SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-KSB
(Mark One)
|X| ANNUAL REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT
OF 1934 For the fiscal year ended December 31, 2004
|_| TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the transition period from ___________ to _____________
Commission file number: 000-27642
TRANSDERM LABORATORIES CORPORATION
(Name of small business issuer in its charter)
Delaware 13-3518345
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
101 Sinking Springs Lane, Emigsville, PA 17318
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(Address of principal executive offices) (Zip code)
Issuer's telephone number, including area code: 717-764-1191
Securities registered under Section 12(b) of the Exchange Act: None
Securities registered under Section 12(g) of the Exchange Act:
Common Stock, $.001 Par Value
-----------------------------
(Title of class)
Check whether the issuer (1) filed all reports required to be filed by Section
13 or 15(d) of the Exchange Act during the past 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 |X| No
Check if there is no disclosure of delinquent filers in response to Item 405 of
Regulation S-B contained in this form, and no disclosure will be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-KSB or any
amendment to this Form 10-KSB. |X|
State the issuer's revenues for its most recent fiscal year: $9,192,000
State the aggregate market value of the voting and non-voting common equity held
by non-affiliates computed by reference to the price at which the common equity
was sold, or the average bid and asked price of such common equity, as of a
specified date within the past 60 days. (See definition of affiliate in Rule
12b-2 of the Exchange Act.): Not applicable.
Indicate by check mark whether the registrant is a shell company (as defined in
Rule 12b-2 of the Exchange Act). |_| Yes |X| No
State the number of shares outstanding of each of the issuer's classes of common
equity, as of the latest practicable date: 40,000,000 as of January 5, 2007.
DOCUMENTS INCORPORATED BY REFERENCE
None.
Transitional Small Business Disclosure Format (Check one): |_| Yes |X| No
SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS..............................3
INTRODUCTORY NOTE..............................................................5
PART I.........................................................................5
ITEM 1. DESCRIPTION OF BUSINESS............................................5
ITEM 2. DESCRIPTION OF PROPERTIES.........................................34
ITEM 3. LEGAL PROCEEDINGS.................................................35
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS...............35
PART II.......................................................................35
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.........................................................35
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.............................36
ITEM 7. FINANCIAL STATEMENTS..............................................51
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON
ACCOUNTING AND FINANCIAL DISCLOSURE.............................51
ITEM 8A. CONTROLS AND PROCEDURES...........................................51
ITEM 8B. OTHER INFORMATION.................................................52
PART III......................................................................52
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL
PERSONS; COMPLIANCE WITH SECTION 16(A) OF THE
EXCHANGE ACT....................................................52
ITEM 10. EXECUTIVE COMPENSATION............................................53
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND
MANAGEMENT AND RELATED STOCKHOLDER MATTERS......................55
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS....................56
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K..................................58
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES............................63
SIGNATURES....................................................................64
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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report on Form 10-KSB for the years ended December 31, 2003
and 2004 ("Annual Report") contains forward-looking statements. We have based
these forward-looking statements on our current expectations and projections
about future events. These statements include, but are not limited to:
o statements relating to our ability to restructure our outstanding
past due liabilities;
o statements as to the development of new products and the
commercialization of products;
o statements as to the anticipated timing of clinical tests and other
business developments;
o expectations as to the adequacy of our cash balances to support our
operations for specified periods of time and as to the nature and
level of cash expenditures; and
o expectations as to the market opportunities for our products, as
well as our ability to take advantage of those opportunities.
These statements may be found in the sections of this Annual Report
entitled "Description of Business", "Risk Factors", and "Management's Discussion
and Analysis of Financial Condition and Results of Operations," as well as in
this Annual Report generally. Actual results could differ materially from those
anticipated in these forward-looking statements as a result of various factors,
including all the risks discussed in "Risk Factors" and elsewhere in this Annual
Report.
In addition, statements that use the terms "can," "continue," "could,"
"may," "potential," "predicts," "should," "will," "believe," "expect," "plan,"
"intend," "estimate," "anticipate," "scheduled" and similar expressions are
intended to identify forward-looking statements. All forward-looking statements
in this Annual Report reflect our current views about future events and are
based on assumptions and are subject to risks and uncertainties that could cause
our actual results to differ materially from future results expressed or implied
by the forward-looking statements. Many of these factors are beyond our ability
to control or predict. Forward-looking statements do not guarantee future
performance and involve risks and uncertainties. Actual results will differ, and
may differ materially, from projected results as a result of certain risks and
uncertainties. The risks and uncertainties include, without limitation, those
described under "Risk Factors" and those detailed from time to time in our
filings with the Securities and Exchange Commission, and include, among others,
the following:
o our ability to restructure outstanding liabilities and continue as a
going concern;
o our ability to successfully develop and commercialize new products;
o a lengthy approval process and the uncertainty of the Food and Drug
Administration and other government regulatory requirements;
o the degree and nature of our competition;
o our continued ability to obtain certain raw materials from which we
manufacture our products;
o our ability to employ and retain qualified employees; and
o the other factors referenced in this Annual Report, including,
without limitation, under the section entitled "Risk Factors",
"Management's Discussion and Analysis of Financial Condition and
Results of Operations," and "Description of Business."
-3-
These risks are not exhaustive. Other sections of this Annual Report
may include additional factors that could adversely impact our business and
financial performance. Moreover, we operate in a very competitive and rapidly
changing environment. New risk factors emerge from time to time, and it is not
possible for our management to predict all risk factors, nor can we assess the
impact of all factors on our business or the extent to which any factor, or
combination of factors, may cause actual results to differ materially from those
contained in any forward-looking statements. Given these risks and
uncertainties, investors should not place undue reliance on forward-looking
statements as a prediction of actual results. These forward-looking statements
are made only as of the date of this Annual Report. Except for our ongoing
obligation to disclose material information as required by federal securities
laws, we do not intend to update you concerning any future revisions to any
forward-looking statements to reflect events or circumstances occurring after
the date of this Annual Report.
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INTRODUCTORY NOTE
Transderm Laboratories Corporation has not filed a report with the
Securities and Exchange Commission, or SEC, under the Securities Exchange Act of
1934, as amended, which describes its business and financial condition since
1999, as more fully explained in PART I, Item 1, below. This Annual Report
covers the years ended December 31, 2003 and 2004. In some cases, such as under
the headings "Recent Sales of Unregistered Securities," "Equity and Related
Stockholder Matters" and "Certain Relationships and Related Transactions" this
report includes information from the period January 1, 1999 through December 31,
2004 because we believe this information is of particular interest and
importance to investors.
Transderm Laboratories Corporation previously had filed annual reports
on Form 10-K but is entitled to file this Annual Report on Form 10-KSB because
it met the definition of "small business issuer" at the end of each of 2003 and
2004 (revenues and public float of less than $25 million).
PART I
ITEM 1. DESCRIPTION OF BUSINESS
Overview.
Transderm Laboratories Corporation ("Transderm") is a Delaware
corporation that conducts its business primarily through its subsidiary, Hercon
Laboratories Corporation ("Hercon"). Unless the context otherwise requires, the
terms "we", "us", the "Company" or similar terminology, includes Transderm
Laboratories Corporation and Hercon, of which Transderm owns 98.5%. Our
executive offices are located in Emigsville, Pennsylvania. Transderm is a
90%-owned subsidiary of Health-Chem Corporation ("Health-Chem" which, together
with Transderm, Hercon and Health-Chem's other subsidiaries, is referred to as
the "Group").
We develop, manufacture and market transdermal drug delivery systems. A
transdermal drug delivery system is an adhesive patch containing medication
which is released through the skin into the bloodstream at a controlled rate
over an extended period of time. Transdermal delivery can significantly enhance
the therapeutic benefit of certain drugs, through improved efficacy, safety and
patient compliance, when compared to conventional methods of drug
administration, such as oral or parenteral (drugs that are delivered other than
by the digestive tract, such as subcutaneous or intramuscular injection, or
intravenous) delivery. Over the last several years, our sole product and
continuing source of revenue has been a transdermal nitroglycerin patch for the
relief of angina pectoris (chest pain). We manufacture our nitroglycerin patch
both on a contract basis for specific clients and for sale to distributors and
wholesalers for distribution in the United States. We manufacture our products
in accordance with Good Manufacturing Practices, or GMP, prescribed by the
United States Food and Drug Administration, or FDA, at our facility in
Emigsville, Pennsylvania.
Transderm has developed a base of technology in the design of
transdermal systems by applying its expertise in the area of skin biology,
pharmaceutical and polymer chemistry, drug diffusion, adhesive technology,
pharmacokinetics and clinical protocol design. We believe that integration of
our technology and manufacturing experience gives us a competitive advantage by
providing us with the capability to custom design and produce individual,
cost-effective transdermal delivery systems for specific drugs. As a result,
over the last several years, we have been engaged by third parties to conduct
feasibility studies and development and related activities with respect to new
pharmaceutical products that may be amenable to transdermal delivery and, in
some cases, to manufacture such products for them on a commercial basis if they
reach the market.
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Operations from 2000 through 2003.
Transderm has not filed any of the annual or quarterly reports which it
is required to file under the Securities Exchange Act of 1934, as amended, and
the rules and regulations promulgated thereunder, since November 1999, when it
filed a Form 10-K for the year ended December 31, 1998 (the "1998 Annual
Report") and quarterly reports on Form 10-Q for each of the first three quarters
of 1999 (collectively, the "1999 Quarterly Reports"). Set forth below is a brief
chronological account of the Group's and Transderm's operations since the date
it filed its last reports under the Securities Exchange Act and the events which
caused it to suspend filing reports.
Until the late 1990's, the Group developed, manufactured and
distributed a wide range of products relying on or derived from laminated or
coated films. At that time, the Group conducted its business primarily through
Transderm and its subsidiary, Hercon, and through Health-Chem's wholly-owned
subsidiaries, Herculite Products, Inc. ("Herculite") and Pacific Combining Corp.
("Pacific"), and through Health-Chem's majority-owned subsidiary Hercon
Environmental Corporation ("Hercon Environmental"), of which Health-Chem owns
98.5%. The Group's products included controlled release dispensers for
prescription pharmaceuticals and over-the-counter pharmaceutical and cosmetic
products (Transderm and Hercon); reinforced synthetic fabrics for industrial and
health care use (Herculite and Pacific); and controlled release dispensers for
environmental chemicals (Hercon Environmental).
At the conclusion of 1996, the peak of the Group's operations, it
employed 242 persons and generated $47.6 million in revenue but suffered a net
loss of approximately $1.3 million and was encumbered with debts and liabilities
aggregating in excess of $25 million. During the period 1996 through 1998, sales
of the Group's core products declined in each year (though in 1998 the Company
reported higher net sales revenues than in 1997 as a result of sales of a new
product by Transderm, the market for which evaporated in 1999, at which time
Transderm discontinued this product, as described below). For the year ended
December 31, 1998, the Group reported a net loss of $10.6 million on net sales
of $6.9 and its aggregate liabilities were approximately $24 million which
included (i) approximately $10 million of debt under a bank line of credit and
term loan secured by substantially all of the Group's assets (the "Bank Loan"),
(ii) $8 million of principal under certain convertible subordinated debentures
issued by Health-Chem and due on April 15, 1999 ("Debentures") and (iii) $6
million of trade payables and other miscellaneous liabilities.
Our financial and operating condition is inextricably entwined with
that of Health-Chem, which owns 90% of our outstanding common stock, and
Transderm's operating results during the period 1995 to 1998 were equally
undistinguished. For the year ended December 31, 1995, Transderm reported net
income of approximately $1.4 million on net sales of approximately $12.5
million, which had declined to a net loss of $2.2 million on net sales of
approximately $5.3 million for the year ended December 31, 1997. While net sales
for the year ended December 31, 1998 increased to approximately $6.9 million,
Transderm reported a net loss of $674,000 for the year. The increase in net
sales during 1998 was attributable to sales of a non-transdermal product, a deep
cleansing facial pore strip, to two customers. Sales of the facial pore strips
declined during each quarter of 1999 and Transderm discontinued selling this
product in July 1999 when customers ceased ordering the product from us.
While the Group did not have the personnel or funds sufficient to
prepare or audit financial statements during the period 1999 through 2002 for
the reasons described below, management believes that the Group incurred
significant losses in each such year. The Group's principal creditors at the
time, including the holders of the Debentures, other miscellaneous creditors
and, after 2001, Key Pharmaceuticals Inc. ("Key") under a technology license
agreement described below, did not vigorously pursue payment of the sums owed to
them and despite poor operating results, the Group was able to continue
operations at a subsistence level.
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The Company's and the Group's deteriorating financial and operating
condition was caused, in large part, by the inability to offer a new generation
of transdermal patch products which incorporated technical design improvements.
Transderm was prevented from selling products incorporating the new design both
because (i) the FDA delayed the approval of the new transdermal patch which had
been expected during the first half of 1997, and (ii) Key had filed a legal
action against Hercon which alleged that the Company's new transdermal patch
infringed an existing patent issued to Key (the "Key Lawsuit"). These
circumstances cast doubt about when, if ever, Hercon would be able to offer the
new transdermal patch product on a commercial basis and rendered management
uncertain as to how the Group would generate revenues sufficient to satisfy its
obligations going forward. On October 30, 1998, Hercon received FDA market
approval for its improved nitroglycerin patch but was prevented from selling
products incorporating this technology because of the Key Lawsuit. Sales of the
older generation patch were declining rapidly.
In November 1998, management of Health-Chem took steps to address the
Group's declining financial condition by restructuring the Group's operations,
including discontinuing a portion of its synthetic fabric manufacturing
operations and closing a manufacturing plant owned and operated by Health-Chem's
Pacific subsidiary. The restructuring reduced annual payroll expenses but did
not generate the cash required to service the Group's debt. In August 1999,
Health-Chem sold all of the assets of its Herculite and Hercon Environmental
subsidiaries to a management-led group that included two members of
Health-Chem's Board of Directors, one of whom was its vice president of finance,
and one other Health-Chem executive, which assumed certain liabilities of these
companies (the "Asset Sale"). After settlement of a shareholder derivative suit
which sought to enjoin the Asset Sale, which is more fully described below, the
proceeds derived from the Asset Sale, equal to $14.2 million, were used to repay
all amounts outstanding under the Bank Loan ($9.8 million) and to make a $1.9
million payment on the Debentures, which allowed Health-Chem to remain current
on its annual redemption obligations under the sinking fund provisions of such
instruments. Management believed that these actions would provide the Group with
additional time in which to increase cash flow from operations and secure new
funding sources; however, notwithstanding the application of the proceeds from
the Asset Sale, the Group continued to carry substantial liabilities and debt
which it could not service, let alone satisfy, with the then current or
projected revenues.
Health-Chem was unable to pay the $8 million principal amount of the
Debentures which was due on April 15, 1999 and, therefore, was in default under
these instruments. Given the default under the Debentures and management's
inability to develop an effective plan with which to mitigate this condition,
management of each of Health-Chem and Transderm concluded that the companies
should present their financial statements on a liquidation basis for the year
ended December 31, 1998, meaning that all assets and liabilities that were
subject to binding sale agreements would be reflected in the financial
statements at realizable values and they would cease taking charges for
depreciation on their remaining assets after the Asset Sale.
On August 9, 1999, in advance of the closing of the Asset Sale, Andy
Yurowitz, then a stockholder of Health-Chem and the current president and a
director of each of Health-Chem and Transderm, initiated an action to enjoin the
Asset Sale and compel Health-Chem to hold a stockholders meeting for the purpose
of electing directors on the grounds that management had not provided
stockholders with current public information (neither Health-Chem nor Transderm
had filed period reports under the Securities and Exchange Act of 1934 since the
third quarter of 1998) or otherwise provided stockholders with information
regarding the Asset Sale. Health-Chem counter-sued Mr. Yurowitz claiming, among
other things, that he did not have standing to enjoin the Asset Sale. In late
November 1999, Mr. Yurowitz filed a proxy statement with the SEC soliciting
proxies to elect an independent slate of directors at the December stockholders
meeting. At the end of November 1999, Health-Chem filed a Definitive Proxy
Statement with the SEC in support of management's slate of directors and the
annual report for the year ended December 31, 1998 and quarterly reports for the
first three quarters of 1999.
-7-
In December 1999, Health-Chem held a shareholders meeting at which Mr.
Yurowitz's slate of directors prevailed. Health-Chem's new board members assumed
control of Health-Chem and Transderm in February 2000 but did not become fully
apprised of the gravity of the Group's financial, operating and administrative
condition until it was seated. All cash generated from the Asset Sale had been
expended to satisfy the Bank Loan and reduce the sum outstanding on the
Debentures, leaving the Group sufficient cash, as of February 2000, to operate
at then existing levels for less than eight weeks. Moreover, the Group was
precluded from selling products incorporating its new generation transdermal
drug delivery technology, which had been approved by the FDA in October 1998,
because of the outstanding patent infringement action against the use of this
technology by the Group. The Group had almost no inventory of its only remaining
product available for sale and no cash with which to purchase the raw materials
from which to manufacture such products. In short, the Group did not have any
money and had no immediate prospects to generate revenue. Two members of
Health-Chem's new board of directors resigned immediately when they ascertained
the Group's financial condition, and another director resigned shortly
thereafter.
In the spring of 2000, management obtained a $1.6 million loan from a
non-traditional lender accruing interest at 15% per year which was secured by a
mortgage on the Company's Pennsylvania facility in order to fund operations
until the Group could begin generating revenues from product sales. During that
period, management of the Company negotiated a license with the Key, the holder
of the patent whose intellectual property the Company was ruled to have
infringed in the patent litigation, which permitted the Group to sell products
incorporating the new transdermal drug delivery technology (the "Key License").
In late summer 2000, when the proceeds of the mortgage loan were nearly
exhausted, the FDA advised the Company that because it had obtained a new
manufacturer for the release liner used in its new generation nitroglycerin
patch, the FDA would require additional testing and new approval before the
product could be sold, a process that management believed could extend at least
into the late winter of 2001.
Faced with the prospect of at least six months, and potentially longer,
without revenue, and with no further borrowing capacity, Health-Chem's new board
members were forced to choose between immediately ceasing the Group's operations
and winding up its business or personally lending the Group funds to continue
business operations. Management elected to lend the Group nearly $1 million over
a 2-year period, which loans were secured by second liens on the Company's
Pennsylvania facility and certain other Group assets. The funds were utilized to
satisfy the Group's current obligations to ensure uninterrupted operations,
including making interest payments on the first mortgage, maintaining its
manufacturing facility within FDA standards and retaining a skeleton staff. In
an effort to reduce cash expenditures, the Group eliminated non-essential
management personnel and put manufacturing personnel on indefinite furlough
until the Group could resume its manufacturing operations. In addition,
management accrued all salaries during this period. The Group lacked the cash
with which to satisfy its other outstanding obligations, which included
$10,197,000 of principal plus interest accrued due under the Debentures through
December 31, 2004, approximately $4.5 million owed to Key under the Key License
at December 31, 2004, potential state taxes as well as trade and other payables.
-8-
The Group received the additional FDA approval required for the new
release liner incorporated into its second generation transdermal nitroglycerin
patch in June 2001. The Group commenced marketing this product shortly
thereafter but did not begin to generate material revenues from sales until
2003. Meanwhile, the Group had made no progress in reducing its liabilities,
which, in fact, continued to increase. Moreover, the Group was on a cash on
delivery basis with its most important suppliers and was forced to factor its
accounts receivable, further squeezing its margins and, hence, its cash
availability.
In June 2001, management sought to diversify the Group's business to
reduce its reliance on its nitroglycerin transdermal patch product and
investigated a variety of strategies which had the potential to develop into a
new and ongoing product pipeline. Toward that end, the Group leased and
eventually purchased from a related party the key machinery and equipment of
TCPI, Inc., a Florida-based manufacturer of medical diagnostic products, out of
bankruptcy in December 2001. In February 2002, the Group organized a division
which entered into a series of agreements pursuant to which it (i) licensed
thirty diagnostic products derived from a common platform technology, (ii)
retained the inventor of these products to continue development work and (iii)
arranged to manufacture the products at a leased facility located in Pompano
Beach, Florida. The new diagnostic division purchased pregnancy test wands
manufactured by a third party under the licenses and launched shipment of these
products to European customers. However, the division was unable to manufacture
the pregnancy test wands utilizing the equipment it purchased. Moreover, the
Group brought to market only two additional diagnostic products of the thirty it
licensed and generated minimal revenues from sales of these products. After
sales of the pregnancy test products declined dramatically due to patent issues,
and with continuing operating losses and cash flow drains, the Group divested
itself of this division in 2004. Health-Chem became involved in protracted
litigation with respect to the divestiture of this division and the decision of
the trial court in favor of Health-Chem remains on appeal.
In May 2002, Health-Chem rehired a former financial officer on a
part-time basis, though it was not until July 2002, when he was engaged on a
full-time basis, that the Group began to reestablish accounting controls and
procedures.
Management attributes Transderm's and Health-Chem's failure to file
Securities Exchange Act reports after 1998 primarily to a lack of available
funds caused by substantial operating losses which began in 1996 coupled with
the Group's excessive obligations and liabilities. Revenues from operations were
sufficient to support only the staff required to maintain the Group's
pharmaceutical manufacturing facilities in accordance with FDA requirements and
satisfy newly incurred obligations, such as then-current trade payables. In
fact, until 2002, the Group did not have the funds required to retain the
personnel essential to manage its day-to-day operations, including competent
accounting personnel to undertake financial record-keeping and prepare financial
statements acceptable for audit. It was not until late 2003 that the Group both
restored financial record keeping practices to a level that would prospectively
allow Transderm and Health-Chem to prepare financial statements which could be
audited and also began to generate revenues which would permit it to pay the
fees of independent auditors to audit financial statements and legal counsel to
prepare periodic reports required under federal securities laws, thereby
allowing management to begin considering the preparation and filing of reports
with the SEC.
-9-
Current Condition of Transderm.
Transderm continues its efforts to recover from the operational and
financial adversity it has experienced since 1997. While net sales increased
during 2003 and 2004 compared to 2002, Transderm continues to post significant
operating losses. Transderm's current financial condition, highlighted by the
royalty owed to Key, negatively impacts its day-to-day operations as well as its
ability to grow its business. In addition, Health-Chem's financial condition,
principally resulting from the continuing default under the Debentures, also
bears on Transderm's current and future prospects because Transderm's financing
options will be limited by Health-Chem's debt. Accordingly, Transderm's ability
to return to profitability from the precarious financial condition by which it
has been beset over the last several years is predicated on a number of factors,
including the Group's ability to restructure its substantial outstanding debts
and liabilities, its ability to reduce operating expenses as a percentage of
revenues, its ability to obtain financing and its ability to identify and bring
to market new products. At December 31, 2004, the Company had aggregate debts
and liabilities of $37,414,000, including $12,949,000 related to certain
redeemable preferred stock under which the Company is currently in default,
$7,158,000 related to a subordinated promissory note due to Health-Chem under
which the Company is currently in default and $8,342,000 related to a long-term
payable to Health-Chem, and $4,522,000 of royalties due under the Key License.
In addition, as reported in Health-Chem's annual report for the year ended
December 31, 2004, the Group had aggregate debts and liabilities of
approximately $19,898,000, including $10,197,000 under the Debentures and
$5,179,000 of miscellaneous debts and liabilities. At December 31, 2005, the
Group's total outstanding debts and liabilities (excluding inter-company
accounts) were nearly $23 million. These obligations and liabilities have
limited the Group's ability to access the cash or credit required to take the
steps necessary to grow its business.
Transderm's and the Group's financial condition leaves them vulnerable
because:
o the deficiency of funds prevents the Group from diversifying
operations by developing new products and reducing reliance on
revenues generated from sales of a single product;
o their obligations and liabilities do not allow them to obtain
financing for operations;
o the condition makes it difficult to endure business cycles resulting
from general economic conditions or the effects of competition,
among other things, as they occur;
o the condition prevents them from taking advantage of business
opportunities as they may arise; and
o the condition does not allow them to retain senior management who
have experience in the pharmaceutical industry or in any business in
which they may become involved in the future.
Transdermal Delivery Systems.
A transdermal drug delivery system, known as a transdermal patch or
skin patch, is a medicated adhesive patch that is placed on the skin to deliver
a time released dose of medication through the skin and into the bloodstream.
These systems utilize a special membrane to control the rate at which the liquid
drug contained in the patch can pass through the skin and into the bloodstream.
Transdermal drug delivery involves the inherent challenge of overcoming the skin
barrier. Skin protects the body from the environment very effectively and
generally is only permeable to small molecule, lipophilic (oil soluble) drugs
which require only limited dose sizes. Transdermal delivery systems, therefore,
not only have to provide drug to the skin under stable conditions in controlled
dosages and in a format convenient to the patient, but also serve to locally
increase the permeability of skin to larger, charged, or hydrophilic (easily
dissolved in water) drug molecules while minimizing irritation.
-10-
The first transdermal patch was approved by the FDA in 1979. It
contained the drug scopolamine used to prevent the nausea and vomiting
associated with motion sickness. In 1981, the FDA approved a patch for
nitroglycerin and today patches have been approved to deliver 15 molecules
spanning 35 different drugs, including combination patches utilized for, among
other purposes, contraception and hormone replacement.
The first transdermal systems consisted of plastic dipped into a drug
that was dissolved in alcohol. The plastic had an adhesive around the edges.
These patches created a significant number of skin reactions and frequently
became dislodged from the skin. Second, third and fourth generation patches have
been developed which have significantly advanced adhesion properties, delivery
control and skin permeability.
There are four major types of transdermal drug delivery systems in use today:
single layer drug-in-adhesive systems, multi-layer drug-in-adhesive systems,
reservoir transdermal systems and matrix systems. The basic components of
current transdermal delivery systems include the drug(s) either incorporated
directly into the adhesive or dissolved or dispersed in a reservoir or inert
polymer matrix; an outer backing film of paper, plastic, or foil; and a
pressure-sensitive adhesive that anchors the patch to the skin. Developments and
improvements to transdermal systems are being made rapidly.
Transdermal drug delivery has numerous advantages over conventional
drug delivery methods, such as oral and parenteral administration. Transdermal
systems are convenient, they are easy for patients to apply and remove, and
provide even and continuous delivery of a therapeutic level of drug, which
ensures patient compliance with dosing schedules, particularly in the case of
drugs that require frequent administration. Transdermal patches allow effective
use of drugs with short half-lives that otherwise require large initial doses
(bolus dosing) to achieve desired drug levels (nitroglycerin, for example). As a
result, the side effects, or variability in therapeutic effect due to peaks and
troughs in blood concentration, that are seen with bolus administration are
minimized. Delivery is painless (the patient does not need to inject himself),
noninvasive and poses little risk of infection. There are no bulky delivery
devices to manage or dangerous needles to dispose of, and there are few or no
gastrointestinal effects from the drug itself. In addition, transdermal delivery
is useful for those drugs that have a high first pass effect through the liver,
have poor oral uptake, need frequent administration, or that interact with
stomach acid. The first pass effect results in the destruction of a significant
amount of the drug. Drugs absorbed through the skin, however, enter the general
circulation directly, thereby avoiding the liver, with less total drug
absorption occurring.
Although transdermal drug delivery patches have a relatively short
regulatory history compared to other, more traditional dosage forms, the
technology has a proven record of FDA approval. Since the first transdermal
patch was approved in 1979, the FDA has approved more than 35 transdermal patch
products spanning 15 molecules. In 2001, the US transdermal market approached
$1.2 billion and was based on 11 drug molecules. By the end of 2003, the market
for transdermal patches was based on 15 drug molecules and growing at an annual
revenue rate of 12 percent with a worldwide market of approximately $3 billion,
with the U.S. constituting about $1.7 billion (56%) of the market.
-11-
Our Nitroglycerin Transdermal Patch.
In 1986, we introduced the first FDA-approved generic transdermal
nitroglycerin patch into the United States market. Currently, we manufacture and
market a transdermal nitroglycerin patch which provides relief from angina
pectoris or angina.
Angina pectoris, or "heart pain," is the chest discomfort that occurs
when the blood oxygen supply to an area of the heart muscle does not meet the
demand. Blood returning from the body in the veins must be pumped by the heart
through the lungs and into the arteries against the high pressure in the
arteries. In order to accomplish this work, the heart's muscle must produce and
use energy. The production of energy requires oxygen. Angina is due to an
inadequate flow of blood (and oxygen) to the muscle of the heart. In most cases,
the lack of blood supply is due to a narrowing of the coronary arteries as a
result of arteriosclerosis. Angina is usually felt as a squeezing, pressure or
tightening across the chest, particularly behind the breastbone and often
radiates to the neck, jaw, arms, back, or even the teeth. Angina usually occurs
during exertion, severe emotional stress, or after a heavy meal. During these
periods, the heart muscle demands more blood oxygen than the narrowed coronary
arteries can deliver. Angina typically lasts from 1 to 15 minutes and is
relieved by rest or by administering nitroglycerin, also known as glycerin
trinitrate. It is believed that all nitrates, of which nitroglycerin is but one,
correct the imbalance between the flow of blood and oxygen to the heart and
relieves the work that the heart must do by dilating the arteries and veins in
the body. Dilation of the veins reduces the amount of blood that returns to the
heart that must be pumped. Dilation of the arteries lowers the pressure in the
arteries against which the heart must pump. As a consequence, the heart works
less and requires less blood and oxygen. Additionally, nitroglycerin
preferentially dilates blood vessels that supply the areas of the heart where
there is not enough oxygen, thereby delivering oxygen to the heart tissue that
needs it most.
Since no one holds a valid patent covering nitroglycerin, which would
grant to the patent holder the exclusive right to sell the drug while the patent
is in effect and which is intended to protect the holder's development
investment, others can seek to obtain FDA approval to sell nitroglycerin based
products, assuming the proposed product meets certain specific criteria, by
submitting an Abbreviated New Drug Application, or ANDA. The ANDA approval
process can be substantially quicker and significantly less expensive than the
new drug approval process because the applicant can rely on results collected
from clinical trials conducted by the new drug developer.
Our nitroglycerin transdermal patch comprises a multi-layer
drug-in-adhesive system wherein the medication and all the excipients (the inert
substance used as a diluent or vehicle for a drug) are incorporated into a
membrane between two distinct drug-in-adhesive layers under a single backing
film. Our patch is comprised of three layers; a transparent outer backing layer
composed of a composition plastic film and printed with the name of the drug and
strength; nitroglycerin in a acrylic-based polymer adhesive with a cross-linking
agent; and a protective, translucent peelable liner which covers the second
layer and must be removed prior to use. Our nitroglycerin transdermal patch is
AB2 rated, which means it is considered bioequivalent to Novartis' NitroDerm(TM)
product based on clinical trial data. Our patch is a one-day use patch and is
sold in shelf cartons, with each shelf carton containing thirty patches. Our
patch is produced in three different dosage sizes, with each size delivering
different milligrams per hour (mg/hr) amounts of nitroglycerin to the patient.
The three sizes are: 0.2mg/hr, 0.4mg/hr and 0.6mg/hr.
Our second generation transdermal patch technology developed during the
mid 1990's, as described above, incorporates certain technology which,
unbeknownst to us at the time of development, was the subject of a patent held
by Key Pharmaceuticals, Inc., or Key, a subsidiary of Schering-Plough
Corporation. In December 1997, Key obtained a court order enjoining us from
making, using, offering for sale, selling or importing any transdermal
nitroglycerin patches that have been found to infringe Key's patent, before the
expiration of Key's patent on February 16, 2010. In March 2000, we acquired a
non-exclusive license from Key to manufacture, use, import, sell and offer for
sale any drug-in-adhesive transdermal nitroglycerin patch product developed by
the Company either before or during the term of the license which provided for
the payment of a royalty per unit sold in amounts ranging from $2 to $3, based
upon the dosage delivered. The license extends to February 16, 2010, the
expiration of Key's patents. We have not made royalty payments under our license
with Key and as of December 31, 2004 we owed aggregate royalties to Key of
approximately $4,522,000. We recently entered into discussions with Key with
respect to payment of past due royalties. Any failure to negotiate a repayment
agreement with Key on terms favorable to us could have a material negative
impact on our Company, as more fully described under the headings "Risk Factors"
and "Management's Discussion and Analysis of Financial Condition and Results of
Operations."
-12-
Research and Development.
Our primary research and development strategy is to identify generic
drugs which can be delivered transdermally, which are suitable for delivery
utilizing our patch technology and which we believe have substantial market
potential or for which a product niche may exist. We may also explore developing
transdermal products that use approved drugs that currently are being delivered
to patients through means other than transdermal delivery. In addition, we may
seek to supplement our research and development efforts by entering into
research and development agreements, joint ventures and other collaborative
arrangements with other companies.
Our research and development efforts are severely constrained by our
lack of cash, as described elsewhere in this Annual Report, and other than
activities currently being undertaken for third parties as described below, we
are not engaging in any research and development on our own behalf.
By focusing on bringing new products to market based upon unprotected,
generic drugs that are then being delivered transdermally, we will not have to
bear the same level of research and development and other expenses associated
with bringing a new drug formulation to market. Thus, we believe that we would
be able to charge significantly less for a product, a decided competitive
advantage in our industry, given that managed care organizations typically favor
generic products over brand name drugs, and governments encourage, or under some
circumstances mandate generic drugs.
We currently are developing transdermal products for two companies, one
of which has engaged us to assist in the development of two drug formulations to
be delivered transdermally. In all cases, we act as an independent contractor
for the party that engaged us and said party owns all intellectual property
which may emanate from the projects we are retained to complete or the services
which we render.
In February 2001, Hercon entered into a series of agreements with
Ranbaxy Pharmaceuticals Inc. under which we:
o granted a worldwide, non-exclusive, royalty-free license to Ranbaxy
to use certain intellectual property we developed relating to the
transdermal delivery of a certain generic pharmaceutical compound;
o acquired a license from Ranbaxy to use certain intellectual property
it had developed in connection with the pharmaceutical compound and
were retained by Ranbaxy to assist in the development of commercial
products to deliver the pharmaceutical compound transdermally; and
o agreed to supply the products which may be developed and approved by
the FDA exclusively to Ranbaxy which agreed to purchase from us all
of its requirements for such products from us on an exclusive basis.
-13-
We currently are producing a supply of the pharmaceutical compound to
permit Ranbaxy to complete pilot bioequivalence study results which will be
appended with the ANDA filed by Ranbaxy with the FDA.
We have undertaken to provide certain services, including, completing
the development of the initial formulation of the pharmaceutical compound for
transdermal delivery, demonstrating that our production techniques can be
scaled-up to meet anticipated production runs of the transdermal patch,
providing all laboratory data relating to the utilization of our patch
technology for this pharmaceutical compound, completing documentation necessary
for GMP production of the product, providing dosage forms for the pilot and
bioequivalence studies, conducting the pilot and other studies and providing
underlying documentation required for Ranbaxy to gain regulatory approval for
the product and support Ranbaxy's ANDA filing. We are performing under this
agreement as requested by Ranbaxy.
Ranbaxy granted us a license to utilize certain intellectual property
we will require for the manufacture of the products which are the subject of the
agreement and we have agreed to supply Ranbaxy with such product in the
strengths and amounts as Ranbaxy may require for its bioequivalence studies.
Thereafter, assuming Ranbaxy's ANDA for this product is approved by the FDA, of
which neither we nor Ranbaxy can be certain, we will manufacture and supply
Ranbaxy with all of its commercial requirements of the product, subject to its
right to acquire the product elsewhere if we are unable to furnish the supplies
it requires, under the circumstances provided in the agreement. We have agreed
to sell the product exclusively to Ranbaxy. We also have agreed to conform to
GMP's in connection with the manufacture of the product and otherwise supply
product in conformity with Ranbaxy's specifications as enumerated in the
agreement which relate to quality control, packaging and labeling, among other
things. Ranbaxy will pay us fixed prices for the products of various dosages and
a royalty in excess of the per product price in the event it achieves certain
net sales milestones. The agreement has a ten-year term from the date of the
first commercial sale of the products. We have agreed to indemnify Ranbaxy for
damages resulting from, among other things, our formulation or manufacturing of
the product and Ranbaxy has agreed to indemnify us for damages relating to
regulatory improprieties.
In June 2004, Hercon entered into a Development, Manufacturing and
Supply Agreement with Ranbaxy relating to a generic pharmaceutical compound
subject to transdermal delivery. Under the agreement, we have been engaged to
manufacture and supply products for use both in connection with Ranbaxy's
regulatory approval requirements and ANDA application and thereafter, if FDA
approval is granted for the product, of which neither we nor Ranbaxy can be
certain, on an ongoing basis to meet its requirements. In furtherance of our
efforts, Ranbaxy extended a loan to us in the amount of $166,664 to purchase
certain equipment required in connection with our obligations under the
agreement which is repayable by offsetting amounts payable for product which may
eventually be purchased from us, agreed to pay for the active pharmaceutical
ingredient incorporated into the product during the trial phases and to pay for
a contract research organization to conduct bioequivalence studies of the
proposed product. Our obligations under this agreement are similar to those in
our agreement with Ranbaxy described above. For example, we have agreed to
conform to GMP's in connection with the manufacture of the product and otherwise
supply product in conformity with Ranbaxy's specifications as enumerated in the
agreement which relate to quality control, packaging and labeling, among other
things, and in accordance with all applicable laws. The successful completion of
the development portion of the agreement could yield us an aggregate of $678,800
of gross revenues, payable in tranches upon achieving certain milestones.
Ranbaxy will purchase products from us at prices calculated in relation to the
price we pay for the underlying active pharmaceutical ingredient and in the
event that the price for said ingredient exceeds the maximum amount set forth in
the agreement, Ranbaxy may terminate the agreement as to that specific product.
We have agreed to indemnify Ranbaxy for damages resulting from, among other
things, our development and related obligations under the agreement and Ranbaxy
has agreed to indemnify us for damages relating to regulatory improprieties.
-14-
In April 2006, Hercon entered into a Development, Manufacturing and
Supply Agreement with Cure Therapeutics, Inc., or CTI, relating to the
development of a transdermal patch which delivers a generic pharmaceutical
compound which will be utilized for new indications (i.e., the treatment of
conditions not covered by the original FDA approval) for such drugs. Under the
agreement, CTI engaged us to undertake all processing of the pharmaceutical
compound for the purpose of filing a new drug application, or NDA, with the FDA
and to manufacture and supply sufficient quantities of the compound required for
obtaining approval of the NDA. Our engagement is divided into three stages:
technology transfer, formulation optimization, and scale-up; FDA phase 2
clinical trial batch manufacturing; and FDA phase 3 clinical trial batch
manufacturing. Our obligations under the agreement include all manner of
analyzing, testing, optimizing the formulation of our process by which clinical
trial products are made, creation of dedicated tooling, scaling-up our
manufacturing facility to produce commercial quantities of product, finishing,
packaging, inspecting, labeling and preparing product for shipment, all as
required under applicable law. In addition, we are required to maintain data and
records with respect to all aspects of the foregoing for the specific purpose of
filing same with the FDA with respect to the NDA and to report to CTI with
respect to each phase of the process. CTI pays us fees upon our successful
completion of milestones enumerated in the agreement. We are currently working
on the first stage under the agreement. CTI has agreed, at its own cost and
expense, to engage a contract research organization to conduct safety and
efficacy studies of the clinical trial products we manufacture and, in the event
that such studies fail to demonstrate the safety or efficacy of such products,
CTI may terminate the agreement. We have agreed to conform to GMP's in
connection with the manufacture of the product and otherwise supply product in
conformity with CTI's specifications as enumerated in the agreement which relate
to quality control, packaging and labeling, among other things, and in
accordance with all applicable laws. We have agreed to indemnify CTI for damages
resulting from, among other things, our performance of or failure to perform our
obligations under the agreement and CTI has agreed to indemnify us for damages
relating to regulatory improprieties. Each party has agreed to maintain the
confidentiality of the other's confidential information. The agreement has a
term of two years but is subject to prior termination by either party in the
event of a material breach by the other party and by CTI for any reason at any
time upon written notice. The parties recognize the possibility that no
commercial product may arise from their efforts.
We are also conducting a number of feasibility studies on transdermal
products on behalf of client companies and are pursuing additional contract
manufacturing opportunities. We do not undertake clinical studies. As a contract
manufacturer for developing products, it would be the responsibility of our
client to undertake and absorb the cost of these clinical studies, including
preparing and filing all documents required by the FDA. We would, however,
perform routine chemical analysis of these products to determine if they meet
proposed product specifications.
For the years ended December 31, 2004 and 2003, we spent $414,000 and
$418,000, respectively, for research and development activities. Our research
and development expense may vary significantly from quarter to quarter and year
to year depending on, among other things, product development cycles and whether
we or a third party are funding development. These variations in research and
development spending may not be accurately anticipated and may have a material
effect on our results of operations. Currently, research and development
personnel engage in assisting with technical transfers of existing formulation
and test methodology to our production facility. In addition, our personnel
perform small scale development work on behalf of clients, including producing
hand cut transdermal patches on a research laminator for analytical testing or
performing permeation studies to show how drug formulations penetrate a skin
layer. Our personnel also work on improving test methods that may impact day to
day testing requirements for commercial products. We periodically outsource
analytical testing due to either lack of equipment on-site or cost justification
due to the test not being of a routine nature.
-15-
The time necessary to complete clinical trials and the regulatory
process to obtain marketing approval varies significantly. We cannot be certain
that we will have the financial resources necessary to complete products which
we propose to develop, that those projects to which we dedicate resources will
be successfully completed, that we will be able to obtain regulatory approval
for any such product, or that any approved product may be produced in commercial
quantities, at reasonable costs, and be successfully marketed. Similarly, we
cannot assure that our competitors, most of which have greater resources than we
do, will not develop and introduce products that will adversely affect our
business and results of operations.
Manufacturing.
We conduct our manufacturing operations in a single facility comprised
of an approximately 61,000 square foot building located on approximately 3.5
acres in Emigsville, Pennsylvania. Our products are manufactured in accordance
with GMPs prescribed by the FDA. The FDA visited our facilities in November 2003
and June 2006 and issued establishment inspection reports. The reports indicated
that there were no objectionable conditions or practices noted during their
reviews. The FDA did not issue a Form FDA 483 (Inspectional Observations) report
to us during either of these two visits. The FDA uses the Form FDA 483 report to
communicate all observations of objectionable conditions noted during their
inspection process. This facility has also been licensed by the United States
Drug Enforcement Administration ("DEA") to conduct research and manufacture
products containing Schedule II controlled substances. To bring new products to
market as quickly as possible, we will seek to have the manufacturing capacity
to produce the new product prior to obtaining FDA approval.
Our products are manufactured according to current GMPs as specified by
federal regulations which require us to maintain and update procedures and
specifications as provided under federal law. We must maintain records that
demonstrate the application of raw materials from receipt to use in a finished
product. In addition, any complaints received must be documented and
investigated. We are obligated to submit to the FDA reports covering our
marketed products that include both chemistry information and adverse event
information on an annual basis. If current GMPs are not adhered to, the FDA and
courts can seek an injunction barring commercial distribution of our products.
The manufacture of advanced transdermal drug delivery systems requires
specialized skills in several areas, as well as specialized manufacturing
equipment. Our process development and design engineers work closely with the
research and development department starting early in the product design stage,
resulting in efficiencies in the manufacturing development process. All scale-up
work (spanning the gamut of initial research on a potential product to
large-scale manufacturing for clinical and stability work), commencing with
initial product development trials, is conducted on full-size, completely
functional manufacturing equipment, reducing delays in the development and
approval process and smoothing the transition to commercial production. Some of
this equipment is manufactured in-house; the balance is fabricated by outside
manufacturers to our specifications. We believe that this equipment provides a
decided advantage in the manufacture of the complex multi-layer systems
necessary for successful transdermal drug delivery. We currently have assembly
packaging equipment in place having a single shift capacity of over 24 million
patches annually. We believe that our current manufacturing facility is adequate
for our intended purposes and will be sufficient for product expansion for the
foreseeable future.
-16-
As part of the manufacturing process, we have developed and perform
appropriate quality control procedures including testing of all raw materials
and finished product. Quality Control procedures are specific checks and
balances performed on raw materials and finished product to ensure materials
adhere to the predetermined specifications.
Several raw materials used in the manufacture of our products are only
available from single sources, all of which are domestic companies. These
materials have generally been available to us and the pharmaceutical industry on
commercially reasonable terms. To date, we have not experienced difficulty
acquiring necessary materials. We will seek to negotiate supply agreements, as
appropriate, for certain components.
Any curtailment in the availability of such raw materials could result
in production or other delays, and, in the case of products for which only one
raw material supplier exists, could result in a material loss of sales, with
consequent adverse effects on our business and results of operations. In
addition, because most raw material sources for transdermal patches must
generally be approved by regulatory authorities, changes in raw material
suppliers may result in production delays, higher raw material costs and loss of
sales, customers and market share.
We do not believe that compliance with federal, state or local laws and
regulations which have been enacted or adopted regulating the discharge of
materials into the environment or otherwise relating to the protection of the
environment has or will have any material effect upon our capital expenditures,
earnings or competitive position. There can be no assurance, however, (i) that
changes in federal, state or local laws or regulations, changes in regulatory
policy or the discovery of unknown problems or conditions will not in the future
require substantial expenditures, or (ii) as to the extent of the Company's
liabilities, if any, for past failures, if any, to comply with laws, regulations
and permits applicable to its operations. Any interruption of supply could have
a material adverse effect on the Company's ability to manufacture its products.
Marketing and Sales.
We have contracted with a full-service sales and marketing outsourcing
company that focuses on generic and branded pharmaceutical companies to handle
the majority of the sales and marketing efforts for our transdermal
nitroglycerin product. This company monitors client sales, as well as examines
our competition in order to anticipate and recommend changes to our sales,
marketing and promotional strategy. This company also assists in providing the
industry contacts to reach all distribution channels.
We have engaged Cardinal Health, Inc. as a non-exclusive distributor of
our transdermal patches pursuant to an agreement dated October 1, 2001. We sell
product to Cardinal at our list price and Cardinal is entitled to receive
certain discounts and rebates as stipulated in the agreement. During the years
ended December 31, 2003 and 2004, Cardinal purchased products representing in
excess of 10% of our total sales.
We market our products directly to wholesalers, distributors, retail
pharmacy chains, mail order pharmacies and group purchasing organizations. We
also market our products indirectly to independent pharmacies, managed care
organizations, hospitals, nursing homes and pharmacy benefit management
companies, collectively referred to as "indirect customers." We may enter into
agreements with our indirect customers to establish contract pricing for certain
products. The indirect customers then independently select a wholesaler whom
they actually purchase the products at these contracted prices. Alternatively,
certain wholesalers may enter into agreements with indirect customers which
establish contract pricing for certain products which the wholesalers provide.
-17-
Competition.
The market for our nitroglycerin transdermal patches is highly
competitive. Because nitroglycerin is generic drug, companies willing and able
to comply with FDA and other applicable regulations can produce nitroglycerin
based products. Moreover, nitroglycerin can be administered utilizing a wide
array of conventional and alternate forms of drug delivery. Accordingly, our
product faces intense competition from a diverse group of domestic and
multinational companies most of which possess significantly greater financial
and personnel resources than we do and that includes:
o large conglomerates of which pharmaceutical formulations, including
nitroglycerin based products, represent only a portion of the
products they offer;
o pharmaceutical companies of all sizes which focus on the development
of advanced transdermal systems which deliver nitroglycerin;
o pharmaceutical companies which offer nitroglycerin based products
other than transdermal patches or other formulations which relieve
angina; and
o companies that offer alternate non-drug therapies.
In addition, medical science is constantly evolving and the entities
against which we currently compete may change in the future. As developments in
medicine are made, drugs and delivery methods may become obsolete or fall out of
favor with physicians.
Most of our competitors have substantially greater financial resources
and larger research and development staffs than we do and may have substantially
greater experience in developing products, in obtaining regulatory approvals and
in manufacturing and marketing pharmaceutical products. Many other
pharmaceutical companies have the financial resources to acquire the skills
necessary to develop transdermal systems.
Advances in transdermal patch technology have intensified over the last
several years. As new materials have been developed which allow for more
efficient delivery of drugs through the patch membrane and adhesive,
manufacturers have been able to develop smaller patches which are more
comfortable for the user. New adhesive technologies have recently been
incorporated into patches which have selective adhesive properties once in
contact with the skin, exhibit substantial strength of initial adhesion and
duration of adhesion and are compatible with skin and various drug molecules.
Other advances in patch technology include the development of chemical
penetration enhancers, substances that make the skin more permeable and allow
drug molecules to cross the skin at a faster rate, and the development of
micro-needles to enlarge the skin pores through which drugs flow. In addition,
active transdermal patches which use energy, such as electricity and ultrasound,
to enhance the extent and rate at which pharmaceutical compounds cross the skin
and which will allow for larger drug molecules to be delivered transdermally,
are being developed at a rapid rate. All of these new transdermal technologies
could supplant our technology and render our product obsolete.
-18-
Since we manufacture a generic drug product and are not subject to the
myriad of factors which impact drug developers, such as high development costs
and establishing name and brand recognition, we believe that the principal
factors that bear upon our competitive position are price, consistency and
quality of product, our ability to deliver product on a timely basis,
reliability and patient convenience. We have been manufacturing nitroglycerin
patches for nearly twenty years and believe that we have gained significant
experience that contributes to our ability to compete effectively in the market.
Our competitive position will also depend on our ability to attract and retain
qualified scientific and other personnel, develop effective proprietary
products, implement production and marketing plans, effect distribution of our
products, obtain patent protection and secure adequate capital resources.
Patents and Proprietary Rights.
We seek to obtain patent protection on our delivery systems and
manufacturing processes whenever possible. We have obtained eleven United States
and foreign patents and trademarks relating to our transdermal delivery systems
and manufacturing processes. While we view our patents and trademarks as a
valuable asset, we do not consider any single patent or trademark to be of
material importance to our business as a whole.
As a result of changes in United States patent law under the General
Agreement on Tariffs and Trade and the accompanying agreement on Trade-Related
Aspects of Intellectual Property Law, which took effect in their entirety on
January 1, 1996, the terms of some of our existing patents have been extended
beyond the original term of seventeen years from the date of grant. Our patents
filed after June 7, 1995 will have a term of twenty years computed from the
effective filing date.
We are unaware of any challenge to the validity of our patents or of
any third party claim of patent infringement with respect to any of our
products, in either case that could have a material adverse effect on our
business or prospects.
Although there is a statutory presumption as to a patent's validity,
the issuance of a patent is not conclusive as to such validity, or as to the
enforceable scope of the claims of the patent. We cannot assure that our patents
or any future patents will prevent other companies from developing similar or
functionally equivalent products. We cannot assure that we would have the
resources to prosecute an action to enforce our patent rights against an alleged
infringer or that we would be successful in any infringement action that we
elect to bring. Likewise, we cannot assure that we would have the resources to
defend an infringement action or that we would be successful in any such
defense. Furthermore, we cannot assure that any of our future processes or
products will be patentable, that any pending or additional patents will be
issued in any or all appropriate jurisdictions or that our processes or products
will not infringe upon the patents of third parties. In addition, since our
patents typically cover our product formulation rather than the compound being
delivered, competitors may seek to create functionally equivalent products
(i.e., patches delivering the same compound over the same time period to treat
the same indication) that avoid our patents. In those cases, we may face
competition from functionally equivalent products even before our patents
expire.
We also attempt to protect our proprietary information under trade
secret and confidentiality agreements. Generally, our agreements with each
employee, client, consultant and agent contain provisions designed to protect
the confidentiality of our proprietary information. There can be no assurance
that these agreements will not be breached, that we will have adequate legal
remedies as a result thereof, or that our trade secrets will not otherwise
become known or be independently developed by others.
-19-
Government Regulation.
Our operations are subject to extensive regulation by governmental
authorities in the United States and in other countries in which we or our
distributors may sell products which we manufacture with respect to the testing,
approval, manufacture, labeling, marketing and sale of pharmaceutical products
and the possession and use of controlled substances. We devote significant time,
effort and expense to address the extensive government regulations applicable to
our business.
The marketing of pharmaceutical products requires the approval of the
FDA in the United States. The process for obtaining such approval varies
depending upon the nature of the product we are seeking to manufacture and sell.
The FDA has established regulations, guidelines and safety standards, which
apply to the pre-clinical evaluation, clinical testing, manufacturing and
marketing of pharmaceutical products. New drugs or drugs to be delivered by a
new route of administration are subject to a more lengthy approval process.
Typically, drugs that, among other factors, have been previously approved by the
FDA are subject to a less stringent, less time consuming and less expensive
approval process.
The process of obtaining FDA approval for a new product may take
several years or more and is likely to involve the expenditure of substantial
resources. The steps required before a product can be produced and marketed for
human use typically include: (i) pre-clinical studies; (ii) submission to the
FDA of an Investigational New Drug Exemption ("IND"), which must become
effective before human clinical trials may commence in the United States; (iii)
adequate and well controlled human clinical trials; (iv) submission to the FDA
of a New Drug Application ("NDA"); and (v) review and approval of the NDA by the
FDA. Approval of a product by the FDA does not serve as a guaranty of the
product's safety or efficacy.
Generally, products with new active ingredients, new indications, new
routes of administration, new dosage forms or new strengths require an NDA to be
filed with the FDA. An NDA requires that complete clinical studies of a
product's safety and efficacy be submitted to the FDA, the cost of which is
substantial. These costs can be reduced, however, for delivery systems that
utilize approved drugs. In these cases, the company seeking approval may refer
to safety and toxicity data reviewed by the FDA in its approval process for the
innovator product. In addition, a supplemental NDA may be filed to add an
indication to an already approved product.
Since we expect that any new products we may bring to market will
contain drugs previously approved by the FDA for transdermal delivery, an
abbreviated approval process may be available. Such products must have, among
other requirements, the same active ingredient(s), indication, route of
administration, dosage form and dosage strength as an existing FDA-approved
product covered by an NDA, if clinical studies have demonstrated bio-equivalence
of the new product to the FDA-approved product covered by an NDA. For this
abbreviated process, we would submit an ANDA to the FDA instead of an NDA. Under
FDA ANDA regulations, companies that seek to introduce an ANDA product must also
certify that the product does not infringe on any approved product's patent
listed with the FDA or that such patent has expired. If the applicant certifies
that its product does not infringe on the approved product's patent or that such
patent is invalid, the patent holder may institute legal action to determine the
relative rights of the parties and the application of the patent. Under the Drug
Price Competition and Patent Term Restoration Act of 1984 (the "Hatch-Waxman
Act"), the FDA may not finally approve the ANDA until the later of thirty months
from the date of the legal action or a final determination by a court that the
applicable patent is invalid or would not be infringed by the applicant's
product.
With respect to any new products we or our clients may seek to develop,
the results of product development and pre-clinical and clinical studies (if
necessary) will be submitted to the FDA as an NDA or ANDA for approval. If an
application is submitted, there can be no assurance that the FDA will review and
approve the NDA or ANDA in a timely manner. The FDA may deny an NDA or ANDA if
applicable regulatory criteria are not satisfied or it may require additional
clinical testing. Even if such data is submitted, the FDA may ultimately deny
approval of the product. Further, if there are modifications to the drug,
including changes in indication, manufacturing process, labeling, or a change in
manufacturing facility, an NDA or ANDA notification may be required to be
submitted to the FDA and FDA approval required prior to implementation of the
change. Product approvals may be withdrawn after the product reaches the market
if compliance with regulatory standards is not maintained or if problems occur
regarding the safety or efficacy of the product. The FDA may require testing and
surveillance programs to monitor the effect of products that have been
commercialized, and has the power to prevent or limit further marketing of these
products based on the results of these post-marketing programs.
-20-
Manufacturing facilities are subject to periodic inspections for
compliance with the FDA's good manufacturing practices (GMP's) regulations and
each domestic drug manufacturing facility must be registered with the FDA. In
addition, our manufacturing operations must be registered with the Pennsylvania
Department of Health. In complying with standards set forth in these
regulations, we must expend significant time, money and effort in the area of
quality assurance to ensure full technical compliance. Facilities handling
controlled substances, such as ours, also must be licensed by the Drug
Enforcement Administration, or DEA, and are subject to more extensive regulatory
requirements than those facilities not licensed to handle controlled substances.
We also require approval of the DEA to obtain and possess controlled substances.
We produce transdermal drug delivery products in accordance with United States
regulations for manufacturing process validation studies and commercial sale.
FDA approval to manufacture a drug product is site specific. In the event our
approved manufacturing facility becomes inoperable, obtaining the required FDA
approval to manufacture such drug at a different manufacturing site could result
in production delays, which could adversely affect our business and results of
operations.
Failure to comply with governmental regulations may result in fines,
warning letters, unanticipated compliance expenditures, interruptions or
suspension of production and resulting loss of sales, product seizures or
recalls, injunctions prohibiting further sales, withdrawal of previously
approved marketing applications and criminal prosecution.
Our activities are subject to various federal, state and local laws and
regulations regarding occupational safety, sales practices, laboratory
practices, environmental protection and hazardous substance control, and may be
subject to other present and possible future local, state, federal and foreign
regulations. Under certain of these laws, we could be liable for substantial
costs and penalties in the event that waste is disposed of improperly. While it
is impossible to accurately predict the future costs associated with
environmental compliance and potential remediation activities, compliance with
environmental laws is not expected to require significant capital expenditures
and has not had, and is not presently expected to have, a material adverse
effect on our earnings or competitive position.
Employees.
We employ approximately fifty two employees, of whom seventeen are
covered by a collective bargaining agreement with a local unit of the Retail
Wholesale and Department Store Union, AFL-CIO ("R.W.D.S.U."). The R.W.D.S.U.
agreement is for a three year period ending December 10, 2007. The contract is
subject to annual renewal thereafter and acknowledges that the R.W.D.S.U. is the
exclusive bargaining agent for the Company's regular production employees,
excluding all other employees including but not limited to supervisors, foremen,
clerical employees, time-keepers, watchmen, guards, maintenance personnel and
part-time employees. We believe our employee relations are good.
-21-
Risk Factors.
The following is a summary of certain risk factors that may cause our
results to differ from the "forward-looking statements" made in this report. The
risks and uncertainties described below are not listed in order of priority and
are not the only ones we face. Additional risks not presently known to us or
other factors not perceived by us to present significant risks to our business
at this time also may impair our business operations. If any of these risks
actually occur, our business, financial condition, and/or results of operations
would likely suffer significantly. We do not undertake to update any of these
forward-looking statements or to announce the results of any revisions to these
forward-looking statements except as required by law.
Risks Relating to Our Financial Condition.
We believe that our financial condition as of December 31, 2004 gives
rise to several risks and uncertainties. In addition, because of our status as a
majority owned subsidiary of Health-Chem, that company's financial condition and
future operating results may directly impact Transderm. We believe that the
financial information set forth below is relevant in this regard.
As of December 31, 2004:
o Transderm had aggregate debts and liabilities of approximately $9
million, which excludes approximately $28 million owed to
Health-Chem, but includes $4,522,000 due under the Key License,
which represents royalty payments owed over the last five years (the
"Key Royalty"), and had negative working capital of approximately
$21.9 million and combined cash on hand and accounts receivable of
approximately $3.9 million (the "Transderm Liabilities");
o Transderm owes approximately $28 million to Health-Chem in respect
of intercompany accounts, including $12,949,000 related to
redeemable preferred stock under which Transderm is currently in
default; $7,158,000 related to a subordinated promissory note under
which Transderm is currently in default; and $8,342,000 related to a
long-term payable (each of which items is more fully described under
"Management Discussion and Analysis of Financial Condition and
Results of Operations" and in the notes to the Financial Statements
and are herein collectively referred to as the "Intercompany
Obligations"); and
o Health-Chem had aggregate debts and liabilities of approximately
$19,898,000 (the "Group Liabilities"), including $10,197,000 under
the outstanding Debentures under which Health-Chem currently is in
default.
As of December 31, 2005, we estimate:
o Transderm had aggregate debts and liabilities of approximately
$8,421,000 (unaudited), which excludes intercompany obligations of
nearly $29 million, but includes $6,108,000 for royalties due under
the Key License; and
o the Group had aggregate debts and liabilities of approximately
$21,826,000 (unaudited), including $10,830,000 under the Debentures.
-22-
Risks relating to our financial condition include the following:
Our financial condition creates substantial doubt as to whether we will continue
to operate as a going concern. If we can not continue to operate as a going
concern, we may have to cease all operations and investors will lose their
entire investment in our company.
Transderm's audited consolidated financial statements for the years
ended December 31, 2003 and 2004 have been prepared assuming that we will
continue as a going concern. However, Note 3 of the Notes to Consolidated
Financial Statements details certain conditions and other factors that raise
substantial doubt about our ability to continue to operate as a going concern,
including:
o the aggregate amount of Transderm's outstanding debts and
liabilities at December 31, 2004 and specifically the amounts due to
Health-Chem (approximately $28 million) and Key;
o the fact that we currently are in default under our obligations to
Key under the Key License, having not made any payments to Key since
the inception of the license and that we have been able to continue
as a going concern because we have not paid Key;
o we do not have cash on hand to make the royalty payment owed to Key;
o our financial condition has prevented us from securing financing or
obtaining loans from third parties from which we could repay all or
a portion of the amounts due; and
o if our creditors initiated legal action against us, we would not be
able to continue to operate as a going concern unless there was an
increase in profitability and/or an infusion of additional funds in
order to meet these obligations for both the past amounts due and
ongoing amounts as they became due.
We have experienced net losses from operations in every year since 1995
and have an accumulated deficit of approximately $30.3 million at December 31,
2004. In addition, we had a working capital deficit of approximately $21.9
million at December 31, 2004.
Our independent auditors have cited certain of these conditions in an
explanatory paragraph to their audit report issued on our financial statements
for the years ended December 31, 2003 and 2004, and indicated that these
factors, among others, raise substantial doubt about our ability to continue as
a going concern.
We have been able to continue operating over the last several years
because we have not paid Health-Chem or Key. We do not have the means to satisfy
the amounts due to Health-Chem or pay the Key Royalty but we have been paying
our debts and liabilities not related to Health-Chem or the Key License on a
current basis from cash flow generated from operations. Our financial condition
has prevented us from securing financing or obtaining loans from which we could
repay all or a portion of the amounts due. We are further constrained from
obtaining financing because of Health-Chem's financial condition, as more fully
described in the ensuing risk factor. We recently have entered into discussions
with Key in an effort to develop payment arrangements for the amount owed to it,
though we cannot be certain we will be successful in our efforts in reaching an
agreement that allows us to continue our operations.
-23-
While management has formulated a plan to address the conditions cited
by the auditor in its report, as described under the heading "Management's
Discussion and Analysis of Financial Condition and Results of Operation" and in
Note 3 of the Notes to Consolidated Financial Statements, we cannot be certain
that we will be successful in executing this plan or that if we are successful
that we will achieve profitability. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
If we are unable to address successfully the conditions that raise
doubt about our ability to continue to operate as a going concern, particularly
our efforts to negotiate favorable payment terms of the amounts due to Key, we
may have to discontinue our operations and possibly seek protection under
bankruptcy laws, which likely would result in the loss of all value which our
stock now or at such time may have and result in investors losing the entire
amount of their investment.
Health-Chem's ability to achieve financial stability will bear on our financial
condition, ability to continue to operate as a going concern and achieve
profitability. If Health-Chem does not effectively address its financial
concerns, it may be required to take steps to wind-up the Group's, including
Transderm's, operations, in which case holders of our stock could lose the
entire amount of their investment.
As stated in the footnotes to the audited consolidated financial
statement included in Health-Chem's annual report for the year ended December
31, 2004 and the auditor's report on such financial statements, Health-Chem's
financial condition casts doubt upon its ability to continue operating as a
going concern. Health-Chem's principal liability (excluding liabilities and
obligations attributable exclusively to Transderm) consists of approximately
$10.2 million due under the Debentures.
Health-Chem is in default under several provisions of the Debentures as
a result of its failure to have paid principal and interest when they became due
in April 1999. A default allows the Trustee or the holders of at least 25% in
aggregate principal amount of all Debentures to declare the outstanding
principal of the Debentures plus all accrued and unpaid interest immediately due
and payable. Health-Chem has been able to continue operating because the Trustee
has not pursued legal redress to obtain the payment due. Health-Chem has
approached the Trustee to negotiate a payment plan but no assurance can be given
that Health-Chem will be successful in negotiating a payment plan that does not
unduly burden or otherwise prohibit normal operations, if at all. If Health-Chem
is unable to negotiate payment terms with the Trustee, it could initiate legal
action against Health-Chem for the entire amount due under the Debentures. In
such case, Health-Chem may have to liquidate all of its assets and dissolve or
wind-up the companies comprising the Group, including Transderm, or seek
protection from creditors under the federal bankruptcy laws which likely would
result in the loss of all value which our stock now or at such time may have and
result in investors losing the entire amount of their investment.
Even if payment terms for the Group's debts and liabilities are negotiated, the
Group's cash flow and ability to operate may be adversely affected.
If the Group successfully negotiates payment plans with respect to the
Key Royalties and the amount due under the Debentures, it is likely that a
significant portion of the Group's revenues will be allocated to making payments
under such agreements and there will be little capital to fund other business
opportunities, including new product development and marketing. In addition, the
Group's substantial indebtedness could have other important consequences to both
Transderm and Health-Chem, including, with respect to each company:
-24-
o negatively impacting its ability to remain current in the payment of
other liabilities and current accounts payable;
o limiting its ability to obtain additional financing for working
capital, capital expenditures, acquisitions and general corporate or
other purposes;
o increasing its vulnerability to general economic and industry
conditions; and
o placing it at a disadvantage compared to its competitors who have
less debt.
Even if we are able to restructure our debts and liabilities in a way that will
allow us to continue normal operations, we may not be able to generate
sufficient cash from operations to abide by the terms of the restructuring
agreements and we may be forced to take other actions to satisfy our obligations
under our indebtedness and to pay our other principal liabilities, which may not
be successful.
Even if we successfully restructure the Key Royalty, our ability to
make scheduled payments on this obligation and remain current with respect to
our other financial obligations will depend on our operating performance, which
is subject to prevailing economic and competitive conditions and to certain
financial, business and other factors beyond our control. We cannot assure you
that we will maintain a level of cash flows from operating activities sufficient
to permit us to pay Key under any restructuring agreement or remain current with
respect to our other outstanding liabilities
If our cash flows and capital resources are insufficient to fund the
payment of our obligations, we could face substantial liquidity problems and may
be forced to reduce or delay investments and capital expenditures and we might
be required to dispose of material assets or operations to meet our obligations.
These alternative measures may not be successful and may not permit us to
satisfy our obligations. We may not be able to consummate those dispositions or
to obtain the proceeds that we could realize from them and these proceeds may
not be adequate to meet any debt service obligations then due. Our inability to
generate cash from operations could have a material negative impact on Transderm
and the value of your investment in our common stock.
Health-Chem will bear similar risks with respect to the Debentures.
Transderm's Intercompany Obligations to Health-Chem are approximately $28
million. Health-Chem has not sought to collect on these obligations since they
began to accrue in 1995. If Health-Chem were to seek collection of such
Intercompany Obligations, Transderm would not be able to pay them and may be
forced to seek protection under bankruptcy laws.
Transderm owes Health-Chem approximately $28 million in intercompany
obligations as reported in its financial statements, some of which extend back
to 1995. To date, Health-Chem has not sought to collect the amounts due from
Transderm. Transderm does not currently have and does not expect to have in the
near future, sufficient funds to repay such obligations. If Health-Chem were to
seek collection of the amounts due, Transderm may have to seek protection under
bankruptcy laws and investors would lose the amount of their investment in
Transderm.
Risks Relating to Our Failure to File Reports under Federal Securities Laws.
We have not filed the periodic reports we are required to file with the SEC
since 1999 and we could become the subject of enforcement proceedings by the
SEC, including the de-registration of our securities, which could materially
adversely affect our business and your ability to obtain information about our
company.
-25-
For the reasons explained elsewhere in this report, since 1999 we have
not filed a report under the Securities Exchange Act which describes our
business and financial condition. Our failure to file such reports could give
rise to action by the SEC or private litigation by our current and former
shareholders. Among other possible penalties to which we may be subject, the SEC
could seek to revoke registration of our common stock under the Securities
Exchange Act which could result in less public information available to our
security holders and make it more difficult for us to raise capital in the
future. The inclusion in this report of audited financial and other information
for the years 2003 and 2004 will not cure our failure to file reports for 1999,
2000, 2001 and 2002 and the SEC could compel us to prepare and file such
reports, which may not be possible given the inadequate financial and other
records available to us for those years. We cannot predict what, if any,
penalties, fines, sanctions, enforcement or other actions or proceedings the SEC
may impose upon or take against our company; however, any such actions could
cause us to incur significant additional compliance expenditures and divert
management's attention from our core business activities. Moreover, we may be
subject to private suit by our current and former security holders for failing
to make available current information about our company which could subject
Transderm as well as our officers and directors to civil liabilities.
We have expended and will continue to apply considerable time, effort and
expense in connection with preparing and filing delinquent reports under the
federal securities laws which may divert our attention from our core business
and negatively impact our operations.
We have expended considerable administrative time, financial resources
and effort to prepare and file this annual report under the federal securities
laws. We expect to continue expending significant time, resources and effort to
file additional delinquent reports under such laws. These efforts will divert
management's attention from our core business which may adversely impact our
current and future operations and financial condition.
Risks Relating to Our Business.
We are dependent on the Key License for certain technology incorporated into our
transdermal patch under which we are five years in arrears in royalty payments
and, consequently, are in breach. If we are unable to negotiate a plan with Key
that allows us to pay the past due royalties and Key revokes the license or if
we otherwise lose our right to utilize the technology subject to such license we
will have to discontinue manufacturing our sole product.
We rely on the Key License to permit us to incorporate certain
transdermal patch technology owned by Key into our second generation transdermal
patch developed during the mid 1990's. If we are unsuccessful in negotiating a
plan with Key to pay past due royalties which does not impede our ability to
operate and does not materially impact our cash, we may be forced to discontinue
selling transdermal patches, and will have no source of revenue from product
sales. Given our current liabilities, it is unlikely we would be able to
continue operating under such circumstances and investors would lose the entire
amount of their investment in Transderm.
-26-
We are subject to all of the risks associated with being a single product
company, including special risks relating to the fact that we manufacture and
sell such product pursuant to a license. If we are unable to develop and bring
to market other products, our current and future operations and financial
condition may be adversely affected.
We manufacture and sell only one product, our nitroglycerin transdermal
patch. We are subject to all of the risks associated with being a single product
company, including
o the inordinate effect of competition on our business which could
cause us to reduce the price we charge for the product or erode
total sales, and the corresponding reduction in earnings we generate
from such product as result of competition;
o the loss of the Key License; and
o our inability to obtain critical raw materials from which we
manufacture the product.
If we experience any of the foregoing or other difficulties or
impediments with respect to sales of such product, our business, financial
condition and results of operations would be materially adversely affected.
We are seeking to develop and bring to market other products to broaden
our revenue base and reduce reliance on revenues generated from sales of our
nitroglycerin patch. We cannot be certain that our efforts to develop and market
other products will be successful. To the extent that we are unable to expand
our product offerings, our business and results of operation could be negatively
impacted and shareholders in our company may lose all or part of their
investment.
The development and manufacturing agreements to which we currently are a party
allow our clients to terminate these agreements at will. The termination of
these agreements for any reason would have a material negative impact on our
operations.
We are party to contracts with two clients under which we have agreed
to develop and manufacture three potential pharmaceutical compounds. We
currently generate revenues from these agreements in connection with our product
development efforts and may generate revenues under these agreements in the
future from the manufacture of products which ultimately are approved by the FDA
for sale in the United States, of which we can offer no assurance. In some
cases, our clients are permitted to terminate these agreements at will for any
reason. If our clients elect to terminate these agreements our current and
future operations would be adversely impacted.
We are subject to extensive regulation by the FDA and other federal and state
agencies. If we fail to maintain satisfactory compliance with FDA regulations
and other governmental agencies, we may be forced to suspend or terminate our
operations and we could be subject to civil or criminal penalties.
Our operations are subject to extensive regulation by governmental
authorities in the United States with respect to the testing, approval,
manufacture, labeling, marketing and sale of pharmaceutical products. These
regulations are wide-ranging and govern, among other things: adverse drug
experience reporting, product promotion, product pricing and discounting, drug
sample accountability, drug product stability, product manufacturing, including
good manufacturing practices, and product changes or modifications. Our
facilities handle controlled substances, resulting in additional extensive
regulatory requirements and oversight. Compliance with the extensive government
regulations applicable to our business requires the allocation of significant
time, effort and expense. Even if a product is approved by a regulatory
authority, product approvals may be withdrawn after the product reaches the
market if compliance with regulatory standards is not maintained or if problems
occur regarding the safety or efficacy of the product. If we fail to comply with
the regulatory requirements of the FDA and other applicable U.S. regulatory
authorities or previously unknown problems with our products or manufacturing
processes are discovered, we could be subject to administrative or judicially
imposed sanctions, including: restrictions on the products, manufacturers or
manufacturing processes; warning letters; civil or criminal penalties; fines;
injunctions; product seizures or detentions; voluntary or mandatory product
recalls and publicity requirements; unanticipated compliance expenditures;
suspension or withdrawal of previously approved marketing applications; total or
partial suspension of production; and criminal prosecution.
-27-
Our product sales are concentrated among a few customers and a substantial
decrease in revenues generated from sales to these customers would have an
adverse effect on our business unless we were able to identify other customers.
During each of fiscal years ended December 31, 2004 and 2003, a
significant portion of our revenues were derived from a small number of
customers. In 2004, two customers accounted for approximately 53% of our
revenues and these customers accounted for approximately 49% of our revenues
during fiscal 2003. A significant decrease in business from these customers and
the revenues lost, if we are unable to replace them, would have a material
adverse effect on our business, financial condition and results of operations.
Because our sales tend to be concentrated among a small number of
customers during any period, our operating results may be subject to substantial
fluctuations. Moreover, we tend to receive relatively large orders for products
from a relatively small number of customers. Consequently, a single order from
one customer may represent a substantial portion of our sales in any one period
and significant orders by any customer during one period may not be followed by
further orders from the same customer in subsequent periods. These and other
factors cause our sales and operating results to be subject to very substantial
periodic variations. Since quarterly performance is likely to vary
significantly, our results of operations for any quarter are not necessarily
indicative of the results that we might achieve for any subsequent period.
Accordingly, quarter-to-quarter comparisons of our operating results may not be
meaningful.
We rely on a single supplier or a limited number of suppliers for certain raw
materials used in our products.
Certain raw materials and components used in the manufacture of our
products are available from limited sources, and, in some cases, a single
source. Generally, regulatory authorities must approve raw material sources for
transdermal products, and in the case of controlled substances, the DEA sets
quotas for controlled substances and we must receive authorization from the DEA
to purchase and handle these substances. We cannot be certain that we will be
granted sufficient DEA quota to meet production requirements for controlled
substances. Without adequate approved supplies of raw materials or packaging
supplies, our manufacturing operations could be interrupted until another
supplier is identified, our products approved and trading terms with it
negotiated. We may not be able to identify an alternative supplier and any
supplier that we do identify may not be able to obtain the requisite regulatory
approvals in a timely manner, or at all. Furthermore, we may not be able to
negotiate favorable terms with an alternative supplier. Any disruptions in our
manufacturing operations from the loss of an approved supplier may cause us to
incur increased costs and lose revenues and may have an adverse effect on our
relationships with our partners and customers, any of which could have adverse
effects on our business and results of operations. Our business also faces the
risk that third party suppliers may supply us with raw materials that do not
meet required specifications, which, if undetected by us, could cause our
products to test out of specification and require us to recall the affected
product.
-28-
We rely on the services of a single agent to market our product and if we were
to lose the services of such entity or it was not as successful in its sales
efforts, our business and results of operations would be adversely affected.
We market all of our products through one entity. If we were to lose
the services of such marketing agent for any reason or said entity does not
maintain a steady demand for our product, and we are unable to identify an
adequate replacement, our business, results of operations and financial
condition would be materially adversely affected.
We may expend significant cash and personnel resources in the development of any
new products and if we do not generate the anticipated level of revenues from
sales of such products, our business will be negatively and adversely affected.
Our efforts to commercialize new products will require significant
expenditures of resources, including cash and time, in the research,
development, testing, preparation and execution of applications with
governmental authorities to manufacture and sell such product, preparation of
manufacturing operations and marketing of such product. If we do not generate
revenues from sales of any such product at levels anticipated prior to embarking
on such development, our business, financial position and results of operations
would be materially adversely affected.
We may lose out to larger and better-established competitors.
The drug delivery industry is intensely competitive. We face
competition from a number of companies that develop, market and sell transdermal
patches that deliver generic drugs, and competition is expected to intensify as
more companies enter the field. Most of our competitors have significantly
greater financial, technical, manufacturing, marketing and distribution
resources as well as greater experience in the drug delivery industry than we
have. The particular medical conditions our product addresses can also be
addressed by other drugs and other delivery modalities. Many of these
alternatives are widely accepted by physicians and have a long history of use.
Physicians may use our competitors' products and/or our products may not be
competitive with other technologies. If these things happen, our sales and
revenues will decline. Competition may result in price reductions, reduced gross
margins and loss of market share.
We cannot assure that our products will compete successfully against
competitive products or that developments by others will not render our products
obsolete or uncompetitive. If we cannot maintain competitive products and
technologies, our current and potential strategic partners may choose to adopt
the drug delivery technologies of our competitors or their own internally
developed technologies.
Our product may be displaced by more effective medications or newer
technologies.
The drug development and delivery industries are undergoing rapid and
significant change. Others may succeed in developing and marketing drugs and
products that are more effective than those developed or marketed by us, or that
would make our product obsolete or non-competitive. Additionally, researchers
could develop new delivery devices and medications that replace or reduce the
importance of our products. Accordingly, our success will depend, in part, on
our ability to respond quickly to medical and technological changes through the
development and introduction of new products. We may not have the resources to
do this. If our products become obsolete and our efforts to develop new products
do not result in any commercially successful products, our sales and revenues
will decline.
-29-
Competitors may use legal, regulatory and legislative strategies to prevent or
delay our launch of generic products.
The Hatch-Waxman Act provides for a period of 180 days of generic
marketing exclusivity for each ANDA applicant that is first to file an ANDA
containing a certification of invalidity, non-infringement or unenforceability
related to a patent listed with respect to a reference drug product, commonly
referred to as a Paragraph IV certification. During this exclusivity period, the
FDA cannot grant final approval to any other Paragraph IV filer. If an ANDA
containing a Paragraph IV certification is successful, it generally results in
higher market share, net revenues and gross margin for that applicant for a
period of time. Even if we obtain FDA approval for generic drug products, we may
lose significant advantages to a competitor who was first to file an ANDA
containing a Paragraph IV certification.
Competitors may also pursue legislative and other regulatory or
litigation strategies to prevent or delay our launch of a generic product. These
strategies include, but are not limited to: seeking to obtain new patents on
drugs for which patent protection is about to expire, changing the labeling for
the branded product, filing a citizen petition with the FDA, pursuing state
legislative efforts to limit the substitution of generic versions of brand
pharmaceuticals, filing patent infringement lawsuits that automatically delay
FDA approval of many generic products, introducing a second generation product
prior to the expiration of market exclusivity for the first generation product
which may reduce demand for a generic first generation product, and obtaining
market exclusivity extensions by conducting pediatric trials of brand drugs.
Unfavorable pricing regulations, third-party reimbursement practices or
healthcare reform initiatives applicable to our product and product candidates
could limit our potential product revenue.
The healthcare industry is undergoing fundamental changes resulting
from political, economic and regulatory influences. In the United States,
comprehensive programs have been proposed that seek to increase access to
healthcare for the uninsured, control the escalation of healthcare expenditures
within the economy and use healthcare reimbursement policies to balance the
federal budget.
We expect that Congress and state legislatures will continue to review
and assess healthcare proposals, and public debate of these issues will likely
continue. We cannot predict which, if any, of such reform proposals will be
adopted and when they might be adopted. Significant changes in the healthcare
system could have a substantial impact on the manner in which we conduct our
business and could require us to revise our strategies and negatively affect our
business, prospects and results of operations.
Legislative or regulatory programs that may influence prices of prescription
drugs could have a material adverse effect on our business, financial position
and results of operations.
Current or future federal or state laws and regulations may influence
the prices of drugs and, therefore, could adversely affect the price that we
receive for our product. Programs in existence in certain states seek to set
prices of all drugs sold within those states through the regulation and
administration of the sale of prescription drugs. Expansion of these programs,
in particular, state Medicaid programs, or changes required in the way in which
Medicaid rebates are calculated under such programs, could adversely affect the
price we receive for our product and could have a material adverse effect on our
business, financial position and results of operations.
-30-
We cannot be certain of the protection or confidentiality of our patents and
proprietary rights.
Our success will depend, in part, on our ability to obtain or license
patents for our products, processes and technologies. If we do not do so, our
competitors may exploit our innovations and deprive us of the ability to realize
revenues from those innovations. There is no assurance that we will be issued
patents for any patent applications we may file, that any existing or future
patents that we receive or license will provide competitive advantages for our
products, or that we will be able to enforce successfully our patent rights.
Additionally, there can be no assurance that our patents or any future patents
we may be issued will prevent other companies from developing similar or
functionally equivalent products, or challenging, invalidating or avoiding our
patent applications or any existing or future patents that we receive or
license.
We also rely on trade secrets, unpatented proprietary know-how and
continuing technological innovation. We use confidentiality agreements with
purchasers, suppliers, employees and consultants to protect our trade secrets,
unpatented proprietary know-how and continuing technological innovation, but
there can be no assurance that these parties will not breach their agreements
with us or that we will be able to effectively enforce our rights under those
agreements. We also cannot be certain that we will have adequate remedies for
any breach. Disputes may arise concerning the ownership of intellectual property
or the applicability of confidentiality agreements. Furthermore, we cannot be
sure that our trade secrets and proprietary technology will not otherwise become
known or that our competitors will not independently develop our trade secrets
and proprietary technology.
Third parties may claim that we infringe their proprietary rights, forcing us to
expend substantial resources in resulting litigation, the outcome of which is
uncertain. Any unfavorable outcome could negatively affect our financial
position and results of operations.
Our success will depend, in part, on our ability to operate without
infringing the proprietary rights of others, and there can be no assurance that
our products and processes will not infringe upon the patents of others. Third
parties may also institute patent litigation against us for competitive reasons
unrelated to any infringement by us. If a third party asserts a claim of
infringement, we may have to seek licenses, defend infringement actions or
challenge the validity of those third-party patents in court. If we cannot
obtain the required licenses, or are found liable for infringement or are not
able to have these patents declared invalid, we may be liable for significant
monetary damages, encounter significant delays in bringing products to market or
be precluded from participating in the manufacture, use or sale of products or
methods of drug delivery covered by the patents of others. There can be no
assurance that we have identified, or that in the future we will be able to
identify, all U.S. and foreign patents that may pose a risk of potential
infringement claims.
We may not be able to manufacture new products in commercial quantities
efficiently.
We may seek to bring to market new products that we have never
manufactured on a commercial scale. Accordingly, inefficiencies and other
scale-up problems may occur in the process of manufacturing new products in
commercial quantities. If we experience manufacturing difficulties, our overall
manufacturing costs may be higher than we had anticipated.
-31-
We may be subject to product liability claims and we cannot be certain that we
will have adequate insurance coverage.
The testing, manufacturing and marketing of our products may expose us
to potential product liability and other claims resulting from their use. If any
such claims against us are successful, we may be required to make significant
compensation payments and suffer adverse publicity. Even unsuccessful claims
could result in the expenditure of funds in litigation and the diversion of
management time and resources. We maintain product liability insurance, but
there can be no assurance that our insurance will cover all future claims or
that we will be able to maintain existing coverage or obtain additional coverage
at reasonable rates. If a claim is not covered or if our coverage is
insufficient, we may incur significant liability payments that would negatively
affect our business, financial position or results of operations.
All of our products are manufactured at one location and any interruption of
production at this facility could negatively affect our business, financial
position and results of operations.
All of our products are manufactured at a single facility in
Emigsville, Pennsylvania. An interruption of manufacturing resulting from
regulatory issues, technical problems, casualty loss or other factors could
result in our inability to meet production requirements, which may cause us to
lose revenues and which could have an adverse effect on our relationships with
our partners and customers, any of which could have a material adverse effect on
our business, financial position or results of operations. We maintain business
interruption insurance, but we cannot assure investors that our insurance will
cover all future claims or that we will be able to maintain existing coverage or
obtain additional coverage at reasonable rates. Without our existing production
facility, we would have no other means of manufacturing our products until we
were able to restore the manufacturing capability at our facility or develop an
alternative manufacturing facility.
Our insurance coverage may not be adequate and rising insurance premiums could
negatively affect our profitability.
We rely on insurance to protect us from many business risks, including
product liability, business interruption, property and casualty loss and
employment practices liability. The cost of insurance has risen significantly in
recent years. In response, we may increase deductibles and/or decrease certain
coverages to mitigate these costs. There can be no assurance that the insurance
that we maintain and intend to maintain will be adequate, or that the cost of
insurance and limitations in coverage will not adversely affect our business,
financial position or results of operations. Furthermore, if is possible that,
in some cases, coverage may not be available at any price.
We enter into agreements that include provisions that require us to indemnify
the other party under certain circumstances. If we are required to perform under
these indemnification provisions, our financial condition and results of
operations could be negatively affected.
Many of the license, development, supply, employment and other
agreements we enter into include indemnification provisions. The various
indemnification provisions in these agreements are not uniform and may be
subject to differing legal interpretations. Accordingly, it may be difficult for
us to determine or accurately predict in advance what indemnification
obligations we may owe under these provisions or, alternatively, what
obligations may be owed to us by these parties, including as it relates to
potential damages, settlement amounts and defense costs associated with the
product liability lawsuits that claim the use of products manufactured by us and
distributed by third parties. Our insurance coverage may mitigate the costs of
some of our obligations under these indemnification provisions but our business,
financial position and results of operations could be harmed if we are required
to perform under these indemnification provisions and there is no or
insufficient insurance coverage.
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We may have difficulty raising capital, which could deprive us of necessary
resources.
We expect to continue to devote significant capital resources to fund
research and development and to maintain existing manufacturing capacity. In
order to support the initiatives envisioned in our business plan, we may need to
raise additional funds through the sale of assets, public or private debt or
equity financing, collaborative relationships or other arrangements. Our ability
to raise financing depends on many factors beyond our control, including the
state of capital markets and the development or prospects for development of
competitive technology by others. Because our common stock is not listed on a
major stock market, many investors may not be willing or allowed to purchase it
or may demand steep discounts. Our current financial condition and the status of
our obligations under the Key License and Health-Chem's obligations under the
Debentures have prevented us and the Group from borrowing money from third
parties or raising capital from the sale of equity. Sufficient additional
financing may not be available to us or may be available only on terms that
would result in further dilution to the current owners of our common stock. If
we are unable to raise additional funds when we need them, we may have to
severely curtail our operations.
Our success depends on attracting and retaining our key employees.
Our success depends on our ability to attract and retain qualified,
experienced personnel. We face significant competition in recruiting talented
personnel. The loss of key personnel, or the inability to attract and retain
additional, competent employees, could adversely affect our business, financial
position or results of operations.
Limitations on liability and indemnification matters.
As permitted by the corporate laws of the State of Delaware, we have
included in our Certificate of Incorporation a provision to eliminate the
personal liability of our directors for monetary damages for breach or alleged
breach of their fiduciary duties as directors, subject to certain exceptions. In
addition, our By-Laws provide that we are required to indemnify our officers and
directors under certain circumstances, including those circumstances in which
indemnification would otherwise be discretionary, and we will be required to
advance expenses to our officers and directors as incurred in connection with
proceedings against them for which they may be indemnified.
We have no intention of paying dividends on our common stock in the near future
and holders of our common stock will have to rely on the appreciation thereof to
realize any monies from holding these securities.
We have not paid any dividends on our common stock and do not
anticipate paying cash dividends in the foreseeable future. Management intends
to retain any earnings to finance the growth of the Company's business.
Management cannot assure you that the Company will ever pay cash dividends.
Accordingly, holders of our common stock will have to rely on the appreciation
thereof to realize any monies from holding these securities.
Our common stock is not traded or admitted to quotation on any market, so you
may not be able to sell your shares of common stock and thus you may never
realize any monies from holding these securities.
-33-
Our common stock is not listed on any stock market or admitted to
quotation on the over-the-counter bulletin board, accordingly, there is no
established public trading market for our common stock. Management does not
expect to seek to develop a market for our common stock. Therefore, you may only
be able to dispose of our common stock in a private transaction.
We must maintain adequate internal controls and in the future be able, on an
annual basis, to provide an assertion as to the effectiveness of such controls.
Effective internal controls are necessary for the Company to provide
reasonable assurance with respect to its financial reports. We may be required
to spend a substantial amount of management time and resources to comply with
changing laws, regulations and standards relating to corporate governance and
public disclosure, including the Sarbanes-Oxley Act of 2002 and new SEC
regulations. In particular, Section 404 of the Sarbanes-Oxley Act of 2002
requires management's annual review and evaluation of our internal control
systems, and attestations as to the effectiveness of these systems by our
independent public accounting firm. If we fail to maintain the adequacy of our
internal controls, we may not be able to ensure that we can conclude on an
ongoing basis that we have effective internal control over financial reporting.
Additionally, internal control over financial reporting may not prevent or
detect misstatements because of its inherent limitations, including the
possibility of human error, the circumvention or overriding of controls, or
fraud. Therefore, even effective internal controls can provide only reasonable
assurance with respect to the preparation and fair presentation of financial
statements. In addition, projections of any evaluation of effectiveness of
internal control over financial reporting to future periods are subject to the
risk that the control may become inadequate because of changes in conditions, or
that the degree of compliance with the policies or procedures may deteriorate.
If the Company fails to maintain the adequacy of its internal controls,
including any failure to implement required new or improved controls, this could
have a material adverse effect on our business, financial position and results
of operations.
There are inherent uncertainties involved in estimates, judgments and
assumptions used in the preparation of financial statements in accordance with
GAAP.
The consolidated and condensed consolidated financial statements
included in the periodic reports we are required to file with the SEC are
prepared in accordance with accounting principles generally accepted in the
United States of America ("GAAP"). The preparation of financial statements in
accordance with GAAP involves making estimates, judgments and assumptions that
affect reported amounts of assets (including intangible assets), liabilities,
revenues, expenses and income. Estimates, judgments and assumptions are
inherently subject to change in the future and any necessary revisions to prior
estimates, judgments or assumptions could lead to a restatement. Any such
changes could result in corresponding changes to the amounts of assets
(including goodwill and other intangible assets), liabilities, revenues,
expenses and income. Any such changes could have a material adverse effect on
our business, financial position and results of operations.
ITEM 2. DESCRIPTION OF PROPERTIES
We lease an approximately 61,000 square foot building, from a related
party, located on approximately 3.5 acres in Emigsville, Pennsylvania which is
used for manufacturing, laboratory, engineering, quality control, research and
development, warehousing, administrative and office purposes. Our manufacturing
facility complies with GMP standards and is operating under registration from
both the FDA and DEA and pursuant to registration with the Pennsylvania
Department of Health. The lease, which expires December 6, 2019, has an annual
rental of $212,400, payable in equal monthly installments of $17,700.
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We believe that our present facilities are in good condition and are
adequate for our current and immediate future requirements.
ITEM 3. LEGAL PROCEEDINGS
The Company is not currently party to any legal proceedings.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None
PART II
ITEM 5. MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS
Our common stock is not currently listed or admitted to quotation on
any established trading market. Our common stock had been quoted on the over the
counter bulletin board until June 2000. Thereafter, quotes for our stock were
reported on the Pink Sheets from time to time through July 2005. The Pink Sheets
is a centralized quotation service that collects and publishes market maker
quotes for over-the-counter securities in real time.
The table below provides information regarding the high and low sales
prices for the Company's common stock, as reported by the Pink Sheets, during
the two years ended December 31, 2004:
QUARTER 2004 2003
-------------- ---------------------------------- ----------------------------------
High Low High Low
-------------- ----------------- ---------------- ----------------- ----------------
1st $0.0001 $0.0001 $0.0001 $0.0001
-------------- ----------------- ---------------- ----------------- ----------------
2nd 0.0001 0.0001 0.0001 0.0001
-------------- ----------------- ---------------- ----------------- ----------------
3rd 0.001 0.0001 0.0001 0.0001
-------------- ----------------- ---------------- ----------------- ----------------
4th 0.0001 0.0001 0.0001 0.0001
-------------- ----------------- ---------------- ----------------- ----------------
As of July 14, 2005, there were approximately 142 holders of record of
our common stock. This number of holders of record does not include beneficial
owners of our common stock whose shares are held in the names of various
security holders, dealers and clearing agencies.
We have not paid any cash dividends on our common stock and we do not
anticipate paying cash dividends in the foreseeable future.
-35-
Recent Sales of Unregistered Securities.
Transderm has not sold or issued any securities since 1998.
ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
The following discussion and analysis, as well as other sections in
this Form 10-KSB, should be read in conjunction with the Consolidated Financial
Statements and related Notes to Consolidated Financial Statements included
elsewhere in this report.
This discussion and analysis may contain "forward-looking statements".
These statements are made pursuant to the safe harbor provisions of the Private
Securities Litigation Reform Act of 1995. Such forward-looking statements may
include, without limitation, statements about the Company's market
opportunities, strategies, competition and expected activities and expenditures,
and at times may be identified by the use of words such as "may", "will",
"could", "should", "would", "project", "believe", "anticipate", "expect",
"plan", "estimate", "forecast", "potential", "intend", "continue" and variations
of these words or comparable words. Forward-looking statements inherently
involve risks and uncertainties. Accordingly, actual results may differ
materially from those expressed or implied by these forward-looking statements.
Factors that could cause or contribute to such differences include, but are not
limited to, the risks described under "Risk Factors" in Item 1. The Company
undertakes no obligation to update any forward-looking statements for revisions
or changes after the date of this Form 10-KSB.
Company Overview.
We manufacture controlled release products to deliver drugs topically
or transdermally (transdermal patches). Since 1986, the Company has manufactured
a transdermal nitroglycerin patch which is used for transdermal relief of
vascular and cardiovascular symptoms related to angina pectoris. This patch was
the first such product introduced in the United States for the generic market
and is currently our sole product. We manufacture our nitroglycerin patch both
on a contract basis for specific clients and for sale to distributors and
wholesalers for distribution in the United States. We have the technical
expertise and manufacturing capability to produce transdermal patches which
deliver other medications. We manufacture our products in accordance with GMP's
prescribed by the FDA at our facility in Emigsville, Pennsylvania. We utilize
the services of an independent sales organization to identify customers and to
market and sell our transdermal patches. We conduct the majority of our business
through our 98.5%-owned subsidiary, Hercon Laboratories Corporation. Health-Chem
owns 90% of our outstanding common stock.
We generate revenues principally from sales of transdermal patches and
secondarily from research and development projects we undertake for third
parties on a contract basis.
Our business faces certain important risks, including that:
o the pharmaceutical industry is highly regulated and intensely
competitive;
o we generate the vast majority of our revenue from sales of a single
product;
o we are in breach of the terms of a technology license agreement (the
Key License) upon which we rely to manufacture our sole product
because we have never made royalty payments thereunder, which
totaled $4,522,000 at December 31, 2004 and $6,108,000 at December
31, 2005 (unaudited);
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o we have no borrowing capacity to expand our product lines and reduce
our reliance on sales from our nitroglycerin patches or to take
advantage of other business opportunities as they arise;
o as of December 31, 2004, we had debts and liabilities to third
parties of approximately $9 million (including $6.1 million under
the Key License) and to Health-Chem of approximately $28 million;
and
o as of December 31, 2004, Health-Chem had aggregate debts and
liabilities of approximately $19,898,000, including $10,197,000 of
principal and accrued interest due under the Debentures, which cast
doubt on its ability to continue to operate as a going concern.
During fiscal 2004, we posted better operating results than fiscal
2003. When comparing 2004 to 2003, net sales increased by 16% to nearly $9.2
million from $7.9 million, while total operating expenses decreased by 7% to
$3.2 million from $3.5 million and the cost of goods sold increased by 4% to
$6.2 million from $6.0 million. Management attributes the increase in net sales
for the years 2004 to 2003 primarily to increased sales volumes of nitroglycerin
patches from existing customers. We were able to increase sales of our patch
product because we have successfully and efficiently ramped-up our manufacturing
capability, which had been dormant for nearly two years; proved to purchasers
that we are a reliable manufacturer of quality products which we deliver on a
timely basis in conformity with contract requirements; and intensified marketing
efforts. We attribute the decline in operating expenses and the
disproportionately low (compared to the percent which sales grew) increase in
cost of sales to increased efficiency resulting from economies of scale.
Historical Perspective.
In 1995, at the peak of operations, the Company generated net income of
approximately $1.4 million on net sales of $12.5 million and employed nearly
seventy full-time employees. After 1995, sales of our core products began to
decline, precipitated by our inability to sell a new generation transdermal
patch by reason of a delay in FDA approval of the product, the initiation of a
lawsuit by Key Pharmaceuticals Inc. which alleged that the Company's new
transdermal patch infringed on a patent issued to Key and the loss of a
significant domestic distributor of our nitroglycerin patch. Moreover, we were
not successful in our efforts to bring to market new transdermal products for
the treatment of post-menopausal symptoms or other hormone replacement therapies
that we were developing in the 1990's. For the year ended December 31, 1997, we
suffered a net loss of $2.2 million on net sales of approximately $5.3 million
and had a working capital deficit in excess of $1 million. While net sales for
the year ended December 31, 1998 increased to approximately $6.9 million, we
reported a net loss of $674,000 for the year. The increase in net sales during
1998 was attributable to sales of a non-transdermal product, a deep cleansing
facial pore strip, to two customers. Sales of the facial pore strips declined
during each quarter of 1999 and we discontinued selling this product in July
1999.
Our financial and operating condition has been and continues to be
inextricably entwined with that of Health-Chem and our other affiliates in the
Group. Our ability to recover from declining operating results during the 1990's
was constrained by the Group's financial performance and condition. During this
period, the Group was suffering declining sales throughout all product lines
within the synthetic fabrics business as a result of lower demand from certain
large customers and the elimination of unprofitable business, including certain
government contracts. The Group did not have further borrowing capacity under
existing lines of credit under which all of the Group's assets were pledged as
security and could not obtain additional financing. Moreover, Health-Chem's
obligations under the Debentures, $10,401,000 of principal as of December 31,
1996, which became due in 1999 ("Debentures") made further borrowing impossible.
-37-
As sales of the Group's core products continued to decline in 1997 and
1998, management determined to restructure a portion of the Group's operations
by closing one of its synthetic fabric manufacturing plants in July 1999.
Continuing pressure to generate cash to service debt obligations prompted
management to sell the assets of Health-Chem's Herculite and Hercon
Environmental subsidiaries to a management-led group in August 1999 (the "Asset
Sale"), the proceeds from which were used to satisfy the entire amount due under
the term loan which aggregated $9.8 million, and to make a $1.9 million payment
on the Debentures.
Upon consummation of the Asset Sale, the Group's sole product was the
Company's nitroglycerin transdermal patch, sales of which declined to under $4.9
million for the first three quarters of 1999. Transderm's financial difficulties
were compounded by the fact that it had discontinued manufacturing its first
generation patch, in anticipation of the impending introduction of its second
generation patch, and had only minimal stock of that product to sell. However,
Transderm was prevented from selling this product for nearly two years both
because Key had obtained an injunction against the Company from selling the
product and the FDA had not approved new manufacturing processes and raw
materials to be used in the product. Moreover, several members of management who
were responsible for accounting and financial functions left the Group to
participate in the management of the businesses the Group sold in the Asset
Sale. Consequently, neither Health-Chem nor Transderm could afford to retain
their remaining senior financial staff and were not generating the revenues
necessary to prepare quarterly and annual reports and discontinued filing
reports with the SEC in 1999.
A proxy contest for control of Health-Chem in late 1999 ushered in new
management who were not fully cognizant of the Group's dire financial condition.
Shortly after taking office in the first quarter of 2000, management became
aware that the Group had cash sufficient to operate at then current levels for
approximately eight weeks and little to no inventory of its first generation
transdermal patch to sell to generate cash.
In March 2000, we negotiated a license with Key to utilize the
technology covered by the patent which was the subject of litigation (the "Key
License") and had received approval from the FDA to proceed with the manufacture
and sale of our second generation patch. We began to sell the new patch product
in late 2000.
Management recognized the need to diversify the Company's operations so
as not to be totally reliant on a single product. Toward that end, in separate
transactions in 2001, Health-Chem acquired certain manufacturing assets and
product schematics with the intention of developing a diagnostic product
division and engaged the inventor of the products it proposed to manufacture and
market. Health-Chem was unable to manufacture the products efficiently,
generated only minimal revenues from their sale and divested the asset of this
division in 2004.
In order to support its operations during the period 1999 through 2002,
the Group obtained a loan from a non-traditional lender secured by a mortgage on
the Company's Pennsylvania facility and borrowed money from management. In 2004,
the Company sold its real property and plant in Pennsylvania to a company owned,
in part, by an affiliate. The Company currently leases this facility through
2019, which it can extend for an additional five years and has the option to
repurchase the property.
-38-
Currently, we utilize the services of an independent sales organization
to identify customers and market our second generation nitroglycerin transdermal
patches. Revenues generated from sales of this product have increased during
2003 and 2004 as we have ramped-up our manufacturing capacity, demonstrated an
ability to produce quality products on a timely basis at a reasonable price and
intensified our marketing efforts.
As of December 31, 2004, the Company had significant debts and
liabilities to third parties. Our substantial unpaid debt and failure to resolve
our obligations under the Key License, along with our lack of profitable
operations from 2003 through 2004 have caused our independent auditors to add an
explanatory paragraph to their audit opinion issued on our financial statements
for the year ended December 31, 2004 indicating that these factors, among
others, raise substantial doubt about our ability to continue as a going
concern.
Organizational Perspective.
In April 1995, the board of directors of Health-Chem approved a plan to
realign certain of its business operations in order to separate its transdermal
pharmaceutical business from its hospital and industrial laminated fabrics and
environmental chemical business. As part of such realignment, our subsidiary
Hercon Laboratories Corporation ("Hercon") effectively transferred its
environmental chemical business to a subsidiary of Health-Chem, Hercon
Environmental Corporation.
Following the completion of the transfer of the environmental business,
Transderm, Hercon, Herculite Products, Inc. ("Herculite"), which is a
wholly-owned subsidiary of Health-Chem, and Health-Chem entered into a Plan of
Reorganization and Asset Exchange Agreement effective August 31, 1995.
The Plan of Reorganization and Asset Exchange Agreement required:
o The transfer from Herculite to the Company of the manufacturing
facility in which Hercon's operations are conducted and the 985
shares of Hercon common stock owned by Herculite in exchange for
1,000,000 shares of the Company's Redeemable Preferred Stock,
$10.00 par value.
o Hercon's issuance to Health-Chem of a $7,000,000, 9% Subordinated
Promissory Note evidencing the approximate amount of intercompany
advances owed by Hercon to Health-Chem.
o The Company's issuance of 40,000,000 shares of its authorized
60,000,000 shares of Common Stock, $.001 par value, in exchange for
the previously issued 50 shares of its $.01 par value common stock.
o The Company's participation in a Corporate Services Agreement with
Health-Chem, described below.
o The Company's payment to Health-Chem as the Company uses its net
operating loss and tax credit carryforwards to offset future taxable
income as a result of entering into a Tax Sharing Agreement, more
fully described below.
In September 1995, Health-Chem issued subscription rights to purchase
up to 4,000,000 shares of Transderm's common stock for $.10 per share to holders
of its common stock. The Rights Offering expired November 10, 1995, with
shareholders subscribing to the 4,000,000 shares of common stock by exercising
their subscription rights.
-39-
Under the Corporate Services Agreement between the Company and
Health-Chem, entered into as a result of the Plan of Reorganization and Asset
Exchange Agreement, Health-Chem provides or otherwise makes available to the
Company certain general corporate services provided by Health-Chem's corporate
staff, including, but not limited to, accounting, tax, corporate communications,
legal, data processing, purchasing, human resources, financial and other
administrative staff functions, and arranges for administration of insurance and
employee benefit programs. The Company reimburses Health-Chem for the actual
out-of-pocket cost to Health-Chem or, for those services not directly
attributable to the Company, reimburses them based upon a method (allocation
based upon the Company's net sales as a percentage of Health-Chem's consolidated
net sales) which is considered by the Company to be reasonable. The Company
reimbursed Health-Chem approximately $229,000 and $393,000 in 2004 and 2003,
respectively. The agreement had an initial term that expired on December 31,
1997 and automatically renews for successive one-year terms unless notice of
non-renewal is given by either party.
The Company is included in the consolidated federal income tax return
of Health-Chem and is party to a Tax Sharing Agreement. Under the Tax Sharing
Agreement, the Company is required to pay Health-Chem as the Company uses its
net operating loss and tax credit carryforwards to offset future taxable income.
The Company participates in Health-Chem's cash management practice,
wherein all cash requirements are borrowed from Health-Chem and all excess cash
is advanced to Health-Chem. The intercompany balance, which was $8,342,000 at
December 31, 2004, is expected to be paid out of future cash flow and is
therefore considered to be long-term. The Company pays interest on the amount
due at a rate calculated based upon the average outstanding intercompany balance
and interest rate on Health-Chem's debt. The average interest rate charged was
11.34% during 2004. On August 31, 1995, Hercon issued to Health-Chem a
$7,000,000, 9% Subordinated Promissory Note in exchange for the then outstanding
borrowings from affiliates under these cash management practices. Under this
promissory note, the Company was required to make semi-annual interest payments
each March and September, with the principal amount of $7,000,000 payable on
March 31, 1999. The Company did not make any interest payments on the promissory
note nor did it repay the principal amount of the promissory note when it came
due and has been in default under the note since March 2002 (after giving effect
to Health-Chem's extension of the note). Health-Chem has not sought collection
of the amounts due under the promissory note.
Factors Which We Believe Affect Our Current Operations and May Materially Impact
Our Future Operations.
Certain existing conditions and known material uncertainties could
impact our business in the short- and long- term. Investors should analyze our
business in light of the issues and uncertainties described in the following
discussion which is intended to highlight and amplify numerical and other
information contained in the remainder of this section and throughout this
Annual Report.
Our Company faces several challenges as we continue our efforts to
emerge from the financial and operating crisis of the late 1990's. In addition
to matters internal to the Company, issues relating to Health-Chem's financial
condition may impact our operations in the future because it owns 90% of our
outstanding stock. Management has identified the following existing factors and
known uncertainties as those most likely to materially impact our current and
future operations:
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o the resolution of our obligations under the Key License;
o Health Chem's ability to resolve its obligations under the
Debentures;
o issues relating to reliance on a single product for the majority of
our revenues;
o the difficulty we will have diversifying our product offerings given
our financial condition;
o short- and long- term liquidity issues;
o the need to identify and retain senior management who have
experience in the pharmaceutical industry or in any business in
which we may become involved in the future;
o the impact of competition on our business; and
o our dependence upon sales to two customers.
Since 2000, sales of nitroglycerin transdermal patches by the Company
have been the sole source of recurring revenue for the Company and the Group.
Revenues generated from sales of this product have been sufficient to allow
Transderm to retain the personnel necessary to reform its internal accounting
practices and resume reporting under federal securities laws but neither the
Company nor Health-Chem has posted a net profit since 1995. Accordingly, neither
company has the financial resources to satisfy its respective outstanding
obligations and liabilities. In order to avoid litigation for the collection of
the sums due, in the case of Transderm, the royalties due under the Key License,
and in the case of Health-Chem, the amount due under the Debentures, a possible
outcome of which for both companies, among others, could be filings for
protection from creditors under the bankruptcy laws, we will have to reach an
agreement with Key and Health-Chem will have to achieve a settlement with the
holders of the Debentures. These agreements will have to provide, among other
critical features, sufficient latitude to permit the Company and the Group to
take the steps necessary to strengthen the business, including allowing the
companies to retain cash sufficient to augment product lines and retain senior
management.
As the Company has re-established product sales over the last few
years, the Group has been able to forestall taking action with respect to
resolving its obligations under the Key License and the Debentures. Management
of Transderm recently commenced discussions with representatives of Key to
develop a plan to pay the royalties due under the Key License but no substantive
terms have been agreed upon as of the date hereof. Over the last several years,
management of Health-Chem has been in sporadic contact with the Trustee of the
Debentures which has proposed opening negotiations with respect to its
satisfying obligations under these instruments, but has not set a meeting date
to discuss the matter. Health-Chem has executed tolling agreements with the
Trustee in each of the last two years extending the time in which the Trustee is
permitted to seek legal redress for Health-Chem's default under the Debentures.
The nature of the agreements with these creditors, if the companies are able to
negotiate them, and the manner in which the parties will be required to satisfy
their respective obligations represent a known uncertainty and will bear
materially on each company's business and financial condition and likely will
significantly impact their respective liquidity positions and cash resources for
the foreseeable future.
Accordingly, short - and long-term liquidity issues represent a
significant challenge as we seek to balance rebuilding and restructuring our
business with and paying past royalties due under the Key License. Our liquidity
likely will be affected by the manner in which Health-Chem negotiates repayment
of the amount due under the Debentures. Our lack of liquidity impacts our
business in many ways, some of which are inexorably intertwined and affect all
aspects of our operations, as more fully described below.
-41-
Sales and revenues have increased during 2003 and 2004 as we have:
successfully ramped-up our manufacturing capability which had been dormant for
nearly two years; proven to purchasers that we are a reliable manufacturer of
quality products which we deliver on a timely basis in conformity with contract
requirements; and intensified our marketing efforts. Despite our increased
sales, we remained unprofitable during the years 2003 and 2004 and operate under
the constant pressure of limited available cash. We cannot be certain that we
ever will achieve profitability.
The Group's lack of liquidity and its constituent's obligations to the
Debenture holders and Key currently and in the future will affect its ability
to:
o diversify operations by developing new products and reduce reliance
on revenues generated from sales of a single product;
o obtain financing for operations;
o engage senior management with experience in the pharmaceutical
industry or any other industry in which we might become involved in
the future;
o endure business cycles resulting from general economic conditions or
the effects of competition, among other things, as they occur; and
o take advantage of business opportunities as they may arise.
Assuming the Group is successful in its efforts to reach favorable
agreements with both Key and the holders of the Debentures, it is severely
constrained by financial and personnel resources from taking the steps required
to diversify its operations to reduce reliance on revenues generated solely from
the sale of transdermal nitroglycerin patches. Management believes it is
critical to the Company's and the Group's future to develop additional sources
of revenue to offset potential adverse business developments which may impact
Transderm's sales of transdermal nitroglycerin patch, which include:
o the potential negative impact of competition, which could require us
to reduce the price we charges for our product or which would result
in diminished sales, either of which would reduce our revenues;
o the introduction by others of new products, such as new drugs or
delivery methods which render our nitroglycerin transdermal patches
obsolete; or
o other events or general economic conditions which result in
diminished demand for our transdermal patch.
Given our current financial and business condition, it is unlikely that
we will be able to obtain outside financing from any source for any purpose,
including introducing new products. We have no material assets to offer as
collateral given that we sold our real property and equipment in 2004 (though we
are able to carry these items on our financial statements because York Realty
Leasing LLC, the entity that purchased the real property and equipment, is
considered a "variable interest entity" and according to GAAP our consolidated
balance sheet must include the assets and liabilities of York Realty Leasing
LLC) and the risks and uncertainties that attach to our operations would present
significant impediments to locating a source of financing. Our inability to
obtain outside financing, among other things:
-42-
o will restrict our ability to develop or add new products;
o restrict our ability to take advantage of business opportunities as
they arise; and
o puts us at risk to period-to-period operating fluctuations resulting
from general economic conditions or the effects of competition.
The Group's efforts to diversify operations may entail developing new
products that are compatible with Transderm's manufacturing and personnel
capabilities or merging with or acquiring an entity that already is selling or
proposes to market a product within the same general industry as our transdermal
patch. In addition, we may seek to enter into research and development
agreements, joint ventures and other collaborative arrangements with other
companies to develop new products. Developing or otherwise acquiring a new
product or entering into a new business, particularly in a highly regulated
industry such as the pharmaceutical business, can be expensive, time consuming
and will divert the attention of management from a company's core operations,
all risks to which we would be subject if we were to pursue such an endeavor.
Moreover, at this time, we do not employ the personnel we likely will need, such
as a chief operating officer who has experience in the pharmaceutical industry,
to attempt to add new products or otherwise diversify our operations in this
area. Further, we can not be certain that we would derive any material revenues
from any diversification and may suffer significant losses from any such
venture. At this time, we do not have capital on-hand nor do we have access to
capital to fund product development or complete an acquisition. We expect that
any available cash from operations we may have in the foreseeable future will be
utilized to satisfy our existing obligations.
We have contracted with a full-service sales and marketing outsourcing
company that focuses on generic and branded pharmaceutical companies to
undertake the majority of the sales and marketing efforts for our transdermal
nitroglycerin product. This company monitors client sales, as well as
scrutinizes the competition in order to anticipate and recommend changes to our
sales, marketing and promotional strategy. This company also assists in
providing the industry contacts to reach all distribution channels. Two
customers accounted for approximately 53% of the sales volume of our patch
during 2004. Management recognizes the need to expand distribution channels to
reduce our reliance on sales to a few customers and will seek to take the steps
necessary to address this situation and alleviate these risks.
Results of Operations.
Overview.
The consolidated financial statements of the Company have been
reclassified to reflect the results of operations and net assets of the
diagnostic product division of the Company as discontinued operations in
accordance with generally accepted accounting principles.
The increase in net sales for the years 2004 to 2003 and 2003 to 2002
were due primarily to increased sales volumes of nitroglycerin patches from
existing customers. We were able to increase sales of this product because we
successfully ramped-up our manufacturing capability which had been dormant for
nearly two years, proved to purchasers that we are a reliable manufacturer of
quality products which we deliver on a timely basis in conformity with contract
requirements and intensified marketing efforts. The higher margins from year to
year reflect the benefits of economies of scale attributable to increased sales
volumes of transdermal nitroglycerin patch products.
-43-
Year ended December 31, 2004 versus December 31, 2003
For the year ended December 31, 2004, our net sales were $9.2 million
consisting solely of transdermal nitroglycerin patches. For the 2003 year, our
net sales were $7.9 million, comprised solely of net sales of transdermal
nitroglycerin patches. Net sales of transdermal nitroglycerin patches increased
16% during the 2004 period. This increase is due primarily to a single customer
who purchased approximately 84% more transdermal nitroglycerin patches in 2004
as compared to the quantity purchased in 2003.
Gross profit increased $1.0 million, or 54%, to $2.9 million for the
twelve months ended December 31, 2004 as compared to $1.9 million for the same
period in 2003. Gross profit as a percent of sales increased from 24% during
2003 to 32% during 2004. The increase in gross profit was due primarily to
increased sales volumes of higher margin products.
Selling, general and administrative expenses decreased $.2 million, or
12%, to $1.7 million for the twelve months ended December 31, 2004 as compared
to $1.9 million for the same period in 2003. The decrease is due primarily to
lower factor expenses.
Research and development expenses for the twelve months ended December
31, 2004 were $414,000, essentially the same as for the 2003 period.
Net interest expense for the twelve months ended December 31, 2004 was
$1.1 million, virtually unchanged from the 2003 period.
Product development income increased $.2 million for the twelve months
ended December 31, 2004 as compared to the same period in 2003, due primarily to
additional development work income associated with a contract signed in June
2004.
Year ended December 31, 2003 versus December 31, 2002
The financial information for the 2002 year in the discussion below is
drawn from unaudited, internally prepared financial statements.
Net sales increased $1.7 million, or 27%, to $7.9 million for the
twelve months ended December 31, 2003 as compared to $6.2 million for the same
period for 2002. Net sales during both years consisted solely of transdermal
nitroglycerin patches. The transdermal nitroglycerin patch sales increase is due
primarily to higher sales volumes to existing customers.
Gross profit increased $.1 million, or 6%, to $1.9 million for the
twelve months ended December 31, 2003 as compared to $1.8 million for the same
period in 2002. Gross profit as a percent of sales was 24% for the year ended
December 31, 2003 and 29% for the 2002 period. The transdermal nitroglycerin
patch gross profit increased due primarily to higher sales volumes to existing
customers. Lower margins reflect increased sales volumes of lower margin
transdermal nitroglycerin patch products.
-44-
Selling, general and administrative expenses increased $.3 million for
the twelve months ended December 31, 2003 as compared to the corresponding
period in 2002. The increase is due primarily to higher consulting, commission
and factor expenses of $146,000, $144,000 and $41,000, respectively.
Research and development expenses decreased $32,000, or 7%, for the
twelve months ended December 31, 2003 as compared to the same period in 2002.
The decrease is due primarily to lower depreciation expense of $70,000,
partially offset by higher building operation and testing supplies expenses of
$17,000 and $12,000, respectively.
Net interest expense was essentially the same for the twelve months
ended December 31, 2003 as compared to the same period in 2002. Outstanding debt
during these periods was relatively constant.
Product development income was essentially the same for the twelve
months ended December 31, 2003 as compared to the same period in 2002.
Liquidity and Capital Resources.
In addition to the discussion on our liquidity and capital resources
below, we refer readers to the section titled "Factors Which We Believe Affect
Our Current Operations and May Materially Impact Our Future Operations"
appearing above, for additional explanation of the issues that affect our
financial and operating condition.
During 2004, we incurred a net loss applicable to common stockholders
of $598,000 whereas during 2003 our net loss applicable to common stockholders
was $2,130,000. Our total capital deficiency at December 31, 2004 was $30.3
million as compared to December 31, 2003, when our total capital deficiency was
$29.7 million. As of December 31, 2004, we had an accumulated deficit of
approximately $30.3 million. Our principal sources of liquidity have been cash
provided by loans from management and cash generated by operations. Our
principal uses of cash have been for working capital and research and
development.
At December 31, 2004, our available cash totaled approximately $851,000
compared to $463,000 at December 31, 2003. We have no borrowing capacity and as
of December 31, 2004 we had debts and liabilities to third parties of
approximately $9 million (including $4.5 million under the Key License) and to
Health-Chem (which owns 90% of our outstanding shares of common stock) of
approximately $28 million.
Our working capital deficit decreased by approximately $.4 million to
$21.9 million from December 31, 2003 to December 31, 2004 due principally to an
increase of $2.9 million in current assets, consisting primarily of increases in
cash, accounts receivable and inventory of $.4 million, $2.0 million and $.5
million, respectively, which was partially offset by an increase of $2.5 million
in current liabilities, consisting primarily of increases in accounts payable,
royalties payable, current portion of redeemable preferred stock, preferred
stock dividends payable and other liabilities of $.4 million, $1.6 million, $1.5
million, $.6 million and $.4 million, respectively, partially offset by a
decrease in the current portion of long-term debt of $2.0 million. The increase
in accounts receivable resulted from an increase in sales in the month of
December 2004 as compared to the month of December 2003 and also reflects the
timing of customer payments. The increase in inventory reflects additional
transdermal nitroglycerin product sales and the timing of raw material
purchases. The royalties payable increase is due to the Company not making
payments to Key. The increases in the current portion of redeemable preferred
stock and preferred stock dividends payable are due to legally available funds
not being available to make the required redemption and dividend payments. The
other liabilities increase is due primarily to increases in accrued chargebacks
and rebates. The current portion of long-term debt decrease is due primarily to
replacing the majority of the current portion with long-term debt (See Note 6 of
the Notes to Consolidated Financial Statements.)
-45-
Net cash provided by operating activities of $.1 million for the twelve
months ended December 31, 2004 was comparable to the same $.1 million of net
cash provided by operating activities for the same period in 2003. Investing
activities for the twelve months ended December 31, 2004 used cash of $279,000
as compared to the same period in 2003 which used cash of $38,000. This increase
in use of cash is due to higher additions to property, plant and equipment for
2004. Financing activities for the twelve months ended December 31, 2004
provided $566,000 of cash as compared to the same period in 2003 which provided
$8,000 of cash.
As of December 31, 2004, we owed an aggregate of $4.5 million to Key
under the Key License. Management has entered into discussions with Key to
resolve the outstanding royalties but the parties have not achieved a
resolution, if one is reached at all. Any failure to enter into an agreement to
satisfy our obligations under the Key License would have a material adverse
effect on the financial condition and operations of the Company.
Expenditures in 2005 such as capital expenditures, research and
development costs and other operating expenses have been financed by cash
generated from operating activities of continuing operations. The Company
anticipates that it will not require any material capital expenditures for
property, plant or equipment in 2006. At December 31, 2005, the Company
estimates that it had expended approximately $100,000 for capital expenditures
for property, plant and equipment in 2005.
Given our current financial condition and outstanding obligations, we
are uncertain as to our future sources of cash as we expect to encounter
difficulty accessing capital markets or obtaining financing from traditional
lenders. We expect that our liquidity position and ability to obtain cash from
outside sources will be materially impacted by the terms of the agreements we
may enter into with the holders of the Debentures and Key and the other factors
enumerated above under the heading "Factors which Affect or May Impact Our
Current and Future Operations."
-46-
Contractual Obligations.
The following table summarizes our contractual obligations at December
31, 2004 (in thousands):
Payments due by Period (in thousands)
-------------------------------------------------------------
Less than 1-3 3-5 More than
Total 1 Year Years Years 5 Years
---------- ---------- ---------- ---------- ----------
Amount due to Health-Chem $ 8,342 $ 8,342
under Corporate Services
Agreement (1)
Note Payable to 7,000 $ 7,000
Subsidiary of Health-Chem (2)
Amount due to holder 12,949 12,949
of preferred stock (3)
Royalties owed to Key (4) 4,522 4,522
Sale/Leaseback 3,186 212 $ 425 $ 425 2,124
(Operating Lease) (5)
Long-term Debt (6) 167 167
---------- ---------- ---------- ---------- ----------
Total $ 36,166 $ 24,683 $ 425 $ 592 $ 10,466
(1) Represents the amount due by the Company to Health-Chem under the Group's
cash management practices, wherein the Company borrows all of its cash
requirements from Health-Chem and advances all excess cash to Health-Chem.
Interest on the balance is calculated based upon the average outstanding
intercompany balance and interest rate on Health-Chem's debt. The average
interest rate charged was 11.34% during both 2004 and 2003.
(2) Represents the amount due, including accrued interest, on a 9% Subordinated
Promissory Note issued by Hercon to Health-Chem on August 31, 1995 in payment of
outstanding borrowings under the Group's cash management practices. The Company
is required to make semi-annual interest payments on this promissory note in
each March and September. The Note was originally due in March 1999 and was
extended by the Board of Health-Chem to March, 2002. The Company currently is in
default on its obligation to repay amount due under this promissory note.
(3) Represents the amount required to (i) redeem 1,000,000 shares of the
Company's redeemable preferred stock, $10.00 par value, originally issued by the
Company to Herculite Products, Inc., a wholly-owned subsidiary of Health-Chem,
on August 31, 1995 in payment for the manufacturing facility in which the
Company's operations are conducted and (ii) to pay the aggregate of the accrued
annual preferred dividends of $.70 payable in each year during which the
preferred stock is outstanding. The preferred stock provided for an annual
sinking fund payment of $1,000,000 in each of the years 1998 through 2004 and a
final redemption payment of $1,500,000 due in March 2005. The Company has not
made any dividend payments since 1998 and did not redeem the preferred stock as
required in March 2005. The preferred stock accrues annual dividends of
$595,000. The $12,949,000 consists of $8,500,000 required to redeem the
preferred stock and $4,449,000 of accrued dividends.
-47-
(4) Royalties consist of the amount due to Key for royalties under the Key
License. We are uncertain as to what arrangements we can make for the payment of
these royalties. Because the Key License provides for payments based upon
products sold, we have excluded future royalty payments from the above table.
(5) The sale/leaseback (operating lease) consists solely of the December 2004
sale/leaseback agreement with York Realty Leasing LLC, the terms of which are
described in Item 12, below.
(6) Other long-term debt consists of a $167,000 note related to the purchase of
certain fixed assets. The purchase of these fixed assets was pursuant to a
development, manufacturing and supply agreement that the Company entered into
with a client company. Payment terms of the note are contingent upon certain
performance criteria under the agreement. One such performance criteria
applicable to the client company may result in the note being forgiven. We
estimate the earliest that the note may need to be repaid is in 2008.
Liquidity and Operations Going Forward.
The Company intends to continue its efforts to complete the necessary
steps in order to meet its future cash flow requirements and to continue its
pursuit of new products and contract manufacturing opportunities. Management's
plans in this regard include, but are not limited to, the following:
o continue with preliminary negotiations with Key with respect to
devising a plan to pay the royalties due under the Key License and
possibly negotiate a new license agreement;
o continue with existing projects whereby the Company is developing
other transdermal products for client companies and where the
Company will be the contract manufacturer of these products, if FDA
approval is obtained;
o form business alliances with other pharmaceutical companies in
connection with the development and/or manufacture of new products;
o raise additional working capital through borrowing or by issuing
equity; and
o evaluate new directions for the Company's operations.
Management believes that actions presently being taken will need to be
further realigned or otherwise amended so that the Company will be in a position
to generate sufficient revenues to provide positive cash flows from operations
and meet its obligations as they become due. However, there can be no assurance
that this will occur.
Off-Balance Sheet Arrangements.
We have not entered into any off-balance sheet arrangements.
Critical Accounting Policies.
Our significant accounting policies are described in Note 2 of the
Notes to Consolidated Financial Statements, which were prepared in accordance
with accounting principles generally accepted in the United States of America.
Included within these policies are certain policies which contain critical
accounting estimates and, therefore, have been deemed to be "critical accounting
policies." Critical accounting estimates are those which require management to
make assumptions about matters that were uncertain at the time the estimate was
made and for which the use of different estimates, which reasonably could have
been used, or changes in the accounting estimates that are reasonably likely to
occur from period to period, could have a material impact on the presentation of
our financial condition, changes in financial condition or results of
operations. The Company has identified revenue recognition and legal matters as
its critical accounting policies.
-48-
Revenue Recognition.
Revenue is recognized for product sales upon shipment when title and
risk of loss have transferred to the customer and when provisions for estimates,
including discounts, rebates, promotional adjustments, price adjustments,
returns, chargebacks, and other potential adjustments are reasonably
determinable. Accruals for these provisions are presented in the Consolidated
Financial Statements as reductions to net revenues and within other current
liabilities. Other current liabilities include $1,267,000 and $824,000 at
December 31, 2004 and 2003, respectively, for certain rebates and other
adjustments that are paid to customers.
Provisions for estimated discounts, rebates, promotional and other
credits are estimated based on historical payment experience, historical
relationship to revenues and contract terms. Such provisions are determinable
due to the limited number of assumptions and consistency of historical
experience. Others, such as price adjustments, returns and chargebacks, require
management to make more subjective judgments and evaluate current market
conditions. These provisions are discussed in further detail below.
Price Adjustments -- Price adjustments, which include shelf stock
adjustments, are credits issued to reflect decreases in the selling prices of
our products. Shelf stock adjustments are based upon the amount of product that
our customers have remaining in their inventories at the time of the price
reduction. Decreases in our selling prices are discretionary decisions made by
us to reflect market conditions. Amounts recorded for estimated price
adjustments are based upon specified terms with direct customers, and in the
case of shelf stock adjustments, estimates of inventory held by the customer.
Returns -- Consistent with industry practice, we maintain a return
policy that allows our customers to return product within a specified period
prior to and subsequent to the expiration date. Our estimate of the provision
for returns is based upon our historical experience with actual returns, which
is applied to the level of sales for the period that corresponds to the period
during which our customers may return product. This period is known by us based
on the shelf lives of our products at the time of shipment.
Chargebacks -- The provision for chargebacks is the most significant
estimate used in the recognition of revenue. The Company markets products
directly to wholesalers, distributors, retail pharmacy chains, mail order
pharmacies and group purchasing organizations. The Company also markets products
indirectly to independent pharmacies, managed care organizations, hospitals,
nursing homes and pharmacy benefit management companies, collectively referred
to as "indirect customers." The Company enters into agreements with its indirect
customers to establish contract pricing for certain products. The indirect
customers then independently select a wholesaler whom they actually purchase the
products at these contracted prices. Alternatively, certain wholesalers may
enter into agreements with indirect customers which establish contract pricing
for certain products which the wholesalers provide. Under either arrangement,
the Company will provide credit to the wholesaler for any difference between the
contracted price with the indirect party and the wholesaler's invoice price.
Such credit is called a chargeback, while the difference between the contracted
price and the wholesaler's invoice price is referred to as the chargeback rate.
The provision for chargebacks is based on expected sell-through levels by our
wholesaler customers to indirect customers. Additionally, internal estimates are
prepared based upon historical buying patterns and estimated end user demand.
Such information allows us to estimate the potential chargeback that we may
ultimately owe to our customers given the quantity of inventory on hand. We
continually monitor our provision for chargebacks and evaluate our reserve and
estimates as additional information becomes available.
-49-
Legal Matters.
The Company is not involved in any legal proceedings. However,
Health-Chem is involved in one legal matter that, if a significant adverse
outcome results, may have an impact on the Company
Recent Accounting Pronouncements.
In January 2003, the Financial Accounting Standards Board ("FASB")
issued FASB Interpretation No. 46 (revised December 2003), Consolidation of
Variable Interest Entities ("FIN 46(R)"). FIN 46(R) addresses the consolidation
of business enterprises to which the usual condition (ownership of a majority
voting interest) of consolidation does not apply. FIN 46(R) focuses on
controlling financial interests that may be achieved through arrangements that
do not involve voting interests. It concludes that in the absence of clear
control through voting interests, a company's exposure (variable interest) to
the economic risks and potential rewards from the variable interest entity's
assets and activities are the best evidence of control. If an enterprise holds a
majority of the variable interests of an entity, it would be considered the
primary beneficiary. Upon consolidation, the primary beneficiary is generally
required to include assets, liabilities and non-controlling interests at fair
value and subsequently account for the variable interest as if it were
consolidated based on majority voting interest. As a result of FIN 46(R),
effective as of December 31, 2004, the Company's consolidated balance sheet
includes the assets and liabilities of York Realty Leasing LLC, which is a
related party.
In November 2004, the FASB issued Statement of Financial Accounting
Standards ("SFAS") No. 151, Inventory Costs - an Amendment of ARB No. 43,
Chapter 4. SFAS 151 clarifies the accounting for abnormal amounts of idle
facility expense, freight, handling costs and spoilage. SFAS 151 also requires
that allocation of fixed production overhead costs be based on normal production
activity. The provisions of SFAS 151 are effective for inventory costs incurred
beginning in January 2006, with adoption permitted for inventory costs incurred
beginning in January 2005. Adoption of this Statement is not expected to have a
material effect on the Company's Consolidated Financial Statements.
In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment.
SFAS 123(R) establishes standards for the accounting for transactions in which
an entity exchanges its equity instruments for goods and services. Under SFAS
123(R), companies will no longer be able to account for share-based compensation
transactions using the intrinsic method in accordance with APB No. 25,
Accounting for Stock Issued to Employees. Instead, companies will be required to
account for such transactions using a fair-value method and to recognize
compensation expense over the period during which an employee is required to
provide services in exchange for the award. In April 2005, the SEC delayed the
effective date of SFAS 123(R) to fiscal years beginning after June 15, 2005.
Management is currently assessing the impact that adoption of this Statement
will have on the Company's Consolidated Financial Statements.
-50-
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections - a Replacement of APB Opinion No. 20 and SFAS No. 3. SFAS 154
changes the requirements for the accounting for and reporting of a change in
accounting principle. This Statement applies to all voluntary changes in
accounting principle. SFAS 154 also applies to changes required by an accounting
pronouncement in the usual instance that the pronouncement does not include
specific transition provisions. The provisions of SFAS 154 are effective for
accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005. Adoption of this Statement is not expected to have a
material effect on the Company's Consolidated Financial Statements.
Inflation.
We believe that our results of operations are not dependent upon
moderate changes in inflation rates.
ITEM 7. FINANCIAL STATEMENTS
Transderm submits with this report the financial statements and related
information listed in the Index to Consolidated Financial Statements on page F-1
following this report's signature page.
ITEM 8. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING
AND FINANCIAL DISCLOSURE
On February 4, 2005, we retained the services of Demetrius & Company,
L.L.C. to serve as our independent accountant to audit our financial statements.
We had not retained an independent auditor since 2000. The engagement of
Demetrius & Company was approved by our Board of Directors.
Prior to its engagement, we had not consulted with Demetrius & Company,
L.L.C. regarding the application of accounting principles to a specific
completed or contemplated transaction, or the type of audit opinion that would
be rendered on our financial statements. Moreover, we did not seek, and
Demetrius & Company, L.L.C. did not furnish, written or oral advice on any
matter that we considered an important factor in reaching a decision as to an
accounting, auditing or financial reporting issue.
Demetrius & Company's offices are located at Wayne Interchange Plaza
II, 155 Route 46, Wayne, New Jersey 07470.
ITEM 8A. CONTROLS AND PROCEDURES
We maintain disclosure controls and procedures designed to ensure that
information required to be disclosed in our reports filed or submitted under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the SEC's rules and forms. As of the end of
the period covered by this Annual Report on Form 10-KSB, we carried out an
evaluation, under the supervision and with the participation of management,
including our Chief Executive Officer and Chief Financial Officer, of the
effectiveness of the design and operation of our disclosure controls and
procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation,
management and our Chief Executive Officer and Chief Financial Officer concluded
that our disclosure controls and procedures are effective. During the periods
covered by this Annual Report on Form 10-KSB, there was no change in our
internal control over financial reporting (as defined in Rule 13a-15(f) under
the Exchange Act) that materially effected, or is reasonably likely to
materially effect, our internal control over financial reporting.
-51-
ITEM 8B. OTHER INFORMATION
None
PART III
ITEM 9. DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE
WITH SECTION 16(A) OF THE EXCHANGE ACT
Directors and Executive Officers.
The following table sets forth certain information about our directors
and executive officers as of January 5, 2007:
Year First
Became
Name Age Position a Director
------------------------------- --------------- ----------------------------------------------- ---------------------
Andy E. Yurowitz 71 Chairman of the Board, President, 2000
Chief Executive Officer and Director
------------------------------- --------------- ----------------------------------------------- ---------------------
Ronald J. Burghauser 46 Chief Financial Officer, Treasurer
and Secretary
------------------------------- --------------- ----------------------------------------------- ---------------------
Andrew J. Levinson 57 Director 2000
------------------------------- --------------- ----------------------------------------------- ---------------------
Manfred Mayerfeld 75 Director 2000
------------------------------- --------------- ----------------------------------------------- ---------------------
The Company's directors are elected to hold office until the next
annual meeting of shareholders and until their respective successors have been
elected and qualified. The Company's officers serve at the pleasure of the Board
of Directors.
Set forth below is biographical information concerning our directors
and executive officers for at least the past five years. All of the following
persons who are executive officers are also full-time employees.
Andy E. Yurowitz has served as Chairman of the Board of Directors,
President, Chief Executive Officer of Transderm since February 2000. Mr.
Yurowitz has also served as Chairman of the Board of Directors, President, Chief
Executive Officer of Health-Chem and all of the Group's subsidiaries since
February 2000.
Ronald J. Burghauser, a certified public accountant, has served as
Chief Financial Officer, Treasurer and Secretary of the Company since November
2003. From May 2002 through October 2003, Mr. Burghauser was Controller of the
Company. From April 1999 through September 2001, Mr. Burghauser was Chief
Financial Officer for Oakworks, Inc., a manufacturer of therapeutic equipment.
Mr. Burghauser serves as the chief financial officer, treasurer and secretary of
each of the Group's subsidiaries, positions which he has held since November
2003.
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Andrew J. Levinson has been a practicing attorney for more than
twenty-nine years. From September 2002 to the present, Mr. Levinson has been
counsel to Greenberg & Kahr in New York City. Previously he was a partner in
Phillips Nizer, LLP from March 2001 to August 2002. Mr. Levinson serves as a
member of the Board of Transderm and each of the Group's subsidiaries, positions
which he has held since February 2000. Mr. Levinson has also served on the Board
of Directors of Health-Chem and all of the Group's subsidiaries since February
2000.
Manfred Mayerfeld retired from teaching in 1991. Since then he has been
active in real estate investing and property management. Mr. Mayerfeld serves as
a member of the Board of Transderm and each of the Group's subsidiaries,
positions which he has held since February 2000. Mr. Mayerfeld has also served
on the Board of Directors of Health-Chem and all of the Group's subsidiaries
since February 2000.
Section 16(a) Beneficial Ownership Reporting Compliance
Section 16(a) of the Securities Act of 1934 requires the Company's
officers and directors, and greater than 10% stockholders, to file reports of
ownership and changes in ownership of its securities with the SEC. Copies of the
reports are required by SEC regulation to be furnished to the Company. Based on
management's review of these reports during the year ended December 31, 2004,
none of the reports required to be filed were filed on a timely basis.
Management advises that it will endeavor to cause its officers and directors to
file all required Section 16(a) reports within thirty days of the date hereof.
Code of Ethics
Our Board of Directors has adopted a Code of Ethics that applies to our
Chief Executive Officer, our Chief Financial Officer and to the other senior
management and senior financial staff of our company. Our Code of Ethics
complies with the requirements imposed by the Sarbanes-Oxley Act of 2002 and the
rules and regulations issued thereunder for codes of ethics applicable to such
officers. Our Board of Directors has reviewed and will continue to evaluate its
role and responsibilities with respect to the new legislative and other
requirements of the SEC. Interested persons can obtain a copy of our Code of
Ethics, without charge and upon request, by writing to the Company's Secretary
at: Transderm Laboratories Corporation, 101 Sinking Springs Lane, Emigsville, PA
17318.
ITEM 10. EXECUTIVE COMPENSATION
Directors' Compensation
The Company does not compensate its employee directors for services
rendered as directors. The Company reimburses non-employee directors for travel
and related expenses for attending board meetings. Effective January 1, 2006,
non-employee directors receive $1,250 per month, an additional fee of $1,000 for
each board meeting attended in person, $500 for each board meeting attended
telephonically and $500 for each committee meeting attended that is
independently scheduled. During the period January 2000 through December 2005,
non-employee directors received no fees.
Executive Compensation
The following Summary Compensation Table sets forth certain information
concerning the annual and long-term compensation of the person serving as the
Company's chief executive officer and each other executive officer who received
annual compensation in excess of $100,000 during the last two fiscal years
(collectively, the "Named Executives").
-53-
SUMMARY COMPENSATION TABLE
-----------------------------------------------------------------------------------------------
Long Term Compensation
----------------------------------------
Annual Compensation Awards Payouts
-------------------------------- ------------------------- -----------
Restricted Securities
Other Annual Stock Underlying All Other
Name and Salary Bonus Compensation Award(s) Options/SARs LTIP Compensation
Principle Position Year ($) ($) ($) ($) (#) Payouts ($) ($)(2)
------------------ ---- -------- ------ ------------ ---------- ------------ ----------- ------------
Andy Yurowitz,
President, Chief 2004 $145,974
Executive Officer
and Chairman 2003 $142,100
Ronald J. Burghauser,
Chief Financial
Officer, Secretary and
Treasurer 2004 $117,036 $4,600 $ 1,583
Kenneth Brody,
Former Chief
Financial Officer (1) 2003 $116,000 $ 1,746
Donald E. Kauffman, 2004 $112,800 $ 1,613
Former Vice President 2003 $128,558 $ 1,868
Richard L. Bulwicz,
Manager - Quality
Operations 2004 $ 97,575 $3,900 $ 1,412
(1) Mr. Brody resigned as our Chief Financial Officer in November 2003 and was
replaced by Mr. Burghauser in the same month.
(2) Consists of the Company matching contributions under our 401(K) plan and
the term cost value of all excess group life insurance policies on behalf
of the Named Executives.
Option Grants.
In April 1996, Transderm adopted the 1996 Performance Equity Plan (the
"Plan") which was designed to attract and retain qualified employees. Under the
Plan, Transderm was authorized to grant stock options or stock related incentive
awards of up to an aggregate of 2,000,000 shares of common stock. The Plan had a
term of ten years and expired in April 2006. Transderm had not granted any
options under the Plan nor were any options were exercised during the period
1999 through 2004. At December 31, 2004, there were no options to purchase
common stock outstanding under the Plan.
As of the date hereof, there are no options to purchase shares of
common stock outstanding, whether granted under the Plan or otherwise.
-54-
Aggregated Option Exercises 1999-2004 and Fiscal Year End Option Values as of
December 31, 2004
None of the executives named in the table included under the heading
"Executive Officers and Directors" owned any options to purchase shares of
common stock during the period 1999 through 2004.
Equity Compensation Plan Information.
Not applicable.
ITEM 11. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL
OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS.
-----------------------------------------------------
The following table sets forth information, as of January 5, 2007 with
respect to the beneficial ownership of our common stock by each person known by
us to be the beneficial owner of more than 5% of the outstanding common stock,
by each of our officers and directors, and by all of our officers and directors
as a group.
For the purpose of this table, the beneficial ownership of a person
includes shares as to which that person has sole or shared voting or investment
power as well as shares that the person has the right to acquire within 60 days
(such as upon conversion of convertible securities or exercise of warrants or
options) as of January 5, 2007. For the purpose of calculating the ownership
percentages for each person listed, we have considered to be outstanding both
the total number shares actually outstanding on January 5, 2007 and the total
number of shares that various people then had the right to acquire within 60
days of said date.
Name and Address Number of Shares Percent
of Beneficial Owner (1) Beneficially Owned (2) of Class (3)
---------------------------------------- ------------------------------------- ---------------------------
Andy E. Yurowitz 227,350 (4) *
---------------------------------------- ------------------------------------- ---------------------------
Manfred Mayerfeld 0 --
---------------------------------------- ------------------------------------- ---------------------------
Andrew J. Levinson 0 --
---------------------------------------- ------------------------------------- ---------------------------
Ronald J. Burghauser 424 (4) *
---------------------------------------- ------------------------------------- ---------------------------
Laura G. Speiser (5) 2,520,362 6.30%
---------------------------------------- ------------------------------------- ---------------------------
All directors and executive
officers as a group (4 persons) 227,774 *
---------------------------------------- ------------------------------------- ---------------------------
* Indicates ownership of less than one percent (1%) of class.
(1) Address is c/o Transderm Laboratories Corporation, 101 Sinking Springs
Lane, Emigsville, PA 17318.
(2) The information concerning security holders is based upon information
furnished to the Company by such security holder. Except as otherwise
indicated, all of the shares are owned of record and beneficially and the
persons identified have sole voting and dispositive power with respect
thereto.
(3) Based upon 40,000,000 shares of common stock outstanding on January 5,
2007.
(4) Voting and/or dispositive power is shared with another individual.
(5) Includes 188,475 shares of common stock owned by Lauralei Investors, Inc.
("Lauralei"), of which Laura G. Speiser is the sole stockholder. The
Company was made aware of Ms. Speiser's demise in May 2006 and has been
unable to ascertain the current owner of these shares.
-55-
ITEM 12. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
In December 2004, Transderm sold its real property, buildings,
improvements and equipment located in Emigsville, Pennsylvania to York Realty
Leasing LLC for a sale price of $1.9 million. Concurrent with the sale,
Transderm entered into a 15-year lease for the property expiring in December
2019, which can be extended by the Company for an additional five years. The
agreement provides for a Company repurchase option at a price of $1,995,000. The
annual lease cost during the initial 15 year term is $212,400. In December 2002,
Transderm had received an appraisal for the real property, including the
structures and appurtenances, by Weinstein Realty Advisors, an independent real
estate agent located in York, Pennsylvania, which appraised the market value of
the real property and structures at $1,850,000. The proceeds from the sale were
used to satisfy a $1.6 million first mortgage associated with the property and
to substantially pay off a $367,500 Second Mortgage (the "Second Mortgage"). Mr.
Andy E. Yurowitz, the Chairman of the Board, President, Chief Executive Officer
and a member of the Board of Directors of each of Transderm and Health-Chem, is
a 50% owner of York Realty Leasing LLC. Transderm entered into the
sale/leaseback arrangement with York Realty Leasing LLC because it required cash
and was unable to obtain a loan or any other financing from an unaffiliated
party on any basis.
Since 1999, Andy Yurowitz, the Chairman of the Board, President, Chief
Executive Officer and a member of the Board of Directors of each of Transderm
and Health-Chem, either has loaned funds or furnished the Transderm and
Health-Chem with cash for the purposes and on the terms described below:
o During 2001 and 2002, Mr. Yurowitz loaned Transderm an aggregate of
$107,500 which was secured by the Second Mortgage on Transderm's
real property and manufacturing equipment located at its facilities
in Emigsville, Pennsylvania. This loan accrued interest at the rate
of 12.5% per annum. Transderm repaid the principal amount of this
loan in December 2004 along with accrued interest of $41,526. As
described below, certain other directors and officers participated
in the loan to Transderm which was secured by the Second Mortgage.
In connection with this loan, Transderm received an opinion dated
August 15, 2001 from its financial advisor, KSH Investment Group
Inc. ("KSH"), that the transaction was fair to Transderm from a
financial point of view. KSH also opined that at that time Transderm
common stock had little or no value.
o During 2000 and 2001, Mr. Yurowitz provided the Group with an
aggregate of $167,500 at various times and for various purposes
including working capital, to pay creditors and to meet payroll.
These loans accrued interest at the rate of 18% per annum, the
amount charged by credit card companies for corporate expenses Mr.
Yurowitz charged to his credit cards. Health-Chem repaid the
principal amount of the loans during 2001 and 2003 along with
aggregate interest of $77,781. In addition to receiving interest on
these loans, Health-Chem granted to Mr. Yurowitz five-year options
to purchase up to 837,500 shares of the Company's common stock (five
options for each dollar loaned) at an exercise price of $0.10 which
expire in April 2007.
o In 1999, Mr. Yurowitz expended $60,000 in connection with a
successful proxy contest brought against Health-Chem in 1999 by a
group led by him. Health-Chem repaid the principal amount of this
loan during 2001 and 2003 with interest of $31,770 (equal to 18% per
annum).
-56-
Since 1999, Manfred Mayerfeld, a member of the Board of Directors of
each of Transderm and Health-Chem, either has loaned funds or furnished
Transderm and Health-Chem with cash for the purposes and on the terms described
below:
o During 2001, Mr. Mayerfeld loaned Transderm an aggregate of $50,000
which was secured by the Second Mortgage on Transderm's real
property and manufacturing equipment located at its facilities in
Emigsville, Pennsylvania. This loan accrued interest at the rate of
12.5% per annum. Transderm repaid the principal amount of this loan
in December 2004 along with accrued interest of $21,174 in January
2005.
o During 2000 and 2001, Mr. Mayerfeld provided Health-Chem with an
aggregate of $191,600 at various times and for various purposes
including working capital, to pay creditors and to meet payroll.
These loans accrued interest at the rate of 18% per annum.
Health-Chem repaid the principal amount of the loans during 2001 and
2003 along with aggregate interest of $91,783 during 2004. In
addition to receiving interest on these loans, Health-Chem granted
to Mr. Mayerfeld five-year options to purchase up to 958,000 shares
of the Company's common stock (five options for each dollar loaned)
at an exercise price of $0.10 which expire in April 2007.
o In 1999, Mr. Mayerfeld expended $40,000 in connection with a
successful proxy contest brought against Health-Chem in 1999 by a
group led by Mr. Yurowitz. Health-Chem repaid the principal amount
of this loan during 2004 with interest of $25,700 (equal to 18% per
annum).
During 2001, Andrew Levinson, a member of the Board of Directors of
each of Transderm and Health-Chem, loaned Transderm $25,000 (before deducting
the sum of $2,846 which was owed to him in connection with funds he advanced on
Transderm's behalf in connection with the lease of an automobile by Transderm)
which it utilized for various corporate purposes and which was secured by the
Second Mortgage on Transderm's real property and manufacturing equipment located
at its facilities in Emigsville, Pennsylvania. This loan accrued interest at the
rate of 12.5% per annum. Transderm repaid the principal amount of this loan in
December 2004 along with accrued interest of $10,818 in January 2005.
Since 1999, Ken Brody, a former officer of Transderm and Health-Chem,
either had loaned funds or furnished Transderm with cash for the purposes and on
the terms described below:
o During 2001 and 2002, Mr. Brody loaned Transderm an aggregate of
$60,000 which was secured by the Second Mortgage on Transderm's real
property and manufacturing equipment located at its facilities in
Emigsville, Pennsylvania. This loan accrued interest at the rate of
12.5% per annum. Transderm repaid the principal amount of this loan
in December 2004 along with accrued interest of $22,803.
o During 2001 and 2002, Mr. Brody provided Health-Chem with an
aggregate of $40,135 at various times and for various purposes
including working capital, to pay creditors and to meet payroll. A
number of the loans were repaid without interest. A loan for $10,000
accrued interest at the rate of 18% per annum. Health-Chem repaid
the principal amount of this loan during 2002 along with aggregate
interest of $2,670. In addition to receiving interest on the $10,000
loan, Health-Chem granted to Mr. Brody five-year options to purchase
up to 50,000 shares of Health-Chem's common stock (five options for
each dollar loaned) at an exercise price of $0.10 which expire in
April 2007.
-57-
ITEM 13. EXHIBITS AND REPORTS ON FORM 8-K
(a) EXHIBITS
Exhibit
No. Exhibit Description Location Reference
------------ ----------------------------------------------------------------- ---------------------------------------
2 Plan of Reorganization and Asset Exchange Agreement dated as of Filed as Exhibit 2 to Transderm's
June 30, 1995, by and among Health-Chem Corporation, Registration Statement on Form S-1
("Health-Chem") Herculite Products, Inc. ("HPI") and Transderm No. 33-95080 filed with the
Laboratories Corporation ("Transderm"). Commission on July 28, 1995
("Registration Statement") and
incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
3.1 Restated Certificate of Incorporation dated April 27, 1995. Filed as Exhibit 3.1 to the
Registration Statement and
incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
3.2 Amendment to Restated Certificate of Incorporation dated July Filed as Exhibit 3.2 to the
13, 1995, Registration Statement and
incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
3.3 By-Laws. Filed as Exhibit 3.3 to the
Registration Statement and
incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.1 Asset Acquisition Agreement dated April 28, 1995 between Hercon Filed as Exhibit 10.7 to the
Environmental Corporation ("HEC") and Hercon Laboratories Registration Statement and
Corporation ("HLC"). incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.2 $7,000,000 principal amount Subordinated Promissory Note of HLC. Filed as Exhibit 10.8 to Amendment
No. 1 and incorporated herein
by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.3 Corporate Services Agreement between Health-Chem and Transderm, Filed as Exhibit 10.9 to Amendment
dated as of August 31, 1995. No. 1 to the Registration Statement
("Amendment No. 1") and incorporated
herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.4 Tax Sharing Agreement between Health Chem and Transderm, dated Filed as Exhibit 10.10 to Amendment
as of August 31, 1995 No. 1 and incorporated herein by
reference.
------------ ----------------------------------------------------------------- ---------------------------------------
-58-
10.5 Second Modification Agreement dated as of October 11, 1995 by Incorporated herein by reference to
and among Health0Chem, HLC, HPI, Pacific Combining Corporation Exhibit 10.5 to the Registrant's
("PCC"), HEC and Transderm. Quarterly Report for the Quarter
ended September 30, 1995.
------------ ----------------------------------------------------------------- ---------------------------------------
10.6 Revolving Credit, Term Loan and Security Agreement dated as of Filed as Exhibit 1 to Health0Chem's
January 9, 1997 by and between HCH, HPI, HEC, PCC, HLC and Current Report on Form 8-K filed with
Transderm and IBJ Schroder Bank & Trust Company, the Commission on January 22, 1997
and incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.7 First Amendment to Revolving Credit, Term Loan and Security Filed as Exhibit 10.18(b) to
Agreement dated as of January 21, 1998 by and between HCH, Health0Chem's Report on Form 10-K for
HPI, HEC, PCC, HLC and Transderm and IBJ Schroder Business the year ended December 31, 1997 and
Credit Corporation. incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.8 Second Amendment to Revolving Credit, Term Loan and Security Filed as the only exhibit to
Agreement dated as of July 31, 1998 by and between HCH, HPI, Health0Chem's Report on Form 10-Q for
HEC, PCC, HLC and Transderm and IBJ Schroder Business Credit the quarter ended September 30, 1998
Corporation. and incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.9 Waiver and Third Amendment to Revolving Credit, Term Loan and Filed as Exhibit 10.18(d) to
Security Agreement dated as of January 11, 1999 by and between Health0Chem's Report on Form 10-K for
Health0Chem, HPI, HEC, PCC, HLC and Transderm and IBJ Whitehall the year ended December 31, 1998 and
Business Credit Corporation. incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.10 Consent and Fourth Amendment to Revolving Credit, Term Loan and Filed as Exhibit 10.18(e) to
Security Agreement dated as of March 24, 1999 by and between Health0Chem's Report on Form 10-K for
HCH, HPI, HEC, PCC, HLC and Transderm and IBJ Whitehall the year ended December 31, 1998 and
Business Credit Corporation. incorporated herein by reference.
------------ ----------------------------------------------------------------- ---------------------------------------
10.11 Amendment and Forbearance Agreements to Revolving Credit, Term Filed as Exhibit 10.18 (f) to
Loan and Security Agreement dated as of April 14, 1999, May 14, Health0Chem's Report on Form 10-K for
1999, June 21, 1999, July 15, 1999 and August 15, 1999 by and the year ended December 31, 1998 and
between Health0Chem, HPI, HEI, PCC, HLC and Transderm and IBJ incorporated herein by reference.
Whitehall Business Credit Corporation.
------------ ----------------------------------------------------------------- ---------------------------------------
-59-
10.12 Asset Purchase Agreement dated as of July 20, 1999 by and among Incorporated herein by reference to
HPI, HEC and Aberdeen Road Company. Exhibit 2.1 to Health0Chem's Current
Report on Form 8-K dated September 2,
1999.
------------ ----------------------------------------------------------------- ---------------------------------------
10.13 License Agreement dated March 13, 2000 between HLC and Key Incorporated herein by reference to
Pharmaceuticals, Inc. Exhibit 10.18 to Health0Chem's Annual
Report on Form 10-KSB for the year ended
December 31, 2004 as filed with the SEC
on July 31, 2006 (the "HC 2004 10-KSB").
------------ ----------------------------------------------------------------- ---------------------------------------
10.14 Mortgage and Security Agreement dated May 23, 2000 between Incorporated herein by reference to
Transderm and Mercury Capital Corp. Exhibit 10.19 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.15 Mortgage Note dated May 23, 2000 made by Transderm in favor of Incorporated herein by reference to
Mercury Capital Corp. Exhibit 10.20 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.16 Guaranty of Transderm in favor of Mercury Capital Corp. dated Incorporated herein by reference to
May 23, 2000. Exhibit 10.21 to HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.17 Assignment of Leases and Rents from Transderm to Mercury Incorporated herein by reference to
Capital Corp. dated May 23, 2000. Exhibit 10.22 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.18 Mortgage Modification Agreement dated June 30, 2000 between Incorporated herein by reference to
Transderm and Mercury Capital Corp. Exhibit 10.23 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.19 Mortgage Modification Agreement dated July 10, 2000 between Incorporated herein by reference to
Transderm and Mercury Capital Corp. Exhibit 10.24 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.20 Assignment of Leases and Rents from Transderm to Mercury Incorporated herein by reference to
Capital Corp. dated July 13, 2000. Exhibit 10.25 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.21 Guaranty of Transderm in favor of Mercury Capital Corp. dated Incorporated herein by reference to
July 13, 2000. Exhibit 10.26 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
-60-
10.22 Sales Representative Agreement dated July 25, 2000 between HLC Incorporated herein by reference to
and Granard Pharmaceutical, LLP. Exhibit 10.27 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.23 Product Purchase Agreement dated February 28, 2001 between HLC Incorporated herein by reference to
and Ranbaxy Pharmaceuticals Inc. (portions of this Exhibit Exhibit 10.28 to the HC 2004 10-KSB.
have been omitted pursuant to a request for confidential
treatment and have been filed separately with the Commission).
------------ ----------------------------------------------------------------- ---------------------------------------
10.24 Development Assistance Agreement dated February 28, 2001 Incorporated herein by reference to
between HLC and Ranbaxy Pharmaceuticals Inc. (portions of Exhibit 10.29 to the HC 2004 10-KSB.
this Exhibit have been omitted pursuant to a request for
confidential treatment and have been filed separately with the
Commission).
------------ ----------------------------------------------------------------- ---------------------------------------
10.25 Finished Goods Supply Agreement dated February 28, 2001 between Incorporated herein by reference to
HLC and Ranbaxy Pharmaceuticals Inc. (portions of this Exhibit Exhibit 10.30 to the HC 2004 10-KSB.
have been omitted pursuant to a request for confidential
treatment and have been filed separately with the Commission).
------------ ----------------------------------------------------------------- ---------------------------------------
10.26 Amendment No. 1 to Sales Representative Agreement between HLC Incorporated herein by reference to
and Granard Pharmaceutical, LLP dated July 24, 2001. Exhibit 10.31 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.27 Mortgage Note in the principal amount of $367,500 dated August Incorporated herein by reference to
7, 2001 among Transderm and certain creditors, including Exhibit 10.32 to the HC 2004 10-KSB.
affiliates of Transderm.
------------ ----------------------------------------------------------------- ---------------------------------------
10.28 Agreement dated May 22, 2002 among Zackfoot Investments, LLC, Incorporated herein by reference to
the holders of the Mortgage Note dated August 7, 2001 and Exhibit 10.34 to the HC 2004 10-KSB.
Transderm.
------------ ----------------------------------------------------------------- ---------------------------------------
10.29 Promissory Note in the principal amount of $164,692.50 dated Incorporated herein by reference to
May 22, 2002 among Transderm and Zackfoot Investments, LLC and Exhibit 10.35 to the HC 2004 10-KSB.
certain other lenders to Transderm.
------------ ----------------------------------------------------------------- ---------------------------------------
10.30 Mortgage Note in the principal amount of $150,000 dated June Incorporated herein by reference to
22, 2002 made by Transderm Laboratories Corporation in favor of Exhibit 10.36 to the HC 2004 10-KSB.
Albert David.
------------ ----------------------------------------------------------------- ---------------------------------------
-61-
10.31 Outline of Agreement between the Registrant and Jack Aronowitz, Incorporated herein by reference to
Leon Services LLC and Health0Chem Diagnostics, LLC, effective Exhibit 10.37 to the HC 2004 10-KSB.
October 31, 2003
------------ ----------------------------------------------------------------- ---------------------------------------
10.32 Development, Manufacturing and Supply Agreement dated June 10, Incorporated herein by reference to
2004 between Hercon Laboratories Corporation and Ranbaxy Exhibit 10.38 to the HC 2004 10-KSB.
Pharmaceuticals Inc. (portions of this Exhibit have been
omitted pursuant to a request for confidential treatment and
have been filed separately with the Commission).
------------ ----------------------------------------------------------------- ---------------------------------------
10.33 Deed dated December 7, 2004 selling and transferring ownership Incorporated herein by reference to
of the land and building owned by Transderm Laboratories Exhibit 10.39 to the HC 2004 10-KSB.
Corporation to York Realty Leasing LLC.
------------ ----------------------------------------------------------------- ---------------------------------------
10.34 Warranty Bill of Sale dated December 7, 2004 selling and Incorporated herein by reference to
transferring ownership of machinery and equipment owned by Exhibit 10.40 to the HC 2004 10-KSB.
Hercon Laboratories Corporation to York Realty Leasing LLC.
------------ ----------------------------------------------------------------- ---------------------------------------
10.35 Commercial Lease Agreement dated December 7, 2004 by Incorporated herein by reference to
and between York Realty Leasing LLC and Transderm. Exhibit 10.41 to the HC 2004 10-KSB.
------------ ----------------------------------------------------------------- ---------------------------------------
10.36 Development, Manufacturing and Supply Agreement dated April 28, Incorporated herein by reference to
2006 between HLC and Cure Therapeutics, Inc. (portions of this Exhibit 10.42 to the HC 2004 10-KSB.
Exhibit have been omitted pursuant to a request for confidential
treatment and have been filed separately with the Commission).
------------ ----------------------------------------------------------------- ---------------------------------------
14 Code of Ethics. Filed herewith.
------------ ----------------------------------------------------------------- ---------------------------------------
21 Subsidiaries of the Registrant. Filed herewith.
------------ ----------------------------------------------------------------- ---------------------------------------
31.1 Certification of Chief Executive Officer pursuant to Rule Filed herewith.
13a014(a) or Rule 15d014(a) as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
------------ ----------------------------------------------------------------- ---------------------------------------
31.2 Certification of Chief Financial Officer pursuant to Rule Filed herewith.
13a014(a) or Rule 15d014(a) as adopted pursuant to Section 302
of the Sarbanes-Oxley Act of 2002.
------------ ----------------------------------------------------------------- ---------------------------------------
32.1 Certification of Chief Executive Officer pursuant to 18 U.S.C. Filed herewith.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
------------ ----------------------------------------------------------------- ---------------------------------------
32.2 Certification of Chief Financial Officer pursuant to 18 U.S.C. Filed herewith.
Section 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.
------------ ----------------------------------------------------------------- ---------------------------------------
-62-
(b) REPORTS ON FORM 8-K
During the quarter ended December 31, 2004 the Company did not file any reports
on Form 8-K.
ITEM 14. PRINCIPAL ACCOUNTANT FEES AND SERVICES
Audit Fees
The aggregate fees billed by Demetrius & Company, L.L.C. for professional
services related to the audit of the Company's consolidated financial statements
for the fiscal years ended December 31, 2003 and 2004 were $61,156.
Audit-Related Fees
There were no fees billed by Demetrius & Company, L.L.C. for audit0related
services for the fiscal years ended December 31, 2003 or 2004.
Tax Fees
There were no fees billed by Demetrius & Company, L.L.C. for tax services during
the fiscal years ended December 31, 2003 or 2004.
All Other Fees
There were no fees billed by Demetrius & Company, L.L.C. for any other
professional services during the fiscal years ended December 31, 2003 or 2004.
-63-
SIGNATURES
In accordance with Section 13 or 15(d) of the Securities Exchange Act of 1934,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
TRANSDERM LABORATORIES CORPORATION
Name and Capacity Date
--------------------------- ----
/s/ Andy E. Yurowitz January 5, 2007
---------------------------
By: Andy E. Yurowitz
Chairman of the Board,
President and Chief Executive
Officer (Principal Executive Officer)
/s/ Ronald J. Burghauser January 5, 2007
---------------------------
By: Ronald J. Burghauser
Chief Financial Officer,
Treasurer and Secretary
(Principal Financial Officer)
(Principal Accounting Officer)
In accordance with the Securities Exchange Act of 1934, this report has been
signed below by the following persons on behalf of the Registrant and in the
capacities and on the dates indicated.
Person Capacity Date
------ -------- ----
/s/ Andy E. Yurowitz Chairman of the Board, President January 5, 2007
--------------------------- and Chief Executive Officer
Andy E. Yurowitz (Principal Executive Officer) and
Director
/s/ Ronald J. Burghauser Chief Financial Officer, January 5, 2007
--------------------------- Treasurer and Secretary
Ronald J. Burghauser (Principal Financial Officer)
(Principal Accounting Officer)
/s/ Andrew J. Levinson Director January 5, 2007
---------------------------
Andrew J. Levinson
/s/ Manfred Mayerfeld Director January 5, 2007
---------------------------
Manfred Mayerfeld
-64-
ITEM 7. FINANCIAL STATEMENTS
Index to Consolidated Financial Statements.
PAGE
Report of Independent Registered Public Accounting Firm F-2
Consolidated Balance Sheets - December 31, 2004 and 2003 F-3
Consolidated Statements of Operations
Years Ended December 31, 2004 and 2003 F-4
Consolidated Cash Flow Statements
Years Ended December 31, 2004 and 2003 F-5
Consolidated Statements of Stockholders' Deficiency
Years Ended December 31, 2004 and 2003 F-6
Notes to Consolidated Financial Statements F-7 to F-24
F-1
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
-------------------------------------------------------
To the Board of Directors and Stockholders
Transderm Laboratories Corporation and Subsidiaries
We have audited the accompanying consolidated balance sheets of Transderm
Laboratories Corporation and Subsidiaries ("Transderm" or the "Company") as of
December 31, 2004 and 2003 and the related consolidated statements of
operations, cash flows, and stockholders' deficiency for the two years then
ended. These financial statements are the responsibility of Transderm's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States). Those standards require that we plan
and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a
test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Transderm
Laboratories Corporation and Subsidiaries at December 31, 2004 and 2003, and the
consolidated results of their operations and their cash flows for the years then
ended, in conformity with accounting principles generally accepted in the United
States of America.
The accompanying financial statements have been prepared assuming that the
Company will continue as a going concern. As more fully described in Note 3, the
Company is in default of payments to its bondholders and licensors, and has
working capital deficiencies that raise substantial doubt about its ability to
continue as a going concern. Management's plans concerning these matters are
also described in Note 3. The financial statements do not include any
adjustments that might result from the outcome of this uncertainty.
/s/ DEMETRIUS & COMPANY, L.L.C.
Wayne, New Jersey
May 31, 2006
F-2
TRANSDERM LABORATORIES CORPORATION
CONSOLIDATED BALANCE SHEETS
(In thousands)
ASSETS December 31,
2004 2003
------- -------
CURRENT ASSETS
Cash $ 851 $ 463
Accounts receivable 2,962 867
Due from financing agency 110 169
Inventories 1,302 766
Other current assets 23 25
------- -------
Total Current Assets 5,248 2,290
------- -------
PROPERTY, PLANT AND EQUIPMENT, net 1,947 1,994
NON-CURRENT ASSETS 44 0
------- -------
TOTAL ASSETS $ 7,239 $ 4,284
======= =======
LIABILITIES AND STOCKHOLDERS' DEFICIENCY
CURRENT LIABILITIES
Accounts payable $ 1,101 $ 673
Royalties payable 4,522 2,928
Other liabilities 1,597 1,227
Current portion of long-term debt 0 1,967
Subordinated promissory note 7,000 7,000
Redeemable preferred stock 8,500 7,000
Preferred stock dividends payable 4,449 3,854
------- -------
Total Current Liabilities 27,169 24,649
------- -------
LONG-TERM LIABILITIES 10,245 7,842
COMMITMENTS
MINORITY INTEREST 130 0
PREFERRED STOCK 0 1,500
STOCKHOLDERS' DEFICIENCY
Common stock, par value $.001 per share;
60,000,000 shares authorized; 40,000,000
shares issued and outstanding in 2004 and 2003 40 40
Accumulated deficit (30,345) (29,747)
------- -------
Total Stockholders' Deficiency (30,305) (29,707)
------- -------
TOTAL LIABILITIES AND STOCKHOLDERS' DEFICIENCY $ 7,239 $ 4,284
======= =======
See Notes to Consolidated Financial Statements.
F-3
TRANSDERM LABORATORIES CORPORATION
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
Years Ended
December 31,
2004 2003
------- -------
REVENUE:
Net sales $ 9,192 $ 7,896
Cost of goods sold 6,248 5,987
------- -------
Gross profit 2,944 1,909
------- -------
OPERATING EXPENSES:
Selling, general and administrative 1,706 1,933
Research and development 414 418
Interest, net 1,121 1,124
------- -------
Total operating expenses 3,241 3,475
------- -------
LOSS FROM OPERATIONS (297) (1,566)
Product development income 239 31
Other income (expense) - net 55 0
------- -------
LOSS FROM OPERATIONS BEFORE TAXES (3) (1,535)
Income tax benefit 0 0
------- -------
NET LOSS (3) (1,535)
PREFERRED DIVIDENDS 595 595
------- -------
NET LOSS APPLICABLE TO COMMON STOCKHOLDERS $ (598) $(2,130)
======= =======
Loss per common share (basic & diluted):
LOSS PER COMMON SHARE $ (.01) $ (.05)
======= =======
Average number of common shares outstanding:
Basic 40,000 40,000
Diluted 40,000 40,000
See Notes to Consolidated Financial Statements.
F-4
TRANSDERM LABORATORIES CORPORATION
CONSOLIDATED CASH FLOW STATEMENTS
(In thousands)
Years Ended
December 31,
2004 2003
------- -------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss applicable to common stockholders $ (598) $(2,130)
Adjustments to reconcile net loss to net cash
provided by operating activities:
Depreciation and amortization 326 381
Preferred dividends payable 595 595
Loss on disposal of property, plant & equipment 0 5
Changes in:
Accounts receivable (2,095) (649)
Due from financing agency 59 (36)
Inventories (536) (170)
Other current assets 2 (3)
Other non-current assets (44) 0
Accounts payable 428 155
Royalties payable 1,594 1,518
Other liabilities 370 431
------- -------
Net cash provided by operating activities 101 97
------- -------
CASH FLOWS FROM INVESTING ACTIVITIES:
Additions to property, plant and equipment (279) (38)
------- -------
Net cash used for investing activities (279) (38)
------- -------
CASH FLOWS FROM FINANCING ACTIVITIES:
Borrowings from affiliates, net 500 158
Long-term debt proceeds 1,903 0
Long-term debt payments (1,967) (150)
Minority interest advances 130 0
------- -------
Net cash provided by financing activities 566 8
------- -------
NET INCREASE IN CASH 388 67
Cash at beginning of year 463 396
------- -------
Cash at end of year $ 851 $ 463
======= =======
Supplemental Disclosures of Cash Flow Information:
Cash paid during the year for:
Interest $ 359 $ 260
Income taxes 0 0
Supplemental Disclosures of Non-Cash Investing Activities - See Note 7
See Notes to Consolidated Financial Statements.
F-5
TRANSDERM LABORATORIES CORPORATION
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' DEFICIENCY
YEARS ENDED DECEMBER 31, 2004 AND 2003
(In thousands)
Common Accumulated
Stock Deficit Total
------------ ------------ ------------
Balance, January 1, 2003 $ 40 $ (27,617) $ (27,577)
Net loss (1,535) (1,535)
Preferred dividends (595) (595)
------------ ------------ ------------
Balance, December 31, 2003 40 (29,747) (29,707)
Net loss (3) (3)
Preferred dividends (595) (595)
------------ ------------ ------------
Balance, December 31, 2004 $ 40 $ (30,345) $ (30,305)
============ ============ ============
See Notes to Consolidated Financial Statements.
F-6
TRANSDERM LABORATORIES CORPORATION
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004 AND 2003
1. Nature of Operations
Transderm Laboratories Corporation ("Transderm") and its subsidiary, Hercon
Laboratories Corporation ("Hercon") (collectively the "Company") are engaged in
the development, manufacture and marketing of transdermal drug delivery systems.
Since 1986, the Company has manufactured a transdermal nitroglycerin patch which
was the first such product introduced for the generic market in the United
States. The product is used for transdermal relief of vascular and
cardiovascular symptoms related to angina pectoris. The Company sells the
transdermal nitroglycerin patch to distributors and wholesalers who distribute
it in the United States.
In addition to its transdermal nitroglycerin products, the Company is developing
other transdermal products for client companies and will be the contract
manufacturer of these products if United States Food and Drug Administration
("FDA") approval is obtained. The Company is also conducting a number of
feasibility studies on drugs to be developed independently or for client
companies and pursuing additional contract manufacturing opportunities. There is
no assurance that FDA filings for additional products will be submitted or that
FDA approval for any additional products will be obtained.
2. Summary of Significant Accounting Policies
a. Principles of Consolidation
The accompanying consolidated financial statements include the accounts of
Transderm and Hercon. As of December 31, 2004, the consolidated financial
statements also include a Variable Interest Entity ("VIE"), York Realty Leasing
LLC, of which Transderm is the primary beneficiary as further described in Note
5. All significant intercompany accounts and transactions, including those
involving the VIE, have been eliminated in consolidation. The Company is a 90%
owned subsidiary of Health-Chem Corporation ("Health-Chem").
b. Cash Equivalents
Money market funds and investment instruments with original maturities of ninety
days or less are considered cash equivalents.
c. Concentrations of Credit Risk
Financial instruments that potentially subject the Company to concentrations of
credit risk consist primarily of cash, cash equivalents and accounts receivable.
Periodically, the Company has cash balances at certain financial institutions in
excess of federally insured limits. However, the Company does not believe that
it is subject to unusual credit risk beyond the normal credit risk associated
with commercial banking relationships. The Company mitigates this risk by
depositing its cash in high quality financial institutions.
F-7
To reduce credit risk related to accounts receivable, the Company performs
ongoing credit evaluations of its customers' financial condition but does not
generally require collateral. Approximately 78% and 54% of the accounts
receivable balances represent amounts due from two customers at December 31,
2004 and 2003, respectively.
The percentage of sales to each major customer who was responsible for 10% or
more of the total revenues is as follows:
Years Ended
December 31,
2004 2003
------ ------
Customer A 23% 15%
Customer B 30% 34%
At December 31, 2004 and 2003, accounts receivable of approximately $2,333,000
and $480,000, respectively were from such customers.
d. Revenue Recognition and Accounts Receivable
The Company recognizes revenue for product sales upon shipment when title and
risk of loss pass to its customers and when provisions for estimates, including
trade discounts, rebates, promotional adjustments, price adjustments, returns,
chargebacks, and other potential adjustments are reasonably determinable. No
revisions were made to the methodology used in determining these provisions
during the years ended December 31, 2004 and 2003.
The Company has historically provided financial terms to customers in accordance
with what management views as industry norms. Financial terms, for
credit-approved customers, are generally on a net 30-61 day basis, though most
customers are entitled to a prompt payment discount. Management periodically and
regularly reviews customer account activity in order to assess the adequacy of
allowances for doubtful accounts, considering factors such as economic
conditions and each customer's payment history and creditworthiness. If the
financial condition of our customers were to deteriorate, or if they were
otherwise unable to make payments in accordance with management's expectations,
we might have to increase our allowance for doubtful accounts, modify their
financial terms and/or pursue alternative collection methods. When accounts
receivable are considered uncollectible, they are charged against the allowance.
The following briefly describes the nature of each provision and how such
provisions are estimated.
Trade discounts are charged to operations when taken by customers.
Rebates are offered to key customers to promote customer loyalty and encourage
greater product sales. These rebate programs provide that upon the attainment of
pre-established volumes or the attainment of revenue milestones for a specified
period, the customer receives credit against purchases. Other promotional
programs are incentive programs periodically offered to our customers. The
Company is able to estimate provisions for rebates and other promotional
programs based on the specific terms in each agreement at the time of shipment.
F-8
Consistent with industry practice, we maintain a return policy that allows
customers to return product within a specified period prior to and subsequent to
the expiration date. The Company's estimate of the provision for returns is
based upon historical experience with actual returns.
Price adjustments, which include shelf stock adjustments, are credits issued to
reflect decreases in the selling prices of products. Shelf stock adjustments are
based upon the amount of product which the customer has remaining in its
inventory at the time of the price reduction. Decreases in selling prices are
discretionary decisions made by the Company to reflect market conditions.
Amounts recorded for estimated price adjustments are based upon specified terms
with direct customers, and in the case of shelf stock adjustments, estimates of
inventory held by the customer.
The Company has agreements with certain indirect customers, such as independent
pharmacies, managed care organizations, hospitals, nursing homes, governmental
agencies and pharmacy benefit management companies, which establish contract
prices for certain products. The indirect customers then independently select a
wholesaler from whom they purchase the products at these contracted prices. The
Company will provide credit to the wholesaler for any difference between the
contracted price with the indirect party and the wholesaler's invoice price.
Such credit is called a chargeback. The provision for chargebacks is based on
expected sell-through levels by our wholesaler customers to indirect customers.
Costs incurred for shipping and handling are recorded in cost of sales.
e. Inventories
Inventories are stated at lower of cost (first-in, first-out basis) or market.
f. Property, Plant and Equipment
Property, plant and equipment are recorded at cost. Maintenance and repairs are
charged to expense as incurred, and costs of improvements are capitalized.
Depreciation and amortization are provided using the straight-line method by
charges to operations over estimated useful lives of five to twenty-five years.
The cost and related accumulated depreciation of disposed assets are removed
from the applicable accounts and any gain or loss is included in income in the
period of disposal.
g. Impairment of Long-Lived Assets
The Company reviews long-lived assets, such as property and equipment, and
purchased intangibles subject to amortization, for impairment whenever events or
changes in circumstances indicate that the carrying amount of an asset may not
be recoverable, in accordance with Statement of Financial Accounting Standards
("SFAS") No. 144, Accounting for the Impairment or Disposal of Long-Lived
Assets. Recoverability of assets to be held and used is measured by a comparison
of the carrying amount of an asset to estimated undiscounted future cash flows
expected to be generated by the asset. If the carrying amount of an asset
exceeds its estimated future cash flows, an impairment charge is recognized by
the amount by which the carrying amount of the asset exceeds the fair value of
the asset. There were no impairment charges in 2004 and 2003.
F-9
h. Fair Value of Financial Instruments
Management believes that the carrying amounts of the Company's financial
instruments, including cash and cash equivalents, accounts receivable, accounts
payable, and accrued liabilities approximate fair value due to the short-term
nature of these instruments. The carrying amount of the Company's long-term debt
also approximates fair value. Management believes that determining a fair value
for the Company's redeemable preferred stock is impractical due to the
closely-held nature of these securities.
i. Accounts Receivable Financing
In January 2001, the Company entered into an agreement to sell certain of its
accounts receivable with full recourse to a factor, Bay View Funding. The
agreement, as amended, allowed for a maximum amount of financing availability of
$1.5 million. Under this agreement, the Company sold, on a revolving basis, an
undivided percentage ownership in certain accounts receivable. As existing
receivables were collected, undivided interests in new eligible receivables were
sold. The Company sold accounts receivable of $3,091,000 and $9,410,000 to Bay
View Funding during 2004 and 2003, respectively. The amounts due from the factor
were $110,000 and $169,000 at December 31, 2004 and 2003, respectively. Accounts
that became 90 days past due were no longer eligible to be sold and the Company
had to repurchase the receivable. The Company addresses the risk of loss
associated with these repurchased receivables in its allowance for doubtful
accounts. Expenses incurred under this factoring program totaling $132,000 and
$243,000 for 2004 and 2003, respectively, are included on the selling, general
and administrative expense line in the Consolidated Statements of Operations.
The Company terminated its agreement with Bay View Funding in April 2005 because
management believed that the Company no longer needed the services of a factor.
j. Research and Development
Research and development costs are charged to operations as incurred.
k. Income Taxes
The Company is included in the consolidated federal income tax return of its
parent, Health-Chem, and is party to a Tax Sharing Agreement. Deferred tax
assets and liabilities are provided by the Company on a stand-alone basis for
differences between the financial statement and tax bases of assets and
liabilities that will result in future taxable or deductible amounts. The
deferred tax assets and liabilities are measured using the enacted tax laws and
rates applicable to the periods in which the differences are expected to affect
taxable income. Income tax expense is computed as the tax payable or refundable
for the period plus or minus the change during the period in deferred tax assets
and liabilities. Deferred tax assets are reduced by a valuation allowance when,
in the opinion of management, it is more likely than not that some portion or
all of the deferred tax assets will not be realized.
F-10
l. Cash Management
The Company participates in Health-Chem's cash management practice, wherein all
cash requirements are borrowed from Health-Chem and all excess cash is advanced
to Health-Chem. The intercompany balance was $8,342,000 and $7,842,000 at
December 31, 2004 and 2003, respectively. Interest is charged based upon the
average outstanding intercompany balance and interest rate on Health-Chem's
debt. The average interest rate charged was 11.34% during both 2004 and 2003. On
August 31, 1995, Hercon issued to Health-Chem a $7,000,000, 9% Subordinated
Promissory Note in exchange for the then outstanding borrowings from affiliates.
The Company is required to make semi-annual interest payments each March and
September on this note. The principal amount of $7,000,000 was due on March 31,
2002. In March, 2002 the Company defaulted on its obligation to repay the
principal amount of $7,000,000.
m. Expenses Charged by Health-Chem
Pursuant to a Corporate Services Agreement between the Company and Health-Chem,
Health-Chem pays for certain administrative expenses on behalf of the Company
for which Health-Chem is reimbursed. These expenses are comprised primarily of
an allocation of corporate services including executive, professional, legal and
accounting. The allocation of these costs, approximately $229,000 and $393,000
for 2004 and 2003, respectively, reflect Health-Chem's estimate of their cost
for these services based upon a method (allocation based upon the Company's net
sales as a percentage of Health-Chem's consolidated net sales) which is
considered by the Company to be reasonable. The Company estimates that these
expenses, on a stand-alone basis, would not have been materially different from
the costs allocated.
n. Per Share Information
Basic and diluted earnings per share are computed based upon the weighted
average number of common shares outstanding during each year after adjustment
for any dilutive effect of the Company's stock options. Stock options are
anti-dilutive for each of the years ended December 31, 2004 and 2003.
A reconciliation of the basic and diluted earnings per common share computations
for the years ended December 31, 2004 and 2003 is presented
F-11
below (in thousands, except per share amounts):
2004 2003
---------------------------------------------- ----------------------------------------------
Income Shares Per Income Shares Per
(Numerator) (Denominator) Share Amount (Numerator) (Denominator) Share Amount
------------- ------------- ------------- ------------- ------------- -------------
Net loss $ (3) $ (1,535)
Preferred stock dividends (595) (595)
------------- -------------
Basic Earnings
Per Common Share
Net loss applicable to
common stockholders (598) 40,000 $ (.01) (2,130) 40,000 $ (.05)
============= =============
Effect of Dilutive
Securities
Stock options 0 0 0 0
------------- ------------- ------------- -------------
Diluted Earnings
Per Common Share
Net loss applicable to
common stockholders $ (598) 40,000 $ (.01) $ (2,130) 40,000 $ (.05)
============= ============= ============= ============= ============= =============
o. Stock Options
In accordance with SFAS No. 123, Accounting for Stock-Based Compensation and
SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure,
the Company accounts for its stock option plans under the intrinsic-value-based
method as defined in APB No. 25, Accounting for Stock Issued to Employees. The
following table illustrates the effect on net earnings and earnings per share if
the Company had applied the fair value recognition provisions of SFAS No. 123 to
stock-based employee compensation (in thousands, except per share amounts):
Years Ended
December 31,
2004 2003
-------- --------
Net loss applicable to common stockholders,
as reported: $ (598) $ (2,130)
Add: Stock-based compensation expense recognized
under the intrinsic value method 0 0
Deduct: Stock-based compensation expense
determined under fair value based method 0 0
-------- --------
Pro forma net loss applicable to common
stockholders $ (598) $ (2,130)
======== ========
Net loss per common share:
Basic - as reported $ (.01) $ (.05)
======== ========
Basic - pro forma $ (.01) $ (.05)
======== ========
Diluted - as reported $ (.01) $ (.05)
======== ========
Diluted - pro forma $ (.01) $ (.05)
======== ========
F-12
p. Use of Estimates in the Preparation of Financial Statements
The preparation of financial statements in conformity with generally accepted
accounting principles 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 financial statements and
the reported amounts of revenues and expenses during the reporting period.
Actual results could differ from those estimates.
q. Recent Accounting Pronouncements
In January 2003, the Financial Accounting Standards Board ("FASB") issued FASB
Interpretation No. 46 (revised December 2003), Consolidation of Variable
Interest Entities ("FIN 46(R)"). FIN 46(R) addresses the consolidation of
business enterprises to which the usual condition (ownership of a majority
voting interest) of consolidation does not apply. FIN 46(R) focuses on
controlling financial interests that may be achieved through arrangements that
do not involve voting interests. It concludes that in the absence of clear
control through voting interests, a company's exposure (variable interest) to
the economic risks and potential rewards from the variable interest entity's
assets and activities are the best evidence of control. If an enterprise holds a
majority of the variable interests of an entity, it would be considered the
primary beneficiary. Upon consolidation, the primary beneficiary is generally
required to include assets, liabilities and noncontrolling interests at fair
value and subsequently account for the variable interest as if it were
consolidated based on majority voting interest. As a result of FIN 46(R),
effective as of December 31, 2004, the Company's consolidated balance sheet
includes the assets and liabilities of York Realty Leasing LLC.
In November 2004, the FASB issued SFAS No. 151, Inventory Costs - an Amendment
of ARB No. 43, Chapter 4. SFAS 151 clarifies the accounting for abnormal amounts
of idle facility expense, freight, handling costs and spoilage. SFAS 151 also
requires that allocation of fixed production overhead costs be based on normal
production activity. The provisions of SFAS 151 are effective for inventory
costs incurred beginning in January 2006, with adoption permitted for inventory
costs incurred beginning in January 2005. Adoption of this Statement is not
expected to have a material effect on the Company's Consolidated Financial
Statements.
In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment. SFAS
123(R) establishes standards for the accounting for transactions in which an
entity exchanges its equity instruments for goods and services. Under SFAS
123(R), companies will no longer be able to account for share-based compensation
transactions using the intrinsic method in accordance with APB No. 25,
Accounting for Stock Issued to Employees. Instead, companies will be required to
account for such transactions using a fair-value method and to recognize
compensation expense over the period during which an employee is required to
provide services in exchange for the award. In April 2005, the SEC delayed the
effective date of SFAS 123(R) to fiscal years beginning after June 15, 2005.
Management is currently assessing the impact that adoption of this Statement
will have on the Company's Consolidated Financial Statements.
F-13
In May 2005, the FASB issued SFAS No. 154, Accounting Changes and Error
Corrections - a Replacement of APB Opinion No. 20 and SFAS No. 3. SFAS 154
changes the requirements for the accounting for and reporting of a change in
accounting principle. This Statement applies to all voluntary changes in
accounting principle. SFAS 154 also applies to changes required by an accounting
pronouncement in the usual instance that the pronouncement does not include
specific transition provisions. The provisions of SFAS 154 are effective for
accounting changes and corrections of errors made in fiscal years beginning
after December 15, 2005. Adoption of this Statement is not expected to have a
material effect on the Company's Consolidated Financial Statements.
3. Going Concern
As of December 31, 2004, the Company had aggregate debts and liabilities of
$37,544,000. These debts and liabilities include $12,949,000 related to
redeemable preferred stock under which the Company is currently in default,
$7,158,000 related to a subordinated promissory note under which the Company is
currently in default and $8,342,000 related to a long-term payable, with all
three of these amounts being owed to Health-Chem. Also included in these debts
and liabilities is $4,522,000 of royalties due under a license agreement with
Key Pharmaceuticals, Inc. ("Key") which allows the Company to utilize certain
technology incorporated into our current transdermal patch which has been
accumulating since 2000. The Consolidated Statement of Operations for the year
ended December 31, 2004 includes $595,000 of preferred dividends expense,
$846,000 of Health-Chem interest expense and $1,594,000 of Key royalty expense.
The Company has been able to continue to operate by not having paid these
creditors. The Company has been paying its debts and liabilities not related to
Health-Chem or the license on a current basis from cash flow generated from
operations. The Company does not have cash on hand to repay any of the amounts
due Health-Chem or the royalty payment owed under the license agreement. The
Company's financial condition has prevented it from securing financing or
obtaining loans from which it could repay all or a portion of the amounts due.
The Company is also in breach of the Key license agreement for failing to pay
royalties as they became due. The Company's default under and breach of this
license agreement entitles the licensor to terminate the agreement. If this
creditor took legal action against the Company, the Company would not be able to
continue as a going concern unless there was an increase in profitability and/or
an infusion of additional funds in order to meet these obligations for both the
past amounts due and ongoing amounts as they became due.
The Company intends to continue its efforts to complete the necessary steps in
order to meet its future cash flow requirements and to continue its pursuit of
new products and contract manufacturing opportunities. Management's plans in
this regard include, but are not limited to, the following:
o Continue with the preliminary negotiations entered into with Key
with respect to devising a plan to pay the royalties due, including
possibly negotiating a new royalty agreement.
o Continue with existing projects where the Company is developing
other transdermal products for client companies and where the
Company will be the contract manufacturer of these products if FDA
approval is obtained.
o Form business alliances with other pharmaceutical companies on the
development and/or manufacturing of new products.
o Raise additional working capital through borrowing or through
issuing equity.
o Evaluate new directions for the Company.
F-14
Management believes that actions presently being taken will need to be further
realigned or otherwise amended so that the Company will be in a position to
generate sufficient revenues to provide positive cash flows from operations and
meet its obligations as they become due. However, there can be no assurance that
this will occur. The accompanying consolidated financial statements do not
include any adjustments that might result from the outcome of this uncertainty.
4. Inventories (In thousands)
December 31,
2004 2003
------ ------
Raw materials $ 525 $ 487
Finished goods and work in process 777 279
------ ------
$1,302 $ 766
====== ======
5. Property, Plant and Equipment
In December 2004, the Company sold its real property, buildings, improvements
and equipment located in Emigsville, Pennsylvania to York Realty Leasing LLC for
a sale price of $1.9 million. Concurrent with the sale, the Company entered into
a 15-year lease for the property expiring in December 2019, which can be
extended by the Company for an additional five years. The agreement provides for
a Company repurchase option at a price of $1,995,000. The annual lease cost
during the initial 15 year term is $212,400. In December 2002, the Company had
received an appraisal for the real property, including the structures and
appurtenances, which appraised the market value of the property at $1,850,000.
The proceeds from the sale were used to satisfy a $1.6 million first mortgage
associated with the property and to substantially pay off a $367,500 second
mortgage, a portion of which was held by related parties. Andy Yurowitz, the
Company's Chairman of the Board, President, Chief Executive Officer and a member
of the Board of Directors, is a 50% owner of York Realty Leasing LLC. The
Company entered into the sale/leaseback arrangement with York Realty Leasing LLC
because it was unable to negotiate a like transaction with an unaffiliated
party. As of December 31, 2004, this sale/leaseback transaction represented the
only business activity of York realty Leasing LLC. As a result of Financial
Interpretation 46(R), effective as of December 31, 2004, the Company's
consolidated balance sheet includes the assets and liabilities of York Realty
Leasing LLC. Subsequent to December 31, 2004, York Realty Leasing LLC obtained a
$1.4 million mortgage on this property with a financial institution.
F-15
The Company's property, plant and equipment balances are as follows (in
thousands):
December 31,
2004 2003
------- -------
Land $ 152 $ 120
Buildings 924 2,734
Equipment and leasehold improvements 617 8,315
Construction-in-progress 254 78
------- -------
Total Property, Plant and Equipment 1,947 11,247
Less accumulated depreciation and amortization 0 9,253
------- -------
Net Property, Plant and Equipment $ 1,947 $ 1,994
======= =======
Depreciation expense for the years ended December 31, 2004 and 2003 was $326,000
and $381,000, respectively.
6. Other Liabilities (In thousands)
December 31,
2004 2003
------- -------
Accrued chargebacks $ 682 $ 557
Accrued rebates 454 193
Accrued audit fees 83 56
Accrued interest - Health-Chem 158 158
Accrued interest on the second mortgage 32 111
Accrued interest on other debt 2 0
Accrued discounts 73 15
Allowance for returns 59 59
Other 54 78
------ ------
$1,597 $1,227
====== ======
7. Long-Term Debt
The Company's long-term debt balances are as follows (in thousands):
December 31,
2004 2003
------- -------
Long-term payable - Health-Chem $ 8,342 $ 7,842
Subordinated promissory note - Health-Chem 7,000 7,000
Mortgage payable 0 1,600
Second mortgage payable - related party 0 367
Payable to York Realty Leasing LLC members 1,736 0
Note payable 167 0
------- -------
Subtotal 17,245 16,809
Less current portion 7,000 8,967
------- -------
Total Long-Term Debt $10,245 $ 7,842
======= =======
The Company participates in Health-Chem's cash management practice, wherein all
cash requirements are borrowed from Health-Chem and all excess cash is advanced
to Health-Chem. The intercompany balance was $8,342,000 and $7,842,000 at
December 31, 2004 and 2003, respectively. Interest is charged based upon the
average outstanding intercompany balance and interest rate on Health-Chem's
debt. The average interest rate charged was 11.34% during both 2004 and 2003. On
August 31, 1995, Hercon issued to Health-Chem a $7,000,000, 9% Subordinated
Promissory Note in exchange for the then outstanding borrowings from affiliates.
The Company is required to make semi-annual interest payments each March and
September on this note. The principal amount of $7,000,000 was due on March 31,
2002. In March, 2002 the Company defaulted on its obligation to repay the
principal amount of $7,000,000.
F-16
In the spring of 2000, the Company obtained a $1.6 million loan from Mercury
Capital Corporation at 15% interest per annum secured by a mortgage on the
Company's Pennsylvania facility. In December 2003, Mercury Capital Corporation
assigned this mortgage to William Robbins. In December 2004, the Company sold
its real property, buildings, improvements and equipment located in Emigsville,
Pennsylvania to York Realty Leasing LLC for a sale price of $1.9 million. The
proceeds from the sale were used to satisfy the $1.6 million first mortgage
noted above and to substantially pay off a $367,500 second mortgage. The Company
entered into the sale/leaseback arrangement with York Realty Leasing LLC because
it was unable to negotiate a like transaction with an unaffiliated party. Andy
Yurowitz, the Company's Chairman of the Board, President, Chief Executive
Officer and a member of the Board of Directors, is a 50% owner of York Realty
Leasing LLC. William Robbins is also a 50% owner of York Realty Leasing LLC. In
addition to capital contributions that Messrs. Yurowitz and Robbins made to York
Realty Leasing LLC, as of December 31, 2004 each made loans to York Realty
Leasing LLC totaling $136,000 and $1.6 million, respectively, with William
Robbins' loan being evidenced by the mortgage. York Realty Leasing LLC has
classified these two member loans of $1,736,000 as long-term and is accruing
interest of 15% per annum on both loans. No principal repayment on either of
these member loans is required at the present time. As a result of Financial
Interpretation 46(R), effective as of December 31, 2004, the Company's
consolidated balance sheet includes the assets and liabilities of York Realty
Leasing LLC. Subsequent to December 31, 2004, York Realty Leasing LLC obtained a
$1.4 million mortgage on this property with a financial institution.
In August 2001, the Company obtained a $367,500 loan from Zackfoot Investments,
LLC at 12.5% interest per annum secured by a mortgage on the Company's
Pennsylvania facility. This loan was repaid during 2004. Of the nine initial
investors in Zackfoot Investments, LLC, five were current or former members of
Health-Chem's Board of Directors and one investor was a former officer of
Health-Chem Corporation. Each investor received eight shares of the
Health-Chem's common stock for each dollar invested.
The $167,000 note relates to the purchase of certain fixed assets. The purchase
of these fixed assets was pursuant to a development, manufacturing and supply
agreement that the Company entered into with a client company. Payment terms of
the note are contingent upon certain performance criteria under the agreement.
One such performance criteria applicable to the client company may result in the
note being forgiven. We estimate the earliest that the note may need to be
repaid is in 2006.
F-17
8. Employee Benefit Plan
All permanent, full-time non-union employees of the Company are eligible to
participate in Health-Chem's 401(k) Plan (the "Plan") following six months of
employment. The Plan allows eligible employees to defer up to 20% of their
compensation on a pre-tax basis through contributions to the Plan. The Company
may contribute for each participant a matching contribution equal to a
percentage of the elective contributions made by the participants. The decision
to make matching contributions and the amount of such contributions will be made
each year by the Company. These Company matching contributions were $13,000 and
$16,000 in 2004 and 2003, respectively.
9. Commitments & Contingencies
In December 2004, the Company entered into a sale/leaseback agreement with York
Realty Leasing LLC for the land, buildings, improvements and equipment at the
Company's previously-owned manufacturing facility in Emigsville, Pennsylvania.
The term of the lease is for fifteen years, expiring in December 2019, can be
extended an additional five years and contains a repurchase option. The selling
price was $1.9 million and annual lease payments are $212,400. The proceeds from
the sale were used to satisfy a $1.6 million first mortgage associated with the
property and to substantially pay off a $367,000 second mortgage. The effects of
this sale/leaseback agreement have been eliminated in consolidation as a result
of York Realty Leasing LLC being considered a Variable Interest Entity.
Approximately forty percent of the Company's employees are covered by a
collective bargaining agreement with a local unit of the Retail Wholesale and
Department Store Union, AFL-CIO ("R.W.D.S.U."). The R.W.D.S.U. agreement is for
a three year period ending December 10, 2007. The contract is subject to annual
renewal thereafter and acknowledges that the R.W.D.S.U. is the exclusive
bargaining agent for the Company's regular production employees, excluding all
other employees including but not limited to supervisors, foremen, clerical
employees, time-keepers, watchmen, guards, maintenance personnel and part-time
employees.
Certain raw materials and components used in the manufacture of our products are
available from limited sources, and, in some cases, a single source. Generally,
regulatory authorities must approve raw material sources for transdermal
products. Without adequate approved supplies of raw materials or packaging
supplies, our manufacturing operations could be interrupted until another
supplier is identified, our products approved and trading terms with it
negotiated. We may not be able to identify an alternative supplier and any
supplier that we do identify may not be able to obtain the requisite regulatory
approvals in a timely manner, or at all. Furthermore, we may not be able to
negotiate favorable terms with an alternative supplier. Any disruptions in our
manufacturing operations from the loss of an approved supplier may cause us to
incur increased costs and lose revenues and may have an adverse effect on our
relationships with our partners and customers, any of which could have adverse
effects on our business and results of operations. Our business also faces the
risk that third party suppliers may supply us with raw materials that do not
meet required specifications, which, if undetected by us, could cause our
products to test out of specification and require us to recall the affected
product.
F-18
We market all of our products through one entity. If we were to lose the
services of such marketing agent for any reason or said entity does not maintain
a steady demand for our product, and we are unable to identify an adequate
replacement, our business, results of operations and financial condition would
be materially adversely affected.
We rely on insurance to protect us from many business risks, including product
liability, business interruption, property and casualty loss and employment
practices liability. The cost of insurance has risen significantly in recent
years. In response, we may increase deductibles and/or decrease certain
coverages to mitigate these costs. There can be no assurance that the insurance
that we maintain and intend to maintain will be adequate, or that the cost of
insurance and limitations in coverage will not adversely affect our business,
financial position or results of operations. Furthermore, if is possible that,
in some cases, coverage may not be available at any price.
10. Preferred Stock
In April 1995, Health-Chem's Board of Directors approved a plan to realign
certain of its business operations in order to separate its transdermal
pharmaceutical business from its then other businesses. As part of such
realignment, on August 31, 1995 the Company issued to Herculite Products, Inc.
("Herculite"), which is a wholly-owned subsidiary of Health-Chem, 1,000,000
shares of the Company's redeemable preferred stock, $10.00 par value, in
exchange for the manufacturing facility in which Hercon's operations are
conducted and the 985 shares of Hercon common stock owned by Herculite. The
Company is required to make semi-annual preferred dividend payments out of funds
legally available each March and September at the annual rate of $0.70 per share
on the then-outstanding shares of its redeemable preferred stock. Legally
available funds were not available to make the 1998 through 2006 preferred
dividend payments, nor were they available to make the required $1,000,000
redemption payments in each March for the years 1998 through 2004. An additional
required redemption payment of $1,500,000 due in March 2005 was also not made
due to legally available funds not being available to make the redemption
payment. The terms of the preferred stock provide that if either dividends
payable on the preferred stock shall be in default in an amount equal to two
full semi-annual dividend payments or a mandatory redemption payment is not
made, the holder of all of the outstanding shares of the preferred stock shall
be entitled to elect the smallest number of Directors necessary to constitute a
majority of the Company's Board of Directors until such time as the default is
cured. Health-Chem waived this right since, as a practical matter, it already
possessed such power.
11. Stock Options
Options granted under the Company's stock option plan are exercisable for up to
ten years from the grant date. A summary of the status of the Company's plan as
of December 31, 2004 and 2003 and changes during the years ended on those dates
is presented below:
F-19
2004 2003
----------------------- ------------------------
Weighted Weighted
Average Average
Exercise Exercise
Shares Price Shares Price
---------- ---------- ---------- ----------
Outstanding at
beginning of year 150,000 $ .125 1,150,000 $ .125
Granted 0 0
Exercised 0 0
Forfeited (150,000) (1,000,000)
---------- ----------
Outstanding at end
of year 0 $ .00 150,000 $ .125
========== ==========
Options exercisable
at year-end 0 150,000
========== ==========
Weighted-average
fair value of
options granted
during the year $ .00 $ .00
========== ==========
The fair value of each option grant is estimated on the date of grant using the
Black-Scholes option-pricing model. The Company did not award any option grants
during the years ended December 31, 2004 and 2003 and no stock options were
outstanding at December 31, 2004.
12. Taxes on Income (In thousands)
Years Ended
December 31,
2004 2003
------- -------
Taxes on income include provision (benefit) for:
Federal income taxes $ 0 $ 0
State and local income taxes 0 0
------- -------
Total $ 0 $ 0
======= =======
Taxes on income are comprised of:
Current $ 0 $ 0
Deferred 0 0
------- -------
Total $ 0 $ 0
======= =======
F-20
A reconciliation of taxes on income to the federal statutory rate is as follows:
Years Ended
December 31,
2004 2003
------- -------
Tax benefit at statutory rate $ (203) $ (724)
Increase (decrease) resulting from:
State and local taxes, net of federal
tax benefit (30) (107)
Other (21) 0
Change in valuation allowance 254 831
------- -------
Tax provision (benefit) $ 0 $ 0
======= =======
At December 31, 2004 and 2003, the deferred tax assets and liabilities result
from the following temporary differences and carryforwards:
2004 2003
------- -------
Deferred tax assets:
Net operating and other tax loss
carryforwards $ 4,900 $ 4,670
------- -------
Total deferred tax assets 4,900 4,670
------- -------
Deferred tax liabilities:
Accelerated depreciation (78) (102)
------- -------
Total deferred tax liabilities (78) (102)
------- -------
Net deferred tax asset before valuation
allowance 4,822 4,568
Valuation Allowance (4,822) (4,568)
------- -------
Net deferred tax asset $ 0 $ 0
======= =======
The Company is part of a consolidated group and included in the consolidated
federal income tax return of its parent, Health-Chem. The Company is also party
to a Tax Sharing Agreement with Health-Chem. Deferred tax assets and liabilities
are provided by the Company on a stand-alone basis for differences between the
financial statement and tax bases of assets and liabilities that will result in
future taxable or deductible amounts. The Company had a deferred tax asset of
$4.9 million at December 31, 2004 as a result of its losses which may be used in
the future should the consolidated group have taxable income. This deferred tax
asset had an allowance reserve of $4.9 million at December 31, 2004. Therefore,
no asset is shown as a deferred tax asset as of December 31, 2004 as a result of
the losses not being used by the Company's parent to offset any taxes due for
2004 since the consolidated group showed a loss for 2004 and has net operating
loss carryforwards. These net operating loss carryforwards expire in various
years through 2024. The Company and its subsidiary file a stand-alone return for
state purposes. At December 31, 2004, the Company had approximately $12.3
million of net operating loss carryforwards in various states in which the
Company and its subsidiary operate which are available to absorb allocated
portions of future taxable income for state tax purposes. The state operating
loss carryforwards, which are limited to $1 million per year, expire in various
years through 2024. At December 31, 2004, valuation allowance relating to tax
loss carryforwards was $4,900,000.
F-21
13. Interest, Net (In thousands)
Years ended
December 31,
2004 2003
------ ------
Interest expense $1,121 $1,124
Interest income 0 0
------ ------
$1,121 $1,124
14. Related Party Transactions
The consolidated financial statements include the following items applicable to
related parties (in thousands):
December 31,
Balance Sheets: 2004 2003
--------------- ------ ------
Property, plant and equipment, net $1,693 $ 0
Second mortgage payable 0 242
Payable to York Realty Leasing LLC members
(See Note 7) 1,736 0
Accrued interest on the second mortgage 32 69
Years ended
December 31,
Income Statements: 2004 2003
------------------ ------ ------
Interest, net $50 $46
Second mortgage payable
In August 2001, the Company obtained a $367,500 loan from Zackfoot Investments,
LLC at 12.5% interest secured by a mortgage on the Company's Pennsylvania
facility. This loan was repaid during 2004. At December 31, 2003, the following
related parties were owed principal of $242,500 with respect to this loan:
Andy Yurowitz (Employee and Director) $107,500
Manfred Mayerfeld (Director) 50,000
Andrew Levinson (Director) 25,000
Ken Brody (Former Employee) 60,000
--------
$242,500
========
F-22
Accrued interest on the second mortgage
In August 2001, the Company obtained a $367,500 loan from Zackfoot Investments,
LLC at 12.5% interest secured by a mortgage on the Company's Pennsylvania
facility. This loan was repaid during 2004. At December 31, 2004 and 2003, the
following related parties were owed interest with respect to this loan:
2004 2003
------- -------
Manfred Mayerfeld (Director) $21,000 $16,000
Andrew Levinson (Director) 11,000 8,000
Andy Yurowitz (Employee and Director) 0 29,000
Ken Brody (Former Employee) 0 16,000
------- -------
$32,000 $69,000
======= =======
Interest, net
Interest expense with respect to related parties for the years ended December
31, 2004 and 2003 is presented below:
Years ended
December 31,
2004 2003
------- -------
Second mortgage $36,000 $46,000
York Realty Leasing LLC members 14,000 0
------- -------
$50,000 $46,000
======= =======
15. Minority Interest
As a result of Financial Interpretation 46(R), effective as of December 31,
2004, the Company's consolidated balance sheet includes the assets and
liabilities of York Realty Leasing LLC. Andy Yurowitz and William Robbins are
each 50% owners of York Realty Leasing LLC. As of December 31, 2004, each had
contributed $65,000 in capital to York Realty Leasing LLC. This $130,000
combined capital has been classified as a minority interest on Transderm's
balance sheet at December 31, 2004. Subsequent to December 31, 2004, Andy
Yurowitz and William Robbins contributed additional capital to York Realty
Leasing LLC, and a portion of each of their new capital balances was converted
to long-term debt.
A former president of Hercon Laboratories Corporation maintains a 1.5% interest
in Hercon Laboratories Corporation.
F-23
16. Quarterly Results of Operations (Unaudited)
First Second Third Fourth
Quarter Quarter Quarter Quarter
---------- ---------- ---------- ----------
(in thousands, except per share data)
2004
----
Net sales $ 1,975 $ 2,128 $ 2,290 $ 2,798
Net income (loss) applicable
to common stockholders $ (372) $ (37) $ 151 $ (340)
Net income (loss) per
common share $ (.009) $ (.001) $ .004 $ (.009)
Diluted net income (loss) per
common share $ (.009) $ (.001) $ .004 $ (.009)
2003
----
Net sales $ 1,926 $ 2,041 $ 2,174 $ 1,755
Net loss applicable to
common stockholders $ (734) $ (471) $ (40) $ (884)
Net loss per common share $ (.018) $ (.012) $ (.001) $ (.022)
Diluted net loss per
common share $ (.018) $ (.012) $ (.001) $ (.022)
F-24