UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005.
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND
EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM _________ TO _________.
COMMISSION FILE NO. 0-9036
LANNETT COMPANY, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
STATE OF DELAWARE 23-0787-699
(STATE OF INCORPORATION) (I.R.S. EMPLOYER I.D. NO.)
9000 STATE ROAD
PHILADELPHIA, PA 19136
(215) 333-9000
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES AND TELEPHONE NUMBER)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months
(or for such shorter period that the registrant was required to file such
reports), and (2) has been subject to such filing requirements for the past 90
days.
YES X NO
----- -----
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
YES X NO
----- -----
As of April 26, 2005, there were 24,060,240 shares of the issuer's common stock,
$.001 par value, outstanding.
Page 1 of 42 pages
Exhibit Index on Page 39
INDEX
PAGE NO.
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PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Balance Sheets as of March 31, 2005
(unaudited) and June 30, 2004........................ 3
Consolidated Statements of Operations (unaudited)
for the three and nine months ended March 31, 2005
and 2004............................................. 4
Consolidated Statement of Changes in Shareholders'
Equity (unaudited) for the nine months ended
March 31, 2005....................................... 5
Consolidated Statements of Cash Flows (unaudited) for
the nine months ended March 31, 2005 and 2004........ 6
Notes to Consolidated Financial Statements.............. 7 - 21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.................. 22 - 34
ITEM 4. CONTROLS AND PROCEDURES................................. 35
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS....................................... 36
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K........................ 37
2
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
LANNETT COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED BALANCE SHEETS
(UNAUDITED)
3/31/05 6/30/04
------------ ------------
ASSETS
CURRENT ASSETS:
Cash $ 10,786,863 $ 8,966,954
Trade accounts receivable (net of allowance for doubtful
accounts of $388,000 and $260,000, respectively) 8,663,377 24,240,887
Inventories 17,923,955 12,813,250
Prepaid taxes 2,181,155 882,613
Other current assets 1,172,315 1,016,050
Deferred tax asset 941,069 942,689
------------ ------------
Total current assets 41,668,734 48,862,443
------------ ------------
PROPERTY, PLANT AND EQUIPMENT 23,571,497 15,259,693
Less accumulated depreciation (6,974,367) (5,666,798)
------------ ------------
16,597,130 9,592,895
INVESTMENT SECURITIES - Available-for-sale 5,944,077 --
DEFERRED TAX ASSET 18,634,013 166,332
INTANGIBLE ASSET, net of accumulated amortization 16,062,002 65,725,490
CONSTRUCTION IN PROGRESS 1,919,674 7,352,821
OTHER ASSETS 187,710 204,103
------------ ------------
TOTAL ASSETS $101,013,340 $131,904,084
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES:
Current portion of long-term debt $ 2,352,259 $ 1,988,716
Accounts payable 701,675 5,640,054
Rebates and chargebacks payable 10,075,000 8,885,000
Accrued expenses 3,100,430 3,424,859
------------ ------------
Total current liabilities 16,229,364 19,938,629
------------ ------------
LONG-TERM DEBT, LESS CURRENT PORTION 7,744,206 8,104,141
UNEARNED GRANT FUNDS 500,000 --
DEFERRED TAX LIABILITY 1,614,323 1,614,323
SHAREHOLDERS' EQUITY:
Common stock - authorized 50,000,000 shares, par value $.001;
issued 24,104,256 shares and 24,074,710 shares, respectively 24,104 24,075
Additional paid-in capital 70,125,755 69,955,855
Retained earnings 5,213,309 32,267,061
Accumulated other comprehensive loss (43,151) --
------------ ------------
75,320,017 102,246,991
Treasury stock at cost - 50,900 shares and 0 shares, respectively (394,570) --
------------ ------------
Total shareholders' equity 74,925,447 102,246,991
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $101,013,340 $131,904,084
============ ============
The accompanying notes to consolidated financial statements are an integral
part of these statements.
3
LANNETT COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
-------------------------- --------------------------
3/31/05 3/31/04 3/31/05 3/31/04
------------ ----------- ------------ -----------
NET SALES $ 7,603,189 $16,000,251 $ 35,533,206 $45,795,638
COST OF SALES 4,266,839 6,947,195 18,973,152 18,405,293
------------ ----------- ------------ -----------
Gross profit 3,336,350 9,053,056 16,560,054 27,390,345
RESEARCH AND DEVELOPMENT EXPENSES 1,172,853 1,361,681 3,521,507 3,500,759
SELLING, GENERAL AND
ADMINISTRATIVE EXPENSES 2,930,801 2,276,780 6,817,487 6,179,980
AMORTIZATION EXPENSE 1,690,083 -- 5,070,251 --
IMPAIRMENT LOSS ON INTANGIBLE ASSET 46,093,236 -- 46,093,236 --
------------ ----------- ------------ -----------
Operating (loss) income (48,550,623) 5,414,595 (44,942,427) 17,709,606
------------ ----------- ------------ -----------
OTHER INCOME (EXPENSE):
Realized loss on sale of investment securities (871) -- (1,466) --
Interest expense (96,373) (5,320) (245,056) (19,830)
Interest income 50,584 6,952 99,361 23,750
------------ ----------- ------------ -----------
(46,660) 1,632 (147,161) 3,920
------------ ----------- ------------ -----------
(LOSS) INCOME BEFORE TAXES (48,597,283) 5,416,227 (45,089,588) 17,713,526
INCOME TAX (BENEFIT) EXPENSE (19,438,913) 2,217,829 (18,035,836) 7,258,196
------------ ----------- ------------ -----------
NET (LOSS) INCOME $(29,158,370) $ 3,198,398 $(27,053,752) $10,455,330
============ =========== ============ ===========
BASIC (LOSS) EARNINGS PER SHARE $ (1.21) $ 0.16 $ (1.12) $ 0.52
DILUTED (LOSS) EARNINGS PER SHARE $ (1.21) $ 0.16 $ (1.12) $ 0.52
BASIC WEIGHTED AVERAGE
NUMBER OF SHARES 24,103,256 20,058,753 24,092,958 20,049,647
DILUTED WEIGHTED AVERAGE
NUMBER OF SHARES 24,103,256 20,265,833 24,092,958 20,263,146
The accompanying notes to consolidated financial statements
are an integral part of these statements.
4
LANNETT COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS' EQUITY
(UNAUDITED)
COMMON STOCK ADDITIONAL TOTAL
------------------- PAID-IN RETAINED TREASURY ACCUMULATED OTHER SHAREHOLDERS'
SHARES AMOUNT CAPITAL EARNINGS STOCK COMPREHENSIVE LOSS EQUITY
---------- ------- ----------- ------------ --------- ------------------ -------------
BALANCE AT JUNE 30, 2004 24,074,710 $24,075 $69,955,855 $ 32,267,061 $ -- $ -- $102,246,991
Exercise of stock options 18,001 18 60,050 60,068
Shares issued in connection
with employee stock purchase plan 11,545 11 109,850 109,861
Purchase of treasury stock (394,570) (394,570)
Unrealized net losses on investment
securities, net of tax (43,151) (43,151)
Net Loss (27,053,752) (27,053,752)
---------- ------- ----------- ------------ --------- -------- ------------
BALANCE AT MARCH 31, 2005 24,104,256 $24,104 $70,125,755 $ 5,213,309 $(394,570) $(43,151) $ 74,925,447
========== ======= =========== ============ ========= ======== ============
The accompanying notes to consolidated financial statements
are an integral part of these statements.
5
LANNETT COMPANY, INC. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE NINE MONTHS ENDED
--------------------------
3/31/05 3/31/04
------------ -----------
OPERATING ACTIVITIES:
Net (loss) income $(27,053,752) $10,455,330
Adjustments to reconcile net (loss) income to net cash
provided by operating activities:
Depreciation 1,307,569 815,067
Amortization 5,070,251 --
Impairment loss on intangible asset 46,093,236 --
Decrease and (increase) in trade accounts receivable 15,577,510 (4,856,022)
Increase in inventories (5,110,706) (2,136,559)
Increase in prepaid taxes (1,298,542) --
Increase in other current assets (139,871) (90,909)
Increase in deferred tax assets (18,466,061)
Decrease in accounts payable (4,938,378) (769,403)
Increase in rebates and chargebacks payable 1,190,000 1,028,313
(Decrease) and increase in accrued expenses (1,824,429) 1,281,052
Increase in income taxes payable -- 590,498
------------ -----------
Net cash provided by operating activities 10,406,827 6,317,367
------------ -----------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment (including construction in progress) (2,878,657) (6,624,489)
Deposits paid on machinery or building additions not placed in service -- (341,400)
Purchase of investment securities - available-for-sale (5,987,228) --
------------ -----------
Net cash used in investing activities (8,865,885) (6,965,889)
------------ -----------
FINANCING ACTIVITIES:
Proceeds from debt financing 1,602,608 5,355,574
Proceeds from grant funding 500,000 --
Repayments of debt (1,599,000) (674,589)
Proceeds from issuance of stock 169,929 358,216
Purchase of treasury stock (394,570) --
------------ -----------
Net cash provided by financing activities 278,967 5,039,201
------------ -----------
NET INCREASE IN CASH 1,819,909 4,390,679
CASH, BEGINNING OF YEAR 8,966,954 3,528,511
------------ -----------
CASH, END OF PERIOD $ 10,786,863 $ 7,919,190
============ ===========
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Interest paid during period $ 245,055 $ 28,999
Income taxes paid during period $ 1,700,000 $ 6,667,698
The accompanying notes to consolidated financial statements
are an integral part of these statements.
6
LANNETT COMPANY, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED
NOTE 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Lannett Company, Inc. and subsidiaries (the "Company"), a Delaware corporation,
develops, manufactures, packages, markets and distributes pharmaceutical
products sold under generic chemical names.
The Company is engaged in an industry which is subject to considerable
government regulation related to the development, manufacturing and marketing of
pharmaceutical products. In the normal course of business, the Company
periodically responds to inquiries or engages in administrative and judicial
proceedings involving regulatory authorities, particularly the Food and Drug
Administration (FDA) and the Drug Enforcement Agency (DEA).
PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the
accounts of the operating parent company, Lannett Company, Inc., its wholly
owned subsidiary, Lannett Holdings, Inc., and its inactive wholly owned
subsidiary, Astrochem Corporation. All intercompany accounts and transactions
have been eliminated.
RECLASSIFICATIONS - Certain reclassifications have been made to the prior year's
financial information to conform to the March 31, 2005 presentation.
REVENUE RECOGNITION - The Company recognizes revenue when its products are
shipped. At this point, title and risk of loss have transferred to the customer
and provisions for estimates, including rebates, promotional adjustments, price
adjustments, returns, chargebacks, and other potential adjustments are
reasonably determinable. Accruals for these provisions are presented in the
consolidated financial statements as rebates and chargebacks payable and
reductions to net sales. The change in the reserves for various sales
adjustments may not be proportionally equal to the change in sales because of
changes in both the product and the customer mix. Increased sales to wholesalers
will generally require additional rebates. Incentives offered to secure sales
vary from product to product. Provisions for estimated rebates and promotional
and other credits are estimated based on historical payment experience,
estimated customer inventory levels, and contract terms. Provisions for other
customer credits, such as price adjustments, returns, and chargebacks require
management to make subjective judgments. Unlike branded innovator companies,
Lannett does not use information about product levels in distribution channels
from third-party sources, such as IMS Health and NDC Health, in estimating
future returns and other credits.
CHARGEBACKS - The provision for chargebacks is the most significant and complex
estimate used in the recognition of revenue. The Company sells its products
directly to wholesale distributors, generic distributors, retail pharmacy chains
and mail-order pharmacies. The Company also sells its products indirectly to
independent pharmacies, managed care organizations, hospitals, nursing homes,
and group purchasing organizations, collectively referred to as "indirect
customers." Lannett enters into agreements with its indirect customers to
establish pricing for certain products. The indirect customers then
independently select a wholesaler from which to actually purchase the products
at these agreed-upon prices. Lannett will provide credit to the wholesaler for
the difference between the agreed-upon price with the indirect customer and the
wholesaler's invoice price if the price sold to the indirect customer is lower
than the direct price to the wholesaler. This credit is called a chargeback. The
provision for chargebacks is based on expected sell-through levels by the
Company's wholesale customers to the indirect customers, and estimated
wholesaler inventory levels. As sales to the large wholesale customers, such as
Cardinal Health, AmerisourceBergen, and McKesson, increase, the reserve for
chargebacks will also generally increase. However, the size of the increase
depends on the product mix. The Company
7
continually monitors the reserve for chargebacks and makes adjustments when
management believes that actual chargebacks may differ from estimated reserves.
REBATES - Rebates are offered to the Company's key customers to promote customer
loyalty and encourage greater product sales. These rebate programs provide
customers with rebate credits upon attainment of pre-established volumes or
attainment of net sales milestones for a specified period. Other promotional
programs are incentive programs offered to the customers. At the time of
shipment, the Company estimates reserves for rebates and other promotional
credit programs based on the specific terms in each agreement. The reserve for
rebates increases as sales to certain wholesale and retail customers increase.
However, these rebate programs are tailored to the customers' individual
programs. Hence, the reserve will depend on the mix of customers that comprise
such rebate programs.
RETURNS - Consistent with industry practice, the Company has a product returns
policy that allows select customers to return product within a specified period
prior to and subsequent to the product's lot expiration date in exchange for a
credit to be applied to future purchases. The Company's policy requires that the
customer obtain pre-approval from the Company for any qualifying return. The
Company estimates its provision for returns based on historical experience,
changes to business practices, and credit terms. While such experience has
allowed for reasonable estimations in the past, history may not always be an
accurate indicator of future returns. The Company continually monitors the
provisions for returns and makes adjustments when management believes that
actual product returns may differ from established reserves. Generally, the
reserve for returns increases as net sales increase. The reserve for returns is
included in the rebates and chargebacks payable account on the balance sheet.
OTHER ADJUSTMENTS - Other adjustments consist primarily of price adjustments,
also known as "shelf stock adjustments," which are credits issued to reflect
decreases in the selling prices of the Company's products that customers have
remaining in their inventories at the time of the price reduction. Decreases in
selling prices are discretionary decisions made by management to reflect
competitive market conditions. Amounts recorded for estimated shelf stock
adjustments are based upon specified terms with direct customers, estimated
declines in market prices, and estimates of inventory held by customers. The
Company regularly monitors these and other factors and evaluates the reserve as
additional information becomes available. Other adjustments are included in the
rebates and chargebacks payable account on the balance sheet.
8
The following tables identify the reserves for each major category of revenue
allowance and a summary of the activity for the nine months ended March 31, 2005
and 2004:
FOR THE NINE MONTHS ENDED
MARCH 31, 2005
Reserve Category Chargebacks Rebates Returns Other Total
- ---------------- ----------- ----------- --------- --------- ------------
Reserve Balance as of
June 30, 2004 $ 6,484,500 $ 1,864,200 $ 448,000 $ 88,300 $ 8,885,000
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2004 (4,966,500) (1,936,500) (408,400) (87,000) (7,398,400)
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2005 (8,494,900) (4,455,300) (736,500) (425,800) (14,112,500)
Additional Reserves Charged to
Net Sales During Fiscal 2005 14,559,400 6,696,800 971,900 472,800 22,700,900
----------- ----------- --------- --------- ------------
Reserve Balance as of
March 31, 2005 $ 7,582,500 $ 2,169,200 $ 275,000 $ 48,300 $ 10,075,000
=========== =========== ========= ========= ============
FOR THE NINE MONTHS ENDED
MARCH 31, 2004
Reserve Category Chargebacks Rebates Returns Other Total
- ---------------- ------------ ----------- --------- --------- ------------
Reserve Balance as of
June 30, 2003 $ 1,638,000 $ 889,900 $ 210,200 $ 33,900 $ 2,772,000
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2003 (1,604,000) (1,166,400) (182,700) -- (2,953,100)
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2004 (9,516,200) (1,749,800) -- (410,000) (11,676,000)
Additional Reserves Charged to
Net Sales During Fiscal 2004 11,663,300 3,309,400 258,200 426,200 15,657,100
------------ ----------- --------- --------- ------------
Reserve Balance as of
March 31, 2004 $ 2,181,100 $ 1,283,100 $ 285,700 $ 50,100 $ 3,800,000
============ =========== ========= ========= ============
The Company ships its products to the warehouses of its wholesale and retail
chain customers. When the Company and a customer come to an agreement for the
supply of a product, the customer will generally continue to purchase the
product, stock its warehouse(s), and resell the product to its own customers.
The Company's customer will continually reorder the product as its warehouse is
depleted. The Company generally has no minimum size orders for its customers.
Additionally, most warehousing customers prefer not to stock excess inventory
levels due to the additional carrying costs and inefficiencies created by
holding excess inventory. As such, the Company's customers continually reorder
the Company's products. It is common for the Company's
9
customers to order the same products on a monthly basis. For generic
pharmaceutical manufacturers, it is critical to ensure that customers'
warehouses are adequately stocked with its products. This is important due to
the fact that several generic competitors compete for the consumer demand for a
given product. Availability of inventory ensures that a manufacturer's product
is considered. Otherwise, retail prescriptions would be filled with competitors'
products. For this reason, the Company periodically offers incentives to its
customers to purchase its products. These incentives are generally up-front
discounts off its standard prices at the beginning of a generic campaign launch
for a newly-approved or newly-introduced product, or when a customer purchases a
Lannett product for the first time. Customers generally inform the Company that
such purchases represent an estimate of expected resales for a period of time.
This period of time is generally up to three months. The Company records this
revenue, net of any discounts offered and accepted by its customers at the time
of shipment. The Company's products have either 24 months or 36 months of
shelf-life at the time of manufacture. The Company monitors its customers'
purchasing trends to attempt to identify any significant lapses in purchasing
activity. If the Company observes a lack of recent activity, inquiries will be
made to such customer regarding the success of the customer's resale efforts.
The Company attempts to minimize any potential return (or shelf life issues) by
maintaining an active dialogue with the customers.
The products that the Company sells are generic versions of brand named drugs.
The consumer markets for such drugs are well-established markets with many years
of historically-confirmed consumer demand. Such consumer demand may be affected
by several factors, including alternative treatments, cost, etc. However, the
effects of changes in such consumer demand for the Company's products, like
generic products manufactured by other generic companies, are gradual in nature.
Any overall decrease in consumer demand for generic products generally occurs
over an extended period of time. This is because there are thousands of doctors,
prescribers, third-party payers, institutional formularies and other buyers of
drugs that must change prescribing habits and medicinal practices before such a
decrease would affect a generic drug market. If the historical data the Company
uses and the assumptions management makes to calculate its estimates of future
returns, chargebacks, and other credits do not accurately approximate future
activity, its net sales, gross profit, net income and earnings per share could
change. However, management believes that these estimates are reasonable based
upon historical experience and current conditions.
ACCOUNTS RECEIVABLE - The Company performs ongoing credit evaluations of its
customers and adjusts credit limits based upon payment history and the
customer's current credit worthiness, as determined by a review of current
credit information. The Company continuously monitors collections and payments
from its customers and maintains a provision for estimated credit losses based
upon historical experience and any specific customer collection issues that have
been identified. While such credit losses have historically been within the both
Company's expectations and the provisions established, the Company cannot
guarantee that it will continue to experience the same credit loss rates that it
has in the past.
INVENTORIES - The Company values its inventory at the lower of cost (determined
by the first-in, first-out method) or market, regularly reviews inventory
quantities on hand, and records a provision for excess and obsolete inventory
based primarily on estimated forecasts of product demand and production
requirements. The Company's estimates of future product demand may prove to be
inaccurate, in which case it may have understated or overstated the provision
required for excess and obsolete inventory. In the future, if the Company's
inventory is determined to be overvalued, the Company would be required to
recognize such costs in cost of goods sold at the time of such determination.
Likewise, if inventory is determined to be undervalued, the Company may have
recognized excess cost of goods sold in previous periods and would be required
to recognize such additional operating income at the time of sale.
PROPERTY, PLANT AND EQUIPMENT - Property, plant and equipment are stated at
cost. Depreciation is provided for by the straight-line and accelerated methods
over estimated useful lives of the assets. Depreciation expense for the three
months ended March 31, 2005 and 2004 was approximately $473,000 and $278,000,
respectively.
10
Depreciation expense for the nine months ended March 31, 2005 and 2004 was
approximately $1,308,000 and $815,000, respectively. Construction in-progress
has been capitalized and depreciation has commenced as a result of the start of
operations at the 9001 Torresdale Avenue facility.
INVESTMENT SECURITIES - The Company's investment securities consist of
marketable debt securities, primarily in U.S. government and agency obligations.
All of the Company's marketable debt securities are classified as
available-for-sale and recorded at fair value, based on quoted market prices.
Unrealized holding gains and losses are recorded, net of any tax effect, as a
separate component of accumulated other comprehensive income. No gains or losses
on marketable debt securities are realized until they are sold or a decline in
fair value is determined to be other-than-temporary. If a decline in fair value
is determined to be other-than-temporary, an impairment charge is recorded and a
new cost basis in the investment is established. There were no securities
determined by management to be other-than-temporarily impaired for the nine
month period ended March 31, 2005.
DEFERRED DEBT ACQUISITION COSTS - Costs incurred in connection with obtaining
financing are amortized by the straight-line method over the term of the loan
arrangements. Amortization expense for debt acquisition costs for the three
months ended March 31, 2005 and 2004 was approximately $5,500 and $2,800,
respectively. Amortization expense for debt acquisition costs for the nine
months ended March 31, 2005 and 2004 was approximately $16,000 and $8,000,
respectively.
SHIPPING AND HANDLING COSTS - The cost of shipping products to customers is
recognized at the time the products are shipped, and is included in COST OF
SALES.
RESEARCH AND DEVELOPMENT - Research and development expenses are charged to
operations as incurred.
INTANGIBLE ASSETS - On March 23, 2004, the Company entered into an agreement
with Jerome Stevens Pharmaceuticals, Inc. (JSP) for the exclusive marketing and
distribution rights in the United States to the current line of JSP products in
exchange for four million (4,000,000) shares of the Company's common stock. As a
result of the JSP agreement, the Company recorded an intangible asset of
$67,040,000 for the exclusive marketing and distribution rights obtained from
JSP. The intangible asset was recorded based upon the fair value of the four
million (4,000,000) shares at the time of issuance to JSP. The agreement was
included as an Exhibit in the Current Report on Form 8-K filed by the Company on
May 5, 2004, as subsequently amended.
In June 2004, JSP's Levothyroxine Sodium tablet product received from the FDA an
AB rating to the brand drug Levoxyl(R). In December 2004, the product received
from the FDA a second AB rating to the brand drug Synthroid(R). As a result of
the dual AB ratings, the Company is required to pay JSP an additional $1.5
million in cash to reimburse JSP for expenses related to obtaining the AB
ratings. As of March 31, 2005, the Company has recorded an addition to the
intangible asset of $1.5 million. Since payment has not yet been made to JSP,
the amount due is shown as an accrued expense on the balance sheet.
Management believed that events (as described below) occurred which indicated
that the carrying value of the intangible asset was not recoverable. In
accordance with Statement of Financial Accounting Standards No. 144 (FAS 144),
Accounting for the Impairment or Disposal of Long-Lived Assets, the Company
engaged a third party valuation specialist to assist in the performance of an
impairment test for the quarter ended March 31, 2005. The impairment test was
performed by discounting forecasted future net cash flows for the JSP products
covered under the agreement and then comparing the discounted present value of
those cash flows to the carrying value of the asset (inclusive of the $1.5
million payable to JSP for the second AB rating). As a result of the testing,
the Company has determined that the intangible asset was impaired as of March
31, 2005. In accordance with FAS 144, the Company recorded a non-cash impairment
loss of approximately $46,093,000 to write the asset down to
11
its fair value of approximately $16,062,000 as of March 31, 2005. This
impairment loss is shown on the statement of operations as a component of
operating loss.
Management believes that several factors contributed to the impairment of this
asset. In December 2004, the Levothyroxine Sodium tablet product received the AB
rating to Synthroid(R). The expected sales increase as a result of the AB rating
did not occur in the third quarter of 2005. The delay in receiving the AB rating
to Synthroid(R), caused the Company to be competitively disadvantaged with its
Levothyroxine Sodium tablet product and to lose market share to competitors
whose products had already received AB ratings to both major brand thyroid
deficiency drugs. Additionally, the generic market for thyroid deficiency drugs
turned out to be smaller than it was anticipated to be as a result of a lower
brand-to-generic substitution rate. Increased competition in the generic drug
market, both from existing competitors and new entrants, has resulted in
significant pricing pressure on other products supplied by JSP. The combination
of these factors has resulted in diminished forecasted future net cash flows
which, when discounted, yield a lower present value than the carrying value of
the asset before impairment.
For the remaining nine years of the contract, the Company will incur annual
amortization expense of approximately $1,785,000. Amortization expense for the
three months ended March 31, 2005 and 2004 was approximately $1,690,000 and $0,
respectively. Amortization expense for the nine months ended March 31, 2005 and
2004 was approximately $5,070,000 and $0, respectively.
ADVERTISING COSTS - The Company charges advertising costs to operations as
incurred. Advertising expense for the three months ended March 31, 2005 and 2004
was approximately $16,000 and $68,000, respectively. Advertising expense for the
nine months ended March 31, 2005 and 2004 was approximately $123,000 and
$204,000, respectively.
INCOME TAXES - The Company uses the liability method specified by Statement of
Financial Accounting Standards (SFAS) No. 109, Accounting for Income Taxes.
Deferred tax assets and liabilities are determined based on the difference
between the financial statement and tax bases of assets and liabilities as
measured by the enacted tax rates which will be in effect when these differences
reverse. Deferred tax expense/(benefit) is the result of changes in deferred tax
assets and liabilities.
SEGMENT INFORMATION - The Company reports segment information in accordance with
SFAS No. 131, Disclosures about Segments of an Enterprise and Related
Information. The Company operates one business segment - generic
pharmaceuticals. In accordance with SFAS No. 131, the Company aggregates its
financial information for all products, and reports on one operating segment.
The Company's products contain various active pharmaceutical ingredients aimed
at treating a diverse range of medical indications. The following table
identifies the Company's approximate net product sales by medical indication for
the three and nine months ended March 31, 2005 and 2004:
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
-------------------------- -------------------------
MEDICAL INDICATION 3/31/05 3/31/04 3/31/05 3/31/04
- ------------------ ---------- ----------- ----------- -----------
Migraine Headache $2,721,000 $ 4,909,000 $ 9,191,000 $12,808,000
Epilepsy 2,026,000 5,083,000 10,900,000 13,832,000
Heart Failure 702,000 2,176,000 3,910,000 6,353,000
Thyroid Deficiency 1,607,000 3,323,000 9,708,000 11,260,000
Other 547,000 509,000 1,824,000 1,543,000
---------- ----------- ----------- -----------
Total $7,603,000 $16,000,000 $35,533,000 $45,796,000
========== =========== =========== ===========
12
CONCENTRATION OF MARKET AND CREDIT RISK - Five of the Company's products,
defined as generics containing the same active ingredient or combination of
ingredients, accounted for approximately 30%, 37%, 9%, 16%, and 5%,
respectively, of net sales for the three months ended March 31, 2005. The same
five products accounted for 32%, 31%, 14%, 13%, and 8%, respectively, of net
sales for the three months ended March 31, 2004; 33%, 27%, 12%, 24% and 5%,
respectively, of net sales for the nine months ended March 31, 2005; and 31%,
29%, 14%, 18%, and 7%, respectively, of net sales for the nine months ended
March 31, 2004.
Credit terms are offered to customers based on evaluations of the customers'
financial condition. Generally, collateral is not required from customers.
Accounts receivable payment terms vary and are stated in the financial
statements at amounts due from customers net of an allowance for doubtful
accounts. Accounts outstanding longer than the payment terms are considered past
due. The Company determines its allowance by considering a number of factors,
including the length of time trade accounts receivable are past due, the
Company's previous loss history, the customer's current ability to pay its
obligation to the Company, and the condition of the general economy and the
industry as a whole. The Company writes-off accounts receivable when they become
uncollectible, and payments subsequently received on such receivables are
credited to the allowance for doubtful accounts.
STOCK OPTIONS - At March 31, 2005, the Company had two stock-based employee
compensation plans. The Company accounts for stock options under FAS 123,
Accounting for Stock-Based Compensation, as amended by FAS 148. Under this
statement, companies may use a fair value-based method for valuing stock-based
compensation, which measures compensation cost at the grant date, based on the
fair value of the award. Compensation is then recognized over the service
period, which is usually the vesting period. Alternatively, FAS 123 permits
entities to continue accounting for employee stock options and similar equity
instruments under Accounting Principles Board (APB) Opinion No. 25, Accounting
for Stock Issued to Employees. Entities that continue to account for stock
options using APB 25 are required to make pro forma disclosures of net income
and earnings per share, as if the fair value-based method of accounting defined
in FAS 123 had been applied. The following table illustrates the effect on net
income and earnings per share if the Company had applied the fair value
recognition provisions of FAS 123 to stock-based employee compensation:
THREE MONTHS ENDED NINE MONTHS ENDED
-------------------------- ---------------------------
3/31/05 3/31/04 3/31/05 3/31/04
------------- ---------- ------------- -----------
Net (loss) income, as reported ($29,158,370) $3,198,398 ($27,053,752) $10,455,330
Deduct: Total compensation expense
determined under fair value based
method for all stock awards (584,146) (307,847) (2,407,795)* (842,186)
Add: Tax savings at effective rate 233,658 126,091 963,118 345,120
------------- ---------- ------------- -----------
Pro forma net (loss) income ($29,508,858) $3,016,642 ($28,498,429) $ 9,958,264
============= ========== ============= ===========
(Loss) Earnings per share:
Basic, as reported $ (1.21) $ .16 $ (1.12) $ .52
Basic, pro forma $ (1.22) $ .15 $ (1.18) $ .50
Diluted, as reported $ (1.21) $ .16 $ (1.12) $ .52
Diluted, pro forma $ (1.22) $ .15 $ (1.18) $ .49
* Options compensation expense increased by $996,862 in the three months
ended December 31, 2004 due to the accelerated vesting of options resulting
from the separation agreement of Larry Dalesandro, the former Chief
Financial Officer.
13
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes options pricing model with the following weighted average
assumptions used for grants in Fiscal 2005 and 2004: expected volatility of
37.5% and 41.8% for 2005 and 53.1% for 2004; risk-free interest rate ranging
between 4.19% and 4.52% for 2005 and ranging between 4.47% and 4.52% for 2004;
and expected lives of 10 years.
In December 2004, the FASB revised FAS 123, Accounting for Stock-Based
Compensation. This Statement supersedes APB 25, Accounting for Stock Issued to
Employees and its related implementation guidance and eliminates the alternative
to use APB 25's intrinsic value method of accounting that was provided in FAS
123 as originally issued. Under APB 25, issuing stock options to employees
generally resulted in recognition of no compensation cost. FAS 123 (revised)
requires entities to recognize the cost of employee services received in
exchange for awards of equity instruments based on the grant-date fair value of
those awards. That cost will be recognized over the period during which an
employee is required to provide service in exchange for the award - the
requisite service period (usually the vesting period). The Company plans to
adopt FAS 123 for the quarter ended September 30, 2005.
UNEARNED GRANT FUNDS - The Company records all grant funds received as a
liability until the Company fulfills all the requirements of the grant funding
program.
USE OF ESTIMATES - The preparation of financial statements in conformity with
accounting principles generally accepted in the United States of America
requires management to make estimates and assumptions that affect the reported
amounts of assets and liabilities and disclosure of contingent assets and
liabilities at the date of the financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ
from those estimates.
In the opinion of management, the accompanying unaudited consolidated financial
statements contain all adjustments (consisting of only normal recurring
adjustments) necessary to present fairly the financial position and the results
of operations and cash flows. The results of operations for the three and nine
month periods ended March 31, 2005 and 2004 are not necessarily indicative of
results for the full year. While management believes that the disclosures
presented are adequate to make the information not misleading, it is suggested
that these consolidated financial statements be read in conjunction with the
consolidated financial statements and the notes included in the Company's Annual
Report on Form 10-K for the year ended June 30, 2004.
NOTE 2. NEW ACCOUNTING STANDARDS
In November 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 151, Inventory Costs - an
amendment of ARB No. 43, Chapter 4 (FAS 151). Paragraph 5 of ARB 43, Chapter 4
previously stated that "...under some circumstances, items such as idle facility
expense, excessive spoilage, double freight, and rehandling costs may be so
abnormal as to require treatment as current period charges..." FAS 151 requires
that those items be recognized as current period charges regardless of whether
they meet the criterion of "so abnormal." The adoption of FAS 151 did not have a
material effect on the Company's consolidated financial position, results of
operations, or cash flows.
NOTE 3. INVENTORIES
Inventories consist of the following:
March 31, June 30,
2005 2004
----------- -----------
(unaudited)
Raw materials $ 5,905,749 $ 4,195,255
Work-in-process 1,909,189 626,647
Finished goods 9,902,682 7,854,975
Packaging supplies 206,335 136,373
----------- -----------
$17,923,955 $12,813,250
=========== ===========
14
The preceding amounts are net of inventory reserves of $1,200,000 and $515,000
at March 31, 2005 and June 30, 2004, respectively.
NOTE 4. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following:
March 31, June 30,
Useful Lives 2005 2004
------------- ----------- -----------
Land -- $ 233,414 $ 33,414
Building and improvements 10 - 39 years 9,631,070 3,526,003
Machinery and equipment 5 - 10 years 12,879,785 11,504,877
Furniture and fixtures 5 - 7 years 827,228 195,399
----------- -----------
$23,571,497 $15,259,693
=========== ===========
NOTE 5. INVESTMENT SECURITIES - AVAILABLE-FOR-SALE
The amortized cost, gross unrealized gains and losses, and fair value of the
Company's available-for-sale securities as of March 31, 2005 are summarized as
follows (there were no investment securities as of March 31, 2004):
March 31, 2005
Available-for-Sale
------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
---------- ---------- ---------- ----------
U.S. Government Agency $4,622,268 $ 33 $(56,726) $4,565,575
Mortgage-Backed Securities 384,659 -- (7,870) 376,789
Asset-Backed Securities 1,009,068 665 (8,020) 1,001,713
---------- ---- -------- ----------
$6,015,995 $698 $(72,616) $5,944,077
========== ==== ======== ==========
The amortized cost and fair value of the Company's current available-for-sale
securities by contractual maturity at March 31, 2005 are summarized as follows:
March 31, 2005
Available for Sale
-----------------------
Amortized Fair
Cost Value
---------- ----------
Due in one year or less $ -- $ --
Due after one year through five years 2,955,161 2,922,784
Due after five years through ten years 837,668 830,033
Due after ten years 2,223,166 2,191,260
---------- ----------
$6,015,995 $5,944,077
========== ==========
The Company uses the specific identification method to determine the cost of
securities sold. For the three months ended March 31, 2005, the Company had
realized losses of $871. For the nine months ended March 31, 2005, the Company
had realized losses of $1,467. There were no realized losses for the three or
nine months ended March 31, 2004.
15
There were no securities held from a single issuer that represented more than
10% of shareholders' equity.
The Company adopted Emerging Issues Task Force (EITF) Issue No. 03-1, The
Meaning of Other than Temporary Impairment and Its Application to Certain
Investments as of June 30, 2004. EITF 03-1 includes certain disclosures
regarding quantitative and qualitative disclosures for investment securities
accounted for under FAS 115, Accounting for Certain Investments in Debt and
Equity Securities that are impaired at the balance sheet date, but an other-than
temporary impairment has not been recognized. The disclosures under EITF 03-1
are required for financial statements for years ending after December 15, 2003
and are included in these financial statements.
The table below indicates the length of time individual securities have been in
a continuous unrealized loss position as of March 31, 2005:
Less than 12 months 12 months or longer Total
----------------------- ------------------- -----------------------
Description of Number of Fair Unrealized Fair Unrealized Fair Unrealized
Securities Securities Value Loss Value Loss Value Loss
- -------------------------- ---------- ---------- ---------- ----- ---------- ---------- ----------
U.S. Government Agency 26 $4,483,780 $(56,726) $-- $-- $4,483,780 $(56,726)
Mortgage-Backed Securities 3 376,789 (7,870) -- -- 376,789 (7,870)
Asset-Backed Securities 7 486,080 (8,020) -- -- 486,080 (8,020)
--- ---------- -------- --- --- ---------- --------
Total temporarily
impaired investment
securities 36 $5,346,649 $(72,616) $-- $-- $5,346,649 $(72,616)
=== ========== ======== === === ========== ========
There were no securities determined by management to be other-than-temporarily
impaired for the nine month period ended March 31, 2005.
NOTE 6. BANK LINE OF CREDIT
The Company has a $3,000,000 line of credit from Wachovia Bank, N.A. that bears
interest at the prime interest rate less 0.25% (5.50% at March 31, 2005). The
line of credit was renewed and extended to October 30, 2005. At March 31, 2005
and 2004, the Company had $0 outstanding and $3,000,000 available under the line
of credit. The line of credit is collateralized by substantially all of the
Company's assets. The Company currently has no plans to borrow under this line
of credit
NOTE 7. UNEARNED GRANT FUNDS
In July 2004, the Company received $500,000 of grant funding from the
Commonwealth of Pennsylvania, acting through the Department of Community and
Economic Development. The grant funding program requires the Company to use the
funds for machinery and equipment located at their Pennsylvania locations, hire
an additional 100 full-time employees by June 30, 2006, operate its Pennsylvania
locations a minimum of five years and meet certain matching investment
requirements. If the Company fails to comply with any of the requirements above,
the Company would be liable to repay the full amount of the grant funding
($500,000). The Company records the unearned grant funds as a liability until
the Company complies with all of the requirements of the grant funding program.
On a quarterly basis, the Company will monitor its progress in fulfilling the
requirements of the grant funding program and will determine the status of the
liability. As of March 31, 2005, the Company has recognized the grant funding as
a long term liability under the caption of Unearned Grant Funds.
16
NOTE 8. LONG-TERM DEBT
Long-term debt consists of the following:
March 31, June 30,
2005 2004
----------- -----------
(unaudited)
Tax-exempt Bond Loan $ 1,809,470 $ 2,287,802
Mortgage Loan 2,700,000 2,700,000
Equipment Loan 4,837,000 4,205,055
Construction Loan 749,995 900,000
----------- -----------
$10,096,465 $10,092,857
Less current portion 2,352,259 1,988,716
----------- -----------
$ 7,744,206 $ 8,104,141
=========== ===========
In April 1999, the Company entered into a loan agreement (the "Agreement") with
a governmental authority, the Philadelphia Authority for Industrial Development
(the "Authority"), to finance future construction and growth projects of the
Company. The Authority issued $3,700,000 in tax-exempt variable rate demand and
fixed rate revenue bonds to provide the funds to finance such growth projects
pursuant to a trust indenture ("the Trust Indenture"). A portion of the
Company's proceeds from the bonds was used to pay for bond issuance costs of
approximately $170,000. The Trust Indenture requires that the Company repay the
Authority loan through installment payments beginning in May 2003 and continuing
through May 2014, the year the bonds mature. The bonds bear interest at the
floating variable rate determined by the organization responsible for selling
the bonds (the "remarketing agent"). The interest rate fluctuates on a weekly
basis. The effective interest rate at March 31, 2005 was 2.44%. At March 31,
2005, the Company has $1,809,470 outstanding on the Authority loan, of which
$655,000 is classified as currently due. The remainder is classified as a
long-term liability. In April 1999, an irrevocable letter of credit of
$3,770,000 was issued by Wachovia Bank, National Association (Wachovia) to
secure payment of the Authority Loan and a portion of the related accrued
interest. At March 31, 2005, no portion of the letter of credit has been
utilized.
As part of the 2003 Loan Financing Agreement, the Philadelphia Industrial
Development Corporation will lend the Company up to $1,250,000 as reimbursement
for a portion of the Mortgage Loan from Wachovia. Until that Conversion Date
occurs, the Company is required to make interest only payments on the Mortgage
Loan. Commencing on the first day of the month following the Conversion Date,
the Company is required to make monthly payments of principal and interest in
amounts sufficient to fully amortize the principal balance of the loan Mortgage
Loan 15 years after the Conversion Date. The entire outstanding principal amount
of this Mortgage Loan, along with any accrued interest, shall be due no later
than 15 years from the Conversion Date. As of March 31, 2005, the Conversion
date has not taken place and the Company continues to make interest only
payments. As of March 31, 2005, the Company has outstanding $2.7 million under
the Mortgage Loan, of which $96,203 is classified as currently due.
The Equipment Loan consists of various term loans with maturity dates ranging
from three to five years. The Company as part of the 2003 Loan Financing
agreement is required to make equal payments of principal and interest. As of
March 31, 2005, the Company has outstanding $4,837,000 under the Equipment Loan,
of which $1,401,056 is classified as currently due.
Under the Construction Loan, the Company is required to make equal monthly
payments of principal and interest beginning on January 1, 2004 and ending on
November 30, 2008, the maturity date of the loan. As of March 31, 2005, the
Company has outstanding $749,995 under the Construction Loan, of which $200,000
is classified as currently due.
17
The financing facilities under the 2003 Loan Financing bear interest at a
variable rate equal to the LIBOR rate plus 150 basis points. The LIBOR rate is
the rate per annum, based on a 30-day interest period, quoted two business days
prior to the first day of such interest period for the offering by leading banks
in the London interbank market of dollar deposits. As of March 31, 2005, the
interest rate for the 2003 Loan Financing was 4.35%.
The Company has executed a Security Agreement with Wachovia in which the Company
has agreed to use substantially all of its assets to collateralize the amounts
due to Wachovia under the 2003 Loan Financing.
The terms of the line of credit, the loan agreement, the related letter of
credit and the 2003 Loan Financing require that the Company meet certain
financial covenants and reporting standards, including the attainment of
standard financial liquidity and net worth ratios. As of March 31, 2005, the
Company has complied with such terms, and successfully met its financial
covenants.
NOTE 9. INCOME TAXES
The (benefit from) provision for federal, state and local income taxes for the
three month period ended March 31, 2005 and 2004 was ($19,438,913) and
$2,217,829, respectively, with effective tax rates of 40.0% and 40.9%,
respectively. The (benefit from) provision for federal, state and local income
taxes for the nine month period ended March 31, 2005 and 2004 was ($18,035,836)
and $7,258,196, respectively, with effective tax rates of 40.0% and 41.0%,
respectively.
NOTE 10. EARNINGS PER SHARE
SFAS No. 128, Earnings Per Share, requires the presentation of basic and diluted
earnings per share on the face of the Company's consolidated statement of income
and a reconciliation of the computation of basic earnings per share to diluted
earnings per share. Basic earnings per share excludes the dilutive impact of
common stock equivalents and is computed by dividing net income by the
weighted-average number of shares of common stock outstanding for the period.
Diluted earnings per share includes the effect of potential dilution from the
exercise of outstanding common stock equivalents into common stock using the
treasury stock method. Earnings per share amounts for all periods presented have
been calculated in accordance with the requirements of SFAS No. 128. A
reconciliation of the Company's basic and diluted earnings per share follows:
THREE MONTHS ENDED MARCH 31,
-----------------------------------------------------------
2005 2004
----------------------------- ---------------------------
NET LOSS SHARES NET INCOME SHARES
(NUMERATOR) (DENOMINATOR) (NUMERATOR) (DENOMINATOR)
------------- ------------- ----------- -------------
Basic (loss) earnings per share factors $(29,158,370) 24,103,256 $3,198,398 20,058,753
Effect of dilutive stock options -- 207,080
------------ ---------- ---------- ----------
Diluted (loss) earnings per share factors $(29,158,370) 24,103,256 $3,198,398 20,265,833
============ ========== ========== ==========
Basic (loss) earnings per share $ (1.21) $ 0.16
Diluted (loss) earnings per share $ (1.21) $ 0.16
18
NINE MONTHS ENDED MARCH 31,
-----------------------------------------------------------
2005 2004
----------------------------- ---------------------------
NET LOSS SHARES NET INCOME SHARES
(NUMERATOR) (DENOMINATOR) (NUMERATOR) (DENOMINATOR)
------------- ------------- ----------- -------------
Basic (loss) earnings per share factors $(27,053,752) 24,092,958 $10,455,330 20,049,647
Effect of dilutive stock options -- 213,499
------------ ---------- ----------- ----------
Diluted (loss) earnings per share factors $(27,053,752) 24,092,958 $10,455,330 20,263,146
============ ========== =========== ==========
Basic (loss) earnings per share $ (1.12) $ 0.52
Diluted (loss) earnings per share $ (1.12) $ 0.52
Dilutive shares have been excluded in the weighted average shares used for the
calculation of earnings per share in periods of net loss because the effect of
such securities would be anti-dilutive. The number of anti-dilutive weighted
average shares that have been excluded in the computation of diluted earnings
per share for the three months ended March 31, 2005 and 2004 were 0 and 178,500,
respectively. The number of anti-dilutive weighted average shares that have been
excluded in the computation of diluted earnings per share for the nine months
ended March 31, 2005 and 2004 were 0 and 7,500, respectively. These shares have
been excluded because the options' exercise price was greater than the average
market price of the common stock.
NOTE 11. COMPREHENSIVE INCOME
The Company's other comprehensive loss is comprised of unrealized losses on
investment securities classified as available-for-sale. The components of
comprehensive income and related taxes consisted of the following as of March
31, 2005 and 2004:
COMPREHENSIVE (LOSS) INCOME
FOR THE THREE MONTHS ENDED FOR THE NINE MONTHS ENDED
-------------------------- -------------------------
3/31/2005 3/31/2004 3/31/2005 3/31/2004
------------ ----------- ----------- -----------
Other Comprehensive Loss:
Unrealized Holding Loss on Securities (66,421) -- (71,918) --
Add: Tax savings at effective rate 26,568 -- 28,767 --
----------- --------- ----------- ----------
Total Unrealized Loss on Securities, Net (39,853) -- (43,151) --
----------- --------- ----------- ----------
Total Other Comprehensive Loss (39,853) -- (43,151) --
Net (Loss) Income (29,158,370) 3,198,398 (27,053,752) 10,455,330
----------- --------- ----------- ----------
Total Comprehensive (Loss) Income (29,198,223) 3,198,398 (27,096,903) 10,455,330
=========== ========= =========== ==========
NOTE 12. RELATED PARTY TRANSACTIONS
The Company had sales of approximately $394,052 and $455,617 during the nine
months ended March 31, 2005 and 2004, respectively, to a distributor (the
"related party") owned by Jeffrey Farber, the son of the Chairman of the Board
of Directors and principal shareholder of the Company, William Farber. Accounts
receivable includes amounts due from the related party of approximately $108,684
(currently due) and $117,000 at March 31, 2005 and June 30, 2004, respectively.
In management's opinion, the terms of these transactions were not more favorable
to the related party than they would have been to a non-related party.
19
Stuart Novick, the son of Marvin Novick, a Director on the Company's Board of
Directors through January 13, 2005, was employed by two insurance brokerage
companies (the "Insurance Brokers") that provide insurance agency services to
the Company. The Company paid approximately $494,752 and $344,000 during the
nine months ended March 31, 2005 and 2004 to the Insurance Brokers for various
insurance policies. There was $0 and $9,400 due to the Insurance Brokers as of
March 31, 2005 and June 30, 2004. In management's opinion, the terms of these
transactions were not more favorable to the related party than they would have
been to a non-related party.
In January 2005, Lannett Holdings, Inc. entered into an agreement in which the
Company purchased for $100,000 and future royalty payments the proprietary
rights to manufacture and distribute a product for which Pharmeral, Inc. owns
the ANDA. This agreement is subject to the Company's ability to obtain FDA
approval to use the proprietary rights. In the event that an approval can not be
obtained, Pharmeral, Inc. must repay the $100,000 to the Company. Accordingly,
the Company has treated this payment as a prepaid asset. Arthur Bedrosian,
President of Lannett Company, Inc. was formerly the President and Chief
Executive Officer and currently owns 100% of Pharmeral, Inc. This transaction
was approved by the Board of Directors of the Lannett Company and in their
opinion the terms were not more favorable to the related party than they would
have been to a non-related party.
NOTE 13. MATERIAL CONTRACT WITH SUPPLIER
The Company's primary finished product inventory supplier is Jerome Stevens
Pharmaceuticals, Inc. (JSP), in Bohemia, New York. On March 23, 2004, the
Company entered into an agreement with JSP for the exclusive distribution rights
in the United States to the current line of JSP products, in exchange for four
million (4,000,000) shares of the Company's common stock. The JSP products
covered under the agreement included Butalbital, Aspirin, Caffeine with Codeine
Phosphate capsules, Digoxin tablets and Levothyroxine Sodium tablets, sold
generically and under the brand name Unithroid(R). The term of the agreement is
ten years, beginning on March 23, 2004 and continuing through March 22, 2014.
Both Lannett and JSP have the right to terminate the contract if one of the
parties does not cure a material breach of the contract within thirty (30) days
of notice from the non-breaching party.
During the term of the agreement, the Company is required to use commercially
reasonable efforts to purchase minimum dollar quantities of JSP's products being
distributed by the Company. The minimum quantity to be purchased in the first
year of the agreement is $15 million. Thereafter, the minimum quantity to be
purchased increases by $1 million per year up to $24 million for the last year
of the ten-year contract. The Company has met the minimum purchase requirement
for the first year of the contract, but there is no guarantee that the Company
will be able to continue to do so in the future. If the Company does not meet
the minimum purchase requirements, JSP's sole remedy is to terminate the
agreement.
Under the agreement, JSP is entitled to nominate one person to serve on the
Company's Board of Directors (the "Board") provided, however, that the Board
shall have the right to reasonably approve any such nominee in order to fulfill
its fiduciary duty by ascertaining that such person is suitable for membership
on the board of a publicly traded corporation. Suitability is determined by, but
not limited to, the requirements of the Securities and Exchange Commission, the
American Stock Exchange, and other applicable laws, including the Sarbanes-Oxley
Act of 2002. As of March 31, 2005, JSP has not exercised the nomination
provision of the agreement. The agreement was included as an Exhibit in the
Current Report on Form 8-K filed by the Company on May 5, 2004, as subsequently
amended.
Management determined that the intangible product rights asset created by this
agreement was impaired as of March 31, 2005. Refer to Note 1 above for
additional disclosure and discussion of this impairment.
The Company has also contracted with Spectrum Pharmaceuticals, based in
California, to purchase and distribute ciprofloxacin tablets which are
manufactured by Spectrum and/or its partners. Ciprofloxacin tablets are the
20
generic version of the brand Cipro(R), an anti-bacterial drug, marketed by Bayer
Corporation, prescribed to treat infections. The Company began selling
ciprofloxacin tablets in February 2005.
In October 2004, the Company signed an agreement with Orion Pharma "Orion",
based in Finland to purchase and distribute three drug products. Under the terms
of the agreement, Orion will supply Lannett with the finished products and all
laboratory documentation and Lannett will coordinate the completion of the
clinical biostudies necessary to submit Abbreviated New Drug Applications
"ANDAs" to the Food and Drug Administration.
NOTE 14. CONTINGENCIES
The Company monitors its compliance with all environmental laws. Any compliance
costs which may be incurred are contingent upon the results of future site
monitoring and will be charged to operations when incurred. No monitoring costs
were incurred during the three months and nine months ended March 31, 2005 and
2004.
The Company is currently engaged in several civil actions as a co-defendant with
many other manufacturers of Diethylstilbestrol ("DES"), a synthetic hormone.
Prior litigation established that the Company's pro rata share of any liability
is less than one-tenth of one percent. Due to the fact that prior litigation
established the "market share" method of prorating liability among the companies
that manufactured DES during the drug's commercial distribution, which ended in
1971, management has accepted this as the most reasonable method of determining
liability for future outcomes of claims. The Company was represented in many of
these actions by the insurance company with which the Company maintained
coverage (subject to limits of liability) during the time period that damages
were alleged to have occurred. The Company has either settled or had dismissed
approximately 250 claims. An additional 283 claims are currently being defended.
Prior settlements have been in the range of $500 to $3,500. Management believes
that the outcome will not have a material adverse impact on the consolidated
financial position or results of operations of the Company.
In addition to the matters reported herein, the Company is involved in
litigation which arises in the normal course of business. In the opinion of
management, the resolution of these lawsuits will not have a material adverse
effect on the consolidated financial position or results of operations.
21
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
INTRODUCTION
The following information should be read in conjunction with the consolidated
financial statements and notes in Part I, Item 1 of this Quarterly Report and
with Management's Discussion and Analysis of Financial Condition and Results of
Operations contained in the Company's Annual Report on Form 10-K for the fiscal
year ended June 30, 2004.
In addition to historical information, this Form 10-Q contains forward-looking
information. The forward-looking information contained herein is subject to
certain risks and uncertainties that could cause actual results to differ
materially from those projected in the forward-looking statements. Important
factors that might cause such a difference include, but are not limited to,
those discussed in the following section entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations." Readers are
cautioned not to place undue reliance on these forward-looking statements, which
reflect management's analysis only as of the date of this Form 10-Q. The Company
undertakes no obligation to publicly revise or update these forward-looking
statements to reflect events or circumstances which arise later. Readers should
carefully review the risk factors described in other documents the Corporation
files from time to time with the Securities and Exchange Commission, including
the Annual report on Form 10-K filed by the Company in Fiscal 2004, and any
Current Reports on Form 8-K filed by the Company.
In addition to the risks and uncertainties posed generally by the generic drug
industry, the Company faces the following risks and uncertainties:
- competition from other manufacturers of generic drugs;
- potential declines in revenues and profits from individual generic
pharmaceutical products due to competitors' introductions of their own
generic equivalents;
- new products or treatments by other manufacturers that could render
the Company's products obsolete;
- the value of the Company's common stock has fluctuated widely in the
past, which could lead to investment losses for shareholders;
- intense regulation by government agencies may delay the Company's
efforts to commercialize new drug products; and
- dependence on third parties to supply raw materials and certain
finished goods inventory - any failure to obtain a sufficient supply
of raw materials from these suppliers could materially and adversely
affect the Company's business.
Because of the foregoing and other factors, the Company may experience
fluctuations in future operating results on a quarterly or annual basis which
could materially adversely affect the business, financial condition, operating
results and the Company's stock price.
22
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of our financial condition and results of operations
are based upon our consolidated financial statements, which have been prepared
in accordance with accounting principles generally accepted in the United States
of America. The preparation of these financial statements requires us to make
estimates and judgments that affect the reported amount of assets and
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities at the date of our financial statements. Actual results may
differ from these estimates under different assumptions or conditions.
Critical accounting policies are defined as those that are reflective of
significant judgments and uncertainties, and potentially result in materially
different results under different assumptions and conditions. We believe that
our critical accounting policies include those described below. For a detailed
discussion on the application of these and other accounting policies, see Note 1
in the Notes to the Consolidated Financial Statements included herein.
REVENUE RECOGNITION - The Company recognizes revenue when its products are
shipped. At this point, title and risk of loss have transferred to the customer
and provisions for estimates, including rebates, promotional adjustments, price
adjustments, returns, chargebacks, and other potential adjustments are
reasonably determinable. Accruals for these provisions are presented in the
consolidated financial statements as rebates and chargebacks payable and
reductions to net sales. The change in the reserves for various sales
adjustments may not be proportionally equal to the change in sales because of
changes in both the product and the customer mix. Increased sales to wholesalers
will generally require additional rebates. Incentives offered to secure sales
vary from product to product. Provisions for estimated rebates and promotional
and other credits are estimated based on historical payment experience,
estimated customer inventory levels, and contract terms. Provisions for other
customer credits, such as price adjustments, returns, and chargebacks require
management to make subjective judgments. Unlike branded innovator companies,
Lannett does not use information about product levels in distribution channels
from third-party sources, such as IMS Health and NDC Health, in estimating
future returns and other credits.
CHARGEBACKS - The provision for chargebacks is the most significant and complex
estimate used in the recognition of revenue. The Company sells its products
directly to wholesale distributors, generic distributors, retail pharmacy chains
and mail-order pharmacies. The Company also sells its products indirectly to
independent pharmacies, managed care organizations, hospitals, nursing homes,
and group purchasing organizations, collectively referred to as "indirect
customers." Lannett enters into agreements with its indirect customers to
establish pricing for certain products. The indirect customers then
independently select a wholesaler from which to actually purchase the products
at these agreed-upon prices. Lannett will provide credit to the wholesaler for
the difference between the agreed-upon price with the indirect customer and the
wholesaler's invoice price if the price sold to the indirect customer is lower
than the direct price to the wholesaler. This credit is called a chargeback. The
provision for chargebacks is based on expected sell-through levels by the
Company's wholesale customers to the indirect customers, and estimated
wholesaler inventory levels. As sales to the large wholesale customers, such as
Cardinal Health, AmerisourceBergen, and McKesson, increase, the reserve for
chargebacks will also generally increase. However, the size of the increase
depends on the product mix. The Company continually monitors the reserve for
chargebacks and makes adjustments when management believes that actual
chargebacks may differ from estimated reserves.
REBATES - Rebates are offered to the Company's key customers to promote customer
loyalty and encourage greater product sales. These rebate programs provide
customers with rebate credits upon attainment of pre-established volumes or
attainment of net sales milestones for a specified period. Other promotional
programs are incentive programs offered to the customers. At the time of
shipment, the Company estimates reserves for rebates and other promotional
credit programs based on the specific terms in each agreement. The reserve for
rebates increases as sales to certain wholesale and retail customers increase.
However, these rebate programs are
23
tailored to the customers' individual programs. Hence, the reserve will depend
on the mix of customers that comprise such rebate programs.
RETURNS - Consistent with industry practice, the Company has a product returns
policy that allows select customers to return product within a specified period
prior to and subsequent to the product's lot expiration date in exchange for a
credit to be applied to future purchases. The Company's policy requires that the
customer obtain pre-approval from the Company for any qualifying return. The
Company estimates its provision for returns based on historical experience,
changes to business practices, and credit terms. While such experience has
allowed for reasonable estimations in the past, history may not always be an
accurate indicator of future returns. The Company continually monitors the
provisions for returns and makes adjustments when management believes that
actual product returns may differ from established reserves. Generally, the
reserve for returns increases as net sales increase. The reserve for returns is
included in the rebates and chargebacks payable account on the balance sheet.
OTHER ADJUSTMENTS - Other adjustments consist primarily of price adjustments,
also known as "shelf stock adjustments," which are credits issued to reflect
decreases in the selling prices of the Company's products that customers have
remaining in their inventories at the time of the price reduction. Decreases in
selling prices are discretionary decisions made by management to reflect
competitive market conditions. Amounts recorded for estimated shelf stock
adjustments are based upon specified terms with direct customers, estimated
declines in market prices, and estimates of inventory held by customers. The
Company regularly monitors these and other factors and evaluates the reserve as
additional information becomes available. Other adjustments are included in the
rebates and chargebacks payable account on the balance sheet.
The following tables identify the reserves for each major category of revenue
allowance and a summary of the activity for the nine months ended March 31, 2005
and 2004:
FOR THE NINE MONTHS ENDED
MARCH 31, 2005
Reserve Category Chargebacks Rebates Returns Other Total
- ---------------- ----------- ----------- --------- --------- ------------
Reserve Balance as of
June 30, 2004 $ 6,484,500 $ 1,864,200 $ 448,000 $ 88,300 $ 8,885,000
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2004 (4,966,500) (1,936,500) (408,400) (87,000) (7,398,400)
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2005 (8,494,900) (4,455,300) (736,500) (425,800) (14,112,500)
Additional Reserves Charged to
Net Sales During Fiscal 2005 14,559,400 6,696,800 971,900 472,800 22,700,900
----------- ----------- --------- --------- ------------
Reserve Balance as of
March 31, 2005 $ 7,582,500 $ 2,169,200 $ 275,000 $ 48,300 $ 10,075,000
=========== =========== ========= ========= ============
24
FOR THE NINE MONTHS ENDED
MARCH 31, 2004
Reserve Category Chargebacks Rebates Returns Other Total
- ---------------- ------------ ----------- --------- --------- ------------
Reserve Balance as of
June 30, 2003 $ 1,638,000 $ 889,900 $ 210,200 $ 33,900 $ 2,772,000
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2003 (1,604,000) (1,166,400) (182,700) -- (2,953,100)
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2004 (9,516,200) (1,749,800) -- (410,000) (11,676,000)
Additional Reserves Charged to
Net Sales During Fiscal 2004 11,663,300 3,309,400 258,200 426,200 15,657,100
------------ ----------- --------- --------- ------------
Reserve Balance as of
March 31, 2004 $ 2,181,100 $ 1,283,100 $ 285,700 $ 50,100 $ 3,800,000
============ =========== ========= ========= ============
The Company ships its products to the warehouses of its wholesale and retail
chain customers. When the Company and a customer come to an agreement for the
supply of a product, the customer will generally continue to purchase the
product, stock its warehouse(s), and resell the product to its own customers.
The Company's customer will continually reorder the product as its warehouse is
depleted. The Company generally has no minimum size orders for its customers.
Additionally, most warehousing customers prefer not to stock excess inventory
levels due to the additional carrying costs and inefficiencies created by
holding excess inventory. As such, the Company's customers continually reorder
the Company's products. It is common for the Company's customers to order the
same products on a monthly basis. For generic pharmaceutical manufacturers, it
is critical to ensure that customers' warehouses are adequately stocked with its
products. This is important due to the fact that several generic competitors
compete for the consumer demand for a given product. Availability of inventory
ensures that a manufacturer's product is considered. Otherwise, retail
prescriptions would be filled with competitors' products. For this reason, the
Company periodically offers incentives to its customers to purchase its
products. These incentives are generally up-front discounts off its standard
prices at the beginning of a generic campaign launch for a newly-approved or
newly-introduced product, or when a customer purchases a Lannett product for the
first time. Customers generally inform the Company that such purchases represent
an estimate of expected resales for a period of time. This period of time is
generally up to three months. The Company records this revenue, net of any
discounts offered and accepted by its customers at the time of shipment. The
Company's products have either 24 months or 36 months of shelf-life at the time
of manufacture. The Company monitors its customers' purchasing trends to attempt
to identify any significant lapses in purchasing activity. If the Company
observes a lack of recent activity, inquiries will be made to such customer
regarding the success of the customer's resale efforts. The Company attempts to
minimize any potential return (or shelf life issues) by maintaining an active
dialogue with the customers.
The products that the Company sells are generic versions of brand named drugs.
The consumer markets for such drugs are well-established markets with many years
of historically-confirmed consumer demand. Such consumer demand may be affected
by several factors, including alternative treatments, cost, etc. However, the
effects of changes in such consumer demand for the Company's products, like
generic products manufactured by other generic companies, are gradual in nature.
Any overall decrease in consumer demand for generic products generally occurs
over an extended period of time. This is because there are thousands of doctors,
prescribers, third-party payers, institutional formularies and other buyers of
drugs that must change prescribing habits and
25
medicinal practices before such a decrease would affect a generic drug market.
If the historical data the Company uses and the assumptions management makes to
calculate its estimates of future returns, chargebacks, and other credits do not
accurately approximate future activity, its net sales, gross profit, net income
and earnings per share could change. However, management believes that these
estimates are reasonable based upon historical experience and current
conditions.
ACCOUNTS RECEIVABLE - The Company performs ongoing credit evaluations of its
customers and adjusts credit limits based upon payment history and the
customer's current credit worthiness, as determined by a review of current
credit information. The Company continuously monitors collections and payments
from its customers and maintains a provision for estimated credit losses based
upon historical experience and any specific customer collection issues that have
been identified. While such credit losses have historically been within the both
Company's expectations and the provisions established, the Company cannot
guarantee that it will continue to experience the same credit loss rates that it
has in the past.
INVENTORIES - The Company values its inventory at the lower of cost (determined
by the first-in, first-out method) or market, regularly reviews inventory
quantities on hand, and records a provision for excess and obsolete inventory
based primarily on estimated forecasts of product demand and production
requirements. The Company's estimates of future product demand may prove to be
inaccurate, in which case it may have understated or overstated the provision
required for excess and obsolete inventory. In the future, if the Company's
inventory is determined to be overvalued, the Company would be required to
recognize such costs in cost of goods sold at the time of such determination.
Likewise, if inventory is determined to be undervalued, the Company may have
recognized excess cost of goods sold in previous periods and would be required
to recognize such additional operating income at the time of sale.
INTANGIBLE ASSETS - On March 23, 2004, the Company entered into an agreement
with Jerome Stevens Pharmaceuticals, Inc. (JSP) for the exclusive marketing and
distribution rights in the United States to the current line of JSP products in
exchange for four million (4,000,000) shares of the Company's common stock. As a
result of the JSP agreement, the Company recorded an intangible asset of
$67,040,000 for the exclusive marketing and distribution rights obtained from
JSP. The intangible asset was recorded based upon the fair value of the four
million (4,000,000) shares at the time of issuance to JSP. The agreement was
included as an Exhibit in the Current Report on Form 8-K filed by the Company on
May 5, 2004, as subsequently amended.
In June 2004, JSP's Levothyroxine Sodium tablet product received from the FDA an
AB rating to the brand drug Levoxyl(R). In December 2004, the product received
from the FDA a second AB rating to the brand drug Synthroid(R). As a result of
the dual AB ratings, the Company is required to pay JSP an additional $1.5
million in cash to reimburse JSP for expenses related to obtaining the AB
ratings. As of March 31, 2005, the Company has recorded an addition to the
intangible asset of $1.5 million. Since payment has not yet been made to JSP,
the amount due is shown as an accrued expense on the balance sheet.
Management believed that events (as described below) occurred which indicated
that the carrying value of the intangible asset was not recoverable. In
accordance with Statement of Financial Accounting Standards No. 144 (FAS 144),
Accounting for the Impairment or Disposal of Long-Lived Assets, the Company
engaged a third party valuation specialist to assist in the performance of an
impairment test for the quarter ended March 31, 2005. The impairment test was
performed by discounting forecasted future net cash flows for the JSP products
covered under the agreement and then comparing the discounted present value of
those cash flows to the carrying value of the asset (inclusive of the $1.5
million payable to JSP for the second AB rating). As a result of the testing,
the Company has determined that the intangible asset was impaired as of March
31, 2005. In accordance with FAS 144, the Company recorded a non-cash impairment
loss of approximately $46,093,000 to write the asset down to its fair value of
approximately $16,062,000 as of March 31, 2005. This impairment loss is shown on
the statement of operations as a component of operating loss.
26
Management believes that several factors contributed to the impairment of this
asset. In December 2004, the Levothyroxine Sodium tablet product received the AB
rating to Synthroid(R). The expected sales increase as a result of the AB rating
did not occur in the third quarter of 2005. The delay in receiving the AB rating
to Synthroid(R), caused the Company to be competitively disadvantaged with its
Levothyroxine Sodium tablet product and to lose market share to competitors
whose products had already received AB ratings to both major brand thyroid
deficiency drugs. Additionally, the generic market for thyroid deficiency drugs
turned out to be smaller than it was anticipated to be as a result of a lower
brand-to-generic substitution rate. Increased competition in the generic drug
market, both from existing competitors and new entrants, has resulted in
significant pricing pressure on other products supplied by JSP. The combination
of these factors has resulted in diminished forecasted future net cash flows
which, when discounted, yield a lower present value than the carrying value of
the asset before impairment.
For the remaining nine years of the contract, the Company will incur annual
amortization expense of approximately $1,785,000. Amortization expense for the
three months ended March 31, 2005 and 2004 was approximately $1,690,000 and $0,
respectively. Amortization expense for the nine months ended March 31, 2005 and
2004 was approximately $5,070,000 and $0, respectively.
RESULTS OF OPERATIONS - THREE MONTHS ENDED MARCH 31, 2005 COMPARED WITH
THREE MONTHS ENDED MARCH 31, 2004
Net sales decreased by 52% from $16,000,251 for the three months ended
March 31, 2004 ("Third Quarter Fiscal 2004") to $7,603,189 for the three months
ended March 31, 2005 ("Third Quarter Fiscal 2005"). The decrease was generally
due to increased competition in the generic drug market that affected most of
the Company's products. Sales in the third quarter fiscal 2005 as compared to
the third quarter fiscal 2004 also declined due to slow moving inventory in the
distribution channels as well as lower than anticipated substitution rates in
the generic market for thyroid medication. Sales of Primidone tablets decreased
by approximately $3.1 million. Sales of Butalbital with Aspirin and Caffeine
capsules declined by approximately $2.2 million. Digoxin tablet sales decreased
by approximately $1.5 million. Sales of the Company's Levothyroxine Sodium
tablets decreased by approximately $800,000. The remaining decline in sales were
spread over the Company's other products.
The Company sells its products to customers in various categories. The
table below identifies the Company's approximate net sales to each category for
the three months ended March 31, 2005 and 2004:
FOR THE THREE MONTHS ENDED
--------------------------
CUSTOMER CATEGORY 3/31/2005 3/31/2004
- ---------------------- ---------- -----------
Wholesaler/Distributor $4,141,000 $11,776,000
Retail Chain 1,712,000 2,724,000
Mail-Order Pharmacy 1,000,000 800,000
Private Label 750,000 700,000
---------- -----------
Total $7,603,000 $16,000,000
========== ===========
Cost of sales decreased by 39% from $6,947,195 for the Third Quarter Fiscal
2004 to $4,266,839 for the Third Quarter Fiscal 2005. The decline in cost of
sales is due to a decrease in direct variable costs such as raw materials and
costs of finished goods as a result of lower sales levels. Gross profit margins
for the Third Quarter Fiscal 2005 and the Third Quarter Fiscal 2004 were 44% and
57%, respectively. The decrease in the gross profit
27
percentage is due to increased competition, lower sales prices, and product
sales mix. Depending on future market conditions for each of the Company's
products, changes in the future sales product mix may occur. These changes may
affect the gross profit percentage in future periods.
Research and development ("R&D") expenses decreased by 14% from $1,361,681
for the Third Quarter Fiscal 2004 to $1,172,853 for the Third Quarter Fiscal
2005. The decrease is primarily due to a decrease of approximately $187,000 in
the costs of generic bioequivalence tests which are commonly required for ANDA
submissions.
Selling, general and administrative expenses increased by 29% from
$2,276,780 for the Third Quarter Fiscal 2004 to $2,930,801 for the Third Quarter
Fiscal 2005. The increase is primarily due to: Sarbanes-Oxley- related
accounting and consulting costs of approximately $288,000; depreciation expense
of computer and office equipment of $110,000; insurance expense of approximately
$105,000; charitable contributions of $95,000; various other expenses netting to
approximately $56,000.
Amortization expense for the intangible asset for the three months ended
March 31, 2005 and 2004 was approximately $1,690,083 and $0, respectively. The
amortization expense relates to the March 23, 2004 exclusive marketing and
distribution rights agreement with JSP.
Management believed that events (as described below) occurred which
indicated that the carrying value of the intangible asset was not recoverable.
In accordance with Statement of Financial Accounting Standards No. 144 (FAS
144), Accounting for the Impairment or Disposal of Long-Lived Assets, the
Company engaged a third party valuation specialist to assist in the performance
of an impairment test for the quarter ended March 31, 2005. The impairment test
was performed by discounting forecasted future net cash flows for the JSP
products covered under the agreement and then comparing the discounted present
value of those cash flows to the carrying value of the asset (inclusive of the
$1.5 million payable to JSP for the second AB rating). As a result of the
testing, the Company has determined that the intangible asset was impaired as of
March 31, 2005. In accordance with FAS 144, the Company recorded a non-cash
impairment loss of approximately $46,093,000 to write the asset down to its fair
value of approximately $16,062,000 as of March 31, 2005. This impairment loss is
shown on the statement of operations as a component of operating loss.
Management believes that several factors contributed to the impairment of
this asset. In December 2004, the Levothyroxine Sodium tablet product received
the AB rating to Synthroid(R). The expected sales increase as a result of the AB
rating did not occur in the third quarter of 2005. The delay in receiving the AB
rating to Synthroid(R), caused the Company to be competitively disadvantaged
with its Levothyroxine Sodium tablet product and to lose market share to
competitors whose products had already received AB ratings to both major brand
thyroid deficiency drugs. Additionally, the generic market for thyroid
deficiency drugs turned out to be smaller than it was anticipated to be as a
result of a lower brand-to-generic substitution rate. Increased competition in
the generic drug market, both from existing competitors and new entrants, has
resulted in significant pricing pressure on other products supplied by JSP. The
combination of these factors has resulted in diminished forecasted future net
cash flows which, when discounted, yield a lower present value than the carrying
value of the asset before impairment.
For the remaining nine years of the contract, the Company will incur annual
amortization expense of approximately $1,785,000.
As a result of the items discussed above, the Company's financial results
changed from operating income of $5,414,595 in the Third Quarter Fiscal 2004 to
an operating loss of ($48,550,623) in the Third Quarter of Fiscal 2005.
28
The Company's interest expense increased from approximately $5,320 in the
Third Quarter Fiscal 2004 to approximately $96,373 in the Third Quarter Fiscal
2005 as a result of the borrowing under the "2003 Loan Financing" which included
a mortgage loan, equipment loan and construction loan. Interest income increased
from approximately $6,952 in the Third Quarter Fiscal 2004 to approximately
$50,584 in the Third Quarter Fiscal 2005, as a result of investment of excess
cash in marketable securities and a higher cash balance.
The Company's income tax classification changed from an income tax expense
of $2,217,829 in the Third Quarter Fiscal 2004 to an income tax benefit of
($19,438,913) in the Third Quarter Fiscal 2005 as a result of the Company's
pre-tax loss. The effective tax rate decreased slightly from 40.9% in the Third
Quarter Fiscal 2004 to 40.0% in the Third Quarter of 2005.
The Company reported net loss of ($29,158,370) in the Third Quarter Fiscal
2005, or ($1.21) basic and diluted loss per share, compared to net income of
$3,198,398 in the Third Quarter Fiscal 2004, or $0.16 basic and diluted income
per share.
RESULTS OF OPERATIONS - NINE MONTHS ENDED MARCH 31, 2005 COMPARED WITH NINE
MONTHS ENDED MARCH 31, 2004
Net sales decreased by 22% from $45,795,638 for the nine months ended March
31, 2004 to $35,533,206 for the nine months ended March 31, 2005. The decrease
was generally due to increased competition in the generic drug market that
affected most of the Company's products. The increased competition, both from
existing competitors and new entrants, has resulted in significant pricing
pressures. Sales of Butalbital with Aspirin and Caffeine capsules declined by
approximately $3.6 million. Sales of Primidone tablets decreased by
approximately $2.9 million. Digoxin tablet sales decreased by approximately $2.4
million. Finally, sales of the Company's thyroid deficiency products declined by
approximately $1.5 million. These declines were partially offset by slight
increases the Company's other products.
The Company sells its products to customers in various categories. The table
below identifies the Company's approximate net sales to each category for the
nine months ended March 31, 2005 and 2004:
FOR THE NINE MONTHS ENDED
-------------------------
CUSTOMER CATEGORY 3/31/2005 3/31/2004
- ---------------------- ----------- -----------
Wholesaler/Distributor $22,880,000 $30,309,000
Retail Chain 6,993,000 8,385,000
Mail-Order Pharmacy 3,511,000 3,452,000
Private Label 2,149,000 3,650,000
----------- -----------
Total $35,533,000 $45,796,000
=========== ===========
Cost of sales increased by 3% from $18,405,293 for the nine months ended
March 31, 2004 to $18,973,152 for the nine months ended March 31, 2005. Gross
profit margins for the nine months ended March 31, 2005 and 2004 were 47% and
60%, respectively. The decrease in the gross profit percentage is due to
increased competition resulting in lower sales prices, and changing product
sales mix. Depending on future market conditions for each of the Company's
products, changes in the future sales product mix may occur. These changes may
affect the gross profit percentage in future periods.
29
Research and development ("R&D") expenses increased less than 1% from
$3,500,759 for the nine months ended March 31, 2004 to $3,521,507 for the nine
months ended March 31, 2005.
Selling, general and administrative expenses increased by 10% from
$6,179,980 for the Third Quarter Fiscal 2004 to $6,817,487 for the Third Quarter
Fiscal 2005. The increase is primarily due to: Sarbanes-Oxley- related
accounting and consulting costs of approximately $300,000; depreciation expense
of computer and office equipment of $270,000; insurance expense of approximately
$160,000. These increases were partially offset by modest savings in various
other expense items.
Amortization expense for the intangible asset for the nine months ended
March 31, 2005 and 2004 was approximately $5,070,251 and $0, respectively. The
amortization expense relates to the March 23, 2004 exclusive marketing and
distribution rights agreement with JSP.
Management believed that events (as described below) occurred which
indicated that the carrying value of the intangible asset was not recoverable.
In accordance with Statement of Financial Accounting Standards No. 144 (FAS
144), Accounting for the Impairment or Disposal of Long-Lived Assets, the
Company engaged a third party valuation specialist to assist in the performance
of an impairment test for the quarter ended March 31, 2005. The impairment test
was performed by discounting forecasted future net cash flows for the JSP
products covered under the agreement and then comparing the discounted present
value of those cash flows to the carrying value of the asset (inclusive of the
$1.5 million payable to JSP for the second AB rating). As a result of the
testing, the Company has determined that the intangible asset was impaired as of
March 31, 2005. In accordance with FAS 144, the Company recorded a non-cash
impairment loss of approximately $46,093,000 to write the asset down to its fair
value of approximately $16,062,000 as of March 31, 2005. This impairment loss is
shown on the statement of operations as a component of operating loss.
Management believes that several factors contributed to the impairment of
this asset. In December 2004, the Levothyroxine Sodium tablet product received
the AB rating to Synthroid(R). The expected sales increase as a result of the AB
rating did not occur in the third quarter of 2005. The delay in receiving the AB
rating to Synthroid(R), caused the Company to be competitively disadvantaged
with its Levothyroxine Sodium tablet product and to lose market share to
competitors whose products had already received AB ratings to both major brand
thyroid deficiency drugs. Additionally, the generic market for thyroid
deficiency drugs turned out to be smaller than it was anticipated to be as a
result of a lower brand-to-generic substitution rate. Increased competition in
the generic drug market, both from existing competitors and new entrants, has
resulted in significant pricing pressure on other products supplied by JSP. The
combination of these factors has resulted in diminished forecasted future net
cash flows which, when discounted, yield a lower present value than the carrying
value of the asset before impairment.
For the remaining nine years of the contract, the Company will incur annual
amortization expense of approximately $1,785,000.
As a result of the items discussed above, the Company's financial results
changed from operating income of $17,709,606 for the nine months ended March 31,
2004 to an operating loss of ($44,942,427) for the nine months ended March 31,
2005.
The Company's interest expense increased from approximately $19,830 for the
nine months ended March 31, 2004 to $245,056 for the nine months ended March 31,
2005 as a result of the borrowing under the "2003 Loan Financing" which included
a mortgage loan, equipment loan and construction loan. Interest income increased
from $23,750 for the nine months ended March 31, 2004 to $99,361 for the nine
months ended March 31, 2005 as a result of investment of excess cash in
marketable securities and a higher cash balance.
30
The Company's income tax classification changed from an income tax expense
of $7,258,196 for the nine months ended March 31, 2004 to an income tax benefit
of ($18,035,836) for the nine months ended March 31, 2005. The effective tax
rate decreased slightly from 40.9% for the nine months ended March 31, 2004 to
40.0% for the nine months ended March 31, 2005.
The Company reported net loss of ($27,053,752) for the nine months ended
March 31, 2005, or ($1.12) basic and diluted loss per share, compared to net
income of $10,455,330 for the nine months ended March 31, 2004, or $0.52 basic
and diluted income per share.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities of $10,406,827 for the nine
months ended March 31, 2005 was attributable to net loss of ($27,053,752), as
adjusted for the effects of non-cash items of $52,471,056 and net changes in
operating assets and liabilities totaling ($15,010,477). Significant changes in
operating assets and liabilities are comprised of:
1. A decrease in trade accounts receivable of $15,577,510 due to cash
payments received by the Company in the first quarter of Fiscal 2005,
including the collection of receivables from customers who had
extended payment terms in the fourth quarter of Fiscal 2004 offered by
the Company as a result of compatibility issues related to the
Company's exchange of Electronic Data Interchange (EDI) documents. The
decrease in the trade accounts receivable was also due to a lower
level of sales in the current fiscal year.
2. An increase in inventories of $5,110,706 due to an increase in raw
materials and finished goods inventory. Inventory levels were
increased in anticipation of sales growth, particularly in the
Levothyroxine Sodium tablets. However, as a result of a delayed AB
rating to Synthroid(R) and a lower than expected generic substitution
rate for thyroid medications, inventory continues to be at a higher
level than expected
3. An increase in prepaid taxes of $1,298,542 primarily attributable
estimated tax payments made during Fiscal 2005.
4. An increase in deferred tax assets of $18,466,061 primarily
attributable to the impairment loss of approximately $46,093,000.
5. A decrease in accounts payable of $4,938,378 due to payments for
inventory the Company purchased in the Fourth Quarter Fiscal 2004.
6. An increase in the rebates and chargebacks payable of $1,190,000 was
attributable to an increase in rebate incentives as well as lower than
expected inventory movement through the distribution channels.
The net cash used in investing activities of $8,865,885 for the nine months
ended March 31, 2005 was attributable to the Company's purchase of: $5,987,228
of investment securities, which consist primarily of U. S. government and agency
marketable debt securities, and $2,878,657 of capital expenditures related to
the Company's renovation of its new facility on Torresdale Avenue and the
purchase and installation of new equipment.
31
The following table summarizes the remaining repayments of debt, including
sinking fund requirements as of March 31, 2005 for the subsequent twelve month
periods:
Amounts Payable
Twelve Month Periods to Institutions
- -------------------- ---------------
2006 $ 2,352,259
2007 2,322,972
2008 1,762,012
2009 1,194,353
2010 432,362
Thereafter 2,032,507
-----------
$10,096,465
===========
The Company has a $3,000,000 line of credit from Wachovia Bank, N.A. that
bears interest at the prime interest rate less 0.25% (5.50% at March 31, 2005).
The line of credit was renewed and extended to October 30, 2005. At March 31,
2005 and 2004, the Company had $0 outstanding and $3,000,000 available under the
line of credit. The line of credit is collateralized by substantially all of the
Company's assets. The Company currently has no plans to borrow under this line
of credit.
The terms of the line of credit, the loan agreement, the related letter of
credit and the 2003 Loan Financing require that the Company meet certain
financial covenants and reporting standards, including the attainment of
standard financial liquidity and net worth ratios. As of March 31, 2005, the
Company has complied with such terms, and successfully met its financial
covenants.
In July 2004, the Company received $500,000 of grant funding from the
Commonwealth of Pennsylvania, acting through the Department of Community and
Economic Development. The grant funding program requires the Company to use the
funds for machinery and equipment located at their Pennsylvania locations, hire
an additional 100 full-time employees by June 30, 2006, operate its Pennsylvania
locations a minimum of five years and meet certain matching investment
requirements. If the Company fails to comply with any of the requirements above,
the Company would be liable to the full amount of the grant funding ($500,000).
The Company records the unearned grant funds as a liability until the Company
complies with all of the requirements of the grant funding program. On a
quarterly basis, the Company will monitor its progress in fulfilling the
requirements of the grant funding program and will determine the status of the
liability. As of March 31, 2005, the Company has recognized the grant funding as
a long term liability under the caption of Unearned Grant Funds.
Except as set forth in this report, the Company is not aware of any trends,
events or uncertainties that have or are reasonably likely to have a material
adverse impact on the Company's short-term or long-term liquidity or financial
condition.
PROSPECTS FOR THE FUTURE
The Company has several generic products under development. These products
are all orally-administered, solid-dosage (i.e. tablet/capsule) products
designed to be generic equivalents to brand named innovator drugs. The Company's
developmental drug products are intended to treat a diverse range of
indications. One of these developmental products, an orally-administered obesity
product, represents a generic ANDA currently owned by the Company, but not
currently manufactured and distributed for commercial consumption. As one of the
oldest generic drug manufacturers in the country, formed in 1942, Lannett
currently owns several ANDAs for products which it
32
does not manufacture and market. These ANDAs are simply dormant on the Company's
records. Occasionally, the Company reviews such ANDAs to determine if the market
potential for any of these older drugs has recently changed, so as to make it
attractive for Lannett to reconsider manufacturing and selling it. If the
Company makes the determination to introduce one of these products into the
consumer marketplace, it must review the ANDA and related documentation to
ensure that the approved product specifications, formulation and other features
are feasible in the Company's current environment. Generally, in these
situations, the Company must file a supplement to the FDA for the applicable
ANDA, informing the FDA of any significant changes in the manufacturing process,
the formulation, the raw material supplier or any other major feature of the
previously-approved ANDA. The Company would then redevelop the product and
submit it to the FDA for supplemental approval. The FDA's approval process for
ANDA supplements is similar to that of a new ANDA.
Another developmental product, also an orally-administered obesity product,
is a new ANDA submitted to the FDA in July 2003 for approval. The FDA has
recently disclosed that the average amount of time to review and approve a new
ANDA is approximately seventeen months. Since the Company has no control over
the FDA review process, management is unable to anticipate whether or when it
will be able to begin commercially producing and shipping this product.
The remainder of the products in development represent either previously
approved ANDAs that the Company is planning to reintroduce (ANDA supplements),
or new formulations (new ANDAs). The products under development are at various
stages in the development cycle--formulation, scale-up, and/or clinical testing.
Depending on the complexity of the active ingredient's chemical characteristics,
the cost of the raw material, the FDA-mandated requirement of bioequivalence
studies, the cost of such studies and other developmental factors, the cost to
develop a new generic product varies. It can range from $100,000 to $1 million.
Some of Lannett's developmental products will require bioequivalence studies
while others will not, depending on the FDA's Orange Book classification. Since
the Company has no control over the FDA review process, management is unable to
anticipate whether or when it will be able to begin producing and shipping
additional products.
In addition to the efforts of its internal product development group,
Lannett has contracted with an outside firm (The PharmaNetwork LLC in New
Jersey) for the formulation and development of several new generic drug
products. These outsourced R&D products are at various stages in the development
cycle--formulation, analytical method development and testing and manufacturing
scale-up. These products are orally-administered solid dosage products intended
to treat a diverse range of medical indications. It is the Company's intention
to ultimately transfer the formulation technology and manufacturing process for
all of these R&D products to the Company's own commercial manufacturing sites.
The Company initiated these outsourced R&D efforts to compliment the progress of
its own internal R&D efforts.
The Company is also developing drug products that do not require FDA
approval. The FDA allows generic manufacturers to manufacture and sell products
which are equivalent to innovator drugs which are grand-fathered, under FDA
rules, prior to the passage of the Hatch-Waxman Act of 1984. The FDA allows
generic manufacturers to produce and sell generic versions of such
grand-fathered products by simply performing and internally documenting the
product's stability over a period of time. Under this scenario, a generic
company can forego the time and costs related to a FDA-mandated ANDA approval
process. The Company currently has two products under development in this
category. One of the developmental drugs is an orally-administered, prescription
solid dosage product. The other developmental drug is an oral liquid dosage that
the Company, through an alliance with Cody laboratories is currently developing.
The Company has also contracted with Spectrum Pharmaceuticals, Inc., based
in California, to market generic products developed and manufactured by Spectrum
and/or its partners. The first applicable product under this agreement is
ciprofloxacin tablets, the generic version of Cipro(R), an anti-bacterial drug
marketed by Bayer Corporation and prescribed to treat infections. The Company
has also initiated discussions with other
33
firms for similar new product initiatives, in which Lannett will market and
distribute products manufactured by third parties. Lannett intends to use its
strong customer relationships to build its market share for such products and
increase future revenues and income.
In September 2004, the Company signed an agreement with Unichem
Laboratories Ltd. of India for the exclusive supply of one or more generic drug
products. Under the terms of the agreement, Unichem will develop its formulation
for the finished dosage product using its internally-developed active
pharmaceutical ingredient (API). Unichem and Lannett will share the cost of
bioequivalence studies. Lannett will assist in preparing and submitting the ANDA
to the FDA for approval. Once approved, the Company has the exclusive right to
market and distribute the products in the United States, with the profits from
sales to be shared.
In October 2004, the Company signed an agreement with Orion Pharma (Orion),
based in Finland, to purchase and distribute three drug products. Under the
terms of the agreement, Orion will supply Lannett with the finished products and
all laboratory documentation. Lannett will coordinate the completion of the
clinical biostudies necessary to submit the ANDAs to the FDA.
The majority of the Company's R&D projects are being developed in-house
under Lannett's direct supervision and with Company personnel. Hence, management
does not believe that these outside contracts for product development, including
The PharmaNetwork LLC, or manufacturing supply, including Spectrum
Pharmaceuticals, Inc. and Orion Pharma, are material in nature, nor is the
Company substantially dependent on the services rendered by such outside firms.
Since the Company has no control over the FDA review process, management is
unable to anticipate whether or when it will be able to begin producing and
shipping such additional products.
34
PART I. FINANCIAL INFORMATION
ITEM 4. CONTROLS AND PROCEDURES
EVALUATION OF DISCLOSURE CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed to
ensure that information required to be disclosed in its Exchange Act reports is
recorded, processed, summarized and reported within the time periods specified
in the Securities and Exchange Commission's rules and forms, and that such
information is accumulated and communicated to management, including the Chief
Executive Officer and Chief Financial Officer, as appropriate, to allow timely
decisions regarding required disclosure. Management necessarily applies its
judgment in assessing the costs and benefits of such controls and procedures,
which, by their nature, can provide only reasonable assurance regarding
management's control objectives.
With the participation of management, the Company's Chief Executive Officer and
Chief Financial Officer evaluated the effectiveness of the design and operation
of the Company's disclosure controls and procedures at the conclusion of the
nine months ended March 31, 2005. Based upon this evaluation, the Chief
Executive Officer and Chief Financial Officer concluded that the Company's
disclosure controls and procedures were effective in ensuring that material
information required to be disclosed is included in the reports that it files
with the Securities and Exchange Commission.
CHANGES IN INTERNAL CONTROLS
There were no significant changes in the Company's internal controls or, to the
knowledge of management of the Company, in other factors that could
significantly affect internal controls subsequent to the date of the Company's
most recent evaluation of its disclosure controls and procedures utilized to
compile information included in this filing.
35
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
REGULATORY PROCEEDINGS
The Company is engaged in an industry which is subject to considerable
government regulation relating to the development, manufacturing and marketing
of pharmaceutical products. Accordingly, incidental to its business, the Company
periodically responds to inquiries or engages in administrative and judicial
proceedings involving regulatory authorities, particularly the FDA and the Drug
Enforcement Agency.
EMPLOYEE CLAIMS
A claim of retaliatory discrimination has been filed by a former employee with
the Pennsylvania Human Relations Commission ("PHRC") and the Equal Employment
Opportunity Commission ("EEOC"). The Company was notified of the complaint in
March 1997. The Company has denied liability in this matter. The PHRC has made a
determination that the complaint against the Company should be dismissed because
the facts do not establish probable cause of the allegations of discrimination.
The matter is still pending before the EEOC. At this time, management is unable
to estimate a range of loss, if any, related to this action. Management believes
that the outcome of this claim will not have a material adverse impact on the
financial position or results of operations of the Company.
A claim of discrimination has been filed against the Company with the EEOC and
the PHRC. The Company was notified of the complaint in June 2001. The Company
has filed an answer with the EEOC denying the allegations. The EEOC has made a
determination that the complaint against the Company should be dismissed because
the facts do not establish probable cause of the allegations of discrimination.
The PHRC has also closed its file in this matter. At this time, management is
unable to estimate a range of loss, if any, related to this action. Management
believes that the outcome of this claim will not have a material adverse impact
on the financial position or results of operations of the Company.
A claim of discrimination has been filed against the Company with the PHRC and
the EEOC. The Company was notified of the complaint in July 2001. The Company
has filed an answer with the PHRC denying the allegations. The PHRC has made a
determination that the complaint against the Company should be dismissed because
the facts do not establish probable cause of the allegations of discrimination.
As of September 30, 2004, the EEOC also has closed its file on this matter. At
this time, management is unable to estimate a range of loss, if any, related to
this action. Management believes that the outcome of this claim will not have a
material adverse impact on the financial position or results of operations of
the Company.
DES CASES
The Company is currently engaged in several civil actions as a co-defendant with
many other manufacturers of Diethylstilbestrol ("DES"), a synthetic hormone.
Prior litigation established that the Company's pro rata share of any liability
is less than one-tenth of one percent. The Company was represented in many of
these actions by the insurance company with which the Company maintained
coverage during the time period that damages were alleged to have occurred. The
insurance company denies coverage for actions alleging involvement of the
Company filed after January 1, 1992. With respect to these actions, the Company
paid nominal damages or stipulated to its pro rata share of any liability. The
Company has either settled or is currently defending over 500 such claims. At
this time, management is unable to estimate a range of loss, if any, related to
these actions. Management believes that the outcome of these cases will not have
a material adverse impact on the financial position or results of operations of
the Company.
36
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) A list of the exhibits required by Item 601 of Regulation S-K to be
filed as a part of this Form 10-Q is shown on the Exhibit Index filed
herewith.
(b) On March 14, 2005, the Company filed a Form 8-K disclosing in Item
1.01, Item 5.02, and Item 9.01 thereof, and including as exhibits the
employment agreement and press release, the appointment of Brian
Kearns as Vice President of Finance, Treasurer and Chief Financial
Officer of Lannett Company, Inc.
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SIGNATURE
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
LANNETT COMPANY, INC.
Dated: May 9, 2005 By: /s/ Brian Kearns
----------------------------------------
Brian Kearns
Vice President of Finance, Treasurer and
Chief Financial Officer
By: /s/ William Farber
----------------------------------------
William Farber
Chairman of the Board and
Chief Executive Officer
38
EXHIBIT INDEX
31.1 Certification of Chief Executive Filed Herewith
Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Filed Herewith
Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
32 Certifications of Chief Executive Filed Herewith
Officer and Chief Financial
Officer Pursuant to Section 906
of the Sarbanes-Oxley Act of 2002
39