Form 10-Q DERMA SCIENCES, INC. For: Sep 30

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November 7, 2014 5:27 PM EST

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

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Washington, DC 20549

___________________

FORM 10-Q

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(Mark One)

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x QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

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� � For the quarterly period ended September 30, 2014

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� TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

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� � For the transition period from ____________ to ____________
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� � Commission file number 1-31070

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Derma Sciences, Inc.

(Exact name of registrant as specified in its charter)

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Delaware 23-2328753
(State or other jurisdiction of Incorporation) (IRS employer identification number)

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214 Carnegie Center, Suite 300

Princeton, NJ 08540

(Address of principal executive offices)

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(609) 514-4744

(Issuer’s telephone number)

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Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

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Yes x��No �

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Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (�232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).

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Yes x��No �

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Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

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� Large accelerated filer � Accelerated filer x
� Non-accelerated filer ���(Do not check if a smaller reporting company) Smaller reporting company �

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Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

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Yes����No x

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Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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Date:��November 6, 2014 Class: Common Stock, par value $.01 per share
� � Shares Outstanding:��25,248,398

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PART I – FINANCIAL INFORMATION

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DERMA SCIENCES, INC.

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FORM 10-Q

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INDEX

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Description Page
� � �
Part I – Financial Information �
� � �
� Item 1. Financial Statements (Unaudited) �
� � �
� Consolidated Balance Sheets – September 30, 2014 and ��December 31, 2013 2
� � �
� Consolidated Statements of Comprehensive Loss – Three months ended ��September 30, 2014 and September 30, 2013 3
� � �
� Consolidated Statements of Comprehensive Loss – Nine months ended ��September 30, 2014 and September 30, 2013 4
� � �
� Consolidated Statements of Cash Flows – Nine months ended ��September 30, 2014 and September 30, 2013 5
� � �
� Notes to Consolidated Financial Statements 6
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� Item 2. Management’s Discussion and Analysis of Financial Condition �and Results of Operations 17
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� Item 3. Quantitative and Qualitative Disclosures about Market Risk 27
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� Item 4.� Controls and Procedures 28
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Part II - Other Information �
� � �
� Item 1. Legal Proceedings 29
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� Item 1A. Risk Factors 29
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� Item 2. Unregistered Sales of Equity Securities and Use of Proceeds 30
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� Item 3. Defaults upon Senior Securities 30
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� Item 4.� Mine Safety Disclosures 31
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� Item 5.� Other Information 31
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� Item 6. Exhibits 31

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1
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Part I – Financial Information

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Item 1. Financial Statements.

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Consolidated Balance Sheets (Unaudited)

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ASSETS � September 30,
2014		 � � December 31,
2013		 �
� � � � � � �
Current Assets � � � � � �
Cash and cash equivalents � $ 43,264,398 � � $ 6,501,586 �
Short-term investments � � 41,245,000 � � � 15,478,000 �
Accounts receivable, net � � 7,490,238 � � � 7,332,756 �
Inventories � � 14,969,466 � � � 16,472,640 �
Prepaid expenses and other current assets � � 3,161,291 � � � 3,746,753 �
Total current assets � � 110,130,393 � � � 49,531,735 �
Long-term investments � � 6,756,589 � � � 7,858,140 �
Equipment and improvements, net � � 3,288,167 � � � 2,953,469 �
Identifiable intangible assets, net � � 13,778,674 � � � 14,635,998 �
Goodwill � � 13,457,693 � � � 13,457,693 �
Other assets � � 145,338 � � � 139,318 �
Total Assets � $ 147,556,854 � � $ 88,576,353 �
� � � � � � � � �
LIABILITIES AND STOCKHOLDERS’ EQUITY � � � � � � � �
� � � � � � � � �
Current Liabilities � � � � � � � �
Accounts payable � $ 5,881,844 � � $ 4,522,508 �
Accrued expenses and other current liabilities � � 5,468,467 � � � 4,969,225 �
Total current liabilities � � 11,350,311 � � � 9,491,733 �
Long-term liabilities � � 215,854 � � � 242,325 �
Deferred tax liability � � 1,580,949 � � � 1,694,147 �
Total Liabilities � � 13,147,114 � � � 11,428,205 �
� � � � � � � � �
Contingencies (note 9) � � � � � � � �
� � � � � � � � �
Stockholders’ Equity � � � � � � � �
Convertible preferred stock, $.01 par value; shares authorized 1,468,750;
issued and outstanding 73,332 at September 30, 2014 and December 31,
2013 (liquidation preference of $3,222,368 at September 30, 2014)		 � � 733 � � � 733 �
Common stock, $.01 par value; shares authorized 50,000,000; issued and
outstanding 25,248,398 at September 30, 2014 and 17,347,071 at
December 31, 2013		 � � 252,484 � � � 173,471 �
Additional paid-in capital � � 227,743,162 � � � 140,064,607 �
Accumulated other comprehensive income � � 788,737 � � � 1,080,148 �
Accumulated deficit � � (94,375,376 ) � � (64,170,811 )
Total Stockholders’ Equity � � 134,409,740 � � � 77,148,148 �
Total Liabilities and Stockholders’ Equity � $ 147,556,854 � � $ 88,576,353 �

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See accompanying consolidated notes.

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Consolidated Statements of Comprehensive Loss (Unaudited)

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�� Three Months Ended September 30,�
�� 2014�� 2013�
Net Sales� $20,169,129�� $22,080,434�
Cost of sales� �13,809,872�� �14,046,660�
Gross Profit� �6,359,257�� �8,033,774�
Operating Expenses� ���� ���
Selling, general and administrative� �13,012,520�� �10,743,489�
Research and development� �4,444,368�� �2,677,539�
Total operating expenses� �17,456,888�� �13,421,028�
Operating loss� �(11,097,631)� �(5,387,254)
Other expense (income), net� �164,690�� �(160,736)
Loss before income taxes� �(11,262,321)� �(5,226,518)
Income tax benefit� �(14,573)� �(277,755)
Net Loss� �(11,247,748)� �(4,948,763)
Other Comprehensive (Loss) Income� ���� ���
Foreign currency translation adjustment� �(100,998)� �29,061�
Unrealized (loss) gain on equity securities, net of taxes� �(591,561)� �579,711�
Total other comprehensive (loss) income� �(692,559)� �608,772�
Comprehensive Loss� $(11,940,307)� $(4,339,991)
Net loss per common share – basic and diluted� $(0.45)� $(0.29)
Shares used in computing net loss per common share – basic and diluted� �25,247,565�� �17,262,688�

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See accompanying consolidated notes.

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Consolidated Statements of Comprehensive Loss (Unaudited)

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�� Nine Months Ended September 30,�
�� 2014�� 2013�
Net Sales� $60,872,388�� $59,018,241�
Cost of sales� �39,755,989�� �37,605,841�
Gross Profit� �21,116,399�� �21,412,400�
Operating Expenses� ���� ���
Selling, general and administrative� �38,693,665�� �31,419,944�
Research and development� �12,993,234�� �8,913,303�
Total operating expenses� �51,686,899�� �40,333,247�
Operating loss� �(30,570,500)� �(18,920,847)
Other income, net� �(107,611)� �(88,663)
Loss before income taxes� �(30,462,889)� �(18,832,184)
Income tax benefit� �(258,324)� �(293,969)
Net Loss� �(30,204,565)� �(18,538,215)
Other Comprehensive (Loss) Income� ���� ���
Foreign currency translation adjustment� �(185,860)� �(190,039)
Unrealized (loss) gain on equity securities, net of taxes� �(105,551)� �579,711�
Total other comprehensive (loss) income� �(291,411)� �389,672�
Comprehensive Loss� $(30,495,976)� $(18,148,543)
Net loss per common share – basic and diluted� $(1.24)� $(1.09)
Shares used in computing net loss per common share – basic and diluted� �24,347,155�� �16,977,524�

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See accompanying consolidated notes.

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Consolidated Statements of Cash Flows (Unaudited)

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� � Nine Months Ended September 30, �
� � 2014 � � 2013 � � �
Operating Activities � � � � � �
Net loss � $ (30,204,565 ) � $ (18,538,215 ) � �
Adjustments to reconcile net loss to net cash used in operating activities: � � � � � � � � � �
Depreciation of equipment and improvements � � 656,887 � � � 689,948 � � �
Amortization of identifiable intangible assets � � 2,237,074 � � � 2,144,283 � � �
Provision for bad debts � � 16,480 � � � 21,000 � � �
Allowance for sales adjustments � � 13,035 � � � 18,122 � � �
Provision for inventory obsolescence � � 152,373 � � � 109,862 � � �
Deferred rent � � (20,947 ) � � 1,019 � � �
Stock-based compensation � � 4,887,438 � � � 4,161,221 � � �
Deferred income taxes � � (78,347 ) � � (234,934 ) � �
Changes in operating assets and liabilities: � � � � � � � � � �
Accounts receivable � � (214,614 ) � � (1,458,367 ) � �
Inventories � � 1,029,782 � � � (1,694,372 ) � �
Prepaid expenses and other current assets � � 592,980 � � � (279,008 ) � �
Other assets � � (8,232 ) � � (26,094 ) � �
Accounts payable � � 1,426,546 � � � 1,368,750 � � �
Accrued expenses and other current liabilities � � 589,228 � � � 127,149 � � �
Net cash used in operating activities � � (18,924,882 ) � � (13,589,636 ) � �
Investing Activities � � � � � � � � � �
Purchase of investments � � (60,000,000 ) � � (33,723,000 ) � �
Proceeds from sale of investments � � 35,229,000 � � � 8,980,000 � � �
Purchase of equipment and improvements � � (1,108,859 ) � � (503,652 ) � �
Purchase of intangible assets � � (1,250,000 ) � � (100,000 ) � �
Net cash used in investing activities � � (27,129,859 ) � � (25,346,652 ) � �
Financing Activities � � � � � � � � � �
Proceeds from the sale of common stock, net of costs � � 80,616,032 � � � -- � � �
Proceeds from exercise of stock options and warrants, net of costs � � 2,245,966 � � � 2,811,218 � � �
Payment of withholding taxes related to employee stock compensation � � (121,618 ) � � (76,446 ) � �
Net cash provided by financing activities � � 82,740,380 � � � 2,734,772 � � �
Effect of exchange rate changes on cash � � 77,173 � � � (21,353 ) � �
Net increase (decrease) in cash and cash equivalents � � 36,762,812 � � � (36,222,869 ) � �
Cash and cash equivalents � � � � � � � � � �
Beginning of period � � 6,501,586 � � � 41,616,657 � � �
End of period � $ 43,264,398 � � $ 5,393,788 � � �
Supplemental disclosures of cash flow information: � � � � � � � � � �
Issuance of a warrant in connection with a licensing agreement � $ 129,750 � � $ - � � �
Cash paid during the year for: � � � � � � � � � �
Interest � $ 7,785 � � $ 719 � � �

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See accompanying consolidated notes.

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Notes to Consolidated Financial Statements (Unaudited)

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1.Organization and Summary of Significant Accounting Policies

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Derma Sciences, Inc. and its subsidiaries (the “Company”) is a tissue regeneration company focused on three segments of the wound care marketplace: advanced wound care, traditional wound care and pharmaceutical wound care products. The Company has one drug candidate that initiated its Phase 3 study during the first quarter of 2013. The Company markets its products principally through direct sales representatives in the United States (“U.S.”), Canada and the United Kingdom (“U.K.”), and through independent distributors within other select international markets. The Company’s U.S. distribution facilities are located in St. Louis, Missouri and Houston, Texas. The Company utilizes third party distributors for distribution in Canada, Europe and the Far East. The Company has manufacturing facilities in Toronto, Canada and Nantong, China.

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Basis of Presentation

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The accompanying unaudited consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the U.S. for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the U.S. for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the nine months ended September 30, 2014, are not necessarily indicative of the results that may be expected for the year ending December 31, 2014. Information included in the consolidated balance sheet as of December 31, 2013 has been derived from the consolidated financial statements and footnotes thereto for the year ended December 31, 2013, included in the Annual Report on Form 10-K previously filed with the Securities and Exchange Commission. For further information refer to the Annual Report on Form 10-K.

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Principles of Consolidation – The consolidated financial statements include the accounts of Derma Sciences, Inc. and its wholly owned subsidiaries. All significant intercompany accounts and transactions have been eliminated in consolidation.

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Use of Estimates – The preparation of consolidated financial statements requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Although these estimates are based on knowledge of current events and actions which may be undertaken in the future, actual results may ultimately differ from these estimates. Estimates and assumptions are required in the determination of sales deductions for trade rebates, sales incentives, discounts and allowances. Significant estimates and assumptions are also required in determining the appropriateness of amortization periods for identifiable intangible assets, the potential impairment of goodwill and the valuation of inventory.

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Revenue Recognition – Sales are recorded when product is shipped or title passes to customers and collectability is reasonably assured. Gross sales are adjusted for cash discounts, returns and allowances, trade rebates, distribution fees (in Canada) and other sales deductions in the same period that the related sales are recorded. Freight costs billed to and reimbursed by customers are recorded as a component of revenue. Freight costs to ship product to customers are recorded as a component of cost of sales.

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Net Loss per Share – Net loss per common share – basic is computed by dividing net loss by the weighted average number of common shares outstanding for the period. Net loss per common share – diluted reflects the potential dilution of earnings by including the effects of the assumed exercise, conversion or issuance of potentially issuable shares of common stock (“potentially dilutive securities”), including those attributable to stock options, warrants, convertible preferred stock and restricted stock units in the weighted average number of common shares outstanding for a period, if dilutive. The effects of the assumed exercise of warrants and stock options are determined using the treasury stock method. Potentially dilutive securities have not been included in the computation of diluted loss per share for the three and nine months ended September 30, 2014 and 2013 as the effect would be anti-dilutive.

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Notes to Consolidated Financial Statements (Unaudited)

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Potentially dilutive shares excluded as a result of the effects being anti-dilutive are as follows:

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�� Three and Nine Months Ended
September 30,		�
�� 2014�� 2013�
Excluded dilutive shares:� ��� ��
Convertible preferred stock� �73,332�� �73,332�
Additional stock issuable related �to conversion of preferred stock� �49,782�� �59,154�
Restricted share units� �744,850�� �802,800�
Warrants� �2,143,584�� �2,305,272�
Stock options� �2,268,730�� �1,832,581�
�� ���� ���
Total dilutive shares� �5,280,278�� �5,073,139�

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Recently Issued Accounting Pronouncements – In May 2014, the Financial Accounting Standards Board issued Accounting Standards Update (“ASU”) No. 2014-09, Revenue from Contracts with Customers, which requires an entity to recognize the amount of revenue to which it expects to be entitled for the transfer of promised goods or services to customers. The ASU will replace most existing revenue recognition guidance in U.S. GAAP when it becomes effective. The new standard is effective for the Company on January 1, 2017. Early application is not permitted. The standard permits the use of either the retrospective or cumulative effect transition method. The Company is evaluating the effect that ASU 2014-09 will have on its consolidated financial statements and related disclosures. The Company has not yet selected a transition method nor has it determined the effect of the standard on its ongoing financial reporting.

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2.Cash and Cash Equivalents and Investments

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Cash and Cash Equivalents

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The Company considers cash and cash equivalents as amounts on hand, on deposit in financial institutions and highly liquid investments purchased with an original maturity of three months or less. Money market mutual funds consist of funds deposited into mutual funds investing in U.S. government and non-government obligations. The Company maintains cash and cash equivalents and money market mutual funds with various domestic and foreign financial institutions within the ordinary course of business, which at times may exceed jurisdictional insurance limits.

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Investments in Debt Securities

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Investments in debt securities includes certificates of deposit purchased with an original maturity greater than three months which are deposited in various U.S. financial institutions and are fully insured by the Federal Deposit Insurance Corporation. The Company intends to hold the certificates of deposit to maturity and accordingly these investments are carried at amortized cost. Investments in debt securities with maturities greater than one year from the balance sheet date are classified as a long-term asset.

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Investment in Equity Securities

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In 2013, the Company purchased 2,272,277 shares of Comvita Limited (“Comvita”) common stock for $7,000,000. The equity investment represented 7.3% of Comvita’s outstanding shares on the date of purchase. In conjunction with this investment, the Company’s chairman and chief executive officer was named to Comvita’s board of directors.

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The investment in Comvita common stock is classified as an available-for-sale investment carried at fair value, with any unrealized gains and losses associated with the investment included in accumulated other comprehensive income and any dividends received recorded in other income. The investment is classified as a long term asset. As of September 30, 2014, the fair value of the Comvita common stock was $6,756,589 as determined by the quoted market price of the outstanding stock on the New Zealand stock exchange. The cumulative decrease in fair value from cost of $243,411, has been recorded in accumulated other comprehensive income.

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Notes to Consolidated Financial Statements (Unaudited)

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Cash and cash equivalents and investments at September 30, 2014 and December 31, 2013 consisted of the following:

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� � September 30, 2014 � � December 31, 2013 �
� � � � � � �
Cash � $ 6,772,849 � � $ 5,265,903 �
Money market mutual funds � � 36,491,549 � � � 1,235,683 �
� � � � � � � � �
Cash and cash equivalents � � 43,264,398 � � � 6,501,586 �
� � � � � � � � �
Investments in debt securities � � 41,245,000 � � � 16,474,000 �
Investment in equity securities � � 6,756,589 � � � 6,862,140 �
� � � � � � � � �
Total investments � � 48,001,589 � � � 23,336,140 �
� � � � � � � � �
Total cash and cash equivalents and investments � $ 91,265,987 � � $ 29,837,726 �

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The following table provides fair value information as of September 30, 2014:

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�� ��� Fair Value Measurements, Using�
�� Total carrying
value as of
September 30, 2014		�� Quoted prices
in active
markets
(Level 1)		�� Significant other
observable
inputs
(Level 2)		�� Significant
unobservable
inputs
(Level 3)		�
�� ��� ��� ��� ��
Cash and cash equivalents� $43,264,398�� $43,264,398�� $-�� $-�
�� ���� ���� ���� ���
Investments in debt securities� �41,245,000�� �41,243,383�� �-�� �-�
Investment in equity securities� �6,756,589�� �6,756,589�� �-�� �-�
�� ���� ���� ���� ���
Total investments� �48,001,589�� �47,999,972�� �-�� �-�
�� ���� ���� ���� ���
Total� $91,265,987�� $91,264,370�� $-�� $-�

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Level 1 inputs are quoted prices (unadjusted) in active markets for identical assets. Level 2 inputs are quoted prices for similar assets in active markets or inputs that are observable for the asset, either directly or indirectly through market corroboration, for substantially the full term of the financial instrument. Level 3 inputs are unobservable inputs based on management’s own assumptions used to measure assets at fair value. A financial asset’s classification is determined based on the lowest level input that is significant to the fair value measurement.

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3.Inventories

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Inventories are valued at the lower of cost or market determined based on the first in first out method and include the following:

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�� September 30, 2014�� December 31, 2013�
�� ��� ��
Finished goods� $10,113,801�� $11,044,746�
Work in process� �572,110�� �1,009,315�
Packaging materials� �1,436,596�� �1,408,521�
Raw materials
� �2,846,959�� �3,010,058�
Total inventory� $14,969,466�� $16,472,640�

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DERMA SCIENCES, INC. AND SUBSIDIARIES

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Notes to Consolidated Financial Statements (Unaudited)

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4.BioDLogics, LLC License Agreement

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On January 14, 2014, the Company entered into a license, market development and commercialization agreement (the “Agreement”) with BioDLogics, LLC (“BioD”) relating to BioD’s human placental based products (the “Licensed Products”) and intellectual property related thereto.

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Under the Agreement, BioD granted to the Company an exclusive, perpetual, royalty-bearing license to use, offer for sale and sell, the Licensed Products in North America (the “Territory”), including the rights to sublicense solely as provided in the Agreement, for a broad range of dermal applications (the “Field”). During the term of the Agreement, the Company will be responsible for the sale and marketing of the Licensed Products in the Field throughout the Territory. As part of its commercialization efforts, the Company is required to fund clinical studies up to $2,000,000 in support of the Field pursuant to the Agreement. Through September 30, 2014 the Company funded $182,000 as part of these commercialization efforts.

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The Company paid BioD an initial license fee of $1,250,000 and granted BioD a warrant to purchase 100,000 shares of the Company’s common stock. One quarter (25%) of the warrant was exercisable immediately at a price of $11.81 per share, while the remaining 75% of the warrant becomes exercisable, if at all, upon the achievement of certain milestones. The warrant expires five years from the date of issuance in January 2019 (note 5). The warrant has been valued at $129,750 using the Black-Scholes option pricing model. Total consideration paid to BioD of $1,379,750 has been recorded as an intangible asset and is being amortized to cost of sales over an estimated useful life of seven years. In addition to the initial license fee and warrant, royalties are payable to BioD based upon a sliding scale of the Company’s net sales of Licensed Products within the Territory and declining as net sales increase. Royalty rates range from the low double digits and decline to the mid-single digits. The Agreement also requires the Company to make milestone payments to BioD of up to $19,750,000 based upon the achievement of certain development events and annual net sales levels.

�

The Agreement may be terminated as follows: (i) upon mutual agreement of the parties; (ii) by BioD if the Company challenges certain BioD patents or trade secrets; (iii) by BioD if the Company fails to meet the annual minimum net sales requirement under the Agreement, unless the Company pays the difference between the amount of royalties that would have been due had the minimum annual net sales for such year been achieved and royalty payments made by the Company with respect to net sales during such year plus any milestone payments payable; or (iv) by either party in the event of a material breach or certain events of bankruptcy. The minimum annual net sales requirement commences in 2015.

�

5.Stockholders’ Equity

�

Preferred Stock

�

Subsequent to the issuances of the preferred stock, the Company has undertaken a number of common stock offerings that impact the preferred stock conversion ratios. As of September 30, 2014, current Series A and B preferred stockholders holding 73,332 preferred shares are entitled to receive an aggregate of 123,114 shares (49,782 additional shares) of common stock upon conversion of their holdings, as a result of the conversion ratio adjustments. The number of shares issuable upon conversion is subject to further adjustment should the Company in the future undertake one or more offerings of its common stock at less than the prevailing market price. In the nine months ended September 30, 2014, the Company issued 1,397 common shares to prior preferred stock holders based on the adjustment of the conversion ratios.

�

The 49,782 incremental shares associated with the conversion ratio adjustment will be recorded to common stock at par with the offset to additional paid in capital as all of the convertible preferred stock was issued prior to the November 16, 2000 effective date of certain provisions of Accounting Standards Codification 470 (formerly, EITF 00-27 Application of Issue No. 98-5 to Certain Convertible Instruments).

�

Common Stock

�

On January 29, 2014, the Company raised $80,616,032 (net of $5,633,968 in commission and other offering expenses) from the sale of 7,500,000 shares of the Company’s common stock at $11.50 per share. The Company plans to use the net proceeds from the offering for the continued development of its pharmaceutical product DSC127, for sales force expansion and for general corporate purposes.

�

9
�

�

DERMA SCIENCES, INC. AND SUBSIDIARIES

�

Notes to Consolidated Financial Statements (Unaudited)

�

�

�

On May 20, 2014, stockholders of the Company approved the proposal to increase the number of authorized shares of common stock from 35,000,000 to 50,000,000. On June 6, 2014, the Company amended its Certificate of Incorporation to reflect the increase in the number of authorized shares of common stock. During the nine months ended September 30, 2014, the Company issued 7,901,327 shares of common stock consisting of: 7,500,000 shares in connection with the January 29, 2014 equity offering, 337,437 shares upon the exercise of stock purchase warrants and options for which the Company received $2,245,966; 62,493 shares in connection with the vesting of 71,800 restricted share units, and 1,397 shares in connection with preferred stock conversion ratio adjustments.

�

Stock Purchase Warrants

�

At September 30, 2014, the Company had warrants outstanding to purchase shares of the Company’s common stock consisting of the following:

�

Series� Number of Warrants�� Exercise Price�� Expiration Date
�� ��� ��� �
N� �100,000�� $6.25�� February 22, 2015
O� �102,734�� $5.50�� February 22, 2015
P� �2,187�� $6.25�� February 16, 2015
Q� �133,333�� $5.50�� February 22, 2015
R� �1,705,330�� $9.90�� June 22, 2016
S� �100,000�� $11.81�� January 14, 2019
�� ���� ���� �
Total� �2,143,584�� ���� �

��

During the nine months ended September 30, 2014, a total of 261,688 warrants were exercised on a for cash and cashless basis consisting of 128,166 Series O, 127,272 Series R, and 6,250 Series L warrants. A total of 260,111 shares of common stock were issued in connection with the 2014 warrant exercises.

�

Equity Based Compensation

�

Under the Equity Incentive Plan (the “EIP Plan”) the Company is authorized to issue shares of common stock. On May 20, 2014, stockholders of the Company approved the proposal to increase the number of authorized shares of common stock the Company can issue from 4,500,000 to 6,000,000. The EIP Plan authorizes the Company to grant equity-based and cash-based incentive compensation in the form of stock options, stock appreciation rights, restricted shares, restricted share units, other share-based awards and cash-based awards, for the purpose of providing the Company’s employees, non-employee directors and consultants with incentives and rewards for performance. At September 30, 2014, options to purchase 2,268,730 shares and 744,850 restricted share units were issued and outstanding under the EIP Plan and 2,271,109 shares were available for grant.

�

Stock Options

�

The EIP Plan permits the granting of both incentive and nonqualified stock options to employees and nonqualified stock options to non-employee directors and consultants of the Company. The option exercise price may not be less than the fair market value of the stock on the date of the grant of the option. The duration of each option may not exceed 10 years from the date of grant.

�

10
�

�

DERMA SCIENCES, INC. AND SUBSIDIARIES

�

Notes to Consolidated Financial Statements (Unaudited)

�

�

�

For the three and nine months ended September 30, 2014 and 2013, the fair value of each option award was estimated at the date of grant using the Black-Scholes option-pricing model. The weighted-average assumptions used were as follows:

�

�� Three Months Ended
September 30,		�� Nine Months Ended
September 30,		�
�� 2014�� 2013�� 2014�� 2013�
�� ��� ��� ��� ��
Risk-free interest rate� �2.01%� �2.00%� �1.79%� �1.26%
Volatility factor� �61.0%� �67.9%� �63.2%� �69.9%
Dividend yield� �0%� �0%� �0%� �0%
Expected option life (years)� �6.25�� �6.25�� �5.79�� �6.25�

�

The risk-free rate utilized represents the U.S. treasury yield curve rate for the expected option life at the time of grant. The volatility factor was calculated based on the Company’s historical stock price volatility equal to the expected life of the option at the grant date. The dividend yield is 0% since the Company does not anticipate paying dividends in the near future. The simplified expected option life method is used to determine the expected option life for Company employees and directors while the contractual option life period is utilized for consultants.

�

Based on the Company’s historical experience of options that were forfeited before becoming fully vested, the Company has assumed an annualized forfeiture rate of 1.0% for all options. The Company will record additional expense if the actual forfeiture rate is lower than estimated, and will record a recovery of prior expense if the actual forfeiture rate is higher than estimated.

�

A summary of the Company’s stock option activity and related information for the nine months ended September 30, 2014 is as follows:

�

�� Options�� Weighted
Average
Exercise Price		�
�� ��� ��
Outstanding – January 1, 2014� �1,814,233�� $7.67�
Granted� �633,031�� $13.01�
Forfeited� �(48,381)� $11.52�
Exercised� �(121,928)� $6.65�
Expired� �(8,225)� $12.38�
�� ���� ���
Outstanding – September 30, 2014� �2,268,730�� $9.12�
�� ���� ���
Expected to vest – September 30, 2014� �2,246,043�� $9.12�
�� ���� ���
Exercisable at September 30, 2014� �1,555,845�� $7.57�

�

During 2014, the Company granted 447,105 service based options and 185,926 performance based options to Company employees and consultants. The weighted average fair value per share of options granted during the nine months ended September 30, 2014 was $7.63.

�

During the nine months ended September 30, 2014, 121,928 stock options were exercised on a for cash and cashless basis. A total of 77,326 shares of common stock were issued in connection with the 2014 stock option exercises. The intrinsic value of options exercised in 2014 was $597,142.

�

11
�

�

DERMA SCIENCES, INC. AND SUBSIDIARIES

�

Notes to Consolidated Financial Statements (Unaudited)

�

�

�

During the three and nine months ended September 30, 2014 and 2013, stock option compensation expense was recorded as follows:

�

�� Three Months Ended
September 30,		�� Nine Months Ended
September 30,		�
�� 2014�� 2013�� 2014�� 2013�
�� ��� ��� ��� ��
Cost of sales� $28,453�� $17,337�� $137,757�� $85,678�
Selling, general and administrative expenses� �620,560�� �536,755�� �2,456,718�� �1,672,548�
Research and development� �20,518�� �55,925�� �132,431�� �127,580�
�� ���� ���� ���� ���
Total stock option compensation expense� $669,531�� $610,017�� $2,726,906�� $1,885,806�

�

As of September 30, 2014, there was $3,031,787 of unrecognized compensation cost related to nonvested service based awards and $249,251 related to nonvested performance based awards. These costs are expected to be recognized over the options’ remaining weighted average vesting period of 2.00 years and 0.25 years for the service and performance based awards, respectively.�

�

Restricted Share Units

�

The Company has issued service, performance and market based restricted share units to employees and directors of the Company. Expense for restricted share awards is amortized on a straight-line basis over the awards’ vesting period. The fair value of service and performance awards are determined using the quoted market price of the Company’s common stock on the date of grant, while market based performance awards are valued using a binomial/lattice pricing model.

�

�The following table summarizes the restricted share unit activity for the period:

�

�� Number of
Units		�� Weighted Average
Fair Value		�
�� ��� ��
Unvested–January 1, 2014� �720,550�� $9.03�
�� ���� ���
Granted� �101,100�� �10.05�
Vested� �(71,800)� �13.48�
Forfeited� �(5,000)� �10.74�
�� ���� ���
Unvested–September 30, 2014� �744,850�� $8.82�

�

In connection with the vesting of restricted share unit awards during the nine months ended September 30, 2014, 9,307 common stock shares with a fair value of $121,618 were withheld in satisfaction of employee tax withholding obligations.

�

During the three months ended September 30, 2014 and 2013, restricted share unit compensation expense was $721,963 and $745,067, respectively, and for the nine months ended September 30, 2014 and 2013, restricted share unit compensation expense was $2,111,996 and $1,937,993, respectively, and included in selling, general and administrative expense.

�

As of September 30, 2014, there was $3,547,181 of unrecognized compensation cost related to unvested restricted share units. These costs are expected to be recognized over the restricted shares units’ remaining weighted average vesting period of 1.07 years.

�

In consideration of prior service, the Company accelerated the vesting of any unvested stock options and the restricted share units scheduled to vest in 2014 of a retiring director and extended the date to exercise vested stock options to 24 months (versus 90 days) from the date of retirement. An additional $48,536 of stock based compensation expense was recognized during the nine months ended September 30, 2014 and included in selling, general and administrative expense in connection with the retirement. For the nine months ended September 30, 2013, the Company recognized an additional $337,422 of stock based compensation expense associated with a director’s retirement and a former director’s consulting expenses which were included in selling, general and administrative expense.

�

12
�

�

DERMA SCIENCES, INC. AND SUBSIDIARIES

�

Notes to Consolidated Financial Statements (Unaudited)

�

�

�

Shares Reserved for Future Issuance

�

At September 30, 2014, the Company had reserved the following shares of common stock for future issuance:

�

Convertible preferred stock (series A – B)� �73,332�
Additional stock issuable related to conversion of �preferred stock (series A – B)� �49,782�
Common stock options outstanding� �2,268,730�
Common stock warrants outstanding� �2,143,584�
Restricted share units outstanding� �744,850�
Common stock equivalents available for grant� �2,271,109�
�� ���
Total common stock shares reserved� �7,551,387�

�

6.Accumulated Other Comprehensive Income

�

The Company’s accumulated other comprehensive income as of September 30, 2014 was as follows:

��

�� Foreign Currency Translation
Adjustments		�� Unrealized Loss on Equity Securities�� Total�
�� ��� ��� ��
Balance at January 1, 2014� $1,218,008�� $(137,860)� $1,080,148�
�� ���� ���� ���
Current period - other comprehensive loss� �(185,860)� �(105,551)� �(291,411)
�� ���� ���� ���
Balance at September 30, 2014� $1,032,148�� $(243,411)� $788,737�

�

7.Operating Segments

�

The Company operates in three segments: advanced wound care, traditional wound care and pharmaceutical wound care products. They are managed separately as each segment requires different technology, marketing and sales strategies. Advanced wound care products principally consist of both novel and otherwise differentiated dressings, devices and skin substitutes designed to promote wound healing and/or prevent infection. Traditional wound care products principally consist of commodity related dressings, ointments, gauze bandages, adhesive bandages, wound closure strips, catheter fasteners and skin care products. Pharmaceutical wound care products consist of DSC127, a novel, first in class angiotensin peptide for the treatment of a variety of dermal applications.

�

Advanced and traditional wound care products are marketed globally to acute care, extended care, home health care, wound and burn care clinics and physician offices. The Company utilizes a broad network of well-established distributors to deploy the majority of its products to end users. A smaller portion of the Company’s sales are sold directly to care providers and through retail. The advanced and traditional wound care products are both manufactured internally and sourced from third party suppliers. The majority of marketing expenses are deployed in support of advanced wound care products with traditional wound care products requiring limited support. The Company utilizes direct sales representatives, distributor relationships and contractual relationships with buying groups and wound care service providers to sell its products. Direct sales representatives are used solely in support of advanced wound care sales in the U.S. and the U.K. and for both advanced and traditional wound care products in Canada.

�

The pharmaceutical wound care segment is presently limited to the development of DSC127 for diabetic foot ulcers and pre-clinical work on scar prevention.

�

Each operating segment is managed at the segment contribution level consisting of gross profit minus direct expense consisting of distribution, marketing, sales, research and development and intangible amortization expenses. Expenses are allocated directly by segment to the extent possible. Expenses common to all three operating segments are allocated consistently using activity based assumptions. The aggregation or allocation of indirect expenses by segment is not practical.

�

13
�

�

DERMA SCIENCES, INC. AND SUBSIDIARIES

�

Notes to Consolidated Financial Statements (Unaudited)

�

�

�

Operating segment sales, gross profit, segment contribution and other related information for 2014 and 2013 were as follows:

�

Three Months Ended September 30, 2014
�
��

Advanced
Wound Care

��

Traditional

Wound Care�

�� Pharmaceutical Wound Care��

�

Other

��

Total

Company�

�
�� ��� ��� ��� ��� ��
Net sales� $9,473,023�� $10,696,106�� $-�� $-�� $20,169,129�
Gross profit� �3,830,878�� �2,528,379�� �-�� �-�� �6,359,257�
Direct expense� �(7,594,811)� �(1,321,202)� �(4,361,081)� �-�� �(13,277,094)
Segment contribution� $(3,763,933)� $1,207,177�� $(4,361,081)� �-�� �(6,917,837)
Indirect expenses� ���� ���� ���� $(4,329,911)� �(4,329,911)
�� ���� ���� ���� ���� ���
Net loss� ���� ���� ���� ���� $(11,247,748)

�

Three Months Ended September 30, 2013

�

Net sales� $9,090,598�� $12,989,836�� $-�� $-�� $22,080,434�
Gross profit� �4,524,951�� �3,508,823�� �-�� �-�� �8,033,774�
Direct expense� �(5,451,888)� �(1,367,019)� �(2,704,215)� �-�� �(9,523,122)
Segment contribution� $(926,937)� $2,141,804�� $(2,704,215)� �-�� �(1,489,348)
Indirect expenses� ���� ���� ���� $(3,459,415)� �(3,459,415)
�� ���� ���� ���� ���� ���
Net loss� ���� ���� ���� ���� $(4,948,763)

�

Nine Months Ended September 30, 2014

�

��

Advanced
Wound Care

��

Traditional

Wound Care

�� Pharmaceutical Wound Care�� Other��

Total

Company�

�
�� ��� ��� ��� ��� ��
Net sales� $26,637,772�� $34,234,616�� $-�� $-�� $60,872,388�
Gross profit� �12,203,928�� �8,912,471�� �-�� �-�� �21,116,399�
Direct expense� �(22,904,674)� �(3,992,260)� �(12,901,805)� �-�� �(39,798,739)
Segment contribution� $(10,700,746)� $4,920,211�� $(12,901,805)� �-�� �(18,682,340)
Indirect expenses� ���� ���� ���� $(11,522,225)� �(11,522,225)
�� ���� ���� ���� ���� ���
Net loss� ���� ���� ���� ���� $(30,204,565)

�

Nine Months Ended September 30, 2013

�

Net sales� $24,489,596�� $34,528,645�� $-�� $-�� $59,018,241�
Gross profit� �12,080,637�� �9,331,763�� �-�� �-�� �21,412,400�
Direct expense� �(15,883,488)� �(3,847,234)� �(8,989,976)� �-�� �(28,720,698)
Segment contribution� $(3,802,851)� $5,484,529�� $(8,989,976)� �-�� �(7,308,298)
Indirect expenses� ���� ���� ���� $(11,229,917)� �(11,229,917)
�� ���� ���� ���� ���� ���
Net loss� ���� ���� ���� ���� $(18,538,215)

��

The following table presents net sales by geographic region.

�

�� Three Months Ended September 30,�� Nine Months Ended September 30,�
�� 2014�� 2013�� 2014�� 2013�
�� ��� ��� ��� ��
United States� �80%� �77%� �78%� �78%
Canada� �13%� �13%� �15%� �13%
Other� �7%� �10%� �7%� �9%

�

14
�

�

DERMA SCIENCES, INC. AND SUBSIDIARIES

�

Notes to Consolidated Financial Statements (Unaudited)

�

�

�

For the nine months ended September 30, 2014 and 2013, the Company had a major Canadian customer comprising 16% and 13%, respectively, of consolidated net sales. Due to outstanding rebate obligations, the Company was in a net liability position to this customer at September 30, 2014.

�

8.Income Taxes

�

The following table summarizes the income tax expense and effective tax rate for the three and nine months ended September 30, 2014 and 2013:

�

�� Three Months Ended September 30,�
�� 2014�� 2013�
�� ��� ��
Current tax (benefit) expense� $(155,738)� $31,819�
Deferred tax expense (benefit)� �141,165�� �(309,574)
Income tax benefit� $(14,573)� $(277,755)
Effective tax rate� �0.1%� �5.3%

�

�� Nine Months Ended September 30,�
�� 2014�� 2013�
�� ��� ��
Current tax benefit� $(179,977)� $(59,035)
Deferred tax benefit� �(78,347)� �(234,934)
Income tax benefit� $(258,324)� $(293,969)
Effective tax rate� �0.8%� �1.6%

�

The income tax benefit for the three months ended September 30, 2014 consisted of a tax benefit from foreign operations and a U.S. deferred income tax expense related to an increase in the Company’s U.S. valuation allowance to reflect the tax impact of the unrealized loss on equity securities included in accumulated other comprehensive income and the tax effect of differences in financial reporting and tax treatment of goodwill, net of amortization for financial reporting but not for tax purposes of acquired MedEfficiency Inc. (“MedEfficiency”) identified intangible assets.

�

The income tax benefit for the three months ended September 30, 2013 consisted of a U.S. deferred income tax benefit related to a reduction in the Company’s U.S. valuation allowance to offset the tax impact of the unrealized gain on equity securities included in accumulated other comprehensive income and a tax expense foreign operations. In addition, the U.S. income tax benefit was increased by the tax effect of periodic amortization of nondeductible acquired intangible assets acquired in the MedEfficiency acquisition offset by an expense related to indefinite lived intangible assets.

�

The income tax benefit for the nine months ended September 30, 2014 consisted of a tax benefit from foreign operations and a U.S. deferred income tax expense related the tax effect of differences in financial reporting and tax treatment of goodwill, net of amortization for financial reporting but not for tax purposes of acquired MedEfficiency identified intangible assets.

�

The income tax benefit for the nine months ended September 30, 2013 consisted of a U.S. deferred income tax benefit related to a reduction in the Company’s U.S. valuation allowance to offset the tax impact of the unrealized gain on equity securities included in accumulated other comprehensive income and a tax benefit from foreign operations. In addition, the U.S. income tax benefit for the nine months ended September 30, 2013 was increased by the tax effect of periodic amortization of nondeductible acquired intangible assets acquired in the MedEfficiency acquisition offset by an expense related to indefinite lived intangible assets.

�

15
�

�

DERMA SCIENCES, INC. AND SUBSIDIARIES

�

Notes to Consolidated Financial Statements (Unaudited)

�

�

�

9.Contingencies

�

On occasion, the Company is involved in claims and other legal actions arising in the ordinary course of business. In the opinion of management, the ultimate disposition of these matters will not have a material adverse effect on the Company’s consolidated financial position, results of operations, or liquidity.

�

16
�

�

Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations.

�

This Quarterly Report on Form 10-Q (this “Report”) includes certain “forward-looking statements” within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, but are not limited to, statements about the confidence, strategies, plans, expectations, intentions, objectives, technologies, opportunities, market demand or acceptance of new or existing products of Derma Sciences, Inc. and its subsidiaries (“we” or “us” or the “Company”), a Delaware corporation, and other statements contained in this Report that are not historical facts. Forward-looking statements in this Report or hereafter included in other publicly available documents filed with the Securities and Exchange Commission (the “Commission”) reports to our stockholders and other publicly available statements issued or released by us involve known and unknown risks, uncertainties and other factors that could cause our actual results, performance (financial or operating) or achievements to differ from the future results, performance (financial or operating) or achievements expressed or implied by such forward-looking statements. Such future results are based upon management's best estimates, current conditions and the most recent results of operations. When used in this Report, the words “expect,” “anticipate,” “intend,” “plan,” “believe,” “seek,” “estimate” and similar expressions are generally intended to identify forward-looking statements, because these forward-looking statements involve risks and uncertainties. There are important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements, including our plans, objectives, expectations and intentions, changes in political, economic, business, competitive, market and regulatory factors and other factors that are discussed under the section in this Report entitled “Risk Factors,” as well as our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 filed on March 13, 2014 (the “2013 Form 10-K”) and other filings with the Commission. Neither we nor any other person assume responsibility for the accuracy or completeness of these forward-looking statements. We are under no duty to update any of the forward-looking statements after the date of this Report to conform these statements to actual results.

�

17
�

�

Three Months Ended September 30, 2014 Compared to Three Months Ended September 30, 2013

�

Overview

�

Operating Results of Three Months Ended September 30, 2014 and 2013

�

The following table highlights the operating results of the three months ended September 30, 2014 and 2013:

�

�� Three Months Ended September 30,�� Variance�
�� 2014�� 2013�� ��
Gross sales� $22,722,495�� $24,506,522�� $(1,784,027)� �(7.3%)
Sales adjustments� �(2,553,366)� �(2,426,088)� �(127,278)� �5.3%
Net sales� �20,169,129�� �22,080,434�� �(1,911,305)� �(8.7%)
Cost of sales� �13,809,872�� �14,046,660�� �(236,788)� �(1.7%)
Gross profit� �6,359,257�� �8,033,774�� �(1,674,517)� �(20.8%)
�� ���� ���� ���� ���
Selling, general and administrative expense� �13,012,520�� �10,743,489�� �2,269,031�� �21.1%
Research and development expense� �4,444,368�� �2,677,539�� �1,766,829�� �66.0%
Other expense (income), net� �164,690�� �(160,736)� �325,426�� �*
Total expenses� �17,621,578�� �13,260,292�� �4,361,286�� �32.9%
�� ���� ���� ���� ��
Loss before income taxes� �(11,262,321)� �(5,226,518)� �(6,035,803)� �115.5%
Income tax benefit� �(14,573)� �(277,755)� �263,182�� �*
Net loss� $(11,247,748)� $(4,948,763)� $(6,298,985)� �127.3%

��

* – not meaningful

�

18
�

�

Sales Adjustments

�

Gross to net sales adjustments comprise the following:

�

�� Three Months Ended September 30,�
�� 2014�� 2013�
Gross sales� $22,722,495�� $24,506,522�
Trade rebates� �(1,673,448)� �(1,640,054)
Distributor fees� �(249,354)� �(262,875)
Sales incentives� �(317,043)� �(236,873)
Returns and allowances� �(139,502)� �(104,886)
Cash discounts� �(174,019)� �(181,400)
Total adjustments� �(2,553,366)� �(2,426,088)
Net sales� $20,169,129�� $22,080,434�

�

Trade rebates increased in 2014 versus 2013 principally due to an increase in the rebate percentage related to a change in product mix towards higher rebated products, partially offset by lower sales in the United States and Canada. The decrease in distributor fees was commensurate with the decrease in Canadian sales upon which the fees were based. The increase in sales incentives reflected higher sales subject to incentives.

�

Rebate Reserve Roll-Forward

�

A roll-forward of the trade rebate accruals for the three months ended September 30, 2014 and 2013 were as follows:

�

�� Three Months Ended September 30,�
�� 2014�� 2013�
Beginning balance�–�July 1� $2,089,275�� $1,794,556�
Rebates paid� �(1,861,316)� �(1,688,055)
Rebates accrued� �1,673,448�� �1,640,054�
Ending balance�–�September 30� $1,901,407�� $1,746,555�

�

The $187,868 decrease in the trade rebate reserve balance at September 30, 2014 from July 1, 2014 principally reflected a decrease in sales subject to rebate in Canada and the timing of rebate payments, partially offset by an increase in the rebate percentage related to a change in product mix towards higher rebated products. There was no other significant change in the nature of our business during the quarter ended September 30, 2014 as it relates to the accrual and subsequent payment of rebates.

�

Net Sales and Gross Margin

�

The following table highlights the net sales and gross margin for the three months ended September 30, 2014 versus 2013:

�

�� Three Months Ended September 30,�� Variance�
�� 2014�� 2013�� ��� ��
Net Sales� $20,169,129�� $22,080,434�� $(1,911,305)� �(8.7%)
Cost of Sales� �13,809,872�� �14,046,660�� �(236,788)� �(1.7%)
Gross Profit� $6,359,257�� $8,033,774�� $(1,674,517)� �(20.8%)
Gross Profit %� �31.5%� �36.4%� ���� ���

��

Net sales decreased $1,911,305, or 8.7% (8.4% adjusted for exchange) in 2014 versus 2013. Advanced wound care sales increased $382,425, or 4.2%, to $9,473,023 in 2014 from $9,090,598 in 2013. Traditional wound care sales decreased $2,293,730, or 17.7%, to $10,696,106 in 2014 from $12,989,836 in 2013.

�

19
�

�

Sales in the U.S. decreased $1,650,050, or 9.2%, to $16,217,471 in 2014 from $17,867,521 in 2013. The decrease was driven by lower traditional wound care sales of $2,038,320, or 19.9%, partially offset by higher advanced wound care sales of $388,270, or 5.1%. The U.S. advanced wound care sales increase was led by Total Contact Casting (“TCC”), Medihoney and Amnio. The traditional wound care sales decrease was driven principally by lower first aid division and private label sales. The 2013 first aid division sales included a new retail customer initial distributor sales order of approximately $1,000,000, while the 2014 private label sales were unfavorably impacted by approximately $700,000 from the loss of a distributor due to industry consolidation. Sales in Canada decreased $171,617, or 6.0% (1.7% adjusted for exchange), to $2,666,754 in 2014 from $2,838,371 in 2013. This decrease was driven by a decrease in sales to our exclusive distributor of $49,471 along with an unfavorable foreign exchange of $122,146. Sales from our Canadian distributor to end users was down 1.9% for the three months ended September 30, 2014 versus the comparable period in the prior year. Sales to the rest of the world (“International”) decreased $89,638, or 6.5% (12.5% adjusted for exchange), to $1,284,904 in 2014 from $1,374,542 in 2013. The decrease was primarily driven by lower South American advanced wound care sales offset by favorable foreign exchange of $81,843.

�

Gross profit decreased $1,674,517, or 20.8%, in 2014 versus 2013. Advanced wound care gross profit decreased $694,073, or 15.3%, to $3,830,878 in 2014 from $4,524,951 in 2013. Traditional wound care gross profit decreased $980,444, or 27.9%, to $2,528,379 in 2014 from $3,508,823 in 2013. The overall gross profit margin percentage decreased to 31.5% in 2014 from 36.4% in 2013. The decrease in gross profit dollars reflected lower overall sales and gross margin percentage. The lower gross margin percentage principally reflected higher manufacturing costs and sales adjustments along with unfavorable foreign exchange. Manufacturing overhead costs increased reflecting a growth driven investment in infrastructure. The manufacturing costs of the advanced wound care segment for the three months ended September 30, 2014 were also unfavorably impacted by approximately $400,000 of costs associated with TCC manufacturing defects. Unfavorable foreign exchange impact reflected a 4.7% devaluation of the Canadian dollar for the third quarters of 2014 versus 2013.

�

Selling, General and Administrative Expenses

�

The following table highlights selling, general and administrative expenses by type for the three months ended September 30, 2014 versus 2013:

�

�� Three Months Ended September 30,�� Variance�
�� 2014�� 2013�� ��
Distribution� $641,607�� $602,875�� $38,732�� �6.4%
Marketing� �2,057,907�� �1,471,664�� �586,243�� �39.8%
Sales� �5,939,320�� �4,577,291�� �1,362,029�� �29.8%
General and administrative� �4,373,686�� �4,091,659�� �282,027�� �6.9%
Total� $13,012,520�� $10,743,489�� $2,269,031�� �21.1%

��

Selling, general and administrative expenses increased $2,269,031, or 21.1% in 2014 versus 2013.

�

Distribution expense increased $38,732, or 6.4% (7.2% adjusted for exchange), in 2014 versus 2013. The increase reflected higher growth related operating costs, principally compensation due to a growth driven increase in warehouse personnel, as well as repairs and maintenance on warehouse buildings and equipment.

�

Marketing expense increased $586,243, or 39.8%, in 2014 versus 2013. The increase was attributable to higher compensation expense associated with the addition of five marketing, two clinical and one product development positions added in the second half of 2013 and early 2014, coupled with higher associated travel and recruiting, as well as consulting costs principally in support of our advanced wound care growth initiatives.

�

Sales expense increased $1,362,029, or 29.8%, in 2014 versus 2013. The increase was principally attributable to incremental costs consisting of compensation and benefits, commission, travel, samples and tradeshow expenses to support the expansion of the advanced wound care sales force in the U.S and higher administrative fees associated with the expansion of our group purchasing program enrollment. Incremental growth related to International sales expansion also contributed.

�

General and administrative expenses increased $282,027, or 6.9% (7.6% adjusted for exchange), in 2014 versus 2013. The increase was primarily related to due diligence costs incurred in 2014, higher public relations expense, and higher compensation and benefits due to the addition of new positions, partially offset by lower litigation related legal fees from litigation that was incurred in 2013, as well as lower consulting and professional fees.

�

20
�

�

Research and Development Expense

�

Research and development expense increased $1,766,829 to $4,444,368 in 2014 from $2,677,539 in 2013. The increase principally reflected the ongoing DSC127 Phase 3 related expenses, together with incremental pre-clinical DSC127 scar prevention and Amnio post marketing clinical studies.

�

Other Expense (Income), net

�

Other expense (income), net decreased $325,426 to an expense of $164,690 in 2014 from income of $160,736 in 2013 due principally to unfavorable changes in foreign exchange and higher non income related taxes.

�

Income Tax Benefit

�

Income tax benefit decreased $263,182 to $14,573 in 2014 from $277,755 in 2013. The 2014 benefit included a $245,205 foreign tax benefit partially offset by U.S. tax expense of $230,632 due to an increase in the valuation allowance of $217,533 reflecting the tax impact of the unrealized loss on our investment in equity securities included in other comprehensive loss and the tax effect of tax timing differences in the treatment of intangible assets of $13,099. The 2013 benefit included a U.S. tax benefit of $318,919 due to an decrease in the valuation allowance of $362,220 to reflect the tax impact of the unrealized gain on our investment in equity securities included in other comprehensive income partially offset by the U.S. tax effect of tax timing differences in the treatment of intangible assets of $43,301 and foreign tax expense of $41,164.

�

Net Loss

�

We generated a net loss of $11,247,748, or $0.45 per share (basic and diluted) in 2014, compared to a net loss of $4,948,763, or $0.29 per share (basic and diluted), in 2013.

�

21
�

�

Nine Months Ended September 30, 2014 Compared to Nine Months Ended September 30, 2013

�

Overview

Operating Results of Nine Months Ended September 30, 2014 and 2013

�

The following table highlights the operating results of the nine months ended September 30, 2014 and 2013:

�

� Nine Months Ended September 30,�� Variance�
�� 2014�� 2013�� �� �
Gross sales� $68,531,867�� $65,533,051�� $2,998,816�� �4.6%
Sales adjustments� �(7,659,479)� �(6,514,810)� �(1,144,669)� �17.6%
Net sales� �60,872,388�� �59,018,241�� �1,854,147�� �3.1%
Cost of sales� �39,755,989�� �37,605,841�� �2,150,148�� �5.7%
Gross profit� �21,116,399�� �21,412,400�� �(296,001)� �(1.4%)
�� ���� ���� ���� ���
Selling, general and administrative expense� �38,693,665�� �31,419,944�� �7,273,721�� �23.2%
Research and development expense� �12,993,234�� �8,913,303�� �4,079,931�� �45.8%
Other income, net� �(107,611)� �(88,663)� �(18,948)� �*
Total expenses� �51,579,288�� �40,244,584�� �11,334,704�� �28.2%
�
Loss before income taxes		� �(30,462,889)� �(18,832,184)� �(11,630,705)� �61.8%
Income tax benefit� �(258,324)� �(293,969)� �35,645�� �*
Net loss� $(30,204,565)� $(18,538,215)� $(11,666,350)� �62.9%

�

* – not meaningful

�

22
�

�

Gross to Net Sales Adjustments

�

Gross to net sales adjustments comprise the following:

�

�� Nine Months Ended September 30,�
�� 2014�� 2013�
Gross sales� $68,531,867�� $65,533,051�
Trade rebates� �(5,269,469)� �(4,339,488)
Distributor fees� �(843,489)� �(700,473)
Sales incentives� �(707,415)� �(720,957)
Returns and allowances� �(350,270)� �(258,005)
Cash discounts� �(488,836)� �(495,887)
Total adjustments� �(7,659,479)� �(6,514,810)
Net sales� $60,872,388�� $59,018,241�

�

Trade rebates increased in 2014 versus 2013 principally due to higher sales in Canada, and an increase in the rebate percentage due to a change in product mix towards higher rebated products. The increase in distributor fees was commensurate with the increase in Canadian sales upon which the fees were based. The decrease in sales incentives reflected lower sales subject to incentives.

�

Rebate Reserve Roll-Forward

�

A roll-forward of the trade rebate accruals for the nine months ended September 30, 2014 and 2013 were as follows:

�

�� Nine Months Ended September 30,�
�� 2014�� 2013�
Beginning balance�–�January 1� $1,746,993�� $2,466,091�
Rebates paid� �(5,115,055)� �(5,059,024)
Rebates accrued� �5,269,469�� �4,339,488�
Ending balance�–�September 30� $1,901,407�� $1,746,555�

�

The $154,414 increase in the trade rebate reserve balance at September 30, 2014 from January 1, 2014 principally reflected an increase in sales subject to rebate in Canada and the timing of rebate payments. There was no other significant change in the nature of our business during the nine months ended September 30, 2014 as it relates to the accrual and subsequent payment of rebates.

�

Net Sales and Gross Margin

�

The following table highlights the net sales and gross margin for the nine months ended September 30, 2014 versus 2013:

�

�� Nine Months Ended September 30,�� Variance�
�� 2014�� 2013�� ��
Net��Sales� $60,872,388�� $59,018,241�� $1,854,147�� �3.1%
Cost of sales� �39,755,989�� �37,605,841�� �2,150,148�� �5.7%
Gross Profit� $21,116,399�� $21,412,400�� $(296,001)� �(1.4%)
Gross Profit %� �34.7%� �36.3%� ���� ���

�

Net sales increased $1,854,147, or 3.1% (3.7% adjusted for exchange) in 2014 versus 2013. Advanced wound care sales increased $2,148,176, or 8.8%, to $26,637,772 in 2014 from $24,489,596 in 2013. Traditional wound care sales decreased $294,029 or 1.0%, to $34,234,616 in 2014 from $34,528,645 in 2013.

�

23
�

�

Sales in the U.S. decreased $188,443, or 0.4%, to $47,724,681 in 2014 from $47,913,124 in 2013. The decrease was driven by lower traditional wound care sales of $1,722,865, or 6.3%, partially offset by higher advanced wound care sales of $1,534,422, or 7.5%. The traditional wound care sales decrease was driven by lower private label and first aid division sales. The 2014 private label sales were unfavorably impacted by approximately $1,300,000 from the loss of a distributor due to industry consolidation, while the first aid division sales were unfavorably impacted by $400,000 due to timing of the new retail customer’s sales orders. The increase in U.S. advanced wound care sales was led by Total Contact Casting (“TCC”), Medihoney and Amnio. Sales in Canada increased $1,517,360, or 20.1% (28.3% adjusted for exchange), to $9,067,651 in 2014 from $7,550,291 in 2013. This increase was driven by an increase in sales to our exclusive distributor of $2,137,116 to support an increase in its inventory partially offset by unfavorable foreign exchange of $619,756. Sales from our Canadian distributor to end users increased one percent for the nine months ended September 30, 2014 versus the comparable period in the prior year. International sales increased $525,229, or 14.8% (8.0% adjusted for exchange), to $4,080,056 in 2014 from $3,554,826 in 2013. The increase was driven by higher United Kingdom advanced wound care sales along with favorable foreign exchange of $241,190.

�

Gross profit decreased $296,001, or 1.4%, in 2014 versus 2013. Advanced wound care gross profit increased $123,291, or 1.0%, to $12,203,928 in 2014 from $12,080,637 in 2013. Traditional wound care gross profit decreased $419,292, or 4.5%, to $8,912,471 in 2014 from $9,331,763 in 2013. The overall gross profit margin percentage decreased to 34.7% in 2014 from 36.3% in 2013. The decrease in gross profit dollars reflected lower gross margin percentage offset by higher sales of advanced wound care products. The lower gross margin percentage principally reflected higher manufacturing costs, and sales adjustments along with unfavorable foreign exchange. Manufacturing overhead costs increased reflecting a growth driven investment in infrastructure. The manufacturing costs of the advanced wound care segment for the nine months ended September 30, 2014 were also unfavorably impacted by approximately $650,000 of costs associated with TCC manufacturing defects. Unfavorable foreign exchange impact reflected a 6.5% devaluation of the Canadian dollar for nine months of 2014 versus 2013.

�

Selling, General and Administrative Expenses

�

The following table highlights selling, general and administrative expenses by type for the nine months ended September 30, 2014 versus 2013:

�

�� Nine Months Ended September 30,�� Variance�
�� 2014�� 2013�� ��
Distribution� $1,867,048�� $1,722,568�� $144,480�� �8.4%
Marketing� �6,360,476�� �4,187,822�� �2,172,654�� �51.9%
Sales� �17,996,594�� �13,257,340�� �4,739,254�� �35.8%
General and administrative� �12,469,547�� �12,252,214�� �217,333�� �1.8%
Total� $38,693,665�� $31,419,944�� $7,273,721�� �23.2%
�� ���� ���� ���� ���

�

Selling, general and administrative expenses increased $7,273,721, or 23.2% (23.6% adjusted for exchange) in 2014 versus 2013.

�

Distribution expense increased $144,480, or 8.4% (9.4% adjusted for exchange), in 2014 versus 2013. The increase reflected higher operating costs, principally compensation due to a growth driven increase in warehouse personnel, as well as repairs and maintenance on warehouse buildings and equipment.

�

Marketing expense increased $2,172,654, or 51.9% in 2014 versus 2013. The increase was attributable to higher compensation expense associated with the addition of five marketing, two clinical and one product development positions added in the second half of 2013 and early 2014 along with travel and recruiting fees associated with the addition of the new positions, and higher product development and consulting costs, partially offset by lower promotional costs.

�

Sales expense increased $4,739,254, or 35.8% in 2014 versus 2013. The increase was principally attributable to incremental costs consisting of compensation and benefits, commissions, equity based compensation, travel, recruiting, samples and tradeshow expenses to support the expansion of the advanced wound care sales force in the U.S and higher administrative fees associated with the expansion of our group purchasing program enrollment. Incremental growth related to International sales expansion also contributed to the increase.

�

24
�

�

General and administrative expenses increased $217,333, or 1.8% (2.8% adjusted for exchange), in 2014 versus 2013. This increase primarily reflected due diligence costs incurred in 2014, higher compensation and benefits due to the addition of new positions, higher public and investor relation expenses, and other professional fees, partially offset by lower legal fees resulting from litigation incurred in 2013 and lower board of directors’ retirement associated costs.

�

Research and Development Expense

�

Research and development expense increased $4,079,931 to $12,993,234 in 2014 from $8,913,303 in 2013. The increase reflected the ongoing DSC127 Phase 3 related expenses, together with incremental pre-clinical DSC127 scar prevention and Amnio post marketing clinical studies.

�

Other Income, net

�

Other income, net increased $18,948 to $107,611 in 2014 from $88,663 in 2013 due principally to a dividend received from Comvita of $183,258 in 2014, partially offset by unfavorable foreign exchange.

�

Income Tax Benefit

�

Income tax benefit decreased $35,645 to $258,324 in 2014 from $293,969 in 2013. The 2014 benefit included a $288,635 foreign tax benefit partially offset by U.S. tax expense of $30,311 due to the tax effect of tax timing differences in the treatment of intangible assets. The 2013 benefit included a U.S. tax benefit of $254,616 due to a decrease in the valuation allowance of $362,220 reflecting the tax impact of the unrealized gain on our investment in equity securities included in other comprehensive income and a foreign tax benefit of $39,353 partially offset by the U.S. tax effect of tax timing differences in the treatment of intangible assets of $107,604.

�

Net Loss

�

We generated a net loss of $30,204,565, or $1.24 per share (basic and diluted) in 2014, compared to a net loss of $18,538,215, or $1.09 per share (basic and diluted), in 2013.

�

Liquidity and Capital Resources

�

Cash Flow and Working Capital

�

At September 30, 2014 and December 31, 2013, we had cash and cash equivalents of $43,264,398 and $6,501,586, respectively. The $36,762,812 increase in cash and cash equivalents reflected net cash provided by financing activities of $82,740,380 partially offset by cash used in investing activities of $27,129,859, and operating activities of $18,924,882, as well as the exchange rate effect on cash which increased cash by $77,173.

�

Net cash provided by financing activities of $82,740,380 included net proceeds of $80,616,032 from the sale of common stock and $2,245,966 from the exercise of warrants and stock options partially offset by the payment of payroll withholding taxes related to stock compensation of $121,618 in connection with net share settlements.

�

Net cash used in investing activities of $27,129,859 included cash used for the net purchase of investments of $24,771,000, $1,250,000 for the payment of the BioDLogics, LLC (“BioD”) license fee and $1,108,859 for capital expenditures. The majority of the capital expenditures are being made to upgrade and expand our manufacturing capabilities and purchase computer equipment in connection with the upgrade of the U.S. and Canadian computer systems.

�

25
�

�

Net cash used in operating activities of $18,924,882 resulted from $22,340,572 cash used in operations (net loss plus non-cash items) together with $3,415,690 cash provided by the change in operating assets and liabilities. Higher research and development expense and the impact of advanced wound care growth related expenses preceding revenue growth were the main contributors of the cash used in operations. Higher accounts payable and accrued expenses, and lower inventory and prepaid and other current assets, partially offset by higher accounts receivable, were the main drivers behind the net cash provided by the change in operating assets and liabilities. The increase in accounts payable reflected payment timing. The increase in accrued expenses reflected an increase in accrued commissions. The decrease in inventory reflected planned reductions in first-aid division inventory. The decrease in prepaid expenses and other current assets reflected timing of advance payments for the Phase 3 clinical trial and other operating expenditure payments. The increase in receivables reflected timing of sales and payments.

�

Working capital increased $58,740,080 at September 30, 2014 to $98,780,082 from $40,040,002 at December 31, 2013. This increase principally reflected the net cash inflow from the sale of common stock and the exercise of warrants and stock options net of cash outflows from research and development and operating activities. Management believes that it has sufficient working capital on-hand to support our existing operations for at least the next twelve months.

�

Prospective Assessment

�

Our strategic objective is to build the Company by both continuing to progress DSC127, with an initial indication for the treatment of diabetic foot ulcers, as well as in-licensing, acquiring, developing and launching novel higher margin advanced wound care products while utilizing our cash on-hand and cash flow provided by our traditional wound care business (to the extent possible) to fund this objective. In addition, we will continue to evaluate external opportunities to leverage our core capabilities for growth, and additional development programs on new indications for DSC127. To the extent we determine that we cannot finance our growth initiatives internally, additional sources of funding may be available to us through the sale of equity, issuance of debt, the sale of licensing rights of DSC127, jointly developing products with third parties and/or selling a portion of our existing business.

�

The launch of a number of advanced wound product line extensions in recent years, the acquisition of the MedEfficiency line of TCC products in April 2012 and the licensing of the BioD human placental products in January 2014 bodes well for the future growth of our higher-margined advanced wound care products both domestically and abroad. We continue to work on our pipeline and have identified several new products and product line extensions that are capable of contributing to future sales growth.

�

Our strategy for growth is:

�

� � Assuming the existing resources in place are generating the expected return, we will continue to expand our worldwide investment in sales and marketing resources in support of our higher-margined advanced wound care products. Additional sales and marketing resources will continue to be prudently added as needed to support the continued growth of this segment of our business. We have an established presence in Europe, the Middle East, and Africa (“EMEA”) through a direct sales organization in the U.K. and through distributors in a number of other countries. We are in the process of building our presence in Asia, the Pacific, and Latin America (“APLA”) employing the distribution model. We plan to expand our sales and marketing in this and other areas of the world employing a direct sales force or distributor model as the basis for conducting business, as circumstances dictate.
� � �
� � While the potential commercial launch of DSC127 is estimated to be three to four years away (pending the acceptance of a New Drug Application (“NDA”) by the U.S. FDA), we believe the market potential of this product for diabetic foot ulcers and other indications that we have the rights to are significant.��Our toxicology and chemistry, manufacturing and control programs are proceeding as planned.��All aspects of the clinical program are in place. Since the start-up of the clinical trials during the first quarter of 2013 we continue to make progress initiating and activating sites and enrolling patients.��We are working closely with the clinical research organization managing the trials and others to ensure the trials are progressing.��At this time, we are working towards completion of the last trial in the second half of 2016.��The cost of the preparation and execution of the Phase 3 program up to the point of NDA submission is presently estimated to be approximately $62.5 to $67.5 million. This includes the costs for the clinical, manufacturing and the toxicology (nonclinical) programs.��Beyond the initial indication of the treatment of diabetic foot ulcers, we have initiated pre-clinical activities for scar prevention, and anticipate having initial data in the first half of 2015 to help determine whether or not to progress towards an Investigational New Drug application.

�

26
�

�

� � We will continue to nurture our traditional wound care business in an effort to sustain it and grow it where possible, utilizing the appropriate amount of human and financial resources to achieve our objectives. While this area of our business presently represents a significant (albeit diminishing) percentage of our sales and realizes lower gross profit margins, it generates positive cash flow as it does not require extensive sales and marketing resources to sustain it.��Maintenance and growth of this business is important to us as we utilize this cash flow to help support our advanced wound care and pharmaceutical wound care growth initiatives.

�

With the cash on hand, cash equivalents and short-term investments as of September 30, 2014, we anticipate having sufficient liquidity to meet our existing operating and product development needs for at least the next twelve months. Further, if needed, we believe the continued success of our advanced wound care business and the development of DSC127 will serve to improve our ability to raise equity or generate capital from the sale of licensing rights going forward to fund prospective growth initiatives.

�

Our common stock is traded on the NASDAQ Capital Market under the symbol “DSCI.” We have paid no cash dividends in respect of our common stock and do not intend to pay cash dividends in the near future.

�

Additional Financial Information

�

Off-Balance Sheet Arrangements

�

As of September 30, 2014, we had no off-balance sheet arrangements.

�

Critical Accounting Policies

�

There have been no changes in critical accounting policies from those disclosed in the 2013 Form 10-K.

�

Item 3. Quantitative and Qualitative Disclosures about Market Risk.

�

Interest Rate Risk

�

We have investments in certificates of deposit with maturities of up to one year. It is our intention to hold these investments to maturity and therefore we have no exposure to fluctuations in interest rates.

�

Equity Investment Risk

�

We presently have a long term investment in a foreign public company, with whom we have a business relationship, which is subject to foreign market and exchange risk. This investment is classified as an available-for-sale investment carried at fair value, with the resulting unrealized gains and/or losses included in accumulated other comprehensive income in our Consolidated Balance Sheet. We presently do not foresee the need or the desire to liquidate this investment.

�

Foreign Exchange Risk

�

In 2014, we generated approximately 78 percent of our net sales inside the United States. We have wholly owned foreign subsidiaries in Canada and the United Kingdom. Our Canadian subsidiary has a wholly owned Chinese subsidiary. Each of these subsidiaries has their own functional currencies. Each may conduct business with each other, third parties and/or the Company in other than its functional currency, within the normal course of business. Where possible, we manage foreign currency exposures on a consolidated basis, which allows us to take advantage of any natural offsets; therefore, weakness in one currency might be offset by strengths in other currencies over time. Exchange gains and losses are recognized as incurred in our Consolidated Statement of Comprehensive Loss, which historically have not been material. Fluctuations in exchange rates affect our results of operations, financial position and cash flows. We currently do not hedge our exposure to fluctuations in exchange rates.

�

27
�

�

Commodity Price Risk

�

A significant portion of our business is exposed to the price of cotton and directly and indirectly to the price of oil. Fluctuations in the price of these commodities affect our results of operations, financial position and cash flows. We monitor our commodity price risk on an ongoing basis. Steps have been, and will continue to be, taken to manage the adverse impact of price increases on our business relative to the market. We currently do not hedge commodity price risk.

�

At present, we do not believe our operations are subject to significant market risks for interest rates, equity investment, foreign currency exchange, commodity prices or other relevant market price risks of a material nature.

�

Item 4.�Controls and Procedures

�

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures, as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934, as amended, (the “Exchange Act”) as of September 30, 2014. Based on this evaluation, the Company’s Chief Executive Officer and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective for gathering, analyzing and disclosing the information the Company is required to disclose in the reports it files under the Exchange Act, within the time periods specified in the Commission’s rules and forms, and communicated to our management, including the Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding disclosure. However, a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

�

During the three months ended September 30, 2014, there was no change in the Company’s internal controls over financial reporting that materially affected, or is reasonably likely to materially affect, the Company’s internal controls over financial reporting.

�

28
�

�

PART II – OTHER INFORMATION

�

Item 1. Legal Proceedings.

�

None

�

Item 1A. Risk Factors.

�

The following risk factors update the related risk factors set forth in the 2013 Form 10-K:

�

We have a history of losses and can offer no assurance of future profitability.

�

We incurred losses of $30,204,565 in the nine months ended September 30, 2014 (unaudited), $23,964,053 for the year ended December 31, 2013, and additional losses in previous years. At September 30, 2014, we had an accumulated deficit of $94,375,376 (unaudited). We expect to incur losses for the next several years as we continue to develop DSC127, and cannot offer any assurance that we will be able to generate sustained or significant future earnings.

�

The potential increase in common shares due to the conversion, exercise or vesting of outstanding dilutive securities may have a depressive effect upon the market value of our shares.

�

As of September 30, 2014, up to 5,280,278 shares of our common stock are potentially issuable upon the conversion, exercise or vesting of outstanding convertible preferred stock, warrants, options and restricted stock units (“dilutive securities”). The shares of common stock potentially issuable upon conversion, exercise or vesting of dilutive securities are substantial compared to the 25,248,398 shares of common stock outstanding as of September 30, 2014.

�

Earnings per share of common stock may be substantially diluted by the existence of these dilutive securities regardless of whether they are converted, exercised or issued. This dilution of earnings per share could have a depressive effect upon the market value of our common stock.

�

The results of preclinical studies and completed clinical trials are not necessarily predictive of future results, and our current drug candidate may not have favorable results in later studies or trials.

�

Preclinical studies and Phase 1 and Phase 2 clinical trials are not primarily designed to test the efficacy of a drug candidate, but rather to test safety, to study pharmacokinetics and pharmacodynamics, and to understand the drug candidate’s side effects at various doses and schedules. Favorable results in early studies or trials may not be repeated in later studies or trials, including continuing preclinical studies and large-scale Phase 3 clinical trials, and our drug candidate in later-stage trials may fail to show desired safety and efficacy despite having progressed through earlier-stage trials. Unfavorable results from ongoing preclinical studies or clinical trials could result in delays, modifications or abandonment of ongoing or future clinical trials, or abandonment of a clinical program. Preclinical and clinical results are frequently susceptible to varying interpretations that may delay, limit or prevent regulatory approvals or commercialization. Negative or inconclusive results or adverse medical events during a clinical trial could cause a clinical trial to be delayed, repeated or terminated, or a clinical program to be abandoned.

�

29
�

�

We rely on third parties to conduct our clinical trials and many of our preclinical studies. If those parties do not successfully carry out their contractual duties or meet expected deadlines, our drug candidates may not advance in a timely manner or at all.

�

In the course of our preclinical testing and clinical trials, we rely on third parties, including laboratories, investigators, clinical contract research organizations (“CROs”), and manufacturers, to perform critical services for us. For example, we rely on third parties to conduct our clinical trials and many of our preclinical studies. CROs are responsible for many aspects of the trials, including finding and enrolling subjects for testing and administering the trials. Although we rely on these third parties to conduct our clinical trials, we are responsible for ensuring that each of our clinical trials is conducted in accordance with its investigational plan and protocol. Moreover, the FDA and foreign regulatory authorities require us to comply with regulations and standards, commonly referred to as good clinical practices, (“GCP”s), for conducting, monitoring, recording, and reporting the results of clinical trials to ensure that the data and results are scientifically credible and accurate, and that the trial subjects are adequately informed of the potential risks of participating in clinical trials. Our reliance on third parties does not relieve us of these responsibilities and requirements. These third parties may not be available when we need them or, if they are available, may not comply with all regulatory and contractual requirements or may not otherwise perform their services in a timely or acceptable manner, and we may need to enter into new arrangements with alternative third parties and our clinical trials may be extended, delayed or terminated. These independent third parties may also have relationships with other commercial entities, some of which may compete with us. In addition, if such third parties fail to perform their obligations in compliance with our GCPs, our clinical trials may not meet regulatory requirements or may need to be repeated. As a result of our dependence on third parties, we may face delays or failures outside of our direct control. These risks also apply to the development activities of collaborators, and we do not control their research and development, clinical trial or regulatory activities.

�

Our stock price has been volatile and this volatility is likely to continue.

�

Historically, the market price of our common stock has been volatile. The high and low stock prices for the years 2009 through 2013 and the first nine months of 2014 are set forth in the table below:

�

Derma Sciences, Inc.
Trading Range�–�Common Stock

�

Year� Low�� High�
�� ��� ��
2009� $1.92�� $6.80�
2010� $4.40�� $9.00�
2011� $4.50�� $12.72�
2012� $6.94�� $11.89�
2013� $9.93�� $15.45�
2014*� $7.88�� $15.51�

�

(*) January 1 through September 30.

�

Events that may affect our common stock price include:

�

� • Results from further development of DSC127;
� • Quarter to quarter variations in our operating results;
� • Changes in earnings estimates by securities analysts;
� • Changes in interest rates, exchange rates or other general economic conditions;
� • Changes in market conditions in the wound care industry;
� • Fluctuations in stock market prices and trading volumes of similar companies;
� • Discussion of us or our stock price by the financial and scientific press and in online investor communities
� • Additions or departures of key personnel;
� • Changes in third party reimbursement policies;
� • The introduction of new products either by us or by our competitors; and
� • The loss of a major customer.

�

Although all publicly traded securities are subject to price and volume fluctuations, it is likely that our common stock will experience these fluctuations to a greater degree than the securities of more established and better capitalized organizations.

�

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

�

None

�

Item 3. Defaults upon Senior Securities.

�

None

�

30
�

�

Item 4. Mine Safety Disclosures.

�

Not applicable.

�

Item 5. Other Information.

�

None.

�

Item 6. Exhibits.

�

Exhibit Description
� �
31.1 Certification of the Principal Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2 Certification of the Principal Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1 Certification of the Principal Executive Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of the Principal Financial Officer pursuant to U.S.C. Section 1350 as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002
101.INS XBRL Instance Document
� �
101.SCH XBRL Taxonomy Extension Schema Document
� �
101.CAL XBRL Taxonomy Extension Calculation Linkbase Document
� �
101.LAB XBRL Taxonomy Extension Labels Linkbase Document
� �
101.PRE XBRL Taxonomy Extension Presentation Linkbase Document

�

31
�

�

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

�

DERMA SCIENCES, INC.
�
� � �
Dated:��November 7, 2014 By:�� /s/ John E. Yetter
� � John E. Yetter, CPA
� � Chief Financial Officer

�

32

Exhibit 31.1

�

Certification of Principal Executive Officer

Pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002

�

I, Edward J. Quilty, certify that:

�

1. I have reviewed this quarterly report on Form 10-Q of Derma Sciences, Inc. (the “Registrant”);

�

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

�

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this quarterly report;

�

4. The Registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have:


(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;


(c) Evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and


5. The Registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons performing the equivalent functions):


(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

�

�

Dated: November 7, 2014 /s/ Edward J. Quilty
� Edward J. Quilty
� Chairman, President and Chief Executive Officer
� (Principal Executive Officer)

�

�

�

�

Exhibit 31.2

�

Certification of Principal Financial Officer

Pursuant to Section 302 of the

Sarbanes-Oxley Act of 2002

�

I, John E. Yetter, certify that:

�

1. I have reviewed this quarterly report on Form 10-Q of Derma Sciences, Inc. (the “Registrant”);

�

2. Based on my knowledge, this quarterly report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this quarterly report;

�

3. Based on my knowledge, the financial statements, and other financial information included in this quarterly report, fairly present in all material respects the financial condition, results of operations and cash flows of the Registrant as of, and for, the periods presented in this quarterly report;

�

4. The Registrant’s other certifying officer and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the Registrant and have:


(a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the Registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;

(b) Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles;


(c) Evaluated the effectiveness of the Registrant’s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and

(d) Disclosed in this report any change in the Registrant’s internal control over financial reporting that occurred during the Registrant’s most recent fiscal quarter (the Registrant’s fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the Registrant’s internal control over financial reporting; and

�

5. The Registrant’s other certifying officer and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the Registrant’s auditors and the audit committee of the Registrant’s board of directors (or persons performing the equivalent functions):

�

(a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the Registrant’s ability to record, process, summarize and report financial information; and

(b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the Registrant’s internal control over financial reporting.

�

Dated:��November 7, 2014 /s/ John E. Yetter
� John E. Yetter, CPA
� Executive Vice President, Finance and Chief Financial Officer
� (Principal Financial Officer)

��

�

�

�

Exhibit 32.1

�

�

Certification of Principal Executive Officer

Pursuant to U.S.C. Section 1350

As Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

�

I, Edward J. Quilty, Chairman, President and Chief Executive Officer of Derma Sciences, Inc., hereby certify that the Quarterly Report on Form 10-Q for the period ended September 30, 2014 of Derma Sciences, Inc. (the “Form 10-Q”) upon my best knowledge and belief fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934 and that the information contained in the Form 10-Q fairly presents, in all material respects, the financial condition and results of operations of Derma Sciences, Inc.

�

Dated:��November 7, 2014 /s/ Edward J. Quilty
� Edward J. Quilty
� Chairman, President and Chief Executive Officer
� (Principal Executive Officer)

�

�


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