LANNETT CO INC - Quarter Report: 2017 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, 2017

 

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)

 

 

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, a smaller reporting company, or an emerging growth company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” and “emerging growth 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)		Emerging growth company o

 

If an emerging growth company, indicate by check mark if the registrant has elected not to use the extended transition period for complying with any new or revised financial accounting standards provided pursuant to Section 13(a) of the Exchange Act. o

 

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, 2017
Common stock, par value $0.001 per share		37,667,411

 

 

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Table of Contents

 

			Page No.
PART I. FINANCIAL INFORMATION
	ITEM 1.	FINANCIAL STATEMENTS
		Consolidated Balance Sheets as of September 30, 2017 (unaudited) and June 30, 2017	3
		Consolidated Statements of Operations (unaudited) for the three months ended September 30, 2017 and 2016	4
		Consolidated Statements of Comprehensive Income/Loss (unaudited) for the three months ended September 30, 2017 and 2016	5
		Consolidated Statements of Changes in Stockholders’ Equity (unaudited) for the three months ended September 30, 2017	6
		Consolidated Statements of Cash Flows (unaudited) for the three months ended September 30, 2017 and 2016	7
		Notes to Consolidated Financial Statements (unaudited)	8
	ITEM 2.	MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS	26
	ITEM 3.	QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK	33
	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, 2017			June 30, 2017
ASSETS
Current assets:
Cash and cash equivalents		$	92,461		$	117,737
Investment securities		23,973			27,091
Accounts receivable, net		243,326			204,066
Inventories		125,390			122,604
Prepaid income taxes		13,494			16,703
Other current assets		9,325			6,592
Total current assets		507,969			494,793
Property, plant and equipment, net		249,276			243,148
Intangible assets, net		447,797			453,861
Goodwill		339,566			339,566
Deferred tax assets		48,592			52,753
Other assets		22,587			19,191
TOTAL ASSETS		$	1,615,787		$	1,603,312
LIABILITIES
Current liabilities:
Accounts payable		$	49,229		$	44,720
Accrued expenses		13,042			12,499
Accrued payroll and payroll-related expenses		6,706			4,833
Rebates payable		47,336			44,593
Royalties payable		2,480			3,015
Restructuring liability		4,498			5,431
Settlement liability		14,500			17,000
Short-term borrowings and current portion of long-term debt		63,556			60,117
Total current liabilities		201,347			192,208
Long-term debt, net		831,665			843,530
Other liabilities		6,504			6,452
TOTAL LIABILITIES		1,039,516			1,042,190
Commitments and contingencies (Note 12 and 13)
STOCKHOLDERS’ EQUITY
Common stock ($0.001 par value, 100,000,000 shares authorized; 37,672,233 and 37,528,450 shares issued; 37,034,055 and 36,919,296 shares outstanding at September 30, 2017 and June 30, 2017, respectively)		38			37
Additional paid-in capital		295,282			292,780
Retained earnings		291,031			277,774
Accumulated other comprehensive loss		(221		)	(222		)
Treasury stock (638,178 and 609,154 shares at September 30, 2017 and June 30, 2017, respectively)		(9,859		)	(9,247		)
Total stockholders’ equity		576,271			561,122
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY		$	1,615,787		$	1,603,312

 

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,
		2017			2016
Net sales		$	154,961		$	161,559
Cost of sales		79,553			70,820
Amortization of intangibles		7,737			8,887
Gross profit		67,671			81,852
Operating expenses:
Research and development expenses		7,409			12,371
Selling, general and administrative expenses		19,038			21,260
Acquisition and integration-related expenses		18			1,391
Restructuring expenses		527			2,052
Intangible asset impairment charge		—			65,084
Total operating expenses		26,992			102,158
Operating income (loss)		40,679			(20,306		)
Other income (loss):
Investment income		1,164			1,027
Interest expense		(20,912		)	(22,994		)
Other		(251		)	3
Total other income (loss)		(19,999		)	(21,964		)
Income (loss) before income tax		20,680			(42,270		)
Income tax expense (benefit)		7,423			(12,882		)
Net income (loss)		13,257			(29,388		)
Less: Net income attributable to noncontrolling interest		—			20
Net income (loss) attributable to Lannett Company, Inc.		$	13,257		$	(29,408	)
Earnings (loss) per common share attributable to Lannett Company, Inc.:
Basic		$	0.36		$	(0.80	)
Diluted		$	0.35		$	(0.80	)
Weighted average common shares outstanding:
Basic		36,992,064			36,699,267
Diluted		37,730,656			36,699,267

 

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,
		2017			2016
Net income (loss)		$	13,257		$	(29,388	)
Other comprehensive income (loss), before tax:
Foreign currency translation gain (loss)		1			(3		)
Total other comprehensive income (loss), before tax		1			(3		)
Income tax related to items of other comprehensive income		—			—
Total other comprehensive income (loss), net of tax		1			(3		)
Comprehensive income (loss)		13,258			(29,391		)
Less: Total comprehensive income attributable to noncontrolling interest		—			20
Comprehensive income (loss) attributable to Lannett Company, Inc.		$	13,258		$	(29,411	)

 

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)

 

		Common Stock					Additional						Accumulated Other						Total
		Shares Issued		Amount			Paid-In Capital			Retained Earnings			Comprehensive Loss			Treasury Stock			Stockholders’ Equity
Balance, June 30, 2017		37,528		$	37		$	292,780		$	277,774		$	(222	)	$	(9,247	)	$	561,122
Shares issued in connection with share-based compensation plans		144		1			313			—			—			—			314
Share-based compensation		—		—			2,189			—			—			—			2,189
Purchase of treasury stock		—		—			—			—			—			(612		)	(612		)
Other comprehensive income, net of tax		—		—			—			—			1			—			1
Net income		—		—			—			13,257			—			—			13,257
Balance, September 30, 2017		37,672		$	38		$	295,282		$	291,031		$	(221	)	$	(9,859	)	$	576,271

 

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,
		2017			2016
OPERATING ACTIVITIES:
Net income (loss)		$	13,257		$	(29,388	)
Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
Depreciation and amortization		13,778			14,317
Deferred income tax expense (benefit)		4,161			(3,432		)
Share-based compensation		2,189			2,456
Excess tax benefits on share-based compensation awards		—			(644		)
Intangible asset impairment charge		—			65,084
Loss on sale of assets		234			2
(Gain) on investment securities		(864		)	(808		)
Amortization of debt discount and other debt issuance costs		5,017			5,288
Other noncash expenses		—			474
Changes in assets and liabilities which provided (used) cash:
Accounts receivable, net		(39,260		)	15,241
Inventories		(2,786		)	(12,847		)
Prepaid income taxes		3,261			(22,252		)
Other assets		(6,262		)	(1,640		)
Rebates payable		2,743			(1,791		)
Royalties payable		(535		)	(969		)
Restructuring liability		(933		)	637
Accounts payable		2,009			9,267
Accrued expenses		543			(958		)
Accrued payroll and payroll-related expenses		1,873			(1,625		)
Net cash provided by (used in) operating activities		(1,575		)	36,412
INVESTING ACTIVITIES:
Purchases of property, plant and equipment		(12,053		)	(9,945		)
Proceeds from sale of property, plant and equipment		15			33
Purchase of intangible asset		(2,038		)	—
Proceeds from sale of investment securities		27,822			15,703
Purchase of investment securities		(23,840		)	(12,182		)
Net cash used in investing activities		(10,094		)	(6,391		)
FINANCING ACTIVITIES:
Repayments of long-term debt		(13,310		)	(13,308		)
Proceeds from issuance of stock		314			1,355
Excess tax benefits on share-based compensation awards		—			644
Purchase of treasury stock		(612		)	(1,798		)
Net cash used in financing activities		(13,608		)	(13,107		)
Effect on cash and cash equivalents of changes in foreign exchange rates		1			(3		)
NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS		(25,276		)	16,911
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD		117,737			224,769
CASH AND CASH EQUIVALENTS, END OF PERIOD		$	92,461		$	241,680
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Interest paid (net of capitalized interest of $457 thousand and $751 thousand for the three months ended September 30, 2017 and 2016, respectively)		$	15,714		$	17,373
Income taxes paid, net		$	231		$	12,802
Credits issued pursuant to a Settlement Agreement		$	2,500		$	—

 

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 accounting principles generally accepted in the United States (“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, 2017 are not necessarily indicative of the results that may be expected for the fiscal year ending June 30, 2018.  These unaudited financial statements should be read 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 Consolidated Financial Statements, including the Notes to the Consolidated Financial Statements, included in our Annual Report on Form 10-K for the fiscal year ended June 30, 2017.  The Consolidated Financial Statements for the fiscal year ended June 30, 2017 were derived from audited financial statements.

 

Note 2.  The Business And Nature of Operations

 

Lannett Company, Inc. (a Delaware corporation) and its subsidiaries (collectively, the “Company” or “Lannett”) develop, manufacture, package, market and distribute solid oral and extended release (tablets and capsules), topical, nasal and oral solution finished dosage forms of drugs, that address a wide range of therapeutic areas.  Certain of these products are manufactured by others and distributed by the Company, most notably under the Jerome Stevens Distribution Agreement.  The Company also manufactures active pharmaceutical ingredients through its Cody Laboratories, Inc. (“Cody Labs”) subsidiary, providing a vertical integration benefit.

 

On November 25, 2015, the Company completed the acquisition of Kremers Urban Pharmaceuticals, Inc. (“KUPI”), the former U.S. specialty generic pharmaceuticals subsidiary of global biopharmaceuticals company UCB S.A (“UCB”).  KUPI is a specialty pharmaceuticals manufacturer focused on the development of products that are difficult to formulate or utilize specialized delivery technologies.  Strategic benefits of the acquisition include expanded manufacturing capacity, a diversified product portfolio and pipeline and complementary research and development expertise.

 

The Company operates pharmaceutical manufacturing plants in Philadelphia, Pennsylvania; Cody, Wyoming; Carmel, New York and Seymour, Indiana.  The Company’s customers 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

 

Basis of Presentation

 

The Consolidated Financial Statements have been prepared in conformity with United States generally accepted accounting principles (U.S. GAAP).

 

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 had a 50% ownership interest until November 30, 2016, when the Company acquired the remaining 50% interest.  Noncontrolling interest in Realty was recorded net of tax as net income attributable to the noncontrolling interest.  Additionally, all intercompany accounts and transactions have been eliminated.

 

Business Combinations

 

Acquired businesses are accounted for using the acquisition method of accounting, which requires that the assets acquired and liabilities assumed be recorded at the date of acquisition at their respective estimated fair values.  The fair values and useful lives assigned to each class of assets acquired and liabilities assumed are based on, among other factors, the expected future period of

 

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benefit of the asset, the various characteristics of the asset and projected future cash flows.  Significant judgment is employed in determining the assumptions utilized as of the acquisition date and for each subsequent measurement period.  Accordingly, changes in assumptions described above could have a material impact on our consolidated results of operations.

 

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, including goodwill and intangible assets, income taxes, contingencies, share-based compensation and contingent consideration.  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 other comprehensive income (loss).  Gains and losses resulting from transactions denominated in foreign currencies are recognized in the Consolidated Statements of Operations under Other income (loss).  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 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.  Realized and unrealized gains and losses are included in the Consolidated Statements of Operations under Other income (loss).

 

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 obligations 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 and net realizable value 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.

 

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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.

 

Intangible Assets

 

Definite-lived intangible assets are stated at cost less accumulated amortization.  Amortization of definite-lived intangible assets 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 intangible assets are not amortized, but instead are tested at least annually for impairment.  Costs to renew or extend the term of a recognized intangible asset are expensed as incurred.

 

Valuation of Long-Lived Assets, including Intangible Assets

 

The Company’s long-lived assets primarily consist of property, plant and equipment and definite and indefinite-lived intangible assets. Property, plant and equipment and definite-lived intangible 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 asset’s carrying value is compared 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.  Indefinite-lived intangible assets are tested for impairment at least annually during the fourth quarter of each fiscal year or more frequently if events or changes in circumstances indicate that the asset might be impaired.  An impairment loss is measured as the excess of the asset’s carrying value over its fair value, 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.

 

In-Process Research and Development

 

Amounts allocated to in-process research and development (“IPR&D”) in connection with a business combination are recorded at fair value and are considered indefinite-lived intangible assets subject to impairment testing in accordance with the Company’s impairment testing policy for indefinite-lived intangible assets.  As products in development are approved for sale, amounts will be allocated to product rights and will be amortized over their estimated useful lives.  Definite-lived intangible assets are amortized over the expected lives of the related assets. The judgments made in determining the estimated fair value of in-process research and development, as well as asset lives, can materially impact our results of operations.  The Company’s fair value assessments 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.

 

Goodwill

 

Goodwill, which represents the excess of purchase price over the fair value of net assets acquired, is carried at cost.  Goodwill is tested for impairment on an annual basis on the first day of the fourth quarter of each fiscal year or more frequently if events or changes in circumstances indicate that the asset might be impaired.  The Company first performs a qualitative assessment to determine if the quantitative impairment test is required.  If changes in circumstances indicate an asset may be impaired, the Company performs the quantitative impairment test.  The Company first determines the fair value of our reporting unit (generic pharmaceuticals).  If the net book value of our reporting unit exceeds its fair value, the difference will be recorded as a goodwill impairment, not to exceed the carrying amount of goodwill.  The Company’s fair value assessments 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.  The judgments made in determining the estimated fair value of goodwill can materially impact our results of operations.

 

Segment Information

 

The Company operates in 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, 2017 and 2016:

 

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(In thousands)		Three Months Ended September 30,
Medical Indication		2017			2016
Antibiotic		$	3,349		$	3,780
Anti-Psychosis		14,991			17,320
Cardiovascular		11,306			12,694
Central Nervous System		8,818			10,350
Gallstone		6,564			12,883
Gastrointestinal		14,553			18,052
Glaucoma		2,668			5,783
Migraine		15,015			7,160
Muscle Relaxant		3,791			3,532
Pain Management		5,761			6,608
Respiratory		1,647			2,213
Thyroid Deficiency		47,214			39,838
Urinary		2,997			5,101
Other		12,696			11,182
Contract manufacturing revenue		3,591			5,063
Total		$	154,961		$	161,559

 

Customer, Supplier and Product Concentration

 

The following table presents the percentage of total net sales, for the three months ended September 30, 2017 and 2016, for one 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:

 

		2017		2016
Product 1		30	%	25	%

 

The following table presents the percentage of total net sales, for the three months ended September 30, 2017 and 2016, for certain of the Company’s customers which accounted for at least 10% of net sales in any of those periods:

 

		2017		2016
Customer A		27	%	28	%
Customer B		20	%	20	%

 

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 33% and 37% of the Company’s inventory purchases during the three months ended September 30, 2017 and 2016, 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 and collection is reasonably assured.  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 estimated 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 $184.1 million and $175.8 million at September 30, 2017 and June 30, 2017, respectively.  Rebates payable at September 30, 2017 and June 30, 2017 totaled $47.3 million and $44.6 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, including Amortization of Intangibles

 

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 Food and Drug Administration (“FDA”).  Research and development expenses include costs associated with internal projects as well as costs associated with third-party research and development contracts.

 

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.

 

Restructuring Costs

 

The Company records charges associated with approved restructuring plans to remove duplicative headcount and infrastructure associated with business acquisitions or to simplify business processes.  Restructuring charges can include severance costs to eliminate a specified number of employees, infrastructure charges to vacate facilities and consolidate operations and contract cancellation costs. The Company records restructuring charges based on estimated employee terminations, site closure and consolidation plans. The Company accrues severance and other employee separation costs under these actions when it is probable that a liability exists and the amount is reasonably estimable.

 

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 expected forfeitures.  The Company uses the Black-Scholes valuation model to determine the fair value of stock options, the stock price on the grant date to value restricted stock and the Monte-Carlo simulation model to determine the fair value of performance-based shares.  The Black-Scholes valuation and Monte-Carlo simulation models include various assumptions, including the expected volatility, the expected life of the award, dividend yield and the risk-free interest rate as well as performance assumptions of peer companies.  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.

 

Self-Insurance

 

Effective January 1, 2017, the Company self-insures for certain employee medical and prescription benefits.  The Company also maintains stop loss coverage with third party insurers to limit its total liability exposure.  The liability for self-insured risks is primarily calculated using independent third party actuarial valuations which take into account actual claims, claims growth and claims incurred but not yet reported.  Actual experience, including claim frequency and severity as well as health-care inflation, could result in different liabilities than the amounts currently recorded.  The liability for self-insured risks under this plan as of September 30, 2017 totaled $2.1 million and was not material to the financial position of the Company as of June 30, 2017.

 

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Income Taxes

 

The Company uses the 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 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 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.

 

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 accounting standards also provide guidance on de-recognition, classification, interest and penalties on income taxes, accounting in interim periods and requires increased disclosures.

 

Earnings (Loss) 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.  These potentially dilutive securities consist of stock options, unvested restricted stock and performance-based shares and an outstanding warrant.  Anti-dilutive securities are excluded from the calculation.  Dilutive shares are also excluded in the calculation in periods of net loss because the effect of including such securities would be anti-dilutive.

 

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 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 ASU 2014-09, Revenue from Contracts with Customers.  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, 2017.  Based on a preliminary review of the contracts representing a substantial portion of our revenues, the Company does not expect the guidance to have a material impact on our disclosures or the timing and recognition of our revenues.  The Company intends to use the modified retrospective approach upon implementation.

 

In November 2015, the FASB issued ASU 2015-17, Income Taxes — Balance Sheet Classification of Deferred Taxes.  ASU 2015-17 requires all deferred tax assets and liabilities to be classified as noncurrent on the balance sheet.  The guidance may be applied either prospectively or retrospectively.  The guidance became effective for the Company in the first quarter of Fiscal 2018.  Accordingly, the Company currently presents all deferred tax assets and liabilities as noncurrent on the balance sheet.  All prior period amounts have also been reclassified to conform with the current year presentation.

 

In February 2016, the FASB issued ASU 2016-02, Leases.  ASU 2016-02 requires an entity to recognize right-of-use assets and liabilities on its balance sheet for all leases with terms longer than 12 months.  Lessees and lessors are required to disclose quantitative and qualitative information about leasing arrangements to enable a user of the financial statements to assess the amount, timing and uncertainty of cash flows arising from leases.  ASU 2016-02 is effective for annual reporting periods beginning after December 15, 2018, including interim periods within that reporting period and requires a modified retrospective application, with early adoption permitted.  The Company is currently in the process of assessing the impact this guidance will have on the consolidated financial statements.

 

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In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows — Classification of Certain Cash Receipts and Cash Payments.  ASU 2016-15 addresses how certain cash receipts and cash payments are presented and classified in the statement of cash flows.  ASU 2016-15 is effective for annual reporting periods, and interim periods therein, beginning after December 15, 2017.  The Company is currently in the process of assessing the impact this guidance will have on the consolidated financial statements.

 

Note 4.  Restructuring Charges

 

2016 Restructuring Program

 

On February 1, 2016, in connection with the acquisition of KUPI, the Company announced a plan related to the future integration of KUPI and the Company’s operations. The plan focuses on the closure of KUPI’s corporate functions and the consolidation of manufacturing, sales, research and development and distribution functions. The Company estimates that it will incur an aggregate of up to approximately $20.0 million in restructuring charges for actions that have been announced or communicated since the 2016 Restructuring Program began.  Of this amount, approximately $11.0 million relates to employee separation costs, approximately $1.0 million relates to contract termination costs and approximately $8.0 million relates to facility closure costs and other actions. The 2016 Restructuring Program is expected to be completed by the end of Fiscal 2019.  The expenses associated with the restructuring program included in restructuring expenses during the three months ended September 30, 2017 and 2016 were as follows:

 

		Three			Three
		Months Ended			Months Ended
(In thousands)		September 30, 2017			September 30, 2016
Employee separation costs		$	(590	)	$	1,157
Contract termination costs		—			—
Facility closure costs		1,117			895
Total		$	527		$	2,052

 

In the first quarter of Fiscal 2018, the Company decided to retain certain employees who were previously included in the 2016 Restructuring Program.  As a result, the Company reversed all previous charges incurred related to these employees.

 

A reconciliation of the changes in restructuring liabilities associated with the 2016 Restructuring Program from June 30, 2017 through September 30, 2017 is set forth in the following table:

 

(In thousands)		Employee Separation Costs			Contract Termination Costs			Facility Closure Costs			Total
Balance at June 30, 2017		$	5,431		$	—		$	—		$	5,431
Restructuring Charges (Credits)		(590		)	—			1,117			527
Payments		(343		)	—			(1,117		)	(1,460		)
Balance at September 30, 2017		$	4,498		$	—		$	—		$	4,498

 

Note 5.  Accounts Receivable

 

Accounts receivable consisted of the following components at September 30, 2017 and June 30, 2017:

 

(In thousands)		September 30, 2017			June 30, 2017
Gross accounts receivable		$	428,681		$	380,653
Less Chargebacks reserve		(79,274		)	(79,537		)
Less Rebates reserve		(45,312		)	(43,023		)
Less Returns reserve		(45,421		)	(42,135		)
Less Other deductions		(14,057		)	(11,096		)
Less Allowance for doubtful accounts		(1,291		)	(796		)
Accounts receivable, net		$	243,326		$	204,066

 

For the three months ended September 30, 2017, the Company recorded a provision for chargebacks, rebates (including rebates presented as rebates payable), returns and other deductions of $254.7 million, $78.5 million, $10.4 million and $12.4 million, respectively.  For the three months ended September 30, 2016, the Company recorded a provision for chargebacks, rebates (including rebates presented as rebates payable), returns and other deductions of $198.5 million, $69.5 million, $6.8 million and $15.5 million, respectively.

 

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Note 6.  Inventories

 

Inventories at September 30, 2017 and June 30, 2017 consisted of the following:

 

(In thousands)		September 30, 2017			June 30, 2017
Raw Materials		$	59,128		$	57,442
Work-in-process		19,286			15,676
Finished Goods		46,976			49,486
Total		$	125,390		$	122,604

 

Inventories were reduced by $5.3 million and $4.5 million at September 30, 2017 and June 30, 2017, respectively for excess and obsolete inventory amounts.  During the three months ended September 30, 2017 and 2016, the Company recorded provisions for excess and obsolete inventory of $2.2 million and $3.3 million, respectively.

 

Note 7.  Property, Plant and Equipment

 

Property, plant and equipment at September 30, 2017 and June 30, 2017 consisted of the following:

 

(In thousands)		Useful Lives		September 30, 2017			June 30, 2017
Land		—		$	6,191		$	6,191
Building and improvements		10 - 39 years		108,740			108,730
Machinery and equipment		5 - 10 years		142,885			142,086
Furniture and fixtures		5 - 7 years		2,987			2,953
Less accumulated depreciation				(76,809		)	(71,461		)
				183,994			188,499
Construction in progress				65,282			54,649
Property, plant and equipment, net				$	249,276		$	243,148

 

Depreciation expense for the three months ended September 30, 2017 and 2016 was $5.7 million and $5.1 million, respectively.

 

During the three months ended September 30, 2017 and 2016, the Company had no impairment charges related to property, plant and equipment.  Property, plant and equipment, net included amounts held in foreign countries in the amount of $1.0 million at September 30, 2017 and June 30, 2017.

 

Note 8.  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.

 

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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 at September 30, 2017 and June 30, 2017, were as follows:

 

		September 30, 2017
(In thousands)		Level 1			Level 2			Level 3			Total
Assets
Equity securities		$	23,973		$	—		$	—		$	23,973
Total Assets		$	23,973		$	—		$	—		$	23,973

 

		June 30, 2017
(In thousands)		Level 1			Level 2			Level 3			Total
Assets
Equity securities		$	27,091		$	—		$	—		$	27,091
Total Assets		$	27,091		$	—		$	—		$	27,091

 

Note 9.  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 $864 thousand during the three months ended September 30, 2017, which included an unrealized gain related to securities still held at September 30, 2017 of $37 thousand.

 

The Company had a net gain on investment securities of $808 thousand during the three months ended September 30, 2016, which included an unrealized gain related to securities still held at September 30, 2016 of $557 thousand.

 

Note 10.  Goodwill and Intangible Assets

 

The changes in the carrying amount of goodwill for the three months ended September 30, 2017 are as follows:

 

(In thousands)		Generic Pharmaceuticals
Balance at June 30, 2017		$	339,566
Goodwill acquired		—
Impairments		—
Balance at September 30, 2017		$	339,566

 

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Intangible assets, net as of September 30, 2017 and June 30, 2017, consisted of the following:

 

		Weighted		Gross Carrying Amount						Accumulated Amortization						Intangible Assets, Net
(In thousands)		Avg. Life (Yrs.)		September 30, 2017			June 30, 2017			September 30, 2017			June 30, 2017			September 30, 2017			June 30, 2017
Definite-lived:
Cody Labs import license		15		$	582		$	582		$	(357	)	$	(347	)	$	225		$	235
KUPI product rights		15		434,000			434,000			(50,519		)	(43,286		)	383,481			390,714
KUPI trade name		2		2,920			2,920			(2,703		)	(2,338		)	217			582
KUPI other intangible assets		15		19,000			19,000			(2,345		)	(2,028		)	16,655			16,972
Silarx product rights		15		10,000			10,000			(1,556		)	(1,389		)	8,444			8,611
Other product rights		15		2,691			653			(365		)	(355		)	2,326			298
Total definite-lived				$	469,193		$	467,155		$	(57,845	)	$	(49,743	)	$	411,348		$	417,412
Indefinite-lived:
KUPI in-process research and development		—		$	18,000		$	18,000		$	—		$	—		$	18,000		$	18,000
Silarx in-process research and development		—		18,000			18,000			—			—			18,000			18,000
Other product rights		—		449			449			—			—			449			449
Total indefinite-lived				36,449			36,449			—			—			36,449			36,449
Total intangible assets, net				$	505,642		$	503,604		$	(57,845	)	$	(49,743	)	$	447,797		$	453,861

 

For the three months ended September 30, 2017 and 2016, the Company recorded amortization expense of $8.1 million and $9.3 million, respectively.

 

In the first quarter of Fiscal 2018, the Company filed a 505(b)(2) New Drug Application with the FDA for Cocaine Hydrochloride Topical Solution.  The Company paid a $2.0 million filing fee to the FDA along with the application, which was capitalized as an intangible asset that will be amortized over a 15-year useful life period.

 

Future annual amortization expense consisted of the following as of September 30, 2017:

 

(In thousands) Fiscal Year Ending June 30,		Amortization Expense
2018		$	23,530
2019		31,082
2020		31,074
2021		31,074
2022		31,074
Thereafter		263,514
		$	411,348

 

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Note 11. Long-Term Debt

 

Long-term debt, net consisted of the following:

 

		September 30,			June 30,
(In thousands)		2017			2017
Term Loan A due 2020		$	250,938		$	254,375
Unamortized discount and other debt issuance costs		(14,808		)	(16,238		)
Term Loan A, net		236,130			238,137
Term Loan B due 2022		718,045			727,881
Unamortized discount and other debt issuance costs		(59,653		)	(63,106		)
Term Loan B, net		658,392			664,775
Revolving Credit Facility due 2020		—			—
Other		699			735
Total debt, net		895,221			903,647
Less short-term borrowings and current portion of long-term debt		(63,556		)	(60,117		)
Total long-term debt, net		$	831,665		$	843,530

 

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

 

		Amounts Payable
(In thousands)		to Institutions
2018		$	63,556
2019		67,000
2020		67,008
2021		211,390
2022		39,407
Thereafter		521,321
Total		$	969,682

 

Note 12.  Legal, Regulatory Matters and Contingencies

 

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 the 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.  In June 2016, the Connecticut Attorney General issued interrogatories and a subpoena to an employee of the Company in order to gain access to documents and responses previously supplied to the Department of Justice.  In December 2016, the Connecticut Attorney General, joined by numerous other State Attorneys General, filed a civil complaint alleging that six pharmaceutical companies engaged in anti-competitive behavior related to Doxycycline Hyclate and Gliburide.  The Company was not named in the action and does not compete on the products that formed the basis of the complaint.  On October 31, 2017, the state Attorneys General filed a motion for leave to amend their complaint to add numerous additional defendants, including the Company, and claims relating to 13 additional drugs.  The claim relating to Lannett involves alleged price-fixing for one drug, doxycycline monohydrate, but did not involve the pricing for digoxin.  The state Attorneys General also allege that all defendants were part of an overarching, industry-wide conspiracy to allocate markets and fix prices generally.  None of the defendants, including the Company, has responded yet to the motion of the state Attorneys General.

 

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

 

In fiscal years 2015 and 2016, the Company and certain affiliated individuals each were served with a grand jury subpoena relating to a federal investigation of the generic pharmaceutical industry into possible violations of the Sherman Act.  The subpoenas request corporate documents of the Company relating to corporate, financial and employee information, communications or correspondence with competitors regarding the sale of generic prescription medications and the marketing, sale, or pricing of certain products, generally for the period of 2005 through the dates of the subpoenas.

 

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