Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
1 – Organization and Business
ProPhase
Labs, Inc. (“we”, “us” or the “Company”) was initially organized in Nevada in July 1989. Effective
June 18, 2015, we changed our state of incorporation from the State of Nevada to the State of Delaware. We are a manufacturer,
marketer and distributor of a diversified range of health care and cold remedy products that are offered to the general public.
We are also engaged in the research and development of potential over-the-counter (“OTC”) drug and natural base health
products including supplements, personal care and cosmeceutical products.
Discontinued
Operations
Prior
to March 29, 2017, our flagship OTC drug brand was Cold-EEZE
®
and our principal product was Cold-EEZE
®
cold remedy zinc gluconate lozenges, proven in clinical studies to reduce the duration and severity of symptoms of the common
cold. In addition to Cold-EEZE
®
cold remedy lozenges, we also marketed and distributed non-lozenge forms of our
proprietary zinc gluconate formulation, (i) Cold-EEZE
®
cold remedy QuickMelts
®
, (ii) Cold-EEZE
®
Gummies and (iii) Cold-EEZE
®
cold remedy Oral Spray. Each of the Cold-EEZE
®
QuickMelts
®
and Gummies products are based on a proprietary zinc gluconate formulation in combination with certain (i) immune system
support, (ii) energy, (iii) sleep and relaxation, and/or (iv) cold and flu symptom relieving active ingredients.
On
January 6, 2017, we signed an asset purchase agreement (as amended, the “Asset Purchase Agreement”), by and among
the Company, Meda Consumer Healthcare Inc. (“MCH”) and Mylan Inc. (together with MCH, “Mylan”), for the
sale of assets by us to Mylan (see Note 3). The sale of assets (i) was subject to stockholder approval and other customary closing
conditions and (ii) consisted principally of the sale of our intellectual property rights and other assets relating to our Cold-EEZE
®
brand and product line (collectively, referred to herein as the “Cold-EEZE
®
Business”) to Mylan,
including all current and pipeline over-the-counter allergy, cold, flu, multi-symptom relief and immune support treatments for
adults and children to the extent each is, or is intended to be, branded “Cold-EEZE
®
”, and all private
label versions thereof, including all formulations and derivatives thereof as set forth in the Asset Purchase Agreement.
A
special meeting of our stockholders was held on March 29, 2017 (the “Special Meeting”). At the Special Meeting, our
stockholders approved the sale of assets and the transactions contemplated by the Asset Purchase Agreement. Effective March 29,
2017, we completed the sale of the Cold-EEZE
®
Business to Mylan. As a consequence of the sale of the Cold-EEZE
®
Business, for the three and six months ended June 30, 2017 and 2016, we have classified as discontinued operations (i) the
gain from the sale of the Cold-EEZE
®
Business, (ii) all income and expenses attributable to the Cold-EEZE
®
Business and (iii) the income tax expense attributed to the sale of the Cold-EEZE
®
Business (see Notes 3
and 6). Excluded from the sale of the Cold-EEZE
®
Business were our accounts receivable and inventory, and we also
retained all liabilities associated with our Cold-EEZE
®
Business operations arising prior to March 29, 2017.
Continuing
Operations
We
continue to own and operate our manufacturing facility and manufacturing business in Lebanon, Pennsylvania, and our headquarters
in Doylestown, Pennsylvania. As part of the sale of the Cold-EEZE
®
Business, we entered into a manufacturing agreement
(see Note 7) with Mylan and our wholly-owned subsidiary, Pharmaloz Manufacturing, Inc. (“PMI”), to supply various
Cold-EEZE
®
lozenge products to Mylan. In addition to the production services we provide to Mylan under the manufacturing
agreement, we produce OTC drug and dietary supplement lozenges and other products for other third party customers in addition
to performing operational tasks such as warehousing, customer order processing and shipping.
We
are also pursuing a series of new product development and pre-commercialization initiatives in the OTC dietary supplement category.
Initial OTC dietary supplement product development activities were completed in the fourth quarter of Fiscal 2015 under the brand
name of TK Supplements
®
. The TK Supplements
®
product line comprises three men’s health products:
(i) Legendz XL
®
for sexual health, (ii) Triple Edge XL
®
, a daily energy booster plus testosterone
support, and (iii) Super ProstaFlow Plus
TM
for prostate and urinary health. We recently completed a broad series of
clinical studies which support important product claims which have now been incorporated in our product packaging and marketing
communications. In addition to developing direct-to-consumer (“Direct Response”) marketing strategies of Legendz XL
®
,
we received initial product acceptance and shipped into a national chain drug retailer during the second quarter of Fiscal 2017.
In addition, we have received initial product acceptance from several regional retailers to begin shipments in the third and fourth
quarters of Fiscal 2017.
For
the three and six months ended June 30, 2017 and 2016, our revenues from continuing operations have come principally from our
OTC health care products.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
1 – Organization and Business – continued
We
use a December 31 year-end for financial reporting purposes. References herein to “Fiscal 2017” shall mean the fiscal
year ended December 31, 2017 and references to other “Fiscal” years shall mean the year, which ended on December 31
of the year indicated. The term “we”, “us” or the “Company” as used herein also refer, where
appropriate, to the Company, together with its subsidiaries unless the context otherwise requires.
Note
2 – Summary of Significant Accounting Policies
Basis
of Presentation
The
unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles
for interim financial statements and within the rules of the Securities and Exchange Commission (“SEC”) applicable
to interim financial statements and therefore do not include all disclosures that might normally be required for financial statements
prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”). The
accompanying unaudited condensed consolidated financial statements have been prepared by management without audit and should be
read in conjunction with our consolidated financial statements, including the notes thereto, appearing in our Annual Report on
Form 10-K for the year ended December 31, 2016. In the opinion of management, all adjustments necessary for a fair presentation
of the consolidated financial position, consolidated results of operations and consolidated cash flows, for the periods indicated,
have been made. The results of operations for the three and six months ended June 30, 2017 are not necessarily indicative of operating
results that may be achieved over the course of the full year. Historical financial statements have been reclassified to conform
to the current period presentation, principally reflecting the sale of Cold-EEZE
®
Business as discontinued operations.
Discontinued
Operations Carve Out and ProPhase Allocations
For
the three and six months ended June 30, 2017 and 2016, results from operations for our Cold-EEZE
®
Business are
classified as discontinued operations The carve out of the discontinued operations (i) were prepared in accordance with the SEC’s
carve out rules under Staff Accounting Bulletin (“SAB”) Topic 1B1 and (ii) are derived from identifying and carving
out the specific assets, liabilities, net sales, cost of sales, operating expenses and interest expense associated with the Cold-EEZE
®
Business’s operations. General administrative and overhead expenses, including personnel expenses and bonuses, and
research and development overhead expenses incurred by us (for which the discontinued operation benefits from such resources)
are allocated to discontinued operations based upon the percentage of the Cold-EEZE
®
Business’s net sales
to our consolidated net sales. For the three months ended June 30, 2017 and 2016, we allocated (i) zero and $319,000, respectively,
of administrative expenses and (ii) zero and $48,000, respectively, of research and development expenses, to discontinued operations
in the accompanying condensed statements of operations. For the six months ended June 30, 2017 and 2016, we allocated (i) $348,000
and $656,000, respectively, of administrative expenses and (ii) $52,000 and $95,000, respectively, of research and development
expenses, to discontinued operations in the accompanying condensed statements of operations (see Note 3).
Seasonality
of the Business
Our
net sales are derived principally from our OTC heath care and cold remedy products sold in the United States of America. Our sales
are influenced by and subject to fluctuations in the timing of purchase and the ultimate level of demand for our products which
are a function of the timing, length and severity of each cold season. Generally, a cold season is defined as the period of September
to March when the incidence of the common cold rises as a consequence of the change in weather and other factors. We generally
experience in the first, third and fourth quarter higher levels of net sales. Revenues are generally at their lowest levels in
the second quarter when customer demand generally declines.
For
the three and six months ended June 30, 2017 and 2016, our net sales were principally related to domestic markets.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies – continued
Use
of Estimates
The
preparation of financial statements and the accompanying notes thereto, in conformity with GAAP, requires management to make estimates
and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at
the date of the financial statements and reported amounts of revenues and expenses during the respective reporting periods. Examples
include the provision for bad debt, sales returns and allowances, inventory obsolescence, useful lives of property and equipment,
impairment of property and equipment, income tax valuations and assumptions related to accrued advertising. When providing for
the appropriate sales returns, allowances, cash discounts and cooperative incentive promotion costs (“Sales Allowances”),
we apply a uniform and consistent method for making certain assumptions for estimating these provisions. These estimates and assumptions
are based on historical experience, current trends and other factors that management believes to be relevant at the time the financial
statements are prepared. Management reviews the accounting policies, assumptions, estimates and judgments on a quarterly basis.
Actual results could differ from those estimates.
Cash
and Cash Equivalents
We
consider all highly liquid investments with a maturity of three months or less at the time of purchase to be cash equivalents.
Cash equivalents include cash on hand and monies invested in money market funds. The carrying amount approximates the fair market
value due to the short-term maturity of these investments.
Inventory
Valuation
Inventory
is valued at the lower of cost, determined on a first-in, first-out basis (FIFO), or market. Inventory items are analyzed to determine
cost and the market value and appropriate valuation adjustments are established. At June 30, 2017 and December 31, 2016, the financial
statements include adjustments to reduce inventory for excess or obsolete inventory of $1.7 million and $1.6 million, respectively.
The components of inventory are as follows (in thousands):
|
|
June 30, 2017
|
|
|
December 31, 2016
|
|
Raw materials
|
|
$
|
1,590
|
|
|
$
|
1,404
|
|
Work in process
|
|
|
342
|
|
|
|
466
|
|
Finished goods
|
|
|
34
|
|
|
|
866
|
|
|
|
$
|
1,966
|
|
|
$
|
2,736
|
|
Property,
Plant and Equipment
Property,
plant and equipment are recorded at cost. We use the straight-line method in computing depreciation for financial reporting purposes. Depreciation expense is computed in accordance with the following ranges of estimated asset lives: building and improvements – ten to thirty-nine years; machinery and equipment – three to seven years; computer software – three years; and furniture and fixtures – five years.
Concentration
of Risks
Future
revenues, costs, margins and profits will continue to be influenced by our ability to maintain our manufacturing availability
and capacity together with our marketing and distribution capabilities and the regulatory requirements associated with the development
of OTC and other personal care products in order to compete on a national level and/or international level.
Our
business is subject to federal and state laws and regulations adopted for the health and safety of users of our products. Our
OTC health care products are subject to regulations by various federal, state and local agencies, including the Food and Drug
Administration (“FDA”) and, as applicable, the Homeopathic Pharmacopoeia of the United States.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Financial
instruments that potentially subject us to significant concentrations of credit risk consist principally of cash investments and
trade accounts receivable.
We
maintain cash and cash equivalents with certain major financial institutions. As of June 30, 2017, our cash balance was $37.3
million and our bank balance was $38.5 million. Of the total bank balance, $342,000 was covered by federal depository insurance
and $38.1 million was uninsured at June 30, 2017.
Note
2 – Summary of Significant Accounting Policies – continued
Trade
accounts receivable potentially subject us to credit concentrations from time-to-time as a consequence of the timing, payment
pattern and ultimate purchase volumes or shipping schedules with our customers. We extend credit to our customers based upon an
evaluation of the customer’s financial condition and credit history and generally we do not require collateral. Our broad
range of customers includes many large national chain, regional, specialty and local retail stores. These credit concentrations
may impact our overall exposure to credit risk, either positively or negatively, in that our customers may be similarly affected
by changes in economic, regulatory or other conditions that may impact the timing and collectability of amounts due to us. As
a consequence of an evaluation of our customer’s financial condition, payment patterns, balance due to us and other factors,
we did not offset our account receivable with an allowance for bad debt at June 30, 2017 and December 31, 2016.
Long-lived
Assets
We
review our carrying value of our long-lived assets with definite lives whenever events or changes in circumstances indicate that
the carrying amount of the assets may not be recoverable. When indicators of impairment exist, we determine whether the estimated
undiscounted sum of the future cash flows of such assets is less than their carrying amounts. If less, an impairment loss is recognized
in the amount, if any, by which the carrying amount of such assets exceeds their respective fair values. The determination of
fair value is based on quoted market prices in active markets, if available, or independent appraisals; sales price negotiations;
or projected future cash flows discounted at a rate determined by management to be commensurate with our business risk. The estimation
of fair value utilizing discounted forecasted cash flows includes significant judgments regarding assumptions of revenue, operating
and marketing costs; selling and administrative expenses; interest rates; property and equipment additions and retirements; industry
competition; and general economic and business conditions, among other factors.
Fair
value is based on the prices that would be received to sell an asset or paid to transfer a liability in an orderly transaction
between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements,
a three-tier fair value hierarchy prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as
observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets
that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data
exists, therefore requiring an entity to develop its own assumptions.
Fair
Value of Financial Instruments
Cash
and cash equivalents, accounts receivable, assets held for sale, accounts payable, accrued expenses and notes payable are reflected
in the Condensed Consolidated Financial Statements at carrying value which approximates fair value.
Revenue
Recognition
Sales
are recognized at the time ownership is transferred to the customer. Revenue is reduced for trade promotions, estimated sales
returns, cash discounts and other allowances in the same period as the related sales are recorded. We make estimates of potential
future product returns and other allowances related to current period revenue. We analyze historical returns, current trends,
and changes in customer and consumer demand when evaluating the adequacy of the sales returns and other allowances.
Our
return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products that have reached or
exceeded their designated expiration date. We do not impose a period of time within which product may be returned. All requests
for product returns must be submitted to us for pre-approval. The main components of our returns policy are: (i) we will accept
returns that are due to damaged product that is un-saleable and such return request activity falls within an acceptable range,
(ii) we will accept returns for products that have reached or exceeded designated expiration dates and (iii) we will accept returns
in the event that we discontinue a product provided that the customer will have the right to return only such items that it purchased
directly from us. We will not accept return requests pertaining to customer inventory “Overstocking” or “Resets”.
We will only accept return requests for product in its intended package configuration. We reserve the right to terminate shipment
of product to customers who have made unauthorized deductions contrary to our return policy or pursue other methods of reimbursement.
We compensate the customer for authorized returns by means of a credit applied to amounts owed or to be owed and in the case of
discontinued product only, also by way of an exchange. We do not have any significant product exchange history.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies – continued
Pursuant
to the terms of the Asset Purchase Agreement, we are responsible for and continue to accept product returns of the Cold-EEZE
®
Business for product shipped prior to March 30, 2017. Additionally, pursuant to the terms of the Asset Purchase Agreement,
we allocated and, in June 2017, issued a credit to Mylan in an aggregate of $400,000 for future sales returns and allowances
arising from certain product returns that were sold by us prior to March 30, 2017.
As
of June 30, 2017 and December 31, 2016, we included a provision for sales allowances of zero and $108,000, respectively. Additionally,
accrued advertising and other allowances as of June 30, 2017 included (i) $934,000 for estimated future sales returns and (ii)
$598,000 for cooperative incentive promotion costs. As of December 31, 2016, accrued advertising and other allowances included
(i) $1.2 million for estimated future sales returns and (ii) $1.5 million for cooperative incentive promotion costs.
Advertising
and Incentive Promotions
Advertising
and incentive promotion costs are expensed within the period in which they are utilized. Advertising and incentive promotion expense
is comprised of (i) media advertising, presented as part of sales and marketing expense, (ii) cooperative incentive promotions
and coupon program expenses, which are accounted for as part of net sales, and (iii) free product, which is accounted for as part
of cost of sales. Advertising and incentive promotion expenses incurred (i) from continuing operations for the three months ended
June 30, 2017 and 2016 were $21,000 and $139,000, respectively, and (ii) attributed to and classified as discontinued operations
were $205,000 and $471,000, respectively. Advertising and incentive promotion expenses incurred (i) from continuing operations
for the six months ended June 30, 2017 and 2016 were $53,000 and $339,000 , respectively, and (ii) attributed to and classified
as discontinued operations were $2.8 million and $3.3 million, respectively. Included in prepaid expenses and other current assets
was $17,000 and $263,000 at June 30, 2017 and December 31, 2016, respectively, relating to prepaid advertising and promotion expenses.
Shipping
and Handling
Product
sales may carry shipping and handling charges to the purchaser, included as part of the invoiced price, which is classified as
revenue. In all cases, costs related to this revenue are recorded in cost of sales.
Stock-Based
Compensation
We
recognize all share-based payments to employees and directors, including grants of stock options, as compensation expense in the
financial statements based on their fair values. Fair values of stock options are determined through the use of the Black-Scholes
option pricing model. The compensation cost is recognized as an expense over the requisite service period of the award, which
usually coincides with the vesting period.
Stock
and stock options for the purchase of our common stock, $0.0005 par value (“Common Stock”), have been granted to both
employees and non-employees pursuant to the terms of certain agreements and stock option plans (see Note 5). Stock options are
exercisable during a period determined by us, but in no event later than ten years from the date granted. For the three and six
months ended June 30, 2017 and 2016, we charged to operations $18,000 and $1,000, respectively, for share-based compensation expense
for the aggregate fair value of stock grants issued and vested stock options earned.
Research
and Development
Research
and development costs are charged to operations in the period incurred. Research and development costs incurred for the three
months ended June 30, 2017 and 2016 (i) from continuing operations were $224,000 and $121,000, respectively, and (ii) attributed
to and classified as discontinued operations of zero and $48,000, respectively. Research and development costs incurred for the
six months ended June 30, 2017 and 2016 (i) from continuing operations were $258,000 and $160,000, respectively, and (ii) attributed
to and classified as discontinued operations of $52,000 and $95,000, respectively. Research and development costs are principally
related to personnel expenses and new product development initiatives and costs associated with our OTC health care products.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Income
Taxes
We
utilize the asset and liability approach which requires the recognition of deferred tax assets and liabilities for the future
tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences,
we generally consider all expected future events other than enactments of changes in the tax law or rates. Until we have sufficient
taxable income to offset the temporary timing differences attributable to operations and the tax deductions attributable to option,
warrant and stock activities are assured, a full valuation allowance equaling the total deferred tax asset is being provided (see
Notes 3 and 6).
Note
2 – Summary of Significant Accounting Policies – continued
We
utilize a two-step approach to recognizing and measuring uncertain tax positions. The first step is to evaluate the tax position
for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position
will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure
the tax benefit as the largest amount which is more than fifty percent likely of being realized upon ultimate settlement. Any
interest or penalties related to income taxes will be recorded as interest or administrative expense, respectively.
As
a result of our continuing tax losses, we have recorded a full valuation allowance against a net deferred tax asset. Additionally,
we have not recorded a liability for unrecognized tax benefits.
Recently
Issued Accounting Standards
In
May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”)
No. 2014-09, “Revenue from Contracts with Customers”, on revenue recognition. The new standard provides for a single
five-step model to be applied to all revenue contracts with customers as well as requires additional financial statement disclosures
that will enable users to understand the nature, amount, timing and uncertainty of revenue and cash flows relating to customer
contracts. Companies have an option to use either a retrospective approach or cumulative effect adjustment approach to implement
the standard. This ASU, as amended, is effective for fiscal years and interim periods within those years beginning after December
15, 2017. We are currently assessing the impact of this update, but preliminarily believe that its adoption will not have a material
impact on our consolidated financial statements.
In
February 2016, the FASB issued ASU No. 2016-02 “Leases”. The new standard will require most leases to be recognized
on the balance sheet which will increase reported assets and liabilities. Lessor accounting remains substantially similar to current
guidance. The new standard is effective for annual and interim periods in fiscal years beginning after December 15, 2018, which
for us is the first quarter of fiscal 2019 and mandates a modified retrospective transition method. We do not intend to early
adopt and are currently assessing the impact of this update, but preliminarily believe that its adoption will not have a material
impact on our consolidated financial statements.
In
June 2016, the FASB issued ASU No. 2016-13, “Financial Instruments—Credit Losses.” The standard modifies the
impairment model for most financial assets, including trade accounts receivables and loans, and will require the use of an “expected
loss” model for instruments measured at amortized cost. Under this model, entities will be required to estimate the lifetime
expected credit loss on such instruments and record an allowance to offset the amortized cost basis of the financial asset, resulting
in a net presentation of the amount expected to be collected on the financial asset. The effective date of the standard is for
fiscal years beginning after December 15, 2019 with early adoption permitted. We are currently evaluating the impact of adoption
of this update on our consolidated financial statements.
In
August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows: Classification of Certain Cash Receipts and Cash
Payments”
.
The new standard attempts to reduce diversity in practice in how cash receipts and cash payments are presented
and classified in the statement of cash flows. ASU No. 2016-15 provides guidance on eight specific cash flow issues. The new guidance
will be effective for fiscal years beginning after December 15, 2017 and interim periods within those fiscal years. Early adoption
is permitted including adoption in an interim period. We do not intend to early adopt and we are currently assessing the impact
of adoption of this update will have on our consolidated financial statements.
In
October 2016, the FASB issued ASU No. 2016-16, “Income Taxes: Intra-Entity Transfers of Assets Other than Inventory”.
The new standard requires entities should recognize the income tax consequences of an asset other than inventory when the asset
transfer occurs. The new guidance will be effective for fiscal years beginning after December 15, 2017 and requires a modified
retrospective adoption through a cumulative effect adjustment directly to retained earnings as of the beginning of the period
of adoption. We are currently evaluating the impact of adoption of this update on our consolidated financial statements.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
3 – Discontinued Operations, Sale of the Cold-EEZE
®
Business
At
the Special Meeting held on March 29, 2017, our stockholders approved the sale of the Cold-EEZE
®
Business and the
transactions contemplated by the Asset Purchase Agreement. Effective March 29, 2017, we completed the sale of the Cold-EEZE
®
Business to Mylan.
As
a consequence of the sale of the Cold-EEZE
®
Business, for the three and six months ended June 30, 2017 and 2016,
we have classified as discontinued operations (i) the gain from the sale of the Cold-EEZE
®
Business, (ii) all gains
and losses attributable to the Cold-EEZE
®
Business operations and (iii) the income tax expense attributed to the
sale of the Cold-EEZE
®
Business (see Note 6). Excluded from the sale of the Cold-EEZE
®
Business
were our accounts receivable and inventory, and we also retained all liabilities associated with our Cold-EEZE
®
Business
operations arising prior to March 29, 2017.
Pursuant
to the Asset Purchase Agreement, we also agreed to a one-time sale to Mylan of certain non-lozenge-based Cold-EEZE
®
inventory. At June 30, 2017, we classified as assets held for sale approximately $294,000 of such inventory, which approximates
our cost. At December 31, 2016, the balance sheet impact of discontinued operations was deemed not material, as such, no reclassifications
for discontinued operations have been presented.
Pursuant
to the Asset Purchase Agreement, we entered into a 90 day transition service arrangement with Mylan, for which we earned $150,000
in transition service fees through June 30, 2017. Pursuant to this arrangement, we (i) received, processed, fulfilled, and shipped
customer orders, and billed such customers for these shipments on behalf of Mylan from March 30, 2017 to June 30, 2017, (ii) processed
certain sales allowances, returns and other customer promotional deductions, and (iii) paid certain Cold-EEZE
®
Business expenses which are to be reimbursed by Mylan. At June 30, 2017, we have a balance due to Mylan of $717,000 which is comprised
of (i) net billings to Mylan’s customers for product shipments, less sales and other allowances, of $1.8 million (ii) return
allocation of $400,000 for future sales returns and allowances (see Note 2), offset by (ii1) $1.4 million for product shipments
and transition service fee due from Mylan and (iv) $106,000 for the reimbursement of certain Cold-EEZE
®
Business
expenses we paid on behalf of Mylan. For the three and six months ended June 30, 2017, the $150,000 transition service fees earned
are recorded as a component of other income (expense).
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
The
net proceeds received from the sale of the Cold-EEZE
®
Business were as follows (in thousands):
|
|
Amount
|
|
Gross consideration from the sale of the Cold-EEZE
®
Business
|
|
$
|
50,000
|
|
Closing and transaction costs
|
|
|
(4,175
|
)
|
Net proceeds from sale of the Cold-EEZE
®
Business
|
|
|
45,825
|
|
Book value of assets sold
|
|
|
(13
|
)
|
Gain
on sale of the Cold-EEZE
®
Business before income taxes
|
|
|
45,812
|
|
Income tax expense
|
|
|
(19,473
|
)
|
Gain
on sale of the Cold-EEZE
®
Business after income taxes
|
|
$
|
26,339
|
|
|
|
|
|
|
Net proceeds:
|
|
|
|
|
Cash paid at closing, net of closing and transaction costs
|
|
$
|
43,145
|
|
Proceeds due on sale of assets, cash held in escrow (see Note 8)
|
|
|
5,000
|
|
|
|
$
|
48,145
|
|
For
the three and six months ended June 30, 2017, we incurred $10,000 and $4.2 million in closing and transaction costs associated
with the sale of the Cold-EEZE
®
Business which were comprised of (i) transaction fees and related closing costs
of $1.9 million and (ii) performance bonuses, contract termination compensation and severance payments to certain employees associated
with the sale of the Cold-EEZE
®
Business of $2.3 million. The compensation committee of our board of directors
approved these compensation arrangements. These compensation and termination payments were paid by us in April 2017.
Note
3 – Discontinued Operations, Sale of the Cold-EEZE
®
Business – continued
The
following table sets forth the condensed operating results of our discontinued operations for the three and six months ended June
30, 2017 and 2016, respectively, (in thousands):
|
|
Three Months Ended June 30,
|
|
|
Six Months Ended June 30,
|
|
|
|
2017
|
|
|
2016
|
|
|
2017
|
|
|
2016
|
|
Net sales
|
|
$
|
(371
|
)
|
|
$
|
1,826
|
|
|
$
|
4,687
|
|
|
$
|
6,179
|
|
Cost of sales
|
|
|
264
|
|
|
|
728
|
|
|
|
2,037
|
|
|
|
2,427
|
|
Sales and marketing
|
|
|
200
|
|
|
|
533
|
|
|
|
1,720
|
|
|
|
2,833
|
|
Administration
|
|
|
-
|
|
|
|
319
|
|
|
|
348
|
|
|
|
656
|
|
Research and development
|
|
|
-
|
|
|
|
48
|
|
|
|
52
|
|
|
|
95
|
|
Income (loss) from discontinued operations
|
|
$
|
(835
|
)
|
|
$
|
198
|
|
|
$
|
530
|
|
|
$
|
168
|
|
Note
4 – Secured Promissory Notes and Other Obligations
Secured
Promissory Notes
On
December 11, 2015, we executed two Subscription Agreements (the “Subscription Agreements”) with the investors named
therein (the “Investors”) providing for the purchase of 12% Secured Promissory Notes – Series A (“Notes”)
in the aggregate principal amount of up to $3.0 million and warrants to purchase shares of our Common Stock (the “Warrants”).
Notes
in the amount of $1.5 million and 51,000 Warrants, at an exercise price of $1.35 per share, which was equal to the closing price
of our Common Stock on the date of investment, were issued by the Company and its wholly-owned subsidiaries, PMI and Quigley Pharma,
Inc. (collectively, the “Obligors”), and funded on December 11, 2015. We incurred loan origination costs of $22,000
which were recorded as a reduction of the Notes and the origination costs are charged to other income (expense) over the term
of the loan. The Warrants had an exercise term equal to three years and were exercisable commencing on the date of issuance. The
fair value of the Warrants at the date of grant was $14,000 which is recorded as a reduction of the Notes and is charged to other
income (expense) over the term of the loan.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
The
Notes bore interest at the rate of 12% per annum, payable semi-annually and the principal is due and payable on June 15, 2017.
The Notes could be pre-paid at any time prior to maturity without penalty. The effective interest, inclusive of the Warrant and
loan origination costs, was 14.3% per annum. For the six months ended June 30, 2017 and 2016, we charged to other income (expense)
$54,000 and $105,000, respectively, in connection with the Notes.
On
March 29, 2017, in connection with the sale of the Cold-EEZE
®
Business, we paid in full the remaining principal
and accrued interest, in the total amount of $1,553,000, due under the Notes. Of the $1,553,000 paid to the Investors, $69,000
was netted against the aggregate exercise price of the Warrants, which were simultaneously being exercised by the Investors.
In
connection with the issuance of the Notes, the Company entered into a security agreement with John E. Ligums, Jr., as collateral
agent for the Investors (the “Security Agreement”) to secure the timely payment and performance in full of the Company’s
obligations under the Notes. Under the Security Agreement, we granted to the collateral agent, for the benefit of the Investors
a lien upon and security interest in the property and assets listed as collateral in the Security Agreement, including without
limitation, all of our personal property, inventory, equipment, general intangibles, cash and cash equivalents, and proceeds.
In connection with the payoff of the Notes, the Security Agreement was terminated.
Note
5 – Transactions Affecting Stockholders’ Equity
Our
authorized capital stock consists of 50 million shares of Common Stock and 1 million shares of preferred stock, $.0005 par value
(“Preferred Stock”).
Preferred
Stock
On
June 16, 2015, our stockholders approved the change to our state of incorporation from the State of Nevada to the State of Delaware
pursuant to a plan of conversion (the “Conversion Plan”) and the filing of a certificate of incorporation in the State
of Delaware. The Preferred Stock authorized under our certificate of incorporation may be issued from time to time in one or more
series. As of June 30, 2017, no shares of Preferred Stock have been issued. Our board of directors has the full authority permitted
by law to establish, without further stockholder approval, one or more series of Preferred Stock and the number of shares constituting
each such series and to fix by resolution, voting powers, preferences and relative, participating, optional and other special
rights of each series of Preferred Stock, and the qualifications, limitations or restrictions thereof, if any. Subject to the
limitation on the total number of shares of Preferred Stock that we have authority to issue under our certificate of incorporation,
the board of directors is also authorized to increase or decrease the number of shares of any series, subsequent to the issue
of that series, but not below the number of shares of such series then-outstanding. In case the number of shares of any series
is so decreased, the shares constituting such decrease will resume the status that they had prior to the adoption of the resolution
originally fixing the number of shares of such series. We may amend from time to time our certificate of incorporation and bylaws
to increase the number of authorized shares of Preferred Stock or Common Stock or to make other changes or additions to our capital
structure or the terms of our capital stock.
Stockholder
Rights Plan
On
September 8, 1998, our Board of Directors declared a dividend distribution of Common Stock Purchase Rights (each individually,
a “Right” and collectively, the “Rights”) payable to our stockholders of record on September 25, 1998,
thereby creating a Stockholder Rights Plan (the “Rights Agreement”). The Plan was subsequently amended effective each
of (i) May 23, 2008, (ii) August 18, 2009, (iii) June 18, 2014 and (iv) January 6, 2017. The Rights Agreement, as amended and
restated, provides that each Right entitles the stockholder of record to purchase from the Company that number of shares of Common
Stock having a combined market value equal to two times the Rights exercise price of $45. The Rights are not exercisable until
the distribution date, which will be the earlier of a public announcement that a person or group of affiliated or associated persons
has acquired 15% or more of the outstanding shares of Common Stock, or the announcement of an intention by a similarly constituted
party to make a tender or exchange offer resulting in the ownership of 15% or more of the outstanding shares of Common Stock (such
person, the “acquirer”). The Rights Agreement allows for an exemption for Ted Karkus, the Company’s Chairman
and Chief Executive Officer, to acquire up to 20% of our Common Stock without our Board of Directors declaring a dividend distribution.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
The
dividend has the effect of diluting the acquirer by giving our other stockholders a 50% discount on our Common Stock’s current
market value for exercising the Rights. In the event of a cashless exercise of the Right and the acquirer has acquired less than
50% beneficial ownership of the Company, a stockholder may exchange one Right for one share of Common Stock of the Company. The
Rights Agreement, as amended, includes a provision pursuant to which our Board of Directors may exempt from the provisions of
the Rights Agreement an offer for all outstanding shares of our Common Stock that the directors determine to be fair and not inadequate
and to otherwise be in the best interests of the Company and its stockholders, after receiving advice from one or more investment
banking firms. The expiration date of the Rights Agreement, as amended, is June 18, 2024.
Equity
Line of Credit
On
July 30, 2015, we entered into a new equity line of credit agreement (such arrangement, the “2015 Equity Line”) with
Dutchess Opportunity Fund II, LP (“Dutchess”). Pursuant to the 2015 Equity Line, Dutchess committed to purchase, subject
to certain restrictions and conditions, up to 3,200,000 shares of our Common Stock, over a period of 36 months from the effectiveness
of the registration statement registering the resale of shares purchased by Dutchess pursuant to the Investment Agreement.
We
may, at our discretion, draw on the 2015 Equity Line from time to time, as and when we determine appropriate in accordance with
the terms and conditions of the 2015 Equity Line. The maximum number of shares that we are entitled to put to Dutchess in any
one draw down notice shall not exceed 500,000 shares with a purchase price calculated in accordance with the terms of the 2015
Equity Line. We may deliver a notice for a subsequent put from time to time, following the one day pricing period for the prior
put.
Note
5 – Transactions Affecting Stockholders’ Equity – continued
The
purchase price shall be set at ninety-five percent (95%) of the volume weighted average price (VWAP) of the Common Stock during
the one trading day immediately following our put notice. We have the right to withdraw all or any portion of any put, except
that portion of the put that has already been sold to a third party, including any portion of a put that is below the minimum
acceptable price set forth on the put notice, before the closing. In the event Dutchess receives more than a five percent (5%)
return on the net sales for a specific put, Dutchess must remit such excess proceeds to us; however, in the event Dutchess receives
less than a five percent (5%) return on the net sales for a specific put, Dutchess will have the right to deduct from the proceeds
of the put amount on the applicable closing date so Dutchess’s return will equal five percent (5%).
There
are put restrictions applied on days between the draw down notice date and the closing date with respect to that particular put.
During such time, we are entitled to deliver another draw down notice. In addition, Dutchess will not be obligated to purchase
shares if Dutchess’ total number of shares beneficially held at that time would exceed 4.99% of the number of shares of
Common Stock as determined in accordance with Rule 13d-1(j) of the Securities Exchange Act of 1934, as amended. In addition, we
are not permitted to draw on the facility unless there is an effective registration statement to cover the resale of the shares.
Pursuant
to the terms of the 2015 Equity Line, we are obligated to file one or more registration statements with the SEC to register the
resale by Dutchess of the shares of Common Stock issued or issuable under the 2015 Equity Line. In addition, we are obligated
to use all commercially reasonable efforts to have the registration statement declared effective by the SEC within 90 days after
the registration statement is filed. On August 4, 2015, we filed a registration statement for the underlying shares of the 2015
Equity Line with the SEC and the registration statement was declared effective by the SEC on August 21, 2015.
At
June 30, 2017, we have 2,450,000 shares of our Common Stock available for sale, at our discretion, under the terms of our 2015
Equity Line and covered pursuant to an effective registration statement.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
The
2010 Equity Compensation Plan
On
May 5, 2010, our stockholders approved the 2010 Equity Compensation Plan which was subsequently amended, restated and approved
by our stockholders on April 24, 2011, and further amended and approved by stockholders on May 6, 2013, and further amended and
approved by stockholders on May 24, 2016 (the “2010 Plan”). The 2010 Plan provides that the total number of shares
of Common Stock that may be issued under the 2010 Plan is equal to 3.2 million shares, including 900,000 shares that are authorized
for issuance but unissued under a 1997 incentive stock option plan and 700,000 shares added to the 2010 Plan effective May 24,
2016.
For
the six month ended June 30, 2017 and 2016, we granted, 600,000 options, exercisable at $2.00 per share and subject to vesting
over a four year term, and zero options, respectively, to employees to acquire our Common Stock pursuant to the terms of 2010
Plan. The assumptions used in determining the fair value of the 600,000 stock options granted in Fiscal 2017 were (i) expected
option life of 4.5 years, (ii) weighted average risk rate of 1.81%, (iii) dividend yield of 0% and (iv) expected volatility of
44.51%.
For
the six months ended June 30, 2017, 90,000 stock options were exercised pursuant to the 2010 Plan and we derived net proceeds
of $102,000. For the six months ended June 30, 2016, there were no stock options exercised. At June 30, 2017, there were 2,209,000
options outstanding under the 2010 Plan and 133,659 options available to be issued pursuant to the terms of the 2010 Plan.
The
2010 Directors’ Equity Compensation Plan
On
May 5, 2010, our stockholders approved the 2010 Directors’ Equity Compensation Plan, which was subsequently amended and
approved by stockholders on May 6, 2013. A primary purpose of the 2010 Directors’ Equity Compensation Plan is to provide
us with the ability to pay all or a portion of the fees of directors in restricted stock instead of cash. The 2010 Directors’
Equity Compensation Plan provides that the total number of shares of Common Stock that may be issued under the 2010 Directors’
Equity Compensation Plan is equal to 425,000. For the six months ended June 30, 2017 and 2016, no shares were granted to our directors.
At June 30, 2017, there were 147,808 shares of Common Stock that may be issued pursuant to the terms of the 2010 Directors’
Equity Compensation Plan.
Note
5 – Transactions Affecting Stockholders’ Equity – continued
Treasury
Stock Purchase Agreement
On
June 12, 2017 we entered into a Stock Purchase Agreement with each of Mark S. Leventhal, a former director of the Company, and
certain other persons and entities associated and/or affiliated with Mr. Leventhal (the “Leventhal Holders”), pursuant
to which we purchased all 1,061,980 shares of our Common Stock then held by the Leventhal Holders, representing an approximate
6.2% aggregate ownership interest (based on 17,221,776 shares of common stock outstanding as of June 12, 2017). Upon consummation
of the transactions, the Leventhal Holders ceased to hold any direct or indirect ownership interest in the Company.
Pursuant
to the terms of the Stock Purchase Agreements, the total consideration paid by us to the Leventhal Holders for their shares was
$1,858,465, which amount was equal to the product of (i) $1.75 multiplied by (ii) the number of shares purchased.
Note
6 – Income Taxes
At
December 31, 2016, there were $47.1 million in net operating loss carryforwards, subject to applicable limitations, available
to us for federal purposes which will expire beginning for the year ended December 31, 2020 through 2036. Additionally, there
were $22.1 million in net operating loss carryforwards, subject to limitations, available to us for state purposes which will
expire beginning for the year ended December 31, 2020 through 2036.
Based
upon preliminary estimates, we believe that a significant portion of our income tax liability of $19.5 million arising from our
taxable gain for federal and state income tax purposes from the sale of the Cold-EEZE
®
Business will be offset
to the extent of our current year losses from operations, the write-off for tax purposes of the tax-basis of the Cold-EEZE
®
Business and the available net operating loss carryforwards at the federal and state levels. However, for state income tax
purposes, based upon the available state net operating loss carryforwards and corresponding limitations, we estimate a net income
tax expense arising from the sale of the Cold-EEZE
®
Business of $1.3 million.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Utilization
of net operating loss carryforwards may be subject to limitations as set forth in Section 382 of the Internal Revenue Code (“Section
382”). Based on our preliminary Section 382 analysis, we do not believe that our current net operating loss carryforwards
are subject to these limitations as of June 30, 2017. However, until we complete a final Section 382 analysis upon filing of our
2017 income tax return, there can be no assurances that our preliminary analysis is accurate or complete. Should we identify any
limitations upon the completion of our final Section 382 analysis, the impact could be material to our consolidated financial
statements and that we could incur additional income tax expense arising from the sale of the Cold-EEZE
®
Business.
For
the six months ended June 30, 2017, we charged to discontinued operations $19.5 million for estimated federal and state income
taxes arising from the sale of the Cold-EEZE
®
Business and we have realized an income tax benefit from continuing
operations of $18.1 million as a consequence of the utilization of the federal and state net operating losses.
Subsequent
to the income tax effects arising from the sale of the Cold-EEZE
®
Business, we will continue to have net operating
loss carry-forwards for federal income tax purposes. Until sufficient taxable income to offset the temporary timing differences
attributable to operations, and the tax deductions attributable to option, warrant and stock activities are assured, a valuation
allowance equaling the total deferred tax asset is being provided. As a consequence of the accumulated losses of the Company,
we believe that this allowance is required due to the uncertainty of realizing these tax benefits in the future.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
7– Commitments and Contingencies
Escrow
Receivable
We
have indemnification obligations to Mylan under the Asset Purchase Agreement that may require us to make future payments to Mylan
and other related persons for any damages incurred by Mylan or such related persons as a result of any breaches of our representations,
warranties, covenants or agreements contained in the Asset Purchase Agreement, or arising from the Retained Liabilities (as such
term is defined in the Asset Purchase Agreement) or certain third party claims specified in the Asset Purchase Agreement. Generally,
our representations and warranties survive for a period of 24 months from the closing date, other than certain fundamental representations
which survive until the expiration of the applicable statute of limitations. There is a limited indemnification cap with respect
to a majority of the Company’s indemnification obligations under the Asset Purchase Agreement with the exception of claims
for actual fraud, the breach of any fundamental representations and certain other items, which have a larger indemnification cap
(e.g., the purchase price).
Pursuant
to the terms of the Asset Purchase Agreement, we, Mylan, and an escrow agent entered into an Escrow Agreement at closing, pursuant
to which Mylan deposited $5 million of the aggregate purchase price for the Cold-EEZE
®
Business into an escrow
account established with the Escrow Agent in order to satisfy, in whole or in part, certain of our indemnity obligations under
the Asset Purchase Agreement. If, on the 18
th
month anniversary of the closing date, there are funds remaining in the
escrow account, then the escrow account will be reduced by the difference, if a positive number, of (i) $2.5 million minus (ii)
the aggregate amount of all escrow claims asserted by Mylan prior to this date that have either been paid out of the escrow account
or are pending as of such date, and, within two business days of such date, the Escrow Agent will disburse such difference, if
a positive number, to us. Within two business days of the second anniversary of the closing date, the Escrow Agent will release
any funds remaining in the escrow account to us minus any amounts being reserved for escrow claims asserted by Mylan prior to
such date. Upon the resolution of any pending escrow claims, the Escrow Agent will, within two business days of receipt of joint
instructions or a final order from a court (as described in the Escrow Agreement) disburse such reserved amount to the parties
entitled to such funds.
Management
does not believe that we will be subject to indemnity claims contemplated by the Asset Purchase Agreement. However, in the event
that such a claim is made, and if successful, we would be required to pay Mylan pursuant to the indemnification provisions of
the Asset Purchase Agreement which may reduce the amount we ultimately collect from escrow or could even require us to return
a portion of the net proceeds received from the sale of the Cold-EEZE
®
Division.
Manufacturing
Agreement
In
connection with the Asset Purchase Agreement, the Company and its wholly-owned subsidiary, PMI, entered into a Manufacturing Agreement
(the “Manufacturing Agreement”) with Mylan. Pursuant to the terms of the Manufacturing Agreement, Mylan (or an affiliate
or designee) will purchase the inventory of the Company’s Cold-EEZE
®
brand and product line and PMI will
manufacture certain products for Mylan, as described in the Manufacturing Agreement, at prices that reflect current market conditions
for such products and include an agreed upon mark-up on our costs. Unless terminated sooner by the parties, the Manufacturing
Agreement will remain in effect until March 29, 2022. Thereafter, the Manufacturing Agreement may be renewed by Mylan for up to
five successive one year periods by providing notice of its intent to renew not less than 90 days prior to the expiration of the
then-current term.
Transition
Services Agreement
In
connection with the Asset Purchase Agreement, we entered into a transition services agreement with Mylan to provide litigation
support, insurance coverage, supply chain, customer support, finance, accounting, commercial advertising and packaging services,
quality control, IT and research and development services to Mylan for time periods ranging from two to nine months from the closing
date. We will continue to incur certain operating costs during the transition period to support Mylan.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
7– Commitments and Contingencies – continued
Future
Obligations:
We
have estimated future minimum obligations over the next five years, including the remainder of Fiscal 2017, as follows (in thousands):
Fiscal year
|
|
Employment
Contracts
|
|
2017
|
|
|
338
|
|
2018
|
|
|
675
|
|
2019
|
|
|
-
|
|
2020
|
|
|
-
|
|
2021
|
|
|
-
|
|
Total
|
|
$
|
1,013
|
|
Note
8 – Earnings (Loss) Per Share
Basic
earnings (loss) per share for continuing and discontinued operations are computed by dividing respective net income or loss attributable
to common stockholders by the weighted-average number of shares of our Common Stock outstanding for the period. Diluted earnings
(loss) per share reflects the potential dilution that could occur if securities or other contracts to issue Common Stock were
exercised or converted into Common Stock or resulted in the issuance of Common Stock that shared in the earnings of the entity.
Diluted earnings (loss) per share also utilize the treasury stock method which prescribes a theoretical buy-back of shares from
the theoretical proceeds of all options and warrants outstanding during the period. Options and warrants outstanding to acquire
shares of our Common Stock at June 30, 2017 and 2016 were 2,209,000 and 1,706,500, respectively.
For
the three months ended June 30, 2017 and June 30, 2016 dilutive earnings (loss) per share is the same as basic earnings per share
due to (i) the inclusion of Common Stock, in the form of stock options and warrants (“Common Stock Equivalents”),
would have an anti-dilutive effect on the loss per share or (ii) there were no Common Stock Equivalents for the respective period.
For the three months ended June 30, 2017 and 2016 there were 641,754 and 276,165, Common Stock Equivalents which were in the money,
that were excluded from the earnings (loss) per share computation as a consequence of their anti-dilutive effect.
For
the six months ended June 30, 2017 there were 650,190 Common Stock Equivalents which were in the money, that were included in
the fully diluted earnings per share computation. For the six months ended June 30, 2016, for continuing operations dilutive earnings
(loss) per share is the same as basic earnings per share due to (i) the inclusion of Common Stock, in the form of stock options
and warrants (“Common Stock Equivalents”), would have an anti-dilutive effect on the loss per share or (ii) there
were no Common Stock Equivalents for the respective period. For the six months ended June 30, 2016, there were 244,112, Common
Stock Equivalents which were in the money, that were excluded from the earnings (loss) per share computation as a consequence
of their anti-dilutive effect.
ProPhase
Labs, Inc. and Subsidiaries