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Genzyme 10-Q 2010
UNITED STATES
FORM 10-Q
Commission File No. 0-14680 GENZYME CORPORATION
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 ý No o 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). Yes ý No o 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.
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes o No ý Number of shares of Genzyme Stock outstanding as of April 30, 2010: 266,868,620
NOTE REGARDING REFERENCES TO GENZYME Throughout this Form 10-Q, the words "we," "us," "our" and "Genzyme" refer to Genzyme Corporation as a whole, and "our board of directors" refers to the board of directors of Genzyme Corporation. NOTE REGARDING FORWARD-LOOKING STATEMENTS This Form 10-Q contains forward-looking statements. These forward-looking statements include, among others, statements regarding:
2 Table of Contents These statements are subject to risks and uncertainties, and our actual results may differ materially from those that are described in this report. These risks and uncertainties include:
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We refer to more detailed descriptions of these and other risks and uncertainties under the heading "Risk Factors" in Management's Discussion and Analysis of Genzyme Corporation and Subsidiaries' Financial Condition and Results of Operations in Part I., Item 2. of this Form 10-Q. We encourage you to read those descriptions carefully. We caution investors not to place substantial reliance on the forward-looking statements contained in this Form 10-Q. These statements, like all statements in this Form 10-Q, speak only as of the date of this report (unless another date is indicated), and we undertake no obligation to update or revise the statements in light of future developments. NOTE REGARDING INCORPORATION BY REFERENCE The United States Securities and Exchange Commission, commonly referred to as the SEC, allows us to disclose important information to you by referring you to other documents we have filed with them. The information that we refer you to is "incorporated by reference" into this Form 10-Q. Please read that information. NOTE REGARDING TRADEMARKS Genzyme®, Cerezyme®, Fabrazyme®, Thyrogen®, Myozyme®, Renagel®, Renvela®, Campath®, Clolar®, Evoltra®, Mozobil®, Thymoglobulin®, Cholestagel®, Synvisc®, Synvisc-One®, Sepra®, 4 Seprafilm®, Carticel®, Epicel®, MACI® and Hectorol® are registered trademarks, and Lumizyme™ and Jonexa™ are trademarks, of Genzyme or its subsidiaries. Welchol® is a registered trademark of Sankyo Pharma, Inc. Aldurazyme® is a registered trademark of BioMarin/Genzyme LLC. Elaprase® is a registered trademark of Shire Human Genetic Therapies, Inc. Prochymal® and Chondrogen® are registered trademarks of Osiris Therapeutics, Inc. Fludara® and Leukine® are registered trademarks licensed to Genzyme. All other trademarks referred to in this Form 10-Q are the property of their respective owners. All rights reserved. 5
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ITEM 1. FINANCIAL STATEMENTS
The accompanying notes are an integral part of these unaudited, consolidated financial statements. 7
The accompanying notes are an integral part of these unaudited, consolidated financial statements. 8
The accompanying notes are an integral part of these unaudited, consolidated financial statements. 9
1. Description of Business We are a global biotechnology company dedicated to making a major impact on the lives of people with serious diseases. Our products and services are focused on rare inherited disorders, kidney disease, orthopaedics, cancer, transplant and immune disease, and diagnostic testing. Our commitment to innovation continues today with a substantial development program focused on these fields, as well as cardiovascular disease, neurodegenerative diseases, and other areas of unmet medical need. We are organized into five financial reporting units, which we also consider to be our reporting segments:
Effective January 1, 2010, based on changes in how we review our business, we re-allocated certain of our business units among our segments and adopted new names for certain of our reporting segments. Specifically:
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Notes to Unaudited, Consolidated Financial Statements (Continued) 1. Description of Business (Continued)
We report the activities of the following business units under the caption "Other": our genetic testing business unit, which provides testing services for the oncology, prenatal and reproductive markets; and our diagnostic products and pharmaceutical intermediates business units. These operating segments did not meet the quantitative threshold for separate segment reporting. We report our corporate, general and administrative operations and corporate science activities under the caption "Corporate." We have revised our 2009 segment disclosures to conform to our 2010 presentation. On May 6, 2010, we announced that we plan to pursue strategic alternatives for our genetic testing, diagnostic products and pharmaceutical intermediates business units. Options could include divestiture, spin-out or management buy-out. In 2009, our genetic testing business unit had revenue of approximately $317 million and revenue for our diagnostic products business unit was approximately $167 million. We expect these transactions to be completed in 2010. 2. Basis of Presentation and Significant Accounting Policies Basis of Presentation Our unaudited, consolidated financial statements for each period include the statements of operations, balance sheets and statements of cash flows for our operations taken as a whole. We have eliminated all intercompany items and transactions in consolidation. We have reclassified certain 2009 data to conform to our 2010 presentation. We prepare our unaudited, consolidated financial statements following the requirements of the SEC for interim reporting. As permitted under these rules, we condense or omit certain footnotes and other financial information that are normally required by accounting principles generally accepted in the United States, or U.S. GAAP. These financial statements include all normal and recurring adjustments that we consider necessary for the fair presentation of our financial position and results of operations. Since these are interim financial statements, you should also read our audited, consolidated financial statements and notes included in Part II., Item 8. to our 2009 Form 10-K. Revenues, expenses, assets and liabilities can vary from quarter to quarter. Therefore, the results and trends in these interim financial statements may not be indicative of results for future periods. The balance sheet data as of December 31, 2009 that is included in this Form 10-Q was derived from our audited financial statements but does not include all disclosures required by U.S. GAAP. Our unaudited, consolidated financial statements for each period include the accounts of our wholly owned and majority owned subsidiaries. We account for our investments in entities not subject to consolidation using the equity method of accounting if we have a substantial ownership interest (20% to 50%) in or exercise significant influence over the entity. Our consolidated net income (loss) includes our share of the earnings or losses of these entities. All intercompany accounts and transactions have been eliminated in consolidation. 11
Notes to Unaudited, Consolidated Financial Statements (Continued) 2. Basis of Presentation and Significant Accounting Policies (Continued) Revenue Recognition—Recent Healthcare Reform Legislation In March 2010, healthcare reform legislation was enacted in the United States, which contains several provisions that impact our business. Although many provisions of the new legislation do not take effect immediately, several provisions became effective in the first quarter of 2010. These include:
These provisions did not have a significant impact on our results of operations or financial position for the first quarter of 2010. Effective October 1, 2010, the new legislation re-defines the Medicaid average manufacturer price, or AMP, such that the AMP and, consequently, the Medicaid rebate are expected to increase for some of our drugs, in particular those that offer discounted pricing to customers. Beginning in 2011, the new law requires that drug manufacturers provide a 50% discount to Medicare beneficiaries whose prescription drug costs cause them to be subject to the Medicare Part D coverage gap, which is known as the "donut hole." Also beginning in 2011, clinical laboratory fee schedule payments will be reduced by 1.75% over a period of five years and we will be required to pay our share of a new fee assessed on all branded prescription drug manufacturers and importers. This fee will be calculated based upon each organization's percentage share of total branded prescription drug sales to U.S. government programs (such as Medicare and Medicaid, the Department of Veterans Affairs, or VA, the Department of Defense, or DOD, and the TriCare retail pharmacy discount programs) made during the previous year. Sales of orphan drugs, however, are not included in the fee calculation. Final guidance relating to how we will be required to account for this fee is still pending, however, it is expected that the fee will be classified as either a reduction to net sales or an operating expense. The aggregated industry wide fee is expected to total approximately $28 billion through 2019, ranging from $2.5 billion to $4.1 billion annually. Beginning in 2013, a 2.3% excise tax will be imposed on sales of all medical devices except retail purchases by the public intended for individual use. Presently, uncertainty exists as many of the specific determinations necessary to implement this new legislation have yet to be decided and communicated to industry participants. We are still assessing the full extent that the U.S. healthcare reform legislation may have on our business. 12
Notes to Unaudited, Consolidated Financial Statements (Continued) 2. Basis of Presentation and Significant Accounting Policies (Continued) Stock-Based Compensation All stock-based awards to non-employees are accounted for at their fair value. We periodically grant awards, including time vesting stock options, time vesting restricted stock units, or RSUs, and performance vesting restricted stock units, or PSUs, under our employee and director equity plans. Beginning in 2010, our long-term incentive program for senior executives includes a combination of:
Approximately half of each senior executive's grant consists of time vesting stock options with the remainder in PSUs. Grants under our former long-term incentive program were comprised of time vesting stock options and time vesting RSUs. We record the estimated fair value of awards granted as stock-based compensation expense in our consolidated statements of operations over the requisite service period, which is generally the vesting period. Where awards are made with non-substantive vesting periods, such as where a portion of the award vests upon retirement eligibility, we estimate and recognize expense based on the period from the grant date to the date on which the employee is retirement eligible. The fair values of our:
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Notes to Unaudited, Consolidated Financial Statements (Continued) 2. Basis of Presentation and Significant Accounting Policies (Continued) Recent Accounting Pronouncements Periodically, accounting pronouncements and related information on the adoption, interpretation and application of U.S. GAAP are issued or amended by the Financial Accounting Standards Board, or FASB, or other standard setting bodies. Changes to the FASB Accounting Standards Codification™, or ASC, are communicated through Accounting Standards Updates, or ASUs. The following table shows FASB ASUs recently issued that could affect our disclosures and our position for adoption:
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Notes to Unaudited, Consolidated Financial Statements (Continued) 2. Basis of Presentation and Significant Accounting Policies (Continued)
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Notes to Unaudited, Consolidated Financial Statements (Continued) 3. Fair Value Measurements A significant number of our assets and liabilities are carried at fair value. These include:
Fair Value Measurement—Definition and Hierarchy Fair value is defined as the price that would be received to sell an asset or paid to transfer a liability (i.e., the "exit price") in an orderly transaction between market participants at the measurement date. In determining fair value, we are permitted to use various valuation approaches, including market, income and cost approaches. We are required to follow an established fair value hierarchy for inputs used in measuring fair value that maximizes the use of observable inputs and minimizes the use of unobservable inputs by requiring that the observable inputs be used when available. The fair value hierarchy is broken down into three levels based on the reliability of inputs. We have categorized our fixed income, equity securities, derivatives and contingent consideration obligations within the hierarchy as follows:
Valuation Techniques Fair value is a market-based measure considered from the perspective of a market participant who would buy the asset or assume the liability rather than our own specific measure. All of our fixed income securities are priced using a variety of daily data sources, largely readily-available market data and broker quotes. To validate these prices, we compare the fair market values of our fixed income investments using market data from observable and corroborated sources. We also perform the fair value calculations for our derivatives and equity securities using market data from observable and corroborated sources. We determine the fair value of the contingent consideration obligations based on 16
Notes to Unaudited, Consolidated Financial Statements (Continued) 3. Fair Value Measurements (Continued) a probability-weighted income approach. The measurement is based on significant inputs not observable in the market. In periods of market inactivity, the observability of prices and inputs may be reduced for certain instruments. This condition could cause an instrument to be reclassified from Level 1 to Level 2 or from Level 2 to Level 3. During the three months ended March 31, 2010, none of our instruments were reclassified between Level 1, Level 2 or Level 3. The following tables set forth our assets and liabilities that were accounted for at fair value on a recurring basis as of March 31, 2010 and December 31, 2009 (amounts in thousands):
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Notes to Unaudited, Consolidated Financial Statements (Continued) 3. Fair Value Measurements (Continued)
Changes in the fair value of our Level 3 contingent consideration obligations during the three months ended March 31, 2010 were as follows (amounts in thousands):
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Notes to Unaudited, Consolidated Financial Statements (Continued) 3. Fair Value Measurements (Continued) The carrying amounts reflected in our consolidated balance sheets for cash, accounts receivable, other current assets, accounts payable, accrued expenses, current portion of contingent consideration obligations and current portion of long-term debt and capital lease obligations approximate fair value due to their short-term maturities. Derivative Instruments As a result of our worldwide operations, we face exposure to adverse movements in foreign currency exchange rates. Exposures to currency fluctuations that result from sales of our products in foreign markets are partially offset by the impact of currency fluctuations on our international expenses. We may also use derivatives, primarily foreign exchange forward contracts for which we do not apply hedge accounting treatment, to further reduce our exposure to changes in exchange rates, primarily to offset the earnings effect from short-term foreign currency assets and liabilities. We account for such derivatives at market value with the resulting gains and losses reflected within selling, general and administrative expenses, or SG&A, in our consolidated statements of operations. We do not have any derivatives designated as hedging instruments and we do not use derivative instruments for trading or speculative purposes. Foreign Exchange Forward Contracts Generally, we enter into foreign exchange forward contracts with maturities of not more than 15 months. All foreign exchange forward contracts in effect as of March 31, 2010 and December 31, 2009 had maturities of 1 to 2 months. We report these contracts on a net basis. Net asset derivatives are included in other current assets and net liability derivatives are included in accrued expenses in our consolidated balance sheets. The following table summarizes the balance sheet classification of the fair value of these derivatives on both a gross and net basis as of March 31, 2010 and December 31, 2009 (amounts in thousands):
Total foreign exchange (gains) and losses included in SG&A in our consolidated statements of operations includes unrealized and realized (gains) and losses related to both our foreign exchange forward contracts and our foreign currency assets and liabilities. The net impact of our overall unrealized and realized foreign exchange (gains) and losses for both the three months ended March 31, 2010 and 2009 was not significant. The following table summarizes the effect of the unrealized and realized net gains related to our foreign exchange forward contracts on our consolidated statements of operations for the three months ended March 31, 2010 and 2009 (amounts in thousands):
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Notes to Unaudited, Consolidated Financial Statements (Continued) 4. Net Income (Loss) Per Share The following table sets forth our computation of basic and diluted net income (loss) per common share (amounts in thousands, except per share amounts):
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Notes to Unaudited, Consolidated Financial Statements (Continued) 5. Comprehensive Income (Loss) The components of comprehensive income (loss) for the periods presented are as follows (amounts in thousands):
6. Strategic Transactions Purchase of Intellectual Property from EXACT Sciences Corporation On January 27, 2009, we purchased certain intellectual property in the fields of prenatal testing and reproductive health from EXACT Sciences Corporation, or EXACT Sciences, for our genetics business unit and 3,000,000 shares of EXACT Sciences common stock. We paid EXACT Sciences total cash consideration of $22.7 million at that time. Of this amount, we allocated $4.5 million to the acquired shares of EXACT Sciences common stock based on the fair value of the stock on the date of acquisition, which we recorded as an increase to investments in equity securities in our consolidated balance sheet as of March 31, 2009. As the purchased assets did not qualify as a business combination and have not reached technological feasibility nor have alternative future use, we allocated the remaining $18.2 million to the acquired intellectual property, which we recorded as a charge to research and development expenses in our consolidated statements of operations in March 2009. Additional amounts we paid during the first quarter of 2010 and will pay in the future to EXACT Sciences under this agreement are not significant. 21
Notes to Unaudited, Consolidated Financial Statements (Continued) 6. Strategic Transactions (Continued) Purchase of In-Process Research and Development The following table sets forth the significant in-process research and development, or IPR&D, projects for the companies and assets we acquired between January 1, 2006 and March 31, 2010 (amounts in millions):
Pro Forma Financial Summary The following pro forma financial summary is presented as if the acquisition from Bayer was completed as of January 1, 2009. The pro forma combined results are not necessarily indicative of the actual results that would have occurred had the acquisition been consummated on that date, or of the future operations of the combined entities. Material nonrecurring charges related to this acquisition, such as a gain on acquisition of business of $24.2 million, are included in the pro forma financial summaries for the period presented (amounts in thousands, except per share amounts):
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Notes to Unaudited, Consolidated Financial Statements (Continued) 7. Inventories
In order to build a small inventory buffer to help us more consistently manage the resupply of Cerezyme to patients in approximately 100 countries and reduce interruptions in shipping that occur in the absence of inventory, we began shipping 50% of Cerezyme demand at the end of February 2010. Although we achieved our goal of building a small inventory buffer for Cerezyme during the first quarter of 2010, we announced in April 2010 that the 50% shipping allocation will be extended due to an interruption in operations at our Allston facility at the end of March 2010. The interruption resulted from an unexpected city electrical power failure that compounded issues with the plant's water system. The issues have been corrected and the facility is operational. We estimate that we will need to continue the 50% shipping allocation for two to three months. We are currently assessing whether approximately $7 million in the aggregate of Cerezyme and Fabrazyme work-in-process material, the majority of which is Cerezyme, that was unfinished when the interruption occurred can be finished and expect to complete our assessment over the next month. If we determine that this Cerezyme and/or Fabrazyme material cannot be finished, we will have to write off that inventory as a charge to cost of products sold in our consolidated statements of operations in the second quarter of 2010. We capitalize inventory produced for commercial sale, which may result in the capitalization of inventory prior to regulatory approval of a product. If a product is not approved for sale, it would result in the write off of the inventory and a charge to earnings. We have been working to increase the productivity of the Fabrazyme manufacturing process, which has performed at the low end of the historical range since the re-start of production, and have developed a new working cell bank for Fabrazyme that is in its second run. Regulatory approval of the new working cell bank is required. As of March 31, 2010, the amount of inventory for Fabrazyme related to the new working cell bank that has not yet been approved for sale was not significant. Manufacturing-Related Charges We manufacture the majority of our supply requirements for sevelamer hydrochloride (the active ingredient in Renagel) and sevelamer carbonate (the active ingredient in Renvela) at our manufacturing facility in Haverhill, England. In December 2009, equipment failure caused an explosion and fire at this facility, which damaged some of the equipment used to produce these active ingredients as well as the building in which the equipment was located. As a result, we have temporarily suspended production of sevelamer hydrochloride and sevelamer carbonate at this facility while repairs are made. We resumed production of sevelamer hydrochloride in May 2010. We anticipate that the facility will resume production of sevelamer carbonate in the fourth quarter of 2010. We believe that we have adequate supply levels to meet the current demand for both Renagel and Renvela and do not anticipate there will be any supply constraints for either product while the facility undergoes repairs. During the first quarter of 2010, we recorded a total of $7.5 million of expenses, net of $3.0 million of insurance reimbursements, to cost of products sold in our consolidated statements of operations for 23
Notes to Unaudited, Consolidated Financial Statements (Continued) 7. Inventories (Continued) Renagel and Renvela related to the remediation cost of our Haverhill, England manufacturing facility, including repairs and idle capacity expenses. 8. Goodwill and Other Intangible Assets The following table contains the change in our goodwill during the three months ended March 31, 2010 (amounts in thousands):
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Notes to Unaudited, Consolidated Financial Statements (Continued) 8. Goodwill and Other Intangible Assets (Continued) Other Intangible Assets The following table contains information about our other intangible assets for the periods presented (amounts in thousands):
All of our finite-lived other intangible assets are amortized over their estimated useful lives. 25
Notes to Unaudited, Consolidated Financial Statements (Continued) 8. Goodwill and Other Intangible Assets (Continued) As of March 31, 2010, the estimated future amortization expense for our finite-lived other intangible assets for the remainder of fiscal year 2010, the four succeeding fiscal years and thereafter is as follows (amounts in thousands):
9. Investment in BioMarin/Genzyme LLC We and BioMarin Pharmaceutical Inc., or BioMarin, have entered into agreements to develop and commercialize Aldurazyme, a recombinant form of the human enzyme alpha-L-iduronidase, used to treat an LSD known as mucopolysaccharidosis, or MPS, I. Under the relationship, an entity we formed with BioMarin in 1998 called BioMarin/Genzyme LLC has licensed all intellectual property related to Aldurazyme and other collaboration products on a royalty-free basis to BioMarin and us. BioMarin holds the manufacturing rights and we hold the global marketing rights. We are required to pay BioMarin a tiered royalty payment ranging from 39.5% to 50% of worldwide net product sales of Aldurazyme. Prior to January 1, 2010, we determined that we were the primary beneficiary of BioMarin/Genzyme LLC and, as a result, we:
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Notes to Unaudited, Consolidated Financial Statements (Continued) 9. Investment in BioMarin/Genzyme LLC (Continued)
Effective January 1, 2010, in accordance with new guidance we adopted for consolidating variable interest entities, we were required to reassess our designation as primary beneficiary of BioMarin/Genzyme LLC. Under the new guidance, the entity with the power to direct the activities that most significantly impact a variable interest entity's economic performance is the primary beneficiary. We have concluded that BioMarin/Genzyme LLC is a variable interest entity, but does not have a primary beneficiary because the power to direct the activities of BioMarin/Genzyme LLC that most significantly impact its performance, is, in fact, shared equally between us and BioMarin through our commercialization rights and BioMarin's manufacturing rights. Effective January 1, 2010, we no longer consolidate the results of BioMarin/Genzyme LLC and instead record our portion of the results of BioMarin/Genzyme LLC in equity in loss of equity method investments in our consolidated statements of operations. For the three months ended March 31, 2010, the results of BioMarin/Genzyme LLC and our portion of the results of BioMarin/Genzyme LLC were not significant. 10. Investment in Isis Pharmaceuticals, Inc. Common Stock As of March 31, 2010, our investment in Isis common stock had a carrying value of $80.1 million, or $16.02 per share, and a fair market value of $54.7 million, or $10.93 per share. The closing price per share of Isis common stock exhibited volatility during 2009 and the three months ended March 31, 2010 and has remained below our historical cost since September 1, 2009, with closing prices subsequent to that date ranging from a high of $15.69 per share to a low of $8.66 per share. We considered all available evidence in assessing the decline in value of our investment in Isis common stock, including investment analyst reports and Isis's expected results and future outlook, none of which suggests that the decline would be "other than temporary." Currently, the average 12-month price estimate for Isis common stock among some analysts is approximately $16 per share. As a result of our analysis, as of March 31, 2010, we consider the $25.5 million unrealized loss on our investment in Isis common stock to be temporary. We will continue to review the fair value of our investment in Isis common stock in comparison to our historical cost and in the future, if the decline in value has become "other than temporary," we will write down our investment in Isis common stock to its then current market value and record an impairment charge to our consolidated statements of operations. 11. Stockholders' Equity Long-Term Incentive Program for Senior Executives From 2007 through 2009, our long-term incentive program for senior executives was comprised of equity awards in the form of time vesting stock options and time vesting RSUs. Beginning with 2010, the equity vehicles for our long-term incentive program for senior executives includes a combination of:
Approximately half of each senior executive's grant consists of time vesting stock options with the remainder in PSUs. 27
Notes to Unaudited, Consolidated Financial Statements (Continued) 11. Stockholders' Equity (Continued) For the 2010 through 2012 performance period, the performance metrics are:
Each metric is weighted equally. For both metrics, performance between the threshold level and the target level will be awarded in PSUs. The PSUs will be paid out in shares of our stock at the end of the three-year period if performance between the threshold level and target level is achieved. If performance above the target level is achieved, the portion of the award above the target level will be paid out in cash up to a predetermined maximum cash award. Since it is possible that the PSUs may not pay out at all, it is completely "at risk" compensation. In January 2010, the compensation committee of our board of directors approved a range for the three-year cash flow return on invested capital metric of 85% to 115%. For performance between 85% and 100% of the cash flow return on invested capital target, the payout range is 50% to 100% of the senior executive's target PSU award associated with this performance measure. Performance between 101% and 115% of the cash flow return on invested capital target will result in a cash payment that will be awarded based on performance achieved between target and maximum levels, up to a predetermined maximum. The committee also approved the following performance levels for R-TSR:
For performance between the R-TSR threshold and target levels, the payout range is 35% to 100% of the senior executive's target PSU award associated with this performance measure. R-TSR performance between the target and maximum levels will result in a cash payment that will be awarded based on performance achieved between target and maximum levels, up to a predetermined maximum. If a participating senior executive's employment is terminated before the end of the performance period because of death, disability or retirement, payment of the PSU will be pro-rated to the date of termination based upon the company's actual achievement of performance levels at the end of the performance period. Upon a change in control, payment of a PSU will be paid out at the target performance level and pro-rated to the date of the change of control. PSUs During February and March 2010, we granted a total of 214,386 PSUs with a weighted average grant date fair value of $50.10 per share to senior executives under our 2004 Equity Plan. The PSUs are subject to the attainment of certain performance criteria established at the beginning of the performance period, as described above, and cliff vest at the end of the performance period, which ends December 31, 2012. Compensation expense associated with our PSUs is initially based upon the number of shares expected to vest after assessing the probability that certain performance criteria will be met and the associated targeted payout level that is forecasted will be achieved, net of estimated 28
Notes to Unaudited, Consolidated Financial Statements (Continued) 11. Stockholders' Equity (Continued) forfeitures. Compensation expense for our PSUs is recognized over the applicable performance period, adjusted for the effect of estimated forfeitures. The fair value of PSUs subject to the cash flow return on investment performance metric, which includes both performance and service conditions, is estimated based on the market value of our stock on the date of grant. We use a lattice model with a Monte Carlo simulation to determine the fair value of PSUs subject to the R-TSR performance metric, which includes both market and service conditions. The lattice model requires various highly judgmental assumptions to determine the fair value of the awards. This model samples paths of our stock price and the stock prices of a group of peer companies in the S&P 500 Health Care Index, which we refer to as the Peer Group, and calculates the resulting change in cash flow multiple at the end of the forecasted performance period. This model iterates these randomly forecasted results until the distribution of results converge on a mean or estimated fair value. We used the following assumptions to determine the fair value of these awards:
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Notes to Unaudited, Consolidated Financial Statements (Continued) 11. Stockholders' Equity (Continued) Stock-Based Compensation Expense, Net of Estimated Forfeitures We allocated pre-tax stock-based compensation expense, net of estimated forfeitures, based on the functional cost center of each employee as follows (amounts in thousands, except per share amounts):
We amortize stock-based compensation expense capitalized to inventory based on inventory turns. At March 31, 2010, there was $209.5 million of pre-tax stock-based compensation expense, net of estimated forfeitures, related to unvested awards not yet recognized which is expected to be recognized over a weighted average period of 1.6 years. 12. Commitments and Contingencies Pending FDA Consent Decree In March 2010, the FDA notified us that it intended to take enforcement action to ensure that products manufactured at our Allston facility are made in compliance with good manufacturing practice, or GMP, regulations. We have received a draft consent decree from the FDA that provides for a potential up-front disgorgement of past profits of $175.0 million, which we have recorded as a charge to SG&A in our consolidated statements of operations for the first quarter of 2010 and as an increase to accrued expenses on our consolidated balance sheet as of March 31, 2010. We recorded this charge during the first quarter of 2010 because it is probable that we will have to pay this amount to the FDA and we can reasonably estimate the amount that will be paid. In addition, if the fill-finish operations at our Allston facility are still operating after deadlines for domestic and exported products, the draft provides for disgorgement of 18.5% of revenues from sales of products manufactured and distributed from our Allston facility after those deadlines. We and the FDA are having discussions regarding appropriate deadlines for moving fill-finish operations, as well as the details of the disgorgement provisions. Finally, if fill-finish operations are moved from our Allston facility but certain remediation 30
Notes to Unaudited, Consolidated Financial Statements (Continued) 12. Commitments and Contingencies (Continued) actions relating to overall GMP compliance are not met by deadlines over the coming years in a remediation plan to be approved by the FDA, the draft provides for payment of $15,000 per day per violation until the compliance milestones are met. We expect that the FDA will allow us to continue to ship our Cerezyme, Fabrazyme and Myozyme products that are produced or fill-finished at our Allston facility because the FDA has determined that these products meet the definition of "medical necessity" that would justify continued production of these products at Allston during the enforcement period. The FDA, however, has made a preliminary determination that Thyrogen, which is fill-finished at our Allston facility, does not meet the FDA's definition and may require us to cease fill-finishing the product at Allston when we enter into the consent decree. We are actively negotiating with the FDA the terms of the consent decree and presenting our view that there is also patient need for uninterrupted supply of Thyrogen. We expect that the negotiations will be completed during the second quarter of 2010. Legal Proceedings Federal Securities Litigation In July 2009 and August 2009, two purported securities class action lawsuits were filed in the U.S. District Court for the District of Massachusetts against us and our President and Chief Executive Officer. The lawsuits were filed on behalf of those who purchased our common stock during the period from June 26, 2008 through July 21, 2009 and allege violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder. Each of the lawsuits is premised upon allegations that we made materially false and misleading statements and omissions by failing to disclose instances of viral contamination at two of our manufacturing facilities and our receipt of a list of inspection observations from the FDA related to one of the facilities, which detailed observations of practices that the FDA considered to be deviations from GMP. The plaintiffs seek unspecified damages and reimbursement of costs, including attorneys' and experts' fees. In November 2009, the lawsuits were consolidated in In Re Genzyme Corp. Securities Litigation and a lead plaintiff was appointed. In March 2010, the plaintiffs filed a consolidated amended complaint that extended the class period from October 24, 2007 through November 13, 2009. We intend to defend this lawsuit vigorously. Shareholder Demand Letters Since August 2009, we have received nine letters from shareholders demanding that our board of directors take action on behalf of Genzyme Corporation to remedy alleged breaches of fiduciary duty by our directors and certain executive officers. The demand letters are primarily premised on allegations regarding our disclosures to shareholders with respect to manufacturing issues and compliance with GMP and our processes and decisions related to manufacturing at our Allston facility. Several of the letters also assert that certain of our executive officers and directors took advantage of their knowledge of material non-public information about Genzyme to illegally sell stock they personally held in Genzyme. Our board of directors has designated a special committee of three independent directors to oversee the investigation of the allegations made in the demand letters and to recommend to the independent directors of the board whether any action should be instituted on behalf of Genzyme Corporation against any officer or director. The committee has retained independent legal counsel. If the independent members of our board of directors were to make a 31
Notes to Unaudited, Consolidated Financial Statements (Continued) 12. Commitments and Contingencies (Continued) determination that it was in our best interest to institute an action against any officers or directors, any monetary recovery would be to the benefit of Genzyme Corporation. The special committee's investigation is ongoing. Shareholder Derivative Actions In December 2009, two actions were filed by shareholders derivatively for Genzyme's benefit in the U.S. District Court for the District of Massachusetts against our board of directors and certain of our executive officers after a ninety day period following their respective demand letters had elapsed (the "District Court Actions"). In January 2010, a derivative action was filed in Massachusetts Superior Court (Middlesex County) by a shareholder who has not issued a demand letter and in February and March 2010, two additional derivative actions were filed in Massachusetts Superior Court (Suffolk County and Middlesex County, respectively) by two separate shareholders after the lapse of a ninety day period following the shareholders' respective demand letters (collectively, the "State Court Actions"). The derivative actions in general are based on allegations that our board of directors and certain executive officers breached their fiduciary duties by causing Genzyme to make purportedly false and misleading or inadequate disclosures of information regarding manufacturing issues, compliance with GMP, ability to meet product demand, expected revenue growth, and approval of Lumizyme. The actions also allege that certain of our directors and executive officers took advantage of their knowledge of material non-public information about Genzyme to illegally sell stock they personally held in Genzyme. The plaintiffs generally seek, among other things, judgment in favor of Genzyme for the amount of damages sustained by Genzyme as a result of the alleged breaches of fiduciary duty, disgorgement to Genzyme of proceeds that certain of our directors and executive officers received from sales of Genzyme stock and all proceeds derived from their service as directors or executives of Genzyme, and reimbursement of plaintiffs' costs, including attorneys' and experts' fees. The District Court Actions have been consolidated in In Re Genzyme Derivative Litigation and the plaintiffs have agreed to a joint stipulation staying these cases until our board of directors has had sufficient time to exercise its duties and complete an appropriate investigation, which is ongoing. In the State Court Actions, the parties are working to consolidate all three lawsuits. We intend to defend these lawsuits vigorously. Fabrazyme Patent Litigation In October 2009, Shelbyzyme LLC filed a complaint against us in the U.S. District Court for the District of Delaware alleging infringement of U.S. patent 7,011,831 by "making, using, selling and promoting a method for the treatment of" Fabry disease. The '831 patent, which is directed to a method for treating Fabry disease, was issued in March 2006 and expired in March 2009. The plaintiffs seek damages for past infringement, including treble damages for alleged willful infringement and reimbursement of costs, including attorney's fees. We intend to defend this lawsuit vigorously. Other Matters We are party to a legal action brought by Kayat pending before the District Court in Nicosia, Cyprus. Kayat alleges that we breached a 1996 distribution agreement under which we granted Kayat the right to distribute melatonin tablets in the Ukraine, primarily by not providing products or by 32
Notes to Unaudited, Consolidated Financial Statements (Continued) 12. Commitments and Contingencies (Continued) providing non-conforming products. Kayat further claims that due to the alleged breach, it suffered lost profits that Kayat claims it would have received under agreements it alleges it had entered into with subdistributors. Kayat also alleges common law fraud and violations of Mass. Gen. L. c. 93A and the Racketeer Influenced and Corrupt Organizations Act. Kayat filed its suit on August 8, 2002 and a trial began in Cyprus in December 2009. Kayat seeks damages for its legal claims and for expenses it claims it has incurred, including legal fees and advertising, promotion and other out-of-pocket expenses. We believe we acted appropriately in all regards, including properly terminating the agreement when we decided to exit the melatonin business, and we intend to defend this lawsuit vigorously. We are not able to predict the outcome of the lawsuits and matters described above or estimate the amount or range of any possible loss we might incur if we do not prevail in final, non-appealable determination of these matters. Therefore, we have not accrued any amounts in connection with the lawsuits and matters described above. Through June 30, 2003, we had three outstanding series of common stock, which we referred to as tracking stocks: Genzyme General Stock (which we now refer to as Genzyme Stock); Biosurgery Stock; and Molecular Oncology Stock. On August 6, 2007, we reached an agreement in principle to settle for $64.0 million the lawsuits related to our 2003 exchange of Genzyme Stock for Biosurgery Stock. We recorded a liability for the settlement payment of $64.0 million as a charge to SG&A in our consolidated statements of operations for the three months ended June 30, 2007. We paid the settlement in August 2007. The court approved the settlement in October 2007. We have submitted claims to our insurers for reimbursement of portions of the expenses incurred in connection with these cases; the insurers have denied coverage, and therefore, we have not recorded a receivable for any potential recovery from our insurers. In our lawsuit against our primary insurer, the court granted the insurer's motion to dismiss the suit in October 2009. We have appealed this judgment. We also are subject to other legal proceedings and claims arising in connection with our business. Although we cannot predict the outcome of these proceedings and claims, we do not believe the ultimate resolution of any of these existing matters would have a material adverse effect on our consolidated financial position or results of operations. 13. Benefit from (Provision for) Income Taxes
Our effective tax rate for both periods presented varies from the U.S. statutory tax rate as a result of:
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Notes to Unaudited, Consolidated Financial Statements (Continued) 13. Benefit from (Provision for) Income Taxes (Continued)
We are currently under audit by various states and foreign jurisdictions for various years. We believe that we have provided sufficiently for all audit exposures. Settlement of these audits or the expiration of the statute of limitations on the assessment of income taxes for any tax year will likely result in a reduction of future tax provisions. Any such benefit would be recorded upon final resolution of the audit or expiration of the applicable statute of limitations. 14. Segment Information We present segment information in a manner consistent with the method we use to report this information to our management. Effective January 1, 2010, based on changes in how we review our business, we re-allocated certain of our business units amongst our segments and adopted new names for certain of our reporting segments. Under the new reporting structure, we are organized into five reporting segments as described above in Note 1., "Description of Business," to these consolidated financial statements. We have revised our 2009 segment disclosures to conform to our 2010 presentation. We have provided information concerning the operations of these reportable segments in the following tables (amounts in thousands):
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Notes to Unaudited, Consolidated Financial Statements (Continued) 14. Segment Information (Continued)
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Notes to Unaudited, Consolidated Financial Statements (Continued) 14. Segment Information (Continued) Segment Assets We provide information concerning the assets of our reportable segments in the following table (amounts in thousands):
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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF GENZYME CORPORATION AND SUBSIDIARIES' FINANCIAL CONDITION AND RESULTS OF OPERATIONS When reviewing the discussion below, you should keep in mind the substantial risks and uncertainties that characterize our business. In particular, we encourage you to review the risks and uncertainties described under the heading "Risk Factors" below. These risks and uncertainties could cause actual results to differ materially from those forecasted in forward-looking statements or implied by past results and trends. Forward-looking statements are statements that attempt to project or anticipate future developments in our business; we encourage you to review the examples of forward looking statements under "Note Regarding Forward-Looking Statements" at the beginning of this report. These statements, like all statements in this report, speak only as of the date of this report (unless another date is indicated), and we undertake no obligation to update or revise the statements in light of future developments. Note: All references to increases or decreases for the three months ended March 31, 2010 are as compared to the three months ended March 31, 2009. INTRODUCTION We are a global biotechnology company dedicated to making a major impact on the lives of people with serious diseases. Our products and services are focused on rare inherited disorders, kidney disease, orthopaedics, cancer, transplant and immune disease, and diagnostic testing. Our commitment to innovation continues today with a substantial development program focused on these fields, as well as cardiovascular disease, neurodegenerative diseases, and other areas of unmet medical need. We are organized into five financial reporting units, which we also consider to be our reporting segments:
37 Effective January 1, 2010, based on changes in how we review our business, we re-allocated certain of our business units among our segments and adopted new names for certain of our reporting segments. Specifically:
We report the activities of the following business units under the caption "Other": our genetic testing business unit, which provides testing services for the oncology, prenatal and reproductive markets; and our diagnostic products and pharmaceutical intermediates business units. These operating segments did not meet the quantitative threshold for separate segment reporting. We report our corporate, general and administrative operations and corporate science activities under the caption "Corporate." We have revised our 2009 segment disclosures to conform to our 2010 presentation. On May 6, 2010, we announced that we plan to pursue strategic alternatives for our genetic testing, diagnostic products and pharmaceutical intermediates business units. Options could include divestiture, spin-out or management buy-out. In 2009, our genetic testing business unit had revenue of approximately $317 million and revenue for our diagnostic products business unit was approximately $167 million. We expect these transactions to be completed in 2010. STRATEGIC TRANSACTIONS Acquisition from Bayer On May 29, 2009, we completed a transaction with Bayer to:
Prior to this transaction, we shared with Bayer the development and certain commercial rights to alemtuzumab for MS and Campath and received two-thirds of Campath net profits on U.S. sales and a royalty on foreign sales. Under our new arrangement with Bayer, prior to regulatory approval of alemtuzumab for MS, we have primary responsibility for the product's development while Bayer continues to fund development at the levels specified under the previous agreement and participates in 38 a development steering committee. We have worldwide commercialization rights, with Bayer retaining an option to co-promote alemtuzumab for MS. In exchange for the above, Bayer is eligible to receive contingent purchase price payments based on revenues from sales of the products and achievement of sales-based milestones. We will also pay Bayer to acquire the Leukine manufacturing facility following its FDA approval. The terms of these contingent purchase price payments are described in more detail in our 2009 Form 10-K. These contingent purchase price payments could amount to over $2.9 billion in total and extend, in certain circumstances, over more than ten years. The transaction was accounted for as a business combination and is included in our results of operations beginning on May 29, 2009, the date of acquisition. The results for Campath, Fludara and Leukine are included in our Hematology and Oncology reporting segment and the results for alemtuzumab for MS are included in our Multiple Sclerosis reporting segment. The fair value of the total consideration for this transaction was $1.01 billion, consisting of $42.4 million of cash payments net of refundable cash deposits, and $964.1 million of contingent consideration obligations. We allocated the purchase price to the identifiable assets acquired in this transaction based on their estimated fair values as of the date of acquisition, of which $136.4 million was allocated to inventory and $894.3 million was allocated to intangible assets. We recognized a gain on acquisition of business of $24.2 million in our consolidated statements of operations for the second quarter of 2009 representing the amount by which the fair value of the acquired assets of $1.03 billion exceeded the fair value of the purchase price of $1.01 billion. Each period we revalue the contingent consideration obligations to their then fair value and record increases in the fair value as contingent consideration expense and decreases in the fair value as a reduction of contingent consideration expense. Increases or decreases in the fair value of the contingent consideration obligations can result from changes in discount periods and rates, changes in the timing and amount of revenue estimates and changes in probability adjustments with respect to regulatory approval of alemtuzumab for MS. As of December 31, 2009, the fair value of the total contingent consideration obligations was $1.02 billion. During the three months ended March 31, 2010:
As of March 31, 2010, the fair value of the total contingent consideration obligations increased to $1.03 billion primarily due to changes in the assumed timing and amount of revenue and expense estimates. Accordingly, we recorded a total of $62.5 million of contingent consideration expense, of which $35.5 million is related to changes in estimates, in our consolidated statements of operations for the three months ended March 31, 2010 to reflect the increase in fair value, including $21.4 million for our Hematology and Oncology reporting segment and $41.1 million for our Multiple Sclerosis reporting segment. In April 2010, we received $7.6 million of funding from Bayer for the development of alemtuzumab for MS. Purchase of Intellectual Property from EXACT Sciences Corporation On January 27, 2009, we purchased certain intellectual property in the fields of prenatal testing and reproductive health from EXACT Sciences for our genetics business unit and 3,000,000 shares of EXACT Sciences common stock. We paid EXACT Sciences total cash consideration of $22.7 million at that time. Of this amount, we allocated $4.5 million to the acquired shares of EXACT Sciences common stock based on the fair value of the stock on the date of acquisition, which we recorded as an increase to investments in equity securities in our consolidated balance sheet as of March 31, 2009. As the purchased assets did not qualify as a business combination and have not reached technological 39 feasibility nor have alternative future use, we allocated the remaining $18.2 million to the acquired intellectual property, which we recorded as a charge to research and development expenses in our consolidated statements of operations in March 2009. Additional amounts we paid during the first quarter of 2010 and amounts we will pay in the future to EXACT Sciences under this agreement are not significant. CRITICAL ACCOUNTING POLICIES AND SIGNIFICANT JUDGMENTS AND ESTIMATES Our critical accounting policies and significant judgments and estimates are set forth under the heading "Management's Discussion and Analysis of Genzyme Corporation and Subsidiaries' Financial Condition and Results of Operations—Critical Accounting Policies and Significant Judgments and Estimates" in Part II., Item 7. to our 2009 Form 10-K. Excluding the addition of our policy for PSUs to our stock-based compensation policy, there have been no significant changes to our critical accounting policies or significant judgments and estimates since December 31, 2009. Additional information regarding our provisions and estimates for our product sales allowances, sales allowance reserves and accruals, and distributor fees and our revised stock-based compensation policy are included below. Revenue Recognition Product Sales Allowances Sales of many biotechnology products in the United States are subject to increased pricing pressure from managed care groups, institutions, government agencies and other groups seeking discounts. We and other biotechnology companies in the U.S. market are also required to provide statutorily defined rebates and discounts to various U.S. government agencies in order to participate in the Medicaid program and other government-funded programs. In most international markets, we operate in an environment where governments may and have mandated cost-containment programs, placed restrictions on physician prescription levels and patient reimbursements, emphasized greater use of generic drugs and enacted across-the-board price cuts as methods to control costs. In some cases, we have estimated the potential impact of these allowances. The sensitivity of our estimates can vary by program, type of customer and geographic location. Estimates associated with Medicaid and other government allowances may become subject to adjustment in a subsequent period. We record product sales net of the following significant categories of product sales allowances:
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cash discounts by reducing accounts receivable by the full amounts of the discounts. We consider payment performance and adjust the accrual to reflect actual experience; and Our provisions for product sales allowances reduced gross product sales as follows (amounts in thousands):
Total product sales allowances increased for the three months ended March 31, 2010, primarily due to:
These increases were offset, in part, by a $11.2 million decrease in the aggregate product sales allowances for Cerezyme and Fabrazyme as a result of supply constraints. Total product sales allowances as a percentage of total gross product sales increased for the three months ended March 31, 2010, primarily due to decreased sales volumes for Cerezyme and Fabrazyme as a result of the supply constraints for which there was not a proportionate decrease in product sales allowances because these products generally have lower sales allowances. Total estimated product sales allowance reserves and accruals in our consolidated balance sheets increased approximately 9% to approximately $257 million as of March 31, 2010, as compared to approximately $236 million as of December 31, 2009, primarily due to increased contractual adjustments for or Renal and Endocrinology reporting segment and changes in the timing of certain payments. Our actual results have not differed materially from amounts recorded. The annual variation has been less than 0.5% of total product sales for the last three years. 41 Accounts Receivable Related to Sales in Greece Total accounts receivable in our consolidated balance sheets as of March 31, 2010 and December 31, 2009 include sales to government-owned or supported healthcare facilities in Greece. These sales are subject to significant payment delays due to government funding and reimbursement practices. We believe that this is an industry-wide issue for suppliers to these facilities. The outstanding accounts receivable balances, net of reserves, held by our subsidiary in Greece related to such sales were approximately $57 million as of both March 31, 2010 and December 31, 2009. If significant changes occur in the availability of government funding, we may not be able to collect on amounts due from these customers. We do not expect this concentration of credit risk to have a material adverse impact on our financial position or liquidity. Healthcare Reform Legislation In March 2010, healthcare reform legislation was enacted in the United States. Although many provisions of the new legislation do not take effect immediately, several provisions became effective in the first quarter of 2010. These include:
These provisions did not have a significant impact on our results of operations or financial position for the first quarter of 2010. Effective October 1, 2010, the new legislation re-defines the Medicaid AMP such that the AMP and, consequently, the Medicaid rebate are expected to increase for some of our drugs, in particular those that offer discounted pricing to customers. Beginning in 2011, the new law requires drug manufacturers to provide a 50% discount to Medicare beneficiaries whose prescription drug costs cause them to be subject to the Medicare Part D coverage gap, which is known as the "donut hole". Also beginning in 2011, clinical laboratory fee schedule payments will be reduced 1.75% over a period of five years and we will be required to pay our share of a new fee assessed on all branded prescription drug manufacturers and importers. This fee will be calculated based upon each organization's percentage share of total branded prescription drug sales to U.S. government programs (such as Medicare and Medicaid and VA, DOD and TriCare retail pharmacy discount programs) made during the previous year. Sales of orphan drugs, however, are not included in the fee calculation. Final guidance relating to how we will be required to account for this fee is still pending, however, it is expected that the fee will be classified as either a reduction of net sales or an operating expense. The aggregated industry wide fee is expected to total approximately $28 billion through 2019, ranging from $2.5 billion to $4.1 billion annually. Beginning in 2013, a 2.3% 42 excise tax will be imposed on sales of all medical devices except retail purchases by the public intended for individual use. Presently, uncertainty exists as many of the specific determinations necessary to implement this new legislation have yet to be decided and communicated to industry participants. We have made several estimates with regard to important assumptions relevant to determining the financial impact of this legislation on our business due to the lack of availability of both certain information and complete understanding of how the process of applying the legislation will be implemented. Although we are still assessing the full extent that the U.S. healthcare reform legislation may have on our business, we currently estimate that our revenues in the United States will be adversely impacted by less than approximately $20 million in 2010, with most of the impact occurring in the third and fourth quarters, and by approximately $30 million to $40 million in 2011. We expect that the United States Congress and state legislatures will continue to review and assess healthcare proposals, and public debate of these issues will likely continue. We cannot predict which, if any, of such reform proposals will be adopted and when they might be adopted. In addition, we anticipate seeing continued efforts to reduce healthcare costs in many other countries outside the United States. For example, in May 2010, the Greek health ministry imposed a flat mandatory discount of 27% on medicinal products above a certain price level. This discount, however, does not apply to our orphan drugs or Thymoglobulin. The Greek health ministry has stated that this newly imposed pricing is temporary and in two months the ministry will issue new pricing for most medicinal products based on the average of the three lowest prices in the European Union, and at that time, also determine the pricing for orphan products. As another example, the German government is expected to implement measures during the second half of 2010 that, among other things, increase mandatory discounts and impose a three-year price freeze on pharmaceutical prices, based on August 2009 pricing. We expect that our revenues would be negatively impacted if these or similar measures are implemented or maintained. Distributor Fees Cash consideration (including a sales incentive) given by a vendor to a customer is presumed to be a reduction of the selling prices of the vendor's products or services and, therefore, is appropriately characterized as a reduction in revenue. We include such fees in contractual adjustments, which are recorded as a reduction to product sales. That presumption is overcome and the consideration should be characterized as a cost incurred if, and to the extent that, both of the following conditions are met:
We record service fees paid to our distributors as a charge to SG&A, a component of operating expenses, only if the criteria set forth above are met. The following table sets forth the distributor fees recorded as a reduction to product sales and charged to SG&A (amounts in thousands):
43 Stock-Based Compensation We use the Black-Scholes model to value both service condition and performance condition option awards. For awards with only service conditions and graded-vesting features, we recognize compensation cost on a straight-line basis over the requisite service period. For awards with performance conditions, we recognize stock-based compensation expense based on the graded-vesting method. Determining the appropriate fair value model and related assumptions requires judgment, including estimating stock price volatility, forfeiture rates, and expected terms. The expected volatility rates are estimated based on historical and implied volatilities of our common stock. The expected term represents the average time that options that vest are expected to be outstanding based on the vesting provisions and our historical exercise, cancellation and expiration patterns. We estimate pre-vesting forfeitures when recognizing stock-based compensation expense based on historical rates and forward-looking factors. We update these assumptions at least on an annual basis and on an interim basis if significant changes to the assumptions are warranted. We issue PSUs to our senior executives, which vest upon the achievement of certain financial performance goals, including cash flow return on investment and R-TSR. The fair value of PSUs subject to the cash flow return on investment performance metric, which includes both performance and service conditions, is based on the market value of our stock on the date of grant. We use a lattice model with a Monte Carlo simulation to value PSUs subject to the R-TSR performance metric, which is a market condition. We recognize compensation cost for our PSUs on a straight-lined basis over the requisite performance period. Determining the appropriate amount to expense based on the anticipated achievement of the stated goals requires judgment, including forecasting future financial results. The estimate of expense is revised periodically based on the probability of achieving the required performance targets and adjustments are made as appropriate. The cumulative impact of any revision is reflected in the period of change. In the case of PSUs subject to the R-TSR performance metric, if the financial performance goals are not met, the award does not vest, no compensation cost is recognized and any previously recognized stock-based compensation expense is reversed. We review our valuation assumptions periodically and, as a result, we may change our valuation assumptions used to value share-based awards granted in future periods. Such changes may lead to a significant change in the expense we recognize in connection with share-based payments. RESULTS OF OPERATIONS The following discussion summarizes the key factors our management believes are necessary for an understanding of our consolidated financial statements. REVENUES The components of our total revenues are described in the following table (amounts in thousands):
44 Product Revenue The following table sets forth our products and their related indications:
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The following table sets forth our product revenue on a reporting segment basis (amounts in thousands):
Personalized Genetic Health Regulatory and Manufacturing In March 2010, the FDA notified us that it intended to take enforcement action to ensure that products manufactured at our Allston facility are made in compliance with GMP regulations. We have received a draft consent decree from the FDA that provides for an up-front disgorgement of past profits of $175.0 million, which we have recorded as a charge to SG&A in our consolidated statements of operations for the first quarter of 2010 and as an increase to accrued expenses in our consolidated balance sheets as of March 31, 2010. In addition, if the fill-finish operations at our Allston facility is still operating after deadlines for domestic and exported products, the draft provides for disgorgement of 18.5% of revenues from sales of products manufactured and distributed from our Allston facility after those deadlines. We and the FDA are having discussions regarding appropriate deadlines for moving fill-finish operations, as well as the details of the disgorgement provisions. Finally, if fill-finish operations are moved from our Allston facility but certain remediation actions relating to overall GMP compliance are not met by deadlines over the coming years in a remediation plan to be approved by 46 the FDA, the draft provides for payment of $15,000 per day per violation until the compliance milestones are met. We expect that the FDA will allow us to continue to ship our Cerezyme, Fabrazyme and Myozyme products that are produced or fill-finished at our Allston facility because the FDA has determined that these products meet the definition of "medical necessity" that would justify continued production of these products at Allston during the enforcement period. The FDA, however, has made a preliminary determination that Thyrogen, which is fill-finished at our Allston facility, does not meet the FDA's definition and may require us to cease fill-finishing the product at Allston when we enter into the consent decree. We are actively negotiating with the FDA the terms of the consent decree and presenting our view that there is also patient need for uninterrupted supply of Thyrogen. We expect that the negotiations will be completed during the second quarter of 2010. In June 2009, we interrupted production of Cerezyme and Fabrazyme at our Allston facility after identifying a virus, Vesivirus 2117, in a bioreactor used for Cerezyme production. The virus we identified impairs the viability of cells used in the manufacturing process and is not known to cause infection in humans. We completed sanitization of the facility and resumed production there in the third quarter of 2009. Cerezyme and Fabrazyme inventories were not sufficient to avoid shortages. We resumed Cerezyme shipments in the fourth quarter of 2009. In order to build a small inventory buffer to help us more consistently manage the resupply of Cerezyme to patients in approximately 100 countries and reduce interruptions in shipping that occur in the absence of inventory, we began shipping 50% of Cerezyme demand at the end of February 2010. Although we achieved our goal of building a small inventory buffer during the first quarter of 2010, we announced in April 2010 that the 50% shipping allocation will be extended due to an interruption in operations at our Allston facility at the end of March 2010. The interruption resulted from an unexpected city electrical power failure that compounded issues with the plant's water system. The issues have been corrected and the facility is operational. We resumed shipments of vials of Fabrazyme at the beginning of the first quarter of 2010 and have been shipping Fabrazyme to meet approximately 30% of global demand. We have been working to increase the productivity of the Fabrazyme manufacturing process, which has performed at the low end of the historical range since the re-start of production, and have developed a new working cell bank for Fabrazyme that is in its second run. On April 21, 2010, we announced our estimate that we would need to continue the 50% shipping allocation for Cerezyme for two to three months and the 30% shipping allocation for Fabrazyme through the third quarter of 2010. At that time, we also announced that we expect to provide more precise supply updates for Cerezyme and Fabrazyme within a month, once additional information is available about whether we are able to finish approximately $7 million in the aggregate of Cerezyme and Fabrazyme work-in-process material, the majority of which is Cerezyme, that was unfinished when the interruption of operations occurred at our Allston facility, the productivity and timing for regulatory clearance of the new Fabrazyme working cell bank, the impact of the pending consent decree on product release timelines and our assessment for global demand. We will continue to work with minimal levels of inventory for Cerezyme and Fabrazyme until our new Framingham manufacturing facility is approved, which is anticipated to take place in late 2011. Any additional manufacturing delays will likely impact supply of these products. We are also working to transition fill-finish operations out of our Allston facility to our Waterford, Ireland plant and to a contract manufacturer. The fill-finish area of the Waterford facility is being expanded to accommodate the long-term growth of our PGH products, and we currently anticipate receiving approval of this new capacity in 2011. 47 We are pursuing FDA approval of alglucosidase alfa produced using a larger bioreactor scale process, which we refer to as Lumizyme in the United States. Since 2008, we had been seeking approval of the product in the United States using a 2000L scale process, but we stopped manufacturing the product at this scale in 2009. In November 2009, we received a complete response letter from the FDA regarding our application to produce at the 2000L scale stating that satisfactory resolution of deficiencies related to our Allston facility were required before the Lumizyme application could be approved. Based on subsequent conversations with the FDA, we decided to seek approval of the product produced at our Geel, Belgium facility using a 4000L scale process, which will also be known as Lumizyme in the United States. We submitted an amendment to the 2000L BLA to the FDA in December 2009, which the FDA has assigned a June 17, 2010 action date under the Prescription Drug User Fee Act, or PDUFA. Production of alglucosidase alfa at the larger 4000L scale is required to fulfill global demand. In Europe, we received approval for the 4000L scale process in February 2009 and, as of the first quarter of 2010, the majority of markets outside of the United States have transitioned to the 4000L scale product. At our Geel, Belgium facility, we are adding a third bioreactor for the production of Myozyme and approval is anticipated in mid-2011. Personalized Genetic Health Product Revenue
PGH product revenue decreased for the three months ended March 31, 2010, primarily due to:
Cerezyme and Fabrazyme The supply constraint for Cerezyme adversely impacted Cerezyme revenue by $126.5 million for the three months ended March 31, 2010. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, positively impacted Cerezyme revenue by $7.4 million for the three months ended March 31, 2010. Our results of operations are dependent on sales of Cerezyme and any reduction in revenue from sales of this product adversely affects our results of operations. Sales of Cerezyme were approximately 17% of our total revenue for the three months ended March 31, 2010, which reflect periods of supply constraint, as compared to approximately 26% for the same period in 2009. The supply constraint for Fabrazyme adversely impacted Fabrazyme revenue by $72.6 million for the three months ended March 31, 2010. The strengthening of foreign currencies, primarily the Euro, 48 against the U.S. dollar, positively impacted Fabrazyme revenue by $2.1 million for the three months ended March 31, 2010. The Cerezyme and Fabrazyme supply constraints resulting from the suspension of production at our Allston facility have created opportunities for our competitors and our future sales may be negatively affected by competitive products that are being developed by Shire Human Genetic Therapies Inc., or Shire, and Protalix Biotherapeutics Ltd., or Protalix. After our products experienced supply constraints, Shire and Protalix were able to offer their developmental therapies for the treatment of Gaucher disease to patients in the United States through an FDA-approved treatment investigational new drug application, or IND, protocol and to patients in the European Union and other countries through pre-approval access programs. Shire submitted a new drug application, or NDA, to the FDA for its therapy in August 2009 and a Market Authorization Application, or MAA, to the European Medicines Agency, or EMA, in November 2009. Shire received marketing approval for its therapy from the FDA in late February 2010 and announced that it will price this therapy at a 15% savings over Cerezyme. Protalix submitted its NDA to the FDA in December 2009. Outside of the United States, Fabrazyme currently competes with Replagal, a product marketed by Shire. The FDA, however, has approved a treatment IND for Replagal and Shire has submitted a biologics license application, or BLA, with the FDA for this product and been granted "fast track" designation. We are aware that some Gaucher and Fabry patients have switched to one of our competitors' therapies during the period of supply constraint and there is a risk that they may not switch back to our products, which would result in the loss of additional revenue for us. In April 2010, the EMA advised physicians to consider switching Fabry disease patients from Fabrazyme to Replagal based on its concerns that certain patients were not tolerating reduced dosages of Fabrazyme. We also have encouraged patients to switch to competitors products during the period of supply constraint. These actions may result in additional patients switching to our competitors' therapies. In addition, the institution of treatment guidelines and dose conservation measures during the supply constraint present the risk that physicians and patients will not resume prior treatment or dosage levels after the supply constraint has ended, potentially resulting in further loss of revenue for us. Myozyme/Lumizyme Myozyme revenue increased for the three months ended March 31, 2010 due to increased patient identification outside of the United States following the European approval in February 2009 of the product produced at our Belgium facility using the 4000L scale process. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, positively impacted Myozyme revenue by $3.8 million for the three months ended March 31, 2010. We have provided alglucosidase alfa free of charge since 2007 under a temporary access program, and in December 2009 we agreed with the FDA to work with the 81 active study sites in the United States to enroll additional patients into this program. We plan to keep open the temporary access program until commercial approval of Lumizyme produced using the 4000L scale process in the United States. We are currently providing therapy free of charge to more than 200 patients in the United States. We have received a June 17, 2010 PDUFA date in connection with our supplemental BLA for Lumizyme produced at the 4000L scale. If the FDA approves Lumizyme, we would expect revenues for the product to increase in 2011. Aldurazyme Aldurazyme revenue increased for the three months ended March 31, 2010 due to increased patient identification worldwide as Aldurazyme was introduced into new markets. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, positively impacted Aldurazyme revenue by $1.7 million for the three months ended March 31, 2010. 49 Other Personalized Genetic Health Other PGH product revenue increased for the three months ended March 31, 2010, primarily due to increased sales of Elaprase attributable to the continued identification of new patients in our territories. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, had no significant impact on Other PGH product revenue for the three months ended March 31, 2010. Renal and Endocrinology
Sales of Renagel/Renvela, including sales of bulk sevelamer, decreased for the three months ended March 31, 2010, primarily due to the effect of Renagel pricing in Brazil and the conversion of patients to Renvela in the United States. These effects were offset, in part, by increased end-user demand. In 2009, we decreased the price of Renagel in Brazil in connection with successfully negotiating a government tender in the face of competition from two similar products that had been approved in that country. Total revenue for Renagel/Renvela, including sales of bulk sevelamer, reflects the increasing percentage of Renvela sales within the United States. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, positively impacted Renagel revenue by $6.4 million for the three months ended March 31, 2010. We manufacture the majority of our supply requirements for sevelamer hydrochloride (the active ingredient in Renagel) and sevelamer carbonate (the active ingredient in Renvela) at our manufacturing facility in Haverhill, England. In December 2009, equipment failure caused an explosion and fire at this facility, which damaged some of the equipment used to produce these active ingredients as well as the building in which the equipment was located. As a result, we have temporarily suspended production of sevelamer hydrochloride and sevelamer carbonate at this facility while repairs are made. We resumed production of sevelamer hydrochloride in May 2010. We anticipate that the facility will resume production of sevelamer carbonate in the fourth quarter of 2010. We believe that we have adequate supply levels to meet the current demand for both Renagel and Renvela and do not anticipate there will be any supply constraints for either product while the facility undergoes repairs. During the first quarter of 2010, we recorded a total of $7.5 million of expenses, net of $3.0 million of insurance reimbursements, to cost of products sold in our consolidated statements of operations for Renagel and Renvela related to the remediation cost of our Haverhill, England manufacturing facility, including repairs and idle capacity expenses. Sales of Hectorol increased for the three months ended March 31, 2010, primarily due to price increases in the second and fourth quarters of 2009. Sales of Hectorol also include an increase in sales volume due to the addition of the Hectorol 1mcg capsule formulation in August 2009. Renagel/Renvela and Hectorol currently compete with several other marketed products and will have additional competitors in the future. Competitive products, especially if they are lower cost generic or follow-on products, will negatively impact the revenues we recognize from Renagel/Renvela and Hectorol. See "Some of our products may face competition from lower cost generic or follow-on products," under the heading "Risk Factors" below. 50 In addition, our ability to maintain sales of Renagel/Renvela and Hectorol will depend on many other factors, including the availability of coverage and reimbursement under patients' health insurance and prescription drug plans and the ability of health care providers to improve patients' compliance with their prescribed doses. Also, the accuracy of our estimates of fluctuations in the payor mix and our ability to effectively manage wholesaler inventories and the levels of compliance with the inventory management programs we implemented for Renagel/Renvela and Hectorol with our wholesalers could impact the revenue from our Renal and Endocrinology reporting segment that we record from period to period. The Medicare Improvements for Patients and Providers Act of 2008, or MIPPA, directs the Centers for Medicare and Medicaid Services, or CMS, to establish a bundled payment system to reimburse dialysis providers treating patients with end stage renal disease, or ESRD. In September 2009, CMS proposed changes to the prospective payment system that would include drugs and biologicals used to treat ESRD in the bundled payment amount for dialysis treatments. The bundled rate is proposed to include drugs and biologicals that are currently reimbursed separately by Medicare, including intravenous Vitamin D analogs and their oral equivalents such as Hectorol, and oral phosphate binders such as Renagel/Renvela. CMS will issue a final rule in 2010 with an anticipated implementation date of January 2011. We are in the process of evaluating the potential impact of the proposed bundling on our business. We cannot predict whether CMS's final rule would include phosphate binders in the bundled payment. Sales of Thyrogen increased for the three months ended March 31, 2010, primarily due to worldwide volume growth, driven by an increase in the use of the product in thyroid remnant ablation procedures and a price increase in July 2009. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, positively impacted Thyrogen revenue by $1.5 million for the three months ended March 31, 2010. As described above, we are negotiating a consent decree with the FDA with respect to our Allston facility, where Thyrogen is fill-finished. The FDA has made a preliminary determination that Thyrogen does not meet the FDA's definition of "medical necessity" that would justify continued production at Allston during the enforcement period, and may require us to cease fill-finishing the product when we enter into the consent decree. During our negotiations with the FDA, we are presenting our view that there is patient need for uninterrupted supply of Thyrogen. In October 2009, we initiated a process to transfer Thyrogen fill-finish operations to a contract manufacturer. Depending on the timing and terms of the final consent decree and the time required to receive FDA approval for our contract manufacturer, we could experience supply constraints for Thyrogen. Biosurgery
Biosurgery product revenue increased for the three months ended March 31, 2010, primarily due to increased sales for Synvisc/Synvisc-One due to the addition of Synvisc-One sales in the United States. We received marketing approval for Synvisc-One in the United States in February 2009. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, positively impacted Biosurgery revenue by $1.6 million for the three months ended March 31, 2010. Sales of Synvisc/Synvisc-One are subject to seasonality in demand and typically decline in the first quarter. 51 Hematology and Oncology
Hematology and Oncology product revenue increased for the three months ended March 31, 2010, primarily due to:
The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, positively impacted Hematology and Oncology revenue by $2.2 million for the three months ended March 31, 2010. Other Product Revenue
Other product revenue decreased for the three months ended March 31, 2010, primarily due to decreased demand for pharmaceutical intermediates products, offset, in part, by increased demand for diagnostic products. Service Revenue We derive service revenues primarily from the following sources:
52 The following table sets forth our service revenue on a segment basis (amounts in thousands):
Service revenue was relatively consistent for the three months ended March 31, 2010 as compared to the same period of 2009. The strengthening of foreign currencies, primarily the Euro, against the U.S. dollar, had no significant impact on service revenue for the three months ended March 31, 2010. International Product and Service Revenue A substantial portion of our revenue is generated outside of the United States. The following table provides information regarding the change in international product and service revenue as a percentage of total product and service revenue during the periods presented (amounts in thousands):
International product and service revenue decreased for the three months ended March 31, 2010, primarily due to a decrease in international sales volume for Cerezyme and Fabrazyme for the three months ended March 31, 2010 due to supply constraints. This decrease was offset, in part, by:
53 Research and Development Revenue The following table sets forth our research and development revenue on a segment basis (amounts in thousands):
Total research and development revenue decreased for the three months ended March 31, 2010, primarily due to a decrease in Multiple Sclerosis research and development revenue as a result of our acquisition from Bayer and termination of the Campath profit share arrangement. As of May 29, 2009, the effective date of our acquisition from Bayer, we ceased recognizing research and development revenue for Bayer's reimbursement of a portion of the development costs for alemtuzumab for MS. The fair value of the research and development costs to be reimbursed by Bayer is accounted for as an offset to the contingent consideration obligations for alemtuzumab for MS. GROSS PROFIT AND MARGINS The components of our total margins are described in the following table (amounts in thousands):
Gross Product Profit and Product Margin Our overall gross product profit decreased for the three months ended March 31, 2010, primarily due to:
54 These decreases were offset, in part, by:
Our product margin decreased for the three months ended March 31, 2010, primarily due to:
Our gross product profit and product margin for the three months ended March 31, 2010 were also impacted by the favorable effect of foreign exchange rates on product sales outside of the United States, offset, in part, by the unfavorable effect of such rates on the cost of those products. Our gross product profit and product margin for both the three months ended March 31, 2010 and 2009 includes the effect of manufacturing-related charges of:
For purposes of this discussion, the amortization of product related intangible assets is included in amortization expense and, as a result, is excluded from cost of products sold and the determination of product margins described above. Gross Service Profit and Service Margin Our overall gross service profit and total service margin decreased for the three months ended March 31, 2010, primarily due to increased employee, rent and depreciation expenses for our genetic testing business unit. Service revenue for our genetic testing business unit remained relatively consistent for the three months ended March 31, 2010. OPERATING EXPENSES Selling, General and Administrative Expenses The following table provides information regarding the change in SG&A during the periods presented (amounts in thousands):
55 SG&A increased for the three months ended March 31, 2010, primarily due to spending increases of:
SG&A increased by $8.3 million for the three months ended March 31, 2010 due to the unfavorable impact of the strengthening of foreign currencies, primarily the Euro, against the U.S. dollar. Research and Development Expenses The following table provides information regarding the change in research and development expenses during the periods presented (amounts in thousands):
Research and development expenses increased for the three months ended March 31, 2010, primarily due to:
Research and development expense increased by $2.8 million for the three months ended March 31, 2010 due to the unfavorable impact of the strengthening of foreign currencies, primarily the Euro, against the U.S. dollar. These increases were partially offset by a spending decrease of $17.2 million on research and development programs included under the category "Other," primarily due to a payment of $18.2 million to EXACT Sciences for the purchase of intellectual property in January 2009 for which there was no comparable amount for the three months ended March 31, 2010. 56 Amortization of Intangibles The following table provides information regarding the change in amortization of intangibles expense during the periods presented (amounts in thousands):
Amortization of intangibles expense increased for the three months ended March 31, 2010, primarily due to the acquisition of the worldwide marketing and distribution rights to the oncology products Campath, Fludara and Leukine from Bayer and to additional amortization expense for the Synvisc sales and marketing rights we reacquired from Wyeth. As discussed in Note 8., "Goodwill and Other Intangible Assets," to our consolidated financial statements included in this Form 10-Q, we calculate amortization expense for the Synvisc sales and marketing rights we reacquired from Wyeth and the Myozyme patent and technology rights pursuant to a licensing agreement with Synpac by taking into account forecasted future sales of the products, and the resulting estimated future contingent payments we will be required to make. In addition, we also calculate amortization for the technology intangible assets for Fludara based on forecasted future sales of Fludara. We completed the contingent royalty payments to Wyeth related to North American sales of Synvisc in the first quarter of 2010 and anticipate completing the remaining contingent royalty payments to Wyeth related to sales of the product outside of the United States by the end of 2010, the amount of which is not significant. As a result, we expect amortization of intangibles expense to fluctuate over the next five years based on the future contingent payments to Synpac, as well as changes in the forecasted revenue for Fludara. Contingent Consideration Expense The following table provides information regarding the change in contingent consideration expense during the periods presented (amounts in thousands):
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