LANNETT CO INC - Quarter Report: 2014 September (Form 10-Q)

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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 SEPTEMBER 30, 2014

 

o         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 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):

 

Large accelerated filer x		Accelerated filer o
Non-accelerated filer o		Smaller reporting company o
(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12B-12 of the Exchange Act).  Yes o 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 October 31, 2014
Common stock, par value $0.001 per share		35,757,847

 

 

Table of Contents

 

Table of Contents

 

				Page No.
PART I. FINANCIAL INFORMATION
	ITEM 1.		FINANCIAL STATEMENTS
			Consolidated Balance Sheets as of September 30, 2014 (unaudited) and June 30, 2014	3
			Consolidated Statements of Operations (unaudited) for the three months ended September 30, 2014 and 2013	4
			Consolidated Statements of Comprehensive Income (unaudited) for the three months ended September 30, 2014 and 2013	5
			Consolidated Statements of Changes in Stockholders’ Equity (unaudited) for the three months ended September 30, 2014	6
			Consolidated Statements of Cash Flows (unaudited) for the three months ended September 30, 2014 and 2013	7
			Notes to Consolidated Financial Statements (unaudited)	8
	ITEM 2.		MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	22
	ITEM 3.		QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	32
	ITEM 4.		CONTROLS AND PROCEDURES	32
PART II. OTHER INFORMATION
	ITEM 1.		LEGAL PROCEEDINGS	33
	ITEM 1A.		RISK FACTORS	33
	ITEM 6.		EXHIBITS	33

 

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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, 2014			June 30, 2014
ASSETS
Current assets:
Cash and cash equivalents		$	137,395		$	105,587
Investment securities		14,929			40,693
Accounts receivable, net		75,835			61,325
Inventories, net		44,070			44,844
Deferred tax assets		12,220			11,265
Other current assets		3,342			1,833
Total current assets		287,791			265,547
Property, plant and equipment, net		69,736			61,704
Intangible assets, net		1,207			927
Deferred tax assets		14,949			14,234
Other assets		340			361
TOTAL ASSETS		$	374,023		$	342,773
LIABILITIES
Current liabilities:
Accounts payable		$	13,959		$	20,982
Accrued expenses		2,578			3,901
Accrued payroll and payroll-related expenses		3,863			12,860
Rebates payable		6,152			4,558
Income taxes payable		13,735			4,569
Current portion of long-term debt		131			129
Total current liabilities		40,418			46,999
Long-term debt, less current portion		975			1,009
TOTAL LIABILITIES		41,393			48,008
Commitments and Contingencies (Note 13)
STOCKHOLDERS’ EQUITY
Common stock ($0.001 par value, 100,000,000 shares authorized; 36,171,478 and 36,088,272 shares issued; 35,654,486 and 35,571,280 shares outstanding at September 30, 2014 and June 30, 2014, respectively)		36			36
Additional paid-in capital		219,708			216,793
Retained earnings		118,586			83,654
Accumulated other comprehensive loss		(54		)	(54		)
Treasury stock (516,992 shares at September 30, 2014 and June 30, 2014)		(5,959		)	(5,959		)
Total Lannett Company, Inc. stockholders’ equity		332,317			294,470
Noncontrolling Interest		313			295
Total stockholders’ equity		332,630			294,765
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	374,023		$	342,773

 

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,
		2014			2013
Net sales		$	93,387		$	45,829
Cost of sales		21,820			24,423
JSP contract renewal cost		—			20,100
Gross profit		71,567			1,306
Operating expenses:
Research and development		6,363			4,745
Selling, general, and administrative		10,553			7,179
Total operating expenses		16,916			11,924
Operating income (loss)		54,651			(10,618		)
Other income (expense):
Gain (loss) on sale of assets		20			(62		)
Gain on investment securities		15			463
Interest and dividend income		102			46
Interest expense		(38		)	(58		)
Total other income		99			389
Income (loss) before income tax		54,750			(10,229		)
Income tax expense (benefit)		19,800			(4,242		)
Net income (loss)		34,950			(5,987		)
Less: Net income attributable to noncontrolling interest		18			8
Net income (loss) attributable to Lannett Company, Inc.		$	34,932		$	(5,995	)
Earnings (loss) per common share attributable to Lannett Company, Inc.:
Basic		$	0.98		$	(0.20	)
Diluted		$	0.94		$	(0.20	)
Weighted average common shares outstanding:
Basic		35,597,931			29,586,237
Diluted		36,972,646			29,586,237

 

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,
		2014			2013
Net income (loss)		$	34,950		$	(5,987	)
Other comprehensive income (loss), before tax:
Foreign currency translation gain (loss)		—			(1		)
Total other comprehensive income (loss), before tax		—			(1		)
Income tax related to items of other comprehensive income		—			—
Total other comprehensive income (loss), net of tax		—			(1		)
Comprehensive income (loss)		34,950			(5,988		)
Less: Total comprehensive income attributable to noncontrolling interest		18			8
Comprehensive income (loss) attributable to Lannett Company, Inc.		$	34,932		$	(5,996	)

 

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.
		Common Stock					Additional						Accumulated Other						Stockholders’ Equity						Total
		Shares Issued		Amount			Paid-In Capital			Retained Earnings			Comprehensive Loss			Treasury Stock			Attributable to Lannett Co., Inc.			Noncontrolling Interest			Stockholders’ Equity
Balance, July 1, 2014		36,088		$	36		$	216,793		$	83,654		$	(54	)	$	(5,959	)	$	294,470		$	295		$	294,765
Shares issued in connection with share-based compensation plans		83		—			773			—			—			—			773			—			773
Share-based compensation		—		—			1,647			—			—			—			1,647			—			1,647
Excess tax benefits on share-based compensation awards		—		—			495			—			—			—			495			—			495
Net income		—		—			—			34,932			—			—			34,932			18			34,950
Balance, September 30, 2014		36,171		$	36		$	219,708		$	118,586		$	(54	)	$	(5,959	)	$	332,317		$	313		$	332,630

 

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,
		2014			2013
OPERATING ACTIVITIES:
Net income (loss)		$	34,950		$	(5,987	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		1,306			1,573
Deferred income tax benefit		(1,670		)	(3,028		)
Share-based compensation		1,647			897
Excess tax benefits on share-based compensation awards		(495		)	(407		)
Loss (gain) on sale of assets		(20		)	62
Gain on investment securities		(15		)	(463		)
JSP contract renewal cost		—			20,100
Other noncash expenses		21			4
Changes in assets and liabilities which provided (used) cash:
Trade accounts receivable		(14,510		)	(3,336		)
Inventories		774			(1,993		)
Income taxes payable/receivable		9,661			(2,914		)
Prepaid expenses and other assets		(1,509		)	(854		)
Rebates payable		1,594			596
Accounts payable		(7,023		)	(6,032		)
Accrued expenses		(1,323		)	643
Accrued payroll and payroll-related expenses		(8,997		)	(3,856		)
Net cash provided by (used in) operating activities		14,391			(4,995		)
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(9,374		)	(2,018		)
Proceeds from sale of property, plant and equipment		76			40
Purchases of intangible assets		(300		)	—
Proceeds from sale of investment securities		34,213			4,584
Purchase of investment securities		(8,434		)	(5,733		)
Net cash provided by (used in) investing activities		16,181			(3,127		)
FINANCING ACTIVITIES:
Repayments of debt		(32		)	(127		)
Proceeds from issuance of stock		773			881
Excess tax benefits on share-based compensation awards		495			407
Net cash provided by financing activities		1,236			1,161
Effect on cash and cash equivalents of changes in foreign exchange rates		—			(1		)
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS		31,808			(6,962		)
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		105,587			42,689
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	137,395		$	35,727
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid		$	25		$	57
Income taxes paid		$	11,809		$	1,700

 

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 (“U.S. GAAP”) for the 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, 2014 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2015.  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, 2014.

 

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.  Additionally, the Company distributes products under various distribution agreements, most notably the Jerome Stevens Distribution Agreement.

 

The Company operates pharmaceutical manufacturing plants in Philadelphia, Pennsylvania and Cody, Wyoming.  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.  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.

 

Use of estimates

 

The preparation of financial statements in conformity with U.S. 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 and assumptions are required in the determination of revenue recognition and sales deductions 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 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.

 

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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 resulting from transactions denominated in foreign currencies are recognized in the Consolidated Statements of Operations under Other income (expense).  Amounts recorded due to foreign currency fluctuations are immaterial to the consolidated financial statements.

 

Cash and cash equivalents

 

The Company considers all highly liquid investments with original maturities 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 of publicly traded equity securities and certificates of deposit with original maturities greater than three months 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.

 

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 the three months ended September 30, 2014 and 2013 was $1.3 million and $1.1 million, respectively.

 

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.  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 several indefinite-lived intangible assets related to product Abbreviated New Drug Applications (“ANDAs”), valued at $449 thousand.  Amortization on these indefinite-lived intangibles will begin at such time as the Company begins shipping the products 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, 2014 and 2013:

 

(In thousands)		Three Months Ended September 30,
Medical Indication		2014			2013
Antibiotic		$	3,003		$	3,375
Cardiovascular		18,939			4,524
Gallstone		11,761			1,366
Glaucoma		4,691			1,455
Gout		2,299			2,053
Migraine		5,795			2,715
Obesity		915			1,131
Pain Management		6,655			5,218
Thyroid Deficiency		33,346			20,027
Other		5,983			3,965
Total		$	93,387		$	45,829

 

Customer, Supplier and Product Concentration

 

The following table presents the percentage of total net sales, for the three months ended September 30, 2014 and 2013, for certain of the Company’s products, defined as products containing the same active ingredient or combination of ingredients, which accounted for at least 10% of net sales in any of those periods:

 

		2014		2013
Product 1		36	%	44	%
Product 2		19	%	6	%
Product 3		13	%	3	%

 

The following table presents the percentage of total net sales, for the three months ended September 30, 2014 and 2013, for certain of the Company’s customers which accounted for at least 10% of net sales in any of those periods:

 

		2014		2013
Customer A		31	%	14	%
Customer B		9	%	11	%
Customer C		0	%	16	%

 

As shown above, customer concentration was impacted by the strategic partnership between Amerisource Bergen and Walgreens, whereby Amerisource Bergen began product distribution on behalf of Walgreens in third quarter of Fiscal Year 2014.

 

At September 30, 2014 and June 30, 2014, four customers accounted for 83% and 67% 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% of the Company’s inventory purchases during the three months ended September 30, 2014 and 2013.  See Note 20 “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 gross sales is made for chargebacks, rebates, returns, promotional 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 of accounts receivable or included as rebates payable, depending on the nature of the reserve.  The reserves, presented as a reduction of accounts receivable, totaled $57.4 million and $51.9 million at September 30, 2014 and June 30, 2014, respectively.  Rebates payable at September 30, 2014 and June 30, 2014 included $6.2 million and $4.6 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 and costs to renew or extend recognized 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.

 

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.

 

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 expense (benefit) is the result of changes in deferred tax assets and liabilities.  Deferred income tax assets and

 

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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 attributable to Lannett Company, Inc. 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 attributable to Lannett Company, Inc. 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 the Company’s stockholders.  Other comprehensive income (loss) refers to revenues, expenses, gains and losses that are included in comprehensive income (loss), but excluded from net income as these amounts are recorded directly as an adjustment to stockholders’ equity.

 

Recent Accounting Pronouncements

 

In May 2014, the FASB issued authoritative guidance on revenue recognition.  The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services.  The authoritative guidance is effective for annual reporting periods beginning after December 15, 2016.  Early application is not permitted.  The Company is currently in the process of assessing the impact this guidance will have on the consolidated financial statements.

 

Note 4.  Accounts Receivable

 

Accounts receivable consisted of the following components at September 30, 2014 and June 30, 2014:

 

(In thousands)		September 30, 2014			June 30, 2014
Gross accounts receivable		$	133,342		$	113,420
Less Chargebacks reserve		(32,778		)	(30,320		)
Less Rebates reserve		(10,963		)	(10,532		)
Less Returns reserve		(11,962		)	(9,341		)
Less Other deductions		(1,709		)	(1,787		)
Less Allowance for doubtful accounts		(95		)	(115		)
Accounts receivable, net		$	75,835		$	61,325

 

For the three months ended September 30, 2014, the Company recorded a provision for chargebacks, rebates (including rebates presented as rebates payable), returns, and other deductions of $77.9 million, $18.6 million, $4.1 million, and $9.0 million, respectively.  For the three months ended September 30, 2013, the Company recorded a provision for chargebacks, rebates (including rebates presented as rebates payable), returns, and other deductions of $17.7 million, $7.5 million, $1.2 million, and $3.9 million, respectively.

 

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Note 5.  Inventories

 

Inventories, net of allowances, at September 30, 2014 and June 30, 2014 consisted of the following:

 

(In thousands)		September 30, 2014			June 30, 2014
Raw Materials		$	19,039		$	19,767
Work-in-process		5,852			5,440
Finished Goods		17,192			17,592
Packaging Supplies		1,987			2,045
Total		$	44,070		$	44,844

 

The reserve for excess and obsolete inventory was $3.5 million and $2.4 million at September 30, 2014 and June 30, 2014, respectively.

 

Note 6.  Property, Plant and Equipment

 

Property, plant and equipment at September 30, 2014 and June 30, 2014 consisted of the following:

 

(In thousands)		Useful Lives		September 30, 2014			June 30, 2014
Land		—		$	4,641		$	4,641
Building and improvements		10 - 39 years		43,362			42,013
Machinery and equipment		5 - 10 years		39,918			37,678
Furniture and fixtures		5 - 7 years		1,451			1,416
Construction in progress		—		16,761			11,454
Property, plant and equipment, gross				106,133			97,202
Less accumulated depreciation				(36,397		)	(35,498		)
Property, plant and equipment, net				$	69,736		$	61,704

 

During the three months ended September 30, 2014 and 2013 the Company had no impairment charges.  Property, plant and equipment, net included amounts held in foreign countries in the amount of $1.5 million and $1.1 million at September 30, 2014 and June 30, 2014, respectively.

 

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 interest rates available to the Company on similar debt obligations.

 

The Company follows the authoritative guidance of ASC Topic 820 “Fair Value Measurements and Disclosures.”  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.  The Company’s financial assets and liabilities measured at fair value are entirely within Level 1 of the hierarchy as defined 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.

 

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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 at September 30, 2014 and June 30, 2014, were as follows:

 

		September 30, 2014
(In thousands)		Level 1			Level 2			Level 3			Total
Assets
Equity securities		$	14,929		$	—		$	—		$	14,929
Total Investment Securities		$	14,929		$	—		$	—		$	14,929

 

		June 30, 2014
(In thousands)		Level 1			Level 2			Level 3			Total
Assets
Equity securities		$	15,193		$	—		$	—		$	15,193
Certificates of Deposit		25,500			—			—			25,500
Total Investment Securities		$	40,693		$	—		$	—		$	40,693

 

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 $15 thousand during the three months ended September 30, 2014, which included an unrealized loss related to securities still held at September 30, 2014 of $81 thousand.

 

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.

 

Note 9.  Intangible Assets

 

Intangible assets, net as of September 30, 2014 and June 30, 2014, consisted of the following:

 

		Gross Carrying Amount						Accumulated Amortization						Intangible Assets, Net
(In thousands)		September 30, 2014			June 30, 2014			September 30, 2014			June 30, 2014			September 30, 2014			June 30, 2014
Cody Labs Import License		$	582		$	582		$	(241	)	$	(232	)	$	341		$	350
Morphine Sulfate Oral Solution NDA		202			202			(68		)	(65		)	134			137
Other ANDA Product Rights		900			600			(168		)	(160		)	732			440
		$	1,684		$	1,384		$	(477	)	$	(457	)	$	1,207		$	927

 

For the three months ended September 30, 2014 and 2013, the Company incurred amortization expense of approximately $20 thousand and $470 thousand, respectively.  There were no impairments related to intangible assets during each of the three months ended September 30, 2014 and 2013.

 

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Future annual amortization expense consisted of the following as of September 30, 2014:

 

(In thousands) Fiscal Year Ending June 30,		Annual Amortization Expense
2015		$	61
2016		82
2017		82
2018		82
2019		79
Thereafter		372
		$	758

 

The amounts above do not include the product line covered by the ANDA purchased in August 2009 for $149 thousand and ANDAs purchased in September 2014 for $300 thousand.  Amortization on these assets will begin when the Company begins shipping the product.

 

Note 10.  Bank Line of Credit

 

In December 2013, the Company entered into a credit agreement (the “Citibank Line of Credit”) with Citibank, N.A., as administrative agent, and another financial institution. The Citibank Line of Credit provides for a revolving loan commitment in the amount of up to $50.0 million.  Any loans under the Citibank Line of Credit will bear interest at either a “Eurodollar Rate” or a “Base Rate” plus a specified margin.  The Company is also required to pay a commitment fee on any undrawn commitments under the Citibank Line of Credit ranging from 0.2% - 0.3% per annum according to the average daily balance of borrowings under the agreement. The Citibank Line of Credit is collateralized by substantially all of the Company’s assets. In connection with securing the Citibank Line of Credit, the Company repaid substantially all of its outstanding debt. See Note 11 “Long-Term Debt” for more information. As of September 30, 2014 and June 30, 2014, the Company had $50.0 million available under the Citibank Line of Credit.

 

The Citibank Line of Credit contains representations and warranties, affirmative, negative and financial covenants, and events of default, applicable to the Company and its subsidiaries which are customary for credit facilities of this type. As of September 30, 2014 and June 30, 2014, the Company was in compliance with all financial covenants.

 

Note 11. Long-Term Debt

 

Long-term debt consisted of the following:

 

		September 30,			June 30,
(In thousands)		2014			2014
First National Bank of Cody mortgage		$	1,106		$	1,138
Less current portion		131			129
Long-term debt		$	975		$	1,009

 

Current Portion of Long-term Debt:

 

		September 30,			June 30,
(In thousands)		2014			2014
First National Bank of Cody mortgage		$	131		$	129

 

The Company is the primary beneficiary to a VIE called Realty.  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.  As of September 30, 2014 and June 30, 2014, the effective interest rate was 4.5%.  The mortgage is collateralized by the land and building with a net book value of $1.5 million.

 

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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
2015		$	131
2016		137
2017		143
2018		149
2019		156
Thereafter		390
Total		$	1,106

 

Note 12.  Legal and Regulatory Matters

 

Richard Asherman

 

On April 16, 2013, Richard Asherman (“Asherman”), the former President of and a member in Realty, filed a complaint (“Complaint”) in Wyoming state court against the Company and Cody Labs.  At the same time, he also filed an application for a temporary restraining order to enjoin certain operations at Cody Labs, claiming, among other things, that Cody Labs is in violation of certain zoning laws and that Cody Labs is required to increase the level of its property insurance and to secure performance bonds for work being performed at Cody Labs.  Mr. Asherman claims Cody Labs 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, plus the value of any stock options.  Mr. Asherman also asserts that the Company is in breach of the Realty Operating Agreement and, among other requested remedies, he seeks to have the Company (i) pay him 50% of the value of 1.66 acres of land that Realty previously agreed to donate to an economic development entity associated with the City of Cody, Wyoming, which contemplated transaction has since been avoided and cancelled.  Although Mr. Asherman originally sought to require that Lannett acquire his interest in Realty for an unspecified price and/or to dissolve Realty, those claims were recently dismissed.

 

The Company strongly disputes the claims in the Amended Complaint, including that the Company is required to acquire Mr. Asherman’s interest in Realty.  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, if any, 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.

 

Connecticut Attorney General Inquiry

 

In July 2014, the Company received interrogatories and subpoena from the State of Connecticut Office of the Attorney General concerning its investigation into pricing of digoxin.  According to the subpoena, the Connecticut Attorney General is investigating whether anyone engaged in any activities that resulted in (a) fixing, maintaining or controlling prices of digoxin or (b) allocating and dividing customers or territories relating to the sale of digoxin in violation of Connecticut antitrust law.  The Company maintains that it acted in compliance with all applicable laws and regulations and continues to cooperate with the Connecticut Attorney General’s investigation.

 

Federal Investigation into the Generic Pharmaceutical Industry

 

On November 3, 2014, the Senior Vice President of Sales and Marketing of the Company was served with a grand jury subpoena relating to a federal investigation of the generic pharmaceutical industry into possible violations of the Sherman Act.  The subpoena requests corporate documents of the Company relating to communications or correspondence with competitors regarding the sale of generic prescription medications, but is not specifically directed to any particular product and is not limited to any particular time period.  The Company maintains that it has acted in compliance with all applicable laws and regulations and intends to cooperate with the federal investigation.

 

Class Action - David Schaefer

 

On August 27, 2014, David Schaefer, as an alleged class representative, filed a class action complaint in the United States District Court, Eastern District of Pennsylvania (14-cv-05008) against the Company and certain of its officers, alleging violations of federal securities laws arising out of statements about the Company made in its securities filings during the period of September 10, 2013 through July 16, 2014.  The complaint alleges that the statements were false and misleading because the defendants allegedly knew at the time the statements were made that the Company was in violation of Connecticut antitrust laws relating to its sale of digoxin.  Mr. Schaefer’s complaint was voluntarily dismissed in September 2014.

 

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Patent Infringement (Paragraph IV Certification)

 

There is substantial litigation in the pharmaceutical industry with respect to the manufacture, use, and sale of new products which are the subject of conflicting patent and intellectual property claims.  Certain of these claims relate to paragraph IV certifications, which allege that an innovator patent is invalid or would not be infringed upon by the manufacture, use, or sale of the new drug.

 

Zomig®

 

The Company filed with the Food and Drug Administration an Abbreviated New Drug Application (ANDA) No. 206350, along with a paragraph IV certification, alleging that the two patents associated with the Zomig® nasal spray product (U.S. Patent No. 6,750,237 and U.S. Patent No. 67,220,767) are invalid.  In July 2014, AstraZeneca AB, AstraZeneca UK Limited, and Impax Laboratories, Inc. filed two patent infringement lawsuits in the United States District Court for the District of Delaware, alleging that the Company’s filing of ANDA No. 206350 constitutes an act of patent infringement and seeking a declaration that the two patents at issue are valid and infringed.

 

In September 2014, the Company filed a motion to dismiss one patent infringement lawsuit for lack of standing and responded to the second lawsuit by denying that any valid patent claim would be infringed.  Although the ultimate resolution of this matter is unknown, the legal fees associated with this patent challenge may have a significant impact on the Company’s financial position or results of operations in future periods.

 

Note 13.  Commitments and Contingencies

 

Leases

 

The Company leases certain manufacturing and office equipment, in the ordinary course of business, with initial lease terms not greater than 12 months.  These assets are typically renewed annually.  Rental and lease expense was not material for all periods presented.  In addition, the Company owns all of its properties.

 

Note 14.  Accumulated Other Comprehensive Loss

 

The Company’s Accumulated Other Comprehensive Loss was comprised of the following components as of September 30, 2014 and 2013:

 

(In thousands)		September 30, 2014			September 30, 2013
Foreign Currency Translation
Beginning Balance, July 1		$	(54	)	$	(47	)
Net gain (loss) on foreign currency translation (net of tax of $0 and $0)		—			(1		)
Reclassifications to net income (net of tax of $0 and $0)		—			—
Other comprehensive income (loss), net of tax		—			(1		)
Ending Balance, September 30		(54		)	(48		)
Total Accumulated Other Comprehensive Loss		$	(54	)	$	(48	)

 

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Note 15.  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 is computed using the treasury stock method and includes the effect of potential dilution from the exercise of outstanding stock options and treats unvested restricted stock as if it were vested.  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, 2014
(In thousands, except share and per share data)		2014			2013
Net Income (Loss) Attributable to Lannett Company, Inc.		$	34,932		$	(5,995	)
Basic weighted average common shares outstanding		35,597,931			29,586,237
Effect of potentially dilutive options and restricted stock awards		1,374,715			—
Diluted weighted average common shares outstanding		36,972,646			29,586,237
Earnings (loss) per common share attributable to Lannett Company, Inc.:
Basic		$	0.98		$	(0.20	)
Diluted		$	0.94		$	(0.20	)

 

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, 2014 and 2013 were 436 thousand and 3.0 million, respectively.

 

Note 16.  Share-based Compensation

 

At September 30, 2014, the Company had four share-based employee compensation plans (the “2003 Plan,” the 2006 Long-term Incentive Plan (“LTIP”), or “2006 LTIP”, the 2011 LTIP and the 2014 LTIP).  Together these plans authorized an aggregate total of 8.1 million shares to be issued.  The plans have a total of 2.5 million shares available for future issuances.

 

The Company issues share-based compensation awards with a vesting period ranging up to 3 years and a maximum contractual term of 10 years.  The Company issues new shares of stock when stock options are exercised.  As of September 30, 2014, there was $13.2 million of total unrecognized compensation cost related to non-vested share-based compensation awards.  That cost is expected to be recognized over a weighted average period of 2.5 years.

 

Stock Options

 

The Company measures share-based compensation cost for options using the Black-Scholes option pricing model.  The following table presents the weighted average assumptions used to estimate fair values of the stock options granted during the three months ended September 30, 2014 and 2013 and the estimated annual forfeiture rates used to recognize the associated compensation expense:

 

		September 30, 2014		September 30, 2013
Risk-free interest rate		1.7	%	2.1	%
Expected volatility		52.1	%	62.9	%
Expected dividend yield		0.0	%	0.0	%
Forfeiture rate		6.5	%	7.5	%
Expected term (in years)		5.5 years		5.9 years
Weighted average fair value		$16.82		$8.09

 

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.  The Company uses historical information to estimate the expected term, which represents the period of time that options granted are expected to be outstanding.  The risk-free rate for the period equal to the expected life of the option is based on the U.S. Treasury yield curve in effect at the time of grant.  The forfeiture rate assumption is the estimated annual rate at

 

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