For those arrangements for whichWe receive royalty revenues on net sales and mark-up on cost of goods sold information becomes available and collectability is reasonably assured,revenue in the U.S. under our License Agreement with Endo. These are presented in “Royalties” in our condensed consolidated statements of income. We do not have future performance obligations under this revenue stream. In accordance with ASC 606, we recognize revenuerecord these revenues based on estimates of the net sales that occurred during the applicablerelevant period. The relevant period in which it is earned. Forestimates of these royalties are based on interim quarterlydata provided by Endo and year-end reporting purposes, when collectability is reasonably assured, but a reasonable estimateanalysis of royaltyhistorical royalties and mark-up on cost of goods sold cannot be made, therevenue that have been paid to us, adjusted for any changes in facts and circumstances, as appropriate. Differences between actual and estimated royalty and mark-up on cost of goods soldrevenues are generally recognizedadjusted for in the quarter that the applicable licensee provides the written report and related information to us.
Under the License Agreement, we do not participate in the selling, marketing or manufacturing of products for which we receive royalties and a mark-up on the cost of goods sold. The royalty and mark-up on cost of goods sold will generally be recognized in the quarter that Endo provides the written reports and related information to us; that is, royalty and mark-up on cost of goods sold are generally recognized one quarter following the quarterperiod in which they become known, typically the underlying sales by Endo occurred.following quarter. The royalties payable by Endo to us are subject to set-off for certain patent costs.
Pursuant to the First Amendment with Endo, in exchange for a $8.25 million lump sum payment, we will not receive future additional mark-up on cost of goods sold for sales by non-affiliated sublicensees of Endo outside of the U.S.; provided, however, that Endo will still be required to pay a mark-up on cost of goods sold for sales made in the “Endo Territory,” which includes sales made in the U.S. and sales made in any other country where Endo sells the product directly or through affiliated sublicensees. We received this $8.25 million lump sum payment in February 2016. We classified this payment as deferred revenue in our balance sheet and began recognizing this income over time in the second quarter of 2016 based on sales by non-affiliated sublicensees of Endo outside of the U.S. according to our revenue recognition policy. We recognized approximately $266,000 and $895,000 for the three and nine months ended September 30, 2017, respectively. We recognized approximately $274,000 and $546,000 for the three and nine months ended September 30, 2016, respectively.
Licensing Revenue
We include revenue recognized from upfront licensing, sublicensing and milestone payments in “License Revenues” in our condensed consolidated statements of incomeincome.
The Company recognizes licensing revenues generated through development and/or commercialization agreements. The terms of these agreements typically include payment to the Company of one or more of the following: nonrefundable, upfront license fees; sublicensing; development and commercial milestone payments; development activities; and royalties on net sales of licensed products. Each of these types of payments results in this Quarterly Reportlicensing revenues except for revenues from royalties on Form 10-Q.net sales of licensed products and the mark-up of cost of goods sold revenues which are classified as royalty revenues. Revenue is recognized upon satisfaction of a performance obligation by transferring control of a good or service to the customer.
Upfront LicenseFor each development and/or commercialization agreement that result in revenues, the Company identifies all performance obligations, aside from those that are immaterial, which may include a license to intellectual property and Sublicensing Feesknow-how, development activities and/or transition activities. In order to determine the transaction price, in addition to any upfront payment, the Company estimates the amount of variable consideration at the outset of the contract either utilizing the expected value or most likely amount method, depending on the facts and circumstances relative to the contract. The Company constrains (reduces) the estimates of variable consideration such that it is probable that a significant reversal of previously recognized revenue will not occur throughout the life of the contract. When determining if variable consideration should be constrained, management considers whether there are factors outside the Company’s control that could result in a significant reversal of revenue. In making these assessments, the Company considers the likelihood and magnitude of a potential reversal of revenue. These estimates are re-assessed each reporting period as required.
If a license to the Company’s intellectual property is determined to be distinct from the other performance obligations identified in the arrangement, the Company recognizes revenues from nonrefundable, upfront license fees based on the relative standalone selling price prescribed to the license compared to the total value of the arrangement. The revenue from upfront licensing and sublicensing feesis recognized when the license or sublicense agreement is signed, we have completedtransferred to the earnings processcollaborator and we have no ongoingthe collaborator is able to use and benefit from the license. For licenses that are not distinct from other obligations identified in the arrangement, the Company utilizes judgment to assess the nature of the combined performance obligation with respectto determine whether the combined performance obligation is satisfied over time or at a point in time. If the combined performance obligation is satisfied over time, the Company applies an appropriate method of measuring progress for purposes of recognizing revenue from nonrefundable, upfront license fees. The Company evaluates the measure of progress each reporting period and, if necessary, adjusts the measure of performance and related revenue recognition.
Development and Regulatory Milestone Payments
Depending on facts and circumstances, the Company may conclude that it is appropriate to include the milestone, representing variable consideration, in the estimated total transaction price, or that it is appropriate to fully constrain the milestone. The Company may include revenues from certain milestones in the total transaction price in a reporting period before the milestone is achieved if the Company concludes that achievement of the milestone is probable and that recognition of revenue related to the arrangement. Nonrefundable upfront technology license feesmilestone will not result in a significant reversal in amounts recognized in future periods. The Company records a corresponding contract asset when this conclusion is reached. Milestone payments that have not been included in the transaction price to date are fully constrained. The Company re-evaluates the probability of achievement of such development milestones and any related constraint each reporting period. The Company adjusts its estimate of the total transaction price, including the amount of revenue that it has recorded, if necessary.
RECENT ACCOUNTING PRONOUNCEMENTS
Accounting Pronouncements Adopted
Effective January 1, 2018, the Company adopted ASC 606, which provides principles for product candidatesrecognizing revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the Company expects to be entitled in exchange for those goods or services. The Company adopted ASC 606 on a modified retrospective basis through a cumulative adjustment to equity. See Note 3 – Significant Accounting Policies – Revenue Recognition.
The adoption of ASC 606 as of January 1, 2018, applying the modified-retrospective method, changed the timing of our recognition of royalty and mark-up cost of goods sold revenue. Beginning in 2018, we recorded these royalty revenues based on estimates of the net sales and mark-up cost of goods sold that occurred during the relevant period thereby eliminating the one quarter lag. Previously, these amounts were not recognized until they were fixed and determinable. In addition, deferred revenue associated with the prepayment of foreign mark-up on cost of goods sold revenue will no longer be recognized over time based on sales by non-affiliated sublicensees of Endo outside of the U.S. and, under ASC 606, would have been recognized when the transaction occurred in 2016.
The cumulative effect of applying the new guidance of ASC 606 to our License Agreement with Endo as of January 1, 2018 was recorded as an adjustment to retained earnings as of the adoption date. As a result of applying the modified retrospective method to adopt the new revenue guidance, the following adjustments were made to accounts on the Condensed Consolidated Balance Sheet as of January 1, 2018:
The Company recorded the following cumulative effect as of January 1, 2018, itemized here (in millions):
| | | As reported December 31, 2017 | | | Adjustments | | | Adjusted January 1, 2018 | |
| Accounts receivable | | $ | 4.7 | | | $ | 7.6 | (1) | | $ | 12.3 | |
| Deferred revenue | | | (6.4 | ) | | | 6.3 | (2) | | | (0.1 | ) |
| Deferred royalty buy-down | | | (2.5 | ) | | | (0.4 | )(3) | | | (2.9 | ) |
Accounts payable and accrued expenses -third party royalties | | | (0.4 | ) | | | (0.5 | )(3) | | | (0.9 | ) |
| Deferred tax assets, net | | | 1.7 | | | | (1.3 | )(4) | | | 0.4 | |
| Income tax payable | | | - | | | | (1.4 | )(5) | | | (1.4 | ) |
| Retained earnings adjustment | | $ | (2.9 | ) | | $ | 10.3 | | | $ | 7.4 | |
| (1) | This adjustment represents the elimination of the one quarter lag by recognizing royalty revenues based on of XIALFLEX net sales and mark-up on cost of goods sold revenues reported to us by Endo for the fourth quarter of 2017. |
| (2) | Represents the remaining deferred revenue balance of the prepaid mark-up on cost of goods sold based on sales by non-affiliated sublicensees of Endo outside of the U.S. |
| (3) | Represents the amortization of the royalty buy-down and third party royalties expense associated royalty revenues based on XIALFLEX net sales reported to us by Endo for the fourth quarter of 2017. |
| (4) | To reverse a deferred tax asset associated with the deferred revenue balance of the prepaid mark-up on cost of goods sold by non-affiliated sublicensees of Endo outside of the U.S. |
| (5) | To create a tax liability associated the elimination of the one quarter lag by recognizing royalty revenues based on of XIALFLEX net sales and mark-up on cost of goods sold revenues reported to us by Endo for the fourth quarter of 2017. |
At September 30, 2018, contract assets of $8.2 million for which there’s an unconditional right to receive payment were included in accounts receivable on the condensed consolidated balance sheet.
In accordance with the new revenue standard requirements, the impact of adoption on our condensed consolidated balance sheet was as follows (in millions):
| | | September 30, 2018 | |
| | | As Reported | | | Balances Without Adoption of New Revenue Standard | | | Effect of Change Higher / (Lower) | |
| Assets | | | | | | | | | |
| Accounts receivable | | $ | 14.5 | | | $ | 6.3 | | | $ | 8.2 | |
| Deferred royalty buy-down | | | 0.6 | | | | 0.7
| | | | (0.1 | ) |
| Deferred tax assets | | | 0.3 | | | | 1.5 | | | | (1.2 | ) |
| Liabilities | | | | | | | | | | | | |
| Accounts payable and accrued expenses | | | 1.1 | | | | 0.5 | | | | 0.6 | |
| Deferred revenue | | | - | | | | 1.0 | | | | (1.0 | ) |
| Income tax payable | | | 0.7 | | | | (0.6 | )
| | | 1.3 |
|
| Deferred revenue, long term | | | - | | | | 4.5 | | | | (4.5 | ) |
| Equity | | | | | | | | | | | | |
| Retained earnings | | | 66.0 | | | | 55.5 | | | | 10.5 | |
In accordance with the new revenue standard requirements, the impact of adoption on our condensed consolidated statement of operations for the three and nine months ended September 30, 2018 was as follows (in millions):
| | | Three Months Ended September 30, 2018 | |
| | | | | | Balances Without Adoption of New Revenue Standard | | | Effect of Change Higher / (Lower) | |
| | | | | | | | | |
| | | | | | | | | | | | |
| | | | | | | | | | | | |
General and administrative | | | | | | | | | | | -
| |
Provision for income taxes | | | | | | | | | | | -
| |
| | | | | | | | | | | 0.1
| |
| | | Nine Months Ended September 30, 2018 | |
| | | | | | Balances Without Adoption of New Revenue Standard | | | Effect of Change Higher / (Lower) | |
| | | | | | | | | |
| | | | | | | | | | | -
| |
| | | | | | | | | | | | |
General and administrative | | | | | | | | | | | -
| |
Provision for income taxes | | | | | | | | | | | | )
|
| | | | | | | | | | | | |
In January 2016, the FASB issued new guidance on recognition and measurement of financial assets and financial liabilities. The new guidance will impact the accounting for equity investments, financial liabilities under the fair value option, and the presentation and disclosure requirements for financial instruments. All equity investments in unconsolidated entities (other than those accounted for under the equity method of accounting) will generally be measured at fair value with changes in fair value recognized through earnings. There will no longer be an available-for-sale classification (changes in fair value reported in other comprehensive income (loss) for equity securities with readily determinable fair values). In addition, the FASB clarified the need for a valuation allowance on deferred tax assets resulting from unrealized losses on available-for-sale debt securities. In general, the new guidance will require modified retrospective application to all outstanding instruments, with a cumulative effect adjustment recorded to opening retained earnings. The adoption of the new standard as of January 1, 2018 had no impact on our consolidated financial statements and related disclosure as we do not currently have any available-for-sale equity investments.
Accounting Pronouncements Not Yet Adopted
In February 2016, FASB issued Accounting Standards Update (“ASU”) No. 2016-02, Leases (Topic 842) (“ASU 2016-02”). Under the new guidance, lessees will be required to recognize the following for all leases (with the exception of short-term leases) at the lease commencement date: a lease liability, which is a lessee’s obligation to make lease payments arising from a lease, measured on a discounted basis; and a right-of-use asset, which is an asset that represents the lessee’s right to use, or control the use of, a specified asset for the lease term. Under the new guidance, lessor accounting is largely unchanged. Certain targeted improvements were made to align, where necessary, lessor accounting with the lessee accounting model and ASC 606. The new lease guidance simplified the accounting for sale and leaseback transactions primarily because lessees must recognize lease assets and lease liabilities. Lessees will no longer be provided with a source of off-balance sheet financing. Public business entities should apply the amendments in ASU 2016-02 for fiscal years beginning after December 15, 2018, including interim periods within those fiscal years (i.e., January 1, 2019, for a calendar year entity). Early application is permitted. Lessees (for capital and operating leases) and lessors (for sales-type, direct financing, and operating leases) must apply a modified retrospective transition approach for leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements. The modified retrospective approach would not require any transition accounting for leases that expired before the earliest comparative period presented. Lessees and lessors may not apply a full retrospective transition approach. We do not expect the standard will have a material impact on our consolidated financial statements due to the short term nature of our leases.
In June 2016, FASB issued ASU 2016-13, Financial Instruments - Credit Losses. The amendment revises the impairment model to utilize an expected loss methodology in place of the currently used incurred loss methodology, which will result in more timely recognition of losses on financial instruments, including, but not limited to, available for sale debt securities and accounts receivable. The Company is required to adopt this standard starting in the first quarter of fiscal year 2021. Early adoption is permitted. We are providing continuing servicescurrently evaluating the impact of the adoption of this standard on our consolidated financial statements and related disclosures.
Cash, Cash Equivalents and Investments
Cash equivalents include only securities having a maturity of 90 days or less at the time of purchase. Investments are stated on an amortized cost basis. The Company limits its credit risk associated with cash, cash equivalents and investments by placing its investments with banks it believes are highly creditworthy and with highly rated money market funds, certificates of deposit, municipal bonds and corporate bonds. All investments are classified as held to product developmentmaturity. As of September 30, 2018 and December 31, 2017, the amortized cost of these investments was $63.6 million and $57.7 million, respectively. No unrealized gains or losses were recorded in either period.
Fair Value Measurements
Management believes that the carrying amounts of the Company’s financial instruments, including cash, cash equivalents, held to maturity investments, accounts receivable, accounts payable and accrued expenses approximate fair value due to the short-term nature of those instruments. As of September 30, 2018 and December 31, 2017, there were no recorded unrealized gains or losses on our investments as they are deferredclassified as held to maturity. As of September 30, 2018 and recognizedDecember 31, 2017, amortized cost basis of the investments approximated their fair value. At September 30, 2018 and December 31, 2017, the amortized premium included in interest income was $361,000 and $673,000, respectively.
The following table presents the Company’s schedule of maturities at September 30, 2018 and December 31, 2017:
| | | Maturities as of September 30, 2018 | | | Maturities as of December 31, 2017 | |
| | | 1 Year or Less | | | Greater than 1 Year | | | 1 Year or Less | | | Greater than 1 Year | |
| Municipal bonds | | $ | 4,285,175 | | | $ | 100,000 | | | $ | 1,002,650 | | | $ | 100,000 | |
| Corporate bonds | | | 49,052,966 | | | | 4,819,306 | | | | 48,143,495 | | | | 3,155,573 | |
| Certificates of deposit | | | 5,091,070 | | | | 249,016 | | | | 2,827,826 | | | | 2,490,401 | |
| Total | | $ | 58,429,211 | | | $ | 5,168,322 | | | $ | 51,973,971 | | | $ | 5,745,974 | |
The authoritative literature for fair value measurements established a three-tier fair value hierarchy, which prioritizes the inputs in measuring fair value. These tiers are as revenue overfollows: Level 1, defined as observable inputs such as quoted market prices in active markets; Level 2, defined as inputs other than the development period. We recognized deferred revenuequoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as significant unobservable inputs (entity developed assumptions) in which little or no market data exists.
As of $4,408September 30, 2018, the Company held certain investments that are required to be measured at fair value on a recurring basis. The following tables present the Company’s fair value hierarchy for these financial assets as of September 30, 2018 and $13,226December 31, 2017:
September 30, 2018 | Type of Instrument | | Fair Value | | | Level 1 | | | Level 2 | | | Level 3 | |
| | | | | | | | | | | | | | | | | | |
| Cash equivalents | Institutional Money Market | | $ | 9,491,019 | | | $ | 9,491,019 | | | $ | - | | | $ | - | |
| | | | | | | | | | | | | | | | | | |
| Cash equivalents | Corporate Bonds | | | 1,300,000 | | | | 1,300,000 | | | | - | | | | - | |
| | | | | | | | | | | | | | | | | | |
| Investments | Municipal Bonds | | | 4,385,175 | | | | - | | | | 4,385,175 | | | | - | |
| | | | | | | | | | | | | | | | | | |
| Investments | Corporate Bonds | | | 53,872,272 | | | | - | | | | 53,872,272 | | | | - | |
| | | | | | | | | | | | | | | | | | |
| Investments | Certificates of Deposit | | | 5,340,086 | | | | 5,340,086 | | | | - | | | | - | |
December 31, 2017 | Type of Instrument | | Fair Value | | | Level 1 | | | Level 2 | | | Level 3 | |
| | | | | | | | | | | | | | | | | | |
| Cash equivalents | Institutional Money Market | | $ | 3,108,549 | | | $ | 3,108,549 | | | $ | - | | | $ | - | |
| | | | | | | | | | | | | | | | | | |
| Cash equivalents | Municipal Bonds | | | 800,000 | | | | - | | | | 800,000 | | | | - | |
| | | | | | | | | | | | | | | | | | |
| Investments | Municipal Bonds | | | 1,102,650 | | | | - | | | | 1,102,650 | | | | - | |
| | | | | | | | | | | | | | | | | | |
| Investments | Corporate Bonds | | | 51,299,068 | | | | - | | | | 51,299,068 | | | | - | |
| | | | | | | | | | | | | | | | | | |
| Investments | Certificates of Deposit | | | 5,318,227 | | | | 5,318,227 | | | | - | | | | - | |
Concentration of Credit Risk and Major Customers
The Company maintains bank account balances, which, at times, may exceed insured limits. The Company has not experienced any losses with these accounts and believes that it is not exposed to any significant credit risk on cash.
The Company maintains investments in FDIC insured certificates of deposits, municipal bonds and corporate bonds.
The Company is currently dependent on one customer, Endo, who generates almost all its revenues. For the three and nine months ended September 30, 2018, licensing, sublicensing, milestones and royalty revenues under the License Agreement with Endo were approximately $8.2 million and $23.1 million, respectively, and for the three and nine months ended September 30, 2017, respectively,the licensing, sublicensing, milestones and $12,345royalty revenues under the License Agreement with Endo were approximately $6.5 million and $37,034 for the three and nine months ended$20.7 million, respectively.
At September 30, 2016,2018 and December 31, 2017, our accounts receivable balances from Endo were $14.5 million and $4.7 million, respectively.
Milestones
Milestones, in the form of additional license fees, typically represent nonrefundable payments to be received in conjunction with the achievement of a specific event identified in the license or sublicense agreement, such as completion of specified development activities and/or regulatory submissions and/or approvals. We believe that a milestone represents the culmination of a distinct earnings process when it is not associated with ongoing research, development or other performance on our part. We recognize such milestones as revenue when they become due and collection is reasonably assured. When a milestone does not represent the culmination of a distinct earnings process, we recognize revenue in a manner similar to that of an upfront license fee.
The timing and amount of revenue that we recognize from licenses of technology, either from upfront fees or milestones where we are providing continuing services related to product development, are primarily dependent upon our estimates of the development period. We define the development period as the point from which research activities commence up to regulatory approval of either our or our partners’ submission, assuming no further research is necessary. As product candidates move through the development process, it is necessary to revise these estimates to consider changes to the product development cycle, such as changes in the clinical development plan, regulatory requirements, or various other factors, many of which may be outside of our control. Should the U.S. Food and Drug Administration or other regulatory agencies require additional data or information, we would adjust our development period estimates accordingly. The impact on revenue of changes in our estimates and the timing thereof is recognized prospectively over the remaining estimated product development period. We did not recognize any milestone revenue in the three and nine month periods ended September 30, 2017 and 2016.
Treasury Stock
The Company accounts for treasury stock under the cost method and includes treasury stock as a component of stockholders’ equity. For the nine months ended September 30, 20172018, we repurchased 43,705 shares at an average price of $58.55 as compared to the repurchase of 12,048 shares at an average price of $51.17 as compared to the repurchase of 24,020 shares at an average price of $37.39 in the corresponding 20162017 period.
Receivables and Doubtful Accounts
Trade accounts receivable are stated at the amount the Company expects to collect. We may maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. We consider the following factors when determining the collectability of specific customer accounts: customer credit-worthiness, past transaction history with the customer, current economic industry trends, and changes in customer payment terms. Our accounts receivable balance is typically due from Endo, our one large specialty pharmaceutical customer. Endo has historically paid timely and has been a financially stable organization. Due to the nature of the accounts receivable balance, we believe the risk of doubtful accounts is minimal.minimal and therefore no allowance is recorded. If the financial condition of our customer were to deteriorate, adversely affecting its ability to make payments, additional allowances would be required. We may provide for estimated uncollectible amounts through a charge to earnings and a credit to a valuation allowance. Balances that remain outstanding after we have used reasonable collection efforts are written off through a charge to the valuation allowance and a credit to accounts receivable. At September 30, 20172018 and December 31, 2016 2017 our accounts receivable balance was $4.7$14.5 million and $3.8$4.7 million, respectively, and was from one customer, Endo. With the adoption of ASC 606 as of January 1, 2018, using the modified-retrospective adoption method, we recorded an adjustment to our accounts receivable balance of $7.6 million related to royalties associated with the net sales of XIAFLEX that occurred during the fourth quarter of 2017 thereby eliminating the one quarter lag. (For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Deferred Revenue
Deferred revenue consistsWith the adoption of ASC 606 using the modified retrospective adoption method as of January 1, 2018, the remaining $6.5 million related todeferred revenue balance associated with the First Amendment with Endo of mark-up on cost of goods sold revenue for sales by non-affiliated sublicensees of Endo outside of the U.S. as of December 31, 2017 of $6.3 million was recorded as an adjustment to our retained earnings. Additionally, approximately $44,000$35,000 related to nonrefundable upfront product license fees for product candidates for which we are providing continuing services related to product development andhave no remaining performance obligations was recognized during the second quarter of 2018. Finally, during the second quarter of 2018 we determined that the $100,000 related to a milestone payment withheld by Endo due to a foreign tax withholding which remains uncollected. Currently, the Company expectswas uncollectable and have reduced this amount to recover the full amount.zero. As of September 30, 20172018 and December 31, 2016,2017, deferred revenue was $6.7zero and $6.4 million, and $7.6 million, respectively.(For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Reimbursable Third-Party Patent Costs
We accrue patent costs that are reimbursable to Endo by us under the License Agreement. We capitalize certain patent costs related to patent prosecution and maintenance and expense others. As of September 30, 20172018 and December 31, 2016,2017, our net reimbursable third party patent expense was $40,000 and zero, and $25,000, respectively.
Third-Party Royalties
We have entered into licensing and royalty agreements with third parties and agreed to pay certain royalties on net sales of products for specific indications. The royalty rates differ from agreement to agreement and, in certain cases, have been redacted with the permission of the SEC. No assumptions should be made that any disclosed royalty rate payable to a particular third party is the same or similar with respect to any royalty rate payable to any other third parties. We accrue third-party royalty expenses on net sales reported to us by Endo. Third-party royalty costs are generally expensed under general and administrative in the quarter that Endo provides the written reportsnet sales have occurred. For the three and related information to us; that is, generally one quarter following the quarter in which the underlying sales by Endo occurred.nine month periods ended September 30, 2018, third-party royalty expenses were $0.6 million and $1.7 million, respectively. For the three and nine month periods ended September 30, 2017, third-party royalty expenses were $0.4 million and $1.4 million, respectively. ForWith the three and nine month periods ended September 30, 2016, third-party royalty expenses were $0.4adoption of ASC 606 as of January 1, 2018 using the modified-retrospective adoption method, we recorded an adjustment to our retained earnings for third party royalties expense of $0.5 million and $1.2 million, respectively.associated with the net sales of XIAFLEX that occurred during the fourth quarter of 2017 thereby eliminating the one quarter lag. Our third-party royalty expense under general and administrative expenses may increase if net sales by Endo and its partners for XIAFLEX and Xiapex increase and potential new indications for XIAFLEX and Xiapex are approved, marketed and sold.
11 (For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Royalty Buy-Down
On March 31, 2012, we entered into an amendment to our existing agreement with Dr. Martin K. Gelbard, dated August 27, 2008, related to our future royalty obligations in connection with Peyronie’s disease. The amendment enables us to buy down a portion of our future royalty obligations in exchange for an initial cash payment of $1.5 million and five additional cash payments of $600,000, fourall of which have been paid as of September 30, 2017. We are currently making the payments to buy down the future royalty obligations, which royaltyJanuary 1, 2018. Royalty obligations terminate five years after first commercial sale which occurred in January 2014. The Company amortizes long-term contracts with finite lives in a manner that reflects the pattern in which the economic benefits of the assets are consumed or otherwise used up. Dr. Gelbard’s agreement is amortized based on an income forecast method by estimating sales of XIAFLEX and Xiapex for Peyronie’s disease on an annual basis as measured by the proportion of the total estimated sales over the five year period. For the three and nine months ended September 30, 2017,2018, we amortized approximately $0.4$0.6 million and $1.1$1.6 million related to this agreement respectively, and $0.2$0.4 million and $0.7$1.1 million for the three and nine months ended September 30, 2016, respectively.2017. With the adoption of ASC 606 as of January 1, 2018 using the modified-retrospective adoption method, we recorded an adjustment to our capitalized balance of $0.4 million related to royalties associated with the net sales of XIAFLEX that occurred during the fourth quarter of 2017 thereby eliminating the one quarter lag. As of September 30, 20172018 and December 31, 2016,2017, the remaining capitalized balances were approximately $2.3$0.6 million and $3.4$2.5 million, respectively. We perform an evaluation of the recoverability of the carrying value to determine if facts and circumstances indicate that the carrying value of the assets may be impaired and if any adjustment is warranted. As of September 30, 2017,2018, there was no indicator that an impairment existed.(For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Research and Development Expenses
R&D expenses include, but are not limited to, internal costs, such as salaries and benefits, costs of materials, lab expense, facility costs and overhead. R&D expenses also consist of third party costs, such as medical professional fees, product costs used in clinical trials, consulting fees and costs associated with clinical study arrangements. We may fund R&D at medical research institutions under agreements that are generally cancelable. All of these costs are charged to R&D as incurred, which may be measured by percentage of completion, contract milestones, patient enrollment, or the passage of time.
Clinical Trial Expenses
Our cost accruals for clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with various clinical trial centers and clinical research consultants. In the normal course of business, we contract with third parties to perform various clinical trial activities in the ongoing development of potential drugs. The financial terms of these agreements are subject to negotiation and vary from contract to contract and may result in uneven payment flows. Payments under the contracts depend on factors such as the achievement of certain events, the successful enrollment of patients, the completion of portions of the clinical trial, or similar conditions. The objective of our accrual policy is to match the recording of expenses in our financial statements to the actual cost of services received and efforts expended. As such, expenses related to each patient enrolled in a clinical trial are recognized ratably beginning upon entry into the trial and over the course of the patient’s continued participation in the trial. In the event of early termination of a clinical trial, we accrue an amount based on our estimate of the remaining non-cancelable obligations associated with the winding down of the clinical trial. Our estimates and assumptions could differ significantly from the amounts that may actually be incurred.
Stock-Based Compensation
The Company has one stock-based compensation plan in effect. Accounting Standards CodificationASC 718, Compensation - Stock Compensation (“ASC 718”), requires the recognition of compensation expense, using a fair-value based method, for costs related to all stock options including stock options and common stock issued to our employees and directors under our stock plans. ASC 718 requires companies to estimate the fair value of stock option awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statements of operations.
Under ASC 718, we estimate the fair value of our employee stock option awards at the date of grant using the Black-Scholes option-pricing model, which requires the use of certain subjective assumptions. The most significant of these assumptions are our estimates of the expected volatility of the market price of our stock and the expected term of an award. When establishing an estimate of the expected term of an option award, we consider the vesting period for the award, our recent historical experience of employee stock option exercises (including forfeitures) and the expected volatility of our common stock. As required under the accounting rules, we review our estimates at each grant date and, as a result, the valuation assumptions that we use to value employee stock-based awards granted in future periods may change. NoFor the nine months ended September 30, 2018, we granted a total of 31,500 stock options werewith a weighted average grant date fair value of $18.00 per share.
The assumptions used in the valuation of stock options granted during the nine months ended September 30, 2017 and 2016.2018 were as follows:
| | | Nine Months Ended September 30, 2018 | |
| Risk-free interest rate | | 2.62% to 2.81% | |
| Expected term of option | | 6.25 years | |
| Expected stock price volatility | | 39.6% to 39.7% | |
| Expected dividend yield | | $ | 0.0 | |
Further, ASC 718 requires that employee stock-based compensation costs be recognized over the requisite service period, or the vesting period, in a manner similar to all other forms of compensation paid to employees. The allocation of employee stock-based compensation costs to each operating expense line are estimated based on specific employee headcount information at each grant date and estimated stock option forfeiture rates and revised, if necessary, in future periods if actual employee headcount information or forfeitures differ materially from those estimates. As a result, the amount of employee stock-based compensation costs we recognize in each operating expense category in future periods may differ significantly from what we have recorded in the current period.
Stock-based compensation expense recognized in general and administrative expenses was approximately $33,000$64,000 and $100,000$160,000 for eachthe three and nine month periods ended September 30, 20172018 and approximately $33,000 and $100,000 for the three and nine months ended September 30, 2016,2017, respectively.
A summary of our stock option activity during the nine months ended September 30, 20172018 is presented below:
Aggregate intrinsic value represents the total pre-tax intrinsic value based on the closing price of our common stock of $46.52$58.49 on September 30, 2017,28, 2018, which would have been received by the option holders had all option holders exercised their options as of that date. We have approximately $169,000$548,000 in unrecognized compensation cost related to stock options outstanding as of September 30, 2017,2018, which we expect to recognize over the next 1.53.17 years.
Property and equipment are stated at cost, less accumulated depreciation. Machinery and equipment, furniture and fixtures, and autos are depreciated on a straight-line basis over their estimated useful lives of five to ten years. Leasehold improvements are amortized over the lesser of their estimated useful lives or the remaining life of the lease. At each of September 30, 20172018 and December 31, 2016,2017, property and equipment were fully depreciated.
Deferred tax assets and liabilities are recognized based on the expected future tax consequences, using current tax rates, of temporary differences between the financial statement carrying amounts and the income tax basis of assets and liabilities. A valuation allowance is applied against any net deferred tax asset if, based on the weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
The Company recognizes a tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon the ultimate settlement. As of September 30, 20172018 and December 31, 2016,2017, the Company has not recorded any unrecognized tax benefits.
We amortize intangible assets with definite lives on a straight-line basis over their remaining estimated useful lives, ranging from two to ten years, and review for impairment on a quarterly basis and when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We analyze our intangible assets, specifically, capitalized patent costs, on an annual basis for any indicator that an impairment exist.exists.
The amortization expense for patents for the three and nine months ended September 30, 20172018 was approximately $10,200$19,000 and $30,500,$54,000, respectively and for the three and nine months ended September 30, 20162017 was approximately $10,300$10,000 and $29,600,$31,000, respectively. The estimated aggregate amortization expense for the remaining three months of 20172018 and each of the years below is approximately as follows:
For the three and nine months ended September 30, 2017, the provision for income taxes was $1.5 million and $4.7 million, respectively. As of September 30, 2017 and December 31, 2016, our remaining deferred
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Additionally, we agreed that Endo may opt-in early to indications, prior to our submission of a clinical trial report, with our consent, such consent not to be unreasonably withheld. For early opt-ins, Endo will be required to make an opt-in payment of $0.5 million on a per indication basis. For regular opt-ins, following our submission of a clinical trial report, Endo will be required to make an opt-in payment of $0.75 million on a per indication basis.
The two marketed indications involving our injectable collagenase are Dupuytren’s contracture and Peyronie’s disease. Prior to the Acquisition, Auxilium had, and after the Acquisition, Endo has, opted-in to the following indications: frozen shoulder, cellulite, canine lipoma, lateral hip fat, plantar fibromatosis and human lipoma. Endo exercised, with our consent, an early opt-in for lateral hip fat and plantar fibromatosis in November 2015. Endo opted-in for human lipoma in July 2016. We manage the development of XIAFLEX for uterine fibroids and initiate the development of XIAFLEX in new potential indications, not licensed by Endo.
On November 8, 2016, following a change in Endo management, Endo announced that a commercial review is ongoing of the XIAFLEX exercised but non-marketed indications, including frozen shoulder, cellulite, lateral hip fat, plantar fibromatosis and human lipoma, so that Endo can best prioritize its R&D efforts and determine clinical trial timelines moving forward. We are awaiting an update on On February 6, 2018, Endo’s ongoing commercial review but initiated two identical Phase 3 RELEASE clinical trials of XIAFLEX for the treatment of cellulite. On November 7, 2018, Endo is moving forward withreleased positive results from the cellulite indicationmulticenter, randomized, double-blind, placebo-controlled RELEASE studies, which evaluated the safety and has stated publicly their interest efficacy of XIAFLEX in reducing the appearance of cellulite. (For more a more detailed discussion of the results see Note 7 – Subsequent Events to move forward with the frozen shoulder indication.Company’s Condensed Consolidated Financial Statements.)
Endo is currently selling XIAFLEX in the U.S. for the treatment of Dupuytren’s contracture and Peyronie’s disease and has an agreement with Swedish Orphan Biovitrum AB (“Sobi”), pursuant to which Sobi has marketing rights for Xiapex for Dupuytren’s contracture and Peyronie’s disease in Europe and certain Eurasian countries. Sobi is currently selling Xiapex in Europe and certain Eurasian countries for the treatment of Dupuytren’s contracture and Peyronie’s disease. In addition, Endo has an agreement with Asahi Kasei Pharma Corporation (“Asahi”) pursuant to which Asahi has the right to commercialize XIAFLEX for the treatment of Dupuytren’s contracture and Peyronie’s disease in Japan. Asahi is selling XIAFLEX for the treatment of Dupuytren’s contracture in Japan. Endo is currently distributing XIAFLEX in Canada through Paladin Labs Inc, Inc., an operating company of Endo. In December 2016, Endo entered into a new out-licensing agreement with Actelion Pharmaceuticals Ltd. (“Actelion”), pursuant to which Actelion obtained marketing and commercial rights for XIAFLEX in Australia and New Zealand.
Operational HighlightsReimbursable Third-Party Patent Costs
We accrue patent costs that are reimbursable to Endo by us under the License Agreement. We capitalize certain patent costs related to patent prosecution and maintenance and expense others. As of September 30, 2018 and December 31, 2017, our net reimbursable third party patent expense was $40,000 and zero, respectively.
Third-Party Royalties
We have entered into licensing and royalty agreements with third parties and agreed to pay certain royalties on net sales of products for specific indications. The royalty rates differ from agreement to agreement and, in certain cases, have been redacted with the permission of the SEC. No assumptions should be made that any disclosed royalty rate payable to a particular third party is the same or similar with respect to any royalty rate payable to any other third parties. We accrue third-party royalty expenses on net sales reported to us by Endo. Third-party royalty costs are generally expensed under general and administrative in the quarter that the net sales have occurred. For the three and nine month periods ended September 30, 2018, third-party royalty expenses were $0.6 million and $1.7 million, respectively. For the three and nine month periods ended September 30, 2017, third-party royalty expenses were $0.4 million and $1.4 million, respectively. With the adoption of ASC 606 as of January 1, 2018 using the modified-retrospective adoption method, we recorded an adjustment to our retained earnings for third party royalties expense of $0.5 million associated with the net sales of XIAFLEX that occurred during the fourth quarter of 2017 thereby eliminating the one quarter lag. Our third-party royalty expense under general and administrative expenses may increase if net sales by Endo and its partners for XIAFLEX and Xiapex increase and potential new indications for XIAFLEX and Xiapex are approved, marketed and sold. (For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Royalty Buy-Down
On March 31, 2012, we entered into an amendment to our existing agreement with Dr. Martin K. Gelbard, dated August 27, 2008, related to our future royalty obligations in connection with Peyronie’s disease. The amendment enables us to buy down a portion of our future royalty obligations in exchange for an initial cash payment of $1.5 million and five additional cash payments of $600,000, all of which have been paid as of January 1, 2018. Royalty obligations terminate five years after first commercial sale which occurred in January 2014. The Company amortizes long-term contracts with finite lives in a manner that reflects the pattern in which the economic benefits of the assets are consumed or otherwise used up. Dr. Gelbard’s agreement is amortized based on an income forecast method by estimating sales of XIAFLEX and Xiapex for Peyronie’s disease on an annual basis as measured by the proportion of the total estimated sales over the five year period. For the three and nine months ended September 30, 2018, we amortized approximately $0.6 million and $1.6 million related to this agreement and $0.4 million and $1.1 million for the three and nine months ended September 30, 2017. With the adoption of ASC 606 as of January 1, 2018 using the modified-retrospective adoption method, we recorded an adjustment to our capitalized balance of $0.4 million related to royalties associated with the net sales of XIAFLEX that occurred during the fourth quarter of 2017 thereby eliminating the one quarter lag. As of September 30, 2018 and December 31, 2017, the remaining capitalized balances were approximately $0.6 million and $2.5 million, respectively. We perform an evaluation of the recoverability of the carrying value to determine if facts and circumstances indicate that the carrying value of the assets may be impaired and if any adjustment is warranted. As of September 30, 2018, there was no indicator that an impairment existed. (For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Research and Development Expenses
R&D expenses include, but are not limited to, internal costs, such as salaries and benefits, costs of materials, lab expense, facility costs and overhead. R&D expenses also consist of third party costs, such as medical professional fees, product costs used in clinical trials, consulting fees and costs associated with clinical study arrangements. We may fund R&D at medical research institutions under agreements that are generally cancelable. All of these costs are charged to R&D as incurred, which may be measured by percentage of completion, contract milestones, patient enrollment, or the passage of time.
Clinical Trial Expenses
Our Phase 1cost accruals for clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with various clinical trial centers and clinical research consultants. In the normal course of XIAFLEXbusiness, we contract with third parties to perform various clinical trial activities in the ongoing development of potential drugs. The financial terms of these agreements are subject to negotiation and vary from contract to contract and may result in uneven payment flows. Payments under the contracts depend on factors such as the achievement of certain events, the successful enrollment of patients, the completion of portions of the clinical trial, or similar conditions. The objective of our accrual policy is to match the recording of expenses in our financial statements to the actual cost of services received and efforts expended. As such, expenses related to each patient enrolled in a clinical trial are recognized ratably beginning upon entry into the trial and over the course of the patient’s continued participation in the trial. In the event of early termination of a clinical trial, we accrue an amount based on our estimate of the remaining non-cancelable obligations associated with the winding down of the clinical trial. Our estimates and assumptions could differ significantly from the amounts that may actually be incurred.
Stock-Based Compensation
The Company has one stock-based compensation plan in effect. ASC 718, Compensation - Stock Compensation (“ASC 718”), requires the recognition of compensation expense, using a fair-value based method, for costs related to all stock options including stock options and common stock issued to our employees and directors under our stock plans. ASC 718 requires companies to estimate the fair value of stock option awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statements of operations.
Under ASC 718, we estimate the fair value of our employee stock option awards at the date of grant using the Black-Scholes option-pricing model, which requires the use of certain subjective assumptions. The most significant of these assumptions are our estimates of the expected volatility of the market price of our stock and the expected term of an award. When establishing an estimate of the expected term of an option award, we consider the vesting period for the treatmentaward, our recent historical experience of uterine fibroids is ongoingemployee stock option exercises (including forfeitures) and the expected volatility of our common stock. As required under the accounting rules, we planreview our estimates at each grant date and, as a result, the valuation assumptions that we use to announcevalue employee stock-based awards granted in future periods may change. For the results in 2018. nine months ended September 30, 2018, we granted a total of 31,500 stock options with a weighted average grant date fair value of $18.00 per share.
The study, being conducted at the Department of Gynecology & Obstetrics at Johns Hopkins University, is designed to enroll 15 female subjects treated prior to hysterectomy. The primary endpoint of the study will assess the safety and tolerability of a single injection of XIAFLEX directly into the uterine fibroids under transvaginal ultrasound guidance. The secondary endpoints will assess symptoms of pain and bleeding, quality of life throughout the study, shrinkage of XIAFLEX treated fibroids in size, increased rates of apoptosis in treated fibroids and a decreaseassumptions used in the collagen contentvaluation of stock options granted during the treated fibroids.nine months ended September 30, 2018 were as follows:
| | | Nine Months Ended September 30, 2018 | |
| Risk-free interest rate | | 2.62% to 2.81% | |
| Expected term of option | | 6.25 years | |
| Expected stock price volatility | | 39.6% to 39.7% | |
| Expected dividend yield | | $ | 0.0 | |
Further, ASC 718 requires that employee stock-based compensation costs be recognized over the requisite service period, or the vesting period, in a manner similar to all other forms of compensation paid to employees. The allocation of employee stock-based compensation costs to each operating expense line are estimated based on specific employee headcount information at each grant date and estimated stock option forfeiture rates and revised, if necessary, in future periods if actual employee headcount information or forfeitures differ materially from those estimates. As a result, the amount of employee stock-based compensation costs we recognize in each operating expense category in future periods may differ significantly from what we have recorded in the current period.
Stock-based compensation expense recognized in general and administrative expenses was approximately $64,000 and $160,000 for the three and nine month periods ended September 30, 2018 and approximately $33,000 and $100,000 for the three and nine months ended September 30, 2017, respectively.
OutlookStock Option Activity
A summary of our stock option activity during the nine months ended September 30, 2018 is presented below:
| | | Shares | | | Weighted Average Exercise Price | | | Weighted Average Remaining Contractual Term | | | Aggregate Intrinsic Value | |
| Outstanding at December 31, 2017 | | | 232,000 | | | $ | 21.56 | | | | 2.52 | | | $ | 5,050,990 | |
| Grants | | | 31,500 | | | | 41.79 | | | | - | | | | - | |
| Exercised | | | (138,000 | ) | | | 18.63 | | | | - | | | | 3,720,149 | |
| Forfeitures or expirations | | | - | | | | - | | | | - | | | | - | |
| Outstanding at September 30, 2018 | | | 125,500 | | | $ | 29.86 | | | | 5.16 | | | $ | 3,593,430 | |
| Exercisable at September 30, 2018 | | | 86,500 | | | $ | 24.84 | | | | 3.47 | | | $ | 2,910,945 | |
During the nine months ended September 30, 2018 and 2017, the Company received approximately $2.6 million and $258,000, respectively, from stock options exercised by option holders.
Aggregate intrinsic value represents the total pre-tax intrinsic value based on the closing price of our common stock of $58.49 on September 28, 2018, which would have been received by the option holders had all option holders exercised their options as of that date. We generated revenue from primarily one source, the License Agreement. Under the License Agreement, we receive license, sublicense income, royalties, milestones and mark-up onhave approximately $548,000 in unrecognized compensation cost of goods sold payments related to stock options outstanding as of September 30, 2018, which we expect to recognize over the sale, regulatory submissions and approval of XIAFLEX as described above.next 3.17 years.
Significant RisksProperty and Equipment
WeProperty and equipment are dependentstated at cost, less accumulated depreciation. Machinery and equipment, furniture and fixtures, and autos are depreciated on a straight-line basis over their estimated useful lives of five to a significant extent on third parties,ten years. Leasehold improvements are amortized over the lesser of their estimated useful lives or the remaining life of the lease. At each of September 30, 2018 and our principal licensee, Endo, may not be able to continue successfully commercializing XIAFLEX for Dupuytren’s contractureDecember 31, 2017, property and Peyronie’s disease, successfully develop XIAFLEX for additional indications, obtain required regulatory approvals, manufacture XIAFLEX at an acceptable cost, in a timely manner and with appropriate quality, or successfully market products or maintain desired margins for products sold, and, as a result, we may not achieve sustained profitable operations.equipment were fully depreciated.
The Company maintains bank account balances, which, at times, may exceed insured limits. The Company has not experienced any losses with these accounts and believes that it is not exposed to any significant credit risk on cash. The Company maintains its investment in FDIC insured certificates of deposits with several banks, municipal bonds and corporate bonds.Comprehensive Income
For more information regardingeach of the risks facing the Company, please see the risk factors discussed under the heading “Risk Factors” under Item 1A of Part 2 of our Quarterly Reports on Form 10Q for thethree and nine month periods ended March 31,September 30, 2018 and 2017, June 30, 2017 filed with the SEC on May 10, 2017 and filed with the SEC on August 9, 2017, respectively and under item 1Awe had no components of Part 1 of our Annual Report on Form 10-K for the year ended December 31, 2016 filed with the SEC on March 16, 2017.other comprehensive income other than net income itself.
Critical Accounting Policies, Estimates and AssumptionsProvision for Income Taxes
The preparationDeferred tax assets and liabilities are recognized based on the expected future tax consequences, using current tax rates, of condensed consolidatedtemporary differences between the financial statements in conformity with U.S. GAAP requires management to make estimatesstatement carrying amounts and assumptions that affect the reported amountsincome tax basis of assets and liabilitiesliabilities. A valuation allowance is applied against any net deferred tax asset if, based on the weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
We use the asset and disclosureliability method of contingentaccounting for income taxes, as set forth in ASC 740-10-25-2. Under this method, deferred income taxes, when required, are provided on the basis of the difference between the financial reporting and income tax basis of assets and liabilities at the datestatutory rates enacted for future periods. In accordance with ASC 740-10-45-25, Income Statement Classification of Interest and Penalties, we classify interest associated with income taxes under interest expense and tax penalties under other.
The Company recognizes a tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon the ultimate settlement. As of September 30, 2018 and December 31, 2017, the Company has not recorded any unrecognized tax benefits.
Commitments and Contingencies
On September 14, 2018, the Company entered into an agreement with the Landlord, dated August 14, 2018, to extend the term of the lease to the Headquarters for an additional one year period (the “Extended Lease Agreement”). The one year extension will end on November 30, 2019. Pursuant to the Extended Lease Agreement, the base rent is $11,500 per month and the Company may cancel the lease with three months’ prior written notice to the Landlord at any time during the term.
In accordance with ASC 260, Earnings Per Share, basic net income per share amount is computed using the weighted-average number of shares of common stock outstanding during the periods presented, while diluted net income per share is computed using the sum of the weighted-average number of common and common equivalent shares outstanding. Common equivalent shares used in the computation of diluted earnings per share result from the assumed exercise of stock options using the treasury stock method.
The following table summarizes the number of common equivalent shares that were excluded for the calculation of diluted net income per share reported in the condensed consolidated financial statementsstatement of operations.
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Stock options | | | - | | | | 20,000 | | | | - | | | | 20,000 | |
For the three and nine months ended September 30, 2017, the reported amountsCompany had 20,000 options, which have an exercise price of revenues$29.21, and would have vested upon the achievement of certain performance criteria, which were not met. These options would have expired on December 2, 2019. On October 25, 2017, these 20,000 options were cancelled due to a change in status of a certain consultant.
| 5. | ACCOUNTS PAYABLE AND ACCRUED EXPENSES |
Accounts payable and accrued expenses duringconsisted of the reporting period. These estimates arefollowing:
| | | September 30, 2018 | | | December 31, 2017 | |
| Trade accounts payable | | $ | 122,485 | | | $ | 152,542 | |
| Accrued legal and other professional fees | | | 200,116 | | | | 150,691 | |
| Accrued payroll and related costs | | | 183,435 | | | | 215,322 | |
| Third party royalties | | | 589,274 | | | | 329,211 | |
| Other accruals | | | 21,153 | | | | 86,232 | |
| Total | | $ | 1,116,463 | | | $ | 933,998 | |
We amortize intangible assets with definite lives on a straight-line basis over their remaining estimated useful lives, ranging from two to ten years, and review for impairment on a quarterly basis and when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We analyze our intangible assets, specifically, capitalized patent costs, on an annual basis for any indicator that an impairment exists.
For the nine months ended September 30, 2018, we increased our capitalized patent costs based on historical experiencereports provided to us by Endo. Patent costs may be creditable against future royalty revenues. For each period presented below, net patent costs consisted of:
| | | September 30, 2018 | | | December 31, 2017 | |
| Patents | | | 1,020,416 | | | $ | 925,016 | |
| Accumulated amortization | | | (580,524 | ) | | | (527,023 | ) |
| | | $ | 439,892 | | | $ | 397,993 | |
The amortization expense for patents for the three and on various other assumptions that we believe are reasonable under the circumstances. The financial information atnine months ended September 30, 20172018 was approximately $19,000 and $54,000, respectively and for the three and nine months ended September 30, 2017 was approximately $10,000 and 2016$31,000, respectively. The estimated aggregate amortization expense for the remaining three months of 2018 and each of the years below is unaudited, but includes all adjustments (consisting only of normal recurring adjustments) which,approximately as follows:
| October 1, 2018 - December 31, 2018 | | $ | 19,400 | |
| 2019 | | | 72,700 | |
| 2020 | | | | |
| 2021 | | | | |
| 2022 | | | | |
| Thereafter | | | 214,200 | |
| 7. | PROVISION FOR INCOME TAXES |
Our deferred tax liabilities and deferred tax assets are impacted by events and transactions arising in the opinionordinary course of management, are necessary to state fairlybusiness, R&D activities, vesting of nonqualified options and other items. The provision for income taxes is based on an estimated effective tax rate derived from our consolidated earnings before taxes, adjusted for nondeductible expenses and other permanent differences for the financial information set forth herein. Thefiscal year. For the three and nine months ended September 30, 2018, the provision for income taxes was $1.1 million and $3.3 million, respectively. As of September 30, 2018 and December 31, 2016 balance sheet amounts2017, our remaining deferred tax assets were approximately $0.3 million and disclosures included herein have been derived from$1.7 million, respectively.
For the Company’sthree and nine months ended September 30, 2017, the provision for income taxes was $1.5 million and $4.7 million, respectively.
The estimated effective tax rate for the three and nine months ended September 30, 2018 was 18.1% and 19.1%, respectively, of pre-tax income reported in the period, calculated based on the estimated annual effective rate anticipated for the year ending December 31, 2016 audited consolidated financial statements. The interim results are not necessarily indicative2018 plus the effects of results to be expectedcertain discrete items occurring in 2018. Our effective tax rate for the full fiscal year. These unaudited condensed consolidated financial statementsnine months ended September 30, 2018 was impacted primarily by the Tax Cuts and Jobs Act of 2017, which was enacted on December 22, 2017 and lowered the U.S. corporate tax rate from 35% to 21%, beginning in 2018. Our effective tax rate was also impacted by the discrete impact of current period stock option exercises which impacts the effective rate in the period in which it occurs. The effective tax rate for the nine months ended September 30, 2017 was 35% of pre-tax income reported in the period, calculated based on the estimated annual effective rate anticipated for the year ending December 31, 2017 plus the effects of certain material discrete items that occurred in 2017.
As of September 30, 2018, the Company has no unrecognized tax benefits or related interest and penalties. Management does not believe that there is any tax position which it is reasonably possible that will result in unrecognized tax benefit within the next 12 months.
On November 7, 2018, Endo announced positive results from two identical Phase 3 Randomized EvaLuation of CEllulite Reduction by CollAgenaSE Clostridium Histolyticum (“RELEASE”) studies of CCH for the treatment of cellulite in the buttocks. Subjects receiving CCH showed highly statistically significant levels of improvement in the appearance of cellulite with treatment, as measured by the trial's primary endpoint (RELEASE-1, p=0.006 & RELEASE-2, p=0.002), which was at least a 2-level composite improvement in cellulite severity in the target buttock at Day 71 as compared to subjects receiving placebo. In addition, RELEASE-1 passed 8 out of 8 key secondary endpoints and RELEASE-2 passed 7 out of 8 key secondary endpoints. CCH was well-tolerated in the actively-treated subjects with most adverse events (AEs) being mild to moderate in severity and primarily limited to the local injection area.
| Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion should be read in conjunction with the audited condensedconsolidated financial statements forand the year ended December 31, 2016related notes thereto included elsewhere in this Report and is qualified by reference to them.
Overview
We are a biopharmaceutical company involved in the Company’s Annual Reportdevelopment of an injectable collagenase clostridium histolyticum (CCH) for multiple indications. We currently have a development and license agreement with Endo Global Ventures, a Bermuda unlimited liability company (“Endo Global Ventures”), an affiliate of Endo International plc (“Endo”), for injectable collagenase for marketed indications and indications in development. Endo assumed this agreement when Endo acquired Auxilium Pharmaceuticals, Inc. (“Auxilium”) on Form 10-K andJanuary 29, 2015 (the “Acquisition”). Injectable collagenase clostridium histolyticum is marketed as XIAFLEX® (or Xiapex® in Europe).
On February 1, 2016, we entered into with Endo the unaudited condensed consolidated financial statements included in our Quarterly Reports on Form 10-Q for the first and second quarter of 2017 filed with the SEC. While our significant accounting policies are described in more detail in the notes to our unaudited condensed consolidated financial statements, we believe the following accounting policies to be criticalFirst Amendment (the “First Amendment”) to the judgmentsSecond Amended and estimates used in the preparationRestated Development and Licensing Agreement (the “Auxilium Agreement”), by and between us and Auxilium, now a wholly-owned subsidiary of our unaudited condensed consolidated financial statements. Actual results have differed in the past, and may differ in the future, from our estimates and could impact our earnings in any period during which an adjustment is made.
Revenue Recognition
We currently recognize revenues resulting from the licensing, sublicensing and use of our technology and from services we sometimes perform in connection with the licensed technology.
We enter into product development licenses and collaboration agreements that may contain multiple elements, such as upfront license and sublicense fees, milestones relatedEndo, to the achievement of particular stages in product development and royalties. As a result, significant contract interpretation is sometimes required to determine the appropriate accounting, including whether the deliverables specified in a multiple-element arrangement should be treated as separate units of accounting for revenue recognition purposes, and if deliverables should be treated as separate units, how the aggregate contract value should be allocated among the deliverable elements and when to recognize revenue for each element.
We recognize revenue for delivered elements only when the fair values of undelivered elements are known, when the associated earnings process is complete and, to the extent the milestone amount relates to our performance obligation, when our licensee confirms that we have met the requirements under the termsamend certain provisions of the agreement, and when payment is reasonably assured. Changes inAuxilium Agreement (as amended by the allocationFirst Amendment, the “License Agreement”). The effective date of the contract value between various deliverable elements might impact the timing of revenue recognition, but in any event, would not change the total revenue recognized on the contract. For example, nonrefundable upfront product license fees for product candidates for which we are providing continuing services related to product development are deferred and recognized as revenue over the development period.
Milestones, in the form of additional license fees, typically represent nonrefundable payments to be received in conjunction with the achievement of a specific event identified in a contract, such as completion of specified clinical development activities and/or regulatory submissions and/or approvals. We believe that a milestone represents the culmination of a distinct earnings process when it is not associated with ongoing research, development or other performance on our part. We recognize such milestones as revenue when they become due and payment is reasonably assured. When a milestone does not represent the culmination of a distinct earnings process, we recognize revenue in a manner similar to that of an upfront product license fee.
We recognize revenues from product sales in other income when there is persuasive evidence that an arrangement exists, title passes, the price is fixed and determinable, and payment is reasonably assured.
Royalty / Mark-up on Cost of Goods Sold
For those arrangements for which royalty and mark-up on cost of goods sold information becomes available and collectability is reasonably assured, we recognize revenue during the applicable period earned. For interim quarterly reporting purposes, when collectability is reasonably assured, but a reasonable estimate of royalty and mark-up on cost of goods sold cannot be made, the royalty and mark-up on cost of goods sold are generally recognized in the quarter that the applicable licensee provides the written report and related information to us.
Under the License Agreement, we do not participate in the selling, marketing or manufacturing of products for which we receive royalties and a mark-up on the cost of goods sold. The royalty and mark-up on cost of goods sold will generally be recognized in the quarter that Endo provides the written reports and related information to us; that is, royalty and mark-up on cost of goods sold are generally recognized one quarter following the quarter in which the underlying sales by Endo occurred. The royalties payable by Endo to us are subject to set-off for certain patent costs.
First Amendment was January 1, 2016. Pursuant to the First Amendment, withwe and Endo mutually agreed that in exchange for a $8.25 million lump sum payment, we will not receive future additional mark-up on cost of goods sold for sales by non-affiliated sublicensees of Endo outside of the U.S.; provided, however, that Endo will still be required to pay a mark-up on cost of goods sold for sales made in the “Endo“Endo Territory,” which includes sales made in the U.S. and sales made in any other country where Endo sells the product directly or through affiliated sublicensees. We received this $8.25
Additionally, we agreed that Endo may opt-in early to indications, prior to our submission of a clinical trial report, with our consent, such consent not to be unreasonably withheld. For early opt-ins, Endo will be required to make an opt-in payment of $0.5 million lump sumon a per indication basis. For regular opt-ins, following our submission of a clinical trial report, Endo will be required to make an opt-in payment of $0.75 million on a per indication basis.
The two marketed indications involving our injectable collagenase are Dupuytren’s contracture and Peyronie’s disease. Prior to the Acquisition, Auxilium had, and after the Acquisition, Endo has, opted-in to the following indications: frozen shoulder, cellulite, canine lipoma, lateral hip fat, plantar fibromatosis and human lipoma. Endo exercised, with our consent, an early opt-in for lateral hip fat and plantar fibromatosis in FebruaryNovember 2015. Endo opted-in for human lipoma in July 2016. We classified this payment as deferred revenuemanage the development of XIAFLEX for uterine fibroids and initiate the development of XIAFLEX in our balance sheetnew potential indications, not licensed by Endo.
On November 8, 2016, following a change in Endo management, Endo announced that a commercial review is ongoing of the XIAFLEX exercised but non-marketed indications, including frozen shoulder, cellulite, lateral hip fat, plantar fibromatosis and human lipoma, so that Endo can best prioritize its R&D efforts and determine clinical trial timelines moving forward.began recognizing this income over time On February 6, 2018, Endo initiated two identical Phase 3 RELEASE clinical trials of XIAFLEX for the treatment of cellulite. On November 7, 2018, Endo released positive results from the multicenter, randomized, double-blind, placebo-controlled RELEASE studies, which evaluated the safety and efficacy of XIAFLEX in reducing the appearance of cellulite. (For more a more detailed discussion of the results see Note 7 – Subsequent Events to the Company’s Condensed Consolidated Financial Statements.)
Endo is currently selling XIAFLEX in the second quarter of 2016 based on sales by non-affiliated sublicensees of Endo outside of the U.S. according to our revenue recognition policy. We recognized approximately $266,000 and $895,000 for the threetreatment of Dupuytren’s contracture and nine months ended September 30, 2017, respectively. We recognized approximately $274,000Peyronie’s disease and $546,000has an agreement with Swedish Orphan Biovitrum AB (“Sobi”), pursuant to which Sobi has marketing rights for Xiapex for Dupuytren’s contracture and Peyronie’s disease in Europe and certain Eurasian countries. Sobi is currently selling Xiapex in Europe and certain Eurasian countries for the threetreatment of Dupuytren’s contracture and nine months ended September 30,Peyronie’s disease. In addition, Endo has an agreement with Asahi Kasei Pharma Corporation (“Asahi”) pursuant to which Asahi has the right to commercialize XIAFLEX for the treatment of Dupuytren’s contracture and Peyronie’s disease in Japan. Asahi is selling XIAFLEX for the treatment of Dupuytren’s contracture in Japan. Endo is currently distributing XIAFLEX in Canada through Paladin Labs Inc., an operating company of Endo. In December 2016, respectively.Endo entered into a new out-licensing agreement with Actelion Pharmaceuticals Ltd. (“Actelion”), pursuant to which Actelion obtained marketing and commercial rights for XIAFLEX in Australia and New Zealand.
Reimbursable Third-Party Patent Costs
We accrue patent costs that are reimbursable to Endo by us under the License Agreement. We capitalize certain patent costs related to patent prosecution and maintenance and expense others. As of September 30, 20172018 and December 31, 2016,2017, our net reimbursable third party patent expense was $40,000 and zero, respectively.
Third-Party Royalties
We have entered into licensing and $25,000,royalty agreements with third parties and agreed to pay certain royalties on net sales of products for specific indications. The royalty rates differ from agreement to agreement and, in certain cases, have been redacted with the permission of the SEC. No assumptions should be made that any disclosed royalty rate payable to a particular third party is the same or similar with respect to any royalty rate payable to any other third parties. We accrue third-party royalty expenses on net sales reported to us by Endo. Third-party royalty costs are generally expensed under general and administrative in the quarter that the net sales have occurred. For the three and nine month periods ended September 30, 2018, third-party royalty expenses were $0.6 million and $1.7 million, respectively. For the three and nine month periods ended September 30, 2017, third-party royalty expenses were $0.4 million and $1.4 million, respectively. With the adoption of ASC 606 as of January 1, 2018 using the modified-retrospective adoption method, we recorded an adjustment to our retained earnings for third party royalties expense of $0.5 million associated with the net sales of XIAFLEX that occurred during the fourth quarter of 2017 thereby eliminating the one quarter lag. Our third-party royalty expense under general and administrative expenses may increase if net sales by Endo and its partners for XIAFLEX and Xiapex increase and potential new indications for XIAFLEX and Xiapex are approved, marketed and sold. (For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Royalty Buy-Down
On March 31, 2012, we entered into an amendment to our existing agreement with Dr. Martin K. Gelbard, dated August 27, 2008, related to our future royalty obligations in connection with Peyronie’s disease. The amendment enables us to buy down a portion of our future royalty obligations in exchange for an initial cash payment of $1.5 million and five additional cash payments of $600,000, all of which have been paid as of January 1, 2018. Royalty obligations terminate five years after first commercial sale which occurred in January 2014. The Company amortizes long-term contracts with finite lives in a manner that reflects the pattern in which the economic benefits of the assets are consumed or otherwise used up. Dr. Gelbard’s agreement is amortized based on an income forecast method by estimating sales of XIAFLEX and Xiapex for Peyronie’s disease on an annual basis as measured by the proportion of the total estimated sales over the five year period. For the three and nine months ended September 30, 2018, we amortized approximately $0.6 million and $1.6 million related to this agreement and $0.4 million and $1.1 million for the three and nine months ended September 30, 2017. With the adoption of ASC 606 as of January 1, 2018 using the modified-retrospective adoption method, we recorded an adjustment to our capitalized balance of $0.4 million related to royalties associated with the net sales of XIAFLEX that occurred during the fourth quarter of 2017 thereby eliminating the one quarter lag. As of September 30, 2018 and December 31, 2017, the remaining capitalized balances were approximately $0.6 million and $2.5 million, respectively. We perform an evaluation of the recoverability of the carrying value to determine if facts and circumstances indicate that the carrying value of the assets may be impaired and if any adjustment is warranted. As of September 30, 2018, there was no indicator that an impairment existed. (For more a more detailed discussion regarding ASC 606 see Note 3- Summary of Significant Accounting Policies – Recent Accounting Pronouncements - Accounting Pronouncements Adopted.)
Research and Development Expenses
R&D expenses include, but are not limited to, internal costs, such as salaries and benefits, costs of materials, lab expense, facility costs and overhead. R&D expenses also consist of third party costs, such as medical professional fees, product costs used in clinical trials, consulting fees and costs associated with clinical study arrangements. We may fund R&D at medical research institutions under agreements that are generally cancelable. All of these costs are charged to R&D as incurred, which may be measured by percentage of completion, contract milestones, patient enrollment, or the passage of time.
Clinical Trial Expenses
Our cost accruals for clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with various clinical trial centers and clinical research consultants. In the normal course of business, we contract with third parties to perform various clinical trial activities in the ongoing development of potential drugs. The financial terms of these agreements are subject to negotiation and vary from contract to contract and may result in uneven payment flows. Payments under the contracts depend on factors such as the achievement of certain events, the successful enrollment of patients, the completion of portions of the clinical trial, or similar conditions. The objective of our accrual policy is to match the recording of expenses in our financial statements to the actual cost of services received and efforts expended. As such, expenses related to each patient enrolled in a clinical trial are recognized ratably beginning upon entry into the trial and over the course of the patient’s continued participation in the trial. In the event of early termination of a clinical trial, we accrue an amount based on our estimate of the remaining non-cancelable obligations associated with the winding down of the clinical trial. Our estimates and assumptions could differ significantly from the amounts that may actually be incurred.
Stock-Based Compensation
The Company has one stock-based compensation plan in effect. ASC 718, Compensation - Stock Compensation (“ASC 718”), requires the recognition of compensation expense, using a fair-value based method, for costs related to all stock options including stock options and common stock issued to our employees and directors under our stock plans. ASC 718 requires companies to estimate the fair value of stock option awards on the date of grant using an option-pricing model. The value of the portion of the award that is ultimately expected to vest is recognized as expense on a straight-line basis over the requisite service periods in our condensed consolidated statements of operations.
Under ASC 718, we estimate the fair value of our employee stock option awards at the date of grant using the Black-Scholes option-pricing model, which requires the use of certain subjective assumptions. The most significant of these assumptions are our estimates of the expected volatility of the market price of our stock and the expected term of an award. When establishing an estimate of the expected term of an option award, we consider the vesting period for the award, our recent historical experience of employee stock option exercises (including forfeitures) and the expected volatility of our common stock. As required under the accounting rules, we review our estimates at each grant date and, as a result, the valuation assumptions that we use to value employee stock-based awards granted in future periods may change. For the nine months ended September 30, 2018, we granted a total of 31,500 stock options with a weighted average grant date fair value of $18.00 per share.
The assumptions used in the valuation of stock options granted during the nine months ended September 30, 2018 were as follows:
| | | Nine Months Ended September 30, 2018 | |
| Risk-free interest rate | | 2.62% to 2.81% | |
| Expected term of option | | 6.25 years | |
| Expected stock price volatility | | 39.6% to 39.7% | |
| Expected dividend yield | | $ | 0.0 | |
Further, ASC 718 requires that employee stock-based compensation costs be recognized over the requisite service period, or the vesting period, in a manner similar to all other forms of compensation paid to employees. The allocation of employee stock-based compensation costs to each operating expense line are estimated based on specific employee headcount information at each grant date and estimated stock option forfeiture rates and revised, if necessary, in future periods if actual employee headcount information or forfeitures differ materially from those estimates. As a result, the amount of employee stock-based compensation costs we recognize in each operating expense category in future periods may differ significantly from what we have recorded in the current period.
Stock-based compensation expense recognized in general and administrative expenses was approximately $64,000 and $160,000 for the three and nine month periods ended September 30, 2018 and approximately $33,000 and $100,000 for the three and nine months ended September 30, 2017, respectively.
Stock Option Activity
A summary of our stock option activity during the nine months ended September 30, 2018 is presented below:
| | | Shares | | | Weighted Average Exercise Price | | | Weighted Average Remaining Contractual Term | | | Aggregate Intrinsic Value | |
| Outstanding at December 31, 2017 | | | 232,000 | | | $ | 21.56 | | | | 2.52 | | | $ | 5,050,990 | |
| Grants | | | 31,500 | | | | 41.79 | | | | - | | | | - | |
| Exercised | | | (138,000 | ) | | | 18.63 | | | | - | | | | 3,720,149 | |
| Forfeitures or expirations | | | - | | | | - | | | | - | | | | - | |
| Outstanding at September 30, 2018 | | | 125,500 | | | $ | 29.86 | | | | 5.16 | | | $ | 3,593,430 | |
| Exercisable at September 30, 2018 | | | 86,500 | | | $ | 24.84 | | | | 3.47 | | | $ | 2,910,945 | |
During the nine months ended September 30, 2018 and 2017, the Company received approximately $2.6 million and $258,000, respectively, from stock options exercised by option holders.
Aggregate intrinsic value represents the total pre-tax intrinsic value based on the closing price of our common stock of $58.49 on September 28, 2018, which would have been received by the option holders had all option holders exercised their options as of that date. We have approximately $548,000 in unrecognized compensation cost related to stock options outstanding as of September 30, 2018, which we expect to recognize over the next 3.17 years.
Property and Equipment
Property and equipment are stated at cost, less accumulated depreciation. Machinery and equipment, furniture and fixtures, and autos are depreciated on a straight-line basis over their estimated useful lives of five to ten years. Leasehold improvements are amortized over the lesser of their estimated useful lives or the remaining life of the lease. At each of September 30, 2018 and December 31, 2017, property and equipment were fully depreciated.
Comprehensive Income
For each of the three and nine month periods ended September 30, 2018 and 2017, we had no components of other comprehensive income other than net income itself.
Provision for Income Taxes
Deferred tax assets and liabilities are recognized based on the expected future tax consequences, using current tax rates, of temporary differences between the financial statement carrying amounts and the income tax basis of assets and liabilities. A valuation allowance is applied against any net deferred tax asset if, based on the weighted available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized.
We use the asset and liability method of accounting for income taxes, as set forth in ASC 740-10-25-2. Under this method, deferred income taxes, when required, are provided on the basis of the difference between the financial reporting and income tax basis of assets and liabilities at the statutory rates enacted for future periods. In accordance with ASC 740-10-45-25, Income Statement Classification of Interest and Penalties, we classify interest associated with income taxes under interest expense and tax penalties under other.
The Company recognizes a tax benefit from an uncertain tax position only if it is more likely than not that the tax position will be sustained on examination by taxing authorities, based on the technical merits of the position. The tax benefits recognized in the consolidated financial statements from such position are measured based on the largest benefit that has a greater than 50% likelihood of being realized upon the ultimate settlement. As of September 30, 2018 and December 31, 2017, the Company has not recorded any unrecognized tax benefits.
Commitments and Contingencies
On September 14, 2018, the Company entered into an agreement with the Landlord, dated August 14, 2018, to extend the term of the lease to the Headquarters for an additional one year period (the “Extended Lease Agreement”). The one year extension will end on November 30, 2019. Pursuant to the Extended Lease Agreement, the base rent is $11,500 per month and the Company may cancel the lease with three months’ prior written notice to the Landlord at any time during the term.
In accordance with ASC 260, Earnings Per Share, basic net income per share amount is computed using the weighted-average number of shares of common stock outstanding during the periods presented, while diluted net income per share is computed using the sum of the weighted-average number of common and common equivalent shares outstanding. Common equivalent shares used in the computation of diluted earnings per share result from the assumed exercise of stock options using the treasury stock method.
The following table summarizes the number of common equivalent shares that were excluded for the calculation of diluted net income per share reported in the condensed consolidated statement of operations.
| | | Three Months Ended September 30, | | | Nine Months Ended September 30, | |
| | | 2018 | | | 2017 | | | 2018 | | | 2017 | |
| Stock options | | | - | | | | 20,000 | | | | - | | | | 20,000 | |
For the three and nine months ended September 30, 2017, the Company had 20,000 options, which have an exercise price of $29.21, and would have vested upon the achievement of certain performance criteria, which were not met. These options would have expired on December 2, 2019. On October 25, 2017, these 20,000 options were cancelled due to a change in status of a certain consultant.
| 5. | ACCOUNTS PAYABLE AND ACCRUED EXPENSES |
Accounts payable and accrued expenses consisted of the following:
| | | September 30, 2018 | | | December 31, 2017 | |
| Trade accounts payable | | $ | 122,485 | | | $ | 152,542 | |
| Accrued legal and other professional fees | | | 200,116 | | | | 150,691 | |
| Accrued payroll and related costs | | | 183,435 | | | | 215,322 | |
| Third party royalties | | | 589,274 | | | | 329,211 | |
| Other accruals | | | 21,153 | | | | 86,232 | |
| Total | | $ | 1,116,463 | | | $ | 933,998 | |
We amortize intangible assets with definite lives on a straight-line basis over their remaining estimated useful lives, ranging from two to ten years, and review for impairment on a quarterly basis and when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. We analyze our intangible assets, specifically, capitalized patent costs, on an annual basis for any indicator that an impairment exists.
For the nine months ended September 30, 2018, we increased our capitalized patent costs based on reports provided to us by Endo. Patent costs may be creditable against future royalty revenues. For each period presented below, net patent costs consisted of:
| | | September 30, 2018 | | | December 31, 2017 | |
| Patents | | | 1,020,416 | | | $ | 925,016 | |
| Accumulated amortization | | | (580,524 | ) | | | (527,023 | ) |
| | | $ | 439,892 | | | $ | 397,993 | |
Receivables
AtThe amortization expense for patents for the three and nine months ended September 30, 2018 was approximately $19,000 and $54,000, respectively and for the three and nine months ended September 30, 2017 was approximately $10,000 and $31,000, respectively. The estimated aggregate amortization expense for the remaining three months of 2018 and each of the years below is approximately as follows:
| October 1, 2018 - December 31, 2018 | | $ | 19,400 | |
| 2019 | | | 72,700 | |
| 2020 | | | | |
| 2021 | | | | |
| 2022 | | | | |
| Thereafter | | | 214,200 | |
| 7. | PROVISION FOR INCOME TAXES |
Our deferred tax liabilities and deferred tax assets are impacted by events and transactions arising in the ordinary course of business, R&D activities, vesting of nonqualified options and other items. The provision for income taxes is based on an estimated effective tax rate derived from our consolidated earnings before taxes, adjusted for nondeductible expenses and other permanent differences for the fiscal year. For the three and nine months ended September 30, 2018, the provision for income taxes was $1.1 million and $3.3 million, respectively. As of September 30, 2018 and December 31, 20162017, our accounts receivable balance which consists of royalties, mark-up on costs of goods soldremaining deferred tax assets were approximately $0.3 million and a portion of a milestone payment from Endo due to a foreign tax withholding,$1.7 million, respectively.
For the three and nine months ended September 30, 2017, the provision for income taxes was $1.5 million and $4.7 million, and $3.8 million, respectively, and was from one customer, Endo.respectively.
Deferred RevenueThe estimated effective tax rate for the three and nine months ended September 30, 2018 was 18.1% and 19.1%, respectively, of pre-tax income reported in the period, calculated based on the estimated annual effective rate anticipated for the year ending December 31, 2018 plus the effects of certain discrete items occurring in 2018. Our effective tax rate for the nine months ended September 30, 2018 was impacted primarily by the Tax Cuts and Jobs Act of 2017, which was enacted on December 22, 2017 and lowered the U.S. corporate tax rate from 35% to 21%, beginning in 2018. Our effective tax rate was also impacted by the discrete impact of current period stock option exercises which impacts the effective rate in the period in which it occurs. The effective tax rate for the nine months ended September 30, 2017 was 35% of pre-tax income reported in the period, calculated based on the estimated annual effective rate anticipated for the year ending December 31, 2017 plus the effects of certain material discrete items that occurred in 2017.
Deferred revenue consistsAs of September 30, 2018, the Company has no unrecognized tax benefits or related interest and penalties. Management does not believe that there is any tax position which it is reasonably possible that will result in unrecognized tax benefit within the next 12 months.
On November 7, 2018, Endo announced positive results from two identical Phase 3 Randomized EvaLuation of CEllulite Reduction by CollAgenaSE Clostridium Histolyticum (“RELEASE”) studies of CCH for the treatment of cellulite in the buttocks. Subjects receiving CCH showed highly statistically significant levels of improvement in the appearance of cellulite with treatment, as measured by the trial's primary endpoint (RELEASE-1, p=0.006 & RELEASE-2, p=0.002), which was at least a 2-level composite improvement in cellulite severity in the target buttock at Day 71 as compared to subjects receiving placebo. In addition, RELEASE-1 passed 8 out of 8 key secondary endpoints and RELEASE-2 passed 7 out of 8 key secondary endpoints. CCH was well-tolerated in the actively-treated subjects with most adverse events (AEs) being mild to moderate in severity and primarily limited to the local injection area.
| Management’s Discussion and Analysis of Financial Condition and Results of Operations |
The following discussion should be read in conjunction with the condensedconsolidated financial statements and the related notes thereto included elsewhere in this Report and is qualified by reference to them.
Overview
We are a biopharmaceutical company involved in the development of an injectable collagenase clostridium histolyticum (CCH) for multiple indications. We currently have a development and license agreement with Endo Global Ventures, a Bermuda unlimited liability company (“Endo Global Ventures”), an affiliate of Endo International plc (“Endo”), for injectable collagenase for marketed indications and indications in development. Endo assumed this agreement when Endo acquired Auxilium Pharmaceuticals, Inc. (“Auxilium”) on January 29, 2015 (the “Acquisition”). Injectable collagenase clostridium histolyticum is marketed as XIAFLEX® (or Xiapex® in Europe).
On February 1, 2016, we entered into with Endo the First Amendment (the “First Amendment”) to the Second Amended and Restated Development and Licensing Agreement (the “Auxilium Agreement”), by and between us and Auxilium, now a wholly-owned subsidiary of Endo, to amend certain provisions of the Auxilium Agreement (as amended by the First Amendment, the “License Agreement”). The effective date of the First Amendment was January 1, 2016. Pursuant to the First Amendment, we and Endo mutually agreed that in exchange for a $8.25 million lump sum payment, we will not receive future additional mark-up on cost of goods sold for sales by non-affiliated sublicensees and is being recognized as income over time based on sales by non-affiliated sublicensees of Endo outside of the U.SU.S.; provided, however, that Endo will still be required to pay a mark-up on cost of goods sold for sales made in accordancethe “Endo Territory,” which includes sales made in the U.S. and sales made in any other country where Endo sells the product directly or through affiliated sublicensees.
Additionally, we agreed that Endo may opt-in early to indications, prior to our submission of a clinical trial report, with our consent, such consent not to be unreasonably withheld. For early opt-ins, Endo will be required to make an opt-in payment of $0.5 million on a per indication basis. For regular opt-ins, following our submission of a clinical trial report, Endo will be required to make an opt-in payment of $0.75 million on a per indication basis.
The two marketed indications involving our injectable collagenase are Dupuytren’s contracture and Peyronie’s disease. Prior to the Acquisition, Auxilium had, and after the Acquisition, Endo has, opted-in to the following indications: frozen shoulder, cellulite, canine lipoma, lateral hip fat, plantar fibromatosis and human lipoma. Endo exercised, with our consent, an early opt-in for lateral hip fat and plantar fibromatosis in November 2015. Endo opted-in for human lipoma in July 2016. We manage the development of XIAFLEX for uterine fibroids and initiate the development of XIAFLEX in new potential indications, not licensed by Endo.
On November 8, 2016, following a change in Endo management, Endo announced that a commercial review is ongoing of the XIAFLEX exercised but non-marketed indications, including frozen shoulder, cellulite, lateral hip fat, plantar fibromatosis and human lipoma, so that Endo can best prioritize its R&D efforts and determine clinical trial timelines moving forward. On February 6, 2018, Endo initiated two identical Phase 3 RELEASE clinical trials of XIAFLEX for the treatment of cellulite. On November 7, 2018, Endo released positive results from the multicenter, randomized, double-blind, placebo-controlled RELEASE studies, which evaluated the safety and efficacy of XIAFLEX in reducing the appearance of cellulite. (For more a more detailed discussion of the results see Note 7 – Subsequent Events to the Company’s Condensed Consolidated Financial Statements.)
Endo is currently selling XIAFLEX in the U.S. for the treatment of Dupuytren’s contracture and Peyronie’s disease and has an agreement with Swedish Orphan Biovitrum AB (“Sobi”), pursuant to which Sobi has marketing rights for Xiapex for Dupuytren’s contracture and Peyronie’s disease in Europe and certain Eurasian countries. Sobi is currently selling Xiapex in Europe and certain Eurasian countries for the treatment of Dupuytren’s contracture and Peyronie’s disease. In addition, Endo has an agreement with Asahi Kasei Pharma Corporation (“Asahi”) pursuant to which Asahi has the right to commercialize XIAFLEX for the treatment of Dupuytren’s contracture and Peyronie’s disease in Japan. Asahi is selling XIAFLEX for the treatment of Dupuytren’s contracture in Japan. Endo is currently distributing XIAFLEX in Canada through Paladin Labs Inc., an operating company of Endo. In December 2016, Endo entered into a new out-licensing agreement with Actelion Pharmaceuticals Ltd. (“Actelion”), pursuant to which Actelion obtained marketing and commercial rights for XIAFLEX in Australia and New Zealand.
Operational Highlights
On October 31, 2018, we announced positive topline data from our Phase 1 trial of Collagenase Clostridium Histolyticum (“CCH”) for the treatment of uterine fibroids. The study met the primary endpoint of safety and tolerability of a single injection of XIAFLEX directly into the uterine fibroids under transvaginal ultrasound guidance with no observed clinically significant adverse reactions. Pharmacodynamic changes were noted in all secondary endpoints, which included assessment of symptoms of pain and bleeding, quality of life throughout the study, shrinkage of XIAFLEX treated fibroids in size, increased rates of apoptosis in treated fibroids and a decrease in the collagen content of the treated fibroids, with the exception of apoptosis.
Outlook
We generated revenue from primarily one source, the License Agreement. Under the License Agreement, we receive license, sublicense income, royalties, milestones and mark-up on cost of goods sold payments related to the sale, regulatory submissions and approval of XIAFLEX as described above.
Significant Risks
We are dependent to a significant extent on third parties, and our principal licensee, Endo, may not be able to continue successfully commercializing XIAFLEX for Dupuytren’s contracture and Peyronie’s disease, successfully develop XIAFLEX for additional indications, obtain required regulatory approvals, manufacture XIAFLEX at an acceptable cost, in a timely manner and with appropriate quality, or successfully market products or maintain desired margins for products sold, and, as a result, we may not achieve sustained profitable operations.
The Company maintains bank account balances, which, at times, may exceed insured limits. The Company has not experienced any losses with these accounts and believes that it is not exposed to any significant credit risk on cash. The Company maintains its investment in FDIC insured certificates of deposits with several banks, municipal bonds and corporate bonds.
For more information regarding the risks facing the Company, please see the risk factors discussed under the heading “Risk Factors” under item 1A of Part 1 of our Annual Report on Form 10-K for the year ended December 31, 2017 filed with the SEC on March 14, 2018 and under Item 1A of Part 2 of our Quarterly Reports on Form 10Q for the quarter ended March 31, 2018 and June 30, 2018 filed with the SEC on May 10, 2018 and August 9, 2018, respectively.
Critical Accounting Policies, Estimates and Assumptions
The preparation of condensed consolidated financial statements in conformity with U.S. GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. These estimates are based on historical experience, interim data provided by Endo and on various other assumptions that we believe are reasonable under the circumstances. The financial information at September 30, 2018 and for the three and nine months ended September 30, 2018 and 2017 is unaudited, but includes all adjustments (consisting only of normal recurring adjustments) which, in the opinion of management, are necessary to state fairly the financial information set forth herein. The December 31, 2017 balance sheet amounts and disclosures included herein have been derived from the Company’s December 31, 2017 audited consolidated financial statements. The interim results are not necessarily indicative of results to be expected for the full fiscal year. These unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2017 included in the Company’s Annual Report on Form 10-Kfiled and with the unaudited condensed consolidated financial statements included in our Quarterly Reports on Form 10-Q for the first and second quarters of 2018 filed with the SEC. While our significant accounting policies are described in more detail in the notes to our unaudited condensed consolidated financial statements, we believe the following accounting policies to be critical to the judgments and estimates used in the preparation of our unaudited condensed consolidated financial statements. Actual results have differed in the past, and may differ in the future, from our estimates and could impact our earnings in any period during which an adjustment is made.
As described in Note 3 to our accompanying Condensed Consolidated Financial Statements with respect to changes in our revenue recognition policy beginningrelated to our adoption of the requirements of ASC 606, there have been no significant changes to our critical accounting policies for the three and nine months ended September 30, 2018, compared to the critical accounting policies disclosed in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” included in our Annual Report on Form 10-K for the year ended December 31, 2017 and our Quarterly Reports on Form 10-Q for the quarter ended March 31, 2018 and June 30, 2018.
As described in Note 1, in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2018, we underestimated the amount of royalty revenue from Endo by approximately $750,000 because we did not have sufficient controls in place and Endo’s sales materially exceeded our estimates based on available historical data for the relevant period. Consequently, we have corrected that amount for the relevant period in this Quarterly Report on Form 10-Q. We have requested that Endo provide this interim data consistently going forward and, while they have provided it to us for this quarter ended September 30, 2018, there is no guarantee that they will do so in the second quarter of 2016. In addition, deferred revenue consists of licensing fees relatedfuture and we may need to make further corrections or adjustments in the cash payments received under the License Agreement in prior yearsfuture if there are differences between actual and amortized over the expected development period of certain indications for XIAFLEX and a portion of a milestone payment withheld by Endo due to a foreign tax withholding which remains uncollected. As of September 30, 2017 and December 31, 2016, deferred revenue was approximately $6.7 million and $7.6 million, respectively.estimated royalties.
Third-Party Royalties
We have entered into licensing and royalty agreements with third parties and agreed to pay certain royalties on net sales of products for specific indications. The royalty rates differ from agreement to agreement and, in certain cases, have been redacted with the permission of the SEC. No assumptions should be made that any disclosed royalty rate payable to a particular third party is the same or similar with respect to any royalty rate payable to any other third parties. We accrue third-party royalty expenses on net sales reported to us by Endo. Third-party royalty costs are generally expensed under general and administrative in the quarter that Endo provides the written reportsnet sales have occurred. For the three and related information to us; that is, generally one quarter following the quarter in which the underlying sales by Endo occurred.nine month periods ended September 30, 2018, third-party royalty expenses were $0.7 million and $1.7 million, respectively. For the three and nine month periods ended September 30, 2017, third-party royalty expenses were $0.4 million and $1.4 million, respectively. For the three and nine month periods ended September 30, 2016, third-party royalty expenses were $0.4 million and $1.2 million, respectively. Our third-party royalty expense under general and administrative expenses may increase if net sales by Endo and its partners for XIAFLEX and Xiapex increase and potential new indications for XIAFLEX and Xiapex are approved, marketed and sold.
Royalty Buy-Down
On March 31, 2012, we entered into an amendment to our existing agreement with Dr. Martin K. Gelbard, dated August 27, 2008, related to our future royalty obligations in connection with Peyronie’s disease. The amendment enables us to buy down a portion of our future royalty obligations in exchange for an initial cash payment of $1.5 million and five additional cash payments of $600,000, fourall of which have been paid as of September 30, 2017. We are currently making the payments to buy down the future royalty obligations, which royalty2018. Royalty obligations terminate five years after first commercial sale which occurred in January 2014. The Company amortizes long-term contracts with finite lives in a manner that reflects the pattern in which the economic benefits of the assets are consumed or otherwise used up. Dr. Gelbard’s agreement is amortized based on an income forecast method by estimating sales of XIAFLEX and Xiapex for Peyronie’s disease on an annual basis as measured by the proportion of the total estimated sales over the five year period. For the three and nine months ended September 30, 2018 and 2017, we amortized approximately $0.4$0.6 million and $1.1$1.6 million related to this agreement respectively, and $0.2$0.4 million and $0.7$1.1 million for the three and nine months ended September 30, 2016, respectively.2017. As of September 30, 20172018 and December 31, 2016,2017, the remaining capitalized balances were approximately $2.3$0.6 million and $3.4$2.5 million, respectively. We perform an evaluation of the recoverability of the carrying value to determine if facts and circumstances indicate that the carrying value of the assets may be impaired and if any adjustment is warranted. As of September 30, 2017,2018, there was no indicator that an impairment existed.
Stock Based Compensation
Under ASC 718,Compensation - Stock Compensation, or ASC 718, we estimate the fair value of our employee stock option awards at the date of grant using the Black-Scholes option-pricing model, which requires the use of certain subjective assumptions. The most significant assumptions are our estimates of the expected volatility of the market price of our common stock and the expected term of an option award. Expected volatility is based on the historical volatility of our common stock. When establishing an estimate of the expected term of an option award, we consider the vesting period for the award, our historical experience of employee stock option exercises (including forfeitures) and the expected volatility of our common stock. Wevolatility. As required under the accounting rules, we review our estimatesvaluation assumptions at each grant date and, as a result, we are likely to change our valuation assumptions used to value future employee stock-based awards granted, to the extent any such awards are granted.
Further, ASC 718 requires that employee stock-based compensation costs to be recognized over the requisite service period, or the vesting period, in a manner similar to all other forms of compensation paid to employees. The allocation of employee stock-based compensation costs to each operating expense line isare estimated based on specific employee headcount information at each grant date and estimated stock option forfeiture rates and are revised, if necessary, in future periods if actual employee headcount information or forfeitures differ materially from those estimates. As a result, the amount of employee stock-based compensation costs we recognize in each operating expense category in future periods may differ significantly from what we have recorded in the current period.
RESULTS OF OPERATIONS
THREE MONTHS ENDED SEPTEMBER 30, 20172018 COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 20162017
Revenues
Royalties
Royalties consist of royalties and the mark-up on cost of goods sold under the License Agreement. Total royalty and mark-up on cost of goods sold for the three month period ended September 30, 20172018 were $6.5$8.2 million as compared to $6.1$6.5 million in the corresponding 20162017 period, an increase of $0.4$1.7 million or 7%26%. ThisThe increase in royalties andtotal revenues for the mark-up on cost of goods soldquarterly period was primarily due to the increase inroyalties associated with higher net sales of XIAFLEX for the treatment ofin Dupuytren's contracture and Peyronie’s disease and Dupuytren’s contracture partially offset by lower mark-up on cost of goods sold revenue.revenue in prepaid foreign mark-up on cost of goods sold revenue recognized under new revenue standard ASC 606, as of January 1, 2018.
Licensing Revenue
Licensing revenue consists of licensing fees, sublicensing fees and milestones. We recognized certain licensing fees related to the cash payments received under the License Agreement in prior years and amortized them over the expected development period. For the three month periods ended September 30, 2017 and 2016,2018, we recognized licensingzero revenue related to nonrefundable upfront product license fees for product candidates as compared to $4,408 in the development of injectable collagenase of $4,408 and $12,345 respectively. For the three months ended September 30, 2016, we recognized licensing fees related to the exercise of an opt-in right by Endo for the human lipoma indication of $750,000.2017 period.
Milestone revenue recognized for the three months ended September 30, 2017 and 2016 was zero in each period.
Research and Development Activities and Expenses
R&D expenses include, but are not limited to, internal costs, such as salaries and benefits, costs of materials, lab expenses, facility costs and overhead. R&D expenses also consist of third party costs, such as medical professional fees, product costs used in clinical trials, consulting fees, and costs associated with clinical study arrangements. For the three month periods ended September 30, 20172018 and 2016,2017, R&D expenses were approximately $357,000$0.2 million and $313,000,$0.4 million, respectively and in each case, are primarily related to the development work associated with our clinical, programs, preclinical and other R&D programs. The decrease in the 2018 period as compared to the 2017 period was mainly due to lower consulting fees associated with clinical, clinical costs and other R&D programs.
We manage the development of XIAFLEX for uterine fibroids and initiate the development of XIAFLEX in new potential indications, not licensed by Endo. On April 18, 2017, October 31, 2018, we announced the initiation of an open-label, dose escalationpositive topline data from our Phase 1 clinical trial of XIAFLEXCCH for the treatment of uterine fibroids.
We have finished the development work on human lipomas.On July 29, 2016, Endo exercised its opt-in right under the license agreement with respect to the human lipoma indication.
The following table summarizes our R&D expenses related to our development programs:
| | | Three Months Ended September 30, 2018 | | | Three Months Ended September 30, 2017 | |
Program | | | | | | |
| Uterine Fibroids | | $ | 82,716 | | | $ | 129,276 | |
| Pre-clinical/other research projects | | | 79,909 | | | | 227,571 | |
| | | Three Months Ended September 30, 2017 | | | Three Months Ended September 30, 2016 | |
Program | | | | | | |
| Human Lipoma | | $ | - | | | $ | 100,973 | |
| Uterine Fibroids | | | 129,276 | | | | 18,762 | |
| Pre-clinical/other research projects | | | 227,571 | | | | 193,172 | |
The successful development of drugs is inherently difficult and uncertain. Our business requires investments in R&D over many years, often for drug candidates that may fail during the R&D process. Even if the Company is able to successfully complete the development of our drug candidates, our long-term prospects depend upon our ability and the ability of our partners, particularly with respect to XIAFLEX and Xiapex, to continue to commercialize these drug candidates.
There is significant uncertainty regarding our ability to successfully develop drug candidates in other indications. These risks include the uncertainty of:
| · | the nature, timing and estimated costs of the efforts necessary to complete the development of our drug candidate projects; |
| · | the anticipated completion dates for our drug candidate projects; |