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Auxilium Pharmaceuticals 10-Q 2007 Table of ContentsUNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, DC 20549
FORM 10-Q
For the quarterly period ended September 30, 2007 OR
For the transition period from to . Commission File Number: 000-50855
Auxilium Pharmaceuticals, Inc. (Exact name of registrant as specified in its charter)
40 Valley Stream Parkway, Malvern, PA 19355 (Address of principal executive offices) (Zip Code) (484) 321-5900 (Registrant’s telephone number, including area code)
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. Yes x No ¨ Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one): Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨ Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x As of October 31, 2007, the number of shares outstanding of the issuer’s common stock, $0.01 par value, was 40,332,841.
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AUXILIUM PHARMACEUTICALS, INC. AND SUBSIDIARIES Consolidated Balance Sheets (In thousands, except share and per share amounts) (Unaudited)
See accompanying notes to consolidated financial statements.
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Table of ContentsAUXILIUM PHARMACEUTICALS, INC. AND SUBSIDIARIES Consolidated Statements of Operations (In thousands, except share and per share amounts) (Unaudited)
See accompanying notes to consolidated financial statements.
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Table of ContentsAUXILIUM PHARMACEUTICALS, INC. AND SUBSIDIARIES Consolidated Statements of Cash Flows (In thousands) (Unaudited)
See accompanying notes to consolidated financial statements.
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Table of ContentsAUXILIUM PHARMACEUTICALS, INC. AND SUBSIDIARIES Consolidated Statement of Stockholders’ Equity Nine Months Ended September 30, 2007 (In thousands, except share amounts) (Unaudited)
See accompanying notes to consolidated financial statements.
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Table of ContentsAUXILIUM PHARMACEUTICALS, INC. AND SUBSIDIARIES NOTES TO CONSOLIDATED FINANCIAL STATEMENTS September 30, 2007 (Unaudited) 1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (a) Basis of Presentation The accompanying unaudited consolidated financial statements include the accounts of Auxilium Pharmaceuticals, Inc. and its wholly owned subsidiaries (the Company), and have been prepared in accordance with U.S. generally accepted accounting principles for interim financial information and pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) pertaining to Form 10-Q. Certain disclosures required for complete annual financial statements are not included herein. All significant intercompany accounts and transactions have been eliminated in consolidation. The information at September 30, 2007 and for the three and nine month periods ended September 30, 2007 and 2006 is unaudited but includes all adjustments (consisting only of normal recurring adjustments) which, in the opinion of the Company’s management, are necessary to state fairly the financial information set forth herein. The December 31, 2006 balance sheet amounts and disclosures included herein have been derived from the Company’s December 31, 2006 audited consolidated financial statements. The interim results are not necessarily indicative of results to be expected for the full fiscal year. These unaudited consolidated financial statements should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2006 included in the Company’s Annual Report on Form 10-K filed with the SEC. (b) Net Loss Per Common Share Net loss per common share is calculated in accordance with Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share. Under the provisions of SFAS No. 128, basic net loss per common share is computed by dividing the net loss for the period by the weighted average number of common shares outstanding during the period reduced, where applicable, for unvested outstanding restricted shares.
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Table of ContentsThe following table sets forth the computation of basic and diluted net loss per common share (in thousands, except share and per share amounts):
Diluted net loss per common share is computed giving effect to all potentially dilutive securities, including stock options and warrants. Diluted net loss per common share for all periods presented is the same as basic net loss per common share because the potential common stock is anti-dilutive. (c) New Accounting Pronouncements On January 1, 2007, the Company adopted Financial Accounting Standards Board Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes”. This interpretation prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The adoption of FIN 48 had no significant impact on the Company’s consolidated results of operation and financial position. The Company and its subsidiaries file income tax returns in the United Kingdom, United States and various state and local tax jurisdictions in the United States. The Company has net operating loss and credit carry forwards that will be subject to examination beyond the year in which they are ultimately utilized. The Company believes any future potential adjustments of these carryforwards will be immaterial to its financial statements due to the valuation allowance which fully offsets all of its tax assets. The Company’s policy is to record interest and penalties on uncertain tax positions as income tax expense. As of September 30, 2007, the Company believes that there are no significant uncertain tax positions, and no amounts have been recorded for interest and penalties. The Company does not anticipate any events that would require it to record a liability related to any uncertain income tax position in 2007 as prescribed by FIN 48.
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Table of Contents2. INVENTORIES Inventories consist of the following (in thousands):
The Company will be filing a request with the Food and Drug Administration (FDA) to revise its U.S. manufacturing specifications for identified impurities. At September 30, 2007, the ultimate disposition of approximately $700,000 of work-in-process inventory is subject to this request. 3. ACCRUED EXPENSES Accrued expenses consist of the following (in thousands):
4. EMPLOYEE STOCK BENEFIT PLANS (a) Employee Stock Purchase Plan Under the Company’s 2006 Employee Stock Purchase Plan, as approved by the stockholders of the Company, employees may purchase shares of the Company’s common stock at a 15% discount through payroll deductions. Employees may contribute up to 10% of their compensation to the 2006 Employee Stock Purchase Plan. The purchase price is 85% of the fair value per share of common stock on the date the purchase period begins or the date on which the purchase period ends, whichever is lower. The plan restricts the maximum number of shares that an employee may purchase to 15,000 shares during each semi-annual purchase period and to $25,000 worth of common stock during each year. There is a maximum of 300,000 shares issuable under the 2006 Employee Stock Purchase Plan. In January and July 2007, employees purchased 39,721 and 37,920 shares of common stock at a price of $6.8595 and $12.4865 per share, respectively, representing 85% of the closing price of the common stock on July 3, 2006 and January 2, 2007, the first day at the beginning of each respective purchase period on which the market was open. (b) Stock Options and Stock Awards Under the Company’s 2004 Equity Compensation Plan, as amended (the 2004 Plan), as approved by the stockholders of the Company, qualified and nonqualified stock options and stock awards may be granted to employees, non-employee directors and service providers. In June 2007, the stockholders authorized the increase of shares authorized for issuance under the 2004 Plan to 8,000,000 shares. The Compensation Committee of the Board of Directors (the Compensation Committee) administers the 2004
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Table of ContentsPlan and has delegated to each of the Company’s Chief Executive Officer and Chief Financial Officer the authority to grant stock options to newly hired employees below the Vice President level within specified parameters. To date, the Company has granted only nonqualified stock options and restricted stock awards under the 2004 Plan. Stock options are granted with an exercise price equal to 100% of the market value of the common stock on the date of grant, and generally have a ten year contractual term and vest no later than four years from the date of grant (with some providing for automatic vesting upon a change of control of the Company). The Company issues new shares of common stock upon exercise of stock options. At September 30, 2007, there were 2,628,288 shares available for future grants under the 2004 Plan. (c) General Stock Option Information During the nine months ended September 30, 2007, the Company granted 1,126,940 standard non-qualified stock options and 85,000 performance-based non-qualified stock options to employees to purchase shares of the Company’s common stock pursuant to the 2004 Plan. The options expire ten years from date of grant and their exercise prices represent the closing price of the common stock of the Company on the respective dates that the options were granted. The standard non-qualified stock options vest ratably over four years at one year intervals from the grant date, assuming continued employment of the grantee. The performance-based options were awarded to certain officers and accrued on September 19, 2007 with the Compensation Committee determination that the performance metric (resumption of the phase III trials for XIAFLEX™ for the treatment of Dupuytren’s contracture in the fourth quarter of 2007) had been achieved. Each performance-based option has an exercise price of $13.16 and vests in three equal annual installments on September 19, 2008, 2009 and 2010, assuming the continued employment of the grantee (with automatic vesting upon a change of control of the Company). The following tables summarize stock option activity for the nine month period ended September 30, 2007:
During the three and nine month periods ended September 30, 2007, the weighted-average grant-date fair value of options granted was $9.84 and $7.81, the total intrinsic value of options exercised was $1,666,000 and $6,194,000, and the total fair value of options vested was $736,000 and $3,163,000, respectively. The aggregate intrinsic values in the preceding table represent the total pre-tax intrinsic value, based on the Company’s stock closing price of $21.08 as of September 30, 2007, that would have been received by the option holders had all option holders exercised their options as of that date. All 1,225,045 exercisable options as of September 30, 2007 were in-the-money.
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Table of Contents(d) Restricted Stock Information The compensation cost of restricted stock awards is determined by their intrinsic value on the grant date. The following table summarizes the restricted stock activity for the nine month period ended September 30, 2007:
(e) Valuation and Expense Information under SFAS No. 123R The fair value of each share-based award was estimated on the date of grant using the Black-Scholes model and applying the assumptions in the following table. The expected volatility is based on the blended historical volatility of peer group companies and the historical volatility of the Company. The Company uses the simplified calculation of expected option life, described in Staff Accounting Bulletin No. 107, because the Company’s history is inadequate to determine a reasonable estimate of the option life. The dividend yield is determined based on the Company’s history to date and management’s estimate of dividends over the option life. The risk-free interest rate is based on the U.S. treasury yield curve in effect at the time of the grant.
Pre-vesting forfeitures are estimated in the determination of total stock-based compensation cost based on Company experience. The estimate on pre-vesting forfeitures will be adjusted in future periods to the extent actual pre-vesting forfeitures differ, or are expected to differ, from such estimates. As of September 30, 2007, there was approximately $13,687,000 of total unrecognized stock-based compensation cost related to all share-based payments that will be recognized over the weighted-average period of 2.75 years. Future grants will add to this total, whereas future amortization over the vesting period of existing grants will reduce this total.
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Table of Contents5. OTHER COMPREHENSIVE LOSS Total comprehensive loss was as follows (in thousands):
The foreign currency translation amounts relate to the Company’s foreign subsidiary. The unrealized loss on available for sale securities relates to the Company’s short-term investments.
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The following discussion is qualified in its entirety by, and should be read in conjunction with, the more detailed information set forth in the consolidated financial statements and the notes thereto appearing elsewhere in this report. Special Note Regarding Forward-Looking Statements Certain statements in this quarterly report are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements made with respect to our strategy, progress and timing of development programs and related trials, the efficacy of our product candidates, the commercial benefits available to us as a result of our agreements with third parties, future operations, financial position, future revenues, projected costs, the size of addressable markets, prospects, plans and objectives of management and other statements regarding matters that are not historical facts and involve predictions. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance, achievements or prospects to be materially different from any future results, performance, achievements or prospects expressed in or implied by such forward-looking statements. In some cases you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “would,” “expect,” “intend,” “plan,” “anticipate,” “believe,” “estimate,” “predict,” “potential,” “seem,” “seek,” “future,” “continue,” or “appear” or the negative of these terms or similar expressions, although not all forward-looking statements contain these identifying words. These forward-looking statements are subject to a number of risks and uncertainties including, among other things:
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These risks are not exhaustive. For a more detailed discussion of risks and uncertainties, see “Item 1A – Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006 and “Item 1A – Risk Factors” of this quarterly report. Other sections of this quarterly report and in our other SEC filings, verbal or written statements and presentations may include additional factors which could adversely impact our future results, performance, achievements and prospects. Moreover, we operate in a very competitive and rapidly changing environment. Given these risks and uncertainties, you should not place undue reliance on forward-looking statements. Although we believe that the expectations reflected in forward-looking statements are reasonable, we cannot guarantee that the future results, performance, achievements and prospects reflected therein will be achieved or occur. We qualify all forward-looking statements by these cautionary statements. We undertake no obligation to update publicly any forward-looking statement other than as required under the federal securities laws. Overview We are a specialty biopharmaceutical company with a focus on developing and marketing products to urologists, endocrinologists, orthopedists and select primary care physicians. We currently have a sales and marketing organization of approximately 190 people. Our only marketed product, Testim, is a proprietary, topical 1% testosterone once-a-day gel indicated for the treatment of hypogonadism. Hypogonadism is defined as reduced or absent secretion of testosterone which can lead to symptoms such as low energy, loss of libido, adverse changes in body composition, irritability and poor concentration. Our current product pipeline includes: Phase III: - XIAFLEX for the treatment of Dupuytren’s contracture Phase II: - XIAFLEX for the treatment of Peyronie’s disease - XIAFLEX for the treatment of Frozen Shoulder syndrome (or Adhesive Capsulitis) Phase I: - AA4010, for the treatment of overactive bladder using our transmucosal film delivery system Preclinical: - two pain products using our transmucosal film delivery system. In addition to the above, we have the rights to develop other hormone products, urologic products and six other compounds for the treatment of pain using the transmucosal film technology and the option to license other indications for XIAFLEX other than dermal products for topical administration. In August 2007, the U.S. Food and Drug Administration, or FDA, lifted the clinical hold on our phase III trials for XIAFLEX for the treatment of Dupuytren’s contracture. In September 2007, we began dosing patients in the phase III trials in the U.S. and in Australia. In December 2006, we had suspended our phase III trials for XIAFLEX for the treatment of Dupuytren’s contracture because of a
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Table of Contentsmanufacturing issue, the formation of meltback in the product vials, and, as a result, the FDA placed these trials on clinical hold. After implementing corrective actions and following batches of product manufactured earlier this year for stability, we determined that the product exhibited an appropriate, consistent stability profile over a reasonable time period and submitted the data to the FDA, resulting in the FDA lifting the clinical hold. With regard to the development of XIAFLEX for the treatment of Peyronie’s disease, which also had been placed on clinical hold by FDA and then released from clinical hold in August 2007, the FDA is requiring that we conduct animal studies in order to evaluate the impact of XIAFLEX on normal penile tissue, in case the injection misses the targeted plaque, prior to commencing phase IIb studies. In late 2006, we commenced several pilot studies designed to assist us in developing a definitive protocol for such animal studies. Based on current project plans, including communications with the FDA on their expectations for the animal studies, we expect to submit the results of these studies to the FDA during the first half of 2008 and, pending FDA approval, commence a phase IIb study in the first or second quarter of 2008. This phase IIb study will test dosing regimens and validate a patient-reported outcomes questionnaire that we have developed for Peyronie’s disease. We have never been profitable and have incurred an accumulated deficit of $212.3 million as of September 30, 2007. We expect to incur significant operating losses for the foreseeable future. We anticipate that commercialization expenses, development costs, and in-licensing milestone payments related to existing and new product candidates and to enhance our core technologies will continue to increase in the near term. In particular, we expect to incur increased costs for:
We will need to generate significant revenues to achieve profitability. We expect that quarterly and annual results of operations will fluctuate for the foreseeable future due to several factors, for example:
Our limited operating history makes accurate prediction of future operating results difficult. Results of Operations Accounting Changes As discussed in Note 2(e) to the audited consolidated financial statements for the year ended December 31, 2006 included in the Company’s Annual Report on Form 10-K filed with the SEC, in the
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Table of Contentsfirst quarter of 2006 the Company began recognizing revenue for Testim sales at the time of shipment of the product to customers. As a result of this change in revenue recognition, net revenues for nine months ended September 30, 2006 include a one-time benefit of $1.2 million and the net loss for the nine months ended September 30, 2006 includes a one-time benefit of $0.7 million, or $0.02 per share. Three Months Ended September 30, 2007 and 2006 Net revenues. Net revenues increased $8.6 million, or 49%, to $26.2 million for the quarter ended September 30, 2007 from $17.6 million for the comparable 2006 period. While we have inventory management agreements with our major customers that provide for inventory levels to be maintained within certain specified limits of product demand, decisions by our customers concerning the levels of inventory they maintain within these parameters can significantly influence our results for any particular reporting period. We estimate that net revenues for the third quarter of 2007 and 2006 benefited from an increase during the period in wholesaler inventory levels of approximately $0.8 million and $1.1 million, respectively. The increase in net revenues for the third quarter of 2007 compared to the comparable 2006 period resulted primarily from substantial growth in Testim demand resulting from increased prescriptions and increases in pricing, net of discounts, rebates and coupons. According to National Prescription Audit (NPA) data from IMS Health (IMS), a pharmaceutical market research firm, Testim total prescriptions for the third quarter of 2007 grew 33.4% over the comparable period of 2006. We believe that Testim prescription growth in the 2007 period over the 2006 period was driven by physician and patient acceptance that Testim provides better patient outcomes, the shift in prescriptions away from the testosterone patch product and the other gel product to Testim, and the continued focus of our sales force on the promotion of Testim to urologists, endocrinologists and select primary care physicians. Net revenues for the third quarter of 2007 benefited from price increases having a cumulative impact of 11% over the comparable 2006 period, which was partially offset by increased utilization of coupons that are provided to new patients. Revenue from international licensing agreements, representing the amortization of upfront and milestone payments and related product shipments, in the third quarter of 2007 and 2006 amounted to $0.7 million and $0.3 million, respectively. Cost of goods sold. Cost of goods sold was $6.4 million and $4.5 million for the three months ended September 30, 2007 and 2006, respectively. The increase in cost of goods sold for the three months ended September 30, 2007 over the comparable period in 2006 was principally attributable to the increase in Testim units sold. Gross margin on our net revenues was 75.5% in the third quarter of 2007 compared to 74.6% in the comparable 2006 period. Gross margin reflects the cost of product sold as well as royalty payments made to the Company’s licensor on the sales of Testim. The improvement in gross margin reflects the impact of year-over-year price increases, partially offset by increases in coupon usage and low margin international product shipments. Research and development expenses. Research and development costs for the third quarter of 2007 were $9.8 million compared with $8.5 million for the comparable year-ago period. The increase in research and development costs was primarily due to the increased spending for development and manufacturing scale up for XIAFLEX, largely offset by the reduction in spending that resulted from the discontinuance of TestoFilm™ development in October 2006. Selling, general and administrative expenses. Selling, general and administrative expenses totaled $18.2 million for the quarter ended September 30, 2007 compared with $17.1 million for the year-ago quarter. The cost for the third quarter of 2006 included the $1.8 million cost to terminate Auxilium’s co-promotion agreement with Oscient Pharmaceuticals, Inc. Excluding this termination cost, the increase was primarily due to higher investment in promotional spending for Testim, including the cost of increasing our sales force, pre-launch marketing for XIAFLEX, and higher stock-based compensation expense.
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Table of ContentsInterest income (expense), net. Interest income, net was $1.2 million and $0.6 million for the three months ended September 30, 2007 and 2006, respectively. Net interest income relates primarily to interest earned on cash, cash equivalents and short-term investments. Nine Months Ended September 30, 2007 and 2006 Net revenues. Net revenues increased $19.0 million, or 39%, to $68.0 million for the nine months ended September 30, 2007 from $49.0 million for the comparable 2006 period. Net revenues for 2006 included a one-time benefit of $1.2 million, resulting from the adoption of the wholesaler method of revenue recognition. Excluding this one-time increase in 2006 revenue, net revenues for the nine months ended September 30, 2007 increased 42% over the comparable 2006 period. While we have inventory management agreements with our major customers that provide for inventory levels to be maintained within certain specified limits of product demand, decisions by our customers concerning the levels of inventory they maintain within these parameters can significantly influence our results for any particular reporting period. However, we estimate the change in wholesaler inventory levels during the nine months ended September 30, 2007 was not significant. Information necessary to estimate the change in wholesaler inventories during the nine months ended September 30, 2006 is not available. The increase in net revenues for the first nine months of 2007 compared to the comparable 2006 period resulted primarily from substantial growth in Testim demand resulting from increased prescriptions and increases in pricing, net of discounts, rebates and coupons. According to NPA data from IMS, Testim total prescriptions for the first nine months of 2007 grew 36.3% over the comparable period of 2006. We believe that Testim prescription growth in the 2007 period over the 2006 period was driven by physician and patient acceptance that Testim provides better patient outcomes, the shift in prescriptions away from the testosterone patch product and the other gel product to Testim, and the continued focus of our sales force on the promotion of Testim to urologists, endocrinologists and select primary care physicians. Net revenues for the first nine months of 2007 benefited from price increases having a cumulative impact of 10% over the comparable 2006 period, which was partially offset by increased utilization of coupons that are provided to new patients. Revenue from international licensing agreements, representing the amortization of upfront and milestone payments and related product shipments, in the first nine months of 2007 and 2006 amounted to $2.0 million and $0.8 million, respectively. Cost of goods sold. Cost of goods sold was $17.4 million and $12.7 million for the nine months ended September 30, 2007 and 2006, respectively. The increase in cost of goods sold for the nine months ended September 30, 2007 over the comparable period in 2006 was principally attributable to the increase in Testim units sold. Gross margin on our net revenues was 74.5% in the first nine months of 2007 compared to 74.0% in the comparable 2006 period. Excluding the impact of the change to the wholesaler revenue recognition method, gross margin for the first nine months of 2006 was 74.4%. Gross margin reflects the cost of product sold as well as royalty payments made to the Company’s licensor on the sales of Testim. The increase in gross margin from the comparable 2006 level reflects the benefit of the year-over-year price increases, largely offset by the costs of Testim manufacturing and quality improvement programs initiated in the first quarter of 2007 and increases in low margin international product shipments and coupon usage. Research and development expenses. Research and development costs for the first nine months of 2007 were $28.3 million compared with $25.7 million for the comparable year-ago period. The increase in research and development costs was primarily due to the increased spending for development and manufacturing scale up for XIAFLEX, largely offset by the reduction in spending that resulted from the discontinuance of TestoFilm development in October 2006. Selling, general and administrative expenses. Selling, general and administrative expenses totaled $53.9 million for the nine months ended September 30, 2007 compared with $45.4 million for the comparable year-ago period. These costs for the 2006 period included the $1.8 million cost to terminate Auxilium’s co-promotion agreement with Oscient Pharmaceuticals, Inc. Excluding this termination cost,
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Table of Contentsthe increase was primarily due to higher investment in promotional spending for Testim, including the cost of increasing our sales force, pre-launch marketing for XIAFLEX, and higher stock-based compensation expense. Interest income (expense), net. Interest income, net was $2.7 million and $1.7 million for the nine months ended September 30, 2007 and 2006, respectively. Net interest income relates primarily to interest earned on cash, cash equivalents and short-term investments. Liquidity and Capital Resources Since inception through September 30, 2007, we have financed our product development, operations and capital expenditures primarily from private and public sales of equity securities. Since inception through September 30, 2007, we received net proceeds of approximately $275 million from private and public sales of equity securities and the exercise of stock options. We had $82.5 million and $54.7 million in cash, cash equivalents and short-term investments as of September 30, 2007 and December 31, 2006, respectively. We believe that our current financial resources and sources of liquidity will be adequate to fund our anticipated operations until at least 2009. We may, however, need to raise additional funds prior to this time because of a number of factors, including:
Insufficient funds may cause us to delay, reduce the scope of, or eliminate one or more of our development, commercialization or expansion activities. If additional funds are required, we may raise such funds from time to time through public or private sales of equity or debt securities or from bank or other loans. Financing may not be available on acceptable terms, or at all, and our failure to raise capital when needed could materially adversely impact our growth plans and our financial condition or results of
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Table of Contentsoperations. Additional equity financing, if available, may be dilutive to the holders of our common stock and may involve significant cash payment obligations and covenants that restrict our ability to operate our business. In August 2007, we filed a shelf registration statement with the SEC to allow for the potential future sale by us, from time to time, in one or more offerings, of up to $150 million of certain debt and equity instruments specified therein. The shelf registration statement became effective on September 19, 2007. We believe it is good corporate policy to maintain an effective shelf registration statement at this time. Sources and Uses of Cash Cash used in operations was $23.3 million and $30.0 million for the nine months ended September 30, 2007 and 2006, respectively. In both periods, cash used in operations resulted primarily from operating losses. Cash provided by investing activities was $2.4 million and $13.8 million for the nine months ended September 30, 2007 and 2006, respectively. Cash provided by investing activities in the 2007 period and the 2006 period relates primarily to the net effect of purchases and redemptions of short-term investments, together with our investments in property and equipment. Cash provided by financing activities was $54.7 million and $43.8 million for the nine months ended September 30, 2007 and 2006, respectively. Cash provided by financing activities in the 2007 period results primarily from the $49.9 million in net proceeds we received in the June 2007 registered direct offering and the cash receipts from stock option exercises and employee stock purchases. Cash provided by financing activity in the 2006 period resulted primarily from the $43.3 million in net proceeds we received in the September 2006 registered direct offering and the cash receipts from stock option exercises and employee stock purchases, partially offset by debt payments on debt financings. Off-Balance Sheet Arrangements We do not have any off-balance sheet arrangements as defined in Item 303(a) (4) of Regulation S-K. New Accounting Pronouncements See Note 1(c) - New Accounting Pronouncements to the Company’s Consolidated Financial Statements contained in this Report.
We are subject to market risks in the normal course of our business, including changes in interest rates and exchange rates. There have been no significant changes in our exposure to market risks since December 31, 2006. Refer to “Item 7 A. Quantitative and Qualitative Disclosures About Market Risk” of our Annual Report on Form 10-K for the year ended December 31, 2006 for additional information.
Evaluation of Disclosure Controls and Procedures. Our management, with the participation of our Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness of our disclosure controls and procedures as of the end of the period covered by this Report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures as of the end of the period covered by this Report were effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time period specified in the SEC’s rules and forms.
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Table of ContentsChanges in Internal Control over Financial Reporting. There was no change in our internal control over financial reporting during our most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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Table of ContentsPART II. OTHER INFORMATION
In addition to the other information contained in this Report, you should carefully consider the factors discussed in Part I, Item 1A “Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2006 in evaluating our business, financial position, future results, and prospects. The information presented below updates and supplements those risk factors for events, changes and developments since the filing of that Form 10-K and should be read in conjunction with the risks and other information contained in that Form 10-K. The risks described in our Form 10-K, as updated below, are not the only risks we face. Additional risks that we do not presently know or that we currently believe are immaterial could also materially adversely affect our business, financial position, future results and prospects. Risks Related to Our Financial Results and Need for Additional Financing If we are unable to meet our needs for additional funding in the future, we may be required to limit, scale back or cease our operations. Our operations to date have generated substantial and increasing needs for cash. Our negative cash flows from operations are expected to continue for at least the foreseeable future. Our strategy contains elements that we will not be able to execute without outside funding. Specifically, we may need to raise additional capital to:
We believe that our existing cash resources and interest on these funds will be sufficient to meet our anticipated operating requirements until at least 2009. Our future funding requirements will depend on many factors, including:
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These factors could result in variations from our currently projected operating and liquidity requirements. If our existing resources are insufficient to satisfy our liquidity requirements, we may need to borrow money or sell additional equity or debt securities. We may not be able to borrow money on commercially reasonable terms. Moreover, the terms of the sale of any equity or debt securities may not be acceptable to us and could result in substantial dilution of your investment. If we are unable to obtain this additional financing, we may be required to:
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Table of ContentsRisks Related to Development of Our Product Candidates We may not be able to develop product candidates into viable commercial products, which would impair our ability to grow and could cause a decline in the price of our stock. The process of developing product candidates involves a high degree of risk and may take several years. Product candidates that appear promising in the early phases of development may fail to reach the market for several reasons, including:
Success in preclinical and early clinical trials does not ensure that large-scale clinical trials will be successful. Clinical results are frequently susceptible to varying interpretations that may delay, limit or prevent regulatory approvals. The length of time necessary to complete clinical trials and to submit an application for marketing approval for a final decision by a regulatory authority varies significantly and may be difficult to predict. Currently, there is substantial congressional and administration review of the regulatory approval process for drug candidates in the U.S. Any changes to the U.S. regulatory approval process could significantly increase the timing or cost of regulatory approval for our product candidates making further development uneconomical or impossible. In addition, developing product candidates is very expensive and will have a significant impact on our ability to generate profits. Factors affecting our product development expenses include:
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Table of ContentsOur product development efforts also could result in large and immediate write-offs, significant milestone payments, incurrence of debt and contingent liabilities or amortization of expenses related to intangible assets, any of which could negatively impact our financial results. Additionally, if we are unable to develop our product candidates into viable commercial products, we may remain reliant solely on Testim sales for our revenues, potentially limiting our growth opportunities. If clinical trials for our product candidates are delayed, we would be unable to commercialize our product candidates on a timely basis, which could materially harm our business. Clinical trials that we may conduct may not begin on time or may need to be restructured or temporarily suspended after they have begun. Clinical trials can be delayed or may need to be restructured for a variety of reasons, including delays or restructuring related to:
Prior to commencing clinical trials in the U.S., we must have an effective IND for each of our product candidates. An IND has been filed and is effective for XIAFLEX for the treatment of Dupuytren’s contracture, XIAFLEX for the treatment of Peyronie’s disease, and XIAFLEX for the treatment of Frozen Shoulder syndrome; however, INDs have not been filed for AA4010 or our pain transmucosal film product candidates. We will not be able to commence clinical trials in the U.S. for these product candidates until we file, and the FDA fails to object to, an IND for each candidate. We have four projects in clinical development, specifically XIAFLEX for the treatment of Dupuytren’s contracture, Peyronie’s disease and Frozen Shoulder syndrome, and AA4010. Completion of clinical trials for each product candidate will be required before commercialization. In December 2006, we suspended the dosing of patients in our ongoing phase III trials for XIAFLEX for the treatment of Dupuytren’s contracture because of an issue related to the manufacture of clinical supplies of XIAFLEX and, as a result, the FDA placed a clinical hold on our XIAFLEX trials for the treatment of Dupuytren’s contracture and Peyronie’s disease. The FDA lifted the clinical hold in August 2007 and cleared us to resume our XIAFLEX trials. With regard to the development of XIAFLEX for the treatment
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Table of Contentsof Peyronie’s disease, the FDA is requiring that certain additional pre-clinical studies be completed prior to the initiation of the phase IIb dose ranging study or any other human study for Peyronie’s disease. If we experience delays in, or termination of, clinical trials, or fail to enroll patients in clinical trials in a timely manner or if the cost or timing of the regulatory approval process increases, our financial results and the commercial prospects for our product candidates will be adversely impacted. In addition, our product development costs would increase and our ability to generate additional revenue from new products could be impaired. Risks Related to Regulatory Approval of Our Product Candidates Our controls over external financial reporting may fail or be circumvented. We regularly review and update our internal controls, disclosure controls and procedures, and corporate governance policies. In addition, we are required under the Sarbanes Oxley Act of 2002 to report annually on our internal control over financial reporting. If we, or our independent registered public accounting firm, determine that our internal control over financial reporting is not effective, this shortcoming could have an adverse effect on our business and financial results and the price of our common stock could be negatively affected. This reporting requirement could also make it more difficult or more costly for us to obtain certain types of insurance, including director and officer liability insurance, and we may be forced to accept reduced policy limits and coverage or incur substantially higher costs to obtain the same or similar coverage. Any system of internal controls, however well designed and operated, is based in part on certain assumptions and can provide only reasonable, not absolute, assurances that the objectives of the system are met. Any failure or circumvention of the controls and procedures or failure to comply with regulation concerning control and procedures could have a material effect on our business, results of operation and financial condition. The impact of these events could also make it more difficult for us to attract and retain qualified persons to serve on our board of directors, our board committees and as executive officers. Risks Related to the Manufacture of XIAFLEX Our Horsham facility is subject to regulatory oversight, which may delay or disrupt our development and commercialization efforts for XIAFLEX. We must ensure that all of the processes, methods, equipment and facilities employed in the manufacture of XIAFLEX at our Horsham facility are compliant with the current Good Manufacturing Practices (cGMP). The cGMP requirements govern quality control of the manufacturing process and documentation policies and procedures. Compliance with cGMP requires record keeping and quality control to assure that the clinical and commercial product meets applicable specifications and other requirements. Our Horsham facility will be subject to inspection by regulatory agencies after the filing for approval of XIAFLEX with regulatory authorities. If an inspection by regulatory authorities indicates that there are deficiencies including non-compliance with regulatory requirements, we could be required to take remedial actions, stop production or close our Horsham facility, which would disrupt the manufacturing processes, limit the supplies of XIAFLEX and delay clinical trials and subsequent licensure. If we fail to comply with these requirements, we may not be permitted to sell our products or may be limited in the jurisdictions in which we are permitted to sell them. Following licensure of our Horsham facility, noncompliance with any applicable regulatory requirements may result in refusal by regulatory authorities to allow use of XIAFLEX made at our Horsham facility in clinical trials, refusal of the government to allow distribution of XIAFLEX for
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Table of Contentscommercialization, criminal prosecution and fines, recall or seizure of products, total or partial suspension of production, prohibitions or limitations on the commercial sale of products or refusal to allow the entering into of federal and state supply contracts. Risks Related to Our Dependence on Third-Party Manufacturers and Service Providers Since we currently rely on third-party manufacturers and suppliers, we may be unable to control the availability or cost of manufacturing our products, which could adversely affect our results of operations. We currently do not manufacture Testim or any of our product candidates, except for the active ingredient for XIAFLEX for which we are the sole source of supply. Testim is manufactured for us by DPT Laboratories, Ltd., or DPT, under a contract that expires on December 31, 2010. We have qualified a back-up supplier to manufacture Testim. The manufacture of pharmaceutical products requires significant expertise and capital investment. DPT, our back-up supplier for Testim, or any other third-party manufacturer may encounter difficulties in production. These problems may include:
DPT, PharmaForm, or any of our other third-party manufacturers may not perform as agreed or may terminate its agreement with us, which would adversely impact our ability to produce and sell Testim or our ability to produce XIAFLEX or other product candidates for clinical trials. The number of third-party manufacturers with the expertise, required regulatory approvals and facilities to manufacture bulk drug substance on a commercial scale is limited, and it would take a significant amount of time to arrange and receive regulatory approval for alternative arrangements. We may not be able to contract for the manufacturing of Testim or any of our product candidates on acceptable terms, if at all, which would materially impair our business. In December 2006, we suspended the dosing of our ongoing phase III trials for XIAFLEX for the treatment of Dupuytren’s contracture in response to an issue related to the manufacture of clinical supplies and, as a result, the FDA placed these trials on clinical hold. The FDA lifted the clinical hold in August 2007 and cleared us to resume our XIAFLEX trials. While we believe that we have taken all appropriate remedial measures to address this issue, we cannot assure you that we will not encounter similar or other issues related to the manufacture of our products and product candidates. Any of these factors could increase our costs and result in us being unable to effectively commercialize or develop our products. Furthermore, if DPT, our back-up supplier for Testim or any
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Table of Contentsother third-party manufacturer fails to deliver the required commercial quantities of finished product on a timely basis and at commercially reasonable prices, we may be unable to meet the demand for our products and we may lose potential revenues. Approximately 94% of our product shipments are to only three customers; if any of these customers refuse to distribute Testim on commercially favorable terms, or at all, our business will be adversely affected. We sell Testim to wholesale drug distributors and chain drug stores who generally sell products to retail pharmacies, hospitals and other institutional customers. We do not promote Testim to these customers, and they do not determine Testim prescription demand. However, approximately 94% of our product shipments during the period covered by this Report were to only three customers: Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation. Our business would be harmed if any of these customers refused to distribute Testim or refuse to purchase Testim on commercially favorable terms to us. It is possible that wholesalers could decide to change their policies or fees, or both, in the future. This could result in their refusal to distribute smaller volume products, or cause higher product distribution costs, lower margins or the need to find alternative methods of distributing products. Such alternative methods may not exist or may not be economically viable. Risks Related to Intellectual Property We have only limited patent protection for Testim and our product candidates, and we may not be able to obtain, maintain and protect proprietary rights necessary for the development and commercialization of Testim or our product candidates. Our business and competitive positions are dependent upon our ability to obtain and protect our proprietary position for Testim and our product candidates in the U.S., Europe and elsewhere. Because of the substantial length of time and expense associated with development of new products, we, along with the rest of the biopharmaceutical industry, place considerable importance on obtaining and maintaining patent protection for new technologies, products and processes. The patent positions of pharmaceutical, biopharmaceutical and biotechnology companies, including ours, are generally uncertain and involve complex legal and factual questions. Our and our licensors’ patents and patent applications may not protect our technologies and products because, among other things:
We attempt to protect our intellectual property position by filing or obtaining licenses to patent applications and, where appropriate, patent applications in other countries related to our proprietary technology, inventions and improvements that are important to the development of our business. Our
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Table of ContentsFormulation Technologies L.L.C., d/b/a PharmaForm, or PharmaForm, transmucosal film product candidates are covered by a formulation patent in the U.S. only. This patent expires in 2020. Testosterone, the active ingredient in Testim, is off-patent and is included in competing testosterone replacement therapy, or TRT, products. The U.S. patent that we license from Bentley Pharmaceuticals, Inc., or Bentley, covers the composition of matter and formulation of Testim and expires in June 2008. Bentley filed a new patent application in the U.S. which could provide patent protection for Testim in the U.S. The U.S. Patent and Trademark Office, or USPTO, has issued a Notice of Allowance for this patent, but it has not yet issued. Even if this new patent application issues in the U.S. and covers Testim, there is no guarantee that it will issue before the current Bentley U.S. patent expires in June 2008, thereby creating a gap in patent protection for Testim in the U.S. If a generic version of Testim is launched in the U.S. during such a gap in patent protection, we may not be able to halt sales of such generic after the new patent application issues and during the pendency of a patent infringement suit against generics, if ever. The Canadian patents that we license from Bentley expire in January 2010. In July 2005, an additional patent covering Testim issued in Canada, and this patent is included in our license from Bentley. This patent expires in 2023. The European patent that we license from Bentley for Testim expired in November 2006, and in August 2007, the European Patent Office issued an additional patent covering Testim that will expire in 2023. The Japanese patent that we license from Bentley for Testim expired in November 2006, and Bentley has filed a new patent application in Japan which, if issued, could provide additional patent protection for Testim. XIAFLEX, licensed from BioSpecifics Technologies Corp., or BioSpecifics, is covered by two method of use patents in the U.S., one for the treatment of Dupuytren’s contracture and one for the treatment of Peyronie’s disease. The Dupuytren’s patent expires in 2014, and the Peyronie’s patent expires in 2019. The patents are limited to the use of XIAFLEX for the treatment of Dupuytren’s contracture and Peyronie’s disease, respectively, with certain dose ranges and/or concentration ranges. The patent relating to Dupuytren’s contracture has been the subject of a reissue application in the USPTO for, among other things, the purpose of submitting prior art that was not previously submitted during the prosecution of the Dupuytren’s patent. The USPTO issued a Notice of Allowance for this patent in May 2007. In January 2005, a patent application was filed with regard to XIAFLEX for the treatment of Frozen Shoulder syndrome. If this patent is granted, it would expire in 2026. Currently there is not enough data to establish whether any approved product for Dupuytren’s contracture or Peyronie’s disease or Frozen Shoulder syndrome will be covered by these patents. In January 2006, we filed a patent application with regard to the manufacturing process for XIAFLEX; if this patent is granted, it would expire in January 2027. Foreign patents and pending applications may also cover these products in certain countries depending upon the concentration and dosage ranges of such products. Some countries will not grant patents on patent applications that are filed after the public sale or disclosure of the material claimed in the patent application. The U.S., by contrast, allows a one year grace period after public disclosure in which to file a patent application. Because the European patent application was filed after Testim went on the market in the U.S., our ability to obtain additional patent protection outside of the U.S. may be limited. The standards that the USPTO and its foreign counterparts use to grant patents are not always applied predictably or uniformly and can change. Limitations on patent protection in some countries outside the U.S., and the differences in what constitutes patentable subject matter in these countries, may limit the protection we seek outside of the U.S. For example, methods of treating humans are not patentable subject matter in many countries outside of the U.S. In addition, laws of foreign countries may not protect our intellectual property to the same extent as would laws of the U.S. In determining whether or not to seek a patent or to license any patent in a particular foreign country, we weigh the relevant costs and benefits, and consider, among other things, the market potential of our product candidates in the
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Table of Contentsjurisdiction, and the scope and enforceability of patent protection afforded by the law of the jurisdiction. Failure to obtain adequate patent protection for our proprietary product candidates and technology would impair our ability to be commercially competitive in these markets. Accordingly, we do not know the degree of future protection for our proprietary rights or the breadth of claims allowed in any patents issued to us or others. We intend to seek patent protection whenever it is available for any products or product candidates we acquire in the future. However, any patent applications for future products may not issue as patents, and any patent issued on such products may be challenged, invalidated, held unenforceable or circumvented. Furthermore, the claims in patents which have been issued on products we may acquire in the future may not be sufficiently broad to prevent third parties from commercializing competing products. If we fail to obtain adequate patent protection for our products, our ability to compete could be impaired. Technology in-licensed by us is important to our business. We may not control the patent prosecution, maintenance or enforcement of our in-licensed technology. Accordingly, we may be unable to exercise the same degree of control over this intellectual property as we would over our internally developed intellectual property. For example, in-licensed patents for which our rights are limited to a particular field of use could be or become licensed in other fields to other licensees and, therefore, become subject to enforcement by such other licensees without our participation. Consequently, such licensed patents could be held invalid or unenforceable or could have claims construed in a manner adverse to our interests in litigation, which we would not control or to which we would not be a party. If any of the intellectual property rights of our licensors is found to be invalid, this could have a material adverse impact on our operations. If we are not able to protect and control unpatented trade secrets, know-how and other technological innovation, we may suffer competitive harm. We also rely on trade secrets, know-how and technology, which are not protected by patents, to maintain our competitive position. However, trade secrets are difficult to protect. To maintain the confidentiality of trade secrets and proprietary information, we generally seek to enter into confidentiality agreements with our employees, consultants and collaborators upon the commencement of a relationship with us. However, we may not obtain these agreements in all circumstances. Nor can we guarantee that these agreements will provide meaningful protection, that these agreements will not be breached, or that we will have an adequate remedy for any such breach. In addition, adequate remedies may not exist in the event of unauthorized use or disclosure of this information. Others may have developed, or may develop in the future, substantially similar or superior know-how and technology. The loss or exposure of our trade secrets, know-how and other proprietary information, as well as independent development of similar or superior know-how, could harm our operating results, financial condition and future growth prospects. Many of our employees and consultants were, and many of our consultants may currently be, parties to confidentiality agreements with other companies. Although our confidentiality agreements with these employees and consultants require that they do not bring to us, or use without proper authorization, any third party’s proprietary technology, if they violate their agreements, we could suffer claims or liabilities. Risks Related to Employees and Growth Our operations may be impaired unless we can successfully manage our growth. As of September 30, 2007, we had 292 full-time and 9 part-time employees. In order to continue to expand Testim’s sales and commercialize our other product candidates, we currently anticipate that we will need to add some managerial, selling, operational, financial and other employees to our existing
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Table of Contentsdepartments over each of the next two years. Expansion may place a significant strain on our management, operational and financial resources. Moreover, higher than expected market growth of Testim, the acquisition or in-licensing of additional products, as well as the development and commercialization of our other product candidates or marketing arrangements with third parties, could accelerate our hiring needs beyond our current expectations. To manage further growth, we will be required to continue to improve existing, and implement additional, operational and financial systems, procedures and controls, and hire, train and manage additional employees. Our current and planned personnel, systems, procedures and controls may not be adequate to support our anticipated growth and we may not be able to hire, train, retain, motivate and manage required personnel. Our failure to manage growth effectively could limit our ability to achieve our business goals. In addition, our direct sales force consists of relatively newly hired employees. Turnover in our direct sales force or marketing team could adversely affect Testim and future product sales growth. Risks Related to Stock Market Price The market price of our common stock is likely to be volatile. Prior to our initial public offering in July 2004, there was no public market for our common stock. Since our initial public offering, our stock price has, at times, been volatile. We cannot assure you that an active trading market for our common stock will exist at any time. Holders of our common stock may not be able to sell shares quickly or at the market price if trading in our common stock is not active. Substantially all of our outstanding shares of our common stock are eligible for sale in the public market. For the 30 days prior to the end of the period covered by this Report, our average daily trading volume was approximately 330,000 shares. Sales of a substantial number of shares of our common stock in the public market, or the perception in the market that holders of a large number of shares intend to sell shares, could depress the market price of our common stock and impair our ability to raise capital through the sale of additional equity securities, even if our business is doing well. In addition, the market price of our common stock could be subject to wide fluctuations in price in response to various factors, many of which are beyond our control, including:
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Furthermore, market prices for securities of pharmaceutical, biotechnology and specialty biopharmaceutical companies have been particularly volatile in recent years. The broad market and industry factors may seriously harm the market price of our common stock, regardless of our operating performance. If any of these risks occurs, it could cause our stock price to fall and may expose us to class action lawsuits that, even if unsuccessful, could be costly to defend and a distraction to management.
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Issuer Purchases of Equity Securities The following table summarizes the Company’s purchases of its common stock for the three months ended September 30, 2007:
Unregistered Sale of Equity Securities None. Use of Proceeds None.
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Table of ContentsSIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned thereunto duly authorized.
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Table of ContentsEXHIBIT INDEX
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