Akorn 10-K 2011
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
Commission File Number: 001-32360
(Exact name of registrant as specified in its charter)
1925 W. Field Court, Suite 300, Lake Forest, Illinois 60045
(Address of principal executive offices and zip code)
Registrant’s telephone number, including area code: (847) 279-6100
SECURITIES REGISTERED PURSUANT TO SECTION 12(b) OF THE ACT:
SECURITIES REGISTERED PURSUANT TO SECTION 12(g) OF THE ACT:
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. Yes o No þ
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No þ
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 þ No o
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 o No o
Indicate by check mark if disclosure of delinquent filers in response to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer”, “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes o No þ
The aggregate market value of the voting stock of the registrant held by non-affiliates (affiliates being, for these purposes only, directors, executive officers and holders of more than 5% of the registrant’s common stock) of the registrant as of June 30, 2010 was approximately $191,703,000 based on the closing market price of $2.97 reported on the Nasdaq Stock Market LLC.
The number of shares of the registrant’s common stock, no par value per share, outstanding as of March 9, 2011 was 94,189,029.
Documents incorporated by reference: Definitive Proxy Statement for the 2011 Annual Meeting incorporated by reference into Part III, Items 10-14 of this Form 10-K.
Forward-Looking Statements and Factors Affecting Future Results
Certain statements in this Form 10-K 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 our intent, belief or expectations are not guarantees of future performance. These statements are subject to 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:
See “Item 1A. Risk Factors”. You should read this report completely with the understanding that our actual results may differ materially from what we expect. Unless required by law, we undertake no obligation to update publicly any forward-looking statements, whether as a result of new information, future events or otherwise.
FORM 10-K TABLE OF CONTENTS
We manufacture and market a full line of diagnostic and therapeutic ophthalmic pharmaceuticals as well as niche hospital drugs and injectable pharmaceuticals. In addition, we have marketed and distributed vaccines purchased from outside sources. Our customers include physicians, optometrists, hospitals, wholesalers, group purchasing organizations, retail pharmacy chains and other pharmaceutical companies. Akorn, Inc. is a Louisiana corporation founded in 1971 in Abita Springs, Louisiana. In 1997, we relocated our corporate headquarters to the Chicago, Illinois area. We operate pharmaceutical manufacturing facilities in Decatur, Illinois and Somerset, New Jersey. The Decatur, Illinois facilities operate as part of Akorn, Inc., while the Somerset, New Jersey facility operates as Akorn (New Jersey), Inc., a wholly-owned subsidiary incorporated in Illinois.
In this annual report, we have reported results for four operating segments: ophthalmic; hospital drugs & injectables; contract services; and biologics & vaccines. These four segments are described in greater detail below. For information regarding revenues and gross profit for each of our segments, see Item 8. Financial Statements and Supplementary Data, Note L — “Segment Information.”
Three of these segments – ophthalmic, hospital drugs & injectables, and contract services – have been identified and reported in each quarterly period during the three years ended December 31, 2010. The biologics & vaccines segment was reported for each quarterly period during 2008 and 2009, and the first quarter of 2010. During the fourth quarter of 2009, we reached the strategic decision to exit the biologics & vaccines segment and did so toward the end of the first quarter of 2010.
Ophthalmic Segment. We market a full line of diagnostic and therapeutic ophthalmic pharmaceutical products. Diagnostic products, primarily used in the office setting, include mydriatics and cycloplegics, anesthetics, topical stains, gonioscopic solutions, angiography dyes and others. Therapeutic products, sold primarily to wholesalers, chain drug stores and other national account customers, include antibiotics, steroids, steroid combinations, glaucoma medications, decongestants/antihistamines and anti-edema medications. Non-pharmaceutical products include various artificial tear solutions, preservative-free lubricating ointments and eyelid cleansers.
Hospital Drugs & Injectables Segment. We market a line of niche hospital drug and injectable pharmaceutical products, including antidotes, anti-infectives, controlled substances for pain management and anesthesia, and other selected pharmaceutical products. These products are predominately sold to hospitals through the wholesale distribution channel. We target products with limited competition due to difficulty in manufacturing and/or the product’s market size.
Contract Services Segment. We manufacture ophthalmic and injectable pharmaceutical products for third party pharmaceutical customers based on their specifications.
Biologics & Vaccines Segment. We marketed adult Td vaccines during 2008, 2009 and the first quarter of 2010, as well as flu vaccines during 2008 and 2009. These vaccines were marketed directly to hospitals and physicians as well as through wholesalers and national distributors. In the fourth quarter of 2009, the strategic decision was made to exit this segment, and we exited the biologics & vaccines segment in the first quarter of 2010.
Manufacturing. We have manufacturing facilities located in Decatur, Illinois and Somerset, New Jersey. (See Item 2. Properties, for more information.) Through our two manufacturing facilities, we manufacture a diverse group of sterile pharmaceutical products, including dye products, liquid injectables, lyophilized injectables, gels, and ophthalmic solutions and ointments for our ophthalmic, hospital drugs & injectables and contract services segments. Our Somerset facility manufactures ophthalmic solutions and ointment products for our ophthalmic and contract services segments, and gels for our hospital drugs & injectables segment. Our Decatur manufacturing facility manufactures dye products, liquid injectables, lyophilized injectables and ophthalmic solutions for our ophthalmic, hospital drugs & injectables and contract services segments.
Sales and Marketing. We rely on our sales and marketing teams to help us maintain and, where possible, increase our market shares in our predominantly non-proprietary product offering. We have a three-tiered sales organization focused on our hospital drugs & injectables segment and our ophthalmic segment, which consists of (1) outside sales; (2) inside sales and customer service; and (3) national accounts sales. Outside sales representatives sell ophthalmic products directly to retinal surgeons and ophthalmologists, and sell hospital drugs & injectables directly to local hospitals to support compliance and pull through against group purchasing organization contracts. Inside sales and customer service augment our outside sales team in the sale of ophthalmic and hospital drugs & injectables products in markets where outside sales would not be cost effective. Our national accounts sales team seeks to establish and maintain contracts with wholesalers, retail pharmacy chains and group purchasing organizations that represent hospitals in the United States. To support our contract services segment, we have a separate team that focuses on marketing our contract manufacturing capabilities through direct mail, trade shows and direct industry contacts.
Research and Development (“R&D”). In February 2010, we opened a new R&D facility at the Illinois Science and Technology Park in Skokie, Illinois. The majority of our internal product development activities are taking place at this facility, with a smaller subset occurring at our manufacturing plant in Somerset, NJ. Our manufacturing plants in Decatur, IL and Somerset, NJ provide support for the latter phases of product development. In addition, we continue to work with strategic partners for the external development of certain products. We believe that having our own centralized and dedicated R&D facility will allow us to significantly increase the size of our product pipeline as well as shorten the time from project start to filing for approval with the U.S. Food and Drug Administration (“FDA”). As of December 31, 2010, we had 22 full-time employees directly involved in product research and development activities.
Research and development costs are expensed as incurred. Such costs amounted to $6,975,000, $4,764,000 and $6,801,000 for the years ended December 31, 2010, 2009 and 2008, respectively, and includes both internal R&D expenses and milestone fees paid to our strategic partners. Our strategic partnerships are discussed further in “Business Development.”
In 2010, we received four Abbreviated New Drug Application (“ANDA”) product approvals from the FDA. In 2009, we received ten ANDA product approvals from the FDA. As of December 31, 2010, we had 11 ANDA product submissions for generic pharmaceuticals under review at the Office of Generic Drugs: five from internal development and six from various strategic agreements with other external partners. In most but not all instances, we own, or will own, the ANDAs that are produced by our strategic partnerships. We plan to continue to file ANDAs on a regular basis in anticipation of selected pharmaceutical products coming off patent, thereby allowing us to compete by marketing generic equivalents. For more information, see “Government Regulation”.
No assurance can be given as to: (1) whether we will file New Drug Applications (“NDAs”) or ANDAs when anticipated; (2) whether or not we will ultimately develop marketable products based on any filings we do make; (3) the actual size of the market for any such products, or (4) whether our participation in such market would be profitable. See “Government Regulation” and Item 1A. Risk Factors – “Our growth depends on our ability to timely develop additional pharmaceutical products and manufacturing capabilities”.
Business Development. In additional to our internal research and development, we also maintain a business development program that identifies potential product acquisition or product licensing opportunities. We have strategically focused our business development efforts on products that complement our existing product lines and are expected to have few competitors.
In 2004, as part of our business development efforts, we entered into a 50/50 strategic partnership with Strides Arcolab Limited (“Strides”) in a new company named Akorn-Strides LLC (the “Joint Venture Company”) for the development and marketing of a number of injectable ANDA products for the U.S. hospital and alternate site markets. Each partner funded the Joint Venture Company with $1,500,000 for initial development projects. See Item 8. Financial Statements and Supplementary Data, Note P – “Business Alliances” for more information. Strides is responsible for developing, manufacturing and supplying products that are sold to the Joint Venture Company. Akorn then provides sales and marketing services to the Joint Venture Company for sales of these products in the United States on an exclusive basis. To supplement Strides’ manufacturing capabilities, during 2010 we began manufacturing one Joint Venture Company product in our Decatur, Illinois manufacturing plant. The Joint Venture Company launched its first products in the second half of 2008. For the years 2010, 2009 and 2008, the Joint Venture Company generated net sales of $16,260,000, $10,910,000 and $2,024,000, respectively. The Joint Venture Company product pipeline was limited to those products identified at the founding of the Joint Venture Company and placed into development shortly thereafter.
On December 29, 2010, the Joint Venture Company entered into a purchase agreement with Pfizer, Inc. (“Pfizer”) to sell all of its ANDAs to Pfizer for a purchase price of $63.2 million (the “Pfizer Sale Agreement”). Pursuant to the terms of the Pfizer Sale Agreement, the Joint Venture Company will continue to sell its actively-marketed ANDA products through April 30, 2011. The Joint Venture Company and Pfizer agreed to structure the sale by establishing two closings; an initial closing that occurred on December 29, 2010, when the Joint Venture Company delivered to Pfizer dormant and not yet approved ANDAs, and a contemplated May 1, 2011 closing, when the Joint Venture Company will transfer to Pfizer the actively-marketed and approved product ANDAs.
In October 2004, we entered into an exclusive drug development and distribution agreement for oncology drug products for the United States and Canada with Serum Institute of India, Ltd. (“Serum”). Serum constructed and commissioned a new, FDA approved facility to support oncology products for distribution by us in the United States and Canada, and by Serum to customers in other parts of the world. Under our agreement, Akorn owns the approved ANDAs for U.S. marketed products and can buy the products developed under the agreement from Serum under a negotiated transfer price arrangement for sale in the United States and Canada under the Akorn label. To date we have received approval for three ANDAs, none of which has yet been launched due to aggressive market competition and price erosion.
On November 16, 2004, we entered into an Exclusive License and Supply Agreement with Hameln Pharmaceuticals (“Hameln”) for two Orphan Drug NDAs — pentetate calcium trisodium (“Ca-DTPA”) and pentetate zinc trisodium (“Zn-DTPA”) – which were both approved by the FDA in August 2004 (collectively, the “DTPA Products”). The DTPA Products are antidotes for the treatment of radioactive poisoning. Under the terms of the agreement, we paid a one-time license fee of 1,550,000 Euros ($2,095,000 at such time) for an exclusive license for five years, subject to automatic extension for successive two-year periods. Orphan drug exclusivity status is granted by the FDA for a period of seven years from the date of approval of the NDA. Hameln manufactures both drugs, and we market and distribute both drugs in the United States and Canada. We share revenues equally, subject to certain adjustments. We pay any annual FDA establishment fees and for the cost of any post-approval studies. On December 30, 2005, we were awarded a $21,491,000 contract from the United States Department of Health and Human Services (“HHS”) for these products which we subsequently sold to HHS in March of 2006. In December 2006, we sold HHS an additional $3,502,000 of these products. An automatic two-year extension in the Agreement would have extended this agreement until November 16, 2011. However, in September 2009, we agreed with Hameln to early terminate the agreement on September 30, 2010. Our 2010, 2009 and 2008 sales were $244,000, $1,262,000 and $322,000, respectively, for these antidote products, none of which were sales to HHS.
On March 7, 2006, we entered into a 10-year exclusive agreement with Cipla, Ltd. (“Cipla”), an Indian pharmaceutical company located in Mumbai, India. Under the terms of the agreement, Cipla manufactures and supplies oral Vancomycin, an ANDA anti-infective in capsule form, using our formulation, and we are responsible for the ANDA regulatory submission and clinical development. We also funded the purchase of specialized manufacturing equipment and paid Cipla milestone fees for Cipla’s assistance with ANDA development and submission. We agreed to purchase oral Vancomycin from Cipla and Cipla agreed to supply this product to us on an exclusive basis in the United States. We will own the ANDA in the United States. We are still awaiting final FDA review and approval for generic oral Vancomycin capsules.
On March 22, 2007, we entered into an Exclusive Distribution Agreement (the “MBL Distribution Agreement”) with Massachusetts Biological Laboratories of the University of Massachusetts (“MBL”) for distribution of Td vaccines. MBL manufactured the Td vaccine products and we marketed and distributed them on an exclusive basis in the United States and Puerto Rico. In July 2008, the MBL Distribution Agreement was amended to: (i) allow us to destroy our remaining inventory of Td vaccine, 15 dose/vial, in exchange for receiving an equivalent number of doses of preservative-free Td vaccine, single-dose/vial (the "Single-dose Product") at no additional cost other than destruction and documentation expenses; (ii) reduce the aggregate purchase price of the Single-dose Product during the first year of the MBL Distribution Agreement by approximately 14.4%; (iii) reduce our purchase commitment for the second year of the MBL Distribution Agreement by approximately 34.7%; and (iv) reduce our purchase commitment for the third year of the MBL Distribution Agreement by approximately 39.5%.
We were unable to make a payment of approximately $3,375,000 for Td vaccine products that was due to MBL by February 27, 2009 under our MBL Distribution Agreement. While we made a partial payment of $1,000,000 to MBL on March 13, 2009, we were also unable to make another payment of approximately $3,375,000 due to MBL on March 28, 2009. Accordingly, we entered into a letter agreement with MBL on March 27, 2009 ("MBL Letter Agreement"), pursuant to which we agreed to pay MBL the $5,750,000 remaining due for these Td vaccine products plus an additional $4,750,000 in consideration of the amendments to the MBL Distribution Agreement payable according to a periodic payment schedule through June 30, 2010. In addition, pursuant to the MBL Letter Agreement, the MBL Distribution Agreement was converted to a non-exclusive agreement, we provided MBL a standby letter of credit to secure our obligation to pay amounts due to MBL, and we were released from our obligation to further purchase Td vaccine products from MBL upon providing MBL with such letter of credit. Pursuant to the MBL Letter Agreement, MBL agreed not to declare a breach or otherwise act to terminate the MBL Distribution Agreement provided that we comply with the terms of the MBL Letter Agreement, the MBL Distribution Agreement (as amended by the MBL Letter Agreement) and any agreements required to be entered into pursuant to the MBL Letter Agreement.
We made all scheduled payments to MBL during 2009 and 2010 in accordance with the MBL Letter Agreement and sold all existing Td inventory by December 31, 2009. We subsequently agreed to a limited sale of Td vaccine in the first quarter of 2010. However, we were not able to reach a long-term agreement with MBL regarding the business terms that would govern the purchase of new Td inventory. As a result, on December 14, 2009, MBL delivered to us a ninety-day notice of termination of the MBL Distribution Agreement, and accordingly, the MBL Distribution Agreement terminated on March 14, 2010. Upon the termination of this agreement, we exited the biologics & vaccines segment.
Patents, Trademarks and Proprietary Rights. We consider the protection of discoveries in connection with our development activities important to our business. We have sought, and intend to continue to seek, patent protection in the United States and selected foreign countries where deemed appropriate. As of December 31, 2010, we had received two U.S. patents which expire in 2019 and had three additional U.S. patent applications pending and one international patent pending. The importance of these patents does not vary among our business segments.
We also rely upon trademarks, trade secrets, unpatented proprietary know-how and continuing technological innovation to maintain and develop our competitive position. We enter into confidentiality agreements with certain of our employees pursuant to which such employees agree to assign to us any inventions relating to our business made by them while in our employ. However, there can be no assurance that others may not acquire or independently develop similar technology or, if patents are not issued with respect to products arising from research, that we will be able to maintain information pertinent to such research as proprietary technology or trade secrets. See Item 1A. Risk Factors — “Our patents and proprietary rights may not adequately protect our products and processes” for more information.
Employee Relations. As of December 31, 2010, we had 410 full-time employees of which 188 worked at our manufacturing facilities in Decatur, Illinois, 101 worked at our manufacturing facility in Somerset, New Jersey and the remaining 121 worked in corporate support functions, either at our corporate offices in Lake Forest, Illinois, our R&D facility in Skokie, Illinois, our distribution facility in Gurnee, Illinois, or in outside sales in major metropolitan areas throughout the United States. We believe we have good relations with our employees. None of our employees is represented by a collective bargaining agreement.
Competition. The marketing and manufacturing of pharmaceutical products is highly competitive, with many established manufacturers, suppliers and distributors actively engaged in all phases of the business. Most of our competitors have substantially greater financial and other resources, including greater sales volume, larger sales forces and greater manufacturing capacity. See Item 1A. Risk Factors — “Our industry is very competitive. Additionally, changes in technology could render our products obsolete” for more information.
The companies that compete with our ophthalmic segment include Alcon Laboratories, Inc., Allergan Pharmaceuticals, Inc., Novartis International AG, Bausch & Lomb, Inc., and Apotex, among others. The ophthalmic segment competes primarily on the basis of price and service.
The companies that compete with our hospital drugs & injectables segment include both generic and name brand companies such as Hospira, Inc., Teva Pharmaceutical Industries, Fresenius Kabi, American Regent, Inc. and Baxter International, Inc. The hospital drugs & injectables segment competes primarily on the basis of price.
Competitors in our contract services segment include Baxter International, Inc., Hospira, Inc., Ben Venue Laboratories, Inc. and Patheon, Inc. The contract services segment competes primarily on the basis of price and technical capabilities.
Competitors in our biologics & vaccine market included Sanofi Aventis and GlaxoSmithKline plc. The vaccine segment competed primarily on the basis of price and service.
Suppliers and Customers. In 2010, 2009 and 2008, purchases from MBL represented 14%, 38% and 62% of our purchases, respectively. In 2010, 2009 and 2008, MBL was our sole supplier of Td vaccine for our biologics & vaccines segment. As discussed above, our MBL Distribution Agreement terminated on March 14, 2010 and we anticipate no future purchases of vaccine products from MBL. No other suppliers represented 10% or more of our purchases in 2010, 2009 or 2008.
We require a supply of quality raw materials and components to manufacture and package pharmaceutical products for ourselves and for third parties with which we have contracted. The principal components of our products are active and inactive pharmaceutical ingredients and certain packaging materials. Many of these components are available from only a single source and, in the case of many of our ANDAs and NDAs, only one supplier of raw materials has been identified. Because FDA approval of drugs requires manufacturers to specify their proposed suppliers of active ingredients and certain packaging materials in their applications, FDA approval of any new supplier would be required if active ingredients or such packaging materials were no longer available from the specified supplier. The qualification of a new supplier could delay our development and marketing efforts. If for any reason we are unable to obtain sufficient quantities of any of the raw materials or components required to produce and package our products, we may not be able to manufacture our products as planned, which could have a material adverse effect on our business, financial condition and results of operations.
In 2010, 2009 and 2008, a high percentage of our sales were to the three large wholesale drug distributors noted below. These three large wholesale drug distributors account for a large portion of our gross sales, net revenues and accounts receivable in all our business segments except for contract services. The three distributors are:
On a combined basis, these three wholesale drug distributors accounted for approximately 64% of our total gross sales and 45% of our net revenue in 2010, and 70% of our gross accounts receivable as of December 31, 2010. The difference between gross sales and net revenue is that gross sales is calculated before allowances for chargebacks, rebates and product returns (See Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations — “Critical Accounting Policies” for more information).
The table below presents the percentages of our total gross sales, net revenue and gross trade accounts receivable attributed to each of these three wholesale drug distributors as of and for the years ended December 31, 2010, 2009 and 2008:
AmerisourceBergen, Cardinal and McKesson are key distributors of our products, as well as a broad range of health care products for many other companies. None of these distributors is an end user of our products. If sales to any one of these distributors were to diminish or cease, we believe that the end users of our products would find little difficulty obtaining our products either directly from us or from another distributor. However, the loss of one or more of these distributors, together with a delay or inability to secure an alternative distribution source for end users, could have a material negative impact on our revenue, business, financial condition and results of operations. We consider our business relationships with these three wholesalers to be in good standing and have fee for services contracts with each of them. A change in purchasing patterns, a decrease in inventory levels, an increase in returns of our products, delays in purchasing products and delays in payment for products by one or more of these distributors could have a material negative impact on our revenue, business, financial condition and results of operations. See Item 1A Risk factors – “We depend on a small number of distributors, the loss of any of which could have a material adverse effect” for more information.
Backorders. As of December 31, 2010, we had approximately $545,000 of products on backorder as compared to approximately $1,404,000 of backorders as of December 31, 2009. We anticipate filling all current open backorders during 2011.
Government Regulation. Pharmaceutical manufacturers and distributors are subject to extensive regulation by government agencies, including the FDA, the Drug Enforcement Administration (“DEA”), the Federal Trade Commission (“FTC”) and other federal, state and local agencies. The Federal Food, Drug and Cosmetic Act (the “FDC Act”), the Controlled Substance Act and other federal statutes and regulations govern or influence the development, testing, manufacture, labeling, storage and promotion of products that we manufacture and market. The FDA inspects drug manufacturers and storage facilities to determine compliance with its current Good Manufacturing Practices (“cGMP”) regulations, non-compliance with which can result in fines, recall and seizure of products, total or partial suspension of production, refusal to approve NDAs and ANDAs and criminal prosecution. The FDA also has the authority to revoke approval of drug products.
FDA approval is required before any application drug product can be manufactured and marketed. New drugs require the application filing of an 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 application filing of an ANDA. An ANDA does not, for the most part, require clinical studies since safety and efficacy have already been demonstrated by the product originator. However, the ANDA must, for example, provide data demonstrating the equivalency of the generic formulation in terms of bioavailability. The time required by the FDA to review and approve NDAs and ANDAs is variable and, to a large extent, beyond our control.
We are subject to periodic inspections by the FDA and the DEA. In March 2007, we receive an FDA Warning Letter (the “Warning Letter”) following a routine inspection of our Decatur, Illinois manufacturing facility in September 2006. The Warning Letter alleged violations of the current cGMP regulations. We responded to the Warning Letter in April 2007 providing clarifying information and describing corrective actions planned and/or completed After subsequent FDA inspection of our Decatur facility in July/August 2007 and related communications between us and the FDA, we were notified by the FDA in December 2007 that all cGMP issues had been satisfactorily resolved, resulting in removal of the Warning Letter's potential restrictions on new product approvals, approval of the lyophilization and filling operations of the Decatur facility and approval of the site transfer for manufacture of IC Green to the Decatur facility. Subsequent FDA inspections, the most recent of which was conducted during August and September 2010 at our Decatur, Illinois manufacturing facility, have produced no observations resulting in warning letters. The Warning Letter had no impact on FDA approved products manufactured or distributed by our Decatur facility, and we have continued to submit and received FDA approval for the manufacture of additional new products at our manufacturing plants in Decatur, Illinois and Somerset, New Jersey. Throughout the five year period ended December 31, 2010, there have been no product interruptions associated with regulatory inspection or review activities.
Product Recalls. We were prompted to initiate one product recall of our Cyanide Antidote Kit during 2008, due to the third quarter recall notification by Becton, Dickinson and Company (“BD”), of their 60ml syringe. This syringe is included as part of a packaged kit along with drug components manufactured and sourced by us, to support the Cyanide Antidote Kit. Our recall of the Cyanide Antidote Kit was necessitated by the BD recall, and has resulted in no patient impact and no shortage of product supply to the marketplace. We recorded a $440,000 additional provision to sales returns in 2008 to recognize the impact of this recall. In 2009, we recorded an additional sales returns provision of $102,000, which is net of a $140,000 settlement we received from BD related to the Cyanide Antidote Kit recall. Our supporting efforts were reviewed by the FDA, as part of our due diligence in apprising the Agency of our reaction to the BD recall. There were no product recalls during 2010 or 2009.
DEA Regulation. We also manufacture and distribute several controlled-drug substances, the distribution and handling of which are regulated by the DEA. Failure to comply with DEA regulations can result in fines or seizure of product. There were no DEA citations issued to us in 2010 or 2009.
Environment. We do not anticipate any material adverse effect from compliance with federal, state and local provisions that have been enacted or adopted regulating the discharge of materials into the environment, or otherwise relating to the protection of the environment.
Foreign Sales. During 2010, 2009 and 2008, approximately $1,139,000, $818,000 and $1,384,000 of our net revenue, respectively, was from customers located in foreign countries.
Seasonality and other Cyclical Sales Fluctuations. Most of our business segments do not experience significant seasonality. We do market certain allergy products that typically generate higher sales volume in the warmer months, but these products do not materially impact our overall sales trends. Additionally, we market various antidote products through our Hospital Drugs & Injectables segment, the sales of which are largely timed to the expiration of existing stock held by our ongoing customers. The products we previously marketed through our Biologics & Vaccines segment were subject to seasonal fluctuations, with Td vaccines sold in the spring through fall seasons and flu vaccine products typically sold in the August through November period. We discontinued distribution of flu vaccines during 2009 and ceased distribution of Td vaccines as of March 14, 2010 upon the termination of our MBL Distribution Agreement.
Government Contracts. None of our business segments are generally subject to renegotiation of profits or termination of contracts at the election of the Federal government.
Available Information. We file annual, quarterly and special reports, proxy statements and other information with the Securities and Exchange Commission (“SEC”). Materials filed with the SEC can be read and copied at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549, on official business days during the hours of 10 a.m. to 3 p.m. Information on the operation of the Public Reference Room may be obtained by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet web site that contains reports, proxy and information statements and other information regarding issuers that file electronically with the SEC. Our filings are available to the public at the website maintained by the SEC, http://www.sec.gov. We also make available, free of charge, through our web site at www.akorn.com, our reports on Forms 10-K, 10-Q, and 8-K, and amendments to those reports, as soon as reasonably practicable after they are filed with or furnished to the SEC. The information contained on our web site is not a part of this document.
We own two facilities in Decatur, Illinois. One is a 76,000 square foot facility, located on 15 acres of land, which is currently used for packaging, distribution, warehousing and office space. The other is a 65,000 square-foot manufacturing facility. Our Decatur facilities support our ophthalmic, hospital drugs & injectables, and contract services segments.
Our wholly-owned subsidiary, Akorn (New Jersey) Inc. leases approximately 50,000 square-foot facility in Somerset, New Jersey pursuant to a seven-year lease agreement that commenced on August 1, 2010. The lease allows us the option to renew for up to four additional 5-year periods beyond the initial expiration date of July 31, 2017. The Somerset facility is used for drug manufacturing, research and development and administrative activities related to our ophthalmic and hospital drugs & injectables segments.
Our current space in Decatur is considered adequate to accommodate our manufacturing needs for the foreseeable future and we have expanded our manufacturing space and continue to make capital improvement at our Somerset production facility to accommodate both current demand and anticipated future growth opportunities.
Our corporate headquarters and administrative offices consist of 34,000 square feet of leased space in an office building in Lake Forest, Illinois. Effective April 1, 2010, we sublet approximately 4,100 square feet of this space to EJ Financial, a company wholly-owned by the Chairman of our Board of Directors. We also maintain a leased space in Gurnee, Illinois, consisting of 74,000 square feet in total, to accommodate our product warehousing and distribution needs. Both leases extend through March 2018. On February 1, 2010, we took occupancy of a 5,800 square foot leased space in the Illinois Science & Technology Park in Skokie, Illinois for purposes of supporting our research and development efforts. Effective November 30, 2010, we amended the lease to add additional space, bringing the total leased space to 8,700 square feet. The initial term of this lease extends through January 31, 2016.
We are party to legal proceedings and potential claims arising in the ordinary course of our business. The amount, if any, of ultimate liability with respect to such matters cannot be determined. Despite the inherent uncertainties of litigation, we at this time do not believe that such proceedings will have a material adverse impact on our financial condition, results of operations, or cash flows.
On April 3, 2009, our former President and Chief Executive Officer, Arthur Przybyl, filed a demand for arbitration against the Company under his April 24, 2006 Executive Employment Agreement (the "Employment Agreement"). A copy of the Employment Agreement was included as Exhibit 10.1 to the Current Report on Form 8-K we filed with the SEC on April 28, 2006. Mr. Przybyl initiated this arbitration with the Chicago, Illinois office of the American Arbitration Association under an arbitration provision in the Employment Agreement. In his arbitration demand, Mr. Przybyl sought severance and related benefits that would have been payable under the Employment Agreement were Mr. Przybyl terminated without cause and had he met additional requirements. Mr. Przybyl demanded more than $1,250,000. In our response to Mr. Przybyl’s claim, we asserted counterclaims against Mr. Przybyl for (among other things) breach of contract and breach of fiduciary duty. We sought affirmative monetary relief under our counterclaims
On November 9, 2010, we entered into a confidential settlement agreement with Mr. Przybyl. The settlement contained mutual general releases of all claims between the parties. In connection with the settlement, we recognized expenses of approximately $600,000 in the fourth quarter of 2010.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.>
The following table sets forth, for the fiscal periods indicated, the high and low sales prices for our common stock for the two most recent fiscal years and for the first quarter of our current fiscal year. On February 7, 2007, our common stock was listed on the NASDAQ Global Market under the symbol “AKRX” and continues to be listed there as of the date hereof. Previously, from November 24, 2004 until February 6, 2007, our common stock was listed on the American Stock Exchange under the symbol “AKN.”
As of March 9, 2011, 94,189,029 shares of our common stock were outstanding, held by approximately 448 stockholders of record. This number does not include stockholders for which shares are held in a “nominee” or “street” name. The closing price of our common stock on March 9, 2011 was $5.54 per share.
We did not pay cash dividends in 2010, 2009 or 2008 and do not expect to pay dividends on our common stock in the foreseeable future. Moreover, we are currently prohibited from making any dividend payment under the terms of our various financing relationships.
For information regarding unregistered sales of our securities, see Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations – “Overview.”
We did not repurchase any shares of our common stock during the fourth quarter of the fiscal year covered by this report.
EQUITY COMPENSATION PLANS
Equity Compensation Plans Approved by Stockholders.
The Akorn, Inc. 2003 Stock Option Plan (“2003 Stock Option Plan”) was approved by our Board of Directors on November 6, 2003 and approved by our stockholders on July 8, 2004. Under the 2003 Stock Option Plan, 2,519,000 options were granted and none remain outstanding as of December 31, 2010. On March 29, 2005, our Board of Directors approved the Amended and Restated Akorn, Inc. 2003 Stock Option Plan (the “Amended 2003 Plan”), effective as of April 1, 2005, and this plan was subsequently approved by our stockholders on May 27, 2005. The Amended 2003 Plan is an amendment and restatement of the 2003 Stock Option Plan and provides us with the ability to grant other types of equity awards to eligible participants besides stock options. Starting on May 27, 2005, all new awards have been granted under the Amended 2003 Plan. The aggregate number of shares of our common stock authorized to be issued pursuant to awards granted under the Amended 2003 Plan was initially set at 5,000,000. On August 7, 2009, our shareholders voted affirmatively to increase the number of shares available for issuance under the Amended 2003 Plan to 11,000,000. Under the Amended 2003 Plan, 12,258,000 options have been granted to employees and directors, of which 3,884,000 options have been canceled or exchanged, 414,000 have been exercised and 7,960,000 remain outstanding as of December 31, 2010. Options granted under the 2003 Stock Option Plan and the Amended 2003 Plan have exercise prices equivalent to the market value of our common stock on the date of grant and generally vest ratably on each grant date anniversary over a three-year period and expire five years from date of grant.
On November 19, 2009, we completed a tender offer to employees (the “Option Exchange Program”) for the purpose of completing a one-for-one exchange of their existing out-of-the-money vested and unvested options for new options granted at a price per option equal to the greater of $1.34 or the closing market price of our stock on November 19, 2009. The Option Exchange Program applied to shares granted prior to February 27, 2009 under the 2003 Stock Option Plan or the Amended 2003 Plan. Under the terms of the Option Exchange Program, new options were issued with the same vesting schedule and life in years as the surrendered options, except that the clock on both vesting and expiration was restarted on November 19, 2009. Accordingly, in certain cases, vested options were exchanged for unvested options. A total of 1,744,069 options were eligible for exchange and 1,637,652 options were actually surrendered and exchanged under the Option Exchange Program. The grant price on the new options was $1.60 per share, the closing price of our common stock on November 19, 2009. In relation to the Option Exchange Program, we filed a Schedule TO-I with the Securities and Exchange Commission on October 21, 2009 and a Schedule TO-I/A on November 20, 2009 once the offering was completed.
The Amended and Restated Akorn, Inc. Employee Stock Purchase Plan (the “Akorn ESPP”) permits eligible employees to acquire shares of our common stock through payroll deductions in whole percentages from 1% and 15% of base pay, at a 15% discount from the market price of our common stock, subject to an annual maximum purchase of $25,000 in market value of common stock. A maximum of 2,000,000 shares of our common stock may be issued under the terms of the ESPP. Shares issued under the ESPP cannot be sold until ninety days after the purchase date.
The following table sets forth certain information as of December 31, 2010, with respect to compensation plans under which shares of common stock were issuable as of that date. We have no equity compensation plans that have not been approved by our shareholders.
The following table sets forth selected summary historical financial data. We have prepared this table using our consolidated financial statements for the five years ended December 31, 2010. Our consolidated financial statements for 2010, 2009 and 2008 were audited by Ernst & Young LLP, independent registered public accounting firm, and our consolidated financial statements for 2007 and 2006 were audited by BDO Seidman, LLP, independent registered public accounting firm. This summary should be read in conjunction with our audited Consolidated Financial Statements and Notes thereto, and "Item 7 -- Management's Discussion and Analysis of Financial Condition and Results of Operations" and other financial information included herein.
We manufacture and market a full line of diagnostic and therapeutic ophthalmic pharmaceuticals as well as niche hospital drugs and injectable pharmaceuticals. We are a manufacturer and/or marketer of diagnostic and therapeutic pharmaceutical products in various specialty areas, including ophthalmology, antidotes, anti-infectives, controlled substances for pain management and anesthesia, and vaccines, among others. We report revenue and gross profit for four operating segments:
Segment terminated in the quarter ended March 31, 2010:
In 2010 we reported net income rather than a net loss for the first time in a decade, grew revenues from the introduction of several new products, such as Hydromorphone Hydrochloride injection 10mg/mL and Erythromycin ophthalmic ointment, USP 1.0g and 3.5g, and stabilized our financial position and liquidity through cost containment efforts, improved inventory management and better plant utilization. We ended the year with virtually no debt and over $41 million in cash and cash equivalents on our balance sheet. Our cash reserves were significantly bolstered by the $35 million we received from the Joint Venture Company’s sale on December 29, 2010 of all of its ANDAs to Pfizer, Inc. This transaction has provided us with capital that we expect to use to fund future growth plans and opportunities.
Our success during 2010 built on the momentum created by our new management team in the second half of 2009, during which time we focused on cost containment, improved business practices and inventory management, and accelerating our R&D activities to lay the groundwork for future growth.
On March 11, 2010, we completed a private placement of stock with Serum Institute of India (“Serum”), issuing 1,838,235 shares for $2.5 million. In connection with this private placement, we issued 1,404,494 warrants, which were exercised by Serum on May 24, 2010 generating another $2.5 million in cash. This $5 million of cash along with our positive operating cash flow for the year allowed us sufficient reserves to early pay the outstanding balance on our Subordinated Promissory Note (“Subordinated Note”) on December 16, 2010. The Subordinated Note was held by a company controlled by our Chairman.
At the end of the first quarter of 2010, we exited the Biologics & Vaccines segment. Beginning in 2007, we had been engaged in the marketing, sale and distribution of tetanus-diphtheria (“Td”) vaccines and influenza (“flu”) vaccines on behalf of various manufacturers. We terminated distribution of flu vaccines in 2009 and terminated the distribution of Td vaccines in March 2010. Our exit from this segment was the result of a strategic decision to focus on our three core product segments and was hastened by our inability to reach agreement with MBL regarding the terms of a new Td vaccine purchase agreement. We remain committed to growing our three core segments: Ophthalmic; Hospital drugs & injectables; and Contract services.
RESULTS OF OPERATIONS
For the years 2010, 2009 and 2008, we have identified and reported operating results for four distinct business segments: Ophthalmic; Hospital drugs & injectables; Contract services; and Biologics & vaccines. Our reported results by segment are based upon various internal financial reports that disaggregate certain operating information. Our chief operating decision maker, as defined in Accounting Standards Codification (“ASC”) Topic 280, Segment Reporting (formerly SFAS No. 131, Disclosures about Segments of an Enterprise and Related Information), is our CEO. Our CEO oversees operational assessments and resource allocations based upon the results of our reportable segments, all of which have available discrete financial information. We exited the Biologics & vaccines segment in the first quarter of 2010.
The following table sets forth the amounts and percentages of total revenue for certain items from our Consolidated Statements of Operations and our segment reporting information for the years ended December 31, 2010, 2009 and 2008 (dollar amounts in thousands):
COMPARISON OF TWELVE MONTHS ENDED DECEMBER 31, 2010 AND 2009
Our revenues were $86,409,000 in 2010, an increase of $10,518,000, or 13.9%, compared to 2009. This increase in revenue was related to a number of factors, including the introduction of new products, such as Erythromycin ophthalmic ointment and Hydromorphone Hydrochloride, price increases for certain products, and increases in contract manufacturing for the Joint Venture Company and unrelated third party companies. The increases in our core segments – ophthalmic, hospital drugs & injectables and contract services – offset a $25,930,000 decline in biologics & vaccines segment revenues due to our exit from this segment in March 2010.
Our 2010 revenues of $86,409,000 was net of adjustments totaling $50,474,000 for chargebacks, rebates, administration fees, returns, discounts and allowances. Chargeback and rebate expense for 2010 was $45,028,000, or 32.9% of gross revenue, compared to 2009 expense of $29,821,000, or 26.6% of gross revenue. The $15,207,000 increase in chargeback expense was due to higher gross sales volume in 2010 as well as an increase in the percentage of our sales that were through Group Purchasing Organization (“GPO”) contracts and thereby subject to chargeback adjustments. This second factor, along with a shift in segment mix due to our exit from the biologics & vaccines segment, were the primary reasons that chargeback and rebate expenses increased as a percentage of gross sales in 2010. Our products returns provision was $1,535,000 in 2010 compared to $4,806,000 in 2009. This $3,271,000 decrease was due to improved inventory management practices and a related reduction of inventory days of our product at the major wholesalers, which resulted in lower actual product returns and a reduction to potential future returns.
Our consolidated gross profit for 2010 was $42,465,000, or 49.1% of revenue, compared to $15,672,000, or 20.7% of revenue, in 2009. This gross profit increase of $26,793,000, or 171.0%, was due to several factors, including our introduction of new products in 2010 carrying higher profit margins, improved plant utilization and stable wholesaler inventory levels during 2010 compared to a strategic decrease of wholesaler inventory levels in 2009. The gross profit margin on ophthalmic segment sales increased to 59.4% in 2010 compared to 25.5% in 2009, and the gross profit margin on hospital drugs & injectables increased to 47.5% in 2010 compared to 16.7% in the prior year. These increases were due to a variety of factors, including sales from new products that carried higher profit margins, improved plant utilization, and selected price increases for certain of our existing products. The gross profit margin on contract services increased to 36.9% in 2010 compared to 16.0% in the prior year, this increase being primarily attributable to improved plant utilization and price increases for certain products.
Selling, general and administrative (“SG&A”) expenses were $22,721,000 in 2010, a decrease of $122,000, or 0.5%, from the prior year. This small decrease in SG&A expenses, despite the increase in sales volume, was primarily the result of significant cost reductions where we reduced personnel and travel costs, and also negotiated lower fees and operating costs with key service providers toward the end of 2009 and early 2010. This was partially offset by increased management bonus and stock option expense in accordance with our improved financial performance in 2010.
Research and development (“R&D”) expenses were $6,975,000 in 2010 compared to $4,764,000 in 2009. This increase of $2,211,000 was the result of a renewed focus on enhancing our internal R&D infrastructure in 2010, as we opened a new R&D center in Skokie, Illinois early in February 2010 and hired additional scientists to staff it.
Amortization of intangibles consists of the amortization of NDA and ANDA drug acquisition costs over the anticipated market life of the acquired products. Amortization of intangibles was $1,497,000 in 2010 compared to $1,647,000 in 2009. This decline was due to prior year write-downs of various intangible assets, along with the fact that we purchased no additional products in 2010.
In 2009, we incurred $5,929,000 in supply agreement termination expense related to the MBL Distribution Agreement for our distribution of Td vaccine products. We were unable to make scheduled payments to MBL in February and March 2009, and negotiated a settlement agreement with MBL that changed our agreement from an exclusive to a non-exclusive agreement and also eliminated the future minimum purchase commitments contained in the original agreement. We incurred no similar expense in 2010.
Write-off and amortization of deferred financing costs totaled $2,841,000 in 2010 compared to $2,013,000 in 2009. In each year, the majority of the expense was related to write-offs. In December 2010, we early paid the balance due under our Subordinated Note, writing off $1,176,000 of unamortized deferred financing costs and $585,000 of early payment fee. In the prior year, in March 2009 we wrote off $1,454,000 of deferred financing costs upon the assignment of our Credit Agreement from GE Capital to EJ Funds.
Interest expense was $942,000 in 2010 compared to $1,516,000 in the prior year. This decline was related to a lower level of borrowing under our revolving Credit Agreement. We repaid the outstanding balance during the quarter ended March 31, 2010 and made no subsequent borrowings.
We are a 50% partner in the Joint Venture Company, which we account for using the equity method. During 2010, we recorded $23,368,000 of equity in income from this unconsolidated joint venture, compared to $1,580,000 in the prior year. Of the $23,368,000 income in 2010, $21,563,000 was related to our share of the gain from the Joint Venture Company’s sale of its ANDAs to Pfizer on December 29, 2010, and the remaining $1,805,000 was from the Joint Venture Company’s operations. The Joint Venture Company entered into an Asset Purchase Agreement to sell the rights to all of its ANDAs to Pfizer for $63.2 million in cash. This transaction is expected to result in income to Akorn of $34,943,000, of which $21,563,000 was recognized in the fourth quarter of 2010 and the remaining $13,380,000 is expected to be recognized in the second quarter of 2011. The Asset Purchase Agreement contains two closing dates, with some ANDAs having been transferred on the initial close date of December 29, 2010 and the rest to be transferred on the final closing date of May 1, 2011. The gains are being allocated between these two dates based on the relative fair value of the ANDAs transferred to Pfizer on each date. The Joint Venture Company will continue to market and sell the actively-marketed products through April 30, 2011 in “the ordinary course of business”, as defined in the Asset Purchase Agreement. Thereafter, its operations are expected to essentially cease.
During 2010 and 2009, we incurred non-cash expenses of $8,881,000 and $3,843,000, respectively, related to the change in fair value of warrants we granted at various dates in 2009 to companies controlled by our Chairman, Dr. John Kapoor. We classified the Kapoor Warrants as current liabilities from their grant dates until June 28, 2010, and adjusted their book values quarterly to reflect changes in their fair values. As a result of an amendment to the registration rights agreement associated with these warrants, on June 28, 2010 we reclassified the Kapoor Warrants from current liabilities to a component of shareholders’ equity and made no subsequent fair value adjustments beyond that date.
COMPARISON OF TWELVE MONTHS ENDED DECEMBER 31, 2009 AND 2008
Our consolidated revenues were $75,891,000 for 2009, a decrease of $17,707,000, or 18.9%, compared to 2008. This decline was primarily attributable to the biologics & vaccines segment, which generated revenue of $31,111,000 in 2009 compared to $44,602,000 in 2008, a decline of $13,491,000, or 30.2%. This decline related to lower sales of Td vaccine, combined with our decision during 2009 to exit the distribution of flu vaccine. Ophthalmic revenue of $20,169,000 in 2009 was only slightly lower than our 2008 revenue of $20,447,000 for this segment. Hospital drugs & injectables revenue declined by $3,171,000, or 16.2%, in 2009 compared to the prior year due to targeted wholesaler reduction in stocking levels and decreases in sales volume of anesthesia and antidote products. Contract services revenue declined $767,000, or 8.6% in 2009 compared to 2008, mainly due to decreased order volumes on ophthalmic products.
For 2009, our revenue of $75,891,000 was net of adjustments for chargebacks and rebates, returns and discounts and allowances totaling $36,379,000. Chargeback and rebate expense for 2009 was $29,821,000, or 26.6% of gross revenue, compared to the prior year total of $31,330,000, representing 23.9% of revenue. The $1,509,000 decline in chargeback expense was related to the decrease in gross sales volume. The increase in percentage of gross revenue was related to shifts in mix of our business, in part due to a decline in flu and Td vaccine sales. Our products returns provision increased to $4,806,000 in 2009 from $3,159,000 in 2008. This $1,647,000 increase was due to an $863,000 provision related to the Company’s Akten® ophthalmic solution, along with increased provisions due to lower than anticipated pull through on ophthalmic products and an increase in anticipated returns from wholesalers on certain other products.
Our consolidated gross profit for 2009 was $15,672,000, or 20.7% of revenue, compared to $26,592,000, or 28.4% of revenue, in 2008. The $10,920,000 decline in gross profit was due to a combination of lower overall unit sales and lower gross profit margins across all of our segments. The biologics & vaccines gross profit margin was 20.9% in 2009 compared to 29.6% in 2008, this decline being primarily attributable to an increase in the unit cost of Td vaccines. Hospital drugs & injectables segment margins declined to 16.7% in 2009 from 25.7% in 2008 primarily due to a shift in mix toward lower margin products. The ophthalmic segment gross profit margin declined slightly from 28.1% in 2008 to 25.5% in 2009, and the contract services gross profit margin declined from 28.9% in 2008 to 16.0% in 2009. These declines are primarily related to changes in product mix and unabsorbed overhead resulting from a targeted reduction in wholesaler days on hand and a corresponding reduction in production.
Selling, general and administrative (“SG&A”) expenses were $22,843,000 in 2009, a decrease of $2,777,000, or 10.8%, from the prior year. Decreases in salaries, wages and related costs accounted for approximately $2.0 million of this overall decrease. As part of our overall cost-cutting initiative, various positions were restructured or eliminated, resulting in severance expense of $722,000 for the year, less was paid out for sales commissions, and our fringe benefits expense declined, in part due to suspension of our 401(k) employer match as of May 1, 2009. Travel and entertainment expenses declined by approximately $1.0 million in 2009 compared to the prior year. This decline was partially offset by an increase in legal expenses of approximately $300,000.
In early 2009, we incurred $5,929,000 in supply agreement termination expense related to the MBL Distribution Agreement for our distribution of Td vaccine products. We were unable to make scheduled payments to MBL in February and March 2009, and negotiated a settlement agreement with MBL that changed our agreement from an exclusive to a non-exclusive agreement and also eliminated the future minimum purchase commitments contained in the original agreement. We incurred no similar expense in 2008.
Research and development (“R&D”) expenses were $4,764,000 in 2009, a decline of $2,037,000, or 30.0%, compared to the prior year. The decline was primarily related to a decrease in milestone payments to strategic partners and a reduction in write-offs of unusable new product inventories and product filing and licensing fees
In 2009, we recorded interest expense of $1,516,000 compared to $870,000 in the prior year. This increase was due to an overall increase in borrowing levels in 2009 compared to the prior year.
We incurred $2,013,000 in expense in 2009 for the write-off and amortization of deferred financing costs, as we signed a new revolving debt agreement with GE Capital in January 2009 and subsequently wrote off the related deferred financing costs of $1,454,000 in March 2009 when the agreement was assigned from GE Capital to EJ Funds. During 2009, we also incurred non-cash expense of $3,843,000 related to the change in fair value of stock warrants issued during the year. No similar expenses were recorded in 2008.
For the year 2009, we recorded $1,580,000 of equity in earnings of unconsolidated joint venture related to our proportionate share of the earnings of the Joint Venture Company. In 2008, we recorded $295,000 of equity in earnings of unconsolidated joint venture related to the Joint Venture Company. This increase was due to increased sales volume in 2009 compared to 2008, which was the first year the Joint Venture Company began selling product.
FINANCIAL CONDITION AND LIQUIDITY
We had cash and cash equivalents of $41,623,000 as of December 31, 2010 compared to $1,617,000 as of December 31, 2009, an increase of $40,006,000. Our net working capital was $51,673,000 at December 31, 2010 compared to $4,403,000 at December 31, 2009. This increase of $47,270,000 was primarily due to the $35,000,000 distribution we received from the Joint Venture Company related to the sale of its ANDAs to Pfizer on December 29, 2010, as well as our positive operating cash flows during the year.
During 2010, we generated $12,282,000 in positive cash flow from operations. This positive operating cash flow was primarily due to the combination of $21,824,000 of net income, plus $19,489,000 of non-cash expenses. These positive cash flows were partially offset by $23,368,000 amount for the equity in earnings of the Joint Venture Company, a $5,750,000 increase in inventories, and a $2,045,000 increase in accounts receivable. In 2009, we generated negative cash flow from operations of only $1,038,000, despite the fact that our net loss for the year was $25,306,000. This loss and our use of $5,509,000 to pay down accounts payable were largely offset by a $16,996,000 reduction in inventory and $14,722,000 on non-cash expenses.
In 2010, we generated $31,555,000 in cash flow from investing activities. The primary source of this positive investing cash flow was $36,265,000 in distributions from the Joint Venture Company, of which $35,000,000 was received on December 30, 2010 as our proportionate share of the proceeds from the Joint Venture Company’s sale of its ANDAs to Pfizer on December 29, 2010. Partially offsetting these positive cash flows was $4,710,000 of cash used for the purchase of property, plant and equipment, much of which was used for capital projects to expand production capabilities at our manufacturing plants. In 2009, we used $1,397,000 of cash for investing activities, consisting of $1,147,000 used for the purchase of property, plant and equipment, and $250,000 used to acquire drug product licensing rights.
We used $3,831,000 in cash related to financing activities in 2010. In the fourth quarter, we used $6,439,000 in cash to early pay the balance due under our Subordinated Note, plus applicable early payment fee, and we used $3,000,000 in the first quarter to pay off the outstanding balance under our revolving Credit Facility. These uses of cash were partially offset by $4,969,000 in cash generated from a private sale of stock to Serum and subsequent warrant exercise, and $639,000 of proceeds from issuance of stock under our stock option plan and employee stock purchase plan. In 2009, financing activities provided us with cash of $2,989,000, consisting of $3,000,000 borrowed under our revolving Credit Facility and $1,359,000 generated from employee stock plan activity, partially offset by $1,370,000 used to pay loan origination fees.
As of December 31, 2010, we had $41,623,000 in cash and cash equivalents and no outstanding balance under our credit facility with EJ Funds, leaving us the full $10,000,000 in borrowing capacity as of December 31, 2010. There are no fees assessed on the unused portion of the Credit Facility. We believe that our cash reserves, operating cash flows and availability under our Credit Facility will be sufficient to meet our cash needs for the foreseeable future.
We are party to a $10 million revolving Credit Agreement (the “Credit Agreement”) with EJ Funds LP (“EJ Funds”) that extends through January 7, 2013. Originally, we entered into the Credit Agreement on January 7, 2009 with General Electric Credit Corporation (“GE Capital”) as agent for several financial institutions (the “Lenders”) to replace our previous Credit Facility with Bank of America that expired on January 1, 2009. Pursuant to the Credit Agreement, the Lenders agreed, among other things, to extend loans to us under a revolving credit facility (including a letter of credit sub-facility) up to an aggregate principal amount of $25,000,000 (the “Credit Facility”). At our election, borrowings under the Credit Facility bore interest at a rate equal to either: (i) the base rate (defined as the highest of the Wall Street Journal prime rate, the federal funds rate plus 0.5% or LIBOR plus 1.0%), plus a margin equal to (x) 4% for the period commencing on the closing date through April 14, 2009, or (y) a percentage that ranged between 3.75% and 4.25% for the period after April 14, 2009, or (ii) LIBOR (or 2.75%, if LIBOR is less than 2.75%), plus a margin equal to (x) 5% for the period commencing on the closing date through April 14, 2009, or (y) a percentage that ranged between 4.75% and 5.25% for the period after April 14, 2009. Upon the occurrence of any event of default, we were to pay interest equal to an additional 2.0% per year. The Credit Agreement contained affirmative, negative and financial covenants customary for financings of this type. The negative covenants included restrictions on liens, indebtedness, payments of dividends, disposition of assets, fundamental changes, loans and investments, transactions with affiliates and negative pledges. The financial covenants included fixed charge coverage ratio, minimum-EBITDA, minimum liquidity and a maximum level of capital expenditures. In addition, our obligations under the Credit Agreement could have been accelerated upon the occurrence of an event of default under the Credit Agreement, which included customary events of default such as payment defaults, defaults in the performance of affirmative and negative covenants, the inaccuracy of representations or warranties, bankruptcy and insolvency related defaults, defaults relating to judgments, defaults relating to certain governmental enforcement actions, and a change of control default.
Also on January 7, 2009, in connection with the Credit Agreement, we entered into a Guaranty and Security Agreement (the “Guaranty and Security Agreement”) with GE Capital, as agent for the Lenders and each other secured party thereunder. Pursuant to the Guaranty and Security Agreement, we granted a security interest to GE Capital in the collateral described in the Guaranty and Security Agreement as security for the Credit Facility. Our obligations were secured by substantially all of its assets, excluding its ownership interest in Akorn-Strides, LLC and in certain licenses and other property in which assignments are prohibited by confidential provisions.
In connection with the Credit Agreement, on January 7, 2009, we also entered into a Mortgage, Security Agreement, Assignment of Leases and Rents, Financing Statement and Fixture Filing by us, in favor of GE Capital, relating to the real property owned by us located in Decatur, Illinois. The mortgage granted a security interest in the two parcels of real property to GE Capital, as security for the Credit Facility.
On January 7, 2009, we also entered into a Subordination Agreement with the Kapoor Trust and GE Capital, as agent for the Lenders. Pursuant to the Subordination Agreement, the Kapoor Trust and we agreed that the Subordinated Note payable to the Kapoor Trust was subordinated to the Credit Facility, except that so long as there was no event of default outstanding under the Credit Agreement, we could repay that debt in full if the repayment occurred by July 28, 2009.
On February 19, 2009, GE Capital informed us that it was applying a reserve against availability which effectively restricted our borrowings under the Credit Agreement to the balance outstanding as of February 19, 2009, which was $5,523,620. GE Capital advised that it had applied this reserve due to concerns about financial performance, including our prospective compliance with certain covenants in the Credit Agreement for the quarter ended March 31, 2009.
On March 31, 2009, we consented to an Assignment Agreement (“Assignment”) between GE Capital and EJ Funds which transferred to EJ Funds all of GE Capital’s rights and obligations under the Credit Agreement. Pursuant to the Assignment, EJ Funds became the agent and lender under the Credit Agreement. Accordingly, GE was no longer our lender. Dr. Kapoor is the President of EJ Financial Enterprises, Inc., a healthcare consulting investment company (“EJ Financial”) and EJ Financial is the general partner of EJ Funds. Dr. Kapoor is also the Chairman of our Board of Directors and a significant shareholder in our company.
In connection with the Assignment of the Credit Agreement to EJ Funds, on April 13, 2009, we entered into a Modification, Warrant and Investor Rights Agreement (the “Modification Agreement”) with EJ Funds that, among other things, (i) reduced the revolving loan commitment under the Credit Agreement to $5,650,000, (ii) provided an extended cure period until July 22, 2009 for any event, other than specified types of “material defaults” listed in the Modification Agreement, which could constitute an event of default under the Credit Agreement, unless that period is terminated earlier due to the occurrence of a material default or as otherwise provided in the Modification Agreement, (iii) set the interest rate for all amounts outstanding under the Credit Agreement at an annual rate of 10% with interest payable monthly, (iv) granted a security interest in and lien upon all the collateral under the Credit Agreement to the Kapoor Trust as security for the Subordinated Note, and (v) requires the us, within 30 days after the date of the Modification Agreement, to enter into security similar to the corresponding security documents under the Credit Agreement for the Kapoor Trust’s interest in connection with the Subordinated Note. The Modification Agreement also granted EJ Funds the right to require us to nominate two directors to serve on its Board of Directors. The Kapoor Trust is entitled to require us to nominate a third director under its Stock Purchase Agreement dated November 15, 1990 with the Kapoor Trust. In addition, we agreed to pay all accrued legal fees and other expenses of EJ Funds that relate to the Credit Agreement and other loan documents, including legal expenses incurred with respect to the Modification Agreement and the Assignment.
Pursuant to the Modification Agreement, on April 13, 2009, we granted EJ Funds a warrant (the “Modification Warrants”) to purchase 1,939,639 shares of its common stock at an exercise price of $1.11 per share, subject to certain adjustments. The Modification Warrants expire five years after issuance and are exercisable upon payment of the exercise price in cash or by means of a cashless exercise yielding a net share figure. Under the Modification Agreement, we have the right to convert the Subordinated Note into term indebtedness under the Credit Agreement in exchange for additional warrants, on terms substantially identical to the Modification Warrant, to purchase 343,299 shares of its common stock for each $1,000,000 of converted debt. The exercise price of those warrants would also be $1.11 per share.
On August 17, 2009, we completed negotiations with EJ Funds for additional capacity on its Credit Facility, increasing the loan commitment from $5,650,000 to $10,000,000. The Credit Facility is secured by our assets and is not subject to debt covenants until April 1, 2010. In connection with this loan commitment increase, we issued EJ Funds 1,650,806 warrants (the “Credit Facility Warrants”) to purchase its common stock at an exercise price of $1.16, the closing price of our stock on August 14, 2009. The estimated fair value of these warrants, using a Black-Scholes valuation model, was $1,238,000 on August 17, 2009, and this amount was capitalized as financing costs and is being amortized over the remaining term of the Credit Facility.
In 2008, we capitalized $272,000 of loan origination fees and costs in association with the Credit Facility. In 2009, we incurred closing costs and additional legal fees related to the Credit Facility of $1,182,000. Upon the assignment of the Credit Facility to EJ Funds effective March 31, 2009, we expensed the total deferred financing costs of $1,454,000 and capitalized $1,518,000 in costs related to the Assignment. This $1,518,000 represents the fair value of the Modification Warrants and other ancillary costs we incurred related to the Assignment of the Credit Facility to EJ Funds. This $1,518,000 along with the $1,238,000 we capitalized on August 17, 2009 in connection with our issuance of the Credit Facility Warrants is being amortized over the remaining life of the Credit Facility. In 2010, we recorded expense of $772,000 related to our amortization of these deferred financing costs.
On January 13, 2010, the parties entered into an amendment to the Credit Agreement which, among other things, reduced the number of financial covenants to two: (1) a limit on capital expenditures of $7,500,000 in 2010, $5,000,000 in 2011, and $5,000,000 in 2012 and (2) a requirement to have positive liquidity throughout the life of the Credit Agreement. Positive liquidity is defined as the revolving line of credit borrowing base (up to $10,000,000) plus cash and cash equivalents less the outstanding principal on the revolving line of credit, the total of which must be greater than zero. The capital expenditures limit allows that any unused portion from one year may be carried over and added to the next year’s limit.
On January 27, 2011, we and EJ Funds signed a Waiver and Consent that waived our obligation to comply with the capital expenditure limit for 2011.
On July 28, 2008, we borrowed $5,000,000 from the Kapoor Trust dated September 20, 1989, the sole trustee and sole beneficiary of which is Dr. John N. Kapoor, the Chairman of our Board of Directors and the holder of a significant stock position in the Company, in return for issuing the trust a Subordinated Note. The Subordinated Note accrued interest at a rate of 15% per year and was due and payable on July 28, 2009.
On August 17, 2009, we refinanced our $5,000,000 Subordinated Note payable to the Kapoor Trust. The principal amount was increased to $5,853,267 to include interest accrued through August 16, 2009 and the term of the Subordinated Note was extended by an additional five years to August 17, 2014. The interest rate remained unchanged at 15% per year, and interest on the refinanced note was payable monthly. As part of this refinancing agreement, we issued to the Kapoor Trust an additional 2,099,935 warrants (the “Subordinated Note Warrants”) to purchase our common stock at an exercise price of $1.16, the closing price of the our stock on August 14, 2009. The fair value of these warrants on August 17, 2009, as calculated using a Black-Scholes valuation model, was $1,575,000. This amount, along with $28,000 in legal fees, was capitalized as deferred financing costs and was being amortized over the term of the subordinated debt.
On December 16, 2010, we voluntarily prepaid the principal of the Subordinated Note, along with a 10% early payment fee and all accrued interest. Our total cash payment on December 16, 2010, including principal, accrued interest, and the early payment fee, was $6,475,176. Upon completing this early payment we expensed the remaining $1,176,000 unamortized balance of the $1,603,000 in deferred financing costs incurred when we refinanced the Subordinated Note.
In June 1998, we entered into a 10-year, $3,000,000 mortgage agreement with Standard Mortgage Investors, LLC. The mortgage note bore a fixed interest rate of 7.375% and was secured by the real property located in Decatur, Illinois. The final payment of principal and interest was completed in the second quarter of 2008 to retire this mortgage.
Preferred Stock and Warrants
Series B Preferred Stock and Warrants
On August 23, 2004, we issued to certain investors an aggregate of 141,000 shares of Series B 6.0% Participating Preferred Stock (“Series B Preferred Stock”) at a price of $100 per share, that was convertible into common stock at a price of $2.70 per share, with warrants to purchase 1,566,667 additional shares of common stock at an exercise price of $3.50 per share (the “Series B Warrants”). There were 455,556 Series B Warrants outstanding as of December 31, 2008. These remaining warrants expired unexercised on August 23, 2009. We received net proceeds of approximately $13,044,000 from our issuance of the Series B Preferred Stock. This dollar amount is net of investment banker fees and expenses and other transaction costs of approximately $1,056,000.
On March 8, 2006, we issued 4,311,669 shares of our common stock in a private placement with various investors at a price of $4.50 per share which included warrants to purchase 1,509,088 additional shares of common stock. The warrants were exercisable for a five year period ended March 8, 2011 at an exercise price of $5.40 per share and may be exercised by cash payment of the exercise price or by means of a cashless exercise. Holders submitted 77,779 warrants for cashless exercise during 2010, leaving 1,431,309 remaining outstanding as of December 31, 2010. Subsequently, during the period from January 1, 2011 through March 8, 2011, holders submitted 1,197,975 of the warrants for exercise. The remaining 233,334 warrants expired unexercised on March 8, 2011.
During 2009, in connection with modifications to our Subordinated Note, Credit Agreement and MBL Distribution Agreement, we granted various warrants to acquire our common stock (the “Kapoor Warrants”) to EJ Funds and the Kapoor Trust, companies controlled by the Chairman of our Board of Directors, Dr. John N. Kapoor. Each of the Kapoor Warrants will expire five years after its grant date, if not exercised.
The fair value of each of the Kapoor Warrants was calculated at their grant dates using the Black-Scholes option pricing model. From their grant dates until June 28, 2010, the Kapoor Warrants were classified as current liabilities on our consolidated balance sheets and adjusted quarterly to reflect changes in their calculated fair values. Increases in fair value, or decreases in fair value to, but not below, their initial calculated fair values, were recorded as non-operating expenses or income in our condensed consolidated statements of operations for the applicable periods. We classified the fair value of the Kapoor Warrants as a current liability in accordance with ASC 815-40-15-3, Derivatives and Hedging, (formerly EITF 00-19, Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock) . This is a result of a requirement in the Registration Rights Agreement – entered into among the Kapoor Trust, EJ Funds and us on August 17, 2009 – that the shares to be issued upon exercise of the warrants be registered shares, which cannot be absolutely assured.
On June 28, 2010, we entered into an Amended and Restated Registration Rights Agreement (the “Amended Agreement”) with Dr. Kapoor which modified certain terms related to our obligation to obtain and maintain registration of any shares issued pursuant to exercise of the Kapoor Warrants. The Amended Agreement still requires us to use “commercially reasonable efforts” to file a registration statement pursuant to Rule 415 of the Securities Act of 1933 (“Registration Statement”) for any shares of common stock that may be issued under the applicable warrant agreements, and to maintain the continuous effectiveness of such Registration Statement until the earliest of: (i) the date no shares of the our common stock qualify as registrable securities, (ii) the date on which all of the registrable securities may be sold in a single transaction by the holder to the public pursuant to Rule 144 or similar rule, or (iii) the date upon which the John N. Kapoor Trust dated September 20, 1989 (the “Kapoor Trust”) and EJ Funds, LP (“EJ Funds”) have transferred all of the registrable securities. However, the Registration Rights Agreement has been amended to explicitly state that in the event that we, after using good faith commercially reasonable efforts, are not able to obtain or maintain registration of the common stock, delivery of unregistered shares upon exercise of the Kapoor Warrants will be deemed acceptable and a net cash settlement will not be required. The Amended Agreement further provides that the term “commercially reasonable efforts” in such instance shall not mean an absolute obligation of ours to obtain and maintain registration.
On June 28, 2010, upon entering into the Amended Agreement, we completed a final Black-Scholes calculation of the fair value of the Kapoor Warrants and adjusted their book value accordingly, then reclassified the Kapoor Warrants from a current liability to a component of shareholders’ equity. No future fair value adjustments are required.
The increases in fair value of the Kapoor Warrants have been recorded as expenses under the caption “Change in fair value of warrants liability” in our consolidated statement of operations for the years ended December 31, 2010 and 2009. We recorded expenses of $8,881,000 and $3,843,000 during 2010 and 2009, respectively, related to the increase in fair value of the Kapoor Warrants.
The assumptions used in estimating the fair value of the warrants at June 28, 2010 and December 31, 2009 were as follows:
The following table provides summarized information about the Kapoor Warrants:
In our efforts to continually increase and update the list of pharmaceutical products that we market and sell, we will from time to time partner with outside firms for the development of selected product. These development agreements frequently call for the payment of “milestone payment” as various steps in the process are completed in relation to product development and submission to the FDA for approval. The dollar amount of these payments is generally fixed contractually, assuming that the required milestones are achieved. However, the timing of such payments is contingent based on a variety of factors and is therefore subject to change. The amounts disclosed below under the caption “Strategic Partners – Contingent Payments” represents our best estimate of the amount and expected timing of the “milestone payments” and other fees we expect to pay to outside development partners based on our current contractual agreements with them.
As more fully described in Properties on Page 16, we lease the facilities that we occupy in Gurnee, Lake Forest and Skokie, Illinois and in Somerset, New Jersey. We also lease various office equipment at these facilities and our manufacturing plant in December, Illinois. Our remaining obligations under these leases are summarized in the table below.
On December 16, 2010, we paid off the outstanding principal balance payable under our Subordinated Note, and as of December 31, 2010, we had no outstanding balance under our $10,000,000 revolving Credit Facility. Accordingly, we have no current or long-term debt outstanding at December 31, 2010 related to either the Subordinated Note or the Credit Facility.
The following table details our future contractual obligations as of December 31, 2010 (in thousands):
On March 27, 2007, we entered into an Exclusive Distribution Agreement with the Massachusetts Biologic Laboratories of the University of Massachusetts Medical School (“MBL”) to be the distributor for their Tetanus Diphtheria (“Td”) vaccines in the United States (the “MBL Distribution Agreement”). The MBL Distribution Agreement obligated us to minimum purchase quantities in exchange for being MBL’s exclusive distributor of Td vaccines. We were subsequently unable to meet our payment obligations to MBL in February and March 2009, falling $5,750,000 in arrears. Accordingly, we entered into a letter agreement with MBL on March 27, 2009 (“MBL Letter Agreement”), pursuant to which we agreed to pay MBL the $5,750,000 remaining due for these Td vaccine products plus an additional $4,750,000 in consideration of the amendments to the MBL Distribution Agreement payable according to a periodic payment schedule through June 30, 2010 (the “Settlement Payments”). In addition, pursuant to the MBL Letter Agreement, the MBL Distribution Agreement was converted to a non-exclusive agreement, we became obligated to provide MBL with a standby letter of credit (the “L/C”) to secure our obligation to pay amounts due to MBL, and we were released from our obligation to further purchase Td vaccine products from MBL upon providing MBL with such L/C. In addition, pursuant to the MBL Letter Agreement, MBL agreed not to declare a breach or otherwise act to terminate the MBL Distribution Agreement if we complied with the terms of the MBL Letter Agreement, the MBL Distribution Agreement (as amended by the MBL Letter Agreement) and any agreements required to be entered into pursuant to the MBL Letter Agreement.
On April 15, 2009, we entered into a Settlement Agreement with MBL (the “MBL Settlement Agreement”). See Item 1. Business for more information regarding the MBL Letter Agreement. The MBL Settlement Agreement provided that we will pay MBL the Settlement Payments according to a monthly payment schedule through June 30, 2010. The MBL Settlement Agreement provided that MBL could only draw on the L/C if: (i) we failed to make any Settlement Payment when due, (ii) any Settlement Payment made was set aside or otherwise required to be repaid by MBL, or (iii) we became the debtor in a bankruptcy or other insolvency proceeding that began before October 6, 2010 and no replacement letter of credit had been issued prior to the expiration of the L/C. On April 15, 2009, we entered into a Reimbursement and Warrant Agreement (the “Reimbursement Agreement”) with EJ Funds and the Kapoor Trust pursuant to which the Kapoor Trust agreed to provide the L/C as security for our payment obligations to MBL under the MBL Letter Agreement and the MBL Settlement Agreement. Simultaneous with the delivery of the Reimbursement Agreement, the L/C was issued by the Bank of America in favor of MBL. The Reimbursement Agreement provided, among other things, that we would reimburse the Kapoor Trust for any draws by MBL under the L/C through the mechanism of causing the amount of the draws to become term indebtedness payable to the Kapoor Trust on the same terms as the revolving debt under the Credit Agreement. All of our obligations under the Reimbursement Agreement would also be considered secured obligations under the Credit Agreement. Pursuant to the Reimbursement Agreement, we also issued a warrant to the Kapoor Trust (the “Reimbursement Warrant”) to purchase 1,501,933 shares of our common stock at an exercise price of $1.11 per share, subject to certain adjustments. The Reimbursement Warrant expires five years from the date of issuance and is exercisable upon payment of the exercise price in cash or by means of a cashless exercise yielding a net share figure. In addition, the Reimbursement Agreement provided that if funds were drawn against the L/C, we would be required to issue the Kapoor Trust additional warrants to purchase 200,258 shares of our common stock, at $1.11 per share, for every $1,000,000 drawn on the L/C.
We submitted all Settlement Payments during 2009 and 2010 in accordance with the periodic payment schedule in the MBL Settlement Agreement, submitting our final payment of $1,500,000 on June 30, 2010. We have no further financial obligations to MBL under the MBL Settlement Agreement. In addition, in accordance with the terms contained in the MBL agreements, our L/C requirement expired on October 3, 2010, ninety-five (95) days after June 30, 2010, the date we submitted our final payment due under the MBL Settlement Agreement.
SELECTED QUARTERLY FINANCIAL DATA (UNAUDITED)
CRITICAL ACCOUNTING POLICIES
We recognize product sales for our ophthalmic, hospital drugs & injectables, and biologics & vaccines business segments upon the shipment of goods or upon the delivery of goods, depending on the sales terms. 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 or service as appropriate. Revenue is recognized when all of our obligations have been fulfilled and collection of the related receivable is probable. Provision for estimated doubtful accounts, 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.
Allowance for Chargebacks and Rebates
We enter into contractual agreements with certain third parties such as hospitals and GPOs to sell certain products at predetermined prices. The parties have elected to have these contracts administered through wholesalers that buy the product from us and subsequently sell it to those third parties. When a wholesaler sells products to one of the third parties that are subject to a contractual price agreement, the difference between the price paid to us by the wholesaler and the price under the specific contract is charged back to us by the wholesaler. We track sales and submitted chargebacks by product number and contract for each wholesaler. Utilizing this information, we estimate a chargeback percentage for each product. We reduce gross sales and increase the chargeback allowance by the estimated chargeback amount for each product sold to a wholesaler. We reduce the chargeback allowance when we process a request for a chargeback from a wholesaler. Actual chargebacks processed can vary materially from period to period based upon actual sales volume through the wholesalers. However, our provision for chargebacks is fully reserved for at the time when sales revenues are recognized.
We obtain certain wholesaler inventory reports to aid in analyzing the reasonableness of the chargeback allowance that will be paid out in the future. We assess the reasonableness of our chargeback allowance by applying the product chargeback percentage based on historical activity to the quantities of inventory on hand per the wholesaler inventory reports and an estimate of in-transit inventory that is not reported on the wholesaler inventory reports at the end of the period. In accordance with our accounting policy, our estimate of the percentage amount of wholesaler inventory that will ultimately be sold to a third party that is subject to a contractual price agreement is based on a six-quarter trend of such sales through wholesalers. We use this percentage estimate until historical trends or new information indicates that a revision should be made. On an ongoing basis, we evaluate our actual chargeback rate experience and new trends are factored into our estimates each quarter as market conditions change.
The historical percentages that we have used during 2008, 2009 and 2010 are as follows:
We will continue to use the 98.5% estimate in future periods until trends indicate that a revision should be made.
Similarly, we maintain an allowance for rebates related to fee for service contracts and other programs with certain customers. Rebate percentages vary by product and by volume purchased by each eligible customer. We track sales by product number for each eligible customer and then apply the applicable rebate percentage, using both historical trends and actual experience to estimate our rebate allowance. We reduce gross sales and increase the rebate allowance by the estimated rebate amount when we sell our products to our rebate-eligible customers. We reduce the rebate allowance when we process a customer request for a rebate. At each balance sheet date, we analyze the allowance for rebates against actual rebates processed and make necessary adjustments as appropriate. Actual rebates processed can vary materially from period to period. However, our provision for rebates is fully reserved for at the time when sales revenues are recognized.
The recorded allowances reflect our current estimate of the future chargeback and rebate liability to be paid or credited to our wholesaler and other customers under the various contracts and programs. For the years ended December 31, 2010, 2009 and 2008, we recorded chargeback and rebate expense of $45,209,000, $29,820,000 and $31,330,000, respectively. The allowances for chargebacks and rebates were $2,522,000 and $3,234,000 as of December 31, 2010 and 2009, respectively. The current year decline in our allowance for chargebacks and rebates was the result of a strategic decline in inventory carrying levels of our products at key wholesalers combined with our phase out of Td vaccines. This decline resulted in lower volume of product being subject to future chargeback and rebate claims.
Allowance for Product Returns
Certain of our products are sold with the customer having the right to return the product within specified periods and guidelines for a variety of reasons, including but not limited to pending expiration dates. Provisions are made at the time of sale based upon tracked historical experience, by customer in some cases. We estimate our required product returns reserve based on historical percentage of returns to sales by product, considering actual returns processed to date, the expected impact of product recalls and current wholesaler inventory levels of our products to assess the magnitude of unconsumed product that may result in future product returns. For new products, we assess the market dynamics for that product and consider our past returns experience for similar products in our portfolio.
Until 2008, we had estimated our required sales returns reserve based on our historical percentage of returns to sales utilizing a twelve month look back period. In 2008, we performed a specific detailed review of returns by product/lot and determined that the lag time between product sale and return was longer than we had previously estimated. The gross impact of this adjustment was $761,000 which was partially offset by $418,000 in reduced chargeback liability which specifically relates to this revision in the sales returns reserve estimate. We recorded this change in estimate in the fourth quarter of 2008. One-time historical factors or pending new developments that would impact the expected level of returns are taken into account to determine the appropriate reserve estimate at each balance sheet date. The sales returns level can be impacted by factors such as overall market demand and market competition and availability for substitute products which can increase or decrease the end-user pull through for sales of our products and ultimately impact the level of sales returns. Actual returns experience and trends are factored into our estimates each quarter as market conditions change. Actual returns processed can vary materially from period to period.
For the years ended December 31, 2010, 2009 and 2008, we recorded a net provision for product returns of $1,535,000, $4,806,000 and $3,159,000, respectively. The decline in our 2010 provision compared to the prior two years was primarily the result of improving our inventory management practices and reducing wholesaler inventory levels of our products. The 2009 provision included an $863,000 provision related to our Akten® ophthalmic solution, along with increases due to lower than anticipated pull through on ophthalmic products and an increase in anticipated returns from wholesalers on certain other products. The 2008 provision includes the impact of discontinuing our multi-dose Td vaccine product, a recall associated with a supplier’s syringe in our Cyanide Antidote Kit product, the revision in our lag estimate, increased sales and unfavorable wholesaler product returns experience. The allowances for potential product returns were $3,463,000 and $3,192,000 at December 31, 2010 and 2009, respectively.
Allowance for Doubtful Accounts
Provisions for doubtful accounts, which reflect trade receivable balances owed to us that are believed to be uncollectible, are recorded as a component of SG&A expenses. In estimating the allowance for doubtful accounts, we consider our historical experience with collections and write-offs, the credit quality of our customers and any recent or anticipated changes thereto, and the outstanding balances and past due amounts from our customers.
For the years ended December 31, 2010, 2009 and 2008, we recorded a net expense/(benefit) for doubtful accounts of $92,000, $(18,000) and $17,000, respectively. The expense in 2010 was related to accounts newly-identified as uncollectible, while the reversal of expense in 2009 was due to recoveries and a reduction to previously estimated reserve requirements. Our allowance for doubtful accounts was $3,000 and $4,000 as of December 31, 2010 and 2009, respectively. As of December 31, 2010, we had a total of $833,000 of past due gross accounts receivable, of which $67,000 was more than 60 days past due. On a monthly basis, we perform a detailed analysis of the receivables due from our wholesaler customers and provide a specific reserve against known uncollectible items for each of the wholesaler customers. We also include in the allowance for doubtful accounts an amount that we estimate to be uncollectible for all other customers based on a percentage of the past due receivables. The percentage we reserve increases as the age of the receivables increases.
Allowance for Slow-Moving and Obsolete Inventory
Inventories are stated at the lower of cost (average cost method) or market. We maintain an allowance for slow-moving and obsolete inventory as well as inventory with a carrying value in excess of its net realizable value (“NRV”). For finished goods inventory, we estimate the amount of inventory that may not be sold prior to its expiration or is slow-moving based upon recent sales activity by unit and wholesaler inventory information. We also analyze our raw material and component inventory for slow moving items. For the years ended December 31, 2010, 2009 and 2008, we recorded a provision for inventory obsolescence in cost of sales of $725,000, $1,936,000 and $765,000, respectively. The allowance for inventory obsolescence/NRV was $1,612,000 and $1,780,000 as of December 31, 2010 and 2009, respectively. The increase in the 2009 provision and allowance was mainly due to our decision to phase out certain products.
We capitalize inventory costs associated with our products prior to regulatory approval when, based on management judgment, future commercialization is considered probable and the future economic benefit is expected to be realized. We assess the regulatory approval process and where the product stands in relation to that approval process including any known constraints or impediments to approval. We consider the shelf life of the product in relation to the product timeline for approval.
The product warranty liability primarily relates to a ten-year expiration guarantee on DTPA Products sold to HHS in 2006. We are performing yearly stability studies for this product and, if the annual stability does not support the ten-year product life, we will replace the product at no charge. Our supplier, Hameln Pharmaceuticals, will also share one-half of this cost if the product does not meet the stability requirement. If the ongoing product testing confirms the ten-year stability for the DTPA Products we will not incur a replacement cost and this reserve will be eliminated with a corresponding reduction to cost of sales after the ten-year period.
Deferred income tax assets and liabilities are determined based on differences between the tax and book bases of assets and liabilities, as well as net operating loss and other tax credit carry-forwards. Our deferred tax assets and liabilities are measured using the enacted tax rates and laws that will likely be in effect when the differences are expected to reverse. We record a valuation allowance to reduce deferred income tax assets to the amount that is more likely than not to be realized.
We recorded operating losses totaling $91,908,000 over the ten-year period ended December 31, 2009, generating large net operating loss (“NOL”) carry-forwards during that time. Due to significant doubts regarding our ability to ultimately realize the benefits of those NOL carry-forwards, as of both December 31, 2010 and 2009, we recorded valuation allowances equal to 100% of our net deferred tax assets.
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 6 years to 18 years. Accumulated amortization was $23,263,000 and $21,766,000 at December 31, 2010 and 2009, respectively. Amortization expense was $1,497,000, $1,648,000 and $1,354,000 for the years ended December 31, 2010, 2009, and 2008, respectively. We regularly assess our intangibles for impairment based on several factors, including estimated fair value and anticipated cash flows.
Stock-based compensation cost is estimated at the grant date based on the fair value of the award, and the cost is recognized as expense ratably over the vesting period. We use the Black-Scholes model for estimating the grant date fair value of stock options. Determining the assumptions that enter into the model is subjective and requires a certain amount of judgment. We use an expected volatility that is based on the historical volatility of our stock. The expected life assumption is based on historical employee exercise patterns and employee post-vesting terminations experience. The risk-free interest rate for the expected term of the option is based on the average market rate on U.S. treasury securities in effect during the quarter in which the options were granted. The dividend yield has historically been set at zero, reflecting the fact that we have not historically issued dividends and do not anticipate issuing dividends in the foreseeable future. We estimate forfeitures at the time of grant and revise our estimates in subsequent periods, when necessary, if actual forfeitures differ from those estimates.
RECENT ACCOUNTING PRONOUNCEMENTS
During the second quarter of 2009, we adopted guidance issued by the FASB in April 2009 that requires entities to provide disclosure of the fair value of all financial instruments within the scope of ASC 825, Financial Instruments, for which it is practicable to estimate that value, in interim reporting periods as well as in annual financial statements. Our cash, accounts receivable, accounts payable and debt obligations approximate fair value at December 31, 2010 and 2009.
During the second quarter of 2009, we adopted ASC 855, Subsequent Events (formerly SFAS No. 165, Subsequent Events) which establishes general standards of accounting for and disclosure of events that occur after the balance sheet date but before financial statements are issued for interim and annual periods ending after June 15, 2009. We have considered the accounting and disclosure of events occurring after the balance sheet date through the date and time of issuance of our financial statements. The adoption of this standard had no impact on our consolidated financial statements.
As of December 31, 2010, we had no debt. Further, our existing $10,000,000 Credit Facility carries a fixed interest rate of 10%. Accordingly, we have no market risk related to debts.
We have no material foreign exchange risk. Foreign sales are immaterial to our total sales and are all transacted in U.S. dollars. Our cash and debt is entirely denominated in U.S. currency.
Our financial instruments include cash and cash equivalents, accounts receivable and accounts payable. The fair values of cash and cash equivalents, accounts receivable and accounts payable approximate fair value because of the short maturity of these instruments.
At December 31, 2010, our cash and cash equivalents of $41,623,000 were held in accounts that were not subject to market risk.
The following financial statements are included in Part II, Item 8 of this Form 10-K.
Reports of Independent Registered Public Accounting Firm
Consolidated Balance Sheets as of December 31, 2010 and 2009
Consolidated Statements of Operations for the years ended December 31, 2010, 2009 and 2008
Consolidated Statements of Shareholders’ Equity for the years ended December 31, 2010, 2009 and 2008
Consolidated Statements of Cash Flows for the years ended December 31, 2010, 2009 and 2008
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of Akorn, Inc.
We have audited the accompanying consolidated balance sheets of Akorn, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity, and cash flows for each of the three years in the period ended December 31, 2010. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of Akorn, Inc. at December 31, 2010 and 2009, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2010, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), Akorn, Inc.’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 11, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
March 11, 2011
Report of Independent Registered Public Accounting Firm
The Board of Directors and Shareholders of Akorn, Inc.
We have audited Akorn, Inc.’s internal control over financial reporting as of December 31, 2010 based on criteria established in Internal Control – Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). Akorn, Inc.’s management is responsible for maintaining effective internal control over financial reporting, and for its assessment of the effectiveness of internal control over financial reporting included in the accompanying Management’s Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on the company's internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, testing and evaluating the design and operating effectiveness of internal control based on the assessed risk, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company's internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, Akorn, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Akorn, Inc. as of December 31, 2010 and 2009, and the related consolidated statements of operations, shareholders’ equity and cash flows for each of the three years in the period ended December 31, 2010 and our report dated March 11, 2011 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
March 11, 2011
CONSOLIDATED BALANCE SHEETS
Except Share Data)
See notes to the consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In Thousands, Except Per Share Data)
See notes to the consolidated financial statements.
CONSOLIDATED STATEMENTS OF SHAREHOLDERS’ EQUITY
FOR THE YEARS ENDED DECEMBER 31, 2010, 2009 AND 2008