EROX Human Pheromone Sciences Inc (GM)

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CRITICAL ACCOUNTING POLICIES

The Company’s discussion and analysis of its financial conditions and results of operations are based upon financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures on the date of the financial statements.  On an on-going basis, we evaluate our estimates, including, but not limited to, those related to revenue recognition and license fees.  We use authoritative pronouncements, historical experience and other assumptions as the basis for making judgments.  Actual results could differ from those estimates.  We believe that the following critical accounting policies affect our more significant judgments and estimates in the preparation of our financial statements.

Stock Option Policy

The Company adopted SFAS 123 (R) “Share-Based Payment”, for accounting for its stock options effective with the fiscal year beginning January 1, 2006.   The fair value of each option granted is estimated on the date of the grant using the Black-Scholes option-pricing model.  The Black-Scholes pricing model has assumptions for the risk free interest rates, dividends, stock volatility and expected life of an option grant.  The risk free interest rate is based on the U.S. Treasury Bill rate with a maturity based on the expected life of the options and on the closest day to an individual stock option grant.  Dividend rates are based on the Company’s dividend history.  The stock volatility factor is based on the past seven years of market prices of the Company’s common stock.  The expected life of an option grant is based on various factors including historical exercise rates in addition to the life of the stock option.  The Company adjusts compensation expense by a forfeiture factor based on historical experience. The fair value of each option grant is recognized as compensation expense over the vesting period of the option on a straight line basis.

The Company did not record the stock compensation expense net of taxes since there was no material provision for income taxes for the period ended March 31, 2009 as the Company incurred net operating losses for which no benefit was recognized, or utilized tax loss carryforwards.  The tax benefit is a component of the deferred tax asset disclosed under the heading “Income Taxes” below.

Use of Estimates

The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from those estimates.

Revenue Recognition

Revenue is recorded at the time of merchandise shipment, net of provisions for returns.  The Company records revenue from sales initiated by sales agents, net of the sales commissions earned following the interpretative guidance provided by FASB Emerging Issue Task Force (EITF) No. 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent . License fees are earned over the license period according to the terms of the license agreement and interpretative guidance provided by Staff Accounting Bulletin (SAB) No. 101 Revenue Recognition in Financial Statements and SAB No. 104 Revenue Recognition.   The Company records multiple-element arrangements in accordance with EITF 00-21 Revenue Arrangements with Multiple Deliverables .  

Multiple-element arrangements are assessed to determine whether they can be separated into more than one unit of accounting.  A multiple-element arrangement is separated into more than one unit of accounting if all of the following criteria are met.

● The delivered items or service has value to the customer on a stand alone basis.

● There is objective and reliable evidence of the fair value of the undelivered items or service.

● The delivery or performance of the undelivered items or service is considered probable and substantially in our control.

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If these criteria are not met, then revenues are deferred until such criteria are met or until the period(s) over which the last undelivered element is delivered.  If there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the consideration is allocated to the separate units of accounting based on each unit’s relative fair value.

Our agreement with Personal Products Company (hereinafter referred to as “PPC”) represents a multiple-element arrangement and includes post signing consulting support to PPC as needed to assist them in claims development and manufacturing processes, an exclusive right of first discussion for new compounds that the Company develops and for which we document supportable claims of effectiveness, and an exclusive right to our existing patented compounds in specific consumer product fields.  A portion of the initial payment received as part of the PPC agreement is being recognized as the Company incurs expenses and expends resources towards fulfilling the obligations to PPC, based on interpretative guidance provided by EITF 00-21.  

The PPC agreement was entered into on August 18, 2006 and will expire when the initial patents on the licensed technology expire, in March 2012.  For the services and rights granted in the agreement, the Company received an initial payment of $1,750,000 in September 2006 and will earn royalties on products developed and sold by PPC until the patents expire.  The Company records revenue for the consulting services and right of first discussions as the Company incurs expenses and expends resources towards fulfilling its obligations to PPC.  License revenue is being recognized on a straight-line basis over the life of the agreement of sixty-seven months and when periodic direct costs are incurred to maintain the license.  The Company began recognizing revenue from all three units during the quarter ending September 30, 2006.

A summary of the revenue recognized for these multiple units of accounting follows (in thousands):

The deferred revenue from the PPC license agreement as of March 31, 2009 was $528,000.

The Company granted Schwarzkopf & Henkel a non-exclusive license for the development, manufacture, sale and distribution of certain licensed hair styling products using the Company’s patented technology.   Schwarzkopf & Henkel paid a license fee of $20,000 and is obligated to pay royalties based on net sales of licensed products in specified countries.  The license was effective May 1, 2007 and expires on April 30, 2010.  The license was amended on February 15, 2008 to include other hair care products on a non-exclusive basis.

The $20,000 license fee is being recognized on a straight-line basis over the life of the license of thirty-six months.  There is no discernable service to be provided by the Company to warrant an alternative revenue recognition method.

A summary of the revenue recognized for Schwarzkopf & Henkel under the non-exclusive license follows (in thousands):

The deferred revenue from the Schwarzkopf & Henkel license as of March 31, 2009 was $7,000.

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Inventories

Inventories are stated at the lower of cost (first in - first out method) or market.  A summary of inventories follows (in thousands):

Income Taxes

The Company accounts for income taxes under SFAS 109 “ Accounting for Income Taxes ”.  Deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards, and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities in the Company’s financial statements and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that all or some portion of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would ultimately be sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more-likely-than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. The evaluation of a tax position taken is considered by itself and not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits are classified as interest expense and additional income taxes in the statements of operations.

COMPANY OVERVIEW

The Company is engaged in the research, development, manufacturing and marketing of consumer products containing synthetic human pheromones and other mood enhancing compounds.  The Company initiated commercial operations in late 1994 with a line of fine fragrances and toiletries.  Licensing of the Company’s technology is currently the core business of the Company while the Company directly manages the on-going development of identified compounds for potential new products.  The Company’s patented compounds are sold to licensed customers and included as components in their fragranced consumer products.  The Company also offers private label manufacturing services for third party consumer product licensees.

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Results of Operations

Three Months ended March 31, 2009 compared to the Three Months ended March 31, 2008

Net revenue for the quarters ended March 31, 2009 and 2008 were as follows (in thousands):

Total revenues for the first quarter of 2009 were $165,000, a $101,000 decrease from the prior year’s revenues of $266,000.  Revenues in each of the market segments declined in the current period due to reductions in purchases from long-term customers.   Domestic product sales for the three months ended March 31, 2009 of $41,000 were $70,000 less than the $111,000 in the prior year. This decrease is attributable to $86,000 of sales in 2008 to a  licensee whose ten year old product line appears to have come to the end of its product life cycle.  International sales for the three months ended March 31, 2009 of $12,000 were $18,000 less than sales of $30,000 for the three months ended March 31, 2008, as a result of decreased sales to Latin American, Asian and Eastern European customers.  We believe the general worldwide economic downturn and the significant reduction in sales of consumer products on a worldwide basis has negatively impacted the consumer sales of our licenses.

License revenues for the three months ending March 31, 2009 and 2008 were $112,000 and $125,000, respectively, a decrease of $13,000 or 10%.  The decrease is attributable to the PPC license, from which revenues totaled $84,000 in the three months ending March 31, 2009, compared to $102,000 in the three months ending March 31, 2008.  PPC license revenues in the three months ending March 31, 2009 consisted of $32,000 for first discussion work, $51,000 from license fee amortization and $1,000 for consulting services.  In the three months ending March 31, 2008 the PPC license revenues consisted of $21,000 for first discussion work, $54,000 from license fee amortization and $27,000 for consulting services. The decrease in consulting services is consistent with the Company expectations since much of the technical information required by PPC has been provided. The license with Schwarzkopf and Henkel produced $28,000 for the three months ending March 31, 2009 compared to $23,000 of license revenue for the three months ended March 31, 2008.

Gross profit for the quarter ended March 31, 2009 of $100,000 is 46% less than the gross profit of $185,000 for the quarter ended March 31, 2008.  The decrease in gross profit is attributable to the decrease in revenues in the current quarter.  As a percentage of revenues, gross margin of 61% for the first three months of 2009 was less than gross margin of 70% for the first three months of 2008.  Gross margin on product sales decreased to 749% in 2009 from 78% in 2008. The decreased product sales gross margin is due to reduced sales in 2009 of higher margin products and increased purchase in 2009 by two Schwarzkopf and Henkel consumer product brands that received a reduced supply price in exchange for an increased royalty rate, to be realized in future periods.

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Research and development expenses for the first quarter of 2009 and 2008 were $25,000 and $14,000, respectively.  Research expenditures of $7,000 and $23,000 that were incurred for the three months ended March 31, 2009 and 2008, respectively, to support the PPC license, have been charged as license cost in cost of goods sold. The total research and development costs incurred, including the amounts recorded as license costs, were $32,000 for the three months ended March 31, 2009, which was $5,000 less than the $37,000 incurred for the three months ended March 31, 2008.  Decreased facility rental costs accounted for the reduced total research and development spending. A fifty percent rent reduction for the Utah lab facility began as of September 1, 2008. Research and development on several new compounds, in addition to the two compounds noted in the PPC license, is continuing at reduced funding levels.

Selling, general and administrative expenses for the three months ended March 31, 2009 of $257,000 are $13,000 more than the $244,000 incurred for the three months ended March 31, 2008.  Selling, marketing and distribution expenses of $4,000 were $2,000 more than expenses of $2,000 in prior year due to expenses related to marketing the new compound ER 303. General and administrative and facility costs increased by $11,000 to $253,000 in the three months ended March 31, 2009 from $242,000 in the three months ended March 31, 2008 due to a $30,000 consulting fee for business acquisition and development offset in part by spending reductions in audit and tax fees, stock option compensation and insurance costs.   

The Company earned $1,000 and $11,000 in net interest income during the three months ending March 31, 2009 and 2008, respectively.  The decreased earnings resulted from a reduction in the Company’s cash balances.

The Company has recorded no tax provision for the quarter ended March 31, 2009 and a $1,000 minimum tax provision for the quarter ended March 31, 2008, due primarily to a valuation allowance on deferred tax assets being recorded and the expected utilization of net operating losses carried forward from prior years to offset any significant tax liability.    

Off-Balance Sheet Arrangements.

None.

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2009, the Company had cash of $664,000 with no outstanding bank borrowings and working capital of $383,000.  At December 31, 2008, it had cash of $907,000 with no outstanding bank borrowings and working capital of $609,000.  For the first three months of 2009, net cash used in on-going activities was $243,000 as compared to the prior year’s $40,000, an increase of $203,000.  

The current cash position at March 31, 2009 was $8,000 less than the Company’s annual budget had projected. The Company is aware of its liquidity position and the inconsistent revenue streams, the long lead time involved in product development, the time involved in executing new license agreements and the current difficult economic environment. The Company continues to limit spending to necessary operating expenses. Although the Company’s current cash position and projected results of operations for the next twelve months are not expected to require additional outside financing, the Company must be successful in the next year with its licensing of its current technology and its new compounds, ER 303 and ER 99.  If these efforts are not successful the Company will need to secure additional financing opportunities.  The Company may not be able to obtain such additional funding on commercially reasonable terms, if at all, should such funding be required.

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Item 3. Quantitative and Qualitative Disclosures about Market Risk.

Not required for smaller reporting companies.

Item 4T.   Controls and Procedures

Evaluation of Disclosure Controls and Procedures.  Based on our evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) were effective at the reasonable assurance level.

Changes in Internal Control Over Financial Reporting. There were no changes in our internal control over financial reporting identified in connection with our evaluation that occurred during the fiscal quarter ended March 31, 2009 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II

OTHER INFORMATION

Item 1 .   Legal Proceedings

The Company is not party to any pending legal proceedings.

Item 1A .   Risk Factors

Not required for smaller reporting companies.

Item 2 .   Unregistered Sales of Equity Securities and Use of Proceeds

 Not applicable.

Item 3. Defaults Upon Senior Securities

Not applicable.

Item 4. Submission of Matters to a Vote of Security Holders

Not applicable.

Item 5. Other Information

Not applicable.

Item 6 .   Exhibits

Exhibits

Exhibit 31.1

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act

Exhibit 31.2

Certification Pursuant to Section 302 of the Sarbanes-Oxley Act

Exhibit 32

Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this Report to be signed on behalf by the undersigned thereunto duly authorized.

HUMAN PHEROMONE SCIENCES, INC.

Date:  May 14, 2009

/s / William P. Horgan                                    

William P. Horgan

Chairman and Chief Executive Officer

(Principal Executive Officer)

Date:  May 14, 2009

/s / Gregory S. Fredrick                                 

Gregory S. Fredrick

Chief Financial Officer

(Principal Financial Officer and Principal Accounting Officer)

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