SUPERNUS PHARMACEUTICALS, INC. - Quarter Report: 2018 September (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, DC 20549

 

FORM 10-Q

 

(Mark One)

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2018

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                 to                

 

Commission File Number: 001-35518

 

SUPERNUS PHARMACEUTICALS, INC.

(Exact name of registrant as specified in its charter)

 

 

(301) 838-2500

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  x Yes  o No

 

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

 

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,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

 

 

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-2 of the Exchange Act).  o Yes  x No

 

The number of outstanding shares of the registrant’s common stock, par value $0.001 per share, as of the close of business on November 1, 2018 was 52,257,013.

 

 

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SUPERNUS PHARMACEUTICALS, INC.

FORM 10-Q — QUARTERLY REPORT

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2018

 

	Page No.
PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Consolidated Balance Sheets as of September 30, 2018 (Unaudited) and December 31, 2017	3
Consolidated Statements of Earnings for the three and nine month periods ended September 30, 2018 and 2017 (Unaudited)	4
Consolidated Statements of Comprehensive Earnings for the three and nine month periods ended September 30, 2018 and 2017 (Unaudited)	5
Consolidated Statements of Cash Flows for the nine month periods ended September 30, 2018 and 2017 (Unaudited)	6
Notes to Consolidated Financial Statements (Unaudited)	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	27
Item 3. Quantitative and Qualitative Disclosures about Market Risk	40
Item 4. Controls and Procedures	40
PART II — OTHER INFORMATION
Item 1. Legal Proceedings	41
Item 1A. Risk Factors	41
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	42
Item 3. Defaults Upon Senior Securities	42
Item 4. Mine Safety Disclosures	42
Item 5. Other Information	42
Item 6. Exhibits	42
SIGNATURES	44

 

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PART I — FINANCIAL INFORMATION

 

Supernus Pharmaceuticals, Inc.

Consolidated Balance Sheets

(in thousands, except share amounts)

 

		September 30,			December 31,
		2018			2017
		(unaudited)
Assets
Current assets
Cash and cash equivalents		$	123,818		$	100,304
Marketable securities		156,407			39,736
Accounts receivable, net		77,753			65,586
Inventories, net		23,280			16,304
Prepaid expenses and other current assets		9,299			6,521
Total current assets		390,557			228,451
Long term marketable securities		460,304			133,638
Property and equipment, net		6,930			5,124
Intangible assets, net		32,572			36,019
Deferred income taxes		31,367			20,843
Other non-current assets		782			389
Total assets		$	922,512		$	424,464
Liabilities and stockholders’ equity
Current liabilities
Accounts payable		$	9,838		$	6,844
Accrued sales deductions		85,970			68,343
Accrued expenses		32,098			27,305
Income taxes payable		8,548			15,938
Non-recourse liability related to sale of future royalties, current portion		1,892			4,283
Deferred licensing revenue		—			287
Total current liabilities		138,346			123,000
Deferred licensing revenue, net of current portion		—			1,149
Convertible notes, net		325,666			—
Non-recourse liability related to sale of future royalties, long term		23,305			22,258
Other non-current liabilities		13,259			10,577
Total liabilities		500,576			156,984
Stockholders’ equity
Common stock, $0.001 par value, 130,000,000 shares authorized at September 30, 2018 and December 31, 2017; 52,257,013 and 51,314,850 shares issued and outstanding at September 30, 2018 and December 31, 2017, respectively		52			51
Additional paid-in capital		365,396			294,999
Accumulated other comprehensive loss, net of tax		(4,111		)	(747		)
Retained earnings (accumulated deficit)		60,599			(26,823		)
Total stockholders’ equity		421,936			267,480
Total liabilities and stockholders’ equity		$	922,512		$	424,464

 

See accompanying notes.

 

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Supernus Pharmaceuticals, Inc.

Consolidated Statements of Earnings

(in thousands, except share and per share data)

 

		Three Months ended September 30,						Nine Months ended September 30,
		2018			2017			2018			2017
		(unaudited)						(unaudited)
Revenue
Net product sales		$	100,227		$	78,066		$	286,377		$	207,763
Royalty revenue		2,769			2,010			5,836			4,338
Licensing revenue		—			322			750			1,702
Total revenue		102,996			80,398			292,963			213,803
Costs and expenses
Cost of product sales		4,207			4,251			11,168			11,060
Research and development		20,422			12,980			59,368			33,405
Selling, general and administrative		40,892			40,825			117,838			104,141
Total costs and expenses		65,521			58,056			188,374			148,606
Operating earnings		37,475			22,342			104,589			65,197
Other income (expense)
Interest income		4,461			814			9,331			2,002
Interest expense		(4,374		)	—			(9,415		)	(148		)
Interest expense-nonrecourse liability related to sale of future royalties		(1,191		)	(155		)	(3,096		)	(1,274		)
Changes in fair value of derivative liabilities		—			—			—			76
Loss on extinguishment of debt		—			(91		)	—			(295		)
Total other income (expense)		(1,104		)	568			(3,180		)	361
Earnings before income taxes		36,371			22,910			101,409			65,558
Income tax expense		8,360			6,949			16,309			21,932
Net earnings		$	28,011		$	15,961		$	85,100		$	43,626
Earnings per share:
Basic		$	0.54		$	0.31		$	1.64		$	0.86
Diluted		$	0.52		$	0.29		$	1.57		$	0.82
Weighted-average number of common shares outstanding:
Basic		52,227,630			51,046,375			51,897,240			50,583,726
Diluted		54,239,847			53,628,389			54,098,330			53,227,433

 

See accompanying notes.

 

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Supernus Pharmaceuticals, Inc.

Consolidated Statements of Comprehensive Earnings

(in thousands)

 

		Three Months ended September 30,						Nine Months ended September 30,
		2018			2017			2018			2017
		(unaudited)						(unaudited)
Net earnings		$	28,011		$	15,961		$	85,100		$	43,626
Other comprehensive earnings (loss):
Unrealized (loss) gain on marketable securities, net of tax		8			36			(3,364		)	386
Other comprehensive earnings (loss)		8			36			(3,364		)	386
Comprehensive earnings		$	28,019		$	15,997		$	81,736		$	44,012

 

See accompanying notes.

 

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Supernus Pharmaceuticals, Inc.

Consolidated Statements of Cash Flows

(in thousands)

 

		Nine Months ended September 30,
		2018			2017
		(unaudited)
Cash flows from operating activities
Net earnings		$	85,100		$	43,626
Adjustments to reconcile net earnings to net cash provided by operating activities:
Loss on extinguishment of debt		—			295
Change in fair value of derivative liability		—			(76		)
Depreciation and amortization		5,371			6,462
Amortization of deferred financing costs and debt discount		8,052			50
Amortization of premium/discount on marketable securities		(1,825		)	(342		)
Non-cash interest expense on non-recourse liability related to sale of future royalties		3,096			1,274
Non-cash royalty revenue		(4,300		)	(3,708		)
Share-based compensation expense		8,300			6,447
Deferred income tax provision (benefit)		(6,233		)	13,314
Changes in operating assets and liabilities:
Accounts receivable		(10,687		)	(14,639		)
Inventories		(6,976		)	1,854
Prepaid expenses and other current assets		(2,778		)	(2,712		)
Other non-current assets		(342		)	—
Accounts payable		3,066			(1,312		)
Accrued sales deductions		17,627			17,829
Accrued expenses		5,966			2,769
Income taxes payable		(7,390		)	6,482
Deferred licensing revenue		—			(202		)
Other non-current liabilities		90			894
Net cash provided by operating activities		96,137			78,305
Cash flows from investing activities
Purchases of marketable securities		(491,654		)	(78,938		)
Sales and maturities of marketable securities		45,271			23,052
Purchases of property and equipment		(748		)	(1,273		)
Deferred legal fees		(679		)	(10,130		)
Net cash used in investing activities		(447,810		)	(67,289		)
Cash flows from financing activities
Proceeds from issuance of convertible notes		402,500			—
Convertible notes issuance financing costs		(10,435		)	—
Proceeds from issuance of warrants		65,688			—
Purchases of convertible note hedges		(92,897		)	—
Proceeds from issuance of common stock		10,331			4,510
Net cash provided by financing activities		375,187			4,510
Net change in cash and cash equivalents		23,514			15,526
Cash and cash equivalents at beginning of year		100,304			66,398
Cash and cash equivalents at end of period		$	123,818		$	81,924
Supplemental cash flow information:
Cash paid for interest		$	—		$	134
Income taxes paid		$	29,930		$	2,136
Non-cash investing and financing activity:
Conversion of convertible notes and interest make-whole		$	—		$	4,546
Deferred legal fees included in accounts payable and accrued expenses		$	280		$	1,337
Property and equipment acquired under build-to-suit lease transaction		$	2,304		$	—
Interest capitalized during construction period for build-to-suit lease transaction		$	44		$	—
Facility lease financing obligation		$	2,347		$	—

 

See accompanying notes.

 

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Supernus Pharmaceuticals, Inc.

Notes to Consolidated Financial Statements

For the Nine Months ended September 30, 2018 and 2017

(unaudited)

 

1.  Organization and Business

 

Supernus Pharmaceuticals, Inc. (the Company) was incorporated in Delaware and commenced operations in 2005. The Company is a pharmaceutical company focused on developing and commercializing products for the treatment of central nervous system (CNS) diseases. The Company markets two products, Oxtellar XR for the treatment of epilepsy and Trokendi XR for the prophylaxis of migraine headache and treatment of epilepsy. The Company has several proprietary product candidates in clinical development that address the CNS market.

 

The Company launched Oxtellar XR and Trokendi XR in 2013 for the treatment of epilepsy and launched Trokendi XR for the prophylaxis of migraine headache in adolescents and adults in April 2017.

 

On September 12, 2018, the Company entered into an Agreement and Plan of Merger (the Merger Agreement) with Supernus Merger Sub, Inc., a Delaware corporation, which is an acquisition subsidiary formed and wholly owned by the Company (the Merger Sub), Biscayne Neurotherapeutics, Inc., a Florida corporation (which, as a condition to closing, converted to a Delaware corporation) (Biscayne), and Reich Consulting Group, Inc., as the security holder representative (the Merger). Pursuant to the terms of the Merger Agreement, the Company completed the Merger effective October 4, 2018, and the Merger Sub merged with and into Biscayne, the separate existence of the Merger Sub ceased and Biscayne continued as the surviving corporation and a wholly owned subsidiary of the Company (see Note 16).

 

2.  Summary of Significant Accounting Policies

 

Basis of Presentation

 

The Company’s consolidated financial statements include the accounts of Supernus Pharmaceuticals, Inc., Supernus Merger Sub, Inc. and Supernus Europe Ltd., collectively referred to herein as “Supernus” or “the Company.” All significant intercompany transactions and balances have been eliminated in consolidation. The Company’s unaudited consolidated financial statements have been prepared in accordance with the requirements of the U.S. Securities and Exchange Commission (SEC) for interim financial information.

 

As permitted under Generally Accepted Accounting Principles in the United States (U.S. GAAP), certain notes and other information have been omitted from the interim unaudited consolidated financial statements presented in this Quarterly Report on Form 10-Q. Therefore, these financial statements should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended December 31, 2017, filed with the SEC.

 

In the opinion of management, the consolidated financial statements reflect all adjustments necessary to fairly present the Company’s financial position, results of earnings and cash flows for the periods presented. These adjustments are of a normal recurring nature. The Company, which is primarily located in the United States (U.S.), operates in one operating segment.

 

The results of operations for the three and nine months ended September 30, 2018 are not necessarily indicative of the Company’s future financial results.

 

Use of Estimates

 

The preparation of the Company’s consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets, liabilities, revenue and expenses, as well as related disclosure of contingent assets and liabilities. Actual results could differ materially from the Company’s estimates. To the extent that there are material differences between these estimates and actual results, the Company’s financial condition or operating results will be affected. The Company bases its estimates on: historical experience; various forecasts; information received from its service providers; and other assumptions that the Company believes are reasonable under the circumstances. The Company evaluates the methodology employed in its estimates on an ongoing basis.

 

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Cash and Cash Equivalents

 

The Company considers all investments in highly liquid financial instruments with an original maturity of three months or less to be cash equivalents.

 

Marketable Securities

 

Marketable securities consist of investments in U.S. Treasury bills and notes, certificates of deposit, various U.S. governmental agency debt securities, corporate and municipal bonds and other fixed income securities. The Company places all investments with government, industrial or financial institutions whose debt is rated as investment grade. The Company classifies all available-for-sale marketable securities with maturities greater than one year from the balance sheet date as non-current assets.

 

The Company’s investments are classified as available-for-sale and are carried at estimated fair value. Except for changes in fair value of equity securities which are recognized through net income, any unrealized holding gains or losses are reported, net of any reported tax effects, as accumulated other comprehensive earnings (loss), which is a separate component of stockholders’ equity.

 

Realized gains and losses, and declines in value judged to be other-than-temporary, if any, are included in consolidated results of operations. A decline in the market value of any available-for-sale security below cost that is deemed to be other-than-temporary results in a reduction in fair value, with that reduction charged to earnings in that period. A new cost basis for the security is then established.

 

Dividend and interest income is recognized when earned. The cost of securities sold is calculated using the specific identification method.

 

Concentration of Credit Risk

 

Financial instruments that potentially subject the Company to concentrations of credit risk consist principally of cash, cash equivalents, accounts receivable and marketable securities. The counterparties are various corporations and financial institutions of high credit standing, as described above.

 

Substantially all of the Company’s cash and cash equivalents are maintained in U.S. government agency debt and debt of well-known, investment grade corporations. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand and, therefore, management believes they bear minimal default risk.

 

The majority of our product sales are to pharmaceutical wholesalers and distributors who, in turn, sell the products to chain and independent pharmacies, hospitals and other customers. Three wholesale pharmaceutical distributors collectively accounted for more than 90% of our total revenue for the nine months ended September 30, 2018.

 

Inventories

 

Inventories, which are recorded at the lower of cost or net realizable value, include materials, labor and other direct and indirect costs and are valued using the first-in, first-out method. The Company typically capitalizes inventories produced in preparation for commercial launches when the related product candidates have received regulatory approval and the related costs will be recoverable through the commercial sale of the product.

 

Intangible Assets

 

Intangible assets consist of patent defense costs, which are deferred legal fees that have been incurred in connection with legal proceedings related to the defense of patents for Oxtellar XR and Trokendi XR. Patent defense costs will be charged to expense in the event of an unsuccessful outcome of the ongoing litigation. Patents are carried at cost less accumulated amortization, which is calculated on a straight line basis over the estimated useful lives of the patents. Amortization commences in the quarter after the costs are incurred. The amortization period is based initially upon the remaining patent life and is adjusted, if necessary, for any subsequent settlements or other changes to the expected useful life of the patent. The carrying value of the patents is assessed for impairment annually during the fourth quarter of each year, or more frequently if impairment indicators exist.

 

Impairment of Long-Lived Assets

 

Long-lived assets consist primarily of property and equipment and patent defense costs. The Company assesses the recoverability of its long-lived assets whenever events or changes in circumstances indicate that the carrying amount of an asset may not be recoverable. If indications of impairment exist, projected future undiscounted cash flows associated with the asset are compared to the carrying value to determine whether the asset’s value is recoverable. Evaluating for impairment requires judgment, including the estimation of future cash flows, future growth rates and profitability, and the expected life over which cash flows will occur. Changes

 

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in the Company’s business strategy or adverse changes in market conditions could impact impairment analyses and require recognition of an impairment charge equal to the excess of the carrying value of the long-lived asset over its estimated fair value.

 

Build-to-Suit Lease

 

The Company accounts for the lease agreement for its new headquarters building under the provisions of Accounting Standards Codification (ASC) 840, “Leases.” Because the Company has concluded that it retains substantively all of the risks of ownership during the construction of the leased property, the Company is considered the owner of the property for accounting purposes. The Company has capitalized the estimated fair value of the building shell and the construction costs incurred to date as a construction-in-progress asset and the related financing obligation as Other Non-current Liabilities in the accompanying consolidated balance sheet (see Note 14).

 

Deferred Financing Costs

 

Deferred financing costs consist of costs incurred by the Company in connection with the closing of the Company’s sale of $402.5 million of 0.625% Convertible Senior Notes due 2023 (the 2023 Notes) (see Note 9). The Company amortizes deferred financing costs over the term of the related debt using the effective interest method. When extinguishing debt, the related deferred financing costs are written off.

 

Preclinical Study and Clinical Trial Accruals

 

The Company estimates preclinical study and clinical trial expenses based on the services performed pursuant to contracts with research institutions, clinical investigators, clinical research organizations (CROs) and other service providers that conduct activities on its behalf. In recording service fees, the Company estimates the time period over which the related services will be performed and compares the level of effort expended through the end of each period to the cumulative expenses recorded and payments made for such services. As appropriate, the Company accrues additional service fees or defers any non-refundable advance payments until the related services are performed. If the actual timing of the performance of services or the level of effort varies from the estimate, the Company will adjust its accrued expenses or deferred advance payments accordingly. If the Company later determines that it no longer expects the services associated with a nonrefundable advance payment to be rendered, the remaining portion of that advance payment will be charged to expense in the period in which such determination is made.

 

Revenue Recognition

 

In May 2014, the Financial Accounting Standards Board (FASB) issued a comprehensive new standard, ASC 606, “Revenue from Contracts with Customers” and its related amendments, which amended revenue recognition principles. The Company adopted the new standard on January 1, 2018. While results for reporting periods beginning after January 1, 2018 are presented under the new guidance, prior period amounts are not adjusted and continue to be reported under the accounting standards in effect for the prior period. The accounting policy for revenue recognition for periods prior to January 1, 2018 is described in Note 2 of the Notes to Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2017.

 

 

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Revenue from Product Sales

 

The Company’s products are distributed through a third party fulfillment center. The Company recognizes revenue when its products are shipped from this center to its customers, who are pharmaceutical wholesalers and distributors. The Company’s customers purchase product to fulfill orders from retail pharmacy chains and independent pharmacies of varying size and buying power. The Company’s customers take control of the products, including title and ownership to the products, upon physical receipt of these products at their facilities.

 

Product sales are recorded net of various forms of variable consideration, including estimated rebates, discounts, allowances, and an estimated liability for product returns (collectively, “sales deductions”).

 

Variability in the net transaction price for the Company’s products primarily arises from sales deductions. Significant judgment is required in estimating sales deductions. The Company considers: historical experience; current contract prices under applicable programs; unbilled claims; processing time lags; and inventory levels in the distribution channel in arriving at these estimates. The Company adjusts its estimates of revenue at the earlier of when the most likely amount of consideration it expects to receive changes or when the consideration becomes fixed. If actual results in the future vary from estimates, the Company adjusts these estimates. These adjustments could materially affect net product sales and earnings in the period that such variances become known.

 

Sales Deductions

 

Sales deductions are primarily comprised of rebates, product returns and sales discounts/allowances. The Company records product sales net of the following sales deductions:

 

·                  Rebates:  Rebates are discounts which the Company pays under either private sector or public sector health care programs. Public sector rebate programs encompass: Medicaid Drug Rebate Programs; Medicare Coverage Gap Programs; and programs covering public health service institutions and government entities that purchase drugs under the Federal Supply Schedule. Private sector rebate programs include: contractual agreements with managed care providers, under which the Company pays fees to gain access to that provider’s patient drug formulary and Company sponsored programs under which the Company defrays or eliminates patient co-payment charges that the patient would otherwise pay to their managed care provider. Rebates paid under public sector programs are generally mandated under law, whereas private sector rebates are generally contractually negotiated by the Company with managed care providers.

 

Rebates are owed upon dispensing product to a patient; i.e., filling a prescription. Because rebates are generally invoiced and paid quarterly in arrears, the accrual balance consists of an estimate of the amount expected to be incurred for the current quarter’s activity, plus an accrual balance for known or estimated prior quarters’ unpaid rebates. The period from the date on which the prescription is filled to the date the Company receives and pays the invoice varies, depending on the rebate program. Consequently, the Company’s estimates of expected rebate claims vary by program and by type of customer. For each of its products, the Company bases its estimates of expected rebate claims using multiple factors including historical levels of deductions; contractual terms with managed care providers; actual and anticipated changes in product price; prospective changes in managed care fee for service contractual agreements; prospective changes in co-pay assistance programs; and anticipated changes in program utilization rates (i.e., patient participation rates).

 

The sensitivity of the Company’s estimates can vary by program and type of customer. If actual rebates vary from estimated amounts, the Company may need to adjust the balances of such rebates to reflect actual expenditures with respect to these programs. This could materially affect net product sales and earnings in the period of adjustment. The Company

 

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records an estimated liability for rebates at the time the customer takes title to the product (i.e., at the time of sale) as a reduction to gross product sales and an increase in Accrued Sales Deductions in current liabilities.

 

·                  Returns:  Sales of the Company’s products are not subject to a general right of return. Product that has been used to fill patient prescriptions is no longer subject to any right of return. However, the Company will accept the return of product that is damaged or defective when shipped from its warehouse. In addition, the Company will accept return of expired product six months prior to and up to 12 months subsequent to the product’s expiry date. Expired or defective returned product cannot be re-sold; therefore, a right of return asset is not recorded.

 

The Company estimates liability for returns based on the actual returns experience for its two commercial products, in conjunction with industry return experience for similar products (i.e., ambient temperature storage for oral formulations.) Because the Company’s products have not reached maturity, the return rate of its products has and is expected to continue to vary. The Company records an estimated liability for product returns at the time the customer takes title to the product (i.e., at time of sale) as a reduction to gross product sales and an increase in Accrued Sales Deductions in current liabilities.

 

The Company’s estimated liability for product returns is also affected by price increases. Its products have a shelf life of 36 to 48 months from date of manufacture. Because of the extended shelf life and its return policy, there typically is a significant time lag between the time at which the product is sold and when the Company issues credit on an expired product. The Company’s policy permits product returns to be processed at current wholesaler price rather than historical price. Any price increase(s) taken during the current period increases the provision from product returns and therefore affects its estimated liability for product returns for both sales made in the current period as well as sales made in prior periods. Accordingly, the Company may have to adjust its estimates, favorably or unfavorably, which could have an effect on product sales and earnings in the period of adjustment.

 

·                  Sales discounts and allowances:  Distributors and wholesalers of pharmaceutical products are generally offered various forms of consideration, including allowances, service fees and prompt payment discounts, as consideration for distributing products. Distributor and wholesaler allowances and service fees arise from contractual agreements and are generally a percentage of the price at which the Company sells product to them. In addition, they are offered a prompt pay discount for payment within a specified period.

 

The Company accounts for these discounts at the time of sale as a reduction to gross product sales and are recorded as a reduction to Accounts Receivable. The Company estimates discounts to wholesalers based on contractual terms of agreements and historical experience.

 

Customer orders are generally fulfilled within a few days of receipt, resulting in minimal order backlog. Open purchase orders for products from customers are expected to be fulfilled within the next twelve months. There are no minimum product purchase requirements.

 

Incremental costs for obtaining a contract with a distributor or wholesaler include only those costs that the Company would not have incurred if the contract had not been obtained; e.g., sales commissions. Incremental costs for obtaining a contract are capitalized and amortized on a straight-line basis over the expected customer relationship period. As a practical expedient, the Company expenses incremental costs in obtaining a contract if the expected amortization period of the contract would have been a year or less or if the amount is immaterial. These costs are recorded in Selling, general and administrative expenses in the consolidated statement of earnings. Costs to fulfill a contract are expensed as incurred and recorded in Cost of product sales in the consolidated statement of earnings. There were no contract assets or liabilities recorded as of January 1, 2018 or September 30, 2018.

 

License Revenue

 

License and Collaboration Agreements

 

The Company has entered into collaboration agreements to commercialize both Oxtellar XR and Trokendi XR outside of the U.S. which involve the right to use the Company’s intellectual property as a functional license. These agreements generally include an up-front license fee and ongoing milestone payments upon the achievement of specific events. These agreements may also require minimum royalty payments based on sales of products developed from the applicable intellectual property.

 

Up-front license fees are recognized once the license has been delivered to the customer.

 

Milestones are a form of variable consideration that are recognized when either the underlying events have been achieved (event-based milestone) or the sales-based targets have been met by the collaborative partner (sales-based milestone). Both types of milestone payments are non-refundable. The Company evaluates whether achieving the milestones is considered probable and estimates the amount to be included in the transaction price using the most likely amount method. This can involve management’s

 

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judgment that includes assessing factors that are outside of the Company’s influence, such as: likelihood of regulatory success; availability of third party information; and expected duration of time until achievement of event. These factors are evaluated based on the specific facts and circumstances. If it is probable that a significant revenue reversal would not occur, the value of the associated milestone is included in the transaction price.

 

Event-based milestones are recognized in the period that the related event, such as regulatory approval, occurs. Sales-based milestones are recognized as revenue when the sales target is achieved. Milestone payments that are not within the control of the Company, such as approval from regulatory authorities or where attainment of the specified event is dependent on the development activities of a third-party, are not considered probable of being achieved until the specified event occurs. Revenue is recognized from the satisfaction of performance obligations in the amount billable to the customer.

 

The Company recorded no milestone revenue and $300,000 of milestone revenue for the three months ended September 30, 2018 and 2017, respectively. The Company recorded $750,000 and $1.5 million of milestone revenue for the nine months ended September 30, 2018 and 2017, respectively.

 

Revenue associated with future milestones will be recognized when the related event occurs or sales-based target is achieved. There are no guaranteed minimum amounts owed to the Company related to license and collaboration agreements.

 

Royalty Revenue

 

The Company recognizes non-cash royalty revenue for royalty amounts earned pursuant to a royalty agreement with United Therapeutics Corporation (United Therapeutics) that involves the right to use the Company’s intellectual property as a functional license. In 2014, the Company sold certain of these royalty rights to Healthcare Royalty Partners III, L.P. (HC Royalty) (see Note 15). Accordingly, the Company records non-cash royalty revenue based on estimated product sales by United Therapeutics that result in payments made from United Therapeutics to HC Royalty in connection with these agreements.

 

Royalty revenue also includes royalty amounts received from collaboration partners, including from Shire Plc (Shire) based on net product sales of Shire’s product, Mydayis. Royalty revenue is only recognized when the underlying product sale by Shire occurs. The Shire arrangement also involves the right to use the Company’s intellectual property as a functional license. Royalty revenue is recognized based on estimated net product sales by Shire in the current period.

 

There are no guaranteed minimum amounts owed to the Company related to royalty revenue agreements.

 

For the three and nine months ended September 30, 2018, revenue recognized from performance obligations related to prior periods (for example, due to changes in transaction price) was not material in the aggregate to Net Product Sales, License Revenue and Royalty Revenue.

 

Accounts Receivable, net

 

Accounts receivable are reported on the consolidated balance sheets at outstanding amounts due from customers, less an allowance for doubtful accounts and sales discounts. The Company extends credit without requiring collateral. The Company writes off uncollectible receivables when the likelihood of collection is remote. The Company evaluates the collectability of accounts receivable on a regular basis. An allowance, when needed, is based upon various factors including the financial condition and payment history of customers, an overall review of collections experience on other accounts, and economic factors or events expected to affect future collections experience. All arrangements are payable no later than one year after the transfer of the product. The Company does not assess whether a contract has a significant financing component if the expectation at contract inception is such that the period between the transfer of the promised good to the customer and receipt of payment will be one year or less. There are currently no significant financing components.

 

The Company recorded no allowance for doubtful accounts as of September 30, 2018 and December 31, 2017. There was no provision or write-off recorded for the three and nine months ended September 30, 2018 and September 30, 2017.

 

The Company recorded an allowance of approximately $11.2 million and $8.9 million for expected sales discounts, related to prompt pay discounts and contractual fee for service arrangements, to pharmaceutical wholesalers and distributors as of September 30, 2018 and December 31, 2017, respectively.

 

Cost of Product Sales

 

The cost of product sales consists primarily of materials, third-party manufacturing costs, freight and distribution costs, allocation of labor, quality control and assurance, and other manufacturing overhead costs.

 

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Research and Development Costs

 

Research and development costs are expensed as incurred. Research and development costs consist primarily of: employee-related expenses, including salaries and benefits; share-based compensation expense; expenses incurred under agreements with clinical research organizations (CROs); fees paid to clinical investigators who are participating in our clinical trials; fees paid to consultants and other vendors that assist in the conduct of the Company’s clinical trials; the cost of acquiring and manufacturing clinical trial materials; the cost of manufacturing materials used in process validation, but only to the extent that those materials are manufactured prior to receiving regulatory approval and are not expected to be sold commercially; facilities costs that do not have an alternative future use; related depreciation and other allocated expenses; license fees for, and milestone payments related to, in-licensed products and technologies; and costs associated with animal testing activities and regulatory approvals. Assets acquired that are used for research and development and have no future alternative use are expensed as in-process research and development.

 

Advertising Expense

 

Advertising expense includes costs of promotional materials and activities, such as marketing materials, marketing programs and speaker programs. The costs of the Company’s advertising efforts are expensed as incurred. The Company incurred approximately $11.6 million and $30.5 million in advertising costs for the three and nine months ended September 30, 2018 and approximately $9.6 million and $26.1 million in advertising costs for the three and nine months ended September 30, 2017, respectively. These expenses are recorded in Selling, general and administrative expenses in the consolidated statement of earnings.

 

Share-Based Compensation

 

Employee share-based compensation is measured based on the estimated fair value as of the grant date. The grant date fair value is calculated using the Black-Scholes option-pricing model, which requires the use of subjective assumptions, including: stock volatility; expected term; risk-free rate; and the fair value of the underlying common stock. The Company recognizes expense using the straight-line method.

 

The Company records the expense for stock option grants to non-employees based on the estimated fair value of the stock option using the Black-Scholes option pricing model. The fair value of awards to non-employees is remeasured at each reporting period. As a result, stock compensation expense for non-employee awards can be affected by subsequent changes in the fair value of the Company’s common stock, with those changes recorded in the relevant period.

 

Income Taxes

 

The Company utilizes the asset and liability method of accounting for income taxes. Under this method, deferred tax assets and liabilities are determined based on differences between financial reporting and tax reporting bases of assets and liabilities and are measured using enacted tax rates and laws that are expected to be in effect when the differences are expected to reverse. When appropriate, valuation allowances are established to reduce deferred tax assets to the amounts expected to be realized.

 

The Company accounts for uncertain tax positions in its consolidated financial statements when it is more-likely-than-not that the position will be sustained upon examination by the tax authorities. Such tax positions must initially and subsequently be measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon ultimate settlement with the tax authorities, assuming full knowledge of the position and relevant facts. The Company’s policy is to recognize any interest and penalties related to income taxes as income tax expense in the relevant period.

 

Recently Issued Accounting Pronouncements

 

Accounting Pronouncements Adopted in 2018

 

In May 2014, the FASB issued Accounting Standards Update (ASU) No. 2014-09, “Revenue from Contracts with Customers,” and has subsequently issued a number of amendments to ASU 2014-09. ASU 2014-09 and all the related amendments are codified in ASC 606, “Revenue from Contracts with Customers” (the New Revenue Standard). The New Revenue Standard provides a comprehensive model to be used in the accounting for revenue arising from contracts with customers and supersedes current revenue recognition guidance, including industry-specific guidance.

 

On January 1, 2018, the Company adopted the New Revenue Standard using the modified retrospective method applied to those contracts which had not been completed as of January 1, 2018. The Company recognized the cumulative effect of initially applying the New Revenue Standard as an adjustment to the opening balance of retained earnings.

 

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The Company recorded a decrease of $2.3 million to the accumulated deficit as of January 1, 2018 due to the cumulative impact of adopting the New Revenue Standard. The decrease resulted from the acceleration of both up-front licensing fees from license and collaboration agreements and the acceleration of royalties from sales of licensed product. Under the New Revenue Standard, up-front licensing fees are recognized when the license is delivered to the customer. Royalties from the sale of licensed product will be recognized as the underlying sales of product occur by the licensee. There were no changes in the timing of revenue recognition related to net product sales.

 

The comparative information has not been restated and continues to be reported under the accounting standards in effect for those periods, in thousands of dollars:

 

 

Adoption of the New Revenue Standard had no material impact on the Company’s consolidated balance sheets or statements of earnings and had no impact on cash from or used in operating, investing or financing activities as reported on the Company’s consolidated statements of cash flows.

 

In May 2017, the FASB issued ASU 2017-09, “Compensation—Stock Compensation (Topic 718): Scope of Modification Accounting,” which clarifies when to account for a change to the terms or conditions of a share-based payment award as a modification. Under the new guidance, modification accounting is required only if the fair value, the vesting conditions, or the classification of the award (as equity or liability) changes as a result of the change in terms or conditions. ASU 2017-09 is effective for all annual periods, and interim periods within those annual periods, beginning after December 15, 2017, with early adoption permitted. The adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

 

In August 2016, the FASB issued ASU No. 2016-15, “Classification of Certain Cash Receipts and Cash Payments.” The standard eliminates diversity in the practice of 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 adoption of this guidance did not have a material impact on the Company’s consolidated financial statements.

 

In January 2017, the FASB issued Accounting Standards Update No. 2017-01, “Business Combinations (Topic 805): Clarifying the Definition of a Business,” which clarifies the definition of a business and provides new guidance in evaluating when a set of transferred assets and activities is a business. This guidance requires that if substantially all of the fair value of gross assets acquired or disposed of is concentrated in a single asset or group of similar identifiable assets, the assets would not represent a business. The Company adopted the new standard on January 1, 2018 and will apply the new guidance prospectively to transactions occurring after adoption, including the Biscayne acquisition.

 

New Accounting Pronouncements Not Yet Adopted

 

In February 2016, the FASB issued ASU No. 2016-02, “Leases (Topic 842)” and its related amendments (the New Lease Standard). The New Lease Standard requires a lessee to recognize a right-of-use asset and a lease liability on the balance sheet for leases with lease terms greater than 12 months. The New Lease Standard is effective for fiscal years, and interim periods within those years, beginning after December 15, 2018. Early adoption is permitted. The Company is evaluating the impact of adopting the New Lease Standard on its consolidated financial statements and expects that it will have a material impact on its consolidated balance sheet due to the recognition of assets and liabilities, principally for certain leases currently accounted for as operating leases. The New Lease Standard is also expected to result in enhanced quantitative and qualitative lease-related disclosures. The Company does not expect the New Lease Standard to have a material impact on its cash flows or results of operations.

 

In August 2017, the FASB issued ASU 2017-12, “Derivatives and Hedging (Topic 815): Targeted Improvements to Accounting for Hedging Activities.” ASU 2017-12 provides new guidance about income statement classification and eliminates the requirement to separately measure and report hedge ineffectiveness. The entire change in fair value for qualifying hedge instruments included in the effectiveness measurement will be recorded in other comprehensive income (OCI). Amounts deferred in OCI will be

 

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reclassified to earnings in the same income statement line item in which the earnings effect of the hedged item is reported. This standard will be effective for the first annual period beginning after December 15, 2018, including interim periods within those periods. Early adoption is permitted. The Company is currently assessing the impact that adopting this standard will have on its consolidated financial statements, but does not expect it to have a material impact.

 

The Company has evaluated all other ASUs issued through the date the consolidated financial statements were issued in this Quarterly Report on Form 10-Q and believes that no other ASUs will have a material impact on the Company’s consolidated financial statements.

 

3.  Fair Value of Financial Instruments

 

The fair value of an asset or liability represents the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. Such transactions to sell an asset or transfer a liability are assumed to occur in the principal or most advantageous market for the asset or liability. Accordingly, fair value is determined based on a hypothetical transaction at the measurement date, considered from the perspective of a market participant rather than from a reporting entity’s perspective.

 

The Company reports assets and liabilities that are measured at fair value using a three level fair value hierarchy that prioritizes the inputs used to measure fair value. This hierarchy maximizes the use of observable inputs and minimizes the use of unobservable inputs. The three levels of inputs used to measure fair value are as follows:

 

·                  Level 1—Inputs are unadjusted quoted prices in active markets for identical assets that the Company has the ability to access at the measurement date.

 

·                  Level 2—Inputs are: quoted prices for similar assets and liabilities in active markets; quoted prices for identical or similar assets or liabilities in markets that are not active; inputs other than quoted prices that are observable for the asset or liability (interest rates, yield curves, etc.); and inputs that are derived principally from or corroborated by observable market data by correlation or other means (market corroborated inputs).

 

·                  Level 3—Unobservable inputs that reflect the Company’s own assumptions, based on the best information available, including the Company’s own data.

 

In accordance with the fair value hierarchy described above, the following tables show the fair value of the Company’s financial assets and liabilities that are required to be measured at fair value, in thousands of dollars:

 

 

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		Fair Value Measurements at
		December 31, 2017
								Significant
		Total Carrying			Quoted Prices			Other			Significant
		Value at			in Active			Observable			Unobservable
		December 31,			Markets			Inputs			Inputs
		2017			(Level 1)			(Level 2)			(Level 3)
Assets:
Cash and cash equivalents		$	100,304		$	100,304		$	—		$	—
Marketable securities		39,736			2,118			37,618			—
Long term marketable securities:
Corporate debt securities		132,477			448			132,029			—
Government debt securities		1,161			—			1,161			—
Other non-current assets:
Marketable securities - restricted (SERP)		335			—			335			—
Total assets at fair value		$	274,013		$	102,870		$	171,143		$	—

 

The fair value of the restricted marketable securities is included within other non-current assets in the consolidated balance sheets.

 

The Company’s Level 1 assets include cash held with banks, certificates of deposit, money market funds and investment grade corporate and government debt securities.

 

Level 2 assets include the SERP (Supplemental Executive Retirement Plan) assets, commercial paper and investment grade corporate and government debt securities and other fixed income securities. Level 2 securities are valued using third-party pricing sources that apply applicable inputs and other relevant data in their models to estimate fair value.

 

The carrying value, face value and estimated fair value of the 2023 Notes were approximately $325.7 million, $402.5 million and $450.7 million, respectively, as of September 30, 2018. The fair value was estimated based on actual trade information as well as quoted prices provided by bond traders and are characterized within Level 2 of the fair value hierarchy.

 

The carrying amounts of other financial instruments, including accounts receivable, accounts payable and accrued expenses approximate fair value due to their short-term maturities.

 

Unrestricted marketable securities held by the Company were as follows, in thousands of dollars:

 

At September 30, 2018 (unaudited):

 

Available for Sale		Amortized Cost			Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Corporate and government debt securities		$	621,436		6		(4,731	)	$	616,711

 

At December 31, 2017:

 

Available for Sale		Amortized Cost			Gross Unrealized Gains		Gross Unrealized Losses		Fair Value
Corporate and government debt securities		$	174,235		48		(909	)	$	173,374

 

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The contractual maturities of the unrestricted available for sale marketable securities held by the Company were as follows, in thousands of dollars:

 

		September 30,
		2018
		(unaudited)
Less Than 1 Year		$	156,407
1 year to 2 years		169,074
2 year to 3 years		161,614
3 years to 4 years		129,616
Greater Than 4 Years		—
Total		$	616,711

 

The Company has not experienced any other-than-temporary losses on its marketable securities and restricted marketable securities. The cost of securities sold is calculated using the specific identification method.

 

4. Inventories

 

Inventories consist of the following, in thousands of dollars:

 

		September 30,			December 31,
		2018			2017
		(unaudited)
Raw materials		$	3,925		$	2,995
Work in process		9,321			8,873
Finished goods		10,034			4,436
		$	23,280		$	16,304

 

5.  Property and Equipment, net

 

Property and equipment, net consist of the following, in thousands of dollars:

 

		September 30,			December 31,
		2018			2017
		(unaudited)
Lab equipment and furniture		$	8,957		$	8,331
Leasehold improvements		2,970			2,731
Software		2,157			2,004
Computer equipment		1,309			1,226
Construction-in-progress		2,367			178
		17,760			14,470
Less accumulated depreciation and amortization		(10,830		)	(9,346		)
		$	6,930		$	5,124

 

Construction-in-progress includes capitalized construction costs related to the build-to-suit lease of the Company’s new headquarters (see Note 14). No accumulated depreciation for this asset has been recorded as of September 30, 2018.

 

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Depreciation and amortization expense on property and equipment was approximately $600,000 and $1.5 million for the three and nine months ended September 30, 2018, and approximately $300,000 and $900,000 for the three and nine months ended September 30, 2017, respectively.

 

No indicators of impairment were identified.

 

6.  Intangible Assets

 

Intangible assets consist of patent defense costs, primarily legal fees incurred in conjunction with defending patents for Oxtellar XR and Trokendi XR. The following sets forth the gross carrying amount and related accumulated amortization of the intangible assets, in thousands of dollars:

 

		Weighted-		September 30,			December 31,
		Average Life		2018			2017
				(unaudited)
Capitalized patent defense costs		4.25 -8.50 years		$	44,625		$	44,185
Less accumulated amortization				(12,053		)	(8,166		)
				$	32,572		$	36,019

 

In March 2017, the Company entered into two settlements with several companies related to Trokendi XR patent litigation. The remaining unamortized aggregate capitalized patent defense costs for Trokendi XR have subsequently been amortized over the reduced remaining useful life of the patents at issue, or January 1, 2023. This is the date the Company is obligated under the settlements to grant a non-exclusive license to the patents at issue.

 

Amortization expense on intangible assets was approximately $1.3 million and $3.9 million for the three and nine months ended September 30, 2018, and approximately $4.1 million and $5.5 million for the three and nine months ended September 30, 2017, respectively.

 

No indicators of impairment were identified.

 

7.  Accrued Expenses

 

Accrued expenses are comprised of the following, in thousands of dollars:

 

		September 30,			December 31,
		2018			2017
		(unaudited)
Accrued clinical trial and clinical supply costs		$	12,059		$	6,996
Accrued compensation		11,763			10,279
Accrued product costs		2,640			726
Accrued interest expense		1,363			—
Accrued professional fees		850			2,890
Other accrued expenses		3,423			6,414
		$	32,098		$	27,305

 

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8.  Accrued Sales Deductions

 

Accrued sales deductions are comprised of the following, in thousands of dollars:

 

		September 30,			December 31,
		2018			2017
		(unaudited)
Accrued rebates		$	66,742		$	49,460
Accrued product returns		19,228			18,883
		$	85,970		$	68,343

 

9. Convertible Senior Notes

 

On March 14, 2018, the Company entered into a Purchase Agreement (the Purchase Agreement) with Jefferies LLC, J.P. Morgan Securities LLC and Cowen and Company, LLC, as the initial purchasers (collectively, the Initial Purchasers), in connection with the offering and sale of $350 million aggregate principal amount of 2023 Notes.  The Company also granted the Initial Purchasers an over-allotment option to purchase, within a 30-day period, up to an additional $52.5 million principal amount of additional 2023 Notes on the same terms and conditions, which the Initial Purchasers exercised in full on March 15, 2018.

 

On March 19, 2018, the sale of the 2023 Notes was settled and the 2023 Notes were issued pursuant to an Indenture, dated as of March 19, 2018 (the Indenture), between the Company and Wilmington Trust, National Association, as trustee.  The Indenture includes customary terms and covenants, including certain events of default upon which the 2023 Notes may be due and payable immediately. The Indenture governing the 2023 Notes does not contain any financial or operating covenants or any restrictions on the payment of dividends, the issuance of other indebtedness or the issuance or repurchase of securities by the Company.

 

The Company will pay interest on the 2023 Notes at an annual rate of 0.625%, payable semi-annually in arrears on April 1 and October 1 of each year, beginning on October 1, 2018. The 2023 Notes will mature on April 1, 2023, unless earlier converted or repurchased by the Company.

 

Noteholders may convert their 2023 Notes at their option only in the following circumstances: (1) during any calendar quarter commencing after the calendar quarter ending on June 30, 2018, if the last reported sale price per share of the Company’s common stock for each of at least 20 trading days (whether or not consecutive) during the 30 consecutive trading days ending on, and including the last trading day of the immediately preceding calendar quarter exceeds 130% of the conversion price, or a price of approximately $77.13 per share on such trading day; (2) during the five consecutive business days immediately after any 10 consecutive trading day period (such 10 consecutive trading day period, the “measurement period”) in which the trading price per $1,000 principal amount of notes for each trading day of the measurement period was less than 98% of the product of the last reported sale price per share of the Company’s common stock on such trading day and the conversion rate on such trading day; (3) upon the occurrence of certain corporate events or distributions on the Company’s common stock, as specified in the Indenture; and (4) at any time from, and including, October 1, 2022 until the close of business on the second scheduled trading day immediately before the maturity date. The Company will settle conversions by paying or delivering, as applicable, cash, shares of the Company’s common stock or a combination of cash and shares of the Company’s common stock, at its election, based on the applicable conversion rate. The initial conversion rate is 16.8545 shares per $1,000 principal amount of the 2023 Notes, which represents an initial conversion price of approximately $59.33 per share, and is subject to adjustment as specified in the Indenture.

 

If a “make-whole fundamental change” (as defined in the Indenture) occurs, then the Company will in certain circumstances increase the conversion rate for a specified period of time.  If a “fundamental change” (as defined in the Indenture) occurs, then noteholders may require the Company to repurchase their 2023 Notes at a cash repurchase price equal to the principal amount of the 2023 Notes to be repurchased, plus accrued and unpaid interest, if any.

 

The Company may not redeem the 2023 Notes at its option before maturity.

 

In the event of conversion, holders would forgo all future interest payments, any unpaid accrued interest and the possibility of further stock price appreciation. Upon the receipt of conversion requests, the settlement of the 2023 Notes will be paid pursuant to the terms of the Indenture. In the event that all of the 2023 Notes are converted, the Company would be required to repay the $402.5 million in principal value and any conversion premium in cash, shares or any combination of cash and shares of its common stock (at the Company’s option).

 

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