LANNETT CO INC - Quarter Report: 2013 September (Form 10-Q)

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UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

 

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2013

 

 

FOR THE TRANSITION PERIOD FROM                  TO                 

 

Commission File No. 001-31298

 

LANNETT COMPANY, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

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 o

 

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 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):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12B-12 of the Exchange Act).  Yes x No o

 

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 October 31, 2013
Common stock, par value $0.001 per share		34,772,490

 

 

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Table of Contents

 

			Page No.
PART I. FINANCIAL INFORMATION
	ITEM 1.	FINANCIAL STATEMENTS
		Consolidated Balance Sheets as of September 30, 2013 (unaudited) and June 30, 2013	3
		Consolidated Statements of Operations (unaudited) for the three months ended September 30, 2013 and 2012	4
		Consolidated Statements of Comprehensive Income (unaudited) for the three months ended September 30, 2013 and 2012	5
		Consolidated Statements of Changes in Stockholders’ Equity (unaudited) for the three months ended September 30, 2013	6
		Consolidated Statements of Cash Flows (unaudited) for the three months ended September 30, 2013 and 2012	7
		Notes to Consolidated Financial Statements (unaudited)	8
	ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	23
	ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	34
	ITEM 4.	CONTROLS AND PROCEDURES	34
PART II. OTHER INFORMATION
	ITEM 1.	LEGAL PROCEEDINGS	35
	ITEM 1A.	RISK FACTORS	35
	ITEM 6.	EXHIBITS	35

 

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PART I.  FINANCIAL INFORMATION

 

ITEM 1.  FINANCIAL STATEMENTS

 

LANNETT COMPANY, INC.

CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

 

		(Unaudited)
		September 30, 2013			June 30, 2013
ASSETS
Current assets:
Cash and cash equivalents		$	35,727		$	42,689
Investment securities		10,072			8,461
Accounts receivable, net		29,749			26,413
Inventories, net		34,524			32,531
Income taxes receivable		3,167			—
Deferred tax assets		6,346			4,874
Other current assets		2,823			1,161
Total current assets		122,408			116,129
Property, plant and equipment, net		40,954			40,141
Intangible assets, net		1,881			2,547
Deferred tax assets		9,561			8,005
Other assets		315			930
TOTAL ASSETS		$	175,119		$	167,752
LIABILITIES
Current liabilities:
Accounts payable		$	16,636		$	22,668
Accrued expenses		3,936			2,697
Accrued payroll and payroll related		3,054			6,910
Income taxes payable		—			154
Current portion of long-term debt		673			670
Total current liabilities		24,299			33,099
Long-term debt, less current portion		5,714			5,844
TOTAL LIABILITIES		30,013			38,943
Commitment and Contingencies (Note 13 and 14)
STOCKHOLDERS’ EQUITY
Common stock ($0.001 par value, 50,000,000 shares authorized; 30,958,403 and 29,284,592 shares issued; 30,522,490 and 28,848,679 shares outstanding at September 30, 2013 and June 30, 2013, respectively)		31			29
Additional paid-in capital		126,358			104,075
Retained earnings		20,558			26,553
Accumulated other comprehensive loss		(48		)	(47		)
Treasury stock (435,913 shares at September 30, 2013 and June 30, 2013)		(2,034		)	(2,034		)
Total Lannett Company, Inc. stockholders’ equity		144,865			128,576
Noncontrolling Interest		241			233
Total stockholders’ equity		145,106			128,809
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	175,119		$	167,752

 

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

 

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LANNETT COMPANY, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(UNAUDITED)

(In thousands, except share and per share data)

 

		Three Months Ended September 30,
		2013			2012
Net sales		$	45,829		$	35,294
Cost of sales		24,423			21,668
JSP contract renewal cost		20,100			—
Gross profit		1,306			13,626
Operating expenses:
Research and development		4,745			3,764
Selling, general, and administrative		7,179			6,171
Total operating expenses		11,924			9,935
Operating income (loss)		(10,618		)	3,691
Other income (expense):
Foreign currency gain		—			3
Gain (loss) on sale of assets		(62		)	70
Gain on investment securities		463			234
Litigation settlement		—			1,250
Interest and dividend income		46			35
Interest expense		(58		)	(63		)
Total other income		389			1,529
Net income (loss) before income tax		(10,229		)	5,220
Income tax expense (benefit)		(4,242		)	2,277
Net income (loss)		(5,987		)	2,943
Less: Net income attributable to noncontrolling interest		8			17
Net income (loss) attributable to Lannett Company, Inc.		$	(5,995	)	$	2,926
Earnings (loss) per common share attributable to Lannett Company, Inc.:
Basic		$	(0.20	)	$	0.10
Diluted		$	(0.20	)	$	0.10
Weighted average common shares outstanding:
Basic		29,586,237			28,278,514
Diluted		29,586,237			28,469,224

 

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

 

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LANNETT COMPANY, INC.

CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(UNAUDITED)

(In thousands)

 

		Three Months Ended September 30,
		2013			2012
Net income (loss)		$	(5,987	)	$	2,943
Other comprehensive income (loss), before tax:
Foreign currency translation gain (loss)		(1		)	41
Total other comprehensive income (loss), before tax		(1		)	41
Income tax related to items of other comprehensive income		—			—
Total other comprehensive income (loss), net of tax		(1		)	41
Comprehensive income (loss)		(5,988		)	2,984
Less: Total comprehensive income attributable to noncontrolling interest		8			17
Comprehensive income (loss) attributable to Lannett Company, Inc.		$	(5,996	)	$	2,967

 

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

 

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LANNETT COMPANY, INC.

CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(UNAUDITED)

(In thousands)

 

		Stockholders’ Equity Attributable to Lannett Company Inc.
													Accumulated						Stockholders’
		Common Stock					Additional						Other						Equity						Total
		Shares Issued		Amount			Paid-In Capital			Retained Earnings			Comprehensive Loss			Treasury Stock			Attributable to Lannett Co., Inc.			Noncontrolling Interest			Stockholders’ Equity
Balance, June 30, 2013		29,285		$	29		$	104,075		$	26,553		$	(47	)	$	(2,034	)	$	128,576		$	233		$	128,809
Shares issued in connection with share-based compensation plans		173		1			880			—			—			—			881			—			881
Share-based compensation		—		—			897			—			—			—			897			—			897
Shares issued in connection with the JSP contract renewal		1,500		1			20,099			—			—			—			20,100			—			20,100
Excess tax benefits on stock options exercised		—		—			407			—			—			—			407			—			407
Other comprehensive loss, net of income tax		—		—			—			—			(1		)	—			(1		)	—			(1		)
Net income (loss)		—		—			—			(5,995		)	—			—			(5,995		)	8			(5,987		)
Balance, September 30, 2013		30,958		$	31		$	126,358		$	20,558		$	(48	)	$	(2,034	)	$	144,865		$	241		$	145,106

 

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

 

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LANNETT COMPANY, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(UNAUDITED)

(In thousands)

 

		Three Months Ended September 30,
		2013			2012
OPERATING ACTIVITIES:
Net income (loss)		$	(5,987	)	$	2,943
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		1,573			1,549
Deferred income tax expense (benefit)		(3,028		)	135
Share-based compensation		897			656
Tax benefits on stock options exercised		(407		)	—
Loss (gain) on sale of assets		62			(70		)
Gain on investment securities		(463		)	(234		)
Gain on litigation settlement		—			(800		)
JSP contract renewal cost		20,100			—
Other noncash expenses		4			3
Changes in assets and liabilities which provided (used) cash:
Trade accounts receivable		(3,336		)	1,017
Inventories		(1,993		)	(542		)
Income taxes receivable / Income taxes payable		(2,914		)	3,799
Prepaid expenses and other assets		(854		)	(260		)
Accounts payable		(6,032		)	(5,349		)
Accrued expenses		1,239			793
Accrued payroll and payroll related		(3,856		)	(860		)
Net cash provided by (used in) operating activities		(4,995		)	2,780
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(2,018		)	(821		)
Proceeds from sale of property, plant and equipment		40			70
Proceeds from sale of investment securities		4,584			4,808
Purchase of investment securities		(5,733		)	(2,916		)
Net cash provided by (used in) investing activities		(3,127		)	1,141
FINANCING ACTIVITIES:
Repayments of debt		(127		)	(125		)
Proceeds from issuance of stock		881			296
Tax benefits on stock options exercised		407			—
Purchase of treasury stock		—			(334		)
Net cash provided by (used in) financing activities		1,161			(163		)
Effect on cash and cash equivalents of changes in foreign exchange rates		(1		)	41
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		(6,962		)	3,799
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		42,689			22,562
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	35,727		$	26,361
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid		$	57		$	76
Income taxes paid (refunded)		$	1,700		$	(1,657	)

 

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

 

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LANNETT COMPANY, INC.

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 months ended September 30, 2013 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2014.  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, 2013.

 

Note 2.  The Business And Nature of Operations

 

Lannett Company, Inc. (a Delaware corporation) and subsidiaries (the “Company” or “Lannett”) develop, manufacture, package, market, and distribute solid oral (tablets and capsules), extended release, topical, and oral solution finished dosage forms of drugs, that address a wide range of therapeutic areas.  The Company also manufactures active pharmaceutical ingredients through its Cody Laboratories, Inc. (“Cody Labs”) subsidiary, providing a vertical integration benefit.

 

The Company operates pharmaceutical manufacturing plants in Philadelphia, PA and Cody, WY.  Customers of the Company’s pharmaceutical products include generic pharmaceutical distributors, drug wholesalers, chain drug stores, private label distributors, mail-order pharmacies, other pharmaceutical manufacturers, managed care organizations, hospital buying groups, governmental entities and health maintenance organizations.

 

Note 3.  Summary of Significant Accounting Policies

 

Principles of consolidation

 

The Consolidated Financial Statements include the accounts of Lannett Company, Inc., and its wholly owned subsidiaries, as well as Cody LCI Realty, LLC (“Realty”), a variable interest entity (“VIE”) in which the Company has a 50% ownership interest.  See Note 12 “Consolidation of Variable Interest Entity” for more information.  Noncontrolling interest in Realty is recorded net of tax as net income attributable to the noncontrolling interest.  Additionally, all intercompany accounts and transactions have been eliminated.

 

Reclassifications

 

Certain prior year amounts have been reclassified to conform to the current year financial statement presentation, as follows:

 

In particular, the Company now presents substantially all of the revenue-related reserves for each net sales adjustment, previously presented as “Rebates, chargebacks and returns payable” in the current liabilities section of the Consolidated Balance Sheets, as a reduction of “Accounts Receivable” in the current assets section of the Consolidated Balance Sheets.  See Note 4 “Accounts Receivable” for additional information.

 

The Company also reclassified certain reserve balances related to rebate programs for Medicare Part D, Medicaid and certain sales allowances and other adjustments to indirect customers.  These amounts were previously presented in “Rebates, chargebacks and returns payable” in the current liabilities section of the Consolidated Balance Sheets.  They are now presented as “Accrued Expenses” in the current liabilities section of the Consolidated Balance Sheets.  See Note 3 “Summary of Significant Accounting Policies: Net Sales Adjustments” policy disclosure for additional information.

 

Use of estimates

 

The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period.  Significant estimates

 

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and assumptions are required in the determination of revenue recognition and sales discounts for estimated chargebacks, rebates, returns and other adjustments including a provision for the Company’s liability under the Medicare Part D program.  Additionally, significant estimates and assumptions are required when determining the fair value of long-lived and indefinite-lived assets, income taxes, contingencies, and share-based compensation.  Because of the inherent subjectivity and complexity involved in these estimates and assumptions, actual results could differ from those estimates.

 

Foreign currency translation

 

The Consolidated Financial Statements are presented in U.S. Dollars, the reporting currency of the Company.  The financial statements of the Company’s foreign subsidiary are maintained in local currency and translated into U.S. dollars at the end of each reporting period.  Assets and liabilities are translated at period-end exchange rates, while revenues and expenses are translated at average exchange rates during the period.  The adjustments resulting from the use of differing exchange rates are recorded as part of stockholders’ equity in accumulated comprehensive income (loss).  Gains and losses, which are not significant, resulting from transactions denominated in foreign currencies are recognized in the Consolidated Statements of Operations under Other income (expense).

 

Cash and cash equivalents

 

The Company considers all highly liquid investments with original maturity less than or equal to three months at the date of purchase to be cash and cash equivalents.  Cash and cash equivalents are stated at cost, which approximates fair value, and consist of bank deposits and certificates of deposit that are readily convertible into cash.  The Company maintains its cash deposits and cash equivalents at well-known, stable financial institutions.  Such amounts frequently exceed insured limits.

 

Investment securities

 

The Company’s investment securities consist solely of publicly traded equity securities which are classified as trading investments.  Investment securities are recorded at fair value based on quoted market prices from broker or dealer quotations or transparent pricing sources at each reporting date.  Gains and losses are included in the Consolidated Statements of Operations under Other income (expense).

 

Allowance for doubtful accounts

 

The Company continuously monitors collections and payments from its customers and maintains a provision for estimated credit losses.  The Company determines its allowance for doubtful accounts by considering a number of factors, including the length of time balances 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 are determined to be uncollectible.

 

Inventories

 

Inventories are stated at the lower of cost or market determined by the first-in, first-out method.  Inventories are regularly reviewed and provisions for excess and obsolete inventory are recorded based primarily on current inventory levels and estimated sales forecasts.  During the three months ended September 30, 2013 and 2012, the Company recorded provisions for excess and obsolete inventory of $692 thousand and $92 thousand, respectively.

 

Property, Plant and Equipment

 

Property, plant and equipment are stated at cost less accumulated depreciation.  Depreciation is computed on a straight-line basis over the assets’ estimated useful lives.  Depreciation expense for each of the three months ended September 30, 2013 and 2012 was $1.1 million.

 

Intangible Assets

 

Intangible assets are stated at cost less accumulated amortization.  Amortization is computed on a straight-line basis over the assets’ estimated useful lives, generally for periods ranging from 10 to 15 years.  The Company continually evaluates the reasonableness of the useful lives of these assets.  Indefinite-lived and definite-lived intangible assets are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of the asset may not be recoverable.  Costs to renew or extend the term of a recognized intangible asset are expensed as incurred.  The Company has one indefinite-lived intangible asset related to a product Abbreviated New Drug Application (“ANDA”), valued at $149 thousand.  Amortization on this indefinite-lived intangible will begin at such time as the Company begins shipping the product and determines a finite useful life.

 

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Segment Information — The Company operates one reportable segment, generic pharmaceuticals.  As such, the Company aggregates its financial information for all products.  The following table identifies the Company’s net sales by medical indication for the three months ended September 30, 2013 and 2012:

 

(In thousands)		Three Months Ended September 30,
Medical Indication		2013			2012
Antibiotic		$	3,375		$	1,689
Cardiovascular		4,524			7,100
Gallstone		1,366			1,578
Glaucoma		1,455			1,373
Gout		2,053			165
Migraine		2,715			1,249
Obesity		1,131			1,310
Pain Management		5,218			5,532
Thyroid Deficiency		20,027			13,637
Other		3,965			1,661
Total		$	45,829		$	35,294

 

Customer, Supplier and Product Concentration

 

The following table presents the percentage of total net sales, for the three months ended September 30, 2013 and 2012, for certain of the Company’s products, defined as generic products containing the same active ingredient or combination of ingredients, which accounted for at least 10% of net sales in either of those periods:

 

		2013		2012
Product 1		44	%	39	%
Product 2		6	%	10	%
Product 3		4	%	10	%

 

The following table presents the percentage of total net sales, for the three months ended September 30, 2013 and 2012, for certain of the Company’s customers which accounted for at least 10% of net sales in either of those periods:

 

		2013		2012
Customer A		16	%	17	%
Customer B		14	%	11	%
Customer C		11	%	10	%
Customer D		8	%	10	%

 

At September 30, 2013 and June 30, 2013, four customers accounted for 76% and 78% of the Company’s net accounts receivable balance, respectively.  Credit terms are offered to customers based on evaluations of the customers’ financial condition, and collateral is generally not required.

 

The Company’s primary finished goods inventory supplier is Jerome Stevens Pharmaceuticals, Inc. (“JSP”), in Bohemia, New York.  Purchases of finished goods inventory from JSP accounted for approximately 67% and 59% of the Company’s inventory purchases during the three months ended September 30, 2013 and 2012, respectively.  See Note 21 “Material Contracts with Suppliers” for more information.

 

Revenue Recognition

 

The Company recognizes revenue when 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.  The Company also considers all other relevant criteria specified in Securities and Exchange Commission Staff Accounting Bulletin No. 104, Topic No. 13, “Revenue Recognition”, in determining when to recognize revenue.

 

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Net Sales Adjustments

 

When revenue is recognized a simultaneous adjustment to revenue is made for chargebacks, rebates, returns, promotional adjustments, price adjustments known as shelf-stock adjustments, and other potential adjustments.  These provisions are primarily estimated based on historical experience, future expectations, contractual arrangements with wholesalers and indirect customers, and other factors known to management at the time of accrual.  Accruals for provisions are presented in the Consolidated Financial Statements as a reduction to gross sales with the corresponding reserve presented as a reduction to accounts receivable or in accrued expenses.  The reserves, presented as a reduction of accounts receivable, totaled $20.6 million and $17.5 million at September 30, 2013 and June 30, 2013, respectively.  Accrued expenses at September 30, 2013 and June 30, 2013 included $1.6 million and $1.0 million, respectively, for certain rebate programs, primarily related to Medicare Part D and Medicaid, and certain sales allowances and other adjustments paid to indirect customers.

 

Cost of Sales

 

Cost of sales includes all costs related to bringing products to their final selling destination, which includes direct and indirect costs, such as direct material, labor, and overhead expenses.  Additionally, cost of sales includes product royalties, depreciation, amortization of intangible assets, freight charges and other shipping and handling expenses.

 

Research and Development

 

Research and development costs are expensed as incurred, including all production costs until a drug candidate is approved by the FDA.  Research and Development expenses include costs associated with internal projects as well as costs associated with third-party research and development contracts.

 

Valuation of Long-Lived Assets

 

The Company’s long-lived assets primarily consist of property, plant and equipment as well as definite-lived intangible assets.  Long-lived assets are reviewed for impairment whenever events or changes in circumstances (“triggering events”) indicate that the carrying amount of the asset may not be recoverable.  If a triggering event is determined to have occurred the first step in the impairment test is to compare the asset’s carrying value to the future undiscounted cash flows expected to be generated by the asset.  If the carrying value exceeds the undiscounted cash flow of the asset then impairment exists.  An impairment loss is measured as the excess of the asset’s carrying value over its fair value, which in most cases is calculated using a discounted cash flow model.  Discounted cash flow models are highly reliant on various assumptions which are considered Level 3 inputs, including estimates of future cash flows (including long-term growth rates), discount rates, and the probability of achieving the estimated cash flows.

 

Contingencies

 

Loss contingencies, including litigation related contingencies, are included in the Consolidated Statements of Operations when the Company concludes that a loss is both probable and reasonably estimable.  Legal fees related to litigation related matters are expensed as incurred and included in the Consolidated Statements of Operations under the Selling, general and administrative line item.

 

Advertising Costs

 

The Company expenses advertising costs when incurred.  Advertising expense for the three months ended September 30, 2013 and 2012 was $1 thousand and $2 thousand, respectively.

 

Share-based Compensation

 

Share-based compensation costs are recognized over the vesting period, using a straight-line method, based on the fair value of the instrument on the date of grant less an estimate for forfeitures.  The Company uses the Black-Scholes valuation model to determine the fair value of stock options and the stock price on the grant date to value restricted stock.  The Black-Scholes valuation model includes various assumptions, including the expected volatility, the expected life of the award, dividend yield, and the risk-free interest rate.  These assumptions involve inherent uncertainties based on market conditions which are generally outside the Company’s control.  Changes in these assumptions could have a material impact on share-based compensation costs recognized in the financial statements.

 

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Income Taxes

 

The Company uses the asset and liability method to account for income taxes as prescribed by Accounting Standards Codification (“ASC”) 740, 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 is the result of changes in deferred tax assets and liabilities.  Deferred income tax assets and liabilities are adjusted to recognize the effects of changes in tax laws or enacted tax rates in the period during which they are signed into law.

 

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.  The authoritative standards issued by the Financial Accounting Standards Board (“FASB”) also provide guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.  The factors used to assess the likelihood of realization are the Company’s forecast of future taxable income and available tax planning strategies that could be implemented to realize the net deferred tax assets.  Under ASC 740, Income Taxes, a valuation allowance is required when it is more likely than not that all or some portion of the deferred tax assets will not be realized through generating sufficient future taxable income.  Failure to achieve forecasted taxable income in applicable tax jurisdictions could affect the ultimate realization of deferred tax assets and could result in an increase in the Company’s effective tax rate on future earnings.

 

Earnings Per Common Share

 

Basic earnings per common share is computed by dividing net income attributable to Lannett Company, Inc. common stockholders by the weighted average number of shares outstanding during the period.  Diluted earnings per common share is computed by dividing net income attributable to Lannett Company, Inc. common stockholders by the weighted average number of shares outstanding during the period including additional shares that would have been outstanding related to potentially dilutive securities; Anti-dilutive securities are excluded from the calculation.  These potentially dilutive securities primarily consist of stock options and unvested restricted stock.

 

Comprehensive Income (Loss)

 

Comprehensive income (loss) includes all changes in equity during a period except those that resulted from investments by or distributions to a company’s stockholders.  Other comprehensive income or loss refers to revenues, expenses, gains and losses that are included in comprehensive income (loss), but excluded from net income (loss) as these amounts are recorded directly as an adjustment to stockholders’ equity.

 

Recent Accounting Pronouncements

 

In February 2013, the FASB issued authoritative guidance which requires an entity to provide information about the amounts reclassified out of accumulated other comprehensive income by component.  In addition, an entity is required to present, either on the face of the statement where net income is presented or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income but only if the amount reclassified is required under U.S. GAAP to be reclassified to net income in its entirety in the same reporting period.  For other amounts not required under U.S. GAAP to be reclassified in their entirety to net income, an entity is required to cross-reference to other disclosures required under U.S. GAAP that provide additional detail about those amounts.  This authoritative guidance is effective for reporting periods beginning after December 15, 2012.  The adoption of this guidance by the Company did not have a significant impact on the Company’s consolidated financial statements.

 

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Note 4.  Accounts Receivable

 

Accounts receivable consisted of the following components at September 30, 2013 and June 30, 2013:

 

(In thousands)		September 30, 2013			June 30, 2013
Gross accounts receivable		$	50,355		$	43,923
Less: Chargebacks reserve		(8,780		)	(7,267		)
Less: Rebates reserve		(3,502		)	(2,513		)
Less: Returns reserve		(6,955		)	(6,689		)
Less: Other deductions		(1,318		)	(1,000		)
Less: Allowance for doubtful accounts		(51		)	(41		)
Accounts receivable, net		$	29,749		$	26,413

 

For the three months ended September 30, 2013 and 2012 the Company recorded a provision for chargebacks of $17.7 million and $19.0 million, respectively.  For the three months ended September 30, 2013 and 2012 the Company recorded a provision for rebates of $7.5 million and $5.8 million, respectively.  For the three months ended September 30, 2013 and 2012 the Company recorded a provision for returns of $1.2 million and $1.4 million, respectively.  For the three months ended September 30, 2013 and 2012 the Company recorded a provision for other deductions of $3.9 million and $2.4 million, respectively.

 

Note 5.  Inventories

 

Inventories, net of allowances, at September 30, 2013 and June 30, 2013 consisted of the following:

 

(In thousands)		September 30, 2013			June 30, 2013
Raw Materials		$	16,285		$	14,224
Work-in-process		2,545			3,122
Finished Goods		13,778			13,133
Packaging Supplies		1,916			2,052
Total		$	34,524		$	32,531

 

The reserve for excess and obsolete inventory was $2.1 million and $2.0 million at September 30, 2013 and June 30, 2013, respectively.

 

Note 6.  Property, Plant and Equipment

 

Property, plant and equipment at September 30, 2013 and June 30, 2013 consisted of the following:

 

(In thousands)		Useful Lives		September 30, 2013			June 30, 2013
Land		—		$	1,350		$	1,350
Building and improvements		10 - 39 years		32,844			32,992
Machinery and equipment		5 - 10 years		33,814			32,620
Furniture and fixtures		5 - 7 years		1,292			1,290
Construction in progress		—		3,744			2,892
Property, plant and equipment, at cost				73,044			71,144
Less accumulated depreciation				(32,090		)	(31,003		)
Property, plant and equipment, net				$	40,954		$	40,141

 

During each of the three months ended September 30, 2013 and 2012 the Company had no impairment charges.  Property, plant and equipment, net included amounts held in foreign countries in the amount of $1.2 million and $1.3 million at September 30, 2013 and June 30, 2013, respectively.

 

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Note 7.  Fair Value Measurements

 

The Company’s financial instruments recorded in the Consolidated Balance Sheets include cash and cash equivalents, accounts receivable, investment securities, accounts payable, accrued expenses, and debt obligations.  Included in cash and cash equivalents are certificates of deposit with maturities less than or equal to three months at the date of purchase and money market funds.  The carrying value of certain financial instruments, primarily cash and cash equivalents, accounts receivable, accounts payable, and accrued expenses approximate their estimated fair values based upon the short-term nature of their maturity dates.  The carrying amount of the Company’s debt obligations approximates fair value based on current rates available to the Company on similar debt obligations.

 

The Company follows the authoritative guidance of ASC Topic 820, which clarifies the definition of fair value, establishes a framework for measuring fair value, and expands disclosure requirements.  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.  Observable inputs reflect those inputs which market participants would use in pricing an asset or liability and are derived from independent market data.  Unobservable inputs reflect management’s own assumptions related to market data and the market data which market participants would use in pricing an asset or liability.  Unobservable inputs are developed based on the best information available to management at the measurement date.  The hierarchy includes three levels which are described below:

 

Level 1 — Quoted prices (unadjusted) in active markets for identical assets or liabilities that the reporting entity can access at the measurement date.

 

Level 2 — Directly or indirectly observable inputs, other than quoted 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.

 

Level 3 — Unobservable inputs that are supported by little or no market activity and that are material to the fair value of the asset or liability.  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 are examples of Level 3 assets and liabilities.

 

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 Company’s financial assets and liabilities measured at fair value on a recurring basis at September 30, 2013 and June 30, 2013, were as follows:

 

		September 30, 2013
(In thousands)		Level 1			Level 2			Level 3			Total
Assets
Investment securities		$	10,072		$	—		$	—		$	10,072
Total		$	10,072		$	—		$	—		$	10,072

 

		June 30, 2013
(In thousands)		Level 1			Level 2			Level 3			Total
Assets
Investment securities		$	8,461		$	—		$	—		$	8,461
Total		$	8,461		$	—		$	—		$	8,461

 

Note 8.  Investment Securities

 

The Company uses the specific identification method to determine the cost of securities sold, which consisted entirely of securities classified as trading.  The Company had a net gain on investment securities of $463 thousand during the three months ended September 30, 2013, which included an unrealized gain related to securities still held at September 30, 2013 of $367 thousand.  The Company had a net gain on investment securities of $234 thousand during the three months ended September 30, 2012, which included an unrealized gain related to securities still held at September 30, 2012 of $63 thousand.

 

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Note 9.  Intangible Assets

 

Intangible assets, net as of September 30, 2013 and June 30, 2013, consisted of the following:

 

		Gross Carrying Amount						Accumulated Amortization						Intangible Assets, Net
(In thousands)		September 30, 2013			June 30, 2013			September 30, 2013			June 30, 2013			September 30, 2013			June 30, 2013
JSP Marketing and Dist. Rights		$	16,062		$	16,062		$	(15,170	)	$	(14,723	)	$	892		$	1,339
Cody Labs Import License		582			582			(202		)	(193		)	380			389
Morphine Sulfate Oral Solution NDA		202			398			(57		)	(51		)	145			347
Other ANDA Product Rights (A)		600			600			(136		)	(128		)	464			472
		$	17,446		$	17,642		$	(15,565	)	$	(15,095	)	$	1,881		$	2,547

(A)  Amounts include the product line covered by the ANDA purchased in August 2009 for $149 thousand.  This ANDA is not being amortized at this time and will not be amortized until such time as the Company begins shipping the product.

 

For the three months ended September 30, 2013 and 2012, the Company incurred amortization expense of approximately $470 thousand and $471 thousand, respectively.  There were no impairments related to intangible assets during each of the three months ended September 30, 2013 and 2012.  On September 30, 2013, the Company received a letter from the FDA indicating that a portion of the nonrefundable Morphine Sulfate Oral Solution NDA fee, originally estimated at $398 thousand, would be refunded to the Company.  As a result of this letter the Company adjusted the carrying value of the Morphine Sulfate Oral Solution NDA intangible asset.  Future amortization will be adjusted prospectively.  Further adjustments to the Morphine Sulfate Oral Solution NDA intangible asset may be necessary in the future should the Company receive additional refunds.

 

Future annual amortization expense consisted of the following as of September 30, 2013:

 

(In thousands) Fiscal Year Ending June 30,		Annual Amortization Expense
2014		$	954
2015		82
2016		82
2017		82
2018		82
Thereafter		450
		$	1,732

 

The amounts above do not include the product line covered by the ANDA purchased in August 2009 for $149 thousand, as amortization will begin when the Company begins shipping the product.

 

Note 10.  Bank Line of Credit

 

As of June 30, 2013, the Company had a $3.0 million line of credit from Wells Fargo Bank, N.A. (“Wells Fargo”) which had $3.0 million of availability and an interest rate of 2.19%.  As of June 30, 2013, the Company was in compliance with the financial covenants under the agreement.  The line of credit expired on July 31, 2013.

 

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Note 11.  Long-Term Debt

 

Long-term debt consisted of the following:

 

		September 30,			June 30,
(In thousands)		2013			2013
Pennsylvania Industrial Development Authority loan		$	675		$	696
Tax-exempt bond loan (PAID)		150			150
Wells Fargo N.A. Townsend Road mortgage		2,564			2,614
Pennsylvania Industrial Development Authority Townsend Road mortgage		1,767			1,794
First National Bank of Cody mortgage		1,231			1,260
Total debt		6,387			6,514
Less current portion		673			670
Long term debt		$	5,714		$	5,844

 

Current Portion of Long Term Debt:

 

		September 30,			June 30,
(In thousands)		2013			2013
Pennsylvania Industrial Development Authority loan		$	84		$	84
Tax-exempt bond loan (PAID)		150			150
Wells Fargo N.A. Townsend Road mortgage		204			204
Pennsylvania Industrial Development Authority Townsend Road mortgage		110			109
First National Bank of Cody mortgage		125			123
Total current portion of long term debt		$	673		$	670

 

The Company financed $1.3 million 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 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 $3.7 million 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 $170 thousand.  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 interest rate fluctuates on a weekly basis.  The effective interest rate at September 30, 2013 and June 30, 2013 was 0.27% and 0.26%, respectively.

 

The Company negotiated a set of mortgages on its Townsend Road facility with both Wells Fargo and the PIDA.  The Wells Fargo portion of the loan is for $3.1 million, 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 September 30, 2013 and June 30, 2013 was 3.13% and 3.14%, respectively.  The PIDA portion of the loan is for $2.0 million, bears an interest rate of 3.75% and matures in 15 years.  Both loans closed and were funded in May 2011.  As of September 30, 2013 and June 30, 2013, the Company was in compliance with the financial covenants under the agreements.

 

The Company has executed Security Agreements with Wells Fargo, PIDA and Philadelphia Industrial Development Corporation (“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 Realty.  See Note 12 “Consolidation of Variable Interest Entity” for additional description.  The VIE owns land and a building which is leased to Cody Labs.  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 $15 thousand.  Effective February 2011, the interest rate was modified from a fixed rate of 7.5% to a floating rate based on the New York Prime Rate with a floor of 4.5% and a ceiling of 9.0%, with payments to be made through April 2022.  As of September 30, 2013 and June 30, 2013, the effective rate was 4.5%.  The mortgage is collateralized by the land and building.

 

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Long-term debt amounts due for the twelve month periods ending September 30 were as follows:

 

		Amounts Payable
(In thousands)		to Institutions
2014		$	673
2015		536
2016		548
2017		562
2018		575
Thereafter		3,493
Total		$	6,387

 

Note 12.  Consolidation of Variable Interest Entity

 

The Company consolidates any VIE for which it is the primary beneficiary.  The liabilities recognized as a result of consolidating a VIE do not represent additional claims on the Company’s 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 each of the September 30, 2013 and June 30, 2013 Consolidated Balance Sheets are consolidated VIE assets of approximately $1.7 million, which are comprised mainly of land and a building.  VIE liabilities consist primarily of a mortgage on that property in the amount of $1.2 million and $1.3 million at September 30, 2013 and June 30, 2013, respectively.  Cody Labs leases the building and property from Realty for $20 thousand per month.  All intercompany rent expense is eliminated in the Consolidated Financial Statements.

 

Realty is the only VIE that is consolidated.  Realty had been consolidated by Cody Labs prior to its acquisition by the Company.  Realty is a 50/50 joint venture with a former officer of Cody Labs.  Its purpose was to acquire the facility used by Cody Labs.  Until the acquisition of Cody in April 2007, the Company had not consolidated the VIE because Cody Labs had been the primary beneficiary of the VIE.  Risk associated with our interest 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 the Company’s 50% ownership share.

 

Note 13.  Contingencies

 

On April 16, 2013, Richard Asherman, the former President of Cody and a member in Realty, filed a complaint in Wyoming state court against the Company and Cody.  At the same time, he also filed an application for a temporary restraining order to enjoin certain operations at Cody, claiming, among other things, that Cody is in violation of certain zoning laws and that Cody is required to increase the level of its property insurance and to secure performance bonds for work being performed at Cody.  Mr. Asherman claims Cody is in breach of his employment agreement and is required to pay him severance under his employment agreement, including 18 months of base salary, vesting of unvested stock options and continuation of benefits.  The Company estimates that the aggregate value of the claimed severance benefits is approximately $350 thousand to $400 thousand.  Mr. Asherman also asserts that the Company is in breach of the Realty Operating Agreement and, among other requested remedies, he seeks to have Lannett (i) pay him 50% of the value of 1.66 acres of land that Realty agreed to donate to the city of Cody, Wyoming, which land was previously valued at approximately $380 thousand, and (ii) acquire Mr. Asherman’s interest in Realty for an unspecified price.  Alternatively, Mr. Asherman seeks to dissolve Realty.

 

The Company and Cody opposed the application for a temporary restraining order and, following a hearing on April 18, 2013, the Court denied the relief to Mr. Asherman.  The Company strongly disputes the claims in the complaint, including that the Company is required to acquire Mr. Asherman’s interest in Realty.  Specifically, the Company asserts that it is and has always been in compliance with local zoning laws, which permits the operation of a pharmaceutical facility, that Mr. Asherman, in fact, previously represented this to Lannett.  It also asserts that the City of Cody has never taken the position or advised Cody that the Cody facility was operating in violation of the local zoning laws.  The Company also asserts that Cody has in place a sufficient level of property insurance coverage.  Cody also strongly disputes the claims in the complaint, including that it is required to pay Mr. Asherman severance, as Cody terminated Mr. Asherman for cause, following the issuance of a letter of reprimand.  If Mr. Asherman were successful on his claim for breach of his employment agreement, he would be entitled to his contractual severance — 18 months’ salary plus the vesting of certain stock options and continuation of benefits.  The amount the Company would be required to pay to Mr. Asherman if he were successful in compelling the buyout of his interest in Realty is dependent upon the value of the real property owned by Realty.  If a buyout were required, Realty would become wholly owned by the Company.  At this time the Company is unable to reasonably estimate a range or aggregate dollar amount of Mr. Asherman’s claims or of any potential loss to the Company.  The Company does not believe that the ultimate resolution of the matter will have a significant impact on the Company’s financial position or results of operations.

 

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Note 14.  Commitments

 

Leases

 

The Company’s subsidiary, Cody Labs, leases a 73,000 square foot facility in Cody, Wyoming.  This location houses Cody Lab’s manufacturing and production facilities.  Cody Labs leases the facility from Realty, a Wyoming limited liability company which is 50% owned by the Company.  See Note 12 “Consolidation of Variable Interest Entity.”

 

Rental and lease expense for the three months ended September 30, 2013 and 2012 was approximately $21 thousand and $24 thousand, respectively.

 

Note 15.  Accumulated Other Comprehensive Loss

 

The Company’s Accumulated Other Comprehensive Loss was comprised of the following components as of September 30, 2013 and 2012:

 

(In thousands)		September 30, 2013			September 30, 2012
Foreign Currency Translation
Beginning Balance, July 1		$	(47	)	$	(63	)
Net gain (loss) on foreign currency translation (net of tax of $0 and $0)		(1		)	41
Reclassifications to net income (net of tax of $0 and $0)		—			—
Other comprehensive income (loss), net of tax		(1		)	41
Ending Balance, September 30		(48		)	(22		)
Total Accumulated Other Comprehensive Loss		$	(48	)	$	(22	)

 

Note 16.  Earnings (Loss) Per Common Share

 

A dual presentation of basic and diluted earnings per common 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 common share to diluted earnings per common share. Basic earnings per common share excludes the dilutive impact of potentially dilutive securities and is computed by dividing net income by the weighted average number of common shares outstanding for the period. Diluted earnings per common share includes the effect of potential dilution from the exercise of outstanding stock options and unvested restricted stock. Potentially dilutive securities have been excluded in the weighted average number of common 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 per common share was as follows:

 

		Three Months Ended September 30, 2013
(In thousands, except share and per share data)		2013			2012
Net Income (Loss) Attributable to Lannett Company, Inc.		$	(5,995	)	$	2,926
Basic weighted average common shares outstanding		29,586,237			28,278,514
Effect of potentially dilutive options and restricted stock awards		—			190,710
Diluted weighted average common shares outstanding		29,586,237			28,469,224
Earnings (loss) per common share attributable to Lannett Company, Inc.:
Basic		$	(0.20	)	$	0.10
Diluted		$	(0.20	)	$	0.10

 

The number of anti-dilutive shares that have been excluded in the computation of diluted earnings per share for the three months ended September 30, 2013 and 2012 were 3.0 million and 2.0 million, respectively.

 

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