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ILIU > SEC Filings for ILIU > Form 10-K on 20-Mar-2014All Recent SEC Filings

Show all filings for INTERLEUKIN GENETICS INC

Form 10-K for INTERLEUKIN GENETICS INC


20-Mar-2014

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

The following discussion of our financial condition and results of operations should be read in conjunction with our audited Financial Statements and the notes thereto included elsewhere in this Annual Report on Form 10-K. As a smaller reporting company, we have elected scaled disclosure reporting obligations and therefore are required to provide the information requested by this Item 7 for only the last two most recent fiscal years.

General Overview and Trends

Interleukin Genetics, Inc. is a personalized health company that develops specific, health area focused, unique genetic tests. Our overall mission is to provide test products that can help individuals improve or maintain their health through preventive measures or lifestyle changes. Our vision is to use the science of applied genetics to empower individuals and physicians to better understand the set of actions and steps necessary to guide the best lifestyle and treatment options. We believe that the science of applied genetics can help companies provide improved services to their consumers, and assist in improving outcomes in drug development and use.

During the year ended December 31, 2013, we continued to focus our resources on commercializing our PerioPredict™ test following completion of the PDPS, the large validation study with the University of Michigan and Renaissance Health Services Corporation ("RHSC") and on the sales of our Inherent Health® brand of genetic tests and related programs.

On February 25, 2013, we entered into a Preferred Participation Agreement with RHSC, for itself and on behalf of certain of its affiliates and subsidiaries, which was amended and restated on November 1, 2013. Pursuant to this agreement, affiliates of RHSC agreed to reimburse us a fixed price for each PerioPredict™ genetic test that we process for a customer of affiliates of RHSC. In addition, if during the term of the agreement we offer the PerioPredict™ test to any other person or party for a lower price, such lower price would then be applicable to tests processed for a customer of such affiliates of RHSC for the remainder of the term of the agreement.

RHSC and its affiliates will continue to receive the preferred pricing (or any lower market price during the term) only for so long as affiliates of RHSC continue to: (a) work to develop and to offer dental plans for which a significant portion of such affiliates' clients are eligible that provides for use of the PerioPredict™ test and reimbursement of the test at the agreed upon price (each such plan, hereinafter referred to as a "Reimbursed Dental Plan") for which a significant portion of employees of RHSC's affiliates' customers are eligible; and (b) exercise their commercially-reasonable best efforts to maximize the number of customers that offer a Reimbursed Dental Plan. This amended agreement has a term of three years beginning February 25, 2013, unless terminated earlier (1) upon the mutual written agreement of us and RHSC, (2) if either party becomes the subject of bankruptcy, insolvency, liquidation or other similar proceedings, or (3) in the event of an uncured breach of the amended agreement by either party.

The timing of any revenues that we may receive under the amended agreement with RHSC is dependent upon the timing of the offering of Reimbursed Dental Plans, which timing is very uncertain at this time and is dependent on a viable market developing for such plans. RHSC intends to offer Reimbursed Dental Plans in a phased approach, beginning with smaller group plans in early 2014. In the latter half of 2014 and 2015, RHSC is expected to offer Reimbursed Dental Plans to a broader group of employer customers. We do not expect to receive any significant revenues under this agreement until the fourth quarter of 2014 or early in 2015, at the earliest, and the timing of any such revenues may be substantially later. We may never receive significant revenues under this agreement.

Our Inherent Health® brand of genetic tests includes the first-of-its-kind test for weight management that identifies an individual's genetic tendencies for weight gain related to either fat or carbohydrates in the diet. The Inherent Health® brand also offers customers a full suite of affordable, easy-to-use and meaningful genetic tests in heart health, bone health and nutritional needs. In addition, we launched additional products under the name Wellness Select that allows our e-commerce customers to purchase any combination of our Inherent Health® genetic tests at a discounted price.

We market our Inherent Health® brand of genetic assessment tests primarily through our commercial relationships with Alticor Inc. affiliated companies. Alticor is a related party. On October 26, 2009, we entered into a Merchant Network and Channel Partner Agreement with Amway Corp., d/b/a/ Amway Global ("Amway Global"), a subsidiary of Alticor. Pursuant to this agreement, Amway Global sells our Inherent Health® brand of genetic tests through its e-commerce website via a hyperlink to our e-commerce site. In 2013 and 2012, revenues from this agreement accounted for approximately 36% and 65% of our revenues, respectively.

Beginning in September 2012 and again in 2013, Access Business Group LLC ("ABG"), an affiliate of Alticor, placed purchase orders for our Weight Management genetic test kits totaling approximately $3.3 million. The kits are included as part of a promotional bundle of products that Amway is now selling to their Individual Business Owners (IBOs) pursuant to programs in 2013 and 2014. Of the $3.3 million in orders $1.8 million was received in 2013 for the 2014 program and $1.5 million for the 2013 program. The 2013 program was amended by ABG so that it would not expire at December 31, 2013. Rather than having all program kits expire at December 31, 2013, cash received from the orders will remain in deferred revenue until the tests are returned and processed.

On September 21, 2012, we entered into a License Agreement with Access Business Group International LLC ("ABGI"), an affiliate of Alticor. Pursuant to this License Agreement, we granted ABGI and its affiliates a non-exclusive license to use the technology related to our Weight Management genetic test and to sell the Weight Management test in Europe, Russia and South Africa. ABGI, or a laboratory designated by ABGI, is responsible for processing the tests, and we receive a royalty for each test sold. The License Agreement has an initial term of five years from the date of first commercial sale of the Weight Management test under the agreement. In 2013, we received $198,960 in license fees under this License Agreement.

Our research and development expenses are focused on our own development and commercialization efforts related primarily to our PerioPredict™ and Osteoarthritis genetic tests. We are also focusing on seeking potential commercial partners to validate our technology within their specific business model as a collaboration with little or no cost to us. This is different than in prior years when our development focus was concentrated in research and development to bring new test configurations to market.

On May 17, 2013, we entered into a Common Stock Purchase Agreement (the "Purchase Agreement") with various accredited investors (the "Purchasers"), pursuant to which we sold securities to the Purchasers in a private placement transaction (the "May 2013 Private Placement"). In the May 2013 Private Placement, we sold an aggregate of 43,715,847 shares of our common stock at a price of $0.2745 per share for gross proceeds of $12,000,000. The Purchasers also received warrants to purchase up to an aggregate of 32,786,885 shares of common stock an exercise price of $0.2745 per share (the "Warrants"). The Warrants are all currently exercisable and have a term of seven years from the date they became exercisable.

In addition, pursuant to the Purchase Agreement, each Purchaser has the right, at any time on or before June 30, 2014 (the "Expiration Date"), to purchase at one or more subsequent closings its pro rata share of up to an aggregate of 18,214,936 additional shares of common stock at a purchase price of $0.2745 per share and warrants to purchase up to an aggregate of 13,661,201 shares of common stock at an exercise price of $0.2745 per share (the "Additional Investment"). If, prior to the Expiration Date, Purchasers have not purchased their entire pro rata share of the Additional Investment, Purchasers who have purchased their entire pro rata share of the Additional Investment, will be entitled to purchase the unsold portion of the Additional Investment.

We recognize revenue from genetic testing services when there is persuasive evidence of an arrangement, service has been rendered, the sales price is determinable and collectability is reasonably assured. Service is deemed to be rendered when the results have been reported to the individual who ordered the test. To the extent that tests have been prepaid but results have not yet been reported, recognition of all related revenue is deferred. During the fourth quarter of 2013, we concluded that sufficient historical customer genetic test redemption patterns existed to determine the period of time after which the likelihood of test redemption was remote for Inherent Health purchased tests purchased. Based on our analysis of the redemption data, we estimate that period of time to be three years after the sale of a genetic test kit. Prior to making this determination, revenue was recognized only on test kits returned and processed. Beginning in the fourth quarter of 2013, we began to recognize breakage revenue related to genetic tests kits utilizing the remote method. Under the remote method, breakage revenue should be recognized when the likelihood of the customer exercising rights of redemption becomes remote. The term remote requires statistical analysis of customer redemption patterns for all tests sold and returned. We analyzed redemption patterns from 2009 through 2013. Included in genetic test revenue in the fourth quarter of 2013 is $213,000 of breakage revenue related to unredeemed genetic test kits from 2009 and 2010. We will continue to recognize breakage revenue and the corresponding deferred cost of goods as well as analyze the data on a quarterly basis based on the historical analysis.

In the genetic test business, competition is in flux and the markets and customer base are not well established. Adoption of new technologies by consumers requires substantial market development and customer education. Historically, we have focused on our relationship with our primary customer, Alticor, a significant direct marketing company, in order to assist us in developing the market for our products and educating our potential customers. Our challenge in 2013 and beyond will be to develop the market for our other personalized health products, in particular our PerioPredict™ test. We continue to allocate considerable resources to commercialization of our PerioPredict™ and Inherent Health® brands of genetic tests. Due to the early stage of these initiatives, we cannot predict with certainty fluctuations we may experience in our genetic test revenues or whether revenues derived from the Preferred Participation Agreement with RHSC and its affiliates or from our arrangements with Alticor-affiliated entities will ever be material, or if material, will be sustained in future periods.

Liquidity and Capital Resources

As of December 31, 2013, we had cash and cash equivalents of $7.5 million.

Cash used in operations was $4.0 million for the year ended December 31, 2013 compared to $4.5 million for the year ended December 31, 2012. Cash used in operations is primarily impacted by operating results and changes in working capital, particularly the timing of the collection of related party receivables, inventory levels, receipt of orders and the timing of payments to suppliers. In the year ended December 31, 2013, approximately $3.3 million was received as payment for weight management kits ordered as part of ABG's promotional product bundle incorporating our weight management genetic test. In addition, $198,960 in royalties was received under our License Agreement with ABGI. Deferred revenue, which consists of cash received from genetic test sales increased by $2.4 million to $4.0 million during the year ended December 31, 2013.

Cash used in investing activities was $832,000 for the year ended December 31, 2013, compared to $5,000 for the year ended December 31, 2012. Capital additions were $838,000 for the year ended December 31, 2013 compared to $5,000 for the year ended December 31, 2012. Approximately $661,000 of genetic test laboratory automation processing equipment was purchased for the introduction of our PerioPredict™ periodontal genetic test beginning in January 2014. In addition $139,000 relates to the development of internal-use software. At December 31, 2013, $375,000 of laboratory equipment and $47,000 of internal-use software is reflected in accounts payable with a corresponding entry to fixed assets. We expect additional capital purchases may be needed in the foreseeable future to further automate some of our laboratory process as we start to process samples related to our PerioPredict™ test.

Cash provided by financing activities was $11.1 million for the year ended December 31, 2013 compared to $4.0 million for the year ended December 31, 2012. On May 17, 2013, we sold an aggregate of 43,715,847 shares of our common stock, at a price of $0.2745 per share in the May 2013 Private Placement for net cash proceeds of $11.0 million. On April 13, 2012, we received $1.3 million in proceeds from the issuance of a note payable under our credit facility with Pyxis. On June 29, 2012, we completed a financing with Delta Dental of Michigan, Inc. ("DDMI"), pursuant to which DDMI purchased 500,000 shares of Series B Convertible Preferred Stock for gross proceeds of $3,000,000. All costs associated with this transaction were paid in the third quarter of 2012. We received $31,453 from stock purchases through the employee stock purchase plan during the year ended December 31, 2013 compared to $8,810 for the year ended December 31, 2012. We received $80,520 from the exercise of employee stock options in the year ended December 31, 2013 while none were exercised in the same period in 2012.

The amount of cash we generate from operations is currently not sufficient to continue to fund operations and grow our business. We expect that our current and anticipated financial resources, including the proceeds from the May 2013 Private Placement and assuming the receipt of an additional $5 million in gross proceeds from the second tranche of the May 2013 Private Placement will be adequate to maintain our current and planned operations at least through the next twelve months. If we do not receive the additional $5 million from our current investors we will be forced to seek additional funding sources. If we are unable to obtain such funding, we may have to end our operations and seek protection under bankruptcy laws. We may need significant additional capital to fund our continued operations, to facilitate the commercial launch of our PerioPredict™ genetic test, for continued research and development efforts, and for obtaining and protecting patents and administrative expenses. We believe our success depends on our ability to have sufficient capital and liquidity to fund operations at least until we begin to receive significant revenues under the Preferred Participation Agreement with RHSC and its affiliates. The timing of any revenues that we may receive under this agreement is dependent upon the timing of the offering of Reimbursed Dental Plans by RHSC affiliates, which timing is uncertain at this time, and is contingent upon a number of factors, including RHSC's affiliates' ability to develop reimbursed Dental Plans and to develop a viable market for such plans. RHSC intends to offer Reimbursed Dental Plans in a phased approach, beginning with smaller group plans in early 2014. In the latter half of 2014 and 2015, RHSC is expected to offer Reimbursed Dental Plans to a broader group of employer customers. We do not expect to receive any significant revenues under this agreement until the fourth quarter of 2014 or early in 2015, at the earliest, and the timing of any such revenues may be substantially later. We may never receive significant revenues under this agreement.

Until such time, if ever, that we generate revenues sufficient to fund operations, we may fund our operations by issuing common stock, debt or other securities in one or more public or private offerings, as market conditions permit, or through the incurrence of debt from commercial lenders. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of our existing stockholders will be diluted, and the terms may include liquidation or other preferences that adversely affect the rights of our stockholders. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions, such as incurring debt, making capital expenditures or declaring dividends. There can be no assurance that additional funds will be available when we need them on terms that are acceptable to us, or at all. If adequate funds are not available to us on a timely basis, we may be required to delay, limit, reduce or cease activities or operations or enter into licenses or other arrangements with third parties on terms that may be unfavorable to us or sell, license or relinquish rights to develop or commercialize our products, technologies or intellectual property. However, no assurance can be given at this time as to whether we will be able to achieve these objectives. The financial statements do not include any adjustment relating to the recoverability and classification of recorded asset amounts or the amounts and classification of liabilities that might be necessary should we be unable to continue as a going concern.

Results of Operations

Years Ended December 31, 2013 and 2012

Total revenue was $2.4 million for the year ended December 31, 2013 compared to $2.2 million for the year ended December 31, 2012. The increase of $193,000, or 8.6%, is primarily attributable to $213,000 of breakage revenue related to unredeemed genetic test kits recognized during the fourth quarter of 2013 and $199,000 of royalty income related to our license agreement with ABGI, offset by lower genetic test processing revenue.

During the year ended December 31, 2013, 36% of our sales revenue came through our Merchant Network and Channel Partner Agreement with Amway Global compared to 65% during the year ended December 31, 2012. During the same period, 40% and 0%, respectively, of our revenue came from sales through ABG's promotional product bundle program.

Cost of revenue for the year ended December 31, 2013 was $1.6 million, or 73.1% of revenue, compared to $1.3 million, or 59.4% of revenue, for the year ended December 31, 2012. The increase in the cost of revenue as a percentage of revenue is primarily attributable to increased laboratory costs associated with processing genetic tests, processed at a lower selling price, as compared to the year ended December 31, 2012. Deferred cost of revenue related to breakage revenue was $10,500 for the year ended December 31, 2013. No breakage revenue or costs were recognized in 2012.

Research and development expenses were $722,000 for the year ended December 31, 2013, compared to $1.3 million for the year ended December 31, 2012. The decrease of $590,000, or 45.0%, in research and development expenses is primarily attributable to decreased compensation, consulting and clinical study costs. In the first quarter of 2013, our Chief Scientific Officer had fully transitioned to his role as Chief Executive Officer and, accordingly, related compensation costs were classified as part of selling, general and administrative expenses in the 2013 period whereas such costs had previously been classified as research and development expenses.

Selling, general and administrative expenses were $6.6 million for the year ended December 31, 2013, compared to $4.2 million for the year ended December 31, 2012. The increase of $2.4 million, or 58.2%, is primarily attributable to increased expenses related to marketing activities for our PerioPredict™ periodontal test, increased consulting and compensation expenses partially offset by lower sales commissions paid to Amway Global as part of our Merchant Network and Channel Partner Agreement.

Interest expense was $472,000 for the year ended December 31, 2013, as compared to $454,000 for the year ended December 31, 2012. The increase in interest expense in 2013 is attributable to $298,000 of non cash interest associated with the fair value of the warrant liability partially offset by lower interest expense due to the conversion of all outstanding convertible debt to common stock on May 17, 2013.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements. The preparation of these financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires us to (i) make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenue and expenses; and (ii) disclose contingent assets and liabilities. A critical accounting estimate is an assumption that could have a material effect on our consolidated financial statements if another, also reasonable, amount were used or a change in the estimates is reasonably likely from period to period. We base our accounting estimates on historical experience and other factors that we consider reasonable under the circumstances. However, actual results may differ from these estimates. To the extent there are material differences between our estimates and the actual results, our future financial condition and results of operations will be affected. Our most critical accounting policies and estimates upon which our financial condition depends, and which involve the most complex or subjective decisions or assessments are set forth in Note 3 to our financial statements included in Item 8 presented elsewhere herein.

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