10-Q: CHINA PHARMA HOLDINGS, INC.

(EDGAR Online via COMTEX) -- ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

The statements contained in this report with respect to our financial condition, results of operations and business that are not historical facts are forward-looking statements. Forward-looking statements can be identified by the use of forward-looking terminology, such as "anticipate", "believe", "expect", "plan", "intend", "seek", "estimate", "project", "could", "may" or the negative thereof or other variations thereon, or by discussions of strategy that involve risks and uncertainties. Management wishes to caution the readers of the forward-looking statements that any such statements that are contained in this report reflect our current beliefs with respect to future events and involve known and unknown risks, uncertainties and other factors, including, but not limited to, economic, competitive, regulatory, technological, key employees, and general business factors affecting our operations, markets, growth, services, products, licenses and other factors, some of which are described in this report and some of which are discussed in our other periodic filings with the Securities and Exchange Commission. These forward-looking statements are only estimates or predictions. No assurances can be given regarding the achievement of future results, as actual results may differ materially as a result of risks facing our company, and actual events may differ from the assumptions underlying the statements that have been made regarding anticipated events.

These risk factors should be considered in connection with any subsequent written or oral forward-looking statements that we or persons acting on our behalf may issue. All written and oral forward looking statements made in connection with this report that are attributable to our company or persons acting on our behalf are expressly qualified in their entirety by these cautionary statements. Given these uncertainties, we caution investors not to unduly rely on our forward-looking statements. We do not undertake any obligation to review or confirm analysts' expectations or estimates or to release publicly any revisions to any forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events, except as required by applicable law or regulation.

Business Overview & Recent Developments

The China Food and Drug Administration ("CFDA") promulgated Good Manufacturing Practices for Pharmaceutical Products (2010 revised version) (the "New GMP Standards") on February 12, 2011, which became effective on March 1, 2011. The New GMP Standards outline the basic principles and standards for the manufacturing of pharmaceutical products and the management of quality controls in the manufacturing process in the PRC. Pursuant to those mandatory requirements, the upgrading of our two sterilization production lines were required to be completed by the end of 2013; and the upgrading of our oral solution production lines were required to be completed by the end of 2015. In November 2014 we received new GMP certificates for the four new injectable production lines in our new factory and initiated production on those lines. In January 2015 we also received new GMP certificates for the tablet and capsule production lines in our old factories. We plan to upgrade the dry powder injectable production line, granule production line and cephalosporin production line in our old factories by the end of 2015.

The products in our pipeline have experienced delays. The CFDA has enhanced its approval criteria and processes, resulting in additional supplemental materials and trials, higher cost, and longer approval time for certain applications across all the pharmaceutical products including all of our product types. We commenced leading formulation screening, new technology exploration, technical criteria improvement activities in 2013. We expect this new model will improve our developments and expand our exploration channels for the pipeline products.

The status of our pipeline products remains the same as we reported in our Annual Report on Form 10-K for the year ended December 31, 2014.

Market Trends

It is noteworthy that in 2014 there were certain state policy changes, such as the intention to release the control over drug prices, the restriction release on Internet drug sales, and the promotion on market-oriented reform of health care, which invigorated the traditional Chinese medicine industry. The logic behind these policies was to allow the market to play a decisive role in the allocation of resources, so as to improve operational efficiency and solve the problem of the inaccessibility of medicine and medical care which was experienced by a lot of people. The development of the pharmaceutical industry seems to fit the characteristics of the new normal Chinese economy: growth enters into the shift period, from high-speed growth to the medium-speed growth and the development of the industry relies on reformation, restructuring and innovation.

Currently, the health insurance fund spending accounts for more than 30% of total health expenditure, which is one of the main forces driving the development of the pharmaceutical industry in recent years. However, faced with huge health care expenses, the health insurance fund shortfall problem needs to be addressed urgently. Medicare cost control has been the focus of the market. From the current situation, it will become a trend. The National Development and Reform Commission issued "Promote Drug Price Reform Program (Draft)" on November 25, 2014, which intends to control medical costs through Medicare spending and bidding, form drug prices by market competition, and abolish the maximum retail price restriction of drugs from January 1, 2015. Some analysts believe that, when this reform program is implemented, the weight of Medicare rights will be enhanced and the bargaining power of medical institutions and other relevant parties will also be improved. Consequently, our whole industry will face even more severe price pressure.

China's pharmaceutical industrial output growth continued to slow down from the second half of 2013. In addition, the industry growth in 2014 experienced significant decline compared to the previous years due to certain medicare cost controls, and the upgrading requirements under the New GMP Standards. The Company believes that this trend will continue. Southern Medicine Economic Institute promulgated by CFDA predicts by 2015 China's pharmaceutical industry output growth of 15%, sales growth of 13%, and profit growth of 11%. Concerning the terminal market, China's pharmaceutical terminal market is expected to reach RMB 1.2457 trillion in 2014, up 13.4%; 2015 pharmaceutical terminal market will reach RMB 1.407 trillion, an increase of 12.9%.

Results of Operations for the Three Months Ended March 31, 2015

China provides a unique opportunity to its pharmaceutical industry; however, real challenges remain: from compulsory GMP upgrading requirements and rising pricing pressure to extended regulatory review time for new medical production applications. Each of these challenges impacted our performance negatively in this period, causing us to experience a significant decrease in our financial results due to lower sales, increased costs related to new product development and continued challenges with the collection of accounts receivable prior to mandatory price reductions imposed by the healthcare reform in China.

Our net loss for the three months ended March 31, 2015 was $8.0 million, compared to net loss of $2.4 million for the three months ended March 31, 2014. Net loss for the three months ended March 31, 2015 was mainly due to a decrease in revenue, and an increase in bad debt expense.

Revenue Revenue decreased by 20% to $5.7 million for the three months ended March 31, 2015, as compared to $7.1 million for the three months ended March 31, 2014. Set forth below are our revenues by product category in millions USD for the three months ended March 31, 2015 and 2014: Product Category Three Months Ended March 31 Net Change % Change 2015 2014 Anti-Viro/ Infection & Respiratory $4.1 $5.0 ($1.0) -19% CNS Cerebral & Cardio Vascular $0.7 $0.9 ($0.2) -22% Digestive Diseases $0.1 $0.3 ($0.2) -52% Other $0.8 $0.9 ($0.1) -11% 

The most significant revenue decrease in terms of dollar amount was in our "Anti-Viro/ Infection & Respiratory" product category, which generated $4.1 million in sales revenue in the first quarter of 2015 as compared to $5.0 million in the same period of 2014, a decrease of $0.9 million. The decrease in this category for the three months ended March 31, 2015 was primarily due to the decrease in Cefaclor sales, which were affected primarily by market demand volatility.

"CNS Cerebral & Cardio Vascular" category decreased by $0.2 million to $0.7 million in the first quarter of 2015 as compared to $0.9 million in the same period of 2014. The decrease was mainly a result of market share loss caused by the production suspension of injectable product lines in 2014.

Sales of the "Digestive Diseases" category decreased by $0.2 million to $0.1 million in the first quarter of 2015 as compared to $0.3 million in the same period of 2014. The decrease was mainly a result of market share loss caused by the production suspension of injectable product lines in 2014.

Our "Other" category generated $0.8 million of sales in the first quarter of 2015 as compared to $0.9 million in the same period of 2014, a decrease of $0.1 million.

In the three months ended March 31, 2015, revenue breakdown by product category showed minor changes. Sales of the "Anti-Viro / Infection & Respiratory" products category represented 71% of total sales in the three months ended March 31, 2015 as compared to 70% in the same period last year. The "CNS, Cerebral & Cardio Vascular" category represented 12% of total revenue in the three months ended March 31, 2015 as compared to 13% in the same period last year. The "Digestive Diseases" category represented 3% of total revenue in three months ended March 31, 2015 as compared to 4% in the same period last year. The "Other" category represented 14% and 13% of revenues in three months ended March 31, 2015 and 2014, respectively.

Cost of Revenue

For the three months ended March 31, 2015, our cost of revenue was $4.4 million, or 78% of total revenue, while it remained flat in terms of dollar amount as compared to $4.4 million in the same period last year, or 63% of total revenue, in the first quarter of 2014.

The increase in cost of revenue as a percentage of revenues was mainly due to the outsourced production costs for certain products incurred during 2014 when our injectable product lines were suspended. These outsourced finished goods were sold during the three months ended March 31, 2015. There were no outsourced production costs for the three months ended March 31, 2014. In addition, we believe our new production lines have not yet reached their optimal efficiency resulting in higher costs for the three months ended March 31, 2015.

Inventory Obsolescence

There was $0.2 million inventory obsolescence recorded for the three months ended March 31, 2015, and no inventory obsolescence for the three months ended March 31, 2014. We started recording inventory obsolescence allowance on a quarterly basis from this period as we believe it may result in material modification in our financial statements; while previously, we tested and recorded inventory obsolescence allowance on an annual basis.

Gross Profit and Gross Margin

Gross profit for the three months ended March 31, 2015 was $1.1 million, a decrease of $1.6 million, from gross profit of $2.7 million in the same period of 2014. Our gross profit margin in the first quarter of 2015 was 19% as compared to 37% in the same period of 2014. The decrease in gross profit margin was mainly due to the outsourced production costs for certain products incurred during 2014 when our injectable product lines were suspended and inventory obsolescence expense incurred in the three months ended March 31, 2015.

Selling Expenses

Our selling expenses for the three months ended March 31, 2015 were $1.0 million, which represented an increase of $0.2 million to $0.8 million in the same period last year. Selling expenses accounted for 17% of the total revenue in the first quarter 2015 compared to 12% in the same period in 2014. The increase in selling expense was mainly due to a $0.2 million expense related to a sales service agreement entered in July 2014, as well as increased travel expenses incurred by sales personnel in the current period. There was no comparable sales service agreement expense for the three months ended March 31, 2014.

General and Administrative Expenses

Our general and administrative expenses for the three months ended March 31, 2015 were $0.5 million as compared to $0.4 million in the same period 2014. General and administrative expenses accounted for 8% and 6% of total revenues in the three months ended March 31, 2015 and 2014, respectively.

Research and Development Expense

Our research and development expenses for the three months ended March 31, 2015 and 2014 were $0.2 million and $0.4 million, respectively. The decrease in research and development expense for the three months ended March 31, 2015 was mainly due to the reduction of costs related to the upgrading of new production lines as compared to the three months ended March 31, 2014.

Bad Debt Expense

Our bad debt expense for the three months ended March 31, 2015 were $7.1 million, which represented an increase of $3.8 million from $3.3 million in the same period of 2014. The increase in bad debt expenses was mainly due to the increased aging of the accounts receivable. We continued the marketing strategy of priority supply to customers with high-quality accounts receivable payment history, which in turn affected our relationship with customers with poor accounts receivable payment performance, and their payment has been further slowed down. Nevertheless, even if the aging of the accounts receivable remains old, the management endeavors to facilitate and incentivize the repayment from such customers and may consider favored policies for that purpose.

In general, our normal credit or payment terms extended to customers are 90 days. This has not changed in recent years. Due to the peculiarity of the Chinese pharmaceutical market environment, deferred payments to pharmaceutical companies by state-owned hospitals and local medicine distributors are a normal phenomenon. Our customers are primarily pharmaceutical distributors who sell our products to mostly government-backed hospitals. Therefore, the age of our receivables from our customers tends to be long. Although these customers typically pay after the due date of the receivables, since the majority of hospitals in China are backed by the government, management believes that the deferred payments from state-owned hospitals are relatively secured. Despite the increased proportion of our long aging accounts receivable, the Company will continue to make every effort in the goal to recover all outstanding arrears of accounts receivable.

The amount of accounts receivable that were past due (or the amount of accounts receivable that were more than 90 days old) was $18.0 million and $23.6 million as of March 31, 2015 and December 31, 2014, respectively. The following table illustrates our accounts receivable aging distribution in terms of percentage of total accounts receivable as of March 31, 2015 and December 31, 2014.

 March 31, December 31, 2015 2014 1 - 90 Days 4.3% 5.2% 90 - 180 Days 4.3% 4.5% 180 - 360 Days 7.1% 6.9% 360 - 720 Days 18.3% 29.7% > 720 Days 66.0% 53.7% Total 100.0% 100.0% 

Our bad debt allowance estimate is currently the sum of 3.5% of accounts receivable that are less than 365 days old, 10% of accounts receivable that are between 365 days and 720 days old and 100% of accounts receivable that are greater than 720 days old.

We recognize bad debt expense per actual write-offs as well as the changes of allowance for doubtful accounts. To the extent that our current allowance for doubtful accounts is higher than that of the previous period, we recognize a bad debt expense for the difference during the current period, and when the current allowance is lower than that of the previous period, we recognize a bad debt benefit for the difference. The allowance for doubtful accounts was $40.6 million and $33.4 million as of March 31, 2015 and December 31, 2014, respectively. The changes in the allowance for doubtful accounts during the three months ended March 31, 2015 and 2014 were as follows:

 For the Three Months Ended March 31, 2015 2014 Balance, Beginning of Period $ 33,350,109 $ 13,301,622 Bad debt expense 7,104,656 3,308,129 Foreign currency translation adjustment 184,176 -141,299 Balance, End of Period $ 40,638,941 $ 16,468,452 

Loss from Operations

Our operating loss for the three months ended March 31, 2015 was $7.7 million as compared to $2.3 million in the same period of 2014. The increase of the operating loss was the primarily due to the decrease in revenue, and the bad debt expense recognized for the three months ended March 31, 2015.

Income Tax Benefit

For the three months ended March 31, 2015 and 2014, our income tax rate was 15%. Income tax benefit was $0.02 million for the three months ended March 31, 2015, remaining to be the similar comparing to $0.02 million benefit recognized for the three months ended March 31, 2014. The income taxes recognized for the three months ended March 31, 2015 and 2014 were related to changes in deferred tax assets and liabilities. We renewed our "National High-Tech Enterprise" status ("National HT Status") from the PRC government in the third quarter of 2013. With this designation, for the years ending December 31, 2014, 2015 and 2016, we will continue to enjoy a preferential tax rate of 15% which is notably lower than the statutory income tax rate of 25%.

Net Loss

Net loss for three months ended March 31, 2015 was $8.0 million, compared to net loss of $2.4 million in the same period of 2014. The increase of the net loss was primarily due to the decrease in revenue and the bad debt expense recognized for the three months ended March 31, 2015.

For the three months ended March 31, 2015, loss per basic and diluted common share was $0.18, compared to loss per basic and diluted share of $0.05 for the same period of 2014.

The number of basic and diluted weighted-average outstanding shares used to calculate loss per share was 43,579,557 for the three months ended March 31, 2015 and 2014, respectively.

Liquidity and Capital Resources

Our principal sources of liquidity are cash generated from operations and short-term bank loans. Our cash and cash equivalents was $5.3 million, which represents 4.2% of our total assets as of March 31, 2015, remaining comparable to $5.3 million, which represented 4.0% of our total assets as of December 31, 2014. All of the $5.3 million of cash and cash equivalents as of March 31, 2015 is considered to be reinvested indefinitely in Helpson and is not expected to be available for payment of dividends, for other payments to our parent company or to its shareholders. As of March 31, 2015, we had a principal balance of $4.9 million in short-term bank loans. This loan is due on November 24, 2015. In addition, we entered into an eight-year construction loan facility with a bank on September 21, 2013. The total loan facility amount is RMB 80,000,000 (approximately $13 million), which had been fully utilized through May 7, 2014. The current portion of the construction loan facility is $1.6 million as of March 31, 2015 and is payable on July 11, 2015. Both the short-term bank loan and the construction loan facility are from the same bank. The cash flow generated from operating activities was used to fund the remaining construction of our GMP upgrading project in our new facility.

Based on our current operating plan, management believes that the cash provided by operations will be sufficient to meet our working capital needs, our construction loan repayment and our anticipated capital expenditures, including expenditures for new formula acquisitions and the new GMP upgrading related construction and equipment in our prior facility for the next twelve months. However, if circumstances change and we do not meet our operating plan as expected, we may be required to seek additional capital and/or to reduce certain discretionary spending, which could have a material adverse effect on our ability to achieve our business objectives. Notwithstanding the foregoing, we may seek additional financing as necessary for expansion purposes and when we believe market conditions are most advantageous, which may include debt and/or equity financing. There can be no assurance that any additional financing will be available on acceptable terms, if at all.

Operating Activities

Net cash used by operating activities was $2,239 in the three months ended March 31, 2015, compared to net cash generated by operating activities of $2.5 million for the same period in 2014. The change in operating cash flow activities was mainly due to decrease in revenue, and increase in payment to suppliers in the three months ended March 31, 2015 compared to December 31, 2014.

As of March 31, 2015, our accounts receivable was $18.8 million, a decrease of $6.0 million from $24.9 million as of December 31, 2014. Our receivables decreased due to our enhanced collection efforts as well as the increased allowance for doubtful accounts as of March 31, 2015 compared to December 31, 2014.

As of March 31, 2015, the total inventory was $15.3 million, remaining comparable to $15.3 million as of December 31, 2014.

Investing Activities

During the three months ended March 31, 2015, net cash used in investing activities was $47,106, compared to $3.8 million for the same period of 2014. The decrease in investment spending in the first quarter in 2015 was mainly due to the decrease in investment in GMP upgrading related construction and equipment.

Financing Activities

There were no financing activities in the three months ended March 31, 2015, and there was $0.6 million cash provided by financing activities in the three months ended March 31, 2014. The financing activities that occurred in 2014 were related to the construction loan facility described under the first paragraph under this section entitled "Liquidity and Capital Resources".

According to relevant PRC laws, companies registered in the PRC, including our PRC subsidiary, Helpson, are required to allocate at least ten percent (10%) of their after-tax net income, as determined under accounting standards and regulations in the PRC, to statutory surplus reserve accounts until the reserve account balances reach fifty percent (50%) of the companies' registered capital prior to their remittance of funds out of the PRC. Allocations to these reserves and funds can only be used for specific purposes and are not transferrable to the parent company in the form of loans, advances or cash dividends. As of March 31, 2015 and December 31, 2014, the net assets of Helpson were $93,961,000 and $124,226,000, respectively. Due to the restriction on dividend distribution to overseas shareholders, the amount of Helpson's net assets that were designated for general and statutory capital reserves, and thus could not be transferred to our parent company as cash dividends, were $8,182,770 and $8,182,770 (50% of registered capital) on March 31, 2015 and December 31, 2014, respectively. Since the amount that Helpson must set aside for the statutory surplus fund only accounts for 8.7% and 6.6%, respectively, of its total net assets, this reserve does not have a major impact on our liquidity. There were no allocations to the statutory surplus reserve accounts during the three months ended March 31, 2015.

The PRC government also imposes controls on the conversion of RMB into foreign currencies and the remittance of currencies out of the PRC. Our businesses and assets are primarily denominated in RMB. All foreign exchange transactions take place either through the People's Bank of China or other banks authorized to buy and sell foreign currencies at the exchange rates quoted by the People's Bank of China. Approval of foreign currency payments by the People's Bank of China or other regulatory institutions requires submitting a payment application form together with applicable invoices and signed contracts. These currency exchange control procedures imposed by the PRC government authorities may restrict the ability of Helpson, our PRC subsidiary, to transfer its net assets to our parent company through loans, advances or cash dividends.

Off-Balance Sheet Arrangements

As of March 31, 2015, we did not have any off-balance sheet arrangements.

Commitments

As of March 31, 2015 we were obligated to pay laboratories and others approximately $4.6 million over approximately the next four years upon completion of the various phases of contracts to provide CFDA production approval of medical formulas.

Critical Accounting Policies

Management's discussion and analysis of its financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with United States generally accepted accounting principles. Our financial statements reflect the selection and application of accounting policies which require management to make significant estimates and judgments. The discussion of our critical accounting policies contained in Note 1 to our consolidated financial statements, "Organization and Significant Accounting Policies", is incorporated herein by reference.

May 11, 2015

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