EROX Human Pheromone Sciences Inc (GM)

Item 2 . Management’s Discussion and Analysis of Financial Conditions and Results of Operations

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended.  Except for the historical information contained in this discussion and analysis of financial condition and results of operations, the matters discussed herein are forward-looking statements.  These forward-looking statements include but are not limited to the Company’s plans for sales growth and expansion into new channels of trade, expectations of gross margin, expenses, new product introduction, and the Company’s liquidity and capital needs.  These matters involve risks and uncertainties that could cause actual results to differ materially from the statements made.  In addition to the risks and uncertainties described in “Risk Factors” below, these risks and uncertainties may include consumer trends, business cycles, scientific developments, changes in governmental policy and regulation, currency fluctuations, economic trends in the United States and inflation.  These and other factors may cause actual results to differ materially from those anticipated in forward-looking statements.  Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date hereof.

CRITICAL ACCOUNTING POLICIES

The Company’s discussion and analysis of its financial conditions and results of operations are based upon financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America.  The preparation of financial statements requires management to make estimates and judgments that affect the reported amounts of assets and liabilities, revenues and expenses and disclosures on the date of the financial statements.  On an on-going basis, we evaluate our estimates, including, but not limited to, those related to revenue recognition and license fees.  We use authoritative pronouncements, historical experience and other assumptions as the basis for making judgments.  Actual results could differ from those estimates.  We believe that the following critical accounting policies affect our more significant judgments and estimates in the preparation of our financial statements.

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Stock Option Policy

The Company adopted SFAS 123 (R) “Share-Based Payment”, for accounting for its stock options effective with the fiscal year beginning January 1, 2006.   The fair value of each option granted is estimated on the date of the grant using the Black-Scholes option-pricing model.  The Black-Scholes pricing model has assumptions for the risk free interest rates, dividends, stock volatility and expected life of an option grant.  The risk free interest rate is based on the U.S. Treasury Bill rate with a maturity based on the expected life of the options and on the closest day to an individual stock option grant.  Dividend rates are based on the Company’s dividend history.  The stock volatility factor is based on the past seven years of market prices of the Company’s common stock.  The expected life of an option grant is based on various factors including historical exercise rates in addition to the life of the stock option.  The Company adjusts compensation expense by a forfeiture factor based on historical experience. The fair value of each option grant is recognized as compensation expense over the vesting period of the option on a straight line basis.

The Company did not record the stock compensation expense net of taxes since there was no material provision for income taxes for the periods ended September 30, 2007 and 2006 as the Company incurred net operating losses for which no benefit was recognized, or utilized tax loss carryforwards.  The tax benefit is a component of the deferred tax asset disclosed in the income taxes footnote.

Use of Estimates

The preparation of the financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements, and the reported amounts of revenue and expenses during the reporting period.  Actual results could differ from those estimates.

Revenue Recognition

Revenue is recorded at the time of merchandise shipment, net of provisions for returns.  The Company records revenues from sales initiated by sales agents, net of the sales commissions earned following the interpretative guidance provided by FASB Emerging Issue Task Force (EITF) EITF No. 99-19 Reporting Revenue Gross as a Principal versus Net as an Agent . License fees are earned over the license period according to the terms of the license agreement and interpretative guidance provided by Staff Accounting Bulletin (SAB) No. 101 Revenue Recognition in Financial Statements, No. 104 Revenue Recognition and EITF No. 00-21 Revenue Arrangements with Multiple Deliverables .  The majority of the Company’s sales are to distributors and licensees, and these distributors and licensees have no right to return products.  

In addition to the aforementioned general policy, we enter into transactions that represent multiple-element arrangements, which may include post signing training and technical support to our licensees as needed to assist them in the use of our products and integration into their product development.  Multiple-element arrangements are assessed to determine whether they can be separated into more than one unit of accounting.  A multiple-element arrangement is separated into more than one unit of accounting if all of the following criteria are met.

●   The delivered items or service has value to the customer on a stand alone basis.

●   There is objective and reliable evidence of the fair value of the undelivered items or service.

●   If the delivery or performance of the undelivered items or service is considered probably and substantially in our control.

If these criteria are not met, then license revenues are deferred until such criteria are met or until the period(s) over which the last undelivered element is delivered.  If there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the consideration is allocated to the separate units of accounting based on each unit’s relative fair value. A portion of the initial payment received as part of a license agreement is being recognized as milestones are achieved towards fulfillment of the license agreement terms, based on interpretative guidance provided by EITF No. 00-21.

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Income Taxes

Deferred income taxes are provided using the liability method whereby deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some portion or all of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

When tax returns are filed, it is highly certain that some positions taken would be sustained upon examination by the taxing authorities, while others are subject to uncertainty about the merits of the position taken or the amount of the position that would ultimately be sustained. The benefit of a tax position is recognized in the financial statements in the period during which, based on all available evidence, management believes it is more-likely-than not that the position will be sustained upon examination, including the resolution of appeals or litigation processes, if any. The evaluation of a tax position taken is considered by itself and not offset or aggregated with other positions. Tax positions that meet the more-likely-than-not recognition threshold are measured as the largest amount of tax benefit that is more than 50 percent likely of being realized upon settlement with the applicable taxing authority. The portion of the benefits associated with tax positions taken that exceeds the amount measured as described above is reflected as a liability for unrecognized tax benefits in the accompanying balance sheet along with any associated interest and penalties that would be payable to the taxing authorities upon examination.

Interest and penalties associated with unrecognized tax benefits are classified as interest expense and additional income taxes in the statements of operations.

COMPANY OVERVIEW

The Company is engaged in the research, development, manufacturing and marketing of consumer products containing synthetic human pheromones and other mood enhancing compounds.  The Company initiated commercial operations in late 1994 with a line of fine fragrances and toiletries.  Licensing of the Company’s technology is currently the core business of the Company while directly managing the on-going development of identified compounds for potential new products.  The Company’s patented compounds are sold to licensed customers and included as components in their fragranced consumer products.  The Company also offers private label manufacturing services for third party consumer product licensees.

Results of Operations

Three Months ended September 30, 2007 compared to the Three Months ended September 30, 2006

Net revenue for the quarters ended September 30, 2007 and 2006 were as follows (in thousands):

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Total revenues for the quarter ended September 30, 2007 were $239,000, representing a 35% decrease from the prior year’s revenues of $365,000.  The $126,000 decrease in total revenues was due to $279,000 reduction in domestic product revenues to our primary customer which expanded into international markets in 2006 and did not have similar purchase requirements this year, with increases in International product revenues and license revenues.  International sales of $75,000 were $55,000 more than 2006 sales of $20,000 due to increased orders from Latin America and Asian markets.   License revenue for the third quarters of 2007 and 2006 were $157,000 and $57,000, respectively, an increase of $100,000.    

Gross profit for the quarter ended September 30, 2007 of $145,000 is 51% less than last year’s gross profit of $297,000.  As a percentage of revenues, gross margin of 61% was less than last year’s gross margin of 81%.  Gross margin on product revenues decreased in 2007 due to the reduced sales of higher margin products during the quarter.  To fulfill a portion of the license agreement terms with Personal Products Company (“PPC”), expenses associated with the PPC work have been included as cost of goods sold to offset the revenue recorded which results in a reduced overall gross margin.  The license revenue margin improved slightly as our second licensee has minimal costs associated with this agreement.

Research and development expenses for the third quarters of 2007 and 2006 were $10,000 and $29,000, respectively.  Research expenditures of $49,000 that were incurred in 2007, and $17,000 incurred in 2006, to support the PPC license have been charged as cost of goods sold. The total research and development costs incurred for the quarters, including the amount recorded as license costs, was $59,000 for the three months ended September 30, 2007, which was $13,000 more than the prior year’s $46,000.  Increased rent and consultant costs accounted for the increased research and development spending.  Research and development on several new compounds, in addition to the two compounds noted in the PPC license, is on-going at a reduced funding level.

Selling, general and administrative expenses of $240,000 are $13,000 more than last year’s $227,000.  Selling, marketing and distribution expenses were $2,000 more than the prior year due to costs associated with changing of our fulfillment center for direct marketing orders.  General and administrative and facility costs increased by $13,000, with increases in audit and tax fees and stock option compensation costs being somewhat offset by expenditures to support the PPC license being charged as cost of goods sold rather than to general and administrative expenses.   

The Company earned $16,000 in net interest income during the three months ending September 30, 2007 and $8,000 for the three months ending September 30, 2006.  The increased earnings were due to the Company’s cash increases resulting from the $1,750,000 payment upon signing the PPC license agreement in August 2006.  

Nine Months ended September 30, 2007 as compared to the Nine Months ended September 30, 2006

Net revenues for the Nine months ended September 30, 2007 and 2006 were as follows (in thousands):

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Net revenues for the nine months ended September 30, 2007 were $902,000.  This was an 11% increase from net revenues of $815,000 for the nine months of 2006.  The increase in total revenues was due to the $355,000 license revenues attributed to the our two license agreements, Personal Products Company (PPC), a division of McNeil-PPC, Inc. (a Johnson & Johnson company) license agreement signed in August 2006 and Schwarzkopf & Henkel, a division of Henkel Consumer Goods, Inc.  Net product revenues of $490,000 for the nine months ending September 30, 2007 was $268,000 less than last year’s $758,000  for the comparable period.  Domestically, revenues were $206,000 less than the prior year’s $536,000.  A new specialty retailer’s initial order was not able to offset the decrease in revenues from our primary customers who expanded into new territories in 2006 and did not require similar quantities in 2007.  Since the Company is not always aware of its customer’s manufacturing and marketing plans, revenue fluctuations will occur.   International revenues were $62,000 less than the prior year due to decreased sales in the Asian private label markets.