Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
1 – Organization and Business
ProPhase
Labs, Inc. (“we”, “us” or the “Company”) was initially organized as a corporation 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 vertically integrated and diversified branding, marketing and technology company engaged in the research, development,
manufacture, distribution, marketing and sale of over-the-counter (“OTC”) consumer healthcare products, dietary supplements
and other remedies in the United States. This includes the development and marketing of dietary supplements under the TK Supplements
®
brand.
In
August 2017, we formed ProPhase Digital Media, Inc. (“PDM”), a Delaware corporation and wholly-owned subsidiary. Our
objective is for PDM to become an independent full-service direct marketing agency. PDM’s first initiative will be to market
the TK Supplements
®
product line. If successful, this may lead to the marketing of other companies’ consumer
products.
In
addition, we also continue to actively pursue acquisition opportunities for other companies, technologies and products within
and outside the consumer products industry.
We
use a December 31 year-end for financial reporting purposes. References herein to “Fiscal 2018” shall mean the fiscal
year ended December 31, 2018 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 and consolidated variable interest entities unless the context otherwise
requires.
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. 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.
Effective
March 29, 2017, we sold our intellectual property rights and other assets related to our Cold-EEZE
®
brand and product
line, including all then current and pipeline over-the-counter allergy, cold, flu, multi-symptom relief and immune support treatments
for adults and children to the extent each was, or was intended to be, branded “Cold-EEZE
®
”, including
all formulations and derivatives thereof (collectively referred to as the “Cold-EEZE
®
Business”) to
Mylan Consumer Healthcare Inc. (formerly known as Meda Consumer Healthcare Inc.) (“MCH”) and Mylan Inc. (together
with MCH, “Mylan”). As a result of the sale of the Cold-EEZE
®
Business, for the three and six months
ended June 30, 2017, we have classified as discontinued operations (i) all income and expenses attributable to the Cold-EEZE
®
Business, (ii) the gain from the sale of the Cold-EEZE
®
Business, and (iii) the income tax expense attributed
to the sale of the Cold-EEZE
®
Business. Excluded from the sale of the Cold-EEZE
®
Business were our
accounts receivable and inventory. We have 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 8) 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 healthcare and dietary supplement 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 and market testing 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
®
, an energy booster plus
testosterone support, and (iii) Super ProstaFlow Plus
TM
for prostate and urinary health. In addition to developing
direct-to-consumer (“Direct Response”) marketing strategies for Legendz XL
®
, we received initial product
acceptance and shipped into a national chain drug retailer and to several regional retailers during Fiscal 2017.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies
For
the three and six months ended June 30, 2018 and 2017, our revenues from continuing operations have come principally from contract
manufacturing OTC health care and dietary supplement products for third parties.
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, as amended on Form 10-K for the fiscal year ended December 31, 2017.
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, 2018 are not necessarily indicative of operating results that
may be achieved over the course of the full year.
Discontinued
Operations Carve Out and ProPhase Allocations
For
the three and six months ended June 30, 2017, 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, we allocated (i) $319,000 of administrative expenses
and (ii) $48,000 of research and development expenses, to discontinued operations in the accompanying condensed statements of
operations. For the six months ended June 30, 2017, we allocated $348,000 of administrative expenses and $52,000 of research and
development expenses to discontinued operations in the accompanying condensed statements of operations (see Note 3). There were
no discontinued operations for the three and six months ended June 30, 2018.
Product
Innovation, Seasonality of the Business and Liquidity
Our
net sales are derived principally from our contract manufacturing of OTC healthcare and dietary supplements products in the United
States. In addition, we are engaged in early stage commercialization and market testing activities for the TK Supplements
®
product line of dietary supplements.
Our sales are influenced
(i) by market acceptance of our TK Supplement
®
products and fluctuations in the timing of purchase and (ii)
by the ultimate level of demand for our contract manufactured OTC healthcare and dietary supplement 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.
As
a consequence of the scope and timing of our TK Supplements
®
product market launch and the seasonality of our contract
manufacturing OTC business, we realize variations in operating results and demand for working capital from quarter to quarter.
As of June 30, 2018, we had working capital of approximately $18.0 million, including $6.8 million marketable securities available
for sale. We believe our current working capital at June 30, 2018 is at an acceptable and adequate level to support our business
for at least the next twelve months.
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
and intangible assets, impairment of property and equipment and intangible assets, income tax valuations and assumptions related
to accrued advertising. 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.
Marketable
Securities
We
have classified our investments in marketable securities as available-for-sale and as a current asset. Our investments in marketable
securities are carried at fair value, with unrealized gains and losses included as a separate component of stockholders’
equity. Realized gains and losses from our marketable securities are recorded as other income (expense). We initiated short term
investments in marketable securities, which carry maturity dates between one and three years from date of purchase with interest
rates of 2.25% - 3.05%, during the first half of Fiscal 2018. For the six months ended June 30, 2018, we reported an unrealized
gain of $25,000 and an accumulated unrealized loss of $53,000. Unrealized gains and losses are classified as other
comprehensive income (loss) and the cost is determined on a specific identification basis. The following is a summary of the components
of our marketable securities and the underlying fair value input level tier hierarchy (see long-lived assets below) (in thousands):
|
|
December
31, 2017
|
|
|
June
30, 2018
|
|
|
|
Amortized
|
|
|
Unrealized
|
|
|
Unrealized
|
|
|
Market
|
|
|
Amortized
|
|
|
Unrealized
|
|
|
Unrealized
|
|
|
Market
|
|
|
|
Cost
|
|
|
Gains
|
|
|
Losses
|
|
|
Value
|
|
|
Cost
|
|
|
Gains
|
|
|
Losses
|
|
|
Value
|
|
U.S.
treasuries
|
|
$
|
1,744
|
|
|
|
-
|
|
|
|
-
|
|
|
|
1,744
|
|
|
|
929
|
|
|
|
-
|
|
|
|
-
|
|
|
|
929
|
|
Corporate
bonds
|
|
|
16,943
|
|
|
|
-
|
|
|
|
(78
|
)
|
|
|
17,021
|
|
|
|
5,900
|
|
|
|
|
|
|
|
(53
|
)
|
|
|
5,847
|
|
|
|
$
|
18,687
|
|
|
$
|
-
|
|
|
$
|
(78
|
)
|
|
$
|
18,765
|
|
|
$
|
6,829
|
|
|
$
|
-
|
|
|
$
|
(53
|
)
|
|
$
|
6,776
|
|
Inventory
Inventory
is valued at the lower of cost, determined on a first-in, first-out basis (FIFO), or net realizable value. Inventory items are
analyzed to determine cost and the net realizable value and appropriate valuation adjustments are established
.
At June 30, 2018, after the 2018 write-off of certain inventory previously recorded, the financial statements include adjustments
to reduce inventory for excess, obsolete or short-dated shelf-life inventory of $495,000, inclusive of adjustments of $144,000
for product samples of TK Supplements
®
products. At
December 31, 2017, the financial statements include
adjustments to reduce inventory for excess, obsolete or short-dated shelf-life inventory of $1.1 million, inclusive of an adjustment
of $541,000 for product samples of TK Supplements
®
products.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies – continued
The
components of inventory are as follows (in thousands):
|
|
June
30, 2018
|
|
|
December
31, 2017
|
|
Raw
materials
|
|
$
|
1,383
|
|
|
$
|
1,269
|
|
Work
in process
|
|
|
466
|
|
|
|
245
|
|
Finished
goods
|
|
|
537
|
|
|
|
17
|
|
|
|
$
|
2,386
|
|
|
$
|
1,531
|
|
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 equipment and software – three
to five 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 consumer healthcare products, dietary supplements and other remedies 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. The
manufacturing and distribution of OTC healthcare and dietary supplement 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.
Financial
instruments that potentially subject us to significant concentrations of credit risk consist principally of cash investments,
marketable securities, and trade accounts receivable. Our marketable securities are fixed income investments, which are highly
liquid and can be readily purchased or sold through established markets.
We
maintain cash and cash equivalents with certain major financial institutions. As of June 30, 2018, our cash and cash equivalents
balance was $3.7 million and our bank balance was $3.8 million. Of the total bank balance, $500,000 was covered by federal depository
insurance and $3.3 million was uninsured at June 30, 2018.
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 customers
include consumer products companies and 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, 2018 and December 31, 2017.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies – continued
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, marketable securities, accounts receivable, assets held for sale, accounts payable, and accrued expenses
are reflected in the Condensed Consolidated Financial Statements at carrying value which approximates fair value. We account for
our marketable securities at fair value pursuant to Accounting Standards Codification, or ASC, 820-10, with the net unrealized
gains or losses reported as a component of accumulated other comprehensive income or loss.
|
|
As
of June 30, 2018
|
|
|
|
Level
1
|
|
|
Level
2
|
|
|
Level
3
|
|
|
Total
|
|
Marketable
securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
U.S.
government obligations
|
|
$
|
-
|
|
|
$
|
929
|
|
|
$
|
-
|
|
|
$
|
929
|
|
Corporate
obligations
|
|
|
-
|
|
|
|
5,847
|
|
|
|
-
|
|
|
|
5,847
|
|
|
|
$
|
-
|
|
|
$
|
6,776
|
|
|
$
|
-
|
|
|
$
|
6,776
|
|
Revenue
Recognition
We
account for revenue in accordance with ASC Topic 606, which requires revenue recognized to represent the transfer of promised
goods or services to customers at an amount that reflects the consideration which is expected to be received in exchange for those
goods or services. The Company recognizes revenue when its performance obligations with its customers have been satisfied. At
contract inception, the Company determines if a contract is within the scope of Topic 606 and then evaluates the contract using
the following five steps: (1) identify the contract with the customer; (2) identify the performance obligations; (3) determine
the transaction price; (4) allocate the transaction price to the performance obligations; and (5) recognize revenue when (or as)
the entity satisfies a performance obligation.
We
have not made any significant changes to judgments in applying ASC 606 during the three or six months ended June 30, 2018.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Performance
Obligations
We
generate sales principally through two types of customers, contract manufacturing and retail customers. Sales from product shipments
to contract manufacturing and retailer customers are recognized at the time ownership is transferred to the customer. Net sales
from contract manufacturing and retail customers were $3.1 million and $80,000, respectively, for the three months ended
June 30, 2018 and $1.9 million and $46,000, respectively, for the three months ended June 30, 2017. Net sales from contract manufacturing
and retail customers was $6.4 million and $154,000, respectively, for the six months ended June 30, 2018 and $2.6 million and
$64,000, respectively, for the six months ended June 30, 2017. Revenue from retailer customers is reduced for trade promotions,
estimated sales returns, cash discounts and other allowances in the same period as the related sales are recorded. No such allowance
is applicable to our contract manufacturing customers. 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.
A
performance obligation is a promise in a contract to transfer a distinct good or service to the customer and is the unit of account
in ASC 606. A contract’s transaction price is allocated to each distinct performance obligation and recognized as revenue
when, or as, the performance obligation is satisfied. The combined duties and responsibilities within each contract will be considered
one single performance obligation under ASC 606 as these items would not be separately identifiable from each other promise in
the contract and we provide a significant service of integrating the duties with other promises in the contracts.
Transaction
Price
The
transaction price is fixed based upon either (i) a combined Master Agreement and each related purchase order, or (ii) if there
is no Master Agreement, the price per the individual purchase order received from each customer. The customers are invoiced at
an agreed upon contractual price for each unit ordered and delivered by the Company.
Consistent
with Company practice prior to the adoption of ASC 606, the Company does not collect sales tax or other similar taxes from customers.
As such, there is no effect on the measurement of the transaction price.
Recognize
Revenue When the Company Satisfies a Performance Obligation
Performance
obligations related to contract manufacturing and retail customers are satisfied at a point in time when the goods are shipped
to the customer as (i) the Company has transferred control of the assets to the customers upon shipping, and (ii) the customer
obtains title and assumes the risks and rewards of ownership after the goods are shipped.
The
Company does not accept returns in the contract manufacturing revenue stream. Our return policy for retailer customers 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 accept return
requests for only products 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.
Under
ASC 606, the Company will continue to recognize contract manufacturing and retail customers at a point in time as the Company
has an enforceable right to payment for goods as products are shipped to customers.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies – continued
As
of June 30, 2018 and December 31, 2017, we included a provision for sales allowances from continuing operations of $10,000 and
$2,000, respectively. Additionally, accrued advertising and other allowances from discontinued operations as of June 30, 2018
included (i) $443,000 for estimated returns and (ii) $98,000 for cooperative incentive promotion costs. As of December 31, 2017,
accrued advertising and other allowances from discontinued operations included (i) $480,000 for estimated future sales returns
and (ii) $200,000 for cooperative incentive promotion costs.
As
of June 30, 2018, we have deferred revenue of $52,000 in relation to Research and Development (“R&D”) stability
and release testing programs.
Disaggregation
of Revenue
We
disaggregate revenue from contracts with customers into two categories: contract manufacturing and retail customers. The Company
determined that disaggregating revenue into these categories achieves the disclosure objective to depict how the nature, amount,
timing and uncertainty of revenue and cash flows are affected by economic factors.
The
following table disaggregates the Company’s revenue by revenue source for the three and six months ended June 30, 2018 (in
thousands):
|
|
Three months ended
|
|
|
Six months ended
|
|
Revenue
by Customer Type
|
|
June
30, 2018
|
|
|
June
30, 2018
|
|
Contract
manufacturing
|
|
$
|
3,106
|
|
|
$
|
6,440
|
|
Retail
|
|
|
80
|
|
|
|
154
|
|
Total
Revenue
|
|
$
|
3,186
|
|
|
$
|
6,594
|
|
Practical
Expedients Elected
The
Company has elected the following practical expedients in applying ASC 606 across all each revenue stream:
Sales
Tax Exclusion from the Transaction Price
The
Company excludes from the measurement of the transaction price all taxes assessed by a governmental authority that are both imposed
on and concurrent with a specific revenue-producing transaction and collected by the Company from the customer.
Shipping
and Handling Activities
The
Company accounts for shipping and handling activities it performs after a customer obtains control of the good as activities to
fulfill the promise to transfer the good.
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 (i) incurred from continuing operations for the three months ended
June 30, 2018 and 2017 were $39,000 and $21,000, respectively, and (ii) attributed to and classified as discontinued operations
for the three months ended June 30, 2018 and 2017 were zero and $205,000, respectively. Advertising and incentive promotion
expenses (i) incurred from continuing operations for the six months ended June 30, 2018 and 2017 were $72,000 and $53,000,
respectively, and (ii) attributed to and classified as discontinued operations for the six months ended June 30, 2018 and 2017
were zero and $2.8 million, respectively. Included in prepaid expenses and other current assets was $139,000 and $139,000
at June 30, 2018 and December 31, 2017, respectively, relating to prepaid advertising and promotion expenses.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies – continued
Share
-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.
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, 2018 and 2017 (i) from continuing operations were $87,000 and $224,000, respectively, and (ii) attributed
to and classified as discontinued operations were zero and $52,000, respectively. Research and development costs incurred for
the six months ended June 30, 2018 and 2017 (i) from continuing operations were $175,000 and $258,000, respectively, and (ii)
attributed to and classified as discontinued operations were zero and $52,000, 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, dietary supplements and other remedies.
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 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 (see Notes 3 and
6).
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
Adopted 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. We adopted the new standard as of January 1, 2018, using the modified retrospective method. See the Revenue Recognition
section within the Summary of Significant Accounting Policies in Note 2 for further details on the impact to our consolidated
financial statements upon adoption and practical expedients elected. The implementation of the new revenue recognition standard
did not have a material impact on our consolidated financial statements.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
2 – Summary of Significant Accounting Policies – continued
In
November 2016, the FASB issued ASU No. 2016-18 “Statement of Cash Flows: Restricted Cash” which requires a statement
of cash flows to explain the change during a period in the total cash, cash equivalents, and amounts generally described as restricted
cash or restricted cash equivalents. Under the new standard, amounts generally described as restricted cash and restricted cash
equivalents should be included with cash and cash equivalents when reconciling the beginning-of-period and end-of-period total
amounts shown in the statement of cash flows. ASU 2016-18 was effective for us as of January 1, 2018. We have not generally had
restricted cash or restricted cash equivalents, and there is no restricted cash on the balance sheet as of June 30, 2018. The
adoption of this update did not have a material impact 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, none of which
currently apply to us. The new guidance was effective for us in the first quarter of 2018. The adoption of ASU 2016-15 did not
have a material impact on the Company’s 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 to recognize the income tax consequences of an asset other than inventory when the asset transfer
occurs. The new guidance was effective for us in the first quarter of 2018. The adoption of ASU 2016-15 did not have a material
impact on the Company’s financial statements.
Recently
Issued Accounting Standards
In
June 2018, the FASB issued Accounting Standards Update (ASU) 2018-07 intended to reduce cost and complexity and to improve financial
reporting for nonemployee share-based payments. Currently, the accounting requirements for nonemployee and employee share-based
payment transactions are significantly different. This ASU expands the scope of Topic 718, Compensation-Stock Compensation (which
currently only includes share-based payments to employees) to include share-based payments issued to nonemployees for goods or
services. Consequently, the accounting for share-based payments to nonemployees and employees will be substantially aligned. This
ASU supersedes Subtopic 505-50, Equity-Equity-Based Payments to Nonemployees. The amendments in this ASU are effective for public
companies for fiscal years beginning after December 15, 2018, with early adoption permitted. The Company is currently evaluating
the impact of this new standard on its 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.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
3 – Discontinued Operations, Sale of the Cold-EEZE
®
Business
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 months ended June 30, 2017, we 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 terms of the asset purchase agreement entered into with Mylan on January 6, 2017 (the “Asset Purchase Agreement”),
we also agreed to a one-time sale to Mylan of certain non-lozenge-based Cold-EEZE
®
inventory for approximately
$699,000, which approximates our cost. At June 30, 2017, we classified in our balance sheet this inventory as an asset held for
sale, discontinued operations. Additionally, pursuant to the terms of the Asset Purchase Agreement, we allocated and agreed to
pay Mylan 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. At June 30, 2017, we classified in our balance sheet this liability as an accrued sales allowance,
discontinued operations. At December 31, 2017, we classified $22,000 of assets held for sale in our balance sheet and as of June
30, 2018, the asset was sold to Mylan and removed from assets held for sale.
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
|
|
|
(3,511
|
)
|
Gain
on sale of the Cold-EEZE
®
Business after income taxes
|
|
$
|
42,301
|
|
|
|
|
|
|
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
Fiscal 2017, we incurred $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.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
The
following table sets forth the condensed operating results of our discontinued operations for the three and six months ended June
30, 2018 and 2017, respectively, (in thousands):
|
|
Three
Months Ended June 30,
|
|
|
Six
Months Ended June 30,
|
|
|
|
2018
|
|
|
2017
|
|
|
2018
|
|
|
2017
|
|
Net
sales
|
|
$
|
-
|
|
|
$
|
(371
|
)
|
|
$
|
-
|
|
|
$
|
4,687
|
|
Cost of sales
|
|
|
-
|
|
|
|
264
|
|
|
|
-
|
|
|
|
2,037
|
|
Sales
and marketing
|
|
|
-
|
|
|
|
200
|
|
|
|
-
|
|
|
|
1,720
|
|
Administration
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
348
|
|
Research
and development
|
|
|
-
|
|
|
|
-
|
|
|
|
-
|
|
|
|
52
|
|
Income
(loss) from discontinued operations
|
|
$
|
-
|
|
|
$
|
(835
|
)
|
|
$
|
-
|
|
|
$
|
530
|
|
There
was no activity related to discontinued operations for the three and six months ended June 30, 2018.
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 was recorded as a reduction of the Notes and the origination costs are charged to interest 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 was recorded as a reduction of the Notes and was charged to
interest expense over the term of the loan.
The Notes bore interest
at the rate of 12% per annum, payable semi-annually and the principal was 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 Warrants and loan origination
costs, was 14.3% per annum. For the three months ended June 30, 2018 and 2017, we charged to interest expense zero and $54,000,
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 due under the Notes, in the total amount of $1,553,000. 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.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
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
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, 2018, no shares of Preferred Stock have been issued. Our board of directors have 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, subject to any required stockholder approval amend from time to time our certificate
of incorporation 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.
2015
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.
The
purchase price is 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 has 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 is not 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, 2018, 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. The 2015 Equity Line expired in July 2018.
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 has been subsequently amended and restated by our stockholders (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 3.9 million shares.
During the six months
ended June 30, 2018, we granted 30,000 options, exercisable at $2.35 per share and subject to vesting over a three-year term,
to a consultant to acquire our Common Stock pursuant to the terms of the 2010 Plan. For the six month ended June 30, 2017, we
granted, 600,000 options to employees, exercisable at $2.00 per share and subject to vesting over a four-year term. We
use the Black-Scholes option pricing model to determine the fair value of the stock options and Warrants at the date of grant.
Based upon our limited historical experience, we determined the expected term of the stock option grants to be 4.5 years, calculated
using the “simplified” method in accordance with the SEC Staff Accounting Bulletin 110. We use the “simplified”
method since our historical data does not provide a reasonable basis upon which to estimate expected term. Presented below is
a summary of the terms of the grant of options. The assumptions used in determining the fair value of the 30,000 stock options
granted in the first quarter of Fiscal 2018 were (i) expected option life of 4.5 years, (ii) weighted average risk rate of 2.37%,
(iii) dividend yield of 0% and (iv) expected volatility of 40.06%.
During
the six months ended June 30, 2018 and 2017, we issued 490,000 and 90,000 shares of common stock, respectively, upon the exercise
of stock options granted under our 2010 Plan, including 250,000 shares that were issued in the six months ended June 30, 2018
pursuant to a cashless exercise. At June 30, 2018, there were 519,500 stock options outstanding under the 2010 Plan and 791,159
shares 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 has been subsequently amended
and restated by our stockholders (the “2010 Directors’ Plan”). A primary purpose of the 2010 Directors’
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’ Plan provides that the total number of shares of Common Stock that may be issued under the 2010 Directors’
Plan is equal to 675,000 shares. For the six months ended June 30, 2018 and 2017, no shares were granted to our directors
under the 2010 Directors’ Plan. At June 30, 2018, there were 397,808 shares of Common Stock that may be issued pursuant
to the terms of the 2010 Directors’ Plan.
The
2018 Stock Incentive Plan
On April 12, 2018, our
stockholders approved the 2018 Stock Incentive Plan (the “2018 Stock Plan”). The 2018 Stock Plan provides for the
grant of incentive stock options to eligible employees of the Company, and for the grant of nonstatutory stock options to eligible
employees, directors and consultants. The purpose of the 2018 Stock Plan is to advance the interests of the Company and its stockholders
by providing an incentive to attract, retain, and reward persons performing services for the Company and by motivating such persons
to contribute to the growth and profitability of the Company. The 2018 Stock Plan provides that the total number of shares that
may be issued pursuant to the 2018 Stock Plan is 2.3 million shares. At June 30, 2018, all 2.3 million shares have been granted
in the form of stock options to Ted Karkus, our Chief Executive Officer and no stock options have been exercised
under the 2018 Stock Plan (the “CEO Options”) none of which have been exercised. (see Note 8). We use the Black-Scholes
option pricing model to determine the fair value of the stock options and Warrants at the date of grant. Based upon our limited
historical experience, we determined the expected term of the stock option grants to be 4.5 years, calculated using the “simplified”
method in accordance with the SEC Staff Accounting Bulletin 110. We use the “simplified” method since our historical
data does not provide a reasonable basis upon which to estimate expected term. The assumptions used in determining the fair value of the 2,300,000 stock options granted
in the second quarter of Fiscal 2018 were (i) expected option life of 4.5 years, (ii) weighted average risk rate of 2.42%,
(iii) dividend yield of 0% and (iv) expected volatility of 40.10%.
The
2018 Plan permits provides for certain proportionate adjustments to be made to stock options granted under the 2018
Plan upon the occurrence of certain events, including a special distribution (whether in the form of cash, shares, other
securities, or other property). Accordingly, the Board has adjusted the terms of the CEO Option, such that the exercise price
of the CEO Option was be reduced from $3.00 per share to $2.00 per share, effective as of June 5, 2018, the date the
special cash dividend was to be paid and subject to such dividend payment being made. Compensation cost was
measured for the difference between the fair value of the modified award and the fair value of the original award on the
modification date. The incremental compensation cost of approximately $900,000 is being recognized over the
remaining service period as the sum of the incremental compensation cost and the remaining unrecognized compensation
cost for the original award on the modification date.
Prior
to the modification, the Company had recognized $143,912 of compensation expense. With an original gross value of $1,554,252,
the unrecognized compensation expense as of the modification date was $1,410,340.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
6 – Income Taxes
At
December 31, 2017, there were $12.2 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, 2032 through 2036. Additionally, there
were $13.8 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, 2019 through 2037.
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, 2018. However, until we complete a final Section 382 analysis upon filing of our
2018 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 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 $3.1 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 $1.0 million as a consequence of the utilization of the federal and state net operating losses.
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.
On
December 22, 2017, the President of the United States signed into law legislation that is commonly referred to as the Tax Cuts
and Jobs Act (the “TCJA”). This legislation reduced the U.S. corporate tax rate from the existing graduated rate of
15-35% to a flat 21% for tax years beginning after December 31, 2017. As a result of the enacted law, we were required to revalue
our deferred tax assets and liabilities existing as of December 31, 2017 from the graduated 15-35% federal rate in effect through
the end of 2017, to the new flat 21% rate. This revaluation resulted in a reduction to our deferred tax asset of $1.8 million.
This amount was offset by a corresponding reduction to our valuation allowance. The other provisions of the TCJA did not have
a material impact on our December 31, 2017 consolidated financial statements. Estimates used to prepare our income tax expense
are based on our initial analysis of the TCJA. Given the complexity of the TCJA, anticipated guidance from the U.S. Treasury regarding
implementation of the TCJA, and the potential for additional guidance from the Securities and Exchange Commission and the FASB
related to the TCJA, these estimates may be adjusted during Fiscal 2018 to reflect any such guidance provided.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
7 – Other Current Liabilities
The
following table sets forth the components of other current liabilities at June 30, 2018 and December 31, 2017, respectively, (in
thousands):
|
|
June
30, 2018
|
|
|
December 31, 2017
|
|
Accrued
Expenses
|
|
$
|
76
|
|
|
$
|
66
|
|
Accrued
Benefits
|
|
|
67
|
|
|
|
15
|
|
Accrued
Payroll
|
|
|
32
|
|
|
|
79
|
|
Accrued
Vacation
|
|
|
81
|
|
|
|
88
|
|
Sales
Tax payable
|
|
|
3
|
|
|
|
3
|
|
Deferred
revenue
|
|
|
52
|
|
|
|
-
|
|
Income
taxes payable
|
|
|
740
|
|
|
|
740
|
|
Due
to Mylan and affiliates
|
|
|
-
|
|
|
|
59
|
|
|
|
$
|
1,051
|
|
|
$
|
1,050
|
|
Note
8– 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.
On
May 31, 2018, we received notice of a claim for $800,000 in losses against the escrow amount. We have disputed this claim and
intend to vigorously contest such claim. In the event that this or any other indemnity claim is successful, we may
be required to pay Mylan such amounts out of escrow fund, 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
®
Business if the escrow funds are insufficient to cover the losses.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
8– Commitments and Contingencies – continued
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) purchased 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.
Employment
Agreement
On
February 16, 2018, our board of directors approved the Amended and Restated 2015 Executive Employment Agreement with Ted Karkus,
our Chief Executive Officer (the “Amended Employment Agreement”), which became effective February 23, 2018, and was
approved by stockholders at a special meeting of stockholders held April 12, 2018. Pursuant to the terms of the Amended Employment
Agreement, Mr. Karkus voluntarily agreed to reduce his base salary from the rate set forth in the 2015 Employment Agreement (
i.e.,
not less than $675,000 per annum) to a base salary of $125,000 per annum (the “Term Base Salary”) through February
22, 2021. Unless otherwise determined by the mutual agreement of the Company and Mr. Karkus, on February 22, 2021 and thereafter,
Mr. Karkus’ salary will increase from the Term Base Salary to not less than $675,000 per annum.
In consideration of Mr.
Karkus’ voluntary reduction in salary, our board of directors awarded Mr. Karkus a stock option to purchase 2,300,000
shares of our Common Stock at an exercise price of $3.00 per share on February 23, 2018 (the “Executive Stock Option”).
The Executive Stock Option will vest and be exercisable in 35 equal monthly installments of 63,888 shares and one monthly installment
of 63,290 shares, subject to his continued employment, and subject to accelerated vesting in the event Mr. Karkus’s employment
is terminated for any reason other than by us for Cause or by Mr. Karkus without Good Reason (as such terms are defined in the
Amended Employment Agreement). The Executive Stock Option is be exercisable for a five year term commencing on the date of grant.
The Executive Stock Option was granted pursuant to the 2018 Stock Plan, which was also adopted and approved by our board of directors
on February 16, 2018. The 2018 Plan, like the Amended Employment Agreement, received stockholder approval at a special meeting
of stockholders held on April 12, 2018 at which time the options were considered granted. The 2018 Plan authorizes the
issuance of up to 2,300,000 shares pursuant to stock options granted under the 2018 Plan, all of which were issued to Mr. Karkus
as part of the Executive Stock Option.
As
discussed further in Note 5, on
May 7, 2018, the Compensation
Committee of the board of directors approved an adjustment to the Executive Stock Option, as permitted under the 2018 Stock Plan,
in relation to the special cash dividend paid to stockholders on June 5, 2018. Specifically, the board of directors reduced
the exercise price of the Executive Stock Option from $3.00 per share to $2.00 per share, effective as of June 5, 2018.
Future
Obligations:
We
have estimated future minimum obligations over the next five years, including the remainder of Fiscal 2018, as follows (in thousands):
Fiscal
Year
|
|
Employment
Contracts
|
|
2018
|
|
$
|
62,500
|
|
2019
|
|
|
125,000
|
|
2020
|
|
|
125,000
|
|
2021
|
|
|
595,136
|
|
2022
|
|
|
675,000
|
|
Total
|
|
$
|
1,582,636
|
|
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
9 – Earnings (Loss) Per Share
Basic
earnings (loss) per share for continuing and discontinued operations are computed by dividing the 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, 2018 and 2017 were 2,819,500 and 2,209,000, respectively.
For
the three months ended June 30, 2018 and June 30, 2017 dilutive earnings (loss) per share were the same as basic earnings
per share due to the inclusion of Common Stock in the form of stock options and warrants (“Common Stock Equivalents”),
when in a net loss position would have an anti-dilutive effect on loss per share. For the three months ended June 30, 2018
and 2017, there were 1,113,320 and 641,754 Common Stock Equivalents, that 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 2018, there were 889,968, 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 that were in the money, which were included in the fully diluted earnings
per share computation.
Note
10 – Significant Customers
Revenue
from continuing operations for the three months ended June 30, 2018 and 2017 was $3.2 million and $1.9 million, respectively.
Two third-party contract manufacturing customers accounted for 57.2% and 29.4%, respectively, of our revenue from continuing operations
for the three months ended June 30, 2018. Two third-party contract manufacturing customers accounted for 63.3% and 13.9%, respectively,
of our revenues from continuing operations for the three months ended June 30, 2017. The loss of sales to either of these large
third-party contract manufacturing customers could have a material adverse effect on our business operations and financial condition.
Revenue
from continuing operations for the six months ended June 30, 2018 and 2017 was $6.6 million and $2.7 million, respectively. Two
third-party contract manufacturing customers accounted for 43.1% and 39.0%, respectively, of our revenue from continuing operations
for the six months ended June 30, 2018. Two third-party contract manufacturing customers accounted for 43.5% and 25.1%, respectively,
of our revenues from continuing operations for the six months ended June 30, 2017. The loss of sales to either of these large
third-party contract manufacturing customers could have a material adverse effect on our business operations and financial condition.
We
are subject to account receivable credit concentrations from time-to-time as a consequence of the timing, payment pattern and
ultimate purchase volumes or shipping schedules with our customers. These 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. Two customers represented 48% and 42% and
one customer represented 84% of our total trade receivable balances at June 30, 2018 and December 31, 2017, respectively. Management
believes that the provision for possible losses on uncollectible accounts receivable is adequate for our credit loss exposure.
The allowance for doubtful accounts was zero for both June 30, 2018 and December 31, 2017.
ProPhase
Labs, Inc. and Subsidiaries