WrinkleAway – Case Alladin Pharma Co., whose shares are...

WrinkleAway – Case

Alladin Pharma Co., whose shares are publicly traded on the TSX, operates in the pharmaceutical industry in North America. It was incorporated under the Canada Business Corporations Act in 1986 and its head office is located in Vancouver. Alladin’s fiscal year end is December 31, and as a public company, it follows International Financial Reporting Standards (IFRS).

Alladin currently owns a number of products, some of which have patent protection in North America, and some of which are off patent. Alladin also licenses and markets products from other pharmaceutical companies, which is a common practice in the industry. All of Alladin’s products are manufactured by contract manufacturing organizations, minimizing the need for investment in property, plant and equipment. Some of its products are distributed to retail outlets, while others are distributed through medical practitioners (such as dermatologists and plastic surgeons).

Effective December 31, 2013, Alladin acquired 100% of the shares of a privately held competitor, Solas Inc., to expand its product portfolio. The transaction offered Alladin the opportunity to broaden its suite of product offerings, which was expected to generate positive revenue and cost synergies from economies of both scale and scope. An external valuation professional was used to value the identifiable tangible and intangible assets and to determine the purchase price allocation as at December 31, 2013.

WrinkleAway was a key product acquired in the acquisition of Solas. WrinkleAway is a patented product that helps reduce or eliminate facial wrinkles. The product has been well accepted in the North American market with growing market share and revenues since its introduction in 2011. The patent was set to expire at December 31, 2020, with a declining amount of residual sales after this point. Alladin determined, in consultation with its auditors at the date of acquisition, that using a straight-line amortization over 10 years for this intangible asset would be appropriate.

Prior to the acquisition, Solas had initiated a patent infringement lawsuit against a generic competitor, Insegra Company Limited, in relation to WrinkleAway.

On September 30, 2014, the court ruled that starting January 1, 2018, Insegra will be allowed to sell a product that uses WrinkleAway’s patented formula to develop its own generic version of WrinkleAway. Alladin’s lawyers had always anticipated competition; however, the expectation at the date of acquisition was that generics would launch after the expiry of the original patent, that being December 31, 2020.

On top of the shortened exclusivity period, Alladin senior management expressed concerns that the level of synergies expected were tracking behind the business case. After nine months of integration, it was confirmed that the actual level of synergies would be lower than anticipated.

Alex Weingart, the CFO of Alladin, has asked for your help in determining the financial reporting implications of these developments. You, a CPA, work as a financial analyst for Mr. Weingart.

Mr. Weingart has requested that you prepare a memo to him assessing whether there has been an impairment in the value of the WrinkleAway intangible asset, and if so, how much.

He provides you with a number of pieces of relevant information he has gathered including:

• Exhibit A: Purchase price allocation of Solas Inc. at December 31, 2013
• Exhibit B: Calculation of WACC as at December 31, 2013
• Exhibit C: Free cash flow projection of WrinkleAway as at December 31, 2013
• Exhibit D: Fair value of WrinkleAway patent as at December 31, 2013
• Exhibit E: Updated financial projection assumptions for WrinkleAway
• Exhibit F: Other information and corporate assumptions

Your response, not including Excel (if applicable), should not exceed 3 pages.

See below

Exhibit E: Updated financial projection assumptions for WrinkleAway

1. As a result of the recent court case ruling, sales of WrinkleAway are expected to start decreasing 20% per annum starting January 1, 2018. Sales are still on track to meet the original projections for 2014, 2015, 2016 and 2017.
2. Due to certain integration challenges, we do not expect to realize any synergies in 2014 that had been projected at the date of acquisition due to higher integration costs than anticipated. We now believe that synergies from the acquisition from 2015 onward will only be 12% of net revenue, instead of the 20% expected at the date of acquisition.
3. All other costs, except for research and development, are expected to be as originally projected on a percentage of net revenue basis.
4. Knowing that WrinkleAway now has a shorter product life cycle with the court’s decision, we now expect to reduce our research and development expenditures and capital expenditures by 50%. Research and development costs will decline from 5% to 2% of net revenues. Capital expenditures will decline from 2% to 1% of net revenues.
5. Investments in working capital expenditures are expected to be 2% of the change in net revenue year over year, which is consistent with the original projection.

Exhibit F: Other information and corporate assumptions

Other information
• Any licensing of the WrinkleAway product patent would align to the remaining exclusivity period. Information gathered on current royalty rates for a variety of similar pharmaceutical product patents are outlined below:
Product patent Royalty rate Product geographic scope Terms and conditions
FX’s sculpting cream 35% Asia only The licence is for 15 years. This global product is the number two seller in the world. The licence is for selling in Asia only. Licensee must pay marketing costs.
Seporana’s acne cream 25% North America The licence is for 10 years for a North American licence. No additional marketing costs are required, as licensor will support product.
Neuvelle antiwrinkle cream for the eyes 30% North America Licence is for four years, and licensee will be required to pay marketing costs of at least 3% to support the product.
Oliveria antiaging cream for the neck and face 31% United States Licence is for 11 years for U.S. distribution. Marketing costs of 5% will be required by the licensee.
Zanas toning cream 28% Europe Licence is for eight years only for European distribution. Marketing costs of 3% will be required by the licensee.

• Any costs of disposal of the WrinkleAway patent are estimated to be 3% of the proceeds on sale.
• Any licensee of the WrinkleAway product will be required to pay 2% for ongoing marketing costs to support the product.

Corporate assumptions

• Impairment analysis (use IAS 36, Impairment of Assets, for guidance):
o For the value-in-use calculation, Alladin uses pre-tax cash flows and a pre-tax discount rate to determine the recoverable amount.
o For the fair value less costs of disposal, Alladin uses the relief-from-royalty approach for valuing pharmaceutical patents.
• All components of the WACC calculation at December 31, 2013, are still relevant at September 30, 2014 (see Exhibit B), other than:
o Risk-free rate of return (long-term government of Canada bond yields) is now
2.9%.
o The cost of debt is now 7.5%.
o Weighting of debt is 30%.
• Effective income tax rate for Alladin and Solas is 25%.

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MEMORANDUM
To: Alex Weingart, CFO of Alladin
From: Lynn, Financial analyst
Date: December 14, 2017
Subject: Assessment of impairment in the value of WrinkleAway.
WrinkleAway was the crown jewel in the acquisition of Solas and has been shown on the balance sheet at carrying value of $525,896,000. However, due to the passing of the new court ruling on September 30, 2014 which shortens the exclusivity period till January 1, 2018, it is expected that there has been an impairment in the value of the intangible asset. The valuation of the asset has been done on the basis of value-in-use and it is expected that the company would not dispose the asset after its exclusivity period expires due to creation of loyal consumer base during the period of exclusivity.
In order to assess whether there has been an impairment loss, the weighted average cost of capital is computed on September 30, 2014. The calculations are shown in Appendix 1 and the new value of the WACC is 9.67%, compared to 11.1% which was used at the time of acquisition. Since the cost of capital has decreased as more of debt and financial leverage is added to the capital structure, it is expected that the fair value of WrinkleAway should increase. However, this is not the case since the estimates about the free cash flow of the asset have reduced drastically....