CHINA PHARMA HOLDINGS, INC. annual report, FY2012

China Pharma Holdings, Inc. — FY2012 Form 10-K

Reporting period: Fiscal year ended December 31, 2012; comparisons are with FY2011. The company develops, manufactures and sells prescription pharmaceuticals in China, primarily through distributors to hospitals. It reported 20 marketed pharmaceutical products and conducts substantially all operations through its PRC subsidiary.

Financial results and liquidity

Metric	FY2012	FY2011
Revenue	$54.5 million	$81.2 million
Gross profit / margin	$14.1 million / 26%	$29.0 million / 36%
Operating income	$5.9 million	$22.0 million
Net income	$4.6 million	$19.3 million
Basic and diluted EPS	$0.11	$0.44
Cash from operations	$3.64 million	$5.24 million
Cash and cash equivalents at year-end	$4.03 million	$4.05 million

• Revenue fell 33%. All four product categories declined: CNS/cerebral/cardiovascular revenue was $15.2 million, down 41%; anti-infection/respiratory was $24.5 million, down 24%; digestive diseases was $7.0 million, down 44%; and other was $7.8 million, down 29%.
• Cost of revenue was $38.7 million, or 71% of revenue, versus $52.2 million, or 64%, in 2011. FY2012 gross profit included a $1.77 million inventory-obsolescence reserve; management estimates gross margin would have been about 29% without that reserve.
• Other notable FY2012 charges included $0.87 million of bad-debt expense and $0.59 million of impairment on two medical formulas. FY2011 included a $0.93 million derivative gain; FY2012 had none. Management estimates net income excluding the inventory reserve in 2012 and derivative gain in 2011 would have been approximately $6.1 million and $18.4 million, respectively.
• Year-end current assets were $112.5 million and current liabilities were $14.6 million. Current assets included $66.2 million of net trade receivables and $36.4 million of inventory. Receivables over 90 days totaled $62.1 million; $30.1 million of receivables related to sales made more than one year earlier. The allowance for doubtful accounts was $4.43 million.
• Short-term bank notes payable were $4.76 million, due within one year and secured by land-use rights, buildings and accounts receivable. The company also owed a director $1.35 million under related-party loans bearing 1% interest, payable December 31, 2013.
• Operating cash flow was lower than in 2011. The company noted that $4.35 million of receivables were collected through bankers’ acceptances with maturities over 90 days, which are not treated as cash equivalents under U.S. GAAP.

Material changes and management commentary

• Management attributed the sales and margin decline to pharmaceutical-market and healthcare-reform pricing pressure, rising raw-material costs, policy changes and weaker demand for certain products. Declines in Bumetanide, Ozagrel and Cefalexin were specifically noted.
• Inventory increased to $36.4 million from $30.4 million. Management said it built inventory partly to mitigate risks from facility transition and GMP-related upgrades; the company also recognized obsolescence in certain raw materials.
• Cash used in investing activities was $4.99 million, mainly for GMP-related construction and equipment and medical formulas. Construction-in-progress assets increased to $3.69 million.
• At year-end, the company had approximately $14.1 million of remaining minimum commitments under facility and manufacturing-improvement agreements, principally $13.1 million due in 2013. It also had approximately $6.48 million of milestone-based obligations to laboratories over about four years for product approvals.
• Management said operating cash flow and anticipated bank financing were expected to fund working capital and planned expenditures for the next 12 months, while cautioning that a shortfall against its operating plan could require additional capital or spending reductions.

Outlook, risks and contingencies

• The company received SFDA production approval for Candesartan in November 2012 and planned a 2013 launch. Rosuvastatin clinical trials were complete and a production-approval application had been submitted. The combination antibiotic remained in Phase II trials; a coronary-heart-disease product was in Phase III, with trial completion timing moved to 2013. These plans depend on regulatory approval and commercialization.
• New GMP requirements apply to the company’s injectable lines by the end of 2013. The company had begun planning and construction, but noncompliance or failure to obtain required certificates could disrupt production. Existing GMP certificates had expirations beginning in May 2013.
• The 15% PRC income-tax rate applies through 2013 under the company’s high-tech status; management expected a 25% rate from 2014 absent renewed preferential treatment.
• Substantially all operations, revenue and manufacturing are in China. Risks include government price controls and reimbursement changes, regulatory delays, intense generic-drug competition, RMB conversion and remittance restrictions, currency movements and reliance on distributors. The top five distributors represented 33% of 2012 revenue.
• The company disclosed no material legal proceedings and no off-balance-sheet arrangements. It said product-liability insurance was unavailable in China and that it had no business-interruption or directors-and-officers insurance.
• Management concluded internal control over financial reporting was not effective at December 31, 2012, citing a material weakness in accounting for inventory obsolescence and long-lived-asset impairment, associated with insufficient U.S. GAAP expertise. Management reported steps to provide training. The auditor gave an unqualified opinion on the financial statements but did not audit internal-control effectiveness.

Important facts for investors to verify

• Whether receivables—especially the $62.1 million past due and the $30.1 million over one year old—are collected, and whether the allowance remains adequate.
• Inventory quality, sell-through and the risk of further obsolescence or write-downs.
• Completion, cost and financing of the GMP/facility program, including the $14.1 million of remaining commitments and timely renewal of manufacturing certifications.
• Actual launch timing, approval status and commercial contribution of Candesartan, Rosuvastatin and other pipeline products.
• Whether the company renews its high-tech tax status after 2013 and the resulting effect of a possible tax-rate increase.
• Remediation of the material weakness and any subsequent changes in reporting controls; also monitor short-term debt repayment and related-party borrowing.