UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
 
FORM 10-K
 
(Mark One)
x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
 
For the fiscal year ended  December 31, 2013
OR
¨ 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 01-21617
 
ProPhase Labs, Inc.
(Exact name of registrant as specified in its charter)
 
Nevada
 
23-2577138
(State or other jurisdiction
 
(I.R.S. Employer
of incorporation or organization)
 
Identification No.)
 
621 N. Shady Retreat Road, Doylestown, Pennsylvania
 
18901
(Address of principal executive offices)
 
(Zip Code)
 
Registrant’s telephone number, including area code (215) 345-0919
 
Securities registered pursuant to Section 12(b) of the Act: 
 
Title of each class
 
Name of each exchange on which registered
Common Stock, $0.0005 par value per share
 
Nasdaq Global Market
Common Share Purchase Rights
 
Nasdaq Global Market
 
Securities registered pursuant to Section 12(g) of the Act: None  
 
Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act.      
Yes ¨    No x
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act.  
Yes ¨    No x
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x      No ¨
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or such shorter period that the registrant was required to submit and post such files).
Yes x      No ¨
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. x
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):
 
Large accelerated filer  ¨
Accelerated filer  ¨
  Non-accelerated filer  ¨
Smaller reporting company  x
 
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨  No x
 
The aggregate market value of the registrant’s voting and non-voting common stock held by non-affiliates was $15,803,329 as of June 30, 2013, based on the closing price of the common stock on The NASDAQ Global Market.
 
Number of shares of each of the registrant’s classes of securities outstanding on March 25, 2014
 
 
Common stock, $0.0005 par value per share: 16,660,324
 
Common share purchase rights:                               -
 
DOCUMENTS INCORPORATED BY REFERENCE
 
Information set forth in Part III of this report is incorporated by reference to the registrant’s proxy statement for the 2014 annual meeting of stockholders.
 
 
 
TABLE OF CONTENTS
 
 
 
 
 
Page
Part I
 
 
 
 
 
 
 
 
 
 
Item
1.
Business
3
 
 
 
 
 
 
 
1A.
Risk Factors
8
 
 
 
 
 
 
 
1B.
Unresolved Staff Comments
17
 
 
 
 
 
 
 
2.
Properties
17
 
 
 
 
 
 
 
3.
Legal Proceedings
17
 
 
 
 
 
 
 
4.
Mine Safety Disclosures
18
 
 
 
 
 
Part II
 
 
 
 
 
 
 
 
 
 
 
5.
Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
19
 
 
 
 
 
 
 
6.
Selected Financial Data
22
 
 
 
 
 
 
 
7.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
23
 
 
 
 
 
 
 
7A.
Quantitative and Qualitative Disclosures About Market Risk
31
 
 
 
 
 
 
 
8.
Financial Statements and Supplementary Data
32
 
 
 
 
 
 
 
9.
Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
57
 
 
 
 
 
 
 
9A
Controls and Procedures
57
 
 
 
 
 
 
 
9B.
Other Information
57
 
 
 
 
 
Part III
 
 
 
 
 
 
 
 
 
 
 
10.
Directors, Executive Officers and Corporate Governance
58
 
 
 
 
 
 
 
11.
Executive Compensation
58
 
 
 
 
 
 
 
12.
Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
58
 
 
 
 
 
 
 
13.
Certain Relationships and Related Transactions and Director Independence
58
 
 
 
 
 
 
 
14.
Principal Accountant Fees and Services
58
 
 
 
 
 
Part IV
 
 
 
 
 
 
15.
Exhibits and Financial Statement Schedules
59
 
 
 
 
 
Signatures
 
 
62
 
 
 
PART I
 
Forward-Looking Statements
 
This Annual Report on Form 10-K (“Report”) contains “forward looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended (the “Securities Act”) and Section 21E of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). These forward looking statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that may cause our or our industry’s actual results, levels of activity, performance or achievements to be materially different from any future results, levels of activity, performance or achievements expressed or implied by the forward-looking statements. Many of these factors are beyond our ability to predict. Given the risks and uncertainties surrounding forward-looking statements, you should not place undue reliance on these statements. Forward-looking statements typically are identified by use of terms such as “anticipate”, “believe”, “plan”, “expect”, “intend”, “may”, “will”, “should”, “estimate”, “predict”, “potential”, “continue” and similar words although some forward-looking statements are expressed differently. This Report may contain forward-looking statements attributed to third parties relating to their estimates regarding the growth of our markets. You are cautioned that such forward looking statements are not guarantees of future performance and that all forward-looking statements address matters that involve risk and uncertainties, and there are many important risks, uncertainties and other factors that could cause our actual results, levels of activity, performance, achievements and prospects, as well as those of the markets we serve, to differ materially from the forward-looking statements contained in this Report.
 
Such risks and uncertainties include, but are not limited to:
 
· The ability of our management to successfully implement our business plan and strategy;
· Our ability to fund our operations including the cost and availability of capital and credit;
· Our ability to compete effectively, including our ability to maintain and increase our markets and/or market share in the markets in which we do business;
· Our dependence on sales from our principal product, Cold-EEZEÒ Cold Remedy, and our ability to successfully develop and commercialize our new products;
· Changes in our retail and distribution customers strategic business plans including, but not limited to, (i) expansions, mergers, and/or consolidations, (ii) retail shelf space allocations for products within each outlet and in particular the cough/cold category in which we compete, (iii) changes in their private label assortment and (iv) product selections, distribution allocation, merchandising programs and retail pricing of our products as well as competitive products;
· The uncertain length and severity of the general financial and economic downturn, the timing and strength of an economic recovery, if any, and their impacts on our business including demand for our products;
· Our ability to protect our proprietary rights;
· Our continued ability to comply with regulations relating to our current products and any new products we develop, including our ability to effectively respond to changes in laws and regulations or the interpretation thereof including changing market rules and evolving federal, state and regional laws and regulations;
· Potential disruptions in our ability to manufacture our products or our access to raw materials;
· Seasonal fluctuations in demand for our products;
· Our ability to attract, retain and motivate our key employees;
· The ability of Phusion Laboratories, LLC, a 50% owned joint venture, to successfully implement its business plan and strategy to develop and commercialize one or more non-prescription remedies using certain patented and proprietary technology; and
· Other risks identified in this Report.
 
You should also consider carefully the statements under other sections of this Report, including the Risk Factors included in Item 1A, which address additional risks that could cause our actual results to differ from those set forth in any forward-looking statements. Our forward-looking statements speak only as the date of this Report. We undertake no obligation to publicly update or review any forward-looking statements, whether as a result of new information, future developments or otherwise.
 
 
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Where You Can Find Other Information
 
ProPhase Labs, Inc. (“we”, “us” or the “Company”) files periodic and current reports, proxy statements and other information with the Securities and Exchange Commission (the “SEC”). We make available on our website (www.ProPhaseLabs.com) free of charge our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K and any amendments to or exhibits included in those reports as soon as reasonably practical after we electronically file such materials with or furnish them to the SEC. Information appearing on our website is not part of this Annual Report on Form 10-K. You can also read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington D.C. 20549-1004. You may request copies of these documents, upon payment of a duplication fee, by writing the SEC at its principal office at 100 F Street, NE Room 1580, Washington, D.C. 20549-1004. In addition, the SEC maintains an Internet site (www.sec.gov) that contains reports, proxy and information statements regarding issuers that file electronically with the SEC, including the Company.
 
Item 1. Business
 
General Development of Business
 
We are a manufacturer, marketer and distributor of a diversified range of homeopathic and health products that are offered to the general public. We are also engaged in the research and development of potential over-the-counter (“OTC”) drug, natural base health products along with supplements, personal care and cosmeceutical products.
 
Our primary business is the manufacture, distribution, marketing and sale of OTC cold remedy products to consumers through national chain, regional, specialty and local retail stores. Our flagship brand is Cold-EEZEÒ Cold Remedy and our principal product is Cold-EEZEÒ zinc gluconate lozenges, proven in clinical studies to reduce the duration and severity of symptoms of the common cold by 42%. In addition to Cold-EEZE® Cold Remedy lozenges, we market and distribute non-lozenge forms of our proprietary zinc gluconate formulation, (i) Cold-EEZE® Cold Remedy QuickMelts® and (ii) Cold-EEZE® Cold Remedy Oral Spray. In Fiscal 2013, we expanded our Cold-EEZE® Cold Remedy QuickMelts® product line and began shipments to retailers in July 2013 two new products, Cold-EEZE® Plus Immune Support QuickMelts® and Cold-EEZE® Plus Immune Support + Energy QuickMelts®. Each of these new Cold-EEZE® QuickMelts® products are based on our proprietary zinc gluconate formulation in combination with certain immune system support and natural energy active ingredients. 
 
Cold-EEZEÒ Cold Remedy is an established product in the health care and cold remedy market. For Fiscal 2013, 2012 and 2011, our revenues have come principally from our OTC cold remedy products. For Fiscal 2013 and 2012, our net sales for each period were related to markets in the United States.
 
We use a December 31 year-end for financial reporting purposes. References herein to the fiscal year ended December 31, 2013 shall be the term “Fiscal 2013” and references to other “Fiscal” years shall mean the year, which ended on December 31 of the year indicated.
 
We are a corporation organized in Nevada in July 1989. Our principal executive offices are located at 621 N. Shady Retreat Road, Doylestown, Pennsylvania 18901 and our telephone number is 215-345-0919. The terms, “we”, “us” and the “Company” refer to the Company together with its consolidated subsidiaries unless the context otherwise requires. 
 
Description of Business Operations
 
Cold-EEZEÒ Cold Remedy is one of our most popular OTC cold remedy products and its benefits are derived from its proprietary zinc gluconate formulation. Cold-EEZEÒ Cold Remedy lozenges effectiveness has been substantiated in two double-blind clinical studies proving that Cold-EEZEÒ Cold Remedy lozenges reduce the duration of the common cold by 42%. We acquired worldwide manufacturing and distribution rights to our lozenge formulation in 1992 and commenced national marketing in 1996. In addition to our lozenge product, the Cold-EEZEÒ Cold Remedy proprietary zinc gluconate formulation is available in two additional cold remedy delivery forms, (i) a fast dissolving QuickMelt and (ii) an Oral Spray. The demand for our OTC cold remedy products is seasonal, where the third and fourth quarters of each year generally have the largest sales volume.
 
 
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Our business operations are concentrated on the development, manufacturing, marketing and distribution of our proprietary Cold-EEZEÒ Cold Remedy lozenge products and on the development of various product extensions. Our product line of OTC cold remedy products are reviewed regularly to identify new consumer opportunities and/or trends in flavor, convenience, packaging and delivery systems or forms to help improve market share for our products. Additionally, we are active in exploring new product technologies, applications, product line extensions and other new product opportunities consistent with our company and brand image, and our standard of proven consumer benefit and efficacy.
 
Manufacturing Facility 
Our wholly owned subsidiary, Pharmaloz Manufacturing, Inc. (“PMI”), produces our Cold-EEZE® Cold Remedy lozenges and other lozenge products in addition to performing operational tasks such as warehousing and shipping. Our PMI facility is located in Lebanon, Pennsylvania. Additionally, our PMI facility is a United States Food and Drug Administration (“FDA”) registered facility that engages in contract manufacturing and distribution activities. PMI also produces and sells therapeutic lozenges to unaffiliated third party retail, wholesale and distribution outlets.
 
Joint Venture – Phusion Laboratories, LLC
On March 22, 2010, we, Phosphagenics Limited (“PSI Parent”), an Australian corporation, Phosphagenics Inc. (“PSI”), a Delaware corporation and subsidiary of PSI Parent, and Phusion Laboratories, LLC (the “Joint Venture”), a Delaware limited liability company, entered into a Limited Liability Company Agreement (the “LLC Agreement”) of the Joint Venture and additional related agreements for the purpose of developing and commercializing, for worldwide distribution and sale, a wide range of non-prescription remedies using PSI Parent’s proprietary patented TPM™ technology (“TPM”).  TPM facilitates the delivery and depth of penetration of active molecules in pharmaceutical, nutraceutical, and other products. Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture.
 
Due to multiple factors affecting our capital position, including (i) the $2.1 million payment we made in December 2012 under the Settlement Agreement and Mutual General Release (the “Settlement Agreement”) between the Company and John C. Godfrey, the Estate of Nancy Jane Godfrey and Godfrey Science and Design (together the “Godfreys”) (see Note 5 to Notes to Consolidated Financial Statements) and (ii) some of the product market research performed, we expect to modify the Joint Venture’s product development plans to stagger and/or defer into future periods certain product development initiatives due to the pre-commercialization investments required.  We expect to continue pre-commercialization research and product development initiatives during the latter half of Fiscal 2014 or Fiscal 2015.  Furthermore, we do not expect that the Joint Venture will derive any meaningful revenues, if any, until its commercialization efforts are completed which is not expected to occur until at the earliest the latter half of Fiscal 2014 or Fiscal 2015.
 
In connection with the LLC Agreement, PSI Parent granted to us, pursuant to the terms of a License Agreement, dated March 22, 2010 (the “Original License Agreement”), (i) an exclusive, royalty-free, world-wide (subject to certain limitations), paid-up license to exploit OTC drugs and certain other products that embody certain of PSI Parent’s TPM-related patents and related know-how (collectively, the “PSI Technology”) and (ii) a non-exclusive, royalty-free, world-wide (subject to certain limitations), paid-up license to exploit certain compounds that embody the PSI Technology for use in a product combining one or more of such compounds with an OTC drug or in a product that is part of a regimen that includes the application of an OTC drug. Pursuant to the terms of the Original License Agreement, we issued to PSI Parent 1,440,000 shares of our common stock, $0.005 par value (“Common Stock”) having an aggregate value of $2.6 million (such share, the “PSI Shares”) and made a one-time payment of $1.0 million.
 
The Joint Venture is managed by a four-person Board of Managers, with two managers appointed by each member. The LLC Agreement contains other standard terms in such arrangements, including provisions relating to the governance of the Joint Venture, indemnification obligations of the Joint Venture, allocation of profits and losses, the distribution of funds to the members and restrictions on transfer of a member’s interest.
 
In accordance with a Contribution Agreement, dated March 22, 2010 (the “Contribution Agreement”), by and among us, PSI Parent, PSI, and the Joint Venture, we transferred, conveyed and assigned to the Joint Venture all of our rights, title and interest in, to and under the Original License Agreement, and the Joint Venture assumed, and undertook to pay, discharge and perform when due, all of our liabilities and obligations under and arising pursuant to the Original License Agreement (such actions, collectively, the “Assignment and Assumption”).
 
 
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Pursuant to the Contribution Agreement and in order to reflect the Assignment and Assumption, we, PSI Parent and the Joint Venture entered into an Amended and Restated License Agreement, dated March 22, 2010 (the “Amended License Agreement”), which amends and restates the Original License Agreement to reflect that the Joint Venture is the licensee thereunder and which otherwise contains substantially the same terms as the Original License Agreement. The Joint Venture has the right to grant one or more sub-licenses of the rights granted under the Amended License Agreement to one or more third parties for reasonable consideration in any part of the applicable territory. The Amended License Agreement provides that PSI Parent shall not, directly or through third parties, exploit the covered intellectual property during the term thereof, subject to certain limitations. The Amended License Agreement will remain in effect until the expiration of the last to expire of the patents included within the PSI Technology or any extensions thereof. Either party may terminate the Amended License Agreement upon written notice to the other party in the event of certain events involving bankruptcy or insolvency. The Amended License Agreement also contains, among other things, provisions concerning the treatment of confidential information, the ownership of intellectual property and indemnification obligations.
 
Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture. PSI Parent conducts and oversees much of the product development, formulation, testing and other research and development needed by the Joint Venture, and we will oversee much of the production, distribution, sales and marketing. The LLC Agreement provides that each member may be required, from time to time and subject to certain limitations, to make capital contributions to the Joint Venture to fund its operations, in accordance with agreed upon budgets for products to be developed. Specifically, we contributed in Fiscal 2010 $500,000 in cash as initial capital and we are committed to fund up to $2.0 million, subject to agreed upon budgets (which have not been established to date), toward the initial development and marketing costs of new products for the Joint Venture. The Joint Venture has not engaged in any financial transactions, other than organizational expenses and general market and initial product evaluation and analysis. At December 31, 2013, cash and equivalents includes $378,000 which is expected to be used by the Joint Venture to fund future product development initiatives currently under consideration by PSI Parent, PSI and us.
 
Our determination is that the Joint Venture qualifies as a VIE and that we are the primary beneficiary.  We have consolidated the Joint Venture financial statements beginning with the quarter ended March 31, 2010.  In Fiscal 2010, we recorded our $3.6 million payment representing the estimated fair value to acquire the product license as an intangible asset.   We currently estimate the expected remaining useful life of the product license to be approximately 13 years which we will begin amortizing the cost of intangible asset once product development and commercialization begins.  Thus far, the Joint Venture has not generated any revenues and its expenses, including organizational, marketing analysis and preliminary formulations have been absorbed by the respective Joint Venture members.  Furthermore, the liabilities and other obligations incurred, if any, by the Joint Venture is without recourse to us and do not create a claim on our general assets.
 
The product development effort of the Joint Venture is a multi-stage process that includes (i) market analysis and research, (ii) product formulation research and development, (iii) product evaluation, (iv) product commercialization, (v) production and distribution, and (vi) retail and consumer advertising and marketing. We conducted preliminary market analysis to identify market opportunities to develop differentiated, science-based, efficacious products that deliver results to consumers and we have worked with PSI and PSI Parent to provide initial formulations for certain identified OTC active ingredients. In December 2011, we initiated a study of these preliminary formulations to evaluate product attributes, performance and potential commercial viability. These initial studies were completed in Fiscal 2013. Our initial studies provided certain positive indications and additional studies will be required. Such additional studies have not yet been scheduled.
 
Products
 
OTC Cold-Remedy Products
In May 1992, we entered into an exclusive agreement for worldwide representation, manufacturing and marketing of a zinc gluconate formulation. This zinc gluconate formulation is the foundation of our brand; Cold-EEZE® Cold Remedy products which are distributed principally in the United States. Cold-EEZE® Cold Remedy is an OTC consumer product used to reduce the duration of the common cold. We have substantiated the effectiveness of Cold-EEZE® Cold Remedy lozenges through a variety of studies. A randomized double-blind placebo-controlled study, conducted at Dartmouth College of Health Science, Hanover, New Hampshire, concluded that the lozenge formulation treatment, initiated within 48 hours of symptom onset, resulted in a significant reduction in the total duration of the common cold.
 
 
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On May 22, 1992, “Zinc and the Common Cold, a Controlled Clinical Study,” was published in England in the Journal of International Medical Research, Volume 20, Number 3, Pages 234-246. According to this publication, (a) flavorings used in other zinc lozenge products (citrate, tartrate, separate, orotate, picolinate, mannitol or sorbitol) render the zinc inactive and unavailable to the patient’s nasal passages, mouth and throat where cold symptoms have to be treated, (b) this patented formulation delivers approximately 93% of the active zinc to the mucosal surfaces and (c) the patient has the same sequence of symptoms as in the absence of treatment but goes through the phases at an accelerated rate and with reduced symptom severity.
 
On July 15, 1996, results of a randomized double-blind placebo-controlled study on the common cold, which commenced at the Cleveland Clinic Foundation on October 3, 1994, were published. The study Zinc Gluconate Lozenges for Treating the Common Cold” was completed and published in The Annals of Internal Medicine – Volume 125 Number 2. Using a 13.3mg lozenge (almost half the strength of the lozenge used in the Dartmouth study), the result still showed a 42% reduction in the duration of common cold symptoms.
 
In addition to Cold-EEZE® Cold Remedy lozenges, we market and distribute non-lozenge forms of our proprietary zinc gluconate formulation, (i) Cold-EEZE® Cold Remedy QuickMelts® and (ii) Cold-EEZE® Cold Remedy Oral Spray. Cold-EEZE® Cold Remedy Oral Spray is a liquid form of our zinc gluconate formulation that is sprayed in the mouth. Cold-EEZE® Cold Remedy QuickMelts® are fast dissolving tablets that are taken orally.
 
The Cold-EEZE® Cold Remedy QuickMelts® product line is comprised of (i) Cold-EEZE® Daytime/Nighttime QuickMelts® (launched in Fiscal 2012) and (ii) Cold-EEZE® Plus Immune Support QuickMelts® and Cold-EEZE® Plus Immune Support + Energy QuickMelts® (each launched in Fiscal 2013). We also manufacture, market and distribute organic cough drops and a Vitamin C supplement (“Organix”) and perform contract manufacturing services of cough drop and other OTC cold remedy products for third parties.
 
Our business is subject to federal and state health and safety laws and regulations. Our OTC cold remedies are subject to regulations by various federal, state and local agencies, including the FDA. Additionally, Cold-EEZE®, a homeopathic cold remedy, is subject to the Homeopathic Pharmacopoeia of the United States. See “Regulatory Matters” below for more information.
 
Patents, Trademarks, Royalty and Commission Agreements
 
We do not currently own patents for our OTC cold-remedy products. We maintain various trademarks for each of our products including Cold-EEZE®, Kids-EEZE®, QuickMelts®, Organix Rx Complete® and Organix Rx Defense®.
 
We currently own various domestic and international patents covering certain product development initiatives principally developed under our Pharma subsidiary operations.  To date, we have not realized any meaningful levels of revenues from such patents and we have suspended in Fiscal 2009 any further commercialization efforts for various products under such patents.
 
Our Joint Venture has (i) an exclusive, royalty-free, world-wide (subject to certain limitations), paid-up license to exploit OTC drugs (and certain other products) that embody certain PSI Technology and (ii) a non-exclusive, royalty-free, world-wide (subject to certain limitations) paid-up license to exploit certain compounds that embody the PSI Technology for use in a product combining one or more of such compounds with an OTC drug or in a product that is part of a regimen that includes the application of an OTC drug.
 
Product Distribution and Customers
 
Our products are distributed through national chain, regional, specialty and local retail stores throughout the United States. Revenues for Fiscal 2013, 2012 and 2011 were $25.0 million, $22.4 million and $17.5 million, respectively. Walgreen Company (“Walgreens”), Wal-Mart Stores Inc (“Wal-Mart”) and CVS Caremark Corporation (“CVS”) accounted for approximately 20.4%, 14.3% and 11.6%, respectively, of our Fiscal 2013 revenues. Walgreens, Wal-Mart and CVS accounted for approximately 19.3%, 13.8% and 13.4%, respectively, of our Fiscal 2012 revenues. Walgreens, Wal-Mart, CVS and Rite-Aid Corp (“Rite Aid”) accounted for approximately 17%, 14%, 13% and 12%, respectively, of our Fiscal 2011 revenues. The loss of sales to any one or more of these large retail customers could have a material adverse effect on our business operations and financial condition.
 
In addition, we have entered into multiple broker, distributor and representative agreements with third parties which provide for commission compensation based on sales performance.
 
 
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Research and Development
 
We have historically invested significantly in research and development activities. Our research and development costs for Fiscal 2013, 2012 and 2011 were $824,000, $1.3 million and $1.1 million respectively.
 
During Fiscal 2013, 2012 and 2011, our research and development initiatives have been principally focused on product line development and/or line extensions for OTC cold remedy products under the Cold-EEZE® brand. In addition, our Joint Venture is at its early stage of development where product and market research has been initiated and new product initiatives are being evaluated and prioritized for future development and commercialization utilizing the licensed PSI Technology. Through the Joint Venture, PSI Parent will conduct and oversee much of the product development, formulation, testing and other research and development needed by the Joint Venture, and we will oversee much of the production, distribution, sales and marketing. 
 
Currently, we fund our research and development costs with cash generated from operations. In addition to funding from operations, we may seek to raise capital through the issuance of securities or to other financing sources to support our research and development activities including new product technologies, applications, licensing, commercialization and other development opportunities, as well as acquisitions of new formulations, ingredients, applications and other products, including those products, if any, that may be developed through the Joint Venture. Any such funding through the issuance of our equity securities would result in the dilution of current stockholder ownership. Should research or commercialization activity progress on certain formulations, resulting expenditures may require substantial financial support and may necessitate the consideration of alternative approaches such as licensing, joint venture or partnership arrangements that meet our long term goals and objectives. Ultimately, should internal working capital be insufficient and external funding methods or other business arrangements become unattainable, it could result in the deferral or loss of future growth and development opportunities.
  
Regulatory Matters
 
We are subject to federal and state laws and regulations adopted for the health and safety of users of pharmaceutical and health care products. Our OTC cold remedy products are subject to regulation by various federal, state, and local agencies, including the FDA. In addition, our Cold-EEZE® Cold Remedy products are subject to the standards established by the Homeopathic Pharmacopoeia of the United States. These regulatory authorities have broad powers, and we may be subject to regulatory and legislative changes that can affect the economics of the industry by requiring changes in operating practices or by influencing the demand for and the costs of manufacturing or distributing its products. Our Cold-EEZE® Cold Remedy products are considered a homeopathic drug and are exempt from pre-approval requirements and other, but not all, FDA requirements. 
 
Many homeopathic drug products, including Cold-EEZEÒ Cold Remedy products, are manufactured and distributed under FDA enforcement policies that provide criteria needed to market a homeopathic OTC drug product without FDA approval. We believe we meet those requirements, which include registration of our manufacturing facility, listing of the product in FDA’s product database, and packaging, labeling, and manufacturing homeopathic drugs in compliance with current good manufacturing practice (“cGMP”) regulations. Due to the unique nature of homeopathic drug products, some cGMP requirements are not applicable, including certain expiration dating, and testing and release for distribution. In addition, the FDA is currently not enforcing the requirement for a laboratory determination of identity and strength of each active ingredient prior to release for distribution, although this exemption is pending FDA review and we cannot assure that the exemption will be permanently implemented. We also cannot assure that the FDA will agree with our determination of compliance. If the FDA disagrees, the FDA could, upon inspection, issue a notice of violations, referred to as a form FDA-483, or issue a Warning Letter, or both. If we fail to take timely corrective actions to the satisfaction of FDA, the agency can initiate legal actions, such as seizure and injunction, which could include a recall order or the entry of a consent decree, or both. In addition, we could be subject to monetary penalties and even criminal prosecution for egregious conduct. We believe that we are in compliance with all such laws, regulations, and standards currently in effect including the Food, Drug, and Cosmetics Act as amended from time to time, and the standards established under the Homeopathic Pharmacopoeia of the United States.
 
Pre-clinical development, clinical trials, product manufacturing, labeling, marketing, distribution and licensing and/or acquisition of potential new products are also generally subject to federal and state regulation in the United States and other countries. Obtaining FDA and any other required regulatory approval for certain OTC products, or seeking the issuance of a final monograph from the FDA for certain OTC products, can require substantial resources and take several years. The length of this process depends on the type, complexity and novelty of the product and the nature of the disease or other indications to be treated. If we cannot obtain regulatory approval of, or final OTC monograph for, a new product(s) in a timely manner or if patents are not granted or are subsequently challenged, it could have a material adverse effect on our business and financial condition.
 
 
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Competition
 
We compete with other suppliers of OTC cold remedy products. These suppliers range widely in size. Some of our competitors have significantly greater financial, technical or marketing resources than we do. Management believes that our Cold-EEZE® Cold Remedy lozenge products, which have been clinically proven in two double-blind studies to reduce the severity of common cold symptoms, offer a significant advantage over many of our competitors in the OTC cold remedy market. We believe that our ability to compete depends on a number of factors, including product quality and price, availability, speed to market, consumer marketing, reliability, credit terms, brand name recognition, delivery time and post-sale service and support.
 
Employees
 
At December 31, 2013, we employed 50 full-time employees, the majority of which were employed at our manufacturing facility in a production function. The remaining employees were involved in an executive, sales, marketing or administrative capacity. None of our employees are covered by a collective bargaining agreement or are members of a union.
 
 Suppliers; Raw Materials
 
We derive our sales principally from our Cold-EEZEÒ Cold Remedy zinc gluconate products which are available in various forms– lozenges, oral spray and QuickMelts® – and various flavors for purchase by consumers at retail stores.  We also produce private label lozenge products for sale to certain retail customers.  Our zinc lozenge products are manufactured by us at our Lebanon, Pennsylvania facility.  The constituent raw materials and packaging used in the manufacture and presentation of these items are procured from various sources with additional suppliers having been identified in the event that alternatives are required.  While the absence of a current raw materials or packaging source may cause short term interruption, we expect that identified alternative sources would fill our needs in a short time and any transition period would be mitigated by adequate levels of finished product available for sale.  Certain products within our line of products such as Cold-EEZEÒ Cold Remedy Oral Spray and Cold-EEZE® Cold Remedy QuickMelts® are manufactured for us by third party contract manufacturers and while currently purchased from single sources, we do not believe that there would be a material revenue risk to us if product availability was jeopardized.
 
Item 1A. Risk Factors
 
Any of the following risks could materially affect our business, financial condition, or results of operations. These risks could also cause our actual results to differ materially from those indicated in the forward-looking statements contained herein and elsewhere. The risks described below are not the only risks facing us. Additional risks not currently known to us or those we currently deem to be immaterial may also materially and adversely affect our business, financial condition or results of operations.
 
Our business is subject to significant competitive pressures
The OTC healthcare product, pharmaceutical and consumer product industries are highly competitive. Many of our competitors have substantially greater capital resources, technical staffs, facilities, marketing resources, product development, distribution and experience than we do. Our competitors may have certain advantages, including the ability to allocate greater resources for new product development, marketing and other purposes.
 
We believe that our ability to compete depends on a number of factors, including product quality and price, availability, speed to market, consumer marketing, reliability, credit terms, brand name recognition, delivery time and post-sale service and support, and new and existing product innovation and commercialization. There can be no assurance that we will be able to compete successfully in the future. If we are unable to compete effectively, our earnings may be significantly negatively impacted.
 
 
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Our long range business plan may not be successful
We have aligned our operations to focus principally in the research, development, manufacture, marketing and sale of OTC cold remedy and consumer products, natural based health products and other supplement and cosmeceutical products. In addition, we may seek to acquire from third parties or enter into other arrangements with respect to new formulations, ingredients, applications and other products developed by third parties who may be seeking our commercialization, marketing and distribution expertise.
 
There can be no assurance that we will be able to effectuate our business plan successfully or that our revenue growth will continue. In addition, we may not be successful in acquiring or otherwise entering into any new lines of business and, if we are successful in doing so, there can be no assurance that such new business will achieve profitability.
 
We will need to obtain additional capital to support long term product development and commercialization programs
Our ability to achieve and sustain operating profitability depends in large part on our ability to commence, execute and complete new and existing product innovation and commercialization, including the Joint Venture product development initiatives, and, if required, clinical programs to obtain regulatory approvals in the United States and elsewhere. We can give no assurance that we will be able to achieve such product innovation and commercialization, to obtain any required approvals or to achieve significant levels of sales.
 
The amount of capital that may be needed to complete product development initiatives will depend on many factors which may include but are not limited to (i) the cost involved in applying for and obtaining FDA, international regulatory or other technical approvals, (ii) whether we elect to establish partnering arrangements for development, sales, manufacturing and marketing of such products, (iii) the level of future sales of OTC cold remedy products, and expense levels for marketing efforts, (iv) whether we can establish and maintain strategic arrangements for development, sales, manufacturing and marketing of our products, and (v) whether any or all of the options for our Common Stock issued to employees of the Company are exercised and the timing and amount of these exercises. 
 
Should research or commercialization activity progress on certain formulations, resulting expenditures may require substantial financial support.  The current sales level of our OTC cold remedy products may not generate all the funds we anticipate will be needed to support future product acquisition or development.  Accordingly, in addition to funding from operations, we may in the short and long term seek to raise capital through the issuance of securities or to secure other financing sources to support our research, new product technologies, applications, licensing, commercialization and other development opportunities.  If we obtain such funding through the issuance of equity securities, it would result in the dilution of current stockholders’ ownership in the Company.  Any debt financing, if available, may include financial and other covenants that could restrict use of proceeds of such financing or impose other business and financial restrictions on us.  In addition, we may consider alternative approaches such as licensing, joint venture, or partnership arrangements to provide long term capital.   There can be no assurances that we will have access to the capital required to fun these aspects of our business on favorable terms or at all.
 
We may not be able to access our Equity Line of Credit under commercially reasonable terms
On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the “Equity Line”) with Dutchess Opportunity Fund II, LP (“Dutchess”) whereby, Dutchess committed to purchase, subject to certain restrictions and conditions, up to 2,500,000 shares of our Common Stock, over a period of 36 months expiring in December 2015.
 
In Fiscal 2013, we sold an aggregate of 289,474 shares of Common Stock to Dutchess in which we derived approximately net proceeds of $444,000. In Fiscal 2012, we sold an aggregate of 883,722 shares of Common Stock to Dutchess in which we derived approximately $1.1 million in net proceeds.  During the period January 1, 2014 through to February 25, 2014, we sold an aggregate of 559,318 shares of Common Stock to Dutchess under and pursuant to the Equity Line and derived net proceeds of approximately $947,000.  At March 15, 2014, we have 767,486 shares of our Common Stock available for sale, at our discretion, under the terms of the Equity Line and covered pursuant to a registration statement.
 
To the extent that we do not generate sufficient cash from operations, we may need to access our Equity Line to finance our growth. Recent volatility in the credit markets and the potential impact on the liquidity of major financial institutions may have an adverse effect on our ability to fund our business strategy through our Equity Line on terms that we believe to be reasonable, or at all.  Our Equity Line is limited and may not be sufficient to meet our capital requirements.
 
 
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Our Equity Line with Dutchess may not be available to us if we elect to make a draw down
Pursuant to the Equity Line, Dutchess committed to purchase, subject to certain conditions, up to 2,500,000 shares of our Common Stock over a thirty-six month period.  Dutchess will not be obligated to purchase shares under the Equity Line unless certain conditions are met, which include, among others:  effectiveness of the registration statement; the continued listing of our stock on the NASDAQ Global Market; our compliance with our obligations under the purchase agreement and registration rights agreement entered into with Dutchess; the absence of injunctions or other governmental actions prohibiting the issuance of our Common Stock to Dutchess; the absence of violations of shareholder approval requirements with respect to such issuance of our common stock to Dutchess and the accuracy of representations and warranties made to Dutchess.  If we are unable to access funds through the Equity Line, we may be unable to access capital on favorable terms or at all.
 
Any draw downs under our Equity Line with Dutchess may result in dilution to our shareholders
If we sell shares to Dutchess under the equity line, it will have a dilutive effect on the holdings of our current shareholders, and may result in downward pressure on the price of our Common Stock.  If we draw down amounts under the equity line, we will issue shares to Dutchess at a discount of 5% from the average price of our Common Stock.  If we draw down amounts under the equity line when our share price is decreasing, we will need to issue more shares to raise the same amount than if our stock price was higher.  Issuances in the face of a declining share price will have an even greater dilutive effect than if our share price were stable or increasing, and may further decrease our share price.
 
We may not be able to commercialize new products through our Joint Venture
The Joint Venture is at its early stage of development where product and market research has been initiated and new product initiatives are being evaluated and prioritized for future development and commercialization. Prior to any new product being available for sale, substantial resources will have to be committed to commercialize a product which may include research, development, preclinical testing, clinical trials, manufacturing scale-up and regulatory approval. The Joint Venture may disrupt our ongoing operations, divert management from day-to-day responsibilities and increase our expenses.
 
We face significant technological risks inherent in developing these products.  The Joint Venture may be subject to delays and/or ultimately unable to successfully implement its business plan and strategy to develop and commercialize one or more non-prescription remedies using certain patented and proprietary TPMTM that exploit certain compounds that embody the TPMTM for use in a product combining one or more of such compounds with an OTC drug.  The commercialization and ultimate product market acceptance is subject to, among other influences, consumer purchasing trends, demand for our OTC drug, health and wellness trends, regulatory factors, retail acceptance and overall economic and market conditions.  As a consequence, we may suspend or abandon some or all of our proposed new products before they become commercially viable which could have an adverse affect on our business.  Even if we develop and obtain approval of a new product, if we cannot successfully commercialize it in a timely manner, our business and financial condition may be materially adversely affected.
 
Instability and volatility in the financial markets could have a negative impact on our business, financial condition, results of operations and cash flows
In recent years, there has been substantial volatility in financial markets due at least in part to the global economic environment. In addition, there has been substantial uncertainty in the capital markets and access to financing is uncertain. Moreover, customer spending habits may be adversely affected by the current economic environment and prevailing high unemployment rates in the United States.  These conditions could have an adverse effect on our industry and business, including our access to funding sources, demand for our products and our customers’ ability to continue to purchase our products, which could have a material adverse effect on our financial condition, results of operations and cash flows.
 
To the extent that we do not generate sufficient cash from operations, we may need to issue equity or to incur indebtedness to finance our growth. Recent turmoil and volatility in the credit markets and the potential impact on the liquidity of major financial institutions may have an adverse effect on our ability to fund our business strategy through borrowings, under either existing or newly created instruments in the public or private markets on terms that we believe to be reasonable, or at all.
 
 
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Commodity price increases will increase our operating costs and may negatively affect financial results
Commodity prices impact our business directly through the cost of raw materials used to make our products (such as corn syrup, sucrose and other commodities and ingredients) and the amount we pay to purchase packaging for our products (such as paper, board and plastic). Commodities such as these are susceptible to price volatility caused by conditions outside of our control, including fluctuations in commodities markets, currency fluctuations, availability of supply, weather, consumer demand and changes in governmental agricultural programs. Increases in the price of our commodities and other raw materials would negatively impact our gross margins and/or our sales volume if we were unable to offset such increases through increases in our selling price, changes in product mix or cost reduction/productivity enhancement efforts.
 
The sales of our primary product fluctuates by season and from Cold Season to Cold Season
Our sales are derived principally from our OTC cold remedy products. A significant portion of our business is highly seasonal, which causes major variations in operating results from quarter to quarter. The third and fourth quarters generally represent the largest sales volume for our OTC cold remedy products. In addition, our sales are influenced by and subject to fluctuations in the timing of purchase and the ultimate level of demand for our products which are a function of the timing, length and severity of each cold season. Generally, a Cold Season is defined as the period of September to March when the incidence of the common cold rises as a consequence of the change in weather and other factors.
 
There can be no assurance that we will be able to manage our working capital needs and inventory to meet the fluctuating demand for these products. Failure to accurately predict and respond to consumer demand may result in the production of excess inventory which may be expensive to store or which we may be required to dispose if such excess inventory remains unsold. Conversely, if products achieve greater success than anticipated for any given quarter, this may result in insufficient inventory to meet customer demand. If we do not manage our working capital needs and inventory, our business and financial condition may be materially adversely affected.
 
Our performance may fluctuate when our retail customers are affected simultaneously by the same economic, regulatory or health and wellness factors
Our revenues are significantly concentrated in our OTC cold remedy products. Our retail customers are subject to fluctuations of business based upon consumer purchasing trends, demand for cold remedy products and overall economic and market conditions. Consequently, many retailers will likely be influenced at the same time by similar economic conditions, regulatory factors or health and wellness trends, which can affect the level of demand for our products. It is reasonable to expect that, if one retailer reduces or delays its purchasing in response to a general economic, regulatory or health and wellness factor, other retailers may also decide to reduce or delay their purchasing at approximately the same time. Accordingly, our sales are subject to fluctuations as a result of such factors.
 
We have a concentration of sales to and accounts receivable from several large retail customers
Although we have a broad range of retail customers that includes many national chain, regional, specialty and local retail stores, our five largest customers account for a significant percentage of our sales, approximately 57% of total revenues for each of Fiscal 2013 and 2012, respectively. In addition, retail customers comprising the five largest accounts receivable balances represented 68% and 65% of total accounts receivable balances at December 31, 2013 and 2012, respectively. We extend credit to retail customers based upon an evaluation of their financial condition and credit history, and collateral is not generally required. If one or more of these large retail customers cannot pay, the write-off of their accounts receivable could have a material adverse effect on our operations and financial condition. The loss of sales to any one or more of these large retail customers would also have a material adverse effect on our financial condition, results of operations and cash flows.
 
Retail customer’s strategic business plans may negatively influence the distribution of our products to consumer.
Changes in our retail and distribution customers strategic business plans including, but not limited to, (i) expansions, mergers, and/or consolidations, (ii) retail shelf space allocations for products within each outlet and in particular the cough/cold category in which we compete, (iii) changes in their private label assortment and (iv) product selections, distribution allocation, merchandising programs and retail pricing of our products as well as competitive products could affect the consumer sales of our products and could result in a material adverse effect to our business and financial condition.
 
 
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Our future success depends on the continued sales of our principal product
For Fiscal 2013 and 2012, our cold remedy products, principally Cold-EEZE® Cold Remedy, represented approximately 94% and 95%, respectively, of our total sales. Accordingly, we depend on the continued acceptance of Cold-EEZE® Cold Remedy products by our customers. Our investments in and strategies used for our brand marketing are critical to achieve brand awareness with current consumers, educate potential new consumers and convert potential consumers into customers. However, there can be no assurance that Cold-EEZE® Cold Remedy products will continue to receive, maintain or increase market acceptance. The inability to successfully commercialize Cold-EEZE® Cold Remedy products in the future and/or expand its product line, for any reason, would have a material adverse effect on our financial condition, prospects and ability to continue operations.
 
Our products and potential new products are or may be subject to extensive governmental regulation
Our business is regulated by various agencies of the states and localities where our products are sold. Governmental regulations in foreign countries where we plan to commence or expand sales may prevent or delay entry into a market or prevent or delay the introduction, or require the reformulation of certain of our products. In addition, no prediction can be made as to whether new domestic or foreign legislation regulating our activities will be enacted. Any new legislation could have a material adverse effect on our business, financial condition and operations. Non-compliance with any applicable requirements may subject us or the manufacturers of our products to agency action, including warning letters, fines, product recalls, seizures and injunctions.
 
The manufacturing, processing, formulation, packaging, labeling and advertising of our cold remedy products are subject to regulation by several federal agencies, including (i) the FDA, (ii) the Federal Trade Commission (“FTC”), (iii) the Consumer Product Safety Commission, (iv) the United States Department of Agriculture, (v) the United States Postal Service, (vi) the United States Environmental Protection Agency and (vii) the United States Occupational Safety and Health Administration.
 
In addition to OTC and prescription drug products, the FDA regulates the safety, manufacturing, labeling and distribution of dietary supplements, including vitamins, minerals and herbs, food additives, food supplements, over-the-counter and prescription drugs and cosmetics. The FTC also has overlapping jurisdiction with the FDA to regulate the promotion and advertising of vitamins, over-the-counter drugs, cosmetics and foods. In addition, our cold remedy products are homeopathic remedies which are subject to standards established by the Homeopathic Pharmacopoeia of the United States (“HPUS”). HPUS sets the standards for source, composition and preparation of homeopathic remedies which are officially recognized under the Federal Food, Drug and Cosmetics Act, as amended.
 
Preclinical development, clinical trials, product manufacturing, labeling, distribution and marketing of potential new products are also subject to federal and state regulation in the United States and other countries. Clinical trials and product marketing and manufacturing are subject to the rigorous review and approval processes of the FDA and foreign regulatory authorities. To obtain approval of a new drug product, a company must demonstrate through adequate and well-controlled clinical trials that the drug product is safe and effective for its intended use. Obtaining FDA and other required regulatory approvals is lengthy and expensive. Typically, obtaining regulatory approval for pharmaceutical products requires substantial resources and takes several years. The length of this process depends on the type, complexity and novelty of the product and the nature of the disease or other indication to be treated. Preclinical studies must comply with FDA regulations. Clinical trials must also comply with FDA regulations to ensure safety of the human subjects in the trial and may require large numbers of test subjects, complex protocols and possibly lengthy follow-up periods. Consequently, satisfaction of government regulations may take several years: may cause delays in introducing potential new products for considerable periods of time and may require imposing costly procedures upon our activities. If regulatory approval of new products is not obtained in a timely manner or not at all, we could be materially adversely affected. Even if regulatory approval of new products is obtained, such approval may impose limitations on the indicated uses for which the products may be marketed which could also materially adversely affect our business, financial condition and future operations.
 
We have a history of losses and limited working capital
We have experienced net losses for each of the seven of the past eight fiscal years. In Fiscal 2013 we realized net income of $405,000. There can be no assurance that our strategic focus will result in any revenue growth or that we will be successful in initiating or acquiring any new lines of business, or that any such new lines of business will achieve profitability. As of December 31, 2013, we had working capital of approximately $6.7 million which we believe is an acceptable and adequate level of working capital to support our business. Our ability to fund working capital needs will depend on our ability to generate cash in the future.
 
 
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Our ability to use our net operating loss carryforwards to offset future taxable income may be subject to certain limitations
In general, under Section 382 of the Internal Revenue Code of 1986, as amended, or the Code, a corporation that undergoes an “ownership change” is subject to limitations on its ability to use its pre-change net operating loss carryforwards, or NOLs, to offset future taxable income. Future changes in our stock ownership, some of which are outside of our control, could result in an ownership change under Section 382 of the Code. Furthermore, our ability to use NOLs of companies that we may acquire in the future may be subject to limitations. For these reasons, we may not be able to use a material portion of the NOLs reflected on our balance sheet, even if we attain profitability.
 
Our success is dependent on key personnel
Our success depends, in part, upon the continued service of key personnel, such as Mr. Ted Karkus, Chairman and Chief Executive Officer, Mr. Robert V. Cuddihy, Jr., Chief Operating Officer and Chief Financial Officer, and certain managers and strategists within the Company. If we are unable to attract and retain such personnel, the loss of the services of any one of them could have a material adverse effect on us.
 
In order to be successful, we must retain and motivate executives and other key employees, including those in managerial, technical, marketing and health product positions. In particular, our product generation efforts depend on hiring and retaining qualified health and science professionals. Competition for skilled employees who can perform the services that we require is intense and hiring, training, motivating, retaining and managing employees with the skills required is time-consuming and expensive. If we are not be able to hire sufficient professional staff to support our operations, or to train, motivate, retain and manage the employees we do hire, it could have a material adverse effect on our business operations or financial results.
 
We are dependent on our manufacturing facility and suppliers for certain of our cold remedy products
Our manufacturing, warehousing and distribution center is located in Lebanon, Pennsylvania. In the event of a disruption of this facility, we would need to outsource to third parties, at least temporarily, our manufacturing, warehousing and distribution requirements. While such secondary sources have been identified for our products, if we are unable to find other sources or there were a delay in the ramp-up for the production and distribution operations for some of our products, it could have a material adverse effect on our operations.
 
Certain raw material active ingredients used in connection with the Cold-EEZE® products are purchased from a single unaffiliated supplier. Should the relationship terminate or the vendor become unable to supply material, we believe that current contingency plans would prevent such termination from materially affecting our operations, although there may be delays in production of our products until an acceptable replacement supplier is located.
 
Our inability to find alternative sources for some of our manufacturing and raw materials may have a material adverse effect on our operations and financial condition. In addition, the terms on which manufacturers and suppliers will make products and raw materials available to us could have a material effect on our success.
 
The manufacturing of OTC products and dietary supplements is subject to applicable current good manufacturing practice (“cGMP”) regulations and FDA inspections. We believe we are in substantial compliance with material provisions of the applicable cGMP regulations. Contract manufacturers are also subject to these same requirements and we require such compliance in our contractual relationships with such manufacturers. However, we cannot assure that the FDA will agree with our determination of compliance. If the FDA disagrees, it could, upon inspection of our facility, issue a notice of violations, referred to as a form FDA-483, or issue a Warning Letter, or both. If the FDA concludes that there is an imminent public health threat or if we fail to take timely corrective actions to the satisfaction of the FDA, the agency can initiate legal actions, such as seizure and injunction, which could include a recall order or the entry of a consent decree, or both. In addition, we could be subject to monetary penalties and even criminal prosecution for egregious conduct. The FDA could initiate similar legal actions against the contract manufacturer if it concludes its facility is not in compliance, which would affect the availability of our products. While secondary sources have been identified for our products, our inability to find other sources or a delay in the ramp-up for the production and distribution operations for some of its products may have a material adverse effect on our operations.
 
 
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We are uncertain as to whether we can protect our proprietary rights
The strength of our patent position and proprietary formulations and compounds may be important to our long-term success. We currently own numerous U.S. and foreign patents in connection with potential products; however there can be no assurance that these patents and proprietary formulations and compounds will effectively protect our products from duplication by others. In addition, we may not be able to afford the expense of any litigation which may be necessary to enforce our rights under any of the patents. Furthermore, there can be no assurance that third parties will not obtain access to or independently develop our technologies, know-how, ideas, concepts and documentation, which could have a material adverse effect on our financial condition.
 
Although we believe that current and future products do not and will not infringe upon the patents or violate the proprietary rights of others, if any of our current or future products do infringe upon the patents or proprietary rights of others, we may have to modify the products or obtain an additional license for the manufacture and/or sale of such products. We could also be prohibited from selling the infringing products. If we were found to infringe on the proprietary rights of others, it is uncertain whether we would be able to take corrective actions in a timely manner, upon acceptable terms and conditions, or at all, and the failure to do so could have a material adverse effect upon our business, financial condition and operations.
 
Our existing products and potential new products expose us to potential product liability claims
Our business results in exposure to an inherent risk of potential product liability claims, including claims for serious bodily injury or death caused by the sales of our existing products and the products which are being developed. These claims could lead to substantial damage awards. While we currently maintain product liability insurance, a successful claim brought against us in excess of, or outside of, existing insurance coverage could have a material adverse effect on our results of operations and financial condition. Claims against us, regardless of their merit or eventual outcome, may also have a material adverse effect on the consumer demand for our products.
 
We are involved in litigation matters and are a defendant in a stockholder derivative lawsuit filed by our former CEO
We are, from time-to-time, subject to various legal proceedings and claims, either asserted or unasserted. Any such claims, whether with or without merit, can be time-consuming and expensive to defend and can divert management's attention and resources. While management believes that we have adequate insurance coverage and, if applicable, accrued loss contingencies for all known matters, there is no assurance that the outcome of all current or future litigation will not have a material adverse effect on us.
 
A purported derivative lawsuit was filed against us, our officers and directors, as described under "Part I, Item 3, Legal Proceedings". We believe the lawsuit is without merit and we intend to engage in a vigorous defense of such litigation. If we are not successful in our defense of this litigation, we could be forced to make significant payments to or other settlements with our stockholders and their lawyers, and such payments or settlement arrangements could have a material adverse effect on our business, operating results or financial condition. Regardless of the outcome, the litigation could result in substantial costs and significant adverse impact on our reputation and divert management's attention and resources, which could have a material adverse effect on our business, operating results or financial condition. We also have certain obligations to indemnify our officers and directors and to advance expenses to such officers and directors. Although we have purchased liability insurance for our directors and officers, if our insurance carriers should deny coverage, or if the indemnification costs exceed the insurance coverage, we may be forced to bear some or all of these indemnification costs directly, which could be substantial and may have an adverse effect on our business, financial condition, results of operations and cash flows. If the cost of our liability insurance increases significantly, or if this insurance becomes unavailable, we may not be able to maintain or increase our levels of insurance coverage for our directors and officers, which could make it difficult to attract or retain qualified directors and officers.
 
A competing brand to Cold-EEZE® owns an Option to Acquire 1,453,427 of our shares of Common Stock from our former CEO, Guy Quigley, and acquired by proxy the voting rights of such shares
In May 2012, we received an expression of interest and a non-binding proposal to be acquired by Matrixx, a competitor of Cold-EEZE®. In September 2012, Matrixx purchased for $200,000 a three year option to acquire 1,453,427 shares of our Common Stock for $1.40 per share from Guy J. Quigley, our former Chairman and Chief Executive Officer. Matrixx also acquired from Mr. Quigley a voting proxy to vote the shares subject to the option.
 
In October 2012, we received a revised non-binding proposal, on essentially the same terms as Matrixx's earlier offer, except that in the latest proposal Matrixx raised the proposed price by $0.20 per share. At a meeting held on October 24, 2012, our board of directors unanimously rejected the October 2012 Matrixx proposal after careful consideration and consultation with its advisors. On February 5, 2013, Matrixx informed us that it has withdrawn its unsolicited offer to acquire us.
 
 
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Matrixx continues to hold its voting proxy and an option to purchase shares from Guy Quigley.  The Matrixx option to purchase shares expires in September 2015.  Circumstances may occur in which the interests of Matrixx could be in conflict with the interests of other shareholders. Accordingly, Matrixx’s ability to influence us through voting their shares may affect our other shareholders or the market price of our Common Stock may be adversely affected.
 
Certain Officers, Directors and former executives and their families own a substantial amount of our Common Stock
As of March 25, 2014, our executive officers and directors beneficially owned approximately 18.6% of our Common Stock and Mr. Guy J. Quigley, Mr. Quigley’s spouse and Matrixx beneficially owned, approximately 17.4% of our Common Stock. These individuals have significant influence over the outcome of all matters submitted to stockholders for approval, including the election of directors. Consequently, they exercise substantial influence over all major decisions including major corporate actions such as mergers and other business combinations transactions which could result in or prevent a change of control of the Company. Circumstances may occur in which the interests of these shareholders could be in conflict with the interests of other shareholders. Accordingly, a stockholder’s ability to influence us through voting their shares may be limited or the market price of our Common Stock may be adversely affected.
 
We incur significant costs as a result of operating as a public company, and our management devotes substantial time to new compliance initiatives
We have incurred and will continue to incur significant legal, accounting and other expenses as a public company, including costs resulting from public company reporting obligations under the Exchange Act and regulations regarding corporate governance practices. The listing requirements of The NASDAQ Global Market require that we satisfy certain corporate governance requirements relating to director independence, distributing annual and interim reports, stockholder meetings, approvals and voting, soliciting proxies, conflicts of interest and a code of conduct. Our management and other personnel will need to devote a substantial amount of time to all of these requirements. Moreover, the reporting requirements, rules and regulations will increase our legal and financial compliance costs and will make some activities more time-consuming and costly. These reporting requirements, rules and regulations, coupled with the increase in potential litigation exposure associated with being a public company, could make it more difficult for us to attract and retain qualified persons to serve on our board of directors or board committees or to serve as executive officers.
 
In addition, the Sarbanes-Oxley Act of 2002 (“Sarbanes-Oxley”) and the related rules of the Securities and Exchange Commission require that we maintain effective internal control over financial reporting and disclosure controls and procedures. During the course of our review and testing, we may identify deficiencies and be unable to remediate them before we must provide the required reports. We or our independent registered public accounting firm may not be able to conclude on an ongoing basis that we have effective internal control over financial reporting, which could harm our operating results, cause investors to lose confidence in our reported financial information and cause the trading price of our stock to fall.
 
Our compliance with Section 404 of Sarbanes-Oxley may require that we incur substantial expense and expend significant management time on compliance related issues. Moreover, if we are not able to comply with the requirements of Section 404 in a timely manner, or if we or our independent registered public accounting firm identify deficiencies in our internal control over financial reporting that are deemed to be material weaknesses, the market price of our stock would likely decline and we could be subject to sanctions or investigations by Nasdaq, the SEC or other regulatory authorities, which would require additional financial and management resources.
 
Our stock price is volatile
The market price of our Common Stock has experienced significant volatility. From January 1, 2013 to March 25, 2014, the trading prices of our stock have ranged from $1.40 to $2.98 per share. There are several factors which could affect the price of our Common Stock, including announcements of technological innovations for new commercial products by us or our competitors, developments concerning propriety rights, new or revised governmental regulation or general conditions in the market for our products. Sales of a substantial number of shares by existing stockholders could also have an adverse effect on the market price of our Common Stock.
 
 
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Future sales of shares of our Common Stock in the public market could adversely affect the trading price of shares of the Common Stock and our ability to raise funds in new stock offerings
Future sales of substantial amounts of shares of our Common Stock in the public market, or the perception that such sales are likely to occur, could affect prevailing trading prices of our Common Stock. As of March 25, 2014, we had 16,660,324 shares of Common Stock outstanding.
 
As of March 25, 2014, there are outstanding options, which are fully vested, to purchase an aggregate of 753,250 shares of our Common Stock at an average exercise price of $1.92 per share. If these options are exercised, and the holders of these options were to attempt to sell a substantial amount of their holdings at once, the market price of our Common Stock would likely decline. Moreover, the perceived risk of this potential dilution could cause stockholders to attempt to sell their shares and investors to “short” our stock, a practice in which an investor sells shares that he or she does not own at prevailing market prices, hoping to purchase shares later at a lower price to cover the sale. As each of these events would cause the number of shares of Common Stock being offered for sale to increase, our Common Stock’s market price would likely further decline. All of these events could combine to make it very difficult for us to sell equity or equity-related securities in the future at a time and price that we deem appropriate.
 
Our Common Stock may be delisted from The NASDAQ Global Market, which would adversely affect the price and liquidity of our Common Stock
Our Common Stock is currently listed on The NASDAQ Global Market. If our Common Stock is delisted, it could reduce the price of our Common Stock and the levels of liquidity available to our stockholders. In addition, the delisting of our Common Stock could materially adversely affect our access to the capital markets, and any limitation on liquidity or reduction in the price of our Common Stock could materially adversely affect our ability to raise capital on terms acceptable to us or at all. Delisting from The NASDAQ Global Market could also result in other negative implications, including the potential loss of confidence by suppliers, customers and employees, the loss of institutional investor interest and fewer business development opportunities.
 
If securities or industry analysts do not publish research or reports about our business or if they issue an adverse or misleading opinion regarding our stock, our stock price and trading volume could decline
The trading market for our Common Stock will be influenced by the research and reports that industry or securities analysts publish about us or our business. If any of the analysts who cover us issue an adverse or misleading opinion regarding us, our business model, products or stock performance, our stock price would likely decline. If one or more of these analysts cease coverage of us or fail to publish reports on us regularly, we could lose visibility in the financial markets, which in turn could cause our stock price or trading volume to decline. Moreover, the unpredictability of our financial results likely reduces the certainty, and therefore reliability, of the forecasts by securities or industry analysts of our future financial results, adding to the potential volatility of our stock price.
 
We do not intend to pay cash dividends in the foreseeable future
We have not paid cash dividends on our Common Stock since our inception. Our intention is to retain earnings, if any, for use in the business and we do not anticipate paying any cash dividends to stockholders in the foreseeable future.
 
Our Articles of Incorporation and By-laws contain certain provisions that may be barriers to a takeover
Our Articles of Incorporation and By-laws contain certain provisions which may deter, discourage, or make it difficult for another person or entity to gain control of the Company through a tender offer, merger, proxy contest or similar transaction or series of transactions.  These provisions may deter a future tender offer or other takeover attempt which could include a premium over the market price of our Common Stock at the time.  Such provisions could depress the trading price of our Common Stock
 
We have agreed to indemnify our Officers and Directors from liability
In accordance with sections 78.7502 and 78.751 of the Nevada General Corporation Law our Articles of Incorporation provide that we will indemnify any person who is or was made a party to, or is or was threatened to be made a party to, any pending, completed, or threatened action, suit or proceeding because he or she is or was a director, officer, employee or agent of the Company or is or was serving at the Company’s request as a director, officer, employee or agent of any corporation, partnership, joint venture, trust or other enterprise. These provisions permit us to advance expenses to an indemnified party in connection with defending any such proceeding, upon receipt of an undertaking by the indemnified party to repay those amounts if it is later determined that the party is not entitled to indemnification. In August 2009, we entered into indemnity agreements with each member of our board of directors and Mr. Cuddihy. These agreements provide, among other things, that we will indemnify each officer and director in the event they become a party or otherwise a participant in any action or proceeding on account of their service as a director or officer of the Company (or service for another corporation or entity in any capacity at the request of the Company) to the fullest extent permitted by applicable law. These indemnity provisions may reduce the likelihood of derivative litigation against directors and officers and discourage or deter stockholders from suing directors or officers for breaches of their duties to the Company, even though such an action, if successful, might otherwise benefit the Company or its stockholders. In addition, to the extent that we expend funds to indemnify directors and officers, funds will be unavailable for operational purposes.
 
 
- 16 -

 
Item 1B. Unresolved Staff Comments
 
Not applicable.
 
Item 2. Properties
 
Our corporate headquarters is located in Doylestown, Pennsylvania.  We purchased this property in 1998.  Our headquarters is approximately 13,000 square feet and is comprised of office space and a storage area.  Our principal manufacturing facility is located in Lebanon, Pennsylvania.  The facility was purchased in October 2004.  The facility has a total area of approximately 57,500 square feet, comprised of manufacturing, warehousing and office space.   We believe that our existing facilities are adequate at this time and do not anticipate the need for additional facilities in the foreseeable future.
 
Item 3.                     Legal Proceedings
 
PROPHASE LABS, INC.(formerly THE QUIGLEY CORPORATION) vs. Guy Quigley, Gary Quigley, Scanda Systems Limited, Scanda Systems LTD, Chilesha Holdings LTD, Kevin Brogan, Innerlight Holdings, Inc., George Longo, Graham Brandon AND Pacific Rim Pharmaceuticals LTD
On August 23, 2010, we initiated an action in the Court of Common Pleas of Bucks County, Pennsylvania Civil Action No. 2010-08227. This action is against certain former officers and directors of the Company, including a shareholder that beneficially owns approximately 17.4% of our Common Stock, and against certain third parties. The Company has asserted claims arising from, among other things, a variety of transactions and payments previously made or entered into by the Company. All of the transactions and events that are the subject of this litigation occurred prior to June 2009 and the installation of the current board of directors. We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going at this time and a date certain for trial has been ordered for June 9, 2014. At this time, no prediction as to the outcome of this action can be made.
 
GUY QUIGLEY VS. TED KARKUS, ROBERT V. CUDDIHY, JR., MARK BURNETT, MARK LEVENTHAL, MARK FRANK, LOUIS GLECKEL, MD, JAMES McCUBBIN AND PROPHASE LABS, INC. AS A NOMINAL DEFENDANT
We were named as a nominal defendant in a purported derivative complaint filed on February 2, 2012 by stockholder and former director and Chief Executive Officer Guy Quigley in the Court of Common Pleas of Philadelphia County, Pennsylvania (No. 111200409). The complaint also names as a defendant each of our directors and executive officers. Among other things, the suit alleges various breaches of fiduciary and other duties, and seeks recovery of unspecified damages and other relief. Prior to filing this complaint, the plaintiff applied to the same court for permission to take pre-complaint discovery on the basis that the plaintiff required such discovery in order to assert claims. The court denied the plaintiff's request. We believe the lawsuit is without merit and intend to vigorously defend against it. On April 5, 2013, the court entered an order allowing limited pre-trial discovery limited to demand futility and plaintiff adequacy issues, which was completed by July 12, 2013. We filed a motion to dismiss on July 26, 2013 on demand futility and plaintiff adequacy issues. On August 26, 2013 the court heard oral arguments regarding the Company’s motion for summary judgment and dismissal with prejudice.  The court stayed any additional discovery until the court rules on our motion to dismiss with and our motion is currently pending with the court. At this time, no prediction as to the outcome of this action can be made.
 
As noted above, we previously commenced litigation against the plaintiff, Guy Quigley, and other parties in August 2010 in the Bucks County Court of Common Pleas, Pennsylvania (No. 2010-08227). The August 2010 action remains pending.
 
 
- 17 -

 
PROPHASE LABS, INC.(formerly THE QUIGLEY CORPORATION) vs. Guy Quigley, KARIBA HOLDINGS, LIMITED, WENDY QUIGLEY, Gary Quigley, FRANCES QUIGLEY (A/K/A FRANCES BOSTON) AND JOSEPHINE QUIGLEY (A/K/A JOSEPHINE GLEESON)
On July 19, 2012, we initiated an action in the Court of Common Pleas of Bucks County, Pennsylvania (“Kariba Complaint”) (No. 2011-09815). The Kariba Complaint names as defendants (i) a former officer and director of the Company, who is a shareholder that beneficially owns approximately 17.4% of our Common Stock, (ii) certain family members of such former officer and director, some of whom are former employees of the Company, and (iii) certain third parties.  The Company has asserted claims arising from, among other things, a variety of transactions and payments previously made or entered into by the Company.  The Kariba Complaint asserts additional claims not previously asserted in the action  ProPhase Labs, Inc. (formerly The  Quigley Corporation) vs. Guy Quigley, Gary Quigley, Scanda Systems Limited, Scanda Systems LTD, Chilesha Holdings LTD, Kevin Brogan, Innerlight Holdings, Inc., George Longo, Graham Brandon, Pacific Rim Pharmaceuticals LTD and John Doe Defendants (No. 2010-08227).  All of the transactions and events that are the subject of the Kariba Complaint occurred prior to June 2009 and the installation of the current board of directors.  We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going and at this time, no prediction as to the outcome of this action can be made.
 
GARY QUIGLEY VS. EAST BAY MANAGEMENT, INC., TED KARKUS AND JOHN DOE 1
East Bay Management, Inc., Ted Karkus and John Doe 1 were named as defendants in a purported complaint filed on June 10, 2013 by Gary Quigley, the brother of our stockholder and former director and Chief Executive Officer Guy Quigley, in the Court of Common Pleas of Philadelphia County, Pennsylvania (No. 2013-04393). The suit alleges five causes of action against the defendants, including the Company’s Chief Executive Officer, for (i) fraud, (ii) conversion, (iii) unjust enrichment, (iv) conspiracy and (v) piercing the corporate veil.  On July 10, 2013, Mr. Karkus removed the case to the United States District Court for Eastern Pennsylvania.  On August 16, 2013, Mr. Karkus filed a Motion to Dismiss for Failure to State a Claim.  Mr. Gary Quigley responded to the motion to dismiss.   On January 7, 2014, the court heard oral arguments regarding the motion to dismiss.  The court stayed any additional discovery until the court rules on the motion to dismiss and the motion is currently pending with the court.  At this time, no prediction as to the outcome of this action can be made.
 
On January 15, 2014, our Board of Directors, without the presence of Ted Karkus, voted to indemnify Mr. Karkus and pay the expenses incurred by him in connection with this legal matter.  This action has been and will continue to be vigorously defended by Mr. Karkus, who denies any wrongdoing.
 
THE ESTATE OF JOSEPHINE QUIGLEY AND KARIBA HOLDINGS LIMITED VS. EAST BAY MANAGEMENT, INC., TED KARKUS, SCOTT STRADY AND JOHN DOE
East Bay Management, Inc., Ted Karkus, Scott Strady and John Doe were named as defendants in a purported complaint filed on August 9, 2013 by the Estate of Josephine Quigley, the mother of our stockholder and former director and Chief Executive Officer Guy Quigley, and Kariba Holdings Limited (see Kariba Compliant above) in the Court of Common Pleas of Philadelphia County, Pennsylvania (No. 2013-006131). Guy Quigley, our stockholder, former director and Chief Executive Officer of the Company, filed this suite as Executor of the Estate of Josephine Quigley and as a representative of Kariba Holdings.  The suit alleges five causes of action against the defendants, including the Company’s Chief Executive Officer, for (i) fraud, (ii) conversion, (iii) unjust enrichment, (iv) conspiracy and (v) piercing the corporate veil.  On September 23, 2013, Mr. Karkus removed the case to the United States District Court for Eastern Pennsylvania.  On September 23, 2013, Mr. Karkus filed a Motion to Dismiss for Failure to State a Claim.  The Estate of Josephine Quigley and Kariba Holdings Limited responded to the motion to dismiss. On January 7, 2014, the court heard oral arguments regarding the motion to dismiss.  The court stayed any additional discovery until the court rules on the motion to dismiss and the motion is currently pending with the court.  At this time, no prediction as to the outcome of this action can be made.
 
On January 15, 2014, our Board of Directors, without the presence of Ted Karkus, voted to indemnify Mr. Karkus and pay the expenses incurred by him in connection with this legal matter.  This action has been and will continue to be vigorously defended by Mr. Karkus, who denies any wrongdoing.
 
 
Other Litigation
In the normal course of our business, we are named as defendant in legal proceedings. It is our policy to vigorously defend litigation and/or enter into settlements of claims where management deems appropriate.
 
Item 4. Mine Safety Disclosures
 
Not applicable.
 
 
- 18 -

 
PART II
 
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
 
Market Information
 
Our Common Stock is currently traded on The NASDAQ Global Market under the trading symbol “PRPH.” The price set forth in the following table represents the high and low bid prices for our Common Stock for each quarter of the Fiscal 2013 and 2012, as reported on The NASDAQ Global Market.
 
Common Stock
 
 
 
2013
 
2012
 
Quarter Ended
 
High
 
Low
 
High
 
Low
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
March 31,
 
$
2.25
 
$
1.40
 
$
1.22
 
$
0.90
 
June 30,
 
$
1.72
 
$
1.42
 
$
1.14
 
$
0.65
 
September 30,
 
$
2.25
 
$
1.42
 
$
1.44
 
$
1.00
 
December 31,
 
$
2.31
 
$
1.52
 
$
1.68
 
$
1.24
 
 
Holders
As of March 17, 2014, there were approximately 249 holders of record of our Common Stock, including brokerage firms, clearing houses, and/or depository firms holding the Company’s securities for their respective clients. The exact number of beneficial owners of our securities is not known but exceeds 400.
 
Dividends
We have not declared, nor paid any cash dividends on our Common Stock since our Company’s inception. At this time, we intend to retain our earnings to finance future growth and maintain liquidity. Future cash dividends, if any, will be at the discretion of our Board of Directors and will depend upon, among other things, our future operations and earnings, capital requirements, general financial condition, contractual and financing restrictions and such other factors as our Board of Directors may deem relevant.
 
Warrants and Options
In addition to our outstanding Common Stock, there were reserved for issuance 753,250 shares of our Common Stock underlying outstanding unexercised and vested options as of December 31, 2013 at the price-per-share stated and expiration date indicated, as follows:
 
Description
 
Number of 
Options
 
Exercise 
Price
 
Expiration Date
 
 
 
 
 
 
 
 
 
 
Option Plan
 
40,500
 
$
9.50
 
October 26, 2014
 
Option Plan
 
26,500
 
$
13.80
 
December 11, 2015
 
Option Plan
 
590,000
 
$
1.00
 
December 14, 2017
 
Option Plan
 
25,000
 
$
1.08
 
May 28, 2018
 
Option Plan
 
10,000
 
$
0.87
 
November 5, 2018
 
Option Plan
 
50,000
 
$
1.17
 
December 18, 2018
 
Option Plan
 
7,500
 
$
1.36
 
December 20, 2019
 
Option Plan
 
3,750
 
$
1.48
 
April 9, 2020
 
Total
 
753,250
 
 
 
 
 
 
 
 
- 19 -

 
Securities Authorized Under Equity Compensation
 
The following table sets forth certain information regarding stock option and warrant grants made to employees, directors and consultants:
 

SECURITIES AUTHORIZED FOR ISSUANCE UNDER EQUITY COMPENSATION PLANS

 
 
 
Number of
 
 
 
 
Number of Securities
 
 
 
Securities to be
 
Weighted
 
Remaining Available for
 
 
 
Issued Upon
 
Average
 
Future Issuance Under Equity
 
 
 
Exercise of
 
Exercise Price
 
Compensation Plans
 
 
 
Outstanding
 
of Outstanding
 
(Excluding Securities
 
 
 
Options
 
Options
 
Reflected in Column A)
 
Plan Category
 
(A)
 
(B)
 
( C )
 
 
 
 
 
 
 
 
 
 
Equity Plans Approved by Security Holders (1,2,3)
 
1,637,500
 
$
1.60
 
438,294
 
 
(1)  An incentive stock option plan was instituted in Fiscal 1997 (the “1997 Plan”) and approved by the stockholders in Fiscal 1998. Options pursuant to the 1997 Plan have been granted to directors, executive officers and employees. At December 31, 2013, we are precluded from issuing any additional options or grants in the future under the 1997 Plan pursuant to the terms of the plan document. An aggregate of 67,000 stock options previously granted pursuant to the terms of the 1997 Plan remain available for exercise at any time prior to such options’ respective expiration dates.
 
(2)  On May 5, 2010, our shareholders approved the 2010 Equity Compensation Plan, which was subsequently amended, restated and approved by shareholders on April 24, 2011 and further amended and approved by our shareholders on May 6, 2013 (the “2010 Plan”). The 2010 Plan provides that the total number of shares of Common Stock that may be issued is equal to 1.6 million shares plus up to 900,000 shares that were authorized for issuance but unissued under the 1997 Plan, an aggregate of 2.5 million shares. All of our employees, including employees who are officers or members of the Board are eligible to participate in the 2010 Plan. Consultants and advisors who perform services for us are also eligible to participate in the 2010 Plan. At December 31, 2013, we have outstanding 1,570,500 stock options, subject to vesting, under the 2010 Plan. For the year ended December 31, 2013, we charged to operations $160,000 for compensation expense for the fair value of the vested portion of the stock options (see Note 6 to Notes to Consolidated Financial Statements). At December 31, 2013, there are 262,159 shares of Common Stock that may be issued in the future pursuant to the 2010 Plan.
 
(3)  On May 5, 2010, our shareholders approved the 2010 Directors’ Equity Compensation Plan which was subsequently amended and approved by our shareholders on May 6, 2013. The 2010 Directors’ Equity Compensation Plan provides that the total number of shares of Common Stock that may be issued under the 2010 Directors’ Equity Compensation Plan is equal to 425,000. For the year ended December 31, 2013, 16,470 shares of our Common Stock were granted. At December 31, 2013, there are 176,135 shares of Common Stock that may be issued pursuant to the 2010 Directors Equity Compensation Plan.
 
Equity Line of Credit
On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the “Equity Line”) with Dutchess whereby Dutchess committed to purchase, subject to certain restrictions and conditions, up to 2,500,000 shares of our Common Stock, over a period of 36 months from the first trading day following the effectiveness of the registration statement registering the resale of shares purchased by Dutchess pursuant to the Equity Line. On November 26, 2012, we filed a registration statement with the SEC to register for sale for up to 2,500,000 shares of our Common Stock and the registration statement was deemed effective by the SEC on December 12, 2012.
 
We may draw on the facility from time to time, as and when we determine appropriate in accordance with the terms and conditions of the Equity Line. The maximum amount that we are entitled to put to Dutchess in any one draw down notice is the greater of (i) 500% of the average daily volume of our Common Stock traded on the NASDAQ Global Market for the one (1) trading day prior to the date of delivery of the applicable draw down notice, multiplied by the closing price for such trading day, or (ii) $250,000.
 
The purchase price under the Equity Line is set at ninety-five percent (95%) of the lowest daily volume weighted average price (VWAP) of our Common Stock during the five (5) consecutive trading day period beginning on the date of delivery of the applicable draw down notice. We have the right to withdraw all or any portion of any put, except that portion of the put that has already been sold to a third party, including any portion of a put that is below the minimum acceptable price set forth on the put notice, before the closing. In the event Dutchess receives more than a five percent (5%) return on the net sales for a specific put, Dutchess must remit such excess proceeds to us; however, in the event Dutchess receives less than a five percent (5%) return on the net sales for a specific put Dutchess has the right to use any such excess proceeds to off-set against the aggregated deficit proceeds.
 
 
- 20 -

 
There are put restrictions applied on days between the draw down notice date and the closing date with respect to that particular put. During such time, we are not allowed to deliver another draw down notice. In addition, Dutchess is not obligated to purchase shares if its total number of shares beneficially held at that time would exceed 9.99% of the number of shares of our Common Stock as determined in accordance with Rule 13d-1(j) of the Securities Exchange Act. In addition, we are not permitted to draw on the facility unless there is an effective registration statement to cover the resale of the shares.
 
In Fiscal 2013, we sold an aggregate of 289,474 shares of Common Stock to Dutchess in which we derived approximately $444,000 in net proceeds. In Fiscal 2012, we sold an aggregate of 883,722 shares of Common Stock to Dutchess under and pursuant to the Equity Line in which we derived approximately net proceeds of $1.1 million. The sales of the shares under the Equity Line were deemed to be exempt from registration under the Securities Act in reliance upon Section 4(2) (or Regulation D promulgated thereunder).
 
During the period January 1, 2014 through to February 25, 2014, we sold an aggregate of 559,318 shares of Common Stock to Dutchess under and pursuant to the Equity Line and derived net proceeds of approximately $947,000. At March 25, 2014, we have 767,486 shares of our Common Stock available for sale, at our discretion, under the terms of the Equity Line and covered pursuant to a registration statement.
 
Other Stock Issuances
 
Pursuant to the terms of Mr. Cuddihy’s prior employment agreement dated August 19, 2009, Mr. Cuddihy received an annual grant of shares of Common Stock equal to $50,000, payable quarterly, promptly following the close of each quarter. The value of the shares is calculated based on the average closing price of our shares for the last five (5) trading days of the quarter in which the shares are earned. For the year ended December 31, 2012, Mr. Cuddihy was issued an aggregate of 10,757 shares earned in Fiscal 2011 pursuant to the terms of his employment agreement.
 
 
- 21 -

 
Item 6. Selected Financial Data
 
The following table sets forth the selected financial data appearing in or derived from our consolidated financial statements for and at the end of the years ended December 31, 2013, 2012, 2011 2010 and 2009. The selected financial data should be read in conjunction with the consolidated financial statements appearing elsewhere herein, and with Item 7 – Management’s Discussion and Analysis of Financial Condition and Results of Operations (in thousands, except per share amounts):
 
 
 
Year Ended December 31,
 
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
Statement of Income Data:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net sales
 
$
25,032
 
$
22,406
 
$
17,453
 
$
14,502
 
$
19,816
 
Gross profit
 
$
16,671
 
$
14,252
 
$
11,282
 
$
8,830
 
$
11,569
 
Income (loss) from operations
 
$
405
 
$
(1,091)
 
$
(2,710)
 
$
(3,501)
 
$
(3,842)
 
Net income (loss)
 
$
405
 
$
(1,091)
 
$
(2,710)
 
$
(3,501)
 
$
(3,842)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic income (loss) per share
 
$
0.03
 
$
(0.07)
 
$
(0.18)
 
$
(0.25)
 
$
(0.30)
 
Diluted income (loss) per share
 
$
0.03
 
$
(0.07)
 
$
(0.18)
 
$
(0.25)
 
$
(0.30)
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average shares outstanding:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Basic
 
 
15,839
 
 
14,843
 
 
14,817
 
 
14,285
 
 
12,963
 
Diluted
 
 
16,276
 
 
14,843
 
 
14,817
 
 
14,285
 
 
12,963
 
 
 
 
As of December 31,
 
 
 
2013
 
2012
 
2011
 
2010
 
2009
 
Balance Sheet Data:
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Working capital
 
$
6,655
 
$
5,809
 
$
5,342
 
$
7,521
 
$
11,475
 
Total assets
 
$
17,420
 
$
16,661
 
$
19,079
 
$
21,695
 
$
21,330
 
Other long term obligations
 
$
200
 
$
300
 
$
-
 
$
-
 
$
-
 
Stockholders’ equity
 
$
12,596
 
$
11,451
 
$
11,226
 
$
13,460
 
$
14,059
 
 
 
- 22 -

 
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
 
Our Business.  We are a manufacturer, marketer and distributor of a diversified range of homeopathic and health products that are offered to the general public.  We are also engaged in the research and development of potential natural based health products along with supplement and cosmeceutical products. 
 
Our primary business is the manufacture, distribution, marketing and sale of over-the-counter (“OTC”) cold remedy products to consumers through national chain, regional, specialty and local retail stores.  One flagship brand is Cold-EEZEÒ  Cold Remedy and our principal product is Cold-EEZEÒ Cold Remedy zinc gluconate lozenges, proven in clinical studies to reduce the duration of the common cold by 42%.  Cold-EEZEÒ Cold Remedy is an established product in the health care and cold remedy market.  For Fiscal 2013, 2012 and 2011, our revenues from continuing operations have come principally from our OTC cold remedy products.
 
Recent Events
Revenue Growth
We have implemented a business and marketing strategy designed to deliver results to our stockholders over the long term.  This multi-phase strategy was implemented during the 2010-2011 Cold Season.  Generally, a cold season is defined as the period of September to March (“Cold Season”) when the incidence of the common cold rises as a consequence of the change in weather and other factors.  
 
Our strategic initiatives include preserving the Cold-EEZE® Cold Remedy brand, repositioning the Cold-EEZE® Cold Remedy brand for growth and then leveraging the Cold-EEZE® Cold Remedy brand.  We believe that by investing in our Cold-EEZE® Cold Remedy brand, we are building our distribution platform and pipeline.  We have made important investments in new product development, consumer and healthcare professional education and consumer and retail-based marketing.  Each of these strategic components, when aggregated, have led to securing increased shelf space with our retailers and have provided us with the opportunity to introduce new and improved products, including the national launch of two additional cold remedy products for the 2013-2014 Cold Season: Cold-EEZE® Cold Remedy Plus Immune Support QuickMelts® and Cold-EEZE® Cold Remedy Plus Immune Support + Energy QuickMelts®.
 
Through our strategic initiatives, we have grown our net sales and generated net income for Fiscal 2013. Our net sales increased 11.7% in Fiscal 2013 as compared to net sales in Fiscal 2012.  In addition, we generated net income of $405,000, or $0.03 per share, in Fiscal 2013 as compared to a net loss of $1.1 million, or ($0.07) per share, for Fiscal 2012.  Our net sales growth is incremental to the net sales growth of 28.4% achieved in Fiscal 2012 as compared to Fiscal 2011.  We have increased our net sales an aggregate of 43.4% in Fiscal 2013 as compared to Fiscal 2011 and we have returned to profitability.
 
Phusion Laboratories, LLC, Joint Venture
On March 22, 2010, we, Phosphagenics Limited (“PSI Parent”), an Australian corporation, Phosphagenics Inc. (“PSI”), a Delaware corporation and subsidiary of PSI Parent, and Phusion Laboratories, LLC (the “Joint Venture”), a Delaware limited liability company, entered into a Limited Liability Company Agreement (the “LLC Agreement”) of the Joint Venture and additional related agreements for the purpose of developing and commercializing, for worldwide distribution and sale, a wide range of non-prescription remedies using PSI Parent’s proprietary patented TPM™ technology (“TPM”).  TPM facilitates the delivery and depth of penetration of active molecules in pharmaceutical, nutraceutical, and other products. Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture. 
 
Due to multiple factors affecting our capital position, including (i) the $2.1 million payment we made in December 2012 under the Settlement Agreement and Mutual General Release (the “Settlement Agreement”) between the Company and John C. Godfrey, the Estate of Nancy Jane Godfrey and Godfrey Science and Design (together the “Godfreys”) (see Note 5 to Notes to Consolidated Financial Statements) and (ii) some of the product market research performed, we expect to modify the Joint Venture’s product development plans to stagger and/or defer into future periods certain product development initiatives due to the pre-commercialization investments required.  We expect to continue pre-commercialization research and product development initiatives during the latter half of Fiscal 2014.  Furthermore, we do not expect that the Joint Venture will derive any meaningful revenues, if any, until its commercialization efforts are completed which is not expected to occur until at the earliest the latter half of Fiscal 2014 or Fiscal 2015.
 
 
- 23 -

 
Income Taxes
 
As of December 31, 2013, we have net operating loss carry-forwards of approximately $34.7 million for federal purposes that will expire beginning in Fiscal 2020 through 2032.  Additionally, there are net operating loss carry-forwards of $20.1 million for state purposes that will expire beginning in Fiscal 2018 through 2032.  Until sufficient taxable income to offset the temporary timing differences attributable to operations, and the tax deductions attributable to option, warrant and stock activities are assured, a valuation allowance equaling the total deferred tax asset is being provided.  As a consequence of the accumulated losses of the Company, we believe that this allowance is required due to the uncertainty of realizing these tax benefits in the future.
 
Seasonality of the Business
 
Our sales are derived principally from our OTC cold remedy products.  A significant portion of our business is highly seasonal, which causes major variations in operating results from quarter to quarter.  The third and fourth quarters generally represent the largest sales volume for our OTC cold remedy products with a corresponding increase in marketing and advertising expenditures designed to promote our products during the Cold Season.  In addition, our sales are influenced by and subject to fluctuations in the timing of purchase and the ultimate level of demand for our products which are a function of the timing, length and severity of each cold season.  We track health and wellness trends and develop retail promotional strategies to align our production scheduling, inventory management and marketing programs to optimize consumer purchases. 
 
Results of Operations
 
Fiscal 2013 compared with Fiscal 2012
Net sales for Fiscal 2013 increased $2.6 million, or 11.7%, to $25.0 million as compared to $22.4 million for Fiscal 2012.  The increase in net sales is principally due to (i) an increase in our retail customers’ purchases in the first and fourth quarter of Fiscal 2013, as compared to the same periods in Fiscal 2012, in an effort by retailers to maintain adequate shelf and warehouse stock during peak seasonal demand to meet an increase in consumer demand at retail of our OTC cold remedy products, (ii) sales of our Cold-EEZE® Cold Remedy Daytime/Nighttime QuickMelts®, launched in July 2012 and Cold-EEZE® Cold Remedy Oral Spray initially launched in August 2011, and (iii) sales of our Cold-EEZE® Cold Remedy Plus Immune Support + Energy QuickMelts® and Cold-EEZE® Cold Remedy Plus Immune Support QuickMelts® launched in July 2013.  In addition, net sales of our contract manufacturing operations increased $568,000 in Fiscal 2013 to $1.8 million as compared to $1.3 million in Fiscal 2012 due to fluctuations in contract manufacturing orders from non-related third party entities to produce lozenge-based products. 
 
Industry data is suggesting that the incidence of upper respiratory disorders for Fiscal 2013 were on average comparable to the incidence levels in Fiscal 2012.  However, within each fiscal period, the incidence of upper respiratory disorders trended significantly higher the first quarter of Fiscal 2013, an increase of approximately 13%, as compared to first quarter of Fiscal 2012, where as the fourth quarter of Fiscal 2013 trended down approximately 11% as compared to the fourth quarter of Fiscal 2012.  Although the average incidence of upper respiratory disorders, on average remained stable from year to year, we believe that we have increased our net sales through, among other initiatives, increased investments in our sales, marketing, advertising, consumer communication and promotion of our flagship brand, Cold-EEZE® Cold Remedy.   In addition, we support our Cold-EEZE® Cold Remedy products through traditional techniques such as in-store promotion, media advertising and other programs.  We compete for market share with new products entering the category and face retailer initiatives that attempt to reduce the number of products they carry on shelf within the cold and flu category. 
 
Cost of sales increased $207,000 for Fiscal 2013 to $8.4 million as compared to $8.2 million for Fiscal 2012.  The increase in cost of sales is principally due to our increased sales from period to period. We realized gross margins of 66.6% for Fiscal 2013, as compared to 63.6% in Fiscal 2012, an increase of 3.0%. The increase of 3.0% in gross margin is principally due to fluctuations in our product mix shipped from period to period and the improved absorption of fixed production costs.  Gross margins are principally influenced by fluctuations in quarter-to-quarter production volume, fixed production costs and related overhead absorption, raw ingredient costs, inventory mark to market write-downs, if any, retail cooperative incentive promotion and the timing of shipments to customers which are factors of the seasonality of our sales activities and products. 
 
 
- 24 -

 
 Sales and marketing expense for Fiscal 2013 increased $592,000 to $9.5 million as compared to $8.9 million for Fiscal 2012.  The increase in sales and marketing expense for Fiscal 2013 as compared to Fiscal 2012 was principally due to an increase in advertising expenditures as we expanded the scope and timing of our media and product promotion advertising campaigns from period to period. We continue to make significant, strategic marketing investments in an effort to build and grow the sales of our OTC cold remedy products. 
 
General and administrative (“G&A”) expenses decreased $234,000 for Fiscal 2013 to $5.9 million as compared to $6.1 million in Fiscal 2012.  The decrease in G&A expense for Fiscal 2013 as compared to Fiscal 2012 was primarily due to a decrease in personnel expenses and professional fees.
 
Research and development costs for Fiscal 2013 and 2012 were $824,000 and $1.3 million, respectively. The decrease of $477,000 in research and development costs for Fiscal 2013 as compared to Fiscal 2012 was principally due a decrease in the scope, timing, cost and amount of research and development activity from period to period.  In February 2013, we introduced to the retail trade two new products, Cold-EEZE® Cold Remedy Plus Immune Support + Energy QuickMelts® and Cold-EEZE® Cold Remedy Plus Immune Support QuickMelts® which began shipping to our retailer customers in July 2013.  Additionally, we continue to engage in other research and development activities that we determine are appropriate and we may increase our research and development activities in future periods.
 
In Fiscal 2012 as a result of the Settlement Agreement, we realized $1.0 million benefit as a consequence of a reduction of the previously recorded accrued royalties and commission obligation of $3.5 million.  Under the Settlement Agreement, the Godfreys assigned, transferred and conveyed to us all of their right, title, and interest in U.S. Trademark Registration No. 1,838,542 for the trademark Cold-EEZE®, among other intellectual property associated with such trademark.
 
Interest and other income for Fiscal 2013 was $2,000 as compared to $7,000 for Fiscal 2012.  The decrease of $5,000 for Fiscal 2013 as compared to Fiscal 2012 was principally the result of decreased bank balances during Fiscal 2013 and lower interest rates.  Interest expense for Fiscal 2013 was $13,000 as compared to zero for Fiscal 2012 as a consequence of interest paid pursuant to the terms of the Settlement Agreement consummated in December 2012.
 
As noted above, we have net operating loss carry-forwards for both federal and certain states.  As a consequence of these loss carry-forwards, we did not incur income tax expense for Fiscal 2013 or Fiscal 2012.
 
As a consequence of the effects of the above, the net income for Fiscal 2013, was $405,000, or $0.03 per share, as compared to a net loss of $1.1 million, or ($0.07) per share, for Fiscal 2012.
 
Fiscal 2012 compared with Fiscal 2011
Net sales for Fiscal 2012 increased $4.9 million, or 28.4%, to $22.4 million as compared to $17.5 million for Fiscal 2011.  The increase in net sales is principally due to (i) an increase in our retail customers’ purchases in the first and fourth quarter of Fiscal 2012, as compared to the same periods in Fiscal 2011, in an effort by those retailers to maintain adequate shelf and warehouse stock during peak seasonal demand to meet an increase in consumer demand at retail of our OTC cold remedy products, (ii) sales of our Cold-EEZE® Cold Remedy Daytime/Nighttime QuickMelts®, a new product launched in July 2012 and Cold-EEZE® Cold Remedy Oral Spray initially launched in August 2011 and expanded its distribution in Fiscal 2012.  In addition, our net sales of our contract manufacturing operations increased $455,000 in Fiscal 2012 to $1.3 million as compared to $856,000 in Fiscal 2011 due to fluctuations in contract manufacturing orders from non-related third party entities to produce lozenge-based products. 
 
Industry data is suggesting that the incidence of upper respiratory disorders for Fiscal 2012 were on average 3% below the incidence levels in Fiscal 2011.  Although the average incidence of upper respiratory declined during Fiscal 2012, we believe that we have increased our net sales through, among other initiatives, increased investments in our sales, marketing, advertising, consumer communication and promotion of our flagship brand, Cold-EEZE® Cold Remedy    In addition, we support our Cold-EEZE® Cold Remedy products through traditional techniques such as in-store promotion, media advertising and other programs.  We compete for market share with new products entering the category and face retailer initiatives that attempt to reduce the number of products they carry on shelf within the cold and flu category. 
 
 
- 25 -

 
Cost of sales increased $2.0 million for Fiscal 2012 to $8.2 million as compared to $6.2 million for Fiscal 2011.  The increase in cost of sales is principally due to our increased sales from period to period. We realized gross margins of 63.6% for Fiscal 2012, as compared to 64.6% in Fiscal 2011, a decrease of 1.0%.  Our gross margin reflects the net effect of (i) an increase in the absorption rate of fixed production overhead costs as a percentage of revenues as a consequence of increased shipments to retailers, offset by (ii) an increase in raw ingredient and packaging costs and (iii) an increase in retail merchandising and promotions.  Gross margins are principally influenced by fluctuations in quarter-to-quarter and year-to-year production volume, fixed production costs and related overhead absorption, raw ingredient costs, inventory mark to market write-downs, if any, and the timing of shipments to customers which are factors of the seasonality of our sales activities and products. 
 
Sales and marketing expense for Fiscal 2012 increased $1.0 million to $8.9 million as compared to $7.9 million for Fiscal 2011.  The increase in sales and marketing expense for Fiscal 2012 as compared to Fiscal 2011 was principally due to an increase in advertising expenditures as we expanded the scope and timing of our media and product promotion advertising campaigns from period to period as we continue to make significant, strategic marketing investments in an effort to build and grow the sales of our OTC cold remedy products. 
 
General and administrative (“G&A”) expenses increased $1.1 million for Fiscal 2012 to $6.1 million as compared to $5.0 million in Fiscal 2011.  The increase in G&A expense for Fiscal 2012 as compared to Fiscal 2011 was primarily due to an increase in personnel expenses and professional fees.
 
Research and development costs for Fiscal 2012 and 2011 were $1.3 million and $1.1 million, respectively. The increase of $200,000 in research and development costs for Fiscal 2012 as compared to Fiscal 2011 was principally due to an increase in personnel expenses and an increase in the scope, timing and amount of research and development activity from period to period.  In February 2012, we introduced to the retail trade an offering of a new product, Cold-EEZE® Cold Remedy Daytime/Nighttime QuickMelts®.  The Cold-EEZE® Cold Remedy Daytime/Nighttime QuickMelts® began shipping to retailers in July 2012.  Additionally, we continue to engage in other research and development activities that we determine are appropriate and we may increase our research and development activities in future periods as a consequence of the Joint Venture.
 
Under the Settlement Agreement, the Godfreys assigned, transferred and conveyed to us all of their right, title, and interest in U.S. Trademark Registration No. 1,838,542 for the trademark Cold-EEZE®, among other intellectual property associated with such trademark.  As a result of the Settlement Agreement, we realized $1.0 million benefit as a consequence of a reduction of the previously recorded accrued royalties and commission obligation of $3.5 million.
 
Interest and other income for Fiscal 2012 was $7,000 as compared to $28,000 for Fiscal 2011.  The decrease of $21,000 for Fiscal 2012 as compared to Fiscal 2011 was principally the result of decreased bank balances and lower interest rates.
 
As noted above, we have net operating loss carry-forwards for both federal and certain states.  As a consequence of these loss carry-forwards and our loss realized during Fiscal 2012, we did not incur income tax expense for Fiscal 2012 or Fiscal 2011.
 
As a consequence of the effects of the above, the net loss for Fiscal 2012, was $1.1 million, or ($0.07) per share, as compared to a net loss of $2.7 million, or ($0.18) per share, for Fiscal 2011.
 
Liquidity and Capital Resources
 
Our aggregate cash and cash equivalents as of December 31, 2013 were $1.6 million as compared to $572,000 at December 31, 2012.  Our working capital was $6.7 million and $5.8 million as of December 31, 2013 and December 31, 2012, respectively.  Changes in working capital for Fiscal 2013 were principally due to the net effect of (i) cash provided by operations of $1.1 million comprised principally of net income of $405,000 and a decrease in prepaid expenses of $886,000, (ii) net proceeds of $471,000 derived from the sale of our Common Stock and the exercise of stock options offset by, (iii) capital expenditures of $442,000 and (iv) the installment payment of $100,000 pursuant to the terms of the Settlement Agreement. 
 
 
- 26 -

 
On November 21, 2012, we entered into the equity line of credit agreement (such arrangement, the “Equity Line”) with Dutchess whereby Dutchess committed to purchase, subject to certain restrictions and conditions, up to 2,500,000 shares of our Common Stock, over a period of 36 months from the first trading day following the effectiveness of the registration statement registering the resale of shares purchased by Dutchess pursuant to the Equity Line.  On November 26, 2012, we filed a registration statement with the SEC to register for sale for up to 2,500,000 shares of our Common Stock and the registration statement was deemed effective by the SEC on December 12, 2012.
 
We may draw on the facility from time to time, as and when we determine appropriate in accordance with the terms and conditions of the Equity Line.  The maximum amount that we are entitled to put to Dutchess in any one draw down notice is the greater of (i) 500% of the average daily volume of our Common Stock traded on the NASDAQ Global Market for the one (1) trading day prior to the date of delivery of the applicable draw down notice, multiplied by the closing price for such trading day, or (ii) $250,000.
 
The purchase price under the Equity Line is set at ninety-five percent (95%) of the lowest daily volume weighted average price (VWAP) of our Common Stock during the five (5) consecutive trading day period beginning on the date of delivery of the applicable draw down notice.  We have the right to withdraw all or any portion of any put, except that portion of the put that has already been sold to a third party, including any portion of a put that is below the minimum acceptable price set forth on the put notice, before the closing.   In the event Dutchess receives more than a five percent (5%) return on the net sales for a specific put, Dutchess must remit such excess proceeds to us; however, in the event Dutchess receives less than a five percent (5%) return on the net sales for a specific put Dutchess has the right to use any such excess proceeds to off-set against the aggregated deficit proceeds.
 
There are put restrictions applied on days between the draw down notice date and the closing date with respect to that particular put.  During such time, we are not allowed to deliver another draw down notice.  In addition, Dutchess is not obligated to purchase shares if its total number of shares beneficially held at that time would exceed 9.99% of the number of shares of our Common Stock as determined in accordance with Rule 13d-1(j) of the Securities Exchange Act.  In addition, we are not permitted to draw on the facility unless there is an effective registration statement to cover the resale of the shares.
 
In Fiscal 2013, we sold an aggregate of 289,474 shares of Common Stock to Dutchess in which we derived approximately $444,000 in net proceeds.  In Fiscal 2012, we sold an aggregate of 883,722 shares of Common Stock to Dutchess under and pursuant to the Equity Line In which we derived approximately net proceeds of $1.1 million.  The sales of the shares under the Equity Line were deemed to be exempt from registration under the Securities Act in reliance upon Section 4(2) (or Regulation D promulgated thereunder).
 
During the period January 1, 2014 through to February 25, 2014, we sold an aggregate of 559,318 shares of Common Stock to Dutchess under and pursuant to the Equity Line and derived net proceeds of approximately $947,000.  At March 25, 2014, we have 767,486 shares of our Common Stock available for sale, at our discretion, under the terms of the Equity Line and covered pursuant to a registration statement.
 
Management believes that its strategy to maintain Cold-EEZEÒ Cold Remedy as a recognized brand name, its broader range of products, its adequate manufacturing capacity, together with revenue for our operations, our current working capital and our available Equity Credit Line, if exercised, should provide a source of capital to fund normal business operations.  Our operations support the current research and development expenditures related to new products.  In addition to the funding from operations, we may in the short and long term raise capital through the issuance of securities through our Equity Credit Line or secure other financing sources to support such product development research, new product acquisitions or a venture investment or acquisition.  Such funding through the issuance of equity securities would result in the dilution of current stockholders’ ownership in the Company.  Should our product development initiatives progress on certain formulations, additional development expenditures may require substantial financial support and may necessitate the consideration of alternative approaches such as licensing, joint venture, or partnership arrangements that we determine will meet our long term goals and objectives.  Ultimately, should internal working capital be insufficient and external funding methods or other business arrangements become unattainable, it would likely result in the deferral or abandonment of future development relative to current and prospective product development initiatives and formulations.
 
 
- 27 -

 
Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture.  PSI Parent will conduct and oversee much of the product development, formulation, testing and other research and development needed by the Joint Venture, and we will oversee much of the production, distribution, sales and marketing.  The LLC Agreement provides that each member may be required, from time to time and subject to certain limitations, to make capital contributions to the Joint Venture to fund its operations, in accordance with agreed upon budgets for products to be developed.  Specifically, we contributed in Fiscal 2010 $500,000 in cash as initial capital and we are committed to fund up to $2.0 million, subject to agreed upon budgets (which have not been established to date), toward the initial development and marketing costs of new products for the Joint Venture.  The newly formed Joint Venture has not engaged in any financial transactions, other than organizational expenses and general market and initial product evaluation and analysis.  At December 31, 2013, cash and equivalents includes $378,000 which is expected to be used by the Joint Venture to fund future product development initiatives currently under consideration by PSI Parent, PSI and us.
 
Management is not aware of any trends, events or uncertainties that have or are reasonably likely to have a material negative impact upon our (i) short-term or long-term liquidity, or (ii) net sales or income from continuing operations.  Any challenge to our patent rights could have a material adverse effect on our future; however, we are not aware of any condition that would make such an event probable.  Our business is subject to seasonal variations thereby impacting liquidity and working capital during the course of our fiscal year.
 
Management believes that cash generated from operations, along with its current cash balances, will be sufficient to finance working capital and capital expenditure requirements for at least the next twelve months.  However, in the longer term, as previously discussed, we may require additional capital to support, among other items, (i) new product introductions, (ii) expansion of our product marketing and promotion activities, (iii) additional research development activities, (iv) further investment in our Joint Venture, (iv) venture investments or acquisitions and/or (v) support current operations.  Since late Fiscal 2008, there has been substantial volatility and a decline in the capital and financial markets due at least in part to the constricted global economic environment resulting in substantial uncertainty and access to financing is uncertain. Moreover, consumer and as a consequence, customer spending habits may be adversely affected by the current economic crisis.  These conditions could have an adverse effect on our industry and business, including our financial condition, results of operations and cash flows. 
 
To the extent that we do not generate sufficient cash from operations, we may need to incur indebtedness to finance plans for growth.  Recent turmoil and stagnation in the credit markets and the potential impact on the liquidity of major financial institutions may have an adverse effect on our ability to fund our business strategy through borrowings, under either existing or newly created instruments in the public or private markets on terms that we believe to be reasonable, if at all. 
 
Our future contractual obligations and commitments at December 31, 2013 consist of the following (in thousands):
 
 
 
Employment
 
Settlement
 
 
 
 
Year
 
Contracts
 
Agreement
 
Total
 
2014
 
$
1,025
 
$
100
 
$
1,125
 
2015
 
 
555
 
 
100
 
 
655
 
2016
 
 
 
 
 
100
 
 
100
 
2017
 
 
-
 
 
 
 
 
-
 
2018
 
 
-
 
 
-
 
 
-
 
Total
 
$
1,580
 
$
300
 
$
1,880
 
 
Off-Balance Sheet Arrangements
 
It is not our usual business practice to enter into off-balance sheet arrangements such as guarantees on loans and financial commitments and retained interests in assets transferred to an unconsolidated entity for securitization purposes.  We have no off-balance sheet arrangements that have, or are reasonably likely to have, a material current or future effect on our financial condition, changes in financial condition, revenues or expenses, results of operations, liquidity, capital expenditures or capital resources.
 
 
- 28 -

 
Impact of Inflation
 
We are subject to normal inflationary trends and anticipate that any increased costs would be passed on to our customers.  Inflation has not had a material effect on our business.
 
Critical Accounting Estimates
 
The preparation of financial statements in conformity with accounting principles generally accepted in the United States (“GAAP”) requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent liabilities at the dates of the financial statements and the reported amounts of revenues and expenses during the reporting periods.  Actual results could differ from those estimates.  Our significant accounting policies are described in Note 2 of the Notes to Consolidated Financial Statements included under Item 8 of this Part II.   However, certain accounting policies are deemed “critical”, as they require management’s highest degree of judgment, estimates and assumptions.  These accounting estimates and disclosures have been discussed with the Audit Committee of our Board of Directors.  A discussion of our critical accounting policies, the judgments and uncertainties affecting their application and the likelihood that materially different amounts would be reported under different conditions or using different assumptions are as follows:
 
Revenue Recognition – Sales Allowances 
When providing for the appropriate sales returns, allowances, cash discounts and cooperative incentive promotion costs (“Sales Allowances”), we apply a uniform and consistent method for making certain assumptions for estimating these provisions.  These estimates and assumptions are based on historical experience, current trends and other factors that management believes to be relevant at the time the financial statements are prepared.  Management reviews the accounting policies, assumptions, estimates and judgments on a quarterly basis.  Actual results could differ from those estimates.
 
Our primary product, Cold-EEZEÒ Cold Remedy lozenges, utilizes a proprietary zinc gluconate formulation which has been clinically proven to reduce the severity and duration of common cold symptoms.  Factors considered in estimating the appropriate sales returns and allowances for this product include it being (i) a unique product with limited competitors, (ii) competitively priced, (iii) promoted, (iv) unaffected for remaining shelf-life as there is no product expiration date and (v) monitored for inventory levels at major customers and third-party consumption data.  In addition to Cold-EEZE® Cold Remedy lozenges, we market and distribute a variety of Cold-EEZE® Cold Remedy QuickMelts® and a Cold-EEZE® Cold Remedy Oral Spray.  We also manufacture, market and distribute an organic cough drop and a Vitamin C supplement (“Organix®”).  Each of the Cold-EEZE® Cold Remedy Oral Spray and QuickMelts® products, and Organix® products carry shelf-life expiration dates for which we aggregate such new product market experience data and update our sales returns and allowances estimates accordingly.  Sales allowances estimates are tracked at the specific customer and product line levels and are tested on an annual historical basis, and reviewed quarterly. Additionally, we monitor current developments by customer, market conditions and any other occurrences that could affect the expected provisions relative to net sales for the period presented.
 
Our return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products that have reached or exceeded their designated expiration date.  We do not impose a period of time within which product may be returned.  All requests for product returns must be submitted to us for pre-approval.  The main components of our returns policy are: (i) we will accept returns that are due to damaged product that is un-saleable and such return request activity fall within an acceptable range, (ii) we will accept returns for products that have reached or exceeded designated expiration dates and (iii) we will accept returns in the event that we discontinue a product provided that the customer will have the right to return only such items that it purchased directly from us.  We will not accept return requests pertaining to customer inventory “Overstocking” or “Resets”.  We will only accept return requests for product in its intended package configuration.  We reserve the right to terminate shipment of product to customers who have made unauthorized deductions contrary to our return policy or pursue other methods of reimbursement. We compensate the customer for authorized returns by means of a credit applied to amounts owed or to be owed and in the case of discontinued product only, also by way of an exchange.  We do not have any significant product exchange history.
 
 
- 29 -

 
We classify product returns into principally three categories, (i) non-routine returns, (ii) obsolete product and (iii) product mix realignment by certain of our customers.  “Non-routine” returns are defined as product returned to us as a consequence of unanticipated circumstances principally due to (i) retail store closings or (ii) unexpected poor retail sell through to consumers causing us to discontinue the product.  “Obsolete” returns are defined as product returned to us as a consequence of product shelf-life “use by” expiration date.  Product mix realignment” returns are defined as product returned to us due to initiatives by the trade to discontinue purchasing certain of our products.  Product mix realignment returns are generally nominal and are frequently related to discontinued or soon to be discontinued products.
 
Our return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products that have reached or exceeded designated expiration date. The following is a summary of the change in the return provision for the years ended December 31, 2013 and 2012 (in thousands):
 
 
 
Amount
 
Return provision at December 31, 2011
 
$
1,667
 
Net change in the return provision Fiscal 2012
 
 
(375)
 
Return provision at December 31, 2012
 
 
1,292
 
Net change in the return provision Fiscal 2013
 
 
227
 
Return provision at December 31, 2013
 
$
1,519
 
 
For Fiscal 2013, 2012 and 2011, net sales of products with limited shelf-life and expiration dates were $4.3 million, $3.2 million and $2.0 million, respectively.
 
For Fiscal 2013, the return provision increased by $227,000. The increase in the return provision was principally due to (i) a charge of $1.4 million, including $534,000 for products with shelf-life expiration dates (obsolete returns), offset by (ii) net returns of $1.2 million associated principally with Fiscal 2013 and Fiscal 2012 received and processed during Fiscal 2013.
 
For Fiscal 2012, the return provision decreased by $375,000. The decrease in the return provision was principally due to (i) a charge of $1.1 million, including $631,000 for products with shelf-life expiration dates (obsolete returns), offset by (ii) net returns of $1.4 million associated principally with Fiscal 2012 and Fiscal 2011 received and processed during Fiscal 2012.
 
A one percent deviation for these sales allowance provisions for the Fiscal 2013, 2012 and 2011 would affect net sales by approximately $303,000, $274,000 and $219,000, respectively.  A one percent deviation for cooperative incentive promotions reserve provisions for Fiscal 2013, 2012 and 2011 could affect net sales by approximately $285,000, $260,000 and $210,000, respectively.
 
Effect of Recent Accounting Pronouncements
In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2011-05, “Comprehensive Income (ASU Topic 220): Presentation of Comprehensive Income,” (“ASU 2011-05”) which amends current comprehensive income guidance. This accounting update eliminates the option to present the components of other comprehensive income as part of the statement of shareholders’ equity. Instead, comprehensive income must be presented in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. ASU 2011-05 was effective for fiscal periods beginning after December 15, 2011 with early adoption permitted. In December 2011, the FASB issued ASU 2011-12 “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This accounting update stated that the specific requirement to present items that are reclassified from other comprehensive income to net income alongside their respective components of net income and other comprehensive income will be deferred.  In February 2013, the FASB issued ASU 2013-02 “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”. This accounting update requires companies to present the effects on the line items of net income of significant reclassifications out of accumulated other comprehensive income if the amount being reclassified is required under U.S. generally accepted accounting principles to be reclassified in its entirety to net income in the same reporting period.  ASU 2013-02 is effective prospectively for fiscal years beginning after December 15, 2012. The adoption of ASU 2013-02 did not have a material impact on our consolidated financial position, results of operations or cash flows.
 
 
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In July 2013, the FASB issued Accounting Standards Update No. 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (“ASU 2013-11”).  ASU 2013-11 amends Accounting Standards Codification 740, “Income Taxes,” to require that in certain cases, an unrecognized tax benefit, or portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward when such items exist in the same taxing jurisdiction. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date, and retrospective application is permitted. We are currently evaluating the impact, if any this update will have on our financial statements.
  
Item 7A.
Quantitative and Qualitative Disclosures About Market Risk
 
Like virtually all commercial enterprises, we can be exposed to the risk (“market risk”) that the cash flows to be received or paid relating to certain financial instruments could change as a result of changes in interest rate, exchange rates, commodity prices, equity prices and other market changes.
 
Our operations are not subject to risks of material foreign currency fluctuations, nor do we use derivative financial instruments in our investment practices. We place our marketable investments in instruments that meet high credit quality standards.  We do not expect material losses with respect to our investment portfolio or excessive exposure to market risks associated with interest rates.  The impact on our results of one percentage point change in short-term interest rates would not have a material impact on our future earnings, fair value, or cash flows related to investments in cash equivalents or interest-earning marketable securities.
 
Current economic conditions may cause a decline in business and consumer spending which could adversely affect our business and financial performance including the collection of accounts receivables, realization of inventory and recoverability of assets.  In addition, our business and financial performance may be adversely affected by current and future economic conditions, including a reduction in the availability of credit, financial market volatility and recession.
 
 
- 31 -

 
Item 8. Financial Statements and Supplementary Data
 
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
To the Board of Directors and Stockholders of
ProPhase Labs, Inc.
 
We have audited the accompanying consolidated balance sheets of ProPhase Labs, Inc. and Subsidiaries (the “Company”) as of December 31, 2013 and 2012, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2013.  The financial statements are the responsibility of the Company’s management.  Our responsibility is to express an opinion on these financial statements based on our audits.
 
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).  Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement.  The Company is not required to have, nor were we engaged to perform, an audit of its internal control over financial reporting. Our audits included consideration of internal control over financial reporting as a basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Company’s internal control over financial reporting. Accordingly, we express no such opinion.  An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements.  An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation.  We believe that our audits provide a reasonable basis for our opinion. 
 
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ProPhase Labs, Inc. and Subsidiaries as of December 31, 2013 and 2012, and the consolidated results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2013, in conformity with accounting principles generally accepted in the United States of America.
 
/S/ EisnerAmper LLP
 
Iselin, New Jersey
March 27, 2014
 
 
- 32 -

 
PROPHASE LABS, INC AND SUBSIDARIES
CONSOLIDATED BALANCE SHEETS
(in thousands, except share amounts)
 
 
 
December 31,
 
 
 
2013
 
2012
 
ASSETS
 
 
 
 
 
 
 
Cash and cash equivalents (Note 2)
 
$
1,638
 
$
572
 
Accounts receivable, net (Note 2)
 
 
5,319
 
 
5,409
 
Inventory (Note 2)
 
 
2,521
 
 
2,051
 
Prepaid expenses and other current assets (Note 2)
 
 
1,801
 
 
2,687
 
Total current assets
 
 
11,279
 
 
10,719
 
 
 
 
 
 
 
 
 
Property, plant and equipment, net of accumulated depreciation
    of $4,064 and $3,860, respectively (Note 3)
 
 
2,564
 
 
2,365
 
Intangible asset, licensed technology (Note 8)
 
 
3,577
 
 
3,577
 
 
 
$
17,420
 
$
16,661
 
 
 
 
 
 
 
 
 
LIABILITIES AND STOCKHOLDERS' EQUITY
 
 
 
 
 
 
 
LIABILITIES
 
 
 
 
 
 
 
Accounts payable
 
$
1,011
 
$
1,296
 
Accrued advertising and other allowances (Note 2)
 
 
2,847
 
 
2,760
 
Other current liabilities (Note 4)
 
 
766
 
 
854
 
Total current liabilities
 
 
4,624
 
 
4,910
 
 
 
 
 
 
 
 
 
Other long term obligation (Note 5)
 
 
200
 
 
300
 
Total long term liabilities
 
 
200
 
 
300
 
 
 
 
 
 
 
 
 
COMMITMENTS AND CONTINGENCIES (Note 5)
 
 
-
 
 
-
 
 
 
 
 
 
 
 
 
STOCKHOLDERS' EQUITY
 
 
 
 
 
 
 
Common stock, $.0005 par value; authorized 50,000,000;
    issued: 21,437,059 and 21,056,115 shares, respectively (Note 6)
 
 
11
 
 
11
 
Additional paid-in-capital
 
 
43,607
 
 
42,867
 
Accumulated deficit
 
 
(5,385)
 
 
(5,790)
 
Treasury stock, at cost, 5,336,053 and 5,336,053 shares,
    respectively (Note 6)
 
 
(25,637)
 
 
(25,637)
 
 
 
 
12,596
 
 
11,451
 
 
 
$
17,420
 
$
16,661
 
 
See accompanying notes to consolidated financial statements
 
 
- 33 -

 
PROPHASE LABS, INC & SUBSIDARIES
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share amounts)
 
 
 
Year Ended December 31,
 
 
 
2013
 
2012
 
2011
 
 
 
 
 
 
 
 
 
 
 
 
Net sales (Notes 2 and 11)
 
$
25,032
 
$
22,406
 
$
17,453
 
Cost of sales (Note 2)
 
 
8,361
 
 
8,154
 
 
6,171
 
Gross profit
 
 
16,671
 
 
14,252
 
 
11,282
 
 
 
 
 
 
 
 
 
 
 
 
Operating expenses:
 
 
 
 
 
 
 
 
 
 
Sales and marketing
 
 
9,538
 
 
8,946
 
 
7,904
 
Administrative
 
 
5,893
 
 
6,127
 
 
5,028
 
Research and development (Note 2)
 
 
824
 
 
1,301
 
 
1,088
 
Settlement benefit (Note 5)
 
 
-
 
 
(1,024)
 
 
-
 
Total operating expense
 
 
16,255
 
 
15,350
 
 
14,020
 
 
 
 
 
 
 
 
 
 
 
 
Income (loss) from operations
 
 
416
 
 
(1,098)
 
 
(2,738)
 
Interest income
 
 
2
 
 
7
 
 
28
 
Interest expense
 
 
(13)
 
 
-
 
 
-
 
Income (loss) from operations before taxes
 
 
405
 
 
(1,091)
 
 
(2,710)
 
 
 
 
 
 
 
 
 
 
 
 
Income tax (benefit) (Note 9)
 
 
-
 
 
-
 
 
-
 
Net income (loss)
 
$
405
 
$
(1,091)
 
$
(2,710)
 
 
 
 
 
 
 
 
 
 
 
 
Basic income (loss) per share:
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
$
0.03
 
$
(0.07)
 
$
(0.18)
 
 
 
 
 
 
 
 
 
 
 
 
Diluted income (loss) per share:
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
$
0.03
 
$
(0.07)
 
$
(0.18)
 
 
 
 
 
 
 
 
 
 
 
 
Weighted average common shares outstanding:
 
 
 
 
 
 
 
 
 
 
Basic
 
 
15,839
 
 
14,843
 
 
14,817
 
Diluted
 
 
16,276
 
 
14,843
 
 
14,817
 
 
See accompanying notes to consolidated financial statements
 
 
- 34 -

 
PROPHASE LABS, INC & SUBSIDARIES
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY
(in thousands, except share data)
 
 
 
 
 
 
 
 
Additional
 
Retained
 
 
 
 
 
 
 
 
 
Common Stock
 
Par
 
Paid-In
 
Earnings
 
Treasury
 
 
 
 
 
 
Shares
 
Value
 
Capital
 
(Deficit)
 
Stock
 
Total
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Balance at December 31, 2010
 
14,707,619
 
 
10
 
 
40,627
 
 
(1,989)
 
 
(25,188)
 
 
13,460
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net loss
 
 
 
 
 
 
 
 
 
 
(2,710)
 
 
 
 
 
(2,710)
 
Share-based compensation expense
 
 
 
 
 
 
 
131
 
 
 
 
 
 
 
 
131
 
Common stock granted pursuant to an
    employment agreement
 
341,254
 
 
 
 
 
294
 
 
 
 
 
 
 
 
294
 
Common stock granted pursuant to a
    compensation plan
 
466,710
 
 
 
 
 
500
 
 
 
 
 
 
 
 
500
 
Treasury stock purchase (Note 8)
 
(690,000)
 
 
 
 
 
 
 
 
 
 
 
(449)
 
 
(449)
 
Balance at December 31, 2011
 
14,825,583
 
 
10
 
 
41,552
 
 
(4,699)
 
 
(25,637)
 
 
11,226
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net loss
 
 
 
 
 
 
 
 
 
 
(1,091)
 
 
 
 
 
(1,091)
 
Share-based compensation expense
 
 
 
 
 
 
 
153
 
 
 
 
 
 
 
 
153
 
Common stock granted pursuant to an
    employment agreement
 
10,757
 
 
 
 
 
93
 
 
 
 
 
 
 
 
93
 
Common stock issued (Note 6)
 
883,722
 
 
1
 
 
1,069
 
 
 
 
 
 
 
 
1,070
 
Balance at December 31, 2012
 
15,720,062
 
 
11
 
 
42,867
 
 
(5,790)
 
 
(25,637)
 
 
11,451
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Net income
 
 
 
 
 
 
 
 
 
 
405
 
 
 
 
 
405
 
Proceeds from exercise of stock options
 
25,000
 
 
 
 
 
27
 
 
 
 
 
 
 
 
27
 
Share-based compensation expense
 
 
 
 
 
 
 
160
 
 
 
 
 
 
 
 
160
 
Common stock granted pursuant to a
    compensation plan
 
66,470
 
 
 
 
 
109
 
 
 
 
 
 
 
 
109
 
Common stock issued (Note 6)
 
289,474
 
 
-
 
 
444
 
 
 
 
 
 
 
 
444
 
Balance at December 31, 2013
 
16,101,006
 
$
11
 
$
43,607
 
$
(5,385)
 
$
(25,637)
 
$
12,596
 
 
See accompanying notes to consolidated financial statements
 
 
- 35 -

 
PROPHASE LABS, INC & SUBSIDARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
 
 
 
Year Ended December 31,
 
 
 
2013
 
2012
 
2011
 
Cash flows from operating activities:
 
 
 
 
 
 
 
 
 
 
Net income (loss)
 
$
405
 
$
(1,091)
 
$
(2,710)
 
Adjustments to reconcile net loss to net cash provided by (used in)
   operating activities:
 
 
 
 
 
 
 
 
 
 
Depreciation and amortization
 
 
243
 
 
252
 
 
355
 
Gain on the sale of fixed assets
 
 
-
 
 
-
 
 
(28)
 
Reduction of payment obligation, settlement benefit
 
 
-
 
 
(1,024)
 
 
-
 
Share-based compensation expense
 
 
269
 
 
246
 
 
631
 
Changes in operating assets and liabilities:
 
 
 
 
 
 
 
 
 
 
Accounts receivable
 
 
90
 
 
(2,190)
 
 
1,602
 
Inventory
 
 
(470)
 
 
637
 
 
(1,006)
 
Prepaid expenses and other assets
 
 
886
 
 
(940)
 
 
(864)
 
Accounts payable
 
 
(285)
 
 
411
 
 
396
 
Accrued advertising and other allowances
 
 
87
 
 
(199)
 
 
(565)
 
Accrued royalties and commissions
 
 
-
 
 
(2,100)
 
 
-
 
Other operating assets and liabilities, net
 
 
(88)
 
 
269
 
 
81
 
Net cash provided by (used in) operating activities
 
 
1,137
 
 
(5,729)
 
 
(2,108)
 
 
 
 
 
 
 
 
 
 
 
 
Cash flows from investing activities:
 
 
 
 
 
 
 
 
 
 
Capital expenditures
 
 
(442)
 
 
(310)
 
 
(300)
 
Proceeds from the sale of fixed assets
 
 
-
 
 
-
 
 
166
 
Net cash flows used in investing activities
 
 
(442)
 
 
(310)
 
 
(134)
 
 
 
 
 
 
 
 
 
 
 
 
Cash flows from financing activities:
 
 
 
 
 
 
 
 
 
 
Proceeds from the exercise of stock options
 
 
27
 
 
-
 
 
-
 
Proceeds from issuance of common stock
 
 
444
 
 
1,070
 
 
-
 
Payment of long term obligation
 
 
(100)
 
 
-
 
 
-
 
Purchase of treasury stock
 
 
-
 
 
-
 
 
(449)
 
Net cash provided by (used in) financing activities
 
 
371
 
 
1,070
 
 
(449)
 
 
 
 
 
 
 
 
 
 
 
 
Net increase (decrease) in cash and cash equivalents
 
 
1,066
 
 
(4,969)
 
 
(2,691)
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents at beginning of year
 
 
572
 
 
5,541
 
 
8,232
 
 
 
 
 
 
 
 
 
 
 
 
Cash and cash equivalents at end of year
 
$
1,638
 
$
572
 
$
5,541
 
 
 
 
 
 
 
 
 
 
 
 
Supplemental disclosures of cash flow information:
 
 
 
 
 
 
 
 
 
 
Income taxes paid
 
$
-
 
$
-
 
$
-
 
Interest paid
 
$
13
 
$
-
 
$
-
 
Common stock issued, in lieu of cash, as payment of accrued compensation
 
$
-
 
$
-
 
$
294
 
 
See accompanying notes to consolidated financial statements
 
 
- 36 -

 
PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS 
 
NOTE 1 – ORGANIZATION AND BUSINESS
 
ProPhase Labs, Inc (“we”, “us” or the “Company”), organized under the laws of the State of Nevada, is a manufacturer, marketer and distributor of a diversified range of homeopathic and health products that are offered to the general public. We are also engaged in the research and development of potential over-the-counter (“OTC”) drug, natural based health products along with supplement, personal care and cosmeceutical products. 
 
Our primary business is the manufacture, distribution, marketing and sale of OTC cold remedy products to consumers through national chain, regional, specialty and local retail stores.  Our flagship brand is Cold-EEZEÒ Cold Remedy and our principal product is Cold-EEZEÒ Cold Remedy zinc gluconate lozenges, proven in clinical studies to reduce the duration of the common cold by 42%.   In addition to Cold-EEZE® Cold Remedy lozenges, we market and distribute non-lozenge forms of our proprietary zinc gluconate formulation, (i) Cold-EEZE® Cold Remedy QuickMelts® and (ii) Cold-EEZE® Cold Remedy Oral Spray.  Cold-EEZE® Cold Remedy Oral Spray is a liquid form of our zinc gluconate formulation that is sprayed in the mouth.  Cold-EEZE® Cold Remedy QuickMelts® are fast dissolving tablets that are taken orally.
 
The Cold-EEZE® Cold Remedy QuickMelts® product line is comprised of (i) Cold-EEZE® Daytime/Nighttime QuickMelts® (launched in Fiscal 2012) and (ii) Cold-EEZE® Plus Immune Support QuickMelts® and Cold-EEZE® Plus Immune Support + Energy QuickMelts®  (each launched in Fiscal 2013).  We also manufacture, market and distribute organic cough drops and a Vitamin C supplement (“Organix”) and perform contract manufacturing services of cough drop and other OTC cold remedy products for third parties.
 
Cold-EEZEÒ Cold Remedy is an established product in the health care and cold remedy market.  For Fiscal 2013, 2012 and 2011, our revenues have come principally from our OTC cold remedy products.  For Fiscal 2013 and 2012, our net sales for each period were related to markets in the United States.
 
On March 22, 2010, we, Phosphagenics Limited (“PSI Parent”), an Australian corporation, Phosphagenics Inc. (“PSI”), a Delaware corporation and subsidiary of PSI Parent, and Phusion Laboratories, LLC (the “Joint Venture”), a Delaware limited liability company, entered into a Limited Liability Company Agreement (the “LLC Agreement”) of the Joint Venture and additional related agreements for the purpose of developing and commercializing, for worldwide distribution and sale, a wide range of non-prescription remedies using PSI Parent’s proprietary patented TPM™ technology (“TPM”).  TPM facilitates the delivery and depth of penetration of active molecules in pharmaceutical, nutraceutical, and other products. Pursuant to the LLC Agreement, we and PSI each own a 50% membership interest in the Joint Venture (see Note 8). 
 
Our business is subject to seasonal variations thereby impacting liquidity and working capital during the course of our fiscal year.
 
We use a December 31 year-end for financial reporting purposes.  References herein to the fiscal year ended December 31, 2013 shall be the term “Fiscal 2013” and references to other “Fiscal” years shall mean the year, which ended on December 31 of the year indicated.  The term the “we”, “us: or the “Company” as used herein also refer, where appropriate, to the Company, together with its subsidiaries unless the context otherwise requires.
 
 
- 37 -

 
PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
 
Basis of Presentation
The consolidated financial statements (“Financial Statements”) include the accounts of the Company and its wholly owned subsidiaries and its Joint Venture, a variable interest entity (see Note 8). All intercompany transactions and balances have been eliminated. 
 
Seasonality of the Business
Our net sales are derived principally from our OTC cold remedy products.  Currently, our sales are influenced by and subject to fluctuations in the timing of purchase and the ultimate level of demand for our products which are a function of the timing, length and severity of each cold season.  Generally, a cold season is defined as the period of September to March when the incidence of the common cold rises as a consequence of the change in weather and other factors.  We generally experience in the third and fourth quarter higher levels of net sales along with a corresponding increase in marketing and advertising expenditures designed to promote its products during the cold season.  Revenues and related marketing costs are generally at their lowest levels in the second quarter when consumer demand generally declines.  We track health and wellness trends and develop retail promotional strategies to align our production scheduling, inventory management and marketing programs to optimize consumer purchases. 
 

Use of Estimates

The preparation of financial statements and the accompanying notes thereto, in conformity with generally accepted accounting principles in the United States (“GAAP”), requires management to make estimates and assumptions that affect reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and reported amounts of revenues and expenses during the respective reporting periods.  Examples include the provision for bad debt, sales returns and allowances, inventory obsolescence, useful lives of property and equipment and intangible assets, impairment of property and equipment and intangible assets, income tax valuations and assumptions related to accrued advertising.  When providing for the appropriate sales returns, allowances, cash discounts and cooperative incentive promotion costs (“Sales Allowances”), we apply a uniform and consistent method for making certain assumptions for estimating these provisions.  These estimates and assumptions are based on historical experience, current trends and other factors that management believes to be relevant at the time the financial statements are prepared.  Management reviews the accounting policies, assumptions, estimates and judgments on a quarterly basis.  Actual results could differ from those estimates.
 
Our primary product, Cold-EEZEÒ Cold Remedy lozenges, utilizes a proprietary zinc gluconate formulation which has been clinically proven to reduce the severity and duration of common cold symptoms.  Factors considered in estimating the appropriate sales returns and allowances for this product include it being (i) a unique product with limited competitors, (ii) competitively priced, (iii) promoted, (iv) unaffected for remaining shelf-life as there is no product expiration date and (v) monitored for inventory levels at major customers and third-party consumption data.  In addition to Cold-EEZE® Cold Remedy lozenges, we market and distribute a variety of Cold-EEZE® Cold Remedy QuickMelts® and a Cold-EEZE® Cold Remedy Oral Spray.  We also manufacture, market and distribute an organic cough drop and a Vitamin C supplement (“Organix®”).  Each of the Cold-EEZE® Cold Remedy Oral Spray and QuickMelts® products, and Organix® products carry shelf-life expiration dates for which we aggregate such new product market experience data and update our sales returns and allowances estimates accordingly.  Sales allowances estimates are tracked at the specific customer and product line levels and are tested on an annual historical basis, and reviewed quarterly. Additionally, we monitor current developments by customer, market conditions and any other occurrences that could affect the expected provisions relative to net sales for the period presented.
 

Cash Equivalents

We consider all highly liquid investments with an initial maturity of three months or less at the time of purchase to be cash equivalents.  Cash equivalents include cash on hand and monies invested in money market funds. The carrying amount approximates the fair market value due to the short-term maturity of these investments.
 
 
- 38 -

 
PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 
Inventory
Inventory is valued at the lower of cost, determined on a first-in, first-out basis (FIFO), or market.  Inventory items are analyzed to determine cost and the market value and appropriate valuation adjustments are established. At December 31, 2013 and 2012 the financial statements include adjustments to reduce inventory for excess or obsolete inventory of $635,000 and $890,000, respectively.  At December 31, 2013 and 2012, inventory included raw material, work in progress and packaging amounts of $1.6 million and $1.0 million, respectively, and finished goods of $958,000 and $1.0 million, respectively.
 
Property, Plant and Equipment
Property, plant and equipment are recorded at cost.  We use the straight-line method in computing depreciation for financial reporting purposes.  The depreciation expense is computed in accordance with the estimated asset lives (see Note 3).
 
Concentration of Risks
Future revenues, costs, margins and profits will continue to be influenced by our ability to maintain our manufacturing availability and capacity together with our marketing and distribution capabilities and the requirements associated with the development of OTC and other personal care products in order to continue to compete on a national and/or international level. 
 
Our business is subject to federal and state laws and regulations adopted for the health and safety of users of our products. Our OTC cold remedy products are subject to regulations by various federal, state and local agencies, including the Food and Drug Administration (“FDA”) and, as applicable, the Homeopathic Pharmacopoeia of the United States.
 
Financial instruments that potentially subject us to significant concentrations of credit risk consist principally of cash investments and trade accounts receivable.
 
We maintain cash and cash equivalents with certain major financial institutions. As of December 31, 2013, our cash was $1.6 million and our bank balance was $1.8 million. Of the total bank balance, $554,000 was covered by federal depository insurance and $1.2 million was uninsured.
 
Trade accounts receivable potentially subjects us to credit risk.  We extend credit to our customers based upon an evaluation of the customer’s financial condition and credit history and generally we do not require collateral.  Our broad range of customers includes many national chain, regional, specialty and local retail stores (see Note 11).  During Fiscal 2013, 2012 and 2011, effectively all of our net revenues were related to domestic markets.
 
Our revenues are principally generated from the sale of OTC cold remedy products which approximated 94%, 95% and 95% of total revenues for Fiscal 2013, 2012 and 2011, respectively.  A significant portion of our business is highly seasonal, which causes major variations in operating results from quarter to quarter.  The third and fourth quarters generally represent the largest sales volume for the OTC cold remedy products. 
 
Raw materials used in the production of the products are available from numerous sources.  Certain raw material active ingredients used in connection with Cold-EEZE® Cold Remedy products are purchased from a single unaffiliated supplier.  Should the relationship terminate or the vendor become unable supply material, we believe that the current contingency plans would prevent a termination from materially affecting our operations.  However, if the relationship was terminated, there may be delays in production of our products until an acceptable replacement supplier is located.
 
 
- 39 -

 
PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 
Long-lived Assets
We review the carrying value of our long-lived assets with definite lives whenever events or changes in circumstances indicate that the carrying amount of the assets may not be recoverable.  When indicators of impairment exist, we determine whether the estimated undiscounted sum of the future cash flows of such assets is less than their carrying amounts.  If less, an impairment loss is recognized in the amount, if any, by which the carrying amount of such assets exceeds their respective fair values.  The determination of fair value is based on quoted market prices in active markets, if available, or independent appraisals; sales price negotiations; or projected future cash flows discounted at a rate determined by management to be commensurate with our business risk.  The estimation of fair value utilizing discounted forecasted cash flows includes significant judgments regarding assumptions of revenue, operating and marketing costs; selling and administrative expenses; interest rates; property and equipment additions and retirements; industry competition; and general economic and business conditions, among other factors. 
 
Fair value is based on the prices that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. In order to increase consistency and comparability in fair value measurements, a three-tier fair value hierarchy prioritizes the inputs used to measure fair value. These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable; and Level 3, defined as unobservable inputs for which little or no market data exists, therefore requiring an entity to develop its own assumptions.
 
Revenue Recognition
Sales are recognized at the time ownership is transferred to the customer.  Revenue is reduced for trade promotions, estimated sales returns, cash discounts and other allowances in the same period as the related sales are recorded. We make estimates of potential future product returns and other allowances related to current period revenue. We analyze historical returns, current trends, and changes in customer and consumer demand when evaluating the adequacy of the sales returns and other allowances.  
 
Our return policy accommodates returns for (i) discontinued products, (ii) store closings and (iii) products that have reached or exceeded their designated expiration date.  We do not impose a period of time within which product may be returned.  All requests for product returns must be submitted to us for pre-approval.  The main components of our returns policy are: (i) we will accept returns that are due to damaged product that is un-saleable and such return request activity fall within an acceptable range, (ii) we will accept returns for products that have reached or exceeded designated expiration dates and (iii) we will accept returns in the event that we discontinue a product provided that the customer will have the right to return only such items that it purchased directly from us.  We will not accept return requests pertaining to customer inventory “Overstocking” or “Resets”.  We will only accept return requests for product in its intended package configuration.  We reserve the right to terminate shipment of product to customers who have made unauthorized deductions contrary to our return policy or pursue other methods of reimbursement. We compensate the customer for authorized returns by means of a credit applied to amounts owed or to be owed and in the case of discontinued product only, also by way of an exchange.  We do not have any significant product exchange history.
 
As of December 31, 2013 and December 31, 2012, we included a provision for sales allowances of $128,000 and $109,000, respectively, which are reported as a reduction to account receivables.  Additionally, accrued advertising and other allowances as of December 31, 2013 include $1.5 million for estimated future sales returns and $1.3 million for cooperative incentive promotion costs.  As of December 31, 2012, accrued advertising and other allowances include $1.3 million for estimated future sales returns and $1.5 million for cooperative incentive promotion costs.
 
Shipping and Handling
Product sales carry shipping and handling charges to the purchaser, included as part of the invoiced price, which is classified as revenue.  In all cases, costs related to this revenue are recorded in cost of sales.  
 
 
- 40 -

 
PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 
Stock Compensation
We recognize all share-based payments to employees and directors, including grants of stock options, as compensation expense in the financial statements based on their fair values.  Fair values of stock options are determined through the use of the Black-Scholes option pricing model.  The compensation cost is recognized as an expense over the requisite service period of the award, which usually coincides with the vesting period.
 
Stock and stock options for purchase of our common stock, $0.0005 par value, (“Common Stock”) have been granted to both employees and non-employees pursuant to the terms of certain agreements and stock option plans (see Note 6).  Stock options are exercisable during a period determined by us, but in no event later than ten years from the date granted.  In Fiscal 2013, 2012 and 2011, we charged to operations $269,000, $246,000 and $631,000, respectively, for share-based compensation expense for the aggregate fair value of stock grants issued and vested stock options earned. 
 
Variable Interest Entity
The Joint Venture, of which we own a 50% membership interest, qualifies as a variable interest entity (“VIE”) and we have consolidated the Joint Venture beginning with the quarter ended March 31, 2010 (see Note 8). 
 
Advertising and Incentive Promotions
Advertising and incentive promotion costs are expensed within the period in which they are utilized. Advertising and incentive promotion expense is comprised of media advertising, presented as part of sales and marketing expense; cooperative incentive promotions and coupon program expenses, which are accounted for as part of net sales; and free product, which is accounted for as part of cost of sales.  Advertising and incentive promotion costs incurred for Fiscal 2013, 2012 and 2011 were $10.8 million, $10.2 million, and $8.8 million, respectively.  Included in prepaid expenses and other current assets was $1.3 million and $2.2 million at December 31, 2013 and 2012, respectively, relating to prepaid deposits for advertising and promotion programs scheduled principally for the first quarter of Fiscal 2014 and 2013, respectively. 
 
Research and Development
Research and development costs are charged to operations in the period incurred.  Expenditures for Fiscal 2013, 2012 and 2011 were $824,000, $1.3 million and $1.1 million, respectively.  For Fiscal 2013, Fiscal 2012 and Fiscal 2011, research and development costs are related principally to new product development initiatives and costs associated with OTC cold remedy products. 
 

Income Taxes

We utilize the asset and liability approach which requires the recognition of deferred tax assets and liabilities for the future tax consequences of events that have been recognized in our financial statements or tax returns. In estimating future tax consequences, we generally consider all expected future events other than enactments of changes in the tax law or rates.  Until sufficient taxable income to offset the temporary timing differences attributable to operations and the tax deductions attributable to option, warrant and stock activities are assured, a valuation allowance equaling the total net current and non-current deferred tax asset is being provided (see Note 9).
 
We utilize a two-step approach to recognizing and measuring uncertain tax positions.  The first step is to evaluate the tax position for recognition by determining if the weight of available evidence indicates that it is more likely than not that the position will be sustained on audit, including resolution of related appeals or litigation processes, if any. The second step is to measure the tax benefit as the largest amount which is more than fifty percent likely of being realized upon ultimate settlement. Any interest or penalties related to uncertain tax positions will be recorded as interest or administrative expense, respectively.
 
The major jurisdiction for which we file income tax returns is the United States.  The Internal Revenue Service (“IRS”) has examined our then tax year ended September 30, 2005 and has made no changes to the filed tax returns.  The tax years 2006 and forward remain open to examination by the IRS.  The tax years 2004 and forward remain open to examination by the various state taxing authorities to which we are subject. 
 
 
- 41 -

 
PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 2 – SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
 
Fair Value of Financial Instruments
Cash and cash equivalents, accounts receivable, accounts payable and long term obligations are reflected in the Financial Statements at carrying value which approximates fair value because of the short-term maturity of these instruments.  Determination of the fair value of related party payables, if any, is not practicable due to their related party nature.
 
Recently Issued Accounting Standards
In June 2011, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2011-05, “Comprehensive Income (ASU Topic 220): Presentation of Comprehensive Income,” (“ASU 2011-05”) which amends current comprehensive income guidance. This accounting update eliminates the option to present the components of other comprehensive income as part of the statement of shareholders’ equity. Instead, comprehensive income must be presented in either a single continuous statement of comprehensive income which contains two sections, net income and other comprehensive income, or in two separate but consecutive statements. ASU 2011-05 was effective for fiscal periods beginning after December 15, 2011 with early adoption permitted. In December 2011, the FASB issued ASU 2011-12 “Deferral of the Effective Date for Amendments to the Presentation of Reclassifications of Items out of Accumulated Other Comprehensive Income in Accounting Standards Update No. 2011-05.” This accounting update stated that the specific requirement to present items that are reclassified from other comprehensive income to net income alongside their respective components of net income and other comprehensive income will be deferred.  In February 2013, the FASB issued ASU 2013-02 “Reporting of Amounts Reclassified Out of Accumulated Other Comprehensive Income”. This accounting update requires companies to present the effects on the line items of net income of significant reclassifications out of accumulated other comprehensive income if the amount being reclassified is required under U.S. generally accepted accounting principles to be reclassified in its entirety to net income in the same reporting period.  ASU 2013-02 is effective prospectively for fiscal years beginning after December 15, 2012. The adoption of ASU 2013-02 did not have a material impact on our consolidated financial position, results of operations or cash flows.
 
In July 2013, the FASB issued Accounting Standards Update No. 2013-11, “Presentation of an Unrecognized Tax Benefit When a Net Operating Loss Carryforward, a Similar Tax Loss, or a Tax Credit Carryforward Exists” (“ASU 2013-11”).  ASU 2013-11 amends Accounting Standards Codification 740, “Income Taxes,” to require that in certain cases, an unrecognized tax benefit, or portion of an unrecognized tax benefit, should be presented in the financial statements as a reduction to a deferred tax asset for a net operating loss carryforward, a similar tax loss, or a tax credit carryforward when such items exist in the same taxing jurisdiction. The amendments in this update are effective for fiscal years, and interim periods within those years, beginning after December 15, 2013. Early adoption is permitted. The amendments should be applied prospectively to all unrecognized tax benefits that exist at the effective date, and retrospective application is permitted. We are currently evaluating the impact, if any this update will have on our financial statements.
 
 
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PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 3 – PROPERTY, PLANT AND EQUIPMENT
 
The components of property and equipment are as follows (in thousands):
 
 
 
December 31,
 
 
 
 
 
2013
 
2012
 
Estimated Useful Life
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Land
 
$
504
 
$
504
 
 
 
Buildings and improvements
 
 
2,852
 
 
2,597
 
10 - 39 years
 
Machinery and equipment
 
 
2,812
 
 
2,771
 
3 - 7 years
 
Computer software
 
 
271
 
 
164
 
3 years
 
Furniture and fixtures
 
 
189
 
 
189
 
5 years
 
 
 
 
6,628
 
 
6,225
 
 
 
 
 
 
 
 
 
 
 
 
 
Less: Accumulated depreciation
 
 
4,064
 
 
3,860
 
 
 
 
 
$
2,564
 
$
2,365
 
 
 
 
Depreciation expense for Fiscal 2013, 2012 and 2011 was $243,000, $252,000, and $355,000, respectively.

NOTE 4 – OTHER CURRENT LIABILITIES
 
At December 31, 2013 and 2012, other current liabilities include $350,000 and $548,000, respectively, related to accrued compensation.

NOTE 5 – COMMITMENTS AND CONTINGENCIES
 
Employment Agreements
On November 8, 2011, we entered into new employment agreements, effective as of January 1, 2012, with each of Mr. Ted Karkus and Mr. Robert Cuddihy (the “Employment Agreements”).  The Employment Agreements supersede the employment agreements of Mr. Karkus and Mr. Cuddihy, dated August 19, 2009, that had been scheduled to terminate on July 15, 2012. The scheduled termination dates of the Employment Agreements is July 15, 2015, which is three years following the scheduled expiration date set forth in the executives’ former employment agreements. 
 
Under his new employment agreement with the Company, Mr. Karkus agreed to an annual base salary of $675,000 as Chief Executive Officer. Under the terms of his former employment agreement with the Company, as amended, Mr. Karkus was entitled to annual base compensation of $750,000, consisting of a $600,000 base salary and $150,000 in stock based compensation. Mr. Karkus is eligible to receive an annual increase in base salary and may be awarded a bonus in the sole discretion of the Compensation Committee and also will receive regular benefits routinely provided to other senior executives of the Company.
 
Under his new employment agreement with the Company, Mr. Cuddihy agreed to an annual base salary of $350,000 as Chief Financial Officer and Chief Operating Officer. Under the terms of his former employment agreement with the Company as the Company’s Chief Operating Officer, Mr. Cuddihy was entitled to annual base compensation of $325,000, consisting of a $275,000 base salary and $50,000 in stock based compensation. Mr. Cuddihy is eligible to receive an annual increase in base salary and may be awarded a bonus in the sole discretion of the Compensation Committee and also will receive regular benefits routinely provided to other senior executives of the Company. 
 
 
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PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 5 – COMMITMENTS AND CONTINGENCIES (CONTINUED)
 
Each executive is subject to non-competition restrictions for up to a period of either six (6) months or eighteen (18) months following termination of employment depending on the nature of the termination. Each executive is also eligible for a gross up payment in the event that any amounts payable under the agreements (or any other plan, program, policy or arrangement with the Company) become subject to the excise tax imposed by Section 4999 of the Internal Revenue Code.
 
The Employment Agreements also provide for payments upon certain terminations and change in control benefits to ensure that they work to secure the best outcome for stockholders in the event of a possible change in control, even if it means that they lose their jobs as a result.  Under the Employment Agreements, in the event of the termination by the Company of the employment of Mr. Karkus or Mr. Cuddihy without cause or due to a voluntary resignation by either executive with Good Reason (as defined in the agreements), each executive will be paid a lump sum severance payment in cash equal to the greater of (A) the amount equal to eighteen (18) months base salary or (B) the amount equal to the his base salary for the remainder of the term as if the agreement had not been terminated. 
 
Additionally, each executive is entitled to receive a lump sum severance payment in cash equal to the greater of A or B, if he, within twenty four (24) months of a Change in Control (as defined in the agreements) of the Company, is terminated without cause or due to a voluntary resignation by him with Good Reason (as defined in the agreements). Each executive may also participate at Company expense in all medical and dental plans for the remainder of the term of his employment agreement in the event the Company terminates the employment agreement for any reason, except for the Company’s termination for Cause (as defined in the agreements) or a voluntary resignation by him without Good Reason (as defined in the agreements).
 
Settlement Agreement
In November 2004 we commenced an action against John C. Godfrey, Nancy Jane Godfrey, and Godfrey Science and Design, Inc. (together the “Godfreys”) for injunctive relief regarding the ownership of the Cold-EEZE® trademark.,  The Godfreys subsequently asserted against us counterclaims and sought monetary damages and injunctive and declaratory relief relative to the Cold-EEZE® trademark and other intellectual property. 
 
On December 20, 2012, we and the Godfreys, including the Estate of Nancy Jane Godfrey, entered into a Settlement Agreement and Mutual General Release (the “Settlement Agreement”), pursuant to which we resolved all disputes, including claims asserted by us and counterclaims asserted against us in the action.   Pursuant to the terms of the Settlement Agreement, we paid the Godfreys $2.1 million in December 2012 and we agreed to make four additional annual payments of $100,000 due in December of each of the next four years.   Each annual payment in the amount of $100,000 will accrue interest at the per annum rate of 3.25%.  The first annual installment of $100,000 plus accrued interest of $13,000 was paid in December 2013. Under the Settlement Agreement, the Godfreys assigned, transferred and conveyed to us all of their right, title, and interest in U.S. Trademark Registration No. 1,838,542 for the trademark Cold-EEZE®, among other intellectual property associated with such trademark.  As a result of the Settlement Agreement, we realized $1.0 million benefit due to the reduction of the previously recorded accrued royalties and commission obligation of $3.5 million.  At December 31, 2013, other current liabilities and other long term obligation include $100,000 and $200,000, respectively, for the three remaining annual installment payments.
 
PROPHASE LABS, INC.(formerly THE QUIGLEY CORPORATION) vs. Guy Quigley, Gary Quigley, Scanda Systems Limited, Scanda Systems LTD, Chilesha Holdings LTD, Kevin Brogan, Innerlight Holdings, Inc., George Longo, Graham Brandon AND Pacific Rim Pharmaceuticals LTD
On August 23, 2010, we initiated an action in the Court of Common Pleas of Bucks County, Pennsylvania Civil Action No. 2010-08227. This action is against certain former officers and directors of the Company, including a shareholder that beneficially owns approximately 17.4% of our Common Stock, and against certain third parties. The Company has asserted claims arising from, among other things, a variety of transactions and payments previously made or entered into by the Company.  The transactions and events that are the subject of this litigation occurred prior to June 2009 and the installation of the current board of directors.  We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going at this time and a date certain for trial has been ordered for June 9, 2014.  At this time, no prediction as to the outcome of this action can be made.
 
 
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PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 5 – COMMITMENTS AND CONTINGENCIES (CONTINUED)
 
GUY QUIGLEY VS. TED KARKUS, ROBERT V. CUDDIHY, JR., MARK BURNETT, MARK LEVENTHAL, MARK FRANK, LOUIS GLECKEL, MD, JAMES McCUBBIN AND PROPHASE LABS, INC. AS A NOMINAL DEFENDANT
We were named as a nominal defendant in a purported derivative complaint filed on February 2, 2012 by stockholder and former director and Chief Executive Officer Guy Quigley in the Court of Common Pleas of Philadelphia County, Pennsylvania (No. 111200409). The complaint also names as a defendant each of our directors and executive officers. Among other things, the suit alleges various breaches of fiduciary and other duties, and seeks recovery of unspecified damages and other relief.  Prior to filing this complaint, the plaintiff applied to the same court for permission to take pre-complaint discovery on the basis that the plaintiff required such discovery in order to assert claims. The court denied the plaintiff's request. We believe the lawsuit is without merit and intend to vigorously defend against it.   On April 5, 2013, the court entered an order allowing limited pre-trial discovery limited to demand futility and plaintiff adequacy issues, which was completed by July 12, 2013.  We filed a motion to dismiss on July 26, 2013 on demand futility and plaintiff adequacy issues. On August 26, 2013 the court heard oral arguments regarding the Company’s motion for summary judgment and dismissal with prejudice.  The court stayed any additional discovery until the court rules on our motion to dismiss with and our motion is currently pending with the court.  At this time, no prediction as to the outcome of this action can be made.
 
As noted above, we previously commenced litigation against the plaintiff, Guy Quigley, and other parties in August 2010 in the Bucks County Court of Common Pleas, Pennsylvania (No. 2010-08227).  The August 2010 action remains pending.
 
PROPHASE LABS, INC.(formerly THE QUIGLEY CORPORATION) vs. Guy Quigley, KARIBA HOLDINGS, LIMITED, WENDY QUIGLEY, Gary Quigley, FRANCES QUIGLEY (A/K/A FRANCES BOSTON) AND JOSEPHINE QUIGLEY (A/K/A JOSEPHINE GLEESON)
On July 19, 2012, we initiated an action in the Court of Common Pleas of Bucks County, Pennsylvania (“Kariba Complaint”) (No. 2011-09815). The Kariba Complaint names as defendants (i) a former officer and director of the Company, who is a shareholder that beneficially owns approximately 17.4% of our Common Stock, (ii) certain family members of such former officer and director, some of whom are former employees of the Company, and (iii) certain third parties.  The Company has asserted claims arising from, among other things, a variety of transactions and payments previously made or entered into by the Company.  The Kariba Complaint asserts additional claims not previously asserted in the action  ProPhase Labs, Inc. (formerly The  Quigley Corporation) vs. Guy Quigley, Gary Quigley, Scanda Systems Limited, Scanda Systems LTD, Chilesha Holdings LTD, Kevin Brogan, Innerlight Holdings, Inc., George Longo, Graham Brandon, Pacific Rim Pharmaceuticals LTD and John Doe Defendants (No. 2010-08227).  All of the transactions and events that are the subject of the Kariba Complaint occurred prior to June 2009 and the installation of the current board of directors.  We are seeking recovery of monetary damages and other relief. Pre-trial discovery is on-going and at this time, no prediction as to the outcome of this action can be made.
 
GARY QUIGLEY VS. EAST BAY MANAGEMENT, INC., TED KARKUS AND JOHN DOE 1
East Bay Management, Inc., Ted Karkus and John Doe 1 were named as defendants in a purported complaint filed on June 10, 2013 by Gary Quigley, the brother of our stockholder and former director and Chief Executive Officer Guy Quigley, in the Court of Common Pleas of Philadelphia County, Pennsylvania (No. 2013-04393). The suit alleges five causes of action against the defendants, including the Company’s Chief Executive Officer, for (i) fraud, (ii) conversion, (iii) unjust enrichment, (iv) conspiracy and (v) piercing the corporate veil.  On July 10, 2013, Mr. Karkus removed the case to the United States District Court for Eastern Pennsylvania.  On August 16, 2013, Mr. Karkus filed a Motion to Dismiss for Failure to State a Claim.  Mr. Gary Quigley responded to the motion to dismiss.   On January 7, 2014, the court heard oral arguments regarding the motion to dismiss.  The court stayed any additional discovery until the court rules on the motion to dismiss and the motion is currently pending with the court.  At this time, no prediction as to the outcome of this action can be made.
 
On January 15, 2014, our Board of Directors, without the presence of Ted Karkus, voted to indemnify Mr. Karkus and pay the expenses incurred by him in connection with this legal matter.  This action has been and will continue to be vigorously defended by Mr. Karkus, who denies any wrongdoing.
 
 
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PROPHASE LABS, INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
 
NOTE 5 – COMMITMENTS AND CONTINGENCIES (CONTINUED)
 
THE ESTATE OF JOSEPHINE QUIGLEY AND KARIBA HOLDINGS LIMITED VS. EAST BAY MANAGEMENT, INC., TED KARKUS, SCOTT STRADY AND JOHN DOE
East Bay Management, Inc., Ted Karkus, Scott Strady and John Doe were named as defendants in a purported complaint filed on August 9, 2013 by the Estate of Josephine Quigley, the mother of our stockholder and former director and Chief Executive Officer Guy Quigley, and Kariba Holdings Limited (see Kariba Compliant above) in the Court of Common Pleas of Philadelphia County, Pennsylvania (No. 2013-006131). Guy Quigley, our stockholder, former director and Chief Executive Officer of the Company, filed this suite as Executor of the Estate of Josephine Quigley and as a representative of Kariba Holdings. The suit alleges five causes of action against the defendants, including the Company’s Chief Executive Officer, for