Infinity Pharmaceuticals 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
Commission File Number 000-31141
DISCOVERY PARTNERS INTERNATIONAL, INC.
(Exact Name of Registrant as Specified in Its Charter)
9640 Towne Centre Drive
San Diego, California 92121
(Address of Principal Executive Offices, Including Zip Code)
(Registrants Telephone Number, Including Area Code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No o
Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes ý No o
As of May 6, 2005 a total of 26,191,885 shares of the Registrants Common Stock, $0.001 par value, were issued and outstanding.
DISCOVERY PARTNERS INTERNATIONAL, INC.
TABLE OF CONTENTS
DISCOVERY PARTNERS INTERNATIONAL, INC.
Discovery Partners International, Inc.
See accompanying notes
Discovery Partners International, Inc.
See accompanying notes
Discovery Partners International, Inc.
See accompanying notes
DISCOVERY PARTNERS INTERNATIONAL, INC.
MARCH 31, 2005
1. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and disclosures required by accounting principles generally accepted in the United States for complete financial statements. The condensed consolidated balance sheet as of March 31, 2005, condensed consolidated statements of operations for the three months ended March 31, 2005 and 2004, and the condensed consolidated statements of cash flows for the three months ended March 31, 2005 and 2004 are unaudited, but include all adjustments (consisting of normal recurring adjustments), which Discovery Partners International, Inc. (the Company) considers necessary for a fair presentation of the financial position, results of operations and cash flows for the periods presented. The results of operations for the three months ended March 31, 2005 shown herein are not necessarily indicative of the results that may be expected for the year ending December 31, 2005. For more complete financial information, these financial statements, and notes thereto, should be read in conjunction with the audited consolidated financial statements for the year ended December 31, 2004 included in the Companys Form 10-K filed with the Securities and Exchange Commission.
The accompanying consolidated financial statements include all of the accounts of the Company and its wholly owned subsidiaries, Discovery Partners International AG (DPI AG), ChemRx Advanced Technologies, Inc., Xenometrix, Inc., Discovery Partners International L.L.C. (DPI LLC), Structural Proteomics, Inc. (substantially inactive), Systems Integration Drug Discovery Company, Inc. (substantially inactive) and Irori Europe, Ltd. (substantially inactive). All intercompany accounts and transactions have been eliminated.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, such as inventory, intangible assets and restructuring accruals, at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
2. Net Income (Loss) Per Share
Basic and diluted net income (loss) per share is presented in conformity with Statement of Financial Accounting Standard (SFAS) No. 128, Earnings per Share. In accordance with SFAS No. 128, basic net income (loss) per share has been computed by dividing net income (loss) by the weighted average number of shares of common stock outstanding during the period, less shares subject to repurchase. Diluted net income per share has been computed by dividing net income by the weighted-average number of common shares outstanding and common stock equivalent shares outstanding during the period calculated using the treasury stock method, less shares subject to repurchase. Common stock equivalent shares, composed of outstanding stock options and warrants, are included in diluted net income per share to the extent these shares are dilutive. In loss periods, common stock equivalents are excluded from the computation of diluted net loss per share as their effect would be anti-dilutive. The computations for basic and diluted earnings per share are as follows:
The total number of shares issuable upon exercise of stock options and warrants excluded from the calculation of diluted earnings per share since they are anti-dilutive were 3,506,466 and 798,688 for the three months ended March 31, 2005 and 2004, respectively.
3. Stock-Based Compensation
As permitted by SFAS No. 123, Accounting for Stock-Based Compensation, as amended by SFAS No. 148, Accounting for Stock-Based Compensation---Transition and Disclosure, the Company accounts for common stock options granted to employees and directors using the intrinsic value method and, thus, recognizes no compensation expense for such stock-based awards where the exercise prices are equal to or greater than the fair value of the Companys common stock on the date of the grant. Pro forma information regarding net income or loss is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS No. 123. The fair value of these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions used for option grants:
For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the vesting period. The Companys pro forma information is as follows:
4. Comprehensive Income (Loss)
SFAS No. 130, Reporting Comprehensive Income, requires the Company to report, in addition to net income (loss), comprehensive income (loss) and its components. A summary follows:
Inventories are recorded at the lower of weighted average cost or market. Inventories consist of the following:
6. Prepaid Royalty, Patents and License Rights
Prepaid royalty, patents and license rights consist of the following:
During the three months ended March 31, 2005 the Company recorded an impairment charge of $1,000,000 on patent rights to a proprietary gene profiling system that is licensed and which enables the Company to offer toxicology research products and services. The loss of a customer, during the three month period, required the reevaluation of the recoverability of the gross carrying value of the asset. In accordance with SFAS 144, Accounting for the Impairment or Disposal of Long-Lived Assets, the Company estimated the future cash flows to test the asset for recoverability. The Company considered all available evidence and developed estimates based on historical rates of attrition of the customer base, future cash generating capacity and future expenditures necessary to maintain the asset. An expected present value technique, in which a series of cash flow scenarios that reflect the range of possible outcomes are discounted to estimate the fair value of the asset. Revenues generated by this asset are included in service revenues.
Amortization expense related to intangible assets was $401,289 and $439,796 for the three months ended March 31, 2005 and 2004, respectively. The Company began amortization in the first quarter of 2004 of the prepaid royalty of $6,034,643 for royalties the Company prepaid to Abbott Laboratories related to the µARCS screening technology. This amortization is being recorded ratably over five years. The estimated amortization expense of
intangible assets for the remaining nine-month period in fiscal 2005 is approximately $1,081,133 and for each of the five succeeding years ending December 31 is as shown in the following table. Actual amortization expense to be reported in future periods could differ from these estimates as a result of acquisitions, divestitures, asset impairments and other factors.
7. Restructuring Accrual
In April 2003, the Company announced that it would consolidate its domestic chemistry facilities into two centers of excellence: in South San Francisco for primary screening library design and synthesis programs and in San Diego for lead optimization and medicinal chemistry projects. At the same time, the Company announced its plans to establish new offshore chemistry capabilities to take advantage of lower cost structures. These actions resulted in the closure of its Tucson facility. In accordance with SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, severance and retention bonuses for involuntary employee terminations and the costs to exit certain contractual and lease obligations were accrued as of the restructuring date. Moving, relocation and other costs related to consolidation of facilities were expensed as incurred. Under the restructuring plan, 28 employees were involuntarily terminated, including scientific and administrative staff. Restructuring charges totaled $1,872,986 for the year ended December 31, 2003 and $129,672 for the three months ended March 31, 2005 and were comprised of the following in the aggregate:
The following table summarizes the activity and balances of the restructuring reserve:
The Company expects to complete the utilization of the reserve related to this restructuring by July 2005.
8. Revenues by Product Category
The Company operates in one industry segment: the development, manufacture and marketing of products and services to make the drug discovery process more efficient, less expensive and more likely to generate a drug target. Such products and services include libraries of drug-like compounds, proprietary instruments, consumable supplies, drug discovery services, computational tools to generate compound libraries, and testing and screening services to optimize potential drugs. Additionally, the Company licenses proprietary gene profiling systems. Our products and services are complementary, and share the same customers, distribution and marketing strategies. In addition, in making operating and strategic decisions, the Companys management evaluates revenues based on the worldwide revenues of each major product line and type of service, and profitability on an enterprise-wide basis. Revenue by product and service category is as follows:
A total of 37% and 51% for the three months ended March 31, 2005 and 2004, respectively of revenue came from Pfizer.
In December 2004, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 123 (revised 2004), Shared-Based Payment, which is a revision of FASB Statement No. 123, Accounting for Stock-Based Compensation. Statement No. 123(R) supersedes APB Opinion No. 25, Accounting for Stock Issued to Employees, and amends FASB Statement No. 95, Statement of Cash Flows. Generally, the approach to accounting for share-based payments in Statement No. 123(R) is similar to the approach described in Statement No. 123. However, Statement 123(R) requires all share-based payments to employees, including grants of employee stock options, to be recognized in the financial statement based on their fair values. In April 2005, the SEC delayed implementation of FASB 123R for publicly traded companies such that they must apply this Standard as of the beginning of the next fiscal year that begins after June 15, 2005. Statement 123(R) permits public companies to adopt its requirements using one of two methods:
1. A modified prospective method in which compensation cost is recognized beginning with the effective date (a) based on the requirements of Statement 123(R) for all share-based payments granted after the effective date and (b) based on the requirements of Statement 123 for all awards granted to employees prior to the effective date of Statement 123(R) that remain unvested on the effective date.
2. A modified retrospective method which includes the requirements of the modified prospective method described above, but also permits entities to restate based on the amounts previously recognized under Statement 123 for purposes of pro forma disclosures either (a) all prior periods presented or (b) prior interim periods of the year of adoption.
The Company plans to adopt Statement No. 123(R) using the modified-prospective method, which will impact all periods beginning after December 31, 2005. As permitted by Statement No. 123(R), the Company currently accounts for share-based payments to employees using Opinion 25s intrinsic value method and, as such, generally recognizes no compensation cost for employee stock options. Accordingly, the adoption of Statement No. 123(R)s fair value method will have a significant impact on our future results from operations, although it will have no impact on our overall financial position. As a result of the anticipated adoption of Statement No. 123(R), the Compensation Committee of the Board of Directors approved the acceleration of vesting on stock options with exercise prices of $5.75 or more effective February 21, 2005, which did not result in an accounting charge under the Opinion 25 intrinsic value method. The Company has not determined the impact of adoption of Statement No. 123(R) at this time since it will depend on levels of share-based payments granted in the future. Statement No.
123(R) also requires the benefits of tax deductions in excess of recognized compensation cost to be reported as a financing cash flow, rather than as an operating cash flow as required under current literature. This requirement will reduce net operating cash flows and increase net financing cash flows in periods after adoption. While the Company cannot estimate what those amounts will be in the future (because they depend on, among other things, when employees exercise stock options), we have not recognized excess tax deductions historically due to our accumulated loss position.
10. Significant Events
On April 22, 2005, Discovery Partners International, Inc. (Discovery Partners), through its newly formed subsidiary Discovery Partners International AG, entered into and completed a Business Transfer Agreement with Biofrontera Discovery GmbH (Biofrontera), a biotechnology company in Heidelberg, Germany and Biofrontera AG, the parent of Biofrontera. Pursuant to the agreement Discovery Partners will acquire substantially all the assets and assume certain liabilities of Biofrontera for an aggregate purchase price of 980,000 (Euros nine hundred eighty thousand) which is equivalent to approximately $1.3 million, plus any applicable value added tax.
On March 31, 2005, Discovery Partners International, Inc. entered into an employment agreement with Michael C. Venuti, Ph.D. to serve as the Companys Chief Scientific Officer. This agreement is for an indefinite term and may be terminated by Dr. Venuti or the Company at any time, with or without cause. In connection with Dr. Venutis employment agreement, the Company awarded Dr. Venuti a restricted stock grant, subject to board approval, for 200,000 shares of the Companys common stock pursuant to the Companys 2000 Stock Incentive Plan. The restricted stock will vest at the end of five years from the grant date subject to acceleration of vesting.
THIS FORM 10-Q CONTAINS CERTAIN STATEMENTS THAT ARE NOT STRICTLY HISTORICAL AND ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING OF THE PRIVATE SECURITIES LITIGATION REFORM ACT OF 1995 AND INVOLVE A HIGH DEGREE OF RISK AND UNCERTAINTY. SUCH STATEMENTS INCLUDE BUT ARE NOT LIMITED TO STATEMENTS REGARDING OUR ESTIMATED FUTURE AMORTIZATION EXPENSE, EXPECTED FUTURE REVENUES UNDER OUR CHEMISTRY CONTRACT WITH PFIZER, THE ESTIMATED COSTS TO CLOSE OUR TUCSON FACILITY, OUR CASH RESOURCES, OUR FUTURE CASH FLOWS, OUR FUTURE DEBT LEVELS, OUR FUTURE CAPITAL EXPENDITURES AND STATEMENTS ABOUT OUR EXPECTATIONS RELATED TO PROFITABILITY. OUR ACTUAL RESULTS MAY DIFFER MATERIALLY FROM THOSE PROJECTED IN THE FORWARD-LOOKING STATEMENTS DUE TO RISKS AND UNCERTAINTIES THAT EXIST IN OUR OPERATIONS, DEVELOPMENT EFFORTS AND BUSINESS ENVIRONMENT, INCLUDING THOSE DESCRIBED BELOW UNDER THE HEADING RISKS AND UNCERTAINTIES AND THOSE DESCRIBED IN OUR FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 2004 AND OTHER REPORTS FILED WITH THE SECURITIES AND EXCHANGE COMMISSION.
Web Site Access to SEC Filings
We maintain an Internet website at www.discoverypartners.com. We make available free of charge on our Internet website our annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
We were founded in 1995 as IRORI. In October 1998, we changed our name to Discovery Partners International, Inc. and in July 2000 we completed our initial public offering and simultaneously reincorporated in the state of Delaware.
We sell a broad range of products and services to pharmaceutical and biopharmaceutical companies to make the drug discovery process for our customers faster, less expensive and more effective at generating drug candidates. We focus on the portion of the drug discovery process that begins after identification of a drug target through when a drug candidate is ready for pre-clinical studies. Our major products and services are as follows:
Instrumentation and Related Consumables. We sell, and provide access to, our proprietary instruments and consumables that automate the process of making and storing collections, or libraries, of chemical compounds. Our compound synthesis instruments are based on a patented core technology, which enables our customers to generate large collections of compounds with efficiency and speed.
Our current products that are based on proprietary technology were developed internally and include the X-Kan, NanoKan Systems, high throughput chemistry systems that can generate up to hundreds of thousands of discrete compounds per year, the AutoSort System, an automated chemistry system and a manual chemistry system. All of these systems include hardware and software platforms and use consumables that our customers purchase for every compound that is synthesized using these automation systems. We also offer Crystal Farm, our proprietary self-contained crystallization and imaging system that provides automated high throughput incubation and imaging of thousands of protein crystallization experiments. In late 2004, we introduced our proprietary vial, tube and microplate storage and retrieval system that provides an automated solution to high volume and variable-sized compound storage formats.
Compounds. As a result of internal development and our acquisitions of Axys Advanced Technologies, Inc. (AAT) in 2000 and Systems Integration Drug Discovery Company (SIDDCO), in 2001, we are able to offer a broad range of highly purified compound libraries that can be screened using assays. After compounds are screened, promising compounds, or hits, are then improved, or optimized, to generate drug candidates, or leads. These hits may be from our compound libraries, our customers internal compound collection or even from another compound library supplier.
Medicinal Chemistry. We also provide a wide range of medicinal chemistry and other lead optimization services. This includes the synthesis of compounds that modify the original hit for improved potency, selectivity and other pharmaceutical characteristics. In some cases we provide medicinal chemistry services in conjunction with our computational drug discovery efforts to design and construct small libraries of compounds to act on specific targets that have known chemical structures.
Drug Discovery Informatics; ADME and Toxicology. In connection with our acquisitions in 2000 of AAT and Structural Proteomics, we acquired and we are further developing computational tools that we believe will allow us to substantially increase our knowledge of the characteristics of targets and leads, and their interaction with certain molecules. We believe these tools could potentially be applied throughout the drug discovery process to significantly reduce the time and cost of developing a drug. We currently have computer algorithms that allow us to design libraries of compounds with high diversity, thereby increasing the likelihood of finding hits during screening.
We have developed novel algorithms to aid in the understanding and utilization of the data resulting from high throughput screening experiments. We expect to use our computational tools to help predict absorption, distribution, metabolism, and excretion, or ADME, and toxicological reactions to classes of compounds. This could allow our customers to avoid spending money and time on hits and leads that will ultimately fail due to their unfavorable ADME and toxicological characteristics.
Compound Repository. We also provide services to establish, maintain and manage compound repositories.
Screening. We offer high throughput screening services through an experienced staff of scientists located at our facility in Allschwil, Switzerland. We also offer our customers access to chemical compounds from many compound suppliers as well as a significant collection of internally developed compounds. To improve the speed and cost effectiveness of the screening process, we have exclusively licensed from Abbott Laboratories and further developed µARCS, a next-generation high throughput screening technology. This platform provides rapid and cost effective, high performance, high throughput screening, while supporting a very broad range of biochemical and cellular assays. We initially acquired our ability to offer these screening services in our acquisition of Discovery Technologies, Ltd. in 1999 (now DPI AG) and have added to our capabilities through further internal development.
Assays. We design and conduct assays, or tests, that generate information about the effect of chemical compounds on a drug target. We believe that our assays help our customers better select drug candidates before moving to the more costly stages of pre-clinical and clinical testing. We develop our assays through our team of scientists who are experienced in working with major disease target classes in a number of significant therapeutic areas, such as cardiovascular, neurology, oncology and ophthalmology. We acquired the ability to provide assay development services through our acquisition of Discovery Technologies, Ltd. in 1999 and further internal development.
Other licenses and services
Royalties. We license our proprietary gene profiling system, under the Xenometrix patent licensing agreements, that characterizes a cells response upon exposure to compounds and other agents by the pattern of gene expression in the cell.
Development Contracts. We collaborate with pharmaceutical and biopharmaceutical companies to develop customized drug discovery technologies to assist in the workflow of the laboratory environment such as in the development of two X-Kan Chemistry Synthesis Systems for GSK. X-Kans are chemical microreactors that combine the two-dimensional tagging features of the previously introduced NanoKan technology with an increased size and scale that are similar to the currently available MicroKan and MiniKan products.
Product Services and Warranty. In connection with our sales of instrumentation products and the related consumables, we provide from time to time related services and provide technical support of our instrumentation products.
During the three months ended March 31, 2005, 37% of our revenue came from our chemistry contract with Pfizer. We anticipate that this contract will provide for $6.7 million in the second quarter of 2005, $6.1 million in the third quarter of 2005 and $3.6 million in the fourth quarter of 2005. The agreement expires by its natural terms on January 6, 2006. It is uncertain at this time whether we will be successful in entering into new agreements with this customer or any others in sufficient amounts to replace the capacity resulting from the completion of this contract.
The pharmaceutical and biopharmaceutical industries provide substantially all of our revenues.
Critical Accounting Policies
This discussion and analysis of our financial condition and results of operations is based upon our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses. On an ongoing basis, we evaluate our estimates. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates, and the estimates themselves might be different if we used different assumptions.
We believe the following critical accounting policies involve significant judgments and estimates that are used in the preparation of our financial statements.
Revenue recognition. Revenue is recognized as follows:
Product sales. Revenue from product sales, which includes the sale of instruments and related consumables, is recorded as products are shipped if the costs of such shipments can be reasonably estimated and if all the customers acceptance criteria have been met. Certain of our contracts for product sales include customer acceptance provisions that give our customers the right of replacement if the delivered product does not meet specified criteria; however, we have historically demonstrated that the products meet the specified criteria and the number of customers exercising their right of replacement has been insignificant and therefore, once we have completed our internal testing, we recognize revenue without providing for such contingency upon shipment. Revenue from product sales by use of distributors is recognized as products are shipped if we meet the criteria set forth in Statement of Financial Accounting Standard No. 48, Revenue Recognition When Right of Return Exists.
Chemistry services. Revenue from the sale of chemical compounds delivered under our chemistry collaborations is recorded as the compounds are shipped. Revenue under chemistry service agreements that are compensated on a full-time equivalent, or FTE, basis is recognized on a monthly basis and is based upon the number of FTE employees that actually worked on each project and the agreed-upon rate per FTE per month. Beginning in April 2004, in accordance with our agreement with Pfizer, we are compensated based on predetermined limits to reserve sufficient resources to complete specific compound related activities, at the customers request, whether or not utilized. Revenue for reserving these resources is recognized based on the predetermined limits stipulated in the contract.
Effective August 20, 2004, the Company entered into a multi-year contract with The National Institutes of Mental Health (NIH) to set up and maintain a Small Molecule Repository to manage and provide up to one million chemical compounds to multiple NIH Screening Centers as part of the NIH Roadmap Initiative. Revenue under this contract is recorded as costs are incurred, which include indirect costs that are based on provisional rates estimated by management at the time we submitted our proposal. We have calculated our actual indirect costs to be greater than our provisional rates and management fully intends to negotiate recovery of these higher costs with the government. Since this is our first government contract, we have no historical experience negotiating final indirect cost rates with the government and therefore all cost overruns have been expensed. This contract is funded, in its entirety, by NIH, Department of Health and Human Services. Payments to us for performance under this contract
are subject to audit by the Defense Contract Audit Agency (DCAA) and are subject to government funding. We provide a reserve against our receivables for estimated losses that may result from rate negotiations, audit adjustments and/or government funding availability. As of March 31, 2005, no such reserve was considered necessary. To the extent that we incur adjustments due to rate negotiations, audit adjustments, or government funding availability, our revenue may be impacted.
Screening services. High throughput screening service revenues are recognized on the proportional performance method. Advances received under these high throughput screening service agreements are initially recorded as deferred revenue, which is then recognized as costs are incurred over the term of the contract. Certain of these contracts may allow the customer the right to reject the work performed; however, we have no history of material rejections and historically we have been able to recognize revenue without providing for such contingency.
Other licenses and services. Other licenses and services revenue includes royalty revenue due to us under the Xenometrix patent licensing agreements, development contract revenue, product related services revenue and warranty services revenue related to our instrumentation sales. Royalty revenue is recognized upon receipt of monies, provided we have no future obligation with respect to such payments. Development contract revenues are recognized on the proportional performance method . Product related service revenues are recognized when the performance of the service is complete. Warranty services revenue is recognized when the related product is shipped and extended warranty services revenue is recognized ratably over the service period.
Integrated drug discovery collaborations may provide chemistry services revenue, screening services revenue and milestone payments and other revenues. Revenue for each of these elements of such collaborations is recognized as described above. Revenue from milestone payments would be recognized upon receipt of monies.
From time to time we receive requests from customers to bill and hold goods for them. In these cases, as long as the specific revenue recognition criteria under accounting principles generally accepted in the United States at the time of the bill and hold are met, including the customer accepting the risk of loss and the transfer of ownership of such goods occurring prior to shipment, the revenue is recognized.
Inventory. Inventories are recorded at the lower of cost or market. We write-down our inventory for estimated obsolescence or non-marketability if there is an excess of cost of inventory over the estimated market value based upon assumptions about future demand and market conditions. If actual market conditions are less favorable than we have projected, additional inventory write-downs may be required. As of March 31, 2005, 97% of our inventory reserve is associated with our chemical compound finished goods inventory. A portion of our net inventory balance represents work-in-process related to two multi-year chemistry collaborations. Estimated losses on any deliverables are recorded when they become apparent. As of March 31, 2005, we have reserved approximately $194,000 against the work-in-process representing the anticipated loss on the sale of a certain chemical compound library. The anticipated loss is based on the estimated revenue that will be recognized upon shipment of the compound library as well as estimated future costs associated with this revenue. The actual loss on the sale of this library could differ from managements estimates.
Long-lived assets. In accounting for long-lived assets, we make estimates about the expected useful lives and the potential for impairment. Changes in the marketplace, technology or our operations could result in changes to these estimates. Our long-lived assets are evaluated for impairment when events and circumstances indicate that the assets may be impaired. If impairment is indicated, we reduce the carrying value of the asset to fair value. As of March 31, 2005, we have prepaid approximately $6.0 million to Abbott Laboratories for royalties related to the µARCS screening technology. This prepayment is carried on our balance sheet as a prepaid royalty. In the first quarter of 2004 we began amortization of this asset using a five-year life as we have begun to derive value from the related technology. This technology has been evaluated by several companies including a major pharmaceutical company and, based on these evaluations and potential revenues from these and other potential customers, we believe that the carrying value of the asset is not impaired. If we are not successful in generating sufficient revenues in the future from this asset, we may be required to record impairment charges up to $4.5 million. During the three months ended March 31, 2005 we recorded an impairment charge of $1,000,000 on patent rights to a proprietary gene profiling system that is licensed and which enables us to offer toxicology research products and services. The loss of a customer required the reevaluation of the recoverability of the gross carrying value of the asset. Revenues generated by this asset are included in service revenues. If we are not successful in generating sufficient revenues in the future from this asset, we may be required to record additional impairment charges up to $820,000.
Results of Operations
Revenue. Total revenue decreased 40% to $7.1 million for the three months ended March 31, 2005 from $11.8 million for the three months ended March 31, 2004. The decrease was due primarily to decreases in chemistry and instrumentation product revenue. The decrease in chemistry services revenue of approximately $2.2 million resulted primarily from a decrease of $3.3 million in revenue generated from Pfizer. In the fourth quarter of 2004, we exercised our right to deliver additional compounds in 2004, not to exceed the number of compounds scheduled for delivery in the first quarter of 2005 as stipulated in the contract. These additional shipments in 2004 equaled our allotment for the first quarter of 2005 and resulted in additional revenue of $4.2 million in the fourth quarter of 2004 that was, therefore, not recognized in the first quarter of 2005. This decrease was partially offset by new business with the National Institutes of Mental Health. The decrease in instrumentation product revenue of approximately $1.3 million was due to the lack of Crystal Farm sales. Additionally, in the first quarter of 2004 we completed a development contract to supply GlaxoSmithKline X-Kan Chemistry Synthesis Systems, which did not generate revenue in the first quarter of 2005.
In the first quarter of 2005 and 2004, 37% and 51%, respectively, of our revenue came from our chemistry contract with Pfizer. We anticipate that this contract will provide for $6.7 million in the second quarter of 2005, $6.1 million in the third quarter of 2005 and $3.6 million in the fourth quarter of 2005. Pfizer has the right to terminate the contract without cause by giving six months notice. The agreement expires by its natural terms on January 6, 2006. It is uncertain at this time whether we will be successful in entering into new agreements with this customer or any others in sufficient amounts to replace the capacity resulting from the completion of this contract. In addition, pursuant to our Crystal Farm distribution agreement with Bruker AXS (Bruker), we shipped Crystal Farm CF-400 units to Bruker during 2004 in accordance with Brukers minimum guaranteed purchase levels but in excess of Brukers actual shipments to end users. As a result of the higher than expected level of inventory Bruker is carrying at present, we do not anticipate a significant volume of Crystal Farm CF-400 shipments during at least the first half of 2005. During the three months ended March 31, 2005, we did not sell any Crystal Farm units.
Gross margin. Gross margin as a percentage of revenue decreased to 23% for the three months ended March 31, 2005 from 45% for the three months ended March 31, 2004. The decrease in gross margin for 2005 is primarily due to lower volumes of screening and chemistry services revenue and instrumentation product revenue. The decrease in gross margin was partially offset by the margin on the new NIH business.
Research and development expenses. Research and development expenses consist primarily of salaries and benefits, supplies and expensed development materials, and facilities costs including equipment depreciation. Research and development expenses increased 40% to $1.3 million for the three months ended March 31, 2005 from $893,000 for the three months ended March 31, 2004. Research and development expenses increased primarily due to an increase in internal programs focused on the Crystal Farm product, compound storage solutions, in silico tools and assays and drug discovery process development. Research and development expenses as a percentage of revenues were 18% and 8% for the three months ended March 31, 2005 and 2004, respectively.
Selling, general and administrative expenses. Selling, general and administrative expenses consist primarily of salaries and benefits for sales, marketing and administrative personnel, advertising and promotional expenses, professional services, and facilities costs. Selling, general and administrative expenses increased 15% to $4.1 million for the three months ended March 31, 2005 compared to $3.6 million for the three months ended March 31, 2004. Selling, general and administrative expenses increased primarily due to the payments made to our former Chief Operating Officer under the separation agreement we entered into in January 2005 and increases in business development activities partially offset by decreased incentive compensation costs due to underperformance against corporate goals. Selling, general and administrative expenses as a percentage of revenues were 58% and 30% for the three months ended March 31, 2005 and 2004, respectively.
Restructuring expenses. During 2003, we closed our Tucson facility. As a result, the estimated costs to exit certain contractual and lease obligations, among other things, were accrued as of the restructuring date. During the three months ended March 31, 2005, we incurred approximately $130,000 in additional restructuring expense resulting from an increase in the estimate to restore the facility to its original condition as stipulated in the lease. We do not expect to incur any additional restructuring charges related to the Tucson closure.
Stock-based compensation. We awarded 142,500 shares of restricted stock and rights to acquire 500,000 shares of restricted stock in August 2003 and July 2004, collectively. As a result, we have recorded deferred stock-based compensation to be amortized on an accelerated basis over the period that these options, restricted stock
grants and rights to acquire restricted stock vest. The deferred stock-based compensation expense was approximately $284,000 and $170,000 for the three months ended March 31, 2005 and 2004, respectively.
Impairment of intangible assets. We recorded an impairment charge of $1,000,000 during the three months ended March 31, 2005 on patent rights to a proprietary gene profiling system that is licensed and which enables the Company to offer toxicology research products and services. The loss of a customer required the reevaluation of the recoverability of the carrying value of the asset. No impairment charges were recognized during the same period in 2004.
Interest income. Interest income increased 35% to $465,000 for the three months ended March 31, 2005 compared to $344,000 for the three months ended in March 31, 2004. The increase in interest income is due primarily to higher yields and a decrease in realized losses in the first quarter 2005 compared to 2004.
Foreign currency transaction losses. We realized $49,000 and $48,000 in foreign currency transaction gains in the three months ended March 31, 2005 and 2004.
Concentrations. We derive a significant percentage (37% and 51% in the three months ended March 31, 2005 and 2004, respectively) of our revenues from a single customer under a chemistry collaboration agreement. This contract may be terminated with six months notice after January 5, 2005 and the terms of this contract or others may not be favorable to us in the future. The agreement expires by its natural terms on January 6, 2006. It is uncertain at this time whether we will be successful in entering into new agreements with this customer or any others in sufficient amounts to replace the capacity resulting from the completion of this contract. Additionally, a large portion of our expenses is relatively fixed in nature. Accordingly, if revenues decline, we may not be able to correspondingly reduce our operating expenses, which would negatively impact our future operating results for a particular fiscal period.
In addition, we believe our operating results may fluctuate significantly from quarter to quarter due to the possibility of fluctuations in revenues as well as other factors, many of which are outside of our control, such as, customers budgetary constraints. Consequently, we believe that quarter-to-quarter comparisons of our operating results are not a good indication of our future performance.
Liquidity and Capital Resources
Since our inception, we have funded our operations with $39.0 million of private equity financings and $94.7 million of net proceeds from our initial public offering in July 2000.
In May 2004 our secondary public offering was declared effective by the SEC. A total of 8,305,300 shares of common stock at a price of $5.00 per share were made available to the public. Axys Pharmaceuticals, Inc., then a stockholder of Discovery Partners International, Inc., registered 7,222,000 shares for resale, with the remaining 1,083,300 shares registered for sale by the Company to the underwriters to cover over-allotments. We received proceeds from the offering, of the shares registered for sale by the Company, of $5.1 million net of underwriters discounts.
At March 31, 2005, cash and cash equivalents and short-term investments totaled approximately $84.9 million, compared to $80.0 million at December 31, 2004.
Operating Activities. We rely on cash on hand and cash flows from operations to provide working capital for current and future operations. We believe we have sufficient cash resources to fund existing operations for the next twelve months. Cash flows provided by operating activities totaled $6.0 million and $432,000 in the first quarter of 2005 and 2004, respectively. The increase in operating cash flows in 2005 compared to 2004 was primarily due to a significant decrease in accounts receivables and increase in deferred revenues as we received payments from our customers in the first quarter of 2005 offset partially by our operating loss, an increase in inventory and a decrease in accounts payable and accrued expenses primarily as a result of incentive payments made to key employees in the first quarter of 2005. We currently expect the acquisition of Biofrontera GmbH to require approximately $2.4 million in cash to fund operations for the remainder of fiscal 2005. We currently expect an operating loss for the year ended December 31, 2005, which could negatively impact our cash flows from operations in the future.
Investing Activities. Cash provided by investing activities totaled $16.3 million in the first quarter 2005 compared to cash used in investing activities of $2.8 million in the first quarter of 2004. The increase in cash provided by investing activities in 2005 compared to 2004 is due primarily to an increase in investment of highly
liquid investments classified as cash equivalents versus short-term investments during the first quarter of 2005 offset by prepayments made in connection with our acquisition of assets from Biofrontera Discovery GmbH.
We currently anticipate investing approximately $4.0 million to $5.0 million during the remainder of 2005 for leasehold improvements and capital equipment necessary to support the future growth in compound management services and integrated drug discovery collaborations. Our actual future capital requirements will depend on a number of factors, including our success in increasing sales of both existing and new products and services, expenses associated with unforeseen litigation, regulatory changes, competition and technological developments, and potential future merger and acquisition activity as well as research and development spending.
Financing Activities. Cash provided by financing activities totaled $153,000 and $295,000 in the first quarter of 2005 and 2004, respectively. This change is primarily due to lower proceeds from the exercise of stock options. Absent any significant merger and acquisition activity, we do not expect to incur debt in 2005.
On October 4, 2001, our board of directors approved a Stock Repurchase Plan, authorizing us to repurchase up to 2,000,000 shares of common stock at no more than $3.50 per share. In 2003, we purchased 115,000 shares under this Plan for $289,000 and in 2001, we purchased 35,000 shares for $119,250. We did not purchase any shares in 2004 pursuant to this Plan. We continue to have the authority to purchase additional shares in the future.
RISKS AND UNCERTAINTIES
In addition to the other information contained herein, you should carefully consider the following risk factors in evaluating our company.
We derive a significant percentage of our revenues from a single customer. If this customer relationship terminated, we could have difficulty finding customers that would purchase our products and services in sufficient amounts to replace the capacity and lost revenues resulting from this significant customer.
A significant portion of our actual first quarter 2005 and anticipated annual 2005 revenues were and will be, as the case may be, derived from the chemistry collaboration we entered into with Pfizer originally in December 2001. In February 2004, the agreement with Pfizer was amended. Under this agreement, Pfizer has a contractual right to terminate the contract, with or without cause, upon six months notice after January 5, 2005. Either party may also terminate the agreement upon the material, uncured breach of the other party, and Pfizer may terminate the agreement if we are acquired by a third party or in the event of a change in control of our company. During the first quarter of 2005, revenue from Pfizer represented 37% of our total revenue. As a result of exercising our right under the Pfizer agreement to deliver additional compounds in 2004, not to exceed the number of compounds scheduled for delivery in the first quarter of 2005, we recognized $4.2 million of additional revenues in 2004, which has reduced the amount of revenues we generated in the first quarter of 2005 under this agreement. As of March 31, 2005, 36% of the total $46 million of potential revenue under the existing Pfizer agreement remains to be earned and recognized. If our relationship with Pfizer or our contracts with other customers to whom we provide significant products or services are terminated, or not renewed after January 5, 2006, we will have substantial capacity available until we are able to find new customers for our products and services to utilize that capacity. We may be delayed in entering or not able to enter into contracts with new customers to utilize any available capacity. We will continue to bear the costs of that capacity until we are able to enter into contracts with customers for those products or services. Revenues with respect to those products and services may be delayed or we may not recognize revenues at all to the extent we are delayed in entering or not able to enter into contracts with new customers to utilize available capacity.
Our strategy places a high degree of emphasis on integrated drug discovery collaborations, an area of higher risk and complexity.
Since our strategy focuses on more significant value added integrated drug discovery collaborations with biotechnology companies we now rely on this relatively complex form of customer engagement to generate revenue. As a result of the inherent complexity of such collaborations, we have an increased risk of being unable to reach agreement with the prospective customer for such collaborations or of structuring sub-optimal arrangements that fail to adequately compensate us for the risks inherent in such collaborations.
The drug discovery industry is highly competitive and subject to technological changes, and we may not have the resources necessary to compete successfully.
We compete with companies in the United States and abroad that engage in the development and production of drug discovery products and services. These competitors include companies engaged in the following areas of drug discovery:
Assay development and screening;
Combinatorial chemistry instruments;
Crystallography incubation and imaging systems;
Compound libraries and lead optimization;
Gene expression profiling.
Academic institutions, governmental agencies and other research organizations also conduct research in areas in which we provide services, either on their own or through collaborative efforts. Also, substantially all of our pharmaceutical and biopharmaceutical company customers have internal departments that provide some or all of the products and services we sell, so these customers may have limited needs for our products and services. Many of our competitors have more experience and have access to greater financial, technical, research, marketing, sales, distribution, service and other resources than we do. We may not yet be large enough to achieve satisfactory market recognition or operating efficiencies, particularly in comparison to some competitors.
Moreover, the pharmaceutical and biopharmaceutical industries are characterized by continuous technological innovation. We anticipate that we will face increased competition in the future as new companies enter the market and our competitors make advanced technologies available. Technological advances or entirely different approaches that we or one or more of our competitors develop may render our products, services and expertise obsolete or uneconomical. For example, advances in informatics and virtual screening may render some of our technologies, such as our large compound libraries, obsolete. Additionally, the existing approaches of our competitors or new approaches or technologies that our competitors develop may be more effective than those we develop. We may not be able to compete successfully with existing or future competitors.
In addition, due to improvements in global communications, combined with the supply of lower cost PhD level scientific talent, we face the growing threat of competition for our chemistry and computational chemistry services from low-cost offshore locations such as China, India and Eastern Europe.
If we do not generate adequate revenues from our intellectual property investments, we may have to record significant impairment charges.
We have prepaid approximately $6.0 million to Abbott Laboratories for royalties related to the µARCS screening technology. This prepayment is carried on our balance sheet as prepaid royalty net of $1.5 million of accumulated amortization. We acquired the patent rights to a proprietary gene profiling system in connection with our acquisition of Xenometrix in 2001. The loss of a customer required the reevaluation of the recoverability of the gross carrying value of the asset in the first quarter of 2005, which resulted in an impairment charge of $1.0 million. If we are not successful in generating revenues in the future from these assets, we may be required to record impairment charges up to $5.3 million collectively, which would materially impact our profitability.
Our financial performance will depend on the prospects of the pharmaceutical and biopharmaceutical industries and the extent to which these industries engage outside parties to perform one or more aspects of their drug discovery process.
Our revenues depend to a large extent on research and development expenditures by the pharmaceutical and biopharmaceutical industries and companies in these industries outsourcing research and development projects. These expenditures are based on a wide variety of factors, including the resources available for purchasing research equipment, the spending priorities among various types of research and policies regarding expenditures during recessionary periods. In recent years, pharmaceutical companies have been attempting to contain spending on drug discovery and many biotechnology companies have found it difficult to raise capital to fund drug discovery activities. Geopolitical uncertainty or general economic downturns in our customers industries or any decrease in
research and development expenditures could harm our operations, as could increased acceptance of management theories that counsel against outsourcing of critical business functions. Any decrease in drug discovery spending by pharmaceutical and biopharmaceutical companies could cause our revenues to decline and hurt our profitability.
The concentration of the pharmaceutical industry and the current trend toward increasing consolidation could hurt our business prospects.
The pharmaceutical customer segment of the market for our products and services is highly concentrated, with approximately 50 large pharmaceutical companies conducting drug discovery research. We have lost customers due to consolidation of pharmaceutical companies and the continuation of this trend may reduce the number of our current and potential customers even further. As a result, a small number of customers could account for a substantial portion of our revenues. In addition, because of the heavy concentration of the pharmaceutical industry and the relatively high cost of our systems, such as NanoKan and µARCS, we expect there will be only a limited number of potential buyers for these systems.
Additional risks associated with a concentrated customer base include:
larger companies may develop and utilize in-house technology and expertise rather than using our products and services; and
larger customers may negotiate price discounts or other terms for our products and services that are unfavorable to us.
Our financial performance will depend on improved market conditions in the segments of the drug discovery and development process in which we participate.
The drug discovery and development process can be broadly separated into the following stages: Target identification; target validation; lead discovery; lead optimization; pre-clinical development; IND filing; clinical trials, phases I-III; new drug application, or NDA; and post market surveillance. We currently participate in the areas of lead discovery and lead optimization. Based on current industry averages, the cost of acquiring a validated target plus the costs of lead discovery and lead optimization are greater than the expected proceeds of out-licensing a potential drug candidate during the pre-clinical phase of drug development. This is primarily due to the negative imbalance between the relatively high cost of obtaining pre-clinical drug candidates, the high failure rate of such pre-clinical candidates, and the relatively low demand for such pre-clinical candidates that exists at present. It is estimated that a positive expected return on investment is not obtained until a drug candidate has passed through phase II clinical trials, which requires a significant commitment of resources to attain. Therefore, many drug companies may be deterred from engaging in drug discovery unless they have the substantial financial resources necessary to fund the drug discovery process all the way through phase II clinical trials. Unless advances are made to either reduce the cost or improve the success rate of pre-clinical drug candidates, or unless the market demand for such pre-clinical drug candidates improves, we might continue to face difficult market conditions for our products and services which might inhibit our growth.
If our revenues decline, we might not be able to correspondingly reduce our operating expenses.
A large portion of our expenses, including expenses for facilities, equipment and personnel, is relatively fixed. Accordingly, if revenues decline, we might not be able to correspondingly reduce our operating expenses. Failure to achieve anticipated levels of revenues could therefore significantly harm our operating results for a particular fiscal period.
Due to the possibility of fluctuations in our revenues (on an absolute basis and relative to our expenses), we believe that quarter-to-quarter comparisons of our operating results are not a reliable indication of our future performance.
We may not achieve or maintain profitability in the future.
We have incurred significant operating and net losses since our inception. As of March 31, 2005, we had an accumulated deficit of $104.3 million. Although we generated net income during 2004 of $3.9 million, we had a net loss of $4.5 million for the first quarter of 2005, respectively. We may also in the future incur operating and net losses and negative cash flow from operations. We did not achieve operating profitability until the third quarter of 2003 and we may not be able to achieve or maintain profitability in any quarter in the future. We currently expect an
operating loss for the year ended December 31, 2005. If we do achieve profitability in the future, the level of any profitability cannot be predicted and may vary significantly from quarter to quarter.
We may fail to expand customer relationships through the integration of products and services.
We may not be able to use existing relationships with customers in individual areas of our business to sell products and services in multiple areas of drug discovery. We may not be successful in selling our offerings in combination across the range of drug discovery disciplines we serve because integrated combinations of our products and services may not achieve time and cost efficiencies for our customers, especially our large pharmaceutical company customers. Biotechnology companies may desire our integrated offerings but are often not sufficiently capitalized to pay for these services. In addition, we may not succeed in further integrating our offerings. If we do not achieve integration of our products and services, we may not be able to take advantage of potential revenue opportunities and differentiate ourselves from competitors.
Our products, services and technologies may never help discover drugs that receive Food and Drug Administration approval, which may make it difficult for us to gain new business.
To date, we are not aware of any of our customers having used any of our drug discovery products, services or technologies to develop a drug that ultimately has been approved by the Food and Drug Administration, and our customers may never do so. Whether our customers use our drug discovery products, services and technologies to develop any drugs that ultimately receive Food and Drug Administration approval will depend heavily on our scientific success and our customers scientific success, as well as on our customers ability to meet applicable Food and Drug Administration regulatory requirements. Our products, services and technologies may fail to assist our customers in achieving their drug discovery objectives, either on a timely basis or at all. For example, when our customers deliver proteins to us for assay development or chemistry library design ideas for chemical compound development and production, we may design assays or develop chemical compound libraries that fail to fully characterize the applicable proteins or compounds therapeutic potential, which could cause its further development to be delayed or abandoned. Additionally, our customers may not deliver to us proteins for assay development or chemistry library design ideas for chemical compound development and production that yield promising lead compounds for further development. Our customers may also lack the resources or experience or be otherwise unable to comply with the Food and Drug Administrations clinical trial requirements. Certain of our competitors are able to claim that their drug discovery products or services have been used in developing drugs that received Food and Drug Administration approval. To the extent that potential customers consider demonstrated therapeutic success an important factor in selecting between us and our competitors, we may be competitively disadvantaged, which would negatively impact our ability to generate new business.
Many of our products and services have lengthy sales cycles, which could cause our operating results to fluctuate significantly from quarter to quarter.
Sales of many of our products and services typically involve significant technical evaluation and commitment of expense or capital by our customers. Accordingly, the sales cycles, or the time from finding a prospective customer through closing the sale, associated with these products or collaborations, typically range from six to eighteen months. Sales of these products and the formation of these collaborations are subject to a number of significant risks, including customers budgetary constraints and internal acceptance reviews that are beyond our control. Due to these lengthy and unpredictable sales cycles, our operating results could fluctuate significantly from quarter to quarter. We expect to continue to experience significant fluctuations in quarterly operating results due to a variety of factors, such as general and industry specific economic conditions, that may affect the research and development expenditures of pharmaceutical and biopharmaceutical companies.
Our products and services involve significant scientific risk of fulfillment.
A large portion of our revenues relies upon our and our customers scientific success. Our products, services and technologies may fail to assist our customers in achieving their drug discovery objectives, on a timely basis or at all. For example, when our customers deliver proteins to us for assay development or chemistry library design ideas for chemical compound development and production, we rely on our customers for timely delivery of those deliverables, and our customers rely on us for timely and effective assay design or compound library development and production that fulfills our scientific obligations to them. To the extent that either we experience delays or failures in receiving specific deliverables required for us to complete our objectives or we encounter delays in our
ability to meet, or are unable to meet, our scientific obligations, we may be unable to receive and recognize revenues in accordance with our expectations.
If our products and services do not become widely used in the pharmaceutical and biopharmaceutical industries, it is unlikely that we will be profitable.
We have a limited history of offering our products and services, including informatics tools, biology services, µARCS, toxicology services, Crystal Farm, natural products, compound management and combinatorial chemistry instrumentation systems. It is uncertain whether our current customers will continue to use these products and services or whether new customers will use these products and services. In order to be successful, our products and services must meet the requirements of the pharmaceutical and biopharmaceutical industries, and we must convince potential customers to use our products and services instead of competing technologies and offerings. Moreover, we cannot thrive unless we can achieve economies of scale on our various offerings. Market acceptance will depend on many factors, including our ability to:
convince potential customers that our technologies are attractive alternatives to other technologies for drug discovery;
manufacture products and conduct services in sufficient quantities with acceptable quality and at an acceptable cost;
convince potential customers to purchase drug discovery products and services from us rather than developing them internally; and
place and service sufficient quantities of our products.
Because of these and other factors, some of which are beyond our control, our products and services may not gain sufficient market acceptance.
The intellectual property rights on which we rely to protect the technology underlying our products and techniques may not be adequate, which could enable third parties to use our technology or very similar technology and could reduce our ability to compete in the market.
Our success will depend, in part, on our ability to obtain, protect and enforce patents on our technology and to protect our trade secrets. We also depend, in part, on patent rights that third parties license to us. Any patents we own or license may not afford meaningful protection for our technology and products. Others may challenge our patents or the patents of our licensors and, as a result, these patents could be narrowed, invalidated or rendered unenforceable. In addition, current and future patent applications on which we depend may not result in the issuance of patents in the United States or foreign countries. Competitors may develop products similar to ours that are not covered by our patents. Further, since there is a substantial backlog of patent applications at the U.S. Patent and Trademark Office, the approval or rejection of our or our competitors patent applications may take several years.
Our European eukaryotic gene profiling patent was opposed by various companies. Oral proceedings were held before the Opposition Division of the European Patent Office in January 2003. At the conclusion of the hearing, the Opposition Division maintained our patent in amended form. The period during which an appeal of the Opposition Division decision could be made has expired. As amended, the patent claims kits and methods for identifying and characterizing the potential toxicity of a compound using expression profiles of four categories of stress.
In addition to patent protection, we also rely on copyright protection, trade secrets, know-how, continuing technological innovation and licensing opportunities. In an effort to maintain the confidentiality and ownership of our trade secrets and proprietary information, we require our employees, consultants and advisors to execute confidentiality and proprietary information agreements. However, these agreements may not provide us with adequate protection against improper use or disclosure of confidential information, and there may not be adequate remedies in the event of unauthorized use or disclosure. Furthermore, like many technology companies, we may from time to time hire scientific personnel formerly employed by other companies involved in one or more areas similar to the activities conducted by us. In some situations, our confidentiality and proprietary information agreements may conflict with, or be subject to, the rights of third parties with whom our employees, consultants or advisors have prior employment or consulting relationships.
We acquired an exclusive license to the µARCS technology from Abbott Laboratories. The µARCS technology provides high throughput screening of compounds against a very broad range of drug discovery targets. Under the
license agreement, Abbott is required to seek patent coverage for the licensed technology. If any license disputes arise between us and Abbott relating to the µARCS technology and we are not able to resolve those disputes, or if Abbott is unsuccessful in obtaining adequate patent coverage for the µARCS technology, our ability to screen compounds may be compromised and we may not be able to prevent competitors, including Abbott, from using the µARCS technology, which could have a material adverse effect on our financial condition and results of operations.
Although we require our employees and consultants to maintain the confidentiality of all confidential information of previous employers, their prior affiliations may subject us or these individuals to allegations of trade secret misappropriation or other similar claims. Finally, others may independently develop substantially equivalent proprietary information and techniques, or otherwise gain access to our trade secrets. Our failure to protect our proprietary information and techniques may inhibit or limit our ability to exclude certain competitors from the market. The drug discovery industry has a history of intellectual property litigation and we may be involved in intellectual property lawsuits, which may be lengthy and expensive.
In order to protect or enforce our patent rights, we may have to initiate legal or administrative proceedings against third parties. In addition, others may sue us or initiate interference proceedings against us for infringing their intellectual property rights, or we may find it necessary to initiate a lawsuit seeking a declaration from a court that we are not infringing the proprietary rights of others. The patent positions of pharmaceutical, biopharmaceutical and drug discovery companies are generally uncertain. A number of pharmaceutical companies, biopharmaceutical companies, independent researchers, universities and research institutions may have filed patent applications or may have been granted patents that cover technologies similar to the technologies owned by, or licensed to, us or our collaborators. A number of patents may have been issued or may be issued in the future that could cover certain aspects of our technology and that could prevent us from using technology that we use or expect to use. In addition, we are unable to determine all of the patents or patent applications that may materially affect our ability to make, use or sell any potential products. Legal or administrative proceedings relating to intellectual property would be expensive, take significant time and divert managements attention from other business concerns, no matter whether we win or lose. The cost of such litigation, interference or administrative proceedings could hurt our profitability.
Further, an unfavorable judgment in an administrative proceeding, interference or infringement lawsuit brought against us, in addition to any damages we might have to pay, could prevent us from obtaining intellectual property protection for our technology, require us to stop the infringing activity or obtain a license. Any required license may not be available to us on acceptable terms, or at all. In addition, some licenses may be nonexclusive, and therefore, our competitors may have access to the same technology that is licensed to us. If we fail to obtain a required license or are unable to design around a patent, we may be unable to sell some of our products or services.
Our stock price will likely be volatile.
The trading price of our common stock has been and will likely continue to be volatile and could be subject to fluctuations in price in response to various factors, many of which are beyond our control, including:
actual or anticipated variations in quarterly operating results;
announcements of technological innovations by us or our competitors;
new products or services introduced or announced by us or our competitors;
changes in financial estimates by (or the beginning or cessation of research coverage by) securities analysts;
the announcements by us or our competitors of financial results that do not meet or exceed the results anticipated by the public markets;
conditions or trends in the pharmaceutical and biopharmaceutical industries or in the drug discovery services industry;
announcements by us or our competitors of significant acquisitions, collaborations, joint ventures or capital commitments, or terminations of collaborations or joint ventures;
the implementation or wind-down of stock buyback programs;
additions or departures of key personnel;
economic and political factors; and
sales of our common stock, including sales by any of our stockholders who beneficially own more than 5% of our common stock and who could potentially sell large amounts of our common stock at any one time.
In addition, price and volume fluctuations in the stock market in general, and the Nasdaq National Market and the market for technology companies in particular, have often been unrelated or disproportionate to the operating performance of those companies. Further, the market prices of securities of life sciences companies have been particularly volatile. Conditions or trends in the pharmaceutical and biopharmaceutical industries generally may cause further volatility in the trading price of our common stock, because the market may incorrectly perceive us as a pharmaceutical or biopharmaceutical company and our customers are pharmaceutical and biopharmaceutical companies. These broad market and industry factors may harm the market price of our common stock, regardless of our operating performance. In the past, plaintiffs have often instituted securities class action litigation following instances of volatility in the market price of a companys securities. A securities class action suit against us could result in potential liabilities, substantial costs and the diversion of managements attention and resources, regardless of whether we win or lose.
Our customers may restrict our use of scientific information, which could prevent us from using this information for additional revenue.
We plan to generate and use information that is not proprietary to our customers and which we derive from performing drug discovery services for our customers. However, our customers may not allow us to use information such as the general interaction between types of chemistries and types of drug targets that we generate when performing drug discovery services for them. Our current contracts typically restrict our use of certain scientific information we generate for our customers, such as the biological activity of chemical compounds with respect to drug targets, and future contracts also may restrict our use of additional scientific information. To the extent that our use of information is restricted, we may not be able to collect and aggregate scientific data and take advantage of potential revenue opportunities.
Our ability to grow will depend on our attracting and retaining key executives, experienced scientists and sales personnel.
Our future success will depend to a significant extent on our ability to attract, retain and motivate highly skilled scientists and sales personnel. In addition, our business would be significantly harmed if we lost the services of Riccardo Pigliucci, our chief executive officer or Dr. Michael Venuti, our chief scientific officer. We do not maintain life insurance on any of our officers. Our ability to maintain, expand or renew existing collaborations with our customers, enter into new collaborations and provide additional services to our existing customers depends, in large part, on our ability to hire and retain scientists with the skills necessary to keep pace with continuing changes in drug discovery technologies and sales personnel who are highly motivated. Additionally, it is difficult for us to find qualified sales personnel in light of the fact that our sales personnel generally hold PhDs in scientific fields. Our U.S. employees are at will, which means that they may resign at any time, and we may dismiss them at any time (subject, in some cases, to severance payment obligations). We believe that there is a shortage of, and significant competition for, scientists with the skills and experience in the sciences necessary to perform the services we offer. We compete with pharmaceutical companies, biopharmaceutical companies, combinatorial chemistry companies, contract research companies and academic institutions for new personnel. If we do not attract new scientists or sales personnel or retain or motivate our existing personnel, we will not be able to grow.
We have acquired several businesses and face risks associated with integrating these businesses and potential future acquisitions.
We have acquired several businesses and plan to continue to review potential acquisition candidates in the ordinary course of our business, and our strategy includes building our business through acquisitions. Acquisitions involve numerous risks, including, among others, difficulties and expenses incurred in the consummation of acquisitions and assimilation of the operations, personnel and services or products of the acquired companies, difficulties of operating new businesses, the diversion of managements attention from other business concerns and the potential loss of key employees of the acquired company. In addition, acquired businesses may have management structures incompatible with our own and may experience difficulties in maintaining their existing levels of business after joining us. If we do not successfully integrate and grow the businesses we have acquired or
any businesses we may acquire in the future, our business will suffer. Additionally, acquisition candidates may not be available in the future or may not be available on terms and conditions acceptable to us. Acquisitions of foreign companies also may involve additional risks of assimilating different business practices, overcoming language and cultural barriers and foreign currency translation. We currently have no agreements or commitments with respect to any acquisition, and we may never successfully complete any additional acquisitions.
We may incur write-downs or write-offs in connection with potential future acquisitions, and exit costs, losses and liabilities in connection with potential future business divestitures or shut-downs.
We incurred a $50.9 million goodwill impairment charge during the fourth quarter of 2002, which represented the write-off of goodwill that we had accumulated in connection with several acquisitions. In the event that we make future acquisitions, we may take additional write-downs or write-offs associated with acquired assets, which could have a material adverse effect on our results of operations and financial condition. Any future acquisitions we make may also not improve our business as much as we expect, or be accretive to our earnings, which could cause the trading price of our common stock to decline. In addition, if any future acquisitions we make do not improve our business as much as we expect, we may choose to discontinue the businesses associated with those acquisitions by divestiture or by shutting those businesses down. We may also choose to divest or shut down existing businesses or product or service lines for strategic reasons. We may incur substantial exit costs, losses and liabilities in connection with any such divestiture or shut-down.
Our success will depend on our ability to manage growth and expansion.
Growth in our operations has placed and, if we grow in the future, will continue to place a significant strain on our operational, human and financial resources. We intend to continue to grow our business internally and by acquisition. As and if we expand our operations we will not necessarily have in place infrastructure and personnel sufficient to accommodate the increased size of our business. Our ability to effectively manage any growth through acquisitions or any internal growth will depend, in large part, on our ability to hire, train and assimilate additional management, professional, scientific and technical personnel and our ability to expand, improve and effectively use our operating, management, marketing and financial systems to accommodate our expanded operations. These tasks are made more difficult as we acquire businesses in geographically disparate locations.
Our operations could be interrupted by damage to our facilities.
Our results of operations are dependent upon the continued use of our highly specialized laboratories and equipment. Our operations are primarily concentrated in facilities in San Diego, California, South San Francisco, California, Allschwil, Switzerland and Heidelberg, Germany. Natural disasters, such as earthquakes or fires, or terrorist acts could damage our laboratories or equipment and these events may materially interrupt our business. We maintain business interruption insurance to cover lost revenues caused by such occurrences. However, this insurance would not compensate us for the loss of opportunity and potential adverse impact on relations with existing customers created by an inability to meet our customers needs in a timely manner, and may not compensate us for the physical damage to our facilities.
We are subject to foreign currency risk related to conducting business in multiple currencies.
Currency fluctuations between the U.S. dollar and the currencies in which we do business, including the British pound, the Japanese yen, the Swiss franc, the Euro and the Indian rupee, will cause foreign currency translation gains and losses. We cannot predict the effects of exchange rate fluctuations on our future operating results because of the number of currencies involved, changes in the percentage of our revenue that will be invoiced in foreign currencies, the variability of currency exposure and the potential volatility of currency exchange rates. Because we conduct business in multiple currencies we are subjected to economic and earnings risk. We do not currently engage in foreign exchange hedging transactions to manage our foreign currency exposure; however, we may begin to hedge certain transactions between the Swiss franc and other currencies that are invoiced from our Swiss affiliate in order to minimize foreign exchange transaction gains and losses.
We may be subject to liability regarding hazardous materials.
Our products and services as well as our research and development processes involve the controlled use of hazardous materials. For example, we often use dangerous acids, bases, oxidants, radio isotopic and flammable materials. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage,
handling and disposal of such materials and certain waste products. We cannot completely eliminate the risk of accidental contamination or injury from these materials. In the event of such an accident, we could be held liable for any damages that result, and any such liability could exceed our resources and disrupt our business. In addition, we may have to incur significant costs to comply with environmental laws and regulations related to the handling or disposal of such materials or waste products in the future, which would require us to spend substantial amounts of money.
Because it is unlikely that we will pay dividends, our stockholders will only be able to benefit from holding our stock if the stock price appreciates.
We have never paid cash dividends on our capital stock and do not anticipate paying any cash dividends in the foreseeable future.
Anti-takeover provisions in our stockholder rights plan and in our charter and bylaws could make a third-party acquisition of us difficult.
In 2003 we adopted a stockholder rights plan (a so-called poison pill). Also, our certificate of incorporation and bylaws contain provisions that could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions could limit the price that investors might be willing to pay in the future for shares of our common stock.
Short-term investments. Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since a significant portion of our investments are and will be in short-term marketable securities, U.S. government securities and corporate bonds. Due to the nature and maturity of our short-term investments, we have concluded that there is no material market risk exposure to our principal. The average maturity of our investment portfolio is six months. A 1% change in interest rates would have an effect of approximately $346,000 on the value of our portfolio.
Foreign currency rate fluctuations. The functional currency for our Discovery Partners International LLC (DPI LLC) group is the US dollar and of Discovery Partners International AG (DPI AG), including Discovery Partners International GmbH, group is the Swiss franc. DPI AG accounts are translated from their local currency to the U.S. dollar using the current exchange rate in effect at the balance sheet date for the balance sheet accounts, and using the average exchange rate during the period for revenues and expense accounts. The effects of translation for our DPI AG group are recorded as a separate component of stockholders equity (accumulated other comprehensive income (loss)). DPI AG conducts its business with customers in local currencies. Exchange gains and losses arising from these transactions are recorded using the actual exchange differences on the date the transaction is settled.
We have not in the past taken any action to reduce our exposure to changes in foreign currency exchange rates, such as options or futures contracts, with respect to transactions with DPI AG or transactions with our worldwide customers, but anticipate that we could begin to hedge against foreign exchange transaction gains and losses resulting from non-Swiss franc invoices issued to customers by DPI AG in the future. A 10% change in the value of the Swiss franc, relative to the U.S. dollar throughout 2005 would have resulted in a 2% change in revenue for the three months ended March 31, 2005.
Inflation. We do not believe that inflation has had a material impact on our business or operating results during the periods presented.
Item 4. Controls and Procedures
(a) Controls and Procedures
We have carried out an evaluation, under the supervision and the participation of our management, including our principal executive officer and principal financial officer, of the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rule 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the Exchange Act), as of the end of the fiscal quarter covered by this report. Based upon that evaluation, our principal executive officer and principal financial officer concluded that our disclosure controls and procedures are effective in providing reasonable assurance that (a) the information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in the SECs rules and forms, and (b) such information is accumulated and communicated to our management, including our principal executive officer and principal financial officer, as appropriate to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating the cost-benefit relationship of possible controls and procedures.
There were no changes in our internal control over financial reporting that occurred in the first quarter of 2005 that materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
Item 1. Legal Proceedings
The registration statement (File No. 333-36638) for our initial public offering was declared effective by the SEC on July 27, 2000. We received net proceeds from the offering of approximately $94.7 million. Through March 31, 2005, we had used approximately $17.6 million of the net proceeds for acquisitions of companies, $6.0 million for prepaid µARCS royalties, $13.1 million for capital expenditures and $1.7 million for costs associated with restructuring.
Item 3. Defaults Upon Senior Securities
Item 5. Other Information
Item 6. Exhibits
(1) Incorporated by Reference to the Companys Registration Statement No. 333-36638 on Form S-1 filed with the Securities and Exchange Commission on June 23, 2000
(2) Incorporated by Reference to the Companys Registration Statement No. 333-36638 on Form S-1 filed with the Securities and Exchange Commission on July 26, 2000
(3) Incorporated by Reference to the Companys Report on Form 8-K filed with the Securities and Exchange Commission on February 24, 2003
(4) Incorporated by Reference to the Company's Report on Form 8-K filed with the Securities and Exchange Commission on April 6, 2005
Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
(1) Incorporated by Reference to the Companys Registration Statement No. 333-36638 on Form S-1 filed with the Securities and Exchange Commission on June 23, 2000
(2) Incorporated by Reference to the Companys Registration Statement No. 333-36638 on Form S-1 filed with the Securities and Exchange Commission on July 26, 2000
(3) Incorporated by Reference to the Companys Report on Form 8-K filed with the Securities and Exchange Commission on February 24, 2003
(4) Incorporated by Reference to the Company's Report on Form 8-K filed with the Securities and Exchange Commission on April 6, 2005