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PRPH > SEC Filings for PRPH > Form 10-Q on 14-Nov-2012All Recent SEC Filings

Show all filings for PROPHASE LABS, INC.

Form 10-Q for PROPHASE LABS, INC.


14-Nov-2012

Quarterly Report

Management's Discussion and Analysis of

Financial Condition and Results of Operations

Item 2. Managements Discussion and Analysis of Financial Condition and
Results of Operations.

General

ProPhase Labs, Inc. ("we", "us", "ProPhase" or the "Company"), organized under the laws of the State of Nevada, is a manufacturer, marketer and distributor of a diversified range of homeopathic and health products that are offered to the general public. We are also engaged in the research and development of potential over-the-counter ("OTC") drug, natural base health products along with supplements, personal care and cosmeceutical products.

Our primary business is currently the manufacture, distribution, marketing and sale of OTC cold remedy products to consumers through food, multi-outlet pharmacy and chain drug stores, large wholesalers and mass merchandisers. Our flagship brand is Cold-EEZEÒCold Remedy and our principal product is Cold-EEZEÒ zinc gluconate lozenges, proven in clinical studies to reduce the duration and severity of the common cold symptoms by nearly half. Cold-EEZEÒis an established product in the health care and cold remedy market. For the nine months ended September 30, 2012 and 2011, our revenues from operations have come principally from our OTC cold remedy products.

Recent Developments

In a letter dated May 29, 2012, ProPhase received an expression of interest and a non-binding proposal to be acquired by a to-be-formed affiliate of Matrixx Initiatives, Inc. ("Matrixx"). At a meeting of the Board of Directors held on June 28, 2012, the Company's Board of Directors, after careful consideration and consultation with its advisors, unanimously voted to reject the Matrixx proposal. Matrixx is the owner of the Zicam® brand of cold and allergy products and is a direct competitor to ProPhase's Cold-EEZE®Cold Remedy product line.

In a letter to ProPhase dated September 6, 2012, Matrixx then repeated its non-binding proposal on the same terms as its May 29, 2012 letter to ProPhase. Matrixx repeated the identical non-binding proposal in a September 14, 2012 letter. The Matrixx September 14, 2012 letter was attached to the report on Schedule 13D filed by Matrixx on September 14, 2012.

On September 4, 2012, Matrixx purchased for $200,000 a three year option to acquire 1,453,427 shares of the Company's common stock for $1.40 per share from Guy J. Quigley, ProPhase's former Chairman and Chief Executive Officer. Matrixx also acquired from Mr. Quigley a voting proxy to vote the shares subject to the option. The Company learned of Matrixx's transactions with Mr. Quigley through the filing by Mr. Quigley of reports on Form 4 and Schedule 13-D filed with the SEC.

On October 9, 2012, ProPhase received a revised non-binding proposal, on essentially the same terms as Matrixx's earlier offer, except that in this latest proposal Matrixx raised the proposed price by $0.20 per share. In response, the Company again sought advice from its independent financial advisors. At a meeting held on October 24, 2012, the Company's Board of Directors unanimously voted to reject this latest Matrixx proposal after careful consideration and consultation with its advisors.

In evaluating the Matrixx revised proposal, the Board unanimously determined, among other things, that:

· The non-binding Matrixx proposal undervalues ProPhase's current business and future prospects.

· The Matrixx proposal does not adequately reflect the true value of ProPhase's unique market position, business opportunities and new product launches. The Board believes that the Company's recent and potential future revenue growth will result in superior value to that offered by Matrixx in a sale transaction.

ProPhase Labs, Inc. and Subsidiaries

Management's Discussion and Analysis of

Financial Condition and Results of Operations

· The Matrixx proposal is conditioned upon Matrixx being permitted access to non-public and confidential ProPhase information. Even if Matrixx were to sign a confidentiality agreement, there is undue risk to ProPhase in disclosing confidential information to one of its largest and most aggressive competitors.

· The interests of ProPhase's stockholders will be best served by the Company continuing to pursue its independent strategic plan. The Company has made substantial investments in its Cold-EEZE® brand and believes that shareholders should be given the opportunity to realize a return on these investments.

Furthermore, we have implemented a business and marketing strategy designed to deliver superior results to our stockholders over the long term. First, we preserved the Cold-EEZE® brand, then we repositioned the brand, and now we are growing and leveraging the brand. As we have consistently explained to our shareholders, it remains our view that by investing in our Cold-EEZE® brand, we are building our distribution platform and pipeline, which has led to securing increased shelf space with our retailers for the upcoming cold season, and which has provided us with the opportunity to introduce new and improved products, including the national launch of Cold-EEZE® Oral Spray and Cold-EEZE® Daytime/Nighttime QuickMelts®for the upcoming cold season. The extra $0.20 per share that Matrixx has tacked on to its prior inadequate offer does not alter our Board's view that the current shareholders of the Company should benefit from the upside created by our current strategies, not the private equity owners of one of our primary competitors

It is understood that Matrixx's goal, like that of any suitor, is to buy our shares at the lowest possible price, which is why Matrixx has acquired the right to buy 1,453,427 shares at $1.40 per share from another shareholder. Nevertheless, our Board of Directors and management are disappointed that Matrixx resorted to publishing faulty arguments in their October 9, 2012 press release as to why the Company should be sold. The Matrixx tactic appears to be an attempt to coerce our shareholders, our Board and our management to accept an inadequate offer from Matrixx. Matrixx's fundamental assertion that ProPhase supposedly 'lacks the scale to effectively compete…' is demonstrably false, as evidenced by the most recent 52 week industry retail sales data (based on reported industry data for the cough cold category through the end of Q3 2012), which shows that even without including ProPhase's new products, our core Cold-EEZE® Cold Remedy products continue to grow at double digit rates while sales of many of our competitor's products, including Matrixx's Zicam® brand core cough/cold products, declined by double digits during the same time period. Matrixx's desire to acquire ProPhase is therefore not surprising.

Management believes we are now beginning to realize the rewards for our efforts and clearly one of our competitors has taken notice. However, our Board continues to believe that the timing is not right to sell the Company for a number of reasons. Sales and shelf space of our flagship Cold-EEZE® brand were in significant decline when new management took the helm in mid-2009, and now, after implementing a broad range of carefully developed strategies, our brand is gaining market share and growing nicely. Our new product introductions have been well received by the retail trade and we look forward to further expanding our product line next season. Our management team is committed to achieving our well planned and outlined longer term goals. If we stay the course, we believe that our shareholders will be well rewarded for their patience.

Certain Risk Factors

Our business is regulated by various agencies of the states and localities where our products are sold. Governmental regulations in foreign countries where we plan to commence or expand sales may prevent or delay entry into a market or prevent or delay the introduction, or require the reformulation of certain of our products. In addition, no prediction can be made as to whether new domestic or foreign legislation regulating our activities will be enacted. Any new legislation could have a material adverse effect on our business, financial condition and operations. Non-compliance with any applicable requirements may subject us or the manufacturers of our products to agency action, including warning letters, fines, product recalls, seizures and injunctions.

ProPhase Labs, Inc. and Subsidiaries

Management's Discussion and Analysis of

Financial Condition and Results of Operations

The manufacturing, processing, formulation, packaging, labeling and advertising of our OTC cold remedy products are subject to regulation by several federal agencies, including (i) the Food and Drug Administration ("FDA"), (ii) the Federal Trade Commission ("FTC"), (iii) the Consumer Product Safety Commission,
(iv) the United States Department of Agriculture, (v) the United States Postal Service, (vi) the United States Environmental Protection Agency and (vii) the United States Occupational Safety and Health Administration.

In addition to OTC and prescription drug products, the FDA regulates the safety, manufacturing, labeling and distribution of dietary supplements, including vitamins, minerals and herbs, food additives, food supplements and cosmetics. The FTC also has overlapping jurisdiction with the FDA to regulate the promotion and advertising of vitamins, OTC drugs, cosmetics and foods. In addition, certain of our OTC cold remedy products are homeopathic remedies which are subject to standards established by the Homeopathic Pharmacopoeia of the United States ("HPUS"). HPUS sets the standards for source, composition and preparation of homeopathic remedies which are officially recognized under the Federal Food, Drug and Cosmetics Act, as amended.

Preclinical development, clinical trials, product manufacturing, labeling, distribution and marketing of potential new products are also subject to federal and state regulation in the United States and other countries. Clinical trials and product marketing and manufacturing are subject to the rigorous review and approval processes of the FDA and foreign regulatory authorities. To obtain approval of a new drug product, a company must demonstrate through adequate and well-controlled clinical trials that the drug product is safe and effective for its intended use. Obtaining FDA and other required regulatory approvals is lengthy and expensive. Typically, obtaining regulatory approval for pharmaceutical products requires substantial resources and takes several years. The length of this process depends on the type, complexity and novelty of the product and the nature of the disease or other indication to be treated. Preclinical studies must comply with FDA regulations. Clinical trials must also comply with FDA regulations to ensure safety of the human subjects in the trial and may require large numbers of test subjects, complex protocols and possibly lengthy follow-up periods. Consequently, satisfaction of government regulations may take several years, may cause delays in introducing potential new products for considerable periods of time and may require imposing costly procedures upon our activities. If regulatory approval of new products is not obtained in a timely manner or not at all, we could be materially adversely affected. Even if regulatory approval of new products is obtained, such approval may impose limitations on the indicated uses for which the products may be marketed which could also materially adversely affect our business, financial condition and future operations.

The Joint Venture is at its early stage of development where product and market research has been initiated and new product initiatives are being evaluated and prioritized for future development and commercialization. Prior to any new product being available for sale, substantial resources will have to be committed to commercialize a product which may include research, development, preclinical testing, clinical trials, manufacturing scale-up and regulatory approval. The Joint Venture may disrupt our ongoing operations, divert management from day-to-day responsibilities and increase our expenses.

We face significant technological risks inherent in developing these products. The Joint Venture may be subject to delays and/or ultimately unable to successfully implement its business plan and strategy to develop and commercialize one or more non-prescription remedies using certain patented and proprietary TPMTM that exploit certain compounds that embody the TPMTM for use in a product combining one or more of such compounds with an OTC drug. The commercialization and ultimate product market acceptance is subject to, among other influences, consumer purchasing trends, demand for our OTC drug, health and wellness trends, regulatory factors, retail acceptance and overall economic and market conditions. As a consequence, we may suspend or abandon some or all of our proposed new products before they become commercially viable. Even if we develop and obtain approval of a new product, if we cannot successfully commercialize it in a timely manner, our business and financial condition may be materially adversely affected.

ProPhase Labs, Inc. and Subsidiaries

Management's Discussion and Analysis of

Financial Condition and Results of Operations

Future revenues, costs, margins, and profits will continue to be influenced by our ability to maintain our manufacturing availability and capacity together with our marketing and distribution capability and the requirements associated with the development of potential OTC drug and other medicinal products in order to continue to compete on a national and international level. Our business development is dependent on continued conformity with government regulations, a reliable information technology system capable of supporting continued growth and continued reliable sources for product and materials to satisfy consumer demand. Many of our competitors have substantially greater capital resources, technical staffs, facilities, marketing resources, product development, distribution and experience than we do. As a consequence, our competitors may have certain advantages, including the ability to allocate greater resources for new product development, marketing and other purposes.

Readers should carefully review the risk factors described in other sections of this filing as well as in other documents we file from time to time with the Securities and Exchange Commission.

Critical Accounting Policies

The preparation of financial statements in conformity with accounting principles generally accepted in the United States ("GAAP") requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods. Actual results could differ from those estimates. Our significant accounting policies are described in Note 2 of Notes to Condensed Consolidated Financial Statements included under Item 1 of this Part I. However, certain accounting policies are deemed "critical", as they require management's highest degree of judgment, estimates and assumptions. These accounting estimates and disclosures have been discussed with Audit Committee of our Board of Directors. A discussion of our critical accounting policies, the judgments and uncertainties affecting their application and the likelihood that materially different amounts would be reported under different conditions or using different assumptions are as follows:

Revenue Recognition - Sales Allowances

When providing for the appropriate sales returns, allowances, cash discounts and cooperative incentive promotion costs ("Sales Allowances"), we apply a uniform and consistent method for making certain assumptions for estimating these provisions. These estimates and assumptions are based on historical experience, current trends and other factors that management believes to be relevant at the time the financial statements are prepared. Management reviews the accounting policies, assumptions, estimates and judgments on a quarterly basis. Actual results could differ from those estimates.

Our primary product, Cold-EEZEÒ lozenges, utilizes a proprietary zinc formulation which has been clinically proven to reduce the severity and duration of common cold symptoms. Factors considered in estimating the appropriate sales returns and allowances for this product include it being (i) a unique product with limited competitors, (ii) competitively priced, (iii) promoted, (iv) unaffected for remaining shelf-life as there is no product expiration date and
(v) monitored for inventory levels at major customers and third-party consumption data. In addition to Cold-EEZE® lozenges we market and distribute Cold-EEZE® Oral Spray, Cold-EEZE® Cold Remedy Daytime/Nighttime QuickMelts®and Kids-EEZE® soft chew children's OTC cold remedies ("Kids-EEZE® Products"). We also manufacture, market and distribute an organic cough drop and a Vitamin C supplement ("Organix®"). Each of the Cold-EEZE® Oral Spray products, Cold-EEZE® Cold Remedy Daytime/Nighttime QuickMelts®, Kids-EEZE® Products and Organix® products carry shelf-life expiration dates for which we aggregate such new product market experience data and update our sales returns and allowances estimates accordingly. Sales allowances estimates are tracked at the specific customer and product line levels and are tested on an annual historical basis, and reviewed quarterly. Additionally, we monitor current developments by customer, market conditions and any other occurrences that could affect the expected provisions relative to net sales for the period presented.

ProPhase Labs, Inc. and Subsidiaries

Management's Discussion and Analysis of

Financial Condition and Results of Operations

Our return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products that have reached or exceeded their designated expiration date. We do not impose a period of time within which product may be returned. All requests for product returns must be submitted to us for pre-approval. The main components of our returns policy are: (i) we will accept returns that are due to damaged product that is un-saleable and such return request activity fall within an acceptable range, (ii) we will accept returns for products that have reached or exceeded designated expiration dates and (iii) we will accept returns in the event that we discontinue a product provided that the customer will have the right to return only such item that it purchased directly from us. We will not accept return requests pertaining to customer inventory "Overstocking" or "Resets". We will only accept return requests for product in its intended package configuration. We reserve the right to terminate shipment of product to customers who have made unauthorized deductions contrary to our return policy or pursue other methods of reimbursement. We compensate the customer for authorized returns by means of a credit applied to amounts owed or to be owed and in the case of discontinued product only, also by way of an exchange. We do not have any significant product exchange history.

We classify product returns into principally three categories, (i) non-routine returns, (ii) obsolete product and (iii) product mix realignment by certain of our customers. "Non-routine" returns are defined as product returned to us as a consequence of unanticipated circumstances principally due to (i) retail store closings or (ii) unexpected poor retail sell through to consumers causing us to discontinue the product. "Obsolete" returns are defined as product returned to us as a consequence of product shelf-life "use by" expiration date. "Product mix realignment" returns are defined as product returned to us due to initiatives by the trade to discontinue purchasing certain of our products. Product mix realignment returns are generally nominal and are frequently related to discontinued or soon to be discontinued products.

As of September 30, 2012 and December 31, 2011, we included a provision for sales allowances of $93,000 and $101,000, respectively, which are reported as a reduction to account receivables. We also included an estimate of the uncollectability of our accounts receivable as an allowance for doubtful accounts of $37,000 and zero as of September 30, 2012 and December 31, 2011, respectively. Additionally, accrued advertising and other allowances as of September 30, 2012 included $1.3 million for estimated future sales returns and $822,000 for cooperative incentive promotion costs. As of December 31, 2011 accrued advertising and other allowances included $1.7 million for estimated future sales returns, $1.0 million for cooperative incentive promotion costs and $279,000 for certain other advertising and marketing promotions.

A one percent deviation for these Sales Allowance provisions for the three months ended September 30, 2012 and 2011 would affect net sales by approximately $66,000 and $68,000, respectively. A one percent deviation for these Sales Allowance provisions for the nine months ended September 30, 2012 and 2011 would affect net sales by approximately $162,000 and $127,000, respectively.

Income Taxes

As of December 31, 2011, we have net operating loss carry-forwards of approximately $31.6 million for federal purposes that will expire beginning in Fiscal 2020 through Fiscal 2031. Additionally, there are net operating loss carry-forwards of approximately $20.0 million for state purposes that will expire beginning in Fiscal 2018 through Fiscal 2031. Until sufficient taxable income to offset the temporary timing differences attributable to operations and the tax deductions attributable to option, warrant and stock are assured, a valuation allowance equaling the total deferred tax asset is being provided. Management believes that this allowance is required due to the uncertainty of realizing these tax benefits in the future. The uncertainty arises largely due to substantial marketing and research and development costs.

ProPhase Labs, Inc. and Subsidiaries

Management's Discussion and Analysis of

Financial Condition and Results of Operations

Seasonality of the Business

Our sales are derived principally from our OTC cold remedy products. As a consequence, a significant portion of our business is highly seasonal, which causes major variations in operating results from quarter to quarter. The third and fourth quarters generally represent the largest sales volume for our OTC cold remedy products with a corresponding increase in marketing and advertising expenditures designed to promote our products during the Cold Season (as defined below). In addition, our sales are influenced by and subject to fluctuations in the timing of purchase and the ultimate level of demand for our products which are a function of the timing, length and severity of each cold season. Generally, a cold season is defined in our industry as the period of September to March ("Cold Season") when the incidence of the common cold rises as a consequence of the change in weather and other factors. We track health and wellness trends and develop retail promotional strategies to align our production scheduling, inventory management and marketing programs to optimize consumer purchases.

Financial Condition and Results of Operations

Results from Operations for the Three Months Ended September 30, 2012

as Compared to the Three Months Ended September 30, 2011

For the three months ended September 30, 2012, net sales were $5.4 million as compared to $5.1 million for the three months ended September 30, 2011. For the three months ended September 30, 2012, net sales of OTC cold remedy products were $5.1 million as compared to net sales of $4.9 million for three months ended September 30, 2011. For the three months ended September 30, 2012 and 2011, our contract manufacturing operations generated net sales to third party customers of $316,000 and $192,000, respectively.

Net sales of OTC cold remedy products remained stable for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011 due to similar timing of shipments to retailers from period to period. The timing, stocking and ultimate level of demand of retailer purchases of our OTC cold remedy products are affected by the change in the timing and the comparative severity of the respective Cold Season as well as the effects of the timing and scope of our marketing and promotional efforts to increase consumer awareness and to influence purchase decisions.

Cost of sales for the three months ended September 30, 2012 were $2.0 million as compared to $1.5 million for the three months ended September 30, 2011. For the three months ended September 30, 2012 as compared to the three months ended September 30, 2011, we realized a gross margin of 62.8% and 70.7%, respectively. The decrease of 7.9% in gross margin is principally due (i) an increase in ingredient commodity costs incurred and (ii) an unfavorable variance in our manufacturing operations overhead absorption rate as a consequence of the timing of production and the product mix shipped to retailers during the three months ended September 30, 2012 as compared to the three months ended September 30, 2011. Gross margins are principally influenced by fluctuations in quarter-to-quarter production volume, fixed production costs and related overhead absorption, raw ingredient costs, inventory mark to market write-downs, if any, retail cooperative incentive promotion and the timing of shipments to customers which are factors of the seasonality of our sales activities and products.

Sales and marketing expense for the three months ended September 30, 2012 decreased $123,000 to $1.0 million as compared to $1.2 million for the three months ended September 30, 2011. The decrease in sales and marketing expense for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011 was due to a decrease in advertising expenditures.

General and administration expense for the three months ended September 30, 2012 were $1.1 million as compared to $1.1 million for the three months ended September 30, 2011 as we continued to control our general and administration expenses from period to period.

ProPhase Labs, Inc. and Subsidiaries

Management's Discussion and Analysis of

Financial Condition and Results of Operations

Research and development costs during the three months ended September 30, 2012 decreased $33,000 to $165,000, as compared to $198,000 for the three months ended September 30, 2011. The decrease in research and development costs for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011 was due principally to a decrease in outside research expenditures. Additionally, we continue to engage in other market analysis, research and development activities that we determine are appropriate and we may increase our research and development activities in future periods as a consequence of the Joint Venture.

Interest and other income for the three months ended September 30, 2012 was $1,000 as compared to $4,000 for the three months ended September 30, 2011. The decrease of $3,000 for the three months ended September 30, 2012 as compared to the three months ended September 30, 2011 was the result of decreased bank balance and lower interest rates.

As a consequence of the effects of the above, the net income for the three months ended September 30, 2012, was $1.1 million or $0.07 per share, as compared to net income of $1.1 million or $0.07 per share, for the three months ended September 30, 2011.

Financial Condition and Results of Operations

Results from Operations for the Nine Months Ended September 30, 2012

as Compared to the Nine Months Ended September 30, 2011

. . .

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