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 September 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.
Our
wholly-owned subsidiary, Pharmaloz Manufacturing, Inc. (“PMI”), is a full service contract manufacturer and distributor
of a broad range of non-GMO, organic and/or natural-based cough drops and lozenges and OTC drug and dietary supplement products.
In
addition, we 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 2019” shall mean the fiscal
year ended December 31, 2019 and references to other “Fiscal” years shall mean the year that 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
For the three and nine
months ended September 30, 2019 and 2018, our revenues have come principally from OTC healthcare contract manufacturing and sales
of dietary supplement products to retail customers in the United States.
Basis
of Presentation
The
unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles
for interim financial statements and 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 audited consolidated financial statements, including the notes thereto, appearing in our Annual Report on Form 10-K for
the fiscal year ended December 31, 2018. 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 nine months ended September 30, 2019 are not necessarily indicative of
operating results that may be achieved over the course of the full year.
Product
Innovation, Seasonality of the Business and Liquidity
Our net sales are derived
principally from our OTC healthcare contract manufacturing and sales of dietary supplement products to retail
customers in the United States. In addition, we are engaged in marketing activities for the TK Supplements® product
line of dietary supplements.
Our
sales are influenced by and subject to (i) the scope and timing of TK Supplements® product market acceptance, and
(ii) fluctuations in the timing of purchase and the ultimate level of demand for the OTC healthcare products that we manufacture
for others, which are a function of the timing, length and severity of each cold season. Generally, a cold season is defined as
the period from 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 quarters higher net sales from our contract manufacturing services.
Revenues are generally at their lowest levels in the second quarter, when customer demand generally declines.
As
a consequence of the scope and timing of our TK Supplements® product market acceptance and the seasonality of our
business, we realize variations in operating results and demand for working capital from quarter to quarter. As of September 30,
2019, we had working capital of approximately $12.1 million, including $3.8 million of marketable debt securities, which are available
for sale. We believe our current working capital at September 30, 2019 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)
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, 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.
Marketable
Debt Securities
We
have classified our investments in marketable debt securities as available-for-sale and as a current asset. Our investments in
marketable debt 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 debt securities are recorded as interest income (expense). We initiated
short term investments in marketable debt securities, which carry maturity dates between one and three years from date of purchase
with interest rates of 1.91% - 4.70% during the first three quarters of Fiscal 2019. For the three months and nine months ended
September 30, 2019, we reported an unrealized loss of $5,000 and unrealized gain of $18,000, respectively, and an accumulated
unrealized loss of $6,000. 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 debt securities and the underlying
fair value input level tier hierarchy (see long-lived assets below) (in thousands):
|
|
As
of September 30, 2019
|
|
|
|
Amortized
|
|
|
Unrealized
|
|
|
Market
|
|
|
|
Cost
|
|
|
Losses
|
|
|
Value
|
|
U.S
treasuries
|
|
$
|
553
|
|
|
$
|
(3
|
)
|
|
$
|
550
|
|
Corporate
bonds
|
|
|
3,213
|
|
|
|
(3
|
)
|
|
|
3,210
|
|
|
|
$
|
3,766
|
|
|
$
|
(6
|
)
|
|
$
|
3,760
|
|
|
|
As
of December 31, 2018
|
|
|
|
Amortized
|
|
|
Unrealized
|
|
|
Market
|
|
|
|
Cost
|
|
|
Losses
|
|
|
Value
|
|
U.S
treasuries
|
|
$
|
2,401
|
|
|
$
|
(3
|
)
|
|
$
|
2,398
|
|
Corporate
bonds
|
|
|
4,310
|
|
|
|
(21
|
)
|
|
|
4,289
|
|
|
|
$
|
6,711
|
|
|
$
|
(24
|
)
|
|
$
|
6,687
|
|
We
have determined that the unrealized losses are deemed to be temporary as of September 30, 2019. We believe that the unrealized
losses generally are the result of increases in the risk premiums required by market participants rather than an adverse change
in cash flows or a fundamental weakness in the credit quality of the issuer or underlying assets. We have the ability and intent
to hold these investments until a recovery of fair value, which may be maturity. We do not consider the investment in corporate
bonds to be other-than-temporarily impaired at September 30, 2019.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
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 September 30,
2019, after the 2019 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 $344,000, inclusive of adjustments of $305,000 for
product samples of TK Supplements® products. At September 30, 2019, the inventory adjustment for excess, obsolete
or short-dated shelf-life inventory included $78,000 in finished goods and $266,000 in raw material and work in process. At December
31, 2018, the financial statements include adjustments to reduce inventory for excess, obsolete or short-dated shelf-life inventory
of $377,000, inclusive of an adjustment of $270,000 for product samples of TK Supplements® products. At December
31, 2018, the inventory adjustment for excess, obsolete or short-dated shelf-life inventory included $319,000 in finished goods
and $58,000 in raw material and work in process. The components of inventory are as follows (in thousands):
|
|
September
30, 2019
|
|
|
December
31, 2018
|
|
Raw
materials
|
|
$
|
1,125
|
|
|
$
|
1,374
|
|
Work
in process
|
|
|
462
|
|
|
|
371
|
|
Finished
goods
|
|
|
299
|
|
|
|
158
|
|
|
|
$
|
1,886
|
|
|
$
|
1,903
|
|
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. We have reviewed our property, plant and equipment for the nine months ended
September 30, 2019 and 2018 and concluded there were no impairments or changes in useful lives.
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 healthcare 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. 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 debt 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 September 30, 2019, our cash and cash equivalents balance was $1.0
million and our bank balance was $1.1 million. Of the total bank balance, $250,000 was covered by federal depository insurance
and $0.8 million was uninsured at September 30, 2019.
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 product 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 September 30, 2019 and December 31, 2018.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
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 of Financial Instruments
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.
Cash
and cash equivalents, marketable debt securities, accounts receivable, 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
debt securities at fair value pursuant to GAAP, with the net unrealized gains or losses reported as a component of accumulated
other comprehensive income or loss.
|
|
As
of September 30, 2019
|
|
|
|
Level
1
|
|
|
Level
2
|
|
|
Level
3
|
|
|
Total
|
|
Marketable
debt securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
U.S.
government obligations
|
|
$
|
-
|
|
|
$
|
550
|
|
|
$
|
-
|
|
|
$
|
550
|
|
Corporate
obligations
|
|
|
-
|
|
|
|
3,210
|
|
|
|
-
|
|
|
|
3,210
|
|
|
|
$
|
-
|
|
|
$
|
3,760
|
|
|
$
|
-
|
|
|
$
|
3,760
|
|
|
|
As
of December 31, 2018
|
|
|
|
Level
1
|
|
|
Level
2
|
|
|
Level
3
|
|
|
Total
|
|
Marketable
debt securities
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
U.S.
government obligations
|
|
$
|
-
|
|
|
$
|
2,398
|
|
|
$
|
-
|
|
|
$
|
2,398
|
|
Corporate
obligations
|
|
|
-
|
|
|
|
4,289
|
|
|
|
-
|
|
|
|
4,289
|
|
|
|
$
|
-
|
|
|
$
|
6,687
|
|
|
$
|
-
|
|
|
$
|
6,687
|
|
There
were no transfers of marketable debt securities between Levels 1, 2 or 3 for the nine months ended September 30, 2019.
Revenue
Recognition
We account for revenue
when our performance obligations with our customers have been satisfied. At contract inception, we evaluate
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
adopted ASC 606 as of January 1, 2018 using the modified retrospective method. There were no changes to our opening balances upon
the adoption of ASC 606 and the amounts which would have been reported under the standards in effect prior to adoption.
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 was $2.5 million and $0.2 million, respectively, for the three months ended September
30, 2019 and $2.3 million and $0.1 million, respectively, for the three months ended September 30, 2018. Net sales from contract
manufacturing and retail customers was $6.1 million and $0.6 million, respectively, for the nine months ended September 30, 2019
and $8.8 million and $0.3 million, respectively, for the nine months ended September 30, 2018. 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. 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 and the R&D services are invoiced at the time the performance
is completed.
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.
We
do 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.
We recognize contract manufacturing and retail customers revenue at a point in time as the Company has an enforceable right
to payment for goods as products are shipped to customers.
As
of September 30, 2019 and December 31, 2018, we included a provision for sales allowances from operations of $500 and $1,000,
respectively, which are reported as a reduction to account receivables. Additionally, accrued advertising and other allowances
from discontinued operations as of September 30, 2019 included (i) $132,000 for estimated returns, which is reported as a reduction
to account receivables, and (ii) $76,000 for cooperative incentive promotion costs, which is reported as accrued advertising and
other allowances under current liabilities. As of December 31, 2018, accrued advertising and other allowances from discontinued
operations included (i) $181,000 for estimated future sales returns, which is reported as a reduction to account receivables,
and (ii) $88,000 for cooperative incentive promotion costs, which is reported as accrued advertising and other allowances under
current liabilities.
As
of September 30, 2019, we have deferred revenue of $247,000 in relation to Research and Development (“R&D”) stability
and release testing programs. Deferred revenues primarily consist of amounts that have been billed to or received from customers
in advance of revenue recognition and prepayments received from customers in advance for implementation, maintenance and other
services, as well as initial subscription fees. We recognize deferred revenues as revenues when the services are performed and
the corresponding revenue recognition criteria are met. Customer prepayments are generally applied against invoices issued to
customers when services are performed and billed.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
The
following table disaggregates the Company’s deferred revenue by recognition period (in thousands):
Recognition
Period
|
|
Deferred
Revenue
|
|
0-12
Months
|
|
$
|
118
|
|
13-24 Months
|
|
|
34
|
|
Over
24 Months
|
|
|
95
|
|
Total
|
|
$
|
247
|
|
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 nine months ended September 30,
2019 and 2018 (in thousands):
|
|
For
the Three Months Ended
|
|
|
For
the Nine Months Ended
|
|
Revenue
by Customer Type
|
|
September
30, 2019
|
|
|
September
30, 2018
|
|
|
September
30, 2019
|
|
|
September
30, 2018
|
|
Contract
manufacturing
|
|
$
|
2,517
|
|
|
$
|
2,324
|
|
|
$
|
6,093
|
|
|
$
|
8,764
|
|
Retail
and others
|
|
|
249
|
|
|
|
115
|
|
|
|
642
|
|
|
|
269
|
|
Total
revenue
|
|
$
|
2,766
|
|
|
$
|
2,439
|
|
|
$
|
6,735
|
|
|
$
|
9,033
|
|
Shipping
and Handling Activities
We
account for shipping and handling activities we perform 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 incurred for the three months ended September 30, 2019 and 2018
were $270,000 and $14,000, respectively. Advertising and incentive promotion expenses incurred for the nine months ended September
30, 2019 and 2018 were $352,000 and $51,000, respectively.
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 at their grant date. 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. We account for forfeitures as they occur.
Stock
and stock options for the purchase of our common stock, have been granted to employees pursuant to the
terms of certain agreements and stock option plans (see Note 4). Stock options are exercisable during a period determined by us,
but in no event later than seven 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 September
30, 2019 and 2018 were $57,000 and $144,000, respectively. Research and development costs incurred for the nine months ended September
30, 2019 and 2018 were $246,000 and $319,000, respectively. Research and development costs are principally related to personnel
expenses and new product development initiatives and costs associated with our OTC healthcare products and dietary supplements.
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 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.
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 losses from continuing operations, we have recorded a full valuation allowance against a net deferred tax asset.
Additionally, we have not recorded a liability for unrecognized tax benefit.
Recently
Adopted Accounting Standards
In
February 2016, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”)
2016-02, Leases (Topic 842) in order to increase transparency and comparability among organizations by, among other provisions,
recognizing lease assets and lease liabilities on the balance sheet for those leases classified as operating leases under previous
GAAP. For public companies, ASU 2016-02 is effective for fiscal years beginning after December 15, 2018 (including interim periods
within those periods) using a modified retrospective approach and early adoption is permitted. In transition, entities may also
elect a package of practical expedients that must be applied in its entirety to all leases commencing before the adoption date,
unless the lease is modified, and permits entities to not reassess (a) the existence of a lease, (b) lease classification or (c)
determination of initial direct costs, as of the adoption date, which effectively allows entities to carryforward accounting conclusions
under previous GAAP. In July 2018, the FASB issued ASU 2018-11, Leases (Topic 842): Targeted Improvements, which provides entities
an optional transition method to apply the guidance under Topic 842 as of the adoption date, rather than as of the earliest period
presented. We adopted Topic 842 on January 1, 2019, using the optional transition method to apply the new guidance as of January
1, 2019, rather than as of the earliest period presented, and elected the package of practical expedients described above. The
adoption of this standard did not have a material impact on our condensed consolidated financial statements.
In August 2018, the SEC
adopted SEC Final Rule Release No. 33-10532, Disclosure Update and Simplification, which amended certain disclosure requirements
that were redundant, duplicative, overlapping, outdated or superseded. In addition, the amendments expanded the disclosure requirements
regarding stockholders’ equity to interim financial statements. Under the amendments, a description of the changes
in each caption of stockholders’ equity presented in the balance sheet must be provided in a note or separate statement.
The description must include a reconciliation of the beginning balance to the ending balance of each period for which a statement
of comprehensive income is required to be filed. The condensed consolidated financial statements included in this Quarterly Report
include a reconciliation of the beginning balance to the ending balance of stockholders’ equity for each period in which
a statement of operations and comprehensive income (loss) is provided.
Recently
Issued Accounting Standards, Not Yet Adopted
In
September 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, subject to a deferral for smaller
reporting companies pending issuance of a final ASU by the FASB. We are currently evaluating the potential impact of the adoption
of this update on our consolidated financial statements.
In June 2018, the FASB
issued ASU 2018-07 “Improvements to Nonemployee Share-Based Payment Accounting”, which simplifies the accounting for
share-based payments granted to nonemployees for goods and services. Under the ASU, most of the guidance on such payments to nonemployees
would be aligned with the requirements for share-based payments granted to employees. The amendments are effective for fiscal
years beginning after December 15, 2019, and interim periods within fiscal years beginning after December 15, 2020. Early adoption
is permitted, but not earlier than an entity’s adoption date of Topic 606. The Company is currently evaluating the impact
of the new standard on its condensed consolidated financial statements.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
Note
3 – Property, Plant and Equipment
The
components of property and equipment are as follows (in thousands):
|
|
September
30, 2019
|
|
|
December
31, 2018
|
|
|
Estimated
Useful Life
|
Land
|
|
$
|
504
|
|
|
$
|
504
|
|
|
|
Building
improvements
|
|
|
3,113
|
|
|
|
3,059
|
|
|
10-39
years
|
Machinery
|
|
|
4,257
|
|
|
|
4,126
|
|
|
3-7
years
|
Computer
equipment
|
|
|
457
|
|
|
|
457
|
|
|
3-5
years
|
Furniture
and fixtures
|
|
|
207
|
|
|
|
207
|
|
|
5
years
|
|
|
|
8,538
|
|
|
|
8,353
|
|
|
|
Less:
accumulated depreciation
|
|
|
(6,156
|
)
|
|
|
(5,854
|
)
|
|
|
Total
property, plant and equipment, net
|
|
$
|
2,382
|
|
|
$
|
2,499
|
|
|
|
Depreciation
expense incurred for the three months ended September 30, 2019 and 2018 was $100,000 and $97,000, respectively. Depreciation expense
incurred for the nine months ended September 30, 2019 and 2018 was $302,000 and $287,000, respectively.
Note
4 – Transactions Affecting Stockholders’ Equity
Our authorized capital
stock consists of 50 million shares of Common Stock, $0.0005 par value (“Common Stock”), and one million shares
of preferred stock, $0.0005 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
September 30, 2019, 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.
Common
Stock Dividend
On May 7, 2018, the Board
declared a special cash dividend of $1.00 per share on the Company’s Common Stock payable on September 5, 2018 to holders
of record of the Company’s Common Stock on September 6, 2018. On September 5, 2018, we made an aggregate cash payment
of $11.7 million to our stockholders.
On December 24, 2018,
the Board declared a special cash dividend of $0.25 per share on the Company’s Common Stock resulting in $2.9 million payable
on January 24, 2019 to holders of record of the Company’s Common Stock on January 10, 2019. On January 24, 2019, we made
an aggregate cash payment of $2.9 million to our stockholders.
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.
During
the three and nine months ended September 30, 2019, 4,727 and 15,464 shares of restricted stock were granted to our directors
under the 2010 Directors’ Plan. We recorded $45,000 of director fees during the nine months ended September 30, 2019
in connection with these grants, which represented the fair value of the shares calculated based on the average closing price
of the Company’s shares of Common Stock for the first five trading days of the quarter in which the Board fee was earned.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
During the nine months
ended September 30, 2018, 7,474 shares of restricted stock were granted to our directors under the 2010 Directors’ Plan.
We recorded $23,000 of director fees during the nine months ended September 30, 2018 in connection with these grants.
As
of September 30, 2019, there were 367,396 shares of Common Stock that may be issued pursuant to the terms of the 2010 Directors’
Plan.
The
2010 Equity Compensation Plan
On
May 5, 2010, our stockholders approved the 2010 Equity Compensation Plan, which was 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.
No
options were granted under the 2010 Plan for the three and nine months ended September 30, 2019. During the three and nine months
ended September 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 pursuant to the terms of the 2010 Plan.
During
the nine months ended September 30, 2018, we issued 490,000 shares of common stock upon the exercise of stock options granted
under our 2010 Plan, including 250,000 shares that were issued in the nine months ended September 30, 2018 pursuant to a cashless
exercise.
As
of September 30, 2019, there were 599,500 options outstanding and 711,159 options available to be issued pursuant to the terms
of the 2010 Plan. We will recognize approximately $309,000 of share-based compensation expense over a weighted average period
of 2.1 years.
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. As of September 30, 2018,
all 2.3 million shares have been granted in the form of stock options to Ted Karkus (the “CEO Option”), our Chief
Executive Officer and no stock options have been exercised under the 2018 Stock Plan. We use the Black-Scholes option pricing
model to determine the fair value of the stock options 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. We will recognize approximately $706,000 of share-based
compensation expense over a weighted average period of 1.4 years.
The
2018 Plan requires certain proportionate adjustments to be made to the 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)
in order to maintain parity. Accordingly, the Compensation Committee of the board of directors, as required by the terms of the
2018 Stock Plan, adjusted the terms of the CEO Option, such that the exercise price of the CEO Option was reduced from $3.00 per
share to $2.00 per share, effective as of September 5, 2018, the date the special $1.00 special cash dividend was paid to stockholders.
The exercise price of the CEO Option was further reduced from $2.00 to $1.75 per share, effective as of January 24, 2019, the
date the $0.25 special cash dividend was paid to stockholders.
The
following table summarizes stock options activity during the nine months ended September 30, 2019 and 2018 for both the 2010 Plan
and 2018 Stock Plan (in thousands, except per share data):
|
|
Number
of Shares
|
|
|
Weighted
Average Exercise Price
|
|
|
Weighted
Average Remaining Contractual Life
(in years)
|
|
|
Total
Intrinsic Value
|
|
Outstanding
as of January 1, 2019
|
|
|
2,980
|
|
|
$
|
1.82
|
|
|
|
4.8
|
|
|
$
|
3,235
|
|
Forfeited
|
|
|
(80
|
)
|
|
|
2.87
|
|
|
|
-
|
|
|
|
-
|
|
Outstanding
as of September 30, 2019
|
|
|
2,900
|
|
|
$
|
1.85
|
|
|
|
3.7
|
|
|
$
|
420
|
|
Options
vested and exercisable
|
|
|
1,397
|
|
|
$
|
2.00
|
|
|
|
3.5
|
|
|
$
|
224
|
|
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
|
|
Number
of Shares
|
|
|
Weighted
Average Exercise Price
|
|
|
Weighted
Average Remaining Contractual Life
(in years)
|
|
|
Total
Intrinsic Value
|
|
Outstanding
as of January 1, 2018
|
|
|
980
|
|
|
$
|
1.82
|
|
|
|
4.8
|
|
|
$
|
31
|
|
Granted
|
|
|
2,330
|
|
|
|
2.00
|
|
|
|
-
|
|
|
|
-
|
|
Cashless
exercised
|
|
|
(250
|
)
|
|
|
1.86
|
|
|
|
-
|
|
|
|
-
|
|
Cash
exercised
|
|
|
(240
|
)
|
|
|
1.41
|
|
|
|
-
|
|
|
|
-
|
|
Outstanding
as of September 30, 2018
|
|
|
2,820
|
|
|
$
|
2.00
|
|
|
|
4.6
|
|
|
$
|
2,812
|
|
Options
vested and exercisable
|
|
|
482
|
|
|
$
|
2.00
|
|
|
|
4.4
|
|
|
$
|
484
|
|
Note
5 – Defined Contribution Plans
We maintain the ProPhase
Labs, Inc. 401(k) Savings and Retirement Plan, a defined contribution plan for our employees. Our contributions to the plan are
based on the amount of the employee plan contributions and compensation. Our contributions to the plan during the three and nine
months ended September 30, 2019 were $20,000 and $63,000, respectively, and for the three and nine months ended 2018 were
$20,000 and $66,000, respectively.
Note
6 – Other Accrued Liabilities
The
following table sets forth the components of other current liabilities at September 30, 2019 and December 31, 2018, respectively,
(in thousands):
|
|
September
30, 2019
|
|
|
December
31, 2018
|
|
Accrued
expenses
|
|
$
|
87
|
|
|
$
|
167
|
|
Accrued
benefits
|
|
|
67
|
|
|
|
23
|
|
Accrued
payroll
|
|
|
64
|
|
|
|
195
|
|
Accrued
vacation
|
|
|
29
|
|
|
|
66
|
|
Sales
tax payable
|
|
|
-
|
|
|
|
3
|
|
Income
taxes payable
|
|
|
-
|
|
|
|
106
|
|
Deferred
revenue
|
|
|
118
|
|
|
|
206
|
|
Total
other current liabilities
|
|
$
|
365
|
|
|
$
|
766
|
|
Note
7– Commitments and Contingencies
Escrow
Receivable
We have indemnification
obligations to Mylan Consumer Healthcare Inc. (formerly known as Meda Consumer Healthcare Inc.) (“MCH”) and Mylan
Inc. (together with MCH, “Mylan”) under the asset purchase agreement pursuant to which we sold the Cold-EEZE®
business to Mylan, 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, which was March 29, 2017, 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
(i.e., 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.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
The
terms of the Escrow Agreement provide that if, as of September 29, 2018, 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. In addition, within two business days of March 29, 2019, 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. As described
below, in August 2018, Mylan asserted an indemnification claim against us, for a yet to be determined amount. Accordingly, the
distributions were not released to us on September 29, 2018 or March 29, 2019.
On
May 31, 2018, we received notice of a claim for $800,000 in losses against the escrow amount. We resolved this claim pursuant
to a settlement agreement, effective October 16, 2018, pursuant to which $160,000 of the funds held in escrow were released to
Mylan. This expense is reflected in discontinued operations in the third quarter of 2018.
On August 2, 2018, we
received notice of an indemnification claim from Mylan in relation to certain product advertising claims brought against Mylan
related to certain Cold-EEZE® products. Pursuant to the terms of the asset purchase agreement, we have elected
to assume the defense of these claims on behalf of Mylan. We dispute these product advertising claims and intend to vigorously
contest such claims. While we believe these claims are without merit, in the event that these or any other indemnity claims are
successful, we may be required to pay Mylan such amounts out of the 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. Management expects to collect the full remaining escrow balance within the next twelve months,
net of an immaterial reserve representative of our best estimate of the cost to adjudicate this matter.
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.
Future
Obligations:
We
have estimated future minimum obligations for an executive’s employment agreement over the next five years, including
the remainder of Fiscal 2019, as follows (in thousands):
|
|
Employment
|
|
|
|
Contracts
|
|
2019
|
|
$
|
31
|
|
2020
|
|
|
125
|
|
2021
|
|
|
595
|
|
2022
|
|
|
675
|
|
2023
|
|
|
675
|
|
Total
|
|
$
|
2,101
|
|
Note
8 – Loss Per Share
Basic
loss per share for continuing 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 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 outstanding to acquire shares of our Common Stock at September 30, 2019 and
December 31, 2018 were 2,900,000 and 2,980,000, respectively.
ProPhase
Labs, Inc. and Subsidiaries
Notes
to Condensed Consolidated Financial Statements
(unaudited)
For
the three months ended September 30, 2019, dilutive loss per share were the same as basic earnings per share due to the exclusion
of Common Stock in the form of stock options (“Common Stock Equivalents”), which in a net loss position would have
an anti-dilutive effect on loss per share. For the three months ended September 30, 2019, there were 2,900,000 potential dilutive
Common Stock Equivalents that were excluded from the loss per share computation as a consequence of their anti-dilutive effect.
For the three months ended September 30, 2018 there were 2,800,000 potential dilutive Common Stock Equivalents that were excluded
from the loss per share computation as a consequence of their anti-dilutive effect.
For
the nine months ended September 30, 2019, dilutive loss per share were the same as basic earnings per share due to the exclusion
of Common Stock Equivalents, which in a net loss position would have an anti-dilutive effect on loss per share. For the nine months
ended September 30, 2019, there were 2,900,000 potential dilutive Common Stock Equivalents that were excluded from the loss per
share computation as a consequence of their anti-dilutive effect. For the nine months ended September 30 2018, there were 2,800,000
potential dilutive Common Stock Equivalents that were excluded from the loss per share computation as a consequence of their anti-dilutive
effect.
Note
9 – Significant Customers
Revenue for the three
months ended September 30, 2019 and 2018 was $2.8 million and $2.4 million, respectively. Three third-party contract manufacturing
customers accounted for 33.04% and 30.1% and 10.2%, respectively, of our revenue from continuing operations for the three
months ended September 30, 2019. Three third-party contract
manufacturing customers accounted for 38.9%, 30.4% and 15.2%, respectively, of our revenue from continuing operations for the
three months ended September 30, 2018. The loss of sales to any of these large third-party contract manufacturing customers
could have a material adverse effect on our business operations and financial condition.
Revenue for the nine months
ended September 30, 2019 and 2018 was $6.7 million and $9.0 million, respectively. Two third-party contract manufacturing customers
accounted for 44.2% and 27.2% respectively, of our revenue from continuing operations for the nine months ended September
30, 2019. Two third-party contract manufacturing customers
accounted for 39.8% and 39.0%, respectively, of our revenue from continuing operations for the nine months ended September 30,
2018. 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 62.5% and 20.1%
of our total trade receivable balances at September 30, 2019 and one customer represented 82% of our total trade receivable
balances at December 31, 2018.