The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited financial statements and related notes appearing elsewhere in this report. In addition to historical financial information, the following discussion contains forward-looking statements that reflect our plans, estimates and beliefs. Our actual results could differ materially from those discussed in the forward-looking statements. Factors that could cause or contribute to these differences include those discussed below and elsewhere in this report.

Overview

We are a leading producer and distributor of milk powder, soybean milk powder, and related dairy products in the People's Republic of China, or the PRC. Using proprietary processing techniques, we make products that are specially formulated for particular ages, dietary needs and health concerns. We have over 200 company-owned milk collection stations, six production and distribution facilities with an aggregate milk powder processing capacity of approximately 2,020 tons per day, and an extensive distribution network that reaches over 80,000 retail outlets throughout China.

Factors Affecting our Results of Operations

Our operating results are primarily affected by the following factors:

• Dairy Industry Growth. We believe the market for dairy products in China for the long term will be growing rapidly, driven by China's economic growth, increased penetration of infant formula, and a growing female working population. Despite the damage to the industry as a result of the melamine crisis in 2008, we expect these factors to continue to drive industry growth. We believe that economic growth in our primary markets has become an increasingly important driver of growth.

• Production Capacity. We believe much of the dairy market in China is still underserved, particularly with respect to infant formula. In addition, since the melamine crisis in 2008, which did not involve any of our products, we have at times operated our milk production facilities at maximum capacity. Accordingly, we believe that the ability to increase production of high quality dairy products will allow well positioned companies to significantly increase revenues and market share.

• Perceptions of Product Quality and Safety. We believe that rising consumer wealth in China has contributed to a greater demand for higher-priced products with perceived quality advantages. We believe our reputation for quality and safety allows us to command higher average selling prices and generate higher gross margins than competitors who do not possess the same reputation, and we have recently launched premium and super-premium product lines. In addition, we believe many consumers in China tend to regard higher prices as indicative of higher quality and higher nutritional value, particularly in the areas of infant formula and nutritional products. Conversely, any decrease in consumer perceptions of quality and safety could adversely impact us.

• Seasonality. The dairy industry remains seasonal, with higher production in the summer season and greater demand in winter months. This seasonality is offset by production of powder products with longer shelf lives.

• Raw Material Supply and Prices. The per unit costs of producing our infant formula are subject to the supply and price volatility of raw milk and other raw materials, which are affected by the PRC and global markets. For example, our raw milk prices decreased by approximately 20% in 2009, increased by approximately 24% in 2010 and increased by approximately 17% in 2011. We expect raw milk prices will continue to be affected by factors such as geographic location, rising feed prices, general economic conditions such as inflation and fuel prices, and fluctuations in production, rising production costs and competition, as well as increased competition abroad and currency fluctuations. In 2011, we sold the Dairy Farms, although we have milk supply arrangements with them described under "-Recent Developments-Discontinued Operations."

• Expenses Associated with Expansion and Competition. In implementing our plan to expand our business, we face corresponding increases in expenses, especially for sales and marketing expenses, in order to attract and retain qualified talent, monitor our sales by region and address potential cross-territory selling activities by distributors, implement strategic advertising campaigns, and finance our expansion.

Recent Developments

Discontinued Operations

In September 2011, we sold two of our former subsidiaries that operated our dairy farms, which we refer to collectively as the "Dairy Farms," for a total purchase price of approximately $133.1 million. This aggregate purchase price included approximately $18 million in cash. The remaining purchase price is to be satisfied by the purchaser's delivery to us, in six quarterly installments, of raw milk with an aggregate value of approximately $115.1 million from the Dairy Farms, or the Supply Obligations. Concurrently, we entered into a raw milk exclusive supply agreement with the Dairy Farms and the purchaser, pursuant to which the Dairy Farms must satisfy the Supply Obligations by supplying raw milk to us valued at approximately $19.2 million during each quarter for a period of 18 months after the closing date. During this period, the Dairy Farms have agreed to supply raw milk to us exclusively until the quarterly quota amounts are delivered and for so long as we require additional supply. In the event the raw milk production of the Dairy Farms is insufficient to fulfill such quarterly amounts, the shortfall will be immediately payable to us in cash by the Dairy Farms. The quality of the milk must meet governmental and our standards, and we have the right to return any milk which does not meet such standards. In addition, we entered into an asset mortgage agreement with the Dairy Farms, pursuant to which the Dairy Farms granted us a primary security interest in certain properties and assets of the Dairy Farms to secure their obligations to us.

Redemption Obligations

In August 2009, pursuant to a subscription agreement, we issued 2,100,000 shares of our common stock to Sequoia Capital China Growth Fund I, LP and certain of its affiliates and designees, or collectively Sequoia, for an aggregate purchase price of $63.0 million. Because we did not meet certain earnings per share targets for 2009, we issued 525,000 additional shares to Sequoia pursuant to the subscription agreement. In February 2011, we entered into a redemption agreement with Sequoia to redeem and repurchase the 2,625,000 shares issued pursuant to the subscription agreement in four equal installments within 30 days of March 31, 2011, September 30, 2011, December 31, 2011 and March 31, 2012, for an aggregate payment on each such date of $15,750,000, together with interest accruing at the rate of 1.5% per annum, compounded annually from August 27, 2009 until such date. In April 2012, we paid the final installment of approximately $16.3 million to Sequoia, and all of the 2,625,000 shares have been redeemed.

Results of Operations



The following table sets forth certain information regarding our results of
operations.

                                                        Three months ended March 31,
                                                         2012                  2011
                                                              ($ in thousands)
Sales                                                        62,936                67,679
Cost of goods sold                                          (28,957 )             (43,242 )
Gross profit                                                 33,979                24,437
Operating expenses:
Sales and marketing expenses                                (18,768 )             (15,945 )
General and administrative expenses                          (5,590 )              (5,720 )
Other operating income, net                                      90                 2,220
Income from operations                                        9,711                 4,992
Other income, net                                               439                   523
Income tax expenses                                          (1,883 )              (1,341 )
Income from continuing operations                             8,267                 4,174
Income from discontinued operations, net of tax                   -                   565
Net income                                                    8,267                 4,739
Net loss attributable to noncontrolling interests               (24 )                 (43 )
Net income attributable to common shareholders of
Feihe International, Inc.                                     8,243                 4,696

Comparison of Three Month Periods Ended March 31, 2012 and 2011

Sales

Our sales consist primarily of revenues generated from sales of milk powder, raw milk powder, soybean powder, rice cereal, and walnut products. Sales decreased by approximately $4.7 million, or 7.0%, from approximately $67.7 million for the three month period ended March 31, 2011 to approximately $62.9 million for the three month period ended March 31, 2012. This decrease was primarily attributable to a decrease in sales of raw milk powder of approximately $15.2 million and a decrease in sales of soybean powder of approximately $1.5 million, offset by an increase in sales of milk powder of approximately $11.5 million. This reflects our strategy to boost sales of high end milk powder products.

The following table sets forth information regarding the sales of our principal products during the three-month periods ended March 31, 2012 and 2011:

                            Three months ended                           Three months ended                            Three months ended
                               March 31, 2012                               March 31, 2011                          March 31, 2012 over 2011
                   Quantity       Amount                        Quantity       Amount                        Quantity       Amount
Product name       (Kg'000)       ($'000)      % of Sales       (Kg'000)       ($'000)      % of Sales       (Kg'000)       ($'000)       % of Sales

Milk powder            4,682        59,406            94.4          5,007        47,902            70.8           (325 )      11,504             24.0
Raw milk powder          242           916             1.5          3,968        16,129            23.8         (3,726 )     (15,213 )          (94.3 )
Soybean powder           163           456             0.7          1,217         1,940             2.9         (1,054 )      (1,484 )          (76.5 )
Rice cereal              136           984             1.6            173         1,152             1.7            (37 )        (168 )          (14.6 )
Walnut products            7            42             0.1             50           307             0.5            (43 )        (265 )          (86.3 )
Other                    460         1,132             1.7             70           249             0.3            390           883            354.6
Total                  5,690        62,936             100         10,485        67,679             100         (4,795 )      (4,743 )           (7.0 )

In the three month period ended March 31, 2012, we also experienced an increase in the average sales price per kilogram of our products, as demonstrated in the table below:

                                                 Three months ended March 31,
                                                   2012                 2011
Sales revenues ($ in thousands)                       62,936               67,679
Total sales volume (kilograms in thousands)            5,690               10,485
Average selling prices ($/kilogram)                    11.06                 6.45

The increase in average sales price per kilogram, as reflected in the table, is primarily attributable to an increase in sales prices of milk powder, a higher margin product, and soybean powder. The following table reflects the average sales price per kilogram by product for the three month periods ended March 31, 2012 and 2011, and the percentage change in the sales price per kilogram.

                                      Average Price Per Kilogram
                                     Three months ended March 31,         Percentage
Product name                            2012                2011            Change

Milk powder                        $         12.69       $      9.57             32.6
Raw milk powder                               3.79              4.06             (6.7 )
Soybean powder                                2.80              1.59             76.1
Rice cereal                                   7.24              6.66              8.7
Walnut products                               6.00              6.14             (2.3 )
Other                                         2.46              3.56            (30.9 )
Average selling price s/kilogram   $         11.06       $      6.45             71.5

The average selling price per kilogram of milk powder increased by 32.6% from $9.57 in the three month period ended March 31, 2011 to $12.69 in the three month period ended March 31, 2012. This increase was primarily attributable to increase in sales of high end milk powder.

Cost of Goods Sold

Our cost of goods sold consist primarily of direct and indirect manufacturing costs, including production overhead costs and shipping and handling costs for the products sold. Cost of goods sold decreased approximately $14.3 million, or 33%, from approximately $43.2 million for the three month period ended March 31, 2011 to approximately $29.0 million for the three month period ended March 31, 2012. This decrease was primarily attributable to decreases in the cost of goods sold of raw milk powder from $17.1 million for the three month period ended March 31, 2011 to $1.2 million for the three month period ended March 31, 2012. This decrease also reflects our decision to decrease production of raw milk powder, which generated a negative margin for the three month period ended March 31, 2012.

Gross Profit Margin

Our gross profit margin increased from 36.1% for the three month period ended March 31, 2011 to 54.0% for the three month period ended March 31, 2012. This increase was primarily attributable to general increases in the sales of high end milk powder and a decrease in sales of raw milk powder. We plan to continue our efforts to expand our sales of higher margin products and strengthen our premium quality brand awareness, enhance market recognition of our secured raw milk sources, and improve the efficiency of our distribution network.

Operating Expenses

Our total operating expenses consist primarily of sales and marketing expenses, and general and administrative expenses. Our total operating expenses increased by approximately $2.7 million, or 12.4%, from approximately $21.7 million in the three month period ended March 31, 2011 to approximately $24.4 million in the three month period ended March 31, 2012. This increase was primarily attributable to an increase of approximately $2.8 million, or 17.7%, in sales and marketing expenses from approximately $15.9 million for the three month period ended March 31, 2011 to approximately $18.8 million for the three month period ended March 31, 2012. The increased sales and marketing expenses primarily related to a increase in advertisement fees and transportation cost of our sales personnel, which was offset in part by an decrease in other sales and marketing expenses.

Income from Operations

As a result of the foregoing, we had income from operations of approximately $9.7 million in the three month period ended March 31, 2012, representing an increase of approximately $4.7 million, or 94.5%, from approximately $5.0 million in the three month period ended March 31, 2011.

Income Tax Expenses

We are subject to U.S. federal and state income taxes, and our subsidiaries incorporated in the PRC are subject to enterprise income taxes in the PRC. We recorded an income tax expense of approximately $1.9 million and $1.3 million for the three months ended March 31, 2012 and 2011, respectively. The increase in income tax expense was primarily due to the increase in profits of Feihe Dairy, which is one of our major operations.

Liquidity and Capital Resources

In general, our primary uses of cash are providing for working capital purposes, which principally include the purchase of inventory, servicing debt and financing construction related to our expansion plans. Our largest source of operating cash flows is cash collections from our customers. We have been able to meet our cash needs principally by using cash on hand, cash flows from operations, bank loans and borrowings under our line of credit.

The accompanying unaudited condensed consolidated financial statements have been prepared assuming we will continue as a going concern. We had working capital of approximately $18.6 million as of March 31, 2012, compared to a working capital deficiency of approximately $8.0 million as of December 31, 2011. We have significant cash commitments in the 12 months following March 31, 2012, including maturity of short term bank loans of $53.2 million, the current portion of long term bank loans of $5.9 million and redemption of redeemable common stock of $16.4 million plus interest (which was fully redeemed after March 31, 2012). We believe we will be able to refinance much of our short term bank loans when they become due and intend to do so. We have also taken steps to reduce our operating expenses, including our sale in the third quarter of 2011 of the Dairy Farms we previously operated, with commitments from the Purchaser to supply milk to us. Accordingly, we believe that our cash generated from operations, existing cash and ability to draw down on unutilized credit lines will be sufficient to fund our expected cash flow requirements for at least next 12 months.

Cash Flows

As of March 31, 2012, we had retained earnings of approximately $68.9 million, cash and cash equivalents of approximately $9.8 million, total current assets of approximately $194.7 million and working capital of approximately $18.6 million.

Our summary cash flow information is as follows:

                          Three months ended March 31,
                            2012                 2011
                                ($ in thousands)
Operating activities            19,919               3,706
Investing activities            (2,848 )            (2,318 )
Financing activities           (22,654 )                 5

Net Cash Provided by Operating Activities

Net cash provided by operating activities increased approximately $16.2 million, from approximately $3.7 million for the three month period ended March 31, 2011 to approximately $19.9 million for the three month period ended March 31, 2012. This increase primarily reflected the following changes in working capital items:

· Increase in net income of approximately $3.5 million, reflecting our strengthened profitability as discussed above;

· Decrease in trade receivables of approximately $26.6 million, reflecting our decreased sales and our efforts to collect from customers in a shorter period, compared to higher trade receivables and higher sales in the three month period ended March 31, 2011;

· Increase in account payable of approximately $5.6 million, reflecting our efforts to improve our working capital;

· Increase in advances to suppliers of $7.4 million, primarily due to increased prices of raw material and increased number of suppliers;

· Decrease in advances from customers of approximately $6.3 million, reflecting our more efficient completion of sales of milk powder; and

· Decrease in other payables of approximately $6.4 million, primarily due to our paying more other taxes.

Net Cash Used in Investing Activities

Net cash used in investing activities primarily relates to our expenditures associated with property, plant and equipment and construction of our new facilities. Net cash used in investing activities increased approximately $0.5 million, from approximately $2.3 million for the three month period ended March 31, 2011 to approximately $2.8 million for the three month period ended March 31, 2012. This increase was primarily attributable to a decrease of approximately $4.0 million in cash used in discontinued operations relating to the purchase of property, plant and equipment and biological assets, offset by an increase of approximately $4.5 million in restricted cash.

Net Cash Used in Financing Activities

Net cash used in financing activities increased approximately $22.7 million, from net cash provided by financing activities of approximately $5,000 for the three month period ended March 31, 2011 to net cash used in financing activities of approximately $22.7 million for the three month period ended March 31, 2012. This increase in financing cash outflow was primarily attributable to an increase of approximately $21.1 million in payment for long term deposit associated with our financing of the redemption of Sequoia's shares and our redemption payment for Sequoia's shares of approximately $16.3 million, offset by proceeds from other long term loans of approximately $16.5 million.

Outstanding Indebtedness

Redemption Obligation

In August 2009, pursuant to a subscription agreement, we issued 2,100,000 shares of our common stock to Sequoia for an aggregate purchase price of $63.0 million. Because we did not meet certain earnings per share targets for 2009, we issued 525,000 additional shares to Sequoia pursuant to the subscription agreement. In February 2011, we entered into a redemption agreement with Sequoia to redeem and repurchase the 2,625,000 shares issued pursuant to the subscription agreement in four equal installments within 30 days of March 31, 2011, September 30, 2011, December 31, 2011 and March 31, 2012, for an aggregate payment on each such date of $15,750,000, together with interest accruing at the rate of 1.5% per annum, compounded annually from August 27, 2009 until such date. In April 2011, October 2011 and January 2012, we paid Sequoia approximately $16.1 million, $16.3 million and $16.3 million, respectively, to redeem an aggregate of 1,968,750 shares of common stock. The outstanding liability of redeemable common stock was $16,379,092 as of March 31, 2012. In April 2012, we paid the final installment of approximately $16.3 million to Sequoia, and all of the 2,625,000 shares have been redeemed. All shares of our common stock we redeem constitute authorized but unissued shares.

Short and Long Term Loans Payable

As of March 31, 2012, we had short term bank loans of approximately $53.2 million and long term bank loans of approximately $11.9 million from PRC banks. As of March 31, 2012, approximately $10.3 million of our short term bank loans contained various financial covenants. These covenants include requiring certain of our subsidiaries to maintain debt-to-equity ratios of not more than 60%, current ratios of at least 100% to 120%, quick ratios of at least 50%, or current assets of at least RMB8 million, depending on the loan. If our subsidiaries are unable to comply with these covenants or service our debt, we may lose control of parts of our business and be forced to reduce or delay planned capital expenditures, sell assets, restructure our indebtedness or submit to foreclosure proceedings, all of which could adversely effect our business, results of operations and financial condition. We may also need to secure additional future debt financing directly or through subsidiaries, which may contain various restrictive covenants and agreements, including cross-acceleration or cross-default provisions that could result in the default or acceleration under debt agreements based upon default or acceleration of any other debt agreement. As of March 31, 2012, we had met all of the financial covenants of the bank loans, except for a loan of $2,381,671. Despite the non-compliance, the bank did not demand immediate repayment of this loan, which was secured by a personal guarantee of Mr. Leng.

During the three month period ended March 31, 2012, the largest aggregate amount of short term bank loans was approximately $23.8 million. The maturity dates of the short term bank loans outstanding from PRC banks as of March 31, 2012 ranged from April 6, 2012 to December 31, 2012. All short term bank loans that have become due have been refinanced or repaid. During the three month period ended March 31, 2012, the largest aggregate amount of long term bank loans was approximately $8.3 million. Long term bank loans outstanding from PRC banks as of March 31, 2012 will fall due on December 23, 2013. The weighted average annual interest rate on short term bank loans and long term bank loans from PRC banks outstanding as of March 31, 2012 was 6.7% and 5.9%, respectively. The loans were secured by pledges of certain property, plant and equipment held by our subsidiaries, guarantees of certain of our subsidiaries and personal guarantees of one of our directors. Our ability to incur additional secured indebtedness depends in part on the value of our assets, which depends, in turn, on the strength of our cash flows, results of operations, economic and market conditions and other factors.

Line of Credit

We have a one year, unsecured line of credit with a bank of approximately $111.6 million (RMB703 million) scheduled to expire in the last quarter of 2012. The line of credit entitles us to draw demand loans for general corporate purposes. If we were to draw on the line of credit, interest would be a base rate established by the People's Bank of China on the unpaid principal amount. As of March 31, 2012, there were borrowings of approximately $31.8 million at a weighted average interest rate of 6.56% under the line of credit. The net availability of the line of credit was approximately $79.8 million as of March 31, 2012. During the three month periods ended March 31, 2012, the largest aggregate amount of borrowing under the line of credit was approximately $23.8 million.

Equipment Financing

We have a six-year capital lease agreement for certain equipment under construction. The terms of the lease required an initial payment of approximately $784,000 and require a payment of approximately $159,000 on January 30th of each year after successful completion of production quality tests. The equipment is depreciated over its estimated productive life of 14 years. As of each of March 31, 2012 and December 31, 2011, we had approximately $1.5 million of equipment under construction subject to the capital lease obligation.

Off-Balance Sheet Arrangements

We have not entered into any transactions, agreements or other contractual arrangements to which an entity unconsolidated with us is a party and under which we have (i) any obligation under a guarantee, (ii) any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity, (iii) any obligation under derivative instruments that are indexed to our shares and classified as shareholders' equity in our consolidated balance sheets, or
(iv) any obligation arising out of a variable interest in any unconsolidated entity that provides financing, liquidity, market risk or credit support to us or engages in leasing, hedging or research and development services with us.

Critical Accounting Policies

The consolidated financial statements include the financial statements of us and our subsidiaries. All transactions and balances among us and our subsidiaries have been eliminated upon consolidation. Certain amounts included in or affecting our consolidated financial statements and related disclosures must be estimated, requiring us to make certain assumptions with respect to values or . . .