EROX Human Pheromone Sciences Inc (GM)

INCOME TAXES

A provision for income taxes for the three month period ended March 31, 2008 was recorded for minimum tax liabilities incurred.  

A reconciliation of the effective tax and the statutory U.S. federal income tax is as follows (in thousands):

At December 31, 2007, the Company had federal and state net operating loss carryforwards of approximately $21,446,000 with $4,100,000 set to expire on December 31, 2008.  The Company also had at December 31, 2007 federal and state research and development tax carryforwards of approximately $176,000 with $28,000 to expire on December 31, 2008.  The remaining net operating loss and credit carryforwards will expire between 2009 and 2021.

 The utilization of certain of the loss carryforwards maybe limited under Section 382 of the Internal Revenue Code.  The Company has not finalized its study to assess whether an ownership change has occurred that would materially impact the utilization of NOLs. The work performed to date does not indicate a material limitation of any NOLs, however there may be additional ownership changes in the future, and any future change at its current market capitalization would severely limit the annual use of these NOLs going forward. Such limitation could also result in expiration of a portion of the NOLs before utilization. Further, until the study is completed and any limitations known, no amounts are being considered as an uncertain tax position or disclosed as an unrecognized tax benefit under FIN 48. Due to the existence of the valuation allowance, future changes in the Company’s unrecognized tax benefits will not impact its effective tax rate. Any NOLs that expire prior to utilization as a result of such limitations will be removed from deferred tax assets with a corresponding reduction of the valuation allowance.

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The Company believes that all of its tax positions are sustainable and that no significant adjustment to its unrecognized tax benefits is expected.  The majority of the unrecognized tax benefits relates to positions where only the timing of a deduction item is in question. Such liabilities are offset by deferred tax assets and the only effect on the Company's statements of operations relates to the interest accrued on such liabilities.

2.    SEGMENT INFORMATION

Sales by geographic markets for the three months ended March 31, 2008 and 2007 were as follows (in thousands):

3.    NEW ACCOUNTING PRONOUNCEMENTS

In March 2008, the FASB released FASB No. 161, Disclosures about Derivative Instruments and Hedging Activities – an amendment of FASB Statement No.133.  FAS No. 161 requires enhanced disclosures about an entity’s derivative instruments and hedging activities and thereby improves the transparency of financial reporting.  This statement is effective for financial statements issued for fiscal years and interim periods beginning after November 15, 2008.  Management does not believe the adoption of FAS No. 161 will have a material impact on the Company's financial position or results of operations.

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

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

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CRITICAL ACCOUNTING POLICIES

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

Stock Option Policy

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

The Company did not record the stock compensation expense net of taxes since there was no material provision for income taxes for the period ended March 31, 2008 as the Company incurred net operating losses for which no benefit was recognized, or utilized tax loss carryforwards.  The tax benefit is a component of the deferred tax asset disclosed in the income taxes footnote.

Use of Estimates

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

Revenue Recognition

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

Multiple-element arrangements are assessed to determine whether they can be separated into more than one unit of accounting.  A multiple-element arrangement is separated into more than one unit of accounting if all of the following criteria are met.

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

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

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

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If these criteria are not met, then revenues are deferred until such criteria are met or until the period(s) over which the last undelivered element is delivered.  If there is objective and reliable evidence of fair value for all units of accounting in an arrangement, the consideration is allocated to the separate units of accounting based on each unit’s relative fair value.

The agreement with Personal Products Company (hereinafter referred to as “PPC”) represents a multiple-element arrangement and includes post signing consulting support to PPC as needed to assist them in claims development and manufacturing processes, an exclusive right of first discussion for new compounds that the Company develops and documents supportable claims of effectiveness, and an exclusive right to our existing patented compounds in specific consumer product fields.  A portion of the initial payment received as part of the PPC agreement is being recognized as the Company incurs expenses and resources towards fulfilling the obligations to PPC, based on interpretative guidance provided by EITF 00-21.  

The PPC agreement was entered into on August 18, 2006 and will expire when the initial patents on the licensed technology expire, in December 2010 and March 2012.  For the services and rights granted in the agreement, the Company received an initial payment of $1,750,000 in September 2006 and will earn royalties on products developed and sold by PPC until the patents expire.  The Company records revenue for the consulting services and right of first discussions as the Company incurs expenses and resources towards fulfilling its obligations to PPC.  License revenue is being recognized on a straight-line basis over the life of the agreement of sixty-seven months and when periodic direct costs are incurred to maintain the license.  The Company began recognizing revenue from all three units during the quarter ending September 30, 2006.

A summary of the revenue recognized for these multiple units of accounting follows (in thousands):

The deferred revenue from the PPC license agreement as of March 31, 2008 was $966,000.

The Company granted Schwarzkopf & Henkel a non-exclusive license for the development, manufacture, sale and distribution of certain licensed hair styling products using the Company’s patented technology.   Schwarzkopf & Henkel paid a license fee of $20,000 plus royalties based on net sales of licensed products in specified countries.  The license was effective May 1, 2007 and expires on April 30, 2010.  The license was amended on February 15, 2008 to include other hair care products on a non-exclusive basis.

The $20,000 license fee is being recognized on a straight-line basis over the life of the license of thirty-six months.  There is no discernable service to be provided by the Company to warrant an alternative revenue recognition method.  The revenue recognized under this agreement for the three months ending March 31, 2008 was $23,000 consisting of royalties of $22,000 and amortization of the license fee of $1,000.  The deferred revenue from the  Schwarzkopf & Henkel  license as of March  31, 2008 was $15,000.

Income Taxes

The Company accounts for income taxes under SFAS 109 “ Accounting for Income Taxes ”.  Deferred tax assets are recognized for deductible temporary differences and operating loss and tax credit carryforwards, and deferred tax liabilities are recognized for taxable temporary differences. Temporary differences are the differences between the reported amounts of assets and liabilities in the Company’s financial statements and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that all or some portion of the deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects of changes in tax laws and rates on the date of enactment.

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

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

COMPANY OVERVIEW

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

Results of Operations

Three Months ended March 31, 2008 compared to the Three Months ended March 31, 2007

Net revenue for the quarters ended March 31, 2008 and 2007 were as follows (in thousands):

Total revenues for the first quarter of 2008 were $266,000, a $68,000 decrease from the prior year’s revenues of $334,000.  Revenues in each of the market segments declined in the current period due to specific customers not ordering as they had last year last year.   Domestic sales for the three months ended March 31, 2008 were $43,000 less than the prior year, primarily attributable to decreased pheromone reorders from one existing licensee.  International sales for the three months ended March 31, 2008 of $30,000 were $15,000 less than sales of $45,000 for the three months ended March 31, 2007, a result of a private label customer’s cyclical orders.  Existing international customer orders made up over half of the private label revenue that was recorded last year.   License revenue decreased by $10,000 to $125,000 for the three months ending March 31, 2008.

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Gross profit for the quarter ended March 31, 2008 of $185,000 is 18% less than the gross profit of $227,000 for the three months ended March 31, 2007.  As a percentage of revenues, gross profit of 70% for the first three months of 2008 was slightly higher than gross profit of 68% for the three months ended March 31, 2007.  Gross margin on product sales decreased to 78% for the first three months of 2008 from 81% for the first three months of 2007. The decreased product sales gross margin is due to an amendment with a licensee which reduced the supply price in exchange for an increased royalty rate.  The decrease in gross profit is attributed to the decreased revenues in the current quarter.

Research and development expenses for the first quarters of 2008 and 2007 were $14,000 and $12,000, respectively.  Research expenditures of $23,000 that were incurred for the three months ended March 31, 2008, and $35,000 incurred for the three months ended March 31, 2007, to support the PPC license have been charged as cost of goods sold. The total research and development costs incurred for the quarters, including the amount recorded as license costs, were $37,000 for the three months ended March 31, 2008, which was $10,000 less than the $47,000 incurred for the three months ended March 31, 2007.  Decreased consultant costs accounted for the reduced research and development spending.  Research and development on several new compounds, in addition to the two compounds noted in the PPC license, is on-going at a reduced basic funding level.

Selling, general and administrative expenses for the three months ended March 31, 2008 of $244,000 are $36,000 more than the $208,000 incurred for the three months ended March 31, 2007.  Selling, marketing and distribution expenses were $3,000 less than the prior year as the Company continues to focus on product licensing which is less promotionally intensive.    General and administrative and facility costs increased by $39,000, primarily a result of increases in audit and tax fees, stock option compensation costs and decreased costs being charged as cost of goods sold  to support the PPC license.

The Company earned $11,000 and $18,000 in net interest income during the three months ending March 31, 2008 and 2007, respectively.  The decreased earnings was due to decreasing interest rates and the Company’s reduction in cash balances.

The Company has recorded $1,000 minimum tax provisions for the quarters ended March 31, 2008 and 2007, due primarily to a valuation allowance on deferred tax assets being recorded and the expected utilization of net operating losses carried forward from prior years to offset any significant tax liability.  

LIQUIDITY AND CAPITAL RESOURCES

At March 31, 2008, the Company had cash of $1,397,000 with no outstanding bank borrowings and working capital of $878,000.  At December 31, 2007, it had cash of $1,437,000 with no outstanding bank borrowings and working capital of $1,009,000.  For the first three months of 2008, net cash used in on-going activities was $39,000 as compared to the prior year’s $82,000, an improvement of $43,000.  

Risk Factors

Our business is subject to various risks, including those described below.  You should carefully consider the following risk factors and all other information contained in this Form 10-Q. If any of the following events or outcomes actually occurs, our business, operating results, and financial condition would likely suffer.

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The Company has not had sustained profitable operations since 1997 and may need additional funding to continue operations.  Since 1997, the Company has incurred losses from operations.  In May 2000, the Company refocused its business model based on product licensing agreements.  While the Company anticipated that this change in its business will result in profitable operations, it has not to date, and the Company’s license based business model may not be successful in the future.  Although the Company’s current cash position and projected results of operations for the next twelve months are not expected to require additional outside financing, the Company is continuing to seek additional financing opportunities.  The Company may not be able to obtain such additional funding on commercially reasonable terms if such funding is required.

The Company’s marketing strategy may not be successful. The Company may not be able to establish and maintain the necessary sales and distribution channels.  Consumer product companies may choose not to license or private label the Company’s products.

The Company may not be able to protect its technology or trade secrets from others who choose to violate the Company’s patents.  The Company intends to protect and defend its patent rights from those who might violate them. However, the costs to defend and litigate may exceed the Company’s financial resources.

The Company may not be able to develop new patentable compounds.  The Company’s success substantially depends upon developing and obtaining patents for new mood and sensory enhancing compounds.   The Company requires that its products be scientifically tested validating the human responses to the compounds.  The Company may not be successful in validating that the desired human responses are obtained.

The Company may not be able to recruit and retain key personnel.  The Company’s success substantially depends upon recruiting and retaining key employees and consultants with research, product development and marketing experience.  The Company may not be successful in recruiting and retaining these key people.

The Company relies upon other companies to manufacture its products. The Company and its distributors/licensees rely upon other companies to manufacture its pheromones, supply components, and to blend, fill and package its fragrance products.  The Company and its distributors/licensees may not be able to obtain or retain pheromone manufacturers, fragrance suppliers, or component manufacturers on acceptable terms.   This would adversely affect operating results.

Item 4.  Controls and Procedures

Evaluation of Disclosure Controls and Procedures.  Based on our evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our chief executive officer and chief financial officer have concluded that our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms.

Changes in Internal Control Over Financial Reporting. There were no changes in our internal control over financial reporting identified in connection with our evaluation that occurred during the fiscal quarter ended March 31, 2008 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

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PART II

OTHER INFORMATION

Item 1 .   Legal Proceedings

The Company is not party to any pending legal proceedings.

Item 2 .   Unregistered Sales of Equity Securities and Use of Proceeds

In December 2007, the Board of Directors approved a stock repurchase program for the Company to buy back up to 400,000 shares of the Company’s common stock.  No shares were repurchased in the quarter ended March 31, 2008.

Item 6 .   Exhibits

Exhibits

       Exhibit 31.1  Certification Pursuant to Section 302 of the Sarbanes-Oxley Act

       Exhibit 31.2  Certification Pursuant to Section 302 of the Sarbanes-Oxley Act

       Exhibit 32     Certification of Chief Executive Officer and Chief Financial Officer Pursuant to 18 U.S.C. 1350

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant had duly caused this Report to be signed on behalf by the undersigned thereunto duly authorized.

HUMAN PHEROMONE SCIENCES, INC.

Date:  May 14, 2008

/s / William P. Horgan                                    

William P. Horgan

Chairman and Chief Executive Officer

(Principal Executive Officer)

Date:  May 14, 2008

/s / Gregory S. Fredrick                                 

Gregory S. Fredrick

Chief Financial Officer

(Principal Financial Officer and Principal Accounting

Officer)

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