UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

[ X ]

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2012

 

 

 

[    ]

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD FROM ____________ TO ____________.

 

Commission File No. 001-31298

 

LANNETT COMPANY, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

State of Delaware

23-0787699       

(State of Incorporation)

(I.R.S. Employer I.D. No.)

 

9000 State Road

Philadelphia, PA 19136

(215) 333-9000

(Address of principal executive offices and telephone number)

 

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

 

Yes   x  

No      

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer o

Accelerated filer x

 

 

Non-accelerated filer o

Smaller reporting company o

(Do not check if a smaller reporting company)

 

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x No  o

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12B-12 of the Exchange Act).

                                               

 

Yes      

No     x

 

Indicate the number of shares outstanding of each class of the registrant’s common stock, as of the latest practical date.

 

Class

Outstanding as of May 3, 2012

Common stock, par value $0.001 per share

28,365,296 shares

 



 

Table of Contents

 

 

 

 

Page No.

 

 

 

 

PART I. FINANCIAL INFORMATION

 

 

 

 

 

 

ITEM 1.

FINANCIAL STATEMENTS

 

 

 

 

 

 

 

Consolidated Balance Sheets
as of March 31, 2012 (unaudited) and June 30, 2011

3

 

 

 

 

 

 

Consolidated Statements of Operations (unaudited)
for the three and nine months ended March 31, 2012 and 2011

4

 

 

 

 

 

 

Consolidated Statement of Changes in Shareholders’ Equity (unaudited)
for the nine months ended March 31, 2012

5

 

 

 

 

 

 

Consolidated Statements of Cash Flows (unaudited)
for the nine months ended March 31, 2012 and 2011

6

 

 

 

 

 

 

Notes to Consolidated Financial Statements (unaudited)

7

 

 

 

 

 

ITEM 2.

MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

26

 

 

 

 

 

ITEM 3.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

37

 

 

 

 

 

ITEM 4.

CONTROLS AND PROCEDURES

38

 

 

 

 

 

 

 

 

PART II. OTHER INFORMATION

 

 

 

 

 

 

ITEM 1.

LEGAL PROCEEDINGS

38

 

 

 

 

 

ITEM 6.

EXHIBITS

39

 

2



 

PART I.  FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

 

 

 

(Unaudited)

 

 

 

 

March 31, 2012

 

June 30, 2011

ASSETS

 

 

 

 

Current Assets

 

 

 

 

Cash and cash equivalents

 

   $

 18,989,168

 

   $

 5,276,735

Investment securities

 

5,571,049

 

19,382,079

Trade accounts receivable (net of allowance of $123,573 and $123,573 respectively)

 

37,499,169

 

33,464,440

Inventories, net

 

27,975,938

 

26,902,521

Income taxes receivable

 

3,205,508

 

3,636,306

Deferred tax assets

 

4,867,255

 

4,537,881

Other current assets

 

1,472,069

 

941,902

Total Current Assets

 

99,580,156

 

94,141,864

 

 

 

 

 

Property, plant and equipment

 

58,181,257

 

54,516,229

Less accumulated depreciation

 

(27,371,657)

 

(24,586,448)

 

 

30,809,600

 

29,929,781

 

 

 

 

 

Construction in progress

 

6,266,583

 

5,760,686

Intangible assets (product rights) - net of accumulated amortization

 

4,899,021

 

5,909,636

Deferred tax assets

 

8,747,015

 

10,446,500

Other assets

 

1,174,377

 

1,555,831

Total Assets

 

   $

 151,476,752

 

   $

 147,744,298

 

 

 

 

 

LIABILITIES AND SHAREHOLDERS’ EQUITY

 

 

 

 

LIABILITIES

 

 

 

 

Current Liabilities

 

 

 

 

Accounts payable

 

   $

 15,753,524

 

   $

 18,377,782

Accrued expenses

 

1,170,576

 

1,354,095

Accrued payroll and payroll related

 

2,159,723

 

934,504

Current portion of long-term debt

 

639,591

 

629,435

Rebates, chargebacks and returns payable

 

15,394,344

 

13,564,395

Total Current Liabilities

 

35,117,758

 

34,860,211

 

 

 

 

 

Long-term debt, less current portion

 

6,781,862

 

7,192,496

Other long-term liabilities

 

-

 

2,417

Total Liabilities

 

41,899,620

 

42,055,124

Commitment and Contingencies, See notes 9 and 10

 

 

 

 

 

 

 

 

 

SHAREHOLDERS’ EQUITY

 

 

 

 

Common stock - authorized 50,000,000 shares, par value $0.001;

 

 

 

 

issued and outstanding, 28,572,304 and 28,403,946 shares, respectively

 

28,572

 

28,404

Additional paid in capital

 

98,925,755

 

97,082,360

Retained earnings

 

11,820,680

 

9,287,732

Noncontrolling interest

 

173,154

 

139,082

Accumulated other comprehensive (loss) income

 

(19,293)

 

23,899

 

 

110,928,868

 

106,561,477

Less: Treasury stock at cost - 280,469 and 156,611 shares, respectively

 

(1,351,736)

 

(872,303)

TOTAL SHAREHOLDERS’ EQUITY

 

109,577,132

 

105,689,174

 

 

 

 

 

TOTAL LIABILITIES AND SHAREHOLDERS’ EQUITY

 

   $

 151,476,752

 

   $

 147,744,298

 

The accompanying notes to the consolidated financial statements are an integral part of these statements.

 

3



 

LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

 

 

 

Three months ended

 

Nine months ended

 

 

March 31,

 

March 31,

 

 

2012

 

2011

 

2012

 

2011

 

 

 

 

 

 

 

 

 

Net sales

 

  $

 30,687,726

 

  $

 25,892,483

 

  $

 87,299,709

 

  $

 81,327,667

Cost of sales

 

19,275,765

 

20,098,084

 

58,788,334

 

60,667,878

Amortization of intangible assets

 

470,409

 

463,769

 

1,409,015

 

1,385,892

Product royalties

 

50,054

 

26,980

 

168,142

 

(290,380)

 

 

 

 

 

 

 

 

 

Gross profit

 

10,891,498

 

5,303,650

 

26,934,218

 

19,564,277

 

 

 

 

 

 

 

 

 

Research and development expenses

 

2,911,530

 

1,854,216

 

7,850,744

 

5,557,296

Selling, general, and administrative expenses

 

5,616,186

 

4,279,502

 

14,779,953

 

11,755,062

 

 

 

 

 

 

 

 

 

Operating income (loss)

 

2,363,782

 

(830,068)

 

4,303,521

 

2,251,919

 

 

 

 

 

 

 

 

 

Other income (expense):

 

 

 

 

 

 

 

 

Foreign currency (loss) gain

 

(3,308)

 

1,529

 

(5,804)

 

5,494

(Loss) gain on sale of assets

 

-

 

(17,565)

 

3,536

 

(16,299)

Realized gain on investments

 

361,059

 

59,689

 

214,696

 

74,454

Unrealized gain (loss) on investments

 

104,896

 

(17,898)

 

(45,776)

 

(17,898)

Interest and dividend income

 

28,305

 

24,744

 

117,252

 

39,852

Interest expense

 

(63,698)

 

(28,030)

 

(213,406)

 

(174,882)

 

 

427,254

 

22,469

 

70,498

 

(89,279)

 

 

 

 

 

 

 

 

 

Income (loss) before income tax expense (benefit)

 

2,791,036

 

(807,599)

 

4,374,019

 

2,162,640

Income tax expense (benefit)

 

1,056,684

 

(449,797)

 

1,787,999

 

554,568

Net income (loss)

 

1,734,352

 

(357,802)

 

2,586,020

 

1,608,072

 

 

 

 

 

 

 

 

 

Less net income attributable to noncontrolling interest

 

(16,468)

 

(4,259)

 

(53,072)

 

(20,540)

 

 

 

 

 

 

 

 

 

Net income (loss) attributable to Lannett Company, Inc.

 

  $

 1,717,884

 

  $

 (362,061)

 

  $

 2,532,948

 

  $

 1,587,532

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per common share - Lannett Company, Inc.

 

  $

 0.06

 

  $

 (0.01)

 

  $

 0.09

 

  $

 0.06

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per common share - Lannett Company, Inc.

 

  $

 0.06

 

  $

 (0.01)

 

  $

 0.09

 

  $

 0.06

 

 

 

 

 

 

 

 

 

Basic weighted average number of shares

 

28,571,062

 

28,373,436

 

28,509,595

 

26,215,510

Diluted weighted average number of shares

 

28,719,669

 

28,373,436

 

28,668,281

 

26,558,432

 

The accompanying notes to the consolidated financial statements are an integral part of these statements.

 

4



 

LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENT OF CHANGES IN SHAREHOLDERS’ EQUITY

(UNAUDITED)

 

 

 

Common Stock

 

Additional

 

 

 

 

 

 

 

Accum. Other

 

 

 

 

Shares

 

 

 

Paid-in

 

Retained

 

Treasury

 

Noncontrolling

 

Comprehensive

 

Shareholders’

 

 

Issued

 

Amount

 

Capital

 

Earnings

 

Stock

 

Interest

 

Income (Loss)

 

Equity

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, June  30, 2011

 

28,403,946

 

  $

 28,404

 

  $

 97,082,360

 

  $

 9,287,732

 

  $

 (872,303)

 

  $

 139,082

 

  $

 23,899

 

  $

 105,689,174

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Exercise of stock options

 

5,000

 

5

 

13,945

 

-

 

-

 

-

 

-

 

13,950

Shares issued in connection with employee stock purchase plan

 

50,858

 

51

 

177,377

 

-

 

-

 

-

 

-

 

177,428

Share based compensation

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Restricted stock

 

-

 

-

 

539,887

 

-

 

-

 

-

 

-

 

539,887

Stock options

 

-

 

-

 

1,074,100

 

-

 

-

 

-

 

-

 

1,074,100

Employee stock purchase plan

 

-

 

-

 

45,414

 

-

 

-

 

-

 

-

 

45,414

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares issued in connection with restricted stock grant

 

112,500

 

112

 

(112)

 

-

 

-

 

-

 

-

 

-

Tax shortfall on stock options exercised

 

-

 

-

 

(7,216)

 

-

 

-

 

-

 

-

 

(7,216)

Purchase of treasury stock

 

-

 

-

 

-

 

-

 

(479,433)

 

-

 

-

 

(479,433)

Distribution to noncontrolling interests

 

-

 

-

 

-

 

-

 

-

 

(19,000)

 

-

 

(19,000)

Other comprehensive loss, net of income tax

 

-

 

-

 

-

 

-

 

-

 

-

 

(43,192)

 

(43,192)

Net income

 

-

 

-

 

-

 

2,532,948

 

-

 

53,072

 

-

 

2,586,020

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Balance, March 31, 2012

 

28,572,304

 

  $

 28,572

 

  $

 98,925,755

 

  $

 11,820,680

 

  $

 (1,351,736)

 

  $

 173,154

 

  $

 (19,293)

 

  $

 109,577,132

 

The accompanying notes to the consolidated financial statements are an integral part of these statements.

 

5



 

LANNETT COMPANY, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

 

 

 

For the nine months ended March 31,

 

 

2012

 

2011

 

 

 

 

 

OPERATING ACTIVITIES:

 

 

 

 

Net income

 

   $

 2,586,020

 

   $

 1,608,072

Adjustments to reconcile net income to net cash provided by (used in) operating activities:

 

 

 

 

Depreciation and amortization

 

4,206,252

 

3,652,356

Deferred tax expense

 

1,371,322

 

3,133,015

Stock compensation expense

 

1,659,401

 

1,438,069

Realized gain on investments

 

(214,696)

 

(74,454)

Unrealized loss on investments

 

45,776

 

17,898

(Gain) loss on sale of assets

 

(3,536)

 

16,299

Other noncash expenses

 

9,510

 

16,697

Changes in assets and liabilities which provided (used) cash:

 

 

 

 

Trade accounts receivable

 

(4,034,729)

 

3,456,112

Inventories

 

(1,073,417)

 

(5,689,291)

Prepaid and income taxes payable

 

430,798

 

(3,887,008)

Prepaid expenses and other assets

 

(559,040)

 

(34,222)

Accounts payable

 

(2,624,258)

 

823,803

Accrued expenses

 

(183,519)

 

(2,468,929)

Rebates, chargebacks and returns payable

 

1,829,949

 

(1,412,848)

Accrued payroll and payroll related

 

1,225,219

 

(5,219,431)

Net cash provided by (used in) operating activities

 

4,671,052

 

(4,623,862)

 

 

 

 

 

INVESTING ACTIVITIES:

 

 

 

 

Purchases of property, plant and equipment (including construction in progress)

 

(4,186,417)

 

(5,663,361)

Proceeds from sale of property, plant and equipment

 

7,000

 

8,306

Purchases of investment securities

 

(18,662,147)

 

(11,925,702)

Proceeds from sale of investment securities

 

32,639,069

 

4,434,800

Net cash provided by (used in) investing activities

 

9,797,505

 

(13,145,957)

 

 

 

 

 

FINANCING ACTIVITIES:

 

 

 

 

Proceeds from public stock offering

 

-

 

14,950,342

Proceeds from issuance of stock

 

191,378

 

397,506

Purchase of treasury stock

 

(479,433)

 

(220,890)

Tax shortfall on stock options exercised

 

(7,216)

 

(49,917)

Repayments of debt

 

(400,478)

 

(4,734,895)

Distribution to noncontrolling interests

 

(19,000)

 

(10,000)

Net cash (used in) provided by financing activities

 

(714,749)

 

10,332,146

 

 

 

 

 

Effect of foreign currency rates on cash and cash equivalents

 

(41,375)

 

(8,671)

 

 

 

 

 

NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS

 

13,712,433

 

(7,446,344)

 

 

 

 

 

CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD

 

5,276,735

 

21,895,648

 

 

 

 

 

CASH AND CASH EQUIVALENTS, END OF PERIOD

 

   $

 18,989,168

 

   $

 14,449,304

 

 

 

 

 

SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION -

 

 

 

 

Interest paid

 

   $

 213,062

 

   $

 235,000

Income taxes (refunded) paid

 

   $

 (6,905)

 

   $

 1,363,186

 

The accompanying notes to the consolidated financial statements are an integral part of these statements.

 

6



 

LANNETT COMPANY, INC.  AND SUBSIDIARIES

 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - UNAUDITED

 

 

Note 1.  Interim Financial Information

 

The accompanying unaudited financial statements have been prepared in accordance with U.S. generally accepted accounting principles for presentation of interim financial statements and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, the unaudited financial statements do not include all the information and footnotes necessary for a comprehensive presentation of the financial position, results of operations, and cash flows for the periods presented. In the opinion of management, the unaudited financial statements include all the normal recurring adjustments that are necessary for a fair presentation of the financial position, results of operations, and cash flows for the periods presented.  Operating results for the three and nine months ended March 31, 2012 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2012. You should read these unaudited financial statements in combination with the other Notes in this section; “Management’s Discussion and Analysis of Financial Condition and Results of Operations” appearing in Item 2; and the Financial Statements, including the Notes to the Financial Statements, included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2011.

 

Note 2.  Summary of Significant Accounting Policies

 

Lannett Company, Inc., a Delaware corporation, and subsidiaries (the “Company” or “Lannett”), develop, manufacture, package, market, and distribute active pharmaceutical ingredients as well as pharmaceutical products sold under generic chemical names.  The Company manufactures solid oral dosage forms, including tablets and capsules, topical and oral solutions, and is pursuing partnerships and research contracts for the development and production of other dosage forms, including ophthalmic, nasal and parenterals products.

 

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., and its wholly owned subsidiaries, as well as the consolidation of Cody LCI Realty, LLC, a variable interest entity (“VIE”).  See Note 15 regarding the consolidation of this variable interest entity.  All intercompany accounts and transactions have been eliminated.

 

Foreign Currency Translation - The local currency is the functional currency of the Company’s foreign subsidiary. Assets and liabilities of the foreign subsidiary are translated into U.S. dollars at the period-end currency exchange rate and revenues and expenses are translated at an average currency exchange rate for the period. The resulting translation adjustment is recorded in a separate component of shareholders’ equity and changes to such are included in comprehensive income (loss). Exchange adjustments resulting from transactions denominated in foreign currencies are recognized in the consolidated statements of operations.

 

Reclassifications - Certain prior year amounts have been reclassified to conform to the current period financial statement 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, chargebacks and returns 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 accruals as they are the primary recipient of chargebacks and rebates. Incentives offered to secure sales vary from product to product. Provisions for estimated rebates and promotional credits are estimated based upon contractual terms.  Provisions for other customer credits, such as price adjustments, returns, and chargebacks, require management to make subjective judgments on customer mix. Unlike branded innovator drug companies, Lannett does not

 

7



 

use information about product levels in distribution channels from third-party sources, such as IMS and Wolters Kluwer, in estimating future returns and other credits. Lannett calculates a chargeback/rebate rate based on contractual terms with its customers and applies this rate to customer sales.  The only variable is customer mix, and this assumption is based on historical data and sales expectations.

 

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 and the amount of those sales that end up at indirect customers with which the Company has specific chargeback agreements.  The Company continually monitors the reserve for chargebacks and makes adjustments when management believes that expected chargebacks on actual sales may differ from actual chargeback reserves.

 

Rebates – Rebates are offered to the Company’s key chain drug store, distributor and wholesaler customers to promote customer loyalty and increase 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. As a result of the Patient Protection and Affordable Care Act (“PPACA”) enacted in the U.S. in March 2010, the Company participates in a new cost sharing program for certain Medicare Part D beneficiaries designed primarily for the sale of brand drugs and certain generic drugs if their FDA approval was granted under a New Drug Application (“NDA”) or 505(b) NDA versus an Abbreviated New Drug Application (“ANDA”). Because our drugs used for the treatment of thyroid deficiency and our Morphine Sulfate Oral Solution product were approved by the FDA as a 505(b)(2) NDA, they qualify as “branded” drugs for purposes of the PPACA.  Drugs purchased under this program during Medicare Part D coverage gap (commonly referred to as the “donut hole”) result in additional rebates.  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, since these rebate programs are not identical for all customers, the size of the reserve will depend on the mix of customers that are eligible to receive rebates.

 

Returns – Consistent with industry practice, the Company has a product returns policy that allows 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, chargebacks and returns 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, chargebacks and returns payable account on the balance sheet.

 

8



 

The following tables identify the reserves for each major category of revenue allowance and a summary of the activity for the nine months ended March 31, 2012 and 2011:

 

For the nine months ended March 31, 2012

 

Reserve Category

 

Chargebacks

 

Rebates

 

Returns

 

Other

 

Total

 

 

 

 

 

 

 

 

 

 

 

Reserve Balance as of June 30, 2011

 

  $

 5,496,911

 

$

 2,925,477

 

$

 5,142,007

 

$

-     

 

$

13,564,395

Actual credits issued related to sales recorded in prior fiscal years

 

(5,350,016)

 

(3,083,836)

 

(3,426,013)

 

(151,846)

 

(12,011,711)

Reserves or (reversals) charged during Fiscal 2012 related to sales in prior  fiscal years

 

(54,015)

 

158,359

 

-    

 

151,846

 

256,190

Reserves charged to net sales during Fiscal 2012 related to sales recorded in Fiscal  2012

 

50,391,821

 

15,405,473

 

3,566,636

 

487,945

 

69,851,875

Actual credits issued related to sales recorded in Fiscal 2012

 

(44,091,799)

 

(11,686,661)

 

-    

 

(487,945)

 

(56,266,405)

Reserve Balance as of March 31, 2012

 

  $

 6,392,902

 

$

 3,718,812

 

$

 5,282,630

 

$

-     

 

$

15,394,344

 

 

 

 

 

 

 

 

 

 

 

For the nine months ended March 31, 2011

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Reserve Category

 

Chargebacks

 

Rebates

 

Returns

 

Other

 

Total

 

 

 

 

 

 

 

 

 

 

 

Reserve Balance as of June 30, 2010

 

  $

 6,282,127

 

$

 3,566,031

 

$

 5,401,254

 

$

 -     

 

$

 15,249,412

Actual credits issued related to sales recorded in prior fiscal years

 

(6,258,862)

 

(3,946,924)

 

(3,290,619)

 

-     

 

(13,496,405)

Reserves or (reversals) charged during Fiscal 2011 related to sales in prior  fiscal years

 

-     

 

380,893

 

-     

 

-     

 

380,893

Reserves charged to net sales during Fiscal 2011 related to sales recorded in Fiscal  2011

 

40,105,340

 

12,276,977

 

5,602,225

 

2,739,301

 

60,723,843

Actual credits issued related to sales recorded in Fiscal 2011

 

(34,059,033)

 

(10,144,801)

 

(2,078,044)

 

(2,739,301)

 

(49,021,179)

Reserve Balance as of March 31, 2011

 

  $

 6,069,572

 

$

 2,132,176

 

$

 5,634,816

 

$

-     

 

$

 13,836,564

 

The total reserve for chargebacks, rebates, returns and other adjustments increased from $13,564,395 at June 30, 2011 to $15,394,344 at March 31, 2012.  The increase in total reserves was partially due to an increase in rebate reserves as a result of increased sales, the timing of credits taken, as well as an additional rebate program the Company became obligated under Medicare Part D.  The increase in chargeback reserves is related to sales to major wholesalers resulting in increased inventory levels at wholesaler distribution centers. The activity in the Other category for the nine months ended March 31, 2012 includes shelf-stock, shipping, and other sales adjustments.

 

The Company ships its products to the warehouses of its wholesale and retail chain customers.  When the Company and a customer enter into 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 reorder the product as its warehouse is depleted.  The Company generally has no minimum size orders for its customers.  Additionally, most warehousing customers prefer not to stock excess inventory levels due to the additional carrying costs and inefficiencies created by holding excess inventory.  As such, the Company’s customers continually reorder the Company’s products.  It is common for the Company’s customers to order the same products on a monthly basis.  For generic pharmaceutical manufacturers, it is critical to ensure that customers’ warehouses are adequately stocked with its products.  This is important due to the fact that several generic competitors compete for the consumer demand for a given product.  Availability of inventory ensures that a manufacturer’s product is considered.  Otherwise, retail prescriptions would be filled with competitors’ products.  For this reason, the Company periodically offers incentives to its customers to purchase its products.  These incentives are generally up-front discounts off its standard prices at the beginning of a

 

9



 

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 generally have 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 customers 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 and costs.  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.

 

Cash and cash equivalents – The Company considers all highly liquid securities purchased with original maturities of 90 days or less to be cash equivalents.  Cash equivalents are stated at cost, which approximates fair value, and consist of certificates of deposit that are readily convertible to cash. The Company maintains cash and cash equivalents with several major financial institutions.

 

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 both the 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.

 

Fair Value of Financial Instruments - The carrying value of certain financial instruments, primarily cash and cash equivalents, accounts receivable, accounts payable, accrued expenses approximate their estimated fair values based upon the short-term nature of these instruments.  The carrying amount of the Company’s debt obligations approximates fair value based on current rates available to the Company on similar debt obligations.

 

Investment Securities - The Company’s investment securities consist of certificates of deposit, equity securities and marketable debt securities.  The Company’s certificates of deposit are classified as held-to-maturity, its equity securities are classified as trading and all of its marketable debt securities are classified as available-for-sale. Available-for-sale and trading investment securities are recorded at fair value based on quoted market prices.  For trading investments, unrealized holding gains and losses are recorded on the consolidated statements of operations.  For available-for-sale investments, unrealized holding gains and losses are recorded, net of any tax effect, as a separate component of accumulated other comprehensive income.  No gains or losses on investment securities are realized until they are sold or a decline in fair value is determined to be other-than-temporary.  The Company reviews its investment securities and determines whether the investments are other-than-temporarily impaired. If the investments are deemed to be other-than-temporarily impaired, the investments are written down to their then current fair market value with a new cost basis being established.  There were no securities determined by management to be other-than-temporarily impaired during the nine months ended March 31, 2012 or the fiscal year ended June 30, 2011.

 

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.

 

10



 

Other Assets - As of July 2010, Lannett stopped manufacturing and distributing Morphine Sulfate Oral Solution.  Lannett filed a 505(b)(2) New Drug Application (“MS NDA”) in February 2010 and received FDA approval on the submission in June 2011.  The filing fee related to this application totaled $1,405,500 and was initially recorded within other current assets on the consolidated balance sheets because part or all of this fee was thought to be refundable.  Lannett met with the FDA in January 2011 to review the status of the application.  At that time, the FDA stated that it will need to finalize and issue its Establishment Inspection Report for the February 2011 inspection of Lannett’s facilities before it could give final approval on the MS NDA.  Additionally, the Company corresponded with the FDA in March 2011 regarding whether any of the fee is refundable.  The FDA’s initial response was that all of the filing fee was not refundable, but the Company awaits a final decision from the FDA.

 

As of June 30, 2011, the Company received approval on the MS application, but, as of March 31, 2012, it has not received final determination on whether any of the fee is refundable. The Company’s position is that the value related to the part of the fee that is not refunded is the cost of getting regulatory approval for its MS product and that this value should be properly recorded as an intangible asset based upon approval and amortized over the product’s estimated useful life upon shipment of the product.  The revenues and gross profit margins attained by the Company when it was previously selling its MS product currently substantiate its value as an intangible asset.  As of March 31, 2012, the Company has restarted shipments of the MS product. As a result of the FDA approval of the MS NDA, an estimate of the nonrefundable amount totaling $398,400 determined based upon a third party analysis was reclassified to intangible assets upon shipment of the product which commenced in August 2011.

 

Intangible Assets – In March 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 4,000,000 shares of the Company’s common stock.  As a result of the JSP agreement, the Company recorded an intangible asset for the exclusive marketing and distribution rights obtained from JSP.  The Company will incur annual amortization expense of approximately $1,785,000 for the JSP intangible asset over the remaining term of the agreement.

 

In April 2007, the Company entered into a Stock Purchase Agreement to acquire Cody Laboratories, Inc. (“Cody”) by purchasing all of the remaining shares of common stock of Cody. The consideration for the April 2007 acquisition was approximately $4,438,000, which represented the fair value of the tangible net assets acquired. The agreement also required Lannett to issue to the sellers up to 120,000 shares of unregistered common stock of the Company contingent upon the receipt of a license from a regulatory agency.  This license was subsequently received in July 2008 and triggered the payment of 105,000 shares (87.5% of the 120,000 shares to be issued as the Company already owned 12.5% of Cody) of Lannett stock to the former owners of Cody Labs, which was completed in October 2008.  Therefore, the Company recorded an intangible asset related to the acquisition of a drug import license in the original amount of $581,175 and recorded a corresponding deferred tax liability of approximately $150,700 due to the non-deductibility of the amortization for tax purposes.  The Company has assigned a 15 year life to this intangible asset based on average life cycles of Lannett products.

 

In January 2005, Lannett Holdings, Inc. entered into an agreement in which the Company purchased, for $100,000 and future royalty payments, the proprietary rights to manufacture and distribute a product for which Pharmeral, Inc. owned the ANDA.  In May 2008, the Company and Pharmeral waived their rights to any royalty payments on the sales of the drug by Lannett under Lannett’s current ownership structure.  Should Lannett undergo a change in control transaction with a third party, this royalty would be reinstated.  In Fiscal 2008, the Company obtained FDA approval to use these proprietary rights.  Accordingly, the Company originally capitalized these purchased product rights as an indefinite lived intangible asset and tested this asset for impairment at least on an annual basis.  During the fourth quarter of fiscal year 2009, it was determined that this intangible asset no longer had an indefinite life.  No impairment existed because the estimated fair value exceeded the carrying amount on that date. Accordingly, the $100,000 carrying amount of this intangible asset is being amortized on a straight line basis prospectively over its 10 year estimated useful life.

 

11



 

In August 2009, the Company acquired eight new ANDAs covering three separate product lines from another generic drug manufacturer for a purchase price of $500,000.  The Company began shipping one of these product lines in October 2010.  Accordingly, the Company allocated $325,000 of the purchase price to this product line, based on the relative fair market values of the acquired ANDAs, which is being amortized on a straight line basis over its 15 year estimated product life. It is expected that the Company will be able to produce one of the other product lines by the first half of the fiscal year ended June 30, 2013.  Since it has no current plans to manufacture the third product line acquired under these new ANDAs, the Company wrote off the purchase price that was allocated to that product line during the fourth quarter of fiscal year 2011 which amounted to $26,000.  Amortization will begin on the remaining $149,000 when the Company starts shipping this product.

 

An intangible asset that is not subject to amortization shall be tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired.  An impairment loss is measured as the excess of the asset’s carrying value over its fair value, calculated using a discounted future cash flow method.  Our discounted cash flow models are highly reliant on assumptions which are considered level 3 inputs, including estimates of future cash flows (including long-term growth rates), discount rates, and expectations about variations in the amount and timing of cash flows and the probability of achieving the estimated cash flows.  As of March 31, 2012 and June 30, 2011, no impairment existed with respect to these non-amortized assets.

 

As of July 2010, Lannett stopped manufacturing and distributing Morphine Sulfate Oral Solution.  Lannett filed a MS NDA in February 2010 and received FDA approval on the submission in June 2011.  As of March 31, 2012, the Company has restarted shipments of the MS product, but it has not received final determination on whether any of the filing fee is refundable. As a result of the FDA approval of the MS NDA, an estimate of the nonrefundable amount totaling $398,400 determined based upon a third party analysis was reclassified to intangible assets upon shipment of the product which commenced in August 2011.  Amortization began upon shipment of the product in August 2011 over the products estimated 15 year remaining useful life.  Amortization will be adjusted prospectively once the nonrefundable amount is finalized.  See “Other Assets” above.

 

For the three months ended March 31, 2012 and 2011, the Company incurred amortization expense of approximately $470,000 and $464,000, respectively.  For the nine months ended March 31, 2012 and 2011, the Company incurred amortization expense of approximately $1,409,000 and $1,386,000, respectively.  As of March 31, 2012 and June 30, 2011, accumulated amortization totaled approximately $12,743,000 and $11,334,000, respectively.

 

Future annual amortization expense consists of the following as of March 31, 2012:

 

Fiscal Year Ending June 30,

 

Annual Amortization
Expense

2012

 

$

 470,411

2013

 

1,881,639

2014

 

1,435,472

2015

 

96,972

2016

 

96,972

Thereafter

 

768,555

 

 

$

 4,750,021

 

The amounts above do not include the non-amortized product line covered by the ANDAs purchased in August 2009 for $149,000 as amortization will begin when the Company starts shipping this product.

 

Advertising Costs - The Company charges advertising costs to operations as incurred.  Advertising expense for the nine months ended March 31, 2012 and 2011 was approximately $26,000 and $23,000, respectively.

 

Income Taxes - The Company uses the liability method to account 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.  The Company may recognize the tax benefit from an uncertain tax position claimed on a tax return only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements

 

12



 

from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement. The authoritative standards issued by the FASB also provide guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.

 

Segment Information - The Company operates one business segment - generic pharmaceuticals; accordingly the Company has one reporting segment.  The Company aggregates its financial information for all products and reports as one operating segment.  The following table identifies the Company’s approximate net product sales by medical indication for the three and nine months ended March 31, 2012 and 2011:

 

 

 

For the Three Months Ended
March 31,

 

For the Nine Months Ended
March 31,

 

 

 

 

 

 

 

 

 

Medical Indication

 

2012

 

2011

 

2012

 

2011

 

 

 

 

 

 

 

 

 

Migraine Headache

 

  $

 1,441,975

 

  $

 1,949,168

 

  $

 4,601,079

 

  $

 6,984,922

Prescription Vitamin

 

-

 

-

 

-

 

1,820,867

Cardiovascular

 

6,049,949

 

3,012,168

 

11,511,861

 

9,816,836

Thyroid Deficiency

 

12,542,855

 

12,330,638

 

36,788,397

 

34,897,688

Antibiotic

 

1,662,408

 

1,664,403

 

4,798,040

 

4,502,155

Pain Management

 

4,042,947

 

2,735,294

 

14,609,187

 

11,137,244

Glaucoma

 

993,084

 

860,415

 

3,092,604

 

2,175,635

Gallstone Prevention

 

1,418,857

 

1,718,553

 

4,285,549

 

4,310,952

Obesity

 

978,923

 

842,465

 

2,570,007

 

2,500,399

Other

 

1,556,728

 

779,379

 

5,042,985

 

3,180,969

 

 

 

 

 

 

 

 

 

Total

 

  $

 30,687,726

 

  $

 25,892,483

 

  $

 87,299,709

 

  $

 81,327,667

 

 

Concentration of Market and Credit Risk - The following table identifies certain of the Company’s products, defined as generics containing the same active ingredient or combination of ingredients, which accounted for greater than 10% of net sales in either of the three and nine month periods ended March 31, 2012 and 2011, respectively.

 

 

 

For the Three Months Ended
March 31,

 

For the Nine Months Ended
March 31,

 

 

 

 

 

 

 

 

 

 

 

2012

 

2011

 

2012

 

2011

 

 

 

 

 

 

 

 

 

Product 1

 

41%

 

48%

 

42%

 

43%

Product 2

 

11%

 

-     

 

-      

 

-     

Product 3

 

9%

 

12%

 

9%

 

12%

 

The following table identifies certain of the Company’s customers which accounted for greater than 10% of net sales in either of the three and nine month periods ended March 31, 2012 and 2011, respectively.

 

 

 

For the Three Months Ended
March 31,

 

For the Nine Months Ended
March 31,

 

 

 

 

 

 

 

 

 

 

 

2012

 

2011

 

2012

 

2011

 

 

 

 

 

 

 

 

 

Customer A

 

16%

 

22%

 

18%

 

22%

Customer B

 

11%

 

12%

 

9%

 

11%

Customer C

 

10%

 

12%

 

11%

 

13%

Customer D

 

9%

 

9%

 

13%

 

8%

 

13



 

At March 31, 2012 and June 30, 2011, four customers accounted for 64% and 69% of the Company’s accounts receivable balances, respectively.  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 when they become uncollectible.

 

Share-based Compensation - The Company recognizes compensation cost for share-based compensation issued to or purchased by employees, net of estimated forfeitures, under share-based compensation plans using a fair value method.

 

At March 31, 2012, the Company had four stock-based employee compensation plans (the “Old Plan,” the “2003 Plan,” the 2006 Long-term Incentive Plan, or “2006 LTIP” and the 2011 Long-Term Incentive Plan or “2011 LTIP”).

 

At March 31, 2012, there were 2,735,813 options outstanding.  Of those, 1,637,850 were options issued under the 2006 LTIP, 892,730 were issued under the 2003 Plan, and 205,233 under the Old Plan.  There are no further shares authorized to be issued under the Old Plan.  1,125,000 shares were authorized to be issued under the 2003 Plan, with 58,658 shares under options having already been exercised under that plan since its inception, leaving a balance of 173,612 shares in that plan for future issuances.  2,500,000 shares were authorized to be issued under the 2006 LTIP, with 163,500 shares under options having already been exercised under that plan since its inception.  At March 31, 2012, there were 74,177 nonvested restricted shares outstanding which were issued under the 2006 LTIP, with 600,178 shares having already vested under that plan since its inception.  At March 31, 2012, a balance of 24,295 shares is available in the 2006 LTIP for future issuances.

 

In January 2011, the shareholders of the Company approved a new stock option and restricted stock award plan, the 2011 LTIP, which authorized 1,500,000 new shares of common stock for future issuances under this plan.  As of March 31, 2012, no shares have been issued under this plan.

 

During the nine months ended March 31, 2012, the Company awarded 35,000 shares of fully vested restricted stock to Board members under the 2006 LTIP.  Stock compensation expense of $0 and $126,750 was recognized during the three and nine months ended March 31, 2012, respectively, related to these shares of restricted stock.

 

During the fiscal year ended June 30, 2010, the Company awarded 237,500 shares of restricted stock to management employees under the 2006 LTIP which vest in equal portions on October 29, 2010, 2011 and 2012.  Stock compensation expense of $124,013 and $126,593 was recognized during the three months ended March 31, 2012 and 2011, respectively, related to these shares of restricted stock. Stock compensation expense of $413,137 and $406,808 was recognized during the nine months ended March 31, 2012 and 2011, respectively, related to these shares of restricted stock.

 

During the fiscal year ended June 30, 2008, the Company awarded 209,264 shares of restricted stock to management employees under the 2006 LTIP, of which 74,464 of these shares vested 100% on January 1, 2008, and the remainder vested in equal portions on September 18, 2008, 2009 and 2010.  Stock compensation expense of $29,968 was recognized during the nine months ended March 31, 2011 related to these shares of restricted stock.

 

The Company measures the fair value of share-based compensation cost for options using the Black-Scholes option pricing model.

 

14



 

The following table presents the weighted average assumptions used to estimate fair values of the stock options granted and the estimated forfeiture rates during the nine months ended March 31:

 

 

 

 

 

 

 

 

 

 

 

 

Incentive Stock
Options

 

 

Non-qualified
Stock Options

 

 

Incentive Stock
Options

 

 

Non-qualified
Stock Options

 

 

FY 2012

 

 

FY 2012

 

 

FY 2011

 

 

FY 2011

Risk-free interest rate

 

1.1%

 

 

1.0%

 

 

-%

 

 

-%

Expected volatility

 

63.5%

 

 

63.9%

 

 

-%

 

 

-%

Expected dividend yield

 

-%

 

 

-%

 

 

-%

 

 

-%

Forfeiture rate

 

7.50%

 

 

7.50%

 

 

-%

 

 

-%

Expected term

 

5.2 years

 

 

5.1 years

 

 

n/a 

 

 

n/a 

Weighted average fair value at date of grant

 

$2.03

 

 

$1.98

 

 

$-  

 

 

$-  

 

Expected volatility is based on the historical volatility of the price of our common shares during the historical period equal to the expected term of the option.  We use historical information to estimate expected term within the valuation model. The expected term of awards represents the period of time that options granted are expected to be outstanding.  The risk-free rate for periods within the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.  Compensation cost is recognized using the straight-line method over the vesting or service period and is net of estimated forfeitures.

 

The forfeiture rate assumption is the estimated annual rate at which unvested awards are expected to be forfeited during the vesting period. This assumption is based on our historical forfeiture rate. Periodically, management will assess whether it is necessary to adjust the estimated rate to reflect changes in actual forfeitures or changes in expectations. For example, adjustments may be needed if forfeitures were affected by turnover that resulted from a business restructuring that is not expected to recur.  The Company will incur additional expense if the actual forfeiture rate is lower than originally estimated. A recovery of prior expense will be recorded if the actual rate is higher than originally estimated.

 

The following table presents all share-based compensation costs recognized in our statements of operations, substantially all of which is reflected in the selling, general and administrative expense line:

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

March 31,

 

March 31,

 

 

2012

 

2011

 

2012

 

2011

Stock based compensation

 

 

 

 

 

 

 

 

Stock options

 

  $

 346,905

 

  $

 212,916

 

  $

 1,074,100

 

  $

 770,534

Employee stock purchase plan

 

26,736

 

24,292

 

45,414

 

48,584

Restricted stock

 

124,013

 

308,768

 

539,887

 

618,951

Tax benefit at statutory rate

 

30,606

 

16,895

 

98,866

 

70,003

 

Options outstanding that have vested and are expected to vest as of March 31, 2012 are as follows:

 

 

 

Awards

 

Weighted -
Average
Exercise
Price

 

Aggregate
Intrinsic
Value

 

Weighted
Average
Remaining
Contractual
Life

Options vested

 

1,702,961

 

$     7.72

 

  $

196,352

 

4.6

Options expected to vest

 

939,929

 

$     4.35

 

  $

400,470

 

9.0

Total vested and expected to vest

 

2,642,890

 

$     6.52

 

  $

596,822

 

6.2

 

15



 

A summary of nonvested restricted stock award activity as of March 31, 2012 and changes during the nine months then ended, is presented below:

 

 

 

Awards

 

Weighted
Average Grant
Date Fair Value

 

 

 

 

 

Nonvested at July 1, 2011

 

155,011

 

  $

 1,075,776

 

 

 

 

 

Granted

 

35,000

 

126,750

 

 

 

 

 

Vested

 

(112,500)

 

(664,600)

 

 

 

 

 

Forfeited

 

(3,334)

 

 

(23,138)

 

 

 

 

 

Nonvested at March 31, 2012

 

74,177

 

  $

 514,788

 

A summary of award activity under the Plans as of March 31, 2012 and 2011, and changes during the nine months then ended, is presented below:

 

 

 

Incentive Stock Options

 

Nonqualified Stock Options

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

 

 

 

Weighted-

 

 

 

Average

 

 

 

Weighted-

 

 

 

Average

 

 

 

 

Average

 

Aggregate

 

Remaining

 

 

 

Average

 

Aggregate

 

Remaining

 

 

 

 

Exercise

 

Intrinsic

 

Contractual

 

 

 

Exercise

 

Intrinsic

 

Contractual

 

 

Awards

 

Price

 

Value

 

Life

 

Awards

 

Price

 

Value

 

Life

Outstanding at July 1, 2011

 

1,195,716

 

$    6.19

 

 

 

 

 

749,597

 

 $

  9.77

 

 

 

 

Granted

 

714,185

 

$    3.74

 

 

 

 

 

118,815

 

 $

  3.65

 

 

 

 

Exercised

 

(5,000)

 

$    2.79

 

 

 

 

 

-

 

  $

 -

 

 

 

 

Forfeited, expired or repurchased

 

(37,500)

 

$    5.50

 

 

 

 

 

-

 

  $

 -

 

 

 

 

Outstanding at March 31, 2012

 

1,867,401

 

$    5.28

 

$ 522,881

 

7.1

 

868,412

 

 $

  8.93

 

$ 119,201

 

4.5

Outstanding at March 31, 2012 and not yet vested

 

887,919

 

$    4.33

 

$ 377,231

 

9.0

 

144,933

 

 $

  4.25

 

$   68,499

 

9.1

Exercisable at March 31, 2012

 

979,482

 

$    6.13

 

$ 145,650

 

5.4

 

723,479

 

 $

  9.87

 

$   50,702

 

3.6

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Incentive Stock Options

 

Nonqualified Stock Options

 

 

 

 

 

 

 

 

Weighted

 

 

 

 

 

 

 

Weighted

 

 

 

 

Weighted-

 

 

 

Average

 

 

 

Weighted-

 

 

 

Average

 

 

 

 

Average

 

Aggregate

 

Remaining

 

 

 

Average

 

Aggregate

 

Remaining

 

 

 

 

Exercise

 

Intrinsic

 

Contractual

 

 

 

Exercise

 

Intrinsic

 

Contractual

 

 

Awards

 

Price

 

Value

 

Life

 

Awards

 

Price

 

Value

 

Life

Outstanding at July 1,  2010

 

1,309,254

 

$    6.11

 

 

 

 

 

749,597

 

 $

9.77

 

 

 

 

Granted

 

-

 

$        -

 

 

 

 

 

-

 

  $

 -

 

 

 

 

Exercised

 

(59,200)

 

$   3.88

 

 

 

 

 

-

 

  $

 -

 

 

 

 

Forfeited, expired or repurchased

 

(37,285)

 

$   7.92

 

 

 

 

 

-

 

  $

 -

 

 

 

 

Outstanding at March 31, 2011

 

1,212,769

 

$    6.17

 

$ 737,617

 

6.8

 

749,597

 

 $

9.77

 

$  225,865

 

4.7

Outstanding at March 31, 2011 and not yet vested

 

428,677

 

$    6.36

 

$ 143,105

 

8.4

 

76,082

 

 $

6.99

 

-

 

8.6

Exercisable at March 31, 2011

 

784,092

 

$    6.07

 

$ 594,512

 

5.9

 

673,515

 

 $

10.08

 

$  225,865

 

4.3

 

16



 

Options with a fair value of $944,711 vested during the nine months ended March 31, 2012.  As of March 31, 2012, there was $1,832,879 of total unrecognized compensation cost related to nonvested share-based compensation awards granted under the Plans.  That cost is expected to be recognized over a weighted average period of 1.7 years.  The Company issues new shares when stock options are exercised.

 

Earnings(Loss) per Common Share – A dual presentation of basic and diluted earnings (loss) per share is required on the face of the Company’s consolidated statement of operations as well as a reconciliation of the computation of basic earnings per share to diluted earnings per share.  Basic earnings per share excludes the dilutive impact of common stock equivalents and is computed by dividing net income by the weighted-average number of shares of common stock outstanding for the period.  Diluted earnings per share includes the effect of potential dilution from the exercise of outstanding common stock equivalents into common stock using the treasury stock method.  Dilutive shares are 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.  A reconciliation of the Company’s basic and diluted earnings (loss) per share follows:

 

 

 

Three Months Ended March 31,

 

Nine Months Ended March 31,

 

 

2012

 

2011

 

2012

 

2011

 

 

Net Income
Attributable to
Lannett

 

Shares

 

Net Income
Attributable to
Lannett

 

Shares

 

Net Income
Attributable to
Lannett

 

Shares

 

Net Income
Attributable to
Lannett

 

Shares

 

 

(Numerator)

 

(Denominator)

 

(Numerator)

 

(Denominator)

 

(Numerator)

 

(Denominator)

 

(Numerator)

 

(Denominator)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share factors

 

$

 1,717,884

 

28,571,062

 

$

 (362,061)

 

28,373,436

 

$

 2,532,948

 

28,509,595

 

$

 1,587,532

 

26,215,510

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Effect of potentially dilutive option and restricted stock plans

 

-

 

148,607

 

-

 

-

 

-

 

158,686

 

-

 

342,922

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Diluted earnings (loss) per share factors

 

$

 1,717,884

 

28,719,669

 

$

 (362,061)

 

28,373,436

 

$

 2,532,948

 

28,668,281

 

$

 1,587,532

 

26,558,432

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic earnings (loss) per share

 

$

 0.06

 

 

 

$

 (0.01)

 

 

 

$

 0.09

 

 

 

$

 0.06

 

 

Diluted earnings (loss) per share

 

$

 0.06

 

 

 

$

 (0.01)

 

 

 

$

 0.09

 

 

 

$

 0.06

 

 

 

The number of anti-dilutive shares that have been excluded in the computation of diluted earnings per share for the three months ended March 31, 2012 and 2011 were 2,307,131 and 2,117,377, respectively. The number of anti-dilutive shares that have been excluded in the computation of diluted earnings per share for the nine months ended March 31, 2012 and 2011 were 2,307,131 and 1,405,879, respectively.

 

Note 3.  New Accounting Standards

 

In January 2010, the FASB issued authoritative guidance which requires reporting entities to make new disclosures about recurring or nonrecurring fair value measurements including significant transfers into and out of Level 1 and Level 2 fair value measurements and information on purchases, sales, issuances, and settlements on a gross basis in the reconciliation of Level 3 fair value measurements. The authoritative guidance is effective for interim and annual reporting periods beginning after December 15, 2009, except for Level 3 reconciliation disclosures which are effective for fiscal years beginning after December 15, 2010 and for interim periods within those fiscal years. This update did not have a material impact on our consolidated financial statements.

 

In June 2011, the FASB issued authoritative guidance which allows an entity the option to present the total of comprehensive income, the components of net income, and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements.  In both options, an entity is required to present each component of net income along with total net income, each component of other comprehensive income along with a total for other comprehensive income, and a total amount for comprehensive income.  This guidance eliminates the option to present the components of other comprehensive income as part of the statement of changes in stockholders’ equity.  This guidance does not change the items that must be reported in other comprehensive income or when an item of other comprehensive income must be reclassified to net income.  This authoritative guidance must be applied retrospectively, and is effective for fiscal years and interim periods within those years, beginning after December 15, 2011.  In December 2011, the FASB issued an update deferring the effective date for amendments to the presentation of reclassifications of items out of accumulated other comprehensive income. The adoption of this guidance

 

17



 

by the Company on July 1, 2012 will not have a significant impact on the Company’s consolidated financial statements as it only requires a change in the format of the current presentation.

 

Note 4.  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.  The Company’s estimates of future product demand may fluctuate, in which case estimated required reserves for excess and obsolete inventory may increase or decrease.  If the Company’s inventory is determined to be overvalued, the Company recognizes 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 recognize such additional operating income at the time of sale.

 

Inventories consist of the following:

 

 

 

March 31, 2012

 

June 30, 2011

 

 

 

 

 

 

 

 

 

 

Raw materials

 

$ 10,970,813

 

$ 11,810,564

Work-in-process

 

3,414,588

 

2,430,108

Finished goods

 

12,399,745

 

11,636,942

Packaging supplies

 

1,190,792

 

1,024,907

 

 

$ 27,975,938

 

$  26,902,521

 

The preceding amounts are net of excess and obsolete inventory reserves of $1,604,021 and $3,486,450 at March 31, 2012 and June 30, 2011, respectively.

 

Recently, the FDA increased its efforts to force companies to file and seek FDA approval for GRASE or Grandfathered products. GRASE products are those “old drugs that do not require prior approval from FDA in order to be marketed because they are generally recognized as safe and effective based on published scientific literature.” Similarly, Grandfathered products are those which “entered the market before the passage of the 1906 act, the 1938 act or the 1962 amendments to the act.”  Efforts have included granting market exclusivity to approved GRASE or Grandfathered products and issuing notices to discontinue marketing certain products to companies currently producing these products.  Lannett currently manufactures and markets several products that are considered Grandfathered products, including Morphine Sulfate Oral Solution.  The Company is currently litigating the issue of Grandfathered drugs with the FDA.  The FDA is currently undertaking activities to force all companies who manufacture Morphine Sulfate Oral Solution to file applications and seek approval for this product or remove their product from the market.

 

Although the Company received FDA approval to begin selling Morphine Sulfate Oral Solution in June 2011, the Company had approximately $2,063,000 of Morphine Sulfate Oral Solution finished goods inventory value which was fully reserved as of June 30, 2011 and subsequently scrapped during the first quarter of Fiscal 2012.  Lannett also has approximately $2,792,554 of net inventory value at March 31, 2012 of other Grandfathered products which would also be at risk if the FDA were to pursue enforcement actions on these products similar to their actions on Morphine Sulfate Oral Solution.

 

Note 5.  Property, Plant and Equipment

 

Property, plant and equipment are stated at cost.  Depreciation is provided for by the straight-line method for financial reporting purposes over the estimated useful lives of the assets.  Depreciation expense for the three months ended March 31, 2012 and 2011 was approximately $934,000 and $822,000, respectively. Depreciation expense for the nine months ended March 31, 2012 and 2011 was approximately $2,797,000 and $2,266,000, respectively.

 

18



 

Property, plant and equipment consist of the following:

 

 

 

 

 

March 31,

 

June 30,

 

 

Useful Lives

 

2012

 

2011

Land

 

-

 

  $

 1,350,499

 

  $

 1,350,499

Building and improvements

 

10 - 39 years

 

25,785,643

 

25,476,506

Machinery and equipment

 

5 - 10 years

 

29,789,894

 

26,555,033

Furniture and fixtures

 

5 - 7 years

 

1,255,221

 

1,134,191

 

 

 

 

  $

 58,181,257

 

  $

 54,516,229

Accumulated depreciation

 

 

 

(27,371,657)

 

(24,586,448)

 

 

 

 

  $

 30,809,600

 

  $

 29,929,781

 

Note 6.  Investment Securities

 

The Company follows the authoritative guidance which clarifies the definition of fair value, establishes a framework for measuring fair value, and expands the disclosures on fair value measurements. Fair value is defined as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. The authoritative guidance also establishes a fair value hierarchy which requires an entity to maximize the use of observable inputs and minimize the use of unobservable inputs when measuring fair value. Three levels of inputs were established that may be used to measure fair value:

 

Level 1 — Quoted prices in active markets for identical assets or liabilities.  The fair value of the Company’s equity securities classified as trading securities in the table below are derived solely from Level 1 inputs.

 

Level 2 — Observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices for identical or similar instruments in markets that are not active; or model-derived valuations whose inputs are observable or whose significant value drivers are observable. The Company’s Level 2 assets and liabilities primarily include debt securities with quoted prices that are traded less frequently than exchange-traded instruments, corporate bonds, U.S. government and agency securities and certain mortgage-backed and asset-backed securities whose values are determined using pricing models with inputs that are observable in the market or can be derived principally from or corroborated by observable market data.  The fair value of the Company’s available-for-sale securities in the table below are derived solely from Level 2 inputs.

 

Level 3 — Unobservable inputs that are supported by little or no market activity and that are financial instruments whose values are determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant judgment or estimation. The Company does not have any Level 3 investment securities as of March 31, 2012 or June 30, 2011.

 

If the inputs used to measure the financial assets and liabilities fall within more than one level described above, the categorization is based on the lowest level input that is significant to the fair value measurement of the instrument.

 

The amortized cost, gross unrealized gains and losses, and fair value of the Company’s investment securities are summarized as follows:

 

March 31, 2012

 

 

 

 

 

 

 

 

 

Trading

 

Amortized Cost

 

Gross Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair Value

Equity securities

 

$    5,485,006 

 

$          86,043  

 

$            - 

 

$    5,571,049  

 

19



 

June 30, 2011

 

 

 

 

 

 

 

 

 

Available-for-Sale

 

Amortized Cost

 

Gross Unrealized
Gains

 

Gross
Unrealized
Losses

 

Fair Value

Corporate Bonds

 

  $

 179,507

 

  $

 3,028

 

-

 

  $

 182,535

 

 

 

 

 

 

 

 

 

Trading

 

 

 

 

 

 

 

 

Equity securities

 

7,067,677

 

131,819

 

-

 

7,199,496

 

 

 

 

 

 

 

 

 

Held-to -Maturity

 

 

 

 

 

 

 

 

Certificates of Deposit

 

12,000,048

 

-    

 

-

 

12,000,048

 

 

 

 

 

 

 

 

 

Total

 

  $

 19,247,232

 

  $

 134,847

 

  $

-

 

  $

19,382,079

 

The Company uses the specific identification method to determine the cost of securities sold. For the three months ended March 31, 2012, the Company had gains on investments of $465,955, of which $361,059 was realized gains and $104,896 was unrealized gains. For the nine months ended March 31, 2012, the Company had gains on investments of $168,920, of which $214,696 was realized gains and $45,776 was unrealized losses. For the three months ended March 31, 2011, the Company had gains on investments of $41,791, of which $59,689 was realized gains and $17,898 was unrealized losses.  For the nine months ended March 31, 2011, the Company had gains on investments $56,556, of which $74,454 was realized gains and $17,898 was unrealized losses.

 

As of June 30, 2011, the available-for-sale and held-to-maturity investment securities were due in one year or less.  As of March 31, 2012 and June 30, 2011, there were no securities held from a single issuer that represented more than 10% of shareholders’ equity.  As of March 31, 2012, securities with an aggregate fair value of $1,798,458 were in an unrealized loss position totaling $141,609.  No individual securities were in a continuous unrealized loss position for more than 12 months.

 

Note 7. Bank Line of Credit

 

The Company has a $3,000,000 line of credit from Wells Fargo Bank, N.A. (“Wells Fargo”) that was scheduled to expire on March 31, 2012.  The line of credit was renewed and extended until April 30, 2013 and bears interest of 1-month LIBOR Market Index Rate plus 2.00% (2.24% at March 31, 2012).  Availability under the line of credit is reduced by outstanding letters of credit totaling $5,000 at March 31, 2012 and June 30, 2011.  As of March 31, 2012 and June 30, 2011, the Company had $2,995,000 of availability under the line of credit.  The availability fee on the unused balance of the line of credit is 0.375%.  The line of credit is collateralized by the working capital assets of the Company.  As of March 31, 2012, the Company was in compliance with the financial covenants under the agreement.

 

Note 8.  Long-Term Debt

 

Long-term debt consists of the following:

 

 

 

 

March 31,

 

June 30,

 

 

2012

 

2011

Pennsylvania Industrial Development Authority loan

 

  $

 797,333

 

  $

 856,549

Tax-exempt bond loan (PAID)

 

425,000

 

425,000

Wells Fargo N.A. Townsend Road mortgage

 

2,869,245

 

3,022,046

PIDA Townsend Road mortgage

 

1,924,410

 

2,000,000

First National Bank of Cody mortgage

 

1,405,465

 

1,518,336

 

 

 

 

 

Total debt

 

7,421,453

 

7,821,931

Less current portion

 

639,591

 

629,435

 

 

 

 

 

Long term debt

 

  $

 6,781,862

 

  $

 7,192,496

 

 

 

 

 

Current Portion of Long Term Debt

 

March 31,

 

June 30,

 

 

2012

 

2011

Pennsylvania Industrial Development Authority loan

 

  $

 80,877

 

  $

 79,228

Tax-exempt bond loan (PAID)

 

135,000

 

135,000

Wells Fargo N.A. Townsend Road mortgage

 

203,733

 

203,733

PIDA Townsend Road mortgage

 

104,283

 

101,262

First National Bank of Cody mortgage

 

115,698

 

110,212

 

 

 

 

 

Total current portion of long term debt

 

  $

 639,591

 

  $

 629,435

 

20



 

The Company financed $1,250,000 through the Pennsylvania Industrial Development Authority (PIDA).  The Company is required to make equal payments each month for 180 months starting February 1, 2006 with interest of 2.75% per annum.

 

In April 1999, the Company entered into a loan agreement (the “Agreement”) with a governmental authority, the Philadelphia Authority for Industrial Development (the “Authority” or “PAID”), to finance future construction and growth projects of the Company. The Authority issued $3,700,000 in tax-exempt variable rate demand and fixed rate revenue bonds to provide the funds to finance such growth projects pursuant to a trust indenture (“the Trust Indenture”).  A portion of the Company’s proceeds from the bonds was used to pay for bond issuance costs of approximately $170,000.  The Trust Indenture requires that the Company repay the Authority loan through installment payments beginning in May 2003 and continuing through May 2014, the year the bonds mature. The bonds bear interest at the floating variable rate determined by the organization responsible for selling the bonds (the “remarketing agent”).  The interest rate fluctuates on a weekly basis.  The effective interest rate at March 31, 2012 and June 30, 2011 was 0.40% and 0.40%, respectively.

 

During the third and fourth quarters of Fiscal 2011, the Company negotiated a set of mortgages on its Townsend Road facility with both Wells Fargo and PIDA.  The Wells Fargo portion of the loan is for $3,056,000, bears a floating interest rate of the One Month LIBOR rate plus 2.95%, amortizes over a 15 year term and has an 8 year maturity date.  The effective interest rate at March 31, 2012 and June 30, 2011 was 3.19% and 3.14%, respectively.  The PIDA portion of the loan is for $2,000,000, bears an interest rate 3.75% and matures in 15 years.  Both loans closed and were funded in May 2011. As of March 31, 2012, the Company was in compliance with the financial covenants under the loan agreements.

 

The Company has executed Security Agreements with Wells Fargo, PIDA and PIDC in which the Company has agreed to pledge its working capital, some equipment and its Townsend Road property to collateralize the amounts due.

 

The Company is the primary beneficiary to a VIE called Cody LCI Realty, LLC.  See Note 15, Consolidation of Variable Interest Entity for additional description.  The VIE owns land and a building which is being leased to Cody.  A mortgage loan with First National Bank of Cody has been consolidated in the Company’s financial statements, along with the related land and building.  The mortgage requires monthly principal and interest payments of $14,782.  Effective February 2011, the interest rate was modified from a fixed rate of 7.5% to a floating rate with a floor of 4.5% and a ceiling of 9.0%, with payments to be made through April 2022.  As of March 31, 2012 and June 30, 2011, the effective rate was 4.50%.  The mortgage is collateralized by the land and building.

 

Long-term debt amounts due, for the twelve month periods ending March 31 are as follows:

 

Twelve Month

 

Amounts Payable to

Periods

 

Institutions

 

 

 

2013

 

  $

 639,591

2014

 

515,851

2015

 

527,797

2016

 

540,255

2017

 

553,219

Thereafter

 

4,644,740

 

 

 

 

 

  $

 7,421,453

 

Note 9.  Contingencies

 

In January 2010, the Company initiated an arbitration proceeding against Olive Healthcare (“Olive”) for damages arising out of Olive’s delivery of defective soft-gel prenatal vitamin capsules.  The Company seeks damages in excess of $3.5 million. Olive has denied liability and filed a counterclaim in February 2010 for breach of contract.  The arbitration proceeding is in the discovery phase and is scheduled to be heard in June 2012.  Olive also filed a lawsuit against the

 

21



 

Company in December 2010 in Daman, India seeking to enjoin the United States arbitration and claiming damages of approximately $6.8 million for compensatory damages and an additional approximately $6.8 million for loss of business.  The Company has engaged Indian counsel and is actively defending that suit.  On October 13, 2011 the Indian court dismissed the lawsuit brought by Olive.  Thereafter, Olive filed a Writ Petition with Bombay High Court seeking to reverse the decision of the court in Daman, India, which dismissed Olive’s lawsuit.  The Bombay High Court heard argument on the matter in January 2012.  On March 7, 2012, the Bombay High Court issued its ruling, affirming the decision of the court in Daman, India and dismissing the Olive lawsuit.  On or about April 2, 2012, Olive filed a Special Leave Petition with the Indian Supreme Court, challenging the ruling of the Bombay High Court.  The Indian Supreme Court has not yet taken up the matter.

 

Note 10.   Commitments

 

Leases

 

Lannett’s subsidiary, Cody leases a 73,000 square foot facility in Cody, Wyoming.  This location houses Cody’s manufacturing and production facilities. Cody leases the facility from Cody LCI Realty, LLC, a Wyoming limited liability company which is 50% owned by Lannett.  See Note 15.

 

Rental and lease expense for the three months ended March 31, 2012 and 2011 was approximately $19,000 and $22,000, respectively. Rental and lease expense for the nine months ended March 31, 2012 and 2011 was approximately $68,000 and $68,000, respectively.

 

Employment Agreements

 

The Company has entered into employment agreements with Arthur P. Bedrosian, President and Chief Executive Officer, Martin P. Galvan, Vice President of Finance and Chief Financial Officer, Kevin Smith, Vice President of Sales and Marketing, William Schreck, Chief Operating Officer, Ernest Sabo, Vice President of Regulatory Affairs and Chief Compliance Officer and Robert Ehlinger, Vice President of Logistics and Chief Information Officer.  Each of the agreements provide for an annual base salary and eligibility to receive a bonus.  The salary and bonus amounts of these executives are determined by the Board of Directors.  Additionally, these executives are eligible to receive stock options and restricted stock awards, which are granted at the discretion of the Board of Directors, and in accordance with the Company’s policies regarding stock option and restricted stock grants.  Under the agreements, these 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 these executives of between 18 months and three years.

 

Effective August 1, 2011, Keith R. Ruck, the former Vice President of Finance and Chief Financial Officer of the Company, separated his employment from the Company.  Mr. Ruck entered into a Separation Agreement and Release with the Company dated August 1, 2011, pursuant to which he received seven months base salary totaling $110,833, medical benefits and vesting of outstanding options and previously awarded restricted stock grants.

 

22



 

Note 11.  Comprehensive Income (loss)

 

The Company’s other comprehensive (loss) income is comprised of unrealized losses on investment securities classified as available-for-sale as well as foreign currency translation adjustments.  There is no other comprehensive income (loss) attributable to the noncontrolling interest.

 

The components of comprehensive income (loss) and related taxes consisted of the following:

 

 

 

For the Three Months Ended
March 31,

 

For the Nine Months Ended
March 31,

 

 

2012

 

2011

 

2012

 

2011

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$ 1,734,352

 

$ (357,802)

 

$ 2,586,020

 

$ 1,608,072

Foreign currency translation adjustments

 

(6,594)

 

(16,120)

 

(41,375)

 

(8,671)

Unrealized holding loss on securities

 

(1,299)

 

(1,690)

 

(3,028)

 

(13,424)

Tax effect

 

520

 

676

 

1,211

 

5,369

 

 

 

 

 

 

 

 

 

Total Other Comprehensive Loss

 

(7,373)

 

(17,134)

 

(43,192)

 

(16,726)

 

 

 

 

 

 

 

 

 

Total Comprehensive Income (loss)

 

$ 1,726,979

 

$ (374,936)

 

$ 2,542,828

 

$ 1,591,346

 

Note 12.   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 50% of each employee’s contribution, but not to exceed 4% of the employee’s compensation for the Plan year.  Contributions to the Plan during the three months ended March 31, 2012 and 2011 were $85,000 and $79,000, respectively. For the nine months ended March 31, 2012 and 2011, contributions to the Plan were $243,000 and $302,000, respectively.

 

Note 13.   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 March 31, 2012, 319,419 shares have been issued under the ESPP.  Compensation expense of $26,736 and $24,292 relating to the ESPP was recognized for the three months ended March 31, 2012 and 2011, respectively. Compensation expense of $45,414 and $48,584 relating to the ESPP was recognized for the nine months ended March 31, 2012 and 2011, respectively.

 

Note 14.  Income Taxes

 

The Company uses the liability method to account 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.

 

23



 

The provision for federal, state and local income taxes for the three months ended March 31, 2012 and 2011 was tax expense (benefit) of $1,056,684 and $(449,797), respectively, with effective tax rates of 38% and 56%, respectively. The provision for federal, state and local income taxes for the nine months ended March 31, 2012 and 2011 was tax expense of $1,787,999 and $554,568, respectively, with effective tax rates of 41% and 26%, respectively. The effective tax rate for the three and nine months ended March 31, 2012 includes the impact of nondeductible incentive stock option compensation expenses relative to the expected pretax income for Fiscal 2012 partially offset by the impact of income tax credits.  The effective tax rate for the three and nine months ended March 31, 2011 includes the impact of income tax credits and the reversal of a portion of our liability for unrecognized tax benefits totaling $263,793 related to a settlement with the IRS recorded in the prior year period ended December 31, 2010, partially offset by the impact of nondeductible incentive stock option compensation expenses relative to the expected pretax income for Fiscal 2011. The Company expects its overall effective tax rate will be approximately 40% to 42% for the full year ended June 30, 2012.

 

The Company may recognize the tax benefit from an uncertain tax position claimed on a tax return only if it is more likely than not that the tax position will be sustained on examination by the taxing authorities, based on the technical merits of the position.  The tax benefits recognized in the financial statements from such a position should be measured based on the largest benefit that has a greater than 50% likelihood of being realized upon ultimate settlement.

 

As of March 31, 2012 and June 30, 2011, the Company reported total unrecognized tax benefits of $298,666 and $208,792, respectively.  As a result of the positions taken during the period, the Company has not recorded any interest and penalties for the period ended March 31, 2012 in the statement of operations and no cumulative interest and penalties have been recorded either in the Company’s statement of financial position as of March 31, 2012 and June 30, 2011. The Company will recognize interest accrued on unrecognized tax benefits in interest expense and any related penalties in operating expenses.  The Company does not believe that the total unrecognized tax benefits will significantly increase or decrease in the next twelve months.

 

The Company files income tax returns in the United States federal jurisdiction, Pennsylvania, New Jersey and California.  The Company’s tax returns for Fiscal 2008 and prior generally are no longer subject to review as such years generally are closed. The Company believes that an unfavorable resolution for open tax years would not be material to the financial position of the Company.

 

Note 15. Consolidation of Variable Interest Entity

 

Lannett consolidates any VIE of which it is the primary beneficiary. The liabilities recognized as a result of consolidating a VIE do not represent additional claims on our general assets; rather, they represent claims against the specific assets of the consolidated VIE. Conversely, assets recognized as a result of consolidating a VIE do not represent additional assets that could be used to satisfy claims against our general assets. Reflected in the March 31, 2012 and June 30, 2011 balance sheets are consolidated VIE assets of approximately $1.8 million, which are comprised mainly of land and building. VIE liabilities consist of a mortgage on that property in the amount of approximately $1.4 million and $1.5 million at March 31, 2012 and June 30, 2011, respectively. Cody LCI Realty LLC (“Realty”) is the only VIE that is consolidated.  Realty had been consolidated by Cody prior to its acquisition by Lannett.  Realty is a 50/50 joint venture with a former shareholder of Cody.  Its purpose was to acquire the facility used by Cody.  Until the acquisition of Cody in April 2007, Lannett had not consolidated the VIE because Cody Labs had been the primary beneficiary of the VIE.  The risks associated with our interests in this VIE is limited to a decline in the value of the land and building as compared to the balance of the mortgage note on that property, up to Lannett’s 50% share of the venture.  Realty owns the land and building, and Cody leases the building and property from Realty for $20,000 per month. All intercompany rent expense and income is eliminated upon consolidation with Cody.  The Company is not involved in any other VIE.

 

Note 16.  Related Party Transactions

 

The Company had sales of approximately $330,000 and $184,000 during the three months ended March 31, 2012 and 2011, respectively, to a generic distributor, Auburn Pharmaceutical Company (“Auburn”). Sales to Auburn for the nine months ended March 31, 2012 and 2011 were approximately $456,000 and $658,000, respectively.  Jeffrey Farber (the “related party”), who is a current board member and the son of William Farber, the Chairman Emeritus of the Board of Directors and principal shareholder of the Company, is the owner of Auburn.  Accounts receivable includes amounts due from the related party of approximately $270,000 and $259,000 at March 31, 2012 and June 30, 2011, respectively.  In the

 

24



 

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 in which the Company purchased for $100,000 and future royalty payments the proprietary rights to manufacture and distribute a product for which Pharmeral, Inc. (“Pharmeral”) owned the ANDA.  In Fiscal 2008, the Company obtained FDA approval to use the proprietary rights.  Accordingly, the Company originally capitalized these rights as an indefinite lived intangible asset and tested this asset for impairment at least on an annual basis.  During the fourth quarter of Fiscal 2009, it was determined that this intangible asset no longer has an indefinite life.  No impairment existed because the estimated fair value exceeded the carrying amount on that date. Accordingly, the $100,000 carrying amount of this intangible asset is being amortized on a straight line basis prospectively over its 10 year estimated useful life.

 

Arthur P. Bedrosian, President and Chief Executive Officer, currently owns 100% of Pharmeral.  This transaction was approved by the Board of Directors of the Company and in their opinion the terms were not more favorable to the related party than they would have been to a non-related party. In May 2008, Mr. Bedrosian and Pharmeral waived their rights to any royalty payments on the sales of the drug by Lannett under Lannett’s current ownership structure.  Should Lannett undergo a change in control where a third party is involved, this royalty would be reinstated. The registered trademark OB-Natal® was transferred to Lannett for one dollar from Mr. Bedrosian.

 

Lannett Company, Inc. paid a management consultant who is related to Mr. Bedrosian $26,400 in fees and $3,613 in reimbursable expenses during the three months ended March 31, 2012 and $30,660 in fees during the three months ended March 31, 2011.  The Company paid this consultant $78,800 in fees and $14,996 in reimbursable expenses during the nine months ended March 31, 2012 and $103,600 in fees and $8,079 in reimbursable expenses during the nine months ended March 31, 2011.  This consultant provided management, construction planning, laboratory set up and administrative services in regards to the Company’s initial set up of its bio-study laboratory in a foreign country.  It is expected that this consultant will continue to be utilized into Fiscal 2013. In the Company’s opinion, the fee rates paid to this consultant and the expenses reimbursed to him were not more favorable than what would have been paid to a non-related party.

 

Note 17.  Material Contract with Supplier

 

Jerome Stevens Pharmaceuticals agreement:

 

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 63% and 59% of the Company’s inventory purchases during the three and nine months ended March 31, 2012 and approximately 72% and 64% during the three and nine months ended March 31, 2011, respectively.  In March 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 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®.  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 was $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 seven years of the contract, but there is no guarantee that the Company will be able to continue to do so in the future. If the Company does not meet the minimum purchase requirements, JSP’s sole remedy is to terminate the agreement.

 

Under the agreement, JSP is entitled to nominate one person to serve on the Company’s Board of Directors (the “Board”) provided, however, that the Board shall have the right to reasonably approve any such nominee in order to fulfill its fiduciary duty by ascertaining that such person is suitable for membership on the board of a publicly traded corporation. Suitability is determined by, but not limited to, the requirements of the Securities and Exchange Commission, the American Stock Exchange, and other applicable laws, including the Sarbanes-Oxley Act of 2002.  As of March 31, 2012, JSP has not exercised the nomination provision of the agreement.

 

25



 

The Company’s financial condition, as well as its liquidity resources, are very dependent on an uninterrupted supply of product from JSP.  Should there be an interruption in the supply of product from JSP for any reason, this event would have a material impact to the financial condition of Lannett.

 

 

ITEM 2.          MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.

 

Introduction

 

The following information should be read in conjunction with the consolidated financial statements and notes in Part I, Item 1 of this Quarterly Report and with Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in the Company’s Annual Report on Form 10-K for the fiscal year ended June 30, 2011.

 

This Report on Form 10-Q and certain information incorporated herein by reference contain forward-looking statements which are not historical facts made pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995. Forward-looking statements are not promises or guarantees and investors are cautioned that all forward-looking statements involve risks and uncertainties, including but not limited to the impact of competitive products and pricing, product demand and market acceptance, new product development, the regulatory environment, including without limitation, reliance on key strategic alliances, availability of raw materials, fluctuations in operating results and other risks detailed from time to time in the Company’s filings with the Securities and Exchange Commission. These statements are based on management’s current expectations and are naturally subject to uncertainty and changes in circumstances. We caution you not to place undue reliance upon any such forward-looking statements which speak only as of the date made. Lannett is under no obligation to, and expressly disclaims any such obligation to, update or alter its forward-looking statements, whether as a result of new information, future events or otherwise.

 

 

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.

 

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 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, chargebacks and returns payable and as 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 accruals as they are the primary recipient of chargebacks and rebates. Incentives offered to secure sales vary from product to product. Provisions for estimated rebates and promotional credits are estimated based upon contractual terms.  Provisions for other customer credits, such as price adjustments, returns, and chargebacks, require management to make subjective judgments on customer mix. Unlike branded innovator drug companies, Lannett does not use information about product levels in distribution channels from third-party sources, such as IMS and Wolters Kluwer, in estimating future returns and other credits. Lannett calculates a chargeback/rebate rate based on contractual terms with its customers and applies this rate to customer sales.  The only variable is customer mix, and this assumption is based on historical data and sales expectations.  The chargeback/rebate reserve is reviewed on a monthly basis by management using several ratios and calculated metrics.  As we continue to obtain additional information about our historical experience for chargebacks, rebates and returns, we also update our estimates of the required reserves.

 

26



 

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 by the Company 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 expected mix of product sales to the indirect customers. The Company continually monitors the reserve for chargebacks and makes adjustments when management believes that expected chargebacks on actual sales may differ from the amounts that were assumed in the establishment of the chargeback reserves.

 

Rebates – Rebates are offered to the Company’s key chain drug store, distributor and wholesaler customers to promote customer loyalty and increase 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. As a result of the Patient Protection and Affordable Care Act (“PPACA”) enacted in the U.S. in March 2010, the Company participates in a new cost sharing program for certain Medicare Part D beneficiaries designed primarily for the sale of brand drugs and certain generic drugs if their FDA approval was granted under a New Drug Application (“NDA”) or 505(b) NDA versus an Abbreviated New Drug Application (“ANDA”). Because our drugs used for the treatment of thyroid deficiency and our Morphine Sulfate Oral Solution product were approved by the FDA as a 505(b)(2) NDA, they qualify as “branded” drugs for purposes of the PPACA.  Drugs purchased under this program during Medicare Part D coverage gap (commonly referred to as the “donut hole”) result in additional rebates.  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, since these rebate programs are not identical for all customers, the size of the reserve will depend on the mix of customers that are eligible to receive rebates.

 

Returns – Consistent with industry practice, the Company has a product returns policy that allows certain 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, adjusted for any changes in business practices or conditions that would cause management to believe that future product returns may differ from those returns assumed in the establishment of reserves.  Generally, the reserve for returns increases as sales increase and decrease when credits are issued or payments are made for actual returns received.  The reserve for returns is included in the rebates, chargebacks and returns 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 a 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, chargebacks and returns payable account on the balance sheet.  When competitors enter the market for existing products, shelf stock adjustments may be issued to maintain price competitiveness.

 

The following tables identify the reserves for each major category of revenue allowance and a summary of the activity for the nine months ended March 31, 2012 and 2011:

 

27



 

For the nine months ended March 31, 2012

 

Reserve Category

 

Chargebacks

 

Rebates

 

Returns

 

Other

 

Total

 

 

 

 

 

 

 

 

 

 

 

Reserve Balance as of June 30, 2011

 

$

5,496,911

 

$

2,925,477

 

$

5,142,007

 

$

-        

 

$

13,564,395

Actual credits issued related to sales recorded in prior fiscal years

 

(5,350,016

)

(3,083,836

)

(3,426,013

)

(151,846

)

(12,011,711)

Reserves or (reversals) charged during Fiscal 2012 related to sales in prior fiscal years

 

(54,015

)

158,359

 

     -

 

151,846

 

256,190

Reserves charged to net sales during Fiscal 2012 related to sales recorded in Fiscal 2012

 

50,391,821

 

15,405,473

 

3,566,636

 

487,945

 

69,851,875

Actual credits issued related to sales  recorded in Fiscal 2012

 

(44,091,799

)

(11,686,661

)

-    

 

(487,945

)

(56,266,405)

Reserve Balance as of March 31, 2012

 

$

6,392,902

 

$

3,718,812

 

$

5,282,630

 

$

-        

 

$

15,394,344

 

 

For the nine months ended March 31, 2011

 

Reserve Category

 

Chargebacks

 

Rebates

 

Returns

 

Other

 

Total

 

 

 

 

 

 

 

 

 

 

 

Reserve Balance as of June 30, 2010

 

$

6,282,127

 

$

3,566,031

 

$

5,401,254

 

$

-   

 

$

15,249,412

Actual credits issued related to sales recorded in prior fiscal years

 

(6,258,862

)

(3,946,924

)

(3,290,619

)

-   

 

(13,496,405)

Reserves or (reversals) charged during Fiscal 2011 related to sales in prior fiscal years

 

-   

 

380,893

 

-   

 

-   

 

380,893

Reserves charged to net sales during Fiscal 2011 related to sales recorded in Fiscal 2011

 

40,105,340

 

12,276,977

 

5,602,225

 

2,739,301

 

60,723,843

Actual credits issued related to sales recorded in Fiscal 2011

 

(34,059,033

)

(10,144,801

)

(2,078,044

)

(2,739,301

)

(49,021,179)

Reserve Balance as of March 31, 2011

 

$

6,069,572

 

$

2,132,176

 

$

5,634,816

 

$

-   

 

$

13,836,564

 

 

The total reserve for chargebacks, rebates, returns and other adjustments increased from $13,564,395 at June 30, 2011 to $15,394,344 at March 31, 2012.  The increase in total reserves was partially due to an increase in rebate reserves as a result of increased sales, the timing of credits taken, as well as an additional rebate program the Company became obligated under Medicare Part D.  The increase in chargeback reserves is related to sales to major wholesalers resulting in increased inventory levels at wholesaler distribution centers. The activity in the Other category for the nine months ended March 31, 2012 includes shelf-stock, shipping, and other sales adjustments.

 

Credits issued during the quarter that relate to prior year sales are charged against the opening balance.  In aggregate, additional reserves or reversals of reserves have historically offset each other.  The table above shows the effects of reversals within the rebates, returns and other categories.  It is the Company’s intention that all reserves be charged to sales in the period that the sale is recognized, however, due to the nature of this estimate, it is possible that the Company may sometimes need to increase or decrease the reserve based on prior period sales.  If that were to occur, management would disclose that information at that time.  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.

 

28



 

The rates of reserves will vary, as well as the category under which the credit falls.  This variability comes about when the Company is working with indirect customers to compete with the pricing of other generic companies.  The Company has improved its computer systems in order to improve the accuracy of tracking and processing chargebacks and rebates and will continue to look at ways for further improvements.  Improvements to automate calculation of reserves will not only reduce the potential for human error, but also will result in more in-depth analysis and improved customer interaction for resolution of open credits.

 

Approximately $12,011,711 or 89% of the reserve balance from June 30, 2011 has been processed through the first nine months of Fiscal 2012. Management estimates reserves based on sales mix.  A comparison to wholesaler inventory reports is performed quarterly, in order to justify the balance of unclaimed chargebacks and rebates.  The Company has historically found a direct correlation between the calculation of the reserve based on sales mix, and the wholesaler inventory analysis.

 

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 both the 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.

 

The Company also regularly monitors accounts receivable (“AR”) balances by reviewing day’s sales outstanding (“DSO”).  DSO is calculated by dividing gross accounts receivable by the average daily gross sales for the fiscal quarter.  The Company monitors DSO as an overall check on collections and to assess the reasonableness of the reserves. DSO provides management with an understanding of the frequency of customer payments, and the ability to process customer payments and deductions.  Standard payment terms offered to customers are consistent with industry practice at 60 days.

 

The following table shows the results of these calculations as of the relevant periods:

 

 

 

3/31/12

 

6/30/11

 

3/31/11

 

DSO (in days)

 

63

 

64

 

65

 

 

The level of DSO at March 31, 2012 is consistent with the Company’s expectation that DSO will be in the 60 to 70 day range based on 60 day payment terms for most customers.

 

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.

 

Consolidation of Variable Interest Entity – The Company consolidates any Variable Interest Entity (“VIE”) of which we are the primary beneficiary. The liabilities recognized as a result of consolidating a VIE do not represent additional claims on our general assets; rather, they represent claims against the specific assets of the consolidated VIE. Conversely, assets recognized as a result of consolidating a VIE do not represent additional assets that could be used to satisfy claims against our general assets.  Reflected in the March 31, 2012 and June 30, 2011 balance sheets are consolidated VIE assets of approximately $1.8 million, which is comprised mainly of land and a building. VIE liabilities consist of a mortgage on that property in the amount of approximately $1.4 million and $1.5 million at March 31, 2012 and June 30, 2011, respectively. This VIE was initially consolidated by Cody, as Cody has been the primary beneficiary.  Cody has then been consolidated within Lannett’s financial statements since its acquisition in April 2007.

 

29



 

Results of Operations - Three months ended March 31, 2012 compared with three months ended March 31, 2011

 

Net sales for the three months ended March 31, 2012 (“Fiscal 2012”) increased 19% to $30,688,000 from $25,892,000 for the three months ended March 31, 2011 (“Fiscal 2011”). The following factors contributed to the $4,796,000 increase in sales:

 

Medical indication

 

Sales volume
change %

 

Sales price
change %

Cardiovascular

 

110%

 

-9%

Glaucoma

 

3%

 

13%

Gallstone Prevention

 

-10%

 

-8%

Obesity

 

16%

 

-

Antibiotics

 

42%

 

-42%

Thyroid Deficiency

 

-

 

1%

Pain Management

 

8%

 

40%

Migraine Headache

 

-26%

 

-

 

 

Sales of drugs for cardiovascular treatment increased by approximately $3,038,000 for the three months ended March 31, 2012 compared to March 31, 2011 mainly due to a recently approved product for the treatment of hypertension which commenced shipping at the end of December 2011. Sales of drugs used for pain management increased approximately $1,308,000 for the three months ended March 31, 2012 compared to March 31, 2011. The increase in sales of pain management drugs was due mainly due to  an increase in sales of Morphine Sulfate Oral Solution, an increase in both price and volume for Oxycodone  partially offset by a decrease in volume shipped of Hydromorphone.  The Company commenced shipments of Morphine Sulfate Oral Solution in the first quarter of fiscal year 2012 based on its June 2011 FDA approval.

 

The Company sells its products to customers in various categories.  The table below identifies the Company’s net sales to each category for the three months ended March 31, 2012 and 2011:

 

 

 

Three Months Ended March 31,

 

 

 

 

 

Customer Category

 

2012

 

2011

 

 

 

 

 

Wholesaler/ Distributor

 

$

16,709,000

 

$

14,254,000

Retail Chain

 

11,243,000

 

10,771,000

Mail-Order Pharmacy

 

2,736,000

 

867,000

 

 

 

 

 

Total

 

$

30,688,000

 

$

25,892,000

 

 

The sales to wholesaler/distributor increased primarily as a result of an increase in demand for pain management products discussed above.  Mail-order pharmacy sales increased primarily as a result of increased sales due to a recently approved product for the treatment of hypertension which commenced shipping in January 2012.

 

Cost of sales for the third quarter decreased 4% to $19,796,000 in Fiscal 2012 from $20,589,000 in Fiscal 2011.  The decrease primarily reflected the impact of a change in product mix, manufacturing efficiencies, partially offset by the impact of the 19% increase in sales discussed above.

 

 

Amortization expense included in the cost of sales change above primarily relates to the JSP Distribution Agreement.  For the remaining term of the JSP Distribution Agreement, the Company will incur annual amortization expense of approximately $1,785,000.

 

Gross profit margins for the third quarter of Fiscal 2012 and Fiscal 2011 were 35% and 20%, respectively. Gross profit percentage increased primarily due a change in the mix of products sold as discussed above, in addition to manufacturing efficiencies.  While the Company is continuously striving to keep product costs low, there can be no guarantee that profit margins will not fluctuate in future periods.  Pricing pressure from competitors and costs of producing or purchasing new

 

30



 

drugs may also fluctuate in the future. Changes in the future sales product mix may also occur. These changes may affect the gross profit percentage in future periods.

 

Research and development (“R&D”) expenses in the third quarter increased 57% to $2,912,000 for Fiscal 2012 from $1,854,000 for Fiscal 2011.  The increase is primarily due to compensation related costs incurred in Fiscal 2012 but not incurred in the Fiscal 2011 period, in addition to increased internal research and development activities.  The Company expenses all production costs as R&D until the drug is approved by the FDA.  R&D expenses may fluctuate from period to period, based on R&D plans for submission to the FDA.

 

Selling, general and administrative (“SG&A”) expenses in the third quarter increased 31% to $5,616,000 in Fiscal 2012 from $4,280,000 in Fiscal 2011.  The increase is primarily due to compensation related costs incurred in Fiscal 2012 but not incurred in the Fiscal 2011 period, outsourced sales and marketing expenses, in addition to an increase in legal costs incurred in the third quarter of Fiscal 2012.  While the Company is focused on controlling costs, increases in personnel costs may have an ongoing and longer lasting impact on the administrative cost structure.  Other costs are being incurred to facilitate improvements in the Company’s infrastructure.  These costs are expected to be temporary investments in the future of the Company and may not continue at the same level.

 

Interest expense in the third quarter of Fiscal 2012 increased to $64,000 compared to $28,000 in Fiscal 2011 due to higher levels of long-term debt.  Interest and dividend income totaling $28,000 in Fiscal 2012 remained relatively flat compared to $25,000 in Fiscal 2011. The Company recorded gains on trading investment securities during the third quarter of Fiscal 2012 totaling $466,000, of which $105,000 was unrealized gains and $361,000 was realized gains.

 

The Company recorded income tax expense in the third quarter of 2012 of $1,057,000 compared to an income tax benefit of $450,000 in the third quarter of Fiscal 2011.  The effective tax rate for the three months ended March 31, 2012 was 38%, compared to 56% for the three months ended March 31, 2011.  The effective tax rate for the three months ended March 31, 2012 includes the impact of nondeductible incentive stock option compensation expenses relative to the expected pretax income for Fiscal 2012 partially offset by the impact of income tax credits.  The effective tax rate for the three months ended March 31, 2011 includes the impact of income tax credits and the reversal of a portion of our liability for unrecognized tax benefits totaling $263,793 related to a settlement with the IRS recorded in the prior year period ended December 31, 2010, partially offset by the impact of nondeductible incentive stock option compensation expenses relative to the expected pretax income for Fiscal 2011.  The Company expects its overall effective tax rate will be approximately 40% to 42% for the full year ended June 30, 2012.

 

The Company reported a net income attributable to Lannett of approximately $1,718,000 in the third quarter of Fiscal 2012, or $0.06 basic and diluted earnings per share, as compared to net loss attributable to Lannett of approximately $362,000 in the third quarter Fiscal 2011, or $0.01 basic and diluted loss per share.

 

 

Results of Operations - Nine months ended March 31, 2012 compared with nine months ended March 31, 2011

 

Net sales for the nine months ended March 31, 2012 (“Fiscal 2012”) increased 7% to $87,300,000 from $81,328,000 for the nine months ended March 31, 2011 (“Fiscal 2011”). The following factors contributed to the $5,972,000 increase in sales:

 

Medical indication

 

Sales volume
change %

 

Sales price
change %

Cardiovascular

 

37%

 

-20%

Glaucoma

 

15%

 

28%

Gallstone Prevention

 

22%

 

-22%

Obesity

 

-28%

 

30%

Antibiotics

 

64%

 

-58%

Thyroid Deficiency

 

8%

 

-2%

Pain Management

 

5%

 

26%

Migraine Headache

 

-31%

 

-3%

 

31



 

Sales of drugs used for pain management increased $3,472,000 for the nine months ended March 31, 2012 compared to March 31, 2011. The increase in sales of pain management drugs was due mainly to a price increase as well as additional volume of C-Topical Solution shipped to wholesale distributors.  The Company also commenced shipments of Morphine Sulfate Oral Solution in the first quarter of fiscal year 2012 based on its June 2011 FDA approval which contributed to the overall increase in pain management sales. Partially offsetting these increases was a decrease in volume of Oxycodone shipped.  Sales of drugs used in the treatment of thyroid deficiency increased by approximately $1,891,000 for the nine months ended March 31, 2012 compared to March 31, 2011 primarily as a result of increased sales volume to one of our major retail customers, partially offset by a decrease in price related to a Medicare Part D coverage gap rebate totaling approximately $1,323,000.  Sales of drugs for cardiovascular treatment increased by approximately $1,695,000 for the nine months ended March 31, 2012 compared to March 31, 2011 mainly due to a recently approved product for the treatment of hypertension which commenced shipping at the end of December 2011 partially offset by a competitive price reduction for another cardiovascular product during the third quarter of fiscal 2011 in order to retain one of our major customers.  Sales of drugs for anti-psychosis treatment increased by approximately $928,000 for the nine months ended March 31, 2012 compared to March 31, 2011 mainly due to the Loxapine product launch.  Additional sales can also be attributed to drugs used for the treatment of glaucoma prevention which accounted for an increase in net sales of $917,000 for the nine months ended March 31, 2012 compared to March 31, 2011.  The overall increase in sales was partially offset by a decrease in prescription vitamins which decreased by approximately $1,821,000 due to the settlement agreement reached with KV on December 15, 2010 which required the Company to cease selling products covered by the licensed patents.  Also, sales of drugs used for the treatment of migraine headaches decreased by approximately $2,384,000 for the nine months ended March 31, 2012 compared to March 31, 2011 primarily as a result of decreased volumes to both chain drug stores and wholesale distributors.

 

The Company sells its products to customers in various categories.  The table below identifies the Company’s net sales to each category for the nine months ended March 31, 2012 and 2011:

 

 

 

 

Nine Months Ended March 31,

 

 

 

 

 

Customer Category

 

2012

 

2011

 

 

 

 

 

Wholesaler/ Distributor

 

$

49,144,000

 

$

43,841,000

Retail Chain

 

33,247,000

 

34,577,000

Mail-Order Pharmacy

 

4,909,000

 

2,910,000

 

 

 

 

 

Total

 

$

87,300,000

 

$

81,328,000

 

 

The sales to wholesaler/distributor increased primarily as a result of the increase in sales of pain management products discussed above, partially offset by a decrease in demand for migraine headache products for which the company is no longer the primary supplier.  The sales to retail chains decreased due to the discontinuation of sales of prescription vitamins as a result of the agreement reached with KV which required the Company to cease selling products covered by the licensed patents as discussed above, lower volumes of drugs used for the treatment of migraine headaches, in addition to a Medicare Part D coverage gap rebate totaling approximately $1,323,000 related to sales of drugs used for the treatment of thyroid deficiency. Mail-order pharmacy sales increased primarily as a result of increased sales due to a recently approved product for the treatment of hypertension which commenced shipping in January 2012.

 

Cost of sales for the first nine months decreased 2% to $60,365,000 in Fiscal 2012 from $61,763,000 in Fiscal 2011.  The decrease primarily reflected the impact of a change in product mix, manufacturing efficiencies, partially offset by the impact of the 7% increase in sales discussed above.  Cost of sales for Fiscal 2011 included additional inventory reserves totaling approximately $1,546,000 related to Morphine Sulfate Oral Solution and the reversal of royalty expense totaling approximately $618,000 as a result of the settlement agreement reached with KV in December 2010.

 

Amortization expense included in the cost of sales change above primarily relates to the JSP Distribution Agreement.  For the remaining term of the JSP Distribution Agreement, the Company will incur annual amortization expense of approximately $1,785,000.

 

32



 

Gross profit margins for the first nine months of Fiscal 2012 and Fiscal 2011 were 31% and 24%, respectively.  Gross profit percentage increased due a change in the mix of products sold as discussed above, in addition to manufacturing efficiencies.  Gross profit margins in Fiscal 2011 were negatively impacted by additional inventory reserves totaling approximately $1,546,000 related to Morphine Sulfate Oral Solution partially offset by the reversal of royalty expense totaling approximately $618,000 as a result of the settlement agreement reached with KV in December 2010.  While the Company is continuously striving to keep product costs low, there can be no guarantee that profit margins will not fluctuate in future periods.  Pricing pressure from competitors and costs of producing or purchasing new drugs may also fluctuate in the future. Changes in the future sales product mix may also occur. These changes may affect the gross profit percentage in future periods.

 

Research and development (“R&D”) expenses in the first nine months increased 41% to $7,851,000 for Fiscal 2012 from $5,557,000 for Fiscal 2011.  The increase is primarily due to compensation related costs incurred in Fiscal 2012 but not incurred in the Fiscal 2011 period, in addition to increased internal research and development activities partially offset by a decrease in costs related to biostudies as a result of the timing of milestone achievements for costs of products in development.  The Company expenses all production costs as R&D until the drug is approved by the FDA.  R&D expenses may fluctuate from period to period, based on R&D plans for submission to the FDA.

 

Selling, general and administrative (“SG&A”) expenses in the first nine months increased 26% to $14,780,000 in Fiscal 2012 from $11,755,000 in Fiscal 2011.  The increase is primarily due to compensation related costs incurred in Fiscal 2012 but not incurred in the Fiscal 2011 period, in addition to an increase in outsourced sales and marketing expenses.  Fiscal 2011 includes the reversal of the remaining Fiscal 2010 accrued bonuses totaling $1,391,000, of which $1,010,000 was included in SG&A.  While the Company is focused on controlling costs, increases in personnel costs may have an ongoing and longer lasting impact on the administrative cost structure.  Other costs are being incurred to facilitate improvements in the Company’s infrastructure.  These costs are expected to be temporary investments in the future of the Company and may not continue at the same level.

 

Interest expense in the first nine months of Fiscal 2012 totaling $213,000 remained relatively flat compared to $175,000 in Fiscal 2011.  Interest and dividend income in the first nine months increased to $117,000 in Fiscal 2012 from $40,000 in Fiscal 2011 due to higher dividends earned on larger investment securities balances.  The Company recorded gains on trading investment securities during the first nine months of Fiscal 2012 totaling $169,000, of which $46,000 was unrealized losses and $215,000 was realized gains.

 

The Company recorded income tax expense in the first nine months of 2012 of $1,788,000 compared to income tax expense of $555,000 in the first nine months of Fiscal 2011. The effective tax rate for the nine months ended March 31, 2012 was 41%, compared to 26% for the nine months ended March 31, 2011.  The effective tax rate for the nine months ended March 31, 2012 includes the impact of nondeductible incentive stock option compensation expenses relative to the expected pretax income for Fiscal 2012 partially offset by the impact of income tax credits.  The effective tax rate for the nine months ended March 31, 2012 was higher than the effective rate compared to the nine months ended March 31, 2011 due primarily to the impact in Fiscal 2011 of income tax credits and the reversal of a portion of our liability for unrecognized tax benefits totaling $263,793 related to a settlement with the IRS recorded in the prior year period ended December 31, 2010, partially offset by the impact of nondeductible incentive stock option compensation expenses relative to the expected pretax income for Fiscal 2011.  The Company expects its overall effective tax rate will be approximately 40% to 42% for the full year ended June 30, 2012.

 

The Company reported a net income attributable to Lannett of approximately $2,533,000 in the first nine months of Fiscal 2012, or $0.09 basic and diluted earnings per share, as compared to net income attributable to Lannett of approximately $1,588,000 in the first nine months of Fiscal 2011, or $0.06 basic and diluted earnings per share.

 

Liquidity and Capital Resources

 

The Company has historically financed its operations with cash flow generated from operations, supplemented with borrowings from various government agencies and financial institutions.  At March 31, 2012, working capital was $64,462,000 as compared to $59,282,000 at June 30, 2011, an increase of $5,180,000.

 

Net cash provided by operating activities of $4,671,000 in the first nine months of Fiscal 2012 reflected net income of $2,586,000, after adjusting for non-cash items of $7,074,000, as well as cash used by changes in operating assets and liabilities of $4,989,000  Significant changes in operating assets and liabilities are comprised of:

 

33



 

·

An increase in trade accounts receivable of $4,035,000 primarily as a result of increased sales at the end of the third quarter of Fiscal 2012 compared to the fourth quarter of Fiscal 2011.

·

An increase in inventories of $1,073,000 primarily due to the timing of fulfillment of customer orders, inventory on hand related to new product approvals and additional quota received from the DEA for controlled substances.

·

An increase in prepaid expenses and other current assets of $559,000 primarily related to annual filings fees paid to the FDA as well as insurance premium renewals.

·

A decrease in accounts payable of $2,624,000 due to the timing of payments at the end of the quarter.

·

An increase in rebates, chargebacks and returns payable of $1,830,000 primarily due to an increase in rebate reserves as a result of increased sales, the timing of credits taken, as well as an additional rebate program the Company became obligated under Medicare Part D, and an increase in chargeback reserves due primarily to an increase in inventory levels at wholesaler distribution centers.

·

An increase in accrued payroll and payroll related costs of $1,225,000 primarily related to accrued incentive related costs in Fiscal 2012.

 

Net cash provided by investing activities of $9,798,000 for the nine months ended March 31, 2012 is mainly the result of proceeds of $32,639,000 from the sale of investment securities partially offset by purchases of investment securities of $18,662,000 and purchases of property, plant and equipment of $4,186,000.

 

Net cash used in financing activities of $715,000 for the nine months ended March 31, 2012 was primarily due to the purchase of shares of treasury stock, pursuant to the Company’s share repurchase program, totaling $479,000, partially offset by proceeds from the issuance of stock related to employee stock plans of $191,000.  Additional financing activities included scheduled debt repayments of $400,000.

 

Long-term debt amounts due, for the twelve month periods ended March 31 are as follows:

 

 

Twelve Month
Periods

 

Amounts Payable to
Institutions

 

 

 

2013

 

$

639,591

2014

 

515,851

2015

 

527,797

2016

 

540,255

2017

 

553,219

Thereafter

 

4,644,740

 

 

 

 

 

$

7,421,453

 

The Company has a $3,000,000 line of credit from Wells Fargo Bank, N.A. (“Wells Fargo”) that was scheduled to expire on March 31, 2012.  The line of credit was renewed and extended until April 30, 2013 and bears interest of 1-month LIBOR Market Index Rate plus 2.00% (2.24% at March 31, 2012).  Availability under the line of credit is reduced by outstanding letters of credit totaling $5,000 at March 31, 2012 and June 30, 2011.  As of March 31, 2012 and June 30, 2011, the Company had $2,995,000 of availability under the line of credit.  The availability fee on the unused balance of the line of credit is 0.375%.  The line of credit is collateralized by the working capital assets of the Company.  As of March 31, 2012, the Company was in compliance with the financial covenants under the agreement.

 

The Company borrowed $1,250,000 through the Pennsylvania Industrial Development Authority (“PIDA”).  The Company is required to make equal payments each month for 180 months starting February 1, 2006 with interest of 2.75% percent per annum.  The PIDA Loan has $797,333 outstanding as of March 31, 2012 with $80,877 currently due.

 

In April 1999, the Company entered into a loan agreement with the Philadelphia Authority for Industrial Development (the “Authority” or “PAID”), 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

 

34



 

used to pay for bond issuance costs of approximately $170,000.  The Trust Indenture requires that the Company repay the Authority loan through installment payments beginning in May 2003 and continuing through May 2014, the year the bonds mature. The bonds bear interest at the floating variable rate determined by the organization responsible for selling the bonds (the “remarketing agent”).  The interest rate fluctuates on a weekly basis.  The effective interest rate at March 31, 2012 and June 30, 2011 was 0.40% and 0.40%, respectively.  At March 31, 2012, the Company has $425,000 outstanding on the Authority loan, of which $135,000 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 Wells Fargo.  This letter of credit is renewed annually to secure payment of the outstanding Authority loan balance and a portion of the related accrued interest.  At March 31, 2012, no portion of the letter of credit has been utilized.

 

The Company negotiated a set of mortgages on its Townsend Road facility with both Wells Fargo and PIDA.  The Wells Fargo portion of the loan is for $3,056,000, bears a floating interest rate of the One Month LIBOR rate plus 2.95%, amortizes the loan over a 15 year term and has an 8 year maturity date.  The effective interest rate at March 31, 2012 and June 30, 2011 was 3.19% and 3.14%, respectively.  The PIDA portion of the loan is for $2,000,000, bears an interest rate 3.75% and matures in 15 years.  Both loans closed and were funded in May 2011.  At March 31, 2012, the Company has $2,869,245 outstanding on the Wells Fargo portion of the loan, of which $203,733 is classified as currently due. The PIDA Loan has $1,924,410 outstanding as of March 31, 2012 with $104,283 currently due. As of March 31, 2012, the Company was in compliance with the financial covenants under the agreements.

 

The Company has executed Security Agreements with Wells Fargo, PIDA and PIDC in which the Company has agreed to pledge its working capital, some equipment and its Townsend Road property to collateralize the amounts due.

 

The Company consolidates Cody LCI Realty, LLC, a VIE, for which Cody Labs is the primary beneficiary.  See note 15 to our Consolidated Financial Statements for “Consolidation of Variable Interest Entities.”  A mortgage loan with First National Bank of Cody related to the purchase of land and building by the VIE has also been consolidated in the Company’s consolidated balance sheets.  The mortgage requires monthly principal and interest payments of $14,782.  Effective February 2011, the interest rate was modified from a fixed rate of 7.5% to a floating rate with a floor of 4.5% and a ceiling of 9.0%, with payments to be made through April 2022.  As of March 31, 2012, $1,405,465 is outstanding under the mortgage loan, of which $115,698 is classified as currently due with a rate of 4.5%. The mortgage is collateralized by the land and building.

 

Prospects for the Future

 

Generic pharmaceutical manufacturers and distributors are constantly faced with pricing pressure in the marketplace as competitors attempt to lure business from distributors, wholesalers and chain retailers by offering lower prices than the incumbent supplier.  Lannett tries to differentiate itself in the marketplace by complementing its lower cost offerings with higher levels of customer service and quality of the products.  There continues to be an increasing number of competitors on our key products that are attempting to supplant Lannett as the preferred vendor.  Lannett will continue to evaluate each event as it arises, but any reductions in either volumes or pricing will have a negative impact on the gross profit margins of the Company.

 

Beginning in the first quarter of Fiscal 2011, Lannett faced significant pricing challenges on its top two selling products.  In order to keep the volume of business with the specific customers involved, Lannett chose to reduce its selling price on both of the products.  These price reductions will have a significant impact to the gross profit margins and profitability of Lannett expected in the future.

 

The Company has had difficulty marketing its Oxycodone HCL Solution product starting in the third quarter of Fiscal 2011 due to the current delay by the DEA to grant additional manufacturing quota to Cody Labs for its production.  This product contributed approximately $4.6 million in revenue in Fiscal 2011.  The loss of this product will have a significant impact to the gross profit margins and profitability of Lannett expected in the future.

 

The Company has several drug products under development.  These products are all orally-administered, topical, or parenteral 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 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 dormant on the Company’s records.  Occasionally, the Company reviews such ANDAs to determine if

 

35



 

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.  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.   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. Recently, the FDA has announced that it will prioritize its review of 3,800 Chemistry Manufacturing and Control (“CMC”) supplements in order to make progress on reviewing a backlog of over 2,200 ANDAs.  This could negatively impact the sales of existing products.

 

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 and can range from $100,000 to $1.7 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.

 

The Company anticipates that the demand for narcotics and controlled drugs will continue to grow with the “Baby Boomer” generation demographics and that it is well-positioned to take advantage of these opportunities by concentrating additional resources in the narcotic area. The sale of pain management products approximated 14% of Net Sales for the Fiscal 2011.  Due to the FDA’s actions against Morphine Sulfate Oral Solution and a slowdown in the demand for one other product that is manufactured at Cody, Lannett incurred a decrease in the percentage of sales related to pain management products during Fiscal 2011. Since the Company received the FDA approval for its 505(b)(2) New Drug Application for Morphine Sulfate Oral Solution in June 2011, the Company expects the portion of net sales related to pain management products to increase again.  The sale of pain management products approximated 17% of Net Sales for the first nine months of Fiscal 2012.

 

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, analytical method development and testing and manufacturing scale-up.  These products are orally-administered solid dosage products, topical, or parenterals intended to treat a diverse range of medical indications.  We intend to ultimately transfer the formulation technology and manufacturing process for most of these R&D products to our own commercial manufacturing sites.  The Company initiated these outsourced R&D efforts to complement the progress of its own internal R&D efforts.

 

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Occasionally, the Company will work on developing a drug product that does not require FDA approval.  Certain prescription drugs do not require prior FDA approval before marketing.  They include, for instance, drugs listed as DESI drugs (Drug Efficacy Study implementation) which are under evaluation by FDA, Grandfathered Drugs, and prescription multivitamin drugs. A generic manufacturer may sell products which are chemically equivalent to innovator drugs, under FDA rules by simply performing and internally documenting the normal research and development involved in bringing a new product to market.  Under this scenario, a generic company can forego the time required for FDA approval.

 

More specifically, certain products, marketed prior to the Federal Food, Drug and Cosmetic Act may be considered GRASE or Grandfathered.  GRASE products are those “old drugs that do not require prior approval from FDA in order to be marketed because they are generally recognized as safe and effective based on published scientific literature.”  Similarly, Grandfathered products are those which “entered the market before the passage of the 1938 act or the 1962 amendments to the act.”  Under the grandfather clause, such a product is exempted from the “effectiveness requirements [of the act] if its composition and labeling have not changed since 1962 and if, on the day before the 1962 amendments became effective, it was (1) used or sold commercially in the United States, (2) not a new drug as defined by the act at that time, and (3) not covered by an effective application.” Recently, the FDA has increased its efforts to force companies to file and seek FDA approval for these GRASE products.  Efforts have included granting market exclusivity to approved GRASE products and issuing notices to companies currently producing these products.

 

The Company has entered supply and development agreements with certain international companies, including Wintac of India, Orion Pharma of Finland, Azad Pharma AG and Swiss Caps of Switzerland, Pharma 2B (formerly Pharmaseed) of Israel and the GC Group, as well as certain domestic companies, including JSP, Banner Pharmacaps, Cerovene and Summit Bioscience LLC.  The Company is currently in negotiations on similar agreements with other international companies, through which Lannett will market and distribute products manufactured by Lannett or 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 are material in nature, nor is the Company substantially dependent on the services rendered by such outside firms.

 

Lannett may increase its focus on certain specialty markets in the generic pharmaceutical industry.  Such a focus is intended to provide Lannett customers with increased product alternatives in categories with relatively few market participants.  While there is no guarantee that Lannett has the market expertise or financial resources necessary to succeed in such a market specialty, management is confident that such future focus will be well received by Lannett customers and increase shareholder value in the long run.

 

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.  The Company plans to continue to explore such areas for potential opportunities to enhance shareholder value.

 

ITEM 3.                                       QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

The Company has debt instruments with variable interest rates.  The Company has a $3,000,000 line of credit from Wells Fargo that was scheduled to expire on March 31, 2012.  The line of credit was renewed and extended until April 30, 2013 and bears interest of 1-month LIBOR Market Index Rate plus 2.00% (2.24% at March 31, 2012).  Availability under the line of credit is reduced by outstanding letters of credit totaling $5,000 at March 31, 2012 and June 30, 2011.  As of March 31, 2012 and June 30, 2011, the Company had $2,995,000 of availability under the line of credit.  The availability fee on the unused balance of the line of credit is 0.375%.  The line of credit is collateralized by the working capital assets of the Company.  As of March 31, 2012, the Company was in compliance with the financial covenants under the agreement.

 

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The Company has negotiated a set of mortgages on its new Townsend Road facility with both Wells Fargo and PIDA.  The Wells Fargo portion of the loan is for $3,056,000, bears a floating interest rate of the One Month LIBOR rate plus 2.95%, amortizes the loan over a 15 year term and has an 8 year maturity date.  The effective interest rate at March 31, 2012 and June 30, 2011 was 3.19% and 3.14%, respectively.  At March 31, 2012, the Company has $2,869,245 outstanding on the loan, of which $203,733 is classified as currently due.

 

A mortgage loan with First National Bank of Cody related to the purchase of land and building by Cody LCI Realty, LLC, a variable interest entity, has also been consolidated in the Company’s consolidated balance sheets.  The mortgage requires monthly principal and interest payments of $14,782.  Effective February 2011, the interest rate was modified from a fixed rate of 7.5% to a floating rate with a floor of 4.5% and a ceiling of 9.0%, with payments to be made through April 2022.  As of March 31, 2012, $1,405,465 is outstanding under the mortgage loan with a rate of 4.5%.  The mortgage is collateralized by the land and building.

 

The Company invests in equity securities and marketable debt securities, which are exposed to market and interest rate fluctuations.  The interest and dividends earned on these investments may vary based on fluctuations in interest rate and market conditions.

 

ITEM 4.  CONTROLS AND PROCEDURES

 

 

Evaluation of Disclosure Controls and Procedures

 

As of the end of the period covered by this Form 10-Q, management performed, with the participation of our Chief Executive Officer and Chief Financial Officer, an evaluation of the effectiveness of our disclosure controls and procedures as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Our disclosure controls and procedures are designed to provide reasonable assurance that information required to be disclosed in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosures.

 

Based upon the evaluation, the Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures were effective as of the end of the period covered by this report.

 

Change in Internal Control Over Financial Reporting

 

There has been no change in the Company’s internal control over financial reporting during the three months ended March 31, 2012 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

PART II.  OTHER INFORMATION

 

 

ITEM 1.  LEGAL PROCEEDINGS

 

In January 2010, the Company initiated an arbitration proceeding against Olive Healthcare (“Olive”) for damages arising out of Olive’s delivery of defective soft-gel prenatal vitamin capsules.  The Company seeks damages in excess of $3.5 million. Olive has denied liability and filed a counterclaim in February 2010 for breach of contract.  The arbitration proceeding is in the discovery phase and is scheduled to be heard in June 2012.  Olive also filed a lawsuit against the Company in December 2010 in Daman, India seeking to enjoin the United States arbitration and claiming damages of approximately $6.8 million for compensatory damages and an additional approximately $6.8 million for loss of business.  The Company has engaged Indian counsel and is actively defending that suit.  On October 13, 2011 the Indian court dismissed the lawsuit brought by Olive.  Thereafter, Olive filed a Writ Petition with Bombay High Court seeking to reverse the decision of the court in Daman, India, which dismissed Olive’s lawsuit.  The Bombay High Court heard argument on the matter in January 2012.  On March 7, 2012, the Bombay High Court issued its ruling, affirming the

 

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decision of the court in Daman, India and dismissing the Olive lawsuit.  On or about April 2, 2012, Olive filed a Special Leave Petition with the Indian Supreme Court, challenging the ruling of the Bombay High Court.  The Indian Supreme Court has not yet taken up the matter.

 

Regulatory Proceedings

 

The Company is engaged in an industry which is subject to considerable government regulation relating to the development, manufacturing and marketing of pharmaceutical products.  Accordingly, incidental to its business, the Company periodically responds to inquiries or engages in administrative and judicial proceedings involving regulatory authorities, particularly the FDA and the Drug Enforcement Agency.

 

ITEM 6.  EXHIBITS

 

(a)                        A list of the exhibits required by Item 601 of Regulation S-K to be filed as a part of this Form 10-Q is shown on the Exhibit Index filed herewith.

 

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SIGNATURES

 

In accordance with the requirements of the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.

 

 

 

LANNETT COMPANY, INC.

 

 

 

 

 

Dated: May 9, 2012

By:

/s/ Arthur P. Bedrosian

 

 

 

Arthur P. Bedrosian

 

 

 

President and Chief Executive Officer

 

 

 

 

 

 

 

 

 

Dated: May 9, 2012

By:

/s/ Martin P. Galvan

 

 

 

Martin P. Galvan

 

 

 

Vice President of Finance and
Chief Financial Officer

 

 

 

 

 

 

 

 

 

Dated: May 9, 2012

By:

/s/ G. Michael Landis

 

 

 

G. Michael Landis

 

 

 

Director of Financial Reporting and Principal Accounting Officer

 

 

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Exhibit Index

 

 

31.1

 

Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

Filed Herewith

31.2

 

Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002

 

Filed Herewith

32

 

Certifications of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 

Filed Herewith

101

 

The following financial statements and notes from the Lannett Company, Inc. Quarterly Report on Form 10-Q for the quarter ended March 31, 2012 formatted in eXtensible Business Reporting Language (XBRL): (i) unaudited condensed consolidated balance sheets, (ii) unaudited condensed consolidated statements of operations, (iii) unaudited condensed consolidated statement of changes in shareholders’ equity, (iv) unaudited condensed consolidated statements of cash flows, and (v) the notes to the unaudited condensed consolidated financial statements.*

 

 

 

________________________

 

*   Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities Exchange Act of 1934, as amended, and otherwise are not subject to liability under those

 

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