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Nuvo Research Inc. Annual Report 2012 Corporate Profile Nuvo is a publicly traded, Canadian specialty pharmaceutical company, headquartered in Mississauga, Ontario, Canada dedicated to building a portfolio of commercialized pharmaceutical products. The Company’s Pain Group located in West Chester, Pennsylvania is focused on the development and commercialization of topically delivered pain products including three FDA approved products: Pennsaid®, Pliaglis® and Synera®. The Company’s Immunology Group is developing WF10, for the treatment of immune related diseases from its research and development facility in Leipzig, Germany. Nuvo trades on the Toronto Stock Exchange under the symbol NRI. Product Pipeline Formulation Development/ Preclinical IND Filed Phase 1 Phase 2 Phase 3 Regulatory Submission Commercialization PAIN GROUP Pennsaid (U.S., Canada, Europe) Pennsaid 2% OSTEOARTHRITIS – KNEE (Covidien-U.S., Paladin-Canada, Vianex-Greece, Italchimici-Italy) OSTEOARTHRITIS (Covidien-U.S., Paladin-Canada, Central & South America, Israel, South Africa) Pliaglis (Approved Argentina, U.S., Europe) Synera (U.S., Europe) DERMAL ANESTHESIA – COSMETIC (Galderma-Worldwide) DERMAL ANALGESIA – PREVENTION NEEDLE INSERTION PAIN (Nuvo-N. America, Eurocept-E.U. & China) Synera FOCAL ACUTE MUSCULOSKELETAL PAIN NRI – ANA ACUTE NEUROPATHIC PAIN Topical Pain Products ACUTE PAIN IMMUNOLOGY GROUP WF10 IMMUNE MODULATION (ALLERGIC RHINITIS) Table of contents 1 Letter to Shareholders 2 Pain Group 3 Immunology Group 4 Management’s Discussion and Analysis 58 Management’s Report 59 Independent Auditor’s Report 60 Consolidated Financial Statements 100 Corporate Information 100 Board of Directors and Executive Officers Letter To Shareholders Like many companies in and outside of the pharmaceuticals industry, we are continually striving to diversify our revenue stream and maximize the value of our products. Through the acquisition of ZARS Pharma, Inc. in 2011, we acquired two U.S. Food and Drug Administration (FDA) approved products – Pliaglis® and Synera® – and a robust technology base with strong intellectual property. This was an important and valuable strategic transaction for Nuvo that moved the Company from having only one FDA approved product, Pennsaid® to a diversified portfolio of three FDA approved topical pain products. Below is an update of the recent progress that we have made with each of our main products. PLIAGLIS Pliaglis is a topical local anesthetic cream that uses Nuvo’s proprietary Phase-Changing technology. It is applied to the skin as a cream and forms a pliable layer when exposed to air that can be easily peeled 20 to 30 minutes after application, anesthetising the underlying skin. Pliaglis is indicated for use on intact skin in adults to provide local analgesia for superficial aesthetic procedures, such as dermal filler injection, pulsed dye laser therapy, facial laser resurfacing and laser-assisted tattoo removal. In 2012, regulatory approval of Pliaglis was secured in the U.S. and E.U. Pliaglis was launched by our global marketing partner, Galderma Pharma S.A. (Galderma) in the U.S. in March 2013 and in the E.U. in April 2013, providing Nuvo with a new additional source of royalty revenue going forward. SYNERA Synera is approved in the U.S. to provide local dermal analgesia for superficial venous access and superficial dermatological procedures, such as excision, electrodessication and shave biopsy of skin lesions. Synera uses Nuvo’s proprietary Controlled Heat Assisted Drug Deliver (CHADD™) technology. In early February 2012, we launched Synera in the U.S. with a small contract sales force. When sales did not materialize as anticipated, we terminated the sales force and refocused our resources on large national accounts such as dialysis centers, infusion centers, home nursing care and blood diagnostic laboratories. We are using our existing internal Pain Group executive team to pursue these national accounts. We have planned two pilot studies with national accounts that are evaluating Synera for subsets of their patient population. We believe the change in strategy regarding the sale and marketing of Synera in the U.S. is showing promise and could be an effective low cost strategy to significantly increase sales for the existing indication. We are also working on the design of a clinical program with the goal of obtaining an expanded indication for Synera for the treatment of acute musculoskeletal pain. We have had interactions with, and feedback from, the FDA to understand the required regulatory pathway for approval and have assembled a group of external scientific leaders to assist with the design of the clinical trials. If the program is successful, Synera would provide clinicians and patients with a non-invasive treatment option for managing acute musculoskeletal pain which we believe represents a significant market opportunity. We do not have sufficient financial resources to conduct these studies on our own and we are actively seeking co-development partners that could contribute to the development cost and participate in the marketing and sale of Synera for the expanded indication throughout the U.S. PENNSAID 2% Pennsaid 2% is the follow-on product to Pennsaid, our non-steroidal anti-inflammatory drug (NSAID) used to treat the signs and symptoms of osteoarthritis of the knee. In July 2012, our U.S. licensing partner, Mallinckrodt Inc. (Mallinckrodt), the Pharmaceuticals business of Covidien, filed a new drug application with the FDA for the U.S. approval of Pennsaid 2%. While Mallinckrodt received a Complete Response Letter on March 4, 2013, we believe that it now has a clearly defined lowrisk pathway to FDA approval of Pennsaid 2% in early 2014. Mallinckrodt is developing a sales and marketing plan to launch Pennsaid 2% shortly after FDA approval. Mallinckrodt plans to discontinue promoting original Pennsaid to focus on promoting Pennsaid 2% once it is approved. We continue to believe that Pennsaid 2% has the potential to provide increased revenues and a longer product life for the Pennsaid franchise due to its unique two times per day metered dosing convenience and two issued patents, that upon approval, can be listed in the FDA’s Orange Book. Nuvo receives a double digit royalty from the U.S. net sales of Pennsaid from Mallinckrodt that will continue and be equally applicable to Pennsaid 2% when approved. WF10™ In partnership with the University of Leipzig and the Fraunhofer Institute in Leipzig, Germany and with funding provided by the Development Bank of Saxony, our Immunology Group is developing our immunology drug platform candidate WF10. We believe that WF10 has the potential to be a game-changing medical technology that can be used to effectively treat a broad range of allergic, autoimmune and oncology conditions. Original WF10 does not have the benefit of broad patent protection. We have developed improved formulations for which we have filed for patent protection and are currently conducting preclinical studies to demonstrate that these improved WF10 formulations have similar safety and efficacy as original WF10. Once these preclinical studies are complete, we plan to conduct a series of proof of concept phase 2 clinical studies to demonstrate WF10 efficacy in a number of indications and then initiate outlicensing discussions with potential pharma partners. 2013 will be an exciting year for Nuvo, as we move closer to profitability. The resubmission by Mallinckrodt of its application for FDA approval of Pennsaid 2%, the Pliaglis launches in the U.S and E.U. by Galderma and the anticipated traction with Synera national accounts are all important events for Nuvo and our shareholders that should enhance the value of our Company. We would like to thank all of our shareholders for their continuing support, our management and employees for their ongoing dedication to Nuvo and the Nuvo strategic plans and to our Board of Directors for their advice and commitment. Daniel Chicoine John London Chairman & Co-Chief Executive Officer President & Co-Chief Executive Officer Pain Group The Pain Group’s President, Dr. Bradley Galer, MD is a renowned pain neurologist and a former senior executive at the pain specialty company Endo Pharmaceuticals (Endo). He was instrumental in the clinical development and commercialization of a number of Endo’s pain products in the U.S., including the Lidoderm Patch – the most successful U.S. topical pain product to-date, Opana and Percocet line-extensions. The Pain Group Management Team has extensive experience in analgesic drug development and commercialization, with prior experience at Endo, Merck, Pfizer and Alpharma. The Pain Group is headquartered in West Chester, Pennsylvania with a manufacturing facility and research and development centre in Varennes, Québec. The Group is focused on the development and commercialization of branded topical medications for the treatment of pain and building a portfolio of pain products. PLIAGLIS ® PENNSAID ® SYNERA ® The Company’s first topical pain product, Pennsaid, is approved for the treatment of the signs and symptoms of osteoarthritis (OA) of the knee. Pennsaid combines a transdermal carrier (dimethyl sulfoxide, popularly known as DMSO) with the active drug, diclofenac sodium, a non-steroidal anti-inflammatory drug (NSAID) and delivers the active drug through the skin directly to the site of pain. While conventional oral NSAIDs expose patients to potentially serious systemic side effects due to higher systemic blood levels of the NSAID, topical NSAIDs, such as Pennsaid, act locally where applied and thus produce significantly lower systemic blood levels of the NSAID. Nuvo’s clinical trials suggest that some of the NSAID associated systemic side effects may occur less frequently with topically applied Pennsaid, while providing a similar degree of symptom relief. Pennsaid is sold and marketed in the U.S. by Nuvo’s U.S. licensing partner, Mallinckrodt Inc. (Mallinckrodt), the Pharmaceuticals business of Covidien. Pennsaid is sold and marketed in Canada by its licensee Paladin Labs Inc. (Paladin). Pennsaid is also available in Greece, Italy and the United Kingdom. Nuvo Manufacturing manufactures Pennsaid for all of its partners globally. Synera is a topical patch that combines lidocaine, tetracaine and heat, using the Company’s proprietary “Controlled Heat Assisted Drug Delivery” (CHADD™) technology. Synera is approved (i) in the U.S. to provide local dermal analgesia for superficial venous access and superficial dermatological procedures, such as excision, electrodessication, and shave biopsy of skin lesions; and (ii) in Europe for surface anaesthesia of normal intact skin in connection with needle puncture in adults and children from three years of age, as well as for cases of superficial surgical procedures on normal intact skin in adults. The Company launched Synera in the U.S. targeting interventional pain doctors with a small contract sales force in early 2012. In September 2012, the Company terminated its agreement with its contract sales organization and refocused its resources on large national accounts such as dialysis centers, infusion centers, home nursing care and blood diagnostic laboratories. Nuvo is encouraged by the response from the National accounts and their ongoing studies with potential customers that, if successful, could lead to Synera sales growth. In May 2012, the Company successfully completed a licensing and supply agreement with Paladin, granting it exclusive Canadian rights to market and sell Synera upon regulatory approval. The Company will receive a double digit royalty on net sales of Synera in Canada. Eurocept BV (Eurocept), a Dutch-based pharmaceutical company has licensed the sales and marketing rights for Synera (under the name Rapydan®) for: Western Europe, Russia and most of its former Republics, Turkey, Israel and the People’s Republic of China. Eurocept has responsibility for all commercialization activities and costs, including marketing, selling and medical education in the above countries. Under the terms of the license agreement, the Company earns royalties on the net sales of Rapydan and is eligible to receive sales milestones. The Company has successfully completed a study for the purpose of supporting removal of the “not for home use” condition currently on the U.S. label of Synera®. The Company expects to file an supplemental New Drug Application (sNDA) with the FDA to remove the “not for home use” condition from the label in the first half of 2013. It is anticipated that the FDA will take at least 4 months to review this application. Removal of this restriction may increase usage by allowing patients to apply Synera at home. PENNSAID 2% Pennsaid 2%, the follow-on product to original Pennsaid, contains 2% diclofenac sodium compared to 1.5% for original Pennsaid. It is more viscous than original Pennsaid, is supplied in a metered dose pump bottle and is designed to be applied twice each day as compared to four times a day for original Pennsaid. In July 2012, Mallinckrodt filed a New Drug Application (NDA) with the U.S. Food and Drug Administration (FDA) for Pennsaid 2%. In March 2013, Mallinckrodt received a Complete Response Letter (CRL) from the FDA following the review of Mallinckrodt’s NDA for Pennsaid 2%. The FDA confirmed that the only additional substantive requirement for approval is the completion of a repeat pharmacokinetic (PK) study comparing Pennsaid 2% to original Pennsaid. Mallinckrodt has indicated that it expects to complete the study and submit the results to the FDA in the third quarter of 2013 and anticipates receiving a formal response from the FDA in the first quarter of 2014. There can be no assurance that Pennsaid 2% will meet all FDA requirements or that it will be approved for marketing by the FDA. Nuvo believes that upon FDA approval, Pennsaid 2% will provide significant patient advantages versus competitor products including an improved dosing regimen and a metered dispensing device. In addition to manufacturing Pennsaid, Nuvo will be manufacturing the commercial supply of Pennsaid 2% at its Varennes facility. 2 Nuvo Research Inc. Annual Report 2012 Pliaglis is a topical local anesthetic cream which uses the Company’s proprietary Phase-Changing Topical Peel technology and is approved and marketed in the U.S., E.U. and certain South American countries. The Company has licensed worldwide marketing rights for Pliaglis to Galderma Pharma, S.A. (Galderma), a global pharmaceutical company specialized in dermatology. Pliaglis is indicated for use on intact skin in adults to provide local analgesia for superficial aesthetic procedures, such as dermal filler injection, pulsed dye laser therapy, facial laser resurfacing and laser-assisted tattoo removal. In March 2013, Galderma launched Pliaglis in the U.S. and in April 2013 in the E.U. Galderma is planning an expanded global launch in Asia, Australia, Canada, South America and South Africa as the product is approved in those countries over the next several years. Immunology Group The Immunology Group is led by its President, Dr. Henrich Guntermann, MD, MSc. Dr. Guntermann has over 15 years of experience in the life sciences industry. The Group is headquartered in Germany and includes a manufacturing facility in Wanzleben and an office in Leipzig that manages all research and development (R&D) activities. The Group is focused on the R&D of existing and reformulated versions of WF10™, a solution of OXO-K993 containing stabilized chlorite ions. WF10 supports the immune system by targeting certain types of cells, including the macrophage, a white blood cell species that is key for the regulation of normal and pathological immune function. ADDITIONAL FUNDING FROM THE DEVELOPMENT BANK OF SAXONY In early 2010, the Company initiated a Phase 2 clinical trial to evaluate WF10 as a treatment for moderate to severe allergic rhinitis. The trial was a 60-subject randomized double-blind, placebo-controlled, single-centre trial to assess the efficacy and safety of a regimen of five daily WF10 infusions for the treatment of patients with moderate to severe persistent allergic rhinitis. The trial met its primary endpoint as measured by the change in Total Nasal Symptom Score (TNSS) from baseline to assessment after three weeks comparing the WF10 group with the placebo group (p<0.001). The TNSS is a validated scale to measure the aggregation of nasal symptoms associated with allergic rhinitis. Also, the Total Ocular Symptom Score (TOSS) was statistically significantly improved against placebo. According to the Allergy & Asthma Medical Group & Research Center, allergic rhinitis is an extremely common condition that currently affects approximately 1.4 billion people globally. A portion of the cost of the trial was funded by the Development Bank of Saxony (SAB) under a 2009 three-year funding commitment to support drug development projects between the Company and the Fraunhofer Institute for Cell Therapy and Immunology IZI in Leipzig, Germany. This significant financial support facilitated the preclinical and clinical development of WF10 as a potential treatment for allergic rhinitis and rheumatoid arthritis. In July 2012, the SAB agreed to provide the Company with additional funding for the further development of its improved reformulated versions of WF10. The SAB funding, which expires in July 2014, will be used to support a number of preclinical studies focused on demonstrating, the efficacy, safety and stability of the new derivative formulations. These studies will continue to be conducted by Nuvo in partnership with the University of Leipzig and the Fraunhofer Institute. PATENT UPDATE In December 2012, the Company filed an international PCT application and a U.S. patent application covering new derivative formulations. In addition, in August 2012, the U.S. Patent and Trademark Office issued a method of use patent covering treatment of allergic rhinitis, allergic asthma and atopic dermatitis with formulations that include WF10. This U.S. patent has an expiry date of March 4, 2029. DEVELOPMENT PLAN Given the recently issued U.S. method of use patent referred to immediately above, the Company is currently exploring commercial potential and regulatory requirements in the U.S. for the development and regulatory approval of a WF10-derivative formulation in the field of airway diseases including allergic rhinitis and allergic asthma. In 2012, the Company conducted preclinical and chemistry, manufacturing and controls (CMC) activities in an effort to better understand stability, safety and efficacy of the new derivative formulations relative to original WF10. The Company plans to continue these studies in 2013 and hopes to advance in 2014 and 2015 to multiple proof of concept Phase 2 clinical studies in different indications to confirm the platform technology capability of the new formulations. If these studies are successful, by 2015, the Company expects to be in a position to seek outlicensing partners that could fund completion of development and seek requisite regulatory approvals. Nuvo Research Inc. Annual Report 2012 3 Management’s Discussion and Analysis (MD&A) The following information should be read in conjunction with the Nuvo Research Inc. (Nuvo or the Company) audited Consolidated Financial Statements and for the year ended December 31, 2012 which were prepared in accordance with International Financial Reporting Standards (IFRS) and filed on SEDAR on March 27, 2013. Additional information relating to the Company, including its Annual Information Form (AIF), can be found on SEDAR at www.sedar.com. All amounts in the MD&A, Consolidated Financial Statements and related notes are expressed in Canadian dollars, unless otherwise noted. F O R WA R D - L O O K I N G S TAT E M E N T S This MD&A contains forward-looking statements that are subject to risks and uncertainties beyond management’s control. Actual results could differ materially from those expressed here. Risk factors are discussed more fully in the Company’s AIF filed with the securities commissions in each Canadian province. Nuvo undertakes no obligation to revise forwardlooking statements in light of future events. OVERVIEW Background Nuvo is a publicly traded, Canadian specialty pharmaceutical company headquartered in Mississauga, Ontario. The Company is dedicated to building a portfolio of pharmaceutical products through internal research and development (R&D) and by in-licensing and acquisition, with a focus on the treatment of pain and the development of its immunology drug, WF10. The Company operates two distinct business units, the Pain Group and the Immunology Group. The Pain Group, located in West Chester, Pennsylvania is focused on the development and commercialization of topically delivered pain products which include Pennsaid®, Pennsaid® 2%, Synera® and Pliaglis®. The Immunology Group manages the immune related assets and is focused on the development of WF10, a compound for the treatment of immune related diseases from its R&D facility in Leipzig, Germany. As of December 31, 2012, the Company and its subsidiaries employed a total of 79 full-time employees at its head office in Mississauga, Ontario, its manufacturing and research facility in Varennes, Québec, its Pain Group Offices in West Chester, Pennsylvania and Salt Lake City, Utah, the OXO-K993 manufacturing facility in Wanzleben, Germany and its R&D facility in Leipzig, Germany. 4 Nuvo Nuvo Research ResearchInc. Inc.Annual AnnualReport Report2012 2012 Strategy The Company’s long-term strategy is to build a profitable company focused on the development and commercialization of pharmaceutical products for the treatment of pain and on the development of its platform drug WF10, for the treatment of immune related diseases. Pain Group The Pain Group is based in West Chester, Pennsylvania and is focused on the research, development and commercialization of the Company’s topically delivered pain products including Pennsaid, Pennsaid 2%, Synera and Pliaglis. In May 2011, the Pain Group began a major transformation when Nuvo acquired ZARS Pharma, Inc. (ZARS) (see Significant Transactions – 2011 – ZARS Acquisition). This transaction shifted the focus of the Pain Group from early stage drug development to later stage drug development and commercialization. This transformational acquisition added two approved products – Synera and Pliaglis, a pipeline of pain products in various stages of development and two important novel and proprietary drug delivery platforms. The Pain Group is marketing Synera in the U.S. targeting national accounts and hospitals – the first product to be directly marketed by the Company in the U.S. To market its other products, Pennsaid, Pennsaid 2% and Pliaglis and for Synera in other territories, the Company relies on marketing, licensing and distribution partners who have the required skill and scale to effectively market each pharmaceutical product. From its inception, the Pain Group has developed topical drugs for the treatment of pain through the use of molecular skin penetration enhancers (MPE™s) and transdermal carriers, to topically deliver drugs into and through the skin directly to the site of pain, such as local soft tissue and peripheral nerve or transdermally into the bloodstream with systemic activity, if desirable. Unlike oral medications, the Company’s topical products do not rely on bloodstream circulation to reach affected parts of the body as they offer site-specific treatment while limiting systemic exposure to the active drug; thereby, reducing the potential for systemic side effects, adverse events and potential drug-drug interactions. The Pain Group’s development focus is on the treatment of pain topically, particularly in cases where changing the dosage form of proven active drugs from oral to topical provides the possibility of clinical benefit with reduced systemic exposure and fewer systemic side effects. With its broadened scope of products, knowledge and capabilities, Nuvo believes it is well positioned to acquire and develop new and existing drug product candidates in the area of pain for topical delivery into and through the skin and to commercialize these pharmaceutical products. Nuvo has assembled a team of scientists, clinicians, regulatory and commercial experts, both internally and through its Advisory Boards, who have significant expertise and experience in all aspects of the pharmaceutical business from drug development through commercialization, focused in the area of pain. With the acquisition of ZARS, the Company significantly broadened its portfolio of development stage products and proprietary platform technologies. However, the focus of the Pain Group has shifted from early stage development to later stage development and commercialization for the near term. Nonetheless, important chemistry, manufacturing and controls (CMC) activities will continue for Nuvo’s pipeline products. The Company will also continue to seek co-development partners for products in its topical pain portfolio. In addition to Pennsaid, Pennsaid 2%, Synera and Pliaglis, Nuvo has a pipeline of topical pain medications for a variety of pain conditions, including a novel Lidocaine spray formulation (NRI-ANA) and other novel formulations for the treatment of pain of inflammatory, nociceptive and neuropathic origin. All of these pain medications are being designed to treat the pain locally, while limiting systemic exposure to the active drug; thereby, reducing the potential for negative side effects, adverse events and potential drug-drug interactions. Pennsaid Pennsaid, the Company’s first commercialized pain product, is used to treat the signs and symptoms associated with knee osteoarthritis (OA). OA is the most common joint disease affecting middle-age and older people. It is characterized by progressive damage to the joint cartilage and causes changes in the structures around the joint. These changes can include fluid accumulation, bony overgrowth and loosening and weakness of muscles and tendons, all of which may limit movement and cause pain and swelling. The drug combines the transdermal carrier (containing dimethyl sulfoxide, popularly known as DMSO), with diclofenac sodium, a leading non-steroidal antiinflammatory drug (NSAID) and delivers the active drug through the skin directly to the site of inflammation and pain. While, conventional oral NSAIDs expose patients to potentially serious systemic side effects, such as gastrointestinal bleeding and cardiovascular risks, Nuvo’s clinical trials suggest that some of these systemic side effects occur less frequently with topically applied Pennsaid. The American College of Rheumatology (ACR) Subcommittee on OA Guidelines has approved and issued updates to Clinical Practice Guidelines for the treatment of OA, based on evidence and expert consensus-based recommendations. These new OA Guidelines, published in the April 2012 issue of the medical journal Arthritis Care & Research, conditionally recommend that healthcare providers consider topical NSAIDs as one option for the pharmacologic management of knee OA. The ACR guidelines strongly recommend the use of oral or topical NSAIDs or intra articular corticosteroid injections in patients with an unsatisfactory clinical response to acetaminophen. They also state oral NSAIDs should not be prescribed in patients with contraindications to oral NSAIDs, such as cardiovascular risk factors, and that patients and doctors should be aware of warnings and precautions relating to oral NSAIDs. The ACR Guidelines “strongly recommends the use of topical rather than oral NSAIDs” in those patients aged 75 years or older. In addition, the National Health Service in the United Kingdom recommends first-line use of topical NSAIDs ahead of oral NSAIDs. In September 2012, the University of Oxford published a thorough meta-analysis scientific review in the Cochrane Database of Systematic Reviews focused on “Topical NSAIDs for chronic musculoskeletal pain in adults”. This review found that topical diclofenac is as effective as oral diclofenac in knee and hand OA and is likely a safer choice for elderly patients and others at risk for gastrointestinal adverse effects. In addition, the review compared different formulations of topical NSAIDs and found that topical diclofenac solution with DMSO (Pennsaid) demonstrated superior efficacy as measured by the number of patients needed to get one patient whose pain is reduced by 50% (known as number needed to treat or NNT). Compared to topical diclofenac gel (Voltaren Gel), topical diclofenac solution with DMSO (Pennsaid) demonstrated an NNT of 6.4 vs. 11 meaning you would need to treat approximately 5 more patients with diclofenac gel to get 1 with a 50% reduction in pain. These conclusions were based on a review of all published and available randomized, double-blind studies with placebo or active comparators in which at least a single treatment was a topical NSAID used to treat chronic pain caused by OA and in which treatment lasted at least 2 weeks. The analysis included data from 7,688 participants in 34 studies, 23 of which compared a topical NSAID with placebo. Pennsaid received U.S. Food and Drug Administration (FDA) approval in November 2009 and was launched by the Company’s U.S. licensee, Mallinckrodt, Inc. Nuvo Research Inc. Annual Report 2012 5 Management’s Discussion and Analysis cont’d (Mallinckrodt), the pharmaceuticals business of Covidien plc, in April 2010. The FDA approval of Pennsaid included the requirement that the Company complete several post-marketing animal studies, including a two-year dermal carcinogenicity study (the Carc Study) and two DMSO based preclinical studies, all of which are being conducted and paid for by Mallinckrodt as they became Mallinckrodt’s responsibility once the NDA for Pennsaid was formally transferred by the Company to Mallinckrodt post FDA approval as required pursuant to the terms of the U.S. Licensing and Development Agreement (U.S. Licensing Agreement). Mallinckrodt has completed the Carc Study without any significant adverse finding and submitted the results to the FDA in October 2012. The two DMSO based studies, a Fertility and Early Embryonic Development study and an evaluation of Peri- and Postnatal Development in a single species with DMSO, were both completed by Mallinckrodt in 2011 without any significant adverse findings and submitted to the FDA. Prior to FDA approval, the Company’s patents that protected Pennsaid in the U.S. had expired. However, upon FDA approval of Pennsaid in the U.S., the product received a three-year period of marketing exclusivity from the date of approval pursuant to a 1984 U.S. federal law, the Drug Price Competition and Patent Term Restoration Act, informally known as the “Hatch-Waxman Act”, and Code of Federal Regulations (C.F.R.) 314.108(b)(4) which provide that a product filed as a 505(b)(2) application and supported by sponsor initiated clinical studies required as a condition of approval is entitled to three years of marketing exclusivity starting from the effective date of approval. This period of marketing exclusivity prohibited the sale of generic versions of Pennsaid in the U.S. until November 4, 2012, three years from the effective date of approval. As such market exclusivity has now expired a generic version of Pennsaid can be sold in the U.S., if such generic version is approved by the FDA. In July 2012, the U.S. Patent Office issued Patent No. 8,217,078 relating to a method of using Pennsaid (Pennsaid Patent) with an expiry date of July 10, 2029. Mallinckrodt listed the Pennsaid Patent in the FDA’s Orange Book. The Orange Book listing required any Abbreviated New Drug Application (ANDA) applicant seeking FDA approval for a generic version of Pennsaid prior to expiration of the patent to notify Nuvo and Mallinckrodt of its ANDA before it can obtain FDA approval. Prior to the Orange Book listing, there was no such requirement imposed on the generic applicants. 6 Nuvo Research Inc. Annual Report 2012 Subsequent to the Orange Book listing, Nuvo and Mallinckrodt received Paragraph IV certification notices from three companies advising Nuvo and Mallinckrodt that they each filed an ANDA with the FDA seeking approval to market a generic version of Pennsaid. One of the applicants has since withdrawn from the process. Nuvo and Mallinckrodt filed a patent infringement complaint with the courts against the two generic companies, Apotex Inc. and Apotex Corp. (together Apotex) and Lupin Ltd and Lupin Pharmaceuticals (together Lupin). In January 2013, Nuvo and Mallinckrodt entered into a settlement agreement with Apotex respecting patent infringement litigation brought by Nuvo and Mallinckrodt in response to Apotex’s filing of an ANDA with the FDA seeking approval to market a generic version of Pennsaid (Apotex Settlement Agreement). Under the terms of the Apotex Settlement Agreement, Nuvo and Mallinckrodt granted a license to Apotex that permits Apotex, upon approval of its ANDA by the FDA, to launch its generic version of Pennsaid on a date that is the earlier of 45 days after Mallinckrodt or Nuvo makes a first commercial shipment of Pennsaid 2% in the U.S. and April 1, 2014, or earlier under certain circumstances. The complaint is pending against Lupin. In February 2013, Nuvo and Mallinckrodt received a fourth Paragraph IV certification notice from a company advising Nuvo and Mallinckrodt that they have filed an ANDA with the FDA seeking approval to market a generic version of Pennsaid. The Pennsaid Patent does not automatically prevent a generic version of Pennsaid from being approved by the FDA or if approved, from being sold in the U.S. However, it does provide the Company with the opportunity to commence legal action against the ANDA applicants for patent infringement. A patent infringement complaint has not been filed at this time against this fourth company. Pennsaid is approved for sale and has been marketed under license and/or distribution agreements for many years in Canada, Greece, Italy and the United Kingdom. Vianex, the Company’s partner in Greece, launched Pennsaid as a prescription-only product with government reimbursement in Greece in 2007 and it quickly became the market leader. During the first half of 2010, the National Organization for Medicines in Greece (NOMG) published a proposed list of drugs for which it would no longer provide reimbursement and Pennsaid was named on this list. This list, that included all topical antirheumatics, became effective in February 2011. In addition, Pennsaid was reclassified as an over-the-counter (OTC) product in Greece. Vianex revamped their sales and marketing plan and relaunched the product into the Greek OTC market in the second half of 2011. The global OA prescription drug market is estimated to have annual sales of approximately US$5 billion and as a result, Pennsaid faces many competitors in all of the markets in which it is sold, including generic versions of Pennsaid in some markets. In the U.S., a number of existing pharmaceutical products treat the pain associated with OA. The many products available to address this condition include: OTC oral medications that are accessible without a doctor’s prescription, such as acetaminophen (Tylenol®) and low-dose NSAIDs such as ibuprofen (Advil®, Motrin®) and naproxen (Aleve®); and prescription only medications, including oral, full-dose NSAIDs, oral, full dose NSAIDs combined with proton pump inhibitors (PPI), topical NSAIDs, oral COX-2 selective NSAIDs and oral opioid analgesics. In the U.S., topical NSAIDs are one of the newest segments. The first topical NSAID was approved in 2008 and since then, the market has grown to include three products including Pennsaid. It is estimated that in 2012, this segment captured 4 million prescriptions and that the size of the market exceeded US$500 million. Pennsaid 2% Pennsaid 2% is an improved version of Pennsaid that contains 2% diclofenac sodium compared to 1.5% for original Pennsaid. It is more viscous than Pennsaid, is supplied in a metered dose pump bottle and was studied in clinical trials using twice daily dosing compared to four times a day for Pennsaid. Under the terms of the U.S. Licensing Agreement, Mallinckrodt assumed full responsibility for managing, planning, executing and paying for all development activities for Pennsaid 2%. Although Nuvo has four of eight seats on the joint steering committee (Pennsaid JSC), that was established as per the U.S. Licensing Agreement with Mallinckrodt to monitor and provide advice respecting the commercialization plans for Pennsaid and the development of Pennsaid 2%, the Company, with limited exceptions, no longer controls the strategy or the execution of the clinical development program for Pennsaid 2% or the commercialization of Pennsaid and Pennsaid 2%. Those responsibilities having been contractually assumed by Mallinckrodt. The Company does have approval rights with respect to any changes to the development plan for Pennsaid 2%. Any such changes require the unanimous approval of the Pennsaid JSC of which the Company has equal representation. Under the terms of the U.S. Licensing Agreement, the parties negotiated and agreed to a development plan for Pennsaid 2% (the Pennsaid 2% Development Plan). The Pennsaid 2% Development Plan described specific development activities to be conducted by Mallinckrodt and timelines for the carrying out of those activities. The Pennsaid 2% Development Plan included a Phase 2 clinical trial which if successful was to be followed immediately by two Phase 3 pivotal clinical studies. The Company estimates the cost of conducting the two Phase 3 clinical trials to be approximately US$30 to US$40 million. The Phase 2 clinical study was successfully concluded during the first half of 2011, but later than contemplated by the Pennsaid 2% Development Plan. In June 2011, Mallinckrodt provided the Company with the Phase 2 clinical trial top-line results that demonstrated that Pennsaid 2% met its primary endpoint of reducing OA pain greater than a placebo vehicle control with a p-value of 0.042. By September 2011, Mallinckrodt was significantly behind the timelines set out in the Pennsaid 2% Development Plan which had provided that the two Phase 3 pivotal clinical studies were to have commenced no later than February 2010. The date of Mallinckrodt’s commencement of the Phase 3 clinical studies was very important to the Company – so much so that the Company had insisted that a specific termination provision be included in the U.S. Licensing Agreement that would allow the Company to terminate the U.S. Licensing Agreement as it relates to Pennsaid 2% and to a reversion of the U.S. marketing rights to Pennsaid 2% to the Company if the two Phase 3 studies were not commenced within 20 months of the date of the agreement. The U.S. Licensing Agreement was dated June 15th, 2009 which means the Company had the right to terminate the agreement if the two Phase 3 clinical studies are not initiated by February 15, 2011. In September 2011, Mallinckrodt advised the Company that it wished to pursue a Supplementary New Drug Application (sNDA) regulatory approval pathway for Pennsaid 2% supported by the data from the Phase 2 clinical study rather than a 505(b)(2) New Drug Application (NDA) regulatory approval pathway supported by two Phase 3 clinical studies as contemplated by the Pennsaid 2% Development Plan. Mallinckrodt advised the Company that it believed data obtained through the Phase 2 clinical trial could be used to support the sNDA and that conducting the two Phase 3 clinical studies was not required. Mallinckrodt further advised the Company that it believed that a sNDA could be filed sooner with the FDA than a NDA, that the FDA review would be expected to be shorter with a sNDA and; therefore, that Pennsaid 2% could be approved more quickly than if Mallinckrodt followed the 505(b)(2) NDA pathway. Mallinckrodt then formally requested that the Company and its representatives on the Pennsaid JSC consent to this change to the Pennsaid 2% Nuvo Research Inc. Annual Report 2012 7 Management’s Discussion and Analysis cont’d Development Plan. The Company declined to provide its requested consent. The Company advised Mallinckrodt that in its view the revised regulatory pathway proposed by Mallinckrodt was riskier than the pathway contemplated by the Pennsaid 2% Development Plan, that the successful Phase 2 study had never been designed or powered as a pivotal study to support approval, that Nuvo would be deprived of the benefit of the Phase 3 study data that, under the terms of the U.S. Licensing Agreement, it was entitled to use to support applications for regulatory approval of Pennsaid 2% in territories outside of the U.S. and that Mallinckrodt’s decision was being driven by its failure to meet the timelines set out in the Pennsaid 2% Development Plan and its desire to save the US$30-40 million cost of conducting the two Phase 3 clinical studies that the Company had negotiated for as part of the consideration for the grant of U.S. marketing rights to Mallinckrodt. Notwithstanding that, Nuvo did not provide its consent to the change in the Pennsaid 2% Development Plan as requested by Mallinckrodt, Mallinckrodt proceeded to file an sNDA supported by the Phase 2 clinical study data without the benefit of the data from two Phase 3 clinical studies. The Company has continued to operationally support Mallinckrodt in its efforts to obtain FDA approval for Pennsaid 2%, but has specifically reserved its legal rights pursuant to the U.S. Licensing Agreement including its right to claim damages, to terminate the U.S. Licensing Agreement for default by Mallinckrodt and to terminate the U.S. Licensing Agreement as it relates to Pennsaid 2% by the failure of Mallinckrodt to commence two Phase 3 clinical studies within 20 months of the date of the U.S. Licensing Agreement. Mallinckrodt submitted an sNDA for Pennsaid 2% to the FDA in May 2012. Mallinckrodt advised the Company that in July 2012, the FDA requested that Mallinckrodt withdraw the sNDA and refile it as an NDA. Mallinckrodt complied with the request and resubmitted the application as an NDA on July 15, 2012. Mallinckrodt advised Nuvo that the FDA accepted the NDA for Pennsaid 2% for review. The FDA set a Prescription Drug User Fee Act (PDUFA) date of March 4, 2013 for action on the submission. Mallinckrodt received a Complete Response Letter (CRL) to the NDA for Pennsaid 2% in which the FDA confirmed the only substantive additional requirement is the completion of a pharmacokinetic (PK) study comparing Pennsaid 2% to original Pennsaid. Mallinckrodt has indicated that it expects to complete the study, submit the results and receive a formal response from the FDA in late 2013 or early 2014. However, there can be no assurance that Pennsaid 2% will meet all FDA requirements or that it will be approved for marketing by the FDA. 8 Nuvo Research Inc. Annual Report 2012 The entry of a generic version of Pennsaid into the U.S. market before FDA approval and the commercial launch of Pennsaid 2% could have a significant adverse effect on Pennsaid and Pennsaid 2% sales and the resulting level of royalties and milestone payments earned by the Company. Under the terms of the Apotex Settlement, Apotex is permitted upon approval of its ANDA by the FDA, to launch its generic version of Pennsaid on a date that is the earlier of 45 days after Mallinckrodt or Nuvo makes a first commercial shipment of Pennsaid 2% in the U.S. and April 1, 2014, or earlier under certain circumstances. In addition to Apotex, there are two other companies including Lupin that have ANDA’s under review with the FDA for Pennsaid for which the Company has filed a patent infringement compliant against Lupin. Pennsaid 2% is not currently approved for sale or marketing in any jurisdiction, but it has been licensed to Mallinckrodt in the U.S. and to Paladin Labs Inc. (Paladin) for Canada, South Africa, Israel and Central and South America. Additional clinical and non-clinical studies, beyond those being conducted by Mallinckrodt, may be required to support applications for the regulatory approval of Pennsaid 2% in the U.S. and other jurisdictions in which the Company, or other licensees and distributors, could potentially market the product. The Company has been advised by regulatory authorities in Canada and the United Kingdom that the data from the Phase 2 study conducted by Mallinckrodt is insufficient to support approval of Pennsaid 2% in their respective jurisdictions and that additional clinical studies will be required. In the U.S., Mallinckrodt is responsible for implementing the development plan for all clinical and non-clinical studies in support of FDA approval. There can be no assurance that the current trials and studies will be sufficient for regulatory authorities in any jurisdiction or that all studies will yield successful results or that the required regulatory approvals will be obtained. In September 2012, the U.S. Patent Office issued U.S. Patent No. 8,252,838 relating to compositions and methods of using Pennsaid 2% (Pennsaid 2% Patent). The patent expires on April 21, 2028. Mallinckrodt has taken the necessary steps to have the new patent listed in the FDA Orange Book once Pennsaid 2% obtains FDA approval. Synera Synera was added to Nuvo’s product portfolio through the acquisition of ZARS (see Significant Transactions – 2011 – ZARS Acquisition). Synera is a topical patch that combines lidocaine, tetracaine and heat, using proprietary “Controlled Heat Assisted Drug Delivery” (CHADD™) technology. The CHADD unit generates gentle heating of the skin and in a well-controlled clinical trial demonstrated that it contributes to the efficacy of Synera. Synera is approved in the U.S. to provide local dermal analgesia for superficial venous access and superficial dermatological procedures, such as excision, electrodessication and shave biopsy of skin lesions. Synera resembles a small adhesive bandage in appearance and is applied to the skin 20 to 30 minutes prior to painful medical procedures, such as venous access, blood draws, needle injections and minor dermatologic surgical procedures. In most European countries, this topical patch is marketed under the trade name Rapydan® and is approved for surface anaesthesia of normal intact skin in connection with needle punctures in adults and children from 3 years of age and for use in cases of superficial surgical procedures on normal intact skin in adults. The FDA approval of Synera included the requirement that the Company complete a post-marketing study commitment for use on intact skin to provide local dermal analgesia for superficial venous access and superficial dermatological procedures such as excision, electrodessication and shave biopsy of skin lesions in pediatric patients ages 0 to 4 months. It is common for the FDA to request the sponsors of an NDA to determine how their product can be used safely in children. The Company has not completed this commitment due to difficulty in getting Institutional Review Board (IRB) approvals, the IRB and/or Medical Executive Committee expressions of serious scientific and ethical concerns regarding the need for and the conduct of the trial, limited investigator interest, limited investigator access at any study site to the required patient populations and the unsuitability of the current patch size for this age group. In September 2011, the Company requested a waiver from the FDA due to the above mentioned issues. In November 2011, the Company had a telephone conference with the FDA regarding the waiver and on this call, the Company agreed to provide the FDA with additional information including the Company’s ability to produce a smaller patch size for use in the neonatal age group. The Company submitted this additional information to the FDA in December 2012. The Company has licensed the sales and marketing rights to Eurocept International B.V. (Eurocept), a Dutch-based pharmaceutical company, for Western Europe, Russia and most of its former Republics, Turkey, Israel and the People’s Republic of China. Eurocept has responsibility for all commercialization activities and costs, including marketing, selling and medical education in the above countries. Under the terms of the agreement, the Company earns royalties on the net sales of Rapydan and is eligible to receive sales milestones. Nuvo holds the sales and marketing rights for Synera in the U.S., Mexico, South America, Australia, Africa and most regions in Asia, although of these jurisdictions, it is only approved in the U.S. In February 2012, the Company’s Pain Group launched Synera in the U.S., targeting interventional pain doctors with a small pain specialty contract sales force managed by the Pain Group. In August 2012, the Company refocused its resources on large national accounts such as dialysis centers, infusion centers and blood diagnostic laboratories. To execute this strategy, the Company terminated its agreement with its contract sales organization and will use its internal Pain Group commercial team to focus on these national accounts and the key interventional pain doctors who use Synera. Synera is manufactured by a third-party contract manufacturing organization (CMO) in the U.S. In May 2012, the Company entered into a license and supply agreement granting Paladin exclusive Canadian rights to market and sell Synera, upon regulatory approval. Under the terms of the agreement, Nuvo will receive a double digit royalty on net sales of Synera in Canada and will supply Synera to Paladin (see Significant Transactions – 2012 – Paladin). Synera has not yet been approved by Canadian regulatory authorities for marketing in Canada. In July 2012, the U.S. Patent Office reinstated Patent No. 6,465,709 providing patent coverage for Synera. This patent is listed in the FDA’s Orange Book and extends the patent expiration of the latest expiring Synera Orange Book listed patent to July 7, 2020. In September 2012, the Company successfully completed a study to provide data to support an application for the removal of the “not for home use” condition currently on the U.S. label of Synera. The Company expects to file a prior approval supplement with the FDA requesting the removal of the “not for home use” condition from the label in the first half of 2013. The Company expects the FDA to take at least 4 months to review and respond to this application. The Company’s strategy is to expand the FDA approved indication for Synera for use in acute musculoskeletal pain syndromes such as tendinopathy and shoulder impingement syndrome. Based on communications with the FDA, the Company plans Nuvo Research Inc. Annual Report 2012 9 Management’s Discussion and Analysis cont’d to run a Phase 2/3 development program on two distinct acute musculoskeletal pain conditions. It is expected that this development program would take approximately 3 years to complete before an application for approval could be filed with the FDA for U.S. approval. At this time, the Company does not have sufficient financial resources to conduct these studies on its own and is actively seeking co-development partners for this expanded indication that could contribute to the cost of the development program and participate in the marketing and sale of Synera for the expanded indication throughout the U.S. Pliaglis Pliaglis was added to Nuvo’s product portfolio through the acquisition of ZARS (see Significant Transactions – 2011 – ZARS Acquisition). Pliaglis is a topical local anaesthetic cream that provides safe and effective local dermal anaesthesia on intact skin prior to superficial dermatological procedures, such as dermal filler injection, pulsed dye laser therapy, facial laser resurfacing and laser-assisted tattoo removal. This product consists of a proprietary formulation of lidocaine and tetracaine that utilizes proprietary phasechanging topical cream Peel technology. The Peel technology consists of a drug-containing cream which, once applied to a patient’s skin, dries to form a pliable layer that releases drug into the skin. Pliaglis should be applied to intact skin for 20 to 30 minutes prior to superficial dermatological procedures and for 60 minutes prior to laser-assisted tattoo removal. Following the application period, Pliaglis forms a pliable layer that is easily removed from the skin allowing the dermatological procedure to be performed with minimal to no pain. Galderma Pharma S.A. (Galderma), a global pharmaceutical company specialized in dermatology, holds the worldwide sales and marketing rights for Pliaglis. Under the terms of the licensing agreement, the Company earns royalties on the net sales of Pliaglis and is eligible to receive milestone payments when certain specified approvals are obtained and launches occur. Pliaglis was initially approved by the FDA in June 2006, but was voluntarily removed from the U.S. market by Galderma in 2008, due to manufacturing issues at Galderma’s third-party contract manufacturer (the Former CMO). In December 2011, Galderma submitted an sNDA for Pliaglis and the FDA set a PDUFA date of April 16, 2012. The sNDA addressed a number of manufacturing issues, including the transfer of manufacturing to Galderma. On April 16, 2012, Galderma received the Complete Response Letter from the FDA that outlined additional information the FDA required before it would approve the sNDA for 10 Nuvo Research Inc. Annual Report 2012 Pliaglis. In May 2012, Galderma submitted additional information that addressed the FDA’s issues. On October 18, 2012, the FDA approved the sNDA. Galderma launched the commercial marketing and sale of Pliaglis in the U.S. in early March 2013 at the American Academy of Dermatology Conference in Miami. In Europe, the Marketing Authorization Application (MAA) for Pliaglis that was prepared by ZARS, as per its obligations under the terms of the licensing agreement, was validated in July 2012. The MAA was submitted using the decentralized procedure with Germany as the Reference Member State and filed with 16 countries as Concerned Member States. On May 6, 2012, the Company received notice of a positive opinion from the European decentralized procedure for the approval of Pliaglis from the German Federal Institute for Drugs and Medical Devices (BfArM). The positive opinion required a post approval commitment, the cost of which will be shared equally by Galderma and Nuvo. The decentralized procedure has been closed with a positive recommendation that Pliaglis is approvable for the indication of producing local dermal anesthesia on intact skin in adults prior to superficial dermatological procedures. The regulatory process has entered its final phase known as the national licensing phase. During this phase, the National Agencies in the individual countries will issue the marketing licenses that allow Pliaglis to be marketed in each country. Pursuant to Nuvo’s license agreement with Galderma, Nuvo is entitled to receive milestone payments totaling US$6.0 million when certain specified launches occur or within a predefined 6-month period after marketing approval in three different countries. As at December 31, 2012, Galderma has received marketing licenses in 12 of the 16 countries, of which the first three entitled Nuvo to US$6.0 million in total milestone payments which have been received by the Company. The Company expects that Galderma will launch the commercial marketing and sale of Pliaglis in Europe in the second quarter of 2013 at the Anti-Aging Medicine World Congress & Medispa in Monaco. Pliaglis is currently approved for sale and marketed in Argentina. In September 2011, Galderma filed additional marketing applications in Switzerland and Brazil. In December 2011, Galderma filed a marketing application in Canada and in February 2012, Health Canada accepted this application. The Company expects Galderma to file for marketing approval in other countries around the world, including other South American countries, select Asian countries, South Africa and Australia. Pipeline Expansion and Early Stage Drug Development With the acquisition of ZARS, the Company significantly broadened its portfolio of development stage products and proprietary platform technologies. However, the focus of the Pain Group has shifted from early stage development to later stage development and commercialization for the near term. Nonetheless, important CMC activities will continue for Nuvo’s pipeline products. The Company will also continue to seek co-development partners for products in its topical pain portfolio. In addition to Pennsaid, Pennsaid 2%, Synera and Pliaglis, Nuvo has a pipeline of topical pain medications for a variety of pain conditions, including NRI-ANA and formulations for the treatment of pain of inflammatory, nociceptive and neuropathic origin. All of these pain medications are being designed to treat the pain locally, while limiting systemic exposure to the active drug; thereby, reducing the potential for negative side effects, adverse events and potential drugdrug interactions. In addition to drug candidates developed internally, the Company is actively seeking to continue the expansion of its pipeline by acquiring or in-licensing commercial and late stage pain assets to provide an even broader and more balanced portfolio of products and additional inflection points for prospective and current investors. Although not currently in active development given the Company’s focus on its topical pain products, Nuvo’s past research in the field of dermatology has been directed towards preclinical activities on a topical antifungal drug candidate intended for use in treating onychomycosis, a nail fungal infection that resides in both the nail and the nail bed. In addition, with the acquisition of ZARS, the portfolio of development stage products now includes a topical steroid utilizing the DuraPeel technology that has completed a positive Phase 2 proof-of-concept trial. Technology CHADD™ The Company acquired the proprietary CHADD drug delivery platform as part of the acquisition of ZARS. The CHADD unit consists of a powder-filled pouch laminated between a top cover film with oxygenregulating holes and a bottom film with a pressuresensitive adhesive layer that generates heat when exposed to the air. When the CHADD patch is removed from its hermetically sealed pouch, oxygen in ambient air flows into the heat-generating powder, initiating an oxidative reaction. After an initial rise in temperature, the mild heat generated by the CHADD unit will reach and maintain a controlled temperature range for a predetermined period of time. The CHADD unit may either be incorporated directly into the drug-containing patch as with Synera or placed on top of a transdermal drug patch to initiate temporary increases in drug concentrations. CHADD units can be customized to achieve the specific temperature and duration of heating required for therapy. Depending on the intended application, a CHADD unit can be designed to deliver heat for periods from 20 minutes to 12 hours. The Company believes that the CHADD technology may have a variety of clinically important advantages over traditional patch technologies, including more effective delivery of certain drugs, faster onset of action and reduced side effects. Peel The proprietary phase-changing cream technology has been used in the Company’s Peel drug delivery technology and the DuraPeel technology. The Peel consists of a drug-containing cream which, once applied to a patient’s skin, dries to form a pliable layer that releases drug into the skin. Peel based products can remain on the skin for periods from 20 to 60 minutes, depending on the desired effect. After the desired effect is achieved, the Peel product can be easily removed from the skin. This drug delivery technology is well-suited for drugs that require a single, short-term application, such as local anesthetics applied before a painful procedure and for uneven, irregular or contoured surfaces. DuraPeel™ The DuraPeel technology consists of a drug, containing cream which is spread onto a patient’s skin, where within a few minutes it forms a pliable layer that is not inadvertently removed by touching or contact with clothing. DuraPeel formulations include two solvents: one that evaporates quickly and one that evaporates more slowly. Once applied, one solvent in the cream dries and the product forms a pliable layer. The other solvent remains in the formulation, allowing for sustained drug delivery. While the Peel technology allows for short-term drug delivery for periods of up to an hour, the DuraPeel technology allows for predictable drug delivery for up to 12 hours. Following the desired treatment time, the DuraPeel product can be easily peeled or washed from the skin. As with the Peel technology, DuraPeel based formulations can be applied over uneven, irregular or contoured surfaces of the body. Immunology Group The Immunology Group is based in Leipzig, Germany and is focused on the development of WF10, a compound for the treatment of immune related diseases. Nuvo Research Inc. Annual Report 2012 11 Management’s Discussion and Analysis cont’d The immune system provides an essential defence to micro-organisms, cancer and substances it sees as foreign and potentially harmful. WF10, a solution of OXO-K993 containing stabilized chlorite ions, focuses on supporting the immune system by targeting the macrophage, a type of white blood cell that coordinates much of the immune system, to regulate normal immune function. All immune system regulation research is managed through Nuvo Research AG. On December 13, 2011, Nuvo increased its ownership in the Immunology Group from 60% to 100% by acquiring the minority interest in Nuvo Research AG held by Dr. Kühne. The transaction is fully described under the section entitled Significant Transactions 2011 – Acquisition of Non-Controlling Interest. Complete ownership in Nuvo Research AG improves the Company’s flexibility in managing all aspects of WF10, including future development and financing. WF10 WF10 appears to act on the macrophage. Normally functioning macrophages can alternate between one of two basic states: phagocytic and inflammatory. Phagocytic macrophages digest invading organisms, such as viruses, and initiate a biological defence pathway. Inflammatory macrophages, in turn, induce a variety of reactions, including fever, sweating, swollen glands, malaise and appetite loss, the common, uncomfortable signs of illness. Such responses, while entirely normal, must be turned on and off in a controlled manner. If left unchecked, pathogens can overdrive the system toward the inflammatory state creating an imbalance that may lead to such medical disorders as chronic inflammation, immune deficiency, organ damage and tumour proliferation. WF10’s proposed mode of activity is based on a theory about how macrophages regulate the immune system. Research suggests that, in some cases, WF10 may rebalance improperly functioning immune systems. The drug has potential applications in adjuvant cancer therapy, diseases related to immune deficiencies and the management of chronic viral infections. Based on the concept that WF10 may rebalance improperly functioning immune systems, the Company’s scientists hypothesized that it may be effective for the treatment of conditions such as allergic rhinitis where the body’s immune system inappropriately responds to the presence of foreign allergens and rheumatoid arthritis where autoimmunity plays a pivotal role in the progression of cartilage destruction in the joints. Autoimmunity is the failure of the body to recognize its own cells and tissues and therefore allows the body to initiate an immune response against its own cells and tissues. 12 Nuvo Research Inc. Annual Report 2012 In early 2010, after receiving Germany’s BfArM approval, the Company initiated a Phase 2 clinical trial to evaluate WF10 as a treatment for moderate to severe allergic rhinitis. The trial was a 60-subject randomized double blind, placebo-controlled, single-centre trial to assess the efficacy and safety of a regimen of five WF10 infusions for the treatment of patients with moderate to severe persistent allergic rhinitis. The trial met its primary endpoint as measured by the change in Total Nasal Symptom Score (TNSS) from baseline to assessment after three weeks comparing the WF10 group with the placebo group. The TNSS is a validated scale to measure the aggregation of nasal symptoms associated with allergic rhinitis. The results were statistically significant as the p-value for the primary endpoint was less than 0.001 for the intent-to-treat and per protocol groups. During 2011, the Immunology Group completed its evaluation of the entire data set including the secondary endpoints all of which were achieved. In August 2012, the U.S. Patent Office issued Patent No. 8,252,343 providing patent coverage for WF10 with an expiry date of March 4, 2029. This patent covers a method of treating allergic asthma, allergic rhinitis and atopic dermatitis using a chlorite based formulation, such as WF10. A portion of the cost of the allergic rhinitis trial was funded using proceeds received from the Development Bank of Saxony (SAB) under a 2009 funding commitment for a three-year period that ended in July 2012. This commitment was to support two cooperative drug development projects between the Company and the Fraunhofer Institute for Cell Therapy and Immunology IZI (Fraunhofer Institute) in Leipzig, Germany. These projects were for the preclinical and clinical development of WF10 as a potential treatment for allergic rhinitis and rheumatoid arthritis. The total cost of these projects was estimated to be €4.1 million and the SAB committed to provide up to € 2.2 million in funding to support these projects, €1.9 million of which will be provided to the Company’s co-operative partners and €0.3 million which will be provided directly to the Company. In July 2012, the SAB agreed to provide the Company with an additional €4.4 million of funding for the further development of its improved reformulated versions of WF10 (Reformulated WF10). The SAB funding will be used to support a number of preclinical studies relating to both WF10 and Reformulated WF10 for which the Company filed a U.S. provisional patent in December 2011. In December 2012, the Company filed an international PCT application and a U.S. patent application claiming priority to the December 2011 U.S. provisional application. In addition, Company has an issued patent and an allowed patent application in the U.S. related to a method of using WF10 and Reformulated WF10 to treat allergic asthma, allergic rhinitis and atopic dermatitis. These studies are being conducted by the Company in partnership with the University of Leipzig and the Fraunhofer Institute and are focused on demonstrating, the efficacy, safety and stability of Reformulated WF10. The total cost of this development program is estimated to be €6.3 million and the SAB committed to provide up to €4.4 million in funding to support these projects, €3.7 million of which will be provided to the Company’s co-operative partners and €0.7 million which will be provided directly to the Company. The funding will take the form of a non-repayable reimbursement of specific development monies expended by the Company until July 2014. The Company will have certain contractual obligations to the SAB including the obligation to provide matching funding from its own resources of €1.9 million over the two-year period ending in July 2014. Oxoferin is marketed by Nuvo Manufacturing GmbH and its partners in parts of Europe, Asia and South America as a topical wound healing agent under several trade names including Oxoferin and Oxovasin. The product has also been licensed for Russia, some of the former Soviet republics, including all of the Baltic States, Malaysia, the Philippines, Vietnam, Singapore and other Indochina countries. However, the product has not been approved, nor marketed, in any of these territories. The Company’s partners, including Ranbaxy Laboratories Limited, are at various stages in pursuing the necessary marketing approvals which are not expected until late 2013 at the earliest. The Company is currently exploring WF10’s commercial potential in the U.S. market for airway diseases, as well as the regulatory requirements to get WF10 approved in the U.S. for allergic rhinitis and asthma. Pennsaid The Canadian and U.S.’ composition of matter patents for Pennsaid have expired. However, upon FDA approval of Pennsaid in the U.S., the product received a three-year period of marketing exclusivity from the date of approval pursuant to the “Hatch-Waxman Act”, and C.F.R. 314.108(b)(4) which provide that a product filed as a 505(b)(2) application and supported by sponsor initiated clinical studies required as a condition of approval is entitled to three years of marketing exclusivity starting from the effective date of approval. This period of marketing exclusively prohibited the sale of generic versions of Pennsaid in the U.S. until November 2012, three years from the effective date of approval. As such market exclusivity has now expired a generic version of Pennsaid can be sold in the U.S. if such generic version is approved by the FDA. Regardless of the future development plans for WF10, a number of additional studies will need to be conducted before WF10 can be submitted for regulatory approval for the treatment of allergic rhinitis or any other illness and there can be no assurance that the results of these additional studies will be favourable or that regulators will approve WF10 for these or other purposes. Any such studies and approvals would be expected to take a number of years. WF10 is approved in Thailand as a treatment for post radiation cystitis and diabetic foot ulcers but is not otherwise approved for marketing and sale elsewhere except in its diluted topical form, Oxoferin. Oxoferin™ Oxoferin, a topical wound healing agent, is a diluted form of WF10, a chlorite-based, immunomodulating drug. The Company believes that research to-date suggests Oxoferin™ has a positive impact on wound healing leading to contraction, closure and faster healing of wounds. Chronic, hard-to-heal wounds are a serious problem with an increasing incidence. Chronic wounds can be caused by such conditions as burns, pressure sores and poor circulation in the lower extremities. Co-morbid conditions, such as diabetes and atherosclerosis, reduce blood flow to the extremities and also increase the likelihood of developing chronic wounds such as diabetic foot ulcers and venous ulcers. The Company’s patents associated with Oxoferin have expired. Intellectual Property The pharmaceutical industry is a highly competitive sector where long-term success depends upon developing safe and effective proprietary products. In July 2012, the U.S. Patent Office issued the Pennsaid Patent with an expiry date of July 10, 2029. The Pennsaid Patent is listed in the FDA’s Orange Book. In addition, there are additional U.S. patent applications relating to methods of using Pennsaid that are currently pending. The European composition of matter patent for Pennsaid (covering Austria, Belgium, France, Germany, Italy, Liechtenstein, Luxembourg, Netherlands, Sweden, Switzerland and the United Kingdom) expired in June 2006. In Italy, the Supplementary Protection Certificate that extended the life of this patent expired in March 2011. Nuvo Research Inc. Annual Report 2012 13 Management’s Discussion and Analysis cont’d Pennsaid 2% The Company has filed patent applications to cover Pennsaid 2% and other related formulations in a number of jurisdictions worldwide. The South African and New Zealand patents covering Pennsaid 2% were granted in 2010 and 2012, respectively. In addition, the U.S. Patent Office issued U.S. Patent No. 8,252,838 relating to compositions and methods of using Pennsaid 2% in September of 2012. The U.S. Pennsaid 2% patent expires on April 21, 2028. There are additional patent applications pending in the U.S. that relate to the Pennsaid 2% franchise. Pliaglis Through the acquisition of ZARS, the Company owns two patent families which cover Pliaglis. Claims are directed to compositions of matter and methods of use. A number of patents have issued in Austria, Belgium, Canada, China, Cyprus, Denmark, Finland, France, Germany, Great Britain, Greece, Ireland, Italy, Luxemburg, Monaco, Netherlands, Portugal, Spain, Sweden, Switzerland, and the U.S. In addition, a patent application is pending in Japan. Of the two patent families, the latest expiry date is 2019 in the U.S. and 2020 in countries outside of the U.S. The Company owes royalties to two companies for 1% and 1.5% of sales of Pliaglis. Synera With the acquisition of ZARS, the Company acquired several patent families covering the Synera patch, methods of manufacture and methods of use. One family specifically covers the Synera patch with composition of matter claims, manufacture claims and method of use claims (prescribed indications). In this family, a number of patents have issued in Austria, Belgium, Canada, China, France, Germany, Great Britain, Italy, Netherlands, Spain, Sweden, Switzerland, and the U.S. Several patent applications are also pending in various jurisdictions. Of the several patent families, the latest expiry date is 2020 worldwide. Additionally, two patent families directed to new methods of use are currently pending with anticipated expiry dates of 2030 and 2031 upon grant. The Company owes royalties to two companies for 1% and 1.5% of sales of Synera. WF10 and Oxoferin With the acquisition of Oxo Chemie on May 31, 2002, the Company acquired patents relating to the immune regulation technology underlying WF10 some of which have since expired. The Company does not hold composition of matter patents on WF10 itself or on all its potential uses, but does hold patents and has filed 14 Nuvo Research Inc. Annual Report 2012 patent applications for particular prescribed uses of WF10. For example, the Company has an issued patent and an allowed patent application in the U.S. related to a method of using WF10 and Reformulated WF10 to treat allergic asthma, allergic rhinitis and atopic dermatitis. In 2011, the Company conducted research with a view to developing an improved version of WF10. These research efforts led to the filing of a new U.S. provisional patent application in December 2011. In 2012, an international PCT application and a U.S. patent application were filed claiming priority to this provisional application. All Oxoferin composition of matter patents have expired. The Company is conducting research with a view to developing an improved version of Oxoferin with enhanced wound healing abilities. In 2011, these research efforts led to the filing of an international PCT application that covers a new version of Oxoferin. The Company also filed a U.S. provisional patent application in 2011 covering new compositions and methods for wound healing. In 2012, an international PCT application was filed claiming priority to this provisional application. Developing patent protection for its platforms and future products is a key driver for the long-term success of Nuvo. With this goal in mind, the Company has acquired patents, patent rights and applied for patents to protect its early stage drug development candidates in the field of pain and dermatology. Manufacturing Nuvo’s long-term business strategy does not require internal manufacturing capability as partners or contracted third parties could be contracted to produce future drug products developed by the Company. However, as the Company already has production facilities for its current commercial drug Pennsaid, the follow on product Pennsaid 2% and the drug substance for Synera, management has decided to continue operating its own manufacturing facility for the foreseeable future. In February 2000, the Company acquired its existing manufacturing facility in Varennes, Québec with manufacturing, bottling and packaging capabilities and a research laboratory and, shortly thereafter, received an Establishment License from Health Canada in recognition of compliance with Good Manufacturing Practices (GMP) regulations. Since November 2000, the facility has been approved for the manufacture, testing and warehousing of drug products destined for member countries in the European Union by the United Kingdom Medicines Control Agency. In 2011 the plant was inspected by Canada’s Health Products and Food Branch Inspectorate and found to be compliant with Canadian Drug GMP requirements. In September 2012 and March 2013, the plant passed two FDA inspections as part of the U.S. Pennsaid 2% NDA review and U.S. Synera sNDA review. The facility remains in compliance with current GMP regulations and is the site for commercial production of Pennsaid worldwide. Since 2010, the Company has not pursued contract manufacturing opportunities from third parties as it had done historically, as it has been focused on the supply of Pennsaid for the U.S. launch and planning and validation for the production of Pennsaid 2% and the drug substance for Synera. In 2011, the Company relocated certain ZARS’ production equipment to Varennes so it would have the capability and capacity to manufacture several of ZARS’ drugs and drug candidates, including the drug product for Synera that is used in the patches that are currently manufactured by a third party. The Company has filed an sNDA with the FDA to transfer manufacturing to Varennes and expects to begin commercial production of the drug product in mid 2013. In 2012, the Company modified one of its Pennsaid manufacturing lines to provide the Company with the capacity to meet the anticipated demand for Pennsaid 2% sales in the U.S., if approved by the FDA. The Company also owns a 3,000 square foot manufacturing facility in Wanzleben, Germany, acquired in May 2002 as part of the Oxo Chemie acquisition. This plant produces OXO-K993, the active ingredient in WF10 and Oxoferin. C A PA B I L I T Y T O D E L I V E R R E S U LT S Nuvo will need to spend considerable resources to research, develop, commercialize and manufacture its products and technologies. The Company may finance these activities through: existing cash and cash equivalents; revenue generated by product sales, royalties and sales and other milestones under existing agreements; licensing and co-development agreements for other new drug candidates or for its existing products in territories where they are not currently licensed; or by raising funds in the capital markets. The Company is or will be dependent on its commercial partners for the sales and marketing of its products in the following territories: • Pennsaid – in the U.S., Canada, Greece and Italy; • Pennsaid 2% – U.S., Canada, South Africa, Israel and Central and South America; • Synera – Europe, Russia and many of its former republics, Turkey, Israel and the People’s Republic of China; • Pliaglis – throughout the world; and • Oxoferin – Venezuela, Russia, and several Asian countries. The Company has broad in-house talent with the capability to commercialize and develop its pipeline. To execute the current business plan, the Company may selectively add key personnel and in the future may need to hire more staff as activities expand. In addition, the Company has access to the commercial, regulatory and scientific expertise of its advisory boards to assist it through all aspects of the commercialization and drug development process. GOALS In order to achieve the Company’s vision of becoming a leader in the development and commercialization of pharmaceutical products for the treatment of pain, in May 2011, the Company began a major transformation when it acquired ZARS. This transaction shifted the focus of the Company from early stage drug development to later stage drug development and commercialization. This transformational acquisition added two approved products, Synera and Pliaglis, a pipeline of pain products in various stages of development and two important drug delivery platforms. For 2013, the Company will focus on four main goals: successfully selling Synera in the U.S. to national accounts and building the sales with its existing customers; the launch of Pliaglis in Europe and the U.S.; assisting Covidien with the studies required in response the CRL from the FDA for Pennsaid 2% and selectively advancing the development plan for WF10, while at the same time effectively managing the Company’s cash resources. In addition to devoting a portion of its own resources towards drug development, Nuvo, with its broadened scope of products, knowledge and capabilities believes it is well positioned to acquire additional pain products and to acquire and develop new and existing drug product candidates. Nuvo may commercialize these products or develop them to significant milestones using internal resources and may look for a co-development or licensing partners to mitigate the risk and improve the odds of success. Nuvo Research Inc. Annual Report 2012 15 Management’s Discussion and Analysis cont’d • the entry of a generic version of Pennsaid into the U.S. as this may trigger an event of default on the Paladin Debt and may significantly reduce revenue and cash flow; Nonetheless, companies in the pharmaceutical R&D industry typically require periodic funding in order to develop drug candidate pipelines until such time as at least one drug candidate has been successfully commercialized such that they are receiving sufficient revenue to fund their operations. Nuvo has not yet reached this stage and; therefore, the Company monitors on a regular basis, its liquidity position, the status of its commercialization efforts and those of its partners, the status of its drug development programs, including cost estimates for completing various stages of development, the scientific progress on each drug candidate, the potential to license or co-develop each drug candidate and continues to actively pursue fund raising possibilities through various means, including the sale of its equity securities. There can be no assurance that additional financing would be available on acceptable terms, or at all, when and if required. If adequate funds were not available when required, the Company may have to substantially reduce or eliminate planned expenditures, discontinue its marketing efforts for Synera in the U.S., terminate or delay clinical trials for its product candidates, curtail product development programs designed to expand the product pipeline or discontinue certain operations such as the Immunology Group. If the Company is unable to obtain additional financing when and if required, the Company may be unable to continue operations. • the ability to gain marketing approval in the remaining 2 European countries and Galderma’s ability to successfully launch Pliaglis in the E.U. as it will earn royalties on this product; The Consolidated Financial Statements do not include adjustments to the amounts and classification of assets and liabilities that would be necessary should the Company be unable to continue as a going concern. LIQUIDITY The Company has incurred substantial losses since its inception, as it has invested significantly in drug development activities and other legacy ventures. At December 31, 2012, the Company had an accumulated deficit of $221.2 million, including a net loss of approximately $13.6 million for the year then ended which included an $11.9 million non-cash charge related to the impairment of intangible assets and goodwill. As at December 31, 2012, the Company had cash and cash equivalents of $12.1 million. The Company expects that it will continue to incur losses as its revenue streams are not yet sufficient to fund: its operations, the infrastructure necessary to support Synera in the U.S., the infrastructure necessary to support a public company and the costs of selectively advancing its drug development pipeline. The Company’s ability to continue as a going concern depends on: • the success of its approved products Pennsaid and Synera, as it earns revenue from these products in the form of royalties and product sales and has the ability to earn milestone payments; • Galderma’s ability to successfully relaunch Pliaglis in the U.S., as the Company will earn royalties on this product; • the approval of Pennsaid 2% in the U.S.; and • its ability to secure additional licensing fees, secure co-development agreements, obtain additional capital, gain regulatory approval for other drugs and ultimately achieve profitable operations. The Company currently anticipates that its cash and cash equivalents, together with the revenues it expects to generate from product sales of Pennsaid and Synera, royalty payments from its Canadian and U.S. Pennsaid licensing agreements and Pliaglis licensing agreements, once Pliaglis is launched will be sufficient to fund operations in 2013. 16 Nuvo Research Inc. Annual Report 2012 S E L E C T E D F I N A N C I A L I N F O R M AT I O N Year ended December 31, 2012 Year ended December 31, 2011 in thousands (except per share and share information) (restated) O P E R AT I O N S Product sales Cost of goods sold $ 8,936 7,275 $ 8,948 7,269 GROSS MARGIN ON PRODUCT SALES 1,661 1,679 Royalties Licensing fees Research and other contract revenue 8,284 7,252 178 5,771 1,641 373 17,375 9,464 Operating expenses 21,229 18,797 Loss from operations (3,854) (9,333) 9,513 (2,606) Loss before income taxes Income taxes (13,367) 196 (6,727) 104 Net loss Other comprehensive income (loss) (13,563) (544) (6,831) 1,097 T O TA L C O M P R E H E N S I V E L O S S (14,107) (5,734) (14,107) – (4,433) (1,301) Other (income) expenses C O M P R E H E N S I V E L O S S AT T R I B U T I O N Owners of the parent Non-controlling interest $ (14,107) $ (5,734) S H A R E I N F O R M AT I O N Net loss per share – basic and diluted Average number of common shares outstanding for the period (in millions) – basic and diluted (0.024) (0.014) 567.7 489.3 FINANCIAL POSITION Cash and cash equivalents Total assets Finance lease & other obligations, including current portion Total liabilities Total equity $ 12,149 28,485 3,258 7,016 21,469 $ 14,724 44,854 544 9,944 34,910 Nuvo Research Inc. Annual Report 2012 17 Management’s Discussion and Analysis cont’d Non-IFRS Financial Measure Loss from operations is a non-IFRS financial measure that does not have a standardized meaning prescribed by IFRS. However, the Company believes that the loss from operations is a useful measure as it provides investors with an indication of the performance of the Company before considering gains or losses from foreign exchange or items that are non-recurring transactions. Fluctuations in Operating Results The Company’s results of operations have fluctuated significantly from period-to-period in the past and are likely to do so in the future. The Company anticipates that its quarterly and annual results of operations will be impacted for the foreseeable future by several factors, including the level of Pennsaid’s U.S. net sales and Canadian net sales which impacts royalty payments, the level of sales attained by Synera in the U.S., the timing and amount of royalties and other payments received pursuant to current and future collaborations and licensing arrangements, including those for Pliaglis and Synera and the progress and timing of expenditures related to R&D efforts. Due to these fluctuations, the Company believes that the period-to-period comparisons of its operating results are not necessarily a good indicator of future performance. SIGNIFICANT TRANSACTIONS 2012 Paladin In May 2012, the Company entered into a license and supply agreement with Paladin granting Paladin in thousands Cash consideration 99.8 million common shares issued ZARS Contingent Consideration exclusive Canadian rights to market and sell Synera, upon regulatory approval. Under the terms of the agreement, Nuvo will receive a double digit royalty on net sales of Synera in Canada and will supply Synera to Paladin. Paladin is responsible for obtaining regulatory approval for Synera in Canada. In addition, Paladin has agreed to loan Nuvo $8.0 million in two equal tranches of $4.0 million each. The first tranche was advanced on closing and the second tranche can be drawn by Nuvo, at its option, upon the achievement of predefined milestones. The loan will bear interest at a rate of 15% per annum and matures on May 25, 2016. The loan is secured by a charge over the assets of Nuvo’s Pain Group. 2011 ZARS Acquisition On May 12, 2011 (the Acquisition Date), the Company obtained control of ZARS by acquiring all of the issued and outstanding shares of ZARS. ZARS is a U.S. based specialty pharmaceutical company focused on the development and commercialization of topically administered drugs, primarily with respect to pain. The ZARS acquisition significantly broadened the Company’s pain pipeline by adding two approved products, Synera and Pliaglis, a pipeline of pain products in various stages of development and two important drug delivery platforms; thereby, advancing the Company’s step-by-step approach to transforming the Pain Group into a leader in the topical pain space. The following summarizes the Acquisition Date fair value of the major classes of consideration transferred: $ 149 9,488 5,084 Total consideration Less cash acquired 14,721 1,626 Total consideration, net of cash acquired 13,095 The fair value of the common shares issued is based on the Company’s listed share price of $0.105 at the Acquisition Date, less an adjustment to reflect that the recipients of these shares were subject to a “lock-up Covenant” such that they could not sell or transfer the shares until December 31, 2011. In addition to the total consideration, the Company incurred acquisition related costs of approximately $1.1 million for external consulting, professional and legal fees and costs related to conducting due diligence. These costs have been included in general and administrative expenses (G&A) in the Company’s Consolidated Statements of Comprehensive Loss for the year ended 18 Nuvo Research Inc. Annual Report 2012 December 31, 2011. In addition, the Company incurred $67,000 in costs directly related to issuing the shares to ZARS. These costs were directly recorded as a reduction to common shares in equity. The Company received net cash of $1.5 million on the acquisition of ZARS representing acquired cash and cash equivalents of $1.6 million, net of $0.1 million of cash consideration paid on closing. The fair value of the total consideration (Total Consideration) was directly impacted by management’s estimates at the Acquisition Date of the probability of the Company achieving certain milestones related to Pliaglis, Synera and Pennsaid, which if achieved or in some cases not achieved, would result in the issuance of up to 114.6 million additional common shares (Milestone Shares) to the former ZARS shareholders (ZARS Contingent Consideration). The ZARS Contingent Consideration consisted of: • 74,870,000 Nuvo shares which only become payable if the Company, prior to December 31, 2012, achieved both (i) the re-approval of Pliaglis by the FDA and the first commercial sale of Pliaglis in the U.S. by Galderma after such re-approval, and (ii) the approval of Pliaglis by the Germany’s Federal Institute for Drugs and Medical Devices (Bundesinstitut für Arzneimittel und Medizinprodukte) BfArM and the first commercial sale of Pliaglis in Europe by Galderma (Pliaglis Milestone); and • 39,750,000 (three separate milestones of 13,250,000) Nuvo shares payable upon certain future events. The Total Consideration was allocated to the underlying assets acquired and liabilities assumed based upon their fair value at the Acquisition Date. The Company determined its estimates of fair values based on discounted cash flows, market information, independent valuations and other information. Identifiable assets, liabilities and goodwill: $ in thousands Total consideration Cash Non-cash working capital Property and equipment Intangible assets Bank debt Deferred revenue Net identifiable assets and liabilities Residual purchase price allocated to goodwill The terms of the acquisition included a mechanism to reimburse the Company for certain working capital adjustments that occurred subsequent to the Acquisition Date. Under this mechanism, the Company could elect to be reimbursed for the amount of the adjustment in cash or could compel the former ZARS shareholders to return a sufficient number of Nuvo common shares to satisfy the obligation. During the year ended December 31, 2011, a $32,000 adjustment was calculated and 415,385 common shares with a value of $32,000 were returned to the Company and subsequently cancelled. The value of these cancelled common shares was recorded as a reduction to common shares in equity. In October 2011, one of the milestones relating to the ZARS Contingent Consideration was achieved and in November 2011, the Company issued an additional 13,034,191 common shares and $16,000 cash to the former ZARS shareholders. The fair value of this milestone in the Total Consideration was $137,000 and was transferred to common shares, net of the $16,000 cash paid in lieu of common shares. At December 31, 2012, the Pliaglis Milestone was not achieved. In addition, there were 2 additional milestones representing 13.25 million shares each that were contingent upon the achievement of the Pliaglis 14,721 1,626 (2,621) 457 16,007 (3,022) (1,982) 10,465 4,256 Milestone (Pliaglis Condition Milestones). Therefore, 101.3 million remaining Milestone Shares are no longer issuable and the Company has no further obligations to the ZARS’ former shareholders to issue the Milestone Shares. Through December 31, 2012, the Company had issued a total of 112,440,942 common shares related to the ZARS Acquisition as follows: 99,822,136 common shares issued on the Acquisition Date, 13,034,191 issued upon the achievement of one of the milestones relating to the ZARS Contingent Consideration, less 415,385 that were returned to the Company in satisfaction of the working capital adjustment and subsequently cancelled. Restatement of ZARS Contingent Consideration The Company incorrectly applied IAS 32 Financial Instruments: Presentation, such that the remaining fair value of contingent consideration of $3.3 million was incorrectly classified as contributed surplus when it still met the definition of a financial liability. Management had treated the separate milestones of contingent consideration as distinct targets, independent of one another, issuing a fixed number of the Company’s common shares per milestone. However, the merger agreement, as legally written, required the success of the Pliaglis Milestone to be complete in order for the Nuvo Research Inc. Annual Report 2012 19 Management’s Discussion and Analysis cont’d Pliaglis Conditional Milestones to be eligible for award subject to the achievement of the triggering mechanisms in each of these milestones which deemed the milestones as interdependent. As the milestones were interdependent, a variable number of shares could be delivered. The classification of the obligation should have been based on the overall arrangement, and since the arrangement called for a variable number of shares to be delivered, IAS 32 deems that the arrangement should have been classified as a financial liability and revalued at every reporting date thereafter. As at June 21, 2011, the Company restated the contributed surplus of $3.3 million as a liability and recorded changes in income (loss) based on changes in the Company’s share price in future reporting quarters and the revised probability attached to achieving the Pliaglis Milestone. When one of the milestones was achieved in October 2011, as noted above, the $137,000 debit to contributed surplus would have reduced the liability from $3.3 million to $3.2 million. The effect of the restatement on the Company’s Consolidated Financial Statements at December 31, 2011 was as follows: $ in thousands Increase to current liabilities Increase in gain on ZARS Contingent Consideration and decrease to net loss and accumulated deficit (2,300) Decrease in contributed surplus (3,177) (877) The quarterly effect of the restatement on the Company’s Consolidated Financial Statements is stated below for the three months ending: June 30, 2011 in thousands ZARS Contingent Consideration liability Contributed surplus Deficit Gain on ZARS Contingent Consideration Net loss Net loss per common share – basic and diluted ZARS Contingent Consideration liability Contributed surplus Deficit Loss (gain) on ZARS Contingent Consideration Net income (loss) Net loss per common share – basic and diluted Restated $ Previously Stated $ Restated $ Previously Stated $ Restated $ – 16,341 (200,000) (1,770) (558) 3,840 13,027 (200,525) (1,245) (1,083) – 16,470 (201,747) – (2,203) 3,599 13,156 (202,032) (240) (1,963) – 16,405 (208,465) – (2,582) 2,300 13,228 (207,588) (1,162) (1,420) (0.001) (0.002) (0.004) (0.004) (0.005) (0.003) June 30, 2012 September 30, 2012 Previously Stated $ Restated $ Previously Stated $ Restated $ Previously Stated $ Restated $ – 16,359 (210,572) 4,600 13,182 (211,995) – 16,539 (207,240) 3,910 13,362 (207,973) – 16,711 (210,396) 2,760 13,534 (209,979) – (2,107) 2,300 (4,407) – 3,332 (690) 4,022 – (3,156) (1,150) (2,006) (0.004) (0.008) 0.006 0.007 (0.006) (0.004) As at December 31, 2012, the remaining milestones for the ZARS Contingent Consideration were not achieved and the liability was derecognized resulting in an accumulated gain of $2.3 million for the year then ended. The gains (losses) that would be recorded on the 20 Nuvo Research Inc. Annual Report 2012 December 31, 2011 Previously Stated $ March 31, 2012 in thousands September 30, 2011 ZARS Contingent Consideration are non-cash and by the end of the year ended December 31, 2012 total equity remained unchanged, as the liability was derecognized and the contingent consideration was restated in accumulated deficit from contributed surplus. Acquisition of Non-Controlling Interest On December 13, 2011, the Company increased its ownership in Nuvo Research AG to 100% by acquiring the 40% interest held by the minority owner. In accordance with IAS 27, as there was no change in control of Nuvo Research AG, the difference between the amount by which the non-controlling interest was adjusted and the fair value of the consideration paid was recognized directly in equity and attributed to the owners of the parent. The following summarizes the fair value of the $2.3 million in consideration transferred to the non-controlling interest: • 31,947,668 Nuvo common shares at an agreed price of US$1.7 million ($1.7 million) and in full settlement of a 68,000 euro loan payable to the minority owner; and • A five-year, US$150,000 per annum consulting agreement with the former minority shareholder, with a fair value of US$519,000 ($528,000) when discounted at 15.5%. The following summarizes the difference between the amount by which the non-controlling interest was adjusted and the fair value of the consideration paid to acquire the non-controlling interest which is the amount recognized directly in equity and attributed to the owners of the parent in December 2011: $ in thousands Accumulated losses attributed to non-controlling interest Accumulated other comprehensive income attributed to non-controlling interest Transferred consideration 2,004 92 2,256 Accrued acquisition costs and other 20 Total impact to equity attributable to the parent As the five-year consulting agreement is deemed to be consideration for the acquisition of the non-controlling interest, it is recorded as a liability as other obligation, 4,372 on the Consolidated Statements of Financial Position and accreted, through charges to interest expense, to its nominal value over its term. R E S U LT S O F C O N T I N U I N G O P E R AT I O N S Product Sales and Gross Margin Year ended December 31, 2012 $ Year ended December 31, 2011 $ Pennsaid sales Synera sales WF10 sales 7,119 1,153 664 7,560 681 707 Total product sales Cost of goods sold 8,936 7,275 8,948 7,269 Gross margin on product sales 1,661 1,679 in thousands (except gross margin percentage) Gross margin percentage Product sales for the year ended December 31, 2012 were consistent at $8.9 million compared to the year ended December 31, 2011. Sales of Pennsaid products were the most significant accounting for 80% of total product sales for the year ended December 31, 2012 versus 84% for the year ended December 31, 2011. 19% 19% Pennsaid sales Sales of Pennsaid decreased to $7.1 million for the year ended December 31, 2012 compared to $7.6 million for the year ended December 31, 2011. Sales in the comparative period included $1.6 million of Pennsaid samples, the format given to physicians by sales Nuvo Research Inc. Annual Report 2012 21 Management’s Discussion and Analysis cont’d representatives for physicians to provide trial size bottles to their patients. In November 2011, Mallinckrodt advised the Company that at the request of the FDA, Mallinckrodt ceased distribution of the sample format due to five reports of patients who had used an incorrect route of drug administration. In June 2012, Mallinckrodt resumed distribution of the sample format to U.S. healthcare professionals; however, the samples distributed are from Mallinckrodt’s existing inventory. Commercial sales of Pennsaid increased to $7.1 million from $6.0 million in the comparative period. The increase is primarily due to $1.2 million in higher sales to Mallinckrodt. In January 2012, Endo Pharmaceuticals Holdings Inc. (Endo) indicated that there would be temporary shortages in the U.S. of its licensed product, Voltaren Gel, as a result of manufacturing issues unrelated to Voltaren Gel. These product shortages, which ended during the second quarter, contributed to the increase in Pennsaid shipments to Mallinckrodt. Sales to Greece increased slightly to $2.2 million compared to $2.1 million. The majority of sales in 2011 occurred prior to the Greek austerity measures where all topical antirheumatics, including Pennsaid, lost government reimbursement. In addition, Pennsaid was reclassified as an OTC product and in late 2011, was relaunched by the Company’s Greek partner as an OTC product. In addition, sales to the Company’s Canadian partner increased by $0.2 million. Partially offsetting these increases was a decrease of $0.3 million in sales to Nuvo’s Italian distributor. Geographically for the year ended December 31, 2012, sales in the U.S. were $3.2 million or 45% of total Pennsaid product sales [December 31, 2011 – $3.6 million or 47%], sales in Europe were $2.9 million or 41% of Pennsaid product sales [December 31, 2011 – $3.2 million or 42%] and sales in Canada were $1.0 million representing 14% of Pennsaid’s product sales [December 31, 2011 – $0.8 million or 11%]. The Company expects that U.S. product sales may decline in absolute amount and as a percentage of Pennsaid’s total product sales, as 2012 sales benefitted from the Voltaren Gel product shortage. In addition, Canadian product sales may decline in absolute amount and as a percentage of Pennsaid’s total product sales, as a competitor’s generic version of Pennsaid was approved in Canada during 2010 and could be launched at any time. It is not known, if or when, the generic version of Pennsaid will be sold in the Canadian market. 22 Nuvo Research Inc. Annual Report 2012 Synera sales Synera sales for the year ended December 31, 2012 were $1.2 million compared to $0.7 million for the year ended December 31, 2011. In 2011, sales of Synera commenced on May 12, 2011, the date the Company acquired Synera as part of the ZARS Acquisition. The Company earns revenue from Synera in the U.S. based on its net product sales calculated as gross sales less chargebacks, rebates, distribution fees, allowances for returned product and other customary deductions. The Company directly markets Synera in the U.S. and in February 2012, the Company launched Synera with a dedicated pain specialty contract sales force targeting interventional pain physicians. In the fall of 2012, the Company refocused its resources on large national accounts such as dialysis centers, infusion centers and blood diagnostic laboratories. To execute this strategy, the Company terminated its agreement with its contract sales organization (CSO) and will use its internal Pain Group commercial team to focus on the national accounts and the key interventional pain doctors who use Synera. WF10 sales Sales of WF10 for the year ended December 31, 2012 were $0.7 million consistent with the year ended December 31, 2011. The Company experienced an increase in sales to its distributor in Venezuela, but this was offset by an overall decrease in translated revenues due to the weakening of the euro. Gross margin For the year ended December 31, 2012, the gross margin on product sales was consistent at $1.7 million versus a year ago. A decrease in the gross margin for Pennsaid primarily related to lower product sales and a planned four-week shutdown of the Pennsaid manufacturing facility during the third quarter to prepare for the U.S. launch of Pennsaid 2% (if approved by the FDA), was offset by the margin related to higher Synera sales. During the shutdown, the Company did not produce any Pennsaid and all fixed overhead during this period were expensed and not absorbed into inventory. The gross margin percentage for the year ended December 31, 2012 was consistent at 19% with the comparative period. OTHER REVENUE Year ended December 31, 2012 $ Year ended December 31, 2011 $ 8,284 7,252 178 5,771 1,641 373 15,714 7,785 Year ended December 31, 2012 Year ended December 31, 2011 Pennsaid U.S. scripts 295,000 167,000 Pennsaid U.S. 150ml bottles dispensed 391,000 217,000 in thousands Royalties Licensing fees Research and other contract revenue R O YA LT Y R E V E N U E Royalty revenue is the most important source of ongoing revenue the Company receives, as there are nominal costs associated with this revenue. In the U.S., according to IMS Data, a provider of dispensed prescription data, approximately 295,000 Pennsaid prescriptions were dispensed in 2012, an increase of 77%. For each prescription, approximately 1.32 bottles of Pennsaid were dispensed for the year ended December 31, 2012. Royalty revenue increased to $8.3 million for the year ended December 31, 2012 compared to $5.8 million for the year ended December 31, 2011. The increase in royalty revenue is primarily due to increased Pennsaid sales in the U.S. In January 2012, Endo indicated that there would be temporary shortages in the U.S. of its licensed product, Voltaren Gel, as a result of manufacturing issues unrelated to Voltaren Gel. These product shortages, which ended during the second quarter, contributed to the increase in Pennsaid royalties. Partially offsetting this increase was a decrease in the Company’s licensee’s net sales (defined as gross sales less estimates for chargebacks, rebates, sales incentives and allowances, returns and losses and other customary deductions) during the year, as the Company’s U.S. licensee incurred significantly higher rebates related to new reimbursement coverage that commenced in 2012 compared to the prior year. Royalty revenue earned from the Company’s Canadian licensee was consistent with the comparative period at $1.2 million. Royalties related to sales of Rapydan and the global sales of Pliaglis were not significant. The Company receives royalties from its U.S. and Canadian licensees of Pennsaid, from Eurocept, its European licensee for Rapydan (the European brand name for Synera) and from Galderma, its global licensee for Pliaglis. Royalties from each licensee are determined using agreed upon formulas based upon a definition of the licensee’s net sales as defined in each licensing agreement. While the Company receives royalty payments quarterly, it can only recognize the amount as revenue when reasonable assurance exists regarding measurement and collectability. The Company recognizes royalty revenue based on the net sales of each licensee. License Fees License fees were $7.3 million for the year ended December 31, 2012, versus $1.6 million for the year ended December 31, 2011. In 2012, the increase in license fee revenue of $5.7 million was primarily attributable to a milestone payment earned by the Company of US$6.0 million ($6.2 million). Under the terms of the licensing agreement with Galderma, the Company is entitled to receive milestones payments upon the marketing approval of Pliaglis in the first three European countries which were all earned in the year. Partially offsetting this increase was a decrease of $0.5 million related to the licensing arrangements with Galderma for Pliaglis. Under the terms of these licensing arrangements, ZARS received an upfront payment of US$6.0 million in 2009 and was required to assist in correcting the manufacturing issues and to prepare and submit the MAA and manage the regulatory process for Pliaglis in Europe until approval. The amount was amortized on a straight-line basis over the respective performance period which ended in May 2012. The remaining balance in the current and comparative period was comprised of $0.3 million related to the recognition of a portion of the upfront fees received from Paladin in 2005 for the Canadian marketing rights for Pennsaid. Nuvo Research Inc. Annual Report 2012 23 Management’s Discussion and Analysis cont’d Research and Other Contract Revenue Research and other contract revenue for the year ended December 31, 2012 decreased to $0.2 million compared with $0.4 million for the year ended December 31, 2011. These revenues were mainly derived from development services provided by the Company to Mallinckrodt. in thousands, except percentages Four largest customers % of total revenue Largest customer as % of total revenue Significant Customers As the Company sells product and receives royalties in a limited number of markets through exclusive agreements, it receives most of its revenue from a limited number of customers. Revenue, derived from the Company’s current four largest customers, is illustrated in the following table: Year ended December 31, 2012 $ 21,990 89% 42% Year ended December 31, 2011 $ 13,803 83% 51% O P E R AT I N G E X P E N S E S in thousands Research and development Selling and marketing General and administrative Interest expense (income), net Total operating expenses Year ended December 31, 2012 $ Year ended December 31, 2011 $ 6,849 4,892 9,123 365 7,323 1,312 10,306 (144) 21,229 18,797 Total operating expenses for the year ended December 31, 2012 were $21.2 million compared to $18.8 million for the year ended December 31, 2011. The increase in operating expenses primarily related to sales and marketing (S&M) costs for the Company’s launch of Synera in the U.S. R&D expenditures vary depending on the stage of development of drug products and candidates in the Company’s pipeline and management’s allocation of the Company’s resources to these activities in general and to each drug specifically. Research and Development R&D expenses were $6.8 million for the year ended December 31, 2012 compared to $7.3 million for the year ended December 31, 2011. The decrease in R&D expenses was attributable to the closure of the Company’s San Diego research facility in 2011, a corresponding reduction in the size of the Company’s early stage R&D team and the costs associated with preparing and filing the Investigational New Drug (IND) application for NRI-ANA that were partially offset by: Sales and Marketing S&M expenses were $4.9 million for the year ended December 31, 2012 compared to $1.3 for the year ended December 31, 2011. S&M expenses relate entirely to Synera. In February 2012, the Company launched Synera in the U.S., targeting interventional pain physicians with a dedicated pain specialty contract sales force using a CSO. In August 2012, the Company refocused its resources on large national accounts such as dialysis centers, infusion centers and blood diagnostic laboratories. To execute this strategy, the Company terminated its agreement with its CSO for $0.2 million and also terminated two members of the Pain Group management team focused on the interventional pain doctor initiative. The Pain Group’s internal commercial team will continue to focus on the national accounts and the key interventional pain doctors who use Synera. • The costs associated with ongoing research for Synera; • The operating costs associated with the Company’s laboratory in Varennes, Québec and its CMC, medical affairs and regulatory groups in Mississauga, Ontario, West Chester, Pennsylvania and Salt Lake City, Utah; and • External work in the areas of CMC, intellectual property and preclinical work on early stage pain drug candidates. 24 Nuvo Research Inc. Annual Report 2012 General and Administrative G&A expenses were $9.1 million for the year ended December 31, 2012 compared to $10.3 million for the year ended December 31, 2011. The decrease is related to $1.1 million in consulting, professional and other fees incurred in completing the ZARS Acquisition in the comparative period. The balance of the decrease related to lower termination benefits. Interest Interest expense was $0.4 million for the year ended December 31, 2012 compared to $8,000 for the year ended December 31, 2011. The increase was attributable to the 15% per annum interest cost related to the $4.0 million loan with the Company’s Canadian partner (See – Significant Transactions – 2012 – Paladin) and to the non-cash accretion charges on the five-year consulting agreement as part of the consideration paid for the acquisition of the non-controlling interest. Interest income decreased to $16,000 for the year ended December 31, 2012 compared to $152,000 for the year ended December 31, 2011. The decrease was related to lower average cash balances for the year ended December 31, 2012 versus the year ended December 31, 2011. The aggregate result was net interest expense of $0.4 million for the year ended December 31, 2012 compared to net interest income of $0.1 million for the year ended December 31, 2011. Loss from Operations Loss from operations decreased to $3.9 million for the year ended December 31, 2012 compared to $9.3 million for the year ended December 31, 2011. The decrease in loss was attributable to $6.2 million of milestone revenue earned from Galderma and higher royalty revenue, offset partially by higher operating expenses primarily related to the S&M costs associated with selling Synera in the U.S. OTHER (INCOME) EXPENSES Year ended December 31, 2012 Year ended December 31, 2011 (restated) in thousands Impairment of intangible assets and goodwill Litigation settlement Gain on disposal of property, plant and equipment Gain on ZARS Contingent Consideration Foreign currency loss Total other (income) expense Impairment of Intangible Assets and Goodwill The Company reviewed the carrying values of the intangible assets for potential impairment at December 31, 2012 as commercial efforts for Synera and the launch timing for Pliaglis did not meet expectations. Indications for impairment did exist, and management determined that each asset was impaired, such that recoverable amounts were lower than the carrying amounts. The recoverable amount and value in use (being the present value of expected future cash flows) was calculated using licensing partner revenue forecasts, net of direct costs forecasted by management. The Company recorded an impairment charge for Synera of $0.3 million and an impairment charge for Pliaglis of $7.2 million. The U.S. operations dedicated to generating cash inflows for Synera and Pliaglis were considered to be the cash-generating units (CGU) for recorded goodwill for the purposes of impairment testing. Under the $ $ 11,868 (277) (2) (2,300) 224 – – (114) (2,647) 155 9,513 (2,606) impairment test, the recoverable amount of the CGU was determined at its value in use, based on a discounted cash flow model, and tested for impairment annually at December 31. The value in use calculation considered forecasted cash flows during the patent life of Synera and Pliaglis based on the current commercialization plans for these products. As at December 31, 2012, the recoverable amount was less than its carrying amount, and the entire goodwill of $4.4 million was written off. Gain on ZARS Contingent Consideration The ZARS Contingent Consideration was originally structured as promissory notes payable to the former shareholders of ZARS, but allowed the Company to seek shareholder approval for the issuance of additional shares, in lieu of the promissory notes. The Company’s shareholders approved the conversion of the promissory notes payable into contingent shares at the Company’s Nuvo Research Inc. Annual Report 2012 25 Management’s Discussion and Analysis cont’d Annual and Special Meeting of Shareholders on June 21, 2011. The Company accounted for this conversion by derecognizing the liability related to the promissory notes and recording the value of the potentially issuable shares in liabilities. The Company revalued the consideration of $3.3 million based on the Company’s share price on the date of shareholder approval. This resulted in a gain of $1.8 million representing the difference between the fair value of the ZARS Contingent Consideration derecognized as a liability in the amount of $5.1 million and the fair value of the remaining liability in the amount of $3.3 million. As at December 31, 2011, the ZARS Contingent Consideration liability was revalued at $2.3 million and an additional gain of $0.9 million was recognized. In each reporting period, the ZARS Contingent Consideration liability was revalued based on the Company’s share price and the probability of the Pliaglis Milestone and the Pliaglis Contingent Milestones being achieved. At December 31, 2012, the Pliaglis Milestone was not achieved; therefore, the liability of $2.3 million was derecognized and a corresponding gain was recognized. For the year ended December 31, 2011 the gain was $2.6 million (see Significant Transactions – 2012 – ZARS Acquisition – Restatement of ZARS Contingent Consideration). Litigation Settlement In 2012, the Company reached a settlement with the Liquidator in the Leadenhall matter (see Litigation – Leadenhall). Under the terms of the settlement agreement, the Company received $0.3 million which represents its share of the escrow that was held by the Liquidator. Foreign Currency Losses Net foreign currency losses increased slightly to $224,000 for the year ended December 31, 2012 compared to $155,000 for the year ended December 31, 2011. In 2012, a weaker euro and U.S. dollar decreased the value of the Company’s euro and U.S. denominated cash and receivables. N E T L O S S A N D T O TA L C O M P R E H E N S I V E L O S S in thousands Year ended December 31, 2012 $ Year ended December 31, 2011 $ Net loss before income taxes Income taxes (13,367) 196 (6,727) 104 Net loss Unrealized gains (losses) on translation of foreign operations (13,563) (544) (6,831) 1,097 Total comprehensive loss (14,107) (5,734) Net Loss Net loss was $13.6 million for the year ended December 31, 2012 compared to $6.8 million for the year ended December 31, 2011. The significant increase in net loss related to the $11.9 million impairment of intangible assets and goodwill, offset partially by the improvement in the loss from operations. Net loss for the year ended December 31, 2012 included income tax expense of $196,000 related to U.S. withholding taxes on the royalty income earned on Pennsaid U.S. sales compared with $104,000 in the comparative period. Total Comprehensive Loss Total comprehensive loss was $14.1 million for the year ended December 31, 2012 compared to $5.7 million for the year ended December 31, 2011. The year ended December 31, 2012 included a $0.5 million unrealized loss on the translation of foreign operations versus an unrealized gain of $1.1 million in the comparative period. 26 Nuvo Research Inc. Annual Report 2012 Net Loss Per Common Share Net loss per common share on both a basic and diluted basis was $0.024 for the year ended December 31, 2012 versus a net loss of $0.014 for the year ended December 31, 2011. The weighted average number of common shares outstanding on a basic and diluted basis was 567.7 million for the year ended December 31, 2012 compared to 489.3 million for the year ended December 31, 2011. The majority of the increase in the average number of shares outstanding was attributable to the 112.4 million shares issued for the ZARS acquisition and 31.9 million shares that were issued in December 2011 for the acquisition of the non-controlling interest in Nuvo Research AG. Attribution of Losses Net losses attributable to the parent for the year ended December 31, 2012 was $13.6 million compared to $5.6 million for the year ended December 31, 2011. In the comparative period, the net loss attributable to the Company’s minority interest partner was $1.3 million. In December 2011, the Company acquired the remaining 40% interest in Nuvo Research AG from its minority interest partner and the Company now owns 100% of all its subsidiaries; therefore, all of the Company’s net loss is attributed to the owners of the parent. Segments On a segmented basis, Pain, which includes all Pennsaid activities and the ZARS operations, incurred net loss before income taxes of $10.3 million for the year ended December 31, 2012 compared to net losses before income taxes of $2.8 million for the year ended December 31, 2011. The Pain Group results included the impairment of intangible assets and goodwill and the gain on the ZARS Contingent Consideration. Immunology, which includes all WF10 activities, incurred losses before income taxes of $3.1 million for the year ended December 31, 2012 compared to $3.9 million for the year ended December 31, 2011. L I Q U I D I T Y A N D C A P I TA L R E S O U R C E S Year ended December 31, 2012 Year ended December 31, 2011 (restated) in thousands Net loss Items not involving current cash flows $ $ (13,563) 9,836 (6,831) (3,090) Cash used in operations Net change in non-cash working capital (3,727) (1,348) (9,921) (1,918) Cash used in operating activities Cash provided by (used in) investing activities Cash provided by (used in) financing activities (5,075) (141) 2,714 (11,839) 1,406 (3,037) Effect of exchange rates on cash and cash equivalents (2,502) (73) (13,470) (75) Net change in cash and cash equivalents Cash and cash equivalents, beginning of year (2,575) 14,724 (13,545) 28,269 Cash and cash equivalents, end of year 12,149 14,724 Cash and Cash Equivalents Cash and cash equivalents were $12.1 million as at December 31, 2012 a decrease of $2.6 million compared to $14.7 million as at December 31, 2011, primarily as a result of cash used in operating activities and cash used for loan repayments partially offset by the proceeds from the loan from Paladin. Operating Activities Cash used in operations was $3.7 million for the year ended December 31, 2012 compared to $9.9 million for the year ended December 31, 2011. The improvement in cash used in operations primarily related to the receipt of US$5.0 million from Galderma for the regulatory approval of Pliaglis in Europe in the first two countries. In addition, the higher net loss in the current period included the $11.9 million non-cash impairment charge on intangible assets and goodwill. Overall cash used in operating activities decreased by $6.7 million to $5.1 million for the year ended December 31, 2012 versus $11.8 million for the year ended December 31, 2011. The decrease resulted from lower cash used in operations and a reduced investment in non-cash working capital of $1.3 million in the year ended December 31, 2012 compared to $1.9 million in the year ended December 31, 2011. The $1.3 million investment in non-cash working capital was primarily attributable to a $1.9 million decrease in accounts payable and accrued liabilities offset partially by a reduction in inventory levels. In 2011, the $1.9 million investment in non-cash working capital was attributable to a $2.7 million decrease in accounts payable primarily related to the payment of excess and overdue accounts payable as required as part of the ZARs acquisition. These amounts were partially offset by a $1.1 million decrease in other Nuvo Research Inc. Annual Report 2012 27 Management’s Discussion and Analysis cont’d assets, as the Company received the grant it was awarded in November 2010 under the U.S. Government’s Qualifying Therapeutic Discovery Project. Investing Activities Net cash used in investing activities totaled $0.1 million for the year ended December 31, 2012 compared to net cash provided by investing activities of $1.4 million for the year ended December 31, 2011. For the year ended December 31, 2012, the cash used in investing activities was attributable to the acquisition of property, plant and equipment (PP&E) for production and laboratory equipment acquired by the Company’s manufacturing facility in Varennes, Quebec, partially offset by the proceeds received from the disposition of PP&E. For the comparative period, the cash provided by investing activities was mainly attributable to the net cash acquired from the ZARS Acquisition offset by capital expenditures. Financing Activities Net cash provided by financing activities totaled $2.7 million for the year ended December 31, 2012 compared to net cash used in financing activities of $3.0 million for the year ended December 31, 2011. In 2012, cash of $4.0 million was received from the Company’s Canadian licensing partner (See – Significant Transactions – 2012 – Paladin) which represented the first tranche of an $8.0 million loan that bears interest at 15% per annum and is secured by the assets of the Pain Group. These proceeds were partially offset by payments of other obligations. During the year ended December 31, 2011, the cash used in financing activities related primarily to the repayment of ZARS’ debt that was assumed as part of the ZARS Acquisition. Non-Cash Financing and Investing Activities As fully described in the section entitled, “Significant Transactions – 2011 – ZARS Acquisition”, the Company acquired all of the issued and outstanding shares of ZARS in exchange for the issuance of 99.8 million Nuvo common shares, the ZARS Contingent Consideration and a cash payment of $0.1 million. As fully described in the section entitled, “Significant Transactions – 2011 – Acquisition of Non-Controlling Interest”, the Company acquired the 40% interest in Nuvo Research AG held by the minority owner for non-cash consideration with a fair value of $2.3 million that included the issuance of 31.9 million Nuvo common shares with a fair value of $1.7 million and a five-year consulting contract with a fair value of $0.5 million. As the five-year consulting agreement was considered to be partial consideration for the acquisition, it was recorded as a liability, other obligation, on the Consolidated Statements of Financial Position and accreted, through charges to interest expense, to its nominal value over its term. S E L E C T E D Q U A RT E R LY I N F O R M AT I O N ( U N A U D I T E D ) The following is selected quarterly financial information for the last eight quarterly reporting periods: March 31, 2012 in thousands (except per share data) June 30, 2012 September 30, 2012 December 31, 2012 (restated) (restated) (restated) $ $ $ $ Revenue 6,229 Net income (loss) before income taxes Net income (loss) per common share (4,341)(2) 11,357 4,082(1)(3) 3,500 (1,958)(1)(4) 3,564 (11,150)(5)(6) (0.008)(2) 0.007(1) (0.004)(1) (0.020)(5)(6) – basic and diluted March 31, 2011 $ Revenue Net loss before income taxes Net loss per common share – basic and diluted (1) (2) (3) (4) (5) (6) (3) (4) June 30, 2011 September 30, 2011 December 31, 2011 (restated) (restated) (restated) $ $ $ 3,825 (2,343) 3,761 (1,061)(1) 3,957 (1,933)(1) 5,190 (1,390)(1) (0.006) (0.002)(2) (0.004)(1) (0.003)(1) Net loss before income taxes includes the gains on the ZARS Contingent Consideration as restated in 2012. Net loss before income taxes includes the loss on the ZARS Contingent Consideration as restated in 2012. The quarter ended June 30, 2012 includes US$5.0 million in licensing fees from Galderma representing the milestone payments for the marketing approval of Pliaglis in the first two European countries. The quarter ended September 30, 2012 includes US$1.0 million in licensing fees from Galderma representing the milestone payments for the marketing approval of Pliaglis in the third European country. Net loss before income taxes included an $11.9 million impairment charge on intangible assets and goodwill related to the ZARS Acquisition. Net loss before income taxes included a $2.3 million gain on the ZARS Contingent Consideration. 28 Nuvo Research Inc. Annual Report 2012 F O U RT H Q U A RT E R R E S U LT S Three months ended December 31, 2012 Three months ended December 31, 2011 (restated) $ $ 2,155 1,770 2,611 2,165 385 446 1,278 85 46 1,884 545 150 1,794 3,025 1,539 290 2,084 1,709 1,312 2,380 130 (22) Operating expenses 4,043 5,379 Other (income) expenses 8,901 (964) in thousands Product sales Cost of goods sold Gross margin on product sales Royalties License fees Research and other contract revenue Research and development Selling and marketing expenses General and administrative expenses Interest (income) expense, net Net loss before income taxes Income taxes (11,150) 22 (1,390) 30 Net loss (11,172) (1,420) Other comprehensive income (loss) Total comprehensive loss Key Developments During the quarter and prior to the release of the fourth quarter results: • In October 2012, the Company received confirmation from Galderma of the FDA approval for the marketing of Pliaglis in the U.S.; • In January 2013, the Company entered into the Apotex Settlement Agreement where Nuvo and Mallinckrodt granted a license to Apotex that permits Apotex, upon approval of its ANDA by the FDA, to launch its generic version of Pennsaid on a date that is the earlier of 45 days after Mallinckrodt or Nuvo makes a first commercial shipment of Pennsaid 2% in the U.S. and April 1, 2014, or earlier under certain circumstances; • Galderma launched the commercial marketing and sale of Pliaglis in the U.S. in March 2013 at the American Academy of Dermatology Conference in Miami; and • In March 2013, the Company’s U.S. licensee, Mallinckrodt received a CRL to the NDA for Pennsaid 2% in which the FDA confirmed that the 244 (10,928) (631) (2,051) only substantive additional requirement is the completion of a PK study comparing Pennsaid 2% to original Pennsaid. Mallinckrodt has indicated that it expects to complete the study, submit the results and receive a formal response from the FDA in late 2013 or early 2014. Operating Results Total revenue for the three months ended December 31, 2012 was $3.6 million compared to $5.2 million for the three months ended December 31, 2011. The decrease was attributable to a $0.7 million decrease in royalty revenue from Pennsaid sales in the U.S., a $0.5 million decrease in license fees earned under Galderma licensing arrangements for Pliaglis which were fully amortized in May 2012 and a $0.4 million decrease in Pennsaid product sales. The decrease in Pennsaid U.S. royalties related to lower net sales as our licensee incurred significantly higher rebates related to new reimbursement coverage that commenced in 2012 compared to the prior year. The decrease in Pennsaid product sales related to lower product sales to our U.S. licensee offset partially by higher sales to our Canadian Nuvo Research Inc. Annual Report 2012 29 Management’s Discussion and Analysis cont’d licensee. Sales of Synera were consistent at $0.3 million versus the comparative period. For the three months ended December 31, 2012, gross margin on product sales decreased to $385,000 compared to $446,000 for the comparative quarter in 2011. The decrease in gross margin was primarily related to lower Pennsaid product sales. Total operating expenses for the three months ended December 31, 2012 decreased to $4.0 million versus $5.4 million for the three months ended December 31, 2011. The decrease in operating expenses was primarily due to lower S&M expenses as the Company terminated its agreement with its CSO for Synera in third quarter of 2012. As such, there were no CSO costs in the quarter and lower infrastructure costs for ZARS as a result of integration activities. R&D expenses decreased to $1.5 million for the three months ended December 31, 2012 compared to $1.7 million for the three months ended December 31, 2011. The decrease in the quarter primarily related to lower spending on drug development programs. S&M expenses were $0.3 million for the three months ended December 31, 2012 compared with $1.3 million for the comparative period in 2011. S&M expenses relate entirely to the Company’s marketing costs for Synera in the U.S. In the comparative period, the Company hired experienced pharmaceutical executives to prepare for a U.S. launch of Synera, targeting interventional pain physicians with pain specialty sales representatives using a CSO. In September 2012, the Company refocused its resources on large national accounts and terminated its agreement with its CSO and also terminated two members of the Pain Group management team focused on the interventional pain doctor initiative; therefore, the fourth quarter no longer included costs related to the CSO. G&A expenses decreased to $2.1 million for the three months ended December 31, 2012 compared to $2.4 million for the three months ended December 31, 2011. The decrease in the quarter related to termination benefits incurred in the comparative period. Other expenses increased to $8.9 million for the three months ended December 31, 2012 compared to other income of $1.0 million for the three months ended December 31, 2011 primarily related to the $11.9 million impairment charge on intangible assets and goodwill, offset partially by a $1.6 million increase in the gain on the ZARS Contingent Consideration. Net loss for the three months ended December 31, 2012 was $11.2 million versus $1.4 million for the three months ended December 31, 2011. The increased loss was substantially a result of the impairment charge on intangible assets and goodwill, offset partially by the increased gain on the ZARS Contingent Consideration. Total comprehensive loss was $10.9 million for the quarter ended December 31, 2012 compared to $2.1 million for the quarter ended December 31, 2011. The quarter ended December 31, 2012 included a $0.2 million unrealized gain on the translation of foreign operations versus an unrealized loss of $0.6 million in the quarter ended December 31, 2011. Liquidity Three months ended December 31, 2012 Three months ended December 31, 2011 (restated) in thousands Net loss Items not involving current cash flows $ $ (11,172) 9,222 (1,420) (1,377) (1,950) 2,997 (2,797) (415) 1,047 (111) (447) (3,212) 110 18 489 170 (3,084) (230) Net change in cash and cash equivalents Cash and cash equivalents, beginning of period 659 11,490 (3,314) 18,038 Cash and cash equivalents, end of year 12,149 14,724 Cash used in operations Net change in non-cash working capital Cash provided by (used in) operating activities Cash provided by (used in) investing activities Cash provided by (used in) financing activities Effect of exchange rates on cash and cash equivalents 30 Nuvo Research Inc. Annual Report 2012 Cash and cash equivalents on hand at December 31, 2012 of $12.1 million were $0.6 million higher than the $11.5 million at September 30, 2012. Cash provided by operating activities was $1.0 million compared to cash used in operating activities of $3.2 million for the three months ended December 31, 2011. This improvement was due a significant recovery of the Company’s investment in working capital related to the receipt of the US$5.0 million ($5.1 million) milestone payment from Galderma related to the European regulatory approvals for Pliaglis. Net cash used in investing activities totaled $111,000 for the three months ended December 31, 2012 compared to net cash provided by investing activities of $110,000 for the three months ended December 31, 2011. The amount in the fourth quarter of 2012 related entirely to capital expenditures. The amount in the fourth quarter of 2011 included proceeds on the disposition of PP&E offset partially by capital expenditures. Net cash used in financing activities totaled $0.4 million for the three months ended December 31, 2012, compared to net cash provided by financing activities of $18,000 for the three months ended December 31, 2011. During the fourth quarter of 2012, the Company made $0.5 million of repayments on finance and other obligations. FINANCIAL INSTRUMENTS Fair Values IFRS 7 Financial Instruments: Disclosures requires disclosure of a three-level hierarchy that reflects the significance of the inputs used in making fair value measurements. Fair values of assets and liabilities included in Level 1 are determined by reference to quoted prices in active markets for identical assets and liabilities. Assets and liabilities in Level 2 include those whose valuations are determined using inputs other than quoted prices for which all significant outputs are observable, either directly or indirectly. Level 3 valuations are those based on inputs that are unobservable and significant to the overall fair value measurement. The Company assessed its financial instruments that are reported at market value, cash and cash equivalents of $12.1 million and determined that they are based on Level 1 inputs. The Company has determined the estimated fair values of its financial instruments based on appropriate valuation methodologies. However, considerable judgment is required to develop these estimates. Accordingly, these estimated values are not necessarily indicative of the amounts the Company could realize in a current market exchange. The estimated fair value amounts can be materially affected by the use of different assumptions or methodologies. The methods and assumptions used to estimate the fair value of each class of financial instruments are discussed below. The fair values of short-term financial assets and liabilities, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities as presented in the Consolidated Statements of Financial Position approximate their carrying amounts due to the short period to maturity of these financial instruments. Rates currently available to the Company for long-term obligations, with similar terms and remaining maturities, have been used to estimate the fair value of the finance lease and other obligations. These fair values approximate the carrying values for all instruments. FINANCIAL RISK MANAGEMENT Risk Factors The following is a discussion of credit, liquidity, interest and currency risks and related mitigation strategies that have been identified. This is not an exhaustive list of all risks nor will the mitigation strategies eliminate all risks listed. Credit Risk The Company’s cash and cash equivalents subject the Company to a significant concentration of credit risk. At December 31, 2012, the Company had $10.7 million invested with one financial institution in various bank accounts as per its practice of protecting its capital rather than maximizing investment yield through additional risk. This financial institution is a major Canadian bank which the Company believes lessens the degree of credit risk. The remaining $1.4 million of cash and cash equivalent balances are held in bank accounts in various geographic regions outside of Canada. The Company, in the normal course of business, is exposed to credit risk from its global customers most of whom are in the pharmaceutical industry. The accounts receivable are subject to normal industry risks in each geographic region in which the Company operates. In addition, the Company is exposed to credit related losses on sales to its customers outside North America and the E.U. due to potentially higher risks of enforceability and collectability. The Company attempts to manage these risks prior to the signing of distribution or licensing agreements by dealing with creditworthy customers; however, due to the limited number of potential customers in each market, this is not always possible. In addition, a customer’s creditworthiness may change subsequent to becoming Nuvo Research Inc. Annual Report 2012 31 Management’s Discussion and Analysis cont’d a licensee or distributor and the terms and conditions in the agreement may prevent the Company from seeking new licensees or distributors in these territories during the term of the agreement. At December 31, 2012, the Company’s four largest customers located in North America and the E.U. represent 79% in thousands Current 0-30 days past due 31-60 days past due 61-90 days past due As at March 27, 2013, $486,000 of the past due amounts have been collected. Liquidity Risk While the Company has $12.1 million in cash and cash equivalents at December 31, 2012, it continues to have an ongoing need for substantial capital resources to research, develop, commercialize and manufacture its products and technologies. Other than in the U.S. and Canada, the Company has limited participation in Pennsaid sales revenues in countries where it is currently marketed. In Canada, the Company receives royalties based on Canadian net sales, but the market is relatively small. These funds are used entirely towards repayment of the Paladin Debt. In the U.S., the Company receives royalties based on U.S. net sales at rates consistent with industry standards and has the opportunity to earn up to $100 million in sales milestones. However, Pennsaid is subject to generic risk in the U.S. as three companies have filed ANDAs in the U.S. (one in early 2013) for approval to market a generic version of Pennsaid. Although the Company and Mallinckrodt have filed patent infringement complaints with the courts against two of the generic companies and settled with one, a launch of a generic in the U.S. would materially impact revenues. A generic version of Pennsaid available for commercial sale in the U.S. may trigger an event of default on the Paladin Debt. 32 Nuvo Research Inc. Annual Report 2012 [2011 – 85%], of accounts receivable, and accounts receivable from customers located outside of North America and the E.U. represent 12% [2011 – 7%], of accounts receivable. Pursuant to their collective terms, accounts receivable are aged as follows: Year ended December 31, 2012 $ Year ended December 31, 2011 $ 2,938 543 208 82 3,301 162 226 11 3,771 3,700 In addition, minimal revenues are being generated by Synera and Pliaglis, the two key products added through the acquisition of ZARS. The commercial success for Synera has been limited, as are the royalties generated by the European marketing partner. While the Company has licensed Pliaglis’ worldwide rights to Galderma, Pliaglis was recently approved in 2012 in a number of European countries and the U.S. and just recently launched in the U.S. and the European launch will occur in the second quarter of 2013. Pliaglis is not yet generating any significant royalty revenue for the Company. As a result, the Company’s revenues may not be sufficient to provide the capital required for the Company to be selfsustaining without the need for future financings. The Company has contractual obligations related to accounts payable and accrued liabilities, purchase commitments and finance lease and other obligations of $7.1 million that are due in less than a year and $1.8 million of contractual obligations that are payable from 2014 to 2015. Interest Rate Risk All finance lease and other obligations are at fixed interest rates. Currency Risk The Company operates globally, which gives rise to a risk that earnings and cash flows may be adversely affected by fluctuations in foreign currency exchange rates. The Company is primarily exposed to the U.S. dollar and euro, but also transacts in other foreign currencies. The Company currently does not use financial instruments to hedge these risks. The significant balances in foreign currencies are as follows: Euros in thousands Cash and cash equivalents Accounts receivable Other current assets Accounts payable and accrued liabilities Finance lease and other obligations Based on the aforementioned net exposure as at December 31, 2012, and assuming that all other variables remain constant, a 10% appreciation or U.S. Dollars 2012 2011 2012 2011 € € $ $ 1,620 2,248 6,360 4,482 523 726 2,579 2,260 138 192 (287) (475) (1,220) – (2,562) 623 – – (473) (525) 1,994 2,691 7,246 4,278 depreciation of the Canadian dollar against the U.S. dollar and euro would have resulted in (decreases) increases in total comprehensive loss as follows: Comprehensive loss (income) Canadian Dollar Appreciates Depreciates 10% 10% Versus U.S. dollar 655 (801) Versus euro 238 (291) in thousands In terms of the euro, the Company has three significant exposures: its net investment and net cash flows in its European operations, its euro denominated cash and cash equivalents held in its Canadian operations and sales of Pennsaid by the Canadian operations to European distributors. In terms of the U.S. dollar, the Company has five significant exposures: its net investment and net cash flows in its U.S. operations, its U.S. dollar denominated cash and cash equivalents held in its Canadian operations, the cost of running trials and other studies at U.S. sites, the cost of purchasing raw materials either priced in U.S. dollars or sourced from U.S. suppliers that are needed to produce Pennsaid or other products at the Canadian manufacturing facility and revenue generated in U.S. dollars, including royalties and milestone payments received from licensing agreements with Mallinckrodt, Galderma and Eurocept and product sales to Mallinckrodt. The Company does not actively hedge any of its foreign currency exposures given the relative risk of currency versus other risks the Company faces and the cost of establishing the necessary credit facilities and purchasing financial instruments to mitigate or hedge these exposures. As a result, the Company does not attempt to hedge its net investment in foreign subsidiaries. The Company does not currently hedge its euro cash flows. Sales to European distributors for Pennsaid are primarily contracted in euros. The Company receives payments from the distributors in its euro bank accounts and uses these funds to pay euro denominated expenditures and to fund the net outflows of the European operations as required. Periodically, the Company reviews the amount of euros held, and if they are excessive compared to the Company’s projected future euro cash flows, they may be converted into U.S. or Canadian dollars. The Company does not currently hedge its U.S. dollar cash flows. The Company’s U.S. operations have net cash outflows and currently these are funded using the Company’s U.S. dollar denominated cash and cash equivalents and payments received under the terms of the U.S. Licensing Agreement. Periodically, the Company reviews its projected future U.S. dollar cash flows and if the U.S. dollars held are insufficient, Nuvo Research Inc. Annual Report 2012 33 Management’s Discussion and Analysis cont’d into Canadian dollars or other currencies as needed for the Company’s other operations. the Company may convert a portion of its other currencies into U.S. dollars. If the amount of U.S. dollars held is excessive, they may be converted C O N T R A C T U A L O B L I G AT I O N S The following table lists the Company’s contractual obligations for the twelve-month periods ending December 31 as follows: 2015 and Total 2013 2014 thereafter $ $ $ $ 8 372 1,742 6,746 3 213 1,628 5,260 3 68 114 1,163 2 91 – 323 8,868 7,104 1,348 416 in thousands Finance lease obligations Operating leases Purchase obligations Other obligations (i) (i) Other obligations include accounts payable, accrued liabilities and other obligations. OFF-BALANCE SHEET ARRANGEMENTS The Company does not have any off-balance sheet arrangements. R E L AT E D PA RT Y T R A N S A C T I O N S The Company has a consulting arrangement with one of its independent directors. During 2012, consulting expenses totaled $37,000 [2011 – $68,000]. O U T S TA N D I N G S H A R E D ATA The number of common shares outstanding as at December 31, 2012 was 567.8 million, an increase of 3.8 million from 564.0 million at December 31, 2011. The increase was due to the issuance of 1.8 million shares issued from the employee Share Purchase Plan, 1.5 million shares issued from the Share Bonus Plan upon the vesting of PSUs pursuant to the PSU Plan and 0.5 million shares issued for the settlement of professional fees. As at December 31, 2012, there were 49,129,283 options outstanding of which 32,647,882 were vested. Stock options increased in the year by 6,461,365 million as 11,225,415 new stock options were granted during the year while 4,723,650 were forfeited and 40,400 stock options expired. L I T I G AT I O N From time-to-time, during the ordinary course of business, the Company is threatened with, or is named as, a defendant in various legal proceedings including lawsuits based upon product liability, personal injury, breach of contract and lost profits or other consequential damage claims. 34 Nuvo Research Inc. Annual Report 2012 Leadenhall In July 2003, a $2.0 million short-term loan was extended to the Company by Leadenhall Bank & Trust Company Limited (the Mortgagee). The terms of this loan were for interest to accrue at 2% per month and for full repayment to occur on May 31, 2004. The repayment date was extended on two occasions; first to September 30, 2004 and subsequently to February 28, 2005. The loan was collateralized by a subsidiary of the Company through a $2.0 million mortgage charge (the Mortgage) on the Company’s former head office. In 2005 a dispute surrounding the Mortgage arose between the parties. The Mortgage dispute centered on the calculation and amount of interest owing and was the subject of an Ontario court action (the Ontario Action) commenced by the Mortgagee in April 2005. The Mortgagee’s position was that interest should be calculated monthly at a rate of 2% per month, including interest on late payments and costs. The Company’s position was that the Mortgage was null and void and should be discharged or alternatively, that the interest payable was limited to 5% per annum pursuant to the provisions of the Interest Act (Canada). Subsequent to the filing by the Mortgagee of its Statement of Claim and the Company of its Statement of Defense and Counterclaim, the Mortgagee was placed into voluntary liquidation by its shareholders and a liquidator (the Liquidator) was appointed in the Bahamas, where the Mortgagee is situated to settle the affairs on the Mortgage. The Ontario Action was subsequently dismissed by the courts for delay. In November of 2005, the Company negotiated a written agreement (the Settlement Agreement) with the Liquidator to settle all claims pursuant to the Ontario Action for US$1.1 million (the Settlement Amount) payable out of closing funds received on the sale of the Company’s former head office. The Settlement Agreement was subject to the approval of the Bahamian court that appointed the Liquidator. The Liquidator agreed to seek court approval as soon as possible after signing the Settlement Agreement. The Liquidator did not seek court approval prior to the completion of the head office sale, and in order to allow the sale to proceed, the Liquidator and the Company entered into an escrow arrangement (the Escrow Agreement). Pursuant to the Escrow Agreement, the Liquidator agreed that upon payment of US$1.4 million (the Escrow Amount) to the Liquidator, to be held in escrow pending court approval of the Settlement Agreement, the Liquidator would deliver a discharge of the Mortgage. It was further agreed that upon approval of the Settlement Agreement by the Bahamian Court the Settlement Amount would be released from escrow and paid to the Liquidator and the balance, US$0.3 million, would be released to the Company (the Excess Amount). In January 2006, the Liquidator discharged the mortgage, the Company completed the sale of its head office and it paid the Escrow Amount into escrow with the Liquidator’s Bahamian counsel. Subsequent to receipt of the Escrow Amount, the Liquidator continually delayed seeking court approval of the Settlement Agreement and has not yet presented it to the Bahamian court for approval. Since April 2006, the Liquidator indicated that while still intending to present the Settlement Agreement to the court for its consideration, it would not recommend that the court approve it. In addition, in its February 2007 Affidavit, the Liquidator indicated that if the Court did not approve the Settlement Agreement, it would request that the Bahamian court order that all escrowed funds, including the Excess Amount be released to it and not to the Company. The Liquidator further stated that the full amount in escrow was insufficient to retire the mortgage principal, plus interest at the alleged interest rate of 2% per month and that it may pursue the Company for the deficiency. The Company retained legal counsel in the Bahamas to assist it in securing court approval of the Settlement Agreement and to ensure that if the Settlement Agreement was not approved, that the escrow continues in accordance with the terms of the Escrow Agreement. A hearing in the Bahamian court was held in March 2007. At this hearing, the Liquidator submitted additional arguments to the Bahamian court requesting that all matters, including those that form the basis of the Ontario Action, be decided by the Bahamian court. While this request was not ruled upon, the judge issued an order that the escrow funds continue to be held in escrow for at least 90 days to provide the Company the opportunity to bring an action in the Bahamian courts for the release of the funds based upon the non-ratification of the Settlement Agreement. The judge retired shortly thereafter and the case was not reassigned to another judge for over a year. As a result, the Company was not able to bring its action to release the escrow funds to it before the Bahamian courts. In June 2007, its Bahamian legal counsel filed a summons in the Leadenhall liquidation proceedings requesting that the Company be granted leave to join the liquidation as an interested party. The Summons was served on the Liquidator in June 2007 and required that the Company be notified if the Liquidator intended to make application to have the escrow funds released to it. Since June 2007, the shortage of commercial judges available to hear the case and a lack of co-operation by the Liquidator hindered the Company’s Bahamian legal counsel’s efforts to obtain a date for a hearing at which a judge could consider the Settlement Agreement. Late in 2008, the Company’s Bahamian legal counsel informed the Company that a commercial court judge had been assigned to handle all aspects of the Leadenhall liquidation; however, early in 2009, prior to obtaining a hearing, this judge resigned from the Bench and the case had not yet been assigned to another judge. Given these delays, the Company through its Bahamian legal counsel, reinitiated dialogue with the Liquidator’s counsel in 2009 and presented a proposal aimed at resolving all outstanding matters between the Company and the Liquidator, if acceptable, the parties would jointly approach the courts to seek its approval. The Company did not receive a response to its proposal from the Liquidator’s counsel and subsequently learned that the Liquidator had switched legal counsel (Liquidator’s New Counsel). In November 2010, the Company, the Liquidator and the Liquidator’s New Counsel restarted discussions aimed at resolving all outstanding matters between the Company and the Liquidator and in 2011 were able to reach a settlement agreement (2011 Settlement Agreement). In December 2011, the Bahamian court approved the 2011 Settlement Agreement. Under the terms of the 2011 Settlement Agreement, the funds remaining in escrow were split between the Company and the Liquidator with the Company’s apportionment estimated at approximately $0.3 million (the Settlement Amount). In 2012, the Court signed an Order that approved settlement terms agreed to by the Company and the Liquidator. The Company and the Liquidator executed a mutual release agreement and the Settlement Amount was received and recorded in income. Nuvo Research Inc. Annual Report 2012 35 Management’s Discussion and Analysis cont’d benefit from synergies of the combination. Management first considers the Company’s commercialized products and then determines the operations that contribute to each product’s revenue base and net cash inflows. Management has identified 3 CGUs: the U.S. operations dedicated to generating cash inflows for Synera and Pliaglis, the manufacturing facility in Québec that generates cash inflows for Pennsaid and the Immunology Group that generates cash inflows for WF10. CRITICAL ACCOUNTING POLICIES A N D E S T I M AT E S The preparation of consolidated financial statements in conformity with IFRS requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenue and expenses during the reporting periods. Management has identified the following accounting estimates that it believes are most critical to understanding the Consolidated Financial Statements and those that require the application of management’s most subjective judgments, often requiring the need to make estimates about the effect of matters that are inherently uncertain and may change in subsequent periods. The Company’s actual results could differ from these estimates and such differences could be material. All significant accounting policies are disclosed in Note 3, “Summary of Significant Accounting Policies” of the Company’s Consolidated Financial Statements for the year ended December 31, 2012. Critical Accounting Estimates Key areas of estimation or use of managerial assumptions are as follows: (i) (ii) Business combinations, intangible assets and goodwill: The amount of goodwill initially recognized as a result of a business combination and the determination of the fair value of the identifiable assets acquired and the liabilities assumed is based, to a considerable extent, on management’s judgment. The Company determines fair values based on discounted cash flows, market information, independent valuations and management’s estimates. The values calculated for intangible assets and goodwill involve significant estimates and assumptions, including those with respect to future cash flows, discount rates and asset lives. These significant estimates and judgments could impact the Company’s future results if the current estimates of future performance and fair values change and could affect the amount of amortization expense on intangible assets in future periods. Cash-generating Units The identification of CGUs within the Company requires considerable judgment. Under IFRS, management must determine the smallest group of assets that generate independent cash inflows and allocate goodwill acquired in a business combination to the CGU that is expected to 36 Nuvo Research Inc. Annual Report 2012 (iii) Income taxes: The Company recognizes deferred tax assets, related tax-loss carryforwards and other deductible temporary differences where it is probable that sufficient future taxable income can be generated in order to fully utilize such losses and deductions. This requires significant estimates and assumptions regarding future earnings and the ability to implement certain tax planning opportunities in order to assess the likelihood of utilizing such losses and deductions. (iv) Property, plant and equipment: Measurement of PP&E involves the use of estimates for determining the expected useful lives of depreciable assets. Management’s judgment is also required to determine depreciation methods and an asset’s residual value and whether an asset is a qualifying asset for the purposes of capitalizing borrowing costs. (v) Impairment of goodwill and non-financial assets: The Company reviews the carrying value of goodwill and non-financial assets for potential impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The impairment test on CGUs is carried out by comparing the carrying amount of the CGU and its recoverable amount. The recoverable amount of a CGU is the higher of fair value, less costs to sell and its value in use. This complex valuation process entails the use of methods such as the discounted cash flow method which requires numerous assumptions to estimate future cash flows. The recoverable amount is impacted significantly by the discount rate selected to be used in the discounted cash flow model, as well as the quantum and timing of expected future cash flows and the growth rate used for the extrapolation. (vi) Provisions: A provision is a liability of uncertain timing or amount. Provisions are recognized when the Company has a present obligation (legal or constructive) as a result of a past event, it is probable that the Company will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation. A legal obligation can arise through a contract, legislation or other operation of law. A constructive obligation arises from an entity’s actions; whereby, through an established pattern of past practice, published policies or a sufficiently specific current statement, the entity has indicated it will accept certain responsibilities and has thus created a valid expectation that it will discharge those responsibilities. The amount recognized as a provision is the best estimate, at each period end, of the expenditures required to settle the present obligation considering the risks and uncertainties associated with the obligation. Judgment is necessary to determine the likelihood that pending litigation or other claims will succeed or a liability will arise and then to quantify the amount. (vii) Share-based payments: The Company measures the cost of share-based payments, either equity or cash-settled, with employees by reference to the fair value of the equity instrument or underlying equity instrument at the date on which they are granted. In addition, cash-settled share-based payments are remeasured at fair value at every reporting date. Estimating fair value for share-based payments requires management to determine the most appropriate valuation model for a grant, which is dependent on the terms and conditions of each grant. In valuing certain types of stock-based payments, such as incentive stock options, the Company uses the Black-Scholes option pricing model. Several assumptions are used in the underlying calculation of fair values of the Company’s stock options using the Black-Scholes option pricing model including the expected life of the option, stock price volatility and forfeiture rates. Details of the assumptions used are included in Note 15 of the financial statements. (viii) Foreign Currency translation: The determination of functional currency for each of the Company’s entities requires considerable judgment. The functional currency is determined based on the currency of the primary economic environment in which that entity operates. As the Company generates and expends cash in a variety of currencies, management considers several factors including: the currency in which it receives its various revenue streams and the magnitude of each, the currency in which it purchases materials and pays its employees and the geographic environments influencing each of its consolidated entities and its products. (ix) Revenue Recognition As is typical in the pharmaceutical industry, the Company’s royalty streams are subject to a variety of deductions that generally are estimated and recorded in the same period that the revenues are recognized and primarily represent rebates, discounts and incentives and product returns. These deductions represent estimates of the related obligations. Amounts recorded for sales deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. RECENT ACCOUNTING PRONOUNCEMENTS Certain new standards, interpretations, amendments and improvements to existing standards were issued by the International Accounting Standards Board (IASB) or IFRS Interpretations Committee (IFRIC) that are mandatory for fiscal periods beginning July 1, 2012 or later. The standards impacted that may be applicable to the Company are as follows: IFRS 9 – Financial Instruments In October 2010, the IASB issued IFRS 9 Financial Instruments which replaces IAS 39 Financial Instruments: Recognition and Measurement. IFRS 9 establishes principles for the financial reporting of financial assets and financial liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows. This new standard is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2015. IFRS 10 – Consolidated Financial Statements In May 2011, the IASB issued IFRS 10 Consolidated Financial Statements, which replaces IAS 27 Consolidation and Separate Financial Statements and SIC-12 Consolidation – Special Purpose Entities. IFRS 10 establishes principles for the presentation and preparation of consolidated financial statements when an entity controls one or more entities. This new standard is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2013. Nuvo Research Inc. Annual Report 2012 37 Management’s Discussion and Analysis cont’d IFRS 12 – Disclosure of Interests in Other Entities In May 2011, the IASB issued IFRS 12 Disclosure of Interests in Other Entities. IFRS 12 is a comprehensive new standard on disclosure requirements for all forms of interests in other entities, including subsidiaries, joint arrangements, associates and unconsolidated structured entities. This new standard is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2013. IFRS 13 – Fair Value Measurement In June 2011, the IASB issued new guidance on IFRS 13 Fair Value Measurement. IFRS 13 aims to improve consistency and reduce complexity by providing a single source of guidance for all fair value measurements across all IFRS, clarifying the definition of fair value and enhancing disclosure requirements about fair value measurements. This new guidance is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2013. IAS 1 – Presentation of Financial Statements: Other Comprehensive Income In June 2011, the IASB issued amendments to IAS 1 Presentation of Financial Statements to improve the consistency and clarity of the presentation of items of comprehensive income by requiring that items presented in Other Comprehensive Income (OCI) be grouped on the basis of whether they are at some point reclassified from OCI to net earnings or not. The amendments require companies preparing financial statements in accordance with IFRSs to group together items within OCI that may be reclassified to the profit or loss section of the income statement. The amendments also reaffirm existing requirements that items in OCI and profit or loss should be presented as either a single statement or two consecutive statements. These amendments are effective for annual periods beginning on or after July 1, 2012. The Company is currently assessing the impact of the adoption of these standards on its Consolidated Financial Statements, but it does not anticipate significant changes in 2013. MANAGEMENT’S RESPONSIBILITY FOR F I N A N C I A L R E P O RT I N G Disclosure Controls Disclosure controls and procedures (DCP) are designed to provide reasonable assurance that information required to be disclosed by the Company in its filings under Canadian securities legislation is recorded, processed, summarized and reported in a timely manner. The system of DCP includes, among other 38 Nuvo Research Inc. Annual Report 2012 things, the Company’s Corporate Disclosure and Code of Conduct and Business Ethics policies, the review and approval procedures of the Corporate Disclosure Committee and continuous review and monitoring procedures by senior management. As at December 31, 2012, the system of DCP has been evaluated, under the supervision of the Company’s Chairman and Co-Chief Executive Officer, President and Co-Chief Executive Officer and Vice President and Chief Financial Officer. Based on this evaluation, the Company’s management has concluded that the DCP are effective and provide reasonable assurance that all material information relating to the Company would be made known to them. While the Co-Chief Executive Officers and the Chief Financial Officer believe that the Company’s DCP provide reasonable assurance, they are also aware that any control system can only provide reasonable, not absolute, assurance of achieving its control objectives. Internal Controls Over Financial Reporting Management is also responsible for the design of internal controls over financial reporting (ICFR) within the Company in order to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with IFRS. Due to its inherent limitations, ICFR may not prevent or detect misstatements. In addition, the design of any system of control is based upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all future events, no matter how remote, or that the degree of compliance with the policies or procedures may not deteriorate. Accordingly, even effective ICFR can only provide reasonable, not absolute, assurance of achieving the control objectives for financial reporting. The design and operating effectiveness of the Company’s ICFR were evaluated, under the supervision of the Company’s Chairman and Co-Chief Executive Officer, President and Co-Chief Executive Officer and Vice President and Chief Financial Officer, in accordance with criteria established in the Internal Control Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) and Multilateral Instrument 52-109 as at December 31, 2012, which included the Company’s changes related to its conversion to IFRS. Based on this evaluation, the Company’s management has concluded that ICFR are effective and provided reasonable assurance that its financial reporting is reliable. Changes to Internal Controls Over Financial Reporting During 2012, the Company’s internal controls and procedures were amended to include ZARS [see Significant Transactions – 2011 – ZARS Acquisition] in the scope of the Company’s disclosure controls and procedures and the design of internal controls over financial reporting. Management has reviewed and aligned internal procedures of ZARS to be consistent with the controls and procedures of the Company. R I S K FA C T O R S Prospects for companies in the biotechnology and pharmaceutical industry generally may be regarded as uncertain given the nature of the industry and, accordingly, investments in biotechnology and pharmaceutical companies should be regarded as speculative. R&D involves a high and significant degree of risk. An investor should carefully consider the risks and uncertainties described below, as well as other information contained in this MD&A, as well as broader risk factors discussed in the Company’s AIF. The risks and uncertainties described below are not an exhaustive list. Additional risks and uncertainties not presently known to the Company or that the Company believes to be immaterial may also adversely affect the Company’s business. If any one or more of the following risks occur, the Company’s business, financial condition and results of operations could be seriously harmed. Further, if the Company fails to meet the expectations of the public market in any given period, the market price of the Company’s common shares could decline. Before making an investment decision, each prospective investor should carefully consider the risk factors set out below and those included in the AIF and other public documents. Need for Additional Financing The Company has an ongoing need for substantial capital resources to research, develop, commercialize and manufacture its products and technologies. Other than the U.S. and Canada, the Company only has limited participation in Pennsaid sales revenues in countries where it is currently marketed. In Canada, the Company receives royalties based on Canadian net sales, but the market is relatively small and these funds are used entirely towards repayment of the Paladin Debt. In the U.S., the Company receives royalties based on net sales at rates consistent with industry standards. Pennsaid is subject to generic risk in the U.S., as four companies have filed ANDAs in the U.S. (including one that filed in early 2013 and one has withdrawn its ANDA) for approval to market a generic version of Pennsaid. Although, the Company has the Pennsaid Patent, that was issued in July 2012, it does not automatically prevent a generic version of Pennsaid from being approved by the FDA or if approved, from being sold in the U.S. The Company and Mallinckrodt have filed patent infringement complaints with the courts against Apotex and Lupin and settled with Apotex. A launch of a generic in the U.S. would materially impact revenues and a generic version of Pennsaid available for commercial sale in the U.S. may trigger an event of default on the Paladin Debt. In addition, a condition of the FDA approval of Pennsaid is the completion of certain post-marketing studies including the Carc Study. Mallinckrodt has completed all of the post-marketing studies without any significant adverse finding and submitted the results to the FDA. An unfavourable review in any of these studies could cause the FDA to withdraw the NDA for Pennsaid; therefore, removing Pennsaid from the market in the U.S. Pennsaid 2%, the follow-on product to Pennsaid has patent protection that expires in April 2028. An NDA for Pennsaid 2% was submitted to the FDA by Mallinckrodt and the FDA has set a PDUFA date of March 4, 2013 for action on the submission. Mallinckrodt received a CRL to the NDA for Pennsaid 2% in which the FDA confirmed the only substantive additional requirement is the completion of a PK study comparing Pennsaid 2% to original Pennsaid. Mallinckrodt has indicated that it expects to complete the study, submit the results and receive a formal response from the FDA in late 2013 or early 2014. There can be no assurance that the PK study will be successful or that the FDA review will be completed positively or that if approved, Pennsaid 2% will be launched prior to Apotex launching their generic version of Pennsaid as per the terms of the Apotex Settlement or that another generic company launches their version of Pennsaid. The entry of a generic version of Pennsaid into the U.S. market before FDA approval and the commercial launch of Pennsaid 2% could have a significant adverse effect on Pennsaid and Pennsaid 2% sales and the resulting level of royalties earned by the Company. In any of these scenarios, the Company’s future cash flows would be negatively impacted as the Company would lose all or a significant portion of its royalties and potential milestone payments. In addition, minimal revenues are being generated by Synera and Pliaglis, the two key products added through the acquisition of ZARS. The commercial activities for Synera are limited to product sales in the U.S. and royalties generated by the European marketing partner. While the Company has licensed Pliaglis’ worldwide rights to Galderma, Pliaglis has just recently been approved in a number of European countries and the U.S. Galderma launched the Nuvo Research Inc. Annual Report 2012 39 Management’s Discussion and Analysis cont’d commercial sale and marketing of Pliaglis in the U.S. in March 2013 at the American Academy of Dermatology Conference in Miami and will launch the commercial marketing and sale of Pliaglis in Europe in the second quarter of 2013 at the Anti-Aging Medicine World Congress & Medispa in Monaco. As a result of the recent and upcoming launches, the Company’s revenues may not be sufficient to provide the capital required for the Company to be self-sustaining without the need for future financings. In addition, it may take some time before revenue from these launches is realized. As a result, there can be no assurance that the Company will have sufficient capital to fund its ongoing operations, develop or commercialize any further products without future financings. There can be no assurance, especially considering the current economic environment, that additional financing will be available on acceptable terms, or at all. If adequate funds are not available or Pennsaid is genericized in the U.S. market or if Pennsaid revenues in the U.S. decline or if Pennsaid 2% is not approved in the U.S. or if the sales of Synera in the U.S. do not increase or if the launch of Synera in key European Union markets is not successful or if the launch of Pliaglis in both the U.S. and Europe is not successful or if the Company is unable to avoid an event of default on the Paladin Debt, the Company may have to substantially reduce or eliminate planned expenditures, discontinue its marketing efforts for Synera in the U.S., terminate or delay clinical trials for its product candidates, curtail product development programs designed to expand the product pipeline or discontinue certain operations such as the Immunology Group. Current Economic Environment Challenging global market and economic conditions with a tighter credit environment and recession in most major economies began in fiscal 2008, developed in 2009 and are continuing in 2013. Continued concerns about the systemic impact of potential long-term and wide-spread recession, geopolitical issues, the availability and cost of credit and the global housing and mortgage markets have contributed to increased market volatility and diminished expectations for western and emerging economies. These conditions, combined with declining business and consumer confidence and increased unemployment, have contributed to volatility of unprecedented levels. As a result of these market conditions, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional 40 Nuvo Research Inc. Annual Report 2012 investors to reduce, and in some cases, cease to provide credit to businesses and consumers. These factors have led to a decrease in spending by businesses and consumers alike, and a corresponding decrease in global infrastructure spending. Continued turbulence in Canada and international markets and economies and prolonged declines in business consumer spending may adversely affect the Company’s liquidity and financial condition, and the liquidity and financial condition of the Company’s customers. These factors may limit the Company’s ability to access capital. In addition, lack of access to capital may cause the Company’s suppliers to increase their prices, reduce their output or change their terms of sale. If the Company’s customers’ or suppliers’ operating and financial performance deteriorates or if they are unable to make scheduled payments or obtain credit, its customers may not be able to pay, or may delay payment of accounts receivable owed and its suppliers may restrict credit or impose different payment terms. Any inability of customers to pay the Company for its products or any demands by suppliers for different payment terms, may adversely affect its earnings and cash flow. In addition, many governments used, and continue to use, significant levels of fiscal stimulus in an attempt to avoid recessions and now have significant and growing debts and deficits that may require actions such as spending cuts and higher taxes. These conditions may impact consumer demand for the Company’s products and reimbursement or coverage under government health care programs that may impact future demand. The Company has no control over changes in inflation and interest rates, foreign currency exchange rates and controls or other economic factors affecting its businesses or the possibility of political unrest, legal and regulatory changes in jurisdictions in which the Company operates. These factors could negatively affect the Company’s future results of operations in those markets. Dependence on Sales and Marketing Partnerships The Company has limited sales and marketing experience, though in 2011 it recruited pharmaceutical executives with significant commercialization experience in outpatient pain therapeutics. The Company lacks financial and other resources necessary to undertake marketing and advertising activities worldwide. Accordingly, the Company relies on marketing arrangements, including joint ventures, licensing or other third-party arrangements, to distribute its products in jurisdictions where it lacks the resources or expertise. The Company faces, and will continue to face significant competition in seeking appropriate partners and distributors. Moreover, collaboration and distribution arrangements are complex and time consuming to negotiate, document and implement. Therefore, there can be no assurance that the Company will be able to find additional marketing and distribution partners in any jurisdiction or be able to enter into any marketing and distribution arrangements on any terms, acceptable or not. Moreover, there can be no assurance that its partners will dedicate the resources needed to successfully market and distribute the Company’s products and maximize sales. In addition, under these arrangements, disputes may arise with respect to payments that the Company or its partners believe are due under such distribution or marketing arrangements, a partner or distributor may develop or distribute products that compete with the Company’s products or they may terminate the relationship. The Company has no influence in sales and marketing activities for Pennsaid in Canada. Decisions impacting sales and marketing efforts are made by Paladin which sells and markets Pennsaid in Canada. If Paladin was unable to continue to be successful in selling and marketing Pennsaid in Canada, it could have an adverse effect on the Company’s Canadian product sales, royalty revenue and cash resources. The Company has minimal influence in sales and marketing activities for Pennsaid in the U.S. Although Nuvo has four of eight seats on the Pennsaid JSC that was established as per the U.S. Licensing Agreement with Mallinckrodt to monitor and provide advice respecting the commercialization plans for Pennsaid and the development of Pennsaid 2%. The Company, with limited exceptions, no longer controls the strategy or the execution of the clinical development program for Pennsaid 2% or the commercialization of Pennsaid and Pennsaid 2%, those responsibilities having been contractually assumed by Mallinckrodt. An unsuccessful commercialization would have an adverse effect on the Company’s potential product sales, royalty income, sales milestone payments and cash resources. Mallinckrodt has satisfied the minimum spending and detailing commitments, so if Mallinckrodt was unable or unwilling to continue to market or detail Pennsaid to the same extent, sales of Pennsaid in the U.S. would likely decline. Additionally, if Mallinckrodt terminated the U.S. Licensing Agreement and ceased marketing, promoting and distributing Pennsaid in the U.S., sales would likely decline materially and the Company would need to commercialize Pennsaid for which the Company currently have minimal infrastructure, or alternatively enter into a new agreement with another pharmaceutical company, of which no assurance can be given. If the Company is unable to build the necessary infrastructure to commercialize the product which would substantially increase the Company’s expenses and capital requirements that Nuvo might not be able to fund or are unable to find a suitable partner, the Company may be unable to generate revenue from Pennsaid. Both the aforementioned situations would have an adverse effect on the Company’s product sales, royalty revenue, sales milestone payments and cash resources. In addition, under the terms of the U.S. Licensing Agreement, Mallinckrodt assumed full responsibility for managing, planning, executing and paying for all development activities for Pennsaid 2%. The Company, with limited exceptions, no longer controls the strategy or the execution of the clinical development program for Pennsaid 2%, this responsibility having been contractually assumed by Mallinckrodt. The Company does have approval rights with respect to any changes to the development plan for Pennsaid 2%. Any such changes require the unanimous approval of the Pennsaid JSC of which the Company has equal representation. The Company relies upon Mallinckrodt to execute a successful drug development program and ultimately gain U.S. approval for Pennsaid 2%. If Mallinckrodt fails during this process, it could have an adverse effect on the Company’s future revenue from the U.S. and other jurisdictions where Pennsaid 2% has been licensed. The Company has minimal influence in the worldwide sales and marketing activities for Pliaglis as these decisions are made by Galderma. Although the Company has three seats on the Joint Steering Committee that was established to monitor the development and commercial activities related to Pliaglis, the Company has no direct control over the technical, regulatory and commercial activities for the product with the exception of ownership and responsibility for filing the European MAA and managing the regulatory review process through final approval. Upon approval of the European MAA, the Company transferred ownership of the MAA to Galderma. As the Company does not control the technical and regulatory activities related to Pliaglis outside of the European Union, it must rely on Galderma to execute a successful regulatory program in these regions. In addition, Galderma is responsible for the worldwide commercialization of Pliaglis and, as such, the Company will rely on Galderma to successfully execute a worldwide commercialization program. Delays in obtaining the appropriate regulatory approvals for Pliaglis in Europe and other territories or an unsuccessful launch in any major territory, may have an adverse effect on the Company’s Nuvo Research Inc. Annual Report 2012 41 Management’s Discussion and Analysis cont’d royalty income, milestone payments and cash flows. The Company is eligible to receive milestones payments based on the regulatory approval of Pliaglis in South America. An approval delay in this region may impact the Company’s future cash flows. Under the terms of the First Amendment, ZARS received a cash payment of US$6 million in exchange for agreeing to a downward adjustment to the royalty rates it was to receive on the global net sales of Pliaglis. These reduced royalty rates continue until such time as Pliaglis achieves a predetermined monetary milestone that is based on the cumulative aggregate sales of Pliaglis and the difference between the original and the adjusted royalty rates. In addition, if this milestone is not achieved by April 2015, the royalty rates will be reduced further until such time as the target is reached, subject to a minimum annual royalty rate being paid to ZARS. Upon the sales thresholds being met, the royalty rates revert back to the amounts specified under the original agreements. Additionally, the event driven milestone payments in the Rest of World Pliaglis License Agreement were reduced to US$8 million and ZARS agreed to assume certain costs and responsibilities associated with obtaining regulatory approval for Pliaglis in Europe. The Company has licensed the rights for Synera to Eurocept for Europe and certain other territories and has substantially similar dependence on Eurocept with respect to the sales and marketing for Synera as it does with Galderma for Pliaglis. Generic Drug Manufacturers Regulatory approval for competing generic drugs can be obtained without investing in the same level of costly and time-consuming clinical trials, the Company has conducted, or might conduct, in the future. Due to the substantially reduced development costs, generic drug manufacturers are often able to charge much lower prices for their products than the original developer. The Company may face competition from manufacturers of generic drugs on some of the products it commercializes, since a number of the Company’s patents have expired. If the Company faces generic competition the prices at which the Company’s products are sold, the royalty rates the Company receives, the volume of product sold and the overall revenues it receives may be substantially reduced. In 2010, Health Canada approved a competitor’s generic version of Pennsaid. It is not known if or when the competitor’s generic version of Pennsaid will be sold in the Canadian market. The launch of the generic product could have an adverse effect on the Company’s future revenue from Canada. 42 Nuvo Research Inc. Annual Report 2012 In the U.S., under the “Hatch-Waxman Act”, the FDA can approve an ANDA, for a generic version of a branded drug for a branded variation of an existing branded drug, without undertaking the clinical testing necessary to obtain approval to market a new drug. This is referred to as the “ANDA process”. In place of such clinical studies, an ANDA applicant usually needs only to submit PK data demonstrating that its product has the same active ingredient(s) and is bioequivalent to the branded product, in addition to any data necessary to establish that any difference in inactive ingredients does not result in different safety or efficacy profiles, as compared to the reference drug. The ANDA process was developed primarily for systemic drugs, such as oral dosage forms, and not locally acting drugs, such as topical pain medications. Recently, the FDA has published guidance outlining specific requirements on what information a sponsor would need to include in its ANDA for certain specific topical pain medications, including Pennsaid. The guidance varies depending on the drug and formulation and in some cases requires clinical studies and/or CMC data. The “Hatch-Waxman Act” requires an applicant for a drug that relies, at least in part, on the patent of a branded drug, to notify the sponsor of the branded drug of their application and potential infringement of a patent. Upon receipt of this notice the sponsor of the branded drug has 45 days to bring a patent infringement suit in federal district court against the applicant seeking approval of a product covered by the patent. If such a suit is commenced and the ANDA was filed after the patent had been listed in the FDA Orange Book, then the FDA is generally prohibited from granting approval of the ANDA or Section 505(b)(2) NDA until the earliest of 30 months from the date the FDA accepted the application for filing, or the conclusion of litigation in the generic’s favour or expiration of the patent. If the litigation is resolved in favour of the applicant or the challenged patent expires during the 30-month stay period, the stay is lifted and the FDA may thereafter approve the application based on the standards for approval of ANDAs and Section 505(b)(2) NDAs. Frequently, the unpredictable nature and significant costs of patent litigation leads the parties to settle out of court. Settlement agreements between branded companies and generic applicants may allow, among other things, a generic product to enter the market prior to the expiration of any or all of the applicable patents covering the branded product, either through the introduction of an authorized generic or by providing a license to the patents in suit. In July 2012, the U.S. Patent Office issued the Pennsaid Patent with an expiry date of July 10, 2029. Mallinckrodt listed the Pennsaid Patent in the FDA’s Orange Book. The Orange Book listing requires any ANDA applicant seeking FDA approval for a generic version of Pennsaid prior to expiration of the patent to notify Nuvo and Mallinckrodt of its ANDA before it can obtain FDA approval. Prior to the Orange Book listing, there was no such requirement imposed on the generic applicants. Subsequent to the Orange Book listing, Nuvo and Mallinckrodt received Paragraph IV certification notices in 2012 from three companies advising Nuvo and Mallinckrodt that they have each filed an ANDA with the FDA seeking approval to market a generic version of Pennsaid. One of the applicants has since withdrawn from the process. Nuvo and Mallinckrodt have filed a patent infringement complaint with the courts against the two generic companies, Apotex and Lupin. In January, Nuvo and Mallinckrodt entered into the Apotex Settlement Agreement. Under the terms of the Apotex Settlement Agreement, Nuvo and Mallinckrodt granted a license to Apotex that permits Apotex, upon approval of its ANDA by the FDA, to launch its generic version of Pennsaid on a date that is the earlier of 45 days after Mallinckrodt or Nuvo makes a first commercial shipment of Pennsaid 2% in the U.S. and April 1, 2014, or earlier under certain circumstances. The complaint is pending against Lupin. In February 2013, Nuvo and Mallinckrodt received a fourth Paragraph IV certification notice from a company advising Nuvo and Mallinckrodt that they have filed an ANDA with the FDA seeking approval to market a generic version of Pennsaid. The Pennsaid Patent does not automatically prevent a generic version of Pennsaid from being approved by the FDA or if approved, from being sold in the U.S. However, it does provide the Company with the opportunity to commence legal action against the ANDA applicants for patent infringement. A patent infringement complaint has not been filed at this time against this fourth company. The approval or launch of generic versions of any of the Company’s products in any market could have an adverse effect on the Company’s future revenue and its cash balances if it needs to commence litigation to protect its rights. Obtaining Government and Regulatory Approvals The manufacture and sale of pharmaceutical products in Canada, the U.S. and certain countries of the European Union is highly regulated, which significantly increases the difficulty and costs involved in obtaining and maintaining regulatory approval for marketing new and existing products. The regulatory approval process in Canada, the U.S. and in other countries can be long and may involve significant delays despite the Company’s best efforts. Moreover, regulations are rigorous, time consuming and costly and the Company cannot predict the extent to which it may be affected by changes in regulatory developments and its ability to meet such regulations. There is also a risk that the Company’s products may be withdrawn from the market and the required approvals suspended as a result of non-compliance with regulatory requirements. Furthermore, there can be no assurance that the regulators will not require modification to any submissions, which may result in delays or failure to obtain regulatory approvals. Any delay or failure to obtain regulatory approvals could adversely affect the Company’s business, financial condition and operational results. Further, there can be no assurance that the Company’s products will prove to be safe and effective in clinical trials or receive the requisite regulatory approval in any market. Failure to obtain necessary regulatory approvals, the restriction, suspension or revocation of existing approvals or any other failure to comply with regulatory requirements, could have a material adverse effect on the Company’s business, financial condition and operational results. Changes in Government Regulation The business of the Company may be adversely affected by such factors as changes in the regulatory environment with respect to intellectual property, regulation, export controls or product marketing approvals. Such changes remain beyond the Company’s control and have an unpredictable impact. Competition The pharmaceutical industry is characterized by evolving technology and intense competition. The Company is engaged in areas of research where developments are expected to continue at a rapid pace. Many companies, including major pharmaceutical, as well as specialized biotechnology companies, are engaged in activities focused on medical conditions that are the same as or similar to those targeted by the Company. The Company’s success depends upon maintaining its competitive position in the R&D and commercialization of its products. Competition from pharmaceutical, chemical and biotechnology companies, as well as universities and research institutes, is intense and expected to increase. Many of these organizations have substantially greater R&D capabilities, experience in manufacturing, marketing, financial and managerial resources and they represent significant competition. Nuvo Research Inc. Annual Report 2012 43 Management’s Discussion and Analysis cont’d If the Company fails to compete successfully in any of these areas, its business, results of operations, financial condition and cash flows could be adversely affected. The intensely competitive environment of the branded products business requires an ongoing, extensive search for medical and technological innovations and the ability to market products effectively, including the ability to communicate the effectiveness, safety and value of branded products for their intended uses to healthcare professionals in private practice, group practices and managed care organizations. There can be no assurance that the Company and its drug development partners will be able to successfully develop medical or technological innovations or that the Company and its licensing partners will be able to effectively market the Company’s existing products or any future products. The Company’s branded products may face competition from generic versions. Generic versions are generally significantly cheaper than the branded version, and, where available, may be required or encouraged in preference to the branded version under third-party reimbursement programs, or substituted by pharmacies for branded versions by law. The entrance of generic competition to the Company’s branded products generally reduces the market share and adversely affects the Company’s profitability and cash flows. Generic competition with the Company’s branded products would be expected to have a material adverse effect on net sales and profitability of the branded product and of the Company. Additionally, the Company competes to acquire the intellectual property assets that are required to continue to develop and broaden its product portfolio. In addition to in-house R&D efforts, the Company seeks to acquire rights to new intellectual property through corporate acquisitions, asset acquisitions, licensing and joint venture arrangements. Competitors with greater resources may acquire assets that the Company seeks, and even if the Company is successful, competition may increase the acquisition price of such assets. If the Company fails to compete successfully, its growth may be limited. Since the Company’s drug development process involves applying its DuraPeel™, CHADD™, MMPE™, HTE and other technology platforms, with the expertise and experience of its scientists to formulate topical drugs using existing and unprotected active pharmaceutical ingredients, the Company may face additional regulatory risks if any of its competitors are developing similar drug candidates. Under the 1984 U.S. federal law, the Drug Price Competition and Patent Term Restoration Act, informally known as the “Hatch-Waxman Act”, and C.F.R. 314.108(b)(4) 44 Nuvo Research Inc. Annual Report 2012 a product filed as a 505(b)(2) application and supported by sponsor initiated clinical studies required as a condition of approval is entitled to three years of exclusivity starting from the effective date of approval or longer if granted either orphan drug exclusivity (21 C.F.R. 314.20-316.36) or pediatric exclusivity (section 505A of the Act). If the Company’s competitors receive the benefit of exclusivity under the “HatchWaxman Act” for a drug product similar to one the Company is developing this period of marketing exclusively could prohibit the approval of the Company’s drug candidate in the U.S. for at least three years from the effective date of approval of the competitor’s product. Further, approval or filing of any of the Company’s future 505(b)(2) applications may be delayed because of patent and exclusivity rights that apply to the listed drug (according to 21 C.F.R. 314.50(i), 314.107, and section 505A of the Act). Healthcare Reform in the United States While healthcare reform may increase the number of patients who have insurance coverage for the Company’s products, its cost containment measures may adversely affect reimbursement for these products. In March 2010, the U.S. Health Reform Law was enacted in the U.S. This legislation has both current and longer-term impacts on the Company, as discussed below. The provisions of the U.S. Health Reform Law are effective on various dates over the next several years. The principal provisions affecting the Company provide for the following: • a new Medicare Part D coverage gap discount program, in which manufacturers must agree to offer 50% point-of-sale discounts off negotiated prices of applicable brand drugs to eligible beneficiaries during their coverage gap period, as a condition of the manufacturer’s outpatient drugs to be covered under Medicare Part D (effective January 1, 2011); • an annual fee payable to the federal government (which is not deductible for U.S. income tax purposes) based on the prior-calendar-year share relative to other companies of branded prescription drug sales to specified government programs (effective January 1, 2011, with the total fee to be paid each year by the pharmaceutical industry increasing annually through 2018); • new requirements to report certain financial arrangements with physicians and others, including reporting any “transfer of value” made or distributed to prescribers and other healthcare providers and reporting any investment interests held by physicians and their immediate family members during each calendar year (beginning in 2012, with reporting starting in 2013); • a new requirement to annually report drug samples that manufacturers and distributors provide to physicians (effective April 1, 2012); • creation of the Independent Payment Advisory Board which, beginning in 2014, will have authority to recommend certain changes to the Medicare program that could result in reduced payments for items and services (recommendations could have the effect of law even if Congress does not act on the recommendations); and • establishment of a Center for Medicare Innovation at the Centers for Medicare & Medicaid Services to test innovative payment and service delivery models to lower Medicare and Medicaid spending, potentially including prescription drug spending, (beginning January 1, 2011). A number of the provisions of the U.S. Health Reform Law may adversely affect reimbursement for the Company’s products. Additionally, the best price requirements with respect to Medicaid rebates have traditionally been a significant consideration with respect to the level of rebates in the Company’s Medicare and commercial contracting. The U.S. Health Reform Law’s effects on rebate amounts could adversely impact the Company’s future results of operations. Tracking and reporting on these initiatives will come at a cost which is unknown, but may be significant. In addition, if the Company is found to violate these initiatives, it could have a material adverse effect on the business, financial conditions, results of operations and cash flows of the Company. Over the next few years, regulations and guidance implementing the U.S. Health Reform Law, as well as additional healthcare reform proposals may have a financial impact on the Company. In addition, the U.S. Health Reform Law requires that, except in certain circumstances, individuals must obtain health insurance beginning in 2014 and it also provides for an expansion of Medicaid coverage in 2014. It is expected that, as a result of these provisions, there will be a substantial increase in the number of Americans with health insurance beginning in 2014, a significant portion of whom will be eligible for Medicaid. The Company anticipates that this will increase demand for pharmaceutical products overall. However, in view of the many uncertainties, including, but not limited to, pending litigation challenging the new law and changes in the partisan composition of Congress, it is not possible at this time to determine whether and to what extent sales of the Company’s prescription pharmaceutical products in the U.S. will be impacted. Sales, Marketing and Distribution of Synera in the United States In order to successfully commercialize Synera in the U.S., the Company must devote significant resources to develop a capable sales, marketing and distribution infrastructure or enter into collaborations with partners to perform some or all of these services for the Company. The Company may be unable to devote the resources necessary to develop a suitable sales, marketing and distribution infrastructure. The Company distributes Synera primarily through a small network of third-party wholesalers that generally sell, distribute or provide Synera to hospitals, medical clinics and retail pharmacies. The business would be harmed if any of these wholesalers were unable or unwilling to distribute Synera or unable or unwilling to purchase Synera on commercially favourable terms to the Company. It is possible that distribution partners could decide to change their policies or fees, or both, in the future. This could result in their refusal to distribute smaller volume products, higher product distribution costs, lower margins or the need to find alternative methods of distributing products. Such alternative methods may not exist or may not be economically viable. Factors that may inhibit the Company’s efforts to grow sales, marketing and distribution infrastructure and its ability to successfully commercialize Synera include: • a lack of sufficient financial resources; and • unforeseen costs and expenses associated with maintaining and expanding a sales and marketing infrastructure. The Company may not be able to enter into collaborations on acceptable terms, if at all, and the Company may face competition in the search for partners with whom the Company may collaborate. If the Company is not able to develop and maintain an effective sales, marketing and distribution infrastructure, or collaborate with a partner to perform these functions, the Company may be unable to commercialize Synera successfully in the U.S., which would adversely affect the Company’s financial condition. Manufacturing and Supply Risks The Company purchases key raw materials necessary for the manufacture of its products and finished products from a limited number of suppliers around the world and in some cases relies on its licensing partners to manufacture its products. In the case of Pennsaid, the Company has a supply agreement with a single supplier based in the U.S. to Nuvo Research Inc. Annual Report 2012 45 Management’s Discussion and Analysis cont’d purchase from that supplier all of the Company’s requirements for pharmaceutical grade DMSO (one of the key ingredients in Pennsaid and Pennsaid 2%) until October 31, 2015 using the supplier’s patented process. It may be difficult to find another manufacturer if the supplier is unable to supply the Company with a sufficient amount of DMSO or if the Company is forced for any other reason to find another supplier. It could take another supplier a significant period of time to develop and certify the necessary processes to manufacture the product on terms acceptable to the Company. There may not be suppliers that are able to meet the Company’s volume or quality requirements at a price that is as favourable as those it currently has. Any operating, production or quality problems experienced by these suppliers that result in a reduction or interruption in supply could significantly delay the manufacture and sale of the Company’s products. Synera contains the active drugs lidocaine and tetracaine. The Company has only one approved supplier for tetracaine and two approved suppliers for lidocaine. The Synera patch contains numerous components, many of which are unique to the product, that are purchased either directly or through the CMO that produces the patches. Given the relatively low production volumes and unique nature of many of the components, several are single sourced and will remain single sourced for the foreseeable future. The Company currently depends on one CMO as the only qualified supplier of Synera and Rapydan for all global markets. The Company has initiated discussions pertaining to, but has not yet entered into, a long-term commercial supply agreement with this CMO. Due to the lead-time necessary to obtain FDA approval of a new manufacturing site, if the Company is required for any reason to change manufacturing sites it will be expensive and time consuming and may cause interruptions in the supply of products to customers. As a result, any such delay could have a material adverse effect on the Company’s business, financial condition, results of operations and cash flows. In addition, since Synera, WF10 and Oxoferin are manufactured by CMOs, the Company has limited ability to control the manufacturing process or costs related to this process. Increases in the prices paid to the CMO, price increases from suppliers of any component of the product, interruptions in supply of product or lapses in quality could adversely impact the Company’s margins, profitability and cash flows. The Company is reliant on its third-party CMOs to maintain the facilities at which it manufactures the Company’s products in compliance with FDA, EMA, state and local regulations or other countries regulatory 46 Nuvo Research Inc. Annual Report 2012 authorities. If the CMO fails to maintain compliance with regulatory authorities, they could be ordered to cease manufacturing which would have a material adverse impact on the Company’s business, results of operations, financial condition and cash flows. In addition to FDA regulation, violation of standards enforced by the Environmental Protection Agency (EPA), and the Occupational Safety and Health Administration (OSHA), and their counterpart agencies at the state level, could slow down or curtail operations of the CMO or any of its suppliers. If the relationships with the CMO or any of the single-sourced suppliers is discontinued or, if any manufacturer is unable to supply or produce required quantities of product on a timely basis or at all, or if a supplier ceases production of an ingredient or component, the operations would be negatively impacted and the business would be harmed. The Company will need to strengthen the current Synera supply chain as some component suppliers have discontinued supply of these low volume components in the past. If the Company’s promotional efforts for Synera in the U.S. are successful, this may require significantly higher production volumes that current Synera suppliers may not be able to meet. The failure of any supplier to meet necessary production volumes could materially impact the launch of the product. Under the terms of the Pliaglis license agreements, Galderma has the sole right to manufacture Pliaglis and; therefore, the Company does and will depend on Galderma as the only qualified supplier of the product for all global markets and will have limited ability, if any, to control the manufacturing process. Pliaglis also contains the active drugs lidocaine and tetracaine and in the past the form of tetracaine used in the product has, at times, been difficult to procure. The Company is reliant on Galderma to maintain the facilities at which it manufactures Pliaglis in compliance with FDA, EMA, state and local regulations and other regulatory agencies. If Galderma fails to maintain compliance with FDA, EMA or other critical regulations, they could be ordered to cease manufacturing which would have a material adverse impact on the Company’s business, results of operations, financial condition and cash flows. In addition to FDA regulation, violation of standards enforced by the EPA, and the OSHA, and their counterpart agencies at the state level, could slow down or curtail operations of Galderma. In addition, the FDA and other regulatory agencies, require that raw material manufacturers comply with all applicable regulations and standards pertaining to the manufacture, control, testing and use of the raw materials as appropriate. For the active pharmaceutical ingredient (API) or critical raw materials depending on the drug product, this means compliance to current GMPs for APIs and submission of all data related to the manufacture, control and testing of the API for quality, purity, identity and stability, as well as a complete description of the process, equipment, controls and standards used for the production of the API. This is usually submitted to the FDA in the form of a Drug Master File (DMF) by the manufacturer and referenced by the sponsor of the NDA. The DMF information and data is reviewed by the FDA as a critical component of the approvability of the NDA. As a result, in the case where only one supplier of a particular API or critical raw material meets all of the FDA’s (or other regulatory agencies) requirements and has a DMF (or similar filing) on file with the FDA, the Company is at risk should a supplier violate GMP, fail an FDA inspection, terminate access to its DMF, be unable to manufacture product, choose not to supply the Company or decide to increase prices. For DMSO and tetracaine, the Company has only one approved supplier for all jurisdictions in which Pennsaid and Synera have been approved. For Pennsaid’s API, diclofenac sodium, the Company has two approved suppliers for Canada and Europe, but only one approved supplier for the U.S. For some of the Company’s other raw materials required to manufacture Pennsaid, Synera, Oxoferin and WF10, the Company currently has only one approved supplier. In addition, the Company could be subject to various import duties applicable to both finished products and raw materials and it may be affected by other import and export restrictions, as well as developments with an impact on international trade. Under certain circumstances, these international trade factors could affect manufacturing costs, which will in turn, affect the Company’s margins, as well as the wholesale and retail prices of manufactured products. The Company’s current internal manufacturing capabilities are limited to its site in Varennes, Québec, which is the sole manufacturer of Pennsaid for all markets (and will be the site for the manufacture of Pennsaid 2% and the bulk drug product used in Synera) and its site in Wanzleben, Germany which produces OXO-K993, the active ingredient in WF10 and Oxoferin. The Company has never achieved capacity in these facilities, although it has manufactured Pennsaid and OXO-K993 for existing markets and produced clinical batches. This exposes the Company to the following risks, any of which could delay or prevent the commercialization of its products, result in higher costs or deprive it of potential product revenues: • The Company may encounter difficulties in achieving volume production, quality control and quality assurance, as well as with shortages of qualified personnel. Accordingly, the Company might not be able to manufacture sufficient quantities to meet its clinical trial needs or to commercialize its products; • The Company’s manufacturing facilities are required to undergo satisfactory current GMP inspections prior to regulatory approval and are obliged to operate in accordance with FDA, European and other nationally mandated GMP, which govern manufacturing processes, stability testing, record keeping and quality standards. Failure to establish and follow GMPs and to document adherence to such practices, may lead to significant delays in the availability of material for clinical studies and may delay or prevent filing or approval of marketing applications for the Company’s products; and • Changing manufacturing locations would be difficult and the number of potential manufacturers is limited. Changing manufacturers generally requires re-validation of the manufacturing processes and procedures in accordance with FDA, European and other nationally mandated GMPs. Such re-validation may be costly and would be time consuming. It would be difficult or impossible to quickly find replacement manufacturers on acceptable terms, if at all. The Company’s manufacturing facilities are subject to ongoing periodic unannounced inspection by the FDA and corresponding state and foreign agencies, including European and Canadian agencies, to ensure strict compliance with GMPs and other government regulations. Failure by the Company to comply with applicable regulations could result in sanctions being imposed on it, including fines, injunctions, civil penalties, failure of the government to grant review of submissions or market approval of drugs, delays, suspension or withdrawal of approvals, seizures or recalls of product, operating restrictions, facility closures and criminal prosecutions, any of which could harm the Company’s business. Patents, Trademarks and Proprietary Technology There can be no assurance as to the breadth or degree of protection that existing or future patents or patent applications may afford the Company or that any patent applications will result in issued patents or that the Company’s patents or trademarks will be upheld if challenged. It is possible that the Company’s existing patent or trademark rights may be deemed invalid. Although the Company believes that its products do Nuvo Research Inc. Annual Report 2012 47 Management’s Discussion and Analysis cont’d not, and will not, infringe valid patents or trademarks or violate the proprietary rights of others, it is possible that use, sale or manufacture of its products may infringe on existing or future patents, trademarks or proprietary rights of others. If the Company’s products infringe the patents or proprietary rights of others, the Company may be required to stop selling or making its products, may be required to modify or rename its products or may have to obtain licenses to continue using, making or selling them. There can be no assurance that the Company will be able to do so in a timely manner, upon acceptable terms and conditions, or at all. The failure to do any of the foregoing could have a material adverse effect upon the Company. In addition, there can be no assurance that the Company will have sufficient financial or other resources to enforce or defend a patent infringement or proprietary rights violation action. Moreover, if the Company’s products infringe patents, trademarks or proprietary rights of others, the Company could, under certain circumstances, become liable for substantial damages which could also have a material adverse effect. The Company’s key patents for Pennsaid expired in May 2004 in the U.S., in 2005 in Canada and in 2006 in the European Union. However, in July 2012, the U.S. Patent Office issued the Pennsaid Patent with an expiry date of July 10, 2029. Mallinckrodt listed the Pennsaid Patent in the FDA’s Orange Book. In September 2012, the U.S. Patent Office issued the Pennsaid 2% Patent with an expiry date of April 21, 2028. In addition, the Company has pending patent applications to protect Pennsaid, Pennsaid 2%, Pliaglis, Synera and for other pain formulations and platform technologies, including WF10. However, there can be no assurance that these patent applications will be granted, and there can be no assurance that any of the Company’s issued patents or patent applications, once granted, will not be the target of challenges by third parties or will be upheld. Moreover, there can be no assurance that the use, sale or manufacture of the product will not infringe the patents of others. Regardless of the validity of the Company’s patents, there can be no assurance that others will be unable to obtain patents or develop competitive non-infringing products or processes that permit such parties to compete with the Company. The Company may not be able to protect its intellectual property rights throughout the world as filing, prosecuting and defending patents and trademarks on all of the Company’s product candidates, products and product names, when and if they exist, in every jurisdiction would be prohibitively expensive and can take several years. Competitors may manufacture, sell or use the 48 Nuvo Research Inc. Annual Report 2012 Company’s technologies and use its trademarks in jurisdictions where the Company or its partners have not obtained patent and trademark protection. These products may compete with the Company’s products, when and if it has any, and may not be covered by any of its or its partners’ patent claims or other intellectual property rights. The laws of some countries do not protect intellectual property rights to the same extent as the laws of Canada and the U.S. and many companies have encountered significant problems in protecting and defending such rights in foreign jurisdictions. The legal systems of certain countries, particularly certain developing countries, do not favour the enforcement of patents, trademarks and other intellectual property protection, particularly those protections relating to biotechnology and pharmaceuticals, which could make it difficult for the Company to stop the infringement of its patents. Proceedings to enforce patent rights in foreign jurisdictions could result in substantial cost and divert efforts and attention from other aspects of the business. The discovery, trial and appeals process in patent litigation can take several years. Should the Company commence a lawsuit against a third party for patent infringement or should there be a lawsuit commenced against the Company with respect to the validity of its patents or any alleged patent infringement by the Company, the cost of such litigation as well as the ultimate outcome of such litigation, if commenced, whether or not the Company is successful, could have a material adverse effect on its business, results of operations, financial condition and cash flows. Inability to Achieve Drug Development Goals within Expected Time Frames From time-to-time, the Company sets targets and makes public statements regarding its expected timing for achieving drug development goals. These include targets for the commencement and completion of preclinical and clinical trials, studies and tests and anticipated regulatory filing and approval dates. These targets are set based on a number of assumptions that may not prove to be accurate. The actual timing of these forward-looking events can vary dramatically from the Company’s estimates or they might not be achieved at all, due to factors such as delays or failures in clinical trials or preclinical work, scheduling changes at CROs, the need to develop additional data required by regulators as a condition of approval, the uncertainties inherent in the regulatory approval process, delays in achieving manufacturing or marketing arrangements necessary to commercialize product candidates and limitations on the funds available to the Company. If the Company does not meet these targets, including those which are publicly announced, the ultimate commercialization of its products may be delayed and, as a result, its business could be harmed. Under the terms of the U.S. Licensing Agreement, Mallinckrodt assumed full responsibility for managing, planning, executing and paying for all development activities for Pennsaid 2%. Although Nuvo has four of eight seats on the Pennsaid JSC that was established as per the U.S. Licensing Agreement with Mallinckrodt to monitor and provide advice respecting the development of Pennsaid 2%, the Company, with limited exceptions, no longer controls the strategy or the execution of the clinical development program for Pennsaid 2% those responsibilities having been contractually assumed by Mallinckrodt. The Company does have approval rights with respect to any changes to the development plan for Pennsaid 2%. Any such changes require the unanimous approval of the Pennsaid JSC of which Company has equal representation. In March 2013, Mallinckrodt received a CRL to the NDA for Pennsaid 2% in which the FDA confirmed the only substantive additional requirement is the completion of a PK study comparing Pennsaid 2% to original Pennsaid. Mallinckrodt has indicated that it expects to complete the study, submit the results and receive a formal response from the FDA in late 2013 or early 2014. However, there can be no assurance that such trials and studies will be sufficient for regulatory authorities or that the required regulatory approvals will be obtained. If any of these events were to occur, or if the Pennsaid 2% NDA is not approved, this could have a material adverse effect on the Company. Uncertainty of Drug Research and Development There can be no assurance that any of the Company’s product candidates will be successfully developed in a timely manner or that they will prove to be more effective than products based on existing or new technologies or that a sufficient number of medical professionals will recommend their use. The risk that a product candidate may fail clinical trials, the Company’s inability to successfully complete development or a decision for financial or other reasons to halt development of any product candidate, particularly in instances where significant capital expenditures have already been made, could have a material adverse effect on the Company. The return on the Company’s investment in Nuvo Research AG depends on the successful completion of reformulation activities, attaining new intellectual property protection, clinical development, regulatory approvals and subsequent commercialization of WF10. The results from a Phase 3 AIDS study with WF10 in late-stage AIDS patients were negative and disappointing. For the Company’s Phase 2 clinical trial using WF10 as an adjuvant treatment for inoperable pancreatic cancer, the preliminary results of an interim analysis indicate that the primary end point, greater than six months survival, was successfully achieved. However, it is unclear, based on the open-label study design and the data reviewed whether the positive results could be confirmed in a placebo controlled study. The top-line results from a Phase 2 clinical trial for evaluating WF10 as a treatment for moderate to severe allergic rhinitis were positive. Although these top-line results were positive, reformulation efforts, future clinical trials and preclinical and clinical development programs with WF10 for allergic rhinitis and other disease indications and the pursuit of new IP protection could yield disappointing or negative results, further diminishing or eliminating the Company’s ability to commercially exploit WF10 or recover its investment in Nuvo Research AG. The Company has product candidates that are at an early stage in the drug development process and have not been subjected to clinical trials. There can be no assurance that preclinical or clinical testing of the Company’s product candidates will yield sufficiently positive results to enable progress toward commercialization and any such trials will take significant time to complete. Unsatisfactory results may prompt the Company to reduce or abandon future testing or commercialization of particular product candidates and this may have a material adverse effect on the Company. Due to the inherent risk associated with R&D efforts in the pharmaceutical industry, particularly with respect to new drugs, the Company’s R&D expenditures may not result in the successful introduction of FDA approved new pharmaceutical products. Also, after submitting an NDA, the FDA may require additional studies and as a result, the Company may be unable to reasonably predict the total R&D costs to develop a particular product. Risk Related to Clinical Trials The Company and its drug development partners must demonstrate through preclinical studies and clinical trials that the product being developed is safe and efficacious before obtaining regulatory approval for the commercial sale of such product. The results of preclinical studies and previous clinical trials are not necessarily predictive of future results and the Company’s current product candidates may not have favourable results in later testing or trials. Preclinical Nuvo Research Inc. Annual Report 2012 49 Management’s Discussion and Analysis cont’d tests and Phase 1 and Phase 2 clinical trials are primarily designed to test safety, to study pharmacokinetics and pharmacodynamics and to understand the side effects of products at various doses and schedules. Success in preclinical or animal studies and early clinical trials does not ensure that later large-scale efficacy trials will be successful and such success is not necessarily predictive of final results. Favourable results in early trials may not be repeated in later trials and positive interim results do not ensure success in final results. Even after the completion of Phase 3 clinical trials, the FDA, TPD, EMA or other regulatory authorities may disagree with the clinical trial design and interpretation of data, and may require additional clinical trials to demonstrate the efficacy of product candidates. A number of companies in the biotechnology and pharmaceutical industry have suffered significant setbacks in advanced clinical trials, even after achieving promising results in earlier trials and preclinical studies. In many cases where clinical results were not favourable, were perceived negatively or otherwise did not meet expectations, the share prices of these companies declined significantly. Failure to complete clinical trials successfully and to obtain successful results on a timely basis could have an adverse effect on the Company’s future business and its common share price. Prolonged Development Time It takes considerable time to develop new prescription drug products, to obtain the necessary regulatory approvals permitting sales, to establish appropriate distribution channels and market acceptance and to obtain insurer reimbursement approvals. This time period is generally from five to more than ten years and it exposes the Company to significant risks, including the development of competing products, loss of investor interest, shifting consumer preferences, changes in personnel and new regulatory requirements. During this lengthy period, the Company often incurs significant development-related costs without obtaining offsetting revenues. Competition for Pennsaid Several major pharmaceutical companies have developed oral COX-2 selective NSAIDs designed to reduce gastrointestinal side effects associated with other types of NSAIDs. Many of these products have been taken off the market or drug development has stopped in response to safety concerns. Those that remain, represent competition for market share. More recently oral, full-dose, NSAIDs combined with PPI to reduce certain side effects common to NSAIDs, such as VIMOVO which combines naproxen, an NSAID, with 50 Nuvo Research Inc. Annual Report 2012 esomeprazole magnesium, a PPI. These types of drugs also represent competition for market share. While the Company believes that topical administration gives Pennsaid a better safety profile than all oral NSAIDs, including those with PPIs and Cox-2 selective medications, it may be subject to regulations and regulatory decisions of governing bodies, such as the FDA in the U.S., including label warnings that apply to NSAIDs generally. In the U.S., other topical products for the treatment of medical conditions similar to the indication for Pennsaid have been available OTC for many years and, while a relatively new market segment, other topical prescription NSAIDs were approved and launched before Pennsaid. These competitor topical NSAID products currently have U.S. sales significantly greater then Pennsaid and they provide significant competition for market share. If patients and practitioners believe these competing products provide pain relief, it may be difficult to convince them to use Pennsaid or conversely, if they do not believe that they provide pain relief they may create a perception that all topically applied products have similar efficacy, making it more difficult to convince physicians and their patients of the value of Pennsaid. Pennsaid faces competition in the U.S. from at least two other topically applied diclofenac drug products that were approved for marketing in 2007 by the FDA. The FLECTOR® Patch was approved by the FDA for the topical treatment of acute pain due to minor strains, sprains and contusions and is marketed by Pfizer Inc., one of the largest healthcare companies in the world. The FLECTOR® Patch, launched in 2008, contains the NSAID diclofenac epolamine. The second drug product, Novartis’ Voltaren® Gel which contains the NSAID diclofenac sodium was approved by the FDA for the relief of the pain of OA of joints amenable to topical treatment, such as the knees and those of the hand and was launched by Endo in the first half of 2008. Both of these topical products have achieved respectable sales levels and have benefitted from being launched in the U.S. market prior to Pennsaid and possibly by having different indications than Pennsaid. In 2010, Health Canada approved a competitor’s generic version of Pennsaid. It is not known if or when the generic version of Pennsaid will be sold in the Canadian market. The launch of the competitor’s generic version of Pennsaid would likely have an adverse impact on the Company’s future revenue from Canada. In 2008, Health Canada approved a topical diclofenac product, Novartis’ Voltaren Emul1%™ and it has been available in Canada without a prescription since October 2008. In Europe and Asia, several major pharmaceutical companies market these and other topical NSAIDs that compete against Pennsaid in countries where it is marketed. In Greece, Pennsaid became an OTC product in 2011 and now competes in this market with no reimbursement. In addition to recently approved products, the Company is also aware of other companies that are developing topical NSAID products for the U.S. and other markets that may present additional competition in the future. Like Pennsaid, these drugs may be efficacious yet reduce the incidence of some of the systemic side effects associated with oral NSAIDs. In addition, prior to July 2012, Pennsaid’s U.S. patents had expired. In July 2012, the U.S. Patent Office issued the Pennsaid Patent with an expiry date of July 10, 2029. Mallinckrodt has listed the Pennsaid Patent in the FDA’s Orange Book. The Orange Book listing requires any ANDA applicant seeking FDA approval for a generic version of Pennsaid prior to expiration of the patent to notify Nuvo and Mallinckrodt of its ANDA before it can obtain FDA approval. Prior to the Orange Book listing, there was no such requirement on the generic applicants. Subsequent to the Orange Book listing in July 2012 Nuvo and Mallinckrodt received Paragraph IV certification notices from three companies advising Nuvo and Mallinckrodt that they have each filed an ANDA with the FDA seeking approval to market a generic version of Pennsaid. One of the applicants has since withdrawn from the process. Nuvo and Mallinckrodt have filed a patent infringement complaint with the courts against the two generic companies Apotex and Lupin. In January, the Company entered into the Apotex Settlement Agreement. Under the terms of the Apotex Settlement Agreement, Nuvo and Mallinckrodt granted a license to Apotex that permits Apotex, upon approval of its ANDA by the FDA, to launch its generic version of Pennsaid on a date that is the earlier of 45 days after Mallinckrodt or Nuvo makes a first commercial shipment of Pennsaid 2% in the U.S. and April 1, 2014, or earlier under certain circumstances. The complaint is pending against Lupin. In February 2013, Nuvo and Mallinckrodt received a fourth Paragraph IV certification notice from a company advising Nuvo and Mallinckrodt that they have filed an ANDA with the FDA seeking approval to market a generic version of Pennsaid. The Pennsaid Patent does not automatically prevent a generic version of Pennsaid from being approved by the FDA or if approved, from being sold in the U.S. However, it does provide the Company with the opportunity to commence legal action against the ANDA applicants for patent infringement. A patent infringement complaint has not been filed at this time against this fourth company. Pennsaid 2% is an improved version of Pennsaid that contains 2% diclofenac sodium compared to 1.5% and is more viscous than Pennsaid. Pennsaid 2% is supplied in a metered dose pump bottle and was studied in clinical trials using twice daily dosing compared to four times a day for Pennsaid. Mallinckrodt submitted an NDA on July 15, 2012 and advised Nuvo that the FDA accepted the NDA for Pennsaid 2% for review. The FDA has set a PDUFA date of March 4, 2013 for action on the submission. Mallinckrodt received a CRL to the NDA for Pennsaid 2% in which the FDA confirmed the only substantive additional requirement is the completion of a PK study comparing Pennsaid 2% to original Pennsaid. Mallinckrodt has indicated that it expects to complete the study, submit the results and receive a formal response from the FDA in late 2013 or early 2014. However, there can be no assurance that Pennsaid 2% will meet all government regulatory requirements or that it will be approved for marketing in any jurisdiction. The entry of a generic version of Pennsaid into the U.S. market could have a significant adverse effect on Pennsaid and Pennsaid 2% sales and the resulting level of royalty and milestone payments earned by the Company. Competition for Synera and Pliaglis Synera and Pliaglis face competition in all markets from other topically applied local anaesthetic drug products such as EMLA Cream (a eutectic mixture of lidocaine 2.5% and prilocaine 2.5%), L.M.X 4 and L.M.X.5 Anorectal Creams that are available OTC and compounded anaesthetic creams. EMLA Cream is an emulsion in which the oil phase is a eutectic mixture of lidocaine and prilocaine in a ratio of 1:1 by weight. It is indicated as a topical anaesthetic for use on intact skin to provide local analgesia and on genital mucous membranes for superficial minor surgery and as pre-treatment for infiltration anaesthesia. The product is owned and sold globally by AstraZeneca, but is also available as a generic product. EMLA Cream is applied in a thick layer to intact skin and must be covered with an occlusive dressing. Local dermal analgesia is achieved after approximately 60 to 120 minutes. EMLA is also available in a patch form in multiple jurisdictions for needle punctures. It is used as a topical anaesthetic and contains lidocaine 2.5% and prilocaine 2.5%. L.M.X.4 and L.M.X. 5 Anorectal Creams are topical anaesthetic creams containing 4 and 5% lidocaine, respectively. L.M.X.4 is indicated for the temporary relief of pain and itching due to: minor cuts; minor scrapes; minor burns; sunburn; minor skin irritations and insect bites. L.M.X.5 Anorectal Cream is Nuvo Research Inc. Annual Report 2012 51 Management’s Discussion and Analysis cont’d approved for the temporary relief of local discomfort, including pain and itching, soreness or burning associated with anorectal disorders. The product is also used for cosmetic procedures such as waxing and laser hair removal. L.M.X. 4 and L.M.X.5 Anorectal Creams are OTC products marketed by Ferndale Laboratories, Inc. in the U.S. Compounded anaesthetic creams are prepared by compounding pharmacists and are available in the U.S. Compounded drugs are not FDA approved, but can be prescribed by physicians. Competition for WF10 Several major pharmaceutical companies are at various stages of developing products targeting the immune system. Some of these products have already been approved for marketing and as such, represent competition for market share. In 2010, the Company ran a Phase 2 clinical trial evaluating WF10 as a treatment for moderate to severe allergic rhinitis that met its primary endpoint. During 2011, the Immunology Group completed its evaluation of the entire data set including the secondary endpoints all of which were achieved. In August 2012, the U.S. Patent Office issued Patent No. 8,252,343 providing patent coverage related to WF10 with an expiry date of March 4, 2029. This patent covers a method of treating allergic asthma, allergic rhinitis and atopic dermatitis using a chlorite based formulation, such as WF10. Further, the Company received allowance of an additional patent application in the U.S. related a method of using WF10 and Reformulated WF10 to treat allergic asthma, allergic rhinitis and atopic dermatitis. The Company is using SAB funding to support a number of preclinical studies relating to Reformulated WF10 for which Nuvo filed a U.S. provisional patent in December 2011. In December 2012, the Company filed an international PCT application and a U.S. patent application claiming priority to this provisional application. These studies are being conducted by Nuvo in partnership with the University of Leipzig and the Fraunhofer Institute and are focused on demonstrating, the efficacy, safety and stability of Reformulated WF10. Regardless of the future development plan for WF10, a number of additional studies will need to be conducted before WF10 could be submitted for regulatory approval for the treatment of allergic rhinitis or any other illness and there can be no assurance that the results of these additional studies would be favourable or that regulators will approve WF10 for these or other purposes. Any such studies and approvals would be expected to take a number of years. 52 Nuvo Research Inc. Annual Report 2012 Publications of Negative Study or Clinical Trial Results The Company adheres to the principles outlined by the Pharmaceutical Research and Manufacturers of America (PhRMA) guidelines in that it will submit for journal publication all results of late-stage clinical trials whether the outcomes are positive or negative. The publication of negative results of studies or clinical trials may adversely impact the Company’s sales revenue if the related drug is marketed and it may adversely affect the price of the Company’s common shares. From time-to-time, studies or clinical trials on various aspects of pharmaceutical products are conducted by the Company, academics or others, including government agencies. The results of these studies or trials, when published, may have a dramatic effect on the market for the pharmaceutical product that is the subject of the study. The publication of negative results of studies or clinical trials related to the Company’s products, or the therapeutic areas in which its products compete, could adversely affect sales, the prescription trends for the products, the reputation of the products and the price of the Company’s common shares. In the event of the publication of negative results of studies or clinical trials related to the Company’s marketed products or the therapeutic areas in which these products compete, the business, financial condition, results of operations and cash flows of the Company could be materially adversely affected. Reimbursement and Product Pricing There can be no assurance that Pennsaid, Pliaglis or Synera will be successfully commercialized in current markets or that the additional regulatory approvals necessary to commercialize Pennsaid, Pennsaid 2%, Pliaglis and Synera in markets where they are not currently approved will be obtained. In Canada, private health coverage insurers have generally approved reimbursement of Pennsaid costs, but government health authorities have not approved such reimbursement. Obtaining reimbursement approval for a product from each government or other third-party payer is a time consuming and costly process that could require the Company to provide supporting scientific, clinical and cost effectiveness data for the use of its products to each payer. In certain territories, this process is the responsibility of the licensee and the Company will have little financial impact from this process except to the extent the licensees are forced to provide significant discounts or rebates which would affect the level of net sales of the product and reduce the amount of royalties the Company earns. The Company may not have or be able to provide data sufficient to gain acceptance with respect to reimbursement. Even when a payer determines that a product is eligible for reimbursement, they may impose coverage limitations that preclude payment for some approved uses or that full reimbursement may not be available for the Company’s products. Furthermore, even after approval for reimbursement for the Company’s products is obtained from private health coverage insurers or government health authorities, it may be removed at any time. Significant uncertainty exists as to the reimbursement status of newly approved healthcare products and there can be no assurance that third-party coverage will be sufficient to give the Company an appropriate return on its investment in developing existing or new products. Increasingly, government and other third-party payers are attempting to contain expenditures for new therapeutic products by limiting or refusing coverage, limiting reimbursement levels, imposing high co-pays, requiring prior authorizations and implementing other measures aimed at discouraging use. Inadequate coverage or reimbursement could adversely affect market acceptance of the Company’s products. Third-party payers increasingly challenge the pricing of pharmaceutical products. Moreover, the trend toward managed healthcare in the U.S., the growth of organizations such as health maintenance organizations and reforms to healthcare and government insurance programs, could significantly influence the purchase of healthcare services and products, resulting in lower prices and reduced demand for the Company’s products. The Company expects recent changes in the U.S. Medicare program and increasing emphasis on managed care to continue to put pressure on pharmaceutical product pricing and reimbursement. In the U.S., each third-party payer plan is organized into tiers and the number of tiers will vary. Each tier represents a different reimbursement level. There is no guarantee that the Company’s products will be reimbursed even at tiers where the reimbursement amounts are minimal. In some countries, particularly the countries of the European Union, the pricing of prescription pharmaceuticals is subject to government control. In these countries, pricing negotiations with governmental authorities can take considerable time and delay the introduction of a product to the market. To obtain reimbursement or pricing approval in some countries, the Company may be required to conduct a clinical trial that compares the cost effectiveness of its product candidate to other available therapies. If reimbursement of the Company’s product is unavailable or limited in scope or amount, or if pricing is set at unsatisfactory levels, its business could be adversely affected. In addition, any country could pass legislation or change regulations affecting the pricing of pharmaceuticals in ways adverse to the Company before or after a regulatory agency approves any of its product candidates for marketing. While the Company cannot predict the likelihood of any legislative or regulatory changes, if any government or regulatory agency adopts new legislation or new regulations, the Company’s business could be harmed. “Off-label” Promotion of Drugs Companies may not promote drugs for “off-label” uses – that is, uses that are not approved by the FDA and described in the product’s labelling. Under what is known as the “practice of medicine”, physicians and other healthcare practitioners may prescribe drug products for off-label or unapproved uses, and such uses are common across some medical specialties. While the FDA does not regulate a physician’s choice of medications or treatments, the Federal Food, Drug and Cosmetic Act (FFDCA) and FDA regulations significantly restrict permissible communications on the subject of off-label uses of drug products by pharmaceutical companies. The FDA, HHS OIG, and the Department of Justice (DOJ) actively enforce laws and regulations that prohibit the promotion of off-label uses. A Company that is found to have promoted off-label uses of its products may be subject to significant liability, including civil fines, criminal fines and penalties, civil damages and exclusion from federal funded healthcare programs such as Medicare and Medicaid. Conduct giving rise to such liability could also form the basis for private civil litigation by thirdparty payers or other persons allegedly harmed by such conduct. The Company has endeavoured to establish and implement extensive compliance programs generally delivered by third parties who understand the intricacies of the laws, in order to educate and inform employees and its contract sales force employed by its CSO on how to comply with the relevant advertising and promotion restrictions and requirements imposed under the various laws and regulations. Nonetheless, the FDA, HHS OIG or the DOJ may take the position that the Company is not in compliance with such requirements, and, if such non-compliance is proven, the Company may be subject to significant liability, including administrative, civil and criminal penalties and fines. In addition, management’s attention could be diverted from the Company’s business operations and its reputation could be damaged. Nuvo Research Inc. Annual Report 2012 53 Management’s Discussion and Analysis cont’d Potential Product Liability The Company may be subject to product liability claims associated with the use of its products either after their approval or during clinical trials and there can be no assurance that liability insurance will continue to be available on commercially reasonable terms or at all. Product liability claims might also exceed the amounts, or fall outside of such coverage. Product liability claims against the Company regardless of their merit or potential outcome, could be costly and divert the Company’s management’s attention from other business matters or adversely affect its reputation and the demand for its products. In addition, certain drug retailers and distributors require minimum liability insurance as a condition of purchasing or accepting products for retail or wholesale distribution. Failure to satisfy such insurance requirements could impede the ability of the Company or its potential partners in achieving broad retail distribution of its products, resulting in a material adverse effect on the Company. There can be no assurance that a product liability claim or series of claims brought against the Company would not have an adverse effect on its business, financial condition, results of operations and cash flows. If any claim is brought against the Company, regardless of the success or failure of the claim, there can be no assurance that the Company will be able to obtain or maintain product liability insurance in the future on acceptable terms or with adequate coverage against potential liabilities or the cost of a recall can be given. Goodwill and Intangible Assets The Company has significant intangible assets primarily related to Pliaglis and Synera. Consequently, potential impairment of intangibles may significantly impact the Company’s profitability. Intangible assets are subject to an impairment analysis whenever events or changes in circumstances indicate the carrying amount of the asset may not be recoverable. If any events or change in circumstances occur for Pliaglis or Synera, such as, but not limited to, an unsuccessful commercialization effort, delayed product launches or the failure to gain marketing approvals in key markets the Company may be forced to conduct an impairment analysis of the related intangible assets which may be impaired. If impaired, the Company may be required to record an impairment charge which could significantly impact the Company’s profitability. 54 Nuvo Research Inc. Annual Report 2012 Events giving rise to impairment are an inherent risk in the pharmaceutical industry and cannot be predicted. As a result of the significance of goodwill and other intangible assets, the Company’s results of operations and financial position in a future period could be negatively impacted should an impairment of goodwill or other intangible assets occur. In 2012, the Company conducted an impairment analysis of goodwill and intangible assets. The Company wrote-off 100% of the goodwill value of $4.4 million and $7.5 million of the intangible asset value of which $7.2 million related to Pliaglis and $0.3 million to Synera. At December 31, 2012, intangible assets represented approximately 31% of the Company’s total assets. Personnel The Company depends upon certain key members of its scientific and management teams. The loss of any of these individuals could have a material adverse effect on the Company. The Company does not maintain key-man insurance on any employee. The Company’s success depends, in large part, on its ability to continue to attract and retain qualified scientific, commercial and management personnel. The Company faces intense competition for such personnel. It may not be able to attract and retain qualified management and scientific personnel in the future. Also, it must provide training for its employee base due to the highly specialized nature of pharmaceutical products. Further, the Company expects that its growth and potential expansion into specific areas and activities requiring new or additional expertise, such as in the areas of research and development, preclinical studies, CMC work, clinical trials, regulatory approvals, sales and marketing will place additional requirements on management, operational and financial resources. The Company expects these demands will require an increase in the number of management and scientific personnel and development of additional expertise by existing personnel. The failure to attract and retain such personnel, or to develop such expertise, could materially adversely affect prospects for its success. In addition, to attract qualified personnel the Company may be required to establish offices in different locations. Failure of personnel in different locations to work effectively together could materially adversely affect the Company’s success. Given these potential challenges, current personnel may be unable to adapt or may not have the appropriate skills and the Company may fail to assimilate and train new employees. Highly skilled employees with the education and training required, especially employees with significant experience and expertise in drug delivery systems, are in high demand. Once trained, the Company’s employees may be hired by its competitors. International Operations The Company has operations outside of Canada, primarily in the U.S. and Europe, in order to research, develop, market, distribute and manufacture certain products and potential products, the Company may expand such operations further in the future. Participation in international markets requires resources and management attention and subjects the Company to business risks, including the following: Acquisition and Integration of Complementary Technologies or Businesses The Company may pursue product or business acquisitions that could complement or expand its business. However, it may not be able to identify appropriate acquisition candidates in the future. If an acquisition candidate is identified, the Company may not be able to successfully negotiate the terms of any such acquisition or finance such acquisition. Any such acquisition could result in unanticipated costs or liabilities, diversion of management’s attention from the core business, the expenditure of resources and the potential loss of key employees, particularly those of the acquired organizations. In addition, the Company may not be able to successfully integrate any businesses, products, technologies or personnel that it might acquire in the future, which may harm its business. • different regulatory requirements for approval of its product candidates; To the extent the Company issues common shares or other rights to finance any acquisition, existing shareholders may be diluted. They may also result in goodwill and other long-lived assets that are subject to impairment tests, which could result in future impairment charges. Losses Due to Foreign Currency Fluctuations The Company anticipates that the majority of the revenue from commercialization of its product candidates may be in currencies other than Canadian dollars. Fluctuation in the exchange rate of the Canadian dollar relative to these other currencies could result in the Company realizing a lower profit margin on sales of its product candidates than anticipated at the time of entering into such commercial agreements. Adverse movements in exchange rates could have a material adverse effect on the Company’s financial condition and results of operations. • dependence on local distributors; • longer payment cycles and problems in collecting accounts receivable; • adverse changes in trade and tax regulations; • absence or substantial lack of legal protection for intellectual property rights; • difficulty in managing widespread operations; • political and economic instability; • increased costs and complexities associated with financial reporting; and • currency risks. The occurrence of any of these or other factors may cause the Company’s international operations to not be successful, could lower the prices at which it can sell its products or otherwise have an adverse effect on its operating results. Taxes The Company is a multinational corporation with global operations. As such, it is subject to the tax laws and regulations of Canadian federal, provincial and local governments, the U.S. and of many international jurisdictions including transfer pricing laws and regulations between many of these jurisdictions. Significant judgment is required in determining the Company’s provision for income taxes and claims for investment tax credits (ITCs) related to qualifying Scientific Research and Experimental Development (SR&ED) expenditures. Various internal and external factors may have favourable or unfavourable effects on future provisions for income taxes and the Company’s effective income tax rate. These factors include, but are not limited to, changes in tax laws, regulations and/or Nuvo Research Inc. Annual Report 2012 55 Management’s Discussion and Analysis cont’d rates, results of audits by tax authorities, changing interpretations of existing tax laws or regulations, changes in estimates of prior years’ items, future levels of R&D spending and changes in overall levels of income before taxes. Furthermore, new accounting pronouncements or new interpretation of existing accounting pronouncements can have a material impact on the Company’s effective income tax rate. The Company could be impacted by certain tax treatments for various revenue streams in different tax jurisdictions. The Company is subject to withholding taxes on certain of its revenue streams. The withholding tax rates that have been used are based on the interpretation of specific tax acts and related treaties. If a tax authority has a different interpretation from the Company’s it could potentially impose additional taxes, penalties or fines. This would potentially reduce the amounts of revenue ultimately received by the Company. The Company, from time-to-time, has executed multiple reorganization transactions impacting its tax structure. If a tax authority has a different interpretation from the Company’s, it could potentially impose additional taxes, penalties or fines. Volatility of Share Price Market prices for pharmaceutical related securities, including those of the Company, have been historically volatile and subject to substantial fluctuations. The stock market from time-to-time experiences significant price and volume fluctuations unrelated to the operating performance of particular companies. Future announcements concerning the Company or its competitors, including the results of testing, technological innovations, new commercial products, marketing arrangements, government regulations, developments concerning regulatory actions affecting the Company’s products and its competitors’ products in any jurisdiction, developments concerning proprietary rights, litigation, additions or departures of key personnel, cash flow, public concerns about the safety of the Company’s products and economic conditions and political factors in the U.S., Europe, Canada or other regions – may have a significant impact on the market price of the common shares. In addition, there can be no assurance that the common shares will continue to be listed on the TSX. 56 Nuvo Research Inc. Annual Report 2012 Compliance with Laws and Regulations Affecting Public Companies Any future changes to the laws and regulations affecting public companies, compliance with existing provisions of Multilateral Instrument 52-109 – Certification of Disclosure in Issuer’s Annual and Interim Filings of the Canadian Securities Administrators and the other applicable Canadian securities laws and regulation and related rules and policies, may cause the Company to incur increased costs as it evaluates the implications of new rules and implements any new requirements. Delays or a failure to comply with the new laws, rules and regulations could result in enforcement actions, the assessment of other penalties and civil suits. The new laws and regulations may make it more expensive for the Company to provide indemnities to the Company’s officers and directors and may make it more difficult to obtain certain types of insurance, including liability insurance for directors and officers; as such, the Company may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. The impact of these events could also make it more difficult for the Company to attract and retain qualified persons to serve on its Board of Directors or as executive officers. The Company may be required to hire additional personnel and utilize additional outside legal, accounting and advisory services, all of which could cause general and administrative costs to increase beyond what the Company currently has planned. The Company is continuously evaluating and monitoring developments with respect to these laws, rules and regulations and it cannot predict or estimate the amount of the additional costs it may incur or the timing of such costs. The Company is required annually to review and report on the effectiveness of its internal control over financial reporting in accordance with Multilateral Instrument 52-109 – Certification of Disclosure in Issuer’s Annual and Interim Filings of the Canadian Securities Administrators. The results of this review are reported in the Company’s Annual Report, The Company’s Co-Chief Executive Officers and Chief Financial Officer are required to report on the effectiveness of the Company’s internal control over financial reporting. Management’s review is designed to provide reasonable assurance, not absolute assurance, that all material weaknesses existing within the Company’s internal controls are identified. Material weaknesses represent deficiencies existing in the Company’s internal controls that may not prevent or detect a misstatement occurring which could have a material adverse effect on the quarterly or annual financial statements of the Company. In addition, management cannot provide assurance that the remedial actions being taken by the Company to address any material weaknesses identified will be successful, nor can management provide assurance that no further material weaknesses will be identified within its internal controls over financial reporting in future years. • products may fail to achieve market acceptance; If the Company fails to maintain effective internal controls over its financial reporting, there is the possibility of errors or omissions occurring or misrepresentations in the Company’s disclosures which could have a material adverse effect on the Company’s business, its financial statements and the value of the Company’s common shares. • issue of preferred shares; Additional Risks Additional risks that could be materially adversely affect the Company’s business or an investment in its common shares include, but are not limited to: • government assistance for certain drug development programs; • limits on the marketing approval for the Company’s products such that they are subject to ongoing regulatory review and regulatory requirements; • inadequate patient enrolment for the Company’s current trials or future clinical trials; • rapid technological change that could make the Company’s products or drug delivery technologies obsolete; • further dilution and a declining share price from additional equity financings; • the inability to raise future capital when and if required; • the inability to comply with laws regulating hazardous waste; • public company requirements that may strain resources; • an inability to achieve and maintain profitability; • an inability to realize the anticipated benefits from the acquisition of ZARS; • a failure of its information technology systems; • potential litigation; • the inability to achieve expected savings from restructurings; • shareholders’ rights plan may prevent or delay a change in control; • an inability to manage the growth of the Company; • fluctuations in quarterly results; • absence of dividends; • an active trading market for common shares; • an inability to protect know-how and trade secrets; and • securities industry analyst research reports. A D D I T I O N A L I N F O R M AT I O N Additional information relating to the Company, including the Company’s most recently filed AIF and Management Information Circular, can be found on SEDAR at www.sedar.com. • unsatisfactory performance by third parties whom the Company relies upon to conduct, supervise and monitor its clinical trials and preclinical studies; Nuvo Research Inc. Annual Report 2012 57 Management’s Report The accompanying consolidated financial statements have been prepared by management and approved by the Board of Directors of the Company. Management is responsible for the information and representations contained in these financial statements and the accompanying Management’s Discussion and Analysis. The financial statements have been prepared in accordance with International Financial Reporting Standards (IFRS). The significant accounting policies followed by the Company are set out in note 2 to the consolidated financial statements. To assist management in discharging these responsibilities, the Company maintains a system of procedures and internal controls which are designed to provide reasonable assurance that its assets are safeguarded, that transactions are executed in accordance with management’s authorization, and that the financial records form a reliable base for the preparation of accurate and timely financial information. The Company’s external auditors are appointed by the shareholders. They independently perform the necessary tests of accounting records and procedures to enable them to report their opinion as to the fairness of the consolidated financial statements and their conformity with IFRS. The Board of Directors ensures that management fulfills its responsibilities for financial reporting and internal control. The Board of Directors exercises this responsibility through an Audit Committee composed of three Directors, all of whom are not involved in the day-to-day operations of the Company. The Audit Committee meets quarterly with management, and with external auditors to review audit recommendations and any matters that the auditors believe should be brought to the attention of the Board of Directors. The Audit Committee reviews the consolidated financial statements and Management’s Discussion and Analysis and recommends their approval by the Board of Directors. Chairman and Co-Chief Executive Officer March 27, 2013 58 Nuvo Research Inc. Annual Report 2012 President and Co-Chief Executive Officer March 27, 2013 Vice President and Chief Financial Officer March 27, 2013 Independent Auditors’ Report To the Shareholders of Nuvo Research Inc. We have audited the accompanying consolidated financial statements of Nuvo Research Inc., which comprise the consolidated statement of financial position as at December 31, 2012, and the consolidated statement of loss and comprehensive loss, statement of changes in equity and statement of cash flows for the year then ended, and a summary of significant accounting policies and other explanatory information. Management’s Responsibility for the Consolidated Financial Statements Management is responsible for the preparation and fair presentation of these consolidated financial statements in accordance with International Financial Reporting Standards, and for such internal control as management determines is necessary to enable the preparation of consolidated financial statements that are free from material misstatement, whether due to fraud or error. Auditor’s Responsibility Our responsibility is to express an opinion on these consolidated financial statements based on our audit. We conducted our audit in accordance with Canadian generally accepted auditing standards. Those standards require that we comply with ethical requirements and plan and perform the audit to obtain reasonable assurance about whether the consolidated financial statements are free from material misstatement. An audit involves performing procedures to obtain audit evidence about the amounts and disclosures in the consolidated financial statements. The procedures selected depend on the auditor’s judgment, including the assessment of the risks of material misstatement of the consolidated financial statements, whether due to fraud or error. In making those risk assessments, the auditor considers internal control relevant to the entity’s preparation and fair presentation of the consolidated financial statements in order to design audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the entity’s internal control. An audit also includes evaluating the appropriateness of accounting policies used and the reasonableness of accounting estimates made by management, as well as evaluating the overall presentation of the consolidated financial statements. We believe that the audit evidence we have obtained is sufficient and appropriate to provide a basis for our audit opinion. Opinion In our opinion, the consolidated financial statements present fairly, in all material respects, the financial position of Nuvo Research Inc. as at December 31, 2012, and their financial performance and cash flows for the year then ended in accordance with International Financial Reporting Standards. Restated Comparative Information The consolidated financial statements of Nuvo Research Inc. for the year ended December 31, 2011 (prior to the restatement of the comparative information described in Note 26 to the consolidated financial statements) were audited by another auditor who expressed an unmodified opinion on those consolidated financial statements on February 29, 2012. As part of our audit of the consolidated financial statements of Nuvo Research Inc. for the year ended December 31, 2012, we also audited the adjustments described in Note 26 that were applied to restate the consolidated financial statements for the year ended December 31, 2011. In our opinion, such adjustments are appropriate and have been properly applied. We were not engaged to audit, review, or apply any procedures to the consolidated financial statements of Nuvo Research Inc. for the year ended December 31, 2011 other than with respect to the adjustments and, accordingly, we do not express an opinion or any other form of assurance on the consolidated financial statements for the year ended December 31, 2011 taken as a whole. Emphasis of Matter Without qualifying our opinion, we draw attention to Note 1 in the consolidated financial statements which indicates that the Company incurred a net loss of $13,563 during the year ended December 31, 2012 and, as of that date, the Company had an accumulated deficit of $221,151. These conditions, along with other matters as set forth in Note 1, indicate the existence of a material uncertainty that may cast significant doubt about the Company’s ability to continue as a going concern. Chartered Accountants Licensed Public Accountants March 27, 2013 Toronto, Ontario Nuvo Research Inc. Annual Report 2012 59 Consolidated Statements of Financial Position As at December 31, 2012 As at December 31, 2011 (restated – Note 26) $ $ Cash and cash equivalents Accounts receivable (notes 13, 21) Inventories (note 6) Other current assets (note 7) 12,149 3,771 1,156 1,056 14,724 3,700 1,844 1,307 T O TA L C U R R E N T A S S E T S 18,132 21,575 (Canadian dollars in thousands) ASSETS CURRENT Property, plant and equipment (note 8) Intangible assets (notes 4, 9) 1,614 1,960 8,739 – 16,821 4,498 28,485 44,854 Accounts payable and accrued liabilities ZARS Contingent Consideration (notes 4, 26) Current portion of deferred revenue (note 11) Current portion of finance lease and other obligations (note 12) 3,360 – 341 1,900 5,208 2,300 1,494 55 T O TA L C U R R E N T L I A B I L I T I E S 5,601 9,057 Deferred revenue (note 11) Finance lease and other obligations (note 12) 57 1,358 398 489 T O TA L L I A B I L I T I E S 7,016 9,944 Goodwill (notes 4, 10) T O TA L A S S E T S LIABILITIES AND EQUITY CURRENT EQUITY Common shares Contributed surplus (notes 4, 26) Accumulated other comprehensive income Deficit (notes 4, 26) 228,705 13,495 420 (221,151) 228,306 13,228 964 (207,588) T O TA L E Q U I T Y 21,469 34,910 T O TA L L I A B I L I T I E S A N D E Q U I T Y 28,485 44,854 See accompanying Notes. On behalf of the Board Anthony E. Dobranowski, Director 60 Nuvo Research Inc. Annual Report 2012 Dr. Klaus von Lindeiner, Director Consolidated Statements of Loss and Comprehensive Loss Year ended December 31, 2012 Year ended December 31, 2011 (restated – Note 26) $ $ Product sales Cost of goods sold (notes 6, 15, 17) 8,936 7,275 8,948 7,269 GROSS MARGIN ON PRODUCT SALES 1,661 1,679 8,284 7,252 5,771 1,641 178 373 17,375 9,464 (Canadian dollars in thousands, except per share and share figures) REVENUE OTHER REVENUE Royalties (note 11) Licensing fees (notes 11, 13) Research and other contract revenue O P E R AT I N G E X P E N S E S Research and development expenses (notes 7, 15, 17) Sales and marketing expenses (notes 15, 17) General and administrative expenses (notes 15, 17) Interest expense (note 12) Interest income 6,849 4,892 9,123 381 (16) 7,323 1,312 10,306 8 (152) 21,229 18,797 11,868 (277) (2) (2,300) 224 – – (114) (2,647) 155 Net loss before income taxes Income taxes (13,367) 196 (6,727) 104 NET LOSS (13,563) (6,831) (544) 1,097 T O TA L C O M P R E H E N S I V E L O S S (14,107) (5,734) Net loss attributable to: Owners of the parent Non-controlling interest (13,563) – (5,562) (1,269) (13,563) (6,831) (14,107) – (4,433) (1,301) (14,107) (5,734) (0.024) (0.014) 567.7 489.3 OTHER EXPENSES (INCOME) Impairment of intangible assets and goodwill (notes 9, 10) Litigation settlement (note 25) Gain on disposal of property, plant and equipment Gain on ZARS Contingent Consideration (notes 4, 26) Foreign currency loss Other comprehensive income (loss) Unrealized gains (losses) on translation of foreign operations Total comprehensive loss attributable to: Owners of the parent Non-controlling interest Net loss per common share – basic and diluted (note 16) Average number of common shares outstanding (in millions) – basic and diluted See accompanying Notes. Nuvo Research Inc. Annual Report 2012 61 Consolidated Statements of Changes in Equity (Canadian dollars in thousands, except for number of shares) Equity Attributable to Owners of the Parent NonControlling Total Interest Contributed Surplus AOCI Deficit $ $ $ $ 4, 5, 15 4, 5, 15 4, 15, 26 5 4, 5, 26 Balance, January 1, 2011 418,223 216,864 12,885 (257) (197,654) 31,838 (703) 31,135 Acquisition of ZARS Pharma, Inc. 112,440 9,511 – – – 9,511 – 9,511 31,948 1,720 – 92 (4,372) (2,560) 2,004 (556) – – – 1,129 – 1,129 (32) 1,097 – – 209 – – 209 – 209 250 42 (12) – – 30 – 30 Common Shares (000s) Notes $ $ Total Equity $ 5 (restated see Note 4) Acquisition of non-controlling interest Unrealized gains (losses) on translation of foreign operations Stock option compensation expense Stock options exercised Performance stock unit compensation expense Shares issued under Share Bonus Plan – – 279 – – 279 – 279 591 133 (133) – – – – – 251 18 – – – 18 – 18 251 18 – – – 18 – 18 – – – – (5,562) (5,562) (1,269) (6,831) 563,954 228,306 13,228 964 (207,588) 34,910 – 34,910 – – 339 – – 339 – 339 – – – (544) – (544) – (544) Employee contributions to Share Purchase Plan Employer’s portion of Share Purchase Plan Net loss (restated see Note 26) Balance, December 31, 2011 Stock option compensation expense Unrealized losses on translation of foreign operations Performance stock unit compensation expense Shares issued under Share Bonus Plan – – 180 – – 180 – 180 1,494 252 (252) – – – – – 922 61 – – – 61 – 61 922 61 – – – 61 – 61 500 25 – – – 25 – 25 – – – – (13,563) (13,563) – (13,563) 567,792 228,705 13,495 420 (221,151) 21,469 – 21,469 Employee contributions to Share Purchase Plan Employer’s portion of Share Purchase Plan Professional fees settled in shares Net loss Balance, December 31, 2012 See accompanying Notes. 62 Nuvo Research Inc. Annual Report 2012 Consolidated Statements of Cash Flows Year ended December 31, 2012 Year ended December 31, 2011 (restated – Note 26) (Canadian dollars in thousands) $ $ O P E R AT I N G A C T I V I T I E S Net loss Items not involving current cash flows: Gain on ZARS Contingent Consideration (notes 4, 26) Impairment of intangible assets (note 9) Impairment of goodwill (note 10) Depreciation and amortization (notes 8, 9, 17) Deferred license revenue recognized (note 11) Deferred royalty revenue, net of royalties earned (note 11) Stock-based compensation (note 15) (13,563) (6,831) (2,300) 7,491 4,377 674 (1,092) (385) (2,647) – – 704 (1,641) (331) 734 133 123 (2) 72 11 442 369 109 (114) 6 13 Net change in non-cash working capital (note 18) (3,727) (1,348) (9,921) (1,918) C A S H U S E D I N O P E R AT I N G A C T I V I T I E S (5,075) (11,839) Acquisition of ZARS Pharma, Inc. (note 4) Proceeds on disposal of property, plant and equipment Acquisition of property, plant and equipment (note 8) – 8 (149) 1,394 173 (161) CASH PROVIDED BY (USED IN) INVESTING ACTIVITIES (141) 1,406 4,000 (1,345) 61 (2) – (3,022) 48 (63) 2,714 (3,037) Unrealized foreign exchange loss Inventory write-down (note 6) Gain on disposal of property, plant and equipment Accretion of long-term obligations Other INVESTING ACTIVITIES FINANCING ACTIVITIES Proceeds from other obligations (note 12(i)) Repayment of other obligations (notes 4, 12) Issuance of common shares Repayments of finance lease obligations CASH PROVIDED BY (USED IN) FINANCING ACTIVITIES Effect of exchange rate changes on cash and cash equivalents (73) (75) Net change in cash and cash equivalents during the year Cash and cash equivalents, beginning of year (2,575) 14,724 (13,545) 28,269 C A S H A N D C A S H E Q U I VA L E N T S , E N D O F Y E A R 12,149 14,724 269 21 182 5 161 90 Interest paid1 Interest received1 Income taxes paid1 1. Amounts paid and received for interest and paid for income taxes were reflected as operating cash flows in the consolidated statements of cash flows. See accompanying Notes. Significant non-cash financing activities are discussed in Notes 4 and 5. Nuvo Research Inc. Annual Report 2012 63 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars 1 . N AT U R E O F B U S I N E S S A N D G O I N G C O N C E R N A S S U M P T I O N Nuvo Research Inc. (Nuvo or the Company) was incorporated on August 22, 1983 under the laws of the Province of Ontario as Clark Pharmaceutical Laboratories Ltd. On November 14, 1990, the articles were amended to change the name of the Company from Clark Pharmaceutical Laboratories Ltd. to Dimethaid Research Inc. On September 30, 2005, the articles were further amended to change the name of the Company from Dimethaid Research Inc. to Nuvo Research Inc. On January 1, 2007, the Company completed a short-form amalgamation with Akorn Pharmaceuticals Canada Limited, Excelpharm Inc., Femina Inc., Dimethaid Management Inc. and Dimethaid Manufacturing Inc., certain of its subsidiaries. The amalgamated entity continues as Nuvo. No new securities of the Company were issued in connection with the amalgamation and securities of the Company prior to the amalgamation continue to represent securities of the amalgamated entity. The Company’s registered office and principal place of business is located at 7560 Airport Road, Unit 10, Mississauga, Ontario L4T 4H4. Nuvo is a publicly traded Canadian specialty pharmaceutical company with manufacturing operations. Nuvo is building a portfolio of products for the treatment of pain through internal research and development (R&D) and by in-licensing and acquisition. Three of the pain products in its portfolio have been commercialized and the others are at varying stages of development. The Company’s pain products are primarily medications that are delivered into and through the skin. Nuvo is also involved in R&D activities with WF10, a chlorite-based immunomodulating drug, through Nuvo Research AG. The Company refers to and manages these activities as two distinct business and research segments: the Pain Group and the Immunology Group. Pain Group The Pain Group is focused on the development and commercialization of the Company’s topically delivered pain products. Pennsaid®, the Company’s first commercialized pain product, is used to treat the signs and symptoms of osteoarthritis (OA) of the knee. Pennsaid, combines a transdermal carrier with diclofenac sodium, a leading non-steroidal anti-inflammatory drug (NSAID), and delivers the active drug through the skin directly to the site of pain. Pennsaid is approved and marketed in a number of countries, including the U.S., Canada, Greece, Italy and the U.K. and is manufactured by the Company for sale to all global licensing and distribution partners. In May 2011, the Company acquired ZARS Pharma, Inc. (ZARS). This acquisition expanded the Company’s pain product portfolio by adding Synera® and Pliaglis®. Synera is used to provide rapid, local dermal analgesia prior to potentially painful needle related procedures such as venous access, blood draws, needle injections and minor dermatologic surgical procedures such as shave biopsy and excision. Synera uses a patented, Controlled Heat-Assisted Drug Delivery (CHADD™) technology to facilitate drug delivery from a proprietary local anesthetic formulation that contains lidocaine and tetracaine. Synera is approved and marketed in a number of countries in Europe by its European-based licensee, Eurocept International B.V. (Eurocept) and in the U.S. is marketed by Nuvo. Synera is manufactured by a third-party contract manufacturing organization (CMO) located in the U.S. Pliaglis is a topical local anesthetic phase-changing cream that provides safe and effective local dermal anesthesia on intact skin prior to painful cosmetic procedures, such as dermatologic laser surgery and dermal filler injections. This product consists of a proprietary formulation of lidocaine and tetracaine that utilizes the Company’s Peel technology. Worldwide marketing rights for Pliaglis have been licensed to Galderma S.A. (Galderma), a global company dedicated to dermatology. While the U.S. Food and Drug Administration (FDA) approved Pliaglis, it has not been marketed or sold in the U.S. for several years due to manufacturing issues that arose at the CMO that previously produced the drug. Galderma and ZARS transferred production to Galderma prior to Nuvo’s acquisition of ZARS. Galderma filed a supplementary New Drug Application (sNDA) with the FDA that addressed the manufacturing issues, including the transfer of manufacturing to Galderma. On April 16, 2012, Galderma received a Complete Response Letter from the FDA that outlined additional information the FDA required before it would approve the sNDA for Pliaglis. In May 2012, Galderma submitted additional information that it believed addressed all of the FDA’s issues. The additional information related to the manufacturing transfer of Pliaglis from a third-party contract manufacturer to Galderma’s manufacturing facility and included additional stability data and proposed labeling revisions. The Complete Response Letter did not require any new clinical or toxicology studies. In October 2012, the FDA approved the sNDA. In Europe, Nuvo filed a Marketing Authorization Application (MAA) for Pliaglis in 16 E.U. countries and on May 4, 2012 received a positive recommendation that Pliaglis was approvable. The regulatory process then entered its final phase during which individual countries issue marketing licenses that allow Pliaglis to be marketed in each country. By December 31, 2012, Galderma had 64 Nuvo Research Inc. Annual Report 2012 received twelve of sixteen marketing licenses. The first three marketing licenses entitled Nuvo to earn a total of US$6.0 million of milestone payments from Galderma. The milestone payments were due on the earlier of the launch of Pliaglis in the approved countries or six months from the date of marketing approval. At December 31, 2012, the Company had received US$5.0 million and the balance was received in January 2013. Galderma launched Pliaglis in the U.S. in early March and the Company expects Galderma to launch Pliaglis in the E.U. in the second quarter of 2013. Immunology Group The immune system provides an essential defense to microorganisms, cancer and substances it sees as foreign and potentially harmful. WF10, a proprietary solution of OXO-K993 (TCDO), focuses on supporting the immune system. Oxoferin™, a diluted form of WF10, is a topical wound healing agent that has been commercialized in several countries in Europe, Asia and South America. R&D activities surrounding WF10 for use in other indications are ongoing. OXO-K993 is manufactured by the Company and WF10 and Oxoferin are manufactured by a CMO for sale to all global partners. Going Concern These Consolidated Financial Statements have been prepared on a going-concern basis, which presumes that the Company will be able to realize its assets and discharge its liabilities in the normal course of operations for the foreseeable future. At December 31, 2012, the Company had an accumulated deficit of $221,151, including a net loss of $13,563 for the year then ended which included $11,868 of non-cash charges related to the impairment of intangible assets and goodwill. The Company’s ability to continue as a going concern depends on: the success of its approved products – Pennsaid and Synera, as it earns revenue from these products in the form of royalties and product sales and has the ability to earn milestone payments; the ability to gain marketing approval in the remaining four European countries and successfully launch Pliaglis in both the U.S. and E.U. as the Company will earn royalties on this product; the ability of Galderma to gain marketing approval for Pliaglis in South America as the Company will earn a US$2.0 million milestone upon approval; the ability of Mallinckrodt Inc. (Mallinckrodt) the pharmaceuticals business of Covidien plc to earn marketing approval for Pennsaid 2% in the U.S. and if approved successfully launch the product; the potential entry of a generic version of Pennsaid into the U.S., as this may trigger an event of default on the Paladin Debt (see Note 12) and may significantly reduce revenue and cash flow; and, its ability to secure additional licensing fees, secure co-development agreements, obtain additional capital, gain regulatory approval for other drugs and ultimately achieve profitable operations. Whether and when the Company can achieve the above is uncertain. There can be no assurance that the Company will have sufficient capital to fund its ongoing operations or develop or commercialize any further products without future financings. There can be no assurance, especially considering the current economic environment, that additional financing will be available on acceptable terms or at all. If adequate funds are not available or Pennsaid is genericized in the U.S. or Pennsaid revenues in the U.S. decline or if the revenues of Synera do not increase in the U.S. or if the launch of Synera in key E.U. markets is not successful or if the launch of Pliaglis in both the U.S. and E.U. is not successful or if Pennsaid 2% is not approved in the U.S. or if the Company is unable to avoid an event of default on the Paladin Debt (see Note 12), the Company may have to substantially reduce or eliminate planned expenditures, discontinue its marketing efforts for Synera in the U.S., terminate or delay clinical trials for its product candidates, curtail product development programs designed to expand the product pipeline or discontinue certain operations such as the Immunology Group. If the Company is unable to obtain additional financing when and if required, the Company may be unable to continue operations. These material uncertainties cast significant doubt upon the Company’s ability to continue as a going concern. These Consolidated Financial Statements do not include any adjustments to the amounts and classification of assets and liabilities that would be necessary should the Company be unable to continue as a going concern. 2 . B A S I S O F P R E PA R AT I O N Statement of Compliance These Consolidated Financial Statements have been prepared by management in accordance with International Financial Reporting Standards (IFRS), as issued by the International Accounting Standards Board (IASB). The policies applied in these Consolidated Financial Statements are based on IFRS issued and outstanding as at March 27, 2013, the date the Board of Directors approved these Consolidated Financial Statements. Nuvo Research Inc. Annual Report 2012 65 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars 3 . S U M M A RY O F S I G N I F I C A N T A C C O U N T I N G P O L I C I E S Basis of Measurement The Consolidated Financial Statements have been prepared under the historical cost convention, except for the revaluation of certain financial assets and financial liabilities to fair value. Items included in the financial statements of each consolidated entity in the Company are measured using the currency of the primary economic environment in which the entity operates (the functional currency). The Consolidated Financial Statements are presented in Canadian dollars, which is the Company’s functional currency. Use of Estimates and Judgments The preparation of financial statements requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, the disclosure of contingent assets and liabilities at the date of the Consolidated Financial Statements and the reported amounts of revenue and expenses during the reporting periods. Actual results could differ from estimates and such differences could be material. Key areas of estimation or use of managerial assumptions are as follows: (i) Business combinations, intangible assets and goodwill: The amount of goodwill initially recognized as a result of a business combination and the determination of the fair value of the identifiable assets acquired and the liabilities assumed is based, to a considerable extent, on management’s judgment. The Company determines fair values based on discounted cash flows, market information, independent valuations and management’s estimates. The values calculated for intangible assets and goodwill involve significant estimates and assumptions, including those with respect to future cash flows, discount rates and asset lives. These significant estimates and judgments could impact the Company’s future results if the current estimates of future performance and fair values change and could affect the amount of amortization expense on intangible assets in future periods. (ii) Cash-generating units (CGU): The identification of cash-generating units within the Company requires considerable judgment. Under IFRS, management must determine the smallest group of assets that generate independent cash inflows and allocate goodwill acquired in a business combination to the CGU that is expected to benefit from synergies of the combination. Management first considers the Company’s commercialized products, and then determines the operations that contribute to each product’s revenue base and net cash inflows. Management has identified three CGUs: the U.S. operations dedicated to generating cash inflows for Synera and Pliaglis; the manufacturing facility in Quebec that generates cash inflows for Pennsaid and the Immunology Group that generates cash inflows for WF10. (iii) Income taxes: The Company recognizes deferred tax assets, related tax-loss carryforwards and other deductible temporary differences where it is probable that sufficient future taxable income can be generated in order to fully utilize such losses and deductions. This requires significant estimates and assumptions regarding future earnings and the ability to implement certain tax planning opportunities in order to assess the likelihood of utilizing such losses and deductions. (iv) Property, plant and equipment (PP&E): Measurement of PP&E involves the use of estimates for determining the expected useful lives of depreciable assets. Management’s judgment is also required to determine depreciation methods and an asset’s residual value and whether an asset is a qualifying asset for the purposes of capitalizing borrowing costs. (v) Impairment of goodwill and non-financial assets: The Company reviews the carrying value of goodwill and non-financial assets for potential impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. The impairment test on CGUs is carried out by comparing the carrying amount of the CGU and its recoverable amount. The recoverable amount of a CGU is the higher of fair value, less costs to sell and its value in use. This complex valuation process entails the use of methods such as the discounted cash flow method which requires numerous assumptions to estimate future cash flows. The recoverable amount is impacted significantly by the discount rate selected to be used in the discounted cash flow model, as well as the quantum and timing of expected future cash flows and the growth rate used for the extrapolation. 66 Nuvo Research Inc. Annual Report 2012 (vi) Provisions: A provision is a liability of uncertain timing or amount. Provisions are recognized when the Company has a present obligation (legal or constructive) as a result of a past event. It is probable that the Company will be required to settle the obligation and a reliable estimate can be made of the amount of the obligation. A legal obligation can arise through a contract, legislation or other operation of law. A constructive obligation arises from an entity’s actions; whereby, through an established pattern of past practices, published policies or a sufficiently specific current statement, the entity has indicated it will accept certain responsibilities and has thus created a valid expectation that it will discharge those responsibilities. The amount recognized as a provision is the best estimate, at each period end, of the expenditures required to settle the present obligation considering the risks and uncertainties associated with the obligation. Judgment is necessary to determine the likelihood that pending litigation or other claims will succeed or a liability will arise and then to quantify the amount. (vii) Share-based payments: The Company measures the cost of share-based payments, either equity or cash-settled, with employees by reference to the fair value of the equity instrument or underlying equity instrument at the date on which they are granted. In addition, cash-settled share-based payments are remeasured at fair value at every reporting date. Estimating fair value for share-based payments requires management to determine the most appropriate valuation model for a grant, which is dependent on the terms and conditions of each grant. In valuing certain types of stock-based payments, such as incentive stock options, the Company uses the Black-Scholes option pricing model. Several assumptions are used in the underlying calculation of fair values of the Company’s stock options using the Black-Scholes option pricing model, including the expected life of the option, stock price volatility and forfeiture rates. Details of the assumptions used are included in Note 15. (viii) Foreign currency translation: The determination of functional currency for each of the Company’s entities requires considerable judgment. The functional currency is determined based on the currency of the primary economic environment in which that entity operates. As the Company generates and expends cash in a variety of currencies, management considers several factors including: the currency in which it receives its various revenue streams and the magnitude of each, the currency in which it purchases materials and pays its employees and the geographic environments influencing each of its consolidated entities and its products. (ix) Revenue recognition As is typical in the pharmaceutical industry, the Company’s royalty streams are subject to a variety of deductions that generally are estimated and recorded in the same period that the revenues are recognized and primarily represent rebates, discounts and incentives, and product returns. These deductions represent estimates of the related obligations. Amounts recorded for sales deductions can result from a complex series of judgments about future events and uncertainties and can rely on estimates and assumptions. Basis of Consolidation These Consolidated Financial Statements include the accounts of the Company and all of its subsidiaries as follows: % Ownership December 31, 2012 December 31, 2011 Nuvo Research America, Inc. and its subsidiaries: Nuvo Research US, Inc., ZARS Pharma, Inc., and ZARS (UK) Limited 100% 100% Dimethaid (UK) Ltd. 100% 100% Dimethaid Immunology Inc. 100% 100% Nuvo Research AG and its subsidiaries: Nuvo Manufacturing GmbH and Nuvo Research GmbH (see Note 5) 100% 100% The Company controls the subsidiaries above by having the power to govern their financial and operating policies. All significant inter-company balances and transactions have been eliminated upon consolidation. Nuvo Research Inc. Annual Report 2010 67 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars Business Combinations Acquisitions of subsidiaries and businesses are accounted for using the acquisition method. The consideration for each acquisition is measured at the aggregate of the fair values (at the date of exchange) of assets given, liabilities incurred or assumed and equity instruments issued by the Company in exchange for control of the acquiree. Acquisition-related costs are recognized in profit or loss as incurred. Where applicable, the consideration for the acquisition includes any asset or liability resulting from a contingent consideration arrangement, measured at its acquisition-date fair value. Subsequent changes in such fair values are adjusted against the cost of the acquisition where they qualify as measurement-period adjustments (see below). All other subsequent changes in the fair value of contingent consideration classified as an asset or liability are accounted for in accordance with relevant IFRS sections. Where a business combination is achieved in stages, the Company’s previously held interests in the acquired entity are remeasured to fair value at the acquisition date (i.e. the date the Company attains control) and the resulting gain or loss, if any, is recognized in profit or loss. Amounts arising from interests in the acquiree prior to the acquisition date that have previously been recognized in other comprehensive income (OCI) are reclassified to profit or loss, where such treatment would be appropriate if that interest were disposed of. The acquiree’s identifiable assets, liabilities and contingent liabilities that meet the conditions for recognition under IFRS 3 Business Combinations are recognized at their fair value at the acquisition date, except that: • deferred tax assets or liabilities and liabilities or assets related to employee benefit arrangements are recognized and measured in accordance with IAS 12 Income Taxes and IAS 19 Employee Benefits; • liabilities or equity instruments related to the replacement by the Company of an acquiree’s share-based payment awards are measured in accordance with IFRS 2 Share-based Payment; and • assets (or disposal groups) that are classified as held for sale in accordance with IFRS 5 Non-current Assets Held for Sale and Discontinued Operations are measured in accordance with that Standard. If the initial accounting for a business combination is incomplete by the end of the reporting period in which the combination occurs, the Company reports provisional amounts for the items for which the accounting is incomplete. Those provisional amounts are adjusted during the measurement period (see below) or additional assets or liabilities are recognized, to reflect new information obtained about facts and circumstances that existed as of the acquisition date that, if known, would have affected the amounts recognized as of that date. The measurement period is the period from the date of acquisition to the date the Company obtains complete information about facts and circumstances that existed as of the acquisition date and is subject to a maximum period of one year. Non-Controlling Interests Non-controlling interests represent equity interests in subsidiaries owned by outside parties. The share of net assets of subsidiaries attributable to non-controlling interests is presented as a component of equity. Their share of net loss and comprehensive loss is recognized directly in equity. Changes in the Company’s ownership interest in subsidiaries that do not result in a loss of control are accounted for as equity transactions. Foreign Currency Translation The Company and its subsidiary companies each determine their functional currency based on the currency of the primary economic environment in which they operate. The Company’s functional currency is the Canadian dollar, while subsidiary companies’ functional currencies are either the Canadian or U.S. dollar or the euro. (i) Transactions Transactions denominated in a currency other than the functional currency of an entity are translated at exchange rates prevailing at the time the transaction occurred. The resulting exchange gains and losses are included in each entity’s net loss in the period in which they arise. 68 Nuvo Research Inc. Annual Report 2012 (ii) Translation into presentation currency The Company’s foreign operations are translated to the Company’s presentation currency, which is the Canadian dollar, for inclusion in the Consolidated Financial Statements. Foreign denominated monetary and non-monetary assets and liabilities of foreign operations are translated at exchange rates in effect at the end of the reporting period and revenue and expenses are translated at the average exchange rate for the period (as this is considered a reasonable approximation to actual rates). The resulting translation gains and losses are included in OCI with the cumulative gain or loss reported in accumulated other comprehensive income (AOCI). When the Company disposes of its entire interest in a foreign operation or loses control or influence over a foreign operation, the foreign currency gains or losses in AOCI related to the foreign operation are recognized in profit or loss. If the Company disposes of part of an interest in a foreign operation which remains a subsidiary, the proportionate amount of foreign currency gains or losses in AOCI related to the subsidiary are reallocated between controlling and non-controlling interests. Cash and Cash Equivalents Cash and cash equivalents are comprised of cash on hand and current balances with banks and similar institutions. They are readily convertible into known amounts of cash and have an insignificant risk of changes in value. Cost approximates fair value. Inventories Inventories are comprised of raw materials, work-in-process and finished goods. Raw materials are stated at the lower of cost and replacement cost with cost determined on a first-in, first-out basis. Manufactured inventory (finished goods and work-in-process) is valued at the lower of cost and net realizable value determined on a first-in, first-out basis. Manufactured inventory cost includes the cost of raw materials, direct labour, an allocation of overhead and the cost to acquire finished goods. The Company monitors the shelf life and expiry of finished goods to determine when inventory values are not recoverable and a write-down is necessary. Property, Plant and Equipment PP&E is recorded at cost. Assets acquired under finance leases are carried at cost which is the present value of minimum lease payments after deduction of any executory costs. The Company allocates the amount initially recognized in respect of an item of PP&E to its significant parts and amortizes separately each such part. Depreciation of PP&E is provided for over the estimated useful lives from the date the asset becomes available for use as follows: Buildings Leasehold improvements Furniture and fixtures Computer equipment and software Production, laboratory and other equipment 10 to 25 years Term of lease 5 years 1 to 3 years 3 to 5 years Straight Straight Straight Straight Straight line line line line line Residual values, method of depreciation and useful lives of the assets are reviewed annually and adjusted if appropriate. Intangible Assets Intangible assets acquired in a business combination are recognized separately from goodwill at their fair value at the date of acquisition, which is considered to be cost. Intangible assets consist of the costs to acquire intellectual property under a business acquisition. Amortization commences when the intangible asset is available for use and for patented assets is computed on a straight-line basis over the intangible asset’s estimated useful life, which cannot exceed the lesser of the remaining patent life and 20 years. Nuvo Research Inc. Annual Report 2010 69 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars Goodwill Goodwill represents the excess of the cost of an acquisition over the fair value of the Company’s acquired identifiable assets and liabilities at the date of acquisition. Recognized goodwill is tested annually for impairment and carried at cost less accumulated impairment losses. Gains and losses on the disposal of an entity include the carrying amount of goodwill relating to the entity sold. Goodwill is allocated to the CGU that is expected to benefit from the business combination in which the goodwill arose for the purpose of impairment testing. Impairment of Non-Financial Assets The Company reviews the carrying value of non-financial assets for potential impairment when events or changes in circumstances indicate that the carrying amount may not be recoverable. For the purpose of measuring recoverable amounts, assets are grouped at the lowest levels for which there are separately identifiable cash flows (or CGUs). The recoverable amount is the higher of an asset’s fair value less costs to sell and value in use (being the present value of the expected future cash flows of the relevant asset or CGU). An impairment loss is recognized for the amount by which the asset’s carrying value exceeds its recoverable amount. Borrowing Costs Borrowing costs attributable to the acquisition, construction or production of qualifying assets are added to the cost of those assets, until such time as the assets are substantially ready for their intended use. All other borrowing costs are recognized as interest expense in profit or loss in the period in which they are incurred. Leases Leases are classified as finance leases whenever the terms of the lease transfer substantially all the risks and rewards of ownership to the Company. All other leases are classified as operating leases. The capitalized finance lease obligation reflects the present value of future lease payments, discounted at the appropriate interest rate. Assets under finance leases are amortized over the term of the lease. All other leases are accounted for as operating leases with rental payments being expensed on a straight-line basis. Financial Instruments All financial instruments are classified into one of the following five categories: fair value through profit or loss (FVTPL), held-to-maturity investments, loans and receivables, available-for-sale assets or other financial liabilities. All financial instruments, including derivatives, are included on the Consolidated Statements of Financial Position and are measured at fair market value upon inception. Subsequent measurement and recognition of changes in the fair value of financial instruments depends on their initial classification. FVTPL financial investments are measured at fair value and all gains and losses are included in operations in the period in which they arise. Available-for-sale financial instruments are measured at fair value with revaluation gains and losses included in OCI until the asset is removed from the Consolidated Statements of Financial Position. Loans and receivables, instruments held to maturity and other financial liabilities are measured at amortized cost using the effective interest method. Gains and losses upon inception, impairment write-downs and foreign exchange translation adjustments are recognized immediately. The Company classifies its financial instruments as follows: • Cash and cash equivalents and accounts receivable are classified as loans and receivables and are measured at amortized cost. Interest income is recorded in net income (loss), as applicable. • Accounts payable, accruals, long-term obligations and finance lease obligations are classified as other financial liabilities and are measured at amortized cost using the effective interest method. Interest expense is recorded in net income (loss), as applicable. Financing costs associated with the issuance of debt are netted against the related debt and are deferred and amortized over the term of the related debt using the effective interest method. 70 Nuvo Research Inc. Annual Report 2012 Impairment of Financial Assets At each reporting date, the Company assesses whether there is objective evidence that a financial asset is impaired. If such evidence exists, the Company recognizes an impairment loss. For financial assets carried at amortized cost, the loss is the difference between the amortized cost of the loan or receivable and the present value of the estimated future cash flows, discounted using the instrument’s original effective interest rate. The carrying value of the asset is reduced by this amount either directly or indirectly through the use of an allowance account. Comprehensive Income (Loss) Comprehensive income (loss) is the change in equity from transactions and other events and circumstances from non-shareholder sources. Other comprehensive income (loss) refers to items recognized in comprehensive income (loss), but that are excluded from net income (loss) calculated in accordance with IFRS. The resulting changes from translating the financial statements of foreign operations to the Company’s presentation currency of Canadian dollars are recognized in comprehensive income (loss) for the year. Revenue Recognition The Company recognizes revenue from product sales, R&D collaborations and licensing arrangements which may include multiple elements. Revenue arrangements with multiple elements are reviewed in order to determine whether the multiple elements can be divided into separate units of accounting, if certain criteria are met. If separable, the consideration received is allocated among the separate units of accounting based on their respective fair values and the applicable revenue recognition criteria are applied to each of the separate units. If not separable, the applicable revenue recognition criteria are applied to combined elements as a single unit of accounting. Revenue from product sales is recognized upon shipment of the product to the customer, provided transfer of title to the customer occurs upon shipment and provided the Company has not retained any significant risks of ownership or future obligations with respect to the product shipped, the price is fixed and determinable and collection is reasonably assured. Where applicable, revenue from product sales is recognized net of reserves for estimated sales discounts and allowances, returns, rebates and chargebacks. For upfront, non-refundable payments received in accordance with the execution of licensing and collaboration agreements, distribution agreements and supply agreements, revenue is deferred and recognized over the performance period – the period over which the Company maintains substantive contractual obligations. Amounts the Company expects to earn in the current year are included in the current portion of deferred revenue and amounts expected to be earned in subsequent periods are included in deferred revenue. The term over which upfront fees are recognized is revised if the period over which the Company maintains substantive contractual obligations changes. Milestone payments are immediately recognized as licensing revenue when the condition is met, if the milestone is not a condition to future deliverables and collectability is reasonably assured. Otherwise, they are recognized over the remaining term of the agreement or the performance period. Revenue arising from royalties is recognized when reasonable assurance exists regarding measurement and collectability. Royalties are typically calculated as a percentage of net sales realized by the Company’s licensees of its products (including their sublicensees), as specifically defined in each agreement. The licensees’ sales generally consist of revenues from product sales of the Company’s pharmaceutical products and net sales are determined by deducting the following: estimates for chargebacks, rebates, sales incentives and allowances, returns and losses and other customary deductions in each region where the Company has licensees. While the Company receives royalty payments quarterly, it can only recognize the amounts as revenue when reasonable assurance exists regarding measurement and collectability. Royalty revenue from the launch of a product in a new territory, for which the Company or its licensee are unable to develop the requisite historical data on which to base estimates of returns, may be deferred until such time that a reasonable estimate can be made and once the product has achieved market acceptance. Any royalty payments received or receivable in advance of when they would be recognized as revenue are recorded in deferred revenue. Revenues from R&D collaborations are generally recognized as the contracted services are performed and the related expenditures are incurred pursuant to the terms of the agreement and provided collectability is reasonably assured. Nuvo Research Inc. Annual Report 2012 71 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars Research and Development Research costs, other than capital expenditures, are charged to operations as incurred. Expenditures on internally developed products are capitalized if it can be demonstrated that: • • • • • • it is technically feasible to develop the product for it to be sold; adequate resources are available to complete the development; there is an intention to complete and sell the product; the Company is able to sell the product; sale of the product will generate future economic benefits; and expenditure on the project can be measured reliably. Development expenses are charged to operations as incurred unless such costs meet the criteria for deferral and amortization. No development costs have been deferred to-date. Government Assistance Government assistance received under incentive programs, including investment tax credits for qualifying R&D activities, is accounted for using the cost reduction method; whereby, the assistance is netted against the related expense or capital expenditure to which it relates when there is reasonable assurance that the credits will be realized. Government assistance received under reimbursement or funding programs are accounted for using the cost reduction method; whereby, a receivable is set-up as the costs are incurred based on the terms of reimbursement or funding program and the expected recoveries are netted against the related expense. Net Income or Loss Per Common Share Basic net income or loss per common share is calculated using the weighted average number of common shares outstanding during the year. Diluted net income or loss per common share is calculated assuming the weighted average number of common shares outstanding during the year is increased to include the number of additional common shares that would have been outstanding if the dilutive potential shares had been issued. The dilutive effect of warrants and stock options is determined using the treasury-stock method. The treasury-stock method assumes that the proceeds from the exercise of warrants and options are used to purchase common shares at the volume weighted average market price during the year. The dilutive effect of convertible securities is determined using the “if-converted” method. The “if-converted” method assumes that the convertible securities are converted into common shares at the beginning of the year and all income charges related to the convertible securities are added back to income. Income Taxes Income taxes on profit or loss include current and deferred taxes. Income taxes are recognized in profit or loss except to the extent that they relate to business combinations or items recognized directly in equity or in OCI. Current tax is the expected tax payable or receivable on the taxable income or loss for the period, using tax rates enacted or substantively enacted at the reporting date and any adjustment to tax payable in respect of previous years. The Company is subject to withholding taxes on certain forms of income earned under its in-licensing agreements from foreign jurisdictions. Deferred tax is generally recognized in respect of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for taxation purposes. Deferred tax is measured at the tax rates that are expected to be applied to temporary differences when they reversed, based on the laws that have been enacted or substantively enacted in the relevant jurisdiction by the reporting date. Deferred tax assets and liabilities are recognized where the carrying amount of an asset or liability in the Consolidated Statements of Financial Position differs from its tax base, except for differences arising on: • the initial recognition of goodwill; • the initial recognition of an asset or liability in a transaction which is not a business combination and at the time of the transaction affects neither accounting or taxable profit; and • investments in subsidiaries, branches and associates, and interests in joint ventures where the Company is able to control the timing of the reversal of the difference and it is probable that the difference will not reverse in the foreseeable future. 72 Nuvo Research Inc. Annual Report 2012 A deferred tax asset is recognized for unused tax losses, tax credits and deductible temporary differences, to the extent probable that future taxable income will be available against which they can be utilized. Deferred tax assets are reviewed at each reporting date and are reduced to the extent it is no longer probable the related tax benefit will be realized. Stock-Based Compensation and Other Stock-Based Payments The Company has four stock-based compensation plans: the Share Option Plan, the Share Purchase Plan and the Share Bonus Plan, are each a component of the Company’s Amended and Restated Share Incentive Plan and the fourth is the Deferred Share Unit Plan. All are described in Note 15. Share Incentive Plan The Company measures and recognizes compensation expense for the Share Incentive Plan based on the fair value of the common shares or options issued. Under the Share Option Plan, the Company issues either fixed awards or performance based options. Options vest either immediately upon grant or over a period of one to four years or upon the achievement of certain performance related measures or milestones. Each tranche in an award is considered a separate award with its own vesting period and grant date fair value. Fair value of each tranche is measured at the date of grant using the Black-Scholes option pricing model. Compensation expense is recognized over the tranche’s vesting period based on the number of awards expected to vest, by increasing contributed surplus. When options are exercised, the proceeds received by the Company, together with the fair value amount in contributed surplus, are credited to common shares. Under the Share Purchase Plan, consideration paid by employees on the purchase of common shares is credited to common shares when the shares are issued. The fair value of the Company’s matching contribution, determined based upon the trading price of the common shares, is recorded as compensation expense. These expenses are included in stock-based compensation expense and credited to common shares. Under the Share Bonus Plan, the fair value of the direct award of common shares, determined based upon the trading price of the common shares, is recorded as compensation expense. These expenses are included in stock-based compensation expense and credited to common shares. Deferred Share Unit (DSU) Plan Under the DSU Plan, the Company issues DSUs to non-employee directors based on value of services provided. DSUs that are intended to be settled in cash are recorded as liabilities and included in accounts payable and accrued liabilities. Upon issuance, the fair value of the DSUs is recorded as compensation expense and a corresponding liability (the DSU Accrual) is established. At all subsequent reporting dates, the DSU Accrual is adjusted for movements in fair value, with the amount of the adjustment charged to compensation expense. Performance Share Unit (PSU) Plan A PSU issued to an employee under the Share Bonus Plan, provides an employee with an opportunity to earn common shares of the Company, if certain predefined annual corporate non-market performance objectives (PSU Objectives) are achieved. If these PSU Objectives are achieved, the PSUs are earned by the employee (Earned PSUs). Each Earned PSU then vests over the two calendar years subsequent to the year in which the PSU Objectives were achieved in three equal installments. At each vesting date, one Nuvo common share is issued to the employee for each vesting PSU. Upon the issuance of PSUs to an employee, the Company must calculate the fair value of the grant (PSU Grant Value) by estimating the number of PSUs that will become Earned PSUs and determine the fair value of each of these PSUs. For each PSU that is anticipated to become an Earned PSU, the fair value is determined using the market price of the underlying common shares on the grant date. This value is amortized to income as compensation expense over the relevant vesting period with the corresponding credit recorded as contributed surplus. At each subsequent reporting date prior to final determination of whether a PSU becomes an Earned PSU, management must make an estimate of the number of PSUs expected to be earned by the employees based on the PSU Objectives and, if necessary, adjust the PSU Grant Value accordingly. When a PSU vests and common shares are issued to the employee, the PSU Grant Value related to the vesting PSUs is transferred from contributed surplus to common shares. Nuvo Research Inc. Annual Report 2012 73 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars Issuance Costs of Equity Instruments The Company records issuance costs of equity instruments against the equity instrument that was issued. Accounting Standards Issued But Not Yet Applied Certain new standards, interpretations, amendments and improvements to existing standards were issued by the IASB or IFRS Interpretations Committee (IFRIC) that are mandatory for fiscal periods beginning July 1, 2012 or later. The standards impacted that may be applicable to the Company are as follows: IFRS 9 – Financial Instruments In October 2010, the IASB issued IFRS 9 Financial Instruments which replaces IAS 39 Financial Instruments: Recognition and Measurement. IFRS 9 establishes principles for the financial reporting of financial assets and financial liabilities that will present relevant and useful information to users of financial statements for their assessment of the amounts, timing and uncertainty of an entity’s future cash flows. This new standard is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2015. IFRS 10 – Consolidated Financial Statements In May 2011, the IASB issued IFRS 10 Consolidated Financial Statements, which replaces IAS 27 Consolidation and Separate Financial Statements and SIC-12 Consolidation – Special Purpose Entities. IFRS 10 establishes principles for the presentation and preparation of consolidated financial statements when an entity controls one or more entities. This new standard is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2013. IFRS 12 – Disclosure of Interests in Other Entities In May 2011, the IASB issued IFRS 12 Disclosure of Interests in Other Entities. IFRS 12 is a comprehensive new standard on disclosure requirements for all forms of interests in other entities, including subsidiaries, joint arrangements, associates and unconsolidated structured entities. This new standard is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2013. IFRS 13 – Fair Value Measurement In June 2011, the IASB issued new guidance on IFRS 13 Fair Value Measurement. IFRS 13 aims to improve consistency and reduce complexity by providing a single source of guidance for all fair value measurements across all IFRS, clarifying the definition of fair value and enhancing disclosure requirements about fair value measurements. This new guidance is effective for the Company’s interim and annual consolidated financial statements commencing January 1, 2013. IAS 1 – Presentation of Financial Statements: Other Comprehensive Income In June 2011, the IASB issued amendments to IAS 1 Presentation of Financial Statements to improve the consistency and clarity of the presentation of items of comprehensive income by requiring that items presented in OCI be grouped on the basis of whether they are at some point reclassified from OCI to net earnings or not. The amendments require companies preparing financial statements in accordance with IFRS to group together items within OCI that may be reclassified to the profit or loss section of the income statement. The amendments also reaffirm existing requirements that items in OCI and profit or loss should be presented as either a single statement or two consecutive statements. These amendments are effective for annual periods beginning on or after July 1, 2012. The Company is assessing the impact of the adoption of these standards on its Consolidated Financial Statements, but it does not anticipate significant changes in 2013. 74 Nuvo Research Inc. Annual Report 2012 4. ACQUISITION OF ZARS PHARMA, INC. On May 12, 2011 (the Acquisition Date), the Company obtained control of ZARS by acquiring all of the issued and outstanding shares of ZARS. ZARS was a U.S. based specialty pharmaceutical company focused on the development and commercialization of topically administered drugs, primarily with respect to pain. The ZARS acquisition significantly broadened the Company’s pain pipeline by adding two approved products, Synera and Pliaglis, a pipeline of pain products in various stages of development and two important drug delivery platforms; thereby, advancing the Company’s step-by-step approach to transforming the Pain Group into a leader in the topical pain space. The following summarizes the Acquisition Date fair value of the major classes of consideration transferred: $ Cash consideration 99,822,136 common shares issued ZARS Contingent Consideration 149 9,488 5,084 Total consideration Less: cash acquired 14,721 1,626 Total consideration, net of cash acquired 13,095 The fair value of the common shares issued was based on the Company’s listed share price of $0.105 at the Acquisition Date, less an adjustment to reflect that the recipients of these shares were subject to a “lock-up Covenant”, such that they could not sell or transfer the shares until December 31, 2011. In addition to the total consideration, the Company incurred acquisition related costs of approximately $1.1 million for external consulting, professional and legal fees and costs related to conducting due diligence. These costs have been included in general and administrative (G&A) expenses in the Company’s Consolidated Statements of Comprehensive Loss for the year ended December 31, 2011. In addition, the Company incurred $67 in costs directly related to issuing the shares to ZARS. These costs were directly recorded as a reduction to common shares in equity. The Company received net cash of $1,477 on the acquisition of ZARS representing acquired cash and cash equivalents of $1,626, net of $149 of cash consideration paid on closing. The purchase cost was allocated to the underlying assets acquired and liabilities assumed based upon their fair value at the Acquisition Date. Identifiable assets, liabilities and goodwill: $ Total consideration Cash Non-cash working capital Property and equipment Intangible assets Bank debt Deferred revenue Net identifiable assets and liabilities Residual purchase price allocated to goodwill 14,721 1,626 (2,621) 457 16,007 (3,022) (1,982) 10,465 4,256 On the Acquisition Date, the Company only recognized identifiable assets and liabilities at fair value against the Acquisition Date fair value of consideration. The fair value of drug pipeline opportunities, on a risk-adjusted basis, were not identifiable assets that were recognized. Therefore, the Acquisition Date consideration, net of identifiable assets and liabilities, resulted in residual goodwill. Nuvo Research Inc. Annual Report 2012 75 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars The terms of the acquisition include a mechanism to reimburse the Company for certain working capital adjustments that occur subsequent to the Acquisition Date. Under this mechanism, the Company could elect to be reimbursed for the amount of any adjustment in cash or could compel the former ZARS shareholders to return a sufficient number of Nuvo common shares to satisfy the obligation. During the year ended December 31, 2011, a $32 adjustment was calculated and 415,385 common shares with a value of $32 were returned to the Company and subsequently cancelled. The value of these cancelled common shares was recorded as a reduction to common shares in equity in 2011. The fair value of the total consideration was directly impacted by management’s estimates, at the Acquisition Date, of the probability of the Company achieving certain milestones related to Pliaglis, Synera and Pennsaid, which if achieved or in some cases not achieved, would result in the issuance of up to 114.6 million additional common shares (Milestone Shares) to the former ZARS shareholders (ZARS Contingent Consideration). The ZARS Contingent Consideration consisted of: • 74,870,000 Nuvo shares which only become payable if the Company, prior to December 31, 2012, achieves both (i) the re-approval of Pliaglis by the FDA and the first commercial sale of Pliaglis in the U.S. by Galderma after such re-approval, and (ii) the approval of Pliaglis by the Germany’s Federal Institute for Drugs and Medical Devices (Bundesinstitut für Arzneimittel und Medizinprodukte) BfArM and the first commercial sale of Pliaglis in Europe by Galderma (Pliaglis Milestone); and • 39,750,000 (three separate milestones of 13,250,000) Nuvo shares payable upon certain future events. The ZARS Contingent Consideration was originally structured as promissory notes payable to the former shareholders of ZARS, but allowed the Company to seek shareholder approval for the issuance of additional shares, in lieu of the promissory notes. The Company’s shareholders approved the issuance of contingent shares at the Company’s Annual and Special Meeting of Shareholders on June 21, 2011. See Note 26 for discussion regarding the accounting for, and restatement of, ZARS Contingent Consideration. In October 2011, one of the milestones relating to the ZARS Contingent Consideration was achieved and in November 2011, the Company issued an additional 13,034,191 common shares and paid cash of $16 to the former ZARS shareholders, for a total fair value of $137 of this milestone. Through December 31, 2012, the Company issued a total of 112,440,942 common shares related to the ZARS Acquisition as follows: 99,822,136 common shares issued on the Acquisition Date, 13,034,191 issued upon the achievement of one of the milestones relating to the ZARS Contingent Consideration, less 415,385 that were returned to the Company in satisfaction of the working capital adjustment and subsequently cancelled. 5. ACQUISITION OF NON-CONTROLLING INTEREST On December 13, 2011, the Company increased its ownership in Nuvo Research AG to 100% by acquiring the 40% interest held by the minority owner. In accordance with IAS 27, as there was no change in control of Nuvo Research AG, the difference between the amount which the non-controlling interest was adjusted and the fair value of the consideration paid, was recognized directly in equity and attributed to the owners of the parent. The following summarizes the fair value of the $2,256 in consideration transferred to the non-controlling interest: • 31,947,668 common shares representing an agreed price of US$1.7 million and the settlement of a loan of 68 euro for R&D services performed by the former minority shareholder, totalled $1,728; and • A 5-year, US$150 per annum consulting agreement with the former minority shareholder, discounted at 15.5% and fair valued at US$519 ($528) (see Note 12 (ii)). 76 Nuvo Research Inc. Annual Report 2012 The following summarizes the difference between the amount by which the non-controlling interest was adjusted and the fair value of the consideration paid to acquire the non-controlling interest which is the amount recognized directly in equity and attributed to the owners of the parent in December 2011: $ Accumulated losses attributed to non-controlling interest AOCI attributed to non-controlling interest Transferred consideration Accrued acquisition costs and other 2,004 92 2,256 20 Total decrease in equity attributable to the owners of the parent 4,372 6. INVENTORIES Inventories consist of the following as at: Raw materials Work in process Finished goods December 31, 2012 $ December 31, 2011 $ 669 194 293 1,189 101 554 1,156 1,844 During the year ended December 31, 2012, inventories in the amount of $6.5 million [2011 – $6.5 million] were recognized in cost of goods sold. During the year ended December 31, 2012, $134 of raw materials in the Pain Group was written down. During the year ended December 31, 2011, $109 of finished goods in the Immunology Group was written down, of which $11 was reversed in 2012. 7. OTHER CURRENT ASSETS Other current assets consist of the following as at: Prepaid expenses Other receivables (i) Deposits December 31, 2012 $ December 31, 2011 $ 696 248 112 824 363 120 1,056 1,307 (i) Includes $181 [2011 – $76] related to R&D expenditures for which the Company is eligible for reimbursement under funding agreements with the Development Bank of Saxony (SAB) for the development of WF10 related projects, but for which the Company has not yet filed a claim. As at December 31, 2012, the Company had received reimbursements of $273 (€208) [2011 – $241 (€177)] related to claims made by the Company for eligible expenditures incurred in 2009 through 2012 under the same agreements. The amounts reimbursed are included in R&D expenses. Nuvo Research Inc. Annual Report 2012 77 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars 8 . P R O P E RT Y, P L A N T A N D E Q U I P M E N T Property, plant and equipment (PP&E) consist of: Cost Balance, January 1, 2011 Land Leasehold Buildings Improvements Furniture & Fixtures Computer Equipment & Software Production Laboratory & Other Equipment(i) Total $ $ $ $ $ $ $ 7,224 124 1,956 180 301 907 3,756 Foreign exchange movements – (8) – (1) (1) 80 70 Additions – 28 19 1 70 43 161 Acquisition of ZARS – – – – – 457 457 Disposals – – (25) (28) (19) (1,116) (1,188) 124 1,976 174 273 957 3,220 6,724 Foreign exchange movements – (5) (1) – – (2) (8) Additions – 6 – 3 47 93 149 Disposals – – – – – (35) (35) 124 1,977 173 276 1,004 3,276 6,830 Balance, January 1, 2011 – 1,200 126 272 769 2,841 5,208 Foreign exchange movements – (10) – (1) (1) 79 67 Additions – 139 30 18 72 352 611 Disposals – – (25) (28) (19) (1,050) (1,122) Balance, December 31, 2011 – 1,329 131 261 821 2,222 4,764 Balance, December 31, 2011 Balance, December 31, 2012 Accumulated depreciation Foreign exchange movements – (4) – – – (1) (5) Additions – 91 19 6 75 295 486 Disposals – – – – – (29) (29) Balance, December 31, 2012 – 1,416 150 267 896 2,487 5,216 NBV at December 31, 2011 124 647 43 12 136 998 1,960 NBV at December 31, 2012 124 561 23 9 108 789 1,614 (i) Production, laboratory and other equipment at December 31, 2012, included costs of $56 [2011 – $56] and accumulated depreciation of $50 [2011 – $48] for assets under finance leases. Depreciation of PP&E for the year ended December 31, 2012, included $2 [2011 – $26] related to assets under finance leases. 78 Nuvo Research Inc. Annual Report 2012 9 . I N TA N G I B L E A S S E T S Pliaglis Intellectual Property $ Synera Intellectual Property $ Total $ Acquisition of ZARS Foreign exchange movements 14,604 830 1,403 79 16,007 909 Balance, December 31, 2011 15,434 1,482 16,916 Foreign exchange movements (337) (33) (370) Balance, December 31, 2012 15,097 1,449 16,546 Foreign exchange movements Amortization expense – – 2 93 2 93 Balance, December 31, 2011 – 95 95 Foreign exchange movements Impairment charge Amortization expense 37 7,176 – (4) 315 188 33 7,491 188 Balance, December 31, 2012 7,213 594 7,807 15,434 1,387 16,821 7,884 855 8,739 Cost Accumulated amortization Net carrying amount as at December 31, 2011 Net carrying amount as at December 31, 2012 Intangible assets were acquired from the acquisition of ZARS (see Note 4). The fair values of these assets at the time of acquisition were determined through third-party appraisals. Synera received regulatory approval and is commercialized in the U.S. and many European countries: therefore, amortization of its intellectual property commenced on the Acquisition Date and will continue until July 2019 when its current patents expire. As at December 31, 2012, the Pliaglis intellectual property is not being amortized. Although the product has been approved in the U.S. and in 14 of 16 European countries, amortization will commence when the product is commercially launched. Amortization of intangible assets is included in G&A expenses in the Consolidated Statements of Loss and Comprehensive Loss. The Company reviewed the carrying values of the intangible assets for potential impairment at December 31, 2012 as commercial efforts for Synera and the launch timing of Pliaglis did not meet expectations. Indications for impairment did exist, and management determined that each asset was impaired, such that recoverable amounts were lower than the carrying amounts. The recoverable amount and value in use (being the present value of expected future cash flows) was calculated using licensing partner revenue forecasts, net of direct costs forecasted by management, discounted at an after-tax rate of 15% which approximates the Company’s current weighted average cost of capital. As at December 31, 2012, the Company recorded an impairment charge for Synera of $315 and an impairment charge for Pliaglis of $7,176 in impairment of intangible assets and goodwill in the Consolidated Statement of Loss and Comprehensive Loss. Nuvo Research Inc. Annual Report 2012 79 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars 10. GOODWILL Cost $ Acquisition of ZARS Foreign exchange movements 4,256 242 Balance, December 31, 2011 4,498 Foreign exchange movements Impairment charge (121) (4,377) Balance, December 31, 2012 – Goodwill was generated on the acquisition of ZARS as total consideration of $14,721 exceeded the net identifiable assets acquired of $10,465 (see Note 4). The U.S. operations dedicated to generating cash inflows for Synera and Pliaglis are considered to be the CGU for recorded goodwill for the purposes of impairment testing. Under the impairment test, the recoverable amount of the CGU is determined at its value in use, based on a discounted cash flow model and tested for impairment annually at December 31. The value in use calculation considered forecasted cash flows during the patent life of Synera and Pliaglis based on the current commercialization plans for these products. Cash from product sales and royalties, net of labour and infrastructure costs were included and an after-tax discount rate of 15% was applied, which approximates the Company’s current weighted average cost of capital. As at December 31, 2012, the recoverable amount was less than its carrying amount, and the entire goodwill was written off in impairment of intangible assets and goodwill in the Consolidated Statement of Loss and Comprehensive Loss. 11. DEFERRED REVENUE Deferred revenue is as follows: Balance, beginning of the year Royalties earned under the U.S. Licensing Agreement (ii) Acquisition of ZARS (i) Effects of movement in foreign exchange less: Amortization of license and supply agreements (i), (iii) Recognition of royalty revenue (ii) Balance, end of period Amount to be recognized within one year Long-term balance December 31, 2012 $ December 31, 2011 $ 1,892 5,802 – (17) 1,832 4,236 1,982 50 7,677 8,100 1,092 6,187 1,641 4,567 398 341 1,892 1,494 57 398 (i) Acquisition of ZARS For the year ended December 31, 2012, $0.8 million was recognized as licensing fees in income. Included in deferred revenue at December 31, 2012 was $nil [2011 – $0.8 million] of deferred licensing fees. (ii) U.S. Licensing Agreement On June 15, 2009 (the Effective Date), the Company entered into a License and Development Agreement (U.S. Licensing Agreement) with Mallinckrodt, granting Mallinckrodt exclusive rights to market and sell Pennsaid in the U.S. through the transfer of the Pennsaid New Drug Application (Pennsaid NDA) to Mallinckrodt upon FDA approval in the U.S. Under the terms of the U.S. Licensing Agreement, Nuvo earns royalties on U.S. net sales of Pennsaid based upon a formula. Under the formula, Nuvo earned royalties of $5.8 million for the year ended December 31, 2012 [2011 – $4.2 million]. Based on dispensed prescription data and other information obtained during the year, the Company recorded royalty revenue for the year ended December 31, 2012 of $6.2 million [2011 – $4.6 million]. The Company believes it has sufficient historical experience to assess 80 Nuvo Research Inc. Annual Report 2012 inventory levels and the relative risk of potential product returns; therefore, royalty revenue from the U.S. licensing agreements are no longer deferred. Included in deferred revenue at December 31, 2012 was $nil [2011 – $0.4 million] of deferred royalties. Under the terms of the U.S. Licensing Agreement, Mallinckrodt assumed all responsibility for managing, planning, executing and paying for all development activities for Pennsaid’s follow-on product Pennsaid 2% subsequent to the Effective Date. If Pennsaid 2% is approved by the FDA, Nuvo will be entitled to receive royalties and escalating sales milestone payments. (iii) Canadian Licensing Agreements Under the Canadian licensing arrangements with Paladin Labs Inc. in 2005 and 2006, certain payments were received for the Canadian marketing rights to Pennsaid. All amounts were amortized to income systematically based on the expected performance period. During the year ended December 31, 2012, the Company recorded licensing revenue of $0.3 million [2011 – $0.3 million] pertaining to amounts received in 2005 and at December 31, 2012, $0.4 million remains unamortized and will continue to be amortized systematically over the remaining expected performance period [2011 – $0.7 million]. 1 2 . F I N A N C E L E A S E A N D O T H E R O B L I G AT I O N S Finance lease and other obligations consist of the following as at: December 31, 2012 $ December 31, 2011 $ 2,779 – 471 8 534 10 Less amounts due within one year 3,258 1,900 544 55 Long-term balance 1,358 489 Other loan (i) Long-term consulting agreement from acquisition of non-controlling interest (ii) Finance lease obligations (iii) (i) Other loan In May 2012, the Company signed an agreement to borrow up to $8.0 million from its Canadian licensing partner in two equal tranches of $4.0 million each (Paladin Debt). The first tranche was advanced on closing and the second tranche can be drawn by the Company, at its option, upon the achievement of predefined milestones. The loan bears interest at a rate of 15% per annum and matures on May 25, 2016. The loan was collateralized by a charge over the assets of Nuvo’s Pain Group. The Company is required to make principal repayments on the first tranche of debt when certain circumstances occur. Under the terms of the loan agreement, the Company must pay 10% of all royalty payments received by the Company on the sale of Pennsaid in the U.S.; 10% of all royalty payments and milestones received by the Company on the sale of Pliaglis; however, the US$6.0 million in Pliaglis milestone payments were received prior to the commercial launch in Europe; therefore, the 10% payment related to the milestone payments will be applied to the second tranche of debt if drawn. In addition, Paladin will offset and retain 100% of the royalties payable to the Company on Canadian distribution of Pennsaid and Synera when approved and launched in Canada. The terms of the loan agreement include standard default provisions, one of which is if a generic version of Pennsaid becomes available for commercial sale in the U.S., amounts owing may become due and payable. The timing of the future payments of the loan is based on management’s best estimate of future royalty revenue. Changes in these estimates could significantly affect the outstanding value of the loan at each reporting date. The estimated future payments on the loan, including interest, are as follows for the years ending December 31: $ 2013 2014 2,115 1,014 Total payments Less: amount representing interest (approximately 15%) 3,129 350 Present value of obligation Current portion 2,779 1,809 Long-term balance 970 Nuvo Research Inc. Annual Report 2012 81 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars (ii) Long-term consulting agreement from acquisition of non-controlling interest The Company has a long-term consulting agreement with the former minority shareholder in Nuvo Research AG (Note 5). The future payments of the five-year consulting obligation are as follows for the years ending December 31: $ 2013 2014 2015 2016 2017 149 149 149 149 25 Total payments Less: amount representing interest (approximately 15.5%) 621 150 Present value of obligation, including accretion Current portion 471 89 Long-term balance 382 (iii) Finance lease obligations The Company leases office equipment under finance leases expiring at various dates through December 2015. The minimum future lease payments are as follows for the years ending December 31: $ 2013 2014 2015 3 3 3 Total minimum lease payments Less: amount representing interest (approximately 6.15%) 9 1 Present value of minimum lease payments Current portion 8 2 Long-term balance 6 For the year ended December 31, 2012, interest paid on finance lease obligations was under $1 [2011 – $3]. 13. LICENSING FEES The Company has a license agreement with Galderma, its worldwide marketing partner for Pliaglis. As at December 31, 2012, Galderma had received twelve of sixteen Pliaglis marketing licenses from E.U. countries of which the first three entitled Nuvo to earn a total of US$6.0 million of milestone payments (CDN$6.2 million). The milestone payments were due on the earlier of the launch of Pliaglis in the approved countries or six months from the date of marketing approval, and as of December 31, 2012, the Company received US$5.0 million and the balance was received in January 2013. 1 4 . C A P I TA L S T O C K Authorized • Unlimited first and second preferred shares, non-voting, non-participating, issuable in series, number, designation, rights, privileges, restrictions and conditions are determinable by the Company’s Board of Directors. • Unlimited common shares, voting, without par value. Shareholders’ Rights Plan The Company initially instituted a shareholder rights plan (the Rights Plan) in 1992. Since that time, the Rights Plan has been amended, restated and continued from time-to-time. Most recently, in May 2008, the shareholders approved certain amendments to the Rights Plan, including continuing it until the annual meeting of shareholders in 2013. The Rights Plan is intended to provide some protection to shareholders of the Company from unfair take-over strategies, including the acquisition of control of the Company by a bidder in a transaction or series of transactions 82 Nuvo Research Inc. Annual Report 2012 that does not treat all shareholders equally or fairly or afford all shareholders an equal opportunity to share in the premium paid upon an acquisition of control. One right is, or will be, issued in respect of each outstanding common share. The rights become exercisable only when an acquiring person acquires or announces its intention to acquire 20% or more of the Company’s outstanding common shares without complying with the “permitted bid” provisions of the Rights Plan. Subject to the terms of the Rights Plan, each right will entitle the holder thereof, to purchase a common share of the Company at a 50% discount to the market price. 1 5 . S T O C K - B A S E D C O M P E N S AT I O N A N D O T H E R S T O C K - B A S E D PAY M E N T S The Company has four stock-based compensation plans: the Share Option Plan, the Share Purchase Plan and the Share Bonus Plan, each a component of the Company’s Share Incentive Plan and the DSU Plan. Share Incentive Plan Under the Company’s Share Incentive Plan, there are three sub plans: the Share Purchase Plan, the Share Option Plan and the Share Bonus Plan. The original plan was amended and restated effective September 21, 2005, when shareholders of the Company approved an amendment changing the maximum number of common shares that may be issued under the plan from a fixed maximum number to a fixed maximum percentage. The amendment changes the maximum number of common shares that may be issued under the Share Incentive Plan to a fixed maximum percentage of 15% of the Company’s outstanding common shares (on a fully-diluted basis other than stock options) from time-to-time. The common shares that may be issued under the plan are allocated to the three sub-plans as follows: Share Option Plan 10%, Share Purchase Plan 3% and Share Bonus Plan 2%. As the Share Incentive Plan is a “rolling plan”, the Toronto Stock Exchange (TSX) requires that it, along with any unallocated options, rights or other entitlements receive shareholder approval at the Company’s annual meeting every three years. At the Annual and Special Meeting of Shareholders of the Company held on June 21, 2011, the common shareholders approved an ordinary resolution affirming, ratifying and approving the Share Incentive Plan and approving all of the unallocated common shares issuable pursuant to the Share Incentive Plan. Share Option Plan Under the Share Option Plan, the Company may grant options to purchase common shares to officers, directors, employees or consultants of the Company or its affiliates. Options issued under the Share Option Plan are granted for a term not exceeding ten years from the date of grant. All options issued to-date have a life of 10 years. In general, options have vested either immediately upon grant or over a period of one to four years or upon the achievement of certain performance related measures or milestones. Under the provisions of the Share Option Plan, the exercise price of all stock options shall not be less than the closing price of the common shares on the last trading date immediately preceding the grant date of the option. As at December 31, 2012, the number of unoptioned shares available to be reserved was 7,649,964. The following is a schedule of the options outstanding as at: Number of Options (000s) Range of Exercise Price $ Weighted Average Exercise Price $ Balance, January 1, 2011 Granted Exercised (i) Forfeited Expired 38,445 7,123 (250) (2,617) (33) 0.10 – 5.95 0.085 0.10 – 0.125 0.10 – 3.10 5.95 0.20 0.09 0.12 0.21 5.95 Balance, December 31, 2011 Granted Forfeited Expired 42,668 11,225 (4,724) (40) 0.085 – 3.10 0.08 – 0.10 0.085 – 2.01 3.10 0.18 0.10 0.19 3.10 Balance, December 31, 2012 49,129 0.08 – 2.01 0.15 (i) The weighted average share price on the exercise date was $0.153. Nuvo Research Inc. Annual Report 2012 83 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars The following table summarizes the outstanding and exercisable options held by directors, officers, employees and consultants at December 31, 2012: Outstanding Exercisable Number of Options (000s) Remaining Contractual Life (years) Weighted Average Exercise Price $ Vested Options (000) Weighted Average Exercise Price $ 0.08 – 0.135 0.17 – 0.25 0.30 – 2.01 32,774 11,894 4,461 7.2 4.3 2.0 0.11 0.21 0.33 18,178 10,008 4,461 0.12 0.20 0.33 0.08 – 2.01 49,129 6.0 0.15 32,647 0.18 Exercise Price Range $ Fair value of each tranche is measured at the date of grant using the Black-Scholes option pricing model. Options are valued with a calculated forfeiture rate of 7.0% [December 31, 2011 – 7.0%], and the remaining model inputs for options granted during the year ended December 31, 2012 were: Options (000s) Grant Date Share Price $ 650 10,575 March 6, 2012 March 29, 2012 0.085 0.095 Exercise Price $ Risk-free Interest Rate % Expected Life (years) Volatility Factor % Fair Values $ 0.08 0.10 1.1 – 1.3 1.1 – 1.3 2–5 2–5 59 – 73 60 – 73 0.027 – 0.048 0.033 – 0.059 Share Purchase Plan Under the Share Purchase Plan, eligible officers, employees or consultants of the Company or its affiliates may contribute up to 10% of their annual base salary to the plan to purchase Nuvo common shares. The Company matches each participant’s contribution by issuing Nuvo common shares having a value equal to the aggregate amount contributed by each participating employee. During 2012, employees contributed $61 [2011 – $18] to the plan and the Company matched these contributions by issuing 922,046 common shares [2011 – 250,930] with a fair value of $61 [2011 – $18] that was recorded as compensation expense. The total number of shares issued under this plan during the year ended December 31, 2012 was 1,844,092 [2011 – 501,860]. Share Bonus Plan Performance Share Unit Plan A PSU provides an employee with an opportunity to earn common shares of the Company if certain PSU Objectives are achieved. If these PSU Objectives are achieved, the PSUs are Earned PSUs. Each Earned PSU then vests over the subsequent two calendar years in three equal installments. One PSU has a value equal to one Nuvo common share. 2012 PSUs In the first quarter of 2013, the Board of Directors assessed the PSU Objectives at the end of the performance period, December 31, 2012 and determined that 2,116,728 of the 3,102,432 PSUs granted on March 29, 2012 were Earned PSUs (2012 PSUs). These 2012 PSUs have an aggregate value of $201. During the year ended December 31, 2012, $99 of the aggregate value of the expected Earned PSUs was recognized as compensation expense with a corresponding credit to contributed surplus. The remaining aggregate value of $102 will be amortized over the remaining vesting periods. 2011 PSUs In 2012, the Board of Directors assessed the PSU Objectives at the end of the performance period, December 31, 2011 and determined that 1,813,354 of the 2,479,800 PSUs granted on February 4, 2011 were Earned PSUs (2011 PSUs). These 2011 PSUs have an aggregate value of $281. During the year ended December 31, 2012, $56 of the aggregate 84 Nuvo Research Inc. Annual Report 2012 value of the 2011 PSUs was recognized as compensation expense with a corresponding credit to contributed surplus [$196 for the year ended December 31, 2011]. As at December 31, 2012, 1,208,900 of the 2011 PSUs had vested and were issued in common shares with $188 transferred from contributed surplus to common shares. The remaining aggregate value for the 2011 PSUs of $29 will be amortized over the remaining vesting period. 2010 PSUs In 2010, the Board of Directors assessed the PSU Objectives at the end of the performance period, December 31, 2010 and determined that 918,820 of the 1,312,600 PSUs granted on May 26, 2010 were Earned PSUs (2010 PSUs). These 2010 PSUs had an aggregate value of $197. During the year ended December 31, 2012, $25 of the aggregate value of the 2010 PSUs was recognized as compensation expense with a corresponding credit to contributed surplus [$83 for the year ended December 31, 2011]. As at December 31, 2012, 876,545 of the 2010 PSUs had vested and were issued in common shares with $64 transferred from contributed surplus to common shares. In addition, 42,280 PSU’s were forfeited. The 2010 PSUs are now fully amortized and issued in 2012. Number of PSUs (000s) Balance, December 31, 2011 Common shares issued Unearned units Granted 2,765 (1,494) (1,652) 3,102 Balance, December 31, 2012 2,721 Deferred Share Unit Plan On January 1, 2009, the Company established the DSU Plan, a share-based compensation plan for non-employee directors. Under the DSU Plan, non-employee directors can be allotted and can elect to receive a portion of their annual retainers and other Board-related compensation in the form of DSUs. One DSU has a cash value equal to the market price of one of the Company’s common shares and the number of DSUs issued to a director’s DSU account for any payment is determined using the five-day volume weighted average price of the Company’s common shares immediately preceding the payment date. Upon issuance, the fair value of the DSUs is recorded as compensation expense and the DSU Accrual is established. At all subsequent reporting dates, the DSU Accrual is adjusted to the market value of the underlying shares and the adjustment is recorded as compensation cost. Within a specified time after retirement, non-employee directors receive a cash payment equal to the market value of their DSUs. For the year ended December 31, 2012, $129 was recorded in G&A expenses as compensation expense related to DSUs. The charge for the year ended December 31, 2012 consisted of $100 for the fair value of the DSU’s issued to directors as a portion of their annual director fees, combined with a $29 increase in the aggregate DSU Accrual to the market value of the underlying shares at December 31, 2012. The DSU accrual is included in accounts payable and accrued liabilities. The following table summarizes the outstanding DSUs and related accrual held by directors: Number of DSUs (000s) Average Market Value $ Accural $ Balance, January 1, 2011 Issued for directors’ fees Adjustment to market value 916 537 – 0.150 0.141 – 137 76 (140) Balance, December 31, 2011 Issued for directors’ fees Adjustment to market value 1,453 1,920 – 0.050 0.052 – 73 100 29 Balance, December 31, 2012 3,373 0.060 202 Nuvo Research Inc. Annual Report 2012 85 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars Summary of Stock-Based Compensation Year ended December 31, 2012 $ Year ended December 31, 2011 $ Stock option compensation expense under the Share Option Plan DSUs – issued for settlement of directors’ fees DSUs – adjustment to market value Shares issued to employees under the Share Purchase Plan PSU compensation expense under the Share Bonus Plan Professional fees settled in shares 339 100 29 61 180 25 209 76 (140) 18 279 – Stock-based compensation expense 734 442 Recorded in the Consolidated Statement of Loss and Comprehensive Loss as follows: Cost of goods sold Research and development expenses Selling and marketing expenses General and administrative expenses 17 128 23 566 14 134 6 288 734 442 16. NET LOSS PER COMMON SHARE The following table presents the maximum number of shares that would be outstanding if all dilutive and potentially dilutive instruments were exercised or converted as at: Common shares issued and outstanding ZARS Contingent Consideration of common shares (note 4) Stock options outstanding (note 15) PSUs outstanding (note 15) 86 Nuvo Research Inc. Annual Report 2012 December 31, 2012 (000s) December 31, 2011 (000s) 567,792 – 49,129 2,721 563,954 101,370 42,668 2,765 619,642 710,757 1 7 . E X P E N S E S B Y N AT U R E The Consolidated Statements of Loss and Comprehensive Loss include the following expenses by nature: (a) Employee costs: Year ended December 31, 2012 $ Year ended December 31, 2011 $ 9,723 577 51 38 10,275 474 20 653 10,389 11,422 1,951 3,668 691 4,079 2,130 4,531 468 4,293 10,389 11,422 Year ended December 31, 2012 $ Year ended December 31, 2011 $ Cost of goods sold Research and development expenses General and administrative expenses (i) 244 150 280 319 179 206 Total depreciation and amortization 674 704 Short-term employee wages, bonuses and benefits Share-based payments Post-employment benefits Termination benefits Total employee costs Included in: Cost of goods sold Research and development expenses Selling and marketing expenses General and administrative expenses Total employee costs (b) Depreciation and amortization: (i) G&A expenses include $188 of amortization of intangible assets for the year ended December 31, 2012 [2011 – $93]. 1 8 . N E T C H A N G E I N N O N - C A S H W O R K I N G C A P I TA L The net change in non-cash working capital consists of: Year ended December 31, 2012 $ Year ended December 31, 2011 $ Accounts receivable Inventories Other current assets Accounts payable and accrued liabilities (233) 553 243 (1,911) (467) 152 1,118 (2,721) Net change in non-cash working capital (1,348) (1,918) Nuvo Research Inc. Annual Report 2012 87 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars 1 9 . I N C O M E TA X E S Deferred Tax Assets and Liabilities Deferred income taxes represent the net tax effects of temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The following represents deferred tax assets which have not been recognized in these Consolidated Financial Statements: Year ended December 31, 2012 $ Year ended December 31, 2011 $ Non-capital loss carryforwards U.S. Federal and State research and development credits Canadian Scientific Research and Experimental Development (SR&ED) expenditure pool carryforward Investment tax credits Financing costs Tax basis of property, plant and equipment and intangibles in excess of accounting value Deferred revenue Other 25,039 1,047 23,604 1,070 2,097 1,784 24 2,032 1,879 16 2,365 53 10 282 196 27 Deferred tax assets not recognized 32,419 29,106 A reconciliation between the Company’s statutory and effective tax rates is presented below: Year ended December 31, 2012 % Statutory rate Items not deducted for tax Impact of foreign income tax rate differential Revaluation of future taxes as a result of enacted tax rate changes Unrecognized benefit of current year’s tax loss and other Other 88 Nuvo Research Inc. Annual Report 2012 Year ended December 31, 2011 % 26.6 (4.4) 17.5 4.4 (44.1) (1.5) 28.3 9.0 0.7 (1.9) (36.1) (1.4) (1.5) (1.4) Loss Carryforwards and Canadian SR&EDs The Company and its subsidiaries have non-capital losses available for carryforward to reduce future years’ taxable income, the benefit of which has not been recorded. These losses and the related future tax asset by jurisdiction are as follows: Canada Canada United States (i) United States (ii) United States Switzerland Germany Expiry Period Non-capital losses $ Future tax asset $ 2013 to 2015 2026 to 2032 2025 2023 to 2029 2026 to 2032 2013 to 2019 Indefinite 3,110 46,825 21 6,720 18,640 8,138 2,897 827 12,474 7 2,677 7,425 789 840 86,351 25,039 (i) These U.S. losses carried forward relate to losses acquired upon the purchase of fqubed in 2005. Due to the acquisition of control of this entity, there are restrictions imposed on the use of these losses. (ii) These U.S. losses carried forward relate to losses acquired upon the purchase of ZARS in 2011. Due to the acquisition of control of this entity, there are restrictions imposed on the use of these losses. The Company has approximately $7.9 million of Canadian SR&ED expenditures for federal tax purposes that are available to reduce taxable income in future years and have an unlimited carryforward period, the benefit of which has not been reflected in these financial statements. SR&ED expenditures are subject to audit by the tax authorities and accordingly, these amounts may vary. The Company has net capital losses of $6.2 million in Canada available to offset net taxable capital gains in future years which have not been recognized. Government Assistance A portion of the Company’s R&D expenditures are eligible for Canadian federal investment tax credits that it may carryforward to offset any future Canadian federal income tax payable as follows: Year of credit December December December December December 31, 31, 31, 31, 31, 2005 2006 2007 2008 2009 Amount $ Year of Expiry 438 688 335 420 323 2015 2026 2027 2028 2029 2,204 The benefits of these non-refundable Canadian federal investment tax credits have not been recognized in the financial statements. Nuvo Research Inc. Annual Report 2012 89 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars 20. COMMITMENTS Commitments The Company has commitments under research and other service contracts and minimum future rental payments under operating leases for the years ending December 31 as follows: Research and Other Service Contracts (i) $ 2013 2014 2015 2016 2017 and thereafter Operating Leases $ Total $ 1,628 114 – – – 213 68 43 24 24 1,841 182 43 24 24 1,742 372 2,114 (i) Included under the caption “Research and Other Service Contracts” are commitments totaling $159 that the Company made for services that are reimbursable under the terms of the U.S. Licensing Agreement with Mallinckrodt. For the year ended December 31, 2012, payments under operating leases totaled $215 [2011 – $343]. Under the terms of a 2009 agreement to purchase rights to reference proprietary research, the Company may be required to make a future payment not exceeding US$500, if a specific milestone is achieved. Under the terms of the U.S. Licensing Agreement, Covidien must reimburse the Company for this payment. In three separate transactions, the first of which closed on August 16, 2005, the Company completed the sale of 100% of the common shares of Dimethaid Health Care Limited to Paladin and the transfer of Canadian sales and marketing rights for Pennsaid to Paladin. Among other things, as part of these arrangements, Nuvo is contractually obligated to manufacture Pennsaid for Paladin. Paladin is also entitled to receive a 0.5% royalty from Nuvo on all U.S. Pennsaid revenue the Company receives until February 28, 2014, including royalties and any future milestone payments, if any. Under the terms of the U.S. Licensing Agreement, the Company manufactures and supplies Pennsaid to Mallinckrodt. The price is subject to semi-annual price adjustments based upon raw material increases and changes in the level of an agreed upon price index subject to an annual cap. The Company has a long-term supply agreement with a third-party manufacturer for the supply of dimethyl sulfoxide, one of its key raw materials, for an initial term which extended through October 31, 2012. The agreement automatically renews for successive three-year terms, unless terminated in writing by either party at least 12 months prior to the expiration of the initial term or any successive term. The agreement was not terminated by either party so it has automatically renewed through October 31, 2015. The agreement obligates the Company to purchase 100% of its dimethyl sulfoxide requirements from the third party at specified pricing, but does not contain any minimum purchase commitments. The Company has a long-term supply agreement with a third-party manufacturer for the supply of diclofenac sodium, one of its key raw materials, for an initial term extending through October 31, 2012. The agreement obligates the Company to purchase a declining fixed percentage of its annual U.S. requirements for diclofenac sodium from the third party at specified pricing, but does not contain any minimum purchase commitments. Under the terms of a government reimbursement agreement in Europe, the Company has committed to maintain a minimum employee level over three years commencing with its first claim for reimbursement under the agreement. Under certain licensing agreements, the Company may be required to make payments upon the achievement of specific developmental, regulatory or commercial milestones. As it is uncertain if, and when, these milestones will be achieved, the Company did not accrue for any of these payments at December 31, 2012 or 2011. Under certain licensing agreements, the Company is required to make royalty payments to two companies for a combined 2.5% of annual net sales of Synera and Pliaglis. 90 Nuvo Research Inc. Annual Report 2012 Under the terms of the 2004 agreement and as reiterated in the 2011 agreement to purchase the non-controlling interest in Nuvo Research AG (see Note 5), the Company is obligated to pay 6% of future WF10 licensing and royalty revenue and 6% of proceeds received from the sale of any portion of Nuvo Research AG. No amounts have been paid or are payable. Guarantees The Company periodically enters into research, licensing, distribution or supply agreements with third parties that include indemnification provisions that are customary in the industry. These guarantees generally require the Company to compensate the other party for certain damages and costs incurred as a result of third-party intellectual property claims or damages arising from these transactions. In some cases, the maximum potential amount of future payments that could be required under these indemnification provisions is unlimited. These indemnification provisions generally survive termination of the underlying agreements. The nature of the intellectual property indemnification obligations prevents the Company from making a reasonable estimate of the maximum potential amount it could be required to pay. Historically, the Company has not made any indemnification payments under such agreements and no amount has been accrued in the accompanying Consolidated Financial Statements with respect to these indemnification obligations. 21. FINANCIAL INSTRUMENTS AND RISK MANAGEMENT Fair Values IFRS 7 Financial Instruments: Disclosures requires disclosure of a three-level hierarchy that reflects the significance of the inputs used in making fair value measurements. Fair values of assets and liabilities included in Level 1 are determined by reference to quoted prices in active markets for identical assets and liabilities. Assets and liabilities in Level 2 include those where valuations are determined using inputs other than quoted prices for which all significant outputs are observable, either directly or indirectly. Level 3 valuations are those based on inputs that are unobservable and significant to the overall fair value measurement. The Company assessed its financial instruments that are reported at market value, cash and cash equivalents of $12.1 million and determined that they are based on Level 1 inputs. The Company has determined the estimated fair values of its financial instruments based on appropriate valuation methodologies. However, considerable judgment is required to develop these estimates. Accordingly, these estimated values are not necessarily indicative of the amounts the Company could realize in a current market exchange. The estimated fair value amounts can be materially affected by the use of different assumptions or methodologies. The methods and assumptions used to estimate the fair value of each class of financial instruments are discussed below. The fair values of short-term financial assets and liabilities, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities as presented in the Consolidated Statements of Financial Position approximate their carrying amounts due to the short period to maturity of these financial instruments. Rates currently available to the Company for long-term obligations, with similar terms and remaining maturities, have been used to estimate the fair value of the finance lease and other obligations. These fair values approximate the carrying values for all instruments. FINANCIAL RISK MANAGEMENT Risk Factors The following is a discussion of credit, liquidity, interest and currency risks and related mitigation strategies that have been identified. This is not an exhaustive list of all risks nor will the mitigation strategies eliminate all risks listed. Credit Risk The Company’s cash and cash equivalents subject the Company to a significant concentration of credit risk. At December 31, 2012, the Company had $10.7 million invested with one financial institution in various bank accounts as per its practice of protecting its capital rather than maximizing investment yield through additional risk. This financial institution is a major Canadian bank which the Company believes lessens the degree of credit risk. The remaining $1.4 million of cash and cash equivalent balances are held in bank accounts in various geographic regions outside of Canada. Nuvo Research Inc. Annual Report 2012 91 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars The Company, in the normal course of business, is exposed to credit risk from its global customers most of whom are in the pharmaceutical industry. The accounts receivable are subject to normal industry risks in each geographic region in which the Company operates. In addition, the Company is exposed to credit related losses on sales to its customers outside North America and the E.U. due to potentially higher risks of enforceability and collectability. The Company attempts to manage these risks prior to the signing of distribution or licensing agreements by dealing with creditworthy customers; however, due to the limited number of potential customers in each market, this is not always possible. In addition, a customer’s creditworthiness may change subsequent to becoming a licensee or distributor and the terms and conditions in the agreement may prevent the Company from seeking new licensees or distributors in these territories during the term of the agreement. At December 31, 2012, the Company’s four largest customers located in North America and the E.U. represent 79% [2011 – 85%], of accounts receivable, and accounts receivable from customers located outside of North America and the E.U. represent 12% [2011 – 7%], of accounts receivable. Pursuant to their collective terms, accounts receivable were aged as follows: Year ended December 31, 2012 $ Year ended December 31, 2011 $ 2,938 543 208 82 3,301 162 226 11 3,771 3,700 Current 0-30 days past due 31-60 days past due 61-90 days past due As at March 27, 2013, $486 of the past due amounts have been collected. Liquidity Risk While the Company has $12.1 million in cash and cash equivalents at December 31, 2012, it continues to have an ongoing need for substantial capital resources to research, develop, commercialize and manufacture its products and technologies. Other than in the U.S. and Canada, the Company has limited participation in Pennsaid sales revenues in countries where it is currently marketed. In Canada, the Company receives royalties based on Canadian net sales, but the market is relatively small. These funds are used entirely towards repayment of the Paladin Debt. In the U.S., the Company receives royalties based on U.S. net sales at rates consistent with industry standards and has the opportunity to earn up to $100 million in sales milestones. However, Pennsaid is subject to generic risk in the U.S. as three companies have filed ANDAs in the U.S. (one in early 2013) for approval to market a generic version of Pennsaid. Although the Company and Mallinckrodt have filed patent infringement complaints with the courts against two of the generic companies and settled with one, a launch of a generic in the U.S. would materially impact revenues and as described in Note 12(i). A generic version of Pennsaid available for commercial sale in the U.S. may trigger an event of default on the Paladin Debt. In addition, minimal revenues are being generated by Synera and Pliaglis, the two key products added through the acquisition of ZARS. The commercial success for Synera has been limited, as are the royalties generated by the European marketing partner. While the Company has licensed Pliaglis’ worldwide rights to Galderma, Pliaglis was recently approved in 2012 in a number of European countries and the U.S. and just recently launched in the U.S. and the European launch will occur in the second quarter of 2013. Pliaglis is not yet generating any significant royalty revenue for the Company. As a result, the Company’s revenues may not be sufficient to provide the capital required for the Company to be self-sustaining without the need for future financings. The Company has contractual obligations related to accounts payable and accrued liabilities, purchase commitments and finance lease and other obligations of $7.1 million that are due in less than a year and $1.8 million of contractual obligations that are payable from 2014 to 2015. 92 Nuvo Research Inc. Annual Report 2012 Interest Rate Risk All finance lease and other obligations are at fixed interest rates. Currency Risk The Company operates globally, which gives rise to a risk that earnings and cash flows may be adversely affected by fluctuations in foreign currency exchange rates. The Company is primarily exposed to the U.S. dollar and euro, but also transacts in other foreign currencies. The Company currently does not use financial instruments to hedge these risks. The significant balances in foreign currencies are as follows: Euros Cash and cash equivalents Accounts receivable Other current assets Accounts payable and accrued liabilities Finance lease and other obligations U.S. Dollars 2012 € 2011 € 2012 $ 2011 $ 1,620 523 138 (287) – 2,248 726 192 (475) – 6,360 2,579 – (1,220) (473) 4,482 2,260 623 (2,562) (525) 1,994 2,691 7,246 4,278 Based on the aforementioned net exposure as at December 31, 2012, and assuming that all other variables remain constant, a 10% appreciation or depreciation of the Canadian dollar against the U.S. dollar and euro would have resulted in (decreases) increases in total comprehensive loss as follows: Comprehensive Loss (Income) Canadian Dollar Versus U.S. dollar Versus euro Appreciates 10% Depreciates 10% 655 238 (801) (291) In terms of the euro, the Company has three significant exposures: its net investment and net cash flows in its European operations, its euro denominated cash and cash equivalents held in its Canadian operations and sales of Pennsaid by the Canadian operations to European distributors. In terms of the U.S. dollar, the Company has five significant exposures: its net investment and net cash flows in its U.S. operations, its U.S. dollar denominated cash and cash equivalents held in its Canadian operations, the cost of running trials and other studies at U.S. sites, the cost of purchasing raw materials either priced in U.S. dollars or sourced from U.S. suppliers that are needed to produce Pennsaid or other products at the Canadian manufacturing facility and revenue generated in U.S. dollars, including royalties and milestone payments received from licensing agreements with Mallinckrodt, Galderma and Eurocept and product sales to Mallinckrodt. The Company does not actively hedge any of its foreign currency exposures given the relative risk of currency versus other risks the Company faces and the cost of establishing the necessary credit facilities and purchasing financial instruments to mitigate or hedge these exposures. As a result, the Company does not attempt to hedge its net investment in foreign subsidiaries. The Company does not currently hedge its euro cash flows. Sales to European distributors for Pennsaid are primarily contracted in euros. The Company receives payments from the distributors in its euro bank accounts and uses these funds to pay euro denominated expenditures and to fund the net outflows of the European operations as required. Periodically, the Company reviews the amount of euros held, and if they are excessive compared to the Company’s projected future euro cash flows, they may be converted into U.S. or Canadian dollars. The Company does not currently hedge its U.S. dollar cash flows. The Company’s U.S. operations have net cash outflows and currently these are funded using the Company’s U.S. dollar denominated cash and cash equivalents and payments received under the terms of the U.S. Licensing Agreement. Periodically, the Company reviews its projected future U.S. dollar cash flows and if the U.S. dollars held are insufficient, the Company may convert a portion of its other currencies into U.S. dollars. If the amount of U.S. dollars held is excessive, they may be converted into Canadian dollars or other currencies as needed for the Company’s other operations. Nuvo Research Inc. Annual Report 2012 93 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars 2 2 . C A P I TA L M A N A G E M E N T The Company’s objectives in managing capital are to ensure sufficient liquidity to pursue the Company’s commercialization plans for Synera and its development plans for each of its other drug candidates and to maintain its ongoing operations. Product revenues from the Company’s approved drug products are not yet significant enough to fund ongoing operations. As a result, to secure the capital necessary to pursue its commercialization and development plans and fund ongoing operations, the Company will need to raise additional funds through the issuance of debt or equity, by entering into distribution and license agreements or by entering into co-development agreements. The Company currently defines its capital to include its cash and cash equivalents, finance lease obligations and shareholders’ equity excluding accumulated other comprehensive income. In the past, the Company has financed its operations primarily through the net proceeds received from the sale of common shares and warrants, issuance of secured debt and convertible debentures, finance lease obligations, proceeds from collaborative relationships and investment income earned on cash balances and short-term investments. The Company expects to utilize its cash and cash equivalents which were $12.1 million at December 31, 2012, revenue from its product sales and royalty payments and milestone payments relating to the approval and launch of Pliaglis in South America to fund its operations. The Company currently anticipates that its cash and cash equivalents, together with the revenues it expects to generate from product sales of Pennsaid and Synera, royalty payments from its Canadian and U.S. Pennsaid licensing agreements, milestone and royalty payments relating to Pliaglis will be sufficient to fund operations through 2013. Nonetheless, companies in the pharmaceutical industry typically require periodic funding in order to continue developing their drug candidate pipelines until they have successfully commercialized at least one of their drug candidates and receive sufficient ongoing revenue to fund their operations. Nuvo has not yet reached this stage and; therefore, the Company monitors on a regular basis, its liquidity position, the status of its commercialization efforts and those of its partners, the status of its drug development programs, including cost estimates for completing various stages of development, the scientific progress on each drug candidate, the potential to license or co-develop each drug candidate and continues to actively pursue fund-raising possibilities through various means, including the sale of its equity securities. There can be no assurance, especially considering the economic environment, that additional financing would be available on acceptable terms, or at all, when and if required. If adequate funds are not available when required, the Company may have to substantially reduce or eliminate planned expenditures, discontinue its marketing efforts for Synera in the U.S., terminate or delay clinical trials for its product candidates, curtail product development programs designed to expand the product pipeline or discontinue certain operations such as the Immunology Group. If the Company is unable to obtain additional financing when and if required, the Company may be unable to continue operations. 94 Nuvo Research Inc. Annual Report 2012 2 3 . S E G M E N T E D I N F O R M AT I O N Segments From a financial perspective, executive management uses the net loss before income taxes to assess the performance of each segment. The following tables show certain information with respect to operating segments: Year ended December 31, 2012 Total revenue (i) Depreciation of property, plant and equipment and amortization of intangibles Interest income Interest expense Net loss before income taxes (iii) (iv) Total assets Property, plant and equipment Additions to property, plant and equipment Year ended December 31, 2011 Total revenue (i) Depreciation of property, plant and equipment and amortization of intangibles Interest income Interest expense Net loss before income taxes (iii) Total assets Property, plant and equipment Additions to property, plant and equipment (ii) (i) (ii) (iii) (iv) Pain $ Immunology $ Total $ 23,986 664 24,650 620 761 381 (10,295) 26,370 1,560 141 54 (745) – (3,072) 2,115 54 8 674 16 381 (13,367) 28,485 1,614 149 $ $ $ 16,026 707 16,733 604 577 8 (2,806) 43,728 1,859 600 100 (425) – (3,921) 1,126 101 18 704 152 8 (6,727) 44,854 1,960 618 The Immunology segment currently derives all of its revenue from product sales. Additions to PP&E include equipment acquired through the ZARS Acquisition. The gain on ZARS Contingent Consideration restated in both 2011 and 2012 is included in the Pain segment. The impairment charge of intangible assets and goodwill is included in the Pain segment. Geographic Information The Company’s revenue is derived from sales to and licensing revenue derived from external customers located in the following geographic areas: United States Europe Canada Other foreign countries Year ended December 31, 2012 $ Year ended December 31, 2011 $ 12,298 9,217 2,493 642 9,237 4,534 2,285 677 24,650 16,733 Nuvo Research Inc. Annual Report 2012 95 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars The geographic location of the Company’s PP&E is as follows as at: Canada United States Europe December 31, 2012 $ December 31, 2011 $ 1,515 45 54 1,785 75 100 1,614 1,960 Significant Customers For the year ended December 31, 2012, the Company’s four largest customers, all of which are customers of the Pain segment, represent 89% [2011 – 83%] of total revenue and the Company’s largest customer represents 42% [2011 – 51%] of total revenue. 2 4 . R E L AT E D PA RT Y T R A N S A C T I O N S Key Management Compensation Key management personnel are those persons having authority and responsibility for planning, directing and controlling the activities of the Company, including directors. Key management includes seven executive officers and five non-employee directors. Compensation for the Company’s key management personnel was as follows: Year ended December 31, 2012 $ Year ended December 31, 2011 $ Short-term wages, bonuses and benefits Post-employment benefits Share-based payments Termination benefits 2,917 12 483 – 3,356 7 465 297 Total key management compensation 3,412 4,125 Included in: Research and development General and administrative expenses 500 2,912 1,089 3,036 Total key management compensation 3,412 4,125 Other transactions The Company has a consulting arrangement with one of its independent directors. During 2012, consulting expenses totaled $37 (2011 – $68). 96 Nuvo Research Inc. Annual Report 2012 25. CONTINGENCIES Leadenhall In July 2003, a $2.0 million short-term loan was extended to the Company by Leadenhall Bank & Trust Company Limited (the Mortgagee). The terms of this loan were for interest to accrue at 2% per month and for full repayment to occur on May 31, 2004. The repayment date was extended on two occasions; first to September 30, 2004 and subsequently to February 28, 2005. The loan was collateralized by a subsidiary of the Company through a $2.0 million mortgage charge (the Mortgage) on the Company’s former head office. In 2005 a dispute surrounding the Mortgage arose between the parties. The Mortgage dispute centered on the calculation and amount of interest owing and was the subject of an Ontario court action (the Ontario Action) commenced by the Mortgagee in April 2005. The Mortgagee’s position was that interest should be calculated monthly at a rate of 2% per month, including interest on late payments and costs. The Company’s position was that the Mortgage was null and void and should be discharged or alternatively, that the interest payable was limited to 5% per annum pursuant to the provisions of the Interest Act (Canada). Subsequent to the filing by the Mortgagee of its Statement of Claim and the Company of its Statement of Defense and Counterclaim, the Mortgagee was placed into voluntary liquidation by its shareholders and a liquidator (the Liquidator) was appointed in the Bahamas, where the Mortgagee is situated to settle the affairs on the Mortgage. The Ontario Action was subsequently dismissed by the courts for delay. In November of 2005, the Company negotiated a written agreement (the Settlement Agreement) with the Liquidator to settle all claims pursuant to the Ontario Action for US$1.1 million (the Settlement Amount) payable out of closing funds received on the sale of the Company’s former head office. The Settlement Agreement was subject to the approval of the Bahamian court that appointed the Liquidator. The Liquidator agreed to seek court approval as soon as possible after signing the Settlement Agreement. The Liquidator did not seek court approval prior to the completion of the head office sale, and in order to allow the sale to proceed, the Liquidator and the Company entered into an escrow arrangement (the Escrow Agreement). Pursuant to the Escrow Agreement, the Liquidator agreed that upon payment of US$1.4 million (the Escrow Amount) to the Liquidator, to be held in escrow pending court approval of the Settlement Agreement, the Liquidator would deliver a discharge of the Mortgage. It was further agreed that upon approval of the Settlement Agreement by the Bahamian Court the Settlement Amount would be released from escrow and paid to the Liquidator and the balance, US$303, would be released to the Company (the Excess Amount). In January 2006, the Liquidator discharged the mortgage, the Company completed the sale of its head office and it paid the Escrow Amount into escrow with the Liquidator’s Bahamian counsel. Subsequent to receipt of the Escrow Amount, the Liquidator continually delayed seeking court approval of the Settlement Agreement and has not yet presented it to the Bahamian court for approval. Since April 2006, the Liquidator indicated that while still intending to present the Settlement Agreement to the court for its consideration, it would not recommend that the court approve it. In addition, in its February 2007 Affidavit, the Liquidator indicated that if the Court did not approve the Settlement Agreement, it would request that the Bahamian court order that all escrowed funds, including the Excess Amount be released to it and not to the Company. The Liquidator further stated that the full amount in escrow was insufficient to retire the mortgage principal, plus interest at the alleged interest rate of 2% per month and that it may pursue the Company for the deficiency. The Company retained legal counsel in the Bahamas to assist it in securing court approval of the Settlement Agreement and to ensure that if the Settlement Agreement was not approved, that the escrow continues in accordance with the terms of the Escrow Agreement. A hearing in the Bahamian court was held in March 2007. At this hearing, the Liquidator submitted additional arguments to the Bahamian court requesting that all matters, including those that form the basis of the Ontario Action, be decided by the Bahamian court. While this request was not ruled upon, the judge issued an order that the escrow funds continue to be held in escrow for at least 90 days to provide the Company the opportunity to bring an action in the Bahamian courts for the release of the funds based upon the non-ratification of the Settlement Agreement. The judge retired shortly thereafter and the case was not reassigned to another judge for over a year. Nuvo Research Inc. Annual Report 2012 97 Notes to Consolidated Financial Statements Unless noted otherwise, all amounts shown are in thousands of Canadian dollars As a result, the Company was not able to bring its action to release the escrow funds to it before the Bahamian courts. In June 2007, the Company’s Bahamian legal counsel filed a summons in the Leadenhall liquidation proceedings requesting that the Company be granted leave to join the liquidation as an interested party. The Summons was served on the Liquidator in June 2007 and required that the Company be notified if the Liquidator intended to make application to have the escrow funds released to it. Since June 2007, the shortage of commercial judges available to hear the case and a lack of co-operation by the Liquidator hindered the Company’s Bahamian legal counsel’s efforts to obtain a date for a hearing at which a judge could consider the Settlement Agreement. Late in 2008, the Company’s Bahamian legal counsel informed the Company that a commercial court judge had been assigned to handle all aspects of the Leadenhall liquidation; however, early in 2009, prior to obtaining a hearing, this judge resigned from the Bench and the case had not yet been assigned to another judge. Given these delays, the Company through its Bahamian legal counsel, reinitiated dialogue with the Liquidator’s counsel in 2009 and presented a proposal aimed at resolving all outstanding matters between the Company and the Liquidator, if acceptable, the parties would jointly approach the courts to seek its approval. The Company did not receive a response to its proposal from the Liquidator’s counsel and subsequently learned that the Liquidator had switched legal counsel (Liquidator’s New Counsel). In November 2010, the Company, the Liquidator and the Liquidator’s New Counsel restarted discussions aimed at resolving all outstanding matters between the Company and the Liquidator and in 2011 were able to reach a settlement agreement (2011 Settlement Agreement). In December 2011, the Bahamian court approved the 2011 Settlement Agreement. Under the terms of the 2011 Settlement Agreement, the funds remaining in escrow were split between the Company and the Liquidator with the Company’s apportionment estimated at approximately $0.3 million (Settlement Amount). In 2012, the Court signed an Order that approved settlement terms agreed to by the Company and the Liquidator. The Company and the Liquidator executed a mutual release agreement and the Settlement Amount was received and recorded in income. 2 6 . R E S TAT E M E N T O F Z A R S C O N T I N G E N T C O N S I D E R AT I O N The Company recognized a liability for contingent consideration with a fair value of $5,084 in relation to the acquisition of ZARS on May 12, 2011, the acquisition date. The contingent consideration was originally structured as promissory notes payable to the former shareholders of ZARS, contingent on achievement of certain separate milestones as described in the merger agreement. The structure allowed the Company to seek shareholder approval for the issuance of additional shares, in lieu of promissory notes. The Company’s shareholders approved the conversion of the promissory notes payable into contingent shares at the Company’s Annual and Special Meeting of Shareholders on June 21, 2011. The Company accounted for this conversion by derecognizing the liability and recording the value of the potentially issuable shares in contributed surplus, a component of equity. The Company revalued the consideration at $3,314, based on the Company’s share price on the date of shareholder approval. This resulted in a gain of $1,770 representing the difference between the fair value of the ZARS Contingent Consideration derecognized as a liability, in the amount of $5,084, and the fair value of the equity recorded in contributed surplus, in the amount of $3,314. The Company; therefore, incorrectly applied IAS 32 Financial Instruments: Presentation, because upon conversion to contingent shares, the contingent consideration continued to meet the definition of a financial liability. Management had interpreted the separate milestones as discrete targets, independent of one another, issuing a fixed number of the Company’s common shares per milestone. However, the merger agreement, as legally written, required the achievement of the Pliaglis milestone to be complete in order for the achievement of the triggering mechanisms in each of certain other milestones to warrant delivery of their respective contingent shares. As these milestones are interdependent, a variable number of shares may be delivered. Accordingly, the classification of the obligation should be based on the overall arrangement, and since the arrangement calls for a variable number of shares to be delivered, IAS 32 deems the arrangement to be classified as a financial liability and revalued at each reporting period thereafter. 98 Nuvo Research Inc. Annual Report 2012 As at June 21, 2011, the Company restated the contributed surplus of $3,314 as a liability, and recorded changes in income (loss) based on changes in the Company’s share price in future reporting periods and the corresponding probability to achieving the milestones. When one of the milestones was achieved in October 2011, as noted above, the $137 debit to contributed surplus would have reduced the liability from $3,314 to $3,177. Therefore, the effect of the restatement on the Company’s Consolidated Financial Statements as at, and for year ended December 31, 2011 was as follows: December 31, 2011 ZARS Contingent Consideration liability Contributed surplus Deficit Gain on ZARS Contingent Consideration Net loss Net loss per common share – basic and diluted Previously presented $ Adjustment $ Restated $ – 16,405 (208,465) (1,770) (7,708) 2,300 (3,177) 877 (877) 877 2,300 13,228 (207,588) (2,647) (6,831) (0.016) 0.002 (0.014) As at December 31, 2012, the remaining milestones for the ZARS Contingent Consideration were not achieved, and the liability was derecognized resulting in an accumulated gain of $2,300 for the year then ended. Accordingly, the respective fiscal 2011 and 2012 gains recorded on the ZARS Contingent Consideration were non-cash, and by the end of the year ended December 31, 2012 total equity remained unchanged. Nuvo Research Inc. Annual Report 2012 99 Corporate Information HEAD OFFICE TRANSFER AGENT/REGISTRAR C O R P O R AT E G O V E R N A N C E 7560 Airport Road, Unit 10 Mississauga, Ontario, Canada L4T 4H4 Tel. (905) 673-6980 Fax. (905) 673-1842 Email: [email protected] Website: www.nuvoresearch.com Common Shares CIBC Mellon Trust Company c/o Canadian Stock Transfer Company Inc. P.O. Box 700, Station B Montreal, QC H3B 3K3 Canada Telephone: 1 (800) 387-0825 or (416) 682-3860 Fax: 1 (888) 249-6189 Email: [email protected] Website: www.canstockta.com A statement of the Company’s current corporate governance practices is contained in the management information circular and proxy statement for the June 18, 2013 Annual and Special Meeting of Shareholders. The Company’s website www.nuvoresearch.com contains the Company’s corporate governance documents including Code of Conduct and Business Ethics, Corporate Disclosure Policy, Insider Trading Policy and Audit Committee Charter. STOCK EXCHANGE LISTING The Toronto Stock Exchange Symbol: NRI We invite you to the Annual and Special Meeting of Shareholders AUDITORS Ernst & Young LLP Chartered Accountants Toronto, Canada I N V E S T O R R E L AT I O N S Email: [email protected] LEGAL COUNSEL Tuesday, June 18, 2013 9:00 a.m. ET DoubleTree by Hilton Toronto Airport 655 Dixon Road, Toronto, Ontario Goodmans LLP Toronto, Canada Board of Directors and Executive Officers Daniel N. Chicoine BComm, CA Chairman & Co-Chief Executive Officer Stephen L. Lemieux BA, MMPA, CA Vice President & Chief Financial Officer John C. London LLB, LLM Director President & Co-Chief Executive Officer Tina K. Loucaides MSc, LLB Vice President, Secretary & General Counsel Bradley S. Galer MD President, Pain Group Henrich R.K. Guntermann MD, MSc Director President, Europe & Immunology Group 100 Nuvo Research Inc. Annual Report 2012 David A. Copeland BMath, CA Director – Chair of the Audit Committee Anthony E. Dobranowski Director Jacques Messier DVM, MBA Director – Chair of the Compensation & Corporate Governance Committee Theodore H. Stanley Director MD Klaus von Lindeiner Dr en droit (University of Geneva) BSc, MBA, CA Director F O R WA R D - L O O K I N G S TAT E M E N T S Certain information in this document may constitute forward-looking statements and information within the meaning of applicable securities legislation. These forward-looking statements reflect the current beliefs of Nuvo’s management and are based on assumptions and information currently available to the management team of Nuvo. In some cases, forward-looking statements can be identified by terminology such as “may”, “will”, “expect”, “plan”, “anticipate”, “believe”, “intend”, “estimate”, “predict”, “forecast”, “outlook”, “potential”, “continue”, “should”, “likely”, or the negative of these terms or other comparable terminology. Although management of Nuvo believes that the anticipated future results, performance or achievements expressed or implied by the forward-looking statements and information in this document are based upon reasonable assumptions and expectations, readers of this document and prospective investors should not place undue reliance on such forward-looking statements and information because they involve assumptions, known and unknown risks, uncertainties and other factors which may cause the actual results, performance or achievements of Nuvo to differ materially from anticipated future results, performance or achievements expressed or implied by such forward-looking statements and information. Various factors, in addition to those discussed elsewhere in this document, that could affect the future results of Nuvo and could cause actual results to differ materially from those expressed in the forward-looking statements and information include, but are not limited to: the need for additional financing; the current economic environment; the dependence on sales and marketing partnerships; generic drug manufacturers; the regulatory environment; obtaining governmental and regulatory approvals; changes in government regulation; competitive developments; healthcare reform in the United States; sales, marketing and distribution of Synera® in the United States; manufacturing and supply risks; the availability of government assistance; the protection of patents, trademarks and proprietary technology; the ability to protect know how and trade secrets; the inability to achieve drug development goals within expected time frames; the uncertainty of drug and research development; risks related to clinical trials; patient enrolment not being adequate for current trials or future clinical trials; rapid technological change making products or drug delivery technologies obsolete; reliance on third parties to conduct clinical and preclinical studies; prolonged development time; competition for Pennsaid®; competition for Synera®; competition for Pliaglis®; competition for WF10™; products failing to achieve market acceptance; publications of negative study or clinical trial results; reimbursement and product pricing; the “off-label” promotion of drugs; potential product liability; hazardous materials and environmental risks; operating losses; quarterly fluctuations; impairment of goodwill and intangible assets; loss of personnel; failure of information technology infrastructure; litigation and regulation risks; the acquisition and integration of complementary technologies or businesses; the inability to realize the anticipated benefits from the acquisition of ZARS Pharma, Inc. (“ZARS”); the inability to achieve expected savings from restructurings; losses due to foreign currency fluctuations; business risks relating to international operations; tax-related risks; public company requirements straining resources; volatility of share price; dilution from further equity financings and declining share price; the issuance of preferred shares; the absence of dividends; the availability of an active trading market for the common shares; the Company’s shareholders’ rights plan; securities industry analyst research reports; compliance with laws and regulations affecting public companies; the failure to effectively manage growth; and other risks and factors described from time-to-time in the documents filed by Nuvo with Canadian securities regulatory agencies and commissions, including the risk factors described in our annual information form dated March 27, 2013 (the “AIF”) under the heading “Risks Factors”. The forward-looking statements and information contained in this document are expressly qualified by this cautionary statement. Nuvo undertakes no obligation to publicly update or revise any forward-looking statements or information contained in this document, whether as a result of new information, future events or otherwise, except as required by law. 7560 Airport Road, Unit 10, Mississauga, Ontario, Canada L4T 4H4 Tel: (905) 673-6980 Fax: (905) 673-1842 www.nuvoresearch.com