10-Q 1 insy20150930_10q.htm FORM 10-Q insy20150930_10q.htm

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q 

 

[X]

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES                            

EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2015

 

OR

 

[   ]

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES                            

EXCHANGE ACT OF 1934

 

For the transition period from __________________ to _________________

 

Commission file number: 001-35902

 

Insys Therapeutics, Inc.

(Exact name of registrant as specified in its charter)

 

Delaware

51-0327886

(State or other jurisdiction of incorporation or organization)

(IRS Employer Identification No.)

  

  

1333 S. Spectrum Blvd, Suite 100, Chandler, Arizona

85286

(Address of principal executive offices)

(Zip Code)

 

(602) 910-2617

(Registrant’s telephone number, including area code)

N/A

(Former name, former address and former fiscal year, if changed since last report)

 

Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

 

Yes ☑     No ☐

 

Indicate by a checkmark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

 

Yes ☑     No ☐

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer

 

Accelerated filer

Non-accelerated filer

 

Smaller reporting company

(Do not check if a smaller reporting company)

 

 

 

  

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). 

Yes ☐     No ☑

 

As of October 29, 2015, the registrant had 72,031,148 shares of Common Stock ($0.01 par value) outstanding.

 



  

 

 
 

 

      

INSYS THERAPEUTICS, INC.

FORM 10-Q

 

TABLE OF CONTENTS

 

 

 

 

PAGE NO.

PART I

FINANCIAL INFORMATION

 

 

 

 

 

 

Item 1.

Unaudited Financial Statements:

 

 

 

Condensed Consolidated Balance Sheets as of September 30, 2015 and December 31, 2014

1

 

 

Condensed Consolidated Statements of Income and Comprehensive Income for the Three and Nine Months Ended September 30, 2015 and 2014

2

  

  

Condensed Consolidated Statements of Stockholders’ Equity for the Nine Months Ended September 30, 2015 

3

 

 

Condensed Consolidated Statements of Cash Flows for the Nine Months Ended September 30, 2015 and 2014

4

 

 

Notes to Unaudited Condensed Consolidated Financial Statements

5

 

 

 

 

 

Item 2.

Management’s Discussion and Analysis of Financial Condition and Results of Operations

17

  

  

  

  

  

Item 3

Quantitative and Qualitative Disclosures About Market Risk

28

 

 

 

 

 

Item 4.

Controls and Procedures

29

 

 

 

 

PART II

OTHER INFORMATION

 

 

 

 

 

 

Item 1.

Legal Proceedings

29

 

 

 

 

 

Item 1A.

Risk Factors

29

 

 

 

 

  

Item 2.

Unregistered Sales of Equity Securities and Use of Proceeds

30

  

  

  

  

  

Item 3.

Defaults Upon Senior Securities

30

  

  

  

  

  

Item 4.

Mine Safety Disclosure

30

  

  

  

  

  

Item 5.

Other Information

30

  

  

  

  

 

Item 6.

Exhibits

30

 

 

 

 

 

SIGNATURES

32

 

 

 

 

 

EXHIBIT INDEX

33

    

 

 
 i

 

     

Form 10-Q

GLOSSARY OF TERMS

 

The following glossary provides definitions for certain acronyms and terms used in our periodic filings with the United States Securities and Exchange Commission, including this Quarterly Report on Form 10-Q. These acronyms and terms are specific to our company, commonly used in our industry, or are otherwise frequently used throughout our filings, including this document.

  

Abbreviated Term

 

Defined Term

     

ANDA

 

Abbreviated New Drug Application

API

 

Active pharmaceutical ingredient

Aptar

 

AptarGroup, Inc.

ASC

 

Accounting Standards Codification

ATRA

 

American Taxpayer Relief Act of 2012

AVC

 

Assurance of Voluntary Compliance

BTCP

 

Breakthrough cancer pain

Catalent

 

Catalent Pharma Solutions, LLC

CBD

 

Synthetic cannabidiol

cGMP

 

Current Good Manufacturing Practices

CID

 

Civil Investigative Demand

CINV

 

Chemotherapy-induced nausea and vomiting

CMS

 

Centers for Medicare & Medicaid Services

CRO

 

Contract Research Organization

CSA

 

Federal Controlled Substances Act of 1970

DEA

 

U.S. Drug Enforcement Administration

DPT

 

DPT Lakewood, LLC

ESI

 

Express Scripts, Inc.

FASB

 

Financial Accounting Standards Board

FDA

 

U.S. Food and Drug Administration

FDCA

 

Federal Food, Drug, and Cosmetic Act

FSS

 

Federal Supply Schedule

GCP

 

Good Clinical Practices

GI

 

Gastrointestinal

GLP

 

Good Laboratory Practices

HIPAA

 

Health Insurance Portability and Accountability Act of 1996

HITECH

 

Health Information Technology for Economic and Clinical Health Act of 2009

IND

 

Investigational New Drug Application

Insys Pharma

 

Insys Pharma, Inc.

IPO

 

Initial public offering

IRB

 

Institutional Review Board

JOBS Act

 

Jumpstart Our Business Startups Act of 2012

MMA

 

Medicare Prescription Drug, Improvement, and Modernization Act of 2003

NDA

 

New Drug Application

NeoPharm

 

NeoPharm, Inc.

NOL

 

Net operating loss carryforward

NRV

 

Net Realizable Value

NSAID

 

Non-steroidal anti-inflammatory drug

Orange Book

 

FDA's Approved Drug Products with Therapeutic Equivalence Evaluations

ODOJ

 

Oregon Department of Justice

PBM

 

Pharmacy Benefit Managers

PDUFA   Prescription Drug User Fee Act

PK

 

Pharmacokinetics

PPACA

 

Patient Protection and Affordable Care Act of 2010, as amended by the Health Care and Education Reconciliation Act of 2010

QSR

 

FDA's Quality System Regulation

REMS

 

Risk Evaluation and Mitigation Strategy

RLD

 

Reference listed drug

SEC

 

U.S. Securities and Exchange Commission

THC

 

Delta-9-tetrahydrocannabinol

TIRF

 

Transmucosal immediate-release fentanyl

VC

 

Vomiting center

 

 

 
 ii

 

    

Part I:  FINANCIAL INFORMATION

 

Item 1.      UNAUDITED Financial Statements

  

INSYS THERAPEUTICS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except share and per share data)

   (unaudited)

 

   

September 30, 2015

   

December 31, 2014

 
                 

Assets

               

Current Assets:

               

Cash and cash equivalents

  $ 93,980     $ 58,106  

Short-term investments

    61,490       24,757  

Accounts receivable, net of allowances of $8,677 and $5,816 at September 30, 2015 and December 31, 2014, respectively

    30,475       26,544  

Inventories

    39,374       34,781  

Prepaid expenses and other assets

    5,842       2,243  

Deferred income tax assets

    5,472       4,611  
Total current assets     236,633       151,042  

Property and equipment, net

    36,748       29,872  

Long-term investments

    31,848       23,262  

Deferred income tax assets

    8,822       7,602  

Other assets

    26       3,343  
Total assets   $ 314,077     $ 215,121  
                 

Liabilities and Stockholders' Equity (Deficit)

               

Current Liabilities:

               

Accounts payable and accrued expenses

  $ 24,196     $ 27,454  

Accrued compensation

    10,189       6,926  

Accrued sales allowances

    25,607       11,296  

Accrued litigation award

    9,567       -  
Total current liabilities     69,559       45,676  

Uncertain income tax position

    7,913       3,778  
Total liabilities     77,472       49,454  
                 

Commitments and contingencies

               
                 

Stockholders' Equity:

               
Preferred stock (par value $0.01 per share; 10,000,000 shares authorized; 0 shares issued and outstanding as of September 30, 2015 and December 31, 2014, respectively)     -       -  
Common stock (par value $0.01 per share; 100,000,000 shares authorized; 71,997,884 and 70,702,688 shares issued and outstanding as of September 30, 2015 and December 31, 2014, respectively)     720       707  

Additional paid in capital

    245,463       216,061  

Unrealized gain (loss) on available-for-sale securities

    33       (24 )

Notes receivable from stockholders

    (21 )     (21 )

Accumulated deficit

    (9,590 )     (51,056 )
Total stockholders' equity     236,605       165,667  
                 
Total liabilities and stockholders' equity   $ 314,077     $ 215,121  

 

See accompanying notes to unaudited condensed consolidated financial statements.

   

 

 
1

 

  

INSYS THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF INCOME AND COMPREHENSIVE INCOME

(In thousands, except share and per share data)

(unaudited)

   

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 
                                 

Net revenue

  $ 91,259     $ 58,281     $ 239,663     $ 155,613  

Cost of revenue

    7,707       5,390       22,387       16,718  

Gross profit

    83,552       52,891       217,276       138,895  

Operating expenses:

                 

 

           
Sales and marketing     19,217       15,061       62,119       40,756  
Research and development     12,322       7,018       40,720       20,215  
General and administrative     13,681       10,790       42,212       30,047  
Charges (recovery) related to litigation award     (789 )     -       9,515       -  
Total operating expenses     44,431       32,869       154,566       91,018  

Operating income

    39,121       20,022       62,710       47,877  
                                 

Other income (expense):

                               
Interest income     128       43       360       86  
Other income (expense), net     (37 )     -       (8 )     2  
Total other income     91       43       352       88  
                                 

Income before income taxes

    39,212       20,065       63,062       47,965  

Income tax expense

    13,084       8,560       21,596       19,337  
                                 

Net income

    26,128     $ 11,505       41,466     $ 28,628  

Unrealized gain (loss) on available-for-sale securities

    50       (15 )     57       (20 )

Total comprehensive income

  $ 26,178     $ 11,490     $ 41,523     $ 28,608  
                                 

Net income per common share:

                               
Basic   $ 0.36     $ 0.17     $ 0.58     $ 0.42  
Diluted   $ 0.34     $ 0.16     $ 0.55     $ 0.39  

Weighted average common shares outstanding

                               
Basic     71,905,183       69,233,526       71,446,485       68,321,004  
Diluted     75,991,330       73,128,932       75,542,173       73,113,844  

 

See accompanying notes to unaudited condensed consolidated financial statements.

   

 

 
2

 

   

INSYS THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY

(In thousands, except share data)

(unaudited)

   

                            Unrealized                        
                           

Loss on

   

Notes

                 
                   

Additional

   

Available-

   

Receivable

                 
   

Common Stock

   

Paid in

   

For-Sale

   

From

   

Accumulated

         
   

Shares

   

Amount

   

Capital

   

Securities

   

Stockholders

   

Deficit

   

Total

 

Balance at December 31, 2014

    70,702,688       707       216,061       (24 )     (21 )     (51,056 )     165,667  

Exercise of stock options

    1,206,307       12       7,350       -       -       -       7,362  

Issuance of common stock- employee stock purchase plan

    88,889       1       1,478       -       -       -       1,479  

Excess tax benefits on stock options and awards

    -       -       8,307       -       -       -       8,307  

Stock based compensation - stock options and awards

    -       -       12,267       -       -       -       12,267  

Unrealized gain on available-for-sale securities

    -       -       -       57       -       -       57  

Net income

    -       -       -       -       -       41,466       41,466  

Balance at September 30, 2015

    71,997,884     $ 720     $ 245,463     $ 33     $ (21 )   $ (9,590 )     236,605  

 

See accompanying notes to unaudited condensed consolidated financial statements.

    

 

 
3

 

     

INSYS THERAPEUTICS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(unaudited)

 

   

Nine Months Ended September 30,

 
   

2015

   

2014

 

Cash flows from operating activities:

               

Net income

  $ 41,466     $ 28,628  

Adjustments to reconcile net income to net cash provided by operating activities:

               

Depreciation and amortization

    3,825       1,711  

Stock-based compensation

    12,267       11,224  

Deferred income tax benefit

    (2,082 )     (693 )

Loss on disposal of assets

    41       -  
Litigation Award     9,423       -  

Excess tax benefits on stock options and awards

    (8,307 )     (19,489 )

Changes in operating assets and liabilities:

               

Accounts receivable

    (3,931 )     (11,346 )

Inventories

    (4,593 )     (16,913 )

Prepaid expenses and other current assets

    (280 )     (936 )

Accounts payable, accrued expenses and other current liabilities

    26,902       41,595  

Net cash provided by operating activities

    74,731       33,781  
                 

Cash flows from investing activities:

               

Change in restricted cash

    -       400  

Purchase of investments

    (45,262 )     (42,120 )

Purchases of property and equipment

    (10,743 )     (15,687 )

Net cash used in investing activities

    (56,005 )     (57,407 )
                 

Cash flows from financing activities:

               

Proceeds from issuance of common stock

    1,479       1,108  

Excess tax benefits on stock options and awards

    8,307       19,489  

Proceeds from exercise of stock options

    7,362       5,057  

Net cash provided by financing activities

    17,148       25,654  
                 

Change in cash and cash equivalents

    35,874       2,028  
                 

Cash and cash equivalents, beginning of period

    58,106       45,382  
                 

Cash and cash equivalents, end of period

  $ 93,980     $ 47,410  
                 

Supplemental cash flow disclosures:

               

Cash paid for interest expense

  $ -     $ -  

Cash paid for income taxes

  $ 6,355     $ 2,190  

 

See accompanying notes to unaudited condensed consolidated financial statements.

 

 

 
4

 

      

INSYS THERAPEUTICS, INC.

 

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

 

1.       Nature of Business and Basis of Presentation

 

Insys Therapeutics, Inc., which was incorporated in Delaware in June 1990, and our subsidiaries (collectively, “we,” “us,” and “our”) maintain headquarters in Chandler, Arizona.

 

We are a specialty pharmaceutical company that develops and commercializes innovative supportive care products. We have two marketed products: Subsys, a proprietary sublingual fentanyl spray for BTCP in opioid-tolerant patients and Dronabinol SG Capsule, a generic equivalent to Marinol, an approved second-line treatment for chemotherapy-induced nausea and vomiting and anorexia associated with weight loss in patients with AIDS.

 

The accompanying condensed consolidated financial statements are unaudited and have been prepared in accordance with U.S. generally accepted accounting principles, pursuant to rules and regulations of the SEC. Certain information and footnote disclosures have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the accompanying condensed consolidated financial statements include normal recurring adjustments that are necessary for a fair presentation of the results for the interim periods presented. These condensed consolidated financial statements should be read in conjunction with our audited consolidated financial statements and notes thereto for the fiscal year ended December 31, 2014 included in our Annual Report on Form 10-K. The results of operations for the three and nine months ended September 30, 2015 and 2014 are not necessarily indicative of results to be expected for the full fiscal year or any other periods.

 

The preparation of the condensed consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make a number of estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including those related to revenue recognition (which is affected by prescriptions dispensed, wholesaler discounts, patient discount programs, rebates and chargebacks), inventories, stock-based compensation expense, and deferred tax valuation allowances. We base our estimates on historical experience and on various other assumptions that are believed by management to be reasonable under the circumstances. Actual results may materially differ from these estimates.

 

All significant intercompany balances and transactions have been eliminated in the accompanying unaudited condensed consolidated financial statements.

 

On May 5, 2015, our board of directors approved a two-for-one stock split of our common stock to be effected through a stock dividend. The record date for the stock split was the close of business on May 26, 2015, with share distribution occurring on June 8, 2015. As a result of the dividend, shareholders received one additional share of Insys Therapeutics, Inc. common stock, par value $0.01, for each one share they held as of the record date. All share and per share amounts have been retroactively restated for the effects of this stock split.

 

Recent Accounting Pronouncements

 

In May 2014, the FASB issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (ASU 2014-09), which will supersede nearly all existing revenue recognition guidance under U.S. GAAP. The core principle of ASU 2014-09 is to recognize revenues when promised goods or services are transferred to customers in an amount that reflects the consideration to which an entity expects to be entitled for those goods or services. ASU 2014-09 defines a five step process to achieve this core principle and, in doing so, more judgment and estimates may be required within the revenue recognition process than are required under existing U.S. GAAP. As amended by the FASB in July 2015, the standard is effective for annual periods beginning after December 15, 2017, and interim periods therein, using either of the following transition methods: (i) a full retrospective approach reflecting the application of the standard in each prior reporting period with the option to elect certain practical expedients, or (ii) a retrospective approach with the cumulative effect of initially adopting ASU 2014-09 recognized at the date of adoption (which includes additional footnote disclosures). We are currently evaluating the impact of our pending adoption of ASU 2014-09 on our consolidated financial statements and have not yet determined the method by which we will adopt the standard in 2018.

 

In July 2015, the FASB issued guidance that requires entities to measure most inventory at the lower of cost and NRV, thereby simplifying the current guidance under which an entity must measure inventory at the lower of cost or market. Under the new guidance, inventory is measured at the lower of cost and NRV, which eliminates the need to determine replacement cost and evaluate whether it is above the ceiling (NRV) or below the floor (NRV less a normal profit margin). The guidance defines NRV as the “estimated selling prices in the ordinary course of business, less reasonably predictable costs of completion, disposal, and transportation.” The guidance is effective for annual periods beginning after December 15, 2016, and interim periods therein. Early application is permitted. We are currently evaluating the impact of adoption of this guidance on our financial position and results of operations.

   

 

 
5

 

 

2.        Revenue Recognition

 

We recognize revenue from the sale of Subsys and Dronabinol SG Capsule. Revenue is recognized when (i) persuasive evidence of an arrangement exists, (ii) delivery has occurred and title has passed, (iii) the price is fixed or determinable and (iv) collectability is reasonably assured.

 

Subsys

 

Subsys was commercially launched in March 2012, and is monitored by an FDA mandated Risk Evaluation and Mitigation program known as the Transmucosal Immediate Release Fentanyl program (“TIRF REMS”). We sell Subsys in the United States to wholesale pharmaceutical distributors, and on a very limited basis directly to retail pharmacies, collectively our customers, subject to rights of return within a period beginning six months prior to, and ending 12 months following, product expiration. Subsys currently has a shelf life of 36 months from the date of manufacture. We record revenue for Subsys at the time the wholesaler receives the shipment.

 

We recognize estimated product sales allowances as a reduction of product sales in the same period the related revenue is recognized. Product sales allowances are based on amounts owed or to be claimed on the related sales. These estimates take into consideration the terms of our agreements with customers and third-party payors and the levels of inventory within the distribution channels that may result in future discounts taken. In certain cases, such as patient assistance programs, we recognize the cost of patient discounts as a reduction of revenue based on estimated utilization. If actual future results vary, we may need to adjust these estimates, which could have an effect on product revenue in the period of adjustment. Our product sales allowances include:

 

Product Returns. We allow customers to return product for credit beginning six months prior to, and ending 12 months following, the product expiration date. The shelf life of Subsys is currently 36 months from the date of manufacture. We have monitored actual return history since product launch, which provides us with a basis to reasonably estimate future product returns, taking into consideration the shelf life of product at the time of shipment, shipment and prescription trends, estimated distribution channel inventory levels, and consideration of the introduction of competitive products.

 

Because of the shelf life of our products and our return policy of issuing credits on returned product that is within six months before and up to 12 months after the product expiration date, there may be a significant period of time between when the product is shipped and when we issue credits on returned product. Accordingly, we may have to adjust these estimates, which could have an effect on product sales and earnings in the period of adjustment. The allowance for product returns is included in accrued sales allowances.

 

Wholesaler Discounts.    We offer discounts to certain wholesale distributors based on contractually determined rates. We accrue the discount as a reduction of receivables due from the wholesalers upon shipment to the respective wholesale distributors and retail pharmacies and recognize the estimated discount as a reduction of revenue in the same period the related revenue is recognized.

 

Prompt Pay Discounts.    We offer cash discounts to our customers, generally 2.0% of the sales price, as an incentive for prompt payment. We account for cash discounts by reducing accounts receivable by the full amount and recognize the estimated discount as a reduction of revenue in the same period the related revenue is recognized.

 

 Patient Discount Programs.    We offer discount card programs to patients for Subsys in which patients receive discounts on their prescriptions that are reimbursed to the retailer. We estimate the total amount that will be redeemed based on a percentage of actual redemption applied to inventory in the distribution and retail channel and recognize the estimated discount as a reduction of revenue in the same period the related revenue is recognized. The allowance for patient discount programs is included in accrued sales allowances.

 

Rebates.    We participate in certain rebate programs, which provide discounted prescriptions to qualified insured patients. Under these rebate programs, we pay a rebate to the third-party administrator of the program, generally two to three months after the quarter in which prescriptions subject to the rebate are filled. We estimate and accrue these rebates based on current contract prices, historical and estimated future percentages of products sold to qualified patients and estimated levels of inventory in the distribution channel. Estimated rebates are recognized as a reduction of revenue in the period the related revenue is recognized. The allowance for rebates is included in accrued sales allowances.

 

 

 
6

 

  

Chargebacks.    We provide discounts primarily to authorized users of the FSS of the General Services Administration under an FSS contract negotiated by the Department of Veterans Affairs and various organizations under Medicaid contracts and regulations. These entities purchase products from the wholesale distributors at a discounted price, and the wholesale distributors then charge back to us the difference between the current retail price and the price the entity paid for the product. We estimate and accrue chargebacks based on estimated wholesaler inventory levels, current contract prices and historical chargeback activity. Estimated chargebacks are recognized as a reduction of revenue in the same period the related revenue is recognized. The allowance for chargebacks is included as a reduction to accounts receivable.

 

Dronabinol SG Capsule

  

Dronabinol SG Capsule was commercially launched in December 2011, and we sold Dronabinol SG Capsule exclusively to Mylan Pharmaceuticals, Inc. (“Mylan”) in the United States under a supply and distribution agreement. Pursuant to the terms of the Mylan agreement, we manufacture Dronabinol SG Capsule under the Mylan label. Mylan distributed Dronabinol SG Capsule and on a monthly basis paid us an amount equal to the value of Dronabinol SG Capsule it sold to wholesale pharmaceutical distributors, less contractually defined deductions for chargebacks, rebates, sales discounts, distribution and storage fees, and royalties. Under the terms of the supply and distribution agreement with Mylan, we were obligated to pay Mylan a royalty of between 10% and 20% on Mylan’s net product sales, and a single digit percentage fee on such sales for distribution and storage services. We bore no risk of product return upon acceptance by Mylan. As Mylan had control over the amount it charged to wholesale pharmaceutical distributors for Dronabinol SG Capsule and the discounts offered to the distributors, the sales price was not fixed and determinable at the date we shipped such products to Mylan. Accordingly, we recognized revenue upon Mylan’s sale of products to wholesale distributors, which was the point at which the sales price was fixed and determinable. The allowance for chargebacks was included in accrued sales allowances. We were involved in a dispute with Mylan that commenced in May 2013 and which ultimately led to an arbitration proceeding with the American Arbitration Association (Case No. 55 122 00119 13). In October 2015, we entered into a settlement agreement and full and final mutual and general release with Mylan which the settled the claims in dispute and resulted in the termination of this relationship and confirmed the termination of the supply and distribution agreement. We do not have any current plans to manufacture or market this product in the future.

   

3.

Short-Term and Long-Term Investments 

 

Our policy for short-term and long-term investments is to establish a high-quality portfolio that preserves principal, meets liquidity needs, avoids inappropriate concentrations and delivers an appropriate yield in relationship to our investment guidelines and market conditions. Short-term and long-term investments consist of corporate and various government agency and municipal debt securities, as well as certificates of deposit that have maturity dates that are greater than 90 days. Certificates of deposit are carried at cost which approximates fair value. We classify our marketable securities as available-for-sale in accordance with FASB Accounting Standards Codification Topic 320, Investments — Debt and Equity Securities. Available-for-sale securities are carried at fair value with unrealized gains and losses reported in stockholders’ equity. A decline in the market value of any available-for-sale security below cost that is deemed to be other than temporary, results in impairment of the fair value of the investment. We did not have any realized gains or losses or decline in values judged to be other than temporary during the three and nine months ended September 30, 2015. If we had realized gains and losses and declines in value judged to be other than temporary, we would have been required to include those changes in other income/expense in the condensed consolidated statements of income and comprehensive income. Premiums and discounts are amortized or accreted over the life of the related available-for-sale security. The cost of securities sold is calculated using the specific identification method. At September 30, 2015, our certificates of deposit as well as our marketable securities have been recorded at an estimated fair value of $510,000, 61,490,000 and $31,848,000 in cash and cash equivalents, short-term investments and long-term investments, respectively. 

  

 

 
7

 

 

Investments consisted of the following at September 30, 2015 (in thousands):

   

   

Cost

   

Unrealized

Gains

   

Unrealized

Losses

   

Other-

Than-

Temporary

Impairment

Losses

   

Fair

Value

   

Cash and Cash

Equivalents

   

Short-term

Investments

   

Long-term

Investments

 

Cash

  $ 70,913     $ -     $ -     $ -     $ 70,913     $ 70,913     $ -     $ -  

Money market securities

    22,557       -       -       -       22,557       22,557       -       -  

Certificates of deposit

    25,452       -       -       -       25,452       -       15,852       9,600  

Marketable securities:

                                                               
Corporate securities     21,491       4       (21 )     -       21,474       500       14,868       6,106  
Federal agency securities     8,227       2       -       -       8,229       -       6,228       2,001  
Municipal securities     38,645       55       (7 )     -       38,693       10       24,542       14,141  
Total marketable securities     68,363       61       (28 )     -       68,396       510       45,638       22,248  
                                                                 
    $ 187,285     $ 61     $ (28 )   $ -     $ 187,318     $ 93,980     $ 61,490     $ 31,848  

  

Investments consisted of the following at December 31, 2014 (in thousands):

   

   

Cost

   

Unrealized

Gains

   

Unrealized

Losses

   

Other-

Than-

Temporary

Impairment

Losses

   

Fair

Value

   

Cash and Cash

Equivalents

   

Short-term

Investments

   

Long-term

Investments

 

Cash

  $ 44,785     $ -     $ -     $ -     $ 44,785     $ 44,785     $ -     $ -  

Money market securities

    13,321       -       -       -       13,321       13,321       -       -  

Certificates of deposit

    12,657       -       -       -       12,657       -       3,160       9,497  

Marketable securities:

                            -                                  
Corporate securities     10,837       -       (26 )     -       10,811       -       6,229       4,582  
Federal agency securities     9,512       -       (10 )     -       9,502       -       5,009       4,493  
Municipal securities     15,037       15       (3 )     -       15,049       -       10,359       4,690  
Total marketable securities     35,386       15       (39 )     -       35,362       -       21,597       13,765  
                                                                 
    $ 106,149     $ 15     $ (39 )   $ -     $ 106,125     $ 58,106     $ 24,757     $ 23,262  

 

The amortized cost and estimated fair value of the marketable securities at September 30, 2015, by maturity, are shown below (in thousands):

         

   

September 30, 2015

 
   

Cost

   

Fair Value

 
Marketable securities:                

Due in one year or less

  $ 46,135     $ 46,148  

Due after one year through 5 years

    22,228       22,248  

Due after 5 years through 10 years

    -       -  

Due after 10 years

    -       -  
                 
    $ 68,363     $ 68,396  

 

 

 
8

 

 

The following table shows the gross unrealized losses and the fair value of our investments, with unrealized losses that are not deemed to be other-than-temporarily impaired aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position at September 30, 2015 (in thousands):

  

   

September 30, 2015

 
   

Less Than 12 Months

   

Greater Than 12 Months

 
   

Fair Value

   

Unrealized Loss

   

Fair Value

   

Unrealized Loss

 
Marketable securities:                                

Corporate securities

  $ 13,295     $ (21 )   $ -     $ -  

Federal agency securities

    1,123       -       -       -  

Municipal securities

    6,214       (7 )     -       -  
                                 
    $ 20,632     $ (28 )   $ -     $ -  

 

As of September 30, 2015, we have concluded that all the unrealized losses on our marketable securities are temporary in nature. Marketable securities are reviewed quarterly for possible other-than-temporary impairment. This review includes an analysis of the facts and circumstances of each individual investment such as the severity of loss, the expectation for that security’s performance and the creditworthiness of the issuer. Additionally, we do not intend to sell, and it is not probable that we will be required to sell, any of the securities before the recovery of their amortized cost basis.

 

4.     Fair Value Measurement

 

FASB ASC No. 820, “Fair Value Measurement” defines fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date. It also establishes a three-tier fair value hierarchy, which prioritizes the inputs used in measuring fair value as follows:

 

Level 1:

Observable inputs such as quoted prices in active markets;

 

Level 2:

Inputs, other than the quoted prices in active markets, that are observable either directly or indirectly; and

  

  

Level 3:

Unobservable inputs in which there is little or no market data, which require the reporting entity to develop its own assumptions.

 

At September 30, 2015, we held short-term and long-term investments, as discussed in Note 3, that are required to be measured at fair value on a recurring basis.  All available-for-sale investments held by us at September 30, 2015 have been valued based on Level 2 inputs. Available-for-sale securities classified within Level 2 of the fair value hierarchy are valued utilizing reports from third-party asset managers that hold our investments, showing closing prices on the last business day of the period presented. These asset managers utilize an independent pricing source to obtain quotes for most fixed income securities, and utilize internal procedures to validate the prices obtained. In addition, we use an independent third-party to perform price testing, comparing a sample of quoted prices listed in the asset managers’ reports to quotes listed through a public quotation service. 

 

Our investments measured at fair value on a recurring basis subject to the disclosure requirements of ASC 820, Fair Value Measurements and Disclosures, at September 30, 2015 and December 31, 2014 were as follows (in thousands):

   

   

Fair Value Measurement at Reporting Date

 
   

September 30,

2015

   

Quoted Prices in active Markets (Level 1)

   

Significant Other Observable Inputs

(Level 2)

   

Significant Unobservable Inputs

(Level 3)

 
Marketable securities:                                

Corporate securities

  $ 21,474     $ -     $ 21,474     $ -  

Federal agency securities

    8,229       -       8,229       -  

Municipal securities

    38,693       -       38,693       -  
                                 
Total assets measured at fair value   $ 68,396     $ -     $ 68,396     $ -  

 

 

 
9

 

  

   

Fair Value Measurement at Reporting Date

 
   

December 31,

2014

   

Quoted Prices in active Markets (Level 1)

   

Significant Other Observable Inputs

(Level 2)

   

Significant Unobservable Inputs

(Level 3)

 
Marketable securities:                                

Corporate securities

  $ 10,811     $ -     $ 10,811     $ -  

Federal agency securities

    9,502       -       9,502       -  

Municipal securities

    15,049       -       15,049       -  
                                 
Total assets measured at fair value   $ 35,362     $ -     $ 35,362     $ -  

 

5.        Inventories

 

Inventories are stated at lower of cost or market. Cost, which includes amounts related to materials and costs incurred by our contract manufacturers, is determined on a first-in, first-out basis. Inventories are reviewed periodically for potential excess, dated or obsolete status. Management evaluates the carrying value of inventories on a regular basis, taking into account such factors as historical and anticipated future sales compared to quantities on hand, the price we expect to obtain for products in their respective markets compared with historical cost and the remaining shelf life of goods on hand.

 

The components of inventories, net of allowances, are as follows (in thousands): 

  

   

September 30,

2015

   

December 31,

2014

 

Finished goods

  $ 26,383     $ 30,998  

Work-in-process

    7,381       4,316  

Raw materials and supplies

    5,610       2,785  

Total inventories

    39,374       38,099  

Less: non-current work-in-process

    -       (3,318 )
    $ 39,374     $ 34,781  

 

As of September 30, 2015 and December 31, 2014, raw materials inventories consisted of raw materials used in the manufacture of the active pharmaceutical ingredient (“API”) in our U.S.-based, state-of-the-art dronabinol manufacturing facility and component parts and packaging materials used in the manufacture of Subsys. Work-in-process consists of actual production costs, including facility overhead and tolling costs of in-process dronabinol and Subsys products. Finished goods inventories consisted of finished Subsys products. Non-current work-in-process represent those inventories pending FDA approval which is not expected within 12 months of the balance sheet date and are included in other assets in our condensed consolidated unaudited balance sheets. As of September 30, 2015, all work-in-process inventory is expected to be used within 12 months of the balance sheet date and, therefore, is classified as current inventory.

 

6.       Commitments and Contingencies

 

Legal Matters

 

Other than the matters that we have disclosed below, we from time to time become involved in various ordinary course legal and administrative proceedings, which include intellectual property, commercial, governmental and regulatory investigations, employee related issues and private litigation, which we do not believe are either individually or collectively material.

 

As legal and governmental proceedings are inherently unpredictable and, in part, beyond our control, unless otherwise indicated, we cannot reasonably predict the outcome of these legal proceedings, nor can we estimate the amount of loss, or range of loss, if any, that may result from these proceedings. An adverse outcome in any of these proceedings could have a material adverse effect on our business, financial condition, results of operations and cash flows, and could cause the market value of our common shares to decline.

 

 

 
10

 

   

Government Proceedings

 

Like other companies in the pharmaceutical industry, we are subject to extensive regulation by national, state and local government agencies in the United States. As a result, interaction with government agencies occurs in the normal course of our operations. The following is a brief description of pending governmental investigations which we believe are potentially material at this time. It is possible that criminal charges and substantial payments, fines and/or civil penalties or damages could result from any government investigation or proceeding, as well as a corporate integrity agreement or similar government mandated compliance document, whether we deem an investigation to be material or not at this time.

 

Department of Health and Human Services Investigation. We received a subpoena, dated December 9, 2013, from the Office of Inspector General of the Department of Health and Human Services, or HHS, in connection with an investigation of potential violations involving HHS programs. The subpoena was issued in connection with an investigation by the U.S. Attorney’s Office for the Central District of California. The subpoena requests documents regarding our business, including the commercialization of Subsys. We are cooperating with this investigation and have produced documents in response to the subpoena and have provided other requested information.

 

Health Insurance Portability and Accountability Act Investigation. On September 8, 2014, we received a subpoena issued pursuant to the Health Insurance Portability and Accountability Act of 1996, as amended, from the U.S. Attorney’s Office for the District of Massachusetts. The subpoena requests documents regarding Subsys, including our sales and marketing practices related to this product. We are cooperating with this investigation and have produced documents in response to the subpoena and have provided other requested information.

 

On or about June 23, 2015, a nurse practitioner located in Connecticut, who served on our speaker bureau in connection with our speaker programs designed to educate and promote product awareness and safety for external health care providers, pled guilty to violating the federal Anti-Kickback Statute in connection with payments of approximately $83,000 from the Company. In connection with the review of this matter by the Compliance Committee of the Board of Directors, with the assistance of outside legal counsel reporting directly to the Compliance Committee, we have taken a number of remedial actions and implemented enhancements to the Company’s compliance controls regarding relationships with health care providers. We will continue to assess these matters to ensure we have an effective compliance program.

 

State Related Investigations. We have received CIDs from each of the Office of the Attorney General of the State of Arizona, ODOJ, the Attorney General of the Commonwealth of Massachusetts and the Office of the Attorney General of Illinois. These CIDs request documents regarding Subsys, including the Company’s sales and marketing practices related to Subsys in the applicable state. We are cooperating with each of these investigations and have produced documents in response to these CIDs and related requests for information from each office.

 

In connection with the investigation by the ODOJ we have entered into a settlement agreement with the ODOJ referred to as an AVC, and agreed to make monetary payments totaling approximately $1,100,000. The AVC requires us to maintain certain controls and processes around our promotional and sales activity related to Subsys in Oregon. This AVC expressly provides that we do not admit any violation of law or regulation. This settlement was reached as result of our cooperation with the ODOJ's investigation and after producing documents in response to certain CIDs and related requests for information from the ODOJ. On August 5, 2015, we paid $533,000 to the Oregon State Treasury and at September 30, 2015 we maintained an accrual of $567,000.

 

We believe that the probability of unfavorable outcome or loss related to these governmental proceedings, with the exception of the ODOJ investigation, and an estimate of the amount or range of loss, if any, from an unfavorable outcome are not determinable at this time. We believe we have meritorious legal positions and will continue to represent our interests vigorously in these matters. However, responding to government investigations, defending any claims raised, and any resulting fines, restitution, damages and penalties, settlement payments or administrative actions, as well as any related actions brought by shareholders or other third parties, could have a material impact on our reputation, business and financial condition and divert the attention of our management from operating our business.

 

Federal Securities Litigation

 

Between May 15 and May 19, 2014, two complaints (captioned Larson v. Insys Therapeutics, Inc., Case No. 14-cv-01043-GMS) and (Li vs. Insys Therapeutics, Inc., Case No 14-cv-01077-DGC) were filed in the U.S. District Court for the District of Arizona, or Arizona District Court, against us and certain of our current officers. The complaints were brought as purported class actions, on behalf of purchasers of our common stock. In general, the plaintiffs allege that the defendants violated federal securities laws by making intentionally false and misleading statements regarding our business and operations, therefore artificially inflating the price of our common stock. The plaintiffs seek unspecified monetary damages and other relief. On July 14, 2014, several purported shareholders filed motions to consolidate the two cases, appoint a lead plaintiff, and appoint lead counsel. On August 29, 2014, the Arizona District Court issued an order consolidating the action, appointing Hongwei Li as lead plaintiff, and appointing the lead counsel. Lead plaintiffs complaint was filed on October 27, 2014. On December 11, 2014, we moved to dismiss the amended consolidated complaint. On March 19, 2015, the parties participated in a mediation and the parties subsequently agreed in principle, on April 14, 2015, to settle the action. On April 20, 2015, the parties filed a Notice of Settlement with the Court. On April 29, 2015, the Court ordered that the lawsuit be dismissed within 60 days, vacated all pending hearings, and denied all pending motions as moot. On May 28, 2015, the parties filed a Stipulation of Settlement, which provided the terms of a settlement agreement. On June 2, 2015, the Court granted preliminary approval of the settlement agreement and the potential class members have been (or will be) notified of the proposed settlement and the procedure by which they can object to the settlement or request to be excluded from the class. The settlement remains subject to final approval by the Court and the Court has scheduled a settlement hearing for December 5, 2015. Because we have met our retainage amount under the applicable policy, we believe that any potential obligations that may arise as result of the proposed settlement in this matter will be fully covered under our Directors and Officers insurance policy. Accordingly, we have not accrued for any contingencies in this matter into our operating results.

 

 

 
11

 

 

General Litigation and Disputes

 

Kottayil vs. Insys Pharma, Inc. On September 29, 2009, Insys Pharma, Inc., our wholly owned subsidiary, and certain of our officers and the five directors who comprised the Insys Pharma board of directors as of June 2009, as well as their spouses, were named as defendants in a lawsuit in the Superior Court of the State of Arizona, Maricopa County, or the Arizona Superior Court, brought by Santosh Kottayil, Ph.D., certain of his family members and a trust of which Dr. Kottayil is the trustee. Dr. Kottayil formerly served as President, Chief Scientific Officer and a director of Insys Pharma, among other positions. The complaint brought a cause of action for statutory and common law appraisal of Dr. Kottayil’s Insys Pharma common stock. The cause of action for appraisal relates to a reverse stock split that Insys Pharma effected in June 2009, which resulted in Dr. Kottayil’s ownership position becoming a fractional share of Insys Pharma common stock. Following the reverse stock split, Insys Pharma cancelled all resulting fractional shares, including the fractional share held by Dr. Kottayil, and offered a cash payment in lieu of the fractional shares. The complaint also brought causes of action for breach of fiduciary duty, fraud and negligent misrepresentation in the defendants’ dealings with Dr. Kottayil on the subject of his compensation and stock ownership in Insys Pharma. In January 2010, the plaintiffs added claims seeking to rescind Dr. Kottayil’s assignment to Insys Pharma of his interest in all of the fentanyl and dronabinol patent applications previously assigned to Insys Pharma and to recover the benefits of those interests. Dr. Kottayil was seeking, among other relief, the fair value of his Insys Pharma common stock as of June 2, 2009, compensatory and punitive damages, and rescission of all assignments to Insys Pharma of his interest in the patent applications, as well as attorneys’ fees, costs and interest.

  

In February 2010, Insys Pharma and the other defendants answered and filed counter-claims to Dr. Kottayil’s amended complaint. The counter-claims include actions for breach of fiduciary duty, fraud and negligent misrepresentations and omissions with respect to the time during which Dr. Kottayil was employed at Insys Pharma. The counter-claims, among other relief, seek compensatory and punitive damages.

 

Discovery on all of the foregoing claims was completed and a trial was scheduled to commence on January 27, 2014; however, on January 22, 2014, the court vacated the trial and granted plaintiffs leave to file an amended complaint to add Insys Therapeutics, Inc. as a defendant.

 

On January 29, 2014, the plaintiffs filed a second amended complaint in the Arizona Superior Court in which Insys Therapeutics, Inc. was also named as defendant in this lawsuit. This amended complaint filed by plaintiffs re-alleges substantially the same claims set forth in the prior complaint, except that plaintiffs now allege that they are entitled to rescissory damages, plaintiffs have also added our majority stockholder, a private trust, as a defendant to the breach of fiduciary duty claim and plaintiffs have revised their fraud claim against the Insys Pharma director defendants.

 

On February 25, 2014, we filed a Motion to Dismiss the Kottayil Plantiffs’ claims for a statutory and common law appraisal. The motion was denied on May 2, 2014.

 

The trial commenced on December 1, 2014 with the evidence phase of the trial completed on January 29, 2015.

 

On June 8, 2015, the court issued findings of fact and conclusions of law in its final trial ruling. Specifically, the court found (i) in favor of Insys Pharma, our majority stockholder, a private trust and four of the Insys Pharma directors who were on the board in July 2008 on plaintiffs’ claim for breach of fiduciary duty arising out of transactions the board approved in July 2008, (ii) found in favor of plaintiffs and against Insys Pharma, Inc., our majority stockholder, a private trust and three of the Insys Pharma directors who were on the board in June 2009 on plaintiffs’ claims under Delaware law and for breach of fiduciary duties arising out of the reverse stock split the board approved in June 2009 in the amount of $7,317,450, along with pre-judgment and post-judgment interest and court costs, (iii) found in favor of two of the Insys Pharma directors who were on the Insys Pharma board as of June 2009 and against plaintiffs on plaintiffs’ breach of fiduciary duty claims, (iv) found in favor of Insys Pharma and against plaintiff (Kottayil) on his claim for rescission of the patent application assignments that he entered in favor of Insys Pharma before and after his employment terminated, (v) found in favor of us and against plaintiff on plaintiffs' claims of successor liability and fraudulent transfer, and (vi) found in favor of Kottayil and against Insys Pharma on Insys Pharma’s counterclaims of breach of fiduciary duty, fraud, and negligent misrepresentation. The court still has to resolve certain post-trial issues, which are currently being briefed by the parties, before a final judgment is entered.

 

 

 
12

 

 

On June 29, 2015, we moved the court to award Insys Therapeutics, Inc. its attorneys’ fees in connection with its successful defense of plaintiff’s claims of successor liability and fraudulent transfer. The court denied Insys Therapeutics request for attorney’s fees.

 

On October 2, 2015, the court entered a final judgment, awarding plaintiffs the amount of $7,317,450, along with pre-judgment interest from June 2, 2009, and post-judgment interest, from October 2, 2015, at the rate of 4.25% per annum, compounded quarterly and taxable costs in the amount of $93,163. On the same date, the court denied plaintiffs’ request to submit an application for attorneys’ fees for his defense of the Insys Pharma counterclaims, finding that the request was premature.

 

On October 20, 2015, plaintiffs appealed the foregoing judgment. We and the other defendants against whom judgment was entered anticipate filing a cross-appeal.

 

As a result of the final ruling, we have accrued $9,567,000 at September 30, 2015 including $2,249,000 of estimated pre-and post-judgement interest. Any final judgement entered by the court is subject to a potential appeal which could cause the estimates to vary materially from the final award. 

 

On or around November 1, 2015 we received a notice from Dr. Kottayil’s attorneys demanding indemnification for legal and other defense costs alleged to have been incurred in connection with Dr. Kottayil’s defense of the Insys Pharma counterclaims in the amount of $3,630,000. We are in the process of assessing the merit of such claims as well as evaluating the basis for the costs claimed. Because of the uncertainty surrounding the ultimate outcome we have not accrued for this claim at this time; however, we believe that that it is reasonably possible that there may be a material loss associated with this claim and we currently estimate the range of the reasonably possible loss to be between $0 and the $3,630,000 claimed. 

  

 Insys Therapeutics, Inc. vs. Mylan Pharmaceuticals.  Since May 2013, we have been in a legal dispute with Mylan Pharmaceuticals, Inc. concerning the parties’ Supply and Distribution Agreement dated May 20, 2011. On October 5, 2015, we have entered into a settlement agreement and full and final mutual general release, or the Settlement Agreement, with Mylan that (i) reaffirmed the termination of the Supply and Distribution Agreement and the relationship between the parties with respect to this product, (ii) released the claims in dispute in connection with this arbitration and (iii) contained other customary terms and conditions such as confidentiality. The parties jointly filed with the Panel a Stipulation to Dismiss with Prejudice the arbitration proceedings and definitively resolve this dispute. On October 30, 2015, the parties received the signed order from the Panel granting the stipulation to Dismiss with Prejudice. As a result of the executed Settlement Agreement, we have not accrued for any contingencies in this matter into our operating results and consider the matters in dispute in connection with this arbitration settled.

 

Patent-Related Matters. On August 26, 2015, we received purported service of notice of three inter partes review, or the IPR, petitions filed by a hedge fund with the U.S. Patent and Trademark Office, challenging three of the four Orange Book-listed patents covering Subsys. We intend to oppose the request to institute the IPR and, if any of the three petitions are granted, we intend to defend the validity of each patent challenged in each IPR.

 

Except as it pertains to the $9,567,000 accrued for the dispute with Dr. Kottayil, the $567,000 accrued in connection with the ODOJ settlement payment and the potential for damages in the Federal Securities litigation that should be sufficiently covered by our Director and Officers insurance policies as noted above, we believe that the probability of unfavorable outcome or loss related to all of the above litigation matters and an estimate of the amount or range of loss, if any, from an unfavorable outcome are not determinable at this time. We believe we have meritorious legal positions and will continue to represent our interests vigorously in these matters but the range possible outcomes on these matters is very broad and we are not able to provide a reasonable estimate of our potential liability, if any, nor are we able to predict the outcome of each litigation matter. Responding to each of these litigation matters, defending any claims raised, and any resulting fines, restitution, damages and penalties, or settlement payments as well as any related actions brought by shareholders or other third parties, could have a material impact on our reputation, business and financial condition and divert the attention of our management from operating our business.

 

 

 
13

 

 

Material Agreements

 

In April 2015, we entered into an amendment to our manufacturing and supply agreement with DPT, which extends our existing manufacturing and supply agreement to produce Subsys until the end of 2020. In addition to extending the term, this amendment added certain minimum purchase commitments.

 

On October 30, 2015, we entered into an amended and restated supply, development & exclusive licensing agreement with Aptargroup, Inc. which, among other things, extended our exclusive supply rights to the current sublingual device, currently utilized by Subsys, as well any new device(s) jointly developed by the two companies for a period of seven years. In addition to extending the term, this amendment added certain minimum purchase commitments.

 

The following table sets forth our aggregate minimum purchase commitments with DPT and Aptar under these agreements (in thousands): 

 

Years ending December 31,

       

2015

    1,500  

2016

    2,000  

2017

    10,450  

2018

    14,650  

2019

    18,260  

Thereafter

    25,170  

Total

  $ 72,030  

  

 

7.       Stock-based Compensation  

 

Amounts recognized in the condensed consolidated statements of income and comprehensive income with respect to our stock-based compensation plans were as follows (in thousands):

   

   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 

Research and development

  $ 573     $ 432     $ 1,362     $ 4,294  

General and administrative

    3,747       2,605       10,905       6,930  

Total cost of stock-based compensation

  $ 4,320     $ 3,037     $ 12,267     $ 11,224  

 

As of September 30, 2015, we expected to recognize $41,158,000 of stock-based compensation for outstanding options over a weighted-average period of 2.9 years.

 

 

 
14

 

 

The following table summarizes stock option activity as of December 31, 2014 and for the nine months ended September 30, 2015:

   

   

Shares

   

Price

   

Term (in years)

   

(in millions)

 

Vested and exercisable as of December 31, 2014

    2,660,720     $ 3.95                  
                                 

Outstanding as of December 31, 2014

    7,707,162     $ 7.57                  

Granted

    1,137,500     $ 30.00                  

Cancelled

    (349,158 )   $ 20.20                  

Exercised

    (1,206,307 )   $ 6.10                  
                                 

Outstanding as of September 30, 2015

    7,289,197     $ 10.71       7.8     $ 132.1  
                                 

Vested and exercisable as of September 30, 2015

    3,120,808     $ 5.51       7.0     $ 71.7  

 

Cash received from option exercises under all share-based payment arrangements for the nine months ended September 30, 2015 and 2014 was $7,362,000 and $5,057,000, respectively. For the nine months ended September 30, 2015, we recorded net reductions of $8,307,000 of our federal and state income tax liability, with an offsetting credit to additional paid-in capital, resulting from the excess tax benefits of stock options.

 

8.     Net Income per Share

 

Basic net income per common share is computed by dividing the net income allocable to the common stockholders by the weighted average number of common shares outstanding during the period. The diluted income per share further includes any common shares available to be issued upon exercise of outstanding stock options if such inclusion would be dilutive.

 

The following table sets forth the computation of basic and diluted net income per common share (dollars in thousands, except per share amounts):

 

   

Three Months Ended

   

Nine Months Ended

 
   

September 30,

   

September 30,

 
   

2015

   

2014

   

2015

   

2014

 
                                 

Historical net income per share - Basic

                               

Numerator:

                               

Net income

  $ 26,128     $ 11,505     $ 41,466     $ 28,628  

Denominator:

                               

Weighted average number of common shares outstanding

    71,905,183       69,233,526       71,446,485       68,321,004  

Basic net income per common share

  $ 0.36     $ 0.17     $ 0.58     $ 0.42  
                                 

Historical net income per share - Diluted

                               

Numerator:

                               

Net income

  $ 26,128     $ 11,505     $ 41,466     $ 28,628  

Denominator:

                               

Weighted average number of common shares outstanding

    71,905,183       69,233,526       71,446,485       68,321,004  

Effect of dilutive stock options

    4,086,147       3,895,406       4,095,688       4,792,840  

Weighted average number of common shares outstanding

    75,991,330       73,128,932       75,542,173       73,113,844  

Diluted net income per common share

  $ 0.34     $ 0.16     $ 0.55     $ 0.39  

 

Anti-dilutive share equivalents included 1,122,185 and 2,924,530 outstanding stock options as of September 30, 2015 and 2014, respectively.

 

 

 
15

 

    

9.     Product Lines, Concentration of Credit Risk and Significant Customers

 

We are engaged in the business of developing and selling pharmaceutical products. We have two product lines, consisting of Subsys and Dronabinol SG Capsule. Our chief operating decision-maker evaluates revenues based on product lines.

 

The following tables summarize our net revenue by product line, as well as the percentages of net revenue by route to market (in thousands):

  

   

Net Revenue by Product Line

 
   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 

Subsys

  $ 91,139     $ 58,203     $ 238,380     $ 153,431  

Dronabinol SG Capsule

    120       78       1,283       2,182  

Total net revenue

  $ 91,259     $ 58,281     $ 239,663     $ 155,613  

 

   

Percent of Net Revenue by Route to Market

 
   

Three Months Ended September 30,

   

Nine Months Ended September 30,

 
   

2015

   

2014

   

2015

   

2014

 

Pharmaceutical wholesalers

    98 %     100 %     98 %     99 %
Specialty pharmaceutical retailers     2 %     0 %     1 %     0 %

Generic pharmaceutical distributors

    0 %     0 %     1 %     1 %
      100 %     100 %     100 %     100 %

  

All our products are sold in the United States of America.

 

Product shipments to four pharmaceutical wholesalers accounted for 33%, 20%, 18% and 15% of total shipments for the nine months ended September 30, 2015. Product shipments to four pharmaceutical wholesalers accounted for 39%, 21%, 15% and 14% of total shipments for the nine months ended September 30, 2014. Four pharmaceutical wholesalers’ accounts receivable balances accounted for 35%, 22%, 16%, and 11% of gross accounts receivable as of September 30, 2015. Four pharmaceutical wholesalers’ accounts receivable balances accounted for 39%, 22%, 17% and 10% of gross accounts receivable as of December 31, 2014.

 

10.     Related Party Transactions

 

In March of 2015, we entered into a consultancy agreement with Dr. John Kapoor, our Executive Chairman of our Board of Directors and our majority shareholder, to compensate Dr. Kapoor for his ongoing time and contribution to the Company. Under the terms of the agreement, Dr. Kapoor will receive an annual consulting fee of $300,000. In connection with Dr. Kapoor’s appointment to the position of President and Chief Executive Officer, effective November 4, 2015, the consulting agreement was terminated. 

 

 

 
16

 

    

ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with our unaudited condensed consolidated financial statements and related notes included in this Quarterly Report on Form 10-Q and the audited consolidated financial statements and notes thereto as of and for the year ended December 31, 2014 and the related Management’s Discussion and Analysis of Financial Condition and Results of Operations, both of which are contained in our Annual Report on Form 10-K.

 

Forward-Looking Statements

 

The information in this discussion contains forward-looking statements and information within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, (“the Exchange Act”), which are subject to the “safe harbor” created by those sections. These forward-looking statements include, but are not limited to, statements concerning our strategy, future operations, future financial position, future revenues, projected costs, prospects, and the factors affecting our future performance; plans and objectives of management; that ESI formulary changes relative to Subsys will not have a material impact on our net revenue; our intent to file an IND application for the treatment of epilepsy with Cannabidiol in 2015; the sufficiency of our manufacturing capacity; the beneficial attributes of our dronabinol product candidates; our expectation that gross Dronabinol margins will fluctuate; that sales and marketing and research and development costs will be our largest categories of expenses; that sales and marketing expenses will fluctuate on changes in Subsys net revenue; that our Subsys revenue will increase during the remainder of 2015 and that Dronabinol SG Capsule revenue will continue to be insignificant; that cash flows from operating activities will increase; our development of different dronabinol delivery systems; the source and sufficiency of our liquidity our capital resources to fund our operations; possible capital raising transactions we may pursue; that we will hire additional sales and marketing, research and development and administrative personnel and operating costs relating thereto will increase; that our investments in our sales and research and development infrastructure will result in increased sales; accounting estimates and the impact of new or recently issued accounting pronouncements; that cash flows from operations will increase as a result of increased sales of Subsys; certain anticipated strategies and outcomes of our litigation with Mylan; trends in restrictions and impediments relating to reimbursement policies imposed by pharmacy benefit managers; the impact of pending litigation and our strategy relating thereto; our exposure to interest rate changes and market risks relating to our investments. The words “anticipates,” “believes,” “estimates,” “expects,” “intends,” “may,” “plans,” “projects,” “will,” “should,” “could,” “predicts,” “potential,” “continue,” “would” and similar expressions are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions or expectations disclosed in our forward-looking statements and you should not place undue reliance on our forward-looking statements. Actual results or events could differ materially from the plans, intentions and expectations disclosed in the forward-looking statements that we make. The forward-looking statements are applicable only as of the date on which they are made, and we do not assume any obligation to update any forward-looking statements. All forward-looking statements in this Form 10-Q are made based on our current expectations, forecasts, estimates and assumptions, and involve risks, uncertainties and other factors that could cause results or events to differ materially from those expressed in the forward-looking statements. In evaluating these statements, you should specifically consider various factors, uncertainties and risks that could affect our future results or operations as described from time to time in our SEC reports, including those risks outlined under “Risk Factors” in Item 1A of our Form 10-K for the year ended December 31, 2014. These factors, uncertainties and risks may cause our actual results to differ materially from any forward-looking statement set forth in this Form 10-Q. You should carefully consider these risk and uncertainties described and other information contained in the reports we file with or furnish to the SEC before making any investment decision with respect to our securities. All forward-looking statements attributable to us or persons acting on our behalf are expressly qualified in their entirety by this cautionary statement. Some of the important factors that could cause our actual results to differ materially from those projected in any forward-looking statements including, but are not limited to, the following:

 

 

the impact of ongoing regulatory review of Subsys and other product candidates that receive regulatory approval;

 

our dependence on sales of Subsys;

 

market acceptance, including by third-party payors, of our products;

  

the unpredictability and regulation surrounding the reimbursement of Subsys.

 

the success of our marketing strategies;

 

our early stage of commercialization and history of net losses;

 

our ability to manage growth in our business;

 

our ability to obtain regulatory approval for Dronabinol Oral Solution;

 

manufacturing failures;

 

 

 
17

 

 

 

challenges relating to our construction and operation of a second dronabinol manufacturing facility;

 

our limited manufacturing capabilities and our reliance on third parties in our product supply chain;

 

delays in manufacturing or interruption of our sublingual spray delivery system;

 

competition;

 

our ability to achieve and maintain adequate levels of third-party payor and reimbursement coverage for sales of our products;

 

our reliance on wholesale pharmaceutical distributors for sales of our products through to the retail distribution channel;

 

our reliance on third parties for the performance of services relating to Subsys, including invoicing, storage and transportation;

 

our ability to develop a pipeline of product candidates;

 

our failure to obtain or maintain Schedule III classification for our dronabinol products;

 

failure of our clinical trials to demonstrate acceptable levels of safety and efficacy;

 

expenses, delays, changes and terminations that could adversely affect the design and implementation of our clinical trials;

 

reliance on third parties to conduct and oversee our clinical trials;

 

acceptance by the FDA our data from our clinical trials conducted outside the United States;

 

risks and uncertainties associated with starting materials sourced from India;

 

our ability to meet Section 505(b)(2) regulatory approval pathways or requirements for our product candidates;

 

annual DEA quotas on the amount of dronabinol allowed to be produced in the United States;

 

our failure to successfully acquire, develop or market additional product candidates;

 

our ability to retain key management and other personnel;

 

misconduct and improper activities by our employees, prescribing physicians and other persons involved in the marketing and distribution of our products;

 

our ability to utilize our net operating loss and research and development tax credit carryforwards;

 

the adverse impacts of strategic transactions;

 

our exposure to product liability claims;

 

our ability to comply with environmental laws relating to our use of hazardous materials;

 

accounting estimates;

 

security system failures;

 

natural disasters;

 

our significant operating expenses and need for potential additional funding;

 

our failure to comply with federal and state healthcare laws, including fraud and abuse and health information privacy and security laws;

 

the regulatory impact on our existing Subsys products as well as our future product candidates;

 

undesirable side effects of our products and the potential for post-approval regulatory action relating to such side effects;

 

the impact of changes in policies and funding resulting from healthcare reform measures, including the impact on the funding, staffing and leadership of the FDA and other agencies;

 

our ability to obtain and enforce patent rights or other intellectual property rights that cover our products and product candidates;

 

the potential for rescission of invention assignments existing in favor of the Company from its employees, including the potential for rescission of invention rights resulting from a current lawsuit between Insys Pharma and Santosh Kottayil;

 

costs of litigation and our ability to protect our intellectual property rights;

 

our exposure to litigation relating to infringement suits against the Company;

 

our exposure to claims that our employees or independent contractors have wrongfully used or disclosed to the Company trade secrets of their other clients or former employers;

 

our compliance with the procedural, document submission, fee payment and other requirements needed to apply for patents;

 

control over the Company by its founder, Executive Chairman and principal stockholder;

 

fluctuation in the price of our common stock;

 

lack of, or inaccurate, published research about the Company;

 

the impact of future sales of our common stock or securities convertible into our common stock;

 

the effect of anti-takeover provisions in our charter documents and under Delaware law;

 

the impact of our abbreviated disclosures as allowed by the JOBS Act because of our status as an “emerging growth company”;

 

our intention to not pay dividends in the foreseeable future; and

 

our ability to maintain and improve our financial controls and related compliance with SEC and stock exchange listing standards.

 

  Additionally, there may be other risks that are otherwise described from time to time in the reports that we file with the Securities and Exchange Commission. Any forward-looking statements in this report should be considered in light of various important factors, including the risks and uncertainties listed above, as well as others.

 

 

 
18

 

   

Overview

 

We are a commercial-stage specialty pharmaceutical company that develops and commercializes innovative supportive care products. We have one marketed product and one discontinued product:

 

 

• 

Subsys — a proprietary, single-use product that delivers fentanyl, an opioid analgesic, for transmucosal absorption underneath the tongue, offered in 100, 200, 400, 600, 800, 1,200 and 1,600 mcg dosages. Subsys is approved for the treatment of BTCP in opioid-tolerant patients. We received FDA approval for Subsys in January 2012 and commercially launched Subsys in March 2012.

 

 

• 

Dronabinol SG Capsule — a dronabinol soft gelatin capsule that is a generic equivalent to Marinol, an approved second-line treatment for CINV and anorexia associated with weight loss in patients with AIDS, offered in 2.5, 5.0 and 10.0 milligram dosages. We received FDA approval for Dronabinol SG Capsule in August 2011. We commercially launched Dronabinol SG Capsule through our exclusive distribution partner, Mylan Pharmaceuticals, Inc., in December 2011. We entered into a settlement agreement with Mylan in October 2015, which resulted in termination of our distribution agreement with Mylan.

 

We market Subsys through our U.S.-based field sales force focused on supportive care physicians. We utilize an incentive-based sales model that employs a pay structure where a significant component of the compensation paid to sales representatives is in the form of potential bonuses based on sales performance.

 

Consistent with most pharmaceutical manufacturing companies, we sell Subsys primarily to pharmaceutical wholesalers and collect sales proceeds from those wholesalers. We do not own or have any ownership stake in any pharmaceutical wholesaler, nor do we have an option to acquire any wholesaler. For the nine months ended September 30, 2015, sales to our four largest wholesale customers accounted for 86% of gross revenue. We also sell Subsys on a limited basis directly to specialty pharmaceutical retailers. For the nine months ended September 30, 2015 direct sales to specialty pharmaceutical retailers accounted for 2% of gross revenue. We distribute Subsys through both specialty and traditional retail pharmacies. All pharmacies that fulfill Subsys prescriptions are fully independent. We do not own or have an ownership stake in any pharmacy and do not possess an option to acquire any pharmacy. Our relationships with every pharmacy that fulfills Subsys prescriptions are non-exclusive, in that each of these pharmacies may also fulfill prescriptions for other pharmaceutical manufacturers. For the nine months ended September 30, 2015, more than 600 independent pharmacies have fulfilled at least one Subsys prescription.

 

Our sales of, and revenue from, Subsys depend in significant part on the coverage and reimbursement policies of third-party payers, including government payers such as Medicare and Medicaid, and private health insurers. All third-party payers are sensitive to the cost of drugs and consistently implement efforts to control these costs, which efforts include, but are not limited to, establishing excluded or preferred drug lists. Subsys has been, and will likely continue to be, subject to these restrictions and impediments from third-party payers, particularly PBMs and private health insurers. We provide administrative reimbursement support assistance, in large part through our insurance reimbursement support hub, which provides administrative support assistance to help patients coordinate with their insurance companies.

 

From time to time, third-party payers modify which drugs they choose to reimburse. On or around August 1, 2014, ESI officially released its exclusion list of drugs, effective January 1, 2015, in connection with its national preferred formulary.  Our product, Subsys, was included on this exclusion list. ESI is a large PBM that administers prescription drug benefits for employers and health plans and runs large mail-order pharmacies. While ESI, like most PBMs, has an exception process that physicians may pursue to have an off-formulary, medically necessary drug covered for patients, this decision will make it difficult for many patients covered through an ESI administered plan to have Subsys covered by insurance.  This change in ESI formulary status took effect in 2015. The ESI formulary change has not had a material impact on our net revenue during the nine months ended September 30, 2015; however, we will continue to monitor the effects of this change closely. As we have in the past, we will continue working with other PBMs to evaluate price increases and to communicate with managed care and health-system decision-makers to ensure a balanced approach, which takes into account the clinical performance and efficacy of our products. 

 

 

 
19

 

  

We are also developing other product candidates, such as dronabinol line extensions and sublingual spray product candidates. Our most advanced potential cannabinoid line extension is Dronabinol Oral Solution. This product candidate has demonstrated more rapidly detectable blood levels and a more reliable absorption profile than Marinol in our clinical studies. We believe these attributes may ultimately increase patient compliance because of more rapid onset of action and less dose-to-dose variability, which we believe will allow us to further penetrate and potentially expand the market for the medical use of dronabinol. In August 2015, FDA accepted for filing the NDA for Dronabinol Oral Solution. The PDUFA goal date for a decision on this NDA is April 1, 2016, which reflects a Standard Review by the FDA. 

 

We produce the API for Dronabinol Oral Solution at our U.S.-based, state-of-the-art dronabinol manufacturing facility. While we believe that this facility has the capacity to supply sufficient commercial quantities of dronabinol API for our initial launch quantities of Dronabinol Oral Solution, if approved, and support the continued development of our other dronabinol product candidates in the near-term, we have opened a second dronabinol manufacturing facility, which we anticipate will enable us to supply sufficient commercial quantities of dronabinol API for the anticipated commercialization of our proprietary dronabinol product candidates, if approved.

 

We have the capability to manufacture pharmaceutical CBD, a synthetically produced and over 99.5% pure form of cannabidiol, in our Round Rock, Texas manufacturing facility. On April 23, 2015 we announced that we had commenced dosing of epilepsy patients in a Phase I PK study in pediatric subjects. We intend to file an IND application with the FDA for the treatment of epilepsy.

 

Factors Affecting Our Performance

 

We believe that our performance and future success are dependent upon a number of factors, including our approved product sales, investments in our infrastructure and growth, and our ability to successfully develop product candidates and complete related regulatory processes. In addition, our ability to ensure that our products, policies and practices adhere to the extensive national, state and local regulations applicable to our industry is critical to our success, particularly as our operations and product opportunities continue to grow at a rapid pace. While each of these areas presents significant opportunities for us, they also pose significant risks and challenges that we must successfully address.  

 

Approved Product Sales.    Our operating results will depend significantly upon our, and any of our third-party distributors’, sales of approved products. During the nine months ended September 30, 2015 and 2014, all of our net revenues were generated from the sale of our two approved products, Subsys and Dronabinol SG Capsule, with sales of Subsys accounting for 99% of our 2015 and 2014 year-to-date revenues. We entered into a settlement agreement with Mylan in October 2015, which resulted in termination of our distribution agreement with Mylan. Accordingly, we will not generate any revenue from the sale of Dronabinol SG Capsule in future periods. Our results will depend on prescription volume generally, which we believe will be driven primarily by achievement of broad market acceptance and coverage by third-party payors and effectiveness of the marketing and selling efforts with respect to Subsys. Moreover, our gross margins improve on a unit-by-unit basis as we sell higher dosage strengths of our products. Importantly, the proportion of prescriptions written for repeat Subsys patients has continued to increase since July 2012 from 50% of prescriptions to approximately 90% of prescriptions as of September 30, 2015. Generally, repeat Subsys patients receive significantly higher doses of Subsys on average than first-time patients as patients are titrated from a starter dose of Subsys to their effective dose in accordance with the TIRF REMS protocol.   

 

Investments in Our Infrastructure and Growth.    Our ability to increase our sales and to further penetrate our target market segments is dependent in part on our ability to invest in our infrastructure and in our sales and marketing efforts. In order to drive further growth, we may hire additional sales and marketing personnel and invest in marketing our products to our target physician prescriber base. For example, as of September 30, 2015, we had 355 full-time sales and marketing personnel. This will lead to corresponding increases in our operating expenses, although we anticipate that these investments will result in increased product sales and net revenue. In addition, we have constructed a second dronabinol manufacturing facility, which we anticipate will supply us with sufficient commercial quantities of dronabinol API for the commercialization of our proprietary dronabinol product candidates, if approved. This second facility will also increase our operating expenses.

 

Product Development and Related Regulatory Processes.    Our operating results will also depend significantly on our research and development activities and related regulatory developments. Our research and development expenses were $40.7 million and $20.2 million for the nine months ended September 30, 2015 and 2014, respectively. As of September 30, 2015, we had 66 full-time research and development personnel. We expect research and development expenses to increase as we increase related headcount and continue our planned preclinical studies and clinical trials for our product candidates, particularly our proprietary cannabinoid product candidates, including Dronabinol Oral Solution, and sublingual spray product candidates. We do not expect to realize net revenues from all of these research and development initiatives in the near term and may never realize net revenues from these investments. Due to the risks inherent in conducting preclinical studies and clinical trials, the regulatory approval process and the costs of preparing, filing and prosecuting patent applications, our development completion dates and costs will vary significantly for each product candidate and are very difficult to estimate. The lengthy process of seeking regulatory approvals and the subsequent compliance with applicable regulations require the expenditure of substantial additional resources. Any failure by us to obtain, or any delay in obtaining, regulatory approvals or acceptable DEA classifications for our product candidates, in particular those related to Dronabinol Oral Solution, could cause our research and development expenditures to increase significantly and, in turn, have a material adverse effect on our results of operations.

 

 

 
20

 

 

Basis of Presentation 

 

Net Revenue

 

During the year ended December 31, 2012, we began recognizing net revenue from sales of Subsys made by us, and from Dronabinol SG Capsule under our supply and distribution agreement with Mylan. We sell Subsys in packages of various sized single-dose units in dosage strengths of 100, 200, 400, 600, 800, 1,200 and 1,600 mcg, to wholesale pharmaceutical distributors and retail pharmacies, collectively, our customers, on a wholesale basis. Sales to our customers are subject to specified rights of return. We record revenue for Subsys at the time the wholesaler receives the shipment.

 

We sold Dronabinol SG Capsule exclusively to Mylan in dosage strengths of 2.5, 5.0 and 10.0 milligrams under the Mylan label. Mylan distributed Dronabinol SG Capsule and on a monthly basis paid us an amount equal to the value of Dronabinol SG Capsule it sold to wholesale pharmaceutical distributors and retail pharmacies, less contractually defined deductions for chargebacks, rebates, sales discounts, distribution and storage fees, and royalties. We were obligated to pay Mylan a royalty between 10% and 20% on Mylan’s net product sales, and a single digit percentage fee on such sales for distribution and storage services. We bore no risk of product return upon acceptance by Mylan. As Mylan had control over the amount it charged to wholesale pharmaceutical distributors for Dronabinol SG Capsule and the discounts offered to the distributors, the sales price was not fixed and determinable at the date we shipped such product to Mylan. Accordingly, we recognized revenue on the sale of Dronabinol SG Capsule upon Mylan’s sale of product to wholesale distributors, which was the point at which the sales price was fixed and determinable. We entered into a settlement agreement with Mylan in October 2015, which resulted in termination of our distribution agreement with Mylan. Accordingly, we will not generate any revenue from the sale of Dronabinol SG Capsule in future periods. See Note 6 of the Notes to our Unaudited Condensed Consolidated Financial Statements for a discussion on our dispute with Mylan.

  

Cost of Revenue, Gross Profit and Gross Margin

 

Cost of revenue for Subsys consists primarily of materials, third-party manufacturing costs, freight in, indirect personnel costs, and other overhead costs based on units dispensed through patient prescriptions. Cost of revenue for Dronabinol SG Capsule primarily consists of materials, manufacturing costs and third-party assembly and packaging costs based on units sold by Mylan to wholesale distributors. We manufacture the API for Dronabinol SG Capsule at our U.S.-based, dronabinol manufacturing facility. Also included in cost of revenue are charges for reserves for excess, dated or obsolete commercial inventories and production manufacturing variances.

  

Gross profit is net revenue less cost of revenue. Gross margin is gross profit expressed as a percentage of net revenue.

 

Sales and Marketing Expenses

 

Our sales and marketing expenses consist primarily of salaries, commissions, benefits, consulting fees, costs of obtaining prescription and market data, and market research studies related to Subsys. As of September 30, 2015, we had 355 full-time sales and marketing personnel. We expect the number of our sales and marketing personnel to increase as we seek to continue to increase our existing product sales and as any subsequently approved products are commercialized. We expect our sales and marketing expenses, along with our research and development expenses, to be our largest categories of operating expenses for the foreseeable future. In addition, because we use an incentive-based compensation model for our sales professionals, we expect our sales and marketing expenses to fluctuate from period to period based on changes in Subsys net revenue. Specifically, we expect our sales and marketing expenses to increase in the near future to the extent that expected increases in Subsys net revenue are realized.

 

 

 
21

 

   

Research and Development Expenses

 

Research and development expenses consist of costs associated with our preclinical studies and clinical trials, and other expenses related to our drug development efforts. Our research and development expenses consist primarily of:

 

 

external research and development expenses incurred under agreements with third-party CROs and investigative sites, third-party manufacturers and consultants;

 

 

employee-related expenses, which include salaries, benefits and stock-based compensation for the personnel involved in our preclinical and clinical drug development activities; and

 

 

facilities, depreciation and other allocated expenses, equipment and laboratory supplies.

 

To date, our research and development efforts have been focused primarily on our fentanyl, dronabinol and Cannabidiol programs. As of September 30, 2015, we had 66 full-time research and development personnel. We expect research and development expenses to increase as we increase related headcount and continue our planned preclinical studies and clinical trials for our product candidates, particularly our proprietary dronabinol product candidates, including Dronabinol Oral Solution. We determine which research and development projects to pursue, as well as the level of funding available for each project, based on the scientific and preclinical and clinical results of each product candidate and related regulatory action.

 

The following table provides a breakdown of our research and development expenses during the nine months ended September 30, 2015 and 2014 (in millions):

   

   

Nine Months Ended

 
   

September 30,

 
   

2015

   

2014

 

Cannabidiol

  $ 14.4     $ 1.8  

Dronabinol

    5.0       1.4  

Buprenorphine/Naloxone

    2.6       0.5  

LEP-ETU and IL-13

    1.7       0.9  

Ondansetron

    1.3       0.5  

Naloxone

    1.3       0.1  

Fentanyl

    1.0       2.5  

Other

    0.7       0.5  

Buprenorphine

    0.6       0.5  

Sildenafil

    0.2       0.7  

Internal research and development costs

    11.9       10.8  

Total research and development expenses

  $ 40.7     $ 20.2  

 

General and Administrative Expenses

 

Our general and administrative expenses consist primarily of salaries and related costs for personnel in executive, finance, accounting, legal, business development and internal support functions. In addition, general and administrative expenses include facility costs not otherwise included in research and development expenses, and professional fees for legal, consulting and accounting services. As of September 30, 2015, we had 39 full-time general and administrative personnel. We expect general and administrative expense to increase as a result of increasing related headcount, expanding our operating activities and the costs we will incur operating as a public company. We expect these increases to include salaries and related expenses, legal and consultant fees, accounting fees, director fees, increased directors’ and officers’ insurance premiums, fees for investor relations services, and enhanced business and accounting systems.

 

Charges Related to Litigation Award

 

Charges related to litigation award expenses for the nine months ended September 30, 2015 represent a legal accrual of $9.5 million related to our dispute with Dr. Kottayil. See Note 6 of the Notes to our Unaudited Condensed Consolidated Financial Statements for a discussion on our ongoing dispute with Dr. Kottayil.

  

 

 
22

 

 

Income Tax Expense

 

We account for income taxes based upon an asset and liability approach. Deferred tax assets and liabilities represent the future tax consequences of the differences between the financial statement carrying amounts of assets and liabilities versus the tax basis of assets and liabilities. Under this method, deferred tax assets are recognized for deductible temporary differences, and operating loss and tax credit carryforwards. Deferred tax liabilities are recognized for taxable temporary differences. Deferred tax assets are reduced by a valuation allowance when, in our opinion, it is more likely than not that some portion or all of the deferred tax assets will not be realized. The impact of tax rate changes on deferred tax assets and liabilities is recognized in the year that the change is enacted. We also account for the uncertainty in income taxes by utilizing a comprehensive model for the recognition, measurement, presentation, and disclosure in financial statements of any uncertain tax positions that have been taken or are expected to be taken on an income tax return.

 

Significant Accounting Polices and Estimates

 

There were no changes in our significant accounting policies and estimates during the nine months ended September 30, 2015 from those set forth in “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Significant Accounting Policies and Estimates” in our Annual Report on Form 10-K for the year ended December 31, 2014.  

 

Results of Operations

 

Comparison of Three Months Ended September 30, 2015 to Three Months Ended September 30, 2014

 

The following table presents certain selected consolidated financial data for the three months ended September 30, 2015 and 2014 expressed as a percentage of net revenue:

  

   

Three Months Ended

 
   

September 30,

 
   

2015

   

2014

 

Net revenue

    100.0 %     100.0 %

Cost of revenue

    8.4       9.2  

Gross profit

    91.6       90.8  

Operating expenses:

               
Sales and marketing     21.1       25.8  
Research and development     13.5       12.0  
General and administrative     15.0       18.5  
Charges related to litigation award     (0.9 )     -  
Total operating expenses     48.7       56.3  

Operating income

    42.9       34.5  
                 

Other income (expense):

               
Interest income     0.1       0.1  
Other income (expense), net     0.0       -  
Total other income (expense)     0.1       0.1  
                 

Income before income taxes

    43.0       34.4  

Income tax expense

    14.3       14.7  
                 

Net income

    28.7 %     19.7 %

 

Net Revenue.    Net revenue increased $33.0 million, or 57%, to $91.3 million for the three months ended September 30, 2015, compared to $58.3 million for the three months ended September 30, 2014. The increase in net revenue was attributable to the $32.9 million, or 57%, increase in net revenue of Subsys to $91.1 million for the three months ended September 30, 2015, compared to $58.2 million for the three months ended September 30, 2014. The increase in Subsys revenue is primarily as a result of a 31% increase in shipments to pharmaceutical wholesalers for the three months ended September 30, 2015 as compared to the three months ended September 30, 2014, as well as a 26% increase in net sales price, which was impacted by price increases in July 2014, January 2015 and July 2015, combined with changes in mix of prescribed dosages and changes in provisions for wholesaler discounts, patient discounts, rebates and returns. Provisions for wholesaler discounts, patient discounts, rebates and returns increased to $10.0 million, $13.1 million, $16.6 million and $1.3 million, respectively, from the sale of Subsys for the three months ended September 30, 2015, compared to $6.3 million, $12.3 million, $7.3 million and $0.2 million, respectively, from the sale of Subsys for the three months ended September 30, 2014. The increase in revenue provisions was primarily attributable to increased sales, higher volumes of patient assistance, and higher rebate rates due to recent price increases. We expect net revenue from sales of Subsys to continue to increase during the remainder of 2015 due primarily to anticipated increases in the number of prescriptions fulfilled, combined with changes in prescription strength mix.

 

 

 
23

 

 

Dronabinol SG Capsule net revenue was $0.1 million during both the three month periods ended September 30, 2015 and 2014.

 

We entered into a settlement agreement with Mylan in October 2015, which resulted in termination of our distribution agreement with Mylan. Accordingly, we will not generate any revenue from the sale of Dronabinol SG Capsule in future periods. See Note 6 for a discussion on our dispute with Mylan.

  

Cost of Revenue, Gross Profit and Gross Margin.    Cost of revenue increased $2.3 million to $7.7 million for the three months ended September 30, 2015 compared to $5.4 million for the three months ended September 30, 2014. The increase in cost of revenue was primarily attributable to the increase in sales of Subsys during the three months ended September 30, 2015. Gross profit increased $30.7 million to $83.6 million for the three months ended September 30, 2015 compared to $52.9 million for the three months ended September 30, 2014 due primarily to the increase in sales of Subsys. Gross margin for the three months ended September 30, 2015 was approximately 92% compared to approximately 91% for the three months ended September 30, 2014.

  

Sales and Marketing Expense.    Sales and marketing expense increased $4.1 million to $19.2 million for the three months ended September 30, 2015 compared to $15.1 million for the three months ended September 30, 2014. The increase in sales and marketing expense was due primarily to $5.0 increase in variable sales compensation expense associated with the increase in sales of Subsys and partially offset by $0.9 reduction in product marketing expense. As Dronabinol SG Capsule was marketed by Mylan, we did not incur any sales and marketing expense related to Dronabinol SG Capsule.

 

Research and Development Expense.    Research and development expense increased $5.3 million to $12.3 million for the three months ended September 30, 2015, compared to $7.0 million for the three months ended September 30 2014. The increase in research and development expense was due primarily to an increase in clinical expenses, product development, regulatory fees, and an increase in research and development personnel during 2015 in response to our growing product development efforts.

   

General and Administrative Expense.    General and administrative expense increased $2.9 million to $13.7 million for the three months ended September 30, 2015 compared to $10.8 million for the three months ended September 30, 2014. The increase in general and administrative expense was due primarily to increased stock-based compensation costs and increases in legal expense incurred in connection with various ongoing litigation and subpoena related matters, which includes an accrual of $1.1 million in connection with the AVC entered into with the ODOJ.

  

Charges Related to Litigation Award. We had a reversal of charges related to litigation award expenses of $0.8 million for the three months ended September 30, 2015 associated with our dispute with Dr. Kottayil. See Note 6 of the Notes to our Unaudited Condensed Consolidated Financial Statements for a discussion on our ongoing dispute with Dr. Kottayil. There was no similar expense or reversal for the three months ended September 30, 2014.

  

Income Tax Expense.     Provision for income taxes was $13.1 million for the three months ended September 30, 2015, representing an effective tax rate of 33.4%, as compared to $8.6 million for the three months ended September 30, 2014, representing and effective tax rate of 42.7%. The decrease in effective tax rate was primarily due to deductions for domestic production activities, as well as credits for research and development and orphan drug development. As of September 30, 2015, we had approximately $1.3 million of federal and $278.0 million of state net operating loss carry forwards.

 

We had unrecognized tax benefits of approximately $7.9 million as of September 30, 2015, primarily associated with tax positions taken in prior year. No significant penalties and $0.2 million of interest are included in income taxes and accounted for on the balance sheet related to unrecognized tax positions.