DELCATH SYSTEMS, INC. (DCTH) FY 2021 MD&A

Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.

The following discussion of our financial condition and results of operations should be read in conjunction with our audited consolidated financial statements and notes thereto appearing elsewhere in this Annual Report on Form
10-K.

Overview

We are an interventional oncology company focused on the treatment of primary and metastatic liver cancers. Our lead product candidate, the HEPZATO
™
KIT (melphalan hydrochloride for injection/hepatic delivery system), or HEPZATO
™
, is a drug/device combination product designed to administer high-dose chemotherapy to the liver while controlling systemic exposure and associated side effects. HEPZATO has not been approved for sale in the United States. In Europe, HEPZATO is a stand-alone medical device having the same device components as HEZPATO, but without the melphalan hydrochloride, and is approved for sale under the trade name CHEMOSAT
®
Hepatic Delivery System for Melphalan, or CHEMOSAT, where it has been used at major medical centers to treat a wide range of cancers of the liver.

In the United States, HEPZATO is considered a combination drug and device product and is regulated as a drug by the United States Food and Drug Administration, or the FDA. Primary jurisdiction for regulation of HEPZATO has been assigned to the FDA’s Center for Drug Evaluation and Research. The FDA has granted Delcath six orphan drug designations (five for melphalan in the treatment of patients with ocular (uveal) melanoma, cutaneous melanoma, hepatocellular carcinoma, intrahepatic cholangiocarcinoma, and neuroendocrine tumors) and one for doxorubicin in the treatment of patients with hepatocellular carcinoma). HEPZATO has not been approved for sale in the United States.

Our most advanced development program is the treatment of ocular melanoma liver metastases, or mOM, a type of primary liver cancer. We are currently reviewing the incidence, unmet need, available efficacy data and development requirements for a broad set of liver cancers in order to select a portfolio of indications which will maximize the value of the HEPZATO platform. We believe that the disease states we are investigating and intend to investigate are unmet medical needs that represent significant market opportunities.

We are investigating the objective response rate of HEPZATO in patients with mOM in our FOCUS Clinical Trial for Patients with Hepatic Dominant Ocular Melanoma, or the FOCUS Trial, a global registration clinical trial. For information on the FOCUS Trial, see “Part I, Item 1. Business—Clinical Development Program—The FOCUS Trial” above.

Due to the global outbreak of

SARS-CoV-2,

a novel strain of coronavirus that causes Coronavirus disease
(COVID-19),
the Company experienced an impact on certain areas of its business. These effects included a slowing of patient recruitment in the FOCUS Trial and a reduction in the pace at which we can monitor data at our clinical trial sites. The resulting delay in completing enrollment and additional time required to monitor data caused our planned announcement for the
top-line
data from our FOCUS Trial to shift to December 2021. In December 2021, we announced that HEPZATO met its prespecified endpoint. Based on the FOCUS Trial results, we are preparing to submit a new drug application, or NDA, to the FDA for HEPZATO. We plan to request a
pre-NDA
meeting with the FDA and, pending feedback from FDA and the pace of complete data analysis from our clinical sites which have been impacted by the
COVID-19
pandemic, we intend to submit an NDA to the FDA by
mid-2022
for the use of HEPZATO in the treatment of mOM. The results of the FOCUS Trial should also support securing reimbursement coverage for the use of CHEMOSAT in the European Union. Additional impacts of
COVID-19
on our business may arise that we are not aware of currently. The ultimate impact of the pandemic on the Company’s results of operations, financial position, liquidity, or capital resources cannot be reasonably estimated at this time.

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Liquidity and Capital Resources

At December 31, 2021, we had cash, cash equivalents and restricted cash totaling $27.0 million, as compared to cash, cash equivalents and restricted cash totaling $28.8 million at December 31, 2020. During the years ended December 31, 2021 and 2020, the Company used $22.6 million and $22.9 million respectively, of cash in our operating activities.

Our future results are subject to substantial risks and uncertainties. We have operated at a loss for our entire history and there can be no assurance that we will ever achieve consistent profitability. We have historically funded our operations through a combination of private placements and public offerings of our securities. We will need to raise additional capital under structures available to us, including debt and/or equity offerings.

These circumstances raise substantial doubt about the Company’s ability to continue as a going concern within one year after the date that the financial statements are issued. Our financial statements do not include adjustments to the amounts and classification of assets and liabilities that may be necessary should we be unable to continue as a going concern. Our ability to continue as a going concern depends on our ability to raise additional capital through the sale of equity or debt securities to support our future operations.

Our capital commitments over the next twelve months include (a) $5.2 million to satisfy December 31, 2021 accounts payable, accrued expenses and lease liabilities; (b) $0.6 million of loan principal payments; and (c) potentially $0.5 million of severance payments. Our capital commitments past the next twelve months include (a) $0.2 million of lease liabilities; (b) $10.4 million of loan principal payments; and (c) $4.6 million of convertible note principal payments, if the holders do not elect to convert the notes into equity.

We also expect to use cash, cash equivalents and investment proceeds to fund our clinical research and operating activities. Our future liquidity and capital requirements will depend on numerous factors, including the initiation and progress of clinical trials and research and product development programs; obtaining regulatory approvals and complying with applicable laws and regulations; the timing and effectiveness of product commercialization activities, including marketing arrangements; the timing and costs involved in preparing, filing, prosecuting, defending and enforcing intellectual property rights; and the effect of competing technological and market developments.

If we are unable to secure additional capital, we may be required to curtail our research and development initiatives and take additional measures to reduce costs in order to conserve our cash.

On August 6, 2021, the Company entered into a Loan and Security Agreement (the “Avenue Loan Agreement”) with Avenue Venture Opportunities Fund, L.P. (the “Lender,” or “Avenue”) for a term loan in an aggregate principal amount of up to $20 million (the “Avenue Loan”). The Avenue Loan bears interest at an annual rate equal to the greater of (a) the sum of 7.70% plus the prime rate as reported in The Wall Street Journal and (b) 10.95%. The interest rate at December 31, 2021 was 10.95%. The Avenue Loan is secured by all of the Company’s assets globally, including intellectual property. The Avenue Loan matures on August 1, 2024. Additional information regarding the Avenue Loan can be found in Note 10 to the Company’s audited consolidated financial statements contained in this Annual Report on Form 10-K.

Results of Operations for the Year Ended December 31, 2021; Comparison of Results of the Years Ended December 31, 2021 and 2020

Revenue

We recorded approximately $1.3 million in product revenue and $2.3 million in other revenue during the year ended December 31, 2021. During the same period in 2020, we recorded $1.2 million in product revenue and $0.5 million in other revenue. Our sales in both 2021 and 2020 were primarily generated through our license agreement with medac, pursuant to which medac had served as our exclusive distributor of CHEMOSAT in the United Kingdom

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and European Union. On December 30, 2021, medac terminated the license agreement and ceased distribution activities at the end of a mutually agreed transition period on February 28, 2022. Effective March 1, 2022, the Company began directly marketing CHEMOSAT in these markets. As a result of the termination of the license agreement, the Company changed its estimate of the contract life as of December 31, 2021, which resulted in the immediate recognition of $1.7 million of other revenue that had previously been deferred.

Cost of Goods Sold

During the year ended December 31, 2021, we recognized cost of goods sold of approximately $0.7 million related to product revenue of $1.3 million as compared to cost of goods sold of approximately $0.6 million related to product revenue of $1.2 million in the prior year. The increase is primarily due to the increase in product sales volume.

Research and Development Expenses

For the year ended December 31, 2021, research and development expenses increased to $13.8 million from $11.2 million for the year ended December 31, 2020, an increase of $2.6 million or 23.2%. The increase was due to additional compensation expense related to the hiring of additional employees, $1.2 million of additional stock-based compensation expense, and an increase in costs related to the ongoing FOCUS trial and preparation for the NDA submission.

Selling, General and Administrative Expenses

For the year ended December 31, 2021, selling, general and administrative expenses increased to $13.6 million from $11.1 million for the year ended December 31, 2020, an increase of $2.5 million or 22.5%. The increase is primarily due to a $3.0 million increase in stock-based compensation, partially offset by a $0.5 million decrease in professional fees.

Change in Fair Value of Derivative Liability

For the year ended December 31, 2021, there was no
non-cash
derivative instrument expense, compared to the
non-cash
derivative instrument expense of $2.8 million for the year ended December 31, 2020. In 2019, the Company issued warrants with an initial fair value of $20.8 million. At December 31, 2019, the fair value of the common stock warrants issued by the Company in 2019 was $3.4 million. In February 2020, the fair value of the warrants increased to $6.2 million, resulting in expense of $2.8 million. The entire $6.2 million warrant liability was reclassified to equity at March 31, 2020.

Interest Expense

For the year ended December 31, 2021, we recognized $1.2 million of interest expense, as compared to $0.2 million in the prior year, an increase of $1.0 million. The increase primarily relates to interest expense and amortization of debt discount associated with the Avenue Loan that commenced on August 6, 2021.

Net Loss

We had a net loss for the year ended December 31, 2021 of approximately $25.6 million, an increase of $1.4 million, as compared to a $24.2 million net loss for the same period in 2020. The increase in the net loss is due to a $5.1 million increase in operating expenses and a $1.0 increase in interest expense, partially offset by a $1.9 million increase in gross profit and a $2.8 million decrease in
non-cash
derivative instrument expense.

Critical Accounting Estimates

The Company’s consolidated financial statements have been prepared in accordance with generally accepted accounting principles in the United States of America (“GAAP”). Certain critical accounting estimates have a

49

significant impact on amounts reported in the consolidated financial statements. A summary of those critical accounting estimates is below. Additional details can be found in Note 3 to the Company’s audited consolidated financial statements contained in this Annual Report on Form
10-K.

Fair Value Measurements

GAAP emphasizes that fair value is a market-based measurement, not an entity-specific measurement. Therefore, a fair value measurement should be determined based on the assumptions that market participants would use in pricing the asset or liability. As a basis for considering market participant assumptions in fair value measurements, GAAP establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

Our fair value measurements are generally related to the valuation of warrants and stock-based compensation. Valuation of such financial instruments generally requires certain assumptions, including the fair value of our common stock (generally an observable market price, as our common stock is publicly traded), the expected term of the financial instrument (judgment is required), the expected volatility of our common stock over the expected term (generally estimated by reference to the historical volatility of our common stock), our expected dividend rate over the expected term (currently estimated as zero, given that we are not projecting profits over the intermediate term) and the expected risk-free rate over the expected term (generally estimated by reference to United States treasury instruments with similar remaining terms).

Revenue Recognition

Revenue is generated from proprietary and partnered product sales and license and royalty arrangements. Revenue is recognized when or as we transfer control of the promised goods or services to our customers in an amount that reflects the consideration to which we expect to be entitled to in exchange for those goods or services. When obligations or contingencies remain after the products are shipped, such as training and certifying the treatment centers, revenue is deferred until the obligations or contingencies are satisfied.

We may enter into contracts with partners that contain multiple elements such as licensing, development, manufacturing, and commercialization components. These arrangements are often complex, and we may receive various types of consideration over the life of the arrangement, including up-front fees, reimbursements for research and development services, milestone payments, payments on product shipments, margin sharing arrangements, license fees and royalties.

The Company recognizes revenue in accordance with ASC 606, Revenue from Contracts with Customers (“ASC 606”). The core principle of ASC 606 requires that an entity recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. ASC 606 defines a five-step process to achieve this core principle and, in doing so, it is possible more judgment and estimates may be required within the revenue recognition process, including identifying performance obligations in the contract, estimating the amount of variable consideration to include in the transaction price and allocating the transaction price to each separate performance obligation.

The following five steps are applied to achieve that core principle:

Step 1: Identify the contract with the customer;

Step 2: Identify the performance obligations in the contract;

Step 3: Determine the transaction price, including an estimation of any variable consideration expected to be received in connection with the contract;

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Step 4: Allocate the transaction price to the performance obligations in the contract; and

Step 5: Recognize revenue when the company satisfies a performance obligation.

Each of these steps in the revenue recognition process requires management to make judgments and/or estimates. The most significant judgements and estimates involve the determination of variable consideration to be included in the transaction price. Variable consideration is recognized at an amount we believe is not subject to significant reversal and is adjusted at each reporting period if the most likely amount of expected consideration changes or becomes fixed. We believe this provides a reasonable basis for recognizing revenue; however, actual results could differ from estimates and significant changes in estimates could impact our results of operations in future periods.

As required by GAAP, the Company disaggregates its revenue into the categories of product revenue and other revenue. The Company recognizes product revenue and milestone payments at a point in time, whereas other revenues (primarily license fees) are recognized over time. Milestone payments that are contingent upon the occurrence of future events, are evaluated and recorded at the most likely amount, and to the extent that it is probable that a significant reversal will not occur when the associated uncertainty is resolved

Accrued Expenses

We utilize contract research organizations in order to perform research and development and conduct clinical trials. In some cases, these organization do not bill on a timely basis. Management monitors certain key drivers of these costs and estimates accruals in an attempt to properly match expenses incurred with the appropriate reporting period. However, there is judgment involved and the actual billings could be more or less than the estimated accrual.