86,380 10,382
Pro forma net income 18,028 2,167
Pro forma primary earnings per common share 1.40 0.17
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
a. Basis of consolidation
The consolidated financial statements include the accounts of the
Company and its subsidiaries. All material intra-group balances and
transactions have been eliminated on consolidation.
b. Subsidiary
A subsidiary is a company in which the Company holds, directly or
indirectly, more than 50% of its issued voting share capital.
F-10
<PAGE>
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
c. Inventories
Inventories are stated at the lower of cost, on a weighted average
basis, and market value. Costs of work-in-process and finished goods
are composed of direct materials, direct labor and an attributable
portion of manufacturing overheads.
d. Property, plant and equipment
Property, plant and equipment are stated at cost. Depreciation for
financial reporting purpose is provided using the straight-line method
over the estimated useful lives of the assets after taking into account
of the estimated residual value. The estimated useful lives are as
follows: land use rights - 50 years, buildings - 20 years, machinery
and equipment - 10 years, motor vehicles - 5 years, furniture and
office equipment - 10 years. Gains or losses on disposals are reflected
in current operations. All ordinary repair and maintenance costs are
expensed as incurred.
Construction-in-progress includes the costs of construction and
interest charges arising from borrowings used to finance these assets
during the period of construction. There was no interest capitalized in
1994, 1995 and 1996.
e. Net sales
Net sales represent the invoiced value of goods (excluding value added
tax) supplied to customers, net of sales returns and allowances. Sales
are recognized upon delivery of goods and passage of title to
customers.
All of the Group's sales are made in the PRC and are subject to PRC
value added tax at a rate of 17% ("output VAT"). Such output VAT is
payable after offsetting VAT paid by the Group on purchases ("input
VAT").
f. Income taxes
Income tax is provided under the provisions of Statement of Financial
Accounting Standards No. 109, which requires recognition of deferred
tax assets and liabilities for expected future tax consequences of
events that have been included in the financial statements or tax
returns. Deferred income tax is provided using the liability method.
Under the liability method, deferred income tax is recognized for all
significant temporary differences between the tax and financial
statement bases of assets and liabilities. Income taxes are not accrued
for unremitted earnings of international operations that have been, or
are intended to be, reinvested.
F-11
<PAGE>
4. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Cont'd)
g. Foreign currency translation
The Company considers Renminbi ("Rmb") as its functional currency as
most of the Group's business activities are based in Renminbi.
The translation of the financial statements of group companies into
Renminbi is performed for balance sheet accounts using the closing
exchange rate in effect at the balance sheet date and for revenue and
expense accounts using an average exchange rate during each reporting
period. Gains or losses resulting from translation are included in
shareholders' equity separately as cumulative translation adjustments.
The net gain from foreign currency transactions included in the results
of operations for the years ended December 31, 1994, 1995 and 1996 were
approximately nil, nil and Rmb3,000, respectively.
h. Earnings per common share
The computation of primary earnings per common share is based on the
weighted average number of shares of common stock outstanding and
common stock equivalents arising from exercise of warrants and
conversion of convertible preferred stock based on the average market
price of common stock during the year. Earnings per common share
assuming full dilution is determined by dividing net income by the
weighted average number of shares of common stock outstanding and
common stock equivalents arising from exercise of warrants and
conversion of convertible preferred stock based on the market price of
common stock as of the balance sheet date.
The supplementary earnings per commnon share is determined by dividing
the net income by the weighted average number of shares of common stock
outstanding without taking into account any common stock equivaltents
arising from exercise of warrants and conversion of convertible
preferred stock.
i. Use of estimates
The preparation of financial statements in conformity with generally
accepted accounting principles in the United States of America requires
management to make estimates and assumptions that affect certain
reported amounts and disclosures. Accordingly, actual results could
differ from those estimates.
F-12
<PAGE>
5. ACCOUNTS RECEIVABLE
Accounts receivable comprised:
1995 1996
------- ---------------------
Rmb'000 Rmb'000 US$'000
Trade receivables - 74,480 8,952
Less: Allowance for doubtful accounts - (947) (114)
---- ------ -----
- 73,533 8,838
==== ====== =====
6. PREPAYMENTS AND DEPOSITS
Prepayments and deposits comprised:
1995 1996
------- ---------------------
Rmb'000 Rmb'000 US$'000
Advances to employees for
business trips - 2,123 255
Deposits for purchase of raw materials - 160 19
Prepayments - 324 39
---- ------ ---
- 2,607 313
==== ====== ===
7. INVENTORIES
Inventories comprised:
1995 1996
------- ---------------------
Rmb'000 Rmb'000 US$'000
Raw materials - 3,190 383
Work-in-process - 367 44
Finished goods - 2,356 283
---- ----- ----
- 5,913 710
---- ----- ---
Less: Allowance for obsolete and
slow-moving items - (295) (35)
---- ----- ---
- 5,618 675
==== ===== ===
F-13
<PAGE>
8. INVESTMENT DEPOSITS
Investment deposits comprised:
1995 1996
------- ----------------------
Rmb'000 Rmb'000 US$'000
Deposit with China Food and
Beverage Industrial Co. Limited (a) - 11,648 1,400
Deposit with Simple Win Investment
Limited (b) - 19,900 2,392
--- ------ -----
- 31,548 3,792
=== ====== =====
a. This represents a deposit paid to China Food and Beverage Industrial Co.
Limited ("CFBI"; a company beneficially owned and controlled by Yat-hung
Yiu, a director of the Company) for granting the Company with an exclusive
right to ascertain the feasibility of acquiring not less than 50% equity
interest in CFBI. CFBI is negotiating with an unrelated PRC party to
establish a joint venture to produce beverage products in the PRC. The
Company has to make an investment decision by June 30, 1997. In the event
that the Company decides not to invest, CFBI has agreed to repay the
deposit in full together with accrued interest thereon commencing from
January 1, 1997 at 8% per annum.
b. This represents a deposit paid to Simple Win Investment Limited ("SWI"; an
unrelated entity) for acquiring 100% interest in Asia First Pharmaceutical
Investment Ltd. ("AFPI"; a company incorporated in the British Virgin
Islands), which has a 90% equity interest in Jilin Huajia Pharmaceutical
Company Limited ("JHP"; a sino-foreign joint venture established in
Meihekou, Jilin Province, the PRC). JHP is principally engaged in the
manufacturing and sales of formulated Chinese medicine in the PRC.
According to a letter of intent dated May 15, 1996 between the Company and
SWI, the Company has an option through June 30, 1997 to determine whether
it will proceed or withdraw from such an acquisition after conducting a due
diligence exercise. In the event that the Company decides to withdraw from
the acquisition, the deposit will be refunded without interest.
The Company's directors consider that the Group could realize such deposits
through investments in the aforementioned companies or the Group could
recover the deposits if the Group decides to withdraw from the
acquisitions.
F-14
<PAGE>
9. DEFERRED VALUE ADDED TAX RECOVERABLE
Deferred value added tax ("VAT") recoverable arose from a change in the PRC tax
system and regulations effected January 1, 1994, and was determined at 14% of
the balance of DHPP's inventories as of January 1, 1994. This is part of the
operating assets transferred by DHPP into DHPC in connection with the
establishment of DHPC (see Note 1). Pursuant to a directive issued by the PRC
State Tax Bureau, the amount of deferred VAT recoverable outstanding at January
1, 1995 can be utilized to offset net VAT payable over a period of five years,
with the exact amount of annual utilization varies from 15% to 20% of the
balance outstanding as of January 1, 1995 as determined by individual local tax
bureaus. The amount utilized in 1996 was approximately Rmb338,000.
10. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment comprised:
1995 1996
Rmb'000 Rmb'000 US$'000
Land and buildings in the PRC - 16,119 1,938
Machinery and equipment - 6,236 750
Motor vehicles - 916 110
Furniture and office equipment - 353 42
Construction-in-progress:
Buildings in the PRC - 867 104
--- ------ -----
- 24,491 2,944
Less: Accumulated depreciation - (965) (116)
--- ------ -----
- 23,526 2,828
=== ====== =====
The Group's buildings are located on land in the PRC granted under a land use
right for a term of 50 years.
F-15
<PAGE>
11. ACCRUED EXPENSES AND OTHER PAYABLES
Accrued expenses and other payables comprised:
1995 1996
------- ---------------------
Rmb'000 Rmb'000 US$'000
Accrual for operating expenses
- - Sales commissions - 601 72
- - Advertising and promotional
expenses - 1,495 180
- - Salaries and wages - 865 104
- - Interest expenses - 348 42
- - Legal fees - 269 32
- - Stock issuance costs - 1,997 240
- - Others 66 1,477 177
Provision for funds
- - Salary and welfare fund (a) - 472 57
- - Housing fund (b) - 238 29
--- ----- ---
66 7,762 933
=== ===== ===
a. Salary and welfare fund is provided at 2% of net income of DHPC, as
determined by DHPC's board of directors according to PRC regulations (see
Note 15). The fund is for the payment of non-recurring bonus and welfare
expenses of employees.
b. Housingfund is provided at Rmb98 per employee of DHPC in the PRC in
accordance with PRC regulations. The fund is for the repair and maintenance
of staff quarters.
12. PAYABLE TO A joint venture partner
This represents payable by DHPC to DHPP for the operating assets and liabilities
transferred into DHPC (see Note 1) together with accrued interest thereon. The
payable is unsecured and bears interest at 5.5% per annum. Total interest
accrued on this payable in 1996 amounted to approximately Rmb1,814,000. DHPP has
forgiven its entitlement to the 1996 interest of Rmb1,814,000, and such
foregiveness is accounted for as a capital contribution from DHPP and recorded
as additional paid-in capital. In addition, DHPP has agreed not to demand
repayment until the Group is financially capable to do so.
F-16
<PAGE>
13. CAPITAL STOCKS AND WARRANTS
a. Common stock
The Company's authorized common stock is 50,000,000 shares with par value
of US$0.001 each. In 1996, the Company sold 200,000 shares of common stock,
par value US$0.001 each, for US$200, and issued 7,000,000 shares of common
stock, par value US$0.001 each, in connection with its acquisition of CMDC
(see Note 1).
b. Preferred stock
Effective from May 13, 1996, the Company authorized the creation of
5,000,000 shares of preferred stock with par value US$0.001 each and
authorized the Company's board of directors to assign such shares to
different series and to fix the related designation, powers, preferences
and rights of the shares.
(i) Series A convertible and redeemable preferred stock
In 1996, the Company sold 6,000 shares of Series A convertible and
redeemable preferred stock, par value US$0.001 each, for US$6,000,000
(equivalent of Rmb49,920,000) by capitalizing a loan of the same
amount. The Series A convertible and redeemable preferred stock
carries preferential rights to dividends and distributions convertible
and redeemable upon liquidation. Each share of the Series A
convertible and redeemable preferred stock is convertible into common
stock with the number of shares of common stock determined by 1,000
divided by a conversion factor. The conversion factor equals the
lesser of the average closing market price of the Company's common
stock for the five days immediately preceding the date of notice of
conversion or US$1.00. The outstanding Series A convertible and
redeemable preferred stock is redeemable at the option of the Company
at any time after December 31, 1997 by giving ten days of notice at a
price equal to US$1,000 per share plus any accrued dividends. No
Series A convertible and redeemable preferred stock has been converted
or redeemed.
(ii) Series B supervoting preferred stock
In 1996, the Company issued 100,000 shares of Series B supervoting
preferred stock, par value US$0.001 each, in connection with its
acquisition of CMDC (see Note 1). The series B supervoting preferred
stock carries preferential rights to dividends and distributions upon
liquidation. These 100,000 shares of Series B supervoting preferred
stock carry superior voting rights, which account for 30% of the total
voting rights of the Company on all corporate matters.
F-17
<PAGE>
13. CAPITAL STOCK (Cont'd)
b. Preferred stock (Cont'd)
(iii) Series C convertible and redeemable preferred stock
The Company has authorized the creation of 10,000 shares of Series C
convertible and redeemable preferred stock, par value US$0.001 each.
The Series C preferred stock carries preferential rights to dividends
and distributions upon liquidation. Each share of the Series C
convertible and redeemable preferred storck is convertible into common
stock with the number of shares of common stock determined by 1,000
divided by a conversion factor. The conversion factor is equal to the
lesser of the average closing market price of the Company's common
stock for the five days immediately preceding the date of notice of
conversion or US$3.00. The outstanding Series C convertible and
redeemable preferred stock is redeemable at the option of the Company
at any time after December 31, 1997 by giving ten days of notice at a
price equal to US$1,000 per share plus any accrued dividends. No
Series C convertible and redeemable preferred stock has been issued.
c. Warrants
In 1996, the Company issued 7,000,000 Class A warrants, 7,000,000 Class B
warrants and 7,000,000 Class C warrants in connection with its acquisition
of CMDC (see Note 1). Each of the Class A warrants is exercisable at a
price of US$3.00 in exchange for one share of common stock of the Company
at any time up to June 30, 1998; each of the Class B warrants is
exercisable at a price of US$4.00 in exchange for one share of common stock
of the Company at any time up to June 30, 2000; and each of the Class C
warrants is exercisable at a price of US$5.00 in exchange for one share of
common stock of the Company at any time up to June 30, 2002. The Company's
management believes that the exercise prices of the warrants issued exceed
the fair market value of the Company's common stock on the date of issuance
of the warrants. No warrants has been exercised.
14. TAXATION
The Company and its subsidiaries are subject to income taxes on an entity basis
on income arising in or derived from the tax jurisdiction in which they operate.
The British Virgin Islands subsidiary, CMDC, is incorporated under the
International Business Companies Act of the British Virgin Islands and,
accordingly, is exempted from payment of the British Virgin Islands income
taxes. The joint venture enterprise established in the PRC, DHPC, is subject to
PRC income taxes at a rate of 33% (30% state unified income tax and 3% local
income tax). However, it is exempted from state unified income tax and local
income tax for two years starting from the first year of profitable operations
and then is subject to a 50% reduction in state unified income tax for the next
three years. The first profitable year for DHPC was the year ended December 31,
1996.
F-18
<PAGE>
14. TAXATION (Cont'd)
If the tax holiday for DHPC did not exist, the Group's income tax expenses (net
of minority interest) would have been increased by approximately Rmb5,782,000
for the year ended December 31, 1996. Earnings per common share for the year
ended December 31, 1996 would have been approximately Rmb1.16.
The Company has not provided for income taxes on the undistributed earnings of
its international subsidiaries because the earnings are reinvested and, in the
opinion of management, will continue to be reinvested in the foreseeable future.
The reconciliations of the United States federal income tax rate to the
effective income tax rate based on the income (loss) before provision for income
taxes stated in the consolidated statements of operations is as follows:
Years ended December 31,
----------------------------------
1994 1995 1996
---- ---- ----
U.S. federal income tax rate - - 35%
Effect of different tax rates
in foreign jurisdictions (2%)
Effect of tax exemption for DHPC - - (33%)
--- --- -----
Effective income tax rate - - -
=== === =====
Taxation payable comprised:
December 31,
1995 1996
Rmb'000 Rmb'000 US$'000
Value added tax - 13,616 1,637
Others - 32 3
--- ------ -----
- 13,648 1,640
=== ====== =====
F-19
<PAGE>
15. DISTRIBUTION OF INCOME
At present, substantially all of the Group's income is contributed by its 70%
owned joint venture enterprise in the PRC, DHPC.
Income of DHPC as determined under generally accepted accounting principles in
the PRC is distributable to its joint venture partner after transfer to (i)
contributory dedicated capital as required under PRC government regulations and
the Company's articles of association, and (ii) discretionary dedicated capital
as determined by the Company's board of directors. Contributory dedicated
capital is a form of legal reserve fund. Discretionary dedicated capital
includes salary fund and staff welfare fund. Contributory and discretionary
dedicated capital is not distributable in the form of dividends. In the
Company's financial statements prepared under generally accepted accounting
principles in the United States of America, amounts designated for payments of
employee salary and welfare have been charged to income and the related
provisions are reflected as accrued liabilities in the consolidated balance
sheets.
The income of DHPC available for distribution to its joint venture partner is
based on the income reported in its statutory accounts prepared under generally
accepted accounting principles in the PRC. This differs from the amount reported
under generally accepted accounting principles in the United States of America.
As of December 31, 1996, such difference was insignificant.
16. RETIREMENT PLAN
As stipulated by PRC regulations, DHPC maintains a defined contribution
retirement plan for all its employees. All retired employees of DHPC are
entitled to an annual pension equal to their basic annual salary at retirement.
DHPC contributes to a state sponsored retirement plan approximately 21.5% of the
basic salary of its employees, and has no further obligations for the actual
pension payments or post-retirement benefits beyond the annual contributions.
The state sponsored retirement plan is responsible for the entire pension
obligations payable to retired employees. The contributions made in 1996
amounted to approximately Rmb282,000.
F-20
<PAGE>
17. RELATED PARTY TRANSACTIONS
Name and relationship of related parties:
Name of related parties Existing relationships with the Company
- ---------------------------------- ------------------------------------------
Mr. Yat-hung Yiu Director
New Silver Eagle Holdings Limited
- Hong Kong Common directors with the Company
Huakang Headquarters Common directors with the joint venture
partner, DHPP (see Note 1)
Beautimate Group Limited Shareholder (see Note 1)
Ongoing Limited Shareholder (see Note 1)
Summary of related party balances and transactions is as follows:
1995 1996
------- ----------------------
Rmb'000 Rmb'000 US$'000
Due from a related company
- - Huakang Headquarters - 4,159 500
Due from shareholders
- - Beautimate Group Limited 59 - -
- - Ongoing Limited 25 - -
Due from a director
- - Yat-hung Yiu - 75 9
Due to a related company
- - New Silver Eagle Holdings
Limited - Hong Kong - 3,412 410
Interest expense paid to
related companies
- - Huakang Headquarters - 283 34
- - DHPP (Note12) - 1,814 218
Management fee paid to a related
company
- - Huakang Headquarters - 1,093 131
=== ===== ===
F-21
<PAGE>
17. RELATED PARTY TRANSACTIONS (Cont'd)
In 1996, DHPC and Huakang Headquarters undertook a joint advertisement program
with total advertising expenses amounting to approximately Rmb17,874,000, of
which approximately Rmb7,440,000 was allocated to and absorbed by Huakang
Headquarters.
The balances with a director, shareholders and a related company as listed above
are unsecured, non-interest bearing and without pre-determined repayment terms.
18. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
a. Cash paid (received) for interest comprised:
1995 1996
------- ------------------------
Rmb'000 Rmb'000 US$'000
Interest paid - 65 8
----- ----- ----
Interest received - (520) (63)
===== ===== =====
b. Supplementary disclosure of non-cash investing activities:
(i) In conjunction with the establishment of DHPC, the PRC joint venture
partner, DHPP, transferred the following operating assets
(liabilities) into DHPC:
Rmb'000
Cash 3,111
Accounts receivable 56,187
Due from related companies 8,752
Prepayments and deposits 3,537
Inventories 5,490
Deferred value added tax recoverable 1,349
Property, plant and equipment 18,157
Short-term borrowings (37)
Accounts payable (6,776)
Accrued expenses and other payables (24,900)
Due to related companies (380)
Taxation payable (12,216)
--------
52,274
Less: Negative goodwill adjusted against
property, plant and equipment (1,884)
--------
50,390
========
F-22
<PAGE>
18. SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION (Cont'd)
b. Supplementary disclosure of non-cash investing activities : (Cont'd)
(i) Cont'd
Rmb'000
Represented by -
Capital contribution by DHPP into DHPC (see Note 1) 14,940
Payable to DHPP (see Note 1) 35,450
------
50,390
======
Cash inflow resulting from the establishment of DHPC 3,111
======
(ii) On June 30, 1996, the Company acquired 100% interest in CMDC by
issuing 7,000,000 shares of common stock, 100,000 shares of Series B
preferred stock, 7,000,000 Class A warrants, 7,000,000 Class B
warrants and 7,000,000 Class C warrants (see Note 1). In addition, the
Company capitalized a loan amounting to Rmb49,920,000 by issuance of
6,000 shares of Series A convertible and redeemable preferred stock
(see Note 13 b (i)).
19. OPERATING RISKS
a. Dependence on strategic relationship
The Group conducts its manufacturing operations through a joint venture
with DHPP, a PRC state-owned enterprise (see Note 1). The deterioration of
this strategic relationship may have an adverse effect on the operations of
the Group.
b. Limited product types
Substantially all of the Group's sales were derived from two products in
1996.
c. Concentration of credit risk and major customers
The Group's concentration of credit risk with respect to trade receivables
is limited due to the large number of customers comprising the Group's
customer base. There were no customers which represented a significant
concentration of sales for 1996, or trade receivables as of December 31,
1996. Ongoing credit evaluations of each customer's financial condition are
performed and, generally, no collateral is required. The Group maintains
reserves for potential credit losses and such losses, in the aggregate,
have not exceeded management's expectations.
F-23
<PAGE>
19. OPERATING RISKS (Cont'd)
d. Concentration of suppliers
Details of the suppliers accounting for more than 10% of the Group's
purchases are as follows:
Percentage of purchases for
years ended December 31,
---------------------------------
1994 1995 1996
---- ---- ----
China Herbal Limited(pound)(C) - - 20%
==== ==== ====
e. Country risk
As substantially all of the Group's operations are conducted in the PRC,
the Group is subject to special considerations and significant risks not
typically associated with companies operating in North America and Western
Europe. These include risks associated with, among others, the political,
economic and legal environments and foreign currency exchange. The Group'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, inflationary measures, currency conversion and
remittance abroad, and rates and methods of taxation, among other things.
In addition, a significant portion of the Group's revenue is denominated in
Renminbi ("Rmb") which must be converted into other currencies before
remittance outside the PRC. Both the conversion of Renminbi into foreign
currencies and the remittance of foreign currencies abroad require
approvals of the PRC government.
20. OTHER SUPPLEMENTAL INFORMATION
Years ended December 31,
-----------------------------------------------
1994 1995 1996
------- ------- ---------------------
Rmb'000 Rmb'000 Rmb'000 US$'000
Provision for
doubtful debts - - 947 114
Write-back of allowance
for obsolete and slow-
moving inventories - - (527) (63)
Advertising expenses - - 10,434 1,254
===== ===== ====== =====
F-24
