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. Subsequent to the issuance of the Company's consolidated
financial statements for the year ended December 31, 2001, management of the
Company determined that the balance of the Company's allowance for doubtful
accounts as of December 31, 2000 was understated by $7,520,000 and that bad debt
expense for the years ended December 31, 2000 and 2001 was understated and
overstated, respectively, by a corresponding amount. In addition, management
determined that the Company had not recognized the $1,508,000 beneficial
conversion feature embedded in the convertible notes issued to Dr. Kapoor. The
Company's consolidated financial statements for the years ended December 31,
2000 and 2001 have been restated to appropriately account for these items. See
Note S "Restatement" in the consolidated financial statements included in Item 8
for a summary of the significant effects of the restatement. The following
discussion and analysis give effect to the restatement.
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.... 57 37 26
Amortization of intangibles..................... 4 2 3
Research and development expenses............... 6 6 4
---- --- ---
Operating income (loss)......................... (50) (3) 19
Net income (loss)............................... (36) (4) 10
CRITICAL ACCOUNTING POLICIES
The Company recognizes sales upon the shipment of goods, provided that all
obligations of the Company have been fulfilled and collection of the related
receivable is probable. Provision is made at the time of sale and is analyzed
and adjusted, if necessary, at each balance sheet date for estimated
chargebacks, rebates and product returns. Royalty revenue is recognized when
earned and is based on net sales, as defined.
The Company enters contractual agreements with certain third parties such as
hospitals and group-purchasing organizations to sell certain products at
predetermined prices. The parties have elected to have these contracts
administered through wholesalers. When a wholesaler sells products to one of the
third parties that is subject to a contractual price agreement, the difference
between the price to the wholesaler and the price under the contract is charged
back to the Company by the wholesaler. The Company reduces gross sales and
accounts receivable by the estimated chargeback amount when it sells products to
a wholesaler. The Company evaluates the chargeback allowance against actual
chargebacks processed by wholesalers. Actual chargebacks processed can vary
materially from period to period.
Similarly, the Company maintains an allowance for rebates related to
contract and other programs with wholesalers. These allowances also reduce gross
sales and accounts receivable by the amount of the estimated rebate amount when
the Company sells its products to the wholesalers. The Company evaluates the
allowance against actual rebates processed and such amount can vary materially
from period to period.
The recorded allowances reflect the Company's current estimate of the future
chargeback and rebate liability to be paid or credited to the wholesalers under
these various contracts and programs. For the years ended December 31, 1999,
2000 and 2001, the Company recorded chargeback and rebate expense of
$23,793,000, $29,558,000 and $28,655,000, respectively. The allowance for
chargebacks and rebates was $3,296,000 and $4,190,000 as of December 31, 2000
and 2001.
In May 2001, the Company completed an analysis of its March 31, 2001
allowance for chargebacks and rebates. In performing such analysis, the Company
utilized recently obtained reports of wholesalers' inventory information, which
had not been previously obtained or utilized. Based on the wholesalers' 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, as compared to an allowance of
$3,296,000 at December 31, 2000.
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 greater level of list price business
than is occurring in the current business environment.
11
The Company maintains 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. For the years ended
December 31, 1999, 2000 and 2001, the Company recorded a provision for product
returns of $205,000, $1,159,000 and $4,103,000, respectively. The allowance for
potential product returns was $232,000 and $548,000 at December 31, 2000 and
2001, respectively.
Based on the wholesalers' 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 three months ended March
31, 2001 was $2,559,000.
The Company maintains 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 accounts receivable
balances. The expense related to doubtful accounts is reflected in selling,
general and administrative ("SG&A") expenses. In estimating the allowance for
doubtful accounts, the Company has:
- Identified the relevant factors that might affect the accounting
estimate for allowance for doubtful accounts, including: (a) historical
experience with collections and write-offs; (b) credit quality of
customers; (c) the interaction of credits being taken for discounts,
rebates, allowances and other adjustments; (d) balances of outstanding
receivables, and partially paid receivables; and (e) economic
environmental and other exogenous factors that might affect
collectibility (e.g., bankruptcies of customers, "channel" factors,
etc.).
- Accumulated data on which to base the estimate for allowance for
doubtful accounts, including: (a) collections and write-offs data; (b)
information regarding current credit quality of customers; and (c)
information regarding exogenous factors, particularly in respect of
major customers.
- Developed assumptions reflecting management's judgments as to the most
likely circumstances and outcomes, regarding, among other matters: (a)
collectibility of outstanding balances relating to "partial payments;"
(b) the ability to collect items in dispute (or subject to
reconciliation) with customers; and (c) economic and other exogenous
factors that might affect collectibility of outstanding balances - based
upon information available at the time.
For the years ended December 31, 1999, 2000 and 2001, the Company recorded a
provision for doubtful accounts of $161,000, $8,127,000 and $4,480,000,
respectively. The allowance for doubtful accounts was $8,321,000 and $3,706,000
as of December 31, 2000 and 2001, respectively.
The Company maintains an allowance for discounts, which reflects discounts
available to certain customers based on agreed upon terms of sale. This
allowance is reflected as a reduction of accounts receivable. The Company
evaluates the allowance balance against actual discounts taken. For the year
ended December 31, 2001, the Company recorded a provision for discounts of
$886,000. Previous to 2001, the Company did not grant discounts. The allowance
for discounts was $143,000 as of December 31, 2001.
The Company maintains an allowance for slow-moving and obsolete inventory
based upon recent historical sales by unit and, more recently, wholesaler
inventory information. The Company evaluates the potential sales of its products
over their remaining lives and estimates the amount that may expire before being
sold. For the years ended December 31, 1999, 2000 and 2001, the Company recorded
a provision for inventory obsolescence of $611,000, $3,983,000 and $1,830,000,
respectively. The allowance for inventory obsolescence was $3,171,000 and
$1,845,000 as of December 31, 2000 and 2001, respectively.
The Company files a consolidated federal income tax return with its
subsidiary. Deferred income taxes are provided in the financial statements to
account for the tax effects of temporary differences resulting from reporting
revenues and expenses for income tax purposes in periods different from those
used for financial reporting purposes. The Company records a valuation allowance
to reduce the deferred tax assets to the amount that is more likely than not to
be realized.
Intangibles consist primarily of product licensing and other such costs that
are capitalized and amortized on the straight-line method over the lives of the
related license periods or the estimated life of the acquired product, which
range from 17 months to 18 years. Accumulated amortization at December 31, 2001
and 2000 was $7,132,000 and $5,954,000, respectively. The Company annually
assesses the impairment of intangibles based on several factors, including
estimated fair market value and anticipated cash flows.
12
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 and returns discussed
above. 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 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. In addition, the Company incurred
unfavorable manufacturing variances at 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 unfavorable manufacturing variances will decrease in the future as a result
of the restructuring program (See Note R "Restructuring Charges" in the
consolidated financial statements included in Item 8) 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.
SG&A expenses decreased 3.7% for the year as compared to 2000. The decrease
is primarily due to a year over year decrease in the provision for bad debts of
$3,647,000 partially offset by asset impairment charges related to discontinued
products of $2,132,000 and restructuring-related charges of $1,117,000
(primarily severance and lease costs).
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 ophthalmic products.
Interest expense increased 57.0% compared to 2000, reflecting higher
interest rates on higher average outstanding debt balances and amortization
related to the convertible debt issued during the year (See Note G) partially
offset by capitalized interest related to the lyophilized pharmaceuticals
manufacturing line expansion.
Income tax benefit of $9,780,000 was recorded for the year compared to a
income tax benefit of $1,600,000 recorded in 2000 reflecting a greater level of
operating losses. The effective tax rate for the year was 39.2% compared to an
effective tax rate in 2000 of 39.9%.
Net loss for 2001 was $15,146,000, or $0.78 per share, compared to net loss
of $2,414,000, or $0.13 per share, for the prior year. The decrease in earnings
resulted from the aforementioned items.
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 10.8%, 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. In both segments, wholesaler-discounting programs unfavorably impacted
unit prices. These discounts take the form of chargebacks and rebates. Contract
services revenue increased 43.3% as a result of management's efforts to increase
the volume of business related to commercial contract manufacturing and product
development activities.
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
13
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.
SG&A expenses increased 48.9% for the year as compared to 1999. The primary
source of the increase was the provision for bad debts recorded during the year
of $8,127,000. In late 2000, the Company increased collection attempts of
certain outstanding and past-due receivables, primarily involving certain of its
major customers (including wholesalers). The Company was confronted with
customers unwilling to pay invoiced amounts without the Company meeting certain
high levels of evidentiary support. The Company concluded it would be unable to
collect these amounts from certain customers. As a result, the Company recorded
bad debt expense of $7,520,000 during the fourth quarter of 2000.
Amortization of intangibles decreased 19.1% for the year, reflecting a
patent expiration in the 2nd quarter of 1999.
R&D expenses 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.
Income tax benefit of $1,600,000 was recorded for the year compared to an
income tax provision of $3,969,000 recorded in 2000 reflecting the impact of
operating losses during fiscal 2000. The effective tax rate for the year was
39.9% compared to an effective tax rate in 1999 of 37.3%.
Net loss for 2000 was $2,414,000, or $0.13 per share, compared to net income
of $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 $21,754,000 at December 31, 2000 resulting primarily from
decreases in receivables and inventory and classification of the Company's
senior debt obligation as a current liability.
During the year ended December 31, 2001, the Company used $444,000 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 $9,118,000 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 secured by substantially all of
the assets of the Company. 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. 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 Company remitted the $5.6 million payment on
14
May 8, 2002. The Company is also obligated to remit any additional federal tax
refunds received above the estimated $5.6 million.
The Company's senior lenders agreed to extend the credit agreement to July
31, 2002 and then again to August 31, 2002. These two extensions contain the
same covenants and reporting requirements except that the Company is not
required to comply with conditions (g) and (h) which relate to the offering of
equity securities. In both instances, the balance of $39.2 million was due at
the end of the extension term.
The accompanying financial statements have been prepared on a going concern
basis, which contemplates the realization of assets and the satisfaction of
liabilities in the normal course of business. The Company has experienced losses
from operations in 2001 and 2000 of $21.0 million and $1.7 million, respectively
and has a working capital deficiency of $24.4 million as of December 31, 2001.
As discussed in Note G, the Company has significant borrowings which require,
among other things, compliance with various covenants. On September 16, 2002,
the Company was notified by it senior lenders that it was in default due to
failure to pay the principal and interest owed as of August 31, 2002 under the
most recent extension of the credit agreement. The senior lenders also notified
the Company that they would forbear from exercising their remedies under the
credit agreement until January 3, 2003 if a forbearance agreement could be
reached. On September 20, 2002, the Company and its senior lenders entered into
an agreement under which the senior lenders would agree to forbear from
exercising their remedies (the "Forbearance Agreement) and the Company
acknowledged its current default. The Forbearance Agreement provides a second
line of credit allowing the Company to borrow the lesser of (i) the difference
between the Company's outstanding indebtedness to the senior lenders and
$39,200,000, (ii) the Company's borrowing base and (iii) $1,750,000, to fund the
Company's day-to-day operations. The Forbearance Agreement provides for certain
additional restrictions on operations and additional reporting requirements. The
Forbearance Agreement also requires automatic application of cash from the
Company's operations to repay borrowings under the new revolving loan, and to
reduce the Company's other obligations to the senior lenders. The Company, as
required in the Forbearance Agreement, has agreed to provide the senior lenders
with a plan for restructuring its financial obligations on or before December 1,
2002, and has agreed to retain a consulting firm by September 27, 2002 to assist
in the development and execution of this restructuring plan.
In addition, as discussed in Note M to the consolidated financial statements
in Item 8, the Company is a party in governmental proceedings and potential
claims by the Food and Drug Administration, the Securities and Exchange
Commission and the Drug Enforcement Agency. While the Company is cooperating
with each governmental agency, an unfavorable outcome in one or more proceeding
may have a material impact on the Company's operations and its financial
condition, results of operations and/or cash flows and, accordingly, may
constitute a material adverse action that would result in a covenant violation.
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 and exercise any and all remedies available to it,
including, but not limited to, foreclosure on the Company's assets.
These matters, among others raise substantial doubt about whether the
Company will be able to continue as a going concern. The Company's ability to
operate as a going concern is dependent on its ability to successfully negotiate
with its senior lenders to extend its borrowing on a long term basis, to obtain
such additional financing or re-financing as may be required, and ultimately to
achieve profitable operations. The financial statements do not include any
adjustments relating to the recoverability and classification of recorded asset
amounts or the amounts and classification of liabilities that might be necessary
should the Company be unable to continue as a going concern.
As discussed above, the current credit facility matured on August 31, 2002
and is subject to the Forbearance Agreement discussed above which matures on
January 3, 2003, at which point the Company will need to re-negotiate or obtain
new financing. While there can be no guarantee that the Company will be
successful in re-negotiating or obtaining new financing, the Company believes it
has a good relationship with its lenders, is returning to generating income from
operations and, as required, will retain a consulting firm to assist in the
development of a restructuring plan. As a result, management of the Company
believes that the Company will be able to sustain its operations and continue as
a going concern. However, the ultimate outcome of this uncertainty cannot
presently be determined.
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 July 13, 2001) and
$2,000,000 ("Tranche B" which was received on August 16, 2001). 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
15
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 bears interest
at prime plus 3%, which is the same rate the Company pays on its senior debt.
Interest cannot be paid to the Trust until the repayment of the senior debt
pursuant to the terms of a subordination agreement, which was entered into
between the Trust and the Company's senior lenders. Should the subordination
agreement be terminated, interest may be paid sooner. 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. In accordance
with Emerging Issues Task Force Abstract 00-27, the Company has also computed
and recorded a value related to the "intrinsic" value of the convertible debt.
This calculation determines the value of the embedded conversion option within
the debt that has become beneficial to the owner as a result of the application
of APB Opinion No. 14. This value was determined to be $1,508,000 and was
recorded as additional paid in capital. The remaining $1,976,000 was recorded as
long-term debt. The resultant debt discount of $3,024,000, equivalent to the
value assigned to the warrants and the "intrinsic" value of the convertible
debt, is being 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 accrues 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 NeoPharm as well as in the
Company.
Contemporaneous 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, which was
subsequently extended to December 31, 2002.
In June 1998, the Company entered into a $3,000,000 mortgage agreement with
Standard Mortgage Investors, LLC of which there were outstanding borrowings of
$2,189,000 and $2,442,000 at December 31, 2001 and 2000, respectively. The
principal balance is payable over 10 years, with the final payment due in June
2007. The mortgage note bears an interest rate of 7.375% and is secured by the
real property located in Decatur, Illinois.
The fair value of the debt obligations approximated the recorded value as of
December 31, 2001. The promissory note between the Company and NeoPharm, Inc.
bears interest at a rate that is lower than the Company's current borrowing rate
with its senior lenders. Accordingly, the computed fair value of the debt, which
the Company estimates to be approximately $2,650,000, would be lower than the
current carrying value of $3,250,000.
16
SELECTED QUARTERLY DATA
In Thousands, Except Per Share Amounts
As previously reported:
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
------- -------- --------- ------ ------
Total $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)
------- -------- --------- ------ ------
Total $66,927 $ 28,837 $ 2,187 $ 0.11 $ 0.11
======= ======== ========= ====== ======
As restated, see Note S "Restatement" in the consolidated financial statements
included in Item 8:
NET INCOME (LOSS)
--------------------------------
GROSS PER SHARE PER SHARE
REVENUES PROFIT (LOSS) AMOUNT BASIC DILUTED
-------- ------------- -------- --------- ---------
Year Ended December 31, 2001:
1st Quarter - RESTATED..... $ 6,076 $ (5,783) $ (8,376) $(0.43) $(0.43)
2nd Quarter................ 10,637 2,509 (6,275) (0.33) (0.33)
3rd Quarter - RESTATED..... 12,842 5,013 (536) (0.03) (0.03)
4th Quarter - RESTATED..... 12,693 5,362 41 0.00 0.00
------- -------- --------- ------ ------
Total - RESTATED $42,248 $ 7,101 $ (15,146) $(0.78) $(0.78)
======= ======== ========= ====== ======
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 - RESTATED..... 15,085 3,542 (6,807) (0.35) (0.35)
------- -------- --------- ------ ------
Total - RESTATED $66,927 $ 28,837 $ (2,414) $(0.13) $(0.13)
======= ======== ========== ======= =======
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
$52,646,000, or 69% 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 a number of occasions,
the Company has been out of compliance with many of the financial and other
covenants contained in the documents that govern its debt. To date, the Company
has been able to either renegotiate the terms of such covenants or obtain
waivers or forbearance of such non-compliance.
On September 16, 2002, the Company was notified by it senior lenders that it
was in default due to failure to pay the principal and interest owed as of
August 31, 2002 under the most recent extension of the credit agreement. The
senior lenders also notified the Company that they would forbear from exercising
their remedies under the credit agreement until January 3, 2003 if a forbearance
agreement could be reached. On September 20, 2002, the Company and its senior
lenders entered into an agreement under which the senior lenders would agree to
forbear from exercising their remedies (the "Forbearance Agreement) and the
Company acknowledged its current default. The Company is a party in governmental
proceedings and potential claims by the FDA, the SEC and the DEA.
17
See "Item 3. Legal Proceedings." An unfavorable outcome in one or more
proceeding may constitute a material adverse action that would constitute a
covenant violation. While there can be no guarantee that the Company will be
successful in re-negotiating or obtaining new financing, the Company believes it
has a good relationship with its lenders, is returning to generating income from
operations and, as required, will retain a consulting firm to assist in the
development of the restructuring plan. See Note A "Basis of Presentation" in the
consolidated financial statements included in Item 8 for a discussion on the
Company's ability to continue as a going concern.
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 abandon some or all of its product acquisition,
licensing opportunities, marketing, product development, research and
development and manufacturing opportunities.
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 restriction or prohibition on sales,
halting of manufacturing operations or recalls of the Company's pharmaceutical
products will not occur in the future. Any such actions could have a material
adverse effect on the Company's business, financial condition and results of
operations. Further, such actions, 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.
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,
18
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 its
findings. The Company responded to these findings on January 4, 2002 and the FDA
has accepted the Company's response. The Company anticipates a re-inspection of
its Decatur facility by the FDA in the fourth quarter of 2002. 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. See Item
3 "Legal Proceedings."
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.
Section 801, et. seq. and regulations promulgated under the Act. The Company
continues to have discussions with the United States Attorneys Office and
anticipates that any action under this matter will not have a material impact on
its financial statements. See Item 3 "Legal Proceedings."
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. As of December 31, 2002, the Company had 17 ANDAs in
various stages of development and anticipates filing two NDAs relating to the
19
usage of Indocyanine Green for age-related macular degeneration and intra-ocular
staining 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 other pharmaceutical companies
sell generic and other substitutes for most of its branded pharmaceutical
products. 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 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/or cause the violation of debt covenants) 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
20
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 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.
21
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 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 the terms of a $5,000,000 subordinated debt transaction, which the
Company entered into on July 12, 2001 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 difference 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.
22
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, but not limited to, 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 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, expenditures incurred to pursue or contest pending or threatened
legal action 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, Chief
Executive Officer and a principal shareholder, 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 shareholder. 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 No. 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 an effect on the
Company's financial position or results of operations.
In June 2001, the FASB issued three statements, SFAS No. 141, "Business
Combinations," SFAS No. 142, "Goodwill and Other Intangible Assets," and SFAS
No. 143, "Accounting for Asset Retirement Obligations."
SFAS No. 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 No. 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 No. 141 are effective for all business
combinations completed after June 30, 2001. The adoption of this new standard
did not have an effect on the Company's financial statements.
SFAS No. 142 supercedes APB Opinion No. 17, "Intangible Assets," and
requires goodwill and other intangible assets that have an
23
indefinite useful life to no longer be amortized; however, these assets must be
reviewed at least annually for impairment. The Company has adopted SFAS No. 142
as of January 1, 2002. The adoption of this new standard did not have an effect
on the Company's financial statements as no impairments were recognized.
SFAS No. 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
liability, an entity either settles the obligation for its recorded amount or
incurs a gain or loss upon settlement. The Company has adopted SFAS No. 143 as
of January 1, 2002. The adoption of this new standard did not have an effect on
the Company's financial statements.
In August 2001, the FASB issued SFAS No. 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 an effect on the Company's
financial statements.
In June 2002, the FASB issued SFAS No. 146, "Accounting for Costs Associated
with Exit or Disposal Activities". SFAS No. 146 requires the Company to
recognize costs associated with exit or disposal activities when they are
incurred rather than at the date of a commitment to an exit or disposal plan.
The Company will adopt SFAS No. 146 for exit or disposal activities initiated
after December 31, 2002. The Company does not anticipate that adoption of this
standard will have a material effect on its financial statements.
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