UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2018

OR

Commission file number:  01-37691

ARALEZ PHARMACEUTICALS INC.

(Exact Name of Registrant as Specified in its Charter)

7100 West Credit Avenue, Suite 101, Mississauga, Ontario, Canada L5N 0E4

(Address of registrant’s principal executive offices)

(905) 876-1118

(Registrant’s telephone number, including area code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes ☒  No ☐

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, a smaller reporting company, or an emerging growth company. See the definitions of “large accelerated filer,” “accelerated filer,” “smaller reporting company,” and “emerging growth company” in Rule 12b-2 of the Exchange Act.

Large accelerated filer ◻                  Accelerated filer ☒ Non-accelerated filer   ◻

Smaller reporting company ◻ Emerging growth company ◻

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes ☐  No ☒

As of the close of business on May 4, 2018, 67,194,277 common shares (no par value per share) of the registrant were issued and outstanding.

Aralez Pharmaceuticals Inc.

Form 10-Q

For the Quarter Ended March 31, 2018

Table of Contents

PART I. FINANCIAL INFORMATION

ITEM 1.CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

ARALEZ PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED BALANCE SHEETS (unaudited)

(in thousands, except share and per share data)

The accompanying unaudited notes are an integral part of the condensed consolidated financial statements.

ARALEZ PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (unaudited)

(in thousands, except per share data)

The accompanying unaudited notes are an integral part of the condensed consolidated financial statements.

ARALEZ PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS (unaudited)

(in thousands)

The accompanying unaudited notes are an integral part of the condensed consolidated financial statements.

ARALEZ PHARMACEUTICALS INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (unaudited)

(in thousands)

The accompanying unaudited notes are an integral part of the condensed consolidated financial statements.

ARALEZ PHARMACEUTICALS INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)

(tabular dollars and shares in thousands, except per share data)

1.ORGANIZATION, BASIS OF PRESENTATION AND ACCOUNTING POLICIES

Organization

Aralez Pharmaceuticals Inc., together with its wholly-owned subsidiaries (“Aralez” or the “Company”), is a specialty pharmaceutical company focused on delivering meaningful products to improve patients’ lives while creating shareholder value by acquiring, developing and commercializing products in various specialty areas. The Company’s parent corporation, Aralez Pharmaceuticals Inc., was incorporated under the British Columbia Business Corporations Act (“BCBCA”) on December 2, 2015.  Aralez’s global headquarters is located in Mississauga, Ontario, Canada, and its Irish headquarters is located in Dublin, Ireland. The Company’s common shares are listed on the NASDAQ Global Market under the trading symbol “ARLZ” and on the Toronto Stock Exchange under the trading symbol “ARZ.” Aralez was formed for the purpose of facilitating the business combination of POZEN Inc., a Delaware corporation (“Pozen”), and Aralez Pharmaceuticals Canada Inc. (formerly known as Tribute Pharmaceuticals Canada Inc.), a corporation incorporated under the laws of the Province of Ontario, Canada (“Aralez Canada”), which closed on February 5, 2016. 

On February 5, 2016, pursuant to an Agreement and Plan of Merger and Arrangement between Aralez Pharmaceuticals Inc., Pozen, Aralez Canada and other related parties (as amended, the “Merger Agreement”), Aralez completed the acquisition of Aralez Canada by way of a court approved plan of arrangement in a stock transaction with a purchase price of $137.6 million made up of (i) $115.1 million related to Aralez Canada shares, equity awards and certain warrants outstanding and (ii) $22.5 million in repayments of Aralez Canada indebtedness. In connection with this transaction, Pozen and Aralez Canada were combined under and became wholly-owned subsidiaries of Aralez (the “Merger”). Pursuant to Rule 12g-3(a) under the Securities Exchange Act of 1934, as amended, Aralez Pharmaceuticals Inc. is the successor issuer to Pozen.

On September 6, 2016, Aralez Pharmaceuticals Trading DAC, a wholly-owned subsidiary of Aralez (“Aralez Ireland”), acquired the U.S. and Canadian rights to Zontivity® (vorapaxar), pursuant to an asset purchase agreement (the “Zontivity Asset Purchase Agreement”) with MSD International GmbH (as successor to Schering-Plough (Ireland) Company), an affiliate of Merck & Co., Inc. (“Merck”).

On October 31, 2016, Aralez Ireland acquired the U.S. rights to Toprol-XL® (metoprolol succinate) and its authorized generic (the “AG”, and collectively, the “Toprol-XL Franchise”) pursuant to an asset purchase agreement (the “Toprol-XL Asset Purchase Agreement”) entered into between AstraZeneca AB (“AstraZeneca”), Aralez Ireland and Aralez Pharmaceuticals Inc.

Since the Merger in February 2016, the Company has incurred significant net losses. The Company incurred a net loss of $19.7 million for the three months ended March 31, 2018 and $125.2 million for the year ended December 31, 2017.  Although the Company generated cash from operations for the quarter ended March 31, 2018 of $18.6 million, this relates to a temporary improvement in our working capital. The Company has a history of negative cash flows from operations, including net cash used in operating activities of $28.8 million during the year ended December 31, 2017. The Company’s ability to become profitable and/or to generate positive cash from operations depends upon, among other things, its ability to generate revenues from sales of its products and prudently manage its expenses.  If the Company does not generate sufficient product revenues, or prudently manage its expenses, its business, financial condition, cash flows, results of operations and ability to continue as a going concern could be materially and adversely affected.

The Company’s principal sources of liquidity are the operating income of Aralez Canada; sales from the Toprol-XL Franchise; cash generated from the royalty payments received from our commercialization partners for net sales of Vimovo®; and the financings completed on February 5, 2016 and October 31, 2016. The Company’s principal liquidity requirements are for working capital; our debt service requirements; operational expenses; commercialization

activities for products, including the Company’s Canadian product portfolio, the Toprol-XL Franchise, and product candidates; contractual obligations, including any royalty and milestone payments that will or may become due; and capital expenditures.

During 2017 and early 2018, we implemented a number of cost savings initiatives designed to streamline our business, deliver profitability and support growth, as well as extend our cash runway. The cost-savings initiatives are expected to result in a leaner and more effective performance-oriented operating model.  These cost savings initiatives included a 32% reduction in its U.S. sales force and realignment of certain financial resources to support the launch of Zontivity, together with a significant decrease in marketing spend on Yosprala and other cost reductions across the business designed to attain profitability and enhance the Company’s liquidity position. Further, in March 2018, the Company announced its intention to discontinue Yosprala.

On May 8, 2018, the Company announced that it has determined that a new strategic direction is in the best interests of the Company and its stakeholders. This strategic direction will involve (i) a focus on the Company’s strong Canadian business, supported by the Toprol-XL Franchise as well as Vimovo royalties, and (ii) the discontinuation of the remaining U.S. commercial business. Decisive actions are being taken to wind down our U.S. commercial business immediately and ultimately close the U.S. operations. In addition, the Company continues to explore and evaluate a range of strategic business opportunities, including (i) active discussions for the continued commercialization of Zontivity with a focus on divesting or out-licensing the U.S. rights, (ii) active discussions to divest the U.S. rights to Yosprala, Fibricor® and Bezalip® SR, and (iii) broader strategic and refinancing alternatives for its business. This new strategic direction is expected to significantly reduce the Company’s cost structure. See Note 13, “Subsequent Events” for further discussion.

In addition, the Company has very recently experienced increased generic competition with respect to the Toprol-XL Franchise with a new generic entrant to the market, which may cause a negative impact on future business.

Based on recent events described above, and despite the cost savings initiatives also described above, the Company has determined that there is a reasonable possibility that the Company will not have sufficient liquidity to fund its current and planned operations through the next 12 months, which raises substantial doubt about the Company’s ability to continue as a going concern.  The Company has based this belief on assumptions and estimates that may prove to be wrong, and the Company could generate more or less revenues than expected or spend its available cash and cash equivalents less or more rapidly than expected.    

The Company is continuing to explore and evaluate strategic business opportunities to enhance liquidity, including by any combination of debt refinancing, additional cost savings initiatives, proceeds-generating transactions, such as the divestiture or out-license of certain assets, M&A activities and/or other strategic opportunities. There can be no assurances that these other initiatives will be available on reasonable terms, or at all. If the Company is not successful with respect to the initiatives described above, or if the Company’s future operations fail to meet its current expectations (including as a result of increased generic competition with respect to the Toprol-XL Franchise), the Company’s projected future liquidity may be negatively impacted, which could continue to negatively impact its assessment under this accounting standard in the future and could materially and adversely affect its business, financial condition, cash flows and results of operations.

The unaudited condensed financial statements as of March 31, 2018 have been prepared under the assumption that the Company will continue as a going concern for the next 12 months.  The Company’s ability to continue as a going concern is dependent upon its uncertain ability to obtain additional capital, generate sufficient revenues and reduce expenditures.  The unaudited condensed financial statements as of March 31, 2018 do not include any adjustments that might result from the outcome of this uncertainty.

Basis of Presentation and Consolidation

The accompanying condensed consolidated financial statements are unaudited and have been prepared by Aralez in accordance with accounting principles generally accepted in the United States of America (“GAAP”), and pursuant to, and in accordance with, the instructions to Form 10-Q and Article 10 of Regulation S-X. The condensed

consolidated balance sheet at December 31, 2017 was derived from audited financial statements, but certain information and footnote disclosures normally included in the Company’s annual financial statements have been condensed or omitted. These condensed consolidated financial statements should be read in conjunction with the audited financial statements contained in the Company’s Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”) and with applicable Canadian securities regulators on SEDAR on March 14, 2018 (the “2017 Form 10‑K”).

The condensed consolidated financial statements, in the opinion of management, reflect all normal and recurring adjustments necessary for a fair statement of the Company’s financial position and results of operations. Certain reclassifications with respect to the presentation of accrued expenses were made to prior year figures to conform with current year presentation.

The accompanying condensed consolidated financial statements include the accounts of Aralez Pharmaceuticals Inc. and its wholly-owned subsidiaries. All intercompany balances and transactions have been eliminated in consolidation. The results of operations for the interim periods are not necessarily indicative of the results of operations to be expected for any future period or the entire fiscal year.

Use of Estimates

The preparation of financial statements in conformity with GAAP requires the extensive use of estimates and assumptions that affect the reported amounts of assets, liabilities, revenues, expenses and related disclosures. The most significant assumptions are employed in estimates used in determining values of: inventories; long-lived assets, including goodwill, other intangible assets; accrued expenses; contingent consideration; income taxes; share-based compensation expense; as well as estimates used in accounting for contingencies and revenue recognition. Actual results could differ from these estimates.

Concentration of Risk

Financial instruments, which potentially subject the Company to concentrations of credit risk, consist principally of cash and cash equivalents, including money market funds. The Company’s investment policy places restrictions on credit ratings, maturities, and concentration by type and issuer. The Company is exposed to credit risk in the event of a default by the financial institutions holding our cash and cash equivalents to the extent recorded on the balance sheet.

The Company is also subject to credit risk from accounts receivable related to product sales and monitors its exposure within accounts receivable and records a reserve against uncollectible accounts receivable as necessary. The Company extends credit to pharmaceutical wholesale distributors and specialty pharmaceutical distribution companies, primarily in Canada and the United States, and to other international distributors. Customer creditworthiness is monitored and collateral is not required.

Cash and Cash Equivalents

Cash and cash equivalents consists of cash and short-term, interest-bearing instruments with original maturities of 90 days or less at the date of purchase.

Inventory

Inventories are stated at the lower of cost or net realizable value on a first-in, first-out basis. Cost is determined to be the purchase price for raw materials and the production cost, including materials, labor and indirect manufacturing costs, for work-in-process and finished goods. The Company analyzes its inventory levels quarterly and writes-down inventory that has become obsolete, inventory that has a cost basis in excess of its expected net realizable value, inventory in excess of expected sales requirements or inventory that fails to meet commercial sale specifications to cost of product revenues. Expired inventory is disposed of and the related costs are written off to cost of product revenues.

Property, Plant and Equipment

Fixed assets are stated at cost. Depreciation is provided using the straight-line method based on estimated useful lives or, in the case of leasehold improvements, over the lesser of the useful lives or the lease terms. Repairs and maintenance costs are expensed as incurred.

Intangible Assets

Goodwill

Goodwill relates to amounts that arose in connection with the acquisitions of Aralez Canada, Zontivity and the Toprol-XL Franchise. Goodwill represents the excess of the purchase price over the fair value of the net assets acquired when accounted for using the acquisition method of accounting for business combinations. Goodwill is not amortized but is evaluated for impairment on an annual basis, in the fourth quarter, or more frequently if an event occurs or circumstances change that would more-likely-than-not reduce the fair value of the Company's reporting unit below its carrying amount. See Note 13, “Subsequent Events,” for further discussion relating to the Company’s goodwill.

Other Intangible Assets, net

Other intangible assets consist of acquired technology rights. The Company amortizes its intangible assets using the straight-line method over their estimated economic lives. Costs to obtain, maintain and defend the Company's patents are expensed as incurred. The Company will evaluate the potential impairment of other intangible assets if events or changes in circumstances indicate that the carrying amount of the assets may not be fully recoverable or that the useful lives of these assets are no longer appropriate. Events giving rise to impairment are an inherent risk in the pharmaceutical industry and many factors cannot be predicted. Factors that are considered in deciding when to perform an impairment review include significant changes in forecasted projections for the asset or asset group for reasons including, but not limited to, significant under-performance of a product in relation to expectations, significant changes or planned changes in our use of the assets, significant negative industry or economic trends, and new or competing products that enter the marketplace. The impairment test is based on a comparison of the undiscounted cash flows expected to be generated from the use of the asset group and its eventual disposition to the carrying value of the asset group. If impairment is indicated, the asset is written down by the amount by which the carrying value of the asset exceeds the related fair value of the asset with the related impairment charge recognized within the statements of operations. Such impairment charges may be material to the Company’s results. The valuation techniques utilized in performing the initial valuation of other intangible assets or subsequent quantitative impairment tests incorporate significant assumptions and judgments to estimate the fair value. The use of different valuation techniques or assumptions could result in significantly different fair value estimates. There were no impairment charges during the three months ended March 31, 2018 and 2017, respectively.  See Note 13, “Subsequent Events,” for further discussion relating to the Company’s intangible assets.

Contingent Consideration

Certain of the Company’s business acquisitions involve the potential for future payment of consideration that is contingent upon the achievement of operational and commercial milestones and royalty payments on future product sales. The fair value of contingent consideration liabilities is determined at the acquisition date using unobservable inputs. These inputs include the estimated amount and timing of projected cash flows, the probability of success (achievement of the contingent event) and the risk-adjusted discount rate used to present value the probability-weighted cash flows. Subsequent to the acquisition date, at each reporting period, the contingent consideration liability is remeasured at current fair value with changes recorded in the consolidated statements of operations. Changes in any of the inputs may result in a significantly different fair value adjustment.  See Note 13, “Subsequent Events,” for further discussion relating to the Company’s contingent consideration.

Revenue Recognition

Principal sources of revenue are (i) product revenues from sales of the product portfolio acquired with the Company’s acquisition of Aralez Canada (ii) product revenues from sales of the Toprol-XL Franchise and Zontivity, and (iii) royalty revenues from sales of Vimovo® by the Company’s commercialization partners.

In January 2018, the Company adopted Financial Accounting Standards Board (“FASB”) Accounting Standards Codification (“ASC”) Topic 606, Revenue from Contracts with Customers, using the modified retrospective transition method. Under this method, the Company employed retrospective application with the cumulative effect of initially applying the guidance recognized at the date of initial application (January 1, 2018).  For a complete discussion of accounting for product revenues, net and other revenues, see Note 3, “Revenue Recognition.”

Income Taxes

The Company accounts for income taxes using the liability method in accordance with FASB ASC Topic 740, “Income Taxes” (“ASC 740”). Deferred tax assets and liabilities are determined based on temporary differences between financial reporting and tax basis assets and liabilities and are measured by applying enacted rates and laws to taxable years in which differences are expected to be recovered or settled. Further, the effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that the rate changes. A valuation allowance is required when it is “more-likely-than-not” that all or a portion of deferred tax assets will not be realized. Since the Company’s inception, substantial cumulative losses have been incurred and substantial and recurring losses may be incurred in future periods. The utilization of the loss carryforwards to reduce future income taxes will depend on the Company’s ability to generate sufficient taxable income prior to the expiration of the loss carryforwards. In addition, the maximum annual use of net operating loss and research credit carryforwards is limited in certain situations where changes occur in stock ownership.

Aralez files federal and state income tax returns, as applicable, with the tax authorities in various jurisdictions including Canada, Ireland and the United States. Pozen is no longer subject to U.S. federal or North Carolina state income tax examinations by tax authorities for years before 2014. Aralez Canada is no longer subject to Canadian income tax examinations by tax authorities for years before 2011. However, the loss and credit carryforwards generated by Pozen and Aralez Canada may still be subject to change to the extent these losses and credits are utilized in a year that is subject to examination by tax authorities.

On December 22, 2017, the U.S. government enacted comprehensive tax legislation, referred to as the Tax Cuts and Jobs Act (the “Tax Act”), which significantly revises U.S. tax law by, among other provisions, lowering the U.S. federal statutory corporate income tax rate from 35% to 21%, imposing a mandatory one-time transition tax on previously deferred foreign earnings, and eliminating or reducing certain income tax deductions.

ASC 740, Income Taxes requires the effects of changes in tax laws to be recognized in the period in which the legislation is enacted. However, due to the complexity and significance of the Tax Act’s provisions, the Securities and Exchange Commission (“SEC”) staff issued SAB 118, which allows companies to record the tax effects of the Tax Act on a provisional basis based on a reasonable estimate, and then, if necessary, subsequently adjust such amounts during a limited measurement period as more information becomes available. The measurement period ends when a company has obtained, prepared, and analyzed the information necessary to finalize its accounting, but cannot extend beyond one year from enactment.

The Tax Act did not have a material impact on the Company’s financial statements since the Company’s deferred temporary differences are fully offset by a valuation allowance and the Company does not have any significant off shore earnings from which to record the mandatory transition tax.   However, given the significant complexity of the Tax Act, anticipated guidance from the U.S. Treasury about implementing the Tax Act, and the potential for additional guidance from the SEC or the FASB related to the Tax Act, these estimates may be adjusted during the measurement period.  The provisional amounts disclosed in the Company’s footnotes were based on the its present interpretations of the Tax Act and current available information, including assumptions and expectations about future events, such as its projected financial performance, and are subject to further refinement as additional information becomes available and further analyses are

completed.  The Company continues to analyze the changes in certain income tax deductions, assess calculations of earnings and profits in certain foreign subsidiaries, including if those earnings are held in cash or other assets and gather additional data to compute the full impacts on the Company’s deferred and current tax assets and liabilities.

ASC 740 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return, including a decision whether to file or not file a return in a particular jurisdiction. The financial statements reflect expected future tax consequences of such positions presuming the taxing authorities’ full knowledge of the position and all relevant facts. The Company recognizes any interest and penalties accrued related to unrecognized tax benefits as income tax expense.

Share-Based Compensation

The Company expenses the fair value of employee share-based compensation over the employees' service periods, which are generally the vesting period of the equity award. For awards with performance conditions granted, the Company recognizes compensation cost over the expected period to achieve the performance conditions, provided achievement of the performance conditions are deemed probable. Awards with market-based conditions are expensed over the service period regardless of whether achievement of the market condition is deemed probable or is ultimately achieved. Compensation expense is measured using the fair value of the award at the grant date. The Company recognizes the impact of forfeitures of share-based awards when they occur, with no adjustment for estimated forfeitures.

In order to determine the fair value of option awards on the grant date, the Company uses the Black-Scholes option pricing model. Inherent in this model are assumptions related to expected share price volatility, estimated option life, risk-free interest rate and dividend yield. The expected share price volatility assumption is based on the historical volatility of the Company’s common shares, which is obtained from public data sources. The expected life represents the weighted average period of time that share-based awards are expected to be outstanding giving consideration to vesting schedules, historical exercise patterns and post-vesting cancellations for terminated employees that have been exhibited historically, adjusted for specific factors that may influence future exercise patterns. The risk-free interest rate is based on factual data derived from public sources. The Company uses a dividend yield of zero as it has no intention to pay cash dividends in the foreseeable future. For performance-based awards with market conditions, the Company uses a Monte Carlo simulation model to determine the fair value of awards on the date of grant.

Determining the appropriate amount to expense for awards with performance conditions based on the achievement of stated goals requires judgment, including forecasting future performance results. The estimate of expense is revised periodically based on the probability of achieving the required performance targets and adjustments are made as appropriate. The cumulative impact of any revisions is reflected in the period of change. If any applicable financial performance goals are not met, no compensation cost is recognized and any previously recognized compensation cost is reversed.

Fair Value Measurements

The accounting standard for fair value measurements defines fair value, establishes a framework for measuring fair value in accordance with GAAP, and requires detailed disclosures about fair value measurements. Under this standard, fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. The valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect certain market assumptions. This standard classifies these inputs into the following hierarchy:

The fair value hierarchy level is determined by asset class based on the lowest level of significant input. In periods of market inactivity, the observability of prices and inputs may be reduced for certain instruments. This condition could cause an instrument to be reclassified between levels.

The carrying amount of cash and cash equivalents approximates its fair value due to the short-term nature of these amounts. The contingent consideration liability is also carried at fair value, and is recorded as separate short and long-term balances on the consolidated balance sheet at March 31, 2018. The significant unobservable inputs used in the fair value measurement of the Company’s contingent consideration liability include the estimated amount and timing of projected cash flows, the probability of success (achievement of the contingent event) and the risk-adjusted discount rate used to present value the probability-weighted cash flows. The use of different inputs in the valuation of the contingent consideration liability could result in materially different fair value estimates.

Foreign Currency

The Company’s reporting currency is the U.S. dollar. The assets and liabilities of subsidiaries that have a functional currency other than the U.S. dollar, primarily the Canadian dollar, are translated into U.S. dollars at the exchange rates in effect at the balance sheet date with the results of operations of subsidiaries translated at average exchange rates for the period. The cumulative foreign currency translation adjustment is recorded as a component of accumulated other comprehensive income within shareholders’ equity.

Transactions in foreign currencies are remeasured into the functional currency of the relevant subsidiary at the exchange rate in effect at the date of the transaction. Any monetary assets and liabilities arising from these transactions are translated into the functional currency at exchange rates in effect at the balance sheet date or on settlement. Resulting gains and losses are recorded in other income (expense), net within the consolidated statements of operations.

Accumulated Other Comprehensive Income

A company is required to present, either on the face of the statement where net income (loss) is presented, in a separate statement of comprehensive income (loss) or in the notes, significant amounts reclassified out of accumulated other comprehensive income by the respective line items of net income (loss). There were no amounts reclassified out of accumulated other comprehensive income for the three months ended March 31, 2018 and 2017, respectively. Other comprehensive income for the three months ended March 31, 2018 and 2017 related to foreign currency translation adjustments.

Going Concern

FASB Accounting Standards Update No. 2014-15, Presentation of Financial Statements — Going Concern (Subtopic 205-40): Disclosure of Uncertainties about an Entity’s Ability to Continue as a Going Concern, defines management’s responsibility to assess an entity’s ability to continue as a going concern, and to provide related footnote disclosures if there is substantial doubt about its ability to continue as a going concern.  The Company performs quarterly evaluations to identify current conditions which may raise substantial doubt about the entity’s ability to continue as a going concern within one year after the date that the financial statements are issued. See Note 1 “Organization, Basis of Presentation and Accounting Policies” for additional information on our liquidity risks and management’s plans.

Recent Accounting Pronouncements

In May 2014, the FASB issued ASU 2014-09, Revenue from Contracts with Customers (“Topic 606”), which amends the guidance for accounting for revenue from contracts with customers and requires revenue recognition based on the transfer of promised goods or services to customers in an amount that reflects consideration Aralez expects to be entitled to in exchange for goods or services.  Topic 606 supersedes prior revenue recognition requirements in ASC Topic 605 and most industry-specific accounting guidance. In 2015 and 2016, the FASB issued additional updated guidance, which clarified certain aspects of the Topic 606 and the related implementation guidance issued by the FASB-IASB Joint Transition Resource Group for Revenue Recognition.

The Company adopted this Topic 606 effective January 1, 2018, using the modified retrospective transition method.  Under this method, the Company employed retrospective application with the cumulative effect of initially applying the guidance recognized at the date of initial application.

The Company analyzed the impacts of Topic 606 on its revenue streams, specifically focusing on (i) revenues from the sale of its products, and (ii) royalty revenues. The Company reviewed its accounting policies and practices to identify potential differences that would result from applying the guidance. The Company assessed its customer contracts throughout 2017 and any impact the standard would have on its processes, systems and controls. The Company’s assessment of the impacts of Topic 606 determined that the adoption of the guidance did not have a material impact on the timing or measurement of the Company’s revenue recognition. One of the most significant changes under the new guidance related to the recognition of variable consideration. The new guidance requires the Company to estimate variable consideration and include in revenue amounts for which is it probable that a significant revenue reversal will not occur. For the majority of the Company’s product revenues, the Company already accounted for these estimates using the expected value method in accordance with topic 605 and as such, the adoption of Topic 606 did not have a significant impact on the Company’s revenue recognition model.

In accordance with Topic 605, Revenue Recognition, revenue recognition is deferred until the transaction price is fixed or determinable. In 2017, the Company only had one product, Yosprala, where it lacked sufficient history to make reasonable and reliable estimates of the transaction price (returns, rebates, chargebacks, etc.) and, as such, the Company previously deferred revenues and costs of inventory for Yosprala shipped to wholesalers in the United States until the product was sold through to the end customer. Under Topic 606, the Company is required to estimate variable consideration when there is a “high degree of confidence” that a significant revenue reversal will not occur in a subsequent reporting period. However, if the possibility of significant revenue reversal in a subsequent reporting period exists, revenue deferral is appropriate until such time the uncertainty, or estimate constraint, associated with the variable consideration is subsequently resolved. In the case of Yosprala, this uncertainty still existed at December 31, 2017. As such, the Company applied a significant estimate constraint related to its variable consideration for this product until such time as this uncertainty is resolved. The adoption of Topic 606 did not have a significant impact on the related revenue recognition for this product since the revenue and cost of inventory amounts deferred as of December 31, 2017 were not significant.

Under Topic 606, the Company’s royalty revenue streams are to be recognized at the later of when (1) the sales occurs or (2) the performance obligation to which some or all of the sales-based royalty has been allocated is satisfied in whole or in part.  With regards to the Company’s royalty revenues, recognition occurs when the sales occur, which is consistent with Topic 605, and therefore the adoption of Topic 606 did not impact the Company’s royalty revenue streams.

Finally, Topic 606 requires more robust disclosures than required by previous guidance, including disclosures related to disaggregation of revenue into appropriate categories, performance obligations, the judgements made in revenue recognition determinations, adjustments to revenue which relate to activities from previous quarters or years, any significant reversals of revenue, and costs to obtain or fulfill contracts. See Note 3, “Revenue Recognition.”

The Company’s cumulative effect of adopting Topic 606 resulted in an immaterial adjustment to accumulated deficit during the three months ended March 31, 2018.

In January 2017, the FASB issued ASU 2017-04, Intangibles-Goodwill and Other (Topic 350): Simplifying the Test for Goodwill Impairment.  The amended guidance eliminates a step from the goodwill impairment test. Under the amended guidance, an entity should perform its annual or interim goodwill impairment test by comparing the fair value of a reporting unit with its carrying amount. An entity would recognize an impairment charge for the amount by which the carrying amount exceeds the reporting unit’s fair value; however, the loss recognized should not exceed the total amount of goodwill allocated to that reporting unit. The Company adopted this new guidance in the fourth quarter of 2017. The adoption of ASU 2017-04 did not have any impact on its consolidated financial statements upon adoption of this new guidance.

In August 2016, the FASB issued ASU 2016-15, Statement of Cash Flows (Topic 230): Classification of Certain Cash Receipts and Cash Payments, providing additional guidance on eight specific cash flow classification issues. The goal of the ASU is to reduce diversity in practice of classifying certain items. The amendments in the ASU are effective for Aralez in the first quarter of 2018 using a retrospective transition method, and early adoption is permitted. The Company’s adoption of ASU-2016-15 did not have a material impact on its consolidated financial statements.

In January 2017, the FASB issued ASU 2017-01, Business Combinations (Topic 805): Clarifying the Definition of a Business, in an effort to clarify the definition of a business with the objective of adding guidance to assist entities with evaluating whether transactions should be accounted for as acquisitions (or disposals) of assets or businesses. The amendments of this ASU are effective for Aralez in the first quarter of 2018 on a prospective basis and early adoption is permitted. The Company’s adoption of ASU-2017-01 did not have a material impact on its consolidated financial statements.

In January 2016, the FASB issued ASU 2016-01, Financial Instruments—Overall (Subtopic 825-10), which requires equity investments to be measured at fair value with changes in fair value recognized in net income. It allows an entity to choose to measure equity investments that do not have readily determinable fair values at cost minus impairment. It also simplifies the impairment assessment of equity investments without readily determinable fair values and eliminates the requirements to disclose the methods used to estimate fair value for instruments measured at amortized cost on the balance sheet. The amendments in the ASU are effective for Aralez in the first quarter of 2018. The Company’s adoption of ASU-2016-01 did not have a material impact on its consolidated financial statements.

In February 2016, the FASB issued ASU 2016-02, Leases (Topic 842), which supersedes current lease accounting guidance. The primary difference between current GAAP and the new standard is the recognition of lease assets and lease liabilities by lessees for those leases classified as operating leases under current GAAP. The standard requires a modified retrospective approach upon adoption, with practical expedients that may be available to elect. The standard is effective for Aralez in the first quarter of 2019 and early adoption is permitted. The Company is evaluating the impact of the ASU on its consolidated financial statements.

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2.BUSINESS AGREEMENTS

Agreements with AstraZeneca for Toprol-XL

On October 31, 2016, Aralez Ireland acquired the U.S. rights to the Toprol-XL Franchise pursuant to the Toprol-XL Asset Purchase Agreement. Toprol-XL is a cardioselective beta-blocker indicated for the treatment of hypertension, alone or in combination with other antihypertensives, the long term treatment of angina pectoris and treatment of stable, symptomatic (NYHA class II or III) heart failure of specific origins. In July 2017, AstraZeneca, Aralez Ireland and Aralez Pharmaceuticals Inc. entered into an amendment to the Toprol-XL Asset Purchase Agreement pursuant to which (1) the milestone payments payable under the Toprol-XL Asset Purchase Agreement were deferred and extended, and (2) the definition of net sales was amended. The purchase price under the Toprol-XL Asset Purchase Agreement, as amended, consists of (i) a payment of $175.0 million by Aralez Ireland to AstraZeneca, which was made on the closing date of the Toprol-XL acquisition; (ii) certain milestone payments payable by Aralez Ireland subsequent to the closing of the acquisition, which the Company is obligated to pay in quarterly installments of approximately $5.6 million for eight consecutive quarters beginning in the second quarter of 2019 due to the occurrence of certain milestone events based on the annual aggregate net sales of the Toprol-XL Franchise and other contingent events; (iii) certain other milestone payments of up to an additional $3.0 million in the event the net sales of the Toprol-XL Franchise exceed $125 million or $135 million in a year; (iv) royalty payments of (A) 15% of total quarterly net sales of branded Toprol-XL and any other authorized or owned generic version of Toprol-XL that is marketed, distributed or sold by Aralez, and (B) 15% of quarterly net sales of the current or any other third party authorized generic, but for purposes of royalty payments and clause (B) only, net sales do not include the supply price paid for the current or other third party authorized generic by Aralez Ireland to AstraZeneca under the supply agreement entered into between Aralez Ireland and AstraZeneca in respect of the applicable period and (v) a payment for the value of the finished inventory of the Toprol-XL Franchise at closing of the Toprol-XL acquisition, not to exceed a cap specified in the Toprol-XL Asset Purchase Agreement.

On October 31, 2016, in connection with the Toprol-XL acquisition, Aralez Ireland entered into a Supply Agreement (the “Toprol-XL Supply Agreement”) with AstraZeneca. Pursuant to the terms of the Toprol-XL Supply Agreement and except as otherwise expressly set forth therein, AstraZeneca will be the exclusive manufacturer and supplier to Aralez Ireland of the Toprol-XL Franchise, each in finished bottled form for exploitation and commercialization in the United States. The initial term of the Toprol-XL Supply Agreement is 10 years (the “Toprol-XL Supply Initial Term”). The Toprol-XL Supply Agreement will continue indefinitely following the expiration of the Toprol-XL Supply Initial Term unless terminated in accordance with its terms. Except in the case of certain uncured material breaches of the Toprol-XL Supply Agreement by Aralez Ireland or certain insolvency related events affecting Aralez Ireland, AstraZeneca may not terminate the Toprol-XL Supply Agreement unless it satisfies certain conditions related to, among other things, the transfer of technology. In addition to termination rights upon certain uncured material breaches of the Toprol-XL Supply Agreement by AstraZeneca or certain insolvency related events affecting AstraZeneca, Aralez Ireland may terminate the Toprol-XL Supply Agreement at any time following the Toprol-XL Supply Initial Term upon providing 12 months prior written notice to AstraZeneca. AstraZeneca also provided certain transition services to Aralez Ireland through December 31, 2017 to facilitate the transition of the supply, sale and distribution of the Toprol-XL Franchise, in exchange for compensation specified in the transition services agreement.

Agreement with the United States Government Regarding Toprol-XL

On February 23, 2017, Aralez Pharmaceuticals US Inc. (“Aralez US”), a Delaware company and a wholly-owned, indirect subsidiary of Aralez Pharmaceuticals Inc., entered into a Novation Agreement (the “Novation Agreement”) with AstraZeneca Pharmaceuticals LP (“AstraZeneca LP”) and the United States of America (the “Government”) pursuant to which all of the rights and responsibilities of AstraZeneca LP under that certain VA National Contract signed February 11, 2016 and effective April 29, 2016 between AstraZeneca LP and the Government were novated to Aralez US (as novated, the “VA Contract”). The Novation Agreement was entered into pursuant to the Toprol-XL Asset Purchase Agreement.

Under the VA Contract, Aralez US provides all requirements of certain pharmaceutical products containing metoprolol succinate as the active pharmaceutical ingredient at fixed prices for the U.S. Department of Veterans Affairs and certain other United States federal government agencies. The VA Contract had an initial one-year term expiring April 28, 2017, renewable at the option of the Government for four successive additional one year terms.  On April 6, 2017, Aralez US and the Government entered into a Modification of Contract with respect to the VA Contract, pursuant to which the Government exercised its first renewal option under the VA Contract, extending the term of the VA Contract by one year to April 28, 2018 with modified pricing as set forth therein.  On April 3, 2018, Aralez US and the Government entered into a Modification of Contract pursuant to which the Government exercised its second renewal option under the VA Contract, extending the term of the VA Contract by one year to April 28, 2019 on the same pricing as had been in effect during the April 29, 2017 to April 28, 2018 annual term, except for a price decrease to the 200mg SKUs only (which are currently the smallest selling SKUs).  The VA Contract is terminable at the convenience of the Government at any time.

Agreements with Merck for Zontivity

On September 6, 2016, Aralez Ireland acquired the U.S. and Canadian rights to Zontivity, pursuant to the Zontivity Asset Purchase Agreement with Merck. Zontivity represents an addition to the Company’s product portfolio in cardiovascular disease and is the first and currently the only approved therapy shown to inhibit the protease-activated receptor-1 (PAR-1), the primary receptor for thrombin, which is considered to be the most potent activator of platelets.  The purchase price for Zontivity consists of (i) a payment of $25.0 million by Aralez Ireland to Merck, which was made on the closing date of the acquisition, (ii) certain milestone payments payable by Aralez Ireland subsequent to the closing of the acquisition upon the occurrence of certain milestone events based on the annual aggregate net sales of Zontivity, any combination product containing vorapaxar sulphate and one or more other active pharmaceutical ingredients or any line extension thereof, which in no event will exceed $80 million in the aggregate, and (iii) royalty payments in the low double digits based on the annual aggregate net sales of Zontivity, any combination product containing vorapaxar sulphate and one or more other active pharmaceutical ingredients or any line extension thereof.

Pursuant to the terms of the Zontivity Asset Purchase Agreement and certain ancillary agreements entered into

in connection with the Zontivity acquisition, Merck has agreed to supply Zontivity to Aralez Ireland for a period of up to three years following the closing of the acquisition (although the packaging component has now been transferred to the Company’s third party provider). Merck also provided certain transition services to Aralez Ireland following the closing of the Zontivity acquisition through March 31, 2017 to facilitate the transition of the supply, sale and distribution of Zontivity, including distributing Zontivity on behalf of Aralez Ireland in exchange for compensation specified in the transition services agreement. In addition, in connection with the foregoing transactions, Merck granted Aralez Ireland, among other things, (i) an exclusive and royalty-free license to certain trademarks solely to exploit Zontivity in the U.S. and Canada and their respective territories, and (ii) an exclusive and royalty-free license to certain know-how solely in connection with the manufacture of Zontivity for exploitation in the U.S. and Canada and their respective territories.

Agreement with AstraZeneca/Horizon regarding Vimovo®

In August 2006, the Company entered into a collaboration and license agreement, effective September 7, 2006 (the “Original AZ Agreement”), with AstraZeneca regarding the development and commercialization of proprietary fixed dose combinations of the proton pump inhibitor (“PPI”) esomeprazole magnesium with the non-steroidal anti-inflammatory drug (“NSAID”) naproxen in a single tablet for the management of pain and inflammation associated with conditions such as osteoarthritis and rheumatoid arthritis in patients who are at risk for developing NSAID-associated gastric ulcers. Under the terms of the Original AZ Agreement, the Company granted to AstraZeneca an exclusive, fee-bearing license, in all countries of the world except Japan, under the Company’s patents and know-how relating to combinations of gastroprotective agents and NSAIDs (other than aspirin and its derivatives). The Company developed Vimovo with AstraZeneca pursuant to this collaboration arrangement, with AstraZeneca responsible for commercialization of Vimovo.

During 2013, AstraZeneca decided to cease promotion and sampling of Vimovo in certain countries, including the United States and all countries in Europe, other than Spain and Portugal, which have pre-existing contractual relationships with third parties. In November 2013, AstraZeneca divested of all of its rights, title and interest to develop, commercialize and sell Vimovo in the United States to Horizon Pharma USA, Inc. (“Horizon”). In connection with this divestiture, in November 2013, the Company and AstraZeneca entered into an Amended and Restated Collaboration and License Agreement for the United States (the “U.S. Agreement”) and an Amended and Restated License and Collaboration Agreement for outside the United States and Japan (the “ROW Agreement”), which agreements collectively amended and restated the Original AZ Agreement (as amended prior to the date of the U.S. Agreement and ROW Agreement). With the Company’s consent pursuant to a letter agreement among the Company, AstraZeneca and Horizon, AstraZeneca subsequently assigned the U.S. Agreement to Horizon in connection with the divestiture. Further, the letter agreement establishes a process for AstraZeneca and Horizon to determine if certain sales milestones are achieved on a global basis and provides other clarifications and modifications required as a result of the contractual framework implemented among, or as otherwise agreed by, the parties. An additional $260.0 million is potentially payable to the Company if such sales milestones are achieved, however, these sales milestones are not currently expected to be achieved.

Under the U.S. Agreement, Horizon is obligated to pay the Company a 10% royalty on net sales of Vimovo and certain other products covered thereby in the United States.  Pursuant to an amendment of the U.S. Agreement (the “Amendment to the U.S. Agreement”) between the Company and Horizon, the Company is guaranteed an annual minimum royalty amount of $7.5 million each calendar year, provided that the patents owned by the Company which cover such products are in effect and certain types of competing products are not in the marketplace. The Amendment to the U.S. Agreement also provides that Horizon has assumed AstraZeneca’s right to lead the on-going Paragraph IV litigation relating to Vimovo currently pending in the United States District Court for the District of New Jersey and will assume all patent-related defense costs relating to such litigation, including reimbursement up to specified amounts of the cost of any counsel retained by us, amends certain time periods for Horizon’s delivery of quarterly sales reports to the Company, and provides for quarterly update calls between the parties to discuss performance of Vimovo and Horizon’s commercialization efforts. In February 2018, the Company entered into a second amendment to the U.S. Agreement that allows Horizon to settle the on-going patent litigation without the Company’s consent under certain circumstances.

Pursuant to the ROW Agreement, AstraZeneca retained the rights to commercialize Vimovo and certain other products covered thereby outside of the United States and Japan and paid us a royalty of 6% on net sales within the applicable territory through 2015 and started paying us a royalty of 10% of net sales commencing in the first quarter of 2016. 

The royalty rates above may be reduced due to the loss of market share as a result of certain competition inside and outside of the United States, as applicable.  Furthermore, the Company’s right to receive royalties from AstraZeneca or Horizon, as applicable, expires on a country-by country basis upon the later of (a) expiration of the last-to expire of certain patent rights related to the applicable product(s) in that country, and (b) ten years after the first commercial sale of such product(s) in such country. In June 2017, the United States District Court for the District of New Jersey upheld the validity of two patents owned by Aralez and licensed to Horizon covering Vimovo in the United States.  Subject to the immediately following sentence or a successful appeal of the decision by the generic competitors party to the suit, this decision is expected to delay generic entry until the expiration of the applicable patents.  There is ongoing litigation with respect to other patents covering Vimovo, which if we are successful (and subject to a provisional license granted to Actavis effective January 1, 2025), would further prevent generic entry by the remaining generic competitors until March 2031.  See Note 11, “Commitments and Contingencies” for more information.  As noted above, in February 2018, the Company entered into a second amendment to its license agreement with Horizon that allows Horizon to settle such patent litigation without the Company’s consent under certain circumstances. As the result of an unfavorable outcome in certain patent litigation in Canada, Mylan’s generic naproxen/esomeprazole magnesium tablets recently became available in Canada.

Certain Other Agreements

Distribution Agreements Regarding Toprol-XL AG

In November 2017, the Company signed a Distribution and Supply Agreement (the “Lannett-Toprol-XL AG Agreement”) with Lannett Company, Inc. (“Lannett”) pursuant to which the Company supplies, and Lannett distributes, the Toprol-XL authorized generic product.  The Lannett-Toprol-XL AG Agreement replaces a previous Toprol-XL authorized generic distribution agreement with Endo Ventures Limited (“Endo”), which terminated in December 2017.  Pursuant to the Lannett-Toprol-XL AG Agreement, Lannett has the exclusive rights in the United States to promote the Toprol-XL authorized generic, while we retain the right to promote the branded Toprol-XL.  Pursuant to the terms of the Toprol-XL AG Agreement, the Company supplies the AG product to Lannett for a base supply price, which ranges depending on dosage strength.  In addition to the base supply price, Lannett pays to the Company, on a quarterly basis, a profit share equal to a certain percentage of the specified profit of this business for the applicable period. The Lannett-Toprol-XL AG Agreement expires at the end of 2020 and may be terminated by either party under certain circumstances, including performance measures.

Agreements with Sun Pharma and Frontida for Fibricor®  

In May 2015, Tribute Pharmaceuticals International Inc. (“TPII”), a Barbados corporation and a wholly-owned subsidiary of Aralez Canada, acquired the U.S. rights to Fibricor® and its related authorized generic (collectively, the “Fibricor Products”) from a wholly-owned step-down subsidiary of Sun Pharmaceutical Industries Ltd. (“Sun Pharma”). Financial terms include a total payment of $10.0 million of which approximately $3.0 million was included as a liability assumed in the Merger and subsequently paid in May 2016. In addition, we may be obligated to pay up to $4.5 million in milestone payments based on annual net sales of Fibricor and its authorized generic as well as royalties ranging from the high single digits to low double digits based on annual net sales of such products. In connection with its acquisition of Fibricor, TPII also entered into a supply agreement with Sun Pharma pursuant to which Sun Pharma agreed to manufacture and supply the Fibricor Products to TPII. On June 3, 2016, Sun Pharma assigned the supply agreement to Frontida BioPharm, Inc. On June 30, 2016, TPII assigned its interest in the Fibricor Products to Aralez Ireland.

Agreements with Novartis for Fiorinal®

In 2014, Aralez Canada entered into an asset purchase agreement (the “Asset Purchase Agreement”) with Novartis AG and Novartis Pharma AG (collectively, “Novartis”) pursuant to which Aralez Canada acquired from

Novartis the Canadian rights to manufacture, market, promote, distribute and sell Fiorinal®, Fiorinal® C, Visken® and Viskazide® for the relief of pain from headache and for the treatment of cardiovascular conditions (the “Novartis Products”), as well as certain other assets relating to the Novartis Products, including certain intellectual property, marketing authorizations and related data, medical, commercial and technical information, and the partial assignment of certain manufacturing and supply agreements and tenders with third parties (the “Acquired Assets”). Aralez Canada also assumed certain liabilities arising out of the Acquired Assets and the Licensed Assets (as defined below) after the acquisition, including product liability claims or intellectual property infringement claims by third parties relating to the sale of the Novartis Products by Aralez Canada in Canada. In connection with the acquisition of the Acquired Assets, and pursuant to the terms of the Asset Purchase Agreement, Aralez Canada concurrently entered into a license agreement with Novartis AG, Novartis Pharma AG and Novartis Pharmaceuticals Canada Inc., under which the Novartis entities agreed to license to Aralez Canada certain assets relating to the Novartis Products, including certain intellectual property, marketing authorizations and related data, and medical, commercial and technical information (the “Licensed Assets”).

Agreement with Faes for BlextenTM

In 2014, Aralez Canada entered into an exclusive license and supply agreement with Faes Farma, S.A. (“Faes”), a Spanish pharmaceutical company, for the exclusive right to sell bilastine, a product for the treatment of allergic rhinitis and chronic idiopathic urticaria (hives) in Canada, which is now named BlextenTM in Canada. The exclusive license is inclusive of prescription and non-prescription rights for Blexten, as well as adult and pediatric presentations in Canada. On March 31, 2016, Aralez Canada assigned its interest in Blexten to Aralez Ireland. Regulatory approval to sell Blexten in Canada was received from Health Canada in April 2016 and the Company began commercializing Blexten in Canada in December 2016. In April 2018, an ophthalmic formulation under development was added to this agreement. The Company will owe milestone payments of approximately $3.5 million to Faes if certain sales targets or other milestone events are achieved.

Agreement with Nautilus for Cambia®

In 2010, Aralez Canada signed a license agreement with Nautilus Neurosciences, Inc. (“Nautilus”) for the exclusive rights to develop, register, promote, manufacture, use, market, distribute and sell Cambia® in Canada. In 2011, Aralez Canada and Nautilus executed the first amendment to the license agreement and in 2012 executed the second amendment to the license agreement. The license was assigned by Nautilus to Depomed, Inc. (“Depomed”) in December 2013. Up to $6.0 million in sales-based milestone payments may be payable over time. Royalty rates are tiered and payable at rates ranging from 22.5% to 27.5% of net sales.

Agreement with Actavis for Bezalip® SR and Soriatane®

In January 2018, Aralez Canada signed an Exclusive Distribution Agreement with Allergan Inc. (“Allergan”) pursuant to which Aralez Canada was appointed as the exclusive distributor to promote, market, purchase, warehouse, distribute and sell the Bezalip® SR and Soriatane® in Canada. This Exclusive Distribution Agreement supersedes the previous Sales, Marketing and Distribution Agreement entered into between Aralez Canada and Allergan in 2008 with respect to Bezalip SR and Soriatane. Pursuant to this Exclusive Distribution Agreement, Aralez Canada will pay Allergan a minimum royalty amount as well as an incremental royalty based on net receipts above 2017 net receipts for the products. In 2011, Aralez Canada signed a Product Development and Profit Share Agreement with Allergan to develop, obtain regulatory approval of, and market Bezalip SR and other formulations of bezafibrate in the United States, which U.S. agreement was amended in 2013 and 2017. The Company may owe a milestone payment to Allergan in the event that the Company pursues and obtains regulatory approval to market Bezalip SR or another bezafibrate formulation in the United States, which milestone will be either $2.5 million or $5.0 million depending on the form of the first product approved.

Agreements with GSK, Pernix and CII regarding MT 400 (including Treximet®)

In June 2003, the Company entered into an agreement with Glaxo Group Limited, d/b/a GlaxoSmithKline (“GSK”) for the development and commercialization of proprietary combinations of a triptan (5-HT1B/1D agonist) and a

long-acting NSAID (the “GSK Agreement”). The combinations covered by the GSK Agreement are among the combinations of MT 400 (including Treximet®). Under the terms of the GSK Agreement, GSK had exclusive rights in the United States to commercialize all combinations which combine GSK’s triptans, including Imitrex® (sumatriptan succinate) or Amerge® (naratriptan hydrochloride), with a long-acting NSAID. The Company was responsible for development of the first combination product, while GSK provided formulation development and manufacturing.

In November 2011, the Company entered into a purchase agreement with CPPIB Credit Investments Inc. (“CII”), pursuant to which the Company sold, and CII purchased, the Company’s right to receive future royalty payments arising from U.S. sales of MT 400, including Treximet. By virtue of the agreement, the Company will receive a 20% interest in royalties, if any, paid on net sales of Treximet and such other products in the United States to CII relating to the period commencing in the second quarter of 2018.

In May 2014, the Company, GSK, CII and Pernix Therapeutics Holdings, Inc. (“Pernix”), entered into certain agreements in connection with GSK’s divestiture of all of its rights, title and interest to develop, commercialize and sell Treximet in the United States to Pernix. Upon the closing of the transaction in August 2014, with the Company’s consent, GSK assigned the GSK Agreement to Pernix. Pernix assumed the obligation to pay two sales performance milestones totaling up to $80.0 million if certain sales thresholds are achieved as well as royalties on all net sales of marketed products until at least the expiration of the last-to-expire issued applicable patent based upon the scheduled expiration of currently issued patents. Pernix may reduce, but not eliminate, the royalty payable to the Company if generic competitors attain a pre-determined share of the market for the combination product, or if Pernix owes a royalty to one or more third parties for rights it licenses from such third parties to commercialize the product. Immediately following the closing of the transaction, the Company entered into an amendment to the GSK Agreement with Pernix. This amendment, among other things, amends the royalty provisions to provide for a guaranteed quarterly minimum royalty of $4.0 million for the calendar quarters commencing in January 2015 and ending in March 2018 and requires that Pernix continue certain of GSK’s ongoing development activities and to undertake certain new activities, for which the Company will provide reasonable assistance. This amendment to the GSK Agreement also eliminates restrictions in the GSK Agreement on the Company’s right to develop and commercialize certain dosage forms of sumatriptan/naproxen combinations outside of the United States and permits the Company to seek approval for these combinations on the basis of the approved new drug application for Treximet.

3. REVENUE RECOGNITION

Principal sources of revenue are (i) product revenues from sales of the product portfolio acquired in the Company’s acquisition of Aralez Canada, (ii) product revenues from sales of the Toprol-XL Franchise and Zontivity, and (iii) royalty revenues from sales of Vimovo by the Company’s commercialization partners.

Product Revenue, Net

The Company’s products are distributed through a limited number of specialty distributors, specialty pharmacy providers and wholesalers in the U.S. and Canada (each a “Customer”, or collectively, its “Customers”).  These Customers subsequently resell the Company’s products to healthcare providers, pharmacies and patients.  In addition to distribution agreements with Customers, the Company enters into arrangements with payors that provide for government-mandated and/or privately-negotiated rebates, chargebacks and discounts with respect to the purchase of the Company’s products.

Revenues from product sales are recognized when the Customer obtains control of the Company’s product, which occurs at a point in time, typically upon delivery to the Customer.  When the Company performs shipping and handling activities after the transfer of control to the Customer (e.g., when control transfers prior to delivery), they are considered fulfillment activities, and accordingly, the costs are accrued for when the related revenue is recognized.  Taxes collected from Customers relating to product sales and remitted to governmental authorities are excluded from revenues.  The Company expenses incremental costs of obtaining a contract as and when incurred if the expected amortization period of the asset that the Company would have recognized is one year or less.

Prior to 2018, revenues from the Toprol-XL Franchise, which was acquired on October 31, 2016 and sold by AstraZeneca on the Company’s behalf under a transition services agreement from the acquisition date through December 31, 2017, were recorded net of related cost since the Company was not the principal in the arrangement. The Company recorded this revenue in other revenues, similar to a royalty arrangement through December 31, 2017 (other than sales under the Lannett Toprol-XL AG Agreement, which was executed in November 2017).  Under a transition services agreement with AstraZeneca, the Company established reserves based on estimates of amounts for rebates, chargebacks, discounts, distributors fees, and returns and allowances earned or to be claimed on the related sales based on information provided by AstraZeneca in accordance with the Toprol-XL Asset Purchase Agreement.

When the Company is the principal in the sales of marketing of a product, the Company recognizes gross revenues and cost of product revenues from the sales of that product. which are classified as product revenues, net and cost of product revenues. Beginning on January 1, 2018, the Company is deemed to be the principal in the sales and marketing of Toprol-XL branded products. The Company became the principal in the sales and marketing of the Toprol-XL AG upon the execution of the Lannett Toprol-XL AG Agreement in November 2017.

Reserves for Variable Consideration

Revenues from product sales are recorded at the net sales price (transaction price), which includes estimates of variable consideration for which reserves are established and which result from discounts, returns, chargebacks, rebates, co-pay assistance and other allowances that are offered within contracts between the Company and its Customers, health care providers, payors and other indirect customers relating to the Company’s sales of its products.  These reserves are based on the amounts earned or to be claimed on the related sales and are classified as reductions of accounts receivable (if the amount is payable to the Customer) or a current liability (if the amount is payable to a party other than a Customer).  Where appropriate, these estimates take into consideration a range of possible outcomes and contemplates relevant factors such as the Company’s historical experience, current contractual and statutory requirements, specific known market events and trends, industry data and forecasted customer buying and payment patterns.  Overall, these reserves reflect the Company’s best estimates of the amount of consideration to which it is entitled based on the terms of the contract.  The amount of variable consideration which is included in the transaction price may be constrained, and is included in the net sales price only to the extent that it is probable that a significant reversal in the amount of the cumulative revenue recognized will not occur in a future period.  Actual amounts of consideration ultimately received may differ from the Company’s estimates. 

The Company believes that the reserves it has established are reasonable based upon current facts and circumstances. Applying different judgments or interpretations to the same facts and circumstances could result in the estimated amount for reserves to vary.  If actual results vary with respect to the Company’s reserves, the Company may need to adjust its estimates, which could have a material effect on the Company’s results of operations in the period of adjustment. To date, such adjustments have not been material.

Trade Discounts and Allowances 

The Company generally provides Customers with discounts which include incentive fees that are explicitly stated in the Company’s contracts and are recorded as a reduction of revenue in the period the related product revenue is recognized.  In addition, the Company receives sales order management, data and distribution services from certain Customers.  To the extent the services received are distinct from the Company’s sale of products to the Customer, these payments are classified in selling, general and administrative expenses in the condensed consolidated statements of operations and comprehensive loss of the Company.

Product Returns

Consistent with industry practice, the Company generally allows the customer to return pharmaceutical products within a specified period of time both prior to and subsequent to the product’s expiration date.  The Company estimates the amount of its product sales that may be returned by its Customers and records this estimate as a reduction of revenue in the period the related product revenue is recognized. The Company’s estimate of the provision for returns is analyzed

quarterly and is based upon many factors, including historical data of actual returns and analysis of the level of inventory in the distribution channel, if any.

Provider Chargebacks and Discounts 

Chargebacks for fees and discounts to providers represent the estimated obligations resulting from contractual commitments to sell products to qualified healthcare providers at prices lower than the list prices charged to Customers who directly purchase the product from the Company.  Customers charge the Company for the difference between what they pay for the product and the ultimate selling price to the qualified healthcare providers.  These reserves are established in the same period that the related revenue is recognized, resulting in a reduction of product revenue and accounts receivable.  Chargeback amounts are generally determined at the time of resale to the qualified healthcare provider by Customers, and the Company generally issues credits for such amounts within a few weeks of the Customer’s notification to the Company of the resale.  Reserves for chargebacks consist of credits that the Company expects to issue for units that remain in the distribution channel inventories at each reporting period end that the Company expects will be sold to qualified healthcare providers, and chargebacks that Customers have claimed but for which the Company has not yet issued a credit.

Government Rebates 

The Company is subject to discount obligations under state Medicaid programs and Medicare.    The Company estimates its Medicaid and Medicare rebates based upon a range of possible outcomes that contemplates its estimated payor mix.  These reserves are recorded in the same period the related revenue is recognized, resulting in a reduction of product revenue and the establishment of a current liability which is included in accrued expenses on the consolidated balance sheet.  For Medicare, the Company makes estimates for prescription drug coverage gap for patients whom the Company will owe an additional liability under the Medicare Part D program.  The Company’s liability for these rebates consists of invoices received for claims from prior quarters that have not been paid or for which an invoice has not yet been received, estimates of claims for the current quarter, and estimated future claims that will be made for product that has been recognized as revenue, but remains in the distribution channel inventories at the end of each reporting period.

Payor Rebates 

The Company contracts with various private payor organizations, primarily insurance companies and pharmacy benefit managers, for the payment of rebates with respect to utilization of its products.  The Company estimates these rebates and records such estimates in the same period the related revenue is recognized, resulting in a reduction of product revenue and the establishment of a current liability.

Other Incentives 

Other incentives which the Company offers include voluntary patient assistance programs, such as co-pay assistance programs which are intended to provide financial assistance to commercially insured patients with prescription drug co-payments required by payors.  The calculation of the accrual for co-pay assistance is based on an estimate of claims and the cost per claim that the Company expects to receive associated with product that has been recognized as revenue, but remains in the distribution channel inventories at the end of each reporting period.

The following table summarizes activity in each of the product revenue allowance and reserve categories for the three months ended March 31, 2018:

In determining the appropriate amount of revenue to be recognized as it fulfills its obligations under each of its agreements, the Company performs the following steps: (i) identification of the promised goods or services in the contract; (ii) determination of whether the promised goods or services are performance obligations including whether they are distinct in the context of the contract; (iii) measurement of the transaction price, including the constraint on variable consideration; (iv) allocation of the transaction price to the performance obligations; and (v) recognition of revenue when (or as) the Company satisfies each performance obligation.  As part of the accounting for these arrangements, the Company must develop assumptions that require judgment to determine the stand-alone selling price for each performance obligation identified in the contract.  The Company uses key assumptions to determine the stand-alone selling price, which may include forecasted revenues, development timelines, reimbursement rates for personnel costs, discount rates and probabilities of technical and regulatory success.

Other Revenues

The Company enters into licensing agreements, from time to time, which are within the scope of Topic 606, under which it may license certain rights to its products or product candidates to third parties.  The terms of these arrangements typically include payment to the Company of one or more of the following: non-refundable, up-front license fees; development, regulatory and commercial milestone payments; and royalties on net sales of licensed products.  Each of these payments results in revenues recognized and classified as other revenues.

Licenses of intellectual property:  If the license to the Company’s intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, the Company recognizes revenues from non-refundable, up-front fees allocated to the license when the license is transferred to the customer and the customer is able to use and benefit from the license.  For licenses that are bundled with other promises, the Company utilizes judgment to assess the nature of the combined performance obligation to determine whether the combined performance obligation is satisfied over time or at a point in time and, if over time, the appropriate method of measuring progress for purposes of recognizing revenue from non-refundable, up-front fees.  The Company evaluates the measure of progress each reporting period and, if necessary, adjusts the measure of performance and related revenue recognition.

Milestone Payments:  At the inception of each arrangement that includes development milestone payments, the Company evaluates whether the milestones are considered probable of being reached and estimates the amount to be included in the transaction price using the most likely amount method.  If it is probable that a significant revenue reversal would not occur, the associated milestone value is included in the transaction price.  Milestone payments that are not within the control of the Company or the licensee, such as regulatory approvals, are not considered probable of being achieved until those approvals are received. The transaction price is then allocated to each performance obligation on a relative stand-alone selling price basis, for which the Company recognizes revenue as or when the performance obligations under the contract are satisfied.  At the end of each subsequent reporting period, the Company re-evaluates the probability of achievement of such development milestones and any related constraint, and if necessary, adjusts its estimate of the overall transaction price.  Any such adjustments are recorded on a cumulative catch-up basis, which would affect license, collaboration and other revenues and earnings in the period of adjustment.

Royalties:  For arrangements that include sales-based royalties, including milestone payments based on the level of sales, and the license is deemed to be the predominant item to which the royalties relate, the Company recognizes revenue at the later of (i) when the related sales occur, or (ii) when the performance obligation to which some or all of the royalty has been allocated has been satisfied (or partially satisfied). 

Under the Company’s various contracts, the Company may receive up-front payments and fees, which may require deferral of revenue recognition to a future period until the Company performs its obligations under these arrangements.  Amounts are recorded as accounts receivable when the Company’s right to consideration is unconditional. The Company does not assess whether a contract has a significant financing component if the expectation at contract inception is such that the period between payment by the customer and the transfer of the promised goods or services to the customer will be one year or less.

The following table presents changes in the Company’s contract assets and liabilities during the three months ended March 31, 2018:

During the three months ended March 31, 2018, the Company recognized the following revenues as a result of changes in the contract asset and the contract liability balances in the respective periods:

4.FAIR VALUE

The following tables set forth the Company’s assets and liabilities that are measured at fair value on a recurring basis at:

Level 3 Disclosures

The following table provides quantitative information associated with the fair value measurement of the Company’s Level 3 inputs at March 31, 2018:

In connection with the acquisitions of Zontivity and the Toprol-XL Franchise, the Company recorded short-term and long-term contingent consideration liabilities for future cash payments based on the occurrence of certain milestone events and royalty payments. The contingent consideration liability for both Zontivity and the Toprol-XL Franchise is valued using a model, which incorporates Level 3 assumptions, including the estimated amount and timing of projected cash flows, the probability of success (achievement of the contingent event) and the risk-adjusted discount rate used to present value the probability-weighted cash flows.

In the third and fourth quarters of 2017, the Company updated its assumptions for the probability of success for certain milestone events in the Toprol-XL Asset Purchase Agreement.  In addition, the Company adjusted the timing of projected milestone payments in connection with the July 2017 amendment to the Toprol-XL Asset Purchase Agreement. Further, the Company updated its assumptions with respect to financial projections for Zontivity and the Toprol-XL Franchise.  These changes in assumptions, along with accretion due to the passage of time, resulted in a net increase in

the contingent consideration liability of $35.7 million during the year ended December 31, 2017.  During the first quarter of 2018, the Company did not make any significant changes to its contingent consideration assumptions.

During the three months ended March 31, 2018 and 2017, the Company recorded expense related to the contingent consideration for its acquisition of Zontivity totaling $0.1 million and $0.6 million, respectively. During the three months ended March 31, 2018 and 2017, the Company recorded expense related to the contingent consideration for its acquisition of the Toprol-XL Franchise totaling $5.0 million and $3.7 million, respectively.

The table below provides a roll-forward of the contingent consideration liability fair value balances that used Level 3 inputs:

5.INVENTORY

Inventory consisted of the following at:

Inventories are net of reserves for excess and obsolete inventory of approximately $0.6 million and $1.1 million as of March 31, 2018 and December 31, 2017, respectively.

6.GOODWILL AND OTHER INTANGIBLE ASSETS, NET

Goodwill

The table below provides a roll-forward of the Company’s goodwill balances:

Other Intangible Assets, Net

Other intangible assets, net consisted of the following at:

The gross carrying amount of acquired technology rights decreased by $2.1 million from December 31, 2017 due to the impact of foreign currency translation adjustments between the Canadian and U.S. dollars. Amortization expense was $9.0 million and $8.5 million for the three months ended March 31, 2018 and 2017, respectively.  

The estimated aggregate amortization of intangible assets as of March 31, 2018, for each of the five succeeding years and thereafter is as follows:

7.ACCRUED EXPENSES

Accrued expenses consisted of the following at: