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UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-Q
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2003
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934 FOR THE TRANSITION PERIOD FROM ______________ TO _______________
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COMMISSION FILE NUMBER: 0-13976
AKORN, INC.
(Exact Name of Registrant as Specified in its Charter)
LOUISIANA 72-0717400
(State or Other Jurisdiction of (I.R.S. Employer
Incorporation or Organization) Identification No.)
2500 MILLBROOK DRIVE
BUFFALO GROVE, ILLINOIS 60089
(Address of Principal Executive Offices) (Zip Code)
(847) 279-6100
(Registrant's telephone number)
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Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2).
Yes No X
--- ---
The financial statements included in this Form 10-Q have not been reviewed
by independent public accountants in accordance with Rule 10-01 (d) of
Regulation S-X. See explanatory Note on Page 3.
At August 13, 2003 there were 19,729,759 shares of common stock, no par
value, outstanding.
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PAGE
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PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (Unaudited)
Condensed Consolidated Balance Sheets-June 30, 2003
and December 31, 2002...................................... 4
Condensed Consolidated Statements of Operations-Three
and Six months ended June 30, 2003 and 2002................ 5
Condensed Consolidated Statements of Cash Flows-Six
months ended June 30, 2003 and 2002........................ 6
Notes to Condensed Consolidated Financial Statements....... 7
ITEM 2. Management's discussion and analysis of financial
condition and results of operations........................ 22
ITEM 3. Quantitative and Qualitative Disclosures about
Market Risks............................................... 31
ITEM 4. Controls and Procedures.................................... 31
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings.......................................... 32
ITEM 2. Changes in Securities and Use of Proceeds.................. 33
ITEM 3. Default Upon Senior Securities............................. 33
ITEM 4. Submission of Matters to a Vote of Security Holders........ 34
ITEM 5. Other Information.......................................... 34
ITEM 6. Exhibits and Reports on Form 8-K........................... 34
2
EXPLANATORY NOTE
On April 24, 2003, Deloitte And Touche, LLP ("Deloitte") notified the
Company that it would decline to stand for re-election as the Company's
independent accountants after completion of the audit of the Company's
consolidated financial statements as of and for the year ended December 31,
2002. Deloitte completed its audit and delivered its auditors' report on May 20,
2003, and has advised the Company that the client-auditor relationship between
the Company and Deloitte has ceased. The Company has begun the process of
selecting a new independent accountant, but has not completed this process as of
the date of this filing. As a result, independent accountants have not reviewed
the financial statements and notes thereto included in this Form 10-Q in
accordance with Rule 10-01(d) of Regulation S-X and this Form 10-Q does not
comply with other requirements of Section 13(a) of the Securities Exchange Act
of 1934 relating to independent accountants or auditors. The Company believes
that the unaudited financial statements and notes to the consolidated financial
statements included herewith contain all of the information and necessary
adjustments for a fair presentation of these financial statements and
accompanying notes.
3
AKORN, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
IN THOUSANDS
(UNAUDITED)
JUNE 30, DECEMBER 31,
2003 2002
-------- ------------
ASSETS
CURRENT ASSETS
Cash and cash equivalents .......................... $ (14) $ 364
Trade accounts receivable (less allowance
for doubtful accounts of $559 and $1,200) ....... (504) 1,421
Inventory .......................................... 9,766 10,401
Deferred income taxes .............................. -- --
Income taxes recoverable ........................... 841 670
Prepaid expenses and other current assets .......... 781 383
-------- --------
TOTAL CURRENT ASSETS .......................... 10,869 13,239
OTHER ASSETS
Intangibles, net ................................... 13,444 14,142
Investment in Novadaq Technologies, Inc. ........... 713 713
Deferred income taxes .............................. -- --
Other .............................................. 130 130
-------- --------
TOTAL OTHER ASSETS .............................. 14,287 14,985
PROPERTY, PLANT AND EQUIPMENT, NET .................... 34,688 35,314
-------- --------
TOTAL ASSETS .................................... $ 59,844 $ 63,538
======== ========
LIABILITIES AND SHAREHOLDERS' EQUITY
CURRENT LIABILITIES
Current installments of long-term debt ............. $ 43,130 $ 35,859
Trade accounts payable ............................. 6,171 5,756
Accrued compensation ............................... 788 836
Accrued expenses and other current liabilities ..... 879 1,352
-------- --------
TOTAL CURRENT LIABILITIES ....................... 50,968 43,803
LONG-TERM DEBT ........................................ 1,468 7,799
OTHER LONG-TERM LIABILITIES ........................... -- 584
-------- --------
TOTAL LIABILITIES ............................... 52,436 52,186
COMMITMENTS AND CONTINGENCIES
SHAREHOLDERS' EQUITY
Common stock ....................................... 26,866 26,866
Accumulated deficit ................................ (19,457) (15,514)
-------- --------
TOTAL SHAREHOLDERS' EQUITY ...................... 7,408 11,352
-------- --------
TOTAL LIABILITIES AND SHAREHOLDERS' EQUITY ...... $ 59,844 $ 63,538
======== ========
See notes to condensed consolidated financial statements.
4
AKORN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
IN THOUSANDS, EXCEPT PER SHARE DATA
(UNAUDITED)
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
---------------------- ----------------------
2003 2002 2003 2002
-------- -------- -------- --------
Revenues ......................................... $ 8,840 $ 14,165 $ 21,622 $ 27,608
Cost of sales .................................... 8,305 7,799 15,243 14,893
-------- -------- -------- --------
GROSS PROFIT ............................... 535 6,366 6,379 12,715
Selling, general and administrative expenses ..... 3,952 6,315 8,121 10,770
Provision, net of recoveries, for bad debts ...... (342) (400) (288) (400)
Amortization of intangibles ...................... 344 355 699 698
Research and development expenses ................ 362 562 835 982
-------- -------- -------- --------
TOTAL OPERATING EXPENSES ................... 4,316 6,832 9,367 12,050
-------- -------- -------- --------
OPERATING INCOME (LOSS) .................... (3,781) (466) (2,988) 667
Interest expense ................................. (612) (826) (1,257) (1,713)
Interest and other income (expense), net ......... -- -- -- --
-------- -------- -------- --------
INTEREST EXPENSE AND OTHER ................. (612) (826) (1,257) (1,713)
-------- -------- -------- --------
INCOME (LOSS) BEFORE INCOME TAXES .......... (4,393) (1,292) (4,245) (1,048)
Income tax provision (benefit) ................... (196) (509) (171) (416)
-------- -------- -------- --------
NET INCOME (LOSS) .......................... $ (4,197) $ (783) $ (4,074) $ (632)
======== ======== ======== ========
NET INCOME (LOSS) PER SHARE:
BASIC ......................................... $ (0.21) $ (0.04) $ (0.21) $ (0.03)
======== ======== ======== ========
DILUTED ....................................... $ (0.21) $ (0.04) $ (0.21) $ (0.03)
======== ======== ======== ========
SHARES USED IN COMPUTING NET LOSS PER SHARE:
BASIC ......................................... 19,723 19,566 19,705 19,545
======== ======== ======== ========
DILUTED ....................................... 19,723 19,566 19,705 19,545
======== ======== ======== ========
See notes to condensed consolidated financial statements.
5
AKORN, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
IN THOUSANDS
(UNAUDITED)
SIX MONTHS ENDED
JUNE 30,
-------------------
2003 2002
------- -------
OPERATING ACTIVITIES
Net income (loss) ............................................... $(4,074) $ (632)
Adjustments to reconcile net income to net cash provided by
operating activities:
Depreciation and amortization ................................ 2,228 2,158
Deferred income taxes ........................................ -- (688)
Write-down of long-lived assets ............................. -- 1,560
Amortization of debt discounts ............................... 500 259
Changes in operating assets and liabilities:
Accounts receivable ....................................... 1,925 409
Income taxes recoverable .................................. (170) 5,874
Inventory ................................................. 635 (2,038)
Prepaid expenses and other current assets ................. (398) (169)
Trade accounts payable .................................... 415 2,592
Accrued compensation ...................................... (48) 188
Income taxes payable ...................................... -- --
Accrued expenses and other liabilities .................... (414) (1,571)
------- -------
NET CASH PROVIDED BY OPERATING ACTIVITIES ....................... 599 7,942
INVESTING ACTIVITIES
Purchases of property, plant and equipment ...................... (903) (2,906)
------- -------
NET CASH (USED IN) INVESTING ACTIVITIES ......................... (903) (2,906)
FINANCING ACTIVITIES
Repayment of long-term debt ..................................... (155) (5,734)
Borrowings under bank credit agreement .......................... 11 --
Proceeds from employee stock purchase plan/exercise
of stock options .............................................. 71 243
------- -------
NET CASH PROVIDED BY FINANCING ACTIVITIES ....................... (73) (5,491)
(DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS ................ (378) (455)
Cash and cash equivalents at beginning of period ................ 364 5,355
------- -------
CASH AND CASH EQUIVALENTS AT END OF PERIOD ...................... $ (14) $ 4,900
======= =======
Amount paid for interest
(net of capitalized interest) ................................. $ 655 $ 1,433
Amount paid for income taxes .................................... -- --
See notes to condensed consolidated financial statements.
6
AKORN, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)
NOTE A - BASIS OF PRESENTATION
Business: Akorn, Inc. ("Akorn" or the "Company") manufactures and markets
diagnostic and therapeutic pharmaceuticals in specialty areas such as
ophthalmology, rheumatology, anesthesia and antidotes, among others. Customers
include physicians, optometrists, wholesalers, group purchasing organizations
and other pharmaceutical companies.
Consolidation: The accompanying unaudited condensed consolidated financial
statements include the accounts of Akorn, Inc. and its wholly owned subsidiary
(the "Company"). Intercompany transactions and balances have been eliminated in
consolidation. These financial statements have been prepared in accordance with
accounting principles generally accepted in the United States of America for
interim financial information and accordingly do not include all the information
and footnotes required by accounting principles generally accepted in the United
States of America for complete financial statements.
Basis of Presentation: 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.
Accordingly, 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.
The Company experienced losses from operations in the first six months of
2003 and in each of the three most recent years (2000-2002) and has a working
capital deficiency of $40.1 million as of June 30, 2003. The Company also is in
default under its existing senior credit agreement and subordinated debt
agreements and is subject to ongoing Food and Drug Administration ("FDA")
compliance matters that could have a material adverse effect on the Company. See
Note H - "Financing Arrangements" and Note M - "Legal Proceedings". Although the
Company has entered into a Forbearance Agreement (as defined below) with its
senior lender, the Company's subordinated lenders are currently prohibited from
taking action to collect the subordinated debt without the consent of the
Company's senior lender, and the Company is working with the FDA to favorably
resolve such compliance matters, there is substantial doubt about the Company's
ability to continue as a going concern. The Company's ability to continue as a
going concern is dependent upon its ability to (i) continue to finance it
current cash needs, (ii) continue to obtain extensions of the Forbearance
Agreement, (iii) successfully resolve the ongoing compliance matters with the
FDA and (iv) ultimately refinance its senior bank debt, resolve the defaults
under its subordinated debt and obtain new financing for future operations and
capital expenditures. If it is unable to do so, it may be required to seek
protection from its creditors under the federal bankruptcy code.
While there can be no guarantee that the Company will be able to continue to
generate sufficient revenues and cash flow from operations to finance its
current cash needs, the Company generated positive cash flow from operations in
2002 and for the first six months of 2003. As of June 30, 2003, the Company had
a deficit of approximately $14,000 in cash and equivalents due to outstanding
checks and approximately $1.3 million of undrawn availability under its second
line of credit described below. As a result of its cash position and its
negative accounts receivable balance, in July, 2003, the Company obtained an
additional $1,000,000 of availability under its second line of credit. There can
be no assurance that the line of credit, together with cash generated from
operations, will be sufficient to meet the cash requirements for operating the
Company's business.
There can also be no guarantee that the Company will successfully resolve
the ongoing compliance matters with the FDA. However, the Company has submitted
to the FDA and begun to implement a plan for comprehensive corrective actions at
its Decatur, Illinois facility.
Moreover, there can be no guarantee that the Company will be successful in
obtaining further extensions of the Forbearance Agreement or in refinancing the
senior debt, resolving the defaults under its subordinated debt and obtaining
new financing for future operations. However, the Company is current on its
interest payment obligations to its senior lender, and, as required, the Company
has retained a consulting firm, submitted a restructuring plan and engaged an
investment banker to assist in raising additional financing and explore other
strategic alternatives for repaying the senior bank debt and resolving the
defaults under its subordinated debt. The Company has also added key management
personnel, including the appointment of a new chief executive officer, vice
president of operations and vice president of quality assurance, quality control
and regulatory affairs, and additional personnel in critical areas. Management
has reduced the Company's cost structure, improved the Company's processes and
systems and
7
implemented strict controls over capital spending. Management believes these
activities have improved the Company's results of operations, cash flow from
operations and its prospects for refinancing its senior debt and obtaining
additional financing for future operations.
As a result of all of the factors cited in the preceding paragraphs,
management of the Company believes that the Company should be able to sustain
its operations and continue as a going concern. However, the ultimate outcome of
this uncertainty cannot be presently determined and, accordingly, there remains
substantial doubt as to whether the Company will be able to continue as a going
concern. Further, even if the Company's efforts to raise additional financing
and explore other strategic alternatives result in a transaction that repays the
senior bank debt and resolves the defaults under its subordinated debt, there
can be no assurance that the current common stock will have any value following
such a transaction. In particular, if any new financing is obtained, it likely
will require the granting of rights, preferences or privileges senior to those
of the common stock and result in substantial dilution of the existing ownership
interests of the common stockholders.
As discussed in Note H - "Financing Arrangements", the Company has
significant borrowings which require, among other things, compliance with
various covenants. The borrowings are incurred primarily under an amended and
restated revolving credit agreement (the "Credit Agreement").
On September 16, 2002, the Company was notified by its senior lender that it
was in default due to failure to pay the principal and interest owed as of
August 31, 2002 under the then most recent extension of the Credit Agreement.
The senior lender also notified the Company that it would forbear from
exercising its remedies under the Credit Agreement until January 3, 2003 (as
indicated below, subsequently extended to August 22, 2003) if a forbearance
agreement could be reached. On September 20, 2002, the Company and its senior
lender entered into an agreement under which the senior lender would agree to
forbear from exercising its remedies (the "Forbearance Agreement") and the
Company acknowledged its current default. The Forbearance Agreement provides a
second line of credit that currently allows the Company to borrow the lesser of
(i) the difference between the Company's outstanding indebtedness to the senior
lender and $39,200,000 and (ii) $2,750,000, 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 lender.
The Company, as required in the Forbearance Agreement, agreed to provide the
senior lender with a plan for restructuring its financial obligations on or
before December 1, 2002, and agreed to retain a consulting firm by September 27,
2002 to assist in the development and execution of this restructuring plan and,
in furtherance of that commitment, on September 26, 2002, the Company entered
into an agreement (the "Consulting Agreement") with a consulting firm, AEG
Partners, LLC (the "Consultant"), whereby the Consultant would assist in the
development and execution of this restructuring plan and provide oversight and
direction to the Company's day-to-day operations. On November 18, 2002, the
Consultant notified the Company of its intent to resign from the engagement
effective December 2, 2002, based upon the Company's alleged failure to
cooperate with the Consultant, in breach of the Consulting Agreement. The
Company's senior lender, upon learning of the Consultant's action, notified the
Company by letter dated November 18, 2002, that, as a result of the Consultant's
resignation, the Company was in default under terms of the Forbearance Agreement
and the Credit Agreement and demanded payment of all outstanding principal and
interest on the loan. This notice was followed by a second letter dated November
19, 2002, in which the senior lender gave notice of its exercise of certain
remedies available under the Credit Agreement including, but not limited to, its
setting off the Company's deposits with the senior lender against the Company's
obligations to the senior lender. The Company immediately entered into
discussions with the Consultant which led, on November 21, 2002, to the
Consultant rescinding its notification of resignation and to the senior lender
withdrawing its demand for payment and restoring the Company's accounts.
During the Company's discussions with the Consultant, the Company agreed to
establish a special committee of the Board (the "Corporate Governance
Committee"), originally consisting of Directors Ellis and Bruhl, with Mr. Ellis
serving as Chairman. Ron Johnson was added to the Corporate Governance Committee
when he was appointed to the Board in March, 2003. The Board delegated to the
Corporate Governance Committee all authority to make any and all decisions with
respect to the evaluation and approval of the restructuring plan to be developed
by the Consultant with respect to the Company's bank debt and to interface with
the Consultant regarding the Company's restructuring actions. The Company also
agreed that the Consultant will oversee the Company's interaction with all
regulatory agencies including, but not limited to, the FDA. In addition, the
Company has agreed to a "success fee" arrangement with the Consultant. Under
terms of the arrangement, if the Company is successful in refinancing or
restructuring its debt pursuant to a new or restated credit facility maturing on
or after January 1, 2004, the Consultant will be paid a cash fee equal to 1 1/2%
of the amount of the debt which is refinanced or restructured. Additionally, the
success fee arrangement provides that the Company will issue a warrant to
purchase 1,250,000 shares of common stock at an exercise price of $1.00 per
share to the Consultant upon the date on which each of the following conditions
have been met or waived by the Company: (i) the Forbearance Agreement
8
shall have been terminated, (ii) the Consultant's engagement pursuant to the
Consulting Agreement shall have been terminated and (iii) the Company shall have
executed a new or restated multi-year credit facility. All unexercised warrants
shall expire on the fourth anniversary of the date of issuance.
As required by the Forbearance Agreement, a restructuring plan was developed
by the Company and the Consultant and presented to the Company's senior lender
in December 2002. The restructuring plan requested that the senior lender
convert the Company's senior debt to a term note that would mature no earlier
than February 2004 and increase the second line of credit from $1.75 million to
$3 million to fund operations and capital expenditures. In light of the FDA's
re-inspection of the Decatur facility in early December 2002, the Company and
the senior lender agreed to defer further discussions of that request until
completion of the re-inspection and the Company's response thereto. As a result,
the senior lender agreed to successive short-term extensions of the Forbearance
Agreement until the completion of the re-inspection. Following completion of the
FDA re-inspection of the Decatur facility on February 6, 2003 and issuance of
the FDA findings (see Note M - "Legal Proceedings"), the senior lender indicated
that it was not willing to convert the senior debt to a term loan, but it did
agree to further extensions of the Forbearance Agreement. As required by one of
these extensions, on May 9, 2003, the Company engaged Leerink Swann, an
investment banking firm, to assist in raising additional financing and explore
other strategic alternatives for repaying the senior bank debt. That process is
continuing.
On July 3, 2003 the senior lender extended the expiration date of the
Forbearance Agreement from June 30, 2003 until July 31, 2003 and agreed to make
up to an additional $1,000,000 available to the Company under its current line
of credit increasing the maximum amount available under the line of credit from
$1,750,000 to $2,750,000. On August 8, 2003, the senior lender extended the
expiration date of the Forbearance Agreement until August 22, 2003.
The Forbearance Agreement, as amended and extended, provides that the senior
lender will forbear from exercising its remedies as a result of specified
existing defaults by Akorn until the earlier of the expiration date and the
occurrence of any additional defaults by Akorn under the Credit Agreement.
Subject to the absence of any additional defaults and subject to the senior
lender's satisfaction with the Company's progress in resolving the matters
raised by the FDA and in obtaining additional financing and exploring other
strategic alternatives, the Company expects to continue obtaining short-term
extensions of the Forbearance Agreement. However, there can be no assurance that
the Company will be successful in obtaining further extensions of the
Forbearance Agreement beyond August 22, 2003.
As described in more detail in Note M - "Legal Proceedings", the Company is
also subject to ongoing compliance matters with the FDA. While the Company is
cooperating with the FDA and seeking to resolve the pending matters, an
unfavorable outcome 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 under the Credit Agreement.
In the event that the Company is not in compliance with the Credit Agreement
covenants and does not negotiate amended covenants or obtain a waiver thereof,
then the senior lender, at its option, may demand immediate payment of all
outstanding amounts due and exercise any and all available remedies, including,
but not limited to, foreclosure on the Company's assets.
Adjustments: In the opinion of management, all adjustments (consisting of
normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the three and six-month period ended June
30, 2003 are not necessarily indicative of the results that may be expected for
a full year. For further information, refer to the consolidated financial
statements and footnotes for the year ended December 31, 2002, included in the
Company's Annual Report on Form 10-K.
NOTE B - USE OF ESTIMATES
The preparation of financial statements in conformity with accounting
principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of
assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ materially
from those estimates. Significant estimates and assumptions relate to the
allowance for doubtful accounts, the allowance for chargebacks, the allowance
for rebates, the reserve for slow-moving and obsolete inventory, the allowance
for product returns, the carrying value of intangible assets and the carrying
value of deferred tax assets.
9
NOTE C - REVENUE RECOGNITION
The Company recognizes product sales for its ophthalmic and injectable
business segments upon the shipment of goods for customers whose terms are FOB
shipping point. The Company has several customers whose terms are FOB
destination point and recognizes revenue upon delivery of the product to these
customers. Revenue is recognized when all obligations of the Company have been
fulfilled and collection of the related receivable is probable. Provision for
estimated chargebacks, rebates, discounts and product returns is made at the
time of sale and is analyzed and adjusted, if necessary, at each balance sheet
date.
The contract services segment, which produces products for third party
customers, based upon their specification, at a pre-determined price, also
recognizes sales upon the shipment of goods or upon delivery of the product as
appropriate. Revenue is recognized when all obligations of the Company have been
fulfilled and collection of the related receivable is probable.
Royalty revenue is recognized in the period to which such revenue relates
based upon when the Company receives notification (monthly or quarterly) from
the counterparty that such counterparty has sold product for which Akorn is
entitled to a royalty.
NOTE D - ACCOUNTS RECEIVABLE ALLOWANCES
The nature of the Company's business inherently involves, in the ordinary
course, significant amounts and substantial volumes of accounting activity
(i.e., transactions and estimates) relating to allowances for product returns,
chargebacks, rebates and discounts given to customers. This is a natural
circumstance of the pharmaceutical industry and not specific to the Company and
inherently lengthens the collection process. Depending on the product, the
end-user customer, the specific terms of national supply contracts and the
particular arrangements with the Company's wholesaler customers, certain
rebates, chargebacks and other credits are deducted from the Company's accounts
receivable. The process of claiming these deductions depends on wholesalers
reporting to the Company the amount of deductions that were earned under the
respective terms with end-user customers. The amount of the deduction (if any)
depends on the identity of the end-user customer and the specific pricing
arrangements that Akorn has with that customer. This process can lead to
"partial payments" against outstanding invoices as the wholesalers take the
claimed deductions at the time of payment. The Company's negative accounts
receivable balance of $504,000 as of June 30, 2003 consists of gross receivables
of $5,601,000, less an aggregate of $5,546,000 in allowances for chargebacks,
rebates, product returns and discounts and a $559,000 allowance for doubtful
accounts.
Allowance for Chargebacks and Rebates
The Company maintains allowances for chargebacks and rebates. These
allowances are reflected as a reduction of accounts receivable.
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 contract is charged back
to the Company by the wholesaler. The Company tracks sales and submitted
chargebacks by product number for each wholesaler. Utilizing this information,
the Company estimates a chargeback percentage for each product. The Company
reduces gross sales and increases the chargeback allowance by the estimated
chargeback amount for each product sold to a wholesaler. The Company reduces the
chargeback allowance when it processes a request for a chargeback from a
wholesaler. Actual chargebacks processed can vary materially from period to
period.
Management obtains wholesaler inventory reports to aid in analyzing the
reasonableness of the chargeback allowance. The Company assesses the
reasonableness of its chargeback allowance by applying the product chargeback
percentage based on historical activity to the quantities of inventory on hand
per the wholesaler inventory reports.
Similarly, the Company maintains an allowance for rebates related to
contract and other programs with certain customers. The rebate allowance also
reduces gross sales and accounts receivable by the amount of the estimated
rebate amount when the Company sells its products to its rebate-eligible
customers. Rebate percentages vary by product and by volume purchased by each
eligible customer. The Company tracks sales by product number for each eligible
customer and then applies the applicable rebate percentage, using both
historical trends and actual experience to estimate its rebate allowance. The
Company reduces gross sales and increases the rebate allowance by the estimated
rebate amount for each product sold to an eligible customer. The Company reduces
the rebate allowance when it processes a customer request for a rebate. At each
balance sheet date, the Company evaluates the allowance against actual rebates
processed and such amount can vary materially from period to period.
10
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
the various contracts and programs. For the three month period ended June 30,
2003 and 2002, the Company recorded chargeback and rebate expense of $3,543,000,
and $3,478,000, respectively. For the six months ended June 30, 2003 and 2002,
the Company recorded chargeback and rebate expense of $6,305,000, and
$7,554,000, respectively. The allowance for chargebacks and rebates was
$4,076,000 and $4,302,000 as of June 30, 2003 and December 31, 2002,
respectively.
Allowance for Product Returns
The Company also maintains an allowance for estimated product returns. This
allowance is reflected as a reduction of accounts receivable balances. The
Company evaluates the allowance balance against actual returns processed. In
addition to considering in process product returns and assessing the potential
implications of historical product return activity, the Company also considers
the wholesaler's inventory information to assess the magnitude of unconsumed
product that may result in a product return to the Company in the future. Actual
returns processed can vary materially from period to period. For the three month
period ending June 30, 2003 and 2002 the Company recorded a provision for
product returns of $640,000, and $588,000, respectively. For the six month
period ending June 30, 2003 and 2002 the Company recorded a provision for
product returns of $1,337,000, and $1,032,000, respectively. The allowance for
potential product returns was $1,354,000 and $1,166,000 at June 30, 2003 and
December 31, 2002, respectively.
Allowance for Doubtful Accounts
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. In estimating the allowance for doubtful accounts, the Company has:
o 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 and other
exogenous factors that might affect collectibility (e.g., bankruptcies
of customers, factors that affect particular distribution channels,
etc.).
o 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) other
information such as buying patterns and payment patterns, particularly
in respect of major customers.
o 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 factors that might
affect collectibility of outstanding balances - based upon information
available at the time.
For the three month periods ending June 30, 2003 and 2002, the Company
recorded a provision, net of recoveries, for doubtful accounts of ($342,000) and
($400,000), respectively. For the six month periods ending June 30, 2003 and
2002, the Company recorded a provision, net of recoveries, for doubtful accounts
of ($288,000) and ($400,000), respectively. The allowance for doubtful accounts
was $559,000 and $1,200,000 as of June 30, 2003 and December 31, 2002,
respectively. As of June 30, 2003, the Company had a total of $2,408,000 of past
due gross accounts receivable, of which $97,000 was over 60 days past due. The
Company performs monthly a detailed analysis of the receivables due from its
wholesaler customers and provides a specific reserve against known uncollectible
items for each of the wholesaler customers. The Company also includes in the
allowance for doubtful accounts an amount that it estimates to be uncollectible
for all other customers based on a percentage of the past due receivables. The
percentage reserved increases as the age of the receivables increases. Of the
recorded allowance for doubtful accounts of $559,000, the portion related to the
wholesaler customers is $397,000 with the remaining $162,000 reserve for all
other customers.
Allowance for Discounts
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 three
month periods ending June 30, 2003 and 2002, the Company recorded a provision
for
11
discounts of $155,000 and $214,000, respectively. For the six months ending June
30, 2003 and 2002, the Company recorded a provision for discounts of $358,000
and $513,000, respectively. The allowance for discounts was $116,000 and
$172,000 as of June 30, 2003 and December 31, 2002, respectively.
NOTE E - INVENTORY
The components of inventory are as follows (in thousands):
JUNE 30, DECEMBER 31,
2003 2002
----------- -----------
Finished goods............... $ 3,875 $ 3,460
Work in process.............. 2,494 1,877
Raw materials and supplies... 3,397 5,064
---------- ----------
$ 9,766 $ 10,401
========== ==========
Inventory at June 30, 2003 and December 31, 2002 is reported net of reserves
for slow-moving, unsaleable and obsolete items of $1,045,000 and $1,206,000,
respectively, primarily related to finished goods. For the three month period
ended June 30, 2003 and 2002, the Company recorded a provision of $239,000 and
$243,000, respectively. For the six months ended June 30, 2003 and 2002, the
Company recorded a provision of $408,000 and $493,000, respectively.
NOTE F - INTANGIBLE ASSETS
Intangible assets consist of product licenses 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. The Company assesses the impairment of intangibles based on
several factors, including estimated fair market value and anticipated cash
flows. The Company has no goodwill or other similar asset with indefinite lives
currently recorded on its balance sheet. A summary of the Company's acquired
amortizable intangible assets as of June 30, 2003 is as follows (in thousands):
AS OF JUNE 30, 2003
-----------------------------------------------
GROSS CARRYING ACCUMULATED NET CARRYING
AMOUNT AMORTIZATION AMOUNT
-------------- ----------- ------------
Product Licenses $22,685 $ 9,241 $13,444
The amortization expense of the above-listed acquired intangible assets for
each of the five years ending December 31, 2007 will be as follows (in
thousands):
For the year ended 12/31/03 (a)..... 1,419
For the year ended 12/31/04......... 1,404
For the year ended 12/31/05......... 1,357
For the year ended 12/31/06......... 1,304
For the year ended 12/31/07......... 1,281
(a) Amortization expense for the three months and six months ended June 30,
2003 amounted to $344,000 and $699,000, respectively.
NOTE G - PROPERTY, PLANT AND EQUIPMENT
Property, plant and equipment consists of the following (in thousands):
JUNE 30, DECEMBER 31,
2003 2002
-------- -----------
Land .................................... $ 396 $ 396
Buildings and leasehold improvements .... 8,890 8,890
Furniture and equipment ................. 27,739 27,390
Automobiles ............................. 55 55
-------- --------
37,080 36,731
Accumulated depreciation ................ (20,766) (19,236)
-------- --------
16,314 17,495
Construction in progress ................ 18,374 17,819
-------- --------
$ 34,688 $ 33,514
======== ========
12
Construction in progress primarily represents capital expenditures related
to the Company's Lyophilization project that, upon completion, is expected to
enable the Company to perform processes in-house that are currently being
performed by a sub-contractor. The Company capitalized interest expense related
to the Lyophilization project of $306,000 and $280,000 during the three-month
periods ended June 30, 2003 and 2002, respectively. For the six month period
ended June 30, 2003 and 2002, the Company capitalized interest expense related
to the Lyophilization project of $602,000 and $545,000, respectively.
NOTE H - FINANCING ARRANGEMENTS
In December 1997, the Company entered into a $15,000,000 revolving Credit
Agreement with The Northern Trust Company, which was increased to $25,000,000 on
June 30, 1998 and to $45,000,000 on December 28, 1999. This Credit Agreement is
secured by substantially all of the assets of the Company and its subsidiaries
and contains a number of restrictive covenants. There were outstanding
borrowings of $35,870,000 as of June 30, 2003 and $39,483,000 as of June 30,
2002. The interest rate as of June 30, 2003 was 7.25%.
On April 16, 2001, the Credit Agreement was amended (the "2001 Amendment")
and included, among other things, extension of the term of the agreement,
establishment of a payment schedule, revision of the method by which the
interest rate was to be determined, and the amendment and addition of certain
covenants. The 2001 Amendment also required the Company to obtain subordinated
debt of $3 million by May 15, 2001 and waived certain covenant violations
through March 31, 2001. The 2001 Amendment required payments throughout 2001
totaling $7.5 million, with the balance of $37.5 million due January 1, 2002.
The method used to calculate interest was changed to the prime rate plus 300
basis points. Previously, the interest rate was computed at the federal funds
rate or LIBOR plus an applicable percentage, depending on certain financial
ratios.
On July 12, 2001, the Company entered into a forbearance agreement (the
"Prior Agreement") with its senior lender under which the lender agreed to
forbear from taking action against the Company to enforce its rights under the
then existing Credit Agreement until January 2, 2002. As part of the Prior
Agreement, the Company acknowledged the existence of certain events of default.
These events included a default on a $1.3 million principal payment, failure to
timely make monthly interest payments due on May 31, 2001 and June 30, 2001
(these interest payments were subsequently made on July 27, 2001) and failure to
receive $3.0 million of cash proceeds of subordinated debt by May 15, 2001
(these proceeds were subsequently received on July 13, 2001).
The Company received two extensions, which extended the Prior Agreement to
February 1, 2002 and March 15, 2002, respectively. Both of these extensions
carried the same reporting requirements and covenants while establishing new
cash receipts covenants for the months of January and February in 2002.
On April 12, 2002, in lieu of further extending the Prior Agreement, the
Company entered into an amendment to the Credit Agreement (the "2002
Amendment"), effective January 1, 2002. The 2002 Amendment included, among other
things, extension of the term of the agreement, establishment of a payment
schedule and the amendment and addition of certain covenants. The new 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 the Company's 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) 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 Credit Agreement required 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 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 lender agreed to extend the Credit Agreement, as
amended, 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
13
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.
On September 16, 2002, the Company was notified by its senior lender that it
was in default due to failure to pay the principal and interest owed as of
August 31, 2002 under the then most recent extension of the Credit Agreement.
The senior lender also notified the Company that it would forbear from
exercising its 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 lender entered into an
agreement under which the senior lender would agree to forbear from exercising
its remedies (the "Forbearance Agreement") and the Company acknowledged its
then-current default. The Forbearance Agreement provides a second line of credit
that currently allows the Company to borrow the lesser of (i) the difference
between the Company's outstanding indebtedness to the senior lender and
$39,200,000, and (ii) $2,750,000, to fund the Company's day-to-day operations.
The Forbearance Agreement requires that, except for existing defaults, the
Company continue to comply with all of the covenants in the Credit Agreement and
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
lender.
The Company, as required in the Forbearance Agreement, agreed to provide the
senior lender with a plan for restructuring its financial obligations on or
before December 1, 2002, and agreed to retain a consulting firm by September 27,
2002 to assist in the development and execution of this restructuring plan and,
in furtherance of that commitment, on September 26, 2002, the Company entered
into an agreement (the "Consulting Agreement") with a consulting firm, AEG
Partners, LLC (the "Consultant") whereby the Consultant would assist in the
development and execution of this restructuring plan and provide oversight and
direction to the Company's day-to-day operations. On November 18, 2002, the
Consultant notified the Company of its intent to resign from the engagement
effective December 2, 2002, based upon the Company's alleged failure to
cooperate with the Consultant, in breach of the Consulting Agreement. The
Company's senior lender, upon learning of the Consultant's action, notified the
Company by letter dated November 18, 2002, that, as a result of the Consultant's
resignation, the Company was in default under terms of the Forbearance Agreement
and the Credit Agreement and demanded payment of all outstanding principal and
interest on the loan. This notice was followed by a second letter dated November
19, 2002, in which the senior lender gave notice of its exercise of certain
remedies available under the Credit Agreement including, but not limited to, its
setting off the Company's deposits with the senior lender against the Company's
obligations to the senior lender. The Company immediately entered into
discussions with the Consultant which led, on November 21, 2002, to the
Consultant rescinding its notification of resignation and to the senior lender
withdrawing its demand for payment and restoring the Company's accounts.
During the Company's discussions with the Consultant, the Company agreed to
establish a special committee of the Board (the "Corporate Governance
Committee"), originally consisting of Directors Ellis, and Bruhl, with Mr. Ellis
serving as Chairman. Ron Johnson was added to the Corporate Governance Committee
when he was appointed to the Board in March 2003. The Board delegated to the
Corporate Governance Committee all authority to make any and all decisions with
respect to the evaluation and approval of the restructuring plan to be developed
by the Consultant with respect to the Company's bank debt and to interface with
the Consultant regarding the Company's restructuring actions. The Company also
agreed that the Consultant will oversee the Company's interaction with all
regulatory agencies including, but not limited to, the FDA. In addition, the
Company has agreed to a "success fee" arrangement with the Consultant. Under
terms of the arrangement, if the Company is successful in refinancing or
restructuring its debt pursuant to a new or restated credit facility maturing on
or after January 1, 2004, the Consultant will be paid a cash fee equal to 1 1/2%
of the amount of the debt which is refinanced or restructured. Additionally, the
success fee arrangement provides that the Company will issue a warrant to
purchase 1,250,000 shares of common stock at an exercise price of $1.00 per
share to the Consultant upon the date on which each of the following conditions
have been met or waived by the Company: (i) the Forbearance Agreement shall have
been terminated, (ii) the Consultant's engagement pursuant to the Consulting
Agreement shall have been terminated and (iii) the Company shall have executed a
new or restated multi-year credit facility. All unexercised warrants shall
expire on the fourth anniversary of the date of issuance.
As required by the Forbearance Agreement, a restructuring plan was developed
by the Company and the Consultant and presented to the Company's senior lender
in December 2002. The restructuring plan requested that the senior lender
convert the Company's senior debt to a term note that would mature no earlier
than February 2004 and increase the second line of credit from $1.75 million to
$3 million to fund operations and capital expenditures. In light of the FDA's
re-inspection of the Decatur facility in early December 2002, the Company and
the senior lender agreed to defer further discussions of that request until
completion of the re-inspection and the Company's response thereto. As a result,
the senior lender agreed to successive short-term extensions the Forbearance
Agreement until the completion of the re-inspection. Following completion of the
FDA re-inspection of the Decatur facility on February 6, 2003
14
and issuance of the FDA findings (see Note M - "Legal Proceedings"), the senior
lender indicated that it was not willing to convert the senior debt to a term
loan, but it did agree to further extensions of the Forbearance Agreement. As
required by one of these extensions, on May 9, 2003, the Company engaged Leerink
Swann, an investment banking firm, to assist in raising additional financing and
explore other strategic alternatives for repaying the senior bank debt. That
process is continuing.
On July 3, 2003 the senior lender extended the expiration date of the
Forbearance Agreement from June 30, 2003 until July 31, 2003 and agreed to make
up to an additional $1,000,000 available to the Company under its current line
of credit increasing the maximum amount available under the line of credit from
$1,750,000 to $2,750,000. On August 8, 2003, the senior lenders extended the
expiration date of the Forbearance Agreement until August 22, 2003.
The Forbearance Agreement, as amended and extended, provides that the senior
lender will forbear from exercising its remedies as a result of specified
existing defaults by Akorn until the earlier of the expiration date and the
occurrence of any additional defaults by Akorn under the Credit Agreement.
Subject to the absence of any additional defaults and subject to the senior
lender's satisfaction with the Company's progress in resolving the matters
raised by the FDA and in obtaining additional financing and exploring other
strategic alternatives, the Company expects to continue obtaining short-term
extensions of the Forbearance Agreement. However, there can be no assurance that
the Company will be successful in obtaining further extensions of the
Forbearance Agreement beyond August 22, 2003.
As described in more detail in Note M - "Legal Proceedings", the Company is
also subject to ongoing compliance matters with the FDA. While the Company is
cooperating with the FDA and seeking to resolve the pending matter, an
unfavorable outcome 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 under the Credit Agreement.
In the event that the Company is not in compliance with the Credit Agreement
covenants through the latest extension of the Forbearance Agreement and does not
negotiate amended covenants or obtain a waiver thereof, then the senior lender,
at its option, may demand immediate payment of all outstanding amounts due and
exercise any and all available remedies, including, but not limited to,
foreclosure on the Company's assets.
On July 12, 2001 as required under the terms of the Prior Agreement, the
Company entered into a $5,000,000 subordinated debt transaction with The John N.
Kapoor Trust dtd. 9/20/89 (the " Kapoor Trust"), the sole trustee and sole
beneficiary of which is Dr. John N. Kapoor, the Company's Chairman of the Board
of Directors. The transaction is evidenced by a Convertible Bridge Loan and
Warrant Agreement (the "Trust Agreement") in which the Kapoor 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
Kapoor Trust for the subordinated debt, the Company issued the Kapoor Trust two
warrants which allow the Kapoor 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 Kapoor Trust's commitment to
provide the subordinated debt. All unexercised warrants expire on December 20,
2006.
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 Kapoor Trust until the repayment of the senior
debt pursuant to the terms of a subordination agreement, which was entered into
between the Kapoor Trust and the Company's senior lender. 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 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 EITF Abstract No.
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.
15
In December 2001, the Company entered into a $3,250,000 five-year loan with
NeoPharm, Inc. ("NeoPharm") to fund the Company's efforts to complete its
lyophilization facility located in Decatur, Illinois. Under the terms of the
Promissory Note, dated December 20, 2001 (the "NeoPharm Promissory Note"),
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 the Company will use the proceeds of the loan solely to
validate and complete the lyophilization facility located in Decatur, Illinois.
The NeoPharm Promissory Note is subordinated to the Company's senior debt but is
senior to the Company's subordinated debt owed to the Kapoor Trust. The note was
executed in conjunction with a Processing Agreement that provides NeoPharm with
the option of securing at least 15% of the capacity of the Company's
lyophilization facility each year. The Company is currently in default under the
NeoPharm Promissory Note as a result of its failure to remove all FDA warning
letter sanctions related to the Company's Decatur, Illinois facility by June 30,
2003. As a result, amounts owed under the NeoPharm Promissory Note now bear
interest at a default rate, which is 3% per annum over the rate that would
otherwise be in effect.. However, the subordination provisions applicable to the
NeoPharm Promissory Note prohibit NeoPharm from taking any action to enforce or
collect the NeoPharm Promissory Note without the consent of the Company's senior
lender. Dr. John N. Kapoor, the Company's chairman 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 Kapoor
Trust, which amended the Trust Agreement. The amendment extended the maturity of
the Trust Agreement from July 12, 2004 to terminate concurrently with the
Promissory Note on December 20, 2006. The amendment also made it possible for
the Kapoor Trust to convert the interest accrued on the $3,000,000 tranche, as
well as interest on the $2,000,000 tranche after the original maturity of the
Tranche B note, into common stock of the Company. Previously, the Kapoor Trust
could only convert the interest accrued on the $2,000,000 tranche through the
original maturity of the Tranche B note. The Company is currently in default
under the Trust Agreement as a result of a cross-default to the NeoPharm
Promissory Note. However, the Kapoor Trust is prohibited from taking any action
to enforce or collect amounts owed to it without the prior written consent of
the Company's senior lender and NeoPharm.
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
$1,773,000 and $1,917,000 at June 30, 2003 and December 31, 2002, 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.
NOTE I - NON-CASH TRANSACTIONS
The Company received an equity ownership in Novadaq Technologies, Inc.,
("Novadaq"), of 4,000,000 common shares (representing approximately 16.4% of the
outstanding shares) as part of the settlement between the Company and Novadaq
reached on January 25, 2002. The Company had previously advanced $690,000 to
Novadaq for development costs and recorded these advances as an intangible
asset. Based on the settlement, the Company has reclassified these advances as
an Investment in Novadaq Technologies, Inc. The Company has determined this
investment should be valued using the cost method as described in Accounting
Principles Board ("APB") Opinion No. 18, "The Equity Method of Accounting for
Investments in Common Stock."
NOTE J - EARNINGS PER COMMON SHARE
Basic net income (loss) per common share is based upon weighted average
common shares outstanding. Diluted net income per common share is based upon the
weighted average number of common shares outstanding, including the dilutive
effect of stock options, warrants and convertible debt using the treasury stock
method.
The following table shows basic and diluted earnings per share computations
for the three-month and six-months periods ended June 30, 2003 and June 30, 2002
(in thousands, except per share information):
16
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- ------------------------
2003 2002 2003 2002
--------- ------------- ---------- -----------
Net loss per share - basic:
Net loss ..................................................... $ (4,197) $ (783) $ (4,074) $ (632)
Weighted average number of shares outstanding ................ 19,723 19,566 19,705 19,545
Net loss per share - basic ...................................... $ (0.21) $ (0.04) $ (0.21) $ (0.03)
======== ======== ======== ========
Net loss per share - diluted:
Net loss ..................................................... $ (4,197) $ (783) $ (4,074) $ (632)
Net loss adjustment for interest on convertible debt
and convertible interest on debt .......................... -- -- -- --
-------- -------- -------- --------
Net loss, as adjusted ........................................ $ (4,197) $ (783) $ (4,074) $ (632)
-------- -------- -------- --------
Weighted average number of shares outstanding ................ 19,723 19,566 19,705 19,545
Additional shares assuming conversion of convertible debt
and convertible interest on debt .......................... -- -- -- --
Additional shares assuming exercise of warrants .............. -- -- -- --
Additional shares assuming exercise of options ............... -- -- -- --
Weighted average number of shares outstanding, as adjusted ... 19,723 19,566 19,705 19,545
Net loss per share - diluted .................................... $ (0.21) $ (0.04) $ (0.21) $ (0.03)
======== ======== ======== ========
Certain warrants, options and conversion rights are not included in the
earnings per share calculation when the exercise price or conversion price is
greater that the average market price for the period. The number of shares
subject to warrants, options and conversion rights excluded in each period is
reflected in the following table (in thousands):
THREE MONTHS ENDED SIX MONTHS ENDED
JUNE 30, JUNE 30,
------------------ ------------------
2003 2002 2002 2002
------ ------- ------- -------
Shares subject to anti-dilutive warrants and conversion rights not
included in earnings per share calculation...................................... 4,474 -- 4,474 --
Shares subject to anti-dilutive options not included in earnings per
share calculation............................................................... 3,600 2,568 3,600 2,568
NOTE K - STOCK BASED COMPENSATION
The Company applies APB Opinion No. 25 "Accounting for Stock Issued to
Employees" in accounting for qualifying options granted to its employees under
its 1988 Incentive Compensation Program and applies Statement of Financial
Accounting Standards No. 123 "Accounting for Stock Issued Employees" ("SFAS
123") for disclosure purposes only. The SFAS 123 disclosures include pro forma
net income and earnings per share as if the fair value-based method of
accounting had been used.
If compensation for employee options had been determined based on SFAS 123,
the Company's pro forma net income and pro forma income per share for the six
months ended June 30, would have been as follows (in thousands, except per share
information):
2003 2002
------- -------
Net loss, as reported $(4,074) $ (632)
Add stock-based employee compensation
expense included in reported net income -- --
Deduct total stock-based employee
compensation expense determined
under fair-value-based method for
all awards (86) (204)
Pro forma net loss $(4,160) $ (836)
Basic and diluted loss per share
of common stock
Basic as reported $ (0.21) $ (0.03)
Basic pro forma $ (0.21) $ (0.03)
Diluted as reported N/A N/A
Diluted pro forma N/A N/A
NOTE L - INDUSTRY SEGMENT INFORMATION
The Company classifies its operations into three business segments,
ophthalmic, injectable and contract services. The ophthalmic segment
manufactures, markets and distributes diagnostic and therapeutic
pharmaceuticals. The injectable segment manufactures, markets and distributes
injectable pharmaceuticals, primarily in niche markets. The contract services
segment manufactures products
17
for third party pharmaceutical and biotechnology customers based on their
specifications. Selected financial information by industry segment is presented
below (in thousands).
THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30,
--------------------------- --------------------------
2003 2002 2003 2002
-------- --------- -------- --------
REVENUES
Ophthalmic ................................ $ 5,965 $ 7,000 $ 11,252 $ 13,785
Injectable ................................ 1,544 4,411 7,449 8,199
Contract Services ......................... 1,331 2,754 2,921 5,624
-------- -------- -------- --------
Total revenues ...................... $ 8,840 $ 14,165 $ 21,622 $ 27,608
======== ======== ======== ========
GROSS PROFIT
Ophthalmic ................................ $ 1,136 $ 3,600 $ 3,087 $ 7,264
Injectable ................................ (228) 2,586 3,777 4,427
Contract Services ......................... (373) 180 (485) 1,024
-------- -------- -------- --------
Total gross profit .................. 535 6,366 6,379 12,715
Operating expenses ........................ 4,316 6,832 9,367 12,050
-------- -------- -------- --------
Total operating income .............. (3,781) (466) (2,988) 665
Interest and other income (expense) ...... (613) (826) (1,257) (1,713)
-------- -------- -------- --------
Loss before income taxes................ $ (4,393) $ (1,292) $ (4,245) $ (1,048)
======== ======== ======== ========
The Company manages its business segments to the gross profit level and
manages its operating costs on a company-wide basis. The Company does not
identify assets by segment for internal purposes.
NOTE M - LEGAL PROCEEDINGS
On March 27, 2002, the Company received a letter informing it that the staff
of the regional office of the Securities and Exchange Commission ("SEC") in
Denver, Colorado, would recommend to the SEC that it bring an enforcement action
against the Company and seek an order requiring the Company to be enjoined from
engaging in certain conduct. The staff alleged that the Company misstated its
income for fiscal years 2000 and 2001 by allegedly failing to reserve for
doubtful accounts receivable and overstating its accounts receivable balance as
of December 31, 2000. The staff alleged that internal control and books and
records deficiencies prevented the Company from accurately recording,
reconciling and aging its accounts receivable. The Company also learned that
certain of its former officers, as well as a then current employee had received
similar notifications. Subsequent to the issuance of the Company's consolidated
financial statements for the year ended December 31, 2001, management of the
Company determined it needed to restate the Company's financial statements for
2000 and 2001 to record a $7.5 million increase to the allowance for doubtful
accounts as of December 31, 2000, which it had originally recorded as of March
31, 2001.
On July 11, 2003, the Company reached a revised agreement in principle with
the staff of the SEC's regional office in Denver, Colorado, that would resolve
the issues arising from the staff's investigation and proposed enforcement
action as discussed above. The Company has offered to consent to the entry of an
administrative cease and desist order as proposed by the staff, without
admitting or denying the findings set forth therein. The proposed consent order
finds that the Company failed to promptly and completely record and reconcile
cash and credit remittances, including from its top five customers, to invoices
posted in its accounts receivable sub-ledger. According to the findings in the
proposed consent order, the Company's problems resulted from, among other
things, internal control and books and records deficiencies that prevented the
Company from accurately recording, reconciling and aging its receivables. The
proposed consent order finds that the Company's 2000 Form 10-K and first quarter
2001 Form 10-Q misstated its account receivable balance or, alternatively,
failed to disclose the impairment of its accounts receivable and that its first
quarter 2001 Form 10-Q inaccurately attributed the increased accounts receivable
reserve to a change in estimate based on recent collection efforts, in violation
of Section 13(a) of the Exchange Act and rules 12b-20, 13a-1 and 13a-13
thereunder. The proposed consent order also finds that the Company failed to
keep accurate books and records and failed to devise and maintain a system of
adequate internal accounting controls with respect to its accounts receivable in
violation of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act. The
proposed consent order does not impose a monetary penalty against the Company or
require any additional restatement of the Company's financial statements. The
proposed consent order, as revised, contains an additional commitment by the
Company to do the following: (A) appoint a special committee comprised entirely
of outside directors, (B) within 30 days after entry of the order, have the
special committee retain a qualified independent consultant ("consultant")
acceptable to the staff to perform a test of the Company's material internal
controls, practices, and policies related to accounts receivable, and (C) within
180 days, have the consultant present his or her findings to the commission for
review to provide assurance that the Company is keeping accurate books and
records and has devised and maintained a system of adequate internal accounting
controls with respect to the Company's accounts
18
receivables. The proposed consent order does not become final until it is
approved by the SEC. Accordingly, the Company may incur additional costs and
expenses in connection with this proceeding.
In October 2000, the FDA issued a warning letter to the Company following
the FDA's routine cGMP inspection of the Company's Decatur manufacturing
facilities. This letter addressed several deviations from regulatory
requirements including cleaning validations and general documentation issues and
requested corrective actions be undertaken by the Company. The Company initiated
corrective actions and responded to the warning letter. Subsequently, the FDA
conducted another inspection in late 2001 and identified deviations from
regulatory requirements including process controls and cleaning validations.
This led to the FDA leaving the warning letter in place and issuing a Form 483
to document its findings. While no further correspondence was received from the
FDA, the Company responded to the inspection findings. This response described
the Company's plan for addressing the issues raised by the FDA and included
improved cleaning validation, enhanced process controls and approximately $2.0
million of capital improvements. In August 2002 the FDA conducted another
inspection of the Decatur facility, which also identified deviations from cGMPs.
The Company responded to these observations in September 2002. In response to
the Company's actions, the FDA conducted another inspection of the Decatur
facility during the period December 10, 2002 to February 6, 2003. This
inspection also identified deviations from regulatory requirements including the
manner in which the Company processes and investigates manufacturing
discrepancies and failures, customer complaints and the thoroughness of
equipment cleaning validations. Deviations identified during this inspection had
been raised in previous FDA inspections. The Company has responded to these
latest findings in writing and in a meeting with the FDA in March 2003. The
Company set forth its plan for implementing comprehensive corrective actions and
has provided progress reports to the FDA on April 15, and May 15, 2003 and June
15, 2003.
As a result of the latest inspection and the Company's response, the FDA may
take any of the following actions: (i) permit the Company to continue its
corrective actions and conduct another inspection (which likely would not occur
before the fourth quarter of 2003) to assess the success of these efforts; (ii)
seek to enjoin the Company from further violations, which may include temporary
suspension of some or all operations and potential monetary penalties; or (iii)
take other enforcement action which may include seizure of Company products. At
this time, it is not possible to predict the FDA's course of action.
FDA approval is required before any drug can be manufactured and marketed.
New drugs require the filing of a New Drug Application ("NDA"), including
clinical studies demonstrating the safety and efficacy of the drug. Generic
drugs, which are equivalents of existing, off-patent brand name drugs, require
the filing of an Abbreviated New Drug Application ("ANDA"). The Company believes
that unless and until the issues identified by the FDA have been successfully
corrected and the corrections have been verified through reinspection, it is
doubtful that the FDA will approve any NDAs or ANDAs that may be submitted by
the Company. This has adversely impacted, and is likely to continue to adversely
impact the Company's ability to grow sales. However, the Company believes that
unless and until the FDA chooses option (ii) or (iii), the Company will be able
to continue manufacturing and distributing its current product lines.
If the FDA chooses option (ii) or (iii), such action could significantly
impair the Company's ability to continue to manufacture and distribute its
current product line and generate cash from its operations, could result in a
covenant violation under the Company's senior debt or could cause the Company's
senior lender to refuse further extensions of the Company's senior debt, any or
all of which would have a material adverse effect on the Company's liquidity.
Any monetary penalty assessed by the FDA also could have a material adverse
effect on the Company's liquidity.
On December 19, 2002 and January 22, 2003, the Company received demand
letters regarding claimed wrongful deaths allegedly associated with the use of
the drug Inapsine, which the Company produced. The total amount claimed was $3.8
million. In July 2003, the Company agreed to a settlement with respect to one of
the claims alleged by these demand letters. The Company does not believe that
this settlement or the outcome of the second alleged claim will have a material
impact on the Company's financial position.
The Company is a party in legal proceedings and potential claims arising in
the ordinary course of its business. The amount, if any, of ultimate liability
with respect to such matters cannot be determined. Despite the inherent
uncertainties of litigation, management of the Company at this time does not
believe that such proceedings will have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
NOTE N - RECENT ACCOUNTING PRONOUNCEMENTS
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."
19
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 to 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 initiated after June 30, 2001. The adoption of this new standard
did not have any 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 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 and no impairments were recognized upon adoption. Subsequent to the
adoption, the Company recorded an impairment charge of $257,000 related to
product license intangibles in the third quarter of 2002.
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 any 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 any effect on the Company's
financial statements upon adoption. Subsequent to the adoption of this standard,
the Company recorded a charge of $545,000 in the third quarter of 2002 related
to abandoned construction projects.
In April 2002, the FASB issued SFAS No. 145 "Recission of FASB Statements
No. 4, 44 and 64, Amendment of FASB Statement No. 13 and Technical Corrections".
This statement updates, clarifies and simplifies existing accounting
pronouncements. SFAS No. 145 rescinds SFAS No. 4, "Reporting Gains and Losses
from Extinguishment of Debt", which requires all gains and losses from
extinguishment of debt to be aggregated and, if material, classified as an
extraordinary item, net of related income tax effect. As a result, the criteria
in APB 30 will now be used to classify those gains and losses. SFAS No. 64,
"Extinguishment of Debt Made to Satisfy Sinking Fund Requirements", which
amended SFAS No. 4, is no longer necessary because SFAS No. 4 has been
rescinded. SFAS No. 145 amends SFAS No. 13 "Accounting for Leases", to require
that certain lease modifications that have economic effects similar to a
sale-leaseback transaction be accounted for in the same manner as a
sale-leaseback transaction. Certain provisions of SFAS No. 145 are effective for
the fiscal years beginning after May 15, 2002, while other provisions are
effective for transactions occurring after May 15, 2002. The adoption of SFAS
No. 145 did not have a material impact 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 adopted SFAS No. 146 for exit or disposal activities initiated after
December 31, 2002. The adoption of this standard did not have a material effect
on its financial statements.
In December 2002, the FASB issued SFAS No. 148, "Accounting for Stock-Based
Compensation - Transition and Disclosure, an amendment of FASB Statement No.
123". This Statement amends FASB Statement No. 123, "Accounting for Stock-Based
Compensation", to provide alternative methods of transition for a voluntary
change to the fair value method of accounting for stock-based employee
compensation. In addition, this Statement amends the disclosure requirements of
Statement No. 123 to require prominent disclosure in both annual and interim
financial statements. Certain of the disclosure requirements are required for
fiscal years ending after December 15, 2002 and are included in the Notes to the
Consolidated Financial Statements.
In November 2002, the FASB issued Interpretation No. 45 ("FIN 45"),
Guarantor's Accounting and Disclosure Requirement for Guarantees, Including
Indirect Guarantees of Indebtedness to Others, an interpretation of FASB
Statements No. 5, 57 and 107 and a rescission of FASB Interpretation No. 34.
This Interpretation elaborates on the disclosure to be made by a guarantor in
its interim and
20
annual financial statements about its obligations under guarantees issued. The
Interpretation also clarifies that a guarantor is required to recognize, at
inception of a guarantee, a liability for the fair value of the obligation
undertaken. The initial recognition and measurement provisions of the
Interpretation are applicable to guarantees issued or modified after December
31, 2002 and are not expected to have a material effect on the Company's
financial statements. The disclosure requirements are effective for financial
statements of interim or annual periods ending after December 15, 2002. The
Company has determined that FIN 45 did not have any effect on the Company's
financial statements.
In January, 2003, the FASB issued Interpretation No. 46. ("FIN 46"),
"Consolidation of Variable Interest Entities" with the objective of improving
financial reporting by companies involved with variable interest entities. A
variable interest entity is a corporation, partnership, trust, or other legal
structure used for business purposes that either (a) does not have equity
investors with voting rights, or (b) has equity investors that do not provide
sufficient financial resources for the equity to support its activities.
Historically, entities generally were not consolidated unless the entity was
controlled through voting interests. FIN 46 changes that by requiring a variable
interest entity to be consolidated by a company if that company is subject to a
majority of risk of loss from the variable interest entity's activities or
entitled to receive a majority of the entity's residual returns, or both. A
company that consolidates a variable interest entity is called the "primary
beneficiary" of that entity. FIN 46 also requires disclosures about variable
interest entities that a company is not required to consolidate but in which it
has significant variable interest. The consolidation requirements of FIN 46
apply immediately to variable interest entities created after January 1, 2003.
The consolidation requirements of FIN 46 apply to existing entities in the first
fiscal year or interim period beginning after June 15, 2003. Also, certain
disclosure requirements apply to all financial statements issued after January
31, 2003, regardless of when the variable interest entity was established. The
Company has determined that FIN 46 will not have an impact on its financial
condition, results of operations or cash flows.
NOTE O - SUBSEQUENT EVENTS
On July 3, 2003 the Company's senior lender extended the expiration date of
the Forbearance Agreement relating to the senior debt to July 31, 2003 and
agreed to make up to an additional $1,000,000 available to the Company under its
current line of credit increasing the maximum amount available under the line of
credit from $1,750,000 to $2,750,000. On August 8, 2003, the senior lender
further extended the expiration date of the Forbearance Agreement to August 22,
2003. For further discussion, refer to Note M - "Legal Proceedings" - to the
Condensed Consolidated Financial Statements.
On July 11, 2003 the Company reached a revised agreement in principle with
the SEC staff that would resolve the issues arising from the SEC's investigation
and proposed enforcement action. For further discussion, refer to Note M -
"Legal Proceedings" - to the Condensed Consolidated Financial Statements.
On July 15, 2003 NeoPharm notified the Company that it believed that the
Company had defaulted on its obligations under the processing agreement entered
into in connection with the NeoPharm Promissory Note. Although the Company does
not agree with NeoPharm's assertions regarding the processing agreement, it has
acknowledged that an event of default occurred under the NeoPharm Promissory
Note as a result of the Company's failure to remove all FDA warning letter
sanctions related to the Company's Decatur, Illinois facility by June 30, 2003.
However, the subordination provisions applicable to the NeoPharm Promissory Note
prohibit NeoPharm from taking any action to enforce or collect the NeoPharm
Promissory Note without the consent of The Northern Trust Company. For further
discussion, refer to Note H - "Financing Arrangements" - to the Condensed
Consolidated Financial Statements.
On July 21, 2003, the Kapoor Trust notified the Company that it was in
default under the Trust Agreement as a result of, among other things, a
cross-default to the NeoPharm Promissory Note. However, the Kapoor Trust is
prohibited from taking any action to enforce or collect amounts owed to it
without the prior written consent of the Company's senior lender and NeoPharm.
For further discussion, refer to Note H - "Financing Arrangements" - to the
Condensed Consolidated Financial Statements.
21
Item 2.
AKORN, INC.
MANAGEMENT'S DISCUSSION AND ANALYSIS
OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
CRITICAL ACCOUNTING POLICIES
REVENUE RECOGNITION
The Company recognizes product sales for its ophthalmic and injectable
business segments upon the shipment of goods for customers whose terms are FOB
shipping point. The Company has several customers whose terms are FOB
destination point and recognizes revenue upon delivery of the product to these
customers. Revenue is recognized when all obligations of the Company have been
fulfilled and collection of the related receivable is probable. Provision for
estimated chargebacks, rebates, discounts and product returns is made at the
time of sale and is analyzed and adjusted, if necessary, at each balance sheet
date.
The contract services segment, which produces products for third party
customers, based upon their specification, at a pre-determined price, also
recognizes sales upon the shipment of goods or upon delivery of the product as
appropriate. Revenue is recognized when all obligations of the Company have been
fulfilled and collection of the related receivable is probable.
Royalty revenue is recognized in the period to which such revenue relates
based upon when the Company receives notification (monthly or quarterly) from
the counterparty that such counterparty has sold product for which Akorn is
entitled to a royalty.
ALLOWANCE FOR CHARGEBACKS AND REBATES
The Company maintains allowances for chargebacks and rebates. These
allowances are reflected as a reduction of accounts receivable.
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 contract is charged back
to the Company by the wholesaler. The Company tracks sales and submitted
chargebacks by product number for each wholesaler. Utilizing this information,
the Company estimates a chargeback percentage for each product. The Company
reduces gross sales and increases the chargeback allowance by the estimated
chargeback amount for each product sold to a wholesaler. The Company reduces the
chargeback allowance when it processes a request for a chargeback from a
wholesaler. Actual chargebacks processed can vary materially from period to
period.
Management obtains wholesaler inventory reports to aid in analyzing the
reasonableness of the chargeback allowance. The Company assesses the
reasonableness of its chargeback allowance by applying the product chargeback
percentage based on historical activity to the quantities of inventory on hand
per the wholesaler inventory reports.
Similarly, the Company maintains an allowance for rebates related to
contract and other programs with certain customers. The rebate allowance also
reduces gross sales and accounts receivable by the amount of the estimated
rebate amount when the Company sells its products to its rebate-eligible
customers. Rebate percentages vary by product and by volume purchased by each
eligible customer. The Company tracks sales by product number for each eligible
customer and then applies the applicable rebate percentage, using both
historical trends and actual experience to estimate its rebate allowance. The
Company reduces gross sales and increases the rebate allowance by the estimated
rebate amount for each product sold to an eligible customer. The Company reduces
the rebate allowance when it processes a customer request for a rebate. At each
balance sheet date, 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
the various contracts and programs. For the three month period ended June 30,
2003 and 2002, the Company recorded chargeback and rebate expense of $3,543,000,
and $3,478,000, respectively. For the six months ended June 30, 2003 and 2002,
the Company recorded chargeback and rebate expense of $6,305,000, and
$7,554,000, respectively. The allowance for chargebacks and rebates was
$4,076,000 and $4,302,000 as of June 30, 2003 and December 31, 2002,
respectively.
22
ALLOWANCE FOR PRODUCT RETURNS
The Company also maintains an allowance for estimated product returns. This
allowance is reflected as a reduction of accounts receivable balances. The
Company evaluates the allowance balance against actual returns processed. In
addition to considering in process product returns and assessing the potential
implications of historical product return activity, the Company also considers
the wholesaler's inventory information to assess the magnitude of unconsumed
product that may result in a product return to the Company in the future. Actual
returns processed can vary materially from period to period. For the three month
period ending June 30, 2003 and 2002 the Company recorded a provision for
product returns of $640,000, and $588,000, respectively. For the six month
period ending June 30, 2003 and 2002 the Company recorded a provision for
product returns of $1,337,000, and $1,032,000, respectively. The allowance for
potential product returns was $1,354,000 and $1,166,000 at June 30, 2003 and
December 31, 2002, respectively.
ALLOWANCE FOR DOUBTFUL ACCOUNTS
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. In estimating the allowance for doubtful accounts, the Company has:
o 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 and other
exogenous factors that might affect collectibility (e.g., bankruptcies
of customers, factors that affect particular distribution channels,
etc.).
o 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) other
information such as buying patterns and payment patterns, particularly
in respect of major customers.
o 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 factors that might
affect collectibility of outstanding balances - based upon information
available at the time.
For the three month periods ending June 30, 2003 and 2002, the Company
recorded a provision, net of recoveries, for doubtful accounts of ($342,000) and
($400,000), respectively. For the six month periods ending June 30, 2003 and
2002, the Company recorded a provision, net of recoveries, for doubtful accounts
of ($288,000) and ($400,000), respectively. The allowance for doubtful accounts
was $559,000 and $1,200,000 as of June 30, 2003 and December 31, 2002,
respectively. As of June 30, 2003, the Company had a total of $2,408,000 of past
due gross accounts receivable, of which $97,000 was over 60 days past due. The
Company performs monthly a detailed analysis of the receivables due from its
wholesaler customers and provides a specific reserve against known uncollectible
items for each of the wholesaler customers. The Company also includes in the
allowance for doubtful accounts an amount that it estimates to be uncollectible
for all other customers based on a percentage of the past due receivables. The
percentage reserved increases as the age of the receivables increases. Of the
recorded allowance for doubtful accounts of $559,000, the portion related to the
wholesaler customers is $397,000 with the remaining $162,000 reserve for all
other customers.
ALLOWANCE FOR DISCOUNTS
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 three
month periods ending June 30, 2003 and 2002, the Company recorded a provision
for discounts of $155,000 and $214,000, respectively. For the six months ending
June 30, 2003 and 2002, the Company recorded a provision for discounts of
$358,000 and $513,000, respectively. The allowance for discounts was $116,000
and $172,000 as of June 30, 2003 and December 31, 2002, respectively.
23
ALLOWANCE FOR SLOW-MOVING INVENTORY
The Company maintains an allowance for slow-moving and obsolete inventory
based upon recent sales activity by unit and wholesaler inventory information.
For the three month period ended June 30, 2003 and 2002, the Company recorded a
provision of $239,000 and $243,000, respectively. For the six months ended June
30, 2003 and 2002, the Company recorded a provision of $408,000 and $493,000,
respectively. The allowance for inventory obsolescence at June 30, 2003 and
December 31, 2002 was $1,045,000 and $1,206,000, respectively.
INCOME TAXES
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. In performing its analysis of whether a valuation allowance to
reduce the deferred tax asset is necessary, the Company considers both negative
and positive evidence, which can be objectively verified. Based upon its
analysis, the Company established a valuation allowance in 2002 and for the
first six months of 2003 to reduce the deferred tax asset to zero.
INTANGIBLES
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 June 30, 2003 and
December 31, 2002 was $9,241,000 and $8,543,000, respectively. The Company
annually assesses the impairment of intangibles based on several factors,
including estimated fair market value and anticipated cash flows.
FORWARD-LOOKING STATEMENTS AND FACTORS AFFECTING FUTURE RESULTS
Certain statements in this Form 10-Q constitute "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act. When used in
this document, the words "anticipate," "believe," "estimate" and "expect" and
similar expressions are generally intended to identify forward-looking
statements. Any forward-looking statements, including statements regarding the
intent, belief or expectations of the Company or its management are not
guarantees of future performance. These statements involve risks and
uncertainties and actual results may differ materially from those in the
forward-looking statements as a result of various factors, including but not
limited to:
o the Company's ability to restructure or refinance its debt to its senior
lender, which is currently in default, but subject to a forbearance
agreement;
o the Company's ability to obtain further extensions of the forbearance
agreement which originally expired on January 3, 2003, but has
subsequently been extended for successive short-term periods, the latest
of which expires on August 22, 2003;
o the subordination provisions that currently prohibit NeoPharm from
taking any action to enforce or collect the NeoPharm Promissory Note,
which is currently in default, without the prior written consent of
Company's senior lender;
o the subordination provisions that currently prohibit the Kapoor Trust
from taking any action to enforce or collect the subordinated debt owed
to the Kapoor Trust, which is currently in default, without the prior
written consent of Company's senior lender and NeoPharm;
o the Company's ability to avoid further defaults under debt covenants;
o the Company's ability to generate cash from operations sufficient to
meet its working capital requirements;
o the Company's ability to obtain additional funding to operate and grow
its business;
o the Company's ability to resolve its Food and Drug Administration
compliance issues at its Decatur, Illinois facility;
o the effects of federal, state and other governmental regulation of the
Company's business;
24
o the Company's success in developing, manufacturing and acquiring new
products;
o the Company's ability to bring new products to market and the effects of
sales of such products on the Company's financial results;
o the effects of competition from generic pharmaceuticals and from other
pharmaceutical companies;
o availability of raw materials needed to produce the Company's products;
o other factors referred to in the Company's other Securities and Exchange
Commission filings including " Item 7. Management's Discussion and
Analysis of Financial Conditions and Results of Operations - Factors
that May Affect Future Results" in the Company's Form 10-K for 2002.
RESULTS OF OPERATIONS
THREE MONTHS ENDED JUNE 30, 2003 COMPARED TO 2002
The following table sets forth, for the periods indicated, revenues by
segment, excluding intersegment sales (in thousands):
THREE MONTHS ENDED JUNE 30,
2003 2002
----------------------------
Ophthalmic segment.......... $ 5,965 $ 7,000
Injectable segment.......... 1,544 4,411
Contract Services segment... 1,331 2,754
--------- ---------
Total revenues.............. $ 8,840 $ 14,165
========= =========
Consolidated revenues decreased 37.6% in the quarter ended June 30, 2003
compared to the same period in 2002.
Ophthalmic segment revenues decreased 14.8%, due to lower volume of the
Company's diagnostic products, particularly Fluress and Fluoracaine which were
impacted by the continued effects of the late 2002 temporary suspension of
production, pending requalification of these products in a new container.
Injectable segment revenues decreased 65.0% for the quarter because the release
of the rheumatology and antidote product backorder in the first quarter of 2003
resulted in surplus customer inventory in the second quarter. The Company
anticipates that injectable revenues will return to 2002 levels in subsequent
quarters. Contract services revenues decreased by 51.7% due to customer concerns
about the status of the ongoing FDA compliance matters at the Company's Decatur
facility as well as the temporary closure for aseptic processing of a production
room at that same facility.
The Company anticipates that revenues from the Contract Services segment
will continue to lag historical levels and that Ophthalmic and Injectable
segment revenues are not likely to grow until the issues surrounding the FDA
review are resolved. The FDA compliance matters are not anticipated to be
resolved prior to the fourth quarter of 2003. See Part II - Item 1 - "Legal
Proceedings". Production of Fluress in a new container resumed in June and sales
resumed in July 2003. However, production of Fluress, Fluoracaine and other
ophthalmic products is currently suspended due to temporary closure of another
production room at the Decatur facility. The Company does not expect to resume
aseptic processing in the aforementioned Decatur production room or to reopen
the other production room prior to the fourth quarter of 2003. While the Company
does have Fluress and other ophthalmic product inventory on hand that it can
ship, revenues and cash flow from operations for the fourth quarter of 2003
could be adversely impacted if the Company is unable to resume aseptic
processing in the aforementioned Decatur production room or reopen the other
production room in the fourth quarter of 2003, as expected.
Consolidated gross margin was 6.1% for the second quarter as compared to a
gross margin of 44.9% in the same period a year ago, mainly due to the volume
decrease in high margin antidote and rheumatology product sales combined with
volume shortfalls in the Ophthalmic and Contract Services segments.
Additionally, increased costs associated with addressing the Company's current
FDA compliance matters had a negative margin impact for the quarter.
Selling, general and administrative (SG&A) expenses decreased 39.1%, to
$3,844,000 from $6,315,000, during the quarter ended June 30, 2003 as compared
to the same period in 2002. 2002 results include a $1,559,500 asset impairment
charge related to the abandonment of the Johns Hopkins patents. Net of this
charge, SG&A expenses decreased 19.2%, due to lower personnel and marketing
costs.
25
Provision, net of recoveries, for bad debts was a net $234,000 recovery for
the second quarter of 2003. Provision, net of recoveries, for bad debts was a
net $400,000 recovery for the second quarter of 2002.
Research and development (R&D) expense decreased 35.6% in the quarter, to
$362,000 from $562,000 for the same period in 2002 due to scaled back activities
from historical levels pending resolution of the FDA warning letter.
Interest and other expense for the second quarter of 2003 was $612,000, a
25.9% decrease compared to the same period in the prior year, primarily due to
lower interest rates as well as a lower debt balance.
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 asset to the amount that is more likely than not to
be realized. The Company recorded a valuation allowance of $1,638,000 in the
second quarter of 2003, which reduced the deferred tax asset to zero.
For the second quarter of 2003, the Company recorded a net tax benefit of
$196,000 relating to anticipated state income tax refunds. For the second
quarter of 2002, the Company recorded a net tax benefit of $509,000 relating to
the pre-tax loss for the period. The $1,638,000 valuation allowance for deferred
taxes described in the preceding paragraph eliminated any potential federal
income tax benefits from the net tax benefit for the second quarter of 2003.
There was no valuation allowance for deferred taxes at the end of the second
quarter of 2002.
The Company reported a net loss of 4,197,000 or $0.21 per weighted average
share for the three months ended June 30, 2003, versus share a loss of $783,000
or $0.04 per weighted average share for the comparable prior year quarter. The
reduction in net income was due primarily to the decrease in revenues and gross
margins and increase in the deferred tax valuation allowance, partially offset
in part by lower expenditures in SG&A, research and development and reduced
interest expenses.
SIX MONTH PERIOD ENDED JUNE 30, 2003 COMPARED TO 2002
The following table sets forth, for the periods indicated, revenues by
segment, excluding intersegment sales (in thousands):
SIX MONTHS ENDED JUNE 30,
2003 2002
----------------------------
Ophthalmic segment.......... $ 11,252 $ 13,785
Injectable segment.......... 7,449 8,199
Contract Services segment... 2,921 5,624
--------- ---------
Total revenues.............. $ 21,622 $ 27,608
========= =========
Consolidated revenues decreased 21.7% for the six months ended June 30, 2003
compared to the same period in 2002.
Ophthalmic segment revenues decreased 18.4%, primarily due to the temporary
suspension in late 2002 of production of Fluress and Fluoracaine, as well as
increased customer purchases of angiography and ointment products in the fourth
quarter of 2002, which resulted in surplus customer inventory during the 2003
period. Injectable segment revenues decreased 9.1% year to date due to lower
volumes of anesthesia products partially offset by increased sales due to the
release of rheumatology and antidote product backorders. The Company anticipates
that injectable revenues will return to 2002 levels in subsequent quarters.
Contract services revenues decreased by 48.1% due mainly to customer concerns
about the status of the ongoing FDA compliance matters at the Company's Decatur
facility as well as the temporary closure for aseptic processing of a production
room at that same facility.
The Company anticipates that revenues from the Contract Services segment
will continue to lag historical levels and that Ophthalmic and Injectable
segment revenues are not likely to grow until the issues surrounding the FDA
review are resolved. The FDA compliance matters are not anticipated to be
resolved prior to the fourth quarter of 2003. See Part II - Item 1 - "Legal
Proceedings". Production of Fluress in a new container resumed in June and sales
resumed in July 2003. However, production of Fluress, Fluoracaine and other
ophthalmic products is currently suspended due to temporary closure of another
production room at the Decatur facility. The Company does not expect to resume
aseptic processing in the aforementioned Decatur production room or to reopen
the other production room prior to the fourth quarter of 2003. While the Company
does have Fluress and other ophthalmic product inventory on hand that it can
ship, revenues and cash flow from operations for the fourth quarter of 2003
could be adversely impacted if the Company is unable to resume aseptic
processing in the aforementioned Decatur production room or reopen the other
production room in the fourth quarter of 2003, as expected.
26
The chargeback and rebate expense for the six months ended June 30, 2003
declined to $6,305,000 from $7,554,000 in the comparable period in the prior
year, due to the increase in the product sales mix of lower chargeback and
rebate percentage items, such as antidote and rheumatology products.
Year to date consolidated gross margin was 29.5% for 2003 as compared to a
gross margin of 46.1% in the same period a year ago. The increase in higher
margin antidote and rheumatology product sales was more than offset by the
volume declines in the Ophthalmic and Contract Services segments and increased
costs associated with the resolution of the Company's current FDA compliance
matters.
Selling, general and administrative (SG&A) expenses decreased 25.6%, to
$8,013,000 from $10,770,000, for the year to date period ended June 30, 2003 as
compared to the same period in 2002. Net of the $1,559,500 asset impairment
charge related to the abandonment of the Johns Hopkins patents, SG&A expenses
decreased 11.8%, due to lower personnel and marketing costs.
Provision, net of recoveries, for bad debts was a $287,000 net recovery year
to date, reflecting a $136,000 provision which was offset by $424,000 in
recoveries for the same period. The bad debt expenses net of recoveries for 2002
was a net $400,000 recovery, reflecting a $0 provision which was offset by
$400,000 in recoveries for the same period.
Research and development (R&D) expense decreased 15.0% in 2003, to $835,000
from $982,000 for the same period in 2002 due to scaled back activities from
historical levels pending resolution of the FDA warning letter.
Interest and other expense for the six month period ending June 30, 2003 was
$1,257,000, a 26.6% decrease compared to the same period in the prior year,
primarily due to lower interest rates as well as a lower debt balance.
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. The Company recorded a valuation allowance of $1,638,000 in the
second quarter of 2003, which reduced the deferred tax asset to zero.
For the six months ending June 30, 2003, the Company recorded a net tax
benefit of $171,000 relating to anticipated state income tax refunds. For the
six months ending June 30, 2002, the Company recorded a net tax benefit of
$416,000 relating to the pre-tax loss for the period. The $1,638,000 valuation
allowance for deferred taxes described in the preceding paragraph eliminated any
potential federal income tax benefits from the net tax benefit for the six
months ending June 30, 2003. There was no valuation allowance for deferred taxes
at the end of the six month period ending June 30, 2002.
The Company reported a net loss of $$4,074,000 or $0.21 per weighted average
share for the six months ended June 30, 2003, versus share $416,000 or $0.03 per
weighted average share for the comparable prior year quarter. The reduction in
net income was due primarily to the decrease in revenues and gross margins and
increase in the deferred tax valuation allowance, partially offset by lower SG&A
and research expenditures as well as reduced interest expenses.
FINANCIAL CONDITION AND LIQUIDITY
Overview
As of June 30, 2003, the Company had a cash and cash equivalent deficit of
$14,000 and net accounts receivable as of June 30, 2003 was a negative $504,000.
The cash and cash equivalents deficit was due to checks that were outstanding as
of June 30, 2003. The Company's negative accounts receivable balance of $504,000
as of June 30, 2003 consists of gross receivables of $5,601,000, less an
aggregate of $5,546,000 in allowances for chargebacks, rebates, product returns
and discounts and a $559,000 allowance for doubtful accounts. The negative
accounts receivable balance resulted from aggressive collection of outstanding
receivables and from reduced sales in the second quarter of 2003. The net
working capital deficiency at June 30, 2003 was $40,099,000 versus $30,564,000
at December 31, 2002. The negative working capital position reflects the
classification of the Company's senior and subordinated debt obligations of
$43,130,000 as a current liability at June 30, 2003, as compared to
reclassification of only the senior debt obligations of $35,859,000 as of
December 31, 2002.
For the six months ended June 30, 2003, the Company had $599,000 in cash
provided by operations, due to a decrease in accounts receivable and inventory,
as well as an increase in accounts payable. The decrease in receivables was due
to the collection on the sale
27
of backordered injectable products from the first quarter of 2003 to customers
whose credit terms were such that collection of the receivables occurred in
April 2003 and from reduced sales in the second quarter of 2003. Inventory
decreased due to strict controls over purchases of raw materials and components.
Investing activities during the period ended June 30, 2003 used $930,000 in
cash, including $780,000 related to the lyophilized (freeze-dried)
pharmaceuticals manufacturing line expansion. Financing activities used $73,000
in cash during the period ended June 30, 2003.
The Company experienced losses from operations for the first six months of
2003 and in each of the three most recent years (2000-2002) and has a working
capital deficiency of $40.1 million as of June 30, 2003. The Company also is in
default under its existing senior credit agreement and subordinated debt
agreements and is subject to ongoing Food and Drug Administration ("FDA")
compliance matters that could have a material adverse effect on the Company. See
"Credit Agreement", "- Subordinated Debt" and Part II - Item 1 - "Legal
Proceedings". Although the Company has entered into a Forbearance Agreement (as
defined below) with its senior lender, the Company's subordinated lenders are
currently prohibited from taking action to collect the subordinated debt without
the consent of the Company's senior lender, and the Company is working with the
FDA to favorably resolve such compliance matters, there is substantial doubt
about the Company's ability to continue as a going concern. The Company's
ability to continue as a going concern is dependent upon its ability to (i)
continue to finance it current cash needs, (ii) continue to obtain extensions of
the Forbearance Agreement, (iii) successfully resolve the ongoing compliance
matters with the FDA and (iv) ultimately refinance its senior bank debt, resolve
the defaults under its subordinated debt and obtain new financing for future
operations and capital expenditures. If it is unable to do so, it may be
required to seek protection from its creditors under the federal bankruptcy
code.
While there can be no guarantee that the Company will be able to continue to
generate sufficient revenues and cash flow from operations to finance its
current cash needs, the Company generated positive cash flow from operations in
2002 and for the first six months of 2003. As of June 30, 2003, the Company a
cash deficit of $14,000 and approximately $1.3 million of undrawn availability
under the second line of credit described below. As a result of its cash
position and its negative accounts receivable balance at the end of the second
quarter, the Company obtained an additional $1,000,000 of availability under its
second line of credit in July, 2003. There can be no assurance that the
increased line of credit, together with cash generated from operations, will be
sufficient to meet the cash requirements for operating the Company's business.
There also can be no guarantee that the Company will successfully resolve
the ongoing compliance matters with the FDA. However, the Company has submitted
to the FDA and begun to implement a plan for comprehensive corrective actions at
its Decatur, Illinois facility.
Moreover, there can be no guarantee that the Company will be successful in
obtaining further extensions of the Forbearance Agreement or in refinancing the
senior debt, resolving the defaults under its subordinated debt and obtaining
new financing for future operations. However, the Company is current on its
interest payment obligations to its senior lender, and, as required, the Company
has retained a consulting firm, submitted a restructuring plan and engaged an
investment banker to assist in raising additional financing and explore other
strategic alternatives for repaying the senior bank debt and resolving the
defaults under its subordinated debt. The Company has also added key management
personnel, including the appointment of a new chief executive officer, vice
president of operations and vice president of quality assurance, quality control
and regulatory affairs, and additional personnel in critical areas, such as
quality assurance. Management has reduced the Company's cost structure, improved
the Company's processes and systems and implemented strict controls over capital
spending. Management believes these activities have improved the Company's
results of operations, cash flow from operations and the prospects for
refinancing its senior debt, resolving the defaults under its subordinated debt
and obtaining additional financing for future operations.
As a result of all of the factors cited in the preceding three paragraphs,
management believes that the Company should be able to sustain its operations
and continue as a going concern. However, the ultimate outcome of this
uncertainty cannot be presently determined and, accordingly, there remains
substantial doubt as to whether the Company will be able to continue as a going
concern. Further, even if the Company's efforts to raise additional financing
and explore other strategic alternatives result in a transaction that repays the
senior bank debt and resolves the defaults under its subordinated debt, there
can be no assurance that the current common stock will have any value following
such a transaction. In particular, if any new financing is obtained, it likely
will require the granting of rights, preferences or privileges senior to those
of the common stock and result in substantial dilution of the existing ownership
interests of the common stockholders.
28
Credit Agreement
As discussed in Note H - "Financing Arrangements" - to the Condensed
Consolidated Financial Statements, the Company has significant borrowings which
require, among other things, compliance with various covenants. The borrowings
consist primarily of an Amended and Restated Revolving Credit Agreement (the
"Credit Agreement").
On September 16, 2002, the Company was notified by its senior lender that it
was in default due to failure to pay the principal and interest owed as of
August 31, 2002 under the then most recent extension of the Credit Agreement.
The senior lender also notified the Company that they would forbear from
exercising its remedies under the Credit Agreement until January 3, 2003 (as
indicated below, subsequently extended to August 22, 2003) if a forbearance
agreement could be reached. On September 20, 2002, the Company and its senior
lender entered into an agreement under which the senior lender would agree to
forbear from exercising its remedies (the "Forbearance Agreement") and the
Company acknowledged its then-current default. The Forbearance Agreement
provides a second line of credit that currently allows the Company to borrow the
lesser of (i) the difference between the Company's outstanding indebtedness to
the senior lender and $39,200,000, (ii) $2,750,000, 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 lender. In the event that
the Company is not in compliance with the continuing covenants under the Credit
Agreement and does not negotiate amended covenants or obtain a waiver thereof,
then the senior lender, at its option, may demand immediate payment of all
outstanding amounts due and exercise any and all available remedies, including,
but not limited to, foreclosure on the Company's assets. This could result in
the Company seeking protection from its creditors and a reorganization under the
federal bankruptcy code.
As required by the Forbearance Agreement, a restructuring plan was developed
by the Company and the Consultant and presented to the Company's senior lender
in December 2002. The restructuring plan requested that the senior lender
convert the Company's senior debt to a term note that would mature no earlier
than February 2004 and increase the current line of credit from $1.75 million to
$3 million to fund operations and capital expenditures. In light of the FDA's
re-inspection of the Decatur facility in early December 2002, the Company and
the senior lender agreed to defer further discussions of that request until
completion of the re-inspection and the Company's response thereto. As a result,
the senior lender agreed to successive short-term extensions of the Forbearance
Agreement until the completion of the re-inspection. Following completion of the
FDA re-inspection of the Decatur facility on February 6, 2003 and issuance of
the FDA findings (see Note M - "Legal Proceedings"), the senior lender indicated
that it was not willing to convert the senior debt to a term loan, but it did
agree to further extensions of the Forbearance Agreement. As required by one of
these extensions, on May 9, 2003, the Company engaged Leerink Swann, an
investment banking firm, to assist in raising additional financing and explore
other strategic alternatives for repaying the senior bank debt. That process is
continuing.
On July 3, 2003 the senior lender extended the expiration date of the
Forbearance Agreement from June 30, 2003 until July 31, 2003 and agreed to make
up to an additional $1,000,000 available to the Company under its current line
of credit increasing the maximum amount available under the line of credit from
$1,750,000 to $2,750,000. On August 8, 2003, the senior lenders extended the
expiration date of the Forbearance Agreement until August 22, 2003.
The Forbearance Agreement, as amended and extended, provides that the senior
lender will forbear from exercising its remedies as a result of specified
existing defaults by Akorn until the earlier of the expiration date and the
occurrence of any additional defaults by Akorn under the Credit Agreement.
Subject to the absence of any additional defaults and subject to the senior
lender's satisfaction with the Company's progress in resolving the matters
raised by the FDA and in obtaining additional financing and exploring other
strategic alternatives, the Company expects to continue obtaining short-term
extensions of the Forbearance Agreement. However, there can be no assurance that
the Company will be successful in obtaining further extensions of the
Forbearance Agreement beyond August 22, 2003.
FDA Compliance Matters
As described in more detail in Part II - Item 1 - "Legal Proceedings", the
Company is subject to ongoing FDA compliance matters. While the Company is
cooperating with the FDA and seeking to resolve the pending matters, an
unfavorable outcome 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 under the Credit Agreement, any or all of which could have a
material adverse effect on the Company's liquidity.
29
Facility Expansion
The Company is in the process of completing an expansion of its Decatur,
Illinois facility to add capacity to provide Lyophilization manufacturing
services, which manufacturing capability the Company currently does not have.
Subject to the Company's ability to refinance its senior debt, resolve the
defaults under its current subordinated debt and obtain new financing for future
operations and capital expenditures, the Company anticipates the completion of
the Lyophilization expansion in the second half of 2004. As of June 30, 2003,
the Company had spent approximately $17.2 million on the expansion and
anticipates the need to spend approximately $1.0 million of additional funds
(excluding capitalized interest) to complete the expansion. The majority of the
additional spending will be focused on validation testing of the Lyophilization
facility as the major capital equipment items are currently in place. Once the
Lyophilization facility is validated, the Company will proceed to produce
stability batches to provide the data necessary to allow the Lyophilization
facility to be inspected and approved by the FDA.
Subordinated Debt
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 "Kapoor Trust"), the
sole trustee and sole beneficiary of which is Dr. John N. Kapoor, the Company's
Chairman of the Board of Directors. The transaction is evidenced by a
Convertible Bridge Loan and Warrant Agreement (the "Trust Agreement") in which
the Kapoor 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 Kapoor Trust for the subordinated debt, the
Company issued the Kapoor Trust two warrants which allow the Kapoor 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 Kapoor Trust's commitment to provide the subordinated debt.
All unexpired warrants will expire on December 20, 2006.
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 Kapoor Trust until the repayment of the senior
debt pursuant to the terms of a subordination agreement, which was entered into
between the Kapoor Trust and the Company's senior lender. 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.
In December 2001, the Company entered into a $3,250,000 five-year loan with
NeoPharm, Inc. ("NeoPharm") to fund the Company's efforts to complete its
lyophilization facility located in Decatur, Illinois. Under the terms of the
Promissory Note, dated December 20, 2001 (the "NeoPharm Promissory Note"),
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 the Company will use the proceeds of the loan solely to
validate and complete the lyophilization facility located in Decatur, Illinois.
The NeoPharm Promissory Note is subordinated to the Company's senior debt but is
senior to the Company's subordinated debt owed to the Kapoor Trust. The note was
executed in conjunction with a Processing Agreement that provides NeoPharm with
the option of securing at least 15% of the capacity of the Company's
lyophilization facility each year. The Company is currently in default under the
NeoPharm Promissory Note as a result of its failure to remove all FDA warning
letter sanctions related to the Company's Decatur, Illinois facility by June 30,
2003. As a result, amounts owed under the NeoPharm Promissory Note now bear
interest at a default rate, which is 3% per annum over the rate that would
otherwise be in effect.. However, the subordination provisions applicable to the
NeoPharm Promissory Note prohibit NeoPharm from taking any action to enforce or
collect the NeoPharm Promissory Note without the consent of the Company's senior
lender. Dr. John N. Kapoor, the Company's chairman, 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 Kapoor
Trust, which amended the Trust Agreement. The amendment extended the maturity of
the Trust Agreement from July 12, 2004 to terminate concurrently with the
Promissory Note on December 20, 2006. The amendment also made it possible for
the Kapoor Trust to convert the interest accrued on the $3,000,000 tranche, as
well as interest on the $2,000,000 tranche after the original maturity of the
Tranche B note, into common stock of the Company. Previously, the Kapoor Trust
could only convert the interest accrued on the $2,000,000 tranche through the
original maturity of the Tranche B note. The Company is currently in default
under the Trust Agreement as a result of a cross-default to the NeoPharm
Promissory Note. However, the Kapoor Trust is prohibited from taking any action
to enforce or collect amounts owed to it without the prior written consent of
the Company's senior lender and NeoPharm.
30
Other Indebtedness
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
$1,773,000 and $1,917,000 at June 30, 2003 and December 31, 2002, 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.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company is subject to market risk associated with changes in interest
rates. The Company's interest rate exposure involves three debt instruments. The
Credit Agreement and the subordinated convertible debentures issued to the John
N. Kapoor Trust bear the same interest rate, which fluctuates at Prime plus 300
basis points (3%). The NeoPharm Promissory Note bears interest at an 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 plus, as long as such note is in default, 300 basis points.
All of the Company's remaining long-term debt is at fixed interest rates.
Management estimates that a change of 100 basis points in its variable rate debt
from the interest rates in effect at June 30, 2003 would result in a $466,000
change in annual interest expense.
The Company's financial instruments consist mainly of cash, accounts
receivable, accounts payable and debt. The carrying amounts of these
instruments, except debt, approximate fair value due to their short-term nature.
The carrying amounts of the Company's bank borrowings under its credit facility
approximate fair value because the interest rates are reset periodically to
reflect current market rates.
The fair value of the debt obligations approximated the recorded value as of
June 30, 2003. 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 lender. Accordingly, the computed fair value of the debt, which the
Company estimates to be approximately $2,649,000, would be lower than the
current carrying value of $3,250,000.
ITEM 4. CONTROLS AND PROCEDURES
The Company maintains disclosure controls and procedures that are designed
to ensure that information required to be disclosed in the Company's Exchange
Act reports is recorded, processed, summarized and reported within the periods
specified in the SEC's rules and forms and that such information is accumulated
and communicated to the Company's management including its Chief Executive
Officer and Chief Financial Officer, as appropriate, to allow timely decisions
regarding required disclosure.
Based on their evaluation of the Company's disclosure controls and
procedures, as required by Rule 13a-15(b) under the Securities Exchange Act of
1934, the Chief Executive Officer and Chief Financial Officer concluded that the
Company's disclosure controls and procedures are effective in timely
communicating to them the material information relating to the Company required
to be included in the Company's periodic SEC filings.
As discussed in greater detail in the Company's Report on Form 8-K dated May
1, 2003, Deloitte & Touche LLP ("Deloitte") informed the Company that, in
connection with its audit of the Company's consolidated financial statements for
the year ended December 31, 2002, it noted certain matters involving the
Company's internal controls that Deloitte considered to be material weaknesses.
Although the Company does not necessarily agree with Deloitte's judgment that
there existed material weaknesses in the Company's internal controls, the
Company is in the process of implementing procedures designed to address all
relevant internal control issues. In the second quarter of 2003, the Company
updated its internal control policies and procedures, expanded its interim
evaluation of accounts receivable for purposes of determining the allowance for
doubtful accounts and reassigned certain personnel to strengthen the accounting
for fixed assets. The Company also is in the process of taking a detailed
inventory of its fixed assets. There were no other changes in the Company's
internal control over financial reporting that have materially affected, or are
reasonably likely to materially affect, the Company's internal control over
financial reporting.
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PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
On March 27, 2002, the Company received a letter informing it that the staff
of the SEC's regional office in Denver, Colorado, would recommend to the
Commission that it bring an enforcement action against the Company and seek an
order requiring the Company to be enjoined from engaging in certain conduct. The
staff alleged that the Company misstated its income for fiscal years 2000 and
2001 by allegedly failing to reserve for doubtful accounts receivable and
overstating its accounts receivable balance as of December 31, 2000. The staff
alleged that internal control and books and records deficiencies prevented the
Company from accurately recording, reconciling and aging its accounts
receivable. The Company also learned that certain of its former officers, as
well as a then current employee had received similar notifications. Subsequent
to the issuance of the Company's consolidated financial statements for the year
ended December 31, 2001, management of the Company determined it needed to
restate the Company's financial statements for 2000 and 2001 to record a $7.5
million increase to the allowance for doubtful accounts as of December 31, 2000,
which it had originally recorded as of March 31, 2001.
On July 11, 2003, the Company reached a revised agreement in principle with
the staff of the SEC's regional office in Denver, Colorado, that would resolve
the issues arising from the staff's investigation and proposed enforcement
action as discussed above. The Company has offered to consent to the entry of an
administrative cease and desist order as proposed by the staff, without
admitting or denying the findings set forth therein. The proposed consent order
finds that the Company failed to promptly and completely record and reconcile
cash and credit remittances, including from its top five customers, to invoices
posted in its accounts receivable sub-ledger. According to the findings in the
proposed consent order, the Company's problems resulted from, among other
things, internal control and books and records deficiencies that prevented the
Company from accurately recording, reconciling and aging its receivables. The
proposed consent order finds that the Company's 2000 Form 10-K and first quarter
2001 Form 10-Q misstated its account receivable balance or, alternatively,
failed to disclose the impairment of its accounts receivable and that its first
quarter 2001 Form 10-Q inaccurately attributed the increased accounts receivable
reserve to a change in estimate based on recent collection efforts, in violation
of Section 13(a) of the Exchange Act and rules 12b-20, 13a-1 and 13a-13
thereunder. The proposed consent order also finds that the Company failed to
keep accurate books and records and failed to devise and maintain a system of
adequate internal accounting controls with respect to its accounts receivable in
violation of Sections 13(b)(2)(A) and 13(b)(2)(B) of the Exchange Act. The
proposed consent order does not impose a monetary penalty against the Company or
require any additional restatement of the Company's financial statements. The
proposed consent order, as revised, contains an additional commitment by the
Company to do the following: (A) appoint a special committee comprised entirely
of outside directors, (B) within 30 days after entry of the order, have the
special committee retain a qualified independent consultant ("consultant")
acceptable to the staff to perform a test of the Company's material internal
controls, practices, and policies related to accounts receivable, and (C) within
180 days, have the consultant present his or her findings to the commission for
review to provide assurance that the Company is keeping accurate books and
records and has devised and maintained a system of adequate internal accounting
controls with respect to the Company's accounts receivables. The proposed
consent order does not become final until it is approved by the SEC.
Accordingly, the Company may incur additional costs and expenses in connection
with this proceeding.
In October 2000, the FDA issued a warning letter to the Company following
the FDA's routine cGMP inspection of the Company's Decatur manufacturing
facilities. An FDA warning letter is intended to provide notice to a company of
violations of the laws administered by the FDA. Its primary purpose is to elicit
voluntary corrective action. The letter warns that if voluntary action is not
forthcoming, the FDA may use other legal means to compel compliance. These
include seizure of products and/or injunction of the company and responsible
individuals. This letter addressed several deviations from regulatory
requirements including cleaning validations and general documentation issues and
requested corrective actions be undertaken by the Company. The Company initiated
corrective actions and responded to the warning letter. Subsequently, the FDA
conducted another inspection in late 2001 and identified additional deviations
from regulatory requirements including cleaning validations and process
controls. This led to the FDA leaving the warning letter in place and issuing a
Form 483 to document its findings. While no further correspondence was received
from the FDA, the Company responded to the inspection findings. This response
described the Company's plan for addressing the issues raised by the FDA and
included improved cleaning validation, enhanced process controls and
approximately $2.0 million of capital improvements. In August, 2002 the FDA
conducted another inspection of the Decatur facility, which also identified
deviations from cGMPs. The Company responded to these observations in September,
2002. In response to the Company's actions, the FDA conducted another inspection
of the Decatur facility during the period December 10, 2002 to February 6, 2003.
This inspection also identified deviations from regulatory requirements
including the manner in which the Company processes and investigates
manufacturing discrepancies and failures, customer complaints and the
thoroughness of equipment cleaning validations. Deviations identified during
this inspection had been raised in previous FDA inspections. The Company has
responded to these latest findings in
32
writing and in a meeting with the FDA in March 2003. The Company set forth its
plan for implementing comprehensive corrective actions and has provided progress
reports to the FDA on April 15, May 15, 2003 and June 15, 2003.
As a result of the latest inspection and the Company's response, the FDA may
take any of the following actions: (i) permit the Company to continue its
corrective actions and conduct another inspection (which likely would not occur
before the fourth quarter of 2003) to assess the success of these efforts; (ii)
seek to enjoin the Company from further violations, which may include temporary
suspension of some or all operations and potential monetary penalties; or (iii)
take other enforcement action which may include seizure of Company products. At
this time, it is not possible to predict the FDA's course of action.
FDA approval is required before any drug can be manufactured and marketed.
New drugs require the filing of a New Drug Application ("NDA"), including
clinical studies demonstrating the safety and efficacy of the drug. Generic
drugs, which are equivalents of existing, off-patent brand name drugs, require
the filing of an Abbreviated New Drug Application ("ANDA"). The Company believes
that unless and until the issues identified by the FDA have been successfully
corrected and the corrections have been verified through reinspection, it is
doubtful that the FDA will approve any NDAs or ANDAs that may be submitted by
the Company. This has adversely impacted, and is likely to continue to adversely
impact the Company's ability to grow sales. However, the Company believes that
unless and until the FDA chooses option (ii) or (iii), the Company will be able
to continue manufacturing and distributing its current product lines.
If the FDA chooses option (ii) or (iii), such action could significantly
impair the Company's ability to continue to manufacture and distribute its
current product line and generate cash from its operations, could result in a
covenant violation under the Company's senior debt or could cause the Company's
senior lender to refuse further extensions of the Company's senior debt, any or
all of which would have a material adverse effect on the Company's liquidity.
Any monetary penalty assessed by the FDA also could have a material adverse
effect on the Company's liquidity.
On December 19, 2002 and January 22, 2003, the Company received demand
letters regarding claimed wrongful deaths allegedly associated with the use of
the drug Inapsine, which the Company produced. The total amount claimed was $3.8
million. In July 2003, the Company agreed to a settlement with respect to one of
the claims alleged by these demand letters. The Company does not believe that
this settlement or the outcome of the second alleged claim will have a material
impact on the Company's financial position.
The Company is a party to legal proceedings and potential claims arising in
the ordinary course of its business. The amount, if any, of ultimate liability
with respect to such matters cannot be determined. Despite the inherent
uncertainties of litigation, management of the Company at this time does not
believe that such proceedings will have a material adverse impact on the
financial condition, results of operations, or cash flows of the Company.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
None
ITEM 3. DEFAULT UPON SENIOR SECURITIES
The Company is currently in default under certain covenants in its senior
credit facility, including the failure to make a $39,200,000 principal payment
that was due on August 31, 2002, as well as under a cross-default to other
indebtedness of the Company. The Company is current on its interest payment
obligations to its senior lender. As long as the Company is in compliance with
the terms of the Forbearance Agreement entered into with the senior lender on
September 20, 2002, as amended, the senior lender has agreed to forbear from
exercising its remedies with respect to specified existing defaults under the
credit facility until August 22, 2003. The total amount owed under the senior
credit facility as of August 13, 2003 was $37,300,000.
The Company also is in default under a Promissory Note to NeoPharm, Inc. in
the principal amount of $3,250,000 as a result of the Company's failure to
remove all FDA warning letter sanctions related to the Company's Decatur,
Illinois facility by June 30, 2003. However, NeoPharm is prohibited from taking
any action to enforce or collect the NeoPharm Promissory Note without the prior
written consent of Company's senior lender.
The Company also is in default under the Convertible Bridge Loan and Warrant
Agreement relating to the $5,000,000 subordinated loan made to the Company by
The John N. Kapoor Trust dtd. 9/20/89 as a result of a cross-default to the
NeoPharm
33
Promissory Note. However, the Kapoor Trust is prohibited from taking any action
to enforce or collect amounts owed to it without the prior written consent of
the Company's senior lender and NeoPharm.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of security holders during the quarter
ended June 30, 2003.
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
(10.1) Amendment #1 to the Pre-Negotiation Agreement by and among the
Company, Akorn (NJ) Inc. and The Northern Trust Company dated as of October
18, 2002
(10.2) Amendment #12 to the Pre-Negotiation Agreement by and among the
Company, Akorn (NJ) Inc. and The Northern Trust Company dated as of June
30, 2003
(10.3) Amendment #13 to the Pre-Negotiation Agreement by and among the
Company, Akorn (NJ) Inc. and The Northern Trust Company dated as of July
31, 2003.
(10.4) Subordination and Standby Agreement executed by The John N. Kapoor
Trust dtd. September 20, 1989 in favor of The Northern Trust Company dated
as of July 12, 2001.
(31.1) Certification of Chief Executive Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934
(31.2) Certification of Chief Financial Officer pursuant to Rule 13a-14(a)
under the Securities Exchange Act of 1934
(32.1) Certification of Chief Executive Officer and Chief Financial Officer
pursuant to 18 U.S.C. ss.1350, as adopted pursuant to ss.906 of the
Sarbanes-Oxley Act of 2002
(b) Reports on Form 8-K
During the quarterly period ended June 30, 2003, the Company filed a report
on Form 8-K dated May 1, 2003 and an amendment to that report on Form 8-K/A
dated May 21, 2003 relating to changes in the Company's certifying
accountant.
34
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
AKORN, INC.
/s/ BERNARD J. POTHAST
-----------------------------------
Bernard J. Pothast
Vice President, Chief Financial
Officer and Secretary
(Duly Authorized and Principal
Financial Officer)
Date: August 14, 2003
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