MBRK Middlebrook Pharmaceuticals (MM)

 

SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

 

Form 10-Q

 

 

Commission File Number: 000-50414

 

 

(301) 944-6600

(Registrant’s telephone number, including area code)

None

(Former name, former address and former

fiscal year — if changed since last report)

 

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes  þ      No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer (as defined in Exchange Act Rule 12b-2). (Check one).

Large Accelerated Filer  o      Accelerated Filer  o      Non-accelerated Filer  þ

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o      No  þ

 

As of November 7, 2007, 46,728,748 shares of common stock of the Registrant were outstanding.

 

 

MIDDLEBROOK PHARMACEUTICALS, INC

 

INDEX

 

FORM 10-Q

 

 

PART I — FINANCIAL INFORMATION

 

 

The accompanying notes are an integral part of these financial statements.

 

 

The accompanying notes are an integral part of these financial statements.

 

The accompanying notes are an integral part of these financial statements.

MIDDLEBROOK PHARMACEUTICALS, INC.

 

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

commercialization efforts, effect changes to its facilities or personnel, or, if possible, enter into arrangements to raise additional capital which may dilute the ownership of its equity investors.

 

 

Use of Estimates

 

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

 

Revenue Recognition

 

Product sales revenue , net of estimated provisions, is recognized when persuasive evidence that an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collectibility is reasonably assured. Provisions for sales discounts, and estimates for chargebacks, rebates, and product returns are established as a reduction of product sales revenue at the time revenues are recognized, based on historical experience adjusted to reflect known changes in the factors that impact these reserves. These factors include current contract prices and terms, estimated wholesaler inventory levels, remaining shelf life of product, and historical information for similar products in the same distribution channel.

 

Deferred product revenue represents goods shipped under guaranteed sales arrangements in connection with initial stocking for a new product launch or other product sale arrangements containing terms that may differ significantly from the Company’s customary terms and conditions. For such arrangements, the risk of loss has not passed to the customer and, accordingly, products delivered under guaranteed sales arrangements or certain incentive terms are accounted for as consignment sales. The Company recognizes revenue when the product is sold by its customer or at the expiration of the consignment period if the product has not been returned.

 

Contract revenues include license fees and milestone payments associated with collaborations with third parties. Revenue from non-refundable, upfront license fees where the Company has continuing involvement is recognized ratably over the development or agreement period.

 

Deferred contract revenue represents cash received in excess of revenue recognized.

 

Research and Development

 

The Company expenses research and development costs as incurred. Research and development costs primarily consist of salaries and related expenses for personnel, fees paid to consultants and outside service providers, including clinical research organizations for the conduct of clinical trials, costs of materials used in clinical trials and research and development, development costs for contract manufacturing prior to FDA approval of products, depreciation of capital resources used to develop products, and costs of facilities.

 

Cash and Cash Equivalents

 

Cash equivalents are highly liquid investments with a maturity of three months or less at date of purchase and consist of time deposits, investments in money market funds with commercial banks and financial institutions, commercial paper and high-quality corporate bonds. At September 30, 2007 and December 31, 2006, the Company maintained all of its cash and cash equivalents in three financial institutions. Deposits held with banks may exceed the amount of insurance provided on such deposits. Generally, these deposits may be redeemed upon demand, and the Company believes there is minimal risk of losses on such cash balances.

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

Marketable Securities

 

The Company classifies all of its marketable securities as available-for-sale. Available-for-sale securities are carried at fair value, with the unrealized gains and losses reported as a component of stockholders’ equity in accumulated other comprehensive income or loss. Marketable securities available for current operations are classified in the balance sheet as current assets; marketable securities held for long-term purposes are classified as noncurrent assets. Interest income, net of amortization of premium on marketable securities, and realized gains and losses on securities are included in “Interest income” in the statements of operations.

 

Fair Value of Financial Instruments

 

The carrying amounts of the Company’s financial instruments, which include cash and cash equivalents, marketable securities, notes payable and line of credit borrowings, approximate their fair values due to their short maturities.

 

Accounts Receivable

 

Accounts receivable represent amounts due from wholesalers for sales of pharmaceutical products. Allowances for estimated product discounts and chargebacks are recorded as reductions to gross accounts receivable. Amounts due for returns and estimated rebates payable to third parties are included in accrued liabilities.

 

Inventories

 

Inventories consist of finished products purchased from third-party contract manufacturers and are stated at the lower of cost or market. Cost is determined on the first-in, first-out (FIFO) method. Reserves for obsolete or slow-moving inventory are recorded as reductions to inventory cost. The Company periodically reviews its product inventories on hand. Inventory levels are evaluated by management relative to product demand, remaining shelf life, future marketing plans and other factors, and reserves for obsolete and slow-moving inventories are recorded for amounts which may not be realizable. In November 2007, the Company sold all of its inventories to Deerfield Management, as discussed further in Notes 6 and 17; the Company retained the right to repurchase the inventories held by Deerfield at a future date, as well as to acquire the inventories as needed in order to operate its Keflex business.

 

Intangible Assets

 

Identifiable intangible assets with definite lives are amortized on a straight-line basis over their estimated useful lives. The Keflex brand rights are amortized over 10 years, the Keflex non-compete agreement with Eli Lilly and Company is amortized over five years, and certain acquired patents are amortized over 10 years. The Company does not have identifiable intangible assets with indefinite lives. The Keflex brand name and other intangible assets were acquired for marketing purposes, and the related amortization is charged to selling expense. In November 2007, the Company sold its Keflex brand rights to Deerfield Management, as discussed further in Notes 8 and 17; the Company retained the right to repurchase at a predetermined price the intangible assets sold at a future date, as well as to continue to utilize the Keflex trademark and other intangible assets in order to continue to operate its Keflex business.

 

Patents are carried at cost less accumulated amortization which is calculated on a straight-line basis over the estimated useful lives of the patents. The Company periodically reviews the carrying value of patents to determine whether the carrying amount of the patent is recoverable. For the years ended December 31, 2006, 2005 and 2004, there were no adjustments to the carrying values of patents. The Company is amortizing the cost of the patent applications over a period of 10 years.

 

Impairment of Long-Lived Assets

 

SFAS No. 144, “Accounting for the Impairment or Disposal of Long-Lived Assets,” establishes accounting standards for the impairment of long-lived assets. The Company reviews its long-lived assets, including property

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

and equipment and intangible assets, for impairment whenever events or circumstances indicate that the carrying amount of an asset may not be recoverable. If this review indicates that the asset will not be recoverable based on the expected undiscounted net cash flows of the related asset, an impairment loss is recognized. There were no indications of impairment through September 30, 2007, and consequently there were no impairment losses recognized in 2007, or prior years. If the Company is not able to obtain approval for its New Drug Application for its Amoxicillin PULSYS product or carry out its business plans, there is the potential that this will be an indicator of an event or change in circumstances under SFAS 144 that would require the Company to perform an impairment analysis, and ultimately may result in impairment of the long-lived assets. As discussed in Note 17, “Subsequent Events” , in November 2007 the Company sold certain assets, including its Keflex brand, to Deerfield Management. As the Keflex assets were not impaired as of September 30, 2007, the recognition of a loss, if any, on the transaction will be recorded in November 2007, when the transaction closed.

 

Leases

 

The Company leases its office and laboratory facilities under operating leases. Lease agreements may contain provisions for rent holidays, rent escalation clauses or scheduled rent increases, and landlord lease concessions such as tenant improvement allowances. The effects of rent holidays and scheduled rent increases in an operating lease are recognized over the term of the lease, including the rent holiday period, so that rent expense is recognized on a straight-line basis. For lease concessions such as tenant improvement allowances, the Company records a deferred rent liability included in “Deferred rent and credit on lease concession” on the balance sheet and amortizes the deferred liability on a straight-line basis as a reduction to rent expense over the term of the lease. The tenant improvements are capitalized as leasehold improvements and are amortized over the shorter of the economic life of the improvement or the lease term (excluding optional renewal periods). Amortization of leasehold improvements is included in depreciation expense. The Company’s leases do not include contingent rent provisions. For leased facilities where the company has ceased use for a portion or all of the space, the Company accrues a loss if the cost of the leased space is in excess of market rates for potential sublease income. In the three months ended September 30, 2007 the Company accrued a loss of $392,000 for excess leased facility space.

 

Earnings Per Share

 

Basic earnings per share is computed based on the weighted average number of common shares outstanding during the period. Diluted earnings per share is computed based on the weighted average shares outstanding adjusted for all dilutive potential common shares. The dilutive impact, if any, of potential common shares outstanding during the period, including outstanding stock options, is measured by the treasury stock method. Potential common shares are not included in the computation of diluted earnings per share if they are antidilutive. The Company incurred net losses for the three and nine months ended September 30, 2007 and 2006, and accordingly, did not assume exercise of any of the Company’s outstanding stock options, because to do so would be antidilutive.

 

The following are the securities that could potentially dilute basic earnings per share in the future that were not included in the computation of diluted earnings per share because to do so would have been antidilutive for the periods presented:

 

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

Recent Accounting Pronouncements

 

In July 2006, the Financial Accounting Standards Board (“FASB”) issued FASB Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes.” The interpretation clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109, “Accounting for Income Taxes.” It prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. Accordingly, the Company adopted FIN 48 effective January 1, 2007. The adoption of FIN 48 had no effect on the Company’s financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (SFAS 157), which provides guidance for how companies should measure fair value when required to use a fair value measurement for recognition or disclosure purposes under generally accepted accounting principle (GAAP). SFAS 157 is effective for fiscal years beginning after November 15, 2007. The Company is currently assessing the impact, if any, the adoption of SFAS 157 will have on its financial statements.

 

In December 2006, FASB Staff Position No. EITF 00-19-2, “Accounting for Registration Payment Arrangements,” was issued. The FSP specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, “Accounting for Contingencies.” The Company believes that its current accounting is consistent with the FSP. Accordingly, adoption of the FSP had no effect on the Company’s financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115,” under which entities will now be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. The Company is currently assessing the impact, if any, the adoption of SFAS 159 will have on its financial statements.

 

 

The Company records revenue from sales of pharmaceutical products under the Keflex brand. The Company’s largest customers are large wholesalers of pharmaceutical products. Three of these large wholesalers accounted for approximately 46.0%, 37.3%, and 10.8% of the Company’s net revenues from product sales in the nine month period ended September 30, 2007.

 

Due to the Company’s corporate name change on June 28, 2007, inventories of products on hand at that time were required to be relabeled. While the relabeling process was underway in July and August 2007, the Company was unable to fill customer orders. In order to minimize the costs of relabeling as well as to avoid stock-out situations at wholesalers while the relabeling process is underway, the Company offered at the end of the second quarter a one-time incentive to wholesalers to purchase up to a two-month supply of Keflex products. This incentive offer resulted in orders of approximately $1.8 million of net sales. Revenue recognition for this transaction was deferred in the second quarter of 2007, but recognized in the third quarter of 2007, as wholesalers sold the related product and commenced ordering the newly-relabeled products. As a result, net revenue recognized in the third quarter of 2007 of $3.1 million consists of the recognition of $1.8 million of revenue deferred from June 30, 2007 together with the recognition of $1.1 million of revenue from sales of products shipped during the third quarter of 2007 and the recognition of deferred revenue of $0.2 million related to the expiration of return rights granted to certain customers at the time of the Keflex 750 launch in 2006.

 

 

 

Each of the Company’s marketable securities at September 30, 2007 and December 31, 2006 matures within six months.

 

 

Accounts receivable, net, consists of the following:

 

 

The Company’s largest customers are large wholesalers of pharmaceutical products. Three of these large wholesalers accounted for approximately 43.3%, 40.3%, and 11.2% of the Company’s accounts receivable for product sales as of September 30, 2007.

 

 

Inventories, net, consist of the following:

 

 

The Company periodically reviews its product inventories on hand. Inventory levels are evaluated by management relative to product demand, remaining shelf life, future marketing plans and other factors, and reserves for obsolete and slow-moving inventories are recorded for amounts which may not be realizable. The reserve for obsolete and slow-moving inventory was increased at September 30, 2007 due to revised estimates of future sales of certain of the Company’s Keflex products.

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

On November 7, 2007, the Company entered into a transaction with Deerfield Management, as described further in Note 17, “Subsequent Events.” As part of the transaction, the Company sold its entire inventory of Keflex products to Deerfield. Under the transaction agreements, which include an inventory consignment agreement, the Company will continue to operate its Keflex business, and will purchase consigned inventory from Deerfield as necessary to fulfill customer orders. The Company has a repurchase right, under which it can re-acquire all the inventories from Deerfield at a future date.

 

 

Property and equipment consists of the following:

 

 

The Company ceased use of one of its facilities during the third quarter of 2007. As a result, the Company abandoned leasehold improvements it had made to the property. Accordingly, the Company revised its depreciation estimate, which resulted in accelerating the depreciation of the remaining balance of $512,000 during the third quarter, with $461,000 charged to research and development expense and $51,000 charged to selling, general and administrative expense. For the same facility, the Company also accrued a loss for the cost of the leased space in excess of potential sublease income in the amount of $392,000, with $294,000 charged to research and development expense and $98,000 charged to selling, general and administrative expense.

 

 

Intangible assets at September 30, 2007 and December 31, 2006 consist of the following:

 

 

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

Identifiable intangible assets with definite lives are amortized on a straight-line basis over their estimated useful lives. The Keflex brand rights are amortized over 10 years, the non-compete agreement with Eli Lilly and Company is amortized over 5 years, and certain acquired patents are amortized over 10 years.

 

Amortization expense for acquired intangible assets with definite lives was $289,419 and $868,257 for the three and nine month periods ended September 30, 2007 and 2006, respectively. For the year ending December 31, 2007 and for the next four years, annual amortization expense for acquired intangible assets is expected to be approximately $1.2 million per year for 2007 and 2008, and approximately $1.1 million for each of 2009, 2010 and 2011.

 

On November 7, 2007, the Company entered into a transaction with Deerfield Management, as described in Note 17, “Subsequent Event.” As part of the transaction, the Company sold its Keflex brand rights, including the trademark, and approved New Drug Applications for the Company’s existing Keflex products, to Deerfield. Under the transaction agreements, the Company retained the right to repurchase the intangible assets sold at a future date, as well as to continue to utilize the Keflex trademark and other intangible assets in order to continue to operate its Keflex business, subject to certain royalty payments to Deerfield. As the Keflex assets were not impaired as of September 30, 2007, the recognition of a loss, if any, on the transaction will be recorded in November 2007, when the transaction closed.

 

 

Accrued expenses consist of the following:

 

 

 

Advance Payment for Potential Sale of Keflex Assets

 

In August 2005, MiddleBrook entered into an agreement in principle with a private company for the potential sale of its Keflex assets, including the rights to the U.S. brand and inventories. As part of the agreement, the potential buyer made a $1,000,000 payment to MiddleBrook, which provided it with exclusive negotiating rights through December 31, 2005. The payment was recorded as an advance, since, under certain conditions, the payment could become refundable or, if the sale were to have been completed, the $1,000,000 payment would have been applied to the purchase price. The two parties did not enter into a definitive agreement for the asset sale, and in

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

January 2006, MiddleBrook decided to retain the Keflex assets. The agreement in principle expired on February 28, 2006. Accordingly, the advance payment of $1,000,000 was recognized as other income in the first quarter of 2006.

 

 

Total lines of credit and short-term debt consist of the following:

 

 

On June 30, 2006, the Company entered into a $12 million senior secured credit facility with Merrill Lynch Capital, consisting of an $8 million term loan (“Term Loan”) and a $4 million revolving loan facility (“Revolving Loan”). On November 8, 2007, the Company repaid the outstanding Merrill Lynch Capital loan balance in full, using $4.6 million of the proceeds from the transaction with Deerfield Management, as discussed further in Note 17, “Subsequent Events.”

 

The Term Loan would have matured on June 30, 2009 and was payable in 36 equal monthly payments of principal. Interest on the outstanding balance of the Term Loan was payable monthly at an annual rate equal to one-month LIBOR plus 5.0 percent, which at December 31, 2006 equaled 10.35 percent. The Company borrowed the entire Term Loan commitment of $8 million at closing on June 30, 2006, and received net proceeds of $7,792,976. From the net loan proceeds, $987,008 was used to fully repay existing bank loans. The Company incurred $207,024 in debt issuance costs, which are included as a component of Deposits and Other Assets and are being amortized using the effective interest method as additional interest expense over the expected 36 month loan term. If the Term Loan is prepaid, the Company is required to pay a prepayment fee of 2.0 percent, 1.25 percent, or 0.75 percent, if the prepayment is made within the first, second, or third years after closing (June 30, 2006), respectively. On November 8, 2007, the Company incurred a $100,000 prepayment penalty for the Term Loan.

 

The Revolving Loan commitment provided for up to $4 million in borrowing capacity with a commitment expiry date of March 30, 2010, with an interest rate equal to one-month LIBOR plus 3.75 percent per annum. Credit available under the Revolving Loan was subject to certain borrowing base conditions based on eligible accounts receivable of the Company. The Revolving Loan commitment could also be used for the issuance of letters of credit, up to an aggregate amount of $1,000,000. There were no borrowings or letters of credit outstanding under this facility at September 30, 2007. An unused line fee of 0.045 percent per month was payable on the average unused daily balance of the Revolving Loan commitment. If the Revolving Loan commitment is terminated prior to the expiration date of March 30, 2010, the Company is required to pay a deferred commitment fee of 2.0 percent, 1.25 percent, 0.75 percent, or 0.25 percent of the Revolving Loan commitment amount if the termination is made within the first, second, third or fourth years after closing (June 30, 2006), respectively. On November 8, 2007, the Company paid a deferred commitment fee of $50,000 upon the termination of the credit facility.

 

Pursuant to the credit and security agreement, the Company granted a security interest in substantially all of its assets existing at the date of closing as well as those acquired during the term of the agreement, to Merrill Lynch Capital, excluding intellectual property, which is subject to a negative pledge under which the Company has agreed not to grant a security interest in its intellectual property, as defined, without the consent of Merrill Lynch Capital. The agreement did not require the issuance of stock warrants or other equity types of securities.

 

The agreement restricted the Company’s ability to incur additional debt, pay dividends, repurchase stock, or engage in specified other transactions outside the normal course of business, as long as borrowings are outstanding under the agreement. The credit and security agreement also required the Company to be in compliance with certain financial covenants, including achievement of a minimum quarterly amount of revenue and maintenance of a minimum liquidity level (cash and marketable securities of $5,000,000). The agreement had been previously amended to remove the revenue covenant for quarters ended December 31, 2006, March 31 and June 30 2007, and

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

on August 14, 2007 agreement was reached to remove the covenant for the quarter ended September 30, 2007. Beginning with the quarter ending December 31, 2007 and continuing thereafter, the financial covenant for minimum quarterly revenue was to be $5,000,000, an amount which significantly exceeded quarterly revenue recorded by the Company in prior periods and which would require the successful commercialization and increased market acceptance of the Company’s Keflex 750 mg product. If the agreement was not amended to remove the financial covenant for revenue / invoiced products for the quarter ending December 31, 2007, and if revenues for the quarter were less than $5,000,000, the lender could have required, among other remedies, the immediate payment of the principal balance, which could have adversely affected the Company’s liquidity and ability to continue as a going concern.

 

Montgomery County Note Payable

 

In December 2001, the Company entered into an Economic Development Fund Agreement with Montgomery County, Maryland. The primary purpose of the Economic Development Fund is to assist private employers who are located, planning to locate or substantially expand operations in Montgomery County. In September 2002, the Company received a $75,000 loan from the County. According to the agreement, the County would permanently forgive part or all of the $75,000 loan principal balance together with the accrued interest if certain conditions relating to employment levels and capital investment are met. During the first quarter of 2007, the Company received notice from Montgomery County that it had met the conditions required for the debt to be forgiven, and accordingly the full amount was recognized as Other Income.

 

 

In April 2007, the Company closed a private placement of 10,155,000 shares of its common stock and warrants to purchase 7,616,250 shares common stock, at a price of $2.36375 per unit. Each unit consists of one share of the Company’s common stock and a warrant to purchase 0.75 shares of common stock. The warrants have a five-year term and an exercise price of $2.27 per share. The transaction raised approximately $24.0 million in gross proceeds. Net proceeds to the Company after deducting commissions and expenses were approximately $22.4 million. Pursuant to the terms of the registration rights agreement, the Company filed with the SEC a registration statement covering the resale of common stock. The registration rights agreement provides that if the initial registration statement is not effective within 120 days of closing, or if the Company does not subsequently maintain the effectiveness of the initial registration statement or any additional registration statements, then in addition to any other rights the investor may have, the Company will be required to pay the investor liquidated damages, in cash, equal to one percent per month of the aggregate purchase price paid by such investor. Maximum aggregate liquidated damages payable to an investor are 20% of the aggregate amount paid by the investor. The SEC declared the Company’s Form S-3 effective on May 23, 2007, which was within 120 days of closing.

 

 

The Company currently grants stock options under the Stock Incentive Plan (the “Plan”). The number of shares available for issuance under the Plan is 9,348,182.

 

Options granted under the Plan may be incentive stock options or non-statutory stock options. Stock purchase rights may also be granted under the Plan. Incentive stock options may only be granted to employees. The compensation committee of the Board of Directors determines the period over which options become exercisable. Options granted to employees and consultants normally vest over a 4-year period. Options granted to directors, upon their initial appointment or election, vest monthly over periods of 36 months. Annual director and advisor grants vest monthly over 12 months. Director and advisor grants are exercisable on the date of grant but are restricted, subject to repurchase until vested. The exercise price of incentive stock options and non-statutory stock options shall be no less than 100% of the fair market value per share of the Company’s common stock on the grant date. The term of all option grants is 10 years. As of September 30, 2007, there were 2,391,947 shares of common stock available for future option grants.

 

 

The total intrinsic value of options exercised during the nine months ended September 30, 2007 was $272,063. Cash received by the Company upon the issuance of shares from option exercises was $115,206. The Company’s policy is to issue new shares of common stock to satisfy stock option exercises.

 

A summary of the Company’s nonvested options as of and for the nine months ended September 30, 2007 is presented below:

 

 

 

The Company has recorded stock-based compensation expense for the grant of stock options to employees and to nonemployee consultants as follows:

 

 

 

 

Nonemployees.   The Company has recorded stock-based compensation expense for options granted to nonemployees, including consultants, Scientific Advisory Board (SAB) members and contracted sales representatives based on the fair value of the equity instruments issued. Stock-based compensation for options granted to non employees is periodically remeasured as the underlying options vest in accordance with Emerging Issues Task Force Issue No. 96-18 , “Accounting for Equity Instruments that are Issued to Other Than Employees for Acquiring, or in Conjunction with Selling, Goods or Services.” The Company recognizes an expense for such options throughout the performance period as the services are provided by the nonemployees, based on the fair value of the options at each reporting period. The options are valued using the Black-Scholes option pricing model. For graded-vesting options, a final measurement date occurs as each tranche vests.

 

 

During 2003, the Company adopted an employee stock purchase plan which provides for the issuance of up to 100,000 shares of common stock. This plan, which is intended to qualify under Section 423 of the Internal Revenue Code, provides the Company’s employees with an opportunity to purchase shares of its common stock through payroll deductions. Options to purchase the common stock may be granted to each eligible employee periodically. The purchase price of each share of common stock will not be less than the lesser of 85% of the fair market value of the common stock at the beginning or end of the option period. Participation is limited so that the right to purchase stock under the purchase plan does not accrue at a rate which exceeds $25,000 of the fair market value of our common stock in any calendar year. To date, no shares have been issued under this plan.

 

 

Effective January 1, 2007, the Company adopted the provisions of Financial Accounting Standards Board Interpretation No. 48, “Accounting for Uncertainty in Income Taxes,” (FIN 48). FIN 48 clarifies the criteria that an individual tax position must satisfy for some or all of the tax benefits of that position to be recognized in a company’s financial statements. FIN 48 prescribes a recognition threshold and a measurement attribute for all tax positions taken or expected to be taken on a tax return, in order for those tax positions to be recognized in the financial statements. The implementation of FIN 48 had no impact on the Company’s financial statements, as the Company has no unrecognized tax benefits.

 

The Company is primarily subject to U.S federal and Maryland state corporate income tax. All tax years from the Company’s inception in 2000 remain open to examination by U.S. federal and state authorities.

 

The Company’s policy is to recognize interest related to income tax matters, if any, in interest expense and penalties related to income tax matters, if any, in operating expenses. As of January 1 and September 30, 2007, the Company had no accruals for interest or penalties related to income tax matters.

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

 

Leases

 

The Company ceased the use of one of its leased facilities during the third quarter of 2007. For leased facilities where the company has ceased use for a portion or all of the space, the Company accrues a loss if the cost of the leased space is in excess of market rates for potential sublease income. In the three months ended September 30, 2007, the Company accrued a loss for the cost of the leased space in excess of potential sublease income in the amount of $392,000, with $294,000 charged to research and development expense and $98,000 charged to selling, general and administrative expense.

 

Royalties

 

On November 7, 2007, the Company closed an agreement with Deerfield Management, a healthcare investment fund and one of the Company’s largest equity shareholders. The Company sold certain assets, and assigned certain intellectual property rights, relating only to its existing cephalexin business, excluding cephalexin PULSYS, to Deerfield for $7.5 million (less a $500,000 payment to Deerfield). Pursuant to an inventory consignment agreement and license of those intellectual property rights back to the Company, the Company will continue to operate its existing cephalexin business, subject to consignment and royalty payments to Deerfield of 20% of net sales, which decline to 15% should the Company elect to make an extension payment, as defined in the agreement. Regardless of the level of net sales, the minimum consignment and royalty payment under the consignment and license agreements will be $400,000 for each calendar quarter.

 

Legal Proceedings

 

In December 2003, Aventis and Aventis Pharmaceuticals Inc., now part of sanofi-aventis, brought an action against MiddleBrook Pharmaceuticals, Inc., then named Advancis Pharmaceutical Corp, alleging, in essence, that the Advancis corporate name was infringing the plaintiff’s trademark and sought injunctive relief. A trial was held in May 2005, and the Court’s decision, dated September 26, 2006, ruled in favor of sanofi-aventis. On June 28, 2007 the name change was completed pursuant to the Company’s jointly submitted Permanent Injunction and Order with sanofi-aventis of October 27, 2006, whereby the Company agreed to cease using the Advancis name by June 30, 2007.

 

No monetary damages were associated with the decision, and the Company agreed to cease using the Advancis name by June 30, 2007. The Company implemented the name change on June 28, 2007, and there was no significant financial impact resulting from the change.

 

In August 2007, Eli Lilly and Company provided notice of a legal matter relating to Keflex to MiddleBrook. A product liability claim was filed by Jamie Kaye Moore against Eli Lilly, Teva Pharmaceuticals, Inc. and Teva Pharmaceuticals Industries Ltd. on March 28, 2007. The claim alleges injury from ingestion of some form of “Keflex.” Lilly has filed preliminary objections to the complaint, and has also requested prescription and other records, in order to determine whether the plaintiff ingested brand or generic cephalexin and which manufacturer might be involved. Since the identity of the manufacturer is not known, Lilly is not currently requesting indemnification from MiddleBrook.

 

 

On November 7, 2007, the Company closed an agreement with Deerfield Management, a healthcare investment fund and one of the Company’s largest equity shareholders, raising up to $10 million in cash. Under the terms of the agreement, $7.5 million (less a $500,000 payment to Deerfield) was received by the Company on November 8, 2007, with an additional $2.5 million to become available, if necessary, if and when the U.S. Food and Drug Administration (FDA) approves the Company’s Amoxicillin PULSYS New Drug Application (NDA). The agreement is designed to provide the Company with the financial flexibility to continue its ongoing strategic discussions beyond the PDUFA date for Amoxicillin PULSYS. Proceeds from the closing of $4.6 million were used by the Company to repay in full its outstanding loan facility with Merrill Lynch Capital.

 

MIDDLEBROOK PHARMACEUTICALS, INC.

 

NOTES TO CONDENSED FINANCIAL STATEMENTS — (Continued)

 

At the transaction closing, the Company sold certain assets, and assigned certain intellectual property rights, relating only to its existing cephalexin business, excluding cephalexin PULSYS, to Deerfield for $7.5 million (less a $500,000 payment to Deerfield). A portion of those proceeds was used to repay the outstanding Merrill Lynch Capital loan balance in full, and the remainder is intended to be used for general corporate purposes. Pursuant to a consignment of those assets and license of those intellectual property rights back to the Company, the Company will continue to operate its existing cephalexin business, subject to consignment and royalty payments to Deerfield of 20% of net sales, which decline to 15% should the Company elect to make an extension payment, as defined in the agreement. In addition, the Company granted to Deerfield a six-year warrant to purchase 3.0 million shares of the Company’s common stock at $1.38 , the closing market price on November 7, 2007.

 

If and when the Company receives approval of its Amoxicillin PULSYS NDA, it may require Deerfield to acquire and license certain intellectual property rights relating only to the Company’s cephalexin PULSYS business for a payment of $2.5 million. Pursuant to a sublicense of those intellectual property rights back to the Company, the Company will continue to operate its cephalexin PULSYS business. Cephalexin PULSYS is not approved for marketing by the FDA.

 

Deerfield also granted the Company the right to repurchase all assets and rights acquired and licensed by Deerfield for a flat purchase price of $14.0 million, if the Company has required Deerfield to acquire the intellectual property rights relating to the Company’s cephalexin PULSYS business, or $11.0 million if Deerfield has not acquired these rights (in each case subject to certain adjustments), assuming the Company exercises its repurchase rights prior to November 7, 2008. Those repurchase prices will increase by $2.0 million on each subsequent anniversary of that date. The Company’s exercise of this purchase right is mandatory upon the change of control of the Company.

 

The accounting for the Deerfield transaction is currently being evaluated.

 

 

The following discussion of our financial condition and results of operations should be read in conjunction with the condensed financial statements and the related notes included elsewhere in this Form 10-Q and the financial statements and related notes and Management’s Discussion and Analysis of Financial Condition and Results of Operations included in our 2006 Annual Report on Form 10-K. This discussion contains forward-looking statements, the accuracy of which involve risks and uncertainties. Our actual results could differ materially from those anticipated in the forward-looking statements for many reasons including, but not limited to, those discussed herein and in our 2006 Annual Report. See “Forward-looking Statements.”

 

Our Business

 

MiddleBrook Pharmaceuticals, Inc. was incorporated in Delaware in December 1999 and commenced operations on January 1, 2000. On June 28, 2007, we changed our corporate name from Advancis Pharmaceutical Corporation to MiddleBrook Pharmaceuticals, Inc. We are a pharmaceutical company focused on developing and commercializing anti-infective drug products that fulfill unmet medical needs in the treatment of infectious disease. We are developing a portfolio of drugs based on the novel biological finding that bacteria exposed to antibiotics in front-loaded, sequential bursts, or pulses, are killed more efficiently than those exposed to standard antibiotic treatment regimens. We currently have 26 issued U.S. patents and two issued foreign patent covering our proprietary once-a-day pulsatile delivery technology called PULSYS. We have initially focused on developing PULSYS product candidates utilizing approved and marketed drugs that no longer have patent protection or that have patents expiring in the next several years. Our lead pulsatile product candidate, based on the antibiotic amoxicillin, is currently under FDA review for marketing approval, and our Keflex PULSYS product candidate, based on the antibiotic cephalexin, is currently under evaluation in Phase I clinical trials. Our New Drug Application (NDA) for our Amoxicillin PULSYS product for adults and adolescents with pharyngitis and/or tonsillitis was accepted for filing by the U.S. Food and Drug Administration (FDA) on May 22, 2007, and we were given a FDA target action date of January 23, 2008. We also have a number of additional pulsatile product candidates in preclinical development, although further development of these candidates will only occur if we secure additional capital resources. We acquired the U.S. rights to Keflex (cephalexin) from Eli Lilly in 2004. We currently sell our line of Keflex products to wholesalers in capsule form, and have received FDA approval for two additional Keflex strengths — 333 mg capsules and 750 mg capsules. We have focused our commercialization initiatives solely on the Keflex 750 mg capsules. In support of the launch of the Keflex 750 mg capsules in 2006, and in anticipation of our first potential pulsatile product, Amoxicillin PULSYS, we entered into an agreement with a contract sales organization and currently deploy approximately 30 contract sales representatives across the United States. We have also entered into agreements with third-party contract manufacturers for the commercial supply of our products. In March 2007, we announced that we are evaluating various strategic alternatives to further enhance shareholder value and have retained an investment banking firm to assist us in this regard. Strategic alternatives we may pursue could include, but are not limited to, continued execution of our operating plan, licensing or development arrangements, the sale of some or all of our company’s assets, partnering or other collaboration agreements, or a merger or other strategic transaction. In November 2007, the Company sold certain assets related to its Keflex business to Deerfield Management, but retained the rights to continue to operate the Keflex business as well as to repurchase those assets at a future date.

 

General

 

Our future operating results will depend largely on our ability to successfully gain approval and commercialize our lead product, Amoxicillin PULSYS, successfully commercialize our launched Keflex 750 mg product, and the progress of other product candidates currently in our research and development pipeline. The results of our operations will vary significantly from year to year and quarter to quarter and depend on a number of factors, including risks related to our business, risks related to our industry, and other risks which are detailed in our 2006 Annual Report on Form 10-K.

 

Management Overview of the Third Quarter of 2007

 

The following is a summary of key events that occurred during and subsequent to the third quarter of 2007.

Amoxicillin PULSYS product development

 

 

Marketed Products — Keflex Capsules (Cephalexin USP)

 

 

Investment Bank Retained to Explore Strategic Alternatives

 

 

Cost Reduction Initiatives for 2007

 

 

Agreement For the Sale and Repurchase Rights to Our Cephalexin Assets

 

 

Focus for Remainder of 2007 and Early 2008

 

Our primary focus for the remainder of 2007 and into early 2008 will be on the regulatory approval process for our Amoxicillin PULSYS product candidate for adults and adolescents, along with the continued commercialization of our Keflex 750 mg capsules. Our NDA supporting Amoxicillin PULSYS was accepted for filing by the FDA on May 22, 2007, and we expect to receive a decision on the filing from the FDA in January 2008. We intend to continue promoting Keflex 750 mg capsules through our approximately 30 contract sales representatives and three MiddleBrook district sales managers to targeted U.S. physicians throughout the remainder of 2007. In order to minimize our financing requirements in 2007, we have continued our program of cost reductions including personnel reductions, postponement of PULSYS clinical development programs other than Amoxicillin PULSYS for adults, and the elimination of other discretionary spending.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses, fair valuation of stock related to stock-based compensation and income taxes. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

 

Revenue Recognition

 

We recognize revenue for the sale of pharmaceutical products and for payments received, if any, under collaboration agreements for licensing, milestones, and reimbursement of development costs as follows:

 

Product Sales.   Revenue from product sales, net of estimated provisions, is recognized when there is persuasive evidence that an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collectibility is reasonably probable. Our customers consist primarily of large pharmaceutical wholesalers who sell directly into the retail channel. Provisions for sales discounts, and estimates for chargebacks, rebates, and product returns are established as a reduction of product sales revenue at the time revenues are recognized, based on historical experience adjusted to reflect known changes in the factors that impact these reserves. Factors include current contract prices and terms, estimated wholesaler inventory levels, remaining shelf life of product, and historical information for similar products in the same distribution channel. These revenue reductions are generally reflected either as a direct reduction to accounts receivable through an allowance, or as an addition to accrued expenses if the payment is due to a party other than the wholesaler.

 

Chargebacks and rebates.   We record chargebacks and rebates based on the difference between the prices at which we sell our products to wholesalers and the sales price ultimately paid under fixed price contracts by third party payers, including governmental agencies. We record an estimate at the time of sale to the wholesaler of the amount to be charged back to us or rebated to the end user. We have recorded reserves for chargebacks and rebates based upon various factors, including current contract prices, historical trends, and our future expectations. The amount of actual chargebacks and rebates claimed could be either higher or lower than the amounts we accrued. Changes in our estimates would be recorded in the income statement in the period of the change.

Product returns.   In the pharmaceutical industry, customers are normally granted the right to return product for a refund if the product has not been used prior to its expiration date, which for our Keflex product is typically three years from the date of manufacture (two years, in the case of oral suspension products). Our return policy typically allows product returns for products within an eighteen-month window from six months prior to the expiration date and up to twelve months after the expiration date. We estimate the level of sales which will ultimately be returned pursuant to our return policy, and record a related reserve at the time of sale. These amounts are deducted from our gross sales to determine our net revenues. Our estimates take into consideration historical returns of our products and our future expectations. We periodically review the reserves established for returns and adjust them based on actual experience. The amount of actual product returns could be either higher or lower than the amounts we accrued. Changes in our estimates would be recorded in the income statement in the period of the change. If we over or under estimate the quantity of product which will ultimately be returned, there may be a material impact to our financial statements.

 

Inventories

 

Inventory is stated at the lower of cost or market with cost determined under the first-in, first-out method. Inventory consists of Keflex finished capsules and finished oral suspension powder. We purchase our Keflex products from third-party manufacturers only at the completion of the manufacturing process, and accordingly have no raw material or work-in-process inventories. At least on a quarterly basis, we review our inventory levels and write down inventory that has become obsolete or has a cost basis in excess of its expected net realizable value or is in excess of expected requirements. Inventory levels are evaluated by management relative to product demand, remaining shelf life, future marketing plans and other factors, and reserves for obsolete and slow-moving inventories are recorded for amounts which may not be realizable.

 

Intangible Assets

 

Acquired Intangible Assets.   We acquired the U.S. rights to the Keflex brand of cephalexin in 2004. We may acquire additional pharmaceutical products in the future that include license agreements, product rights and other identifiable intangible assets. When intangible assets are acquired, we review and identify the individual intangible assets acquired and record them based on relative fair values. Each identifiable intangible asset is then reviewed to determine if it has a definite life or indefinite life, and definite-lived intangible assets are amortized over their estimated useful lives.

 

Impairment.   We assess the impairment of identifiable intangible assets on an annual basis or when events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include significant underperformance compared to historical or projected future operating results, significant changes in our use of the acquired assets or the strategy for our overall business, or significant negative industry or economic trends. If we determine that the carrying value of intangible assets may not be recoverable based upon the existence of one or more of these factors, we first perform an assessment of the asset’s recoverability based on expected undiscounted future net cash flow, and if the amount is less than the asset’s value, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.

 

Accrued Expenses

 

As part of the process of preparing financial statements, we are required to estimate accrued expenses for services performed and liabilities incurred. This process involves identifying services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for such service as of each balance sheet date in our financial statements. Examples of estimated accrued expenses for services include professional service fees, such as lawyers and accountants, contract service fees, such as amounts paid to clinical monitors, data management organizations and investigators in conjunction with clinical trials, fees paid to our contract sales organization, and fees paid to contract manufacturers in conjunction with the production of clinical materials. In connection with such service fees, our estimates are most affected by our understanding of the status and timing of services provided relative to the actual levels of services incurred by such service providers. The majority of our service providers invoice us monthly in arrears for services performed. In the event that we do not identify certain costs that have begun to be incurred or we under- or over-estimate the level of services performed or

the costs of such services, our reported expenses for such period would be too low or too high. The date on which certain services commence, the level of services performed on or before a given date and the cost of such services are often judgmental. We make these judgments based upon the facts and circumstances known to us in accordance with generally accepted accounting principles. We also make estimates for other liabilities incurred, including health insurance costs for our employees. We are self-insured for claims made under our health insurance program and record an estimate at the end of a period for claims not yet reported. Our risk exposure is limited, as claims over a maximum amount are covered by an aggregate stop loss insurance policy.

 

Stock-Based Compensation

 

Effective January 1, 2006, we adopted Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (SFAS 123R). We adopted SFAS 123R using the modified prospective transition method, which requires the recognition of compensation expense under the Statement on a prospective basis only. Accordingly, prior period financial statements have not been restated. Under this transition method, stock-based compensation cost for the three month periods ended September 30, 2007 and 2006, includes (a) compensation cost for all share-based awards granted prior to, but not yet vested as of, January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of SFAS 123, and (b) compensation cost for all share-based awards granted subsequent to January 1, 2006 based on the grant-date fair value estimated in accordance with the fair value provisions of SFAS 123R.

 

SFAS 123R also requires us to estimate forfeitures in calculating the expense related to share-based compensation rather than recognizing forfeitures as a reduction in expense as they occur. To the extent actual forfeitures differ from our estimates, such amounts will be recorded as a cumulative adjustment in the period that the estimates are revised. We plan to refine our estimated forfeiture rate as we obtain more historical data.

 

We determine the value of stock option grants using the Black-Scholes option-pricing model. Our determination of fair value of share-based payment awards on the date of grant is affected by our stock price as well as assumptions regarding a number of highly complex and subjective variables. These variables include, but are not limited to, our expected stock price volatility over the term of the awards and projected employee stock option exercise behaviors. This model requires that we estimate our future expected stock price volatility as well as the period of time that we expect the share-based awards to be outstanding.

 

Income Taxes

 

As part of the process of preparing our financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. We account for income taxes by the liability method. Under this method, deferred income taxes are recognized for tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end, based on enacted laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We have not recorded any tax provision or benefit for the three and nine month periods ended September 30, 2007 or 2006. We have provided a valuation allowance for the full amount of our net deferred tax assets since realization of any future benefit from deductible temporary differences and net operating loss carry forwards cannot be sufficiently assured at December 31, 2006 and September 30, 2007.

 

Recent Accounting Pronouncements

 

In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes,” an interpretation of FASB Statement No. 109 (SFAS 109). The interpretation clarifies the accounting for uncertainty in income taxes recognized in an entity’s financial statements in accordance with SFAS 109, “Accounting for Income Taxes.” It prescribes a recognition threshold and measurement attribute for financial statement recognition and measurement of a tax position taken or expected to be taken on a tax return. FIN 48 is effective for fiscal years beginning after December 15, 2006. Accordingly, we have adopted the provisions of FIN 48 effective January 1, 2007. The adoption of FIN 48 had no effect on our financial statements.

 

In September 2006, the FASB issued SFAS No. 157, “ Fair Value Measurements” (SFAS 157), which provides guidance for how companies should measure fair value when required to use a fair value measurement for

recognition or disclosure purposes under generally accepted accounting principle (GAAP). SFAS 157 is effective for fiscal years beginning after November 15, 2007. We are currently assessing the impact, if any, the adoption of SFAS 157 will have on our financial statements.

 

In December 2006, FASB Staff Position No. EITF 00-19-2, “Accounting for Registration Payment Arrangements,” was issued. The FSP specifies that the contingent obligation to make future payments or otherwise transfer consideration under a registration payment arrangement, whether issued as a separate agreement or included as a provision of a financial instrument or other agreement, should be separately recognized and measured in accordance with SFAS No. 5, “Accounting for Contingencies.” We believe that our current accounting is consistent with the FSP. Accordingly, adoption of the FSP had no effect on our financial statements.

 

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities, Including an Amendment of FASB Statement No. 115,” under which entities will now be permitted to measure many financial instruments and certain other assets and liabilities at fair value on an instrument-by-instrument basis. This Statement is effective as of the beginning of an entity’s first fiscal year that begins after November 15, 2007. Early adoption is permitted as of the beginning of a fiscal year that begins on or before November 15, 2007, provided the entity also elects to apply the provisions of SFAS 157. We are currently assessing the impact, if any, the adoption of SFAS 159 will have on our financial statements.

 

Research and Development Expenses

 

We expect our research and development expenses to be significant as we continue to prepare for regulatory approval and subsequent launch of Amoxicillin PULSYS. These expenses consist primarily of salaries and related expenses for personnel, development costs for contract manufacturing prior to FDA approval of products, costs of materials required to validate the manufacturing process and prepare for commercial launch, depreciation of capital resources used to develop our products, and other costs of facilities. We expense research and development costs as incurred.

 

Summary of Product Development Initiatives.   The following table summarizes our product development initiatives for the three and nine month periods ended September 30, 2007 and 2006. Included in this table is the research and development expense recognized in connection with each product candidate currently in clinical development and all preclinical product candidates as a group.

 

 

 

 

Amoxicillin PULSYS

 

During the second quarter of 2007, we announced that our NDA for our Amoxicillin PULSYS product candidate for the treatment of adults and adolescents with acute pharyngitis and/or tonsillitis due to Group A streptococcal infections (commonly referred to as strep throat) was accepted for filing by the FDA. Our clinical trial, designed to support product approval for Amoxicillin PULSYS, included 620 patients in a double-blind, double-dummy, non-inferiority Phase III trial and was conducted in 50 investigator sites across the U.S. and Canada.

 

We compared our Amoxicillin PULSYS tablet for the treatment of pharyngitis/tonsillitis due to S. pyogenes (Group A streptococcus) delivered in a once-daily, 775 milligram tablet for a period of 10 days to 250 milligrams of penicillin dosed four times daily, for a total of one gram per day, for 10 days. The trial demonstrated statistical non-inferiority of Amoxicillin PULSYS therapy versus the penicillin comparator therapy for the trial’s primary endpoints of bacterial eradication rates for two distinct patient populations. The trial also demonstrated Amoxicillin PULSYS reached 85 percent bacterial eradication for the “per-protocol” group of patients, in accordance with U.S. Food and Drug Administration (FDA) guidance for product approval as first-line pharyngitis therapy.

 

Based on our successful Phase III clinical trial, we submitted a NDA for Amoxicillin PULSYS on December 14, 2006. On February 12, 2007, we received a “refusal to file” letter from the FDA for our Amoxicillin PULSYS NDA, requesting additional information on our planned commercial manufacturing processes. We conducted a meeting with the FDA regarding our Amoxicillin PULSYS NDA on February 26, 2007, where we obtained clarification on the additional information that would be required for the FDA to accept our NDA for filing. The FDA did not raise any clinical or other issues in its communication.

 

Following our clarifying meeting with the FDA, we resubmitted our revised Amoxicillin PULSYS NDA on March 23, 2007. The NDA was accepted for filing on May 22, 2007, and we received a Prescription Drug User Fee Act (PDUFA) target action date of January 23, 2008. These forward-looking statements are based on information available to us at this time. Actual results could differ because of delays in FDA approval, which may never occur

 

Keflex Brand

 

On June 30, 2004, we acquired the U.S. rights to the Keflex brand of cephalexin from Eli Lilly and Company for $11.2 million. The asset purchase includes the exclusive rights to manufacture, market and sell Keflex in the United States and Puerto Rico. We also acquired Keflex trademarks, technology and new drug applications (NDAs) supporting the approval of Keflex. In addition, we entered into a manufacturing supply agreement under which Lilly agreed to continue to manufacture and supply Keflex products for us through December 2005. In December 2004, we entered into an agreement for the future supply of Keflex with Ceph International Corporation, a subsidiary of Patheon, Inc., in Puerto Rico.

Keflex is a first-generation cephalosporin approved for treatment of several types of bacterial infections. Keflex is most commonly used in the treatment of uncomplicated skin and skin structure infections and, to a lesser extent, upper respiratory tract infections. Keflex is among the most prescribed antibiotics in the U.S.; however, generic competition is intense, and a high percentage of all Keflex prescriptions are filled by lower cost, generic versions of cephalexin, the active ingredient in Keflex. We have the exclusive U.S. rights to manufacture, sell and market Keflex pursuant to a purchase agreement with Eli Lilly and Company. We market Keflex in the U.S. to healthcare practitioners, pharmacists, pharmaceutical wholesalers and retail pharmacy chains.

 

 

 

 

In addition to assuming sales and marketing responsibilities for Keflex, we have initiated a research program with the goal of developing a once-a-day cephalexin product utilizing our proprietary once-a-day PULSYS dosing technology. In the event we are able to develop and commercialize a PULSYS-based Keflex product, another cephalexin product relying on the acquired NDAs, or other pharmaceutical products using the acquired trademarks, Eli Lilly will be entitled to royalties on these new products. Royalties are payable on a new product by new product basis for five years following the first commercial sale for each new product, up to a maximum aggregate royalty per calendar year. All royalty obligations with respect to any defined new product cease after the fifteenth anniversary of the first commercial sale of the first defined new product.

 

In May 2006, we announced that the U.S. Food and Drug Administration (FDA) approved our supplemental NDA for two new Keflex strengths — 333 mg capsules and 750 mg capsules. Following FDA approval, we commenced commercialization initiatives focused solely on the Keflex 750 mg capsules through a targeted and dedicated national contract sales force directed by MiddleBrook district sales managers.

 

Along with our contract sales organization, Innovex, the commercialization division of Quintiles Transnational Corp., we completed extensive sales representative training in July 2006. We shipped Keflex 750 mg capsules to pharmacies nationwide, and contract sales representatives began directly promoting Keflex 750 mg capsules to targeted physicians as well as providing patient starter samples in late July 2006.

 

Based on prescription data from IMS Health, total prescriptions filled for Keflex 750 mg capsules in the third quarter of 2007 were 83,767 prescriptions, compared to second quarter 2007 total prescriptions of 82,621.

 

At the end of the first quarter of 2007, we began the process of streamlining our contract sales organization, allocating our sales resources to what we believe are more productive areas and eliminating some underperforming territories. This initiative has reduced our sales force from 75 to approximately 30 contract sales representatives and from eight to three the number of MiddleBrook district sales managers directly promoting Keflex 750 mg capsules to targeted physicians across the U.S.

 

On November 7, 2007, the Company closed an agreement with Deerfield Management, a healthcare investment fund and one of the Company’s largest equity shareholders, whereby the Company sold certain assets, and assigned certain intellectual property rights, relating only to its existing cephalexin business, excluding cephalexin PULSYS, to Deerfield for $7.5 million (less a $500,000 payment to Deerfield). Pursuant to a consignment of those assets and license of those intellectual property rights back to the Company, the Company will continue to operate its existing cephalexin business, subject to royalty payments to Deerfield of 20% of net sales, which declines to a single digit royalty as the agreement matures. In addition, the Company granted to Deerfield a six-year warrant to purchase 3.0 million shares of the Company’s common stock at $1.38 per share , the closing market price of the Company’s common stock on November 7, 2007.

If and when the Company receives approval of its Amoxicillin PULSYS NDA, it may require Deerfield to acquire and license certain intellectual property rights relating only to the Company’s cephalexin PULSYS business for a payment of $2.5 million. Pursuant to a sublicense of those intellectual property rights back to the Company, the Company will continue to operate its cephalexin PULSYS business. Cephalexin PULSYS is not approved for marketing by the FDA.

 

Deerfield also granted the Company the right to repurchase all assets and rights acquired and licensed by Deerfield for a flat purchase price of $14.0 million, if the Company has required Deerfield to acquire the intellectual property rights relating to the Company’s cephalexin PULSYS business, or $11.0 million if Deerfield has not acquired these rights (in each case subject to certain adjustments), assuming the Company exercises its repurchase rights prior to November 7, 2008. Those repurchase prices will increase by $2.0 million on each subsequent anniversary of that date. The Company’s exercise of this purchase right is mandatory upon the change of control of the Company.

 

 

Prior to the third quarter of 2006, net product sales consisted primarily of shipments of the Keflex 250 and 500 milligram strength capsules to wholesalers. In the third quarter of 2006, we launched a 750 mg strength capsule, supported by a targeted and dedicated national contract sales force managed by MiddleBrook district sales managers. Other Keflex product sales improved as compared to 2006 due to increased wholesaler orders as several key wholesalers worked through high inventory levels.

 

Net revenue recognized in the third quarter of 2007 of $3.1 million consists of the recognition of $1.8 million of revenue deferred from June 30, 2007 together with the recognition of $1.1 million of revenue from sales of products shipped during the third quarter of 2007 and the recognition of deferred revenue of $0.2 million related to the expiration of return rights granted to certain customers at the time of the Keflex 750 launch in 2006.

 

Cost of Product Sales.   Cost of product sales represents the purchase cost of the Keflex products sold, royalties on the 750 mg product, and any provisions made for inventory that is not expected to be sold prior to reaching expiration. Cost of product sales increased from $0.4 million in 2006 to $1.2 million in 2007, primarily as the result of provisions of $0.6 million made in 2007 as estimates of the future saleability of certain inventory stocks were revised. Direct cost of products sold and royalty expenses also increased as product sales were higher versus the third quarter of 2006.

 

 

Research and Development Expenses.   Research and development expenses decreased $0.2 million, or 4 percent, to $5.5 million for the three months ended September 30, 2007 from $5.7 million for the three months ended September 30, 2006. Research and development expenses consist of direct costs which include salaries and related costs of research and development personnel, and the costs of consultants, materials and supplies associated

with research and development projects, as well as clinical studies. Indirect research and development costs include facilities, depreciation, and other indirect overhead costs.

 

The following table discloses the components of research and development expenses reflecting our project expenses.

 

 

Direct costs for the third quarter of 2007 decreased by $1.0 million as compared to 2006. Stock-based compensation decreased by $0.4 million as expense relating to existing grants declined faster than expense added by new grants. Clinical trials expense declined by $0.2 million in the period, as 2006 included residual costs related to a Phase III clinical trial for Amoxicillin, versus no major trial activity underway in 2007. The decrease in contract R&D, consultants, materials and other costs of $0.3 million is due to declining effort relating to development of Amoxicillin PULSYS manufacturing capacity at our contract manufacturer’s facility in Clonmel, Ireland, as work at the site is nearly completed.

 

Indirect project costs increased $0.7 million, including a one-time cost of $0.4 million related to a write-down of leasehold improvements in research and development space the company is vacating as part of a consolidation of its operations, and a related charge of $0.3 million represented a potential shortfall in sublease income for the vacated space.

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses increased $0.4 million, or 7%, to $6.5 million for the three months ended September 30, 2007 from $6.1 million for the three months ended September 30, 2006.

 

 

Selling, general and administrative expenses consist of salaries and related costs for executive and other administrative personnel, selling and product distribution costs, professional fees and facility costs. Overall, costs increased $0.4 million primarily due to several components of other expenses, including patent costs of $0.2 million and a $0.1 million expense for the potential shortfall in sublease rental income for vacated space.

 

Marketing costs of $1.3 million in 2007 consist of activities in support of the continuing marketing of our Keflex 750 mg product, including journal advertising, product samples, and market research. In the third quarter of 2007, these costs included a charge of $0.3 million representing the cost of product samples that will not be distributed due to a reduction in the sales force. Contract sales expenses consist of the direct costs of sales representatives we have engaged through a third-party contract sales organization to promote the product to

physicians. In 2006, marketing and sales activity were initiated in the second quarter and were still increasing in the third quarter of 2006, versus a full quarter of activity in 2007.

 

Net Interest Income (Expense).   Net interest income in the three months ended September 30, 2007 was $11,000 lower compared to the three months ended September 30, 2006, due to lower interest income of $94,000 resulting from lower cash balances available, partly offset by reduced interest costs associated with the Merrill Lynch term debt facility of $83,000 as the loan balance is paid down.

 

 

Nine months ended September 30, 2007 compared to nine months ended September 30, 2006

 

Revenues.   We recorded revenues from Keflex product sales of $7,598,000 and $3,567,000 during the nine month periods ended September 30, 2007 and 2006, respectively.

 

 

Prior to the third quarter of 2006, net product sales consisted primarily of shipments of the Keflex 250 and 500 milligram strength capsules to wholesalers. In the third quarter of 2006, we launched a 750 mg strength capsule, supported by a targeted and dedicated national contract sales force managed by MiddleBrook district sales managers. Therefore the primary component of the increase in 750 mg sales of $3.7 million is due to the product being sold for the full 9 months of 2007 versus approximately 3 months in 2006. Other Keflex product sales improved in 2007 versus 2006 due primarily to a price increase implemented at the beginning of April.

 

Cost of Product Sales.   Cost of product sales represents the purchase cost of the Keflex products sold, royalties on the 750 mg product, and any provisions made for inventory that is not expected to be sold prior to reaching expiration. The increase in cost of product sales from $0.5 million in 2006 to $1.9 million in 2007 included $0.7 million of direct costs and royalties increases caused by increased product sales, as well as a provision of $0.6 million made in 2007 as estimates of the future saleability of certain inventory stocks were revised.

 

 

Research and Development Expenses.   Research and development expenses decreased $1.2 million, or 6.2 percent, to $18.5 million for the nine months ended September 30, 2007 from $19.7 million for the nine months ended September 30, 2006. Research and development expenses consist of direct costs which include salaries and related costs of research and development personnel, and the costs of consultants, materials and supplies associated with research and development projects, as well as clinical studies. Indirect research and development costs include facilities, depreciation, and other indirect overhead costs.

The following table discloses the components of research and development expenses reflecting our project expenses.

 

 

Direct costs for the first nine months of 2007 decreased by $1.9 million as compared to 2006. Clinical trials expense declined by $5.2 million in the period, as the first nine months of 2006 include costs incurred for a Phase III clinical trial for Amoxicillin, versus no major trial activity underway in 2007. The increase in contracted R&D, consultants, materials and other costs of $3.1 million is due to the reimbursement of costs associated with development of Amoxicillin PULSYS manufacturing capacity at our contract manufacturer’s facility in Clonmel, Ireland.

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses increased $7.5 million, or 57%, to $20.5 million for the nine months ended September 30, 2007 from $13.0 million for the nine months ended September 30, 2006.

 

 

Selling, general and administrative expenses consist of salaries and related costs for executive and other administrative personnel, selling and product distribution costs, professional fees and facility costs. Overall, costs increased $7.5 million primarily due to expenses incurred related to the Keflex 750 mg product, which was launched in July 2006.

 

Salaries, benefits and related costs increased in 2007 primarily due to the addition of sales and marketing staff in support of the Keflex 750 product launch. Stock-based compensation costs declined as expense related to older grants declines at a rate greater than the expense added for new grants.

 

Legal and consulting expense increased as the company incurred additional costs in the third quarter in support of its efforts to explore strategic alternatives.

 

Marketing costs of $4.0 million in 2007 consist of activities in support of the continuing marketing of our Keflex 750 mg product, including journal advertising, product samples, and market research. These activities were initiated in the second quarter of 2006, as compared to being incurred over the full nine month period in 2007. Contract sales expenses consist of the direct costs of sales representatives we have engaged through a third-party

contract sales organization, to promote the product to physicians. In 2006, marketing and sales activity were initiated late in the second quarter, versus a full nine months of activity in 2007.

 

Net Interest Income (Expense).   Net interest income in the nine months ended September 30, 2007 declined by $0.5 million from 2006, primarily due to interest costs associated with the Merrill Lynch term debt facility which initiated at the end of June 2006, and lower cash and marketable securities balances which reduced interest income.