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INTERLEUKIN GENETICS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations

August 13, 2014

The following discussion of our financial condition and results of operations should be read in conjunction with the unaudited condensed financial statements and the notes thereto included elsewhere in this document.

General Overview and Trends



Interleukin Genetics, Inc. is a personalized health company that develops specific, health area focused, unique genetic tests. Our overall mission is to provide test products that can help individuals improve or maintain their health through preventive or treatment measures. Our vision is to use the science of applied genetics to empower individuals and physicians to better understand the set of actions and steps necessary to guide the best lifestyle and treatment options. We believe that Interleukin Genetics' tests can help individuals and their healthcare providers more effectively prevent common diseases of aging and their complications and thereby extend an individual's years of wellness. Our tests also provide our commercial partners with technologies that can improve services to their consumers.

During the six months ended June 30, 2014, we continued to focus our resources on commercializing our PerioPredict™ test following completion of the PDPS, the large validation study of our PerioPredict™ test with the University of Michigan and Renaissance Health Services Corporation ("RHSC") and on the sales of our Inherent Health® brand of genetic tests and related programs.

The timing of any revenues that we may receive under the Amended and Restated Preferred Participation Agreement (the "Preferred Participation Agreement") with RHSC is dependent upon the timing of the offering of dental benefit plans that provide for use of the PerioPredict™ test and reimbursement of the test (each such plan, hereinafter referred to as a "Reimbursed Dental Plan"), which timing is very uncertain at this time and is dependent on a viable market developing for such plans. RHSC has informed us that it has presented the scientific data underlying Reimbursed Dental Plans to a number of customers and will make available Reimbursed Dental Plans as an alternative to a customer's current plan for any customer that expresses an interest in such a plan. The Company does not expect to receive any significant revenues under this agreement until 2015, at the earliest, and the timing of any such revenues may be substantially later. We may never receive significant revenues under this agreement. We continue to aggressively engage in discussions for the use of our PerioPredict™ test with other dental insurance companies and dental care providers, which began in the first quarter of 2014, through the use of consultants and our internal management team.

On April 11, 2014, we announced the pre-print online publication of our research study titled "Association of interleukin-1 gene variations with moderate to severe chronic periodontitis in multiple ethnicities" in the Journal of Periodontal Research. The study results from multiple ethnic groups further validated the association between periodontitis and the interleukin-1 beta (IL1B) composite genotype pattern, a specific genetic profile that can be elucidated by our PerioPredictTM genetic risk test. In addition, the study results demonstrated that detection of the IL1B variations tested provided added value in the prediction of moderate to severe periodontitis above and beyond the risk attributable to smoking and diabetes alone.

On April 22, 2014, we announced receipt of conditional approval from the New York State Department of Health to offer, process and report the results of the PerioPredict™ Genetic Risk Test for periodontal disease. The State of New York is the only U.S. state that requires an independent regulatory review process including technical validation with clinical utility for laboratory developed tests run within a CLIA certified laboratory. As a result of New York State approval the PerioPredict™ test is now available to dental providers and their patients in all 50 U.S. states.

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

A recently published paper in the Journal of the American College of Cardiology (Tsimikas et al. 2014) extends the scientific evidence supporting the value of Interleukin Genetics' proprietary heart health test to improve the identification of individuals with a prior diagnosis of cardiovascular disease who are at increased risk for a future cardiovascular disease event. This test has the potential to change a physician's clinical actions to better manage cardiovascular disease risk. This test may be most appropriately applied in the future to guide use of drugs currently in development by others that directly address the biological mechanisms identified by our test.

We market our Inherent Health® brand of genetic assessment tests primarily through our commercial relationships with Alticor Inc. affiliated companies. Alticor is a related party. On October 26, 2009, we entered into a Merchant Network and Channel Partner Agreement with Amway Corp., d/b/a/ Amway Global ("Amway Global"), a subsidiary of Alticor. Pursuant to this agreement, Amway Global sells our Inherent Health® brand of genetic tests through its e-commerce website via a hyperlink to our e-commerce site. In the three months ended June 30, 2014 and 2013, revenues from this agreement accounted for approximately 39% and 24% of our revenues, respectively. In the six months ended June 30, 2014 and 2013, revenues from this agreement accounted for approximately 37% and 38% of our revenues, respectively.

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Beginning in September 2012 and again in 2013, Access Business Group LLC ("ABG"), an affiliate of Alticor, a related party, placed purchase orders totaling approximately $3.3 million consisting of Weight Management kits. The kits are included as part of a promotional bundle of products that Amway is now selling to their Individual Business Owners (IBOs). Of the $3.3 million in orders $1.8 million was received in 2013 for the 2014 program and $1.5 million for the 2013 program. All cash for the orders and royalties was received by December 31, 2013. The 2013 program was amended by ABG so that it would not expire at December 31, 2013. Rather than having all program kits expire at December 31, 2013, cash received from the orders will remain in deferred revenue until the tests are returned and processed. For the three months ended June 30, 2014 and 2013, approximately 38% and 67%, respectively, of our revenue came from sales through ABG's promotional product bundle program. For the six months ended June 30, 2014 and 2013, approximately 38% and 49%, respectively, of our revenue came from sales through ABG's promotional product bundle program.

On September 21, 2012, we entered into a License Agreement with Access Business Group International LLC ("ABGI"), an affiliate of Alticor. Pursuant to this License Agreement, we granted ABGI and its affiliates a non-exclusive license to use the technology related to our Weight Management genetic test and to sell the Weight Management test in Europe, Russia and South Africa. ABGI, or a laboratory designated by ABGI, is responsible for processing the tests, and we receive a royalty for each test sold. The License Agreement has an initial term of five years from the date of first commercial sale of the Weight Management test under the agreement. During the three and six months ended June 30, 2014, $43,000 and $97,885, respectively, has been earned. No royalties were earned in the same period in 2013.

In connection with the execution of the License Agreement, the Company and ABGI also entered into a Professional Services Agreement (the "PSA") pursuant to which the Company has agreed to provide services to ABGI in connection with its sale and processing of the tests within the Territories. Services will be provided pursuant to a statement of work to be entered into from time to time between the parties. Such statements of work will also specify the fees to be paid by ABGI to Interleukin for such services. The PSA has no set term and may be terminated by either party, subject to certain conditions. To date, we have earned $5,250 in fees from this agreement.

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

We recognize revenue from genetic testing services when there is persuasive evidence of an arrangement, service has been rendered, the sales price is determinable and collectability is reasonably assured. Service is deemed to be rendered when the results have been reported to the individual who ordered the test. To the extent that tests have been prepaid but results have not yet been reported, recognition of all related revenue is deferred. During the fourth quarter of 2013, we concluded that sufficient historical customer genetic test redemption patterns existed to determine the period of time after which the likelihood of test redemption was remote for Inherent Health tests purchased. Based on our analysis of the redemption data, we estimate that period of time to be three years after the sale of a genetic test kit. Prior to making this determination, revenue was recognized only on test kits returned and processed. Beginning in the fourth quarter of 2013, we began to recognize breakage revenue related to genetic tests kits utilizing the remote method. Under the remote method, breakage revenue should be recognized when the likelihood of the customer exercising rights of redemption becomes remote. The term remote requires statistical analysis of customer redemption patterns for all tests sold and returned. We analyzed redemption patterns from 2009 through 2013. Included in genetic test revenue in the three and six months ended June 30, 2014 is $92,364 and $156,861 of breakage revenue related to unredeemed genetic test kits from the first and second quarter of 2011. We will continue to recognize breakage revenue and the corresponding deferred cost of goods as well as analyze the data on a quarterly basis based on the historical analysis.

In the genetic test business, competition is in flux and the markets and customer base are not well established. Adoption of new technologies by consumers requires substantial market development and customer education. Historically, we have focused on our relationship with our primary customer, Alticor, a significant direct marketing company, in order to assist us in developing the market for our products and educating our potential customers. Our challenge in 2014 and beyond will be to develop the market for our other personalized health products, in particular our PerioPredict™ test. We continue to allocate considerable resources to commercialization of our PerioPredict™ and Inherent Health® brands of genetic tests. Due to the early stage of these initiatives, we cannot predict with certainty fluctuations we may experience in our genetic test revenues or whether revenues derived from the Preferred Participation Agreement with RHSC or from our arrangements with Alticor-affiliated entities will ever be material, or if material, will be sustained in future periods.

19 Results of Operations



Three Months Ended June 30, 2014 and 2013

Total revenue was $529,000 for the three months ended June 30, 2014 compared to $852,000 for the three months ended June 30, 2013. The change in total revenue is attributable to higher revenues in the 2013 period due to a promotion, by our partner Amway, resulting in a larger volume of pre-paid test kits returned for processing. The decrease in genetic testing revenue quarter to quarter was partially offset by $92,364 of breakage revenue recognized in the three months ended June 30, 2014, whereas no breakage revenue was recognized in the three months ended June 30, 2013. In addition, the Company earned $43,000 of royalties in the second quarter of 2014 from our agreement with ABGI whereas no fees were earned under this agreement in the second quarter of 2013.

During the three months ended June 30, 2014, 39% of our sales revenue came through our Merchant Network and Channel Partner Agreement with Amway Global compared to 24% during the three months ended June 30, 2013. During the same period, 38% and 67%, respectively, of our revenue came from sales through ABG's promotional product bundle program.

Cost of revenue for the three months ended June, 30 2014 was $362,000, or 68.4% of revenue, compared to $496,000, or 58.3% of revenue, for the three months ended June 30, 2013. The increase in the cost of revenue as a percentage of revenue in the three months ended June 30, 2014 is primarily attributable to fixed laboratory costs associated with processing a lower volume of genetic tests, as compared to the same period in 2013. Deferred cost of revenue related to breakage revenue was $3,700 for the three months ended June 30, 2014. No breakage revenue or costs were recognized in the three months ended June 30, 2013.

Research and development expenses were $216,000 for the three months ended June 30, 2014, compared to $188,000 for the three months ended June 30, 2013. The increase of $28,000 or 14.8%, in research and development expenses is primarily attributable to increased compensation based primarily on employee annual performance reviews.

Selling, general and administrative expenses were $1.5 million for the three months ended June 30, 2014, compared to $1.6 million for the three months ended June 30, 2013. The decrease of $100,000, or 6.3%, is primarily attributable to decreased expenses related to marketing activities for our PerioPredict™ periodontal test, decreased consulting and professional expenses and lower sales commissions paid to Amway Global as part of our Merchant Network and Channel Partner Agreement, partially offset by increased compensation expenses based primarily on employee annual performance reviews.

Interest income was $1,600 for the three months ended June 30, 2014, as compared to $345,000 in expense for the three months ended June 30, 2013. There was no interest expense in the three months ended June 30, 2014 due to the conversion of all outstanding convertible debt to common stock on May 17, 2013 as part of the May 2013 Private Placement.

Six Months Ended June 30, 2014 and 2013

Total revenue was $1.0 million for the six months ended June 30, 2014 compared to $1.3 million for the six months ended June 30, 2013. The change in total revenue is attributable to higher revenues in the 2013 period due to a promotion, by our partner Amway, resulting in a larger volume of pre-paid test kits returned for processing. The decrease in genetic testing revenue quarter to quarter was partially offset by $156,861 of breakage revenue recognized in the six months ended June 30, 2014, whereas no breakage revenue was recognized in the six months ended June 30, 2013. In addition, we earned $98,000 of royalties in the first and second quarter of 2014 from our agreement with ABGI whereas no fees were earned under this agreement in the same period in 2013.

During the six months ended June 30, 2014, 37% of our sales revenue came through our Merchant Network and Channel Partner Agreement with Amway Global compared to 38% during the six months ended June 30, 2013. During the same period, 38% and 49%, respectively, of our revenue came from sales through ABG's promotional product bundle program.

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Cost of revenue for the six months ended June 30, 2014 was $757,000, or 74.5% of revenue, compared to $880,000, or 65.7% of revenue, for the six months ended June 30, 2013. The increase in the cost of revenue as a percentage of revenue in the six months ended June 30, 2014 is primarily attributable fixed laboratory costs associated with processing a lower volume of genetic tests, as compared to the same period in 2013. Deferred cost of revenue related to breakage revenue was $6,100 for the six months ended June 30, 2014. No breakage revenue or costs were recognized in the six months ended June 30, 2013.

Research and development expenses were $425,000 for the six months ended June 30, 2014, compared to $348,000 for the six months ended June 30, 2013. The increase of $77,000 or 21.9%, in research and development expenses is primarily attributable to increased compensation based primarily on employee annual performance reviews.

Selling, general and administrative expenses were $3.0 million for the six months ended June 30, 2014, compared to $2.6 million for the six months ended June 30, 2013. The increase of $400,000, or 15.4%, is primarily attributable to increased compensation expenses based primarily on employee annual performance reviews, partially offset by decreased expenses related to marketing activities for our PerioPredict™ periodontal test, decreased consulting and professional expenses and lower sales commissions paid to Amway Global as part of our Merchant Network and Channel Partner Agreement.

Interest income was $4,000 for the six months ended June 30, 2014, as compared to $459,000 in expense for the six months ended June 30, 2013. There was no interest expense in the six months ended June 30, 2014 due to the conversion of all outstanding convertible debt to common stock on May 17, 2013 as part of the May 2013 Private Placement.

Liquidity and Capital Resources

As of June 30, 2014, we had cash and cash equivalents of $4.2 million.

Cash used in operations was $3.3 million for the six months ended June 30, 2014 compared to $1.5 million for the six months ended June 30, 2013. Cash used in operations is primarily impacted by operating results and changes in working capital, particularly the timing of the collection of related party receivables, inventory levels, receipt of orders and the timing of payments to suppliers.

Cash used in investing activities was $61,000 for the six months ended June 30, 2014, compared to $10,000 for the six months ended June 30, 2013. These amounts represent capital additions.

Cash provided by financing activities was $19,000 for the six months ended June 30, 2014 compared to $11.1 million for the six months ended June 30, 2013. On May 17, 2013, we entered into a Common Stock Purchase Agreement with various accredited investors, pursuant to which we sold an aggregate of 43,715,847 shares of our common stock, at a price of $0.2745 per share for net cash proceeds of $11.1 million. We received $19,000 from stock purchases through the employee stock purchase plan during the six months ended June 30, 2014 compared to $13,000 for the six months ended June 30, 2013. We received $500 from the exercise of employee stock options during the six months ended June 30, 2013 whereas no employee stock options were exercised during the six months ended June 30, 2014.

The amount of cash we generate from operations is currently not sufficient to continue to fund operations and grow our business. We expect that our current and anticipated financial resources will be adequate to maintain our current and planned operations at least through November 30, 2014. If we are unable to obtain funding from our current or new investors, we may have to end our operations and seek protection under bankruptcy laws. We will need significant additional capital to fund our continued operations, to facilitate the continued commercial launch of our PerioPredict™ genetic test, for continued research and development efforts, and for obtaining and protecting patents and administrative expenses. We believe our success depends on our ability to have sufficient capital and liquidity to fund operations at least until we begin to receive significant revenues from the processing of the PerioPredict™ genetic test under the Preferred Participation Agreement with RHSC, as well as from agreements we may enter into with other dental care providers who may utilize the PerioPredict™ test in their dental plans. The timing of any revenues that we may receive under this agreement or any other agreements we may enter into is dependent upon the timing of the offering of Reimbursed Dental Plans by RHSC affiliates and other insurance companies and dental care providers, which timing is uncertain at this time, and is contingent upon a number of factors, including the ability for a provider to develop Reimbursed Dental Plans and to develop a viable market for such plans. RHSC has informed us that it has presented the scientific data underlying Reimbursed Dental Plans to a number of customers and will make available Reimbursed Dental Plans as an alternative to a customer's current plan for any customer that expresses an interest in such a plan. We do not expect to receive any significant revenues under this agreement until 2015, at the earliest, and the timing of any such revenues may be substantially later. We may never receive significant revenues under this agreement. We continue to discuss the use of the PerioPredict™ test with other dental providers.

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

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of operations are based upon our financial statements. The preparation of these financial statements and related disclosures in conformity with accounting principles generally accepted in the United States of America requires us to (i) make judgments, assumptions and estimates that affect the reported amounts of assets, liabilities, revenue and expenses; and (ii) disclose contingent assets and liabilities. A critical accounting estimate is an assumption that could have a material effect on our financial statements if another, also reasonable, amount were used or a change in the estimates is reasonably likely from period to period. We base our accounting estimates on historical experience and other factors that we consider reasonable under the circumstances. However, actual results may differ from these estimates. To the extent there are material differences between our estimates and the actual results, our future financial condition and results of operations will be affected. Our most critical accounting policies and estimates upon which our financial condition depends, and which involve the most complex or subjective decisions or assessments are set forth in Note 4 to our financial statements included in our Annual Report on Form 10-K for the year ended December 31, 2013. There have been no significant changes in our accounting policies or changes from the methodology applied by management for critical accounting estimates previously disclosed in our most recent Annual Report on Form 10-K.

Recent Accounting Pronouncements

Please see the discussion of "Recent Accounting Pronouncements" in Note 4, "Significant Accounting Policies" contained in the Notes to Financial Statements included in our Annual Report on Form 10-K for the year ended December 31, 2013 and Note 3, "Summary of Significant Accounting Policies" contained in the Notes to Unaudited Condensed Financial Statements included in this Quarterly Report on Form 10-Q.


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