Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion and analysis of the company's financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and the related notes included elsewhere in this report. In this report, the terms "we," "the Company" and "our" refer to Dehaier Medical Systems Limited, a British Virgin Islands company ("Dehaier"), Beijing Dehaier Technology Company Limited, our variable interest entity in the People's Republic of China ("BTL") and Beijing Dehaier Medical Technology Company Limited, our operating subsidiary in the People's Republic of China ("BDL"). This discussion contains forward-looking statements that involve risks and uncertainties. Actual results and the timing of selected events could differ materially from those anticipated in these forward-looking statements as a result of various factors.

This section should be read together with the consolidated financial statements and related notes thereto in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011, which was filed on March 19, 2012.

Overview

We are a company in the business of developing and distributing medical devices. We have been focusing on the respiratory and oxygen homecare industry in particular since 2006.

We design, develop and market our own branded products and medical components. Since we do not operate any fully scaled manufacturing facilities, we contract some of the medical components to outside manufacturers in China. Most of our branded products require light assembly by us before distribution.

We also distribute products designed and manufactured by other companies. We broaden our product portfolio through distribution agreements with international manufacturers, and most of the products we distribute are imported. Our distribution offerings are mostly medical equipment used in the operating room, the intensive care unit ("ICU") and the emergency room.

While we sell our products primarily through distributors, we also make direct sales to hospitals, clinics and government health bureaus. We continue to further our market reach by introducing newer and more advanced product lines that address different end-user needs.

Business Development

In April 2012, we renewed our strategic cooperation agreement with Timesco of London Ltd. The agreement appoints us as the exclusive distributor for Timesco's CXL and Eclipse series laryngoscope products in mainland China for three years.

In May 2012, we extended our exclusive distribution authorization with INTERMEDICAL ("IMD"), to distribute its RADIUS C-arm X-ray machines in mainland China. The extended term runs through 2014.

In June 2012, we entered a three-year strategic mutual cooperation agreement with HEYER Medical AG ("Heyer"). According to this agreement, we will continue to be one of the key Chinese distributors for Heyer's anesthesia machines and the exclusive distributor of its nebulizers in China.

Also in June 2012, we co-developed a "High-Efficiency Oxygen Inhaler" with Dr. Ding Jianzhang of Beijing Haidian Hospital. This inhaler is expected to begin selling in mainland China in the third quarter of 2012. The portable device is designed for use in homecare oxygen therapy, emergency treatment, disaster relief activities and high-altitude settings.

In July 2012, we received approval from China's State Food and Drug Administration ("SFDA") for our proprietary homecare medical CPAP device, the DHR-CPAP-C5. The certificate is valid until July 1,2016 (subject to renewal) and allows us to sell the product in mainland China.

Also between April and June 2012 we obtained software copyrights from China's National Copyright Administration for four of our proprietary technologies, including (1) Analysis and Monitoring Software of Adsorption Tower Oxygen Generation Process, (2) Dehaier Homecare CPAP Controlling Software, (3) Ventilator of CPAP Controlling Software and (4) Air Compressor Controlling Software. These copyrights have been approved for 50 years from the grant date.

Growth Strategies

We plan to build our brand name domestically as both a distributor and a trusted partner by leveraging our relationships with healthcare professionals, agents and other downstream distributors, maintaining and expanding our customer base, and promoting steady business growth.

We plan to broaden the portfolio of products we distribute for other companies by cooperating with more internationally recognized medical equipment manufacturers. We also intend to take advantage of our well-established distribution network to grow sales revenues. By actively participating in state-level contracted healthcare programs, we will continue to expand our key account business and build a higher level of contact and relationships with the government and other healthcare industrial insiders.

We plan to expand our product portfolio through continued investment in research and development and pursuing attractive opportunities to acquire complementary products and technologies. We have had steady growth in our brand name homecare medical products. We will expand our distribution channels through many new options, such as third party e-commerce platforms and retail drugstore chains. We plan to leverage our oxygen delivery service platform to introduce our homecare products to customers, generating potential cross-selling opportunities.

We have started and intend to continue developing our home oxygen service business in Beijing and eventually expand this service platform to all major markets in China. We also plan to offer more value-added services to our customers based on this platform. Our long-term goal is to provide our customers an all-in-one solution in the home healthcare field. Furthermore, we will continue to leverage our existing network of consumer experience centers, or CECs, to showcase our new products and services, such as our home oxygen services.

We will continue to expand into overseas markets and establish a distribution network, through distribution agreements, OEM partnerships, direct sales force efforts and e-commerce platforms. We will build our brand name by actively participating in international trade shows and other marketing activities. To the extent we have adequate demand for our homecare medical products abroad, we will continue seeking regulatory approval to sell these products in the United States and Europe.

Results of Operations

Overview

For the six and three months ended June 30, 2012 and 2011, our total revenues amounted to approximately $10.30 million, $10.67 million, $6.98 million and $7.71 million, respectively. Our revenues are subject to value added tax ("VAT"), sales returns and trade discounts. We deduct these amounts from our gross revenues to arrive at our total revenues. Our net income attributable to Dehaier for the six and three months ended June 30, 2012 and 2011 was approximately $1.82 million, $1.94 million, $1.69 million and $1.74 million, respectively. Both the revenue and net income attributable to Dehaier decreased slightly, mainly due to the Company's operating strategy adjustments. While we continuously developed our sales channels on traditional medical devices sales, in recent months, we also began adjusting our strategy to expand into government procurement projects and the burgeoning respiratory and oxygen homecare market.

Factors Affecting Our Results of Operations - Generally

We believe the most significant factors that directly or indirectly affect our sales revenues and net income are:

• the level of acceptance of our products among hospitals and other healthcare facilities;

• our ability to price our products at levels that provide favorable margins;

• new products introduced by us and our competitors;

• our ability to attract and retain distributors and key customers;

• our continued investment in research and development activities and our retention of key employees;

• changes in China's macro-economic environment and healthcare-related government policies and legislation; and

• global economic conditions.

Revenues

Our total revenues are derived from our medical devices and our respiratory and oxygen homecare products and services.

Medical Devices (Including Related Supporting Products) - Our Proprietary and Distributed Products

We derive revenues in our medical devices product line from the sale of C-arm X-ray systems, anesthesia machines, medical ventilators, general hospital products and related supporting products. Our medical device line is our largest product line and has the most extensive market penetration. We anticipate that we will continue to experience revenue growth in our medical devices line as we further develop our market through the introduction of new advanced product offerings and the participation in favorable government programs. In addition, we have recently begun to engage in state-level healthcare projects. We may procure high-end medical equipment for our clients, which may not necessarily be part of our existing distributed brands portfolio. We refer to these kinds of contracted projects as "key account business." Although this business may carry lower margins, the contract value for such business is typically larger and can contribute materially to our revenues.

Respiratory and Oxygen Homecare Products and Home Oxygen Therapy Service (or "HOTS")

We derive revenues in our respiratory and oxygen homecare line from sales of oxygen concentrators, CPAP devices, and portable sleep diagnostics devices. We anticipate that, on a percentage basis, revenues from our respiratory and oxygen homecare product line will increase more rapidly than total revenues in the near term, as we introduce new and more advanced products. We expect to develop our market for respiratory and oxygen homecare market in China and internationally through the use of distributors as well as through our direct sales platform.

In addition, we launched our home oxygen therapy service ("HOTS") in Beijing in the third quarter of 2011. In 2012, management will focus on laying a solid foundation, such as the delivery network, rather than generating considerable revenue.

Our ability to increase our revenues depends in large part on our ability to
(i) increase the market penetration of our existing products, (ii) successfully identify, develop, introduce and commercialize, in a timely and cost-effective manner, new and upgraded products and (iii) enter into international markets in the future. Generally, we choose to devote our resources to product development efforts that we believe are commercially feasible, can generate significant revenues and margins, and can be introduced into the market quickly.

Operating Costs and Expenses

Our operating costs and expenses consist of cost of revenues, general and administrative expenses, selling expenses and other expenses.

Cost of Revenues

Cost of revenues primarily includes raw materials, parts for assembly, wages, handling charges, amortization of software copyrights, and other expenses associated with the assembly and distribution of product.

General and Administrative Expenses

General and administrative expenses consist primarily of salaries and benefits and related costs for our administrative personnel and management, fees and expenses of our outside advisers, including legal, audit and valuation expenses, expenses associated with our administrative offices and the depreciation of equipment used for administrative purposes. We expect that our general and administrative expenses will increase, both on an absolute basis and as a percentage of revenue, as we hire additional personnel and incur costs related to the anticipated growth of our business. In addition, we expect to continue to incur significant general and administrative expenses as a public company.

Selling Expenses

Selling expenses consist primarily of compensation and benefits for our sales and marketing staff, expenses for promotional, advertising, travel and entertainment activities, lease payments for our sales offices, and depreciation expenses related to equipment used for sales and marketing activities. Going forward, we expect our selling expenses to increase, both on an absolute basis and as a percentage of revenue, as we increase our efforts to promote our products, especially our new respiratory and oxygen homecare products.

Six Months Ended June 30, 2012 Compared to Six Months Ended June 30, 2011.

We believe that historical period-to-period comparisons of operating results should not be relied upon as indicative of future performance.

Revenues

Our total revenues decreased by 3.44% from $10.67 million for the six months ended June 30, 2011 to $10.30 million for the six months ended June 30, 2012. In the first half-year of 2012, we continuously developed our sales channels for traditional medical devices sales. At the same time, we also began to adjust our operating strategy to expand into government procurement projects and the burgeoning respiratory and oxygen homecare market.

Cost of Revenues

Our cost of revenues decreased by 7.46% from $6.83 million for the six months ended June 30, 2011 to $6.32 million for the six months ended June 30, 2012. Our efforts to manage our inventory and costs allowed us to decrease our cost of revenues at a faster rate than our revenues declined. The reduction in material consumption caused our gross margins to increase. However, we predict inflation pressures are likely to persist in China, which could lead to an increase in our cost of revenues in the coming quarters.

Gross Profit

Our gross profit increased from $3.84 million in thesis months ended June 30, 2011 to $3.98 million in the same period of 2012, while our gross margin increased from 35.99% in 2011 to 38.66% in 2012. The management believes such increase in gross margin is the result of operating efficiency.

Operating Expenses

Our operating expenses decreased by 0.95% from $1.71 million for the six months ended June 30, 2011 to $1.69 million for the six months ended June 30, 2012. Our general and administrative and selling expenses generally remained the stable in both 2012 and 2011. We analyzed our six months operating expenses by general and administrative expenses and selling expenses in the following parts.

Operating Expenses-General and Administrative Expenses

General and administrative expenses consist primarily of salaries and benefits and related costs for our administrative personnel and management, and expenses associated with our research and development, registration of patent and intellectual property rights in China and abroad.

Our general and administration expenses increased by 1.51% from $1.02 million for six months ended June 30, 2011 to $1.03 million for the six months ended June 30, 2012, maintained generally the same for the six months ended June 30, 2012 as it was in the same period of 2011.

We expect that our general and administration expenses may increase in the near future as a result of further R&D expenditures.

Operating Expenses - Selling Expenses

Our selling expenses consist primarily of salaries and related expenses for personnel engaged in sales, marketing and customer support functions, and costs associated with advertising and other marketing activities. Our selling expenses decreased by 4.56% from $0.69 million for the six months ended June 30, 2011 to $0.66 million for the six months ended June 30, 2012. These selling expense decreases are a result of operating efficiency. We expect our selling expenses will grow as we invest in strengthening our distribution network, growing relationships with our customers, developing the homecare device market (in particular our oxygen therapy service initiative) and driving top-line growth in these areas.

Operating Income

As a result of the foregoing, we generated operating income of approximately $2.38 million in the six months ended June 30, 2012, compared to approximately $2.22 million in the same period of 2011. Operating income increased by 7.18%, mainly because of the improvement of gross margin and expense management.

Taxation

Our income tax expense was approximately $0.42 million in the six months ended June 30,2012, compared to approximately $0.40 million in the same period of 2011, primarily due to an increase in our taxable income.

Net Income

Our net income was approximately $1.81 million in the six months ended June 30, 2012, compared to approximately $1.95 million in 2011, a decrease by 7.19%, mainly because of a change in the fair value of our warrants liability. We calculate the fair value of our warrants each quarter, resulting in a non-cash liability or benefit, depending on whether the fair value our common shares has increased or decreased over the prior period. Excluding the effects of non-cash change in fair value of our warrants liability (which was a charge to operations of $92,067 and a gain of $149,867 for six months ended June 30, 2012 and 2011, respectively), our net income for the six months ended June 30, 2012 would have been $1,900,990, an increase of 5.65% as compared to $1,799,278 for the same period of 2011. After deduction of non-controlling interest in income, net income attributable to Dehaier was approximately $1.82 million and $1.94 million in the six months ended June 30, 2012 and 2011, respectively.

Three Months Ended June 30, 2012 Compared to Three Months Ended June 30, 2011.

Revenues

Our total revenues decreased by 9.46% from $7.71 million for the three months ended June 30, 2011 to $6.98 million for the three months ended June 30, 2012. In the second quarter of 2012, the decrease in revenues was mainly attributed to the company's operating strategy adjustment. In recent months, the company has made strategic decision by expanding into government procurement projects and homecare oxygen therapy services, while we maintaining our sales growth in our traditional medical devices business. In the short term, this strategy adjustment has caused some temporary softness in our revenue growth. However, the management expects the new strategy to benefit the Company in the futureas we rely more on higher margin proprietary products and services.

Cost of Revenues

Our cost of revenues decreased by 12.90% from $4.87 million for the three months ended June 30, 2011 to $4.24 million for the three months ended June 30, 2012. Our efforts to manage our inventory and costs allowed us to decrease our cost of revenues at a faster rate than our revenues declined. The reduction in material consumption caused our gross margins to increase. However, we predict inflation pressures are likely to persist, which could lead increase our cost of revenues in the coming period.

Gross Profit

Our gross profit decreased from $2.84 million in the three months ended June 30, 2011 to $2.74 million in the same period of 2012, while the gross margin increased from 36.84% in 2011 to 39.24% in 2012. The management believes such increase in gross margin is a result of operating efficiency improvements.

Operating Expenses

Our operating expenses decreased by 8.52% from $0.97 million for the three months ended June 30, 2011 to $0.88 million for the three months ended June 30, 2012. Operating expense was divided into general and administrative and selling expenses, which are analyzed below:

Operating Expenses-General and Administrative Expenses

General and administrative expenses consist primarily of salaries and benefits and related costs for our administrative personnel and management, and expenses associated with our research and development, registration of patent and intellectual property rights in China and abroad.

Our general and administration expenses increased by 5.49% from $0.51 million for the three months ended June 30, 2011 to $0.54 million for the three months ended June 30, 2012. This increase was mainly due to the continuous investment in our R&D projects.

We expect that our general and administration expenses may increase in the near future as a result of further development in our R&D projects and professional fees for being a public company in the U.S.

Operating Expenses - Selling Expenses

Our selling expenses consist primarily of salaries and related expenses for personnel engaged in sales, marketing and customer support functions, and costs associated with advertising and other marketing activities. Our selling expenses decreased by 24.32% from $0.45 million for the three months ended June 30, 2011 to $0.34 million for the three months ended June 30, 2012. These selling expense decreases are considered as a result of operating efficiency and effectiveness management. We expect our selling expenses will grow as we invest in strengthening our distribution network, growing relationships with customers, developing the homecare device market (in particular our oxygen therapy service initiative) and driving top-line growth in these areas.

Operating Income

As a result of the foregoing, we generated operating income of approximately $1.93 million in the three months ended June 30, 2012 and 2011.

Taxation

Tax expenses were calculated by taxable income. Our income tax expense was approximately $0.32 million in the three months ended June 30, 2012, compared to approximately $0.31 million in the same period of 2011.

Net Income

Our net income was approximately $1.68 million in the three months ended June 30,2012, compared to approximately $1.74 million in 2011, a decrease of 3.51%, mainly because of the increase in financial expenses and change in fair value of warrants.

Liquidity and Capital Resources

Cash Flows and Working Capital

As of June 30, 2012, we had approximately $1.11 million in cash and cash equivalents. As a result of the total cash activities, net cash decreased from $3,694,486 at December 31, 2011 to $1,107,942 at June 30, 2012. This is mainly because we invested in obtaining copyright protection for our software, for our future development. We believe that our currently available working capital of $25,920,190, including cash of $1,107,942, should be adequate to meet our anticipated cash needs and sustain our current operations for at least 12 months. To the extent we engage in acquisitions or other business expansion in the future, we will need to rely on a variety of sources of funding, including but not limited to operating cash and debt/equity financings.

Operating Activities

Net cash used in operating activities was $767,199 for the six months ended June 30, 2012, as compared to $3,356,331 for the same period in 2011. The reasons for this change are mainly as follows:

(i) For the six months ended June 30, 2011, account receivables increased by $3,451,269, while in the same period of 2012, it increased by $282,688. There is a decrease of $3,168,581 in account receivables. The decrease is attributable to the better aging management, which enhanced the collection of account receivables.

(ii) For the six months ended June 30, 2011, prepayments and other current assets increased by $4,240,759, while in the same period of 2012, it increased by $522,831. There is a decrease of $3,717,928 in prepayments and other current assets. The Company improved its operating efficiency that accelerated the turnover of prepayments and current assets.

(iii) For the six months ended June 30, 2011, other receivables decreased by $2,810, while in the same period of 2012, other receivables increased by $1,670,623. There is a increase of $1,673,433 in other receivables. The increase is mainly because of implement of large contracts that increased the deposit amount.

(iv) For the six months ended June 30, 2011, tax payable increased by $2,022,812, while in the same period of 2012, it decreased by $1,616,959. There is a decrease of $3,639,771 in tax payable. This is mainly because we have settled up the tax payables of previous years since the last quarter of 2011.

Investing Activities

Net cash used in investing activities for the six months ended June 30, 2012 was $2,405,707, compared to $64,660 for the same period of 2011. The cash used in investing activities in each quarter was mainly attributable to capital expenditures for software copyrights.

Financing Activities

During the first half year 2012, we repaid $1,580,436 of short-term bank loan on maturity and entered into a new loan agreement for $2,373,145. The net amount provided by financing activities was $0.79 million at June 30, 2012.

Capital Expenditures

We made capital expenditures of approximately $2.4 million and $65 thousand in the six months of 2012 and 2011, respectively. In 2011, our capital expenditures were generally used to purchase machinery for our assembly line, while in 2012, our capital expenditures were mainly used to obtain software copyrights.

Off-Balance Sheet Commitments and Arrangements

We have not entered into any financial guarantees or other commitments to guarantee the payment obligations of any third parties. We have not entered into any derivative contracts that are indexed to our shares and classified as shareholder's equity or that are not reflected in our consolidated financial statements. Furthermore, we do not have any retained or contingent interest in assets transferred to an unconsolidated entity that serves as credit, liquidity or market risk support to such entity. We do not have any 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.

Tax Matters Applicable to the Company

Generally

Dehaier is a tax-exempt company incorporated in the British Virgin Islands. BDL and BTL were incorporated in the PRC and are governed by PRC laws.

The Company pays PRC enterprise income taxes, value added taxes and business taxes in China for revenues from BDL, and is governed by British Virgin Islands tax laws as to Dehaier.

British Virgin Islands Tax

We are exempt from all provisions of the Income Tax Act of the British Virgin Islands, including with respect to all dividends, interests, rents, royalties, compensation and other amounts payable by or to persons who are not resident in the British Virgin Islands. Capital gains realized with respect to any of our shares, debt obligations or other securities by persons who are not resident in the British Virgin Islands are also exempt from all provisions of the Income Tax Act of the British Virgin Islands. No estate, inheritance tax succession or gift tax rate, duty, levy or other charge is payable by persons who are not resident in the British Virgin Islands with respect to any of our shares, debt obligations, or other securities. No stamp duty is payable in the British Virgin Islands in relation to a transfer of shares in a British Virgin Islands Business Company.

PRC Enterprise Income Taxes

PRC enterprise income tax is calculated based on taxable income determined under PRC accounting principles. According to the Foreign-invested Enterprises and Foreign Enterprises Income Tax Law (the "FIE Income Tax Law") and the related implementing rules, both of which issued in 1991, foreign-invested enterprises established in China are generally subject to an income tax rate of 33% (consisting of 30% enterprise income tax and 3% local income tax). The FIE Income Tax Law and the related implementing rules provide certain favorable tax treatments to qualified foreign invested enterprises.

The FIE Income Tax Law was replaced by the Enterprise Income Tax Law (the "EIT Law") as of January 1, 2008. Under the EIT Law, a unified enterprise income tax rate of 25% and unified tax deduction standards will be applied equally to both domestic-invested enterprises and foreign-invested enterprises. Enterprises . . .