Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and related notes and other information included elsewhere in this Quarterly Report on Form 10-Q.
Forward-Looking Statements
Our disclosure and analysis in this report, including but not limited to the information discussed in this Item 2, contain forward-looking information about our Company’s financial results and estimates, business prospects and products in research that involve substantial risks and uncertainties. From time to time, we also may provide oral or written forward-looking statements in other materials we release to the public. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historic or current facts. They use words such as anticipate,” estimate,” expect,” project,” intend,” plan,” believe,” will,” and other words and terms of similar meaning in connection with any discussion of future operations or financial performance. In particular, these include statements relating to future actions, prospective products or product approvals, future performance or results of current and anticipated products, sales efforts, expenses, interest rates, foreign exchange rates, intellectual property matters, the outcome of contingencies, such as legal proceedings, and financial results.
We cannot guarantee that any forward-looking statement will be realized, although we believe we have been prudent in our plans and assumptions. Achievement of future results is subject to risks, uncertainties and inaccurate assumptions. Should known or unknown risks or uncertainties materialize, or should underlying assumptions prove inaccurate, actual results could vary materially from past results and those anticipated, estimated or projected. As a result, investors are cautioned not to place undue reliance on any of our forward-looking statements. Investors should bear this in mind as they consider forward-looking statements.
We do not assume any obligation to update or revise any forward-looking statement that we make, even if new information becomes available or other events occur in the future. We are also affected by other factors that may be identified from time to time in our filings with the Securities and Exchange Commission, some of which are set forth in Item 1A - Risk Factors in our Form 10-K filing for the 2008 fiscal year. You are advised to consult any further disclosures we make on related subjects in our Forms 10-Q, 8-K and 10-K reports to the Securities and Exchange Commission. Although we have attempted to provide a list of important factors which may affect our business, investors are cautioned that other factors may prove to be important in the future and could affect our operating results. You should understand that it is not possible to predict or identify all such factors or to assess the impact of each factor or combination of factors on our business. Consequently, you should not consider any such list to be a complete set of all potential risks or uncertainties.
Overview
The Company is a life sciences and biotechnology company focused on harnessing genetic processes to develop research tools and therapeutics and the provision of diagnostic services to the medical community. Since its founding in 1976, Enzo’s strategic focus has been on the development, for commercial purposes, of enabling technologies in the life sciences field. Enzo’s pioneering work in genomic analysis coupled with its extensive patent estate and enabling platforms have strategically positioned Enzo to play a crucially important role in the rapidly growing life sciences and molecular medicine marketplaces.
We are comprised of three operating companies that have evolved out of our core competence: the use of nucleic acids as informational molecules and the use of compounds for immune modulation. These wholly owned operating companies conduct their operations through three reportable segments. Below are brief descriptions of each of the three operating segments (see Note 13 in the notes to consolidated financial statements):
Enzo Life Sciences is a company that manufactures, develops and markets biomedical research products and tools to research and pharmaceutical customers around the world and has amassed a large patent and technology portfolio. The company’s sources of revenue have been from the direct sales of products consisting of labeling and detection reagents for the genomics and sequencing markets, as well as through non-exclusive distribution agreements with other companies, and royalty and licensing fee income. The pioneering platforms developed by Enzo Life Sciences enable the development of a wide range of products in the research products marketplace.
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The division is internationally recognized and acknowledged for its manufacturing, in-licensing, and commercialization of over 8,000 innovative high quality research reagents in key research areas. The division is an established source for a comprehensive panel of products to scientific experts in the fields of gene expression, non-radioactive labeling and detection, adipokines and obesity, apoptosis, bioactive lipids, cell cycle, cytoskeletal research, DNA damage and repair, epigenetic immunology and cancer research, inflammation, neurobiology, nitric oxide & oxidative stress, and signal transduction.
Enzo Therapeutics is a biopharmaceutical company that has developed multiple novel approaches in the areas of gastrointestinal, infectious, ophthalmic and metabolic diseases, many of which are derived from the pioneering work of Enzo Life Sciences. The Company has focused its efforts on developing treatment regimens for diseases and conditions in which current treatment options are ineffective, costly, and/or cause unwanted side effects. This focus has generated a clinical and preclinical pipeline, as well as more than 40 patents and patent applications.
Enzo Clinical Labs is a regional clinical laboratory to the greater New York and New Jersey medical community. The Company believes having this capability allows us to capitalize firsthand on our extensive advanced molecular and cytogenetic capabilities and the broader trends in predictive diagnostics. We offer a menu of routine and esoteric clinical laboratory tests or procedures used in general patient care by physicians to establish or support a diagnosis, monitor treatment or medication, or search for an otherwise undiagnosed condition. We operate a full-service clinical laboratory in Farmingdale, New York, a network of 23 patient service centers, a stand alone “stat” or rapid response laboratory in New York City, and a full-service phlebotomy department. Payments for clinical laboratory testing services are made by the Medicare program, healthcare insurers and patients. Fees billed to patients, Medicare, and third party payers are billed on the laboratory’s standard gross fee schedule, subject to any limitations on fees negotiated with the third party payers or with the ordering physicians on behalf of their patients.
Recent Developments
Biomol International L.P.
On May 8, 2008, Enzo Life Sciences, Inc. acquired substantially all of the U.S. based assets and certain liabilities of Biomol International, LP (“Biomol LP”) through a newly formed US subsidiary Biomol International, Inc. and all of the stock of Biomol’s wholly-owned United Kingdom subsidiary, Affinity Limited by Axxora UK, a wholly-owned subsidiary of Enzo Life Sciences, collectively referred to as “Biomol” for approximately $18.1 million in cash and stock, subject to adjustment, exclusive of acquisition costs of approximately $800,000 and contingent payments which will be accounted for as additional purchase consideration over the next two years if and when the contingencies are resolved beyond a reasonable doubt. At closing, the purchase price was satisfied as follows: $12.9 million in cash was paid to Biomol LP, issuance of 352,000 shares of Enzo common stock, at fair market value, to Biomol LP, $1.5 million in cash was paid to an escrow agent for the one-year period following the closing to satisfy any indemnification obligations of the sellers under the Agreement and $550,000 was paid to an escrow agent, for the 60 day period following the closing to satisfy any specified purchase price adjustments. The $550,000 was released by the escrow agent in August 2008. The earn-outs of $2.5 million on each of the next two anniversaries of the acquisition date will be based on attaining certain revenue and EBITDA targets, as defined. Biomol was a privately owned, closely held global manufacturer and marketer of specialty life sciences research products. Effective May 8, 2008, Biomol became a wholly-owned subsidiary of Enzo Life Sciences. The acquisition was financed with the Company’s cash and cash equivalents and Enzo common stock. The consolidated financial statements include the results of operations for Biomol from the date of acquisition.
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Results of Operations
Three months ended October 31, 2008 as compared to October 31, 2007
Comparative Financial Data for the Three Months Ended October 31,
(in thousands)
| | 2008 | | 2007 | | Increase
(Decrease) | | % Change |
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Revenues: | | | | | | | | | | | | |
Product sales | | $ | 9,976 | | $ | 5,863 | | $ | 4,113 | | | 70 | |
Royalty and license fee income | | | 2,916 | | | 2,318 | | | 598 | | | 26 | |
Clinical laboratory services | | | 8,172 | | | 11,266 | | | (3,094 | ) | | (27 | ) |
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Total revenues | | | 21,064 | | | 19,447 | | | 1,617 | | | 8 | |
Costs and expenses and other (income): | | | | | | | | | | | | | |
Cost of products | | | 6,805 | | | 4,434 | | | 2,371 | | | 53 | |
Cost of laboratory services | | | 5,806 | | | 5,131 | | | 675 | | | 13 | |
Research and development | | | 2,003 | | | 1,703 | | | 300 | | | 18 | |
Selling, general and administrative | | | 9,574 | | | 7,404 | | | 2,170 | | | 29 | |
Provision for uncollectible accounts receivable | | | 1,859 | | | 1,159 | | | 700 | | | 60 | |
Legal expenses | | | 1,210 | | | 2,449 | | | (1,239 | ) | | (51 | ) |
Interest income | | | (509 | ) | | (1,460 | ) | | 951 | | | (65 | ) |
Other income | | | (34 | ) | | (19 | ) | | (15 | ) | | 79 | |
Foreign currency loss (gain) | | | 582 | | | (7 | ) | | 589 | | | n.a. | |
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Total costs and expenses and other- net | | | 27,296 | | | 20,794 | | | 6,502 | | | 31 | |
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Loss before income taxes | | ($ | 6,232 | ) | ($ | 1,347 | ) | ($ | 4,885 | ) | | (363 | %) |
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Consolidated Results:
The “2008 period” and the “2007 period” refer to the three months ended October 31, 2008 and 2007, respectively. The 2008 period includes the three months results of Biomol which was acquired on May 8, 2008.
Product revenues during the 2008 period were $10.0 million compared to $5.9 million in the year ago period, an increase of $4.1 million or 70%. The 2008 period increase is primarily due to the $2.8 million contribution of product revenues from the Biomol acquisition.
Royalty and license fee income during the 2008 period was $2.9 million compared to $2.3 million in the 2007 period, an increase of $0.6 million or 26%. Royalties are earned from the reported net sales of Qiagen products subject to a license agreement and from a license agreement with Abbott. During the 2008 period, the Company recognized royalties of approximately $2.3 million from Qiagen, an increase of approximately $0.4 million over the prior year ago period, and royalties and license fees under the Abbott License Agreement of approximately $0.6 million, an increase of approximately $0.2 million over the year ago period. There are no expenses relating to royalty and license fee income.
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Clinical laboratory revenues during the 2008 period were $8.2 million compared to $11.3 million in the 2007 period. The 2008 period’s decrease over the prior year period was $3.1 million or 27%. During the 2008 period, our contractual adjustments increased and therefore our revenues decreased by $2.2 million due to reduced payer reimbursements. This reduced payer reimbursement experience was caused by reduced billings on our legacy billing system, including the investigation of and rebilling of denials during the period, as a result of the realignment of certain billing personnel to implement our new comprehensive billing and accounts receivable system. This new system was effective for all laboratory services performed after August 1, 2008. We anticipate that the new billing and accounts receivable system will enhance our billing and reimbursement process. The legacy billing system continues to account for all services prior to August 1, 2008. Further, the 2008 period decrease over the 2007 period was partially due to continued competitive pricing throughout the industry which has negatively impacted reimbursement rates for tests and an increase in revenue mix to lower paying insurance providers.
The cost of product revenues during the 2008 period was $6.8 million compared to $4.4 million in the 2007 period, an increase of $2.4 million. The increase is primarily due to the impact of Biomol’s cost of product revenues of approximately $1.6 million for the 2008 period, which includes the impact of an inventory fair value adjustment of $0.5 million related to sales of inventory acquired from Biomol.
The cost of clinical laboratory services during the 2008 period was $5.8 million as compared to $5.1 million in the 2007 period, an increase of $0.7 million or 13%. The Company incurred increased costs primarily relating to reagent costs of $0.1 million, laboratory personnel costs of $0.3 million, outside reference lab costs of $0.1 million, and other related laboratory costs of $0.2 million.
Research and development expenses were approximately $2.0 million during the 2008 period, compared to $1.7 million in the 2007 period, an increase of $0.3 million or 18%. The increase was attributed to additional net costs of $0.4 million at Enzo Life Sciences related to Biomol offset by a decrease of $0.1 million relating to the timing of clinical trial and related activities at the Therapeutics segment.
Selling, general and administrative expenses were approximately $9.6 million during the 2008 period as compared to $7.4 million in the 2007 period, an increase of $2.2 million or 29%. The increase was primarily due to the increases at the Enzo Life Sciences segment of $1.3 million in the 2008 period which included approximately $0.8 million of selling, general and administrative expenses increases related to Biomol operations. The increase from the other segments’ operations of approximately $0.9 million was primarily due to payroll and payroll related costs of $0.2 million, consulting fees of $0.2, professional fees of $0.2 million, overhead operating expenses of $0.2 and information technology costs of $0.1 million.
The provision for uncollectible accounts receivable, primarily relating to the clinical laboratory segment was $1.9 million for the 2008 period as compared to $1.2 million in the 2007 period. The increase of $0.7 million was due to reduced collection efforts by our billing department on the Clinical lab’s legacy billing system that was replaced by a new comprehensive billing and accounts receivable system effective August 1, 2008. Outstanding receivables will remain on the legacy system until either invoices are collected, all collection efforts are exhausted, or the balances are fully reserved and written off in accordance with our critical accounting policy.
Legal expense was $1.2 million during the 2008 period compared to $2.4 million in the 2007 period, a decrease of $1.2 million or 51%, due to a decrease in patent litigation activity in the current period.
Interest income was $0.5 million during the 2008 period as compared to $1.5 million during the 2007 period. The Company earns interest by investing primarily in short term and liquid investments, including money market accounts and US government instruments. The Company had higher average invested balances during the 2007 period. Further, interest income decreased during the 2008 period because the rates declined in response to monetary policy actions taken by the U.S. Federal Reserve.
The loss on foreign currency transactions was $0.6 million during the 2008 period. During the 2008 period, the Company’s Life Sciences segment incurred a foreign exchange loss of approximately $0.6 million on an intercompany term loan denominated in British pounds sterling due to the strengthening of the US dollar as at October 31, 2008 versus July 31, 2008.
The Company’s effective tax rate (provision) benefit for the 2008 period was (2.2%), compared to 8.5% during the 2007 period. The tax (provision) for the 2008 period was based on state and local taxes, domestic and foreign tax for tax deductible goodwill and indefinite lived intangibles, and book to tax differences for acquired inventory and differed from the expected net operating loss carry forward benefit at the U.S. federal statutory rate of 34% primarily due to the inability to recognize such benefit. The carry forward benefit cannot be recognized because of uncertainties relating to future taxable income, in terms of both its timing and its sufficiency.
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The tax provision for the 2007 period was based on state and local taxes, and differed from the expected net operating loss benefit at the U.S. federal statutory rate of 34% primarily due the inability to recognize such benefit. The carry forward benefit cannot be recognized because of uncertainties relating to future taxable income, in terms of both its timing and its sufficiency, which would enable the Company to realize the federal carry forward benefit.
Segment Results
The Life Sciences segment’s income before taxes was approximately $1.1 million for the 2008 period and is comparable to the 2007 period. Product revenues increased by $4.1 million in the 2008 period primarily due to the contribution of product revenues from Biomol which was acquired in May 2008. Royalty and license fee income increased $0.6 million from the existing Qiagen agreement and the Abbott License Agreement. The segment’s gross margin of $6.1 million was negatively impacted by $0.5 million representing the fair value adjustment attributed to the sale of inventory acquired from Biomol. The remaining fair value adjustment attributed to inventory acquired from Biomol of $0.8 million will negatively impact gross margins through May 2009. Segment operating expenses, including selling, general and administrative and research and development, increased by approximately $1.7 million during the 2008 period primarily due to the inclusion of Biomol’s expenses. The foreign exchange loss for the 2008 period was $0.6 million.
The Clinical Laboratory segment’s loss before taxes was $3.4 million for the 2008 period as compared to income of $1.4 million in the 2007 period. The 2008 period was impacted by a decrease in laboratory service revenues of $3.1 million or 27%. During the 2008 period, our contractual adjustments increased and therefore our revenues decreased by $2.2 million due to reduced payer reimbursements. This reduced payer reimbursement experience was caused by reduced billings on our legacy billing system, including the investigation of and rebilling of denials during the period, as a result of the realignment of certain billing personnel to implement our new comprehensive billing and accounts receivable system. Further, the 2008 period decrease was partially due to continued competitive pricing throughout the industry which has negatively impacted reimbursement rates for tests and an increase in revenue mix to lower paying insurance providers. The gross profit was negatively impacted by the increase in the contractual adjustment previously discussed, and an increase in the cost of laboratory services of $0.7 million as compared to the 2007 period. In the 2008 period the selling, general and administrative costs increased by approximately $0.3 million primarily due to increases in payroll and payroll related costs of $0.1 million and operating overhead costs of $0.2 million. The provision for uncollectible accounts receivables increased by $0.7 million due to the impact of the reduced collection efforts by our billing department on the Clinical lab’s legacy billing system. The segment earned interest in the 2008 period of $0.1 million on its accumulated cash generated by operations.
The Therapeutics segment’s loss before income taxes was approximately $0.8 million for the 2008 period as compared to a loss of $0.9 million for the 2007 period. The decrease in the loss of $0.1 million was primarily due to a decrease in clinical trial activities.
The Other segment’s loss before taxes for the 2008 period was approximately $3.2 an increase of $0.2 million as compared to $3.0 million in the 2007 period. The Other segment’s 2008 period loss reflects a decrease in legal expenses of $1.2 million due to a decrease in patent litigation activity in the current period compared to the 2007 period, offset by an increase in general and administrative expenses of $0.6 million, and a decrease in interest income of $0.9 million due to lower levels of cash available for investment and declining interest rates.
Liquidity and Capital Resources
At October 31, 2008, our cash and cash equivalents were $36.8 million, a decrease of $41.5 million from cash and cash equivalents at July 31, 2008. The decrease in cash during the three months ended October 31, 2008 was primarily due to the net purchase of short term investments in U.S. Government agency discount notes of $39.7 million and the impact of other cash flow activities discussed below. The Company had working capital of $86.8 million at October 31, 2008 compared to $92.4 million at July 31, 2008. The decrease in working capital was the result of the decrease in cash and cash equivalents to fund the period net loss and capital expenditures.
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Net cash used in operating activities for the three months ended October 31, 2008 was approximately $1.5 million as compared to $1.2 million for the three months ended October 31, 2007. The increase in net cash used by operating activities in the 2008 period over the 2007 period of approximately $0.3 million was primarily due to the increase in the 2008 period loss, offset by non-cash adjustments in the 2008 period over the 2007 period, including the increases in the provision for doubtful accounts of $0.7 million and depreciation and amortization of $0.3 million, and changes in operating assets and liabilities.
Net cash used in investing activities was approximately $40.2 million as compared to $0.6 million in the year ago period, primarily due to an increase in short term investments in US Government agency discount notes of $39.7 million.
Net cash provided by financing activities was approximately $0.3 million in both the 2008 and 2007 periods, from stock options exercise proceeds.
On May 8, 2008, the Company’s wholly-owned subsidiary, Enzo Life Sciences, acquired substantially all of the U.S. based assets of Biomol International, L.P. (“Biomol”) through Enzo Life Sciences’ newly-formed subsidiary, Biomol International, Inc., and all of the outstanding capital stock of Biomol’s two wholly owned United Kingdom subsidiaries through Enzo Life Sciences’ wholly owned subsidiary, Axxora (UK) Ltd. (the “Biomol Acquisition”), for a purchase price of $18 million, comprised of $15 million in cash, subject to downward adjustment based on net asset value on the closing date, and $3 million of unregistered common stock of the Company. In addition, Biomol may be entitled to receive a maximum of $5 million in earn-out payments over the next two years, payable in two installments of $2.5 million on each of the next two anniversaries of the closing date, if certain revenues and EBITDA targets for the acquired business are attained. The earn-out payments, if any, will be payable in a combination of cash and shares of the Company’s common stock, provided no more than 50% of the earn-out payments will be paid in stock. Biomol was a privately owned global manufacturer and marketer of specialty life sciences research products, with consolidated revenues of approximately $11.5 million for its fiscal year ended December 31, 2007. The Biomol Acquisition strengthens the Company’s position as a global provider of life sciences reagents by broadening the Company’s product offerings and manufacturing capabilities.
The Company believes that its current cash position is sufficient for its foreseeable liquidity and capital resource needs over the next 12 months, although there can be no assurance that future events will not alter such view.
Contractual Obligations
There have been no material changes to our Contractual Obligations as reported in our Form 10-K for the fiscal year ended July 31, 2008. Management is not aware of any material claims, disputes or settled matters concerning third party reimbursement that would have a material effect on our financial statements.
Critical Accounting Policies
The Company’s discussion and analysis of its financial condition and results of operations are based upon Enzo Biochem, Inc.’s consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires the Company to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses; these estimates and judgments also affect related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to contractual adjustments, allowance for uncollectible accounts, inventory, intangible assets and income taxes. The Company bases its estimates on experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.
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Product revenues
Revenues from product sales are recognized when the products are shipped and title transfers, the sales price is fixed or determinable and collectibility is reasonably assured. The revenue from the non-exclusive distribution agreements are recognized when shipments are made to their respective customers and reported to the Company. The Company has certain non-exclusive distribution agreements, which provide for consideration to be paid to the distributors for the manufacture of certain products. The Company records such consideration provided to distributors under these non-exclusive distribution agreements as a reduction to product revenues. The Company did not recognize any revenue from these distributors during the 2008 and 2007 periods. During the three months ended October 31, 2008 and 2007, one customer in the Life Science segment represented $2.1 million and $0.9 million of total product revenues, respectively.
Royalties
Royalty revenues are recorded in the period earned. Royalties received in advance of being earned are recorded as deferred revenues.
License fees and multiple element arrangements
When evaluating multiple element arrangements, the Company considers whether the components of the arrangement represent separate units of accounting as defined in Emerging Issues Task Force (“EITF”) Issue No. 00-21, Revenue Arrangements with Multiple Deliverables (“EITF 00-21”). Application of this standard requires subjective determinations and requires management to make judgments about the fair value of the individual elements and whether such elements are separable from the other aspects of the contractual relationship.
Revenues – Clinical laboratory services
Revenues from the clinical laboratory are recognized upon completion of the testing process for a specific patient and reported to the ordering physician. These revenues and the associated accounts receivable are based on gross amounts billed or billable for services rendered, net of a contractual adjustment, which is the difference between amounts billed to payers and the expected approved reimbursable settlements from such payers.
The following are tables of the Clinical Labs segment’s net revenues and percentages by revenue category for the three months ended October 31, 2008 and 2007:
Clinical Labs net revenues | | Three months ended
October 31, 2008 | | Three months ended
October 31, 2007 | |
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Revenue category | | | | | | | | | | | |
Medicare | | $ | 2,300 | | 28 | | $ | 2,145 | | 19 | |
Third-party payer | | | 3,880 | | 48 | | | 6,508 | | 58 | |
Patient self-pay | | | 1,227 | | 15 | | | 1,516 | | 13 | |
HMO’s | | | 765 | | 9 | | | 1,097 | | 10 | |
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Total | | $ | 8,172 | | 100 | % | $ | 11,266 | | 100 | % |
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The Company provides services to certain patients covered by various third-party payers, including the Federal Medicare program. Laws and regulations governing Medicare are complex and subject to interpretation for which action for noncompliance includes fines, penalties and exclusion from the Medicare programs. The Company believes that it is in compliance with all applicable laws and regulations and is not aware of any pending or threatened investigations involving allegations of potential wrongdoing.
Other than the Medicare program, one provider whose programs are included in the Third-party payer and Health Maintenance Organizations (“HMO’s”) categories represented 27% and 25% of the Clinical Labs services net revenues for the three months ended October 31, 2008 and 2007 respectively.
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Contractual Adjustment
The Company’s estimate of contractual adjustment is based on significant assumptions and judgments, such as its interpretation of payer reimbursement policies, and bears the risk of change. The estimation process is based on the experience of amounts approved as reimbursable and ultimately settled by payers, versus the corresponding gross amount billed to the respective payers. The contractual adjustment is an estimate that reduces gross revenue, based on gross billing rates, to amounts expected to be approved and reimbursed. Gross billings are based on a standard fee schedule we set for all third party payers, including Medicare, health maintenance organizations (“HMO’s) and managed care. The Company adjusts the contractual adjustment estimate quarterly, based on its evaluation of current and historical settlement experience with payers, industry reimbursement trends, and other relevant factors. The other relevant factors that affect our contractual adjustment include the monthly and quarterly review of: 1) current gross billings and receivables and reimbursement by payer, 2) current changes in third party arrangements. 3) the growth of in-network provider arrangements and managed care plans specific to our Company.
Our clinical laboratory business is primarily dependent upon reimbursement from third-party payers, such as Medicare (which principally serves patients 65 and older) and insurers. We are subject to variances in reimbursement rates among different third-party payers, as well as constant changes of reimbursement rates. Changes that decrease reimbursement rates or coverage would negatively impact our revenues.
The number of individuals covered under managed care contracts or other similar arrangements has grown over the past several years and may continue to grow in the future. In addition, Medicare and other government healthcare programs continue to shift to managed care. These trends will continue to reduce our revenues per test.
During the three months ended October 31, 2008 and 2007, the contractual adjustment percentages, determined using current and historical reimbursement statistics, were 77.9%, and 80.6%, respectively, of gross billings. During the three months ended October 31, 2008 changes to the Company’s standard fee schedule resulted in the decrease in the contractual adjustment percentage and gross revenues. The changes were made to maintain a fee schedule in line with other competitors. In addition, during the period our contractual adjustments increased and therefore our revenues decreased by $2.2 million due to reduced payer reimbursements The Company believes the negative impact on revenues from the decline in reimbursement rates or the shift to managed care, other primary third party payers, or similar arrangements may be offset by the positive impact of an increase in the number of tests we perform. However, there can be no assurance that we can increase the number of tests we perform or that if we do increase the number of tests we perform, that we can maintain that higher number of tests performed, or that an increase in the number of tests we perform would result in increased revenue.
The Company estimates (by using a sensitivity analysis) that each 1% point change in the contractual adjustment percentage could result in a change in clinical laboratory services revenues of approximately $348,000, and $580,000 for the three months ended October 31, 2008 and 2007, respectively, and a change in the net accounts receivable of approximately $144,000 as of October 31, 2008.
Our clinical laboratory financial billing system records gross billings using a standard fee schedule for all payers and does not record contractual adjustment by payer at the time of billing. Adjustments to our standard fee schedule will impact the contractual adjustment recorded. Therefore, we are unable to quantify the effect of contractual adjustment recorded during the current period that relate to revenue recorded in a previous period. However, we can reasonably estimate our contractual adjustment to revenue on a timely basis based on our quarterly review process, which includes:
| • | an analysis of industry reimbursement trends; |
| • | an evaluation of third-party reimbursement rates changes and changes in reimbursement arrangements with third-party payers; |
| • | a variance reimbursement analysis of current and historical claim settlement and reimbursement experience with payers; |
| • | an analysis of current gross billings and receivables by payer. |
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Accounts Receivable and Allowance for Doubtful Accounts
Accounts receivable are reported at realizable value, net of allowances for doubtful accounts, which is estimated and recorded in the period of the related revenue.
The following is a table of the Company’s net accounts receivable by segment. The clinical laboratory segment’s net receivables are detailed by billing category and as a percent to its total net receivables. At October 31, 2008 and July 31, 2008, approximately 47% and 58%, respectively, of the Company’s net accounts receivable relates to its clinical laboratory business, which operates in the New York Metropolitan and New Jersey Metropolitan areas.
The Life Sciences segment’s accounts receivable, of which $2.0 million or 29% and $3.3 million or 51% represents foreign receivables as of October 31, 2008 and July 31, 2008 respectively, includes royalty receivables of $2.8 million and $2.1 million, as of October 31, 2008 and July 31, 2008, respectively, of which approximately $2.3 million and $1.5 million, respectively is from Qiagen Corporation. (Note 12).
Net accounts receivable
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October 31, 2008 | | As of
July 31, 2008 | |
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Clinical Labs | | | | | | | | | | | |
Medicare | | $ | 1,260 | | 21 | | $ | 1,600 | | 18 | |
Third party payers | | | 2,677 | | 44 | | | 4,610 | | 52 | |
Patient self-pay | | | 1,900 | | 32 | | | 2,144 | | 24 | |
HMO’s | | | 172 | | 3 | | | 537 | | 6 | |
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Total clinical labs | | $ | 6,009 | | 100 | % | $ | 8,891 | | 100 | % |
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Total life sciences | | | 6,679 | | | | | 6,457 | | | |
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Total accounts receivable | | $ | 12,688 | | | | $ | 15,348 | | | |
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Changes in the Company’s allowance for doubtful accounts are as follows:
In 000’s | | October
31, 2008 | | July 31,
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Beginning balance | | $ | 886 | | $ | 1,404 | |
Provision for doubtful accounts | | | 1,859 | | | 3,716 | |
Write-offs, net | | | (588 | ) | | (4,234 | ) |
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Ending balance | | $ | 2,157 | | $ | 886 | |
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For the Clinical Labs segment, the allowance for doubtful accounts represents amounts that the Company does not expect to collect after the Company has exhausted its collection procedures. The Company estimates its allowance for doubtful accounts in the period the related services are billed and adjusts the estimate in future accounting periods as necessary. It bases the estimate for the allowance on the evaluation of historical collection experience, the aging profile of accounts receivable, the historical doubtful account write-off percentages, payer mix, and other relevant factors.
The allowance for doubtful accounts includes the balances, after receipt of the approved settlements from third party payers for the insufficient diagnosis information received from the ordering physician, which result in denials of payment and the uncollectible portion of receivables from self payers, including deductibles and copayments, which are subject to credit risk and patients’ ability to pay. During the three months ended October 31, 2008 and 2007, the Company determined an allowance for doubtful accounts less than 210 days and wrote off 100% of accounts receivable over 210 days, as it assumed those accounts are uncollectible, except for certain fully reserved balances, principally related to Medicare. These accounts have not been written off because the payer’s filing date deadline has not occurred or the collection process has not been exhausted. The Company’s collection experience on Medicare receivables beyond 210 days has been insignificant. The Company adjusts the historical collection analysis for recoveries, if any, on an ongoing basis.
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The Company’s ability to collect outstanding receivables from third party payers is critical to its operating performance and cash flows. The primary collection risk lies with uninsured patients or patients for whom primary insurance has paid but a patient portion remains outstanding. The Company also assesses the current state of its billing functions in order to identify any known collection or reimbursement issues in order to assess the impact, if any, on the allowance estimates, which involves judgment. The Company believes that the collectibility of its receivables is directly linked to the quality of its billing processes, most notably, those related to obtaining the correct information in order to bill effectively for the services provided. Should circumstances change (e.g. shift in payer mix, decline in economic conditions or deterioration in aging of receivables), our estimates of net realizable value of receivables could be reduced by a material amount. During the quarter ended October 31, 2008, our bad debts expense and related allowance for doubtful accounts were increased by $0.7 million to account for the impact of reduced collection efforts employed by our billing department due to the realignment of efforts to implementation and utilization of the Company’s new billing system. This realignment of personnel is not expected to materially impact future periods. The Company is presently managing two systems until the legacy system activity is deemed completed. Further, the Company believes the current economic condition has impacted collections.
Billing for laboratory services is complicated because of many factors, especially: the differences between our standard gross fee schedule for all payers and the reimbursement rates of the various payers we deal with, disparity of coverage and information requirements among the various payers, and disputes with payers as to which party is responsible for reimbursement.
The following tables indicate the Clinical Labs Aged Gross Receivables by Payer Group (in 000’s), which is prior to adjustment to gross receivables for 1) contractual adjustment, 2) fully reserved balances not yet written off and 3) other revenue adjustments.
As of October 31, 2008 | | Total
Amount | | % | | Medicare
Amount | | % | | Third
Party Payers Amount | | % | | Self-pay Amount | | % | | HMO’s
Amount | | % | |
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1-30 days | | $ 12,893 | | 49 | % | $ 2,415 | | 35 | % | $ 6,383 | | 60 | % | $ 1,241 | | 22 | % | $ 2,854 | | 95 | % |
31-60 days | | 2,740 | | 11 | % | 397 | | 6 | % | 1,541 | | 15 | % | 767 | | 14 | % | 35 | | 1 | % |
61-90 days | | 1,552 | | 6 | % | 237 | | 3 | % | 742 | | 7 | % | 536 | | 10 | % | 37 | | 1 | % |
91-120 days | | 3,401 | | 13 | % | 446 | | 7 | % | 785 | | 7 | % | 2,137 | | 38 | % | 33 | | 1 | % |
121-150 days | | 1,393 | | 5 | % | 469 | | 7 | % | 625 | | 6 | % | 277 | | 5 | % | 22 | | 1 | % |
Greater than 150 days* | | 4,075 | | 16 | % | 2,862 | | 42 | % | 539 | | 5 | % | 652 | | 12 | % | 22 | | 1 | % |
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Totals | | $ 26,054 | | 100 | % | $ 6,826 | | 100 | % | $ 10,615 | | 100 | % | $ 5,610 | | 100 | % | $ 3,003 | | 100 | % |
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As of July 31, 2008 | | Total
Amount | | % | | Medicare
Amount | | % | | Third
Party Payers
Amount | | % | | Self-pay
Amount | | % | | HMO’s
Amount | | % | |
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1-30 days | | $ 15,879 | | 56 | % | $ 3,278 | | 44 | % | $ 7,019 | | 62 | % | $ 1,654 | | 29 | % | $ 3,928 | | 94 | % |
31-60 days | | 4,038 | | 14 | % | 725 | | 10 | % | 2,196 | | 19 | % | 960 | | 17 | % | 157 | | 4 | % |
61-90 days | | 1,836 | | 6 | % | 468 | | 6 | % | 636 | | 6 | % | 682 | | 12 | % | 50 | | 1 | % |
91-120 days | | 1,460 | | 5 | % | 291 | | 4 | % | 534 | | 5 | % | 614 | | 11 | % | 21 | | 1 | % |
121-150 days | | 1,074 | | 4 | % | 192 | | 3 | % | 548 | | 5 | % | 323 | | 6 | % | 11 | | 0 | % |
Greater than 150 days** | | 4,300 | | 15 | % | 2,412 | | 33 | % | 380 | | 3 | % | 1,506 | | 25 | % | 2 | | 0 | % |
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Totals | | $ 28,587 | | 100 | % | $ 7,366 | | 100 | % | $ 11,313 | | 100 | % | $ 5,739 | | 100 | % | $ 4,169 | | 100 | % |
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* | Total includes $2,398 fully reserved over 210 days as of October 31, 2008. |
** | Total includes $2,796 fully reserved over 210 days as of July 31, 2008. |
Income Taxes
The Company accounts for income taxes under the liability method of accounting for income taxes. Under the liability method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases. The liability method requires that any tax benefits recognized for net operating loss carry forwards and other items be reduced by a valuation allowance where it is not more likely than not the benefits will be realized in the foreseeable future.
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Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. Under the liability method, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date.
On August 1, 2007, the Company adopted Financial Accounting Standards Board (“FASB”) Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109” (FIN 48). FIN 48 prescribes a “more-likely-than-not” threshold for the recognition and derecognition of tax positions, provides guidance on the accounting for interest and penalties relating to tax positions and requires that the cumulative effect of applying the provisions of FIN 48 be reported as an adjustment to the opening balance of retained earnings or other appropriate components of equity or net assets in the statement of financial position. The Company did not have any significant unrecognized tax positions and there was no material effect on our financial condition or results of operations as a result of implementing FIN 48.
Inventory
The Company values inventory at the lower of cost (first-in, first-out) or market. Work-in-process and finished goods inventories consist of material, labor, and manufacturing overhead. On a quarterly basis, we review inventory quantities on hand and analyze the provision for excess and obsolete inventory based on our estimate of sales forecasts based on sales history and anticipated future demand. Our estimate of future product demand may not be accurate and we may understate or overstate the provision for excess and obsolete inventory. Accordingly, unanticipated changes in demand could have a significant impact on the value of our inventory and results of operations. At October 31, 2008 and July 31, 2008, our reserve for excess and obsolete inventory was $691,000 and $637,000, respectively.
Recent Accounting Pronouncements
In April 2008, the FASB issued FSP FAS 142-3, “Determination of the Useful Life of Intangible Assets” (“FSP FAS 142-3”). FSP FAS 142-3 amends the factors that should be considered in developing renewal or extension assumptions used to determine the useful life of a recognized intangible asset under FASB Statement No.142, Goodwill and Other Intangible Assets. FSP FAS 142-3 also requires expanded disclosure related to the determination of intangible asset useful lives. FSP FAS 142-3 is effective for financial statements issued for fiscal years beginning after December 15, 2008, and interim periods within those fiscal years. The Company is currently evaluating the impact that the adoption of FSP FAS 142-3 will have on its consolidated results of operations, cash flows or financial condition.
In December 2007, the FASB issued Statement No. 141 (revised 2007),”Business Combinations” (“SFAS No. 141R”). SFAS No. 141R establishes principles and requirements for how the acquirer in a business combination recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any controlling interest in the business and the goodwill acquired. SFAS No. 141R further requires that acquisition-related costs and costs associated with restructuring or exiting activities of an acquired entity will be expensed as incurred. SFAS No. 141R also establishes disclosure requirements that will require disclosure of the nature and financial effects of the business combination. SFAS No. 141R will impact business combinations for the Company that may be completed on or after August 1, 2009.
In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities - Including an amendment of FASB Statement No. 115.” SFAS No. 159 permits entities to choose to measure many financial instruments and certain other items at fair value that are not currently required to be measured at fair value. The objective of SFAS No. 159 is to provide opportunities to mitigate volatility in reported earnings caused by measuring related assets and liabilities differently without having to apply hedge accounting provisions. SFAS No. 159 also establishes presentation and disclosure requirements designed to facilitate comparisons between companies that choose different measurement attributes for similar types of assets and liabilities. SFAS No. 159 is effective for fiscal years beginning after November 15, 2007. The adoption of SFAS No. 159 did not have a material impact on the Company’s consolidated results of operations or financial condition as we have not elected to apply the provisions to our financial instruments or other eligible items that are not required to be measured at fair value.
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Item 3. Quantitative and Qualitative Disclosures About Market Risk
We are exposed to market risk from changes in foreign currency exchange rates and, to a much lesser extent, interest rates on investments in short-term instruments, that could impact our results of operations and financial position. We do not currently engage in any hedging or market risk management tools. There have been no material changes with respect to market risk previously disclosed in our Annual Report on Form 10-K for our 2008 fiscal year.
Foreign Currency Exchange Rate Risk
The financial reporting of our non-U.S. subsidiaries is denominated in currencies other than the U.S. dollar. Since the functional currency of our non-U.S. subsidiaries is the local currency, foreign currency translation adjustments are accumulated as a component of accumulated other comprehensive income in stockholders’ equity. Assuming a hypothetical aggregate change of 10% in the exchange rates of foreign currencies against the U.S. dollar at October 31, 2008, our assets and liabilities would increase or decrease by $2.1 million and $0.5 million, respectively, and our net sales and net (loss) or earnings would increase or decrease by $1.6 million and $0.2 million, respectively, on an annual basis.
We also maintain intercompany balances and loans receivable with subsidiaries with different local currencies. These amounts are at risk of foreign exchange losses if exchange rates fluctuate. Assuming a hypothetical aggregate change of 10% in the exchange rates of foreign currencies against the U.S. dollar at October 31, 2008, our pre-tax earnings would be favorably or unfavorably impacted by approximately $0.4 million, on an annual basis.
Interest Rate Risk
Our excess cash is invested in highly liquid short term money market funds and short term investments in US Government agency discount notes with high credit ratings. Changes in interest rates may affect the investment income we earn on money market funds and short term investments and therefore affect our cash flows and results of operations. As of October 31, 2008, we were exposed to interest rate change market risk with respect to our money market accounts and short term investments totaling $73.6 million. The money market accounts and short-term investments yield or bear interest rates ranging from 0.86% to 2.5%. Each 100 basis point (or 1%) fluctuation in interest rates will increase or decrease interest income on the money market funds and short-term investments by approximately $0.7 million on an annual basis.
As of October 31, 2008, we did not maintain any fixed or variable interest rate financing.
Item 4. Controls and Procedures
(a) Evaluation of Disclosure Controls and Procedures
As of the end of the period covered by this report, the Company’s management conducted an evaluation (as required under Rules 13a-15(b) and 15d-15(b) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) of the Company’s “disclosure controls and procedures” (as such term is defined under the Exchange Act), under the supervision and with the participation of the principal executive officer and the principal financial officer. Based on this evaluation, the principal executive officer and the principal financial officer concluded that the Company’s disclosure controls and procedures are effective as of the end of the period covered by this report. Notwithstanding the foregoing, a control system, no matter how well designed and operated can provide only reasonable, not absolute, assurance that it will detect or uncover failures within the Company to disclose material information otherwise required to be set forth in the Company’s periodic reports.
(b) Changes in Internal Controls over Financial Reporting
There was no change in the Company’s internal controls over financial reporting during the fiscal quarter covered by this report that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II – OTHER INFORMATION
There have been no material developments with respect to previously reported legal proceedings discussed in the annual report on Form 10-K for the fiscal year ended July 31, 2008 filed with the Securities and Exchange Commission.
There have been no material changes from the risk factors disclosed in Part 1, Item 1, of the Company’s Annual Report on Form 10-K for the fiscal year ended July 31, 2008.
Exhibit No. | | Exhibit | |
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31.1 | | Certification of Elazar Rabbani, Ph.D. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
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31.2 | | Certification of Barry Weiner pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
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32.1 | | Certification of Elazar Rabbani, Ph.D. pursuant to 18 U.S.C. ss. 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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32.2 | | Certification of Barry Weiner pursuant to 18 U.S.C. ss.1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
| | ENZO BIOCHEM, INC. |
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|
| | (Registrant) |
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Date: December 10, 2008 | | by: | /s/ Barry Weiner |
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| | | Chief Financial Officer |
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