China Pharma Holdings, Inc.: Form 10-Q for the period ended Mar 31, 2013

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 reader 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 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

China Pharma Holdings, Inc. is a specialty pharmaceutical company that develops, manufactures, and markets pharmaceutical products for human use for a wide range of high incidence and high mortality conditions in China, including cardiovascular, central nervous system (“CNS”), infectious and digestive diseases. The Company has a broad and expanding distribution network across 30 provinces, municipalities and autonomous regions. The Company is currently organized under the laws of the State of Nevada in the United States. Hainan Helpson Medical & Biotechnology Co., Ltd. (Helpson), located in Haikou City, Hainan Province, China, is a wholly-owned subsidiary of China Pharma Holdings, Inc.

The economic and pharmaceutical challenges and uncertainties had negatively impacted our business in 2012, which led to the overall decline in sales of our products. Additionally, in March 2013, the China Food and Drug Administration (“CFDA”) issued a nationwide notice (the “CFDA Notice”) for the cessation of the production, sale and use of Buflomedil effective immediately. The CFDA Notice was a result of the reevaluation done by the CFDA based on the indications from the recent China and international research materials, which found the side effect risks of Buflomedil to nerve system and cardiovascular system have surpassed its clinical treatment effect. It was applicable to all the manufacturers and distributors in China who are in the business of the production and sale of Buflomedil-related products. Pursuant to the CFDA Notice, the Company ceased the production and sale of Buflomedil-based products and recalled its Buflomedil-based products from the market.

During our course of business, we must comply with a variety of product safety and product testing regulations. In particular, our products are subject to, among other statutes and regulations, those issued by the CFDA. If the CFDA issues any updates to cease the production, sale and use of any of our products, we should comply with. As a result, we may incur significant costs in complying with cessation requirements, and our financial results could be materially adversely affected. Furthermore, concerns about potential liability or potential future changes in product safety regulations may lead us to voluntarily recall or otherwise discontinue selling selected products, which could materially and adversely affect our results of operations.

Recalls could also harm our reputation, increase our costs or reduce our net sales. Governments and regulatory agencies in the markets where we manufacture and sell products may enact additional regulations relating to product safety and consumer protection in the future or take other actions. The CFDA has the authority to revoke drug approvals previously granted and remove from the market previously approved products for various reasons. We may be subject from time to time to product recalls initiated by us or by the CFDA. Delays in obtaining regulatory approvals, the revocation of prior approvals, or product recalls could impose significant costs on us and adversely affect our ability to generate revenue.

The CFDA promulgated Good Manufacturing Practices for Pharmaceutical Products (2010 revised version) (the “new GMP”) 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 injectable product lines must be accomplished by the end of 2013. We have completed the planning, design and an environment contamination evaluation, and worked in full swing of the construction relative to certain required facilities and equipment. We continue to evaluate and implement the additional requirements of the standards.

The products in our pipe-line progressed slowly but steadily along the development process, and are getting closer to product launch. The CFDA is also revising its production approval criteria and processes, resulting in longer approval time for new production applications across all types of products. In some cases they are adding additional requirements for products already under review.

The following is a list of the current status of some of our pipeline products:

Ÿ Cadesartan. We received production approval from the CFDA for Candesartan, a front-line drug therapy we developed for the treatment of hypertension in November 2012. We plan to launch this product during 2013.

Ÿ Antibiotic Combination. We completed the Phase I clinical trials of our novel cephalosporin-based combination antibiotic in the third quarter of 2010. We are currently in Phase II of the clinical trial which is progressing well.

Ÿ Rosuvastatin. Rosuvastatin is a generic form of Crestor, a drug for indication of high blood cholesterol level. Clinical trials for this generic drug were completed in the fourth quarter of 2010 and we have submitted an application for production approval.

Ÿ Heart Disease Drug. We are developing a liquid oral medicine for the treatment of coronary heart disease. This product comes with a patented Traditional Chinese Medicine (TCM) formula and we are currently conducting Phase III clinical trials for this drug. Due to the improved regulatory requests for clinical works, we adjusted our anticipated completion time frame for the clinical trials work for this product to 2013.

Market Trends

The Chinese pharmaceutical industry has been a key contributor to the PRC’s economic growth. According to the research report China Pharma Sector issued by CITI on January 13, 2013, they estimated that the Chinese prescription market reached a size of approximately RMB548billion (approximately 88 billion USD) in 2012 and forecast that the pharma market could grow approximately 17% in 2013. We believe the growth of Chinese pharmaceutical industry. According to the CFDA information center, the Chinese pharmaceutical market size has grown from RMB157.2 billion in 2000 to RMB619.4 billion in 2009. Furthermore, according to a report from IMS Health, a leading consulting firm focusing on healthcare and pharmaceutical areas, Asian, Australian and Chinese Pharmaceutical Market 2010-2014 Forecast released on September 2010, the pharmaceutical market in China was expected to grow by a CAGR of 23.2%, and to reach US$90 billion in 2014. According to the report, this projected growth is supported by the strong growth in the Chinese economy, the aging population, increasing rate of chronic disease in the PRC, the recent health care reform, and improvements in intellectual property right protection in the PRC.

The Healthcare Reform program announced by the Chinese government in late 2009 is having a significant impact on all healthcare related industries in China, including the pharmaceutical industry. Over all, the government plans to provide a basic, universal healthcare system to all citizens of China. We believe volume expansion will continue as government subsidies to rural communities expand further. While pricing is generally set at the central government level, provincial government intervention has added complexity to the pricing-volume interaction. In addition to EDL products, we have also seen pricing pressure on most of the drugs we sell. While these changes have more impact on pharmaceutical distribution companies, manufacturers of pharmaceutical products are also affected. We believe the general implication is that gross margins for pharmaceutical products will continue to be under pressure for some time. That being said, a pharmaceutical manufacturer with experienced management and the ability to react quickly to changes will not only survive but thrive in this environment.

Results of Operations for the Fiscal Year Ended March 31, 2013

Revenue

For the three months ended March 31, 2013, our sales revenue was $8.2 million, a decrease of 49%, compared to $16.1 million in the previous year period.

Set forth below are our revenues by product category in millions USD for the three months ended March 31, 2013 and 2012.

Given the capital expenditure pressure from 2013 new GMP upgrade project, we have to control credit expansion in the market, this tightening marketing strategy has negatively impacted our revenue. Sales decreased throughout our major product categories. The most significant revenue decrease in terms of dollar amount was in our “CNS Cerebral & Cardio Vascular” product category, which generated $2.1 million in sales revenue in the three months ended March 31, 2013 compared to $4.8 million a year ago, a decrease of $2.7 million. This decrease was mainly due to sales of Bufomedil, because the CFDA issued a nationwide notice for the cessation of the production, sale and use of Buflomedil effective immediately. The Company ceased the production and sale of this product and voluntarily recalled limited quantities of our sold products from the market as a customer service measure. No further recall is mandated by the CFDA notice. Sales of the “Anti-Viro/Infection & Respiratory” category decreased by $2.2 million to $4.6 million in the three months ended March 31, 2013 compared to $6.8 million in the previous year period. Our “Digestive Diseases” category generated $0.8 million of sales in the three months ended March 31, 2013, compared to $2.5 million in the previous year period, or a decrease of $1.7 million. Our “Other” product category sales fell to $0.7 million from $2.0 million, a decrease of $1.3 million.

In the three months ended March 31, 2013, revenue breakdown by product category showed some changes mainly due to the CFDA notice. Sales of the “CNS, Cerebral & Cardio Vascular” category represented 14% and 24% of total sales in the three months ended March 31, 2013 and 2012 respectively. Sales of the “Anti-Viro & Respiratory” products category represented 32% and 34% of total sales in the three months ended March 31, 2013 and 2012. The “Digestive Diseases” category represented 4% and 11% of total revenue in the three months ended March 31, 2013 and 2012 respectively. The “Other” category represented 6% and 11% of total revenue in the three months ended March 31, 2013 and 2012 respectively.

Cost of Revenue

For the three months ended March 31, 2013, our cost of revenue was $6.1 million, or 74.3% of total revenue, which represented a decrease of $4.7 million from $10.8 million, or 67% of total revenue, in the three months ended March 31, 2012, a decrease of 43.2%. The decrease in cost of revenue during the first quarter of 2013 was not proportional to the revenue decrease, primarily due to increases in our average unit costs for inventory and the continuously rising cost of our raw materials and other fixed cost.

Inventory Obsolescence

In March 2013, as a result of the CFDA Notice, the Company recognized an inventory obsolescence expense in the amount of $3,692,895 to write off all of our Buflomedil-related raw materials and finished goods inventory. This was recorded as inventory obsolescence on the accompanying statement of operations for the three months ended March 31, 2013, which represented 11.1% of total inventory as of March 31, 2013. There was no comparable expense for the three months ended March 31, 2012.

Gross Profit and Gross Margin

Gross loss for the three months ended March 31, 2013 was $1.6 million, while gross profit for the three months ended March 31, 2012 was $5.3 million. Our gross profit margin in the first quarter of 2013 was (19%), compared to 33% in the first quarter of 2012. Without the effect of inventory obsolescence in the first quarter of 2013, management estimates that our gross profit would have been approximately $2.1 million, and gross margin would have been 26%in the first quarter of 2013. The Healthcare Reform instituted by the Chinese government since 2009 has resulted in margin compression in most pharmaceutical products on the markets today, especially in the generic space that many of our products are in. The decrease of sales and continued increases of the purchase price of raw materials attributed to the decrease of gross profit. Going forward, we expect to see continued pricing pressure on most products, but new products such as Candesartan and Rosuvastatin could help to support overall gross margin once they are launched.

Selling Expenses

Our selling expenses for the three months ended March 31, 2013 were $0.81 million, a decrease of approximately $0.08 million, compared to $0.89 million in the same period last year. Selling expenses accounted for 9.8% of the total revenue in the three months ended March 31, 2013 compared to 5.6% in the three months ended March 31, 2012. Due to many adjustments in our selling processes from healthcare reform policies, despite the decrease in sales, we still needed to maintain necessary personnel and expenses to support the sales and collection of accounts receivable.

General and Administrative Expenses

Our general and administrative expenses for the three months ended March 31, 2013 were $0.74 million, an increase of $0.06 million from $0.68 million for the same period of 2012. General and administrative expenses accounted for 7.5% and 4.2% of our total revenues for the three months ended March 31, 2013 and 2012, respectively.

Bad Debt Expense (Benefit)

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 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 secure and will eventually be collected. So far, we have always been able to collect our receivables and have not written-off any receivables in our 19-year history of doing business with hospitals.

The amount of accounts receivable that were past due (or the amount of accounts receivable that were more than 90 days old) was $52.8 million and $62.1 million as of March 31, 2013 and December 31, 2012, respectively. The following table illustrates our accounts receivable aging distribution in terms of percentage of total accounts receivable as of March 31, 2013 and December 31, 2012:

Although we have not had to write off any receivables thus far in our history, we do set aside an allowance for doubtful accounts. 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 (although there were no accounts receivable over 720 days old at March 31, 2013 or December 31, 2012).

To the extent that our current allowance for doubtful accounts is lower than that of the previous period, we recognize a bad debt benefit for the difference during the current period, and when the current allowance is higher than that of the previous period, we recognize a bad debt expense for the difference. The allowance for doubtful accounts was $4.33 million and $4.43 million as of March 31, 2013 and December 31, 2012, respectively. The decrease in the allowance was mainly due to the decrease in our accounts receivable balance during the quarter ended March 31, 2013. The changes in the allowance for doubtful accounts during the three months ended March 31, 2013 and 2012 were as follows (there were no write-offs or recoveries):

Impairment of intangible assets

The carrying values of long-lived assets are reviewed for impairment annually or whenever events or changes in circumstances indicate that the carrying values may not be recoverable. No impairment losses were recognized during the three month ended March 31, 2013 or 2012.

Income (Loss) from Operations

Our operating loss for the three months ended March 31, 2013 was $3.0 million, compared to operating income of $3.4 million in the three months ended March 31, 2012, a decrease of $6.4million. The main reasons for the decrease were lower revenue, and the inventory obsolescence reserve recognized as a result of the CFDA notice on Buflomedil in the first quarter of 2013.

Net Interest Expense

Net interest expense for the three months ended March 31, 2013 and 2012 was $80,859 and $76,847 respectively.

Income Tax Benefit (Expense)

In the three months ended March 31, 2013 and 2012, we paid income tax at the rate of 15%. Income tax benefit was $0.27 million in the three months ended March 31, 2013; and income tax expense was $0.53 million for the three months ended March 31, 2012. As a result of the CFDA notice ceasing production of Buflomedil, we have net operating loss carry forwards of $0.48 million which, under Chinese tax law can be “carried forward” for 5 years. We believe that we will have sufficient taxable income in the near future to utilize this tax benefit. We obtained the "National High-Tech Enterprise" status ("National HT Status") from the PRC government in the fourth quarter of 2010. With this designation, we are entitled to a preferential tax rate of 15% for the years ending December 31, 2011, 2012 and 2013, which is notably lower than the statutory income tax rate of 25%.

Net Income (Loss)

Net loss for three months ended March 31, 2013 was $2.8 million, a decrease of $5.6 million, from the net income of $2.8 million in the three months ended March 31, 2012.The decrease in net income was mainly due to the decrease in revenue, and the inventory obsolescence reserve recognized as a result of the CFDA notice on Buflomedil.

For the three months ended March 31, 2013, earnings per basic and diluted common share was minus $0.06 per share, compared to $0.06 per share in the previous year period.

The number of basic and diluted weighted average outstanding shares used to calculate earnings per share were 43,579,557 for the three months ended March 31, 2013 and 43,529,557 for the three months ended March 31, 2012.

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 $4.75 million, which represents 3.0% of our total assets as of March 31, 2013, was comparable to $4.03 million, which represents 2.5% of our total assets as of December 31, 2012. At March31, 2013, a total of $5.93 million 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, 2013, we had a principal balance of $4.79 million in short-term bank loans. The cash flow generated from operating activities funded our construction of new GMP upgrading project.

During the first quarter in 2013, we continued our vigorous collection efforts from our customers and achieved good results. While we have made progress, improving our accounts receivable collection continues to be a focus of our management team and we expect to make further progress in the quarters to come.

At March 31, 2013, the Company was obligated to pay laboratories $6.52million upon their completion of the various phases of contracts to provide CFDA production approval of more than 10 medical formulas. Those payments are expected to be made out of the Company’s cash flow from operations ratably over approximately the following 48 months, depending on the progress of the various contracts. A typical contract requires an upfront deposit and then two to three additional milestone payments plus a final payment when the CFDA approval is obtained. Since the payments are progress driven, it is difficult to calculate the timing of the payments with any precision; however, management expects that the payments will be somewhat even over the payment period given the number of contracts in progress. The funding obligation is not expected to have an undue negative impact on the liquidity of the Company given the Company’s historical cash flows and estimated future cash flows from operating activities.

Based on our current operating plan, management believes that our cash provided by operations as well as the anticipated capital expenditure project financing from a bank will be sufficient to meet our working capital needs and our anticipated capital expenditures, including expenditures for new formula acquisitions and new GMP upgrading related construction and equipment, for the next twelve months. However, if events or circumstances occur 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 provided by operating activities was $1.11 million in the three months period ended March 31, 2013compared to $0.40 million for the same period in 2012. As a common business practice in China, Banker's Acceptances (BAs) are often used to settle payment instead of checks. During the three months ended March 31, 2013, the Company collected accounts receivable with BAs with a maturity of more than 90 days, and such BAs are not treated as cash and cash equivalent under U.S. GAAP. If cash equivalent treatment were to be applied to BAs with more than 90 days maturity, $2.18million would have been generated in operating activities in the three months ended March 31, 2013. This was mainly because of the improved performance in collection of accounts receivable partially offset the decrease in net income in the first quarter 2013.

At March31, 2013, our accounts receivable was $62.7million, a decrease of $3.5 million from $66.2million at December 31, 2012. Our receivables decreased due to decreased sales and the improved performance of our collection in account receivables. For the three months ended March 31, 2013, $1.9million was generated from decreases in Accounts Receivable, compared to $4.1million was used to fund increases in Accounts Receivable in the comparable period a year ago.

At March31, 2013, total inventory was $33.3 million, a decrease of $3.1 million from $36.4 million at December 31, 2012. This decrease was mainly due to the inventory obsolescence recognized pursuant to the CFDA notice on Buflomedil in March 2013.

For the period ending March 31, 2013, the decrease in our accounts payable was responsible for a cash usage of $0.1 million, compared to a cash usage of $2.7 million in the same period in 2012.

Investing Activities

In the three months ended March 31, 2013, net cash used in investing activities was $0.4 million, a decrease of $0.68 million, compared to $1.08 million in three months ended March 31, 2012.The investment spending in the first quarter of 2013 was mainly for the new GMP upgrading related construction and equipment.

Financing Activities

There was no cash flow generated from financing activities in the three months ended March 31, 2013 or 2012.

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 December 31, 2012 and 2011, the net assets of Helpson were $142,597,000 and $135,748,004, 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 $7,935,122and $7,863,490 (50% of registered capital) for the fiscal years ended December 31, 2012 and 2011. Since the amount that Helpson must set aside for the statutory surplus fund only accounts for 5.6% and 5.8%, 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, 2013.

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, 2013, we did not have any off-balance sheet arrangements.

Commitments

At March31, 2013, we were obligated to pay laboratories and others approximately $6.52 million over approximately the next four years upon completion of the various phases of contracts to provide CFDA production approval of medical formulas.

We entered into purchase and construction agreements during fiscal year 2012 in connection with the construction of a new facility and required manufacturing improvements. Future minimum commitments under the agreements are as follows:

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.

As a “smaller reporting company” as defined by Item 10 of Regulation S-K, we are not required to provide information required by this item.

Evaluation of Disclosure Controls and Procedures

Our Chief Executive Officer and interim Chief Financial Officer, evaluated the effectiveness of our “disclosure controls and procedures” (as defined in the Securities Exchange Act of 1934 (the “Exchange Act”) Rules 13a-15(e) or 15d-15(e)) as of the end of the period covered by this quarterly report. Disclosure controls and procedures are controls and other procedures that are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act (a) is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission’s rules and forms and (b) is accumulated and communicated to management, including our Chief Executive Officer and interim Chief Financial Officer, as appropriate, to allow timely decisions regarding required disclosure. Our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and management necessarily applies its judgment in evaluating the cost-benefit relationship of possible controls and procedures. Our disclosure controls and procedures are designed to provide reasonable assurance of achieving their objectives as described above. Based on this evaluation, our Chief Executive Officer and interim Chief Financial Officer concluded that as of the end of the period covered by this report, our disclosure controls and procedures were effective.

Changes in Internal Controls over Financial Reporting

During the period covered by this report, in order to remediate our material weakness in internal control over financial reporting with respect to our reporting for inventory obsolescence and impairment of long-lived assets as identified in our Annual Report on Form 10-K for the fiscal year ended December 31, 2012, we have retained accounting consultants to assist us with the reporting of such transactions, and we have made this resource available to us on an on-going basis should the need their assistance in the future. There were no other changes in our internal control over financial reporting identified in connection with the evaluation required by paragraph (d) of Exchange Act Rules 13a-15 or 15d-15 that occurred during our last fiscal quarter that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.