ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
Management's discussion and analysis of financial condition and results of
operations should be read in conjunction with the accompanying consolidated
financial statements. The results for 2001 and 2000 are unaudited. See "Item 8,
Statement in Lieu of Independent Auditors' Report."
10
RESULTS OF OPERATIONS
The Company's revenues are derived from sales of diagnostic and therapeutic
pharmaceuticals and surgical instruments by the ophthalmic segment, from sales
of diagnostic and therapeutic pharmaceuticals by the injectable segment and from
contract services revenue. The following table sets forth the percentage
relationships that certain items from the Company's Consolidated Statements of
Income bear to revenues for the years ended December 31, 2001, 2000 and 1999.
YEARS ENDED DECEMBER 31,
------------------------------
2001 2000 1999
---- ---- ----
Revenues
Ophthalmic................................................ 41% 42% 50%
Injectable................................................ 23 38 35
Contract Services......................................... 36 20 15
--- --- ---
Total revenues.............................................. 100% 100% 100%
Gross profit................................................ 17% 43% 52%
Selling, general and administrative expenses................ 75 26 26
Amortization of intangibles................................. 4 2 3
Research and development expenses........................... 6 6 4
--- --- ---
Operating income (loss)..................................... (68) 9 19
Net income (loss)........................................... (46)% 3% 10%
SIGNIFICANT ACCOUNTING POLICIES
The Company accrues an estimate of the difference between the gross sales
price of certain products sold to wholesalers and the expected resale prices of
such products under contractual arrangements with third parties such as
hospitals and group purchasing organizations at the time of sale to the
wholesaler. Similarly, the Company records an allowance for rebates related to
contracts and other programs with wholesalers. These allowances are reflected as
a reduction of account receivable balances. The Company evaluates the allowance
balances against actual chargebacks and rebates processed by wholesalers. Actual
chargebacks and rebates processed can vary materially from period to period. The
Company has an increasing number of contracts and other programs with
wholesalers, each incorporating various numbers and types of chargebacks and
rebates. The recorded allowance amount reflects the Company's current estimate
of the chargeback and rebate amounts wholesalers have earned under these various
contracts and programs.
In May 2001, the Company completed an analysis of its March 31, 2001
allowance for chargebacks and rebates and determined that an increase from the
allowance of $3,296,000 at December 31, 2000 was necessary. In performing such
analysis, the Company utilized recently obtained reports of wholesaler's
inventory information, which had not been previously obtained or utilized. Based
on the wholesaler's March 31, 2001 inventories and historical chargeback and
rebate activity, the Company recorded an allowance of $6,961,000, which resulted
in an expense of $12,000,000 for the three months ended March 31, 2001.
During the quarter ended June 30, 2001, the Company further refined its
estimates of the chargeback and rebate liability determining that an additional
$2,250,000 provision needed to be recorded. This additional increase to the
allowance was necessary to reflect the continuing shift of sales to customers
who purchase their products through group purchasing organizations and buying
groups. The Company had previously seen a much greater level of list price
business than is occurring in the current business environment.
The Company records an allowance for estimated product returns. This
allowance is reflected as a reduction of account receivable balances. The
Company evaluates the allowance balance against actual returns processed. Actual
returns processed can vary materially from period to period.
Based on the wholesaler's inventory information, the Company increased its
allowance for potential product returns to $2,232,000 at March 31, 2001 from
$232,000 at December 31, 2000. The provision for the
11
three months ended March 31, 2001 was $2,559,000. The allowance for potential
product returns was $548,000 at December 31, 2001.
The Company records an allowance for doubtful accounts, which reflects
trade receivable balances owed to the Company that are believed to be
uncollectible. This allowance is reflected as a reduction of account receivable
balances. The expense related to doubtful accounts is reflected in SG&A
expenses.
Based upon its recent unsuccessful efforts to collect past due balances,
the Company updated its analysis of potentially uncollectible trade receivable
balances and recorded a total bad debt provision for the year of $12,000,000.
The Company recorded $7,520,000 and $4,610,00 in the first and second quarter of
2001, respectively and reduced the allowance $130,000 in the fourth quarter of
2001. As a result, and after the effect of balances written off, the allowance
for doubtful accounts increased to $3,706,000 at December 31, 2001 from $801,000
at December 31, 2000.
The Company records an allowance for discounts and allowances, which
reflects discounts and allowances available to certain customers based on agreed
upon terms of sale. This allowance is reflected as a reduction of account
receivable balances. The Company evaluates the allowance balance against actual
discounts taken.
The Company records an estimate for slow-moving and obsolete inventory
based upon recent historical sales by unit. The Company evaluates the potential
sales of its products over their remaining lives and estimates the amount that
may expire before being sold.
In the fourth quarter of 2000, the Company increased this reserve by
$2,700,000 to account for slow moving and obsolete inventory primarily related
to products purchased from third parties in 1998 and 1999 for which the original
sales forecast overestimated actual demand.
In the first quarter of 2001, based on sales trends and forecasted sales
activity by product, the Company increased its allowance for inventory
obsolescence to $4,583,000. The provision for the three months ended March 31,
2001 was $1,500,000. The allowance for inventory obsolescence was $1,845,000 at
December 31, 2001.
All other increases to the allowances for chargebacks and rebates, returns,
doubtful accounts, discounts and allowances and inventory obsolescence occurred
as part of the normal recording of product sales.
COMPARISON OF TWELVE MONTHS ENDED DECEMBER 31, 2001 AND 2000
Revenues decreased 36.9% for the year ended December 31, 2001 compared to
the prior year. Ophthalmic segment revenues decreased 38.2%, primarily
reflecting the decline in sales in the antibiotic, glaucoma and artificial tear
product lines. The remaining decline in ophthalmic revenues reflects the effect
of increases to the allowance for chargebacks and rebates discussed in Note K to
the Consolidated Financial Statements. The allowances for chargebacks and
rebates and returns are recorded as reductions to gross sales in computing net
sales. Ophthalmic net sales were also negatively impacted by price competition
for some of the Company's higher volume product lines. The reduction in sales
was due to both declines in unit price as well as volume. Injectable segment
revenues decreased 60.9%, primarily due to the increases in the allowances for
chargebacks and rebates and returns, discussed in Note K to the Consolidated
Financial Statements and a sharp reduction in anesthesia and antidote product
sales. The sharp reduction is attributable to excessive wholesaler inventories
that were reduced during the year without compensating purchases made by the
wholesalers. Contract services revenues increased 10.6% compared to the same
period in 2000, primarily due to price increases necessary to cover increasing
production costs.
Consolidated gross profit decreased 75.4% for the year, with gross margins
decreasing from 43.1% to 16.8%. This reflects the effects of the aforementioned
decline in net sales, as well as an increase in the reserve for slow-moving,
unsaleable and obsolete inventory items (See Note K). In addition, the Company
incurred unfavorable manufacturing variances at both the Somerset, NJ facility
and its Decatur, IL facility, which eroded the gross margin percentage. These
variances were the result of reduced activity in the plant, primarily caused by
the previously discussed reduction in sales that resulted from the wholesaler
inventories being reduced without compensating purchases. Management anticipates
that manufacturing variances will decrease
12
in the future as a result of the restructuring program (See Note S) implemented
during 2001. The Company is actively looking into increasing its manufacturing
activity at its Somerset facility either through additional product approvals or
increasing its third-party manufacturing business.
Selling, general and administrative expenses ("SG&A") increased 81.2% for
the year as compared to 2000. The increase primarily reflects a provision for
bad debts of $12,000,000. The provision for bad debts in 2000 was $607,000. SG&A
expenses also increased due to asset impairment charges of $2,132,000 and
restructuring-related charges of $1,117,000 primarily severance and lease costs.
Without these charges, SG&A would have decreased 6.4%, reflecting the results of
the cost cutting and restructuring efforts employed during the year.
Amortization of intangibles decreased 1.6% for the year, reflecting the
exhaustion of certain product intangibles.
Research and Development expenses ("R&D") decreased 37.1%, primarily
reflecting a scaling back of research and development activities. The Company is
focusing on strategic product niches in which it believes it will be able to add
value, primarily in the areas of controlled substances and ophthalmics.
Interest expense increased 47.8% compared to 2000, reflecting higher
interest rates on higher average outstanding debt balances (See Note G)
partially offset by capitalized interest related to the lyophilized
pharmaceuticals manufacturing line expansion.
Net loss for 2001 was $19,611,000, or $1.01 per share, compared to net
income of $2,187,000, or $0.11 per share, for the prior year.
COMPARISON OF TWELVE MONTHS ENDED DECEMBER 31, 2000 AND 1999
Revenues increased 3.6% for the year ended December 31, 2000 compared to
the prior year. Ophthalmic segment revenues decreased 13.1%, primarily due to
sharply reduced sales in generic therapeutic pharmaceuticals for glaucoma and
allergies. The reduction in sales was due to both declines in unit price as well
as volume. Injectable segment revenues increased 20.3%, primarily due to sales
of acquired anesthesia products. Injectable segment sales also benefited from
favorable unit prices due to a continuing shortage of certain distributed
products and increased contract-manufacturing activity. In both segments,
wholesaler-discounting programs unfavorably impacted unit prices. These
discounts take the form of chargebacks and rebates. Chargebacks and rebates are
discussed further in Note K to the Consolidated Financial Statements. This
charge is reflected as a reduction in net sales, primarily ophthalmic.
Consolidated gross profit decreased 13.9% for the year, with gross margins
decreasing from 51.8% to 43.1%. Pricing pressure on ophthalmic generic
pharmaceuticals as well as the disproportionate increase in contract
manufacturing revenues caused the decrease in gross margins. Contract
manufacturing activity commands significantly lower margins than sales of the
Company's other product lines. Margins in 2000 were also reduced by a $4.0
million ($2.7 million in the fourth quarter) increase in the reserve for
slow-moving and obsolete inventory. This increase was primarily related to
products purchased from third parties in 1998 and 1999 for which the original
sales forecast overestimated demand.
Selling, general and administrative expenses ("SG&A") increased 4.0%,
reflecting routine escalations in rental and other contracts, routine
compensation increases, and the increase in leased space in the Buffalo Grove
facility.
Amortization of intangibles decreased 19.1% for the year, reflecting a
patent expiration in the 2nd quarter of 1999.
Research and Development expenses ("R&D") increased 50.6%, primarily
reflecting costs associated with Piroxicam clinical trials and beginning stage
development of the Company's age-related macular degeneration product.
Interest expense increased 24.9%, reflecting higher interest rates on
higher average outstanding debt balances partially offset by capitalized
interest related to major capital projects in 2000.
13
Net income for 2000 was $2,187,000, or $0.11 per diluted share, compared to
$6,670,000, or $0.36 per diluted share, for the prior year. The decrease in
earnings resulted from the above mentioned items.
FINANCIAL CONDITION AND LIQUIDITY
As of December 31, 2001, the Company had cash and cash equivalents of
$5,355,000. The net working capital balance at December 31, 2001 was
$(24,357,000) versus $26,355,000 at December 31, 2000 resulting primarily from
decreases in receivables and inventory and reclassification of the Company's
senior debt obligation as a current liability.
During the year ended December 31, 2001, the Company used $654,000 in cash
for operations. Investing activities, which include the purchase of
product-related intangible assets as well as equipment required $4,126,000 in
cash. Fixed asset purchases related to the lyophilized (freeze-dried)
pharmaceuticals manufacturing line expansion accounted for $2,566,000 of the
$4,126,000 cash used in investing activities and the Company expects to spend an
additional $2,500,000 for such expansion during 2002. Financing activities
provided $9,328,000 in cash primarily through the issuance of $5,000,000
subordinated convertible debentures and a $3,250,000 promissory note.
In 1997 the Company entered into a $15 million revolving credit
arrangement, increased to $25 million in 1998, and subsequently increased to $45
million in 1999, subject to certain financial covenants and certain liens on the
Company's fixed assets. The credit agreement, as amended effective January 1,
2002, requires the Company to maintain certain financial covenants. These
covenants include minimum levels of cash receipts, limitations on capital
expenditures, a $750,000 per quarter limitation on product returns and required
amortization of the loan principal. The agreement also prohibits the Company
from declaring any cash dividends on its common stock and identifies certain
conditions in which the principal and interest on the credit agreement would
become immediately due and payable. These conditions include: (a) an action by
the FDA which results in a partial or total suspension of production or shipment
of products, (b) failure to invite the FDA in for re-inspection of the Decatur
manufacturing facilities by June 1, 2002, (c) failure to make a written
response, within 10 days, to the FDA, with a copy to the lender, to any written
communication received from the FDA after January 1, 2002 that raises any
deficiencies, (d) imposition of fines against the Company in an aggregate amount
greater than $250,000, (e) a cessation in public trading of Akorn stock other
than a cessation of trading generally in the United States securities market,
(f) restatement of or adjustment to the operating results of the Company in an
amount greater than $27,000,000, (g) failure to enter into an engagement letter
with an investment banker for the underwriting of an offering of equity
securities by June 15, 2002, (h) failure to not be party to an engagement letter
at any time after June 15, 2002 or (i) experience any material adverse action
taken by the FDA, the SEC, the DEA or any other Governmental Authority based on
an alleged failure to comply with laws or regulations. Management believes it
will be able to comply with the covenants during 2002. In the event that the
Company is not in compliance with the covenants during 2002 and does not
negotiate amended covenants and/or obtain a waiver thereto, then the debt
holder, at its option, may demand immediate payment of all outstanding amounts
due it. The amended credit agreement requires a minimum payment of $5.6 million,
which relates to an estimated federal tax refund, with the balance of $39.2
million due June 30, 2002. The estimated $5.6 million tax refund must be
remitted within three days of receipt from the Internal Revenue Service. The
Company is also obligated to remit any additional federal tax refunds received
above the estimated $5.6 million. The current credit facility matures on June
30, 2002 at which point the Company will need to re-negotiate or obtain new
financing. Management believes that additional long-term financing will be
needed to finance product development or acquisitions. There are no guarantees
that such financing will be available or available at an acceptable cost. See
Note G to Consolidated Financial Statement for a description of this
indebtedness and other indebtedness of the Company.
On July 12, 2001 the Company entered into a $5,000,000 subordinated debt
transaction with the John N. Kapoor Trust dtd. 9/20/89 (the "Trust"), the sole
trustee and sole beneficiary of which is Dr. John N. Kapoor, the Company's
current CEO and Chairman of the Board of Directors. The transaction is evidenced
by a Convertible Bridge Loan and Warrant Agreement (the "Trust Agreement") in
which the Trust agreed to provide two separate tranches of funding in the
amounts of $3,000,000 ("Tranche A" which was received on
14
July 13) and $2,000,000 ("Tranche B" which was received on August 16). As part
of the consideration provided to the Trust for the subordinated debt, the
Company issued the Trust two warrants which allow the Trust to purchase
1,000,000 shares of common stock at a price of $2.85 per share and another
667,000 shares of common stock at a price of $2.25 per share. The exercise price
for each warrant represented a 25% premium over the share price at the time of
the Trust's commitment to provide the subordinated debt.
Under the terms of the Trust Agreement, the subordinated debt will bear
interest at prime plus 3%, which is the same rate the Company pays on its senior
debt. Interest will not be paid to the Trust, but will instead accrue as
required by the terms of a subordination agreement which was entered into
between the Trust and the Company's senior lenders. The convertible feature of
the Trust Agreement, as amended, allows for conversion of the subordinated debt
plus interest into common stock of the Company, at a price of $2.28 per share of
common stock for Tranche A and $1.80 per share of common stock for Tranche B.
The Company, in accordance with Accounting Principles Board ("APB") Opinion
No. 14, recorded the subordinated debt transaction such that the convertible
debt and warrants have been assigned independent values. The fair value of the
warrants was estimated on the date of grant using the Black-Scholes option
pricing model with the following assumptions: (i) dividend yield of 0%, (ii)
expected volatility of 79%, (iii) risk free rate of 4.75%, and (iv) expected
life of 5 years. As a result, the Company assigned a value of $1,516,000 to the
warrants and recorded this amount as additional paid in capital. The remaining
$3,484,000 was recorded as long-term debt. The resultant bond discount,
equivalent to the value assigned to the warrants, will be amortized and charged
to interest expense over the life of the subordinated debt.
In December 2001, the Company entered into a $3,250,000 five-year loan with
NeoPharm, Inc. ("NeoPharm") to fund Akorn's efforts to complete its
lyophilization facility located in Decatur, Illinois. Under the terms of the
Promissory Note, dated December 20, 2001, interest will accrue at the initial
rate of 3.6% and will be reset quarterly based upon NeoPharm's average return on
its cash and readily tradable long and short-term securities during the previous
calendar quarter. The principal and accrued interest is due and payable on or
before maturity on December 20, 2006. The note provides that Akorn will use the
proceeds of the loan solely to validate and complete the lyophilization facility
located in Decatur, Illinois and to address the issues set forth in the Form 483
and warning letter received from the FDA. The Promissory Note is subordinated to
Akorn's senior debt owed to The Northern Trust Company but is senior to Akorn's
subordinated debt owed to the Trust. The note was executed in conjunction with a
Processing Agreement that provides NeoPharm, Inc. with the option of securing at
least 15% of the capacity of Akorn's lyophilization facility each year. Dr. John
N. Kapoor, the Company's chairman and chief executive officer is also chairman
of NeoPharm and holds a substantial stock position in that company as well as in
the Company.
Commensurate with the completion of the Promissory Note between the Company
and NeoPharm, the Company entered into an agreement with the Trust, which
amended the Trust Agreement. The amendment extended the Trust Agreement to
terminate concurrently with the Promissory Note on December 20, 2006. The
amendment also made it possible for the Trust to convert the interest accrued on
the $3,000,000 tranche into common stock of the Company. Previously, the Trust
could only convert the interest accrued on the $2,000,000 tranche. The change
related to the convertibility of the interest accrued on the $3,000,000 tranche
requires that shareholder approval be received by August 31, 2002.
15
SELECTED QUARTERLY DATA
In Thousands, Except Per Share Amounts
(Unaudited)
NET INCOME (LOSS)
----------------------------------
GROSS PER SHARE PER SHARE
REVENUES PROFIT (LOSS) AMOUNT BASIC DILUTED
-------- ------------- ------ --------- ---------
Year Ended December 31, 2001:
1st Quarter.............................. $ 6,076 $(5,783) $(12,977) $(0.67) $(0.67)
2nd Quarter.............................. 10,637 2,509 (6,275) (0.33) (0.33)
3rd Quarter.............................. 12,842 5,013 (479) (0.02) (0.02)
4th Quarter.............................. 12,693 5,362 120 0.01 0.01
------- ------- -------- ------ ------
$42,248 $ 7,101 $(19,611) $(1.01) $(1.01)
======= ======= ======== ====== ======
Year Ended December 31, 2000:
1st Quarter.............................. $16,644 $ 8,413 $ 1,794 $ 0.10 $ 0.09
2nd Quarter.............................. 18,320 9,786 2,184 0.11 0.11
3rd Quarter.............................. 16,878 7,096 415 0.02 0.02
4th Quarter.............................. 15,085 3,542 (2,206) (0.11) (0.11)
------- ------- -------- ------ ------
$66,927 $28,837 $ 2,187 $ 0.11 $ 0.11
======= ======= ======== ====== ======
FACTORS THAT MAY AFFECT FUTURE RESULTS
Financial Risk Factors
A small number of wholesale drug distributors accounts for a large portion
of the Company's revenues. In 2001, sales to five wholesale drug distributors
accounted for 42% of total gross sales and approximately 47% of gross trade
receivables as of December 31, 2001. The loss of one or more of these customers,
a change in purchasing patterns, an increase in returns of the Company's
products, delays in purchasing products and delays in payment for products by
one or more distributors could have a material negative impact on the Company's
revenue and results of operations and may lead to a violation of debt covenants.
At December 31, 2001, the Company had total outstanding indebtedness of
$53,933,000, or 71% of total capitalization. This significant debt load could
limit the Company's operating flexibility as a result of restrictive covenants
placed on the Company by its lenders. Further, the current debt levels could
require usage of a large portion of the cash flow from operations for debt
payments that would reduce the availability of cash flow to fund operations,
product acquisitions, expansion of the Company's sales force, facilities
improvements and research and development activities. On several past occasions,
the Company has been out of compliance with a number of the financial and other
covenants contained in the documents, which govern its debt. To date, the
Company has been able to either renegotiate the terms of such covenants or
obtain waivers of such non-compliance. See "Financial Condition and Liquidity".
No assurance can be given, however, that, if the Company was to fail to comply
in the future with its existing covenants that the Company's lenders would be
willing to either further negotiate the terms of such covenants or waive the
Company's compliance with the covenants. Under the terms of the Company's loan
documents, the Company's lenders would have the right to declare a default under
the loan documents and to thereupon pursue any and all of the remedies available
to them under the loan documents, including, but not limited to, foreclosure on
substantially all of the Company's assets. While the Company believes that it
will be able to fully satisfy all of the terms and conditions set forth in its
loan documents, future events could make such performance more difficult or
impossible.
The Company may need additional funds to operate and grow its business. The
Company may seek additional funds through public and private financing,
including equity and debt offerings. Adequate funds through the financial
markets or from other sources, may not be available when needed or on terms
favorable to the Company or its stockholders. Insufficient funds could cause the
Company to delay, scale back, or
16
abandon some or all of its product acquisition, licensing opportunities,
marketing, product development, research and development and manufacturing
opportunities.
The Company is party to a License Agreement with The Johns Hopkins
University, Applied Physics Laboratory ("JHU/APL") effective April 26, 2000, and
amended effective July 15, 2001 (See Note C). A dispute (see "Legal
Proceedings") has arisen between the Company and JHU/APL concerning the License
Agreement. The Company has an intangible asset valued at $2,084,500 recorded as
a result of the License Agreement, as amended. Unsuccessful resolution of the
dispute could result in a revaluation of this intangible asset.
Government Regulation
Federal and state statutes and government agencies regulate virtually all
aspects of the Company's business. The development, testing, manufacturing,
processing, quality, safety, efficacy, packaging, labeling, record-keeping,
distribution, storage and advertising of the Company's products, and disposal of
waste products arising from such activities, are subject to regulation by one or
more federal agencies. These agencies include the Food and Drug Administration
("FDA"), the Drug Enforcement Agency ("DEA"), the Federal Trade Commission
("FTC"), the Consumer Product Safety Commission, the Occupational Safety and
Health Administration ("OSHA") and the U.S. Environmental Protection Agency
("EPA"). Similar state and local agencies also regulate these activities.
Failure to comply with applicable statutes and government regulations could have
a material adverse effect on the Company's business, financial condition and
results of operations.
All pharmaceutical manufacturers, including the Company, are subject to
regulation by the FDA under the authority of the Federal Food, Drug, and
Cosmetic Act ("FDC Act"). Under the FDC Act, the federal government has
extensive administrative and judicial enforcement powers over the activities of
pharmaceutical manufacturers to ensure compliance with FDA regulations. Those
powers include, but are not limited to, the authority to initiate court action
to seize unapproved or non-complying products, to enjoin non-complying
activities, to halt manufacturing operations that are not in compliance with
current good manufacturing practices ("cGMP"), to recall products which present
a health risk, and to seek civil monetary and criminal penalties. Other
enforcement activities include refusal to approve product applications or the
withdrawal of previously approved applications. Any such enforcement activities,
including the restriction or prohibition on sales of products marketed by the
Company or the halting of manufacturing operations of the Company, could have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, product recalls may be issued at the
discretion of the Company, the FDA or other government agencies having
regulatory authority for pharmaceutical product sales. Recalls may occur due to
disputed labeling claims, manufacturing issues, quality defects or other
reasons. No assurance can be given that recalls of the Company's pharmaceutical
products will not occur in the future. Any product recall could have a material
adverse effect on the Company's business, financial condition and results of
operations. Further, product recalls, in certain circumstances, could constitute
an event of default under the provision of the Company's senior debt.
All "new drugs" must be the subject of an FDA-approved new drug application
("NDA") before they may be marketed in the United States. Certain prescription
drugs are not currently required to be the subject of an approved NDA but,
rather, may be marketed pursuant to an FDA regulatory enforcement policy
permitting continued marketing of those drugs until the FDA determines whether
they are safe and effective. All generic equivalents to previously approved
drugs or new dosage forms of existing drugs must be the subject of an
FDA-approved abbreviated new drug application ("ANDA") before they may be
marketed in the United States. The FDA has the authority to withdraw existing
NDA and ANDA approvals and to review the regulatory status of products marketed
under the enforcement policy. The FDA may require an approved NDA or ANDA for
any drug product marketed under the enforcement policy if new information
reveals questions about the drug's safety or efficacy. All drugs must be
manufactured in conformity with cGMP and drugs subject to an approved NDA or
ANDA must be manufactured, processed, packaged, held, and labeled in accordance
with information contained in the NDA or ANDA.
17
The Company and its third-party manufacturers are subject to periodic
inspection by the FDA to assure such compliance. The FDA imposes additional
stringent requirements on the manufacture of sterile pharmaceutical products to
ensure the sterilization processes and related control procedures consistently
produce a sterile product. Additional sterile manufacturing requirements include
the submission for expert review of detailed documentation for sterilization
process validation in drug applications beyond those required for general
manufacturing process validation. Various sterilization process requirements are
the subject of detailed FDA guidelines, including requirements for the
maintenance of microbiological control and quality stability. Pharmaceutical
products must be distributed, sampled and promoted in accordance with FDA
requirements. The FDA also regulates drug labeling and the advertising of
prescription drugs. A finding by a governmental agency or court that the Company
is not in compliance could have a material adverse effect on the Company's
business, financial condition and results of operations.
During 2000, the Company received a warning letter as a result of a routine
inspection of its Decatur manufacturing facilities. This letter focused on
general documentation and cleaning validation issues. The Company was
re-inspected in late 2001 and the FDA issued a Form 483 documenting their
findings. The Company responded to these findings on January 4, 2002 and is
awaiting a response from the FDA. The warning letter prevents the FDA from
issuing any approval for new products manufactured at the Decatur facility. The
warning letter does not inhibit the Company's ability to continue manufacturing
products that are currently approved. The warning letter does not impact the
operations at the Somerset facility.
While the Company believes that all of its current pharmaceuticals are
lawfully marketed in the United States under current FDA enforcement policies or
have received the requisite agency approvals for manufacture and sale, such
marketing authority is subject to withdrawal by the FDA. In addition,
modifications or enhancements of approved products are in many circumstances
subject to additional FDA approvals which may or may not be granted and which
may be subject to a lengthy application process. Any change in the FDA's
enforcement policy or any decision by the FDA to require an approved NDA or ANDA
for a Company product not currently subject to the approved NDA or ANDA
requirements or any delay in the FDA approving an NDA or ANDA for a Company
product could have a material adverse effect on the Company's business,
financial condition and results of operations.
A number of products marketed by the Company are "grandfathered" drugs that
are permitted to be manufactured and marketed without FDA-issued ANDAs or NDAs
on the basis of their having been marketed prior to enactment of relevant
sections of the FDC Act. The regulatory status of these products is subject to
change and/or challenge by the FDA, which could establish new standards and
limitations for manufacturing and marketing such products, or challenge the
evidence of prior manufacturing and marketing upon which grandfathering status
is based. The Company is not aware of any current efforts by the FDA to change
the status of any of its "grandfathered" products, but there can be no assurance
that such initiatives will not occur in the future. Any such change in the
status of the Company's "grandfathered" products could have a material adverse
effect on the Company's business, financial condition and results of operations.
The Company also manufactures and sells drugs which are "controlled
substances" as defined in the federal Controlled Substances Act and similar
state laws, which establishes, among other things, certain licensing, security
and record keeping requirements administered by the DEA and similar state
agencies, as well as quotas for the manufacture, purchase and sale of controlled
substances. The DEA could limit or reduce the amount of controlled substances
which the Company is permitted to manufacture and market. The Company has not
experienced sanctions or fines for non-compliance with the foregoing
regulations, but no assurance can be given that any such sanctions or fines
would not have a material adverse effect on the Company's business, financial
condition and results of operations.
On March 6, 2002, the Company received a letter from the United States
Attorney's Office, Central District of Illinois, Springfield, Illinois, advising
the Company that the United States Drug Enforcement Administration had referred
a matter to that office for a possible civil legal action for alleged violations
of the Comprehensive Drug Abuse Prevention Control Act of 1970, 21 U.S.C. sec.
801, et. seq. and regulations promulgated under the Act. The Company is
cooperating fully with the government and anticipates that any action under this
matter will not have a material impact on its financial statements.
18
The Company cannot determine what effect changes in regulations or statutes
or legal interpretation, when and if promulgated or enacted, may have on its
business in the future. Changes could, among other things, require changes to
manufacturing methods, expanded or different labeling, the recall, replacement
or discontinuation of certain products, additional record keeping and expanded
documentation of the properties of certain products and scientific
substantiation. Such changes or new legislation could have a material adverse
effect on the Company's business, financial condition and results of operations.
Dependence on Development of Pharmaceutical Products and Manufacturing
Capabilities
The Company's strategy for growth is dependent upon its ability to develop
products that can be promoted through current marketing and distributions
channels and, when appropriate, the enhancement of such marketing and
distribution channels. The Company currently has 17 ANDAs in various stages of
development and anticipates filing two NDAs at some point in the future. See
"Item 1. Description of Business -- Research and Development." The Company may
not meet its anticipated time schedule for the filing of ANDAs and NDAs or may
decide not to pursue ANDAs or NDAs that it has submitted or anticipates
submitting. The internal development of new pharmaceutical products by the
Company is dependent upon the research and development capabilities of the
Company's personnel and its infrastructure. There can be no assurance that the
Company will successfully develop new pharmaceutical products or, if developed,
successfully integrate new products into its existing product lines. In
addition, there can be no assurance that the Company will receive all necessary
approvals from the FDA or that such approvals will not involve delays, which
adversely affect the marketing and sale of the Company's products. Until such
time as the Company receives clearance from the Form 483 and warning letter
received from the FDA, the Company will not receive approval from the FDA to
manufacture any new NDA products at its Decatur facility. The Company's failure
to develop new products or receive FDA approval of ANDAs or NDAs, or address the
issues raised in the Form 483 and warning letter received from the FDA, could
have a material adverse effect on the Company's business, financial condition
and results of operations. Another part of the Company's growth strategy is to
develop the capability to manufacture lyophilized (freeze-dried) pharmaceutical
products. While the Company has devoted resources to developing these
capabilities, it may not be successful in developing these capabilities, or the
Company may not realize the anticipated benefits from developing these
capabilities.
Generic Substitution
The Company's branded pharmaceutical products are subject to competition
from generic equivalents and alternative therapies. Generic pharmaceuticals are
the chemical and therapeutic equivalents of brand-name pharmaceuticals and
represent an increasing proportion of pharmaceuticals dispensed in the United
States. There is no proprietary protection for most of the branded
pharmaceutical products sold by the Company and generic and other substitutes
for most of its branded pharmaceutical products are sold by other pharmaceutical
companies. In addition, governmental and cost-containment pressures regarding
the dispensing of generic equivalents will likely result in generic substitution
and competition generally for the Company's branded pharmaceutical products.
Although the Company attempts to mitigate the effect of this substitution
through, among other things, creation of strong brand-name recognition and
product-line extensions for its branded pharmaceutical products, there can be no
assurance that the Company will be successful in these efforts. Increased
competition in the sale of generic pharmaceutical products could have a material
adverse effect on the Company's business, financial condition and results of
operations. Generic substitution is regulated by the federal and state
governments, as is reimbursement for generic drug dispensing. There can be no
assurance that substitution will be permitted for newly approved generic drugs
or that such products will be subject to government reimbursement.
Dependence on Generic and Off-Patent Pharmaceutical Products
The success of the Company depends, in part, on its ability to anticipate
which branded pharmaceuticals are about to come off patent and thus permit the
Company to develop, manufacture and market equivalent generic pharmaceutical
products. Generic pharmaceuticals must meet the same quality standards as
branded
19
pharmaceuticals, even though these equivalent pharmaceuticals are sold at prices
that are significantly lower than that of branded pharmaceuticals. In addition,
generic products that third parties develop may render the Company's generic
products noncompetitive or obsolete. Although the Company has successfully
brought generic pharmaceutical products to market in a timely manner in the
past, there can be no assurance that the Company will be able to consistently
bring these products to market quickly and efficiently in the future. An
increase in competition in the sale of generic pharmaceutical products or the
Company's failure to bring such products to market before its competitors could
have a material adverse effect on the Company's business, financial condition
and results of operations.
Risks and Expense of Legal Proceedings
The Company is currently involved in several pending or threatened legal
actions with both private parties and certain government agencies. See "Legal
Proceedings". While the Company believes that its positions in these various
matters are meritorious, to the extent that the Company's personnel must spend
time and the Company must expend resources to pursue or contest these various
matters, or any additional matters that may be asserted from the time to time in
the future, this represents time and money that is not available for other
actions that the Company might otherwise pursue which could be beneficial to the
Company's future. In addition, to the extent that the Company is unsuccessful in
any legal proceedings, the consequences could have a negative impact on the
Company or its operations. These consequences could include, but not be limited
to, fines, penalties, injunctions, the loss of patent or other rights, the need
to write down or off the value of assets (which could negatively impact the
Company's earnings) and a wide variety of other potential remedies or actions
that could be taken against the Company. While the Company will continue to
vigorously pursue its rights in all such matters, no assurance can be given that
the Company will be successful in any of these proceedings or, even if
successful, that the Company would be able to recoup any of the moneys expended
in pursuing such matters.
Competition; Uncertainty of Technological Change
The Company competes with other pharmaceutical companies, including major
pharmaceutical companies with financial resources substantially greater than
those of the Company, in developing, acquiring, manufacturing and marketing
pharmaceutical products. The selling prices of pharmaceutical products typically
decline as competition increases. Further, other products now in use, under
development or acquired by other pharmaceutical companies, may be more effective
or offered at lower prices than the Company's current or future products. The
industry is characterized by rapid technological change that may render the
Company's products obsolete, and competitors may develop their products more
rapidly than the Company. Competitors may also be able to complete the
regulatory process sooner, and therefore, may begin to market their products in
advance of the Company's products. The Company believes that competition in
sales of its products is based primarily on price, service, availability and
product efficacy. There can be no assurance that: (i) the Company will be able
to develop or acquire commercially attractive pharmaceutical products; (ii)
additional competitors will not enter the market; or (iii) competition from
other pharmaceutical companies will not have a material adverse effect on the
Company's business, financial condition and results of operations.
Dependence on Supply of Raw Materials and Components
The Company requires a supply of quality raw materials and components to
manufacture and package pharmaceutical products for itself and for third parties
with which it has contracted. The principal components of the Company's products
are active and inactive pharmaceutical ingredients and certain packaging
materials. Many of these components are available from only a single source and,
in the case of many of the Company's ANDAs and NDAs, only one supplier of raw
materials has been identified. Because FDA approval of drugs requires
manufacturers to specify their proposed suppliers of active ingredients and
certain packaging materials in their applications, FDA approval of any new
supplier would be required if active ingredients or such packaging materials
were no longer available from the specified supplier. The qualification of a new
supplier could delay the Company's development and marketing efforts. If for any
reason the Company is unable to obtain sufficient quantities of any of the raw
materials or components required to
20
produce and package its products, it may not be able to manufacture its products
as planned, which could have a material adverse effect on the Company's
business, financial condition and results of operations.
Dependence on Third-Party Manufacturers
The Company derives a significant portion of its revenues from the sale of
products manufactured by third parties, including its competitors in some
instances. There can be no assurance that the Company's dependence on third
parties for the manufacture of such products will not adversely affect the
Company's profit margins or its ability to develop and deliver its products on a
timely and competitive basis. If for any reason the Company is unable to obtain
or retain third-party manufacturers on commercially acceptable terms, it may not
be able to distribute certain of its products as planned. No assurance can be
made that the manufacturers utilized by the Company will be able to provide the
Company with sufficient quantities of its products or that the products supplied
to the Company will meet the Company's specifications. Any delays or
difficulties with third-party manufacturers could adversely affect the marketing
and distribution of certain of the Company's products, which could have a
material adverse effect on the Company's business, financial condition and
results of operations.
Product Liability
The Company faces exposure to product liability claims in the event that
the use of its technologies or products or those it licenses from third parties
is alleged to have resulted in adverse effects in users thereof. Receipt of
regulatory approval for commercial sale of such products does not mitigate such
product liability risks. While the Company has taken, and will continue to take,
what it believes are appropriate precautions, there can be no assurance that it
will avoid significant product liability exposure. In addition, future product
labeling may include disclosure of additional adverse effects, precautions and
contraindications, which may adversely impact sales of such products. The
Company currently has product liability insurance in the amount of $10.0 million
for aggregate annual claims with a $50,000 deductible per incident and a
$250,000 aggregate annual deductible. However, there can be no assurance that
such insurance coverage will be sufficient to fully cover potential claims.
Additionally, there can be no assurance that adequate insurance coverage will be
available in the future at acceptable costs, if at all, or that a product
liability claim would not have a material adverse effect on the Company's
business, financial condition and results of operations.
Acquisition and Licensing of Pharmaceutical Products
The Company may purchase or license pharmaceutical product lines of other
pharmaceutical or biotechnology companies. Other companies, including those with
substantially greater financial, marketing and other resources, compete with the
Company for the right to acquire or license such products. Were the Company to
elect to pursue this strategy, its success would depend, in part, on its ability
to identify potential products that meet the Company's criteria, including
possessing a recognizable brand name or being complementary to the Company's
existing product lines. There can be no assurance that the Company would have
success in identifying potential product acquisitions or licensing opportunities
or that, if identified, it would complete such product acquisitions or obtain
such licenses on acceptable terms or that it would obtain the necessary
financing, or that it could successfully integrate any acquired or licensed
products into its existing product lines. The inability to complete acquisitions
of, or obtain licenses for, pharmaceutical products could have a material
adverse effect on the Company's business, financial condition and results of
operations. Furthermore, there can be no assurance that the Company, once it has
obtained rights to a pharmaceutical product and committed to payment terms, will
be able to generate sales sufficient to create a profit or otherwise avoid a
loss. Any inability to generate such sufficient sales or any subsequent
reduction of sales could have a material adverse effect on the Company's
business, financial condition and result of operations.
Patents and Proprietary Rights
The patent position of competitors in the pharmaceutical industry generally
is highly uncertain, involves complex legal and factual questions, and is the
subject of much litigation. There can be no assurance that any patent
applications relating to the Company's potential products or processes will
result in patents being
21
issued, or that the resulting patents, if any, will provide protection against
competitors who: (i) successfully challenge the Company's patents; (ii) obtain
patents that may have an adverse effect on the Company's ability to conduct
business; or (iii) are able to circumvent the Company's patent position. It is
possible that other parties have conducted or are conducting research and could
make discoveries of pharmaceutical formulations or processes that would precede
any discoveries made by the Company, which could prevent the Company from
obtaining patent protection for these discoveries or marketing products
developed therefrom. Consequently, there can be no assurance that others will
not independently develop pharmaceutical products similar to or obsoleting those
that the Company is planning to develop, or duplicate any of the Company's
products. The inability of the Company to obtain patents for its products and
processes or the ability of competitors to circumvent or obsolete the Company's
patents could have a material adverse effect on the Company's business,
financial condition and results of operations.
Exercise of Warrants, Conversion of Subordinated Debt, May have Dilutive
Effect
Under terms of a $5,000,000 subordinated debt transaction, which the
Company entered into with the John N. Kapoor trust dtd. 9/20/89 (the "Trust"),
the sole trustee and sole beneficiary of which is Dr. John N. Kapoor, the
Company's current CEO and Chairman of the Board of Directors, the Trust agreed
to provide the Company with $5,000,000 of subordinated debt in two separate
tranches of $3,000,000 ("Tranche A") and $2,000,000 ("Tranche B"). In return for
providing the subordinated debt, the Trust was granted Warrants to purchase
1,000,000 shares of common stock, at a purchase price of $2.85 per share for
Tranche A and 667,000 shares of common stock, at a purchase price of $2.25 per
share, for Tranche B. In addition, Tranche A, plus the interest on Tranche A, is
convertible into common stock of the Company at a price of $2.28 per share, and
Tranche B, plus the interest on Tranche B, is convertible into common stock of
the Company at a price of $1.80 per share. If the price per share of the
Company's common stock at the time of exercise of the Warrants or conversion of
the subordinated debt is in excess of the various Warrant exercise or conversion
prices, exercise of the Warrants and conversion of the subordinated debt would
have a dilutive effect on the Company's common stock. The amount of such
dilution, however, cannot currently be determined as it would depend on the
amount disparity between the stock price and the price at which the warrants
were exercised or the subordinated debt was converted at the time of exercise or
conversion.
Need to Attract and Retain Key Personnel in Highly Competitive Marketplace
The Company's performance depends, to a large extent, on the continued
service of its key research and development personnel, other technical
employees, managers and sales personnel and its ability to continue to attract
and retain such personnel. Competition for such personnel is intense,
particularly for highly motivated and experienced research and development and
other technical personnel. The Company is facing increasing competition from
companies with greater financial resources for such personnel. There can be no
assurance that the Company will be able to attract and retain sufficient numbers
of highly-skilled personnel in the future, and the inability to do so could have
a material adverse effect on the Company's business, operating results and
financial condition and results of operations.
Dependence on Key Executive Officers
The Company's success will depend, in part, on its ability to attract and
retain key executive officers. The inability to find or the loss of one or more
of the Company's key executive officers could have a material adverse effect on
the Company's business, financial condition and results of operations.
Quarterly Fluctuation of Results; Possible Volatility of Stock Price
The Company's results of operations may vary from quarter to quarter due to
a variety of factors including the timing of the development and marketing of
new pharmaceutical products, the failure to develop such products, delays in
obtaining government approvals, including FDA approval of NDAs or ANDAs for
Company products, expenditures to comply with governmental requirements for
manufacturing facilities, expenditures incurred to acquire and promote
pharmaceutical products, changes in the Company's customer base, a customer's
termination of a substantial account, the availability and cost of raw
materials, interruptions
22
in supply by third-party manufacturers, the introduction of new products or
technological innovations by the Company's competitors, loss of key personnel,
changes in the mix of products sold by the Company, changes in sales and
marketing expenditures, competitive pricing pressures and the Company's ability
to meet its financial covenants. There can be no assurance that the Company will
be successful in maintaining or improving its profitability or avoiding losses
in any future period. Such fluctuations may result in volatility in the price of
the Company's Common Stock.
Relationships with Other Entities; Conflicts of Interest
Mr. John N. Kapoor, Ph.D., the Company's Chairman of the Board and Chief
Executive Officer is affiliated with EJ Financial Enterprises, Inc., a health
care consulting investment company ("EJ Financial"). EJ Financial is involved in
the management of health care companies in various fields, and Dr. Kapoor is
involved in various capacities with the management and operation of these
companies. The John N. Kapoor Trust, the beneficiary and sole trustee of which
is Dr. Kapoor, is a principal shareholder of each of these companies. As a
result, Dr. Kapoor does not devote his full time to the business of the Company.
Although such companies do not currently compete directly with the Company,
certain companies with which EJ Financial is involved are in the pharmaceutical
business. Discoveries made by one or more of these companies could render the
Company's products less competitive or obsolete. In addition, one of these
companies, NeoPharm, Inc. of which Dr. Kapoor is Chairman and a major
stockholder, recently entered into a loan agreement with the Company. Further,
Dr. Kapoor has loaned the Company $5,000,000 with the result that he has become
a major creditor of the Company as well as a major stockholder. See "Financial
Condition and Liquidity". Potential conflicts of interest could have a material
adverse effect on the Company's business, financial condition and results of
operations.
RECENT ACCOUNTING PRONOUNCEMENTS
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for
Derivatives Instruments and Hedging Activities." SFAS 133 establishes accounting
and reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. SFAS No.
133, as amended by SFAS No. 137 and No. 138, was effective for the Company's
fiscal 2001 financial statements and was adopted by the Company on January 1,
2001. Adoption of these standards did not have a material effect on the
Company's financial position or results of operations.
In July 2001, the FASB approved three statements, SFAS 141, "Business
Combinations," SFAS 142, "Goodwill and Other Intangible Assets," and SFAS 143,
"Accounting for Asset Retirement Obligations."
SFAS 141 supercedes APB Opinion No. 16, "Business Combinations," and
eliminates the pooling-of-interests method of accounting for business
combinations, thus requiring all business combinations be accounted for using
the purchase method. In addition, in applying the purchase method, SFAS 141
changes the criteria for recognizing intangible assets apart from goodwill. The
following criteria is to be considered in determining the recognition of the
intangible assets: (1) the intangible asset arises from contractual or other
legal rights, or (2) the intangible asset is separable or dividable from the
acquired entity and capable of being sold, transferred, licensed, rented, or
exchanged. The requirements of SFAS 141 are effective for all business
combinations completed after June 30, 2001. The adoption of this new standard
did not have a material impact on the Company's financial statements.
SFAS 142 supercedes APB Opinion No. 17, "Intangible Assets," and requires
goodwill and other intangible assets that have an indefinite useful life to no
longer be amortized; however, these assets must be reviewed at least annually
for impairment. The Company has adopted SFAS 142 as of January 1, 2002. The
Company is currently evaluating the impact of this new standard on the Company's
financial statements.
SFAS 143 requires entities to record the fair value of a liability for an
asset retirement obligation in the period in which it is incurred. When the
liability is initially recorded, the entity capitalizes a cost by increasing the
carrying amount of the related long-lived asset. Over time, the liability is
accreted to its present value each period, and the capitalized cost is
depreciated over the useful life of the related asset. Upon settlement of the
23
liability, an entity either settles the obligation for its recorded amount or
incurs a gain or loss upon settlement. The Company has adopted SFAS 143 as of
January 1, 2002. The adoption of this new standard did not have a material
impact on the Company's financial statements.
In August 2001, the FASB issued SFAS 144 "Accounting for the Impairment or
Disposal of Long-Lived Assets." This statement addresses financial accounting
and reporting for the impairment or disposal of long-lived assets. This
statement supercedes SFAS No. 121, "Accounting for the Impairment of Long-Lived
Assets and for Long-Lived Assets to be Disposed Of." This statement also
supercedes the accounting and reporting provisions of APB Opinion No. 30,
"Reporting the Results of Operations -- Reporting the Effects of Disposal of a
Segment of a Business and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions," for the disposal of a segment of a business (as
previously defined in that Opinion). SFAS No. 144 is effective January 1, 2002.
The adoption of this new standard did not have a material impact on the
Company's financial statements.
|