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U.S. SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-K
(Mark One)
[X] ANNUAL REPORT UNDER SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF
1934
FOR THE FISCAL YEAR ENDED JUNE 30, 2004
OR
[ ] TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934
FOR THE TRANSITION PERIOD FROM _____________ TO
Commission File No. 0-9036
LANNETT COMPANY, INC.
(Exact name of registrant as specified in its charter)
STATE OF DELAWARE 23-0787-699
State of Incorporation I.R.S. Employer I.D. No.
9000 STATE ROAD
PHILADELPHIA, PENNSYLVANIA 19136
(215) 333-9000
(Address of principal executive offices and telephone number)
Securities registered under Section 12(b) of the Exchange Act:
NONE
Securities registered under Section 12(g) of the Exchange Act:
COMMON STOCK, $.001 PAR VALUE
(Title of class)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days.
Yes [X] No [ ]
Indicate by check mark if disclosure of delinquent filers pursuant 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.
Yes [ ] No [X]
Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Exchange Act).
Yes [X] No [ ]
Aggregate market value of Common stock held by non-affiliates of the
Registrant, as of December 31, 2003 was $95,366,862 based on the closing price
of the stock on the American Stock Exchange.
As of August 18, 2004, there were 24,083,847 shares of the issuer's common
stock, $.001 par value, outstanding.
Page 1 of 101 pages
Exhibit Index on Page 83-85
1
PART I
ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
Lannett Company, Inc. (the "Company," "Lannett," "we," or "us") was
incorporated in 1942 under the laws of the Commonwealth of Pennsylvania. In
1991, the Company merged into Lannett Company, Inc., a Delaware corporation. The
sole purpose of the merger was to reincorporate the Company as a Delaware
corporation. The Company develops, manufactures, packages, markets and
distributes pharmaceutical products sold under generic chemical names.
References herein to a fiscal year refer to the Company's fiscal year ending
June 30.
Historically, the Company has competed for an increasing share of the
generic market. During each of the fiscal years ended June 30, 2004, 2003 and
2002, the Company surpassed its historical highs in terms of net sales, gross
profit, operating income and net income. This growth is a result of additions to
the Company's line of generic products, new customers, higher unit sales,
increased product prices and a management focus on minimizing unnecessary
overhead and administrative costs. Some of the new generic products sold by
Lannett were developed and are manufactured by Lannett while others are
manufactured by Jerome Stevens Pharmaceutical, Inc. ("JSP"), one of Lannett's
primary suppliers. The products manufactured by Lannett and those manufactured
by JSP are identified in the section entitled "PRODUCTS" in Item 1 of this Form
10-K.
Over the past several years, Lannett has consistently devoted resources to
research and development ("R&D") projects, including new generic product
offerings. The costs of these R&D efforts are expensed during the periods
incurred. However, the Company believes that such investments may be paid back
in future years as it submits applications to the Food and Drug Administration
("FDA"), and if it receives marketing approval from the FDA to distribute such
products. In addition to using cash generated from its operations, the Company
has entered into a number of financing agreements with third parties to provide
for additional cash when it is needed. These financing agreements are more fully
described in the section entitled "LIQUIDITY AND CAPITAL RESOURCES" in Item 7 of
this Form 10-K. The Company has embarked on an industrious plan to grow in
future years. In addition to organic growth to be achieved through its own R&D
efforts, the Company has also initiated marketing projects with other companies
in order to expand future revenue projections. The Company, however, expects
that its growing list of generic drugs under development will drive future
growth. The Company also intends to use the infrastructure it has created, and
to continually devote resources to additional R&D projects. The following
strategies highlight Lannett's plan:
2
RESEARCH AND DEVELOPMENT
There are numerous stages in the generic drug development process:
1.) Formulation and Analytical Method Development: Once a drug candidate
is selected for research, product development scientists perform
various experiments on the active ingredient. These experiments
include the creation of a number of product recipes to determine
which recipe will be most suitable for the Company's subsequent
development process. Various recipes, or formulations, are tested in
the laboratory to measure results against the innovator drug. During
this time, the Company may use reverse engineering methods on
samples of the innovator drug to determine the type and quantity of
inactive ingredients. During the formulation phase, the Company's
research and development chemists begin to develop an analytical,
laboratory testing method. The successful development of this test
method will allow the Company to test developmental and commercial
batches of the product in the future. All of the information used in
the final formulation, including the analytical test methods adopted
for the generic drug candidate, will be included as part of the
documentation submitted to the FDA in the generic drug application.
2.) Scale-up: After the product development scientists and the R&D
chemists agree on a final formulation to use in moving the drug
candidate forward in the developmental process, the company will
attempt to increase the batch size of the product. The batch size
represents the standard magnitude to be used in manufacturing a
batch of the product. The determination of batch size will affect
the amount of raw material that is input into the manufacturing
process, and the number of expected tablets or capsules to be
created during the production sequence. The Company attempts to
determine batch size based on the amount of active ingredient in
each dosage, the available production equipment and unit sales
projections. The scaled-up batch is then generally produced in the
Company's commercial manufacturing facilities. During this
manufacturing process, the Company will document the equipment used,
the amount of time in each major processing step and any other steps
needed to consistently produce a batch of that product. This
information, generally referred to as the validated manufacturing
process, will be included in the Company's generic drug application
submitted to the FDA.
3.) Clinical testing: After a successful scale-up of the generic drug
batch, the Company then schedules and performs clinical testing
procedures on the product. These procedures, which are generally
outsourced to third parties, include testing the absorption of the
generic product in the human bloodstream, compared to the absorption
of the innovator drug. The results of this testing are then
documented and reported to the generic company to determine the
"success" of the generic drug product. Success, in this context,
means the successful comparison of the generic company's product
related to the innovator product. Since bioequivalence and a stable
formula are the primary requirements for a generic drug approval
(assuming the manufacturing plant is in compliance with the FDA's
manufacturing quality standards), lengthy and costly clinical trials
proving safety and efficacy, which are generally required by the FDA
for innovator drug approvals, are unnecessary for generic companies.
If the results are successful, the Company will continue the
collection of documentation and information for assembly of the drug
application.
3
4.) Submission of the ANDA for FDA review and approval: The Abbreviated
New Drug Application (ANDA) process became formalized under The Drug
Price Competition and Patent Term Restoration Act of 1984, also
known as the Hatch-Waxman Act. An ANDA represents a generic drug
company's application to the FDA to manufacture and/or distribute a
drug, which is the generic equivalent to an already-approved brand
named ("innovator") drug. Once bioequivalence studies are complete,
the generic drug company submits an ANDA to the FDA for marketing
approval.
In a presentation to the Generic Pharmaceutical Association on March 2,
2004, Gary J. Buehler, R.Ph., and Director of the FDA's Office of Generic Drugs,
said that the median approval time for a new ANDA for the FDA's Fiscal 2003 year
was 17.3 months. However, there is no guarantee that the FDA will approve a
company's ANDA or that any approval will be given within this time frame.
When a generic drug company files an ANDA to the FDA, it must certify that
no patents are listed in the Orange Book, the FDA's reference listing of
approved drugs, or listed patents have expired. If there are patents covering
some aspect of the innovator drug, the applicant must state whether it is
seeking approval for marketing after the expiration of the Orange Book patents;
or the patents listed therein are invalid, unenforceable, or not infringed --
usually referred to as a Paragraph IV Certification. ANDAs containing Paragraph
IV certifications frequently result in legal actions by the innovator drug
companies. These legal activities may delay the approval of the generic
company's ANDA. Currently, Lannett has not filed any Paragraph IV certifications
in its ANDAs because the ANDAs submitted did not contend with any patents for
the applicable innovator drugs.
Over the past several years, the Company has hired additional personnel in
product development, production, formulation and the R&D laboratory. Lannett
believes that its ability to select appropriate products for development,
develop such products on a timely basis, obtain FDA approval, and achieve
economies in production will be critical for its success in the generic
industry. Generally, Lannett believes in avoiding the well-known "billion dollar
drugs". The strategy involves a combination of decisions focusing on long-term
profitability and a secure market position with fewer challenges from
competitors.
Competition in generic pharmaceutical manufacturing will continue to grow
as more pharmaceutical products lose patent protection. However, the Company
believes with strong technical know-how, low overhead expenses, and efficient
product development, manufacturing and marketing, it can remain competitive. It
is the intention of the Company to reinvest as much capital as possible to
develop new products since the success of any generic pharmaceutical
manufacturer depends on its ability to continually introduce new generic
products to the market. Over time, if a generic drug market for a specific
product remains stable and consumer demand remains consistent, it is likely that
additional generic manufacturing companies will pursue the generic product by
developing it, submitting an ANDA, and potentially receiving marketing approval
from the FDA. If this occurs, the generic competition for the drug increases,
and a company's market share may drop. In addition to reduced unit sales, the
unit selling price may also drop due to the product's availability from
additional suppliers. This may have the effect of reducing a generic company's
future net sales of the product. Due to these factors that may potentially
affect a generic company's future results of operations, the ability to properly
assess
4
the competitive effect of new products, including market share, the number of
competitors and the generic unit price erosion, is critical to a generic
company's R&D plan. A generic company may be able to reduce the potential
exposure to competitive influences that negatively affect its sales and profits
by having several drug candidates in its R&D pipeline queue. As such, a generic
company may be able to avoid becoming materially dependent on the sales of one
drug. Unlike the branded, drug-discovery companies, Lannett currently does not
own proprietary drug patents. However, the typical intellectual property in the
generic drug industry are the ANDAs that generic drug companies own.
VALIDATED PHARMACEUTICAL CAPABILITIES
Lannett's manufacturing facility consists of 31,000 square feet on 3.5
acres owned by the Company. In July 2003, the Company signed a lease/purchase
option agreement for a 63,000 square foot building located at 9001 Torresdale
Avenue, Philadelphia, Pennsylvania. On November 26, 2003, the Company exercised
its option to purchase the facility. The renovation of the building has been
initiated; and the Company expects to begin to move some of its staff and
operations into that building in the fall of 2004. Lannett also leases a 24,000
square foot building approximately 2 miles from the Company's headquarters (9000
State Road). This leased facility serves as the Company's main warehousing
operation, and also houses certain R&D personnel. This facility's extended lease
term initially expired on April 2004. However, the Company has renewed its lease
on a short-term basis and will continue to lease this facility until the move to
the newly renovated facility on Torresdale Avenue in the fall of 2004.
Many FDA regulations relating to cGMP (current Good Manufacturing
Practices) have been adopted by the Company in the last several years. In
designing its facilities, full attention was given to material flow, equipment
and automation, quality control and inspection. A granulator, an automatic film
coating machine, high-speed tablet presses, blenders, encapsulators, fluid bed
dryers, high shear mixers and high-speed bottle filling are a few examples of
the sophisticated product development, manufacturing and packaging equipment the
Company uses. In addition, the Company's Quality Control laboratory facilities
are equipped with high precision instruments, like automated high-pressure
liquid chromatographs, gas chromatographs and laser particle sizers.
Lannett continues to pursue its comprehensive plan for improving and
maintaining quality control and quality assurance programs for its
pharmaceutical development and manufacturing facilities. The FDA periodically
inspects the Company's production facilities to determine the Company's
compliance with the FDA's manufacturing standards. Typically, after the FDA
completes its inspection, it will issue the Company a report, entitled a Form
483, containing the FDA's observations of possible violations of cGMP. Such
observations may be minor or severe in nature. The degree of severity of the
observation is generally determined by the time necessary to remediate the cGMP
violation, any consequences upon the consumer of the Company's drug products,
and whether the observation is subject to a Warning Letter from the FDA. By
strictly enforcing the various FDA guidelines, namely Good Laboratory Practices,
Standard Operating Procedures and cGMP, the Company has successfully reduced the
number of observations in its latest FDA inspection. The Company believes that
such observations are minor in nature, and will be remediated in a timely
fashion with no material effect on its future results of operations.
5
SALES AND CUSTOMER RELATIONSHIPS
The Company sells its pharmaceutical products to generic pharmaceutical
distributors, drug wholesalers, chain drug retailers, private label
distributors, mail-order pharmacies, other pharmaceutical manufacturers, managed
care organizations, hospital buying groups and health maintenance organizations.
It promotes its products through direct sales, the Internet, trade shows, trade
publications, and bids. The Company also licenses the marketing of its products
to other manufacturers and/or marketers in private label agreements.
In Fiscal 2004, 2003 and 2002, the Company's record sales levels can be
attributed to growth in most market segments. The Company continued to expand
its sales to the major chain drug stores, including CVS, Eckerd, Rite Aid and
Walgreen's. The mail order segment continued to be one of the fastest growing
classes of the Company's distribution efforts. Such companies, as Medco Health,
Express Scripts, Caremark and AdvancePCS were leaders in the Company's sales
growth. Lannett also increased its sales in the wholesaler segment led by
AmerisourceBergen, Cardinal Health and McKesson Corporation. Lannett is
recognized by its customers as a dependable supplier of high quality generic
pharmaceuticals. The Company's policy of maintaining an adequate inventory and
fulfilling orders in a timely manner has contributed to this reputation.
MANAGEMENT
As the Company continues to grow, additional managers will be hired to
complement the skilled team. These new managers will serve in a variety of
functions, including Research, Sales, Finance, Quality Control, Quality
Assurance, Regulatory Compliance and Production. Ultimately, the execution of a
sound business strategy requires a capable and knowledgeable management team.
PRODUCTS
As of the date of this filing, the Company manufactured and/or distributed
eleven products:
MANUFACTURE
NAME OF PRODUCT SOURCE MEDICAL INDICATION EQUIVALENT BRAND
- -------------------------------------- ----------- ------------------ ----------------
1) Butalbital, Aspirin and
Caffeine Capsules Lannett Migraine Headache Fiorinal(R)
2) Butalbital, Aspirin, Caffeine
with Codeine Phosphate Capsules JSP Migraine Headache Fiorinal(R)
3) Digoxin Tablets JSP Heart Failure Lanoxin(R)
4) Primidone Tablets Lannett Epilepsy Mysoline(R)
5) Dicyclomine Tablets/Capsules Lannett Irritable Bowels Bentyl(R)
6) Acetazolamide Tablets Lannett Glaucoma Diamox(R)
7) Prednisolone Tablets Lannett Corticosteroid Not applicable
8) Diphenoxylate with Atropine Sulfate
Tablets Lannett Diarrhea Lomotil(R)
9) Levothyroxine Sodium Tablets JSP Thyroid Deficiency Levoxyl(R)
10) Unithroid Tablets JSP Thyroid Deficiency Not applicable
11) Methocarbamol Tablets Lannett Muscle Relaxer Robaxin
6
All of the products currently manufactured and/or sold by the Company are
ethical, or prescription products. Of the products listed above, Unithroid and
those containing butalbital, digoxin, primidone and levothyroxine sodium were
the Company's key products, contributing to more than 97%, 95% and 84% of the
Company's total net sales in Fiscal 2004, 2003 and 2002, respectively.
The Company has two products containing butalbital. One of the products,
Butalbital with Aspirin and Caffeine capsules has been manufactured and sold by
Lannett for more than six years. The other butalbital product, Butalbital with
Aspirin, Caffeine and Codeine Phosphate capsules is manufactured by JSP. Lannett
began buying this product from JSP and selling it to its customers in December
2001. Both products, which are in orally-administered capsule dosage forms, are
prescribed to treat tension headaches caused by contractions of the muscles in
the neck and shoulder area and migraine. The drug is prescribed primarily for
adults of various demographic backgrounds. Migraine headache is an increasingly
prevalent condition in the United States. As conditions continue to grow, the
demand for effective medical treatments will continue to grow. Common side
effects of drugs which contain butalbital include dizziness and drowsiness. The
Company notes that although new innovator drugs to treat migraine headaches have
been introduced by brand name drug companies, there is still a loyal following
of doctors and consumers who prefer to use butalbital products for treatment. As
the brand name companies continue to promote products containing butalbital,
like Fiorinal(R), the Company expects to continue to produce and sell its
generic butalbital products.
Digoxin tablets are produced and marketed with two different potencies
(0.125 and 0.25 milligrams per tablet). This product is manufactured by JSP.
Lannett began buying this product from JSP, and selling it to its customers in
September 2002. Digoxin tablets are used to treat congestive heart failure in
patients of various ages and demographic backgrounds. The beneficial effects of
digoxin result from direct actions on the cardiac muscle, as well as indirect
actions on the cardiovascular system mediated by effects on the autonomic
nervous system. Side effects of digoxin may include apathy, blurred vision,
change in heartbeat, confusion, dizziness, headache, loss of appetite, nausea,
vomiting and weakness.
Primidone tablets are produced and marketed with two different potencies
(50 and 250 milligrams per tablet). This product was developed and manufactured
by Lannett. Lannett has been manufacturing and selling primidone 250 milligram
tablets for more than six years. Lannett began selling primidone 50 milligram
tablets in June 2001. Both products, which are in orally-administered tablet
dosage forms, are prescribed to treat convulsion and seizures in epileptic
patients of all ages and demographic backgrounds. Common side effects of
primidone include lack of muscle coordination, vertigo and severe dizziness.
The Company's products containing levothyroxine sodium tablets are
produced and marketed with eleven different potencies (0.025, 0.05, 0.075,
0.088, 0.1, 0.112, 0.125, 0.15, 0.175, 0.2, and 0.3 milligrams per tablet). In
addition to generic levothyroxine sodium tablets, the Company also markets and
distributes Unithroid tablets, a branded version of levothyroxine sodium
tablets, which is also produced and marketed with eleven different potencies.
Both levothyroxine sodium products are manufactured by JSP. Lannett began buying
generic levothyroxine sodium tablets from JSP, and selling it to its customers
in April 2003. In September 2003, the Company began buying the branded Unithroid
tablets from JSP and selling it to its customers. Levothyroxine Sodium Tablets
are used to treat hypothyroidism and other thyroid
7
disorders. It is currently one of the most prescribed drugs in the United States
with over 13 million patients of various ages and demographic backgrounds. Side
effects from levothyroxine sodium are rare, but may include allergic reactions,
such as rash or hives. With its distribution of these products, Lannett competes
in a market which is currently controlled by two branded levothyroxine sodium
tablet products -- Abbott Laboratories' Synthroid(R) and Monarch
Pharmaceutical's Levoxyl(R). In late June of 2004, JSP received a letter from
the FDA approving its supplemental application for generic bioequivalence to
Levoxyl(R). JSP also received a non-approvable letter from the FDA for its
supplemental application for generic bioequivalence to Synthroid(R), which is
the largest brand name innovator drug for levothyroxine sodium tablets. The
Company learned that at least two other generic pharmaceutical companies
received approval from the FDA for bioequivalence ratings to Synthroid(R). JSP
has appealed the FDA's decision to not approve its supplemental application for
bioequivalence to Synthroid(R), and hopes that it will receive the approval
shortly.
Additional products are currently under development. These products are
all orally-administered, solid-dosage (i.e. tablet/capsule) products designed to
be generic equivalents to brand named innovator drugs. The Company's
developmental drug products are intended to treat a diverse range of
indications. One of these developmental products, an orally-administered obesity
product, represents a generic ANDA currently owned by the Company, but not
currently manufactured and distributed for commercial consumption. As one of the
oldest generic drug manufacturers in the country, formed in 1942, Lannett
currently owns several ANDAs for products which it does not manufacture and
market. These ANDAs are simply dormant on the Company's records. Occasionally,
the Company reviews such ANDAs to determine if the market potential for any of
these older drugs has recently changed, so as to make it attractive for Lannett
to reconsider manufacturing and selling them. If the Company makes the
determination to introduce one of these products into the consumer marketplace,
it must review the ANDA and related documentation to ensure that the approved
product specifications, formulation and other features are feasible in the
Company's current environment. Generally, in these situations, the Company must
file a supplement to the FDA for the applicable ANDA, informing the FDA of any
significant changes in the manufacturing process, the formulation, the raw
material supplier or another major feature of the previously-approved ANDA. The
Company would then redevelop the product and submit it to the FDA for
supplemental approval. The FDA's approval process for ANDA supplements is
similar to that of a new ANDA.
Another developmental product, also an orally-administered obesity
product, is a new ANDA submitted to the FDA in July 2003 for approval. In a
presentation to the Generic Pharmaceutical Association on March 2, 2004, Gary J.
Buehler, R.Ph., and Director of the FDA's Office of Generic Drugs, said that the
median approval time for a new ANDA for the FDA's Fiscal 2003 year was 17.3
months. Since the Company has no control over the FDA review process, management
is unable to anticipate whether or when it will be able to begin commercially
producing and shipping this product.
The remainder of the products in development represent either previously
approved ANDAs that the Company is planning to reintroduce (ANDA supplements),
or new formulations (new ANDAs). The products under development are at various
stages in the development cycle -- formulation, scale-up, and/or clinical
testing. Depending on the complexity of the active ingredient's chemical
characteristics, the cost of the raw material, the FDA-mandated requirement of
bioequivalence studies, the cost of such studies and other developmental
factors, the cost to
8
develop a new generic product varies. It can range from $100,000 to $1 million.
Some of Lannett's developmental products will require bioequivalence studies,
while others will not -- depending on the FDA's Orange Book classification.
Since the Company has no control over the FDA review process, management is
unable to anticipate whether or when it will be able to begin producing and
shipping additional products.
In addition to the efforts of its internal product development group,
Lannett has contracted with an outside firm (The PharmaNetwork LLC in New
Jersey) for the formulation and development of several new generic drug
products. These outsourced R&D products are at various stages in the development
cycle -- formulation, analytical method development and testing and
manufacturing scale-up. These products are orally-administered solid dosage
products intended to treat a diverse range of medical indications. It is the
Company's intention to ultimately transfer the formulation technology and
manufacturing process for all of these R&D products to the Company's own
commercial manufacturing sites. The Company initiated these outsourced R&D
efforts to complement the progress of its own internal R&D efforts.
The Company is also developing a drug product that does not require FDA
approval. The FDA allows generic manufacturers to manufacture and sell products
which are equivalent to innovator drugs which are grand-fathered, under FDA
rules, prior to the passage of the Hatch-Waxman Act of 1984. The FDA allows
generic manufacturers to produce and sell generic versions of such
grand-fathered products by simply performing and internally documenting the
product's stability over a period of time. Under this scenario, a generic
company can forego the time and costs related to a FDA-mandated ANDA approval
process. The Company currently has one product under development in this
category. The developmental drug is an orally-administered, prescription solid
dosage product.
The Company has also contracted with Spectrum Pharmaceuticals Inc., based
in California, to market generic products developed and manufactured by Spectrum
and/or its partners. The first applicable product under this agreement is
ciprofloxacin tablets, the generic version of Cipro(R), an anti-bacterial drug,
marketed by Bayer Corporation, prescribed to treat infections. The Company has
also initiated discussions with other firms for similar new product initiatives,
in which Lannett will market and distribute products manufactured by third
parties. Lannett intends to use its strong customer relationships to build its
market share for such products, and increase future revenues and income.
The majority of the Company's R&D projects are being developed in-house
under Lannett's direct supervision and with Company personnel. Hence, the
Company does not believe that its outside contracts for product development,
including The PharmaNetwork LLC, or manufacturing supply, including Spectrum
Pharmaceuticals Inc., are material in nature, nor is the Company substantially
dependent on the services rendered by such outside firms. Since the Company has
no control over the FDA review process, management is unable to anticipate
whether or when it will be able to begin producing and shipping such additional
products.
9
The following table summarizes key information related to the Company's R&D
products. The column headings are defined as follows:
1.) Stage of R&D - Defines the current stage of the R&D product in the
development process, as of the date of this filing.
2.) Regulatory Requirement - Defines whether the R&D product is or is
expected to be a new ANDA submission, an ANDA supplement, or a
grand-fathered product not requiring specific FDA approval.
3.) Number of Products - Defines the number of products in R&D at the
stage noted. In this context, a product means any finished dosage
form, including all potencies, containing the same API or
combination of APIs and which represents a generic version of the
same Reference Listed Drug (RLD) or innovator drug, identified in
the FDA's Orange Book.
STAGE OF R&D REGULATORY REQUIREMENT NUMBER OF PRODUCTS
- ------------------------------ ---------------------- ------------------
FDA Review ANDA 7
FDA Review ANDA supplement 1
Clinical Testing ANDA 4
Scale-Up Grand-fathered 1
Scale-Up ANDA supplement 5
Scale-Up ANDA 2
Formulation/Method Development ANDA 9
RAW MATERIAL AND INVENTORY SUPPLIERS
The raw materials used by the Company in the production process consist of
pharmaceutical chemicals in various forms, which are generally available from
various sources. FDA approval is required in connection with the process of
using active ingredient suppliers. In addition to the raw materials purchased
for the production process, the Company purchases certain finished dosage
inventories, including capsule and tablet products. The Company then sells these
finished dosage products directly to its customers along with the finished
dosage products internally manufactured.
Currently, the Company's only finished product inventory supplier is
Jerome Stevens Pharmaceuticals, Inc. (JSP), in Bohemia, New York. Purchases of
finished goods inventory from JSP accounted for approximately 81% of the
Company's inventory purchases in Fiscal 2004, 62% in Fiscal 2003 and 26% in
Fiscal 2002. On March 23, 2004, the Company entered into an agreement with JSP
for the exclusive distribution rights in the United States to the current line
of JSP products, in exchange for four million (4,000,000) shares of the
Company's common stock. The JSP products covered under the agreement included
Butalbital, Aspirin, Caffeine with Codeine Phosphate capsules, Digoxin tablets
and Levothyroxine Sodium tablets, sold generically and under the brand name
Unithroid(R). The term of the agreement is ten years, beginning on March 23,
2004 and continuing through March 22, 2014. Both Lannett and JSP have the right
to terminate the contract if one of the parties does not cure a material breach
of the contract within thirty (30) days of notice from the non-breaching party.
During the term of the agreement, the Company is required to use commercially
reasonable efforts to purchase minimum dollar quantities of JSP's products being
distributed by the Company. The Company projects that it will be able to meet
10
the minimum purchase requirements, but there is no guarantee that the Company
will be able to do so. If the Company does not meet the minimum purchase
requirements, JSP's sole remedy is to terminate the agreement. Under the
agreement, JSP is entitled to nominate one person to serve on the Company's
Board of Directors (the "Board"); provided, however, that the Board shall have
the right to reasonably approve any such nominee in order to fulfill its
fiduciary duty by ascertaining that such person is suitable for membership on
the board of a publicly traded corporation including, but not limited to,
complying with the requirements of the Securities and Exchange Commission, the
American Stock Exchange and applicable law including the Sarbanes-Oxley Act of
2002. The Agreement was included as an Exhibit in the Form 8-K filed by the
Company on May 5, 2004. The obligation of the Company to issue the four million
(4,000,000) shares was subject to the receipt of a fairness opinion issued by a
recognized and reputable investment banking firm in opining that the issuance of
the four million (4,000,000) shares and the resulting dilution of the ownership
interest of the Company's minority shareholders was fair to such shareholders in
view of JSP's products' contribution or potential contribution to the Company's
profitability. On April 20, 2004, the investment banker, Donnelly Penman and
Partners, which was selected by the independent Directors of the Company's
Board, opined that the issuance of the four million (4,000,000) shares and the
resulting dilution of the ownership interest of the Company's minority
shareholders was fair to such shareholders from a financial point of view. As
such, subsequent to April 20, 2004, the Company issued four million (4,000,000)
shares to JSP's designees. As a result of the transaction, the Company recorded
an intangible asset related to the contract in the amount of $67,040,000. The
intangible asset was recorded based upon the fair value of the (4,000,000)
shares at the time of issuance to JSP.
Another supplier, Siegfried (USA) Inc., which supplies primidone and
butalbital, the raw materials in the Company's commercial products containing
the same ingredient name, accounted for 6% of the Company's inventory purchases
in Fiscal 2004, 12% in Fiscal 2003 and 30% in Fiscal 2002. Generally, the raw
materials purchased from suppliers are available from a number of vendors. The
finished products purchased from JSP may not be available from other sources due
to the limited number of FDA approvals of competitive products. If suppliers of
a certain material or finished product are limited, the Company will generally
take certain precautionary steps to avoid a disruption in supply. This includes
building a satisfactory inventory level, and obtaining contractual supply
commitments. The Company currently has an agreement with Siegfried (USA) Inc.
for the supply of primidone. The agreement is a standard supply agreement
evidencing the terms of the supply of material. There are no guaranteed purchase
volume commitments; however the agreement does require Lannett to purchase 100%
of its primidone raw material requirements from Siegfried. The price of the
material may vary depending on the quantity of material purchased during the
term of the agreement. The term of the agreement is October 1, 2002 through
December 31, 2003. As of June 30, 2004, a new agreement with Siegfried (USA) had
not yet been executed. The Company continues to purchase raw materials from
Siegfried under the terms of the expired purchase agreement which is included in
Exhibit 10.9 of the 2003 Form 10-KSB. The Company is in the process of
finalizing a new agreement with Siegfried (USA).
11
CUSTOMERS AND MARKETING
The Company sells its products primarily to wholesale distributors,
generic drug distributors, mail-order pharmacies, drug chains, and other
pharmaceutical companies. Sales of the Company's pharmaceutical products are
made on an individual order basis. One customer, Cardinal Health, one of the
largest wholesale distributors in the country, accounted for approximately 17%
and 13% of net sales in Fiscal 2004 and 2003, respectively. Another customer,
McKesson, also a wholesale distributor, accounted for approximately 17% of net
sales in Fiscal 2004. Another customer, AmerisourceBergen, another wholesale
distributor, accounted for approximately 10% of net sales in Fiscal 2004.
Qualitest Pharmaceuticals, a large private-label distributor customer, accounted
for 12% and 22% of net sales in Fiscal 2003 and 2002, respectively. United
Research Laboratories, another large private-label distributor customer,
accounted for 19% of net sales in Fiscal 2002. The Company performs ongoing
credit evaluations of its customers' financial condition, and has experienced no
significant collection problems to date. Generally, the Company requires no
collateral from its customers.
As previously noted, a significant portion of Lannett's sales were to
wholesale customers, such as Cardinal Health. Sales to these wholesale customers
include "indirect sales," which represent sales to third-party entities, such as
independent pharmacies, managed care organizations, hospitals, nursing homes and
group purchasing organizations, collectively referred to as "indirect
customers." Lannett enters into agreements with its indirect customers to
establish pricing for certain products. The indirect customers then
independently select a wholesaler from which to actually purchase the products
at these agreed-upon prices. Lannett will provide credit to the wholesaler for
the difference between the agreed-upon price with the indirect customer and the
wholesaler's invoice price. This credit is called a chargeback. For more
information on chargebacks, see the section entitled "Chargebacks" in Item 6,
"Management's Discussion and Analysis of Financial Condition and Results of
Operations, Significant Accounting Policies" of this Form 10-K. These indirect
sale transactions are recorded on Lannett's books as sales to the wholesale
customers. This has the effect of over-emphasizing the sales volume attributable
to such wholesaler customers because it includes such "indirect sales." The
Company believes that retail-level consumer demand dictates the total volume of
sales for various products. In the event that the Company's wholesale and retail
customers adjust their purchasing volumes, the Company believes that consumer
demand will be fulfilled by other wholesale or retail sources of supply. As
such, Lannett attempts to obtain strong relationships with most of the major
retail chains, wholesale distributors and mail-order pharmacies in order to
facilitate the supply of the Company's products through whatever channel the
consumer prefers. Although the Company has agreements with several customers
governing the transaction terms of its sales, there are no long-term supply
agreements with customers which would require them to purchase the Company's
products.
The Company promotes its products through direct sales, the Internet,
trade shows, trade publications, and bids. The Company also markets its products
through private label arrangements, whereby Lannett produces its products with a
label containing the name and logo of a customer. This practice is commonly
referred to as private label business. It allows the Company to expand on its
own internal sales efforts by using the marketing services from other
well-respected pharmaceutical dosage suppliers. The focus of the Company's sales
efforts is the
12
relationships it creates with its customer accounts. Strong customer
relationships have created a positive platform for Lannett to increase its sales
volumes. Advertising in the generic pharmaceutical industry is generally limited
to trade publications, read by retail pharmacists, wholesale purchasing agents
and other pharmaceutical decision-makers. Historically and in Fiscal 2004, 2003
and 2002, the Company's advertising expenses were immaterial. When the customer
and the Company's sales representatives make contact, the Company will generally
offer to supply the customer its products at fixed prices. If accepted, the
customer's purchasing department will coordinate the purchase, receipt and
distribution of the products throughout its distribution centers and retail
outlets. Once a customer accepts the Company's supply of product, the customer
generally expects a high standard of service. This service standard includes
shipping product in a timely manner on receipt of customer purchase orders,
maintaining convenient and effective customer service functions and retaining a
mutually-beneficial dialogue of communication. The Company believes that
although the generic pharmaceutical industry is a commodity industry, where
price is the primary factor for sales success, these additional service
standards are equally important to the customers that rely on a consistent
source of supply.
COMPETITION
The manufacture and distribution of generic pharmaceutical products is a
highly competitive industry. Competition is based primarily on price, service
and quality. The Company competes primarily on this basis, as well as by
flexibility (reacting to customer needs quickly and decisively -- for example
shipping product via overnight delivery when the customer is in critical need of
inventory), availability of inventory, and by the fact that the Company's
products are available only from a limited number of suppliers. The
modernization of its facilities, hiring of experienced staff, and implementation
of inventory and quality control programs have improved the Company's
competitive position over the past five years.
The Company competes with other manufacturers and marketers of generic and
brand drugs. Each product manufactured and/or sold by Lannett has a different
set of competitors. The list below identifies the companies with which Lannett
primarily competes for each of its major products.
Product Primary Competitors
- ------------------------------------------------------- -----------------------------------------------------------------
Butalbital with Aspirin and Caffeine, with and without Watson Pharmaceuticals Inc., Anabolic Laboratories, Inc. (marketed
codeine phosphate capsules by Breckenridge Pharmaceutical, Inc.)
Digoxin tablets GlaxoSmithKline, Amide Pharmaceutical, Inc. (marketed by Bertek
Pharmaceuticals Inc.), Caraco Pharmaceutical Laboratories, Inc.
Primidone tablets Watson Pharmaceuticals Inc.
Levothyroxine Sodium tablets Abbott Laboratories, Monarch Pharmaceuticals, Mylan Laboratories,
Inc., Sandoz
Unithroid tablets Abbott Laboratories, Monarch Pharmaceuticals, Mylan Laboratories,
Inc., Sandoz
13
GOVERNMENT REGULATION
Pharmaceutical manufacturers are subject to extensive regulation by the
federal government, principally by the FDA and the Drug Enforcement Agency
("DEA"), and, to a lesser extent, by other federal regulatory bodies and state
governments. The Federal Food, Drug and Cosmetic Act, the Controlled Substance
Act and other federal statutes and regulations govern or influence the testing,
manufacture, safety, labeling, storage, record keeping, approval, pricing,
advertising and promotion of the Company's generic drug products. Noncompliance
with applicable regulations can result in fines, recall and seizure of products,
total or partial suspension of production, personal and/or corporate prosecution
and debarment, and refusal of the government to approve new drug applications.
The FDA also has the authority to revoke previously approved drug products.
Generally, FDA approval is required before a prescription drug can be
marketed. The approval procedures are quite extensive. A new drug is one not
generally recognized by qualified experts as safe and effective for its intended
use. New drugs are typically developed and submitted to the FDA by companies
expecting to brand the product, and sell it as a new medical treatment. The FDA
review process for new drugs is very extensive; and it requires a substantial
investment to research and test the drug candidate. However, less burdensome
approval procedures may be used for generic equivalents. Typically, the
investment required to develop a generic drug is less costly than the brand
innovator drug. There are currently three ways to obtain FDA approval of a drug:
NEW DRUG APPLICATIONS ("NDA"): Unless one of the two procedures discussed in the
following paragraphs is available, a manufacturer must conduct and submit to the
FDA complete clinical studies to establish a drug's safety and efficacy.
ABBREVIATED NEW DRUG APPLICATIONS ("ANDA"): An ANDA is similar to an NDA, except
that the FDA waives the requirement of complete clinical studies of safety and
efficacy, although it may require bioavailability and bioequivalence studies.
"Bioavailability" indicates the rate of absorption and levels of concentration
of a drug in the bloodstream needed to produce a therapeutic effect.
"Bioequivalence" compares one drug product with another, and indicates if the
rate of absorption and the levels of concentration of a generic drug in the body
are within prescribed statistical limits to those of a previously approved drug.
Under the Drug Price Act, an ANDA may be submitted for a drug on the basis that
it is the equivalent of an approved drug, regardless of when such other drug was
approved. The Drug Price Act, in addition to establishing a new ANDA procedure,
created statutory protections for approved brand name drugs. Under the Drug
Price Act, an ANDA for a generic drug may not be made effective until all
relevant product and use patents for the brand name drug have expired or have
been determined to be invalid. Prior to enactment of the Drug Price Act, the FDA
gave no consideration to the patent status of a previously approved drug.
Additionally, the Drug Price Act extends for up to five years the term of a
product or use patent covering a drug to compensate the patent holder for the
reduction of the effective market life of a patent due to federal regulatory
review. With respect to certain drugs not covered by patents, the Drug Price Act
sets specified time periods of two to ten years during which ANDAs for generic
14
drugs cannot become effective or, under certain circumstances, cannot be filed
if the brand name drug was approved after December 31, 1981. Lannett, like most
other generic drug companies, uses the ANDA process for the submission of their
developmental generic drug candidates.
PAPER NEW DRUG APPLICATIONS ("PAPER NDA"): For a drug that is identical to a
drug first approved after 1962, a prospective manufacturer need not go through
the full NDA procedure. Instead, it may demonstrate safety and efficacy by
relying on published literature and reports. The manufacturer must also submit,
if the FDA so requires, bioavailability or bioequivalence data illustrating that
the generic drug formulation produces the same effects, within an acceptable
range, as the previously approved innovator drug. Because published literature
to support the safety and efficacy of post-1962 drugs may not be available, this
procedure is of limited utility to generic drug manufacturers. Moreover, the
utility of Paper NDAs has been further diminished by the recently broadened
availability of the ANDA process, as described above.
Among the requirements for new drug approval is the requirement that the
prospective manufacturer's methods conform to the FDA's current good
manufacturing practices ("cGMP Regulations"). The cGMP Regulations must be
followed at all times during which the approved drug is manufactured. In
complying with the standards set forth in the cGMP Regulations, the Company must
continue to expend time, money and effort in the areas of production and quality
control to ensure full technical compliance. Failure to comply with the cGMP
Regulations risks possible FDA action such as the seizure of noncomplying drug
products or, through the Department of Justice, enjoining the manufacture of
such products.
The Company is also subject to federal, state and local laws of general
applicability, such as laws regulating working conditions, and the storage,
transportation or discharge of items that may be considered hazardous
substances, hazardous waste or environmental contaminants. The Company monitors
its compliance with all environmental laws. Compliance costs are charged against
operations when incurred. The Company incurred no monitoring costs during the
years ended June 30, 2004, 2003 or 2002.
RESEARCH AND DEVELOPMENT
The Company incurred research and development expenses of approximately
$5,895,000 in 2004, $2,575,000 in 2003 and $1,749,000 in 2002.
EMPLOYEES
The Company currently has 171 employees, of which 169 are full-time.
SECURITIES EXCHANGE ACT REPORTS
The Company maintains an Internet website at the following address:
www.lannett.com. The Company makes available on or through its Internet website
certain reports and amendments to those reports that are filed with the SEC in
accordance with the Securities Exchange Act of 1934. These include annual
reports on Form 10-K, quarterly reports on Form 10-Q and current
15
reports on Form 8-K. This information is available on the Company's website free
of charge as soon as reasonably practicable after the Company electronically
files the information with, or furnishes it to, the SEC. The contents of the
Company's website are not incorporated by reference in this Annual Report on
Form 10-K and shall not be deemed "filed" under the Securities Exchange Act of
1934.
ITEM 2. DESCRIPTION OF PROPERTY
The Company's headquarters, administrative offices, quality control
laboratory, and manufacturing and production facilities, consisting of
approximately 31,000 square feet, are located at 9000 State Road, Philadelphia,
Pennsylvania.
In December 1997, the Company entered into a three-year and three-month
lease for a 23,500 square foot facility located at 500 State Road, Bensalem
Bucks County, Pennsylvania. This facility houses laboratory research,
warehousing and distribution operations. The leased facility is located
approximately 2 miles from the Company headquarters. In January 2001, the
Company extended this lease through April 30, 2004. After that time, the Company
renewed the lease again on a short-term basis and will continue to lease this
facility until the move to the newly renovated facility at 9001 Torresdale
Avenue, Philadelphia, Pennsylvania in the fall of 2004.
On July 1, 2003, the Company entered into a lease/purchase option
agreement to purchase a 63,000 square foot facility at 9001 Torresdale Avenue,
Philadelphia, Pennsylvania, approximately 1 mile from the Company's
headquarters. On November 26, 2003, the Company exercised its option to purchase
the facility. The Company is planning to move all operations currently performed
at 500 State Road to 9001 Torresdale Avenue. In addition to the laboratory
research, warehousing and distribution operations currently performed at 500
State Road, other operational functions may be moved from the Company
headquarters to 9001 Torresdale Avenue. This move will occur gradually, and will
allow the Company to maximize its FDA approved production facility at 9000 State
Road for production output.
ITEM 3. LEGAL PROCEEDINGS
REGULATORY PROCEEDINGS
The Company is engaged in an industry which is subject to considerable
government regulation relating to the development, manufacturing and marketing
of pharmaceutical products. Accordingly, incidental to its business, the Company
periodically responds to inquiries or engages in administrative and judicial
proceedings involving regulatory authorities, particularly the FDA and the DEA.
EMPLOYEE CLAIMS
A claim of retaliatory discrimination has been filed by a former employee
with the Pennsylvania Human Relations Commission ("PHRC") and the Equal
Employment Opportunity Commission ("EEOC"). The Company was notified of the
complaint in March 1997. The
16
Company has denied liability in this matter. The PHRC has made a determination
that the complaint against the Company should be dismissed because the facts do
not establish probable cause of the allegations of discrimination. The matter is
still pending before the EEOC. At this time, management is unable to estimate a
range of loss, if any, related to this action. Management believes that the
outcome of this claim will not have a material adverse impact on the financial
position or results of operations of the Company.
A claim of discrimination has been filed against the Company with the EEOC
and the PHRC. The Company was notified of the complaint in June 2001. The
Company has filed an answer with the EEOC denying the allegations. The EEOC has
made a determination that the complaint against the Company should be dismissed
because the facts do not establish probable cause of the allegations of
discrimination. The matter is still pending before the PHRC. At this time,
management is unable to estimate a range of loss, if any, related to this
action. Management believes that the outcome of this claim will not have a
material adverse impact on the financial position or results of operations of
the Company.
A claim of discrimination has been filed against the Company with the PHRC
and the EEOC. The Company was notified of the complaint in July 2001. The
Company has filed an answer with the PHRC denying the allegations. The PHRC has
made a determination that the complaint against the Company should be dismissed
because the facts do not establish probable cause of the allegations of
discrimination. The matter is still pending before the EEOC. At this time,
management is unable to estimate a range of loss, if any, related to this
action. Management believes that the outcome of this claim will not have a
material adverse impact on the financial position or results of operations of
the Company.
DES CASES
The Company is currently engaged in several civil actions as a
co-defendant with many other manufacturers of Diethylstilbestrol ("DES"), a
synthetic hormone. Prior litigation established that the Company's pro rata
share of any liability is less than one-tenth of one percent. The Company was
represented in many of these actions by the insurance company with which the
Company maintained coverage during the time period that damages were alleged to
have occurred. The insurance company denies coverage for actions alleging
involvement of the Company filed after January 1, 1992. With respect to these
actions, the Company paid nominal damages or stipulated to its pro rata share of
any liability. The Company has either settled or had dismissed approximately 250
claims. An additional 283 claims are currently being defended. At this time,
management is unable to estimate a range of loss, if any, related to these
actions. Prior settlements have been in the $500 to $3,500 range. Management
believes that the outcome of these cases will not have a material adverse impact
on the financial position or results of operations of the Company.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters have been submitted to a vote of the Company's security holders
during the quarter ended June 30, 2004.
17
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
MARKET INFORMATION
On April 15, 2002, the Company's common stock began trading on the
American Stock Exchange. Prior to this, the Company's common stock traded in the
over-the-counter market through the use of the inter-dealer "pink-sheets"
published by Pink Sheets LLC. The following table sets forth certain information
with respect to the high and low daily closing prices of the Company's common
stock during Fiscal 2004 and 2003, as quoted by the American Stock Exchange.
Such quotations reflect inter-dealer prices without retail mark-up, markdown or
commission and may not represent actual transactions. All share and per share
amounts on this Annual Report and Form 10-K have been adjusted to reflect a
three-for-two stock split, which was effective on February 14, 2003.
FISCAL YEAR ENDED JUNE 30, 2004
HIGH LOW
------ ------
First quarter........................................................ $25.09 $15.65
Second quarter....................................................... $18.88 $16.40
Third quarter........................................................ $19.00 $15.10
Fourth quarter....................................................... $17.00 $13.18
FISCAL YEAR ENDED JUNE 30, 2003
HIGH LOW
------ ------
First quarter........................................................ $ 7.41 $ 4.63
Second quarter....................................................... $13.97 $ 5.67
Third quarter........................................................ $15.52 $11.05
Fourth quarter....................................................... $23.44 $11.36
HOLDERS
As of August 18, 2004, there were approximately 263 holders of record of
the Company's common stock.
18
DIVIDENDS
The Company did not pay cash dividends in Fiscal 2004, Fiscal 2003
or Fiscal 2002. The Company intends to use available funds for working
capital, plant and equipment additions, and various product extension
ventures. It does not anticipate paying cash dividends in the foreseeable
future.
EQUITY COMPENSATION PLAN INFORMATION
The following table summarizes the equity compensation plans as of
June 30, 2004.
Number of securities
remaining available for
future issuance under
Number of securities to be Weighted average equity compensation
issued upon exercise of exercise price of plans (excluding
outstanding options, outstanding options, securities reflected in
Plan warrants and rights warrants and rights column (a)
Category (a) (b) (c)
- ------------------------- -------------------------- -------------------- -----------------------
Equity Compensation plans
approved by security
holders 804,561 $12.46 1,765,506
Equity Compensation plans
not approved by security
holders - - -
Total 804,561 $12.46 1,765,506
19
ITEM 6. SELECTED FINANCIAL DATA
Lannett Company, Inc and Subsidiaries.
Financial Highlights
AS OF OR FOR THE YEAR
ENDED JUNE 30, 2004 2003 2002 2001 2000
------------ ----------- ----------- ------------ -----------
OPERATING HIGHLIGHTS
Net Revenues $ 63,781,219 $42,486,758 $25,126,214 $ 12,090,993 $11,553,457
Gross Profit $ 36,924,344 $26,228,964 $16,673,537 $ 5,556,229 $ 4,367,018
Operating Income $ 20,830,969 $19,060,106 $11,425,483 $ 2,042,585 $ 1,269,897
Net Income $ 13,215,454 $11,666,887 $ 7,195,990 $ 1,829,915 $ 1,044,969
Basic Earnings Per Share $ 0.63 $ 0.58 $ 0.36 $ 0.14 $ 0.08
Diluted Earnings Per Share $ 0.63 $ 0.58 $ 0.36 $ 0.14 $ 0.08
Weighted Average Shares
Outstanding, Basic 20,831,750 19,968,633 19,895,757 13,206,128 13,206,128
Weighted Average Shares
Outstanding, Diluted 21,053,944 20,121,314 20,018,548 13,206,128 13,206,128
BALANCE SHEET HIGHLIGHTS
Current Assets $ 40,143,775 $21,158,048 $ 9,809,630 $ 8,618,835 $ 4,284,664
Working Capital $ 29,090,146 $17,185,052 $ 6,891,998 $ (69,920) $ 1,241,945
Total Assets $123,019,084 $29,062,544 $16,708,503 $ 15,665,617 $12,558,839
Total Debt $ 10,092,857 $ 3,097,802 $ 4,142,538 $ 10,773,222 $11,873,069
Deferred Tax Liabilities $ 1,614,323 $ 1,112,369 $ 681,489 $ 641,285 $ -
Total Stockholders' Equity $102,246,991 $21,597,710 $ 9,766,049 $ 2,515,685 $ 685,770
CAUTIONARY NOTE REGARDING FORWARD-LOOKING STATEMENTS
Any statements made in this report that are not statements of historical fact or
that refer to estimated or anticipated future events are forward-looking
statements. We have based our forward-looking statements on our management's
beliefs and assumptions based on information available to our management at the
time these statements are made. Such forward-looking statements reflect our
current perspective of our business, future performance, existing trends and
information as of the date of this filing. These include, but are not limited
to, our beliefs about future revenue and expense levels and growth rates,
prospects related to our strategic initiatives and business strategies, express
or implied assumptions about government regulatory action or inaction,
anticipated product approvals and launches, business initiatives and product
development activities, assessments related to clinical trial results, product
performance and competitive environment, and anticipated financial performance.
Without limiting the generality of the foregoing, words such as "may," "will,"
"expect," "believe," "anticipate," "intend," "could," "would," "estimate,"
"continue," or "pursue," or the negative other variations thereof or comparable
terminology, are intended to identify forward-looking statements. The statements
are not guarantees of future performance and involve certain risks,
uncertainties and assumptions that are difficult to predict. We caution the
reader that certain important factors may affect our actual operating results
and could cause such results to differ materially from those expressed or
implied by forward-looking statements. We believe the risks and uncertainties
discussed under the Section entitled "Risks
20
Related to Our Business," and other risks and uncertainties detailed herein and
from time to time in our Securities and Exchange Commission filings, may affect
its actual results.
We disclaim any obligation to publicly update any forward-looking statements,
whether as a result of new information, future events or otherwise, except as
required by law. We also may make additional disclosures in our Quarterly
Reports on Form 10-Q and Current Reports on Form 8-K that we may file from time
to time with the Securities and Exchange Commission. Other factors besides those
listed here could also adversely affect us. This discussion is provided as
permitted by the Private Securities Litigation Reform Act of 1995.
RISKS RELATED TO OUR BUSINESS
We operate in a rapidly changing environment that involves a number of risks,
some of which are beyond our control. The following discussion highlights some
of these risks and others are discussed elsewhere in this report. These and
other risks could materially and adversely affect our business, financial
condition, operating results or cash flows
RISKS ASSOCIATED WITH INVESTING IN THE BUSINESS OF LANNETT
IF WE ARE UNABLE TO SUCCESSFULLY DEVELOP OR COMMERCIALIZE NEW PRODUCTS, OUR
OPERATING RESULTS WILL SUFFER.
Our future results of operations will depend to a significant extent upon our
ability to successfully commercialize new generic products in a timely manner.
There are numerous difficulties in developing and commercializing new products,
including:
- - developing, testing and manufacturing products in compliance with
regulatory standards in a timely manner;
- - receiving requisite regulatory approvals for such products in a timely
manner;
- - the availability, on commercially reasonable terms, of raw materials,
including active pharmaceutical ingredients and other key ingredients;
- - developing and commercializing a new product is time consuming, costly and
subject to numerous factors that may delay or prevent the successful
commercialization of new products.
- - experiencing delays or unanticipated costs; and
- - commercializing generic products may be substantially delayed by the
listing with the FDA of patents that have the effect of potentially delaying
approval of the off-patent product by up to 30 months, and in some cases, such
patents have issued and been listed with the FDA after the key chemical patent
on the branded drug product has expired or been litigated, causing additional
delays in obtaining approval.
As a result of these and other difficulties, products currently in development
by Lannett may or may not receive the regulatory approvals necessary for
marketing. If any of our products, when developed and approved, cannot be
successfully or timely commercialized, our operating results could be adversely
affected. We cannot guarantee that any investment we make in developing products
will be recouped, even if we are successful in commercializing those products.
21
OUR GROSS PROFIT MAY FLUCTUATE FROM PERIOD TO PERIOD DEPENDING UPON OUR PRODUCT
SALES MIX, OUR PRODUCT PRICING, AND OUR COSTS TO MANUFACTURE OR PURCHASE
PRODUCTS.
Our future results of operations, financial condition and cash flows depend to a
significant extent upon our product sales mix. Our sales of products that we
manufacture tend to create higher gross margins than do the products we purchase
and resell. As a result, our sales mix will significantly impact our gross
profit from period to period. Factors that may cause our sales mix to vary
include:
- - the amount of new product introductions;
- - marketing exclusivity, if any, which may be obtained on certain new
products;
- - the level of competition in the marketplace for certain products;
- - the availability of raw materials and finished products from our
suppliers; and
- - the scope and outcome of governmental regulatory action that may involve
us.
The profitability of our product sales is also dependent upon the prices we are
able to charge for our products, the costs to purchase products from third
parties, and our ability to manufacture our products in a cost effective manner.
IF BRANDED PHARMACEUTICAL COMPANIES ARE SUCCESSFUL IN LIMITING THE USE OF
GENERICS THROUGH THEIR LEGISLATIVE AND REGULATORY EFFORTS, OUR SALES OF GENERIC
PRODUCTS MAY SUFFER.
Many branded pharmaceutical companies increasingly have used state and federal
legislative and regulatory means to delay generic competition. These efforts
have included:
- - pursuing new patents for existing products which may be granted just
before the expiration of one patent which could extend patent protection for
additional years or otherwise delay the launch of generics;
- - using the Citizen Petition process to request amendments to FDA standards;
- - seeking changes to U.S. Pharmacopoeia, an organization which publishes
industry recognized compendia of drug standards;
- - attaching patent extension amendments to non-related federal legislation;
and
- - engaging in state-by-state initiatives to enact legislation that restricts
the substitution of some generic drugs, which could have an impact on products
that we are developing.
If branded pharmaceutical companies are successful in limiting the use of
generic products through these or other means, our sales may decline. If we
experience a material decline in product sales, our results of operations,
financial condition and cash flows will suffer.
THIRD PARTIES MAY CLAIM THAT WE INFRINGE THEIR PROPRIETARY RIGHTS AND MAY
PREVENT US FROM MANUFACTURING AND SELLING SOME OF OUR PRODUCTS.
The manufacture, use and sale of new products that are the subject of
conflicting patent rights have been the subject of substantial litigation in the
pharmaceutical industry. These lawsuits relate to the validity and infringement
of patents or proprietary rights of third parties. We may have to defend against
charges that we violated patents or proprietary rights of third parties. This is
especially true in the case of generic products on which the patent covering the
branded product is expiring, an area where infringement litigation is prevalent,
and in the case of new
22
branded products where a competitor has obtained patents for similar products.
Litigation may be costly and time-consuming, and could divert the attention of
our management and technical personnel. In addition, if we infringe on the
rights of others, we could lose our right to develop or manufacture products or
could be required to pay monetary damages or royalties to license proprietary
rights from third parties. Although the parties to patent and intellectual
property disputes in the pharmaceutical industry have often settled their
disputes through licensing or similar arrangements, the costs associated with
these arrangements may be substantial and could include ongoing royalties.
Furthermore, we cannot be certain that the necessary licenses would be available
to us on terms we believe to be acceptable. As a result, an adverse
determination in a judicial or administrative proceeding or failure to obtain
necessary licenses could prevent us from manufacturing and selling a number of
our products, which could harm our business, financial condition, results of
operations and cash flows.
IF WE ARE UNABLE TO OBTAIN SUFFICIENT SUPPLIES FROM KEY SUPPLIERS THAT IN SOME
CASES MAY BE THE ONLY SOURCE OF FINISHED PRODUCTS OR RAW MATERIALS, OUR ABILITY
TO DELIVER OUR PRODUCTS TO THE MARKET MAY BE IMPEDED.
We are required to identify the supplier(s) of all the raw materials for our
products in our applications with the FDA. To the extent practicable, we attempt
to identify more than one supplier in each drug application. However, some
products and raw materials are available only from a single source and, in some
of our drug applications, only one supplier of products and raw materials has
been identified, even in instances where multiple sources exist. To the extent
any difficulties experienced by our suppliers cannot be resolved within a
reasonable time, and at reasonable cost, or if raw materials for a particular
product become unavailable from an approved supplier and we are required to
qualify a new supplier with the FDA, our profit margins and market share for the
affected product could decrease, as well as delay our development and sales and
marketing efforts.
OUR POLICIES REGARDING RETURNS, ALLOWANCES AND CHARGEBACKS, AND MARKETING
PROGRAMS ADOPTED BY WHOLESALERS, MAY REDUCE OUR REVENUES IN FUTURE FISCAL
PERIODS.
Based on industry practice, generic product manufacturers, including us, have
liberal return policies and have been willing to give customers post-sale
inventory allowances. Under these arrangements, from time to time, we give our
customers credits on our generic products that our customers hold in inventory
after we have decreased the market prices of the same generic products.
Therefore, if new competitors enter the marketplace and significantly lower the
prices of any of their competing products, we would likely reduce the price of
our product. As a result, we would be obligated to provide credits to our
customers who are then holding inventories of such products, which could reduce
sales revenue and gross margin for the period the credit is provided. Like our
competitors, we also give credits for chargebacks to wholesale customers that
have contracts with us for their sales to hospitals, group purchasing
organizations, pharmacies or other retail customers. A chargeback is the
difference between the price the wholesale customer pays and the price that the
wholesale customer's end-customer pays for a product. Although we establish
reserves based on our prior experience and our best estimates of the impact that
these policies may have in subsequent periods, we cannot ensure that our
reserves are adequate or that actual product returns, allowances and chargebacks
will not exceed our estimates.
23
THE DESIGN, DEVELOPMENT, MANUFACTURE AND SALE OF OUR PRODUCTS INVOLVES THE RISK
OF PRODUCT LIABILITY CLAIMS BY CONSUMERS AND OTHER THIRD PARTIES, AND INSURANCE
AGAINST SUCH POTENTIAL CLAIMS IS EXPENSIVE AND MAY BE DIFFICULT TO OBTAIN.
The design, development, manufacture and sale of our products involve an
inherent risk of product liability claims and the associated adverse publicity.
Insurance coverage is expensive and may be difficult to obtain, and may not be
available in the future on acceptable terms, or at all. Although we currently
maintain product liability insurance for our products in amounts we believe to
be commercially reasonable, if the coverage limits of these insurance policies
are not adequate, a claim brought against Lannett, whether covered by insurance
or not, could have a material adverse effect on our business, results of
operations, financial condition and cash flows.
THE LOSS OF OUR KEY PERSONNEL COULD CAUSE OUR BUSINESS TO SUFFER.
The success of our present and future operations will depend, to a significant
extent, upon the experience, abilities and continued services of key personnel.
If the employment of any of our current key personnel is terminated, we cannot
assure you that we will be able to attract and replace the employee with the
same caliber of key personnel. As such, we have entered into employment
agreements with most of our senior executive officers.
RISING INSURANCE COSTS COULD NEGATIVELY IMPACT PROFITABILITY.
The cost of insurance, including workers compensation, product liability and
general liability insurance, have risen significantly in the past year and are
expected to continue to increase in 2005. In response, we may increase
deductibles and/or decrease certain coverages to mitigate these costs. These
increases, and our increased risk due to increased deductibles and reduced
coverages, could have a negative impact on our results of operations, financial
condition and cash flows.
SIGNIFICANT BALANCES OF INTANGIBLE ASSETS, INCLUDING PRODUCT RIGHTS ACQUIRED,
ARE SUBJECT TO IMPAIRMENT TESTING AND MAY RESULT IN IMPAIRMENT CHARGES, WHICH
WILL ADVERSELY AFFECT OUR RESULTS OF OPERATIONS AND FINANCIAL CONDITION.
Our acquired contractual rights to market and distribute JSP's products are
stated at cost, less accumulated amortization. We determined the initial cost by
referring to the original fair value of the assets exchanged. Future
amortization periods for product rights are based on our assessment of various
factors impacting estimated useful lives and cash flows of the acquired
products. Such factors include the product's position in its life cycle, the
existence or absence of like products in the market, various other competitive
and regulatory issues and contractual terms. Significant changes to any of these
factors would require us to perform an impairment test on the affected asset
and, if evidence of impairment exists, we would be required to take an
impairment charge with respect to the asset. Such a charge would adversely
affect our results of operations and financial condition.
24
RISKS RELATING TO INVESTING IN THE PHARMACEUTICAL INDUSTRY
EXTENSIVE INDUSTRY REGULATION HAS HAD, AND WILL CONTINUE TO HAVE, A SIGNIFICANT
IMPACT ON OUR BUSINESS, ESPECIALLY OUR PRODUCT DEVELOPMENT, MANUFACTURING AND
DISTRIBUTION CAPABILITIES.
All pharmaceutical companies, including Lannett, are subject to extensive,
complex, costly and evolving regulation by the federal government, principally
the FDA and to a lesser extent by the DEA and state government agencies. The
Federal Food, Drug and Cosmetic Act, the Controlled Substances Act and other
federal statutes and regulations govern or influence the testing, manufacturing,
packing, labeling, storing, record keeping, safety, approval, advertising,
promotion, sale and distribution of our products.
Under these regulations, we are subject to periodic inspection of our
facilities, procedures and operations and/or the testing of our products by the
FDA, the DEA and other authorities, which conduct periodic inspections to
confirm that we are in compliance with all applicable regulations. In addition,
the FDA conducts pre-approval and post-approval reviews and plant inspections to
determine whether our systems and processes are in compliance with current Good
Manufacturing Practice, or cGMP, and other FDA regulations. Following such
inspections, the FDA may issue notices on Form 483 and warning letters that
could cause us to modify certain activities identified during the inspection. A
Form 483 notice is generally issued at the conclusion of a FDA inspection and
lists conditions the FDA inspectors believe may violate cGMP or other FDA
regulations. FDA guidelines specify that a warning letter is issued only for
violations of "regulatory significance" for which the failure to adequately and
promptly achieve correction may be expected to result in an enforcement action.
Any such sanctions, if imposed, could materially harm our operating results and
financial condition. Under certain circumstances, the FDA also has the authority
to revoke previously granted drug approvals. Similar sanctions as detailed above
may be available to the FDA under a consent decree, depending upon the actual
terms of such decree. Although we have instituted internal compliance programs,
if these programs do not meet regulatory agency standards or if compliance is
deemed deficient in any significant way, it could materially harm our business.
Certain of our vendors are subject to similar regulation and periodic
inspections.
The process for obtaining governmental approval to manufacture and market
pharmaceutical products is rigorous, time-consuming and costly, and we cannot
predict the extent to which we may be affected by legislative and regulatory
developments. We are dependent on receiving FDA and other governmental or
third-party approvals prior to manufacturing, marketing and shipping our
products. Consequently, there is always the chance that we will not obtain FDA
or other necessary approvals, or that the rate, timing and cost of such
approvals, will adversely affect our product introduction plans or results of
operations. We carry inventories of certain product(s) in anticipation of
launch, and if such product(s) are not subsequently launched, we may be required
to write-off the related inventory.
25
FEDERAL REGULATION OF ARRANGEMENTS BETWEEN MANUFACTURERS OF BRANDED AND GENERIC
PRODUCTS COULD ADVERSELY AFFECT OUR BUSINESS.
As part of the Medicare Prescription Drug, Improvement, and Modernization Act of
2003, companies are now required to file with the Federal Trade Commission and
the Department of Justice certain types of agreements entered into between brand
and generic pharmaceutical companies related to the manufacture, marketing and
sale of generic versions of branded drugs. This new requirement could affect the
manner in which generic drug manufacturers resolve intellectual property
litigation and other disputes with branded pharmaceutical companies and could
result generally in an increase in private-party litigation against
pharmaceutical companies or additional investigations or proceedings by the FTC
or other governmental authorities. The impact of this new requirement and the
potential private-party lawsuits associated with arrangements between brand name
and generic drug manufacturers is uncertain, and could adversely affect our
business.
THE PHARMACEUTICAL INDUSTRY IS HIGHLY COMPETITIVE.
We face strong competition in our generic product business. Revenues and gross
profit derived from the sales of generic pharmaceutical products tend to follow
a pattern based on certain regulatory and competitive factors. As patents for
brand name products and related exclusivity periods expire, the first generic
manufacturer to receive regulatory approval for generic equivalents of such
products is generally able to achieve significant market penetration. As
competing off-patent manufacturers receive regulatory approvals on similar
products or as brand manufacturers launch generic versions of such products (for
which no separate regulatory approval is required), market share, revenues and
gross profit typically decline, in some cases dramatically. Accordingly, the
level of market share, revenue and gross profit attributable to a particular
generic product is normally related to the number of competitors in that
product's market and the timing of that product's regulatory approval and
launch, in relation to competing approvals and launches. Consequently, we must
continue to develop and introduce new products in a timely and cost-effective
manner to maintain our revenues and gross margins.
SALES OF OUR PRODUCTS MAY CONTINUE TO BE ADVERSELY AFFECTED BY THE CONTINUING
CONSOLIDATION OF OUR DISTRIBUTION NETWORK AND THE CONCENTRATION OF OUR CUSTOMER
BASE.
Our principal customers are wholesale drug distributors and major retail drug
store chains. These customers comprise a significant part of the distribution
network for pharmaceutical products in the U.S. This distribution network is
continuing to undergo significant consolidation marked by mergers and
acquisitions among wholesale distributors and the growth of large retail drug
store chains. As a result, a small number of large wholesale distributors
control a significant share of the market, and the number of independent drug
stores and small drug store chains has decreased. We expect that consolidation
of drug wholesalers and retailers will increase pricing and other competitive
pressures on drug manufacturers, including Lannett.
For the year ended June 30, 2004, our three largest customers accounted for 17%,
17% and 10% respectively, of our net revenues. The loss of any of these
customers could materially adversely affect our business, results of operations
and financial condition and our cash flows. In addition,
26
the Company has no long-term supply agreements with its customers which would
require them to purchase our products.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS.
In addition to historical information, this Form 10-K contains
forward-looking information. The forward-looking information is subject to
certain risks and uncertainties that could cause actual results to differ
materially from those projected in the forward-looking statements. Important
factors that might cause such a difference include, but are not limited to,
those discussed in the following section entitled "Management's Discussion and
Analysis of Financial Condition and Results of Operations." Readers are
cautioned not to place undue reliance on these forward-looking statements, which
reflect management's analysis only as of the date of this Form 10-K. The Company
undertakes no obligation to publicly revise or update these forward-looking
statements to reflect events or circumstances, which arise later. Readers should
carefully review the risk factors described in other documents the Company files
from time to time with the Securities and Exchange Commission, including the
Quarterly reports on Form 10-Q to be filed by the Company in Fiscal 2005, and
any Current Reports on Form 8-K filed by the Company. All share and per share
amounts on this Annual Report and Form 10-K have been adjusted to reflect a
three-for-two stock split, which was effective on February 14, 2003.
CRITICAL ACCOUNTING POLICIES
The discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have been
prepared in accordance with accounting principles generally accepted in the
United States of America. The preparation of these financial statements requires
us to make estimates and judgments that affect the reported amount of assets and
liabilities, revenues and expenses, and related disclosure of contingent assets
and liabilities at the date of our financial statements. Actual results may
differ from these estimates under different assumptions or conditions.
Critical accounting policies are defined as those that are reflective of
significant judgments and uncertainties, and potentially result in materially
different results under different assumptions and conditions. We believe that
our critical accounting policies include those described below. For a detailed
discussion on the application of these and other accounting policies, see Note 1
in the Notes to the Consolidated Financial Statements included herein.
REVENUE RECOGNITION
The Company recognizes revenue when its products are shipped. At this
point, title and risk of loss have transferred to the customer, and provisions
for estimates, including rebates, promotional adjustments, price adjustments,
returns, chargebacks, and other potential adjustments are reasonably
determinable. Accruals for these provisions are presented in the Consolidated
Financial Statements as reductions to net sales and accounts receivable.
Accounts
27
receivable are presented net of allowances relating to these provisions, which
were approximately $8,885,000 at June 30, 2004 and $2,772,000 at June 30, 2003.
The change in the reserves for various sales adjustments was not proportionally
equal to the change in sales because of changes in the product mix and the
customer mix. Provisions for rebates, promotional and other credits are
estimated based on historical payment experience, estimated customer inventory
levels and contract terms. Provisions for other customer credits, such as price
adjustments, returns and chargebacks require management to make subjective
judgments. Unlike branded innovator companies, Lannett does not use information
about product levels in distribution channels from third-party sources, such as
IMS Health and NDC Health in estimating future returns and other credits. These
provisions are discussed in more detail below and in the Notes to the
Consolidated Financial Statements.
CHARGEBACKS - The provision for chargebacks is the most significant and
complex estimate used in the recognition of revenue. The Company sells its
products directly to wholesale distributors, generic distributors, retail
pharmacy chains and mail-order pharmacies. The Company also sells its products
indirectly to independent pharmacies, managed care organizations, hospitals,
nursing homes and group purchasing organizations, collectively referred to as
"indirect customers." Lannett enters into agreements with its indirect customers
to establish pricing for certain products. The indirect customers then
independently select a wholesaler from which to actually purchase the products
at these agreed-upon prices. Lannett will provide credit to the wholesaler for
the difference between the agreed-upon price with the indirect customer and the
wholesaler's invoice price. This credit is called a chargeback. The provision
for chargebacks is based on expected sell-through levels by the Company's
wholesale customers to the indirect customers, and estimated wholesaler
inventory levels. As sales to the large wholesale customers, such as Cardinal
Health, AmerisourceBergen and McKesson Corporation, increase, the reserve for
chargebacks will also generally increase. However, the size of the increase
depends on the product mix. The Company continually monitors the reserve for
chargebacks and makes adjustments when it believes that actual chargebacks may
differ from estimated reserves.
REBATES - Rebates are offered to the Company's key customers to promote
customer loyalty and encourage greater product sales. These rebate programs
provide customers with rebate credits upon attainment of pre-established volumes
or attainment of net sales milestones for a specified period. Other promotional
programs are incentive programs offered to the customers. At the time of
shipment, the Company estimates reserves for rebates and other promotional
credit programs based on the specific terms in each agreement. The reserve for
rebates increases as sales to certain wholesale and retail customers increase.
However, these rebate programs are tailored to the customers' individual
programs. Hence, the reserve will depend on the mix of customers that comprise
such rebate programs.
RETURNS - Consistent with industry practice, the Company has a product
returns policy that allows select customers to return product within a specified
period prior to and subsequent to the product's lot expiration date, in exchange
for a credit to be applied to future purchases. The Company's policy requires
that the customer obtain pre-approval from the Company for any qualifying
return. The Company estimates its provision for returns based on historical
experience, changes to business practices and credit terms. While such
experience has allowed for reasonable estimations in the past, history may not
always be an accurate indicator of future returns. The Company continually
monitors the provisions for returns, and makes adjustments
28
when it believes that actual product returns may differ from established
reserves. Generally, the reserve for returns increases as net sales increase.
PRICE ADJUSTMENTS - Price adjustments, also known as "shelf stock
adjustments," are credits issued to reflect decreases in the selling prices of
the Company's products that customers have remaining in their inventories at the
time of the price reduction. Decreases in selling prices are discretionary
decisions made by management to reflect competitive market conditions. Amounts
recorded for estimated shelf stock adjustments are based upon specified terms
with direct customers, estimated declines in market prices and estimates of
inventory held by customers. The Company regularly monitors these and other
factors and evaluates the reserve as additional information becomes available.
The following table identifies the reserves for each major category of revenue
allowance and a summary of the activity:
Reserve Category/ Chargebacks Rebates Returns Other Total
- ----------------------------------- ------------ ----------- --------- --------- ------------
Reserve Balance as of June 30, 2003 $ 1,638,000 $ 889,900 $ 210,200 $ 33,900 $ 2,772,000
Actual Credits Issued-Related to
Sales Recorded in Fiscal 2003 (1,604,000) (1,166,400) (182,700) - (2,953,100)
Actual Credits Issued-Related to
Sales Recorded in Fiscal 2004 (12,447,000) (2,723,200) (60,100) (410,000) (15,640,300)
Additional Reserves Charged to Net
Sales During Fiscal 2004 18,897,500 4,863,900 480,600 464,400 24,706,400
Reserve Balance as of June 30, 2004 $ 6,484,500 $ 1,864,200 $ 448,000 $ 88,300 $ 8,885,000
============ =========== ========= ========= ============
The Company ships its products to the warehouses of its wholesale and
retail chain customers. When the Company and a customer come to an agreement for
the supply of a product, the customer will generally continue to purchase the
product, stock its warehouse(s) and resell the product to its own customers. The
Company's customer will continually reorder the product as its warehouse is
depleted. Lannett generally has no minimum size orders for its customers.
Additionally, most warehousing customers prefer not to stock excess inventory
levels due to the additional carrying costs and inefficiencies created by
holding extra inventory. As such, Lannett's customers continually reorder the
Company's products. It is common for Lannett's customers to order the same
products on a monthly basis. For generic pharmaceutical manufacturers, it is
critical to ensure that customers' warehouses are adequately stocked with its
products. This is important due to the fact that several generic competitors
compete for the consumer demand for a given product. Availability of inventory
ensures that a manufacturer's
29
product is considered. Otherwise, retail prescriptions would be filled with
competitors' products. For this reason, the Company periodically offers
incentives to its customers to purchase its products. These incentives are
generally up-front discounts off its standard prices at the beginning of a
generic campaign launch for a newly-approved or newly-introduced product, or
when a customer purchases a Lannett product for the first time. Customers
generally inform the Company that such purchases represent an estimate of
expected resales for a period of time. This period of time is generally up to
three months. The Company records this revenue, net of any discounts offered and
accepted by its customers, and net of any estimated returns and other credits,
at the time of shipment. The Company's products have either 24 months or 36
months shelf-life at the time of manufacture. The Company monitors its
customers' purchasing trends to attempt to identify any significant lapses in
purchasing activity. If the Company observes a lack of recent activity,
inquiries will be made to such customer regarding the success of the customer's
resale efforts. The Company will attempt to minimize any potential return (or
shelf life issues) by maintaining an active dialogue with its customers.
The products that the Company sells are generic versions of brand named
drugs. The consumer markets for such drugs are well-established markets with
many years of historically-confirmed consumer demand. Such consumer demand may
be affected by several factors, including alternative treatments, cost, etc.
However, the effects of changes in such consumer demand for Lannett's products,
like generic products manufactured by other generic companies, are gradual in
nature. Any overall decrease in consumer demand for generic products generally
occurs over an extended period of time. This is because there are thousands of
doctors, prescribers, third-party payers, institutional formularies and other
buyers of drugs that must change prescribing habits, and medicinal practices
before such a decrease would affect a generic drug market. If the historical
data the Company uses, and the assumptions management makes to calculate its
estimates of future returns, chargebacks and other credits do not accurately
approximate future activity, its net sales, gross profit, net income and
earnings per share could change. However, management believes that these
estimates are reasonable based upon historical experience and current
conditions.
ACCOUNTS RECEIVABLE
The Company performs ongoing credit evaluations of its customers and
adjusts credit limits based upon payment history and the customer's current
credit worthiness, as determined by a review of their current credit
information. The Company continuously monitors collections and payments from its
customers and maintains a provision for estimated credit losses based upon
historical experience and any specific customer collection issues that have been
identified. While such credit losses have historically been within the Company's
expectations and the provisions established, the Company cannot guarantee that
it will continue to experience the same credit loss rates that it has in the
past.
INVENTORIES
The Company values its inventory at the lower of cost or market and
regularly reviews inventory quantities on hand and records a provision for
excess and obsolete inventory based primarily on estimated forecasts of product
demand and production requirements. The Company's estimates of future product
demand may prove to be inaccurate, in which case it may have understated or
overstated the provision required for excess and obsolete inventory. In the
30
future, if the Company's inventory is determined to be overvalued, the Company
would be required to recognize such costs in cost of goods sold at the time of
such determination. Likewise, if inventory is determined to be undervalued, the
Company may have recognized excess cost of goods sold in previous periods and
would be required to recognize such additional operating income at the time of
sale.
RESULTS OF OPERATIONS - FISCAL 2004 COMPARED TO FISCAL 2003
Net sales increased by 50%, from $42,486,758 in Fiscal 2003 to $63,781,219
in Fiscal 2004. Sales increased as a result of additions to the Company's
prescription line of products, including Digoxin tablets, first marketed in
September 2002, Levothyroxine Sodium tablets, first marketed in April 2003 and
Unithroid tablets, first marketed in August 2003. These product additions had
the effect of increasing the total net sales for Fiscal 2004 as compared to
Fiscal 2003 due to the fact the Company sold the products for longer periods of
time in the twelve months ended June 30, 2004. These product additions accounted
for approximately $20.5 million of the increase in net sales from Fiscal 2003 to
Fiscal 2004. Additionally, sales of a portion of the Company's previously
marketed products, such as Primidone tablets, Butalbital with Aspirin and
Caffeine with Codeine capsules and Dicyclomine tablets increased by
approximately $4.8 million from Fiscal 2003 to Fiscal 2004 as a result of new
customer accounts, increased unit sales and increased unit sales prices. The
Company from time to time will raise its sales prices if there is an increase in
the price of the brand named drug. Generally, the Company sells its products at
the accepted market prices for such products. If the competitive environment
changes, the Company monitors such changes to determine the effect on the market
prices for its products. Such changes may include new competitors, fewer
competitors, or an increase in the price of the innovator drug. The increase in
sales of a portion of the Company's products was partially offset by a decrease
in sales of certain other products, including Butalbital with Aspirin and
Caffeine capsules (which decreased $3.9 million) due to increased competition
and a discontinuation of Pseudoephedrine Hydrochloride tablets (which resulted
in a loss of sales of $681,000).
The Company sells its products to customers in various categories. The
table below identifies the Company's net sales to each category.
Fiscal 2003 Net Fiscal 2002 Net
Customer Category Fiscal 2004 Net Sales Sales Sales
- ---------------------- --------------------- --------------- ---------------
Wholesaler/Distributor $43.0 million $20.6 million $10.4 million
Retail Chain $12.1 million $ 9.9 million $ 3.3 million
Mail-Order Pharmacy $ 4.3 million $ 2.6 million $ 1.1 million
Private Label $ 4.4 million $ 9.4 million $10.3 million
------------- ------------- -------------
Total $63.8 million $42.5 million $25.1 million
31
Sales in every category, with the exception of `Private Label,' increased each
of the past three years. This is a result of the factors described in the
previous paragraph. Sales to `Private Label' customers decreased in Fiscal 2004
and 2003 as a result of the Company's successful efforts in growing the Lannett
label accounts. Increasing sales to customers that purchased the Lannett label
products (i.e. the `Wholesale,' `Retail' and `Mail-Order' customer categories)
had the effect of reducing sales to `Private Label' customers.
Cost of sales increased by 65%, from $16,257,794 in Fiscal 2003 to
$26,856,875 in Fiscal 2004. The cost of sales increase is due to an increase in
direct variable costs and certain indirect costs as a result of the increase in
sales volume, and related production activities. These costs include raw
materials/cost of finished goods purchased and resold, which increased
approximately $8,613,000, labor and benefits expenses, which increased by
approximately $1,641,000 and other miscellaneous production-related expenses
which increased in total by approximately $345,000. Gross margins decreased from
62% in Fiscal 2003 to 58% in Fiscal 2004. The decrease in gross profit margins
is a result of a decrease in net weighted average prices from some of the
Company's products due to increased market competition, increases in direct and
indirect costs as well as a change in the product sales mix. During Fiscal 2004,
a larger percentage of the Company's total net sales were from products supplied
by JSP. The Company's average gross profit margin for products from JSP is less
than the average gross profit margin for products internally manufactured.
Depending on future market conditions for each of the Company's products,
changes in the future sales product mix may occur. These changes may affect the
gross profit percentage in future periods.
Research and development ("R&D") expenses increased by 129%, from
$2,575,178 in Fiscal 2003 to $5,895,096 in Fiscal 2004. This increase is
primarily due to an increase in the costs of generic bioequivalence tests which
are commonly required for ANDA submissions. The Company incurred approximately
$2.3 million in Fiscal 2004 for bioequivalence testing fees, compared to
approximately $265,000 in Fiscal 2003. The increase in R&D is also a result of
an increase in the number of chemists in the R&D laboratory and the related
payroll and benefits expenses, which increased by approximately $1.1 million in
Fiscal 2004 as compared to Fiscal 2003 and an increase of raw material
consumption of approximately $200,000 used in the development and formulation of
new products not yet approved by the FDA.
Selling, general and administrative expenses increased by 104%, from
$4,337,558 in Fiscal 2003 to $8,863,966 in Fiscal 2004. This increase is a
result of an increase in the following expenses: payroll/incentive compensation
and benefits, which increased by approximately $2.4 million, consulting
services, which increased by approximately $343,000(including Sarbanes-Oxley
consulting), legal expenses, which increased by approximately $282,000, computer
support costs, which increased by approximately $180,000, advertising expenses,
which increased by approximately $172,000, travel and entertainment expenses,
which increased by approximately $109,000, insurance expenses, which increased
by approximately $114,000, investor relations/marketing expenses, which
increased by approximately $85,000, directors fees, which increased by
approximately $174,000 and miscellaneous other expenses, including utilities,
training, general and safety supplies, office supplies, accounting fees,
telephone and rent expense. Such miscellaneous expenses comprised the remainder
of the increase in selling, general and administrative expenses. The increases
were due to the hiring of additional
32
administrative employees and a general increase in administrative expenses due
to the growth of the Company in terms of employees, production volume and sales.
Currently, the Company's only finished product inventory supplier is Jerome
Stevens Pharmaceuticals, Inc. (JSP), in Bohemia, New York. Purchases of finished
goods inventory from JSP accounted for approximately 81% of the Company's
inventory purchases in Fiscal 2004, 62% in Fiscal 2003 and 26% in Fiscal 2002.
On March 23, 2004, the Company entered into an agreement with JSP for the
exclusive distribution rights in the United States to the current line of JSP
products, in exchange for four million (4,000,000) shares of the Company's
common stock. The JSP products covered under the agreement included Butalbital,
Aspirin, Caffeine with Codeine Phosphate capsules, Digoxin tablets and
Levothyroxine Sodium tablets, sold generically and under the brand name
Unithroid(R). The term of the agreement is ten years, beginning on March 23,
2004 and continuing through March 22, 2014. Both Lannett and JSP have the right
to terminate the contract if one of the parties does not cure a material breach
of the contract within thirty (30) days of notice from the non-breaching party.
During the term of the agreement, the Company is required to use commercially
reasonable efforts to purchase minimum dollar quantities of JSP's products being
distributed by the Company. The Company projects that it will be able to meet
the minimum purchase requirements, but there is no guarantee that the Company
will be able to do so. If the Company does not meet the minimum purchase
requirements, JSP's sole remedy is to terminate the agreement. Under the
agreement, JSP is entitled to nominate one person to serve on the Company's
Board of Directors (the "Board"); provided, however, that the Board shall have
the right to reasonably approve any such nominee in order to fulfill its
fiduciary duty by ascertaining that such person is suitable for membership on
the board of a publicly traded corporation including, but not limited to,
complying with the requirements of the Securities and Exchange Commission, the
American Stock Exchange and applicable law including the Sarbanes-Oxley Act of
2002. The Agreement was included as an Exhibit in the Form 8-K filed by the
Company on May 5, 2004. The obligation of the Company to issue the four million
(4,000,000) shares was subject to the receipt of a fairness opinion issued by a
recognized and reputable investment banking firm in opining that the issuance of
the four million (4,000,000) shares and the resulting dilution of the ownership
interest of the Company's minority shareholders was fair to such shareholders in
view of JSP's products' contribution or potential contribution to the Company's
profitability. On April 20, 2004, the investment banker, Donnelly Penman and
Partners, which was selected by the independent Directors of the Company's
Board, opined that the issuance of the four million (4,000,000) shares and the
resulting dilution of the ownership interest of the Company's minority
shareholders was fair to such shareholders from a financial point of view. As
such, subsequent to April 20, 2004, the Company issued four million (4,000,000)
shares to JSP's designees. As a result of the transaction, the Company recorded
an intangible asset related to the contract in the amount of $67,040,000. The
intangible asset was recorded based upon the fair value of the (4,000,000)
shares at the time of issuance to JSP. The Company will incur non-cash
amortization expense for the intangible asset over the term of the contract. For
the period April 2004 to June 2004, the Company incurred $1,314,510 of non-cash
amortization expense associated with the JSP intangible asset.
As a result of the items discussed above, the Company increased its
operating income by 9%, from $19,060,106 in Fiscal 2003 to $20,830,969 in Fiscal
2004.
33
The Company's income tax expense increased from $7,334,740 in Fiscal 2003
to $7,594,316 in Fiscal 2004 as a result of the increase in taxable income.
The Company reported net income of $13,215,454 for Fiscal 2004, or $0.63
basic and diluted income per share, compared to net income of $11,666,887 for
Fiscal 2003, or $0.58 basic and diluted income per share.
RESULTS OF OPERATIONS - FISCAL 2003 TO FISCAL 2002
Net sales increased by 69%, from $25,126,214 in Fiscal 2002 to $42,486,758
in Fiscal 2003. Sales increased as a result of additions to the Company's
prescription line of products, including Prednisolone tablets, first marketed in
October 2001, Butalbital with Aspirin, Caffeine and Codeine Phosphate capsules,
first marketed in December 2001, Isoniazid tablets, first marketed in January
2002, Digoxin tablets, first marketed in September 2002 and Levothyroxine Sodium
tablets, first marketed in April 2003. These product additions had the effect of
increasing the total annual sales in Fiscal 2003, compared to Fiscal 2002, due
to the fact that the Company sold the products for longer periods of time in
Fiscal 2003, compared to Fiscal 2002. Of these product additions, Butalbital
with Aspirin, Caffeine and Codeine Phosphate capsules, Digoxin tablets and
Levothyroxine Sodium tablets accounted for approximately $9.7 million of the
increase in net sales from Fiscal 2002 to Fiscal 2003. Additionally, sales of a
portion of the Company's previously marketed products, including Primidone
tablets and Butalbital with Aspirin and Caffeine capsules, increased due to new
customer accounts, increased unit sales, and higher unit sales prices. The
Company raised its sales prices for Primidone 50 milligram tablets in Fiscal
2003 subsequent to an increase in the price of the brand named drug. Generally,
the Company sells its products at the accepted market prices for such products.
If the competitive environment changes, the Company monitors such changes to
determine the effect on the market prices for its products. Such changes may
include new competitors, fewer competitors, or an increase in the price of the
innovator drug. The increase in sales of a portion of the Company's products was
offset by a decrease of approximately $2.6 million in net sales of certain other
products, including pseudoephedrine hydrochloride tablets and
guaifenesin/ephedrine hydrochloride tablets.
Due to increased competition for these two products, and the Company's decision
to allocate its production capacity to higher margin prescription products, the
Company discontinued its production, marketing and distribution of these two
products in Fiscal 2003. Such higher margin products included Primidone 50 and
250 milligram tablets and Butalbital with Aspirin and Caffeine capsules.
Cost of sales increased by 92%, from $8,452,677 in Fiscal 2002 to $16,257,794 in
Fiscal 2003. The cost of sales increase is due to an increase in direct variable
costs and certain indirect overhead costs as a result of the increase in sales
volume and related production activities. These costs include raw materials/cost
of finished goods purchased and resold, which increased by approximately
$6,308,000, labor and benefits expenses, which increased by approximately
$1,126,000, depreciation expense, which increased by approximately $140,000 and
other miscellaneous production-related expenses, which increased in total by
approximately $231,000.
34
Gross profit margins for Fiscal 2003 and Fiscal 2002 were 62% and 66%,
respectively. The decrease in the gross profit percentage is due to the product
sales mix. Incremental sales in Fiscal 2003 of some or all of the Company's new
products were at gross profit percentages less than the Company's average gross
profit percentage from Fiscal 2002. This is a result of more competition for
such drugs, and an erosion in generic market pricing for such drugs. During
Fiscal 2003, a larger percentage of the Company's total net sales were of
JSP-manufactured products, as compared to the percentage of the Company's total
net sales during Fiscal 2002. The Company's average gross profit margin for the
JSP products is less than the average gross profit margin for products
internally manufactured. As such, the change in product sales mix reduced the
gross profit percentage in Fiscal 2003. Depending on future market conditions
for each of the Company's products, changes in the future sales product mix may
occur. These changes may affect the gross profit percentage in future periods.
Research and development expenses increased by 47%, from $1,748,631 in
Fiscal 2002 to $2,575,178 in Fiscal 2003. This increase is a result of an
increase in the cost of clinical bioequivalence testing fees, which increased by
approximately $261,000, outsourced product development consulting services,
which increased by approximately $300,000, payroll and benefits expenses, which<