U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED JUNE 30, 2005
OR
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES 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, PENNSYLVANIA 19136
(215) 333-9000
(Address of principal executive offices and telephone number)
Securities registered under Section 12(b) of the Exchange Act:
NONE
Securities registered under Section 12(g) of the Exchange Act:
COMMON STOCK, $.001 PAR VALUE
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 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 if disclosure of delinquent filers pursuant to
Item 405 of Regulation S-K is not contained herein, and will not be contained,
to the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.
Yes No X
----- -----
Indicate by check mark whether the registrant is an accelerated filer
(as defined in Rule 12b-2 of the Exchange Act).
Yes X No
----- -----
Indicate by check mark whether the registrant is a shell company (as
defined in Rule 12B-12 of the Exchange Act).
Yes No X
----- -----
Aggregate market value of Common stock held by non-affiliates of the
Registrant, as of December 31, 2004 was $99,942,641 based on the closing price
of the stock on the American Stock Exchange.
As of August 25, 2005, there were 24,118,674 shares of the issuer's
common stock, $.001 par value, outstanding.
Page 1 of 100 pages
Exhibit Index on Pages 93-94
1
PART I
ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
Lannett Company, Inc. (the "Company," "Lannett," "we," or "us") was incorporated
in 1942 under the laws of the Commonwealth of Pennsylvania. In 1991, the Company
merged into Lannett Company, Inc., a Delaware corporation. The sole purpose of
the merger was to reincorporate the Company as a Delaware corporation. The
Company develops, manufactures, packages, markets and distributes pharmaceutical
products sold under generic chemical names. References herein to a fiscal year
refer to the Company's fiscal year ending June 30.
Historically, the Company has competed for an increasing share of the
generic market. Although net sales and operating income declined in fiscal 2005,
the Company plans to improve future financial performance as a result of
additions to the Company's line of generic products, additional sales to current
customers, higher unit sales and a management focus on minimizing unnecessary
overhead and administrative costs. Some of the new generic products sold by
Lannett were developed and are manufactured by Lannett while others are
manufactured by others. The products manufactured by Lannett and those
manufactured by others are identified in the section entitled "PRODUCTS" in Item
1 of this Form 10-K.
Over the past several years, Lannett has consistently devoted resources
to research and development (R&D) projects, including new generic product
offerings. The costs of these R&D efforts are expensed during the periods
incurred. The Company believes that such investments may be paid back in future
years as it submits applications to the Food and Drug Administration (FDA), and
when it receives marketing approval from the FDA to distribute such products. In
addition to using cash generated from its operations, the Company has entered
into a number of financing agreements with third parties to provide for
additional cash when it is needed. These financing agreements are more fully
described in the section entitled "LIQUIDITY AND CAPITAL RESOURCES" in Item 7 of
this Form 10-K. The Company has embarked on an industrious plan to grow in
future years. In addition to organic growth to be achieved through its own R&D
efforts, the Company has also initiated marketing projects with other companies
in order to expand future revenue projections. The Company expects that its
growing list of generic drugs under development will drive future growth. The
Company also intends to use the infrastructure it has created, and to
continually devote resources to additional R&D projects. The following
strategies highlight Lannett's plan:
RESEARCH AND DEVELOPMENT
There are numerous stages in the generic drug development process:
1.) Formulation and Analytical Method Development: Once a drug candidate is
selected for future sales, product development scientists perform
various experiments on the incorporation of active ingredients into a
dosage form. These experiments include the creation of a number of
product formulations to determine which formula will be most
2
suitable for the Company's subsequent development process. Various
formulations, are tested in the laboratory to measure results against
the innovator drug. During this time, the Company may use reverse
engineering methods on samples of the innovator drug to determine the
type and quantity of inactive ingredients. During the formulation
phase, the Company's research and development chemists begin to develop
an analytical, laboratory testing method. The successful development of
this test method will allow the Company to test developmental and
commercial batches of the product in the future. All of the information
used in the final formulation, including the analytical test methods
adopted for the generic drug candidate, will be included as part of the
Chemical, Manufacturing and Controls section of the Abbreviated New
Drug Application (ANDA) submitted to the FDA in the generic drug
application
2.) Scale-up: After the product development scientists and the R&D chemists
agree on a final formulation to use in moving the drug candidate
forward in the developmental process, the Company will attempt to
increase the batch size of the product. The batch size represents the
standard magnitude to be used in manufacturing a batch of the product.
The determination of batch size will affect the amount of raw material
that is input into the manufacturing process, and the number of
expected tablets or capsules to be created during the production cycle.
The Company attempts to determine batch size based on the amount of
active ingredient in each dosage, the available production equipment
and unit sales projections. The scaled-up batch is then generally
produced in the Company's commercial manufacturing facilities. During
this manufacturing process, the Company will document the equipment
used, the amount of time in each major processing step and any other
steps needed to consistently produce a batch of that product. This
information, generally referred to as the validated manufacturing
process, will be included in the Company's generic drug application
submitted to the FDA.
3.) Clinical testing: After a successful scale-up of the generic drug
batch, the Company then schedules and performs clinical testing
procedures on the product if required by the FDA. These procedures,
which are generally outsourced to third parties, include testing the
absorption of the generic product in the human bloodstream, compared to
the absorption of the innovator drug. The results of this testing are
then documented and reported to the Company to determine the "success"
of the generic drug product. Success, in this context, means the
successful comparison of the Company's product related to the innovator
product. Since bioequivalence and a stable formula are the primary
requirements for a generic drug approval (assuming the manufacturing
plant is in compliance with the FDA's manufacturing quality standards),
lengthy and costly clinical trials proving safety and efficacy, which
are generally required by the FDA for innovator drug approvals, are
unnecessary for generic companies. If the results are successful, the
Company will continue the collection of documentation and information
for assembly of the drug application.
4.) Submission of the ANDA for FDA review and approval: The ANDA process
became formalized under The Drug Price Competition and Patent Term
Restoration Act of 1984, also known as the Hatch-Waxman Act. An ANDA
represents a generic drug company's application to the FDA to
manufacture and/or distribute a drug that is the generic equivalent to
an already-approved brand named ("innovator") drug. Once bioequivalence
studies are complete, the generic drug company submits an ANDA to the
FDA for marketing approval.
3
In a presentation to the Generic Pharmaceutical Association on February 26,
2005, Lester M. Crawford, D.V.M., Ph.D., and the Acting Commissioner of Food and
Drugs at the FDA, said that the median approval time for a new ANDA for the
FDA's Fiscal 2004 year was 16.2 months. However, there is no guarantee that the
FDA will approve a company's ANDA or that any approval will be given within this
time frame.
When a generic drug company files an ANDA to the FDA, it must certify that
no patents are listed in the Orange Book, the FDA's reference listing of
approved drugs, or listed patents have expired. If there are patents covering
some aspect of the innovator drug, the applicant must state whether it is
seeking approval for marketing after the expiration of the Orange Book patents;
or the patents listed therein are invalid, unenforceable, or not infringed --
usually referred to as a Paragraph IV Certification. ANDAs containing Paragraph
IV certifications frequently result in legal actions by the innovator drug
companies. These legal activities can trigger an automatic 30 month stay of our
ANDA if the innovator company files a claim and it will delay the approval of
the generic company's ANDA. Currently, Lannett has filed two Paragraph IV
certifications in its ANDAs.
Over the past several years, the Company has hired additional personnel in
product development, production, formulation and the R&D laboratory. Lannett
believes that its ability to select appropriate products for development,
develop such products on a timely basis, obtain FDA approval, and achieve
economies in production will be critical for its success in the generic
industry. The strategy involves a combination of decisions focusing on long-term
profitability and a secure market position with fewer challenges from
competitors.
Competition in generic pharmaceutical manufacturing will continue to grow as
more pharmaceutical products lose patent protection. However, the Company
believes that with strong technical know-how, low overhead expenses, and
efficient product development, manufacturing and marketing, it can remain
competitive. It is the intention of the Company to reinvest as much capital as
possible to develop new products since the success of any generic pharmaceutical
manufacturer depends on its ability to continually introduce new generic
products to the market. Over time, if a generic drug market for a specific
product remains stable and consumer demand remains consistent, it is likely that
additional generic manufacturing companies will pursue the generic product by
developing it, submitting an ANDA, and potentially receiving marketing approval
from the FDA. If this occurs, the generic competition for the drug increases,
and a company's market share may drop. In addition to reduced unit sales, the
unit selling price may also drop due to the product's availability from
additional suppliers. This may have the effect of reducing a generic company's
future net sales of the product. Due to these factors that may potentially
affect a generic company's future results of operations, the ability to properly
assess the competitive effect of new products, including market share, the
number of competitors and the generic unit price erosion, is critical to a
generic company's R&D plan. A generic company may be able to reduce the
potential exposure to competitive influences that negatively affect its sales
and profits by having several drug candidates in its R&D pipeline. As such, a
generic company may be able to avoid becoming materially dependent on the sales
of one drug. Unlike the branded, innovator companies, Lannett currently does not
own proprietary drug patents. However, the typical intellectual property in the
generic drug industry are the ANDAs that generic drug companies own.
4
VALIDATED PHARMACEUTICAL CAPABILITIES
Lannett's manufacturing facility consists of 31,000 square feet on 3.5 acres
owned by the Company. In July 2003, the Company signed a lease/purchase option
agreement for a 63,000 square foot building located at 9001 Torresdale Avenue,
Philadelphia, Pennsylvania. On November 26, 2003, the Company exercised its
option to purchase the facility. The initial renovation of the building is
complete and the Company moved some of its staff and operations into that
building in the fall of 2004. Lannett currently plans to move certain additional
non manufacturing personnel into the 9001 Torresdale building over the next
year.
Many FDA regulations relating to cGMP (current Good Manufacturing Practices)
have been adopted by the Company in the last several years. In designing its
facilities, full attention was given to material flow, equipment and automation,
quality control and inspection. A granulator, an automatic film coating machine,
high-speed tablet presses, blenders, encapsulators, fluid bed dryers, high shear
mixers and high-speed bottle filling are a few examples of the sophisticated
product development, manufacturing and packaging equipment the Company uses. In
addition, the Company's Quality Control laboratory facilities are equipped with
high precision instruments, like automated high-pressure liquid chromatographs,
gas chromatographs and laser particle sizers.
Lannett continues to pursue its comprehensive plan for improving and maintaining
quality control and quality assurance programs for its pharmaceutical
development and manufacturing facilities. The FDA periodically inspects the
Company's production facilities to determine the Company's compliance with the
FDA's manufacturing standards. Typically, after the FDA completes its
inspection, it will issue the Company a report, entitled a Form 483, containing
the FDA's observations of possible violations of cGMP. Such observations may be
minor or severe in nature. The degree of severity of the observation is
generally determined by the time necessary to remediate the cGMP violation, any
consequences upon the consumer of the Company's drug products, and whether the
observation is subject to a Warning Letter from the FDA. By strictly enforcing
the various FDA guidelines, namely Good Laboratory Practices, Standard Operating
Procedures and cGMP, the Company has successfully reduced the number of
observations in its latest FDA inspection. The Company believes that such
observations are minor in nature, and will be remediated in a timely fashion
with no material effect on its future results of operations.
SALES AND CUSTOMER RELATIONSHIPS
The Company sells its pharmaceutical products to generic pharmaceutical
distributors, drug wholesalers, chain drug retailers, private label
distributors, mail-order pharmacies, other pharmaceutical manufacturers, managed
care organizations, hospital buying groups and health maintenance organizations.
It promotes its products through direct sales, trade shows, trade publications,
and bids. The Company also licenses the marketing of its products to other
manufacturers and/or marketers in private label agreements.
Despite the decline of Company sales in Fiscal 2005, the Company continues to
expand its sales to the major chain drug stores, including CVS, Brooks, Rite Aid
and Walgreen's. The mail order
5
segment continued to be one of the fastest growing classes in the Company's
distribution efforts. Such companies, as Medco Health, Express Scripts and
Caremark are leaders in sales growth in the pharmaceutical market. Lannett also
increased distribution in the wholesaler segment led by Cardinal Health and
McKesson Corporation. Lannett is recognized by its customers as a dependable
supplier of high quality generic pharmaceuticals. The Company's policy of
maintaining an adequate inventory and fulfilling orders in a timely manner has
contributed to this reputation.
MANAGEMENT
As the Company continues to grow, additional managers will be hired to
complement the skilled team. These new managers will serve in a variety of
functions, including Research, Sales, Finance, Quality Control, Quality
Assurance, Regulatory Compliance and Production. Ultimately, the execution of a
sound business strategy requires a capable and knowledgeable management team.
PRODUCTS
As of the date of this filing, the Company manufactured and/or distributed
sixteen products:
<Table>
<Caption>
MANUFACTURE EQUIVALENT
NAME OF PRODUCT SOURCE MEDICAL INDICATION BRAND
--------------- ------------------ ------------------ ----------------
1) Acetazolamide Tablets Lannett Glaucoma Diamox(R)
2) Butalbital, Aspirin and Caffeine Capsules Lannett Migraine Headache Fiorinal(R)
3) Butalbital, Aspirin, Caffeine with Codeine JSP Migraine Headache Fiorinal w/
Phosphate Capsules Codeine #3(R)
4) Ciprofloxacin Tablets Spectrum Antibiotic Cipro(R)
5) Digoxin Tablets JSP Congestive Heart Failure Lanoxin(R)
6) Dicyclomine Tablets/Capsules Lannett Irritable Bowels Bentyl(R)
7) Diphenoxylate with Atropine Sulfate Lannett Diarrhea Lomotil(R)
Tablets
8) Hydromorphone HCl Tablets Lannett Pain Management Dilaudid
9) Levothyroxine Sodium Tablets JSP Thyroid Deficiency Levoxyl(R)/
Synthroid(R)
10) Methocarbamol Tablets Lannett Muscle Relaxer Robaxin(R)
11) Methyltestoterone/Esterified Estrogens Lannett Hormone Replacement Estratest(R)
Tablets
12) Phentermine HCl Tablets Lannett Weight Loss Adipex-P(R)
13) Phenylpropanolamine Tablets-Vet Lannett Incontinence Propagest(R)
14) Primidone Tablets Lannett Epilepsy Mysoline(R)
15) Terbutaline Sulfate Tablets Lannett Bronchospasms Brethine(R)
16) Unithroid Tablets JSP Thyroid Deficiency N/A
</Table>
All of the products currently manufactured and/or sold by the Company are
prescription products. Of the products listed above, Unithroid and those
containing butalbital, digoxin, primidone and
6
levothyroxine sodium were the Company's key products, contributing to more
than 93%, 97% and 95% of the Company's total net sales in Fiscal 2005, 2004 and
2003, respectively.
The Company has two products containing butalbital. One of the products,
Butalbital with Aspirin and Caffeine capsules has been manufactured and sold by
Lannett for more than seven years. The other butalbital product, Butalbital with
Aspirin, Caffeine and Codeine Phosphate capsules is manufactured by JSP. Lannett
began buying this product from JSP and selling it to its customers in December
2001. Both products, which are in orally administered capsule dosage forms, are
prescribed to treat tension headaches caused by contractions of the muscles in
the neck and shoulder area and migraine. The drug is prescribed primarily for
adults of various demographic backgrounds. Migraine headache is an increasingly
prevalent condition in the United States. As conditions continue to grow, the
demand for effective medical treatments will continue to grow. Common side
effects of drugs which contain butalbital include dizziness and drowsiness. The
Company notes that although new innovator drugs to treat migraine headaches have
been introduced by brand name drug companies, there is still a loyal following
of doctors and consumers who prefer to use butalbital products for treatment. As
the brand name companies continue to promote products containing butalbital,
like Fiorinal(R), the Company expects to continue to produce and sell its
generic butalbital products.
Digoxin tablets are produced and marketed with two different potencies (0.125
and 0.25 milligrams per tablet). This product is manufactured by JSP. Lannett
began buying this product from JSP, and selling it to its customers in September
2002. Digoxin tablets are used to treat congestive heart failure in patients of
various ages and demographic backgrounds. The beneficial effects of Digoxin
result from direct actions on the cardiac muscle, as well as indirect actions on
the cardiovascular system mediated by effects on the autonomic nervous system.
Side effects of Digoxin may include apathy, blurred vision, changes in
heartbeat, confusion, dizziness, headaches, loss of appetite, nausea, vomiting
and weakness.
Primidone tablets are produced and marketed with two different potencies (50 and
250 milligrams per tablet). This product was developed and manufactured by
Lannett. Lannett has been manufacturing and selling Primidone 250-milligram
tablets for more than seven years. Lannett began selling Primidone 50-milligram
tablets in June 2001. Both products, which are in orally administered tablet
dosage forms, are prescribed to treat convulsion and seizures in epileptic
patients of all ages and demographic backgrounds. Common side effects of
primidone include lack of muscle coordination, vertigo and severe dizziness.
The Company's products containing Levothyroxine Sodium tablets are produced and
marketed with eleven different potencies (0.025, 0.05, 0.075, 0.088, 0.1, 0.112,
0.125, 0.15, 0.175, 0.2, and 0.3 milligrams per tablet). In addition to generic
Levothyroxine Sodium tablets, the Company also markets and distributes Unithroid
tablets, a branded version of Levothyroxine Sodium tablets, which is produced
and marketed with eleven different potencies. Both Levothyroxine Sodium products
are manufactured by JSP. Lannett began buying generic Levothyroxine Sodium
tablets from JSP, and selling it to its customers in April 2003. In September
2003, the Company began buying the branded Unithroid tablets from JSP and
selling it to its customers. Levothyroxine Sodium tablets are used to treat
hypothyroidism and other thyroid disorders. It remains one of the most
prescribed drugs in the United States with over 13 million patients of various
ages and demographic backgrounds. Side effects from Levothyroxine Sodium are
rare, but may include allergic reactions, such as rash or hives. In late June of
2004, JSP received a letter from the FDA
7
approving its supplemental application for generic bioequivalence to Levoxyl(R).
In December 2004, JSP received a letter from the FDA approving its supplemental
application for generic bioequivalence to Synthroid(R). With its distribution of
these products, Lannett competes in a market which is currently controlled by
two branded Levothyroxine Sodium tablet products -- Abbott Laboratories'
Synthroid(R) and Monarch Pharmaceutical's Levoxyl(R) as well as generic
competition from Mylan Laboratories and Sandoz.
In April 2005, Lannett received a letter from the FDA with approval to market
and launch Phentermine Hydrochloride tablets 37.5 mg., which is a central
nervous system stimulant and anorexiant. Phentermine HCl tablets are the generic
version of Adipex-P manufactured and sold by TEVA through its Gate
Pharmaceutical division. It is indicated for the short-term management of
obesity.
In March 2005, Lannett received approval from the FDA for the ANDA of
Terbutaline Sulfate tablets 2.5mg and 5 mg. Terbutaline Sulfate is indicated for
the prevention and reversal of bronchospasm in patients 12 years of age and
older with asthma and reversible bronchospasm associated with bronchitis and
emphysema, and is the generic equivalent of Brethine(R) tablets marketed by
Novartis Pharmaceuticals and aaiPharma Inc.
Additional products are currently 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. The products
under development are at various stages in the development cycle -- formulation,
scale-up, clinical testing and FDA review.
The cost associated with each product currently under development is dependent
on numerous factors not limited to the following: the complexity of the active
ingredient's chemical characteristics, the price of the raw materials, the
FDA-mandated requirement of bioequivalence studies -- depending on the FDA's
Orange Book classification and other developmental factors. The overall cost to
develop a new generic product varies in range from $100,000 to $1 million.
In addition, as one of the oldest generic drug manufacturers in the country,
formed in 1942, Lannett currently owns several ANDAs for products which it 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, to make it
attractive for Lannett to reconsider manufacturing and selling them. 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 factors
meet current FDA requirements for the marketing of that drug. 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 another
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.
In addition to the efforts of its internal product development group, Lannett
has contracted with several outside firms 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,
8
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 complement the progress of its
own internal R&D efforts.
The Company has 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, prescribed to treat infections. The Company has
also initiated discussions with other 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 these third party products, and increase future revenues and
income.
The majority of the Company's R&D projects are being developed in-house under
Lannett's direct supervision and with Company personnel. Hence, the Company does
not believe that its' outside contracts for product development or manufacturing
supply, including Spectrum Pharmaceuticals Inc., 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.
The following table summarizes key information related to the Company's R&D
products. The column headings are defined as follows:
1.) Stage of R&D - Defines the current stage of the R&D product in the
development process, as of the date of this filing.
2.) Regulatory Requirement - Defines whether the R&D product is or is
expected to be a new ANDA submission, an ANDA supplement, or a
grand-fathered product not requiring specific FDA approval.
3.) Number of Products - Defines the number of products in R&D at the
stage noted. In this context, a product means any finished dosage
form, including all potencies, containing the same API or combination
of APIs and which represents a generic version of the same Reference
Listed Drug (RLD) or innovator drug, identified in the FDA's Orange
Book.
<Table>
<Caption>
STAGE OF R&D REGULATORY REQUIREMENT NUMBER OF PRODUCTS
------------ ---------------------- ------------------
FDA Review ANDA 11
FDA Review ANDA supplement 3
Clinical Testing ANDA 7
Scale-Up Grand-fathered 2
Scale-Up ANDA supplement 0
Scale-Up ANDA 0
Formulation/Method Development ANDA 25
</Table>
9
RAW MATERIAL(s) AND FINISHED GOOD(s) INVENTORY SUPPLIERS
The raw materials used by the Company in the production process consist of
pharmaceutical chemicals in various forms and are generally available from
several sources. FDA approval is required in connection with the process of
using active ingredient suppliers. In addition to the raw materials purchased
for the production process, the Company purchases certain finished dosage
inventories, including capsule, tablet, and oral liquid products. The Company
then sells these finished dosage products directly to its customers along with
the finished dosage products internally manufactured. If suppliers of a certain
material or finished product are limited, the Company will generally take
certain precautionary steps to avoid a disruption in supply.
The Company's primary finished product inventory supplier is Jerome Stevens
Pharmaceuticals, Inc. (JSP), in Bohemia, New York. Purchases of finished goods
inventory from JSP accounted for approximately 42% of the Company's inventory
purchases in Fiscal 2005, 81% in Fiscal 2004 and 62% in Fiscal 2003. 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. Refer to the Materials Contract footnote for more information on the
terms, conditions, and financial impact of this agreement.
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.
The Company has also contracted with Spectrum Pharmaceuticals (Spectrum), based
in California, to purchase and distribute Ciprofloxacin tablets which are
manufactured by Spectrum and/or its partners. Ciprofloxacin tablets are the
generic version of the brand Cipro(R), an anti-bacterial drug marketed by Bayer
Corporation and 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 FDA.
Another supplier, Siegfried (USA), Inc. (Siegfried), supplies primidone and
butalbital, the raw materials in the Company's commercial products of the same
name, and accounted for 4% of the Company's inventory purchases in Fiscal 2005,
6% in Fiscal 2004 and 12% in Fiscal 2003. This includes building a satisfactory
inventory level, and obtaining contractual supply commitments.
10
The agreement is a standard supply agreement evidencing the terms of the supply
of material. There are no guaranteed purchase volume commitments; however the
agreement does require Lannett to purchase 100% of its primidone raw material
requirements from Siegfried. The price of the material may vary depending on the
quantity of material purchased during the term of the agreement. The term of the
agreement was October 1, 2002 through December 31, 2003. As of June 30, 2005, a
new agreement with Siegfried had not yet been executed. The Company continues to
purchase raw materials from Siegfried under the terms of the expired purchase
agreement which is included in Exhibit 10.9 of the Company's Form 10-KSB for the
year ended June 30, 2004. The Company is in the process of finalizing a new
agreement with Siegfried.
The Company has also contracted with API Provider for the supply of raw
materials and oral dosage forms relating to future products. The agreements are
standard supply agreements evidencing the terms of the supply of material. There
are no guaranteed purchase volume commitments. The price of the material may
vary depending on the quantity of material purchased during the term of the
agreement.
CUSTOMERS AND MARKETING
The Company sells its products primarily to wholesale distributors, generic drug
distributors, mail-order pharmacies, group purchasing organizations, drug
chains, and other pharmaceutical companies. The wholesale distributors McKesson,
Cardinal Health, and Amerisource Bergen accounted for 17%, 14%, and 9%,
respectively, of net sales in Fiscal 2005. The Company performs ongoing credit
evaluations of its customers' financial condition, and has experienced no
significant collection problems to date. Generally, the Company requires no
collateral from its customers.
Sales to these wholesale customers include "indirect sales," which represent
sales to third-party entities, such as 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. This credit is called a
chargeback. For more information on chargebacks, refer to the section entitled
"Chargebacks" in Item 7, "Management's Discussion and Analysis of Financial
Condition and Results of Operations" of this Form 10-K. These indirect sale
transactions are recorded on Lannett's books as sales to the wholesale
customers. This has the effect of over-emphasizing the sales volume attributable
to such wholesaler customers.
The Company believes that retail-level consumer demand dictates the total volume
of sales for various products. In the event that wholesale and retail customers
adjust their purchasing volumes, the Company believes that consumer demand will
be fulfilled by other wholesale or retail sources of supply. As such, Lannett
attempts to obtain strong relationships with most of the major retail chains,
wholesale distributors, and mail-order pharmacies in order to facilitate the
supply of the Company's products through whatever channel the consumer prefers.
Although the Company has agreements with customers governing the transaction
terms of its sales, there are no minimum purchase quantities with these
agreements.
11
The Company promotes its products through direct sales, trade shows, trade
publications, and bids. The Company also markets its products through private
label arrangements, whereby Lannett produces its products with a label
containing the name and logo of a customer. This practice is commonly referred
to as private label business. It allows the Company to expand on its own
internal sales efforts by using the marketing services from other well-respected
pharmaceutical dosage suppliers. The focus of the Company's sales efforts is the
relationships it creates with its customer accounts. Strong customer
relationships have created a positive platform for Lannett to increase its sales
volumes. Advertising in the generic pharmaceutical industry is generally limited
to trade publications, read by retail pharmacists, wholesale purchasing agents
and other pharmaceutical decision-makers. Historically and in Fiscal 2005, 2004
and 2003, the Company's advertising expenses were immaterial. When the customer
and the Company's sales representatives make contact, the Company will generally
offer to supply the customer its products at fixed prices. If accepted, the
customer's purchasing department will coordinate the purchase, receipt and
distribution of the products throughout its distribution centers and retail
outlets. Once a customer accepts the Company's supply of product, the customer
generally expects a high standard of service. This service standard includes
shipping product in a timely manner on receipt of customer purchase orders,
maintaining convenient and effective customer service functions, and retaining a
mutually beneficial dialogue of communication. The Company believes that
although the generic pharmaceutical industry is a commodity industry, where
price is the primary factor for sales success, these additional service
standards are equally important to the customers that rely on a consistent
source of supply.
COMPETITION
The manufacture and distribution of generic pharmaceutical products is a highly
competitive industry. Competition is based primarily on price, service and
quality. The Company competes primarily on this basis, as well as by flexibility
(reacting to customer needs quickly and decisively -- for example shipping
product via overnight delivery when the customer is in critical need of
inventory), availability of inventory, and by the fact that the Company's
products are available only from a limited number of suppliers. The
modernization of its facilities, hiring of experienced staff, and implementation
of inventory and quality control programs have improved the Company's
competitive position over the past five years.
The Company competes with other manufacturers and marketers of generic and brand
drugs. Each product manufactured and/or sold by Lannett has a different set of
competitors. The list below identifies the companies with which Lannett
primarily competes for each of its major products.
<Table>
<Caption>
PRODUCT PRIMARY COMPETITORS
------- -------------------
Butalbital with Aspirin and Caffeine, with Watson Pharmaceuticals, Breckenridge
and without Codeine Phosphate Capsules Pharmaceutical mfd. by Anabolic Laboratories,
GlaxoSmithKline, Amide (marketed by Bertek
Digoxin Tablets Pharmaceuticals), Caraco Pharmaceutical
Laboratories
12
Levothyroxine Sodium Tablets Abbott Laboratories, Monarch Pharmaceuticals,
Mylan Laboratories, Sandoz
Methyltestoterone/Esterified Estrogens Solvay Pharmaceuticals, Syntho Pharmaceuticals
Tablets (marketed by Breckenridge Pharmaceutical)
Phentermine HCL Tablets Eon Laboratories, Amide Pharmaceutical, Purepac
Pharmaceutical Co.
Primidone Tablets Watson Pharmaceuticals, Qualitest Pharmaceuticals
Unithroid Tablets Abbott Laboratories, Monarch Pharmaceuticals,
Mylan Laboratories, Sandoz
</Table>
GOVERNMENT REGULATION
Pharmaceutical manufacturers are subject to extensive regulation by the federal
government, principally by the FDA and the Drug Enforcement Agency (DEA) and to
a lesser extent, by other federal regulatory bodies and state governments. The
Federal Food, Drug and Cosmetic Act, the Controlled Substance Act, and other
federal statutes and regulations govern or influence the testing, manufacture,
safety, labeling, storage, record keeping, approval, pricing, advertising, and
promotion of the Company's generic drug products. Noncompliance with applicable
regulations can result in fines, recall and seizure of products, total or
partial suspension of production, personal and/or corporate prosecution and
debarment, and refusal of the government to approve new drug applications. The
FDA also has the authority to revoke previously approved drug products.
Generally, FDA approval is required before a prescription drug can be marketed.
A new drug is one not generally recognized by qualified experts as safe and
effective for its intended use. New drugs are typically developed and submitted
to the FDA by companies expecting to brand the product and sell it as a new
medical treatment. The FDA review process for new drugs is very extensive and
requires a substantial investment to research and test the drug candidate.
However, less burdensome approval procedures may be used for generic
equivalents. Typically, the investment required to develop a generic drug is
less costly than the brand innovator drug.
There are currently three ways to obtain FDA approval of a drug:
- NEW DRUG APPLICATIONS (NDA): Unless one of the two procedures
discussed in the following paragraphs is available, a manufacturer
must conduct and submit to the FDA complete clinical studies to
establish a drug's safety and efficacy.
- ABBREVIATED NEW DRUG APPLICATIONS (ANDA): An ANDA is similar to an NDA
except that the FDA generally waives the requirement of complete
clinical studies of safety and efficacy. However, it may require
bioavailability and bioequivalence studies. Bioavailability indicates
the rate of absorption and levels of concentration of a drug in the
bloodstream
13
needed to produce a therapeutic effect. Bioequivalence compares one
drug product with another and indicates if the rate of absorption and
the levels of concentration of a generic drug in the body are within
prescribed statistical limits to those of a previously approved drug.
Under the Drug Price Act, an ANDA may be submitted for a drug on the
basis that it is the equivalent of an approved drug regardless of when
such other drug was approved. In addition to establishing a new ANDA
procedure, this act created statutory protections for approved brand
name drugs. Under the act, an ANDA for a generic drug may not be made
effective until all relevant product and use patents for the brand
name drug have expired or have been determined to be invalid. Prior to
this act, the FDA gave no consideration to the patent status of a
previously approved drug. Additionally, the Drug Price Act extends for
up to five years the term of a product or use patent covering a drug
to compensate the patent holder for the reduction of the effective
market life of a patent due to federal regulatory review. With respect
to certain drugs not covered by patents, the act sets specified time
periods of two to ten years during which ANDAs for generic drugs
cannot become effective or, under certain circumstances, cannot be
filed if the branded drug was approved after December 31, 1981.
Lannett, like most other generic drug companies, uses the ANDA process
for the submission of its developmental generic drug candidates.
- PAPER NEW DRUG APPLICATIONS (PAPER NDA): For a drug that is identical
to a drug first approved after 1962, a prospective manufacturer need
not go through the full NDA procedure. Instead, it may demonstrate
safety and efficacy by relying on published literature and reports.
The manufacturer must also submit, if the FDA so requires,
bioavailability or bioequivalence data illustrating that the generic
drug formulation produces the same effects, within an acceptable
range, as the previously approved innovator drug. Because published
literature to support the safety and efficacy of post-1962 drugs may
not be available, this procedure is of limited utility to generic drug
manufacturers. Moreover, the utility of Paper NDAs has been further
diminished by the recently broadened availability of the ANDA process,
as described above.
Among the requirements for new drug approval is the requirement that the
prospective manufacturer's methods conform to the FDA's current Good
Manufacturing Practices (cGMP Regulations). The cGMP Regulations must be
followed at all times during which the approved drug is manufactured. In
complying with the standards set forth in the cGMP Regulations, the Company must
continue to expend time, money, and effort in the areas of production and
quality control to ensure full technical compliance. Failure to comply with the
cGMP Regulations risks possible FDA action, including but not limited to, the
seizure of noncomplying drug products or, through the Department of Justice,
enjoining the manufacture of such products.
The Company is also subject to federal, state, and local laws of general
applicability, such as laws regulating working conditions and the storage,
transportation, or discharge of items that may be considered hazardous
substances, hazardous waste, or environmental contaminants. The Company monitors
its compliance with all environmental laws.
RESEARCH AND DEVELOPMENT
The Company incurred research and development expenses of approximately
$6,266,000 in 2005, $5,896,000 in 2004 and $2,575,000 in 2003.
14
EMPLOYEES
The Company currently has 172 employees, of which 167 are full-time.
SECURITIES EXCHANGE ACT REPORTS
The Company maintains an Internet website at the following address:
www.lannett.com. The Company makes available on or through its Internet website
certain reports and amendments to those reports that are filed with the
Securities and Exchange Commission (SEC) in accordance with the Securities
Exchange Act of 1934. These include annual reports on Form 10-K, quarterly
reports on Form 10-Q and current reports on Form 8-K. This information is
available on the Company's website free of charge as soon as reasonably
practicable after the Company electronically files the information with, or
furnishes it to, the SEC. The contents of the Company's website are not
incorporated by reference in this Form 10-K and shall not be deemed "filed"
under the Securities Exchange Act of 1934.
15
ITEM 2. DESCRIPTION OF PROPERTY
The Company's headquarters, administrative offices, quality control laboratory,
and manufacturing and production facilities, consisting of approximately 31,000
square feet, are located at 9000 State Road, Philadelphia, Pennsylvania.
On July 1, 2003, the Company entered into a lease/purchase option agreement for
a 63,000 square foot facility at 9001 Torresdale Avenue, Philadelphia,
Pennsylvania, approximately 1 mile from the Company's headquarters. On November
26, 2003, the Company exercised its option to purchase the facility. The
Company's research laboratory, warehousing and distribution operations, and
sales and accounting departments are now housed there.
In December 1997, the Company entered into a three-year and three-month lease
for a 23,500 square foot facility located at 500A State Road, Bensalem,
Pennsylvania. This facility housed laboratory research, warehousing and
distribution operations. The leased facility is located approximately 2 miles
from the Company headquarters. In January 2001, the Company extended this lease
through April 30, 2004. After that time, the Company renewed the lease again
through April 30, 2005. The Company no longer utilizes nor has any lease
obligations related to the 500A State Road, Bensalem, Pennsylvania facility.
16
ITEM 3. 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 DEA.
In 2004 and 2005, the Company entered into three, separate confidential
agreements with ThePharmaNetwork, LLC (TPN) pursuant to which the company agreed
to collaborate to develop, manufacture, supply, and commercialize a certain
generic pharmaceutical drug product. In August 2005, TPN filed a lawsuit against
various defendants, including the Company, seeking, among other things, to
terminate the three agreements between the Company and TPN. The matter is
currently pending before the United States District Court for the District of
New Jersey. The Company has filed an answer denying the allegations. The Company
has also filed counterclaims against TPN and its principal, Jonathan B. Rome,
for, among other things, breach of contract. Because of the confidential nature
of the agreements and the generic pharmaceutical drug product at issue, the
Company has requested that the Court place all documents under seal to prevent
the wrongful disclosure of the Company's sensitive, confidential, and
proprietary information. The Company's request for a temporary restraining order
was granted. As a result, TPN is temporarily restrained from competing against
Lannett or collaborating with Lannett's competitors with respect to the drug
product at issue. TPN is also temporarily restrained from using, disclosing or
disseminating any confidential information about this drug product until after
the hearing on the preliminary injunction, which is scheduled for Sept. 14,
2005. TPN received a temporary restraining order prohibiting Lannett from
disclosing TPN's "confidential information" until after the preliminary
injunction hearing on Sept. 14, 2005. 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 litigation will not have a material adverse impact on
the financial position or results of operation 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.
17
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters have been submitted to a vote of the Company's security holders
during the quarter ended June 30, 2005.
18
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
On April 15, 2002, the Company's common stock began trading on the American
Stock Exchange. Prior to this, the Company's common stock traded in the
over-the-counter market through the use of the inter-dealer "pink-sheets"
published by Pink Sheets LLC. The following table sets forth certain information
with respect to the high and low daily closing prices of the Company's common
stock during Fiscal 2005 and 2004, as quoted by the American Stock Exchange.
Such quotations reflect inter-dealer prices without retail mark-up, markdown, or
commission and may not represent actual transactions.
FISCAL YEAR ENDED JUNE 30, 2005
HIGH LOW
First quarter........................................................ $15.19 $9.50
Second quarter....................................................... $12.80 $8.25
Third quarter........................................................ $10.05 $5.95
Fourth quarter....................................................... $6.45 $3.88
FISCAL YEAR ENDED JUNE 30, 2004
HIGH LOW
First quarter........................................................ $25.09 $15.65
Second quarter....................................................... $18.88 $16.40
Third quarter........................................................ $19.00 $15.10
Fourth quarter....................................................... $17.00 $13.18
</Table>
HOLDERS
As of August 25, 2005, there were approximately 249 holders of record of the
Company's common stock.
DIVIDENDS
The Company did not pay cash dividends in Fiscal 2005, Fiscal 2004 or Fiscal
2003. The Company intends to use available funds for working capital, plant and
equipment additions, and various product extension ventures. The Company does
not expect to pay, nor should shareholders expect to receive, cash dividends in
the foreseeable future.
19
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes the equity compensation plans as of June 30,
2005.
<Table>
<Caption>
Plan Category Number of securities to be Weighted average exercise Number of securities
issued upon exercise of price of outstanding options, remaining available for
outstanding options, warrants and rights future issuance under equity
warrants and rights compensation plans
(b) (excluding securities
(a) reflected in column (a)
(c)
Equity Compensation 857,108 $13.72 1,395,267
plans approved by
security holders
Equity Compensation - - -
plans not approved by
security holders
Total 857,108 $13.72 1,395,267
</Table>
20
ITEM 6. SELECTED FINANCIAL DATA
LANNETT COMPANY, INC. AND SUBSIDIARIES
FINANCIAL HIGHLIGHTS
<Table>
<Caption>
AS OF OR FOR THE YEAR
ENDED JUNE 30, 2005 2004 2003 2002 2001
---- ---- ---- ---- ----
OPERATING HIGHLIGHTS
Net Sales $ 44,901,645 $ 63,781,219 $ 42,486,758 $ 25,126,214 $ 12,090,993
Gross Profit $ 13,484,737 $ 36,924,344 $ 26,228,964 $ 16,673,537 $ 5,556,229
Operating (Loss)/Income $ (53,825,498) $ 20,830,969 $ 19,060,106 $ 11,425,483 $ 2,042,585
Net (Loss)/Income $ (32,779,596) $ 13,215,454 $ 11,666,887 $ 7,195,990 $ 1,829,915
Basic (Loss)/Earnings Per $ (1.36) $ 0.63 $ 0.58 $ 0.36 $ 0.14
Share
Diluted (Loss)/Earnings $ (1.36) $ 0.63 $ 0.58 $ 0.36 $ 0.14
Per Share
Weighted Average Shares 24,097,472 20,831,750 19,968,633 19,895,757 13,206,128
Outstanding, Basic
Weighted Average Shares 24,097,472 21,053,944 20,121,314 20,018,548 13,206,128
Outstanding, Diluted
BALANCE SHEET HIGHLIGHTS
Current Assets $ 33,938,115 $ 48,862,443 $ 23,930,048 $ 10,439,630 $ 8,884,835
Working Capital* $ 17,542,553 $ 28,923,814 $ 17,185,052 $ 6,891,998 $ (69,920)
Total Assets $ 94,917,060 $ 131,904,084 $ 31,834,544 $ 17,338,503 $ 15,931,617
Total Debt $ 9,532,448 $ 10,092,857 $ 3,097,802 $ 4,142,538 $ 10,773,222
Deferred Tax Liabilities $ 2,009,582 $ 1,614,323 $ 1,112,369 $ 681,489 $ 641,285
Total Stockholders' Equity $ 69,249,244 $ 102,246,991 $ 21,597,710 $ 9,766,049 $ 2,515,685
</Table>
*Working capital equals current assets less current liabilities
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Any statements made in this report that are not statements of historical fact or
that refer to estimated or anticipated future events are forward-looking
statements. We have based our forward-looking statements on our management's
beliefs and assumptions based on information available to them at this time.
Such forward-looking statements reflect our current perspective of our business,
future performance, existing trends and information as of the date of this
filing. These include, but are not limited to, our beliefs about future revenue
and expense levels and growth rates, prospects related to our strategic
initiatives and business strategies, express or implied assumptions about
government regulatory action or inaction, anticipated product approvals and
launches, business initiatives and product development activities, assessments
related to clinical trial results, product performance and competitive
environment, and anticipated financial performance. Without limiting the
generality of the foregoing, words such as "may," "will," "expect," "believe,"
"anticipate," "intend," "could," "would," "estimate," "continue," or "pursue,"
or the negative other variations thereof or comparable terminology, are intended
to identify forward-looking statements. The statements are not guarantees of
future performance and involve certain risks, uncertainties and assumptions that
are difficult to predict. We caution the reader that certain important factors
may affect our actual operating results and
21
could cause such results to differ materially from those expressed or implied by
forward-looking statements. We believe the risks and uncertainties discussed
under the Section entitled "Risks
Related to Our Business," and other risks and uncertainties detailed herein and
from time to time in our Securities and Exchange Commission filings, may affect
its actual results.
We disclaim any obligation to publicly update any forward-looking statements,
whether as a result of new information, future events or otherwise, except as
required by law. We also may make additional disclosures in our quarterly
reports on Form 10-Q and current reports on Form 8-K that we may file from time
to time with the SEC. Other factors besides those listed here could also
adversely affect us. This discussion is provided as permitted by the Private
Securities Litigation Reform Act of 1995.
RISKS RELATED TO OUR BUSINESS
We operate in a rapidly changing environment that involves a number of risks,
some of which are beyond our control. The following discussion highlights some
of these risks and others are discussed elsewhere in this report. These and
other risks could materially and adversely affect our business, financial
condition, operating results or cash flows
RISKS ASSOCIATED WITH INVESTING IN THE BUSINESS OF LANNETT
IF WE ARE UNABLE TO SUCCESSFULLY DEVELOP OR COMMERCIALIZE NEW PRODUCTS, OUR
OPERATING RESULTS WILL SUFFER.
Our future results of operations will depend to a significant extent upon our
ability to successfully commercialize new generic products in a timely manner.
There are numerous difficulties in developing and commercializing new products,
including:
o developing, testing and manufacturing products in compliance with
regulatory standards in a timely manner;
o receiving requisite regulatory approvals for such products in a timely
manner;
o the availability, on commercially reasonable terms, of raw materials,
including active pharmaceutical ingredients and other key ingredients;
o developing and commercializing a new product is time consuming, costly and
subject to numerous factors that may delay or prevent the successful
commercialization of new products;
o experiencing delays or unanticipated costs; and
o commercializing generic products may be substantially delayed by the
listing with the FDA of patents have the effect of potentially delaying approval
of the off-patent product by up to 30 months, and in some cases, such patents
have issued and been listed with the FDA after the key chemical patent on the
branded drug product has expired or been litigated, causing additional delays in
obtaining approval.
As a result of these and other difficulties, products currently in development
by Lannett may or may not receive the regulatory approvals necessary for
marketing. If any of our products, when developed and approved, cannot be
successfully or timely commercialized, our operating results
22
could be adversely affected. We cannot guarantee that any investment we make in
developing products will be recouped, even if we are successful in
commercializing those products.
OUR GROSS PROFIT MAY FLUCTUATE FROM PERIOD TO PERIOD DEPENDING UPON OUR PRODUCT
SALES MIX, OUR PRODUCT PRICING, AND OUR COSTS TO MANUFACTURE OR PURCHASE
PRODUCTS.
Our future results of operations, financial condition and cash flows depend to a
significant extent upon our product sales mix. Our sales of products that we
manufacture tend to create higher gross margins than do the products we purchase
and resell. As a result, our sales mix will significantly impact our gross
profit from period to period. Factors that may cause our sales mix to vary
include:
o the amount of new product introductions;
o marketing exclusivity, if any, which may be obtained on certain new
products;
o the level of competition in the marketplace for certain products;
o the availability of raw materials and finished products from our suppliers;
and
o the scope and outcome of governmental regulatory action that may involve
us.
The profitability of our product sales is also dependent upon the prices we are
able to charge for our products, the costs to purchase products from third
parties, and our ability to manufacture our products in a cost effective manner.
IF BRANDED PHARMACEUTICAL COMPANIES ARE SUCCESSFUL IN LIMITING THE USE OF
GENERICS THROUGH THEIR LEGISLATIVE AND REGULATORY EFFORTS, OUR SALES OF GENERIC
PRODUCTS MAY SUFFER.
Many branded pharmaceutical companies increasingly have used state and federal
legislative and regulatory means to delay generic competition. These efforts
have included:
o pursuing new patents for existing products which may be granted just before
the expiration of one patent which could extend patent protection for
additional years or otherwise delay the launch of generics;
o using the Citizen Petition process to request amendments to FDA standards;
o seeking changes to U.S. Pharmacopoeia, an organization which publishes
industry recognized compendia of drug standards;
o attaching patent extension amendments to non-related federal legislation;
and
o engaging in state-by-state initiatives to enact legislation that restricts
the substitution of some generic drugs, which could have an impact on
products that we are developing.
If branded pharmaceutical companies are successful in limiting the use of
generic products through these or other means, our sales may decline. If we
experience a material decline in product sales, our results of operations,
financial condition and cash flows will suffer.
THIRD PARTIES MAY CLAIM THAT WE INFRINGE THEIR PROPRIETARY RIGHTS AND MAY
PREVENT US FROM MANUFACTURING AND SELLING SOME OF OUR PRODUCTS.
The manufacture, use and sale of new products that are the subject of
conflicting patent rights have been the subject of substantial litigation in the
pharmaceutical industry. These lawsuits relate to the validity and infringement
of patents or proprietary rights of third parties. We may
23
have to defend against charges that we violated patents or proprietary rights of
third parties. This is especially true in the case of generic products on which
the patent covering the branded product is expiring, an area where infringement
litigation is prevalent, and in the case of new branded products where a
competitor has obtained patents for similar products. Litigation may be costly
and time-consuming, and could divert the attention of our management and
technical personnel. In addition, if we infringe on the rights of others, we
could lose our right to develop or manufacture products or could be required to
pay monetary damages or royalties to license proprietary rights from third
parties. Although the parties to patent and intellectual property disputes in
the pharmaceutical industry have often settled their disputes through licensing
or similar arrangements, the costs associated with these arrangements may be
substantial and could include ongoing royalties. Furthermore, we cannot be
certain that the necessary licenses would be available to us on terms we believe
to be acceptable. As a result, an adverse determination in a judicial or
administrative proceeding or failure to obtain necessary licenses could prevent
us from manufacturing and selling a number of our products, which could harm our
business, financial condition, results of operations and cash flows.
IF WE ARE UNABLE TO OBTAIN SUFFICIENT SUPPLIES FROM KEY SUPPLIERS THAT IN SOME
CASES MAY BE THE ONLY SOURCE OF FINISHED PRODUCTS OR RAW MATERIALS, OUR ABILITY
TO DELIVER OUR PRODUCTS TO THE MARKET MAY BE IMPEDED.
We are required to identify the supplier(s) of all the raw materials for our
products in our applications with the FDA. To the extent practicable, we attempt
to identify more than one supplier in each drug application. However, some
products and raw materials are available only from a single source and, in some
of our drug applications, only one supplier of products and raw materials has
been identified, even in instances where multiple sources exist. To the extent
any difficulties experienced by our suppliers cannot be resolved within a
reasonable time, and at reasonable cost, or if raw materials for a particular
product become unavailable from an approved supplier and we are required to
qualify a new supplier with the FDA, our profit margins and market share for the
affected product could decrease, as well as delay our development and sales and
marketing efforts.
OUR POLICIES REGARDING RETURNS, ALLOWANCES AND CHARGEBACKS, AND MARKETING
PROGRAMS ADOPTED BY WHOLESALERS, MAY REDUCE OUR REVENUES IN FUTURE FISCAL
PERIODS.
Based on industry practice, generic product manufacturers, including us, have
liberal return policies and have been willing to give customers post-sale
inventory allowances. Under these arrangements, from time to time, we give our
customers credits on our generic products that our customers hold in inventory
after we have decreased the market prices of the same generic products.
Therefore, if new competitors enter the marketplace and significantly lower the
prices of any of their competing products, we would likely reduce the price of
our product. As a result, we would be obligated to provide credits to our
customers who are then holding inventories of such products, which could reduce
sales revenue and gross margin for the period the credit is provided. Like our
competitors, we also give credits for chargebacks to wholesale customers that
have contracts with us for their sales to hospitals, group purchasing
organizations, pharmacies or other retail customers. A chargeback is the
difference between the price the wholesale customer pays and the price that the
wholesale customer's end-customer pays for a product. Although we establish
reserves based on our prior experience and our best estimates of the impact that
these policies may have in subsequent periods, we cannot ensure that our
reserves
24
are adequate or that actual product returns, allowances and chargebacks will not
exceed our estimates.
THE DESIGN, DEVELOPMENT, MANUFACTURE AND SALE OF OUR PRODUCTS INVOLVES THE RISK
OF PRODUCT LIABILITY CLAIMS BY CONSUMERS AND OTHER THIRD PARTIES, AND INSURANCE
AGAINST SUCH POTENTIAL CLAIMS IS EXPENSIVE AND MAY BE DIFFICULT TO OBTAIN.
The design, development, manufacture and sale of our products involve an
inherent risk of product liability claims and the associated adverse publicity.
Insurance coverage is expensive and may be difficult to obtain, and may not be
available in the future on acceptable terms, or at all. Although we currently
maintain product liability insurance for our products in amounts we believe to
be commercially reasonable, if the coverage limits of these insurance policies
are not adequate, a claim brought against Lannett, whether covered by insurance
or not, could have a material adverse effect on our business, results of
operations, financial condition and cash flows.
RISING INSURANCE COSTS COULD NEGATIVELY IMPACT PROFITABILITY.
The cost of insurance, including workers compensation, product liability and
general liability insurance, have risen in prior years and may increase in the
future. In response, we may increase deductibles and/or decrease certain
coverages to mitigate these costs. These increases, and our increased risk due
to increased deductibles and reduced coverages, could have a negative impact on
our results of operations, financial condition and cash flows.
THE LOSS OF OUR KEY PERSONNEL COULD CAUSE OUR BUSINESS TO SUFFER.
The success of our present and future operations will depend, to a significant
extent, upon the experience, abilities and continued services of key personnel.
If the employment of any of our current key personnel is terminated, we cannot
assure you that we will be able to attract and replace the employee with the
same caliber of key personnel. As such, we have entered into employment
agreements with most of our senior executive officers.
SIGNIFICANT BALANCES OF INTANGIBLE ASSETS, INCLUDING PRODUCT RIGHTS ACQUIRED,
ARE SUBJECT TO IMPAIRMENT TESTING AND MAY RESULT IN IMPAIRMENT CHARGES, WHICH
WILL ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.
Our acquired contractual rights to market and distribute JSP's products are
stated at cost, less accumulated amortization and related impairment charges
identified to date. We determined the initial cost by referring to the original
fair value of the assets exchanged. Future amortization periods for product
rights are based on our assessment of various factors impacting estimated useful
lives and cash flows of the acquired products. Such factors include the
product's position in its life cycle, the existence or absence of like products
in the market, various other competitive and regulatory issues and contractual
terms. Significant changes to any of these factors would require us to perform
an additional impairment test on the affected asset and, if evidence of
impairment exists, we would be required to take an impairment charge with
respect to the asset. Such a charge would adversely affect our results of
operations and financial condition.
25
RISKS RELATING TO INVESTING IN THE PHARMACEUTICAL INDUSTRY
EXTENSIVE INDUSTRY REGULATION HAS HAD, AND WILL CONTINUE TO HAVE, A SIGNIFICANT
IMPACT ON OUR BUSINESS, ESPECIALLY OUR PRODUCT DEVELOPMENT, MANUFACTURING AND
DISTRIBUTION CAPABILITIES.
All pharmaceutical companies, including Lannett, are subject to extensive,
complex, costly and evolving regulation by the federal government, principally
the FDA and to a lesser extent by the DEA and state government agencies. The
Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other
federal statutes and regulations govern or influence the testing, manufacturing,
packing, labeling, storing, record keeping, safety, approval, advertising,
promotion, sale and distribution of our products.
Under these regulations, we are subject to periodic inspection of our
facilities, procedures and operations and/or the testing of our products by the
FDA, the DEA and other authorities, which conduct periodic inspections to
confirm that we are in compliance with all applicable regulations. In addition,
the FDA conducts pre-approval and post-approval reviews and plant inspections to
determine whether our systems and processes are in compliance with current Good
Manufacturing Practice, or cGMP, and other FDA regulations. Following such
inspections, the FDA may issue notices on Form 483 and warning letters that
could cause us to modify certain activities identified during the inspection. A
Form 483 notice is generally issued at the conclusion of a FDA inspection and
lists conditions the FDA inspectors believe may violate cGMP or other FDA
regulations. FDA guidelines specify that a warning letter is issued only for
violations of "regulatory significance" for which the failure to adequately and
promptly achieve correction may be expected to result in an enforcement action.
Any such sanctions, if imposed, could materially harm our operating results and
financial condition. Under certain circumstances, the FDA also has the authority
to revoke previously granted drug approvals. Similar sanctions as detailed above
may be available to the FDA under a consent decree, depending upon the actual
terms of such decree. Although we have instituted internal compliance programs,
if these programs do not meet regulatory agency standards or if compliance is
deemed deficient in any significant way, it could materially harm our business.
Certain of our vendors are subject to similar regulation and periodic
inspections.
The process for obtaining governmental approval to manufacture and market
pharmaceutical products is rigorous, time-consuming and costly, and we cannot
predict the extent to which we may be affected by legislative and regulatory
developments. We are dependent on receiving FDA and other governmental or
third-party approvals prior to manufacturing, marketing and shipping our
products. Consequently, there is always the chance that we will not obtain FDA
or other necessary approvals, or that the rate, timing and cost of such
approvals, will adversely affect our product introduction plans or results of
operations. We carry inventories of certain product(s) in anticipation of
launch, and if such product(s) are not subsequently launched, we may be required
to write-off the related inventory.
26
FEDERAL REGULATION OF ARRANGEMENTS BETWEEN MANUFACTURERS OF BRANDED AND GENERIC
PRODUCTS COULD ADVERSELY AFFECT OUR BUSINESS.
As part of the Medicare Prescription Drug, Improvement, and Modernization Act of
2003, companies are now required to file with the Federal Trade Commission and
the Department of Justice certain types of agreements entered into between brand
and generic pharmaceutical companies related to the manufacture, marketing and
sale of generic versions of branded drugs. This new requirement could affect the
manner in which generic drug manufacturers resolve intellectual property
litigation and other disputes with branded pharmaceutical companies and could
result generally in an increase in private-party litigation against
pharmaceutical companies or additional investigations or proceedings by the FTC
or other governmental authorities. The impact of this new requirement and the
potential private-party lawsuits associated with arrangements between brand name
and generic drug manufacturers is uncertain, and could adversely affect our
business.
THE PHARMACEUTICAL INDUSTRY IS HIGHLY COMPETITIVE.
We face strong competition in our generic product business. Revenues and gross
profit derived from the sales of generic pharmaceutical products tend to follow
a pattern based on certain regulatory and competitive factors. As patents for
brand name products and related exclusivity periods expire, the first generic
manufacturer to receive regulatory approval for generic equivalents of such
products is generally able to achieve significant market penetration. As
competing off-patent manufacturers receive regulatory approvals on similar
products or as brand manufacturers launch generic versions of such products (for
which no separate regulatory approval is required), market share, revenues and
gross profit typically decline, in some cases dramatically. Accordingly, the
level of market share, revenue and gross profit attributable to a particular
generic product is normally related to the number of competitors in that
product's market and the timing of that product's regulatory approval and
launch, in relation to competing approvals and launches. Consequently, we must
continue to develop and introduce new products in a timely and cost-effective
manner to maintain our revenues and gross margins.
SALES OF OUR PRODUCTS MAY CONTINUE TO BE ADVERSELY AFFECTED BY THE CONTINUING
CONSOLIDATION OF OUR DISTRIBUTION NETWORK AND THE CONCENTRATION OF OUR CUSTOMER
BASE.
Our principal customers are wholesale drug distributors and major retail drug
store chains. These customers comprise a significant part of the distribution
network for pharmaceutical products in the U.S. This distribution network is
continuing to undergo significant consolidation marked by mergers and
acquisitions among wholesale distributors and the growth of large retail drug
store chains. As a result, a small number of large wholesale distributors
control a significant share of the market, and the number of independent drug
stores and small drug store chains has decreased. We expect that consolidation
of drug wholesalers and retailers will increase pricing and other competitive
pressures on drug manufacturers, including Lannett.
For the year ended June 30, 2005, our three largest customers accounted for 17%,
14% and 9% respectively, of our net revenues. The loss of any of these customers
could materially adversely affect our business, results of operations and
financial condition and our cash flows. In addition, the Company has no
long-term supply agreements with its customers which would require them to
purchase our products.
27
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
In addition to historical information, this Form 10-K contains forward-looking
information. The forward-looking information 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-K. The Company undertakes no
obligation to publicly revise or update these forward-looking statements to
reflect events or circumstances that may occur. Readers should carefully review
the risk factors described in other documents the Company files from time to
time with the SEC, including the quarterly reports on Form 10-Q to be filed by
the Company in Fiscal 2006, and any current reports on Form 8-K filed by the
Company. All share and per share amounts on this Form 10-K have been adjusted to
reflect a three-for-two stock split effective on February 14, 2003.
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, refer to
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, 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 drug
28
companies, Lannett does not use information about product levels in distribution
channels from third-party sources, such as IMS 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 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
29
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 years ended June 30, 2005 and
2004:
<Table>
<Caption>
FOR THE YEAR ENDED
JUNE 30, 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 (4,978,300) (1,970,000) (523,100) (95,800) (7,567,200)
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2005 (14,534,600) (5,965,500) (1,166,800) (586,400) (22,253,300)
Additional Reserves Charged to
Net Sales During Fiscal 2005 21,028,100 7,100,100 2,933,900 623,400 31,685,500
----------- ----------- ---------- --------- -----------
Reserve Balance as of
June 30, 2005 $ 7,999,700 $ 1,028,800 $1,692.000 $ 29,500 $10,750,000
=========== =========== ========== ========= ===========
<Caption>
FOR THE YEAR ENDED
JUNE 30, 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 (12,447,000) (2,723,200) (60,100) (410,000) (15,640,300)
Additional Reserves Charged to
Net Sales During Fiscal 2004 18,897,500 4,863,900 480,600 464,400 24,706,400
----------- ----------- ---------- --------- -----------
Reserve Balance as of
June 30, 2004 $ 6,484,500 $ 1,864,200 $ 448,000 $ 88,300 $ 8,885,000
=========== =========== ========== ========= ===========
</Table>
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
30
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 resale 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.
31
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 ASSET - 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. An impairment charge
was recorded against this intangible asset in the current fiscal year. The
agreement was included as an Exhibit in the 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 was 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 recorded an addition to the
intangible asset of $1.5 million.
Management believes that events occurred during Fiscal 2005 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 paid to
JSP for the duel AB ratings). As a result of the testing, the Company 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 the date of the impairment. This impairment loss is shown on
the statement of operations as a component of operating loss. Management
concluded that, as of June 30, 2005, the intangible asset is correctly stated at
fair value and, therefore, no adjustment was required.
NEW ACCOUNTING PRONOUNCEMENTS - In November 2004, the Financial Accounting
Standards Board (FASB) issued Statement of Financial Accounting Standards No.
151 (SFAS No. 151), Inventory Costs - an amendment of ARB No. 43, Chapter 4.
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
32
treatment as current period charges..." SFAS No. 151 requires that those items
be recognized as current period charges regardless of whether they meet the
criterion of "so abnormal." The adoption of SFAS No. 151 did not have a material
effect on the Company's consolidated financial position, results of operations,
or cash flows.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets
- - an amendment of APB Opinion No. 29 (SFAS No. 153). APB Opinion No. 29 requires
a nonmonetary exchange of assets be accounted for at fair value, recognizing any
gain or loss, if the exchange meets a commercial substance criterion and fair
value is determinable. The commercial substance criterion is assessed by
comparing the entity's expected cash flows immediately before and after the
exchange. SFAS No. 153 eliminates the "similar productive assets exception,"
which accounts for the exchange of assets at book value with no recognition of
gain or loss. SFAS No. 153 will be effective for nonmonetary asset exchanges
occurring in fiscal periods beginning after June 15, 2005. We do not believe the
adoption of SFAS No. 153 will have a material impact on our financial
statements.
In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment (SFAS No.
123R), which requires companies to expense the fair value of stock options and
other equity-based compensation to employees. It also provides guidance for
determining whether an award is a liability-classified award or an
equity-classified award, and determining fair value. SFAS No. 123R applies to
all unvested stock-based payment awards outstanding as of the adoption date.
Pursuant to a rule announced by the Securities and Exchange Commission in April
2005, SFAS No. 123R must be adopted no later than the beginning of the first
fiscal year that begins after June 15, 2005. We have not completed an assessment
of the impact on our financial statements resulting from potential modifications
to our equity-based compensation structure or the use of an alternative fair
value model in anticipation of adopting SFAS No. 123R. The Company plans to
adopt SFAS No. 123R for the quarter ended September 30, 2005.
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections - a replacement of APB Opinion No. 20 and FASB Statement No. 3 (SFAS
No. 154), which replaces APB Opinion No. 20, Accounting Changes, and SFAS No. 3,
Reporting Accounting Changes in Interim Financial Statements, and changes the
requirements for the accounting for and reporting of a change in accounting
principle. SFAS No. 154 applies to all voluntary changes in accounting
principle, and also applies to changes required by an accounting pronouncement
in the unusual instance that the pronouncement does not include specific
transition provisions. SFAS No. 154 will be effective for accounting changes and
corrections of errors made in fiscal years beginning after December 15, 2005.
SFAS No. 154 does not change the transition provisions of any existing
accounting pronouncements, including those that are in a transition phase as of
the effective date of SFAS No. 154. We do not believe the adoption of SFAS No.
154 will have a material impact on our financial statements.
In March 2005, the FASB issued FIN 47 "Accounting for Conditional Asset
Retirement Obligations, an Interpretation of FASB Statement No. 143." This
Interpretation clarifies that a conditional retirement obligation refers to a
legal obligation to perform an asset retirement activity in which the timing and
(or) method of settlement are conditional on a future event that may or may not
be within the control of the entity. The obligation to perform the asset
retirement activity is unconditional even though uncertainty exists about the
timing and (or) method of settlement. Accordingly, an entity is required to
recognize a liability for the fair value of a conditional asset retirement
obligation if the fair value of the liability can be reasonably estimated. The
liability should be recognized when incurred, generally upon acquisition,
33
construction or development of the asset. FIN 47 is effective no later than the
end of the fiscal years ending after December 15, 2005. We have not completed an
assessment of the impact that adoption of FIN 47 will have on our financial
statements.
RESULTS OF OPERATIONS - FISCAL 2005 COMPARED TO FISCAL 2004
Net sales decreased by 30%, from $63,781,219 in Fiscal 2004 to $44,901,645 in
Fiscal 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 price pressures. Sales of the Levothyroxine Sodium line of products
declined by $4,948,000 due in part to a delay in the AB rating, which gave the
competition a market advantage. The sales of Unithroid tablets declined
$2,036,000. Sales of Butalbital with Aspirin and Caffeine capsules declined
$3,240,000. Sales of Primidone tablets, seeing competition for the first time,
declined $4,390,000. Sales of Digoxin tablets declined $3,480,000.
The Company sells its products to customers in various categories. The table
below identifies the Company's net sales to each category.
<Table>
<Caption>
Customer Category Fiscal 2005 Net Sales Fiscal 2004 Net Sales Fiscal 2003 Net Sales
----------------- --------------------- --------------------- ---------------------
Wholesaler/Distributor $24.8 million $43.0 million $20.6 million
Retail Chain $10.5 million $12.1 million $9.9 million
Mail-Order Pharmacy $5.9 million $ 4.3 million $2.6 million
Private Label $3.7 million $ 4.4 million $9.4 million
------------ ------------- ------------
Total $44.9 million $63.8 million $42.5 million
</Table>
Sales in every category, with the exception of 'Mail Order Pharmacy,' decreased
the past year. This is a result of the factors described in the previous
paragraph. Sales to mail order pharmacy increased due to an increase in product
line, and a general increase across the business sector. Sales to
wholesalers/distributors declined mainly due to the loss of primary position on
the Amerisource Bergen pro-generic contract and a decrease in pricing with all
wholesalers and distributors due to the competitive market.
Cost of sales increased by 17%, from $26,856,875 in Fiscal 2004 to $31,416,908
in Fiscal 2005. These costs include raw materials/cost of finished goods
purchased and resold, which increased approximately $4,071,000, shipping
expense, which increased by approximately $199,000 and other miscellaneous
production-related expenses which increased in total by approximately $290,000.
Gross margin decreased from 58% in Fiscal 2004 to 30% in Fiscal 2005. The
decrease in gross profit margin is a result of a decrease in net weighted
average prices from some of the Company's
34
products due to increased market competition, increases in direct and indirect
costs as well as a change in the 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 increased by 6%, from $5,895,096 in
Fiscal 2004 to $6,265,522 in Fiscal 2005. The increase in R&D is a result of
contracting formulation development out to a third party laboratory for product
development for $940,000 in Fiscal 2005, and an increase of raw material
consumption of approximately $1,200,000 used in the development and formulation
of new products not yet approved by the FDA. These costs were offset by a
decrease in Bio studies of $1,185,000 from Fiscal 2004 to Fiscal 2005.
Selling, general and administrative expenses increased by 4%, from $8,863,966 in
Fiscal 2004 to $9,194,377 in Fiscal 2005. This increase is primarily a result of
Sarbanes-Oxley related accounting and consulting costs of approximately $520,000
and an increase in insurance of $160,000. These increases were partially offset
by savings in various other expense accounts.
The Company's interest expense increased from approximately $45,000 in Fiscal
2004 to approximately $351,000 in Fiscal 2005 as a result of the borrowing under
the "2003 Loan Financing" which included a mortgage loan, equipment loan and
construction loan, each of which started in Fiscal 2005. Interest income
increased from approximately $24,000 in Fiscal 2004 to approximately $165.622 in
Fiscal 2005, as a result of investment of excess cash in marketable securities
and a higher cash balance.
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. An impairment
charge was recorded against this intangible asset in the current fiscal year.
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 was required to pay JSP an additional $1.5
million in cash to reimburse JSP for expenses related to obtaining the AB
ratings. As of June 30, 2005, the Company had recorded an addition to the
intangible asset of $1.5 million.
Management believed that events (as described in the next paragraph) occurred
during Fiscal 2005 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
35
present value of those cash flows to the carrying value of the asset (inclusive
of the $1.5 million paid to JSP for the dual AB ratings). As a result of the
testing, the Company 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.
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
Fiscal year ended June 30, 2005 and 2004 was approximately $5,517,000 and
$1,315,000, respectively.
As a result of the items discussed above, the Company's financial results
changed from an operating income of $20,830,969 in Fiscal 2004 to an operating
loss of ($53,639,659) in Fiscal 2005.
The Company's income tax classification changed from an income tax expense of
$7,594,316 in Fiscal 2004 to an income tax benefit of ($21,045,902) in Fiscal
2005 as a result of the Company's pre-tax loss. The effective tax rate increased
slightly from 36.5% in 2004 to 39.1% in 2005.
The Company reported net loss of ($32,779,596) for Fiscal 2005, or ($1.36) basic
and diluted loss per share, compared to net income of $13,215,454 for Fiscal
2004, or $0.63 basic and diluted earnings per share.
RESULTS OF OPERATIONS - FISCAL 2004 COMPARED TO FISCAL 2003
Net sales increased by 50%, from $42,486,758 in Fiscal 2003 to $63,781,219 in
Fiscal 2004. Sales increased as a result of additions to the Company's
prescription line of products, including Digoxin tablets, first marketed in
September 2002, Levothyroxine Sodium tablets, first marketed in April 2003 and
Unithroid tablets, first marketed in August 2003. These product additions had
the effect of increasing the total net sales for Fiscal 2004 as compared to
Fiscal 2003 due to the fact the Company sold the products for longer periods of
time in the twelve months ended June 30, 2004. These product additions accounted
for approximately $20.5 million of the increase in net sales from Fiscal 2003 to
Fiscal 2004. Additionally, sales of a portion of the Company's previously
marketed products, such as Primidone tablets, Butalbital with Aspirin and
Caffeine capsules and Dicyclomine HCL tablets and capsules increased by
approximately $4.8 million from Fiscal 2003 to Fiscal 2004
36
as a result of new customer accounts, increased unit sales and increased unit
sales prices. The Company from time to time will raise its sales prices if there
is an increase in the price of the brand named drug. Generally, the Company
sells its products at the accepted market prices for such products. If the
competitive environment changes, the Company monitors such changes to determine
the effect on the market prices for its products. Such changes may include new
competitors, fewer competitors, or an increase in the price of the innovator
drug. The increase in sales of a portion of the Company's products was partially
offset by a decrease in sales of certain other products, including Butalbital
with Aspirin and Caffeine capsules (which decreased $3.9 million) due to
increased competition and a discontinuation of Pseudoephedrine Hydrochloride
tablets (which resulted in a loss of sales of $681,000).
The Company sells its products to customers in various categories. The table
below identifies the Company's net sales to each category.
<Table>
<Caption>
Customer Category Fiscal 2004 Net Sales Fiscal 2003 Net Sales Fiscal 2002 Net Sales
----------------- --------------------- --------------------- ---------------------
Wholesaler/Distributor $43.0 million $20.6 million $10.4 million
Retail Chain $12.1 million $ 9.9 million $3.3 million
Mail-Order Pharmacy $4.3 million $ 2.6 million $1.1 million
Private Label $4.4 million $ 9.4 million $10.3 million
------------ ------------- -------------
Total $63.8 million $42.5 million $25.1 million
</Table>
Sales in every category, with the exception of private label, increased each of
the past three years. This is a result of the factors described in the previous
paragraph. Sales to private label customers decreased in Fiscal 2004 and 2003 as
a result of the Company's successful efforts in growing the Lannett label
accounts. Increasing sales to customers that purchased the Lannett label
products (i.e. the wholesale, retail, and mail-order customer categories) had
the effect of reducing sales to private label customers.
Cost of sales increased by 65%, from $16,257,794 in Fiscal 2003 to $26,856,875
in Fiscal 2004. The cost of sales increase is due to an increase in direct
variable costs and certain indirect costs as a result of the increase in sales
volume, and related production activities. These costs include raw
materials/cost of finished goods purchased and resold, which increased
approximately $8,613,000, labor and benefits expenses, which increased by
approximately $1,641,000 and other miscellaneous production-related expenses
which increased in total by approximately $345,000. Gross margins decreased from
62% in Fiscal 2003 to 58% in Fiscal 2004. The decrease in gross profit margins
is a result of a decrease in net weighted average prices from some of the
Company's products due to increased market competition, increases in direct and
indirect costs as well as a change in the product sales mix. During Fiscal 2004,
a larger percentage of the Company's total net sales were from products supplied
by JSP. The Company's average gross profit margin for products from JSP is less
than the average gross profit margin for products internally manufactured.
Depending on
37
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 increased by 129%, from $2,575,178 in
Fiscal 2003 to $5,895,096 in Fiscal 2004. This increase is primarily due to an
increase in the costs of generic bioequivalence tests which are commonly
required for ANDA submissions. The Company incurred approximately $2.3 million
in Fiscal 2004 for bioequivalence testing fees, compared to approximately
$265,000 in Fiscal 2003. The increase in R&D is also a result of an increase in
the number of chemists in the R&D laboratory and the related payroll and
benefits expenses, which increased by approximately $1.1 million in Fiscal 2004
as compared to Fiscal 2003 and an increase of raw material consumption of
approximately $200,000 used in the development and formulation of new products
not yet approved by the FDA.
Selling, general and administrative expenses increased by 104%, from $4,337,558
in Fiscal 2003 to $8,863,966 in Fiscal 2004. This increase is a result of an
increase in the following expenses: payroll/incentive compensation and benefits,
which increased by approximately $2.4 million, consulting services, which
increased by approximately $343,000 (including Sarbanes-Oxley consulting), legal
expenses, which increased by approximately $282,000, computer support costs,
which increased by approximately $180,000, advertising expenses, which increased
by approximately $172,000, travel and entertainment expenses, which increased by
approximately $109,000, insurance expenses, which increased by approximately
$114,000, investor relations/marketing expenses, which increased by
approximately $85,000, directors fees, which increased by approximately $174,000
and miscellaneous other expenses, including utilities, training, general and
safety supplies, office supplies, accounting fees, telephone and rent expense.
Such miscellaneous expenses comprised the remainder of the increase in selling,
general and administrative expenses. The increases were due to the hiring of
additional administrative employees and a general increase in administrative
expenses due to the growth of the Company in terms of employees, production
volume and sales.
Currently, the Company's only finished product inventory supplier is Jerome
Stevens Pharmaceuticals, Inc. (JSP), in Bohemia, New York. Purchases of finished
goods inventory from JSP accounted for approximately 81% of the Company's
inventory purchases in Fiscal 2004, 62% in Fiscal 2003 and 26% in Fiscal 2002.
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 Company projects that it will be able to meet
the minimum purchase requirements, but there is no guarantee that the Company
will be able to do so. 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
38
ascertaining that such person is suitable for membership on the board of a
publicly traded corporation including, but not limited to, complying with the
requirements of the Securities and Exchange Commission, the American Stock
Exchange and applicable law including the Sarbanes-Oxley Act of 2002. The
Agreement was included as an Exhibit in the Form 8-K filed by the Company on May
5, 2004. The obligation of the Company to issue the four million (4,000,000)
shares was subject to the receipt of a fairness opinion issued by a recognized
and reputable investment banking firm in opining that the issuance of the four
million (4,000,000) shares and the resulting dilution of the ownership interest
of the Company's minority shareholders was fair to such shareholders from a
financial point of view. On April 20, 2004, the investment banker, Donnelly
Penman and Partners, which was selected by the independent Directors of the
Company's Board, opined that the issuance of the four million (4,000,000) shares
and the resulting dilution of the ownership interest of the Company's minority
shareholders was fair to such shareholders, from a financial point of view, in
light of JSP's products' contribution or potential contribution to the Company's
profitability. As such, subsequent to April 20, 2004, the Company issued four
million (4,000,000) shares to JSP's designees. As a result of the transaction,
the Company recorded an intangible asset related to the contract in the amount
of $67,040,000. The intangible asset was recorded based upon the fair value of
the (4,000,000) shares at the time of issuance to JSP. An impairment charge was
recorded against this intangible asset in the fiscal year 2005. The Company will
incur non-cash amortization expense for the intangible asset over the term of
the contract. For the period April 2004 to June 2004, the Company incurred
$1,314,510 of non-cash amortization expense associated with the JSP intangible
asset.
As a result of the items discussed above, the Company increased its operating
income by 9%, from $19,060,106 in Fiscal 2003 to $20,830,969 in Fiscal 2004.
The Company's income tax expense increased from $7,334,740 in Fiscal 2003 to
$7,594,316 in Fiscal 2004 as a result of the increase in taxable income.
The Company reported net income of $13,215,454 for Fiscal 2004, or $0.63 basic
and diluted income per share, compared to net income of $11,666,887 for Fiscal
2003, or $0.58 basic and diluted income per share.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities of $8,079,212 for the year ended June
30, 2005 was attributable to net loss of ($32,779,596), as adjusted for the
effects of non-cash items of $53,064,168 and net changes in operating assets and
liabilities totaling ($12,205,360). Significant changes in operating assets and
liabilities are comprised of:
1. A decrease in trade accounts receivable of $15,370,358 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.
39
2. A decrease in net inventory of $2,824,481 primarily due to the
increase in inventory reserve for obsolescence, specifically
related to the anticipated expiration of Levothyroxine held in
finished goods.
3. An increase in prepaid taxes of $3,075,380 primarily attributable
to estimated tax payments made during Fiscal 2005.
4. An increase in deferred tax assets of $20,229,832 primarily
attributable to the impairment loss of approximately $46,093,000.
5. A decrease in accounts payable of $4,431,906 is due to payments
for inventory the Company purchased in the Fourth Quarter Fiscal
2004.
The net cash used in investing activities of $12,627,198 for the twelve months
ended June 30, 2005 was attributable to the Company's purchase of: $7,913,901 of
investment securities, which consist primarily of U. S. government and agency
marketable debt securities, and $3,213,297 of capital expenditures related to
the Company's renovation of its new facility on Torresdale Avenue and the
purchase and installation of new equipment. The company additionally spent
$1,500,000 on an intangible asset related to an agreement with Jerome Stevens
Pharmaceuticals, Inc. (JSP) for exclusive marketing and distribution rights in
the United States.
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 remainder of the proceeds was deposited into a money
market account, which was restricted for future plant and equipment needs of the
Company, as specified in the Agreement. 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 June 30, 2005 was
2.44%. At June 30, 2005, the Company has $1,646,000 outstanding on the Authority
loan, of which $644,000 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 a bank, Wachovia Bank, National Association
(Wachovia), to secure payment of the Authority Loan and a portion of the related
accrued interest. At June 30, 2005, no portion of the letter of credit has been
utilized
The Company has entered into agreements (the "2003 Loan Financing") with
Wachovia to finance the purchase of the building, the renovation and setup of
the building, and the Company's other anticipated capital expenditures for
Fiscal 2004, including the implementation of its new Enterprise Resource
Planning (ERP) system, and a new fluid bed drying process center at its current
manufacturing plant at 9000 State Road. The 2003 Loan Financing includes the
following:
1) A Mortgage Loan for $2.7 million, used to finance the purchase of the
Torresdale Avenue facility, and certain renovations at the facility.
2) An Equipment Loan for up to $6 million, which will be used to finance
equipment, the ERP system implementation and other capital
expenditures.
40
3) A Construction Loan for $1 million, used to finance the construction
and fit up of the fluid bed drying process center, which is adjacent to
the Company's current manufacturing plant at 9000 State Road.
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 June 30, 2005, the Conversion date
has not taken place and the Company continues to make interest only payments. As
of June 30, 2005, the Company has outstanding $2.7 million under the Mortgage
Loan, of which $95,000 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
June 30, 2005, the Company has outstanding $4,487,000 under the Equipment Loan,
of which $1,342,000 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 $700,000 under the Construction Loan, of which $189,000
is classified as currently due.
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 June 30, 2005, the
interest rate for the 2003 Loan Financing was 4.93%.
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% (6.00% at June 30, 2005). The
line of credit was renewed and extended to October 30, 2005. At June 30, 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 June 30, 2005, the
Company obtained a waiver from the lender due to a violation of one of its
covenants. The Company expects to meet the financial covenants in the future.
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
41
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 will record 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 June 30, 2005, the
Company has recognized the grant funding as a current liability under the
caption of Unearned Grant Funds.
In August 2005, the Company loaned $2 million to an active pharmaceutical
ingredient (API) supplier. The Company also purchased shares of this API
supplier from one of the founding partners for $500,000 cash. Refer to Note 19
for further discussion.
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, 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. As the oldest generic drug manufacturer in
the country, formed in 1942, Lannett currently owns several ANDAs for products
which it 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 factors
meet current FDA requirements for the marketing of that drug. 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, or the raw material supplier 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.
A majority 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.
42
In addition to the efforts of its internal product development group, Lannett
has contracted with an outside firm 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.
Occasionally the Company will work on developing a drug product that does 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 required for FDA ANDA approval.
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, prescribed to treat infections. The Company has
also initiated discussions with UniChem, of India, and Orion Pharma, of Finland,
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.
The majority of the Company's R&D projects are being developed in-house under
Lannett's direct supervision and with Company personnel. Hence, the Company does
not believe that its outside contracts for product development and manufacturing
supply, including Spectrum Pharmaceuticals Inc., 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.
The Company plans to enhance relationships with strategic business partners,
including providers of product development research, raw materials, active
pharmaceutical ingredients as well as finished goods. Management believes that
mutually beneficial strategic relationships in such areas, including potential
financing arrangements, partnerships, joint ventures or acquisitions, could
allow for potential competitive advantages in the generic pharmaceutical market.
For example, the Company has entered into prepayment arrangements in exchange
for discounted purchase prices on certain active pharmaceutical ingredients
(API) and oral dosage forms. The Company has also arranged for a loan to a
certain API provider that should facilitate the availability of difficult to
source material in the future. The Company plans to continue to explore such
areas for potential opportunities to enhance shareholder value.
43
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements and Report of the Independent Registered
Public Accounting Firm filed as a part of this Form 10-K are listed in the
Exhibit Index filed herewith.
44
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE
None.
45
ITEM 9A. CONTROLS AND PROCEDURES
Disclosure Controls and Procedures
We carried out an evaluation under the supervision and with the participation of
our management, including our chief executive officer and chief financial
officer, of the effectiveness of the design and operation of our disclosure
controls and procedures, as such term is defined under Rule 13a-15(e)
promulgated under the Securities Exchange Act of 1934 (the "Exchange Act"),, as
amended for financial reporting as of June 30, 2005. Based on that evaluation,
our chief executive officer and chief financial officer concluded that these
controls and procedures are effective to ensure that information required to be
disclosed by the Company in reports that it files or submits under the Exchange
Act is recorded, processed, summarized, and reported as specified in Securities
and Exchange Commission rules and forms. There were no changes in these controls
or procedures identified in connection with the evaluation of such controls or
procedures that occurred during our last fiscal quarter, or in other factors
that have materially affected, or are reasonably likely to materially affect
these controls or procedures.
Our disclosure controls and procedures are designed to ensure that information
required to be disclosed by us in the reports that we file or submit under the
Exchange Act is recorded, processed, summarized, and reported, within the time
periods specified in the rules and forms of the Securities and Exchange
Commission. These disclosure controls and procedures include, among other
things, controls and procedures designed to ensure that information required to
be disclosed by us in the reports that we file under the Exchange Act is
accumulated and communicated to our management, including our chief executive
officer and chief financial officer, as appropriate to allow timely decisions
regarding required disclosure.
Management's Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal
control over financial reporting. Internal control over financial reporting is
defined in Rule 13a-15(f) and 15d-15(f) under the Exchange Act as a process
designed by, or under the supervision of, the chief executive officer and chief
financial officer and effected by the board of directors and management to
provide reasonable assurance regarding the reliability of financial reporting
and the preparation of financial statements for external purposes in accordance
with generally accepted accounting principles and includes those policies and
procedures that:
o Pertain to the maintenance of records that in reasonable
detail accurately and fairly reflect the transactions and
dispositions of our assets;
o Provide reasonable assurance that transactions are recorded as
necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and
that receipts and expenditures of the company are being made
only in accordance with authorizations of our management and
board of directors;
o Provide reasonable assurance regarding prevention or timely
detection of unauthorized acquisition, use or disposition of
our assets that could have a material effect on the financial
statements.
46
Because of its inherent limitations, internal control over financial reporting
may not prevent or detect misstatements. Projections of any evaluation of
effectiveness to future periods are subject to the risks that controls may
become inadequate because of changes in conditions, or that the degree of
compliance with the policies or procedures may deteriorate.
Our management assessed the effectiveness of our internal control over financial
reporting as of June 30, 2005. In making this assessment, our management used
the criteria set forth by the Committee of Sponsoring Organizations of the
Treadway Commission (COSO) in Internal Control-Integrated Framework.
Based on our assessment, our management believes that, as of June 30, 2005, our
internal control over financial reporting is effective.
47
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
DIRECTORS AND EXECUTIVE OFFICERS
The directors and executive officers of the Company are set forth below:
<Table>
<Caption>
Age Position
--- --------
Directors:
- ---------
William Farber 73 Chairman of the Board and Chief
Executive Officer
Ronald A. West 71 Director
Myron Winkelman 67 Director
Albert Wertheimer 62 Director
Officers:
- --------
Arthur P. Bedrosian 59 President
Brian J. Kearns 39 Vice President of Finance, Treasurer,
Secretary and Chief Financial Officer
Kevin Smith 45 Vice President of Sales and Marketing
Bernard Sandiford 76 Vice President of Operations
William Schreck 56 Vice President of Logistics
</Table>
WILLIAM FARBER R. PH. was elected as Chairman of the Board of Directors and
Chief Executive Officer in August 1991. From April 1993 to the end of 1993, Mr.
Farber was the President and a director of Auburn Pharmaceutical Company. From
1990 through March 1993, Mr. Farber served as Director of Purchasing for Major
Pharmaceutical Corporation. From 1965 through 1990, Mr. Farber was the Chief
Executive Officer of Michigan Pharmacal Corporation. Mr. Farber is a registered
pharmacist in the State of Michigan.
ALBERT I. WERTHEIMER was elected a Director of the Company in September 2004.
Dr. Wertheimer has a long and distinguished career in various aspects of
pharmacy, health care, education and pharmaceutical research. Since 2000, Dr.
Wertheimer has been a professor at the School of Pharmacy at Temple University,
and director of its Center for Pharmaceutical Health Services Research. From
1997 to 2000, Dr. Wertheimer was Director of Outcomes Research and Management at
Merck & Co., Inc. In addition to his academic responsibilities, he is the author
of 20 books and more than 350 journal articles. Dr. Wertheimer also provides
consulting services to institutions in the pharmaceutical industry. Dr.
Wertheimer's academic experience
48
includes professorships and other faculty and administrative positions at
several educational institutions, including the Medical College of Virginia, St.
Joseph's University, Philadelphia College of Pharmacy and Science and the
University of Minnesota. Dr. Wertheimer's previous professional experience
includes pharmacy services in commercial and non-profit environments. Professor
Wertheimer is a licensed pharmacist in five states, and is a member of several
health associations, including the American Pharmacists Association and the
American Public Health Association. Dr. Wertheimer is the editor of the "Journal
of Pharmaceutical Finance and Economic Policy"; and he has been on the editorial
board of the Journal of Managed Pharmaceutical Care, Medical Care, and other
healthcare journals. Dr. Wertheimer has a Bachelor of Science Degree in Pharmacy
from the University of Buffalo, an Master of Business Administration from the
State University of New York at Buffalo, a Physical Science Doctorate from
Purdue University and a Post Doctoral Fellowship from the University of London,
St. Thomas' Medical School.
RONALD A. WEST was elected a Director of the Company in January 2002. Mr. West
is currently a Director of Beecher Associates, an industrial real estate
investment company, R&M Resources, an investment and consulting services company
and North East Staffing, Inc., an employee services company. Prior to this, from
1983 to 1987, Mr. West, financial expert for the audit committee at Lannett,
served as Chairman and Chief Executive Officer of Dura Corporation, an original
equipment manufacturer of automotive products and other engineered equipment
components. In 1987, Mr. West sold his ownership position in Dura Corporation,
at which time he retired from active management positions. Mr. West was employed
at Dura Corporation since 1969. Prior to this, he served in various financial
management positions with TRW, Inc., Marlin Rockwell Corporation and National
Machine Products Group, a division of Standard Pressed Steel Company. Mr. West
studied Business Administration at Michigan State University and the University
of Detroit.
MYRON WINKELMAN, R. PH. was elected a Director of the Company in June 2003. Mr.
Winkelman has significant career experience in various aspects of pharmacy and
health care. He is currently President of Winkelman Management Consulting (WMC),
which provides consulting services to both commercial and governmental clients.
He has served in this position since 1994. Mr. Winkelman has recently managed
multi-state drug purchasing initiatives for both Medicaid and state entities.
Prior to creating WMC, he was a senior executive with ValueRx, a large pharmacy
benefits manager, and served for many years as a senior executive for the Revco,
Rite Aid and Perry Drug chains. While at ValueRx, Mr. Winkelman served on the
Board of Directors of the Pharmaceutical Care Management Association. He belongs
to a number of pharmacy organizations, including the Academy of Managed Care
Pharmacy and the Michigan Pharmacy Association. Mr. Winkelman is a registered
pharmacist and holds a Bachelor of Science Degree in Pharmacy from Wayne State
University.
ARTHUR P. BEDROSIAN, J.D. was elected President of the Company in May 2002.
Prior to this, he served as the Company's Vice President of Business Development
from January 2002 to April 2002, and as a Director from February 2000 to January
2002. Mr. Bedrosian has operated generic drug manufacturing, sales, and
marketing businesses in the healthcare industry for many years. Prior to joining
the Company, from 1999 to 2001, Mr. Bedrosian served as President and Chief
Executive Officer of Trinity Laboratories, Inc., a medical device and drug
manufacturer. Mr. Bedrosian also operated Pharmaceutical Ventures Ltd, a
healthcare consultancy and Interal Corporation, a computer consultancy to
Fortune 100 companies. Mr. Bedrosian holds a Bachelor of Arts Degree in
Political
49
Science from Queens College of the City University of New York and a Juris
Doctorate from Newport University in California.
BRIAN J. KEARNS was elected Vice President of Finance, Treasurer and Chief
Financial Officer of the Company in March 2005 and Secretary in May 2005. Prior
to joining the Company, Mr. Kearns served as the Executive Vice President,
Treasurer and Chief Financial Officer of MedQuist Inc., a healthcare information
management company, from 2000 through 2004. Prior to joining MedQuist, Mr.
Kearns was Vice President and Senior Health Care IT analyst at Banc of America
Securities from 1999 trough 2000. Mr. Kearns also held various positions with
Salomon Smith Barney from 1994 through 1998, including Senior Analyst of
Business Services Equity Research. Prior to that, Mr. Kearns held several
financial management positions during his seven years at Johnson & Johnson. Mr.
Kearns holds a Bachelor of Science degree in Finance from Lehigh University and
a Master of Business Administration degree from Rider University, where he
matriculated with distinction.
KEVIN SMITH joined the Company in January 2002 as Vice President of Sales and
Marketing. Prior to this, from 2000 to 2001, he served as Director of National
Accounts for Bi-Coastal Pharmaceutical, Inc., a pharmaceutical sales
representation company. Prior to this, from 1999 to 2000, he served as National
Accounts Manager for Mova Laboratories Inc., a pharmaceutical manufacturer.
Prior to this, from 1991 to 1999, Mr. Smith served as National Sales Manager at
Sidmak Laboratories, a pharmaceutical manufacturer. Mr. Smith has extensive
experience in the generic sales market, and brings to the Company a vast network
of customers, including retail chain pharmacies, wholesale distributors,
mail-order wholesalers and generic distributors. Mr. Smith has a Bachelor of
Science Degree in Business Administration from Gettysburg College.
BERNARD SANDIFORD joined the Company in November 2002 as Vice President of
Operations. Prior to this, from 1998 to 2002, he was the President of Sandiford
Consultants, a firm specializing in providing consulting services to drug
manufacturers for Good Manufacturing Practices and process validations. His
previous employment included senior operating positions with Halsey Drug
Company, Barr Laboratories, Inc., Duramed Pharmaceuticals, Inc., and Revlon
Health Care Group. In addition to these positions, Mr. Sandiford performed
various consulting assignments regarding Good Manufacturing Practices for
several companies in the pharmaceutical industry. Mr. Sandiford has a Bachelor
of Science Degree in Chemistry from Long Island University.
WILLIAM SCHRECK joined the Company in January 2003 as Materials Manager. In May
2004, he was promoted to Vice President of Logistics. Prior to this, from 1999
to 2001, he served as Vice President of Operations at Nature's Products, Inc.,
an international nutritional and over-the-counter drug product manufacturing and
distribution company. Mr. Schreck's prior experience also includes executive
management positions at Ivax Pharmaceuticals, Inc., a division of Ivax
Corporation, Zenith-Goldline Laboratories and Rugby-Darby Group Companies, Inc.
Mr. Schreck has a Bachelor of Arts Degree from Hofstra University.
To the best of the Company's knowledge, there have been no events under any
bankruptcy act, no criminal proceedings and no judgments or injunctions that are
material to the evaluation of the ability or integrity of any director,
executive officer, or significant employee during the past five years.
50
SECTION 16(a) BENEFICIAL OWNERSHIP REPORTING COMPLIANCE
Section 16(a) of the Securities Exchange Act of 1934 requires the Company's
directors, officers, and persons who own more than 10% of a registered class of
the Company's equity securities to file with the SEC reports of ownership and
changes in ownership of common stock and other equity securities of the Company.
Officers, directors and greater-than-10% stockholders are required by SEC
regulations to furnish the Company with copies of all Section 16(a) forms they
file.
Based solely on review of the copies of such reports furnished to the Company or
written representations that no other reports were required, the Company
believes that during Fiscal 2005, all filing requirements applicable to its
officers, directors and greater-than-10% beneficial owners were complied with,
except for the following:
None
CODE OF ETHICS AND FINANCIAL EXPERT
The Company has adopted the Code of Professional Conduct (the "code of ethics"),
a code of ethics that applies to the Company's Chief Executive Officer, Chief
Financial Officer, Chief Accounting Officer and Corporate Controller, and other
finance organization employees. The code of ethics is publicly available on our
website at www.lannett.com. If the Company makes any substantive amendments to
the finance code of ethics or grant any waiver, including any implicit waiver,
from a provision of the code to our Chief Executive Officer, Chief Financial
Officer, or Chief Accounting Officer and Corporate Controller, we will disclose
the nature of such amendment or waiver on our website or in a report on Form
8-K.
The Board of Directors has determined that Mr. West, current director of Lannett
as well as director of Beecher Associates, an industrial real estate investment
company, R&M Resources, an investment and consulting services company and North
East Staffing, Inc., an employee services company and previously the Chief
Executive Officer of Dura Corporation, is the audit committee financial expert
as defined in section 3(a)(58) of the Exchange Act and the related rules of the
Commission.
51
ITEM 11. EXECUTIVE COMPENSATION
SUMMARY COMPENSATION TABLE
The following table summarizes all compensation paid to or earned by the named
executive officers of the Company for Fiscal 2005, Fiscal 2004 and Fiscal 2003.
<Table>
<Caption>
Long Term Compensation
-----------------------------------
Annual Compensation Awards Payouts
- ------------------------------------------------------------------------ ------------------------- ----------
(A) (B) (C) (D) (E) (F) (G) (H) (I)
Name and Restricted Securities LTIP All Other
Principal Fiscal Other Annual Stock Underlying Payouts Compensation
Position Year Salary Bonus Compensation Award(s) Options/ Amount Amounts
---- ------ ----- ------------ -------- SARs ------ -------
----
William Farber 2005 0 0 0 0 0 0 44,000(4)
Chairman of the 2004 0 0 0 0 87,500 0 26,000(4)
Board of
Directors and 2003 0 0 0 0 37,500 0 3,000(4)
Chief Executive
Officer
Arthur P. 2005 236,709(1) 168,750 0 0 0 0 0
Bedrosian(2)
2004 212,548(1) 240,000 0 0 177,900 0 0
President
2003 179,175 77,500 0 0 114,600 0 0
Kevin Smith 2005 171,578 95,518 0 0 0 0 0
Vice President of 2004 160,488 158,410 0 0 0 0 0
Sales and
Marketing 2003 156,504 46,500 0 0 0 0 0
William Schreck 2005 140,862 73,750 0 0 0 0 0
Vice President of 2004 103,927 37,500 0 0 0 0 0
Logistics
2003 41,154(5) 0 0 0 0 0 0
Larry Dalesandro(3) 2005 134,993 99,645 0 0 0 0 0
Former Chief 2004 135,842(1) 156,000 0 0 129,595 0 0
Financial
Officer, Treasurer 2003 134,984(1) 59,675 0 0 74,595 0 0
</Table>
52
(1) Includes matching contribution payments made to the Company's
401(k) Plan (3% of eligible compensation) for the benefit of
the employee noted.
(2) Mr. Bedrosian joined the Company on January 24, 2002 as Vice
President of Business Development. On May 5, 2002, he was
elected President of the Company.
(3) Mr. Dalesandro joined the Company on January 11, 1999 as
Controller. He was elected Chief Operating Officer on November
1, 1999. On June 18, 2003, he was elected Chief Financial
Officer, and voluntarily resigned the position of Chief
Operating Officer. Dec. 2, 2004, he resigned from the Company.
(4) These amounts represent payments to Mr. Farber for
participation and attendance at Board of Director Meetings.
(5) Mr. Schreck was hired mid-fiscal year 2003 as Material Manager
and then promoted May 2004 to Vice President of Logistics.
53
AGGREGATED OPTIONS/SAR EXERCISES AND FISCAL YEAR-END OPTIONS/SAR VALUES
<Table>
<Caption>
(a) (b) (c) (d) (e)
VALUE OF
UNEXERCISED
NUMBER OF SECURITIES IN-THE-MONEY
SHARES UNDERLYING UNEXERCISED OPTIONS AT
ACQUIRED OPTIONS AT FY-END FY-END
ON VALUE EXERCISABLE/ EXERCISABLE/
NAME EXERCISE REALIZED UNEXERCISABLE UNEXERCISABLE
- -------------------------- ----------------- ------------------ --------------------------- ------------------------
Kevin Smith 0/ 0/
Vice President of Sales 10,001 100% $0 $0
- -------------------------- ----------------- ------------------ --------------------------- ------------------------
William Farber 54,165/ $0/
Chariman of the Board of 0 0 33,335 $0
Directors and Chief
Executive Officer
- -------------------------- ----------------- ------------------ --------------------------- ------------------------
Arthur Bedrosian 87,599/ $0/
0 0 60,301 $0
- -------------------------- ----------------- ------------------ --------------------------- ------------------------
</Table>
COMPENSATION OF DIRECTORS
Directors received compensation of $1,000 per Board meeting in Fiscal 2005.
Additionally, starting in January of 2004, directors received compensation of
$2,500 per month retainer. There were thirteen Board meetings held during Fiscal
2005. Additional committees of the Board of Directors included the Audit
Committee, the Compensation Committee and the Strategic Planning Committee.
Committee members received compensation of $1,000 per Committee meeting in
Fiscal 2005. There were six Audit Committee meetings and two Strategic Planning
Committee Meetings held during Fiscal 2005. There were no Compensation Committee
Meetings held during Fiscal 2005. Directors are reimbursed for expenses incurred
in attending Board and Committee meetings. In addition to the Committees noted,
in February 2004, the Board of Directors created a Special Committee, consisting
of the three independent Board Directors, to look after the best interests of
the shareholders of the Company. The Committee was created after William Farber
entered into an option agreement with Perrigo Company, Inc. to potentially
acquire all of the shares owned by William Farber and his wife. Special
Independent Committee members received $3,000 per meeting. There were seven
Special Independent Committee meetings held during Fiscal 2005. The following
table identifies the stock options granted to directors in Fiscal 2005.
54
<Table>
<Caption>
(a) (b) (c) (d) (e)
NAME NUMBER OF % OF TOTAL EXERCISE OR BASE PRICE EXPIRATION DATE
SECURITIES OPTIONS/SARS ($/SHARE)
UNDERLYING GRANTED TO
OPTIONS/SARS RECIPIENTS IN
GRANTED (#) FISCAL YEAR
Albert Wertheimer 20,000 15.2% 20,000@9.02 12/8/2014
</Table>
EMPLOYMENT AGREEMENTS
The Company has entered into employment agreements with Arthur Bedrosian, Brian
Kearns, Kevin Smith, Bill Schreck, and Bernard Sandiford (the "Named
Executives"). Each of the agreements provide for an annual base salary and
eligibility to receive a bonus. The salary and bonus amounts of the Named
Executives are determined by the Board of Directors. Additionally, the Named
Executives are eligible to receive stock options, which are granted at the
discretion of the Board of Directors, and in accordance with the Company's
policies regarding stock option grants.
Under the agreements, the Named Executive employees may be terminated at any
time with or without cause, or by reason of death or disability. In certain
termination situations, the Company is liable to pay severance compensation to
the Named Executive of between one year and three years.
55
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND
RELATED STOCKHOLDER MATTERS
The following table sets forth, as of June 30, 2005, information regarding the
security ownership of the directors and certain executive officers of the
Company and persons known to the Company to be beneficial owners of more than
five (5%) percent of the Company's common stock:
<Table>
<Caption>
Excluding Options
and Debentures Including Options (*)
-------------- ---------------------
Name and Address of Number Percent Number Percent of
--
Beneficial Owner Office of Shares of Class of Shares Class
- ---------------- ------ --------- -------- --------- -----
Directors/Executive Officers:
- ----------------------------
William Farber Chairman of the 13,619,129(1) 56.22% 13,656,629(2) 56.38%
9000 State Road Board
Philadelphia, PA 19136
Albert Wertheimer Director 0 0.00% 20,000 0.08%
9000 State Road
Philadelphia, PA 19136
Myron Winkelman Director 1,000 0.00% 1,000 0.00%
9000 State Road
Philadelphia, PA 19136
Ronald A. West Director 7,310 0.03% 17,258(3) 0.07%
9000 State Road
Philadelphia, PA 19136
Arthur Bedrosian President 448,697(4) 1.85% 492,997(5) 2.04%
9000 State Road
Philadelphia, PA 19136
Brian Kearns CFO 0 0.00% 100,000 0.41%
9000 State Road
Philadelphia, PA 19136
Kevin Smith Vice President of 76 0.00% 71,836 0.30%
9000 State Road Sales and
Philadelphia, PA 19136 Marketing
William Schreck
9000 State Road Vice President of 0 0.00% 17,745 0.07%
Philadelphia, PA 19136 Logistics
Bernard Staniford
9000 State Road Vice President of 287 0.00% 38,167 0.15%
Operations
Philadelphia, PA 19136
All directors and 14,076,499 58.43% 14,415,632 59.52%
executive officers as a
group (7 persons)
</Table>
56
(1) Includes 300,000 shares owned jointly by William Farber and his spouse
Audrey Farber.
(2) Includes 37,500 vested options to purchase common stock at an exercise
price of $7.97 per share.
(3) Includes 9,948 vested options to purchase common stock at an exercise price
of $7.97 per share.
(4) Includes 27,450 shares owned by Arthur Bedrosian's wife, Shari Bedrosian
and 9,000 shares owned by Arthur Bedrosian's daughter, Talin Bedrosian. Mr.
Bedrosian disclaims beneficial ownership of these shares.
(5) Includes 12,000 vested options to purchase common stock at an exercise
price of $4.63 per share and 32,300 vested options to purchase common stock at
an exercise price of $7.97 per share.
* Assumes that all options exercisable within sixty days have been
exercised, which results in 24,222,960 shares outstanding.
57
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The Company had sales of approximately $590,000, $590,000 and $348,000 during
the years ended June 30, 2005, 2004 and 2003, respectively, to a generic
distributor, Auburn Pharmaceutical Company (the "related party") in which the
owner, Jeffrey Farber, is 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 $179,000, and
$117,000 at June 30, 2005 and 2004, respectively. In the Company's opinion, the
terms of these transactions were not more favorable to the related party than
would have been to a non-related party.
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 $732,000, $499,000 and $28,000
during Fiscal 2005, 2004 and 2003, respectively, to the Insurance brokers for
various insurance coverage policies. There was approximately $71,200 and $9,400
due to the Insurance brokers as of June 30, 2005 and 2004, respectively. In the
Company's opinion, the terms of these transactions were not more favorable to
the related party than would have been to a non-related party.
In January 2005, Lannett Holdings, Inc. entered into an agreement pursuant which
it 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 Lannett Holdings, Inc's ability to obtain FDA
approval to use the proprietary rights. In the event that such FDA approval
cannot be obtained, Pharmeral, Inc. must repay the $100,000 to Lannett Holdings,
Inc. Accordingly, the Company has treated this payment as a prepaid asset.
Arthur Bedrosian, President of Lannett, 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 Lannett and, in its opinion, the terms
were not more favorable to the related party than they would have been to a
non-related party.
58
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Grant Thornton LLP served as the independent auditors of the Company during
Fiscal 2005, 2004 and 2003. No relationship exists other than the usual
relationship between independent public accountant and client. The following
table identifies the fees paid to Grant Thornton LLP in Fiscal 2005, 2004 and
2003.
<Table>
<Caption>
AUDIT FEES AUDIT-RELATED FEES TAX FEES ALL OTHER FEES TOTAL FEES
(1) (2) (3)
Fiscal 2005:
$110,500 $2,850 $52,475 $203,895 $369,720
Fiscal 2004:
$92,124 $5,000 $29,621 $38,325 $165,070
Fiscal 2003:
$72,561 $7,700 $17,816 $45,343 $143,420
</Table>
(1) Audit-related fees include fees paid for preparation and participation in
Board of Director meetings, and Audit Committee meetings.
(2) Tax fees include fees paid for preparation of annual federal, state and
local income tax returns, quarterly estimated income tax payments, and various
tax planning services. Fiscal 2005 includes fees paid to Grant Thornton for
services rendered during an IRS audit.
(3) Other fees include:
Fiscal 2005 - A large portion of the fees paid were for services
rendered in connection with Sarbanes - Oxley compliance and internal
control assessment. Other fees were for review of various SEC
correspondence and fees for services rendered in connection with the
Company's application to various local and state entities for benefits
related to the Company's facility expansion.
Fiscal 2004 - Fees paid for services rendered in connection with
arbitrage calculations on certain tax exempt bond issues, review of
stock option documentation, review of S-3 registration statement filing
for the four million shares granted to JSP, review of various SEC
correspondence and fees for services rendered in connection with the
Company's application to various local and state entities for benefits
related to the Company's facility expansion.
Fiscal 2003 - Fees paid for services rendered in connection with the
Company's application to various local and state entities for benefits
related to the Company's facility expansion; and services rendered in
connection with an engagement for interest expense arbitrage
calculations on certain tax exempt bond issues.
The non-audit services provided to the Company by Grant Thornton LLP were
pre-approved by the Company's audit committee. Prior to engaging its auditor to
perform non-audit services, the Company's audit committee reviews the particular
service to be provided and the fee to be paid by the Company for such service
and assesses the impact of the service on the auditor's independence.
59
PART IV
ITEM 15. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) A list of the exhibits required by Item 601 of Regulation S-K to be filed
as of this Form 10-K is shown on the Exhibit Index filed herewith
(b) Consolidated Financial Statements and Supplementary Data
The following are included herein:
<Table>
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of June 30, 2005 and 2004
Consolidated Statements of Operations for each of the three years in the period ended June 30, 2005
Consolidated Statements of Cash Flows for each of the three years in the period ended June 30, 2005
Consolidated Statements of Changes in Shareholders' Equity for each of the three years in the period
ended June 30, 2005
Notes to Consolidated Financial Statements
Supplementary Data (Unaudited)
</Table>
(c) On March 21, 2005, the Company filed a Form 8-K disclosing Item 7 and Item
12 thereof and including as an exhibit the press release announcing its
employment agreement with Brian Kearns.
On Dec. 3, 2004, the Company filed a Form 8-K disclosing Item 2 and Item 7
thereof and including as an exhibit the agreement and press release
announcing that on Dec. 1, 2004 the Company came to a separation agreement
with the CFO Larry Dalesandro.
On August 20, 2004, , the Company filed a Form 8-K disclosing Item 2 and
Item 7 thereof and including as an exhibit and press release, the Company
announced its results of operations for the quarter ended and fiscal year
ended June 30, 2004.
60
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange
Act of 1934, the registrant has duly caused this report to be signed on its
behalf by the undersigned, thereunto duly authorized.
LANNETT COMPANY, INC.
Date: September 13, 2005 By: / s / William Farber
------------------ ---------------------
William Farber,
Chairman of the Board and
Chief Executive Officer
Date: September 13, 2005 By: / s / Brian Kearns
------------------ -------------------
Brian Kearns,
Vice President of Finance, Treasurer, and
Chief Financial Officer
Date: September 13, 2005 By: / s / Ronald West
------------------ ------------------
Ronald West,
Director, Chairman of Audit Committee
Date: September 13, 2005 By: / s / Myron Winkelman
------------------ ----------------------
Myron Winkelman,
Director
Pursuant to the requirements of the Securities Exchange Act of 1934, this report
has been signed by the following persons on behalf of the registrant and in the
capacities and on the dates indicated.
Date: September 13, 2005 By: / s / William Farber
------------------ ---------------------
William Farber,
Chairman of the Board and
Chief Executive Officer
Date: September 13, 2005 By: / s / Brian Kearns
------------------ -------------------
Brian Kearns,
Vice President of Finance, Treasurer, and
Chief Financial Officer
61
EXHIBIT 13
ANNUAL REPORT ON FORM 10-K
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and
Shareholders of Lannett Company, Inc.
We have audited the accompanying consolidated balance sheets of
Lannett Company, Inc. (a Pennsylvania corporation) as of June 30 2005
and 2004, and the related consolidated statements of operations,
shareholders' equity, and cash flows for each of the three years in
the period ended June 30, 2005. These financial statements are the
responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the
Public Company Accounting Oversight Board (United States). Those
standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test
basis, evidence supporting the amounts and disclosures in the
financial statements. An audit also includes assessing the accounting
principles used and significant estimates made by management, as well
as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position
of Lannett Company, Inc. as of June 30, 2005 and 2004, and the
results of its operations and its cash flows for each of the three
years in the period ended June 30, 2005 in conformity with accounting
principles generally accepted in the United States of America.
We also have audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the effectiveness
of Lannett Company, Inc.'s internal control over financial reporting
as of June 30, 2005, based on criteria established in Internal
Control--Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO) and our report dated
September 1, 2005 expressed an unqualified opinion on management's
assessment of the effectiveness of internal controls over financial
reporting and an unqualified opinion on the effectiveness of internal
control over financial reporting.
/s/ GRANT THORNTON LLP
Philadelphia, Pennsylvania
September 1, 2005
62
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
Board of Directors and
Shareholders of Lannett Company, Inc.
We have audited management's assessment, included in the accompanying
Management's Report on Internal Control Over Financial Reporting, that
Lannett Company, Inc. (a Pennsylvania Corporation) maintained effective
internal control over financial reporting as of June 30, 2005, based on
criteria established in Internal Control -- Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Lannett Company, Inc.'s management is responsible for
maintaining effective internal control over financial reporting and for
its assessment of the effectiveness of internal control over financial
reporting. Our responsibility is to express an opinion on management's
assessment and an opinion on the effectiveness of the company's
internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public
Company Accounting Oversight Board (United States). Those standards
require that we plan and perform the audit to obtain reasonable
assurance about whether effective internal control over financial
reporting was maintained in all material respects. Our audit included
obtaining an understanding of internal control over financial
reporting, evaluating management's assessment, testing and evaluating
the design and operating effectiveness of internal control, and
performing such other procedures as we considered necessary in the
circumstances. We believe that our audit provides a reasonable basis
for our opinion.
A company's internal control over financial reporting is a process
designed to provide reasonable assurance regarding the reliability of
financial reporting and the preparation of financial statements for
external purposes in accordance with generally accepted accounting
principles. A company's internal control over financial reporting
includes those policies and procedures that (1) pertain to the
maintenance of records that, in reasonable detail, accurately and
fairly reflect the transactions and dispositions of the assets of the
company; (2) provide reasonable assurance that transactions are
recorded as necessary to permit preparation of financial statements in
accordance with generally accepted accounting principles, and that
receipts and expenditures of the company are being made only in
accordance with authorizations of management and directors of the
company; and (3) provide reasonable assurance regarding prevention or
timely detection of unauthorized acquisition, use, or disposition of
the company's assets that could have a material effect on the financial
statements.
Because of its inherent limitations, internal control over financial
reporting may not prevent or detect misstatements. Also, projections of
any evaluation of effectiveness to future periods are subject to the
risk that controls may become inadequate because of changes in
conditions, or that the degree of compliance with the policies or
procedures may deteriorate.
63
In our opinion, management's assessment that Lannett Company, Inc.
maintained effective internal control over financial reporting as of
June 30, 2005, is fairly stated, in all material respects, based on
criteria established in Internal Control -- Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission
(COSO). Also in our opinion, Lannett Company, Inc. maintained, in all
material respects, effective internal control over financial reporting
as of June 30, 2005, based on criteria established in Internal Control
-- Integrated Framework issued by the Committee of Sponsoring
Organizations of the Treadway Commission (COSO).
We have also audited, in accordance with the standards of the Public
Company Accounting Oversight Board (United States), the consolidated
balance sheets of Lannett Company, Inc. as of June 30, 2005 and 2004,
and the related consolidated statements of operations, shareholders'
equity, and cash flows for each of the three years in the period ended
June 30, 2005 and our report dated September 1, 2005 expressed an
unqualified opinion on those financial statements.
/s/ GRANT THORNTON LLP
Philadelphia, Pennsylvania
September 1, 2005
64
<Table>
<Caption>
CONSOLIDATED BALANCE SHEETS
JUNE 30, 2005 2004
ASSETS
CURRENT ASSETS
Cash $ 4,165,601 $ 8,966,954
Trade accounts receivable (net of allowance for doubtful accounts 10,735,529 24,240,887
of $70,000 and $260,000, respectively)
Inventories 9,988,769 12,813,250
Prepaid taxes 3,957,993 882,613
Other current assets 1,966,270 1,016,050
Deferred tax assets 3,123,953 942,689
------------ ------------
Total current assets 33,938,115 48,862,443
PROPERTY, PLANT AND EQUIPMENT 23,746,161 15,259,693
Less accumulated depreciation (7,121,313) (5,666,798)
------------ ------------
16,624,848 9,592,895
CONSTRUCTION IN PROGRESS 2,079,650 7,352,821
INVESTMENT SECURITIES - Available for Sale 7,888,708 -
DEFERRED TAX ASSETS 18,610,159 166,332
INTANGIBLE ASSET (Product rights), net of accumulated amortization 15,615,835 65,725,490
OTHER ASSETS 159,745 204,103
------------ ------------
TOTAL ASSETS $ 94,917,060 $131,904,084
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Current portion of long-term debt $ 2,269,776 $ 1,988,716
Accounts payable 1,208,148 5,640,054
Rebates and chargebacks payable 10,750,000 8,885,000
Accrued expenses 1,667,638 3,424,859
Unearned grant funds 500,000 -
------------ ------------
Total current liabilities 16,395,562 19,938,629
LONG-TERM DEBT, LESS CURRENT PORTION 7,262,672 8,104,141
DEFERRED TAX LIABILITY 2,009,582 1,614,323
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY:
Common stock - authorized 50,000,000 shares, par value $0.001;
issued and outstanding, 24,111,140 and 24,074,710 shares,
respectively 24,111 24,075
Additional paid-in capital 70,157,431 69,955,855
Retained (deficit) earnings (512,535) 32,267,061
Accumulated other comprehensive loss (25,193) -
------------ ------------
69,643,814 102,246,991
Treasury Stock at Cost - 50,900 and 0 shares, respectively 394,570 -
------------ ------------
Total shareholders' equity 69,249,244 102,246,991
------------ ------------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY $ 94,917,060 $131,904,084
============ ============
The accompanying notes to consolidated financial statements are an integral part
of these statements.
65
<Table>
<Caption>
CONSOLIDATED STATEMENTS OF OPERATIONS
YEARS ENDED JUNE 30,
2005 2004 2003
- -----------------------------------------------------------------------------------------------------------------------
NET SALES $ 44,901,645 63,781,219 $ 42,486,758
COST OF SALES 31,416,908 26,856,875 16,257,794
------------- ------------ ------------
Gross profit 13,484,737 36,924,344 26,228,964
RESEARCH AND DEVELOPMENT EXPENSES 6,265,522 5,895,096 2,575,178
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES 9,194,377 8,863,966 4,337,558
AMORTIZATION EXPENSE 5,516,417 1,314,510 -
LOSS ON SALE OF ASSETS 1,466 19,803 119,279
LOSS ON IMPAIRMENT/ABANDONMENT OF ASSETS 46,146,613 - 136,843
------------- ------------ ------------
Operating (loss)income (53,639,658) 20,830,969 19,060,106
------------- ------------ ------------
OTHER INCOME(EXPENSE):
Interest income 165,622 43,101 2,297
Interest expense (351,462) (64,300) (60,776)
------------- ------------ ------------
(185,840) (21,199) (58,479)
------------- ------------ ------------
(LOSS)/INCOME BEFORE INCOME TAX EXPENSE(BENEFIT) (53,825,498) 20,809,770 19,001,627
INCOME TAX (BENEFIT)EXPENSE (21,045,902) 7,594,316 7,334,740
------------- ------------ ------------
NET (LOSS)INCOME $ (32,779,596) $ 13,215,454 $ 11,666,887
============= ============ ============
Basic (loss)earnings per common share $ (1.36) $ 0.63 $ 0.58
============= ============ ============
Diluted (loss)earnings per common share $ (1.36) $ 0.63 $ 0.58
============= ============ ============
The accompanying notes to consolidated financial statements are an integral part
of these statements.
66
CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY
YEARS ENDED JUNE 30, 2005, 2004 AND 2003
COMMON STOCK
--------------------------- ADDITIONAL RETAINED
SHARES PAID-IN EARNINGS TREASURY ACCUM. OTHER SHAREHOLDERS'
ISSUED AMOUNT CAPITAL (DEFICIT) STOCK COMP. LOSS EQUITY
BALANCE, JUNE 30, 2002 19,894,257 19,894 2,360,261 7,385,894 - - 9,766,049
Exercise of stock options 131,709 132 165,816 - - - 165,948
Stock Split-shares repurchased
due to odd quantity holders (95) - - (1,174) - - (1,174)
Net income - - - 11,666,887 - - 11,666,887
------------ --------- ------------ ------------- ---------- --------- -------------
BALANCE, JUNE 30, 2003 $ 20,025,871 $ 20,026 $ 2,526,077 $ 19,051,607 $ - $ - $ 21,597,710
-
Exercise of stock options 36,867 37 232,079 - - - 232,116
Shares issued in connection
with employee stock
purchase plan 11,972 12 161,699 - - - 161,711
Shares issued in connection
with JSP product rights
contract 4,000,000 4,000 67,036,000 - - - 67,040,000
Net Income - - - 13,215,454 - - 13,215,454
------------ --------- ------------ ------------- ---------- --------- -------------
BALANCE, JUNE 30, 2004 $ 24,074,710 $ 24,075 $ 69,955,855 $ 32,267,061 $ - $ - $ 102,246,991
------------ --------- ------------ ------------- ---------- --------- -------------
Exercise of stock options 19,136 19 60,892 - - - 60,911
Shares issued in connection
with employee stock purchase plan 17,304 17 140,684 - - - 140,701
Other Comp. Loss - - - - - (25,193) (25,193)
Cost of Treasury Stock - - - - (394,570) - (394,570)
Net Loss - - - (32,779,596) - - (32,779,596)
------------ --------- ------------ ------------- ---------- --------- -------------
BALANCE, JUNE 30, 2005 $ 24,111,140 $ 24,111 $ 70,157,431 $ (512,535) $(394,570) $(25,193) $ 69,249,244
============ ========= ============ ============= ========== ========= =============
The accompanying notes to consolidated financial statements are an integral part
of these statements.
67
<Table>
<Caption>
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JUNE 30, 2005 2004 2003
- ------------------------------------------------------------------------------------------------------------------------
OPERATING ACTIVITIES:
Net (loss) income $ (32,779,596) $ 13,215,454 $ 11,666,887
Adjustments to reconcile net (loss) income to
net cash provided by operating activities:
Depreciation and amortization
6,970,932 2,506,427 982,188
Loss on disposal/impairment of assets 46,093,236 19,803 256,122
Deferred tax (benefit) expense
(20,229,832) (37,209) 161,390
Changes in assets and liabilities which provided (used) cash:
Trade accounts receivable 15,370,358 (12,953,719) (6,137,916)
Inventories
2,824,481 (4,637,452) (3,238,591)
Prepaid taxes (3,075,380) (882,613) -
Prepaid expenses and other current assets (905,862)
(356,057) (261,230)
Accounts payable (4,431,906) 9,089,751
4,017,952
Accrued expenses
(1,757,219) 2,898,429 (131,461)
Income taxes payable - (63,617) (662,935)
-------------- -------------- --------------
Net cash provided by operating activities 8,079,212 8,799,197 6,652,406
-------------- -------------- --------------
INVESTING ACTIVITIES:
Purchases of property, plant and equipment
(3,213,297) (10,749,636) (2,618,936)
Deposits paid on machinery and equipment not yet - - -
received
Purchase of intangible asset (1,500,000) - -
Purchases of AFS investment securities (7,913,901) - -
Proceeds from sale of property, plant and equipment - - 375,003
-------------- -------------- --------------
Net cash used in investing activities (12,627,198) (10,749,636) (2,243,933)
============== ============== ==============
FINANCING ACTIVITIES:
Net repayments under line of credit - - (202,688)
Repayments of debt
(2,163,015) (1,085,669) (842,048)
Proceeds from grant funding 500,000 - -
Proceeds from debt, net of restricted cash released 1,602,606 8,080,724 -
Proceeds from issuance of stock 201,612 393,827 165,948
Treasury stock transactions (394,570) - -
Payments made in lieu of stock split - - (1,174)
-------------- -------------- --------------
Net cash (used in)provided by financing activities (253,367) 7,388,882 (879,962)
-------------- -------------- --------------
NET (DECREASE)/INCREASE IN CASH (4,801,353) 5,438,443 3,528,511
CASH, BEGINNING OF YEAR 8,966,954 3,528,511 -
-------------- -------------- --------------
CASH, END OF YEAR $ 4,165,601 $ 8,966,954 $ 3,528,511
============== ============== ==============
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION -
Interest paid $ (351,462) $ 32,102 $ 57,688
============== ============== ==============
Income taxes paid $ 3,149,620 $ 8,540,546 $ 7,436,964
============== ============== ==============
</Table>
NON-CASH TRANSACTION: In Fiscal 2004, the Company had a non-cash transaction
associated with the JSP Product Rights Contract. For the exclusive rights to all
of JSP products, the Company issued 4,000,000 shares to JSP. The Company
recorded an intangible asset in the amount of $67,040,000. No cash was exchanged
in the transaction. The accompanying notes to consolidated financial statements
are an integral part of these statements.
68
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
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).
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.
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 prior years'
financial information to conform to the June 30, 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, 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 drug companies, Lannett does not
use information about product levels in distribution channels from third-party
sources, such as IMS 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
69
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 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.
70
The following tables identify the reserves for each major category of revenue
allowance and a summary of the activity for the years ended June 30, 2005 and
2004:
<Table>
<Caption>
FOR THE YEAR ENDED
JUNE 30, 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 (4,978,300) (1,970,000) (523,100) (95,800) (7,567,200)
Actual Credits Issued-Related
To Sales Recorded in Fiscal 2005 (14,534,600) (5,965,500) (1,166,800) (586,400) (22,253,300)
Additional Reserves Charged to
Net Sales During Fiscal 2005 21,028,100 7,100,100 2,933,900 623,400 31,685,500
----------- ----------- ---------- --------- -----------
Reserve Balance as of
June 30, 2005 $ 7,999,700 $ 1,028,800 $1,692.000 $ 29,500 $10,750,000
=========== =========== ========== ========= ===========
<Caption>
FOR THE YEAR ENDED
JUNE 30, 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 (12,447,000) (2,723,200) (60,100) (410,000) (15,640,300)
Additional Reserves Charged to
Net Sales During Fiscal 2004 18,897,500 4,863,900 480,600 464,400 24,706,400
----------- ----------- ---------- --------- -----------
Reserve Balance as of
June 30, 2004 $ 6,484,500 $ 1,864,200 $ 448,000 $ 88,300 $ 8,885,000
=========== =========== ========== ========= ===========
</Table>
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
71
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 resale 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
72
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 the estimated useful lives of the assets. Depreciation expense for the
years ended June 30, 2005, 2004, and 2003 was approximately $1,799,000,
$1,192,000, and $945,000, respectively.
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 loss. 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 twelve
month period ended June 30, 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
agreements. Amortization expense for debt acquisition costs for they years ended
June 30, 2005, 2004 and 2003 was approximately $23,000, $35,000 and $37,000,
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. An impairment charge
was recorded against this intangible asset in the current fiscal year. 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 June 30, 2005, the Company had recorded an addition to the
intangible asset of $1.5 million.
73
Management believes that events occurred (as described in subsequent paragraphs)
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 had 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 the date of the impairment.
This impairment loss is shown on the statement of operations as a component of
operating loss. Management concluded that, as of June 30, 2005, the intangible
asset is correctly stated at fair value and, therefore, no adjustment was
required.
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 resulted in diminished forecasted future net cash flow which,
when discounted, yield a lower present value than the carrying value of the
asset before impairment.
The Company will incur annual amortization expense of approximately $1,785,000
for the intangible asset over the remaining term of the contract. For the period
ending June 30, 2005, the Company incurred $5,516,000 of non-cash amortization
expense associated with the JSP intangible asset.
Future annual amortization expense of the JSP intangible asset consists of the
following:
<Table>
<Caption>
Year Ending June 30, Annual Amortization Expense
- -------------------- ---------------------------
2006 $1,785,000
2007 1,785,000
2008 1,785,000
2009 1,785,000
2010 1,785,000
Thereafter 6,691,000
-------------
$15,616,000
=============
</Table>
ADVERTISING COSTS - The Company charges advertising costs to operations as
incurred. Advertising expense for the years ended June 30, 2005, 2004 and 2003
was approximately $157,000, $291,000, and $118,000, respectively.
74
INCOME TAXES - The Company uses the liability method specified by Statement of
Financial Accounting Standards No. 109 (FAS), 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
Statement of Financial Accounting Standard No. 131 (FAS 131), Disclosures about
Segments of an Enterprise and Related Information. The Company operates one
business segment-generic pharmaceuticals, accordingly the Company has one
reporting segment. In accordance with FAS 131, the Company aggregates its
financial information for all products and reports on one operating segment.
LONG-LIVED ASSETS - 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 on the JSP product rights
intangible asset 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. Impairment losses
recognized during the years ended June 30, 2005, 2004 and 2003 were $46,093,000,
$0 and $137,000, respectively.
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 31%, 24%, 16%, 10% and 12%,
respectively, of net sales for the fiscal year ended June 30, 2005; and 22%,
21%, 17%, 15%, and 10%, respectively, of net sales for the fiscal year ended
June 30, 2004.
Three of the Company's customers accounted for 17%, 14%, and 9%, respectively,
of net sales for the fiscal year ended June 30, 2005; and 17%, 17%, and 10%,
respectively, of net sales for the fiscal year ended June 30, 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 remaining 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
75
when they become uncollectible, and payments subsequently received on such
receivables are credited to the allowance for doubtful accounts.
STOCK OPTIONS - At June 30, 2005, the Company had two stock-based employee
compensation plans (See Note 9). The Company accounts for stock options under
Statement of Financial Accounting Standards 123 (FAS 123), Accounting for
Stock-Based Compensation, as amended by Statement of Financial Accounting
Standards No. 148 (FAS 148), Accounting for Stock Based Compensation -
Transition and Disclosure. 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 Opinion No. 25 (APB 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 as if the Company had applied the fair value recognition provisions of
FAS 123 to stock-based employee compensation.
FISCAL YEAR ENDED JUNE 30,
2005 2004 2003
Net (loss)/income, as reported $(32,779,596) $ 13,215,454 $ 11,666,887
Deduct: Total compensation expense
determined under fair value-based
method for all stock awards (2,616,888) (950,658) (539,029)
Add: Tax savings at effective rate 1,023,203 346,933 208,065
-----------------------------------------------------
Pro forma net (loss)/income (34,373,282) 12,611,729 11,335,923
=====================================================
(Loss)/Earnings per share:
Basic, as reported $ (1.36) $ 0.63 $ 0.58
=====================================================
Basic, pro forma $ (1.43) $ 0.61 $ 0.57
=====================================================
Diluted, as reported $ (1.36) $ 0.63 $ 0.58
=====================================================
Diluted, pro forma $ (1.43) $ 0.60 $ 0.56
=====================================================
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 2005, 2004 and 2003: expected volatility of
42.6%, 31.2% and 79.1%, respectively; risk-free interest rates between 4.13% and
4.52% for 2005, 4.36% and 4.79% for 2004 and 3.89% and 4.47% for 2003; and
expected lives of ten years.
In December 2004, the FASB revised FAS 123. This Statement supersedes APB 25 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
76
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 123R (revised) for the quarter ended September 30,
2005 and is currently assessing the impact of this adoption. For further
discuss, refer to Note 2.
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.
NOTE 2. NEW ACCOUNTING STANDARDS
In November 2004, the Financial Accounting Standards Board (FASB) issued
Statement of Financial Accounting Standards No. 151 (SFAS No. 151), Inventory
Costs - an amendment of ARB No. 43, Chapter 4. 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..." SFAS No. 151
requires that those items be recognized as current period charges regardless of
whether they meet the criterion of "so abnormal." The adoption of SFAS No. 151
did not have a material effect on the Company's consolidated financial position,
results of operations, or cash flows.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets
- - an amendment of APB Opinion No. 29 (SFAS No. 153). APB Opinion No. 29 requires
a nonmonetary exchange of assets be accounted for at fair value, recognizing any
gain or loss, if the exchange meets a commercial substance criterion and fair
value is determinable. The commercial substance criterion is assessed by
comparing the entity's expected cash flows immediately before and after the
exchange. SFAS No. 153 eliminates the "similar productive assets exception,"
which accounts for the exchange of assets at book value with no recognition of
gain or loss. SFAS No. 153 will be effective for nonmonetary asset exchanges
occurring in fiscal periods beginning after June 15, 2005. We do not believe the
adoption of SFAS No. 153 will have a material impact on our financial
statements.
In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment (SFAS No.
123R), which requires companies to expense the fair value of stock options and
other equity-based compensation to employees. It also provides guidance for
determining whether an award is a liability-classified award or an
equity-classified award, and determining fair value. SFAS No. 123R applies to
all unvested stock-based payment awards outstanding as of the adoption date.
Pursuant to a rule announced by the Securities and Exchange Commission in April
2005, SFAS No. 123R must be adopted no later than the beginning of the first
fiscal year that begins after June 15, 2005. We have not completed an assessment
of the impact on our financial statements resulting from potential modifications
to our equity-based compensation structure or the use of an alternative fair
value model in anticipation of adopting SFAS No. 123R. The Company plans to
adopt SFAS No. 123R for the quarter ended September 30, 2005.
In May 2005, the FASB issued SFAS No.
154, Accounting Changes and Error Corrections - a replacement of APB Opinion No.
20 and FASB Statement No. 3 (SFAS No. 154), which replaces APB Opinion No. 20,
Accounting Changes, and SFAS No. 3, Reporting Accounting Changes in Interim
Financial Statements, and changes the requirements for the accounting for and
reporting of a change in accounting principle. SFAS No. 154 applies to all
voluntary changes in accounting principle, and also applies to changes required
by an accounting pronouncement in the unusual instance that the pronouncement
does not include specific transition provisions.
77
SFAS No. 154 will be effective for accounting changes and corrections of errors
made in fiscal years beginning after December 15, 2005. SFAS No. 154 does not
change the transition provisions of any existing accounting pronouncements,
including those that are in a transition phase as of the effective date of SFAS
No. 154. We do not believe the adoption of SFAS No. 154 will have a material
impact on our financial statements.
In March 2005, the FASB issued FIN 47 "Accounting for Conditional Asset
Retirement Obligations, an Interpretation of FASB Statement No. 143." This
Interpretation clarifies that a conditional retirement obligation refers to a
legal obligation to perform an asset retirement activity in which the timing and
(or) method of settlement are conditional on a future event that may or may not
be within the control of the entity. The obligation to perform the asset
retirement activity is unconditional even though uncertainty exists about the
timing and (or) method of settlement. Accordingly, an entity is required to
recognize a liability for the fair value of a conditional asset retirement
obligation if the fair value of the liability can be reasonably estimated. The
liability should be recognized when incurred, generally upon acquisition,
construction or development of the asset. FIN 47 is effective no later than the
end of the fiscal years ending after December 15, 2005. We have not completed an
assessment of the impact that adoption of FIN 47 will have on our financial
statements.
NOTE 3. INVENTORIES
Inventories at June 30, 2005 and 2004 consist of the following:
<Table>
<Caption>
2005 2004
---- ----
Raw Materials $ 5,091,883 $ 4,195,255
Work-in-process 1,351,112 626,647
Finished Goods 3,303,478 7,854,975
Packaging Supplies 242,296 136,373
------------- -------------
$ 9,988,769 $ 12,813,250
============= =============
</Table>
The preceding amounts are net of inventory obsolescence reserves of $5,300,000
and $515,000 at June 30, 2005 and 2004, respectively.
78
NOTE 4. PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment at June 30, 2005 and 2004 consist of the
following:
USEFUL LIVES 2005 2004
---- ----
Land - $ 233,414 $ 33,414
Building and improvements 10 - 39 years 9,339,706 3,526,003
Machinery and equipment 5 - 10 years 13,347,416 11,504,877
Furniture and fixtures 5 - 7 years 825,625 195,399
------------ ------------
$ 23,746,161 $ 15,259,693
============ ============
NOTE 5. BANK LINE OF CREDIT
The Company has a $3,000,000 line of credit from Wachovia that bears interest at
the prime interest rate less 0.25% (6.00% at June 30, 2005). The line of credit
was renewed and extended to October 2005, at which time the Company expects to
renew and extend the due date. At June 30, 2005 and 2004, the Company had $0
outstanding and $3,000,000 available under the line of credit. The Company does
not currently expect to borrow cash under this line of credit in the future due
to the available cash on hand, and the cash expected to be provided by its
results of operations in the future. The line of credit is collateralized by
substantially all Company assets.
NOTE 6. LONG-TERM DEBT
Long-term debt at June 30, 2005 and 2004 consists of the following
<Table>
<Caption>
2005 2004
---- ----
Tax-exempt Bond Loan $ 1,645,720 $ 2,287,802
Mortgage Loan 2,700,000 2,700,000
Equipment Loan 4,486,729 4,205,055
Construction Loan 699,999 900,000
-------------- -------------
$ 9,532,448 $ 10,092,857
Less current portion 2,269,776 1,988,716
-------------- -------------
$ 7,262,672 $ 8,104,141
============== =============
</Table>
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 remainder of the proceeds was deposited into a money
market
79
account, which was restricted for future plant and equipment needs of the
Company, as specified in the Agreement. 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 June 30, 2005 was
2.44%. At June 30, 2005, the Company has $1,646,000 outstanding on the Authority
loan, of which $644,000 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 a bank, Wachovia Bank, National Association
(Wachovia), to secure payment of the Authority Loan and a portion of the related
accrued interest. At June 30, 2005, no portion of the letter of credit has been
utilized.
The Company has entered into agreements (the "2003 Loan Financing") with
Wachovia to finance the purchase of the building, the renovation and setup of
the building, and the Company's other anticipated capital expenditures for
Fiscal 2004, including the implementation of its new Enterprise Resource
Planning (ERP) system, and a new fluid bed drying process center at its current
manufacturing plant at 9000 State Road. The 2003 Loan Financing includes the
following:
1) A Mortgage Loan for $2.7 million, used to finance the purchase of the
Torresdale Avenue facility, and certain renovations at the facility.
2) An Equipment Loan for up to $6 million, which will be used to finance
equipment, the ERP system implementation and other capital
expenditures.
3) A Construction Loan for $1 million, used to finance the construction
and fit up of the fluid bed drying process center, which is adjacent to
the Company's current manufacturing plant at 9000 State Road.
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 June 30, 2005, the Conversion date
has not taken place and the Company continues to make interest only payments. As
of June 30, 2005, the Company has outstanding $2.7 million under the Mortgage
Loan, of which $95,000 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
June 30, 2005, the Company has outstanding $4,487,000 under the Equipment Loan,
of which $1,342,000 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
80
maturity date of the loan. As of June 30, 2005, the Company has outstanding
$700,000 under the Construction Loan, of which $189,000 is classified as
currently due.
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 June 30, 2005, the
interest rate for the 2003 Loan Financing was 4.93%.
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 June 30, 2005, the
Company obtained a waiver from the lender due to a violation of one of its
covenants. The Company expects to meet the financial covenants in the future.
Annual repayments of debt, including sinking fund requirements, as of June 30,
2005 are as follows:
YEAR ENDING AMOUNTS PAYABLE
JUNE 30, TO INSTITUTIONS
2006 2,269,776
2007 1,666,991
2008 1,388,022
2009 1,318,736
2010 307,951
Thereafter 2,580,972
-----------------------
9,532,448
=======================
NOTE 7. INCOME TAXES
The provision for income taxes consists of the following for the years ended
June 30.
2005 2004 2003
---- ---- ----
Current Income Taxes
Federal $ (815,930) $ 6,054,428 $ 5,928,720
State and Local Taxes 1,577,097 1,244,630
------------- ----------- -----------
Total (815,930) 7,631,525 7,173,350
Deferred Income Taxes
Federal (16,861,925) (35,349) 153,320
State and Local Taxes (3,368,047) (1,860) 8,070
------------- ----------- -----------
Total (20,229,972) (37,209) 161,390
Total $ (21,045,902) $ 7,594,316 $ 7,334,740
============= =========== ===========
81
A reconciliation of the differences between the effective rates and statutory
rates is as follows:
2005 2004 2003
---- ---- ----
Federal income tax at statutory rate 35.0% 35.0% 35.0%
State and local income tax, net 4.1% 4.9% 6.5%
Disqualifying dispositions 0.0% -0.8% -
Other 0.0% -2.6% -2.9%
----- ----- -----
Income taxes expense 39.1% 36.5% 38.6%
===== ===== =====
The principal types of differences between assets and liabilities for financial
statement and tax return purposes are accruals, reserves, impairment of
intangibles, accumulated amortization and accumulated depreciation. A deferred
tax asset is recorded for the future benefits created by the timing of accruals
and reserves and the application of different amortization lives for financial
statement and tax return purposes. A deferred tax liability is recorded for the
future liability created by different depreciation methods for financial
statement and tax return purposes.
As of June 30, 2005 and 2004, temporary differences which give rise to deferred
tax assets and liabilities are as follows:
Deferred tax assets:
Accrued expenses $ 14,069 $ 7,020
Reserves for Accounts Receivable and Inventory 3,109,884 935,669
Intangible impairment 17,976,270
State net operating loss 158,517
Accumulated Amortization on Intangible Asset 475,512 166,332
------------ --------------
21,734,252 1,109,021
Valuation allowance - -
------------ --------------
Total 21,734,252 1,109,021
Deferred tax liabilities:
Prepaid Expenses 103,479
Property, Plant and Equipment 1,906,103 1,614,323
------------ --------------
Net Deferred Tax Asset/(Liability) $ 19,724,670 $ (505,302)
============ ==============
NOTE 8. EARNINGS PER SHARE
EARNINGS PER COMMON SHARE - SFAS No. 128, Earnings Per Share, requires a dual
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
82
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:
2005 2004 2003
--------------------------------- -----------------------------------------------------------------
NET (LOSS)/INCOME SHARES NET INCOME SHARES NET INCOME SHARES
(NUMERATOR) (DENOMINATOR) (NUMERATOR) (DENOMINATOR) (NUMERATOR) (DENOMINATOR)
Basic (loss)/earnings per
share factors $ (32,779,596) 24,097,472 $ 13,215,454 20,831,750 $ 11,666,887 19,968,633
Effect of potentially dilutive
option plans 222,194 152,681
-------------- ----------- ------------ ----------- ------------ ----------
Diluted (loss)/earnings per
share factors $ (32,779,596) 24,097,472 $ 13,215,454 21,053,944 $ 11,666,887 20,121,314
============= =========== ============ ========== ============ ==========
Basic (loss)/earnings per share $ (1.36) $ 0.63 $ 0.58
Diluted (loss)/earnings per share $ (1.36) $ 0.63 $ 0.58
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 year ended June 30, 2005,
2004 and 2003 were 857,108, 178,500, and 0, respectively.
NOTE 9. STOCK OPTIONS
In Fiscal 1993, the Company adopted the 1993 Long-Term Incentive Plan (the
"1993 Plan"). Pursuant to the 1993 Plan and its amendments, employees and
non-employees of the Company may be granted stock options, which qualify as
incentive stock options, as well as stock options which are nonqualified.
The exercise price of the options granted were at least equal to the fair
market value of the common stock on the date of grant. There were 2,000,000
shares originally reserved for under the 1993 Plan. Of this amount, options
for 390,419 shares were granted, and were either exercised by the
recipient, or are currently outstanding. Pursuant to the plan provisions,
the 1993 Plan terminated on February 13, 2003. No additional shares were
granted under this Plan after this date.
In February 2003, the Company adopted the 2003 Incentive Stock Option Plan
(the "2003 Plan"). Pursuant to the 2003 Plan, employees and non-employees
of the Company may be granted stock options which may qualify as incentive
stock options, as well as stock options which are nonqualified. The
exercise price of the incentive stock options is at least the fair market
value of the common stock on the date of grant. The exercise price of
nonqualified options may be above or below the fair market value of the
common stock on the date of the grant. The options generally vest over a
three-year period and expire no later than 10 years from the date of grant.
There are 1,125,000 shares reserved for under the 2003 Plan. Of this
amount, options for 131,017 and 428,570 shares were granted in Fiscal 2005
and 2004, respectively, and were either exercised by the recipient, or are
currently outstanding. Options for 1,395,267 shares remain available for
grants under the Plan.
83
A summary of the status of the combined options for both the 1993 Plan and
the 2003 Plan, as of June 30, 2004 and 2003, and the changes during the
years then ended is represented below:
2005 2004 2003
----------------------------- -------------------------------------------------------------
WEIGHTED AVG. WEIGHTED AVG. WEIGHTED AVG.
EXERCISE EXERCISE EXERCISE
SHARES PRICE SHARES PRICE SHARES PRICE
Outstanding, beginning of year 801,424 $ 12.45 409,721 $ 7.47 151,860 $ 0.94
Granted 131,070 7.42 428,570 16.69 398,820 7.82
Exercised (19,126) 3.70 (36,867) 6.29 (131,709) 1.26
Terminated (56,260) 14.02 - (9,250) 3.74
-------- --------- ------- -------- --------- ---------
Outstanding, end of year 857,108 $ 13.72 801,424 $ 12.45 409,721 $ 7.47
======== ========= ======= ======== ========= =========
Options exercisable at year-end 386,271 $ 12.85 179,184 $ 7.39 98,025 $ 6.82
======== ========= ======= ======== ========= =========
Weighted average fair value of options
granted during the year $ 7.23 $ 8.75 $ 6.48
========= ======== =========
OPTIONS OUTSTANDING AT JUNE 30, 2005 OPTIONS EXERCISABLE AT JUNE 30, 2005
---------------------------------------------- ---------------------------------------------
EXERCISE # OF AVERAGE AVERAGE # OF AVERAGE AVERAGE
PRICE SHARES LIFE EXERCISE PRICE SHARES LIFE EXERCISE PRICE
$ 0.75 2,375 4.4 $ 0.75 2,375 4.4 $ 0.75
$ 2.30 0 6.5 $ 2.30 0 6.5 $ 2.30
$ 4.63 29,125 7.0 $ 4.63 19,417 7.0 $ 4.63
$ 6.75 100,000 10.0 $ 6.75 0 10.0 $ 6.75
$ 6.75 3,260 10.0 $ 6.75 0 10.0 $ 6.75
$ 7.48 3,260 10.0 $ 7.48 0 10.0 $ 7.48
$ 7.97 257,703 7.3 $ 7.97 187,617 7.3 $ 7.97
$ 9.02 20,000 9.5 $ 9.02 6,667 9.5 $ 9.02
$10.99 4,550 10.0 $ 10.99 0 10.0 $ 10.99
$11.27 33,125 7.7 $ 11.27 33,125 8.7 $ 11.27
$18.72 7,500 8.2 $ 18.72 5,000 8.2 $ 18.72
$17.36 156,000 8.3 $ 17.36 52,000 8.3 $ 17.36
$16.86 27,710 8.8 $ 16.86 9,237 8.8 $ 16.86
$16.04 212,500 8.9 $ 16.04 70,833 8.9 $ 16.04
----------------- ---------------
857,108 386,271
================= ===============
The Company accounts for stock options under SFAS No. 123, "Accounting for
Stock-Based Compensation," as amended by SFAS No. 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, SFAS No. 123 permits
entities to continue accounting for employee stock options and similar equity
instruments under Accounting Principles Board (APB) Opinion 25, "Accounting for
Stock Issued to Employees." Entities that continue to account for stock options
using APB Opinion 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 SFAS No.123 had been applied. Starting in the first quarter of Fiscal year
84
2006, the Company will account for stock options under SFAS no. 123R,
"Share-Based Payment". For further discussion refer to Note 2, "New Accounting
Standards".
NOTE 10. EMPLOYEE STOCK PURCHASE PLAN
In February 2003, the Company's shareholders approved an Employee Stock Purchase
Plan ("ESPP"). Employees eligible to participate in the ESPP may purchase shares
of the Company's stock at 85% of the lower of the fair market value of the
common stock on the first day of the calendar quarter, or the last day of the
calendar quarter. Under the ESPP, employees can authorize the Company to
withhold up to 10% of their compensation during any quarterly offering period,
subject to certain limitations. The ESPP was implemented on April 1, 2003 and is
qualified under Section 423 of the Internal Revenue Code. The Board of Directors
authorized an aggregate total of 1,125,000 shares of the Company's common stock
for issuance under the ESPP. As of June 30, 2005, 29,293 shares have been issued
under the ESPP.
NOTE 11. EMPLOYEE BENEFIT PLAN
The Company has a defined contribution 401k plan (the "Plan") covering
substantially all employees. Pursuant to the Plan provisions, the Company is
required to make matching contributions equal to each employee's contribution,
but not to exceed 3% of the employee's compensation for the Plan year.
Contributions to the Plan during the years ended June 30, 2005, 2004 and 2003
were $246,000, $187,000 and $103,000, respectively.
NOTE 12. 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 years ended June 30, 2005, 2004 and 2003.
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 amongst the
companies that manufactured DES during the drug's commercial distribution, which
ended in 1971, management has accepted this method as the most reasonably
expected 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 2004 and 2005, the Company entered into three, separate confidential
agreements with ThePharmaNetwork, LLC (TPN) pursuant to which the company agreed
to collaborate to develop, manufacture, supply, and commercialize a certain
generic pharmaceutical drug product. In August 2005, TPN filed a lawsuit against
various defendants, including the Company, seeking, among other things, to
terminate the three agreements between the Company and TPN.
85
The matter is currently pending before the United States District Court for the
District of New Jersey. The Company has filed an answer denying the allegations.
The Company has also filed counterclaims against TPN and its principal, Jonathan
B. Rome, for, among other things, breach of contract. Because of the
confidential nature of the agreements and the generic pharmaceutical drug
product at issue, the Company has requested that the Court place all documents
under seal to prevent the wrongful disclosure of the Company's sensitive,
confidential, and proprietary information. The Company's request for a temporary
restraining order was granted. As a result, TPN is temporarily restrained from
competing against Lannett or collaborating with Lannett's competitors with
respect to the drug product at issue. TPN is also temporarily restrained from
using, disclosing or disseminating any confidential information about this drug
product until after the hearing on the preliminary injunction, which is
scheduled for Sept. 14, 2005. TPN received a temporary restraining order
prohibiting Lannett from disclosing TPN's "confidential information" until after
the preliminary injunction hearing on Sept. 14, 2005. 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 litigation will not have a material
adverse impact on the financial position or results of operation 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.
NOTE 13. COMMITMENTS
LEASES
The Company's headquarters, administrative offices, quality control laboratory,
and manufacturing and production facilities, consisting of approximately 31,000
square feet, are located at 9000 State Road, Philadelphia, Pennsylvania.
In December 1997, the Company entered into a three-year and three-month lease
for a 23,500 square foot facility located at 500 State Road, Bensalem Bucks
County, Pennsylvania. This facility houses laboratory research, warehousing and
distribution operations. The leased facility is located approximately 2 miles
from the Company headquarters. In January 2001, the Company extended this lease
through April 30, 2004. After that time, the Company renewed the lease again
through April 30, 2005. The move to 9001 Torresdale Ave, Philadelphia, PA was
completed in January 2005.
On July 1, 2003, the Company entered into a lease/purchase option agreement for
a 63,000 square foot facility at 9001 Torresdale Avenue, Philadelphia,
Pennsylvania, approximately 1 mile from the Company's headquarters. On November
26, 2003, the Company exercised its option to purchase the facility. The
Company's laboratory research, warehousing and distribution operations, sales
and accounting departments are now housed there. The Company no longer utilizes
nor has any lease obligations to the 500 State Road facility.
In addition to the above, the Company has operating leases, expiring in 2008,
for office equipment. Future minimum lease payments under these agreements are
as follows:
86
<Table>
<Caption>
Year ended June 30, Amount
------
2006 30,132
2007 30,132
2008 30,132
------------
Total $ 90,396
============
</Table>
Rental expense for the years ended June 30, 2005, 2004 and 2003 was
approximately $50,000, $321,000 and $138,000, respectively.
EMPLOYMENT AGREEMENTS
The Company has entered into employment agreements with Arthur Bedrosian, Brian
Kearns, Kevin Smith and Bernard Sandiford (the "Named Executives"). Each of the
agreements provide for an annual base salary and eligibility to receive a bonus.
The salary and bonus amounts of the Named Executives are determined by the Board
of Directors. Additionally, the Named Executives are eligible to receive stock
options, which are granted at the discretion of the Board of Directors, and in
accordance with the Company's policies regarding stock option grants.
Under the agreements, the Named Executive employees may be terminated at any
time with or without cause, or by reason of death or disability. In certain
termination situations, the Company is liable to pay severance compensation to
the Named Executive of between one year and three years.
NOTE 14. RELATED PARTY TRANSACTIONS
The Company had sales of approximately $590,000, $590,000 and $348,000 during
the years ended June 30, 2005, 2004 and 2003, respectively, to a generic
distributor, Auburn Pharmaceutical Company (the "related party") in which the
owner, Jeffrey Farber, is 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 $179,000, and
$117,000 at June 30, 2005 and 2004, respectively. In the Company's opinion, the
terms of these transactions were not more favorable to the related party than
would have been to a non-related party.
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 $732,200, $499,000 and $28,000
during Fiscal 2005, 2004 and 2003, respectively, to the Insurance Companies for
various insurance coverage policies. There was approximately $17,200 and $9,400
due to the Insurance Companies as of June 30, 2005 and 2004, respectively. In
the Company's opinion, the terms of these transactions were not more favorable
to the related party than would have been to a non-related party.
In January 2005, Lannett Holdings, Inc. entered into an agreement pursuant which
it 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 Lannett Holdings, Inc's ability to obtain FDA
approval to use the proprietary rights. In the event that such FDA approval
cannot be obtained, Pharmeral, Inc. must repay the $100,000 to Lannett Holdings,
Inc. Accordingly, the Company has treated this payment as a prepaid asset.
Arthur
87
Bedrosian, President of Lannett, 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 Lannett and, in its opinion, the terms were not
more favorable to the related party than they would have been to a non-related
party.
NOTE 15. MATERIAL CONTRACT WITH SUPPLIER
The Company's primary finished product inventory supplier is Jerome Stevens
Pharmaceuticals, Inc. (JSP), in Bohemia, New York. Purchases of finished goods
inventory from JSP accounted for approximately 62% of the Company's inventory
purchases in Fiscal 2005, 81% in Fiscal 2004 and 62% in Fiscal 2003. 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 June 30, 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 - intangible assets
for additional disclosure and discussion of this impairment.
NOTE 16. 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
88
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 June 30,
2005, the Company has recognized the grant funding as a short term liability
under the caption of Unearned Grant Funds.
NOTE 17. 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 June 30, 2005 are summarized as
follows (there were no investment securities as of June 30, 2004):
Available for Sale Securities 6/30/05
- -----------------------------
Gross Gross
Amortized Unrealized Unrealized
Cost Gains Losses Fair Value
----------- ---------- ---------- ----------
U.S. Government Treasury $ - $ - $ - $ -
U.S. Government Agency 6,582,022 8,970 (35,794) 6,555,198
Mortgage-Backed Securities 363,429 - (10,105) 353,324
Asset-Backed Securities 985,245 5,361 (10,421) 980,185
----------- ---------- ---------- -----------
$ 7,930,696 $ 14,331 $ (56,320) $ 7,888,708
=========== ========== ========== ===========
The amortized cost and fair value of the Company's current available-for-sale
securities by contractual maturity at June 30, 2005 are summarized as follows:
30-Jun-05
Available for Sale
------------------------------
Amortized Fair
Cost Value
-------------- --------------
Due in one year or less $ - $ -
Due after one year through five years 5,136,208 5,115,807
Due after five years through ten years 791,760 792,426
Due after ten years 2,002,728 1,980,475
-------------- --------------
7,930,696 7,888,708
============== ==============
The Company uses the specific identification method to determine the cost of
securities sold. For the year ended June 30, 2005, the Company had realized
losses of $1,466. There were no realized losses for the year ended June 30,
2004.
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
89
investment securities accounted for under Statement of Financial Accounting
Standards No. 115 (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 June 30, 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 4,272,375 (35,794) $ - $ - 4,272,375 (35,794)
Mortgage-Backed Securities 3 353,325 (10,105) - - 353,325 (10,105)
Asset-Backed Securities 7 316,619 (10,421) - - 316,619 (10,421)
------------ ----------------------------- ------------------------- -------------------------
Total temporarily
impaired investment
securities 36 $ 4,942,319 $ (56,320) $ - $ - $ 4,942,319 $ (56,320)
============ ============================= ========================= =========================
There were no securities determined by management to be other-than-temporarily
impaired for the year ended June 30, 2005.
NOTE 18. 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 June 30,
2005 and 2004:
COMPREHENSIVE (LOSS) INCOME FOR YEAR ENDED:
6/30/2005 6/30/2004
-------------- --------------
Other Comprehensive Loss:
Unrealized Holding Loss on Securities (41,989) -
Add: Tax savings at effective rate 16,796 -
-------------- --------------
Total Unrealized Loss on Securities, Net (25,193) -
-------------- --------------
Total Other Comprehensive Loss (25,193) -
Net (Loss) Income (32,779,596) 13,215,454
-------------- --------------
Total Comprehensive (Loss) Income (32,804,789) 13,215,454
============== ==============
There were no items of other comprehensive income in Fiscal years 2004 and 2003.
NOTE 19. SUBSEQUENT EVENT
In August 2005, the Company loaned $2 million to an active pharmaceutical
ingredient (API) supplier. Terms of the loan included an initial annual interest
rate of 10%, payable interest only on an annual basis for the first three years
of the loan. The loan then converts to an interest rate
90
of Prime rate plus 500 basis points for monthly payments for year four, when the
remaining interest and entire principal amount is scheduled to be paid down. The
Company received warrants associated with this loan that may be exercised at a
future date. The Company also purchased shares of this API supplier from one of
the founding partners for $500,000 cash. This founding partner has an option to
buy back these shares at any time over the next 30 months for $600,000. The
combined total of the shares associated with the warrants and the equity
purchase represents a minority position in this API supplier.
NOTE 20. QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
Lannett's unaudited quarterly consolidated results of operations and market
price information are shown below:
FOURTH THIRD SECOND FIRST
Quarter Quarter Quarter Quarter
FISCAL 2005
Net Sales $ 9,368,438.00 $ 7,603,189.00 $ 12,918,522.00 $ 15,011,496.00
Cost of Goods Sold 12,443,756.00 4,266,839.00 7,085,479.00 7,620,834.00
--------------- --------------- --------------- ---------------
Gross Profit (3,075,318.00) 3,336,350.00 5,833,043.00 7,390,662.00
Other Operating Expenses 5,620,448.00 51,888,438.00 4,466,319.00 5,149,190.00
--------------- --------------- --------------- ---------------
Operating Income (8,695,766.00) (48,552,088.00) 1,366,724.00 2,241,472.00
Other Expense 40,145.00 45,194.00 54,326.00 46,175.00
Income Taxes (3,010,067.00) (19,438,914.00) 524,921.00 878,156.00
--------------- --------------- --------------- ---------------
Net (Loss) Income (5,725,844) (29,158,368) 787,477 1,317,141
=============== =============== =============== ===============
Basic (Loss) Earnings Per Share $ (0.24) $ (1.21) $ 0.03 $ 0.05
=============== =============== =============== ===============
Diluted (Loss) Earnings Per Share $ (0.24) $ (1.21) $ 0.03 $ 0.05
=============== =============== =============== ===============
FISCAL 2004
Net Sales $ 17,985,581.00 $ 16,000,251.00 $ 16,573,601.00 $ 13,221,786.00
Cost of Goods Sold 8,451,582.00 6,947,195.00 6,660,845.00 4,797,253.00
--------------- --------------- --------------- ---------------
Gross Profit 9,533,999.00 9,053,056.00 9,912,756.00 8,424,533.00
Other Operating Expenses 6,412,636.00 3,638,461.00 3,429,246.00 2,613,032.00
--------------- --------------- --------------- ---------------
Operating Income 3,121,363.00 5,414,595.00 6,483,510.00 5,811,501.00
Other Income/(Expense) (25,119.00) 1,632.00 10,404.00 (8,116.00)
Income Taxes 336,120.00 2,217,829.00 2,661,367.00 2,379,000.00
--------------- --------------- --------------- ---------------
Net Income 2,760,124 3,198,398 3,832,547 3,424,385
=============== =============== =============== ===============
Basic Earnings Per Share $ 0.12 $ 0.16 $ 0.19 $ 0.17
=============== =============== =============== ===============
Diluted Earnings Per Share $ 0.12 $ 0.16 $ 0.19 $ 0.17
=============== =============== =============== ===============
91
FOURTH THIRD SECOND FIRST
QUARTER QUARTER QUARTER QUARTER
FISCAL 2003
Net Sales $ 12,157,035 $ 11,019,906 $ 10,183,161 $ 9,126,656
Cost of Goods Sold 4,479,690 3,976,519 3,965,474 3,836,110
--------------- --------------- --------------- ---------------
Gross Profit 7,677,345 7,043,387 6,217,687 5,290,546
Other Operating Expenses 2,156,995 1,869,699 1,791,829 1,350,336
--------------- --------------- --------------- ---------------
Operating Income 5,520,350 5,173,688 4,425,858 3,940,210
Other Expense 17,244 3,974 13,321 23,940
Income Taxes 2,406,418 1,914,081 1,649,624 1,364,617
--------------- --------------- --------------- ---------------
Net Income 3,096,688 3,255,633 2,762,913 2,551,653
=============== =============== =============== ===============
Basic Earnings Per Share $ 0.15 $ 0.16 $ 0.14 $ 0.13
=============== =============== =============== ===============
Diluted Earnings Per Share $ 0.15 $ 0.16 $ 0.14 $ 0.13
=============== =============== =============== ===============
92
EXHIBIT INDEX
Exhibit
Number Description Method of Filing Page
------ ----------- ---------------- ----
3.1 Articles of Incorporation Incorporated by reference to the Proxy Statement -
filed with respect to the Annual Meeting of
Shareholders held on December 6, 1991 (the "1991
Proxy Statement").
3.2 By-Laws, as amended Incorporated by reference to the 1991 Proxy -
Statement.
4 Specimen Certificate for Common Incorporated by reference to Exhibit 4(a) to -
Stock Form 8 dated April 23, 1993 (Amendment No. 3 to
Form 10-KSB for Fiscal 1992) ("Form 8")
10.1 Line of Credit Note dated March Incorporated by reference to Exhibit 10(ad) to -
11, 1999 between the Company and the Annual Report on 1999 Form 10-KSB
First Union National Bank
10.2 Philadelphia Authority for Incorporated by reference to Exhibit 10(ae) to -
Industrial Development Taxable the Annual Report on 1999 Form 10-KSB
Variable Rate Demand/Fixed Rate
Revenue Bonds, Series of 1999
10.3 Philadelphia Authority for Incorporated by reference to Exhibit 10(af) to -
Industrial Development the Annual Report on 1999 Form 10-KSB
Tax-Exempt Variable Rate
Demand/Fixed Revenue Bonds
(Lannett Company, Inc. Project)
Series of 1999
10.4 Letter of Credit and Agreements Incorporated by reference to Exhibit 10(ag) to -
supporting bond issues between the Annual Report on 1999 Form 10-KSB
the Company and First Union
National Bank
10.5 2003 Stock Option Plan Incorporated by reference to the Proxy Statement -
for Fiscal Year Ending June 30, 2002
10.6 Terms of Employment Agreement Incorporated by reference to Exhibit 10.6 to the
with Kevin Smith Annual Report on 2003 Form 10-KSB
93
Exhibit
Number Description Method of Filing Page
------ ----------- ---------------- ----
10.7 Terms of Employment Agreement Incorporated by reference to Exhibit 10 to the
with Arthur Bedrosian Quarterly Report on Form 10-Q dated May 12, 2004.
10.8 Terms of Employment Agreement Incorporated by reference to Exhibit 10.9 to the
with Larry Dalesandro Annual Report on 2004 Form 10-KSB
10.9 (Note A) Agreement between Lannett Incorporated by reference to Exhibit 10.9 to the
Company, Inc and Siegfried Annual Report on 2003 Form 10-KSB
(USA), Inc.
10.10 (Note A) Agreement between Lannett Incorporated by reference to Exhibit 2.1 to Form
Company, Inc and Jerome Stevens, 8-K dated April 20, 2004
Pharmaceutical, Inc.
11 Computation of Earnings Per Share Filed Herewith 95
13 Annual Report on Form 10-K Filed Herewith 1-100
21 Subsidiaries of the Company Filed Herewith 96
23.1 Consent of Grant Thornton Filed Herewith 97
31.1 Certification of Chief Executive Filed Herewith 98
Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
31.2 Certification of Chief Financial Filed Herewith 99
Officer Pursuant to Section 302
of the Sarbanes-Oxley Act of 2002
32 Certifications of Chief Filed Herewith 100
Executive Officer and Chief
Financial Officer Pursuant to
Section 906 of the
Sarbanes-Oxley Act of 2002
94