SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
(Mark One)
[X] Quarterly Report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934 for the quarterly period ended September 30, 1998
[ ] Transition report pursuant to section 13 or 15(d) of the Securities
Exchange Act of 1934 for the transition period from _______ to _______
Commission File Number 0-24760
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Orphan Medical, Inc.
--------------------
(Exact name of registrant as specified in its charter)
Minnesota 41-1784594
--------- ----------
(State or other jurisdiction of (I.R.S. Employer Identification Number)
incorporation or organization)
13911 Ridgedale Drive, Suite 475,
Minnetonka, MN 55305 (612) 513-6900
-------------------- --------------
(Address of principal executive offices (Registrant's telephone number,
and zip code) including area code)
Indicate by check mark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding 12 months, and (2) has been subject to such filing requirements
for the past 90 days.
Yes [X] No [ ]
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practical date.
Common Stock, $.01 par value 6,354,373
---------------------------- ---------
(Class) (Outstanding at November 9, 1998)
<PAGE>
INDEX
ORPHAN MEDICAL, INC.(R)
(A Development Stage Company)
Page No.
--------
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements (Unaudited)
Balance Sheets - September 30, 1998 and December 31, 1997. 3
Statements of Operations - Three month and nine month periods ended
September 30, 1998 and September 30, 1997 and for the period January 1,
1993 (inception) through September 30, 1998. 4
Statements of Cash Flows - Nine months ended September 30, 1998 and
September 30, 1997 and for the period January 1, 1993 (inception) through
September 30, 1998. 5
Notes to Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations. 8
Item 3. Quantitative and Qualitative Disclosures about Market Risks 13
PART II. OTHER INFORMATION
Items 1, 3 and 4 have been omitted since all items are inapplicable or
answers negative.
Item 2. Changes in Securities and Use of Proceeds 13
Item 5. Other Information 13
Item 6. Exhibits and Reports on Form 8-K 14
Signature 15
Antizol(R), Antizol-Vet(R), Caprogel(TM), Busulfex(TM), Intrachol(TM),
Colomed(TM), Cystadane(R), Elliotts B(R) Solution, Sucraid(R), Xyrem(TM), "The"
Orphan Drug Company(TM), Orphan Medical(R), Inc. and Dedicated to Patients with
Uncommon Diseases(R) are trademarks of the Company.
<PAGE>
BALANCE SHEETS
ORPHAN MEDICAL, INC.
(A Development Stage Company)
<TABLE>
<CAPTION>
September 30, December 31,
1998 1997
------------- --------------
<S> <C> <C>
ASSETS (Unaudited) (Note)
Current assets:
Cash and cash equivalents $ 3,599,354 $ 2,150,877
Available-for-sale securities 5,176,148 5,018,353
Accounts receivable, less allowance for doubtful
accounts of $28,136 and $22,617 484,810 238,356
Other receivables 7,125 143,581
Inventories 196,402 308,548
Prepaid expenses 57,002 41,599
------------ ------------
Total current assets 9,520,841 7,901,314
Property and equipment:
Property and equipment 547,116 494,680
Accumulated depreciation (229,562) (157,044)
------------ ------------
317,554 337,636
------------ ------------
Total assets $ 9,838,395 $ 8,238,950
============ ============
LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Chronimed Inc. obligation - current portion $ 669,662 $ 876,655
Accounts payable and accrued expenses 3,093,320 2,494,766
Accrued payroll and related taxes 57,828 50,179
------------ ------------
Total current liabilities 3,820,810 3,421,600
Non current liabilities:
Chromined Inc. obligation -- 1,171,448
Commitments
Shareholders' equity:
Senior Convertible Preferred Stock, $.01 par value; 14,400
shares authorized; 7,500 shares issued and outstanding 7,078,035
Common Stock, $.01 par value; 25,000,000 shares authorized;
6,354,373 and 6,099,562 shares issued and outstanding 63,543 60,996
Additional paid-in capital 31,492,396 29,783,404
Deficit accumulated during the development stage (32,615,067) (26,196,538)
------------ ------------
6,018,907 3,647,862
Unrealized gain (loss) on available-for-sale securities (1,322) (1,960)
------------ ------------
Total shareholders' equity 6,017,585 3,645,902
------------ -----------
Total liabilities and shareholders' equity $ 9,838,395 $ 8,238,950
============ ============
</TABLE>
NOTE: THE BALANCE SHEET AT DECEMBER 31, 1997 HAS BEEN DERIVED FROM THE AUDITED
FINANCIAL STATEMENTS AT THAT DATE BUT DOES NOT INCLUDE ALL OF THE INFORMATION
AND FOOTNOTES REQUIRED BY GENERALLY ACCEPTED ACCOUNTING PRINCIPLES FOR COMPLETE
FINANCIAL STATEMENTS.
SEE ACCOMPANYING NOTES.
3
<PAGE>
STATEMENTS OF OPERATIONS
ORPHAN MEDICAL, INC.
(A Development Stage Company)
(Unaudited)
<TABLE>
<CAPTION>
Period from
January 1,
For the Three Months Ended For the Nine Months Ended 1993
------------------------------ ------------------------------- (Inception) to
September 30, September 30, September 30, September 30, September 30,
1998 1997 1998 1997 1998
------------- -------------- ------------- ------------- -------------
<S> <C> <C> <C> <C> <C>
Net sales $ 826,858 $ 145,815 $ 3,315,459 $ 412,524 $ 3,986,978
Operating expenses:
Cost of sales 214,734 111,224 605,871 231,905 914,044
Research and
Development 1,764,674 2,319,953 5,382,635 5,132,686 23,588,051
Sales and marketing 572,439 252,815 1,892,281 2,937,287 5,622,713
General and
Administrative 596,321 798,153 1,859,415 1,920,702 8,426,906
----------- ----------- ----------- ----------- ------------
Loss from operations (2,321,310) (3,336,330) (6,424,743) (9,810,056) (34,564,736)
----------- ----------- ----------- ----------- ------------
Other income:
Interest, net 79,811 92,229 114,091 495,445 2,057,546
----------- ----------- ----------- ----------- ------------
Net loss and deficit
accumulated during the (2,241,499) (3,244,101) (6,310,652) (9,314,611) (32,507,190)
development stage
Less: Preferred
stock dividends (107,877) -- (107,877) -- (107,877)
----------- ----------- ----------- ----------- ------------
Net loss and deficit
applicable to common
shareholders
accumulated during
the development stage $(2,349,376) $(3,244,101) $(6,418,529) $(9,314,611) $(32,615,067)
=========== =========== =========== =========== ============
Basic and diluted loss $(.38) $(.53) $(1.04) $(1.54) $(8.96)
per common share
=========== =========== =========== =========== ============
Weighted average
number of shares
outstanding 6,261,505 6,073,391 6,185,684 6,065,842 3,641,151
=========== =========== =========== =========== ============
</TABLE>
SEE ACCOMPANYING NOTES.
4
<PAGE>
STATEMENTS OF CASH FLOWS
ORPHAN MEDICAL, INC.
(A Development Stage Company)
(Unaudited)
<TABLE>
<CAPTION>
Period from
For the Nine Months Ended January 1, 1993
------------------------------- (Inception) to
September 30, September 30, September 30,
1998 1997 1998
------------ ------------- -------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net loss $(6,418,529) $ (9,314,611) $(32,615,067)
Adjustments to reconcile net loss to net cash used
in operating activities:
Depreciation and amortization 72,518 54,089 233,651
Loss on disposition of fixed assets -- -- 4,091
Changes in operating assets and liabilities:
Accounts payable and accrued expenses 606,203 538,769 3,151,148
Inventories 112,146 (163,895) (196,402)
Accounts receivable and other current assets (125,401) (276,613) (558,366)
----------- ------------ ------------
Net cash used in operating activities (5,753,063) (9,162,261) (29,980,945)
INVESTING ACTIVITIES
Purchase of office equipment (52,436) (110,722) (592,680)
Proceeds from fixed asset sales -- -- 38,192
Purchases of short-term investments (8,177,157) (11,178,493) (45,349,790)
Maturities of short-term investments 8,020,000 17,016,772 40,172,320
----------- ------------ ------------
Net cash provided by (used in) investing activities (209,593) 5,727,557 (5,731,958)
FINANCING ACTIVITIES:
Capital contribution -- -- 5,000,000
Chronimed Inc. obligation (1,378,441) 1,984,503 669,662
Stock option exercise proceeds 270,597 213,697 594,622
Value of stock issued to Chronimed 1,440,942 -- 1,440,942
Net proceeds from stock offerings 7,078,035 -- 30,714,701
Expenses paid by Chronimed -- -- 892,330
----------- ------------ ------------
Net cash provided by financing activities 7,411,133 2,198,200 39,312,257
----------- ------------ ------------
Increase (decrease) in cash and cash equivalents 1,448,477 (1,236,504) 3,599,354
Cash and cash equivalents at beginning of
period 2,150,877 3,927,945 --
----------- ------------ ------------
Cash and cash equivalents at end of
period $ 3,599,354 $ 2,691,441 $ 3,599,354
=========== ============ ============
SUPPLEMENTAL CASH FLOW INFORMATION
Cash interest received $ 330,525 $ 629,675 $ 2,279,182
=========== ============ ============
</TABLE>
SEE ACCOMPANYING NOTES
5
<PAGE>
ORPHAN MEDICAL, INC.
(A Development Stage Company)
NOTES TO FINANCIAL STATEMENTS
(Unaudited)
1. BASIS OF PRESENTATION
Orphan Medical, Inc. (the "Company") is a development stage company that
acquires, develops, and markets products of high medical value intended to
address inadequately treated or uncommon diseases within selected strategic
therapeutic market segments. A drug has high medical value if it offers a major
improvement in the safety or efficacy of patient treatment and has no
substantial equivalent substitute. The Company is currently developing two
potential products and has five products that have been approved for marketing
by the Food and Drug Administration (the "FDA").
The accompanying unaudited financial statements have been prepared in accordance
with generally accepted accounting principles for interim financial information
and with the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, these financial statements do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal, recurring accruals) considered necessary for fair presentation have
been included. Operating results for the three and nine month periods ended
September 30, 1998 are not necessarily indicative of the results that may be
expected for the year ended December 31, 1998. For further information, refer to
the audited financial statements and accompanying notes contained in the
Company's Annual Report filed on Form 10-K for the year ended December 31, 1997.
2. USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the amounts reported in the financial statements and accompanying notes.
Actual results could differ from those estimates.
3. LOSS PER SHARE
Basic and diluted loss per share applicable to common shareholders are based
upon the weighted average number of shares outstanding during the respective
period. Common stock equivalents are not included because their effect is
anti-dilutive.
4. CHRONIMED OBLIGATION
The Company and Chronimed Inc. ("Chronimed") entered into an Agreement dated
June 27, 1997, in which Chronimed agreed to terminate certain agreements that
had been in existence since the spin-off of the Company from Chronimed. Among
the terminated agreements was the Marketing and Distribution Agreement dated
July 2, 1994, as amended, under which Chronimed had the exclusive right to
market and distribute four of the Company's proposed products and receive
royalties with respect to two of the
6
<PAGE>
Company's products. In consideration for terminating these agreements, the
Company agreed to pay Chronimed compensation equal to $2,500,000, consisting of
cash and shares of the Company's Common Stock. The Company paid $250,000 on June
27, 1997, with the remaining balance of $2,250,000 payable in quarterly
installments based on a temporary royalty arrangement equal to 3 percent of the
Company's net sales and the issuance on a quarterly basis of Common Stock equal
to 1 percent of the Company's then issued and outstanding Common Stock. Through
September 30, 1998, the Company has paid Chronimed approximately $102,300 in
royalties and issued 185,971 shares of Common Stock, of which 123,056 shares
have been sold by Chronimed in market transactions for net cash proceeds of
$1,063,452. At September 30, 1998, the Company's unpaid obligation to Chronimed
has an estimated value of approximately $669,000, which is classified as a
"Current Liability".
5. COMMITMENTS
The Company has various commitments under agreements with outside consultants,
contract drug development companies, manufacturers, technical service companies,
license and research agreements, and agreements with drug distributors.
Expenditures incurred under these commitments and reported as research and
development expense totaled approximately $1,357,000 and $4,415,000 for the
three and nine month periods ended September 30, 1998, respectively. At
September 30, 1998, the Company estimates that it could incur approximately
$3,052,000 of additional expenditures in subsequent periods under existing
commitments. Commitments for research and development expenditures will likely
fluctuate from quarter to quarter and from year to year depending on, among
other factors, the timing of product development and the progress of clinical
development programs.
6. BORROWINGS
The Company has a commercial revolving line of credit with a bank, which expires
on May 15, 1999. The maximum amount available to the Company under this
arrangement is $500,000, subject to certain limitations. The Company's
indebtedness to the bank may not exceed the lesser of (1) 75 percent of the
Company's trade accounts receivable that have been outstanding for 90 days or
less or (2) $500,000. In addition, the Company must maintain a minimum balance
of at least $250,000 in accounts which the bank controls. Advances are charged a
variable rate of interest equal to the prime rate plus one half of a percent.
Through September 30, 1998, the Company has not borrowed under this arrangement.
7. PREFERRED STOCK OFFERING
On July 23, 1998, the Company issued $7.5 million of Senior Convertible
Preferred Stock (the "Preferred Shares") in a private placement. The private
placement agreement also included an option to purchase up to an additional $4.5
million of the Preferred Shares, which was not exercised by the holders and
expired on October 21, 1998. The Company realized net cash proceeds of
$7,078,035 from the sale of the Preferred Shares after the payment of related
offering expenses. The Preferred Shares are convertible, at the option of the
holders, into shares of the Company's Common Stock at a price equal to $8.50 per
share. The Preferred
7
<PAGE>
Shares have anti-dilution and change of control protection, and bear a dividend
of 7.5% per annum, payable semi annually, which during the first two years may
be paid either in cash or by issuing additional Preferred Shares. In the third
year and thereafter, the dividend may be paid either in cash or by issuing
Common Stock valued at the then current market price. At the Company's option
upon their maturity in July 2008, the Preferred Shares must be (a) converted
into Common Stock, subject to a $3.0 million conversion fee payable in cash or
by issuing additional Common Stock, or (b) redeemed for cash at $1,000 per share
plus accrued dividends. The holders of the Preferred Share are entitled to and
have exercised their right to designate one individual to serve on the Company's
Board of Directors.
8. RECLASSIFICATIONS
Certain prior period balances have been reclassified in order to conform with
the presentation for the three and nine months ended September 30, 1998. These
reclassifications have no impact on the net loss or shareholders' equity as
previously reported.
Item 2. Management's Discussion and Analysis of Financial Condition and Results
of Operations
CAUTIONARY STATEMENT
This Quarterly Report on Form 10-Q contains statements that are not descriptions
of historical facts. The words or phrases "will likely result", "look for", "may
result", "will continue", "is anticipated", "expect", "project", or similar
expressions are intended to identify "forward-looking statements" within the
meaning of the Private Securities Litigation Reform Act of 1995. Such statements
may be forward-looking statements that are subject to risks and uncertainties.
Actual results could differ materially from those currently anticipated due to a
number of factors, including those identified in the Company's "Cautionary
Statements" on Exhibit 99 to this Quarterly Report filed on Form 10-Q for the
quarterly period ended September 30, 1998.
GENERAL
Orphan Medical, Inc., a development stage company, was incorporated on June 17,
1994 in order to carry on the business previously conducted by the Orphan
Medical Division of Chronimed. From inception through September 30, 1998, the
Company has incurred losses totaling $32,615,067, consisting of $23,588,051 of
research and development expenses, $5,622,713 of sales and marketing expenses,
$8,426,906 of general and administrative expenses, $3,072,934 of gross profit on
sales of approved products, $2,057,546 of net interest income and $107,877 of
accrued preferred stock dividends. The Company's activities have consisted
primarily of obtaining the rights for pharmaceutical products, hiring the
personnel required to implement the Company's business plan, managing the
development of these products, preparing for the commercial introduction of five
products and fund raising. At September 30, 1998, five of the Company's products
have been approved by the Food and Drug Administration ("FDA") for marketing and
are commercially available and two products were in development.
8
<PAGE>
The Company has not generated sufficient levels of revenue from its approved
products to date to fund its operating activities and has sustained significant
operating losses each year since inception. The Company expects to continue
reporting as a development stage company at least through 1998. In addition, the
Company expects operating losses to continue through 1999.
Net loss applicable to common shareholders of $2,349,376 in the 1998 third
quarter compares with a net loss of $3,244,101 in the 1997 third quarter. The
net loss applicable to common shareholders of $6,418,529 for the nine month
period ended September 30, 1998 compares with a net loss of $9,810,056 for the
corresponding 1997 period. The smaller 1998 net losses for the quarter and first
nine months when compared to the corresponding 1997 periods were due to
increases in net sales in 1998 and the absence of one-time accounting charges
recorded in 1997 relating to the termination of certain agreements with
Chronimed and the estimated costs to phase out nine development products.
Net sales increased 467% from $145,815 in the 1997 third quarter to $826,858 in
the 1998 third quarter, and increased 704% from $412,524 for the nine month
period ended September 30, 1997 to $3,315,459 for the corresponding 1998 period.
Quarter-to-quarter net sales decreased 14% in the 1998 third quarter when
compared to the 1998 second quarter, following a 10% decrease in the 1997 third
quarter when compared to the 1997 second quarter. The 1998 increase is
attributable to Antizol sales, which the Company commenced shipping for the
first time in December 1997. Antizol sales growth to date reflects the initial
stocking of this product by many hospitals. The Company expects sales of Antizol
after 1998 to be at lower levels on an annualized basis because most hospitals
and wholesalers that were expected to stock Antizol have and future orders will
most likely be based on use or as poisonings occur. Sales of Elliotts B
Solution, Cystadane, Antizol-Vet, Antizol, and Sucraid are consistent with the
Company's expectations for 1998.
Cost of sales increased 93% from $111,214 (76% of net sales) in the 1997 third
quarter to $214,734 (26% of net sales) in the 1998 third quarter, and increased
161% from $231,905 (56% of net sales) for the nine month period ended September
30, 1997 to $605,871 (18% of net sales) for the corresponding 1998 period. The
1998 increase is attributable to significantly higher unit sales volume of new
products, Antizol and Sucraid, and provisions to write off excess inventories.
Cost of sales as a percentage of net sales will fluctuate from quarter to
quarter and from year to year depending on, among other factors, demand for the
Company's products, new product introductions and the mix of approved products
shipped.
Research and development expense decreased by 24% from $2,319,953 in the 1997
third quarter to $1,764,674 in the 1998 third quarter, and increased by 5% from
$5,132,686 for the nine month period ended September 30, 1997 to $5,382,635 for
the corresponding 1998 period. For the nine months ended September 30, 1997,
approximately $1,706,000 (including a one-time charge of $780,000) of research
and development expense related
9
<PAGE>
to the nine development products the Company phased out during 1997. Excluding
the research and development expense of $1,706,000 related to the phased out
development products for the nine months ended September 30, 1997, research and
development expense for the nine months ended September 30, 1998 increased by
approximately $1,956,000 over the corresponding 1997 period. This increase is
largely attributable to significantly higher regulatory and clinical spending
for Busulfex and Xyrem from spending levels for the corresponding 1997 period.
The Company expects research and development expense, principally regulatory
spending for Busulfex, and clinical and toxicology spending for Xyrem to
increase significantly over current levels in subsequent quarters. Clinical
spending for Xyrem will be dependent on a number of factors, including among
others: the number of human subjects required for a trial, the number of human
subjects screened and enrolled in a trial, and the number of active clinical
sites. The Company's product development schedule for Busulfex and Xyrem will be
influenced by regulatory decisions, competitive pressures and the availability
of funding.
Sales and marketing expense increased by 126% from $252,815 in the 1997 third
quarter to $572,439 in the 1998 third quarter, and decreased by 36% from
$2,937,287 for the nine month period ended September 30, 1997 to $1,892,281 for
the corresponding 1998 period. For the nine months ended September 30, 1997,
approximately $2,172,000 (see Note 4 - Chronimed Obligation) was related to a
one-time expense to terminate certain agreements with Chronimed Inc. Excluding
this one-time expense of $2,172,000 for the nine months ended September 30,
1997, sales and marketing expense for the nine months ended September 30, 1998
increased by approximately $1,127,000 over the corresponding 1997 period. This
increase is largely attributable to significantly higher spending related to the
addition of an Antizol sales force, sales and marketing program costs for new
products, and an incentive program for sales and marketing employees. Sales and
marketing expenses will likely increase in subsequent quarters.
General and administrative expense decreased by 25% from $798,153 in the 1997
third quarter to $596,321 in the 1998 third quarter, and decreased by 3% from
$1,920,702 for the nine month period ended September 30, 1997 to $1,859,415 for
the corresponding 1998 period. This decrease is principally related to reduced
salary expense resulting from staffing realignments. General and administrative
expenses are not expected to increase significantly in subsequent quarters.
Other income is the sum of interest income from investment activities less
interest expense from financing activities. Other income decreased 13% from
$92,229 in the 1997 third quarter to $79,411 in the 1998 third quarter, and
decreased 77% from $495,445 for the nine month period ended September 30, 1997
to $114,091 for the corresponding 1998 period. This decrease is due to less
interest income resulting from lower levels of investable funds, which is
further reduced by interest expense related to the Company's obligation to
Chronimed. Other income is expected to decline in subsequent quarters as
currently invested funds are used to fund Busulfex and Xyrem development
activities, and for working capital requirements.
10
<PAGE>
Preferred stock dividends relate to the Senior Convertible Preferred Stock (see
Note 7 - Preferred Stock Offering) that was issued on July 23, 1998 and has a
dividend rate of 7.5%. Preferred stock dividends increased from $0 in the 1997
third quarter to $107,877 in the 1998 third quarter. Preferred stock dividends
are payable in arrears, when and as declared by the Company's Board of Directors
on August 1 and February 1 of each year, commencing on February 1, 1999. The
Company expects to issue additional Preferred Shares as payment in-kind with
respect to preferred stock dividends accruing on the Preferred Shares through
August 1, 2000. Preferred stock dividends will increase in subsequent quarters.
LIQUIDITY AND CAPITAL RESOURCES
From inception through September 30, 1998, the Company has used $29,980,945 to
fund operating activities. Since July 2, 1994, the effective date the Company
was spun-off from Chronimed, it has financed its operations principally from
initial working capital balances, the net proceeds from the 1995 and 1996 public
offerings, the net proceeds from the 1998 private placement, interest income and
product sales. The 1995 and 1996 public offerings, and the 1998 private
placement, resulted in aggregate net proceeds, after commissions and expenses,
of $30,714,701.
Net working capital (current assets less current liabilities) increased from
$4,479,714 at December 31, 1997 to $5,700,031 at September 30, 1998. Cash and
cash equivalents, and available-for-sale securities increased from $7,169,230 at
December 31, 1997 to $8,775,502 at September 30, 1998. On July 23, 1998, the
Company received from UBS Capital cash proceeds of $7,125,000 from the sale of
the Preferred Shares, which was invested by the Company in interest-bearing,
investment grade securities.
The Company's commitments for outside development spending increased from
approximately $2,700,000 at December 31, 1997 to approximately $3,052,000 at
September 30, 1998. The $352,000 increase resulted principally from accelerating
the Xyrem development program. The Company expects future commitments for
Busulfex and Xyrem to increase significantly over current levels.
The Company has experienced recurring losses from operations and has generated
an accumulated deficit from inception through September 30, 1998 of $32,615,067.
These conditions give rise to the question about the Company's ability to
generate positive cash flow and fund operations. The Company believes that its
current working capital and anticipated gross profits from product sales will be
sufficient to fund its operations through December 31, 1999. These assumptions
are based upon the Company substantially increasing development expenses,
revenues from the sale of its five marketed products, and the successful FDA
approval and market launch of Busulfex in the second half of 1999. Any material
reduction in projected revenues and/or a delay in the FDA approval and market
launch of Busulfex will require the Company to seek additional equity or debt
financing or substantially reduce the Company's expense structure through
reductions in personnel and development.
11
<PAGE>
The Company's ability to raise additional capital and/or raise capital on
acceptable terms could be negatively affected in the event it no longer meets
the Nasdaq's requirements for continued listing on the National Market tier. For
continued listing on the Nasdaq National Market, a company must satisfy a number
of requirements, which in the Company's case includes either: (1) net tangible
assets in excess of $4.0 million as reported on Form 10-Q or Form 10-K or (2) a
market capitalization of at least $50.0 million. At September 30, 1998, the
Company's net tangible assets equaled $6,017,585 and its market capitalization
was approximately $48.9 million (based on the last sale price of $7.688 and
6,354,373 shares outstanding). Net tangible assets are defined as total assets
less total liabilities. The Company estimates that it will have net tangible
assets in excess of the $4.0 million (thereby satisfying Nasdaq's net tangible
asset listing requirement) through the end the fourth quarter of 1998. Should
the Company fail to satisfy at least one of the two aforementioned Nasdaq
listing requirements at any time, the Company's Common Stock would no longer
qualify for listing on the Nasdaq National Market, but would qualify for
quotation on the Nasdaq Small Cap Market provided it had net tangible assets in
excess of $2.0 million.
IMPACT OF YEAR 2000 READINESS ISSUE
The Company has assessed and continues to assess the impact of the so called
"Year 2000 Readiness Issue" on its reporting systems and operations. The Year
2000 Readiness Issue relates to the ability of computer hardware, software, and
firmware products to accurately process date/time data (including calculating,
comparing, and sequencing) from, into, and between the twentieth and
twenty-first centuries, and the years 1999 and 2000 and leap year calculations.
The Year 2000 Readiness Issue also relates to the ability to properly exchange
time/date data between such products. When the year 2000 occurs, systems that
are not year 2000 compliant might recognize the year 2000 as the year 1900, or
not at all. This inability to recognize or properly treat the year 2000 may
cause the Company's systems, or the systems used by its suppliers, distributors,
customers or regulatory agencies (i.e., FDA) to process critical financial and
operational information incorrectly, or not at all.
The Company's information technology ("IT") systems consist of computer hardware
systems and software applications supplied by third parties. The Company's
strategy has been to replace its IT systems with current technology, which is
both year 2000 compliant and more efficient. The Company has also purchased and
implemented financial and operational software upgrades that are year 2000
compliant. For the nine months ended September 30, 1998, the Company IT system
purchases have not been material. The Company's IT systems are year 2000
compliant.
The Company's assessment of internal systems includes a review of
non-information technology ("non IT") systems. This assessment includes a review
of the Company's internal equipment and facilities. Based upon this review, the
Company believes that its processes and equipment are year 2000 compliant.
The Company has identified third parties with which it has material
relationships,
12
<PAGE>
including suppliers, distributors and other key vendors of materials and
services. The Company has confirmed with these parties or organizations that
they have implemented Year 2000 Readiness Programs. The Company has not
developed a contingency plan to provide for continuity of business operations in
the event material third parties experience a disruption of service due to the
Year 2000 Readiness Issue, which could include, but not limited to, loss of
electricity, loss of communications (data and voice), and loss of transportation
services. However, even if all material third parties confirm that they are or
expect to be year 2000 compliant by December 31, 1999, it is not possible to
state with certainty that such parties will be compliant. If the Company's
remediation plan is not successful, or if third party systems on which the
Company relies should fail, there could be a significant disruption of the
Company's ability to transact business with its customers and suppliers. It is
impossible to fully assess the potential consequences in the event service
interruptions from suppliers occur or in the event that there are disruptions in
such infrastructure areas as utilities, communications, transportation, banking
and government.
Item 3. Quantitative and Qualitative Disclosures about Market Risks
Not Applicable
PART II - OTHER INFORMATION
Item 2. Changes in Securities and Use of Proceeds
(b) On July of 1998, the Company issued 7,500 shares of Senior Convertible
Preferred Stock (the "Preferred Shares") in a private placement. These shares
are entitled to receive cumulative dividends at $75.00 per annum (or more in
certain circumstances) and have both dividend and liquidation preferences over
the Common Stock. In addition, the Company may not take certain actions without
the approval of the Preferred Shares holders.
(c) On July 23, 1998, the Company issued $7.5 million of Senior Convertible
Preferred Stock (the "Preferred Shares") in a private placement. The private
placement, which did not involve a public offering of the shares, was exempt
from registration under Section 4(2) of the Securities Act of 1993, as amended.
The Preferred Shares are convertible, at the option of the holders, into shares
of the Company's Common Stock at a price equal to $8.50 per share. At the
Company's option upon their maturity in July 2008, the Preferred Shares must be
(a) converted into Common Stock, subject to a $3.0 million conversion fee
payable in cash or by issuing additional Common Stock, or (b) redeemed for cash
at $1,000 per share plus accrued dividends.
Item 5. Other Information
13
<PAGE>
On August 4, 1998, the Company announced the submission of a new drug
application ("NDA") for Busulfex to the Food and Drug Administration ("FDA").
The FDA has 60 days to accept or refuse the Company's NDA for review.
On August 12, 1998, the Company announced the addition of William Houghton,
M.D., as Chief Operating Officer. Dr. Houghton will manage the Company's
development activities.
On October 5, 1998, the Company announced that the FDA has accepted its August
4, 1998 NDA submission for Busulfex and has granted it priority review status.
This status (priority status) indicates that the FDA has a goal of reviewing the
NDA for Busulfex within a six-month time frame from the August 4, 1998, date of
submission to the FDA. The FDA also informed the Company that Busulfex is
scheduled to be reviewed by an advisory committee in January 1999.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
EXHIBIT INDEX
- --------------------------------------------------------------------------------
Exhibit Number Sequentially
Description Numbered Page
- --------------------------------------------------------------------------------
27 Financial Data Schedule - For SEC EDGAR filing
- --------------------------------------------------------------------------------
99 Cautionary Statements
- --------------------------------------------------------------------------------
(b) Reports on Form 8-K
The Company filed a Current Report dated September 11, 1998 on Form 8-K to
report under Item 5 a private placement of $7.5 million of Senior Convertible
Preferred Stock. The Company filed with the Form 8-K an interim, unaudited
balance sheet of the Company as of July 31, 1998.
14
<PAGE>
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended,
the Registrant has duly caused this report to be signed on its behalf by the
undersigned, thereunto duly authorized.
Orphan Medical, Inc.
--------------------
Registrant
Date November 12, 1998 By /s/ John H. Bullion
----------------- -------------------
John H. Bullion
Chief Executive Officer
(principal executive officer)
15
ORPHAN MEDICAL, INC.
CAUTIONARY STATEMENTS FOR PURPOSES OF THE "SAFE HARBOR" PROVISIONS OF THE
PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995
An investment in the Common Stock involves a number of risks, including
among others risks associated with development stage companies and companies
that operate in the pharmaceutical industry, which are substantial and inherent
in the operations of the Company. You should carefully consider the following
information about these risks, together with the information in the rest of this
Quarterly Report. You should also be aware that certain statements contained in
this Quarterly Report that are not related to historical results are
forward-looking statements. When used in this Quarterly Report on Form 10-Q and
in our future filings with the Securities and Exchange Commission, shareholder
reports, press releases and in oral statements made with the approval of an
authorized executive officer, the words or phrases "will likely result", "look
for", "may result", "will continue", "is anticipated", "expect", "project", or
similar expressions are intended to identify "forward-looking statements" within
the meaning of the Private Securities Litigation Reform Act of 1995 Actual
results may differ materially from those projected or implied in such
forward-looking statement. Factors that could cause or contribute to such
differences include, but are not limited to, the following risk factors.
LOW REVENUES AND LACK OF PROFITABLE OPERATIONS.
The Company has been unprofitable since it began operations in January
1993. As of September 30, 1998, the Company had an accumulated deficit of
$32,615,067. Through September 30, 1998, we sold $3,986,978 and made a gross
profit of $3,072,934 on the following products: Elliotts B Solution, Cystadane,
Antizol-Vet, Sucraid and Antizol. These levels of sales and gross profits are
insufficient to sustain future product development and business growth.
UNCERTAINTY OF FUTURE FINANCIAL RESULTS.
Operating losses of the Company are expected to continue through 1999
because gross profit from our five approved products and from new product
introductions in 1999 are not expected to offset expected additional spending.
We will need to continue to spend on the development plans for Busulfex and
Xyrem, plus additional sales and marketing efforts for the new product
introductions. The amount of future losses may vary significantly at various
times and will depend on several factors, including the timing of product
development and regulatory approval. We cannot give any assurance that the
Company will ever generate significant product revenues or become profitable.
DEVELOPMENT STAGE COMPANY.
We are a development stage company. As such, our operations and our
product development are subject to all of the risks inherent in establishing a
new business enterprise. These risks include the following: reliance on key
personnel; a lack of fully-developed products; insufficient capital; competition
from numerous well-established and well-capitalized competitors; expected
operating losses through 1999; a market subject to extensive regulatory
oversight; and reliance on outside contractors for the manufacture and
distribution of our proposed products.
You should weight the likelihood of our success against the problems,
expenses and delays typically encountered when developing new pharmaceutical or
medical products. You should also consider the highly competitive and heavily
regulated environment in which we operate.
FURTHER FUTURE CAPITAL REQUIREMENTS; NO ASSURANCE OF AVAILABILITY OF FUTURE
CAPITAL.
We expect that our cash, cash equivalents, and short-term investments
as of September 30, 1998 plus the anticipated cash flows from the sale of the
five products that are approved and expected introduction of Busulfex in 1999
will be sufficient to fund the Company's operations through 1999. However, if we
encounter any large reduction in product revenues or a delay in the FDA approval
and market launch of Busulfex, we may require additional funding to fully
implement our development plan for Xyrem. A lack of funding could prevent the
commercial introduction of Xyrem altogether. We may be unable to obtain adequate
funds for the Company's operations, whether from financial markets or from other
sources, on terms attractive to the Company. A lack of
<PAGE>
funding could cause us to delay, scale back or eliminate some or all the
products currently under development, including acquisition and licensing
programs.
DEPENDENCE ON LICENSE AND ACQUISITION STRATEGY.
We have adopted a license and acquisition strategy to build our product
portfolio. Our growth strategy depends upon our continued ability to identify
and acquire new pharmaceutical products targeted at niche strategic therapeutic
markets. We rely on the willingness of others to sell or license pharmaceutical
product opportunities to us because we do not conduct our own proprietary
research and development of new pharmaceutical products. Other companies,
including many with much greater resources, compete with us to acquire such
products. We may not be able to acquire rights to additional products on
acceptable terms, if at all. If we are unable to acquire or license new
pharmaceutical products within a selected niche market or to promote and market
commercially successful products within the selected niche market our business
and prospects could be materially and adversely affected.
We have contractual production rights to certain compounds through
various license agreements. Most of these agreements give the licensors the
right to terminate the license with a short notice for a number of events that
are categorized as "for cause" under the license agreements. These agreements
are also terminable by the licensor if the Company is insolvent or bankrupt,
does not apply minimum resources and efforts to develop the compound under
license or does not achieve certain minimum royalty payments. The agreements may
be terminated and, if terminated, we may not be able to enter into similar
agreements on terms as favorable to us as those contained in its existing
license agreements.
DEPENDENCE ON FOREIGN MARKETING ALLIANCES; NO ASSURANCE OF FOREIGN LICENSEES.
Our strategy for deriving revenues for the sale of our products in
foreign markets is to enter into marketing alliances with multinational and
foreign pharmaceutical companies. From inception through September 30, 1998, we
have entered into distribution agreements to sell Cystadane in Australia, New
Zealand and Europe and Antizol in Europe. Sales of Cystadane for Australia, New
Zealand and Europe have not been and are not expected to be material.
Distribution of Antizol in Europe will initially be done on a "named patient" or
"emergency use" basis until full regulatory approval is obtained. We do not
expect such "emergency use" distribution to result in material sales.
Distribution of Antizol in Europe through normal or the usual distribution
channels will not begin until the product has received marketing approval in
each European country where our distributor expects to sell the product. We
typically receive upfront fees for entering into such distribution arrangements.
We expect to realize future benefits because we will be the exclusive supplier
of the product sold to the distributor in these foreign markets. However, we
cannot provide any assurance that we will be able to negotiate additional
alliances for our other products on acceptable terms, if at all, or that such
alliances will be successful. In addition, the successful distribution of
Cystadane and Antizol outside of the United States is highly dependent on our
marketing partners. If our marketing partners are unsuccessful in their
distribution efforts, we would have difficulty in contracting other distributors
for these products within the licensed territories.
STRINGENT GOVERNMENT REGULATION; NEED FOR FDA AND OTHER REGULATORY APPROVALS.
Government regulation in the United States and abroad is a significant
factor in the production, testing and marketing of our current and future
products. Prior to marketing, each of our products must undergo an extensive
regulatory approval process conducted by the FDA in the United States and by
comparable agencies in other countries. The approval process can take many years
and require the expenditure of substantial resources. We cannot provide any
assurance that the FDA or any foreign regulatory authority will approve in a
timely manner, or at all, any product that we may develop. Generally, only a
very small percentage of newly discovered pharmaceutical compounds that enter
pre-clinical development are approved for sale. We are not allowed to market
medicines that we may develop as a prescription product in jurisdictions in
which the products do not receive regulatory approval. Once approved, a
department of marketing surveillance within the Center for Drugs, an FDA
division, must approve marketing claims, which are the basis for a product's
labeling, advertising and promotion. We cannot provide any assurance that the
FDA's marketing surveillance department will approve the marketing claims that
we are seeking. The failure to obtain approval of acceptable marketing claims on
a product could have a material adverse effect on the Company and its prospects.
The Company depends on external laboratories and medical institutions
to conduct its pre-clinical and clinical testing in compliance with
FDA-established clinical and laboratory practices. The data obtained from
pre-
<PAGE>
clinical and clinical testing are subject to different interpretations that
could delay, limit or prevent regulatory approval. In addition, a product may be
delayed or rejected based upon changes in FDA policy for drug approval during
the period of development. Products may also be delayed or rejected because of
changes in the requirements for regulatory review of each submitted New Drug
Application ("NDA"). Moreover, even if the FDA approves a product, such approval
may entail commercially unacceptable limitations on the uses, or "indications,"
for which a product may be marketed. Further studies may also be required to
provide additional data on safety or effectiveness. The FDA also requires
manufacturers to monitor an approved product's side effects through
post-marketing adverse event surveillance programs.
An FDA approved product and its manufacturer are subject to continual
regulatory review. A discovery of previously unknown problems with a product or
manufacturer may result in restrictions or sanctions on such products or
manufacturer, including the withdrawal of such product from the market. FDA
approval is required before we can implement most changes in the manufacturing
procedures for any of our approved products, as well any change in manufacturers
of such products. Obtaining the FDA's approval for a change in manufacturing
procedures or change in manufacturers could cause production delays and loss of
sales, which would have a material adverse effect on the Company's business and
its prospects.
The FDA has the authority to "Schedule" a drug under the Controlled
Substances Act. Scheduling refers to the specific levels of control a
manufacturer, distributor, pharmacy, and prescribing physician must maintain to
ensure that a drug is appropriately used, and not abused. Generally, states
follow the federal scheduling designation for a specific drug, but a state is
not precluded from adopting a more restrictive scheduling designation for the
same drug. We expect Xyrem will be federally scheduled and we have requested
that it be designated a Schedule IV drug (typically, most hypnotic medications
available by prescription). However, if Xyrem is designated a Schedule II drug
(such as pentobarbitol), the cost to manufacture and distribute Xyrem, should it
receive marketing clearance from the FDA, would be negatively affected. We can
give no assurance that Xyrem will be designated a Schedule IV drug, and if it
receives a more restrictive designation by the federal government or the states,
it may have a material effect on the Company's business and its prospects.
In certain countries, the sales price of a product must also be
approved after marketing approval is granted. We cannot give any assurance that
satisfactory prices can be obtained in foreign markets even if the appropriate
marketing approval is obtained.
RELIANCE ON ORPHAN DRUG STATUS.
Under the Orphan Drug Act, the FDA may grant orphan drug designation to
drugs intended to treat a "rare disease or condition." Generally, a "rare
disease or condition" is regarded as one that affects populations of less than
200,000 people in the United States. Orphan drug designation must be requested
before submitting an NDA. Once the FDA grants orphan drug designation, it will
publish the generic identity of the therapeutic agent and its potential orphan
use. Under current law, the first company to receive FDA approval to market the
designated drug for the designated indication is conferred orphan drug status.
The orphan drug status grants United States marketing exclusivity for a period
of seven years following approval by the FDA, subject to certain limitations.
However, orphan drug designation does not convey any advantage in the regulatory
approval process or shorten its duration. Moreover, although obtaining FDA
approval to market a product with orphan drug status is advantageous, we cannot
provide any assurance that the scope of protection or the level of marketing
exclusivity that the orphan drug status and marketing approval currently provide
will continue.
Currently, two of our products (Busulfex and Xyrem) have orphan drug
designation, while four of our products (Antizol, Elliotts B Solution, Cystadane
and Sucraid) have orphan drug status. We cannot provide any assurance that any
future product candidates will receive an orphan drug designation or that any of
our products with such a designation will be the first to be approved by the FDA
for the designated indication, thereby obtaining orphan drug status (i.e.,
marketing exclusivity). Orphan drug designation does not prevent other
manufacturers from attempting to develop the same drug for the designated
indication or from obtaining the approval of an NDA for their drug prior to the
approval of our NDA. If another sponsor's NDA for the same drug and the same
indication is approved first, and that sponsor has received orphan drug
designation for its drug, that sponsor is entitled to exclusive marketing
rights. In that case, the FDA would delay the approval of our application to
market our competing product for seven years, subject to certain limitations. We
cannot provide any assurance that our products will receive orphan drug
designations and FDA marketing approval before our competitors' products.
<PAGE>
NDA approval of a drug with an orphan drug designation does not prevent
the FDA from approving the same drug for a different indication, or a molecular
variation of the same drug for the same indication. Also, doctors are not
restricted by the FDA from prescribing an approved drug for uses not approved by
the FDA. Therefore, it possible that a competitor's drug could be prescribed for
indications for which the Company's product has received orphan drug designation
and NDA approval. The prescription of approved drugs for unapproved uses
(commonly referred to as "off label" use) could adversely affect the marketing
potential of products that have received orphan drug designation and NDA
approval. In addition, NDA approval of a drug with an orphan drug designation
does not provide any marketing exclusivity in foreign markets.
The United States Congress' possible amendment of the Orphan Drug Act
has been frequently discussed. Although the Orphan Drug Act has not been subject
to significant changes for a number of years, members of Congress have at
various times proposed changes that would limit the application of the Orphan
Drug Act. We cannot provide any assurance as to the precise scope of protection
that orphan drug designation and marketing approval may afford in the future or
that the current level of exclusivity will remain in effect.
RELIANCE ON PATENTS AND OTHER PROPRIETARY RIGHTS.
Obtaining patent and trade secret protection for new technologies,
products and processes is very important in the pharmaceutical industry. Our
success will depend, in part, on our ability to obtain, enjoy and enforce
protection for our products under U.S. and foreign patent laws and other
intellectual property laws, preserve the confidentiality of our trade secrets
and operate without infringing the proprietary rights of third parties. A
pharmaceutical firm's patent position is often very uncertain and generally
involves complex legal and factual questions. At September 30, 1998, Busulfex is
the only product that we have under development for which the use of or
treatment methods licensed by us are covered by U.S. patents. We evaluate the
desirability of seeking patent or other forms of protection for our products in
foreign markets based on the expected costs and relative benefits of attaining
such protection. We cannot provide any assurance that any patents will be issued
from any applications or that any issued patents will give us adequate
protection. Further, issued patents could be challenged, invalidated, infringed
or circumvented. We cannot provide any assurance that any rights granted under
issued patents will actually provide us competitive advantages. Parties not
affiliated with us have obtained or may obtain U.S. or foreign patents or
possess or may possess proprietary rights relating to our products. We cannot
provide any assurance that patents now in existence or issued in the future to
others will not adversely affect the development or commercialization of our
products or that our planned activities will not infringe third parties'
patents.
We could incur substantial costs in defending against infringement
suits brought against us or any of our licensors or in asserting any
infringement claims that we may have against others. We could also incur
substantial costs in connection with any suits relating to matters for which we
have agreed to indemnify our licensors or distributors. An adverse outcome in
any such litigation could have a material adverse effect on our business and
prospects. In addition, we could be required to obtain licenses under patents or
other proprietary rights of third parties. We cannot give any assurance that any
such licenses would be made available on terms acceptable to us, or at all. If
we are required to, and do not obtain any such required licenses, we could be
prevented from, or encounter delays in, developing, manufacturing or marketing
one or more of our products.
Two of the Company's products, Busulfex and Xyrem, are in the
development stage. Even if we successfully develop such products and obtain
marketing clearance from the FDA, there is a risk that applicable patent
coverage, if any, will have expired or will expire shortly after such approval.
The expiration of the patent protection could have a material adverse effect on
the sales and profitability of such product. Further, some of the compounds we
have developed or intend to develop (Cystadane, Elliotts B Solution, Antizol,
Antizol-Vet, Xyrem and Sucraid) are believed to be in the public domain or not
presently subject to patent protection in the United States.
We also seek to protect our proprietary information and technology in
part by confidentiality agreements and inventors' rights agreements with our
employees. There is a risk that these agreements will be breached, that we will
not have adequate remedies for any such breach or that our trade secrets will
otherwise be disclosed to or discovered by our competitors.
<PAGE>
INDUSTRY SUBJECT TO INTENSE COMPETITION.
Competition in the pharmaceutical industry is intense. Potential
competitors in the United States are numerous and include pharmaceutical,
chemical and biotechnology companies. Many competitors have substantially
greater capital resources, marketing experience, research and development staffs
and facilities than us. Although we seek to limit competition by developing
products that are eligible for orphan drug designation and NDA approval or other
forms of protection, there is a risk that our competitors will successfully
develop similar technologies and products more quickly than us. There is also a
risk that these competing technologies and products will be more effective than
any of those that we are or will be developing.
We are aware that potential competitors are developing products that
have received orphan drug designations for the same respective indications as
Busulfex and Xyrem. If these drugs are approved for marketing before our
products, we would be required to obtain a license from these entities before
our own competing products could be marketed. We cannot provide any assurance
that any required license would be available on commercially acceptable terms,
or at all.
INDUSTRY SUBJECT TO RAPID TECHNOLOGICAL CHANGE.
The pharmaceutical industry has experienced rapid and significant
technological change. We expect that pharmaceutical technology will continue to
develop rapidly. Our future success will therefore depend, in large part, on our
ability to develop and maintain a competitive position. Technological
development by others may result in our products' obsolescence before they are
marketed or before we recover a significant portion of the development and
commercialization expenses incurred with respect to such products. In addition,
alternative therapies or new medical treatments could alter existing treatment
regimes, and thereby reduce the need for one or more of our products, which
would adversely affect our business and its prospects.
RISKS OF NEW PRODUCT DEVELOPMENT; MARKET UNCERTAINTY.
Five of our products have been approved for marketing by regulatory
authorities in the United States or elsewhere. Even if the rest of our products
are approved for sale, we cannot provide any assurance that they will be
commercially successful or that they will obtain the results expected. We may
encounter unanticipated problems relating to the development, manufacturing,
distribution and marketing of our products. Some of these problems may be beyond
our financial and technical capacity to solve. The failure to adequately address
any such problems could have a material adverse effect on our business and
prospects.
No drug development portfolio can be completely insulated from
potential failures. It is possible that some products that we have selected for
development will not produce the results expected during clinical studies, not
receive FDA approval or fail to generate product sales of an acceptable level.
To date, we have terminated the development of eleven products from our
portfolio: one in 1994, one in 1996, and nine products in 1997. We terminated
nine products in 1997 to permit us to focus our development efforts on those
products that fit within three selected strategic therapeutic market segments:
Antidote, Oncology Support, and Sleep Disorders. The termination of the
development of any one of our remaining development products could have a
material adverse effect on the Company and its prospects.
Most orphan drugs have a potential United States market of less than
$10 million annually and many target annual markets of less than $1 million. We
can provide no assurance that the sales of our products will be profitable even
if accepted and used by patients and medical specialists.
DEPENDENCE UPON OTHERS FOR CLINICAL TESTING AND MANUFACTURING.
We do not have and do not intend to establish any internal product
testing, manufacturing or distribution capabilities. Accordingly, we will be
required to enter into arrangements with other companies for the clinical
testing, manufacture and distribution of our products. Our inability to retain
third-parties for these purposes on acceptable terms could adversely affect our
ability to develop and market our products. Third-parties' failures to
adequately perform their responsibilities may delay the submission of products
for regulatory approval, impair our ability to deliver our products on a timely
basis or otherwise impair our competitive position. In addition, our dependence
on third-parties for the development, manufacture and distribution of our
products may adversely affect our potential profit margins and our ability to
develop and deliver our products on a timely basis.
<PAGE>
The manufacture of drugs can be an expensive, time consuming and
complex process and may require the use of materials with limited availability
or a dependence on sole suppliers. In addition, Busulfex and Xyrem have not yet
been manufactured in commercial quantities. We cannot provide any assurance that
such products can be so manufactured in a cost-effective manner. Manufacturers
of our products will be subject to applicable FDA-prescribed "good manufacturing
practices" or other rules and regulations prescribed by foreign regulatory
authorities. We cannot provide any assurance that we will be able to enter into
or maintain relationships either domestically or abroad with manufacturers whose
facilities and procedures comply or will continue to comply with FDA-prescribed
practices or applicable foreign requirements. If we enter into manufacturing
agreements, we will be dependent on such manufacturers for continued compliance
with FDA-prescribed practices and applicable foreign standards. The failure of a
manufacturer of a Company product to comply with FDA-prescribed practices or
applicable foreign requirements could result in significant time delays or
hinder our ability to commercialize or continue to market a product. Any of
these negative effects could have a material adverse effect on the Company and
its prospects. In the United States, failure to comply with FDA-prescribed
practices or other applicable legal requirements can lead to federal seizure of
violative products, injunctive actions brought by the federal government, and
potential criminal and civil liability on the part of a company and its officers
and employees.
DEPENDENCE UPON OTHERS FOR DISTRIBUTION.
We have an exclusive agreement with Cardinal Health, Inc. ("Cardinal"),
whereby Cardinal, through its "Specialty Companies," will provide a variety of
services to support the effective distribution of our products. Cardinal will
provide the following services to the Company: integrated distribution and
operations services to process and support transactions between the Company and
wholesalers, specialty distributors, and direct customers; reimbursement
management; patient assistance and information hotline services; and specialty
distribution and marketing services to physician practices. Cardinal currently
distributes Elliotts B Solution, Antizol, Antizol-Vet and Sucraid. Cardinal will
also distribute our proposed products when and if those products receive
marketing clearance from the FDA. We will, therefore, be substantially dependent
upon Cardinal's ability to successfully distribute Elliotts B Solution, Antizol,
Antizol-Vet, Sucraid and the proposed products that may receive FDA marketing
clearance.
Cystadane is currently distributed in the United States by Chronimed
Inc. ("Chronimed"). Chronimed distributes this product directly to patients
through its mail order pharmacy. We are substantially dependent upon Chronimed's
ability to successfully distribute Cystadane directly to patients in the United
States.
Antizol-Vet was distributed on an exclusive basis through W.A. Butler
Company ("Butler") from January 1997 through October 1998. Butler may continue
distributing Antizol-Vet, but on a non-exclusive basis. The Company expects to
market Antizol-Vet directly and utilize Cardinal for distribution. We do not
expect this change to have a material effect on sales of Antizol-Vet.
We cannot provide any assurance that other distribution companies would
be available or continue to be available on commercially acceptable terms, if at
all. The loss of a distributor or failure to renew agreements with an existing
distributor could have a material adverse effect on the Company and its
prospects.
UNCERTAIN EXTENT OF PRICE FLEXIBILITY AND THIRD-PARTY REIMBURSEMENT.
Our ability to commercialize our products successfully will depend in
part on the price we may be able to charge for our products. Another factor is
the extent to which reimbursement for the cost of such products and related
treatment will be available from government health administration authorities,
private health insurers and other third-party payors. Government officials and
private health insurers are increasingly challenging the price of medical
products and services. There is much uncertainty as to the pricing flexibility
suppliers will have with respect to newly approved health care products. There
is also much uncertainty about the reimbursement status of such products.
In the United States, we expect that there will continue to be a number
of federal and state proposals to implement government control of pricing and
profitability of prescription pharmaceuticals. Cost controls, if mandated by a
government agency, could decrease the price that we receive for our current or
future products. Cost controls could also prevent the recovery of potentially
substantial development costs and an appropriate profit margin. These effects
could have a material adverse effect on the Company. Furthermore, federal and
state regulations govern or influence the reimbursement to health care providers
in connection with medical treatment of
<PAGE>
certain patients. The actions of federal and/or state governments could
adversely affect the prospects for sales of our products. We cannot provide any
assurance that the actions of federal and/or state governments, if any, with
regard to health care reform will not have a material adverse effect on the
Company and its prospects.
Certain third-party payors may attempt to further control costs by
selecting exclusive providers of their pharmaceutical products. If such
arrangements were made with our competitors, such payors would not reimburse
patients for purchases of our competing products. This lack of reimbursement
would diminish the market for our products and could have a material adverse
effect on the Company and its prospects.
RISK OF PRODUCT RECALL.
Product recalls may be issued at the discretion of the Company, the
FDA, the U.S. Federal Trade Commission, or other government agencies having
regulatory authority for product sales, and may occur due to disputed labeling
claims, manufacturing issues, quality defects, or other reasons. There is always
a risk that product recalls will occur. We do not carry any insurance to cover
the risk of a potential product recall. Any product recall could have a material
adverse effect on the Company and its prospects.
PRODUCT LIABILITY AND INSURANCE RISKS.
The Company's testing and sale of human health care products entails an
inherent risk of product liability claims against the Company. As we expand the
scope of our clinical testing, we will be exposed to increasing potential
liabilities. Companies operating in the pharmaceutical industry find it
increasingly difficult to maintain product liability insurance coverage at
reasonable levels. Substantial increases in insurance premium costs in many
cases have rendered coverage economically impractical. We currently carry
product liability coverage in the aggregate amount of $10 million for all claims
made in any policy year. Although to date we have not been the subject of any
product liability or other claims, we cannot provide any assurance that we will
be able to maintain product liability insurance on acceptable terms or that our
insurance will provide adequate coverage against potential claims. The
successful assertion of any uninsured product liability or other claim against
us could have a material adverse effect on our business and prospects.
DEPENDENCE ON CERTAIN OFFICERS AND KEY MANAGEMENT PERSONNEL.
Our success will be largely dependent upon the efforts of our executive
officers and key management personnel. The loss of the services of an executive
officer or one or more key employees, or our inability to attract and retain
skilled management and marketing personnel in the future, could have a material
adverse effect on the Company and its prospects.
RESTRICTIONS, COVENANTS AND RIGHTS RELATED TO SENIOR CONVERTIBLE PREFERRED
STOCK.
On July 23, 1998, we completed the sale to UBS Capital II LLC ("UBS
Capital") of a private placement of $7.5 million of Senior Convertible Preferred
Stock (the "Preferred Shares"). The private placement agreement also gave UBS
Capital the option to invest up to an additional $4.5 million within 90 days of
July 23, 1998. UBS Capital did not exercise its option to purchase additional
Preferred Shares, but we are discussing with UBS Capital an extension of time
for the exercise of this option, including other financing alternatives. In
conjunction with the issuance of the Preferred Shares, we agreed to several
restrictions and covenants, and granted certain voting and other rights to
Preferred Shares holders, including but not limited to the following:
1. We are restricted from issuing additional equity securities,
including convertible debt instruments, warrants, and stock options, except for
a "Permitted Issuance", which is limited to: (i) shares of Common Stock issued
after July 23, 1998 to Chronimed pursuant to the terms of the Termination
Agreement between the Company and Chronimed; (ii) shares of Common Stock issued
upon exercise of stock options that are outstanding on July 23, 1998; (iii)
stock options granted and shares of Common Stock issuable upon exercise of such
options pursuant to the terms of stock option plans approved by the Company's
Board of Directors; provided that the aggregate number of shares of Common Stock
issued, or issuable, under (i), (ii) and (iii) cannot exceed two million shares,
(iv) Common Stock issued upon the exercise of warrants that, as of June 30,
1998, entitled holders to purchase an aggregate of 213,255 shares of Common
Stock, (v) Common Stock issued upon the conversion of the Preferred Shares, and
(vi) securities issued pursuant to any public offering of the Company's
securities registered under the Securities Act.
<PAGE>
In addition, the majority of Preferred Shares holders must approve the
sale of any private placement of equity securities. If approved by the Preferred
Shares holders, UBS Capital has the right of first refusal with respect to the
purchase or sale of any such private placement.
2. Preferred Shares holders may convert their shares into shares of
Common Stock at a per share price equal to $8.50 per share. If we issue or sell,
or are deemed to have issued or sold, shares of our Common Stock for a per share
price of less than the conversion price in effect for the Preferred Shares
immediately prior to the time of such issue or sale, then, unless such issuance
or sale was a Permitted Issuance (as described in paragraph 1 above), the
conversion price for the Preferred Shares shall be reduced immediately upon such
issue or sale or deemed issue or sale. The conversion price shall be reduced to
a price determined by dividing (i) the sum of (1) the product derived by
multiplying the conversion price in effect immediately prior to such issue or
sale by the number of shares of Common Stock deemed outstanding immediately
prior to the new issue or sale, plus (2) the consideration, if any, received by
the Company upon the new issue or sale, by (ii) the number of shares of Common
Stock deemed outstanding immediately after such issue or sale.
3. The dividend rate on the Preferred Shares is 7.5 percent
per annum. At the Company's option, dividends are payable in either cash or by
issuing additional Preferred Shares (during the first four dividend payment
dates) or by Common Stock (after the fourth dividend payment date). However, the
dividend rate will increase to 20 percent per annum, payable solely in cash, if
either: (i) at any time during any 730-day period individuals who constituted
the Board of Directors at the beginning of such period, or July 23, 1998
(whichever is later), cease for any reason to constitute a majority of the Board
of Directors then in office; or (ii) the Board of Directors fails to declare and
pay in full, on any date when semi annual dividends are due. The Preferred
Shares holders may waive by majority vote their right to receive the increased
dividend rate.
4. The Company cannot incur any indebtedness unless certain
financial conditions are met. The Company may only incur debt if, after giving
effect to the additional indebtedness, the Company's aggregate indebtedness
outstanding as of the date of such incurrence, but excluding financing that is
secured by accounts receivable but not by the Company's intellectual property
rights, does not exceed two and one-half times the Company's EBITDA. For
purposes of this restriction, EBITDA means the sum of (i) net income, (ii)
interest expense (iii) depreciation and amortization, and other non-cash items
properly deducted in determining net income and (iv) federal, state and local
income taxes, computed and calculated in accordance with generally accepted
accounting principles for the twelve month period immediately prior to the date
of the new debt incurrence for which there are quarterly financial statements
available.
5. The Company cannot pay cash dividends, cash distributions
not classified as dividends with respect to its issued and outstanding Common
Stock or cash payments on the redemption of such Common Stock. This restriction
applies as long as at least 20 percent of the issued Preferred Shares remain
outstanding.
6. For as long as 20 percent of the number of shares of Common
Stock into which the shares of Convertible Preferred Shares first issued to UBS
Capital could be converted remain outstanding, the majority of the Preferred
Shares holders shall be entitled to elect one (1) director to serve on the
Company's Board of Directors until his successor is replaced by a majority of
the Preferred Shares holders. For purposes of this election, Preferred Shares
holders vote separately as a single class to the exclusion of all other classes
of Common Stock and each share of Preferred Shares is entitled to one vote.
7. Preferred Shares holders vote separately as a single class,
and approval of the majority of Preferred Shares holders is required, whenever a
shareholder vote is required pursuant to certain provisions of the Minnesota
Business Corporation Act, for the purpose of according voting rights with
respect to shares acquired or to be acquired in a control share acquisition, as
such term is defined in the Minnesota Business Corporation Act. In addition,
holders of Preferred Shares are entitled to vote on all other matters requiring
shareholder approval on an "as if" converted basis.
8. On July 23, 2008, the Company is required to elect to
either (1) require Preferred Shares holders to convert all remaining unconverted
Preferred Shares into Common Stock upon the payment by the Company of a
conversion fee to the holder, payable in cash or Common Stock, or (2) redeem for
cash the holder's unconverted Preferred Shares for $1,000 per share plus accrued
dividends. The conversion fee cannot exceed $3.0 million and
<PAGE>
will be reduced prorata to the extent the number of unconverted Preferred Shares
at the end of the ten year term is less than the number of Preferred Shares
issued to the holders during the ten year term.
RELATIONSHIP WITH CHRONIMED.
Although the Company believes the agreements that it had with Chronimed since
its July 1, 1994 spin-off were commercially reasonable, such agreements were not
the product of arms-length negotiations. In June 1997, the Company terminated
these agreements (the "Termination Agreement"), except for the Cystadane
Agreement. The Termination Agreement provides that the Company pay Chronimed
compensation equal to $2,500,000, consisting of cash and shares of the Company's
Common Stock. The October 1996 Cystadane Agreement between the Company and
Chronimed applies solely to the domestic distribution of Cystadane. Several of
the Company's directors and executive officers are current or former employees,
shareholders and/or directors of Chronimed. The Termination Agreement and the
October 1996 Cystadane Agreement were approved by all of the independent outside
members of the Company's Board of Directors.
POSSIBLE VOLATILITY OF STOCK PRICE AND DILUTION OF STOCK - TERMINATION AGREEMENT
WITH CHRONIMED.
After paying Chronimed $250,000 on signing the Termination Agreement in
June 1997, we had a remaining obligation to compensate Chronimed with cash and
Common Stock having a total value of $2,250,000. Cash payments against this
remaining obligation are to be based on a 3 percent temporary royalty on our
product sales, which we began paying quarterly on September 30, 1997.
Unregistered shares of Common Stock equal to 1 percent of our outstanding shares
at each quarter end, which we began issuing on March 31, 1998, are to be issued
quarterly to Chronimed. We are obligated to continue paying the royalties and
issuing Common Stock until the sum of all royalty payments and the market value
of all issued Common Stock equals $2,250,000. We are also obligated to file a
registration statement with the Securities and Exchange Commission to register
such shares. The market value of shares issued to Chronimed as payment against
the remaining obligation of $2,250,000 is determined as follows: (1) the market
value of any such shares sold within 90 days after the effective date of a
registration statement covering such shares will be equal to the net proceeds
realized by Chronimed from the sale of such shares; and (2) the market value of
any such shares not sold within 90 days after the effective date of a
registration statement covering such shares will be equal to the average last
bid price for shares of Common Stock as reported on Nasdaq for the last five
days within the 90 day period.
We anticipate that Chronimed will sell in the open market the shares it
receives from us within the 90 day period. We have the option, regardless of the
market price of our Common Stock, to buy-out for cash the remaining obligation
to Chronimed. Through September 30, 1998, we have paid Chronimed approximately
$102,000 in royalties and issued 185,971 shares of Common Stock, of which
123,056 shares have been sold by Chronimed in market transactions for net cash
proceeds of $1,063,452. At September 30, 1998, our unpaid obligation to
Chronimed has an estimated value of approximately $669,000. This obligation is
classified as a "Current Liability."
There is risk that our current shareholders' ownership could be
substantially diluted and/or the market value of their shares adversely affected
in the event any one or a combination of the following events occur: (1) sales
by Chronimed of the Common Stock cause the price of the Common Stock to
decrease; (2) in the event of a decline in the value of the Common Stock, we
would be required to issue more shares in subsequent periods to satisfy its
remaining obligation to Chronimed; or (3) our sales of future products are
significantly less than forecasted, which would decrease the temporary royalty
payments that would be applied against the remaining obligation and, thereby,
increase the number of shares required to be issued to Chronimed.
The realization of one or more of these risks, or our decision to
exercise our option to effect a cash buy-out of the remaining obligation, could
have a material adverse effect on the Company's business, its prospects and its
shareholders.
POSSIBLE VOLATILITY OF STOCK PRICE AND REDUCED LIQUIDITY OF THE MARKET FOR THE
STOCK - LOSS OF NASDAQ NATIONAL MARKET LISTING.
There is risk that the market value and the liquidity of the public
float for the Common Stock could be adversely affected in the event we no longer
meet Nasdaq's requirements for continued listing on the National Market tier.
For continued listing on the Nasdaq National Market, a company must satisfy a
number of requirements, which in our case includes either: (1) net tangible
assets in excess of $4.0 million as reported on Form 10-Q or Form 10-K or (2) a
market capitalization of at least $50.0 million. At September 30, 1998, our net
tangible
<PAGE>
assets equaled $6,017,585 and our market capitalization was approximately $48.9
million (based on the last sale price of $7.688 and 6,354,373 shares
outstanding. Net tangible assets are defined as total assets less total
liabilities. Market capitalization is defined as total outstanding shares
multiplied by the last sales price quoted by Nasdaq. If we fail to satisfy at
least one of the two Nasdaq listing requirements at any time, the Common Stock
would no longer qualify for listing on the Nasdaq National Market. However, the
Common Stock would qualify for quotation on the Nasdaq Small Cap Market if the
Company has net tangible assets in excess of $2.0 million, or local over the
counter trading if the Company does not qualify for the Nasdaq Small Cap Market.
Without additional equity financing, the Company expects that its net tangible
assets will fall below the $4.0 million requirement by March 31, 1999 or sooner,
and below $2.0 million by June 30, 1999, or sooner. A failure to meet Nasdaq's
listing requirements on either the National Market or the Small Cap Market could
have a material adverse effect on our ability to raise additional capital and on
the market value of the Common Stock. The realization of any one or combination
of these risks could have a material adverse effect on the Company's business,
its prospects and its shareholders.
POSSIBLE VOLATILITY OF STOCK PRICE - GENERAL.
Market prices of securities of early stage pharmaceutical companies are
generally subject to significant volatility. Contributing to this volatility are
various factors and events, such as the announcements by the Company or its
competitors of new product developments, clinical testing results, governmental
approvals, regulations or actions, developments or disputes relating to patents
or proprietary rights, public concern over the safety of therapies and
fluctuations in financial performance from period to period. These and other
factors and events may have a significant impact on the Company's business and
on the market price of the Common Stock.
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
ACCOMPANYING BALANCE SHEETS OF ORPHAN MEDICAL, INC. AS OF SEPTEMBER 30, 1998 AND
THE REALTED STATEMENTS OF OPERATIONS FOR THE SIX MONTHS ENDED SEPTEMBER 30, 1998
AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> SEP-30-1998
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<RECEIVABLES> 520,071
<ALLOWANCES> 28,136
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<TOTAL-ASSETS> 9,838,395
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