PDL BioPharma 10-Q 2008
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Commission File Number: 0-19756
PDL BioPharma, Inc.
(Exact name of registrant as specified in its charter)
1400 Seaport Blvd
Redwood City, CA 94063
(Address of principal executive offices and 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 x No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of accelerated filer and large accelerated filer in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer x Accelerated filer o Non-accelerated filer o Smaller reporting company o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes o No x
As of August 4, 2008, there were 119,421,847 shares of the Registrants Common Stock outstanding.
We own or have rights to numerous trademarks, trade names, copyrights and other intellectual property used in our business, including PDL BioPharma and the PDL logo, each of which is considered a trademark, and Nuvion®. All other company names and trademarks included in this Quarterly Report are trademarks, registered trademarks or trade names of their respective owners.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
See accompanying notes.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except per share data)
See accompanying notes.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
See accompanying notes.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2008
1. Summary of Significant Accounting Policies
Organization and Business
We are a biotechnology company focused on the discovery and development of novel antibodies in oncology and immunologic diseases. We receive royalties and other revenues through licensing agreements with biotechnology and pharmaceutical companies based on our proprietary antibody humanization technology platform. The technology subject to these licensing agreements has contributed to the development by our licensees of 10 marketed products. Our research platform is focused on the discovery of novel antibodies for the treatment of cancer and immunologic diseases. We currently have several investigational compounds in clinical development for oncology or immunologic diseases, two of which we are developing in collaboration with Biogen Idec MA, Inc. (Biogen Idec). We began marketing and selling acute-care products in the hospital setting in the United States, Canada and other international markets in March 2005 in connection with our acquisitions of ESP Pharma, Inc. and the rights to Retavase®. In March 2008, we sold the rights to our Cardene®, Retavase and IV Busulfex® commercial products and our ularitide development-stage cardiovascular product (together, the Commercial and Cardiovascular Assets). As a result, the results of the Commercial and Cardiovascular Operations segment, which operations are comprised of those related to the Commercial and Cardiovascular Assets, are presented as discontinued operations. Discontinued operations are reported as a component within the Consolidated Statement of Operations separate from income from continuing operations. For further details and discussion of discontinued operations, see Note 6. Also in March 2008, we sold our manufacturing and related administrative facilities in Brooklyn Park, Minnesota, and related assets therein, and assigned certain of our lease obligations related to our facilities in Plymouth, Minnesota (together, the Manufacturing Assets). For further details and discussion of this transaction, see Note 7.
Basis of Presentation
The accompanying condensed consolidated financial statements are unaudited, but include all adjustments (consisting only of normal, recurring adjustments) that we consider necessary for a fair presentation of our financial position at such dates and the operating results and cash flows for those periods. Certain information normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (GAAP) has been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission (SEC) for quarterly reporting.
The information included in this Quarterly Report on Form 10-Q should be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2007 filed with the SEC. The Condensed Consolidated Balance Sheet as of December 31, 2007 is derived from our audited consolidated financial statements as of that date.
Our revenues, expenses, assets and liabilities vary during each quarter of the year. Therefore, the results and trends in these interim condensed consolidated financial statements may not be indicative of results for any other interim period or for the entire year. For example, we receive a substantial portion of our royalty revenues on sales of the product Synagis®, marketed by MedImmune, LLC, a subsidiary of AstraZeneca plc (MedImmune). This product has significantly higher sales in the fall and winter, which to date have resulted in much higher royalties recognized by us with respect to this product in our first and second quarters than in other quarters since we generally recognize royalty revenue in the quarter subsequent to sales by our licensees.
Additionally, our master patent license agreement with Genentech, Inc. (Genentech) provides for a royalty fee structure that has four tiers, under which the royalty rate Genentech must pay on royalty-bearing products sold in the United States or manufactured in the United States and sold anywhere (U.S.-based Sales) in a given calendar year decreases during that year on incremental U.S.-based Sales above the net sales thresholds. As a result, Genentechs average annual royalty rate during a year declines as Genentechs cumulative U.S.-based Sales increase during that year. Because we receive royalties in arrears, the average royalty rate for payments we receive from Genentech in the second calendar quarter, which would be for Genentechs sales from the first calendar quarter, is higher than the average royalty rate for following quarters. The average royalty rate for payments we receive from Genentech is lowest in the first calendar quarter, which would be for Genentechs sales from the fourth calendar quarter, when more of Genentechs U.S.-based Sales bear royalties at lower royalty rates. With respect to royalty-bearing products that are both manufactured and sold outside of the United States (ex-U.S.-based Sales), the royalty rate that we receive from Genentech is a fixed rate based on a percentage of the underlying ex-U.S.-based Sales. The mix of U.S.-based Sales and ex-U.S.-based Sales and the manufacturing location are outside of our control and have fluctuated in the past and may continue to fluctuate in the future.
Principles of Consolidation
The condensed consolidated financial statements of the Company include the accounts of our wholly-owned subsidiaries after elimination of inter-company accounts and transactions.
We have reclassified certain idle facilities costs related to one of our Plymouth, Minnesota facilities from research and development expenses to restructuring expenses for the second quarter of 2007 to conform with the current presentation of restructuring-related costs. The impact of this reclassification decreased research and development expenses and increased restructuring expenses for the second quarter of 2007 by $1.6 million.
The preparation of financial statements in conformity with GAAP requires the use of managements estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Recent Accounting Pronouncements
In December 2007, the Financial Accounting Standards Board (FASB) ratified the final consensuses in EITF Issue No. 07-1, Accounting for Collaborative Arrangements (EITF 07-1), which requires certain income statement presentation of transactions with third parties and of payments between the parties to the collaborative arrangement, along with disclosure about the nature and purpose of the arrangement. We are required to adopt EITF 07-1 on or before January 1, 2009. We expect that we will change the presentation of our collaboration revenues and expenses upon the adoption of EITF 07-1, resulting in lower collaboration revenues and lower research and development expenses. However, the adoption will not affect our net income (loss) or our financial condition.
The following table summarizes revenues from our licensees which individually accounted for 10% or more of our total revenues from continuing operations for the three and six months ended June 30, 2008 and 2007 (as a percentage of total revenues):
2. Stock-Based Compensation
Stock-based compensation expense recognized under Statement of Financial Accounting Standards (SFAS) No. 123, Share-Based Payment (Revised 2004) (SFAS 123(R)) for employees and directors was as follows:
Stock-based compensation expense for the three and six months ended June 30, 2008 included stock option modification charges totaling $0.7 million and $4.5 million, respectively. These stock option modification charges related to accelerated vesting and extended exercise periods for certain stock options provided in connection with the termination of certain employees. The majority of the stock option modification charges related to the termination of certain employees as a result of the sale of the Commercial and Cardiovascular Assets and, as a result, a portion of such costs are reflected within discontinued operations.
Stock Option Activity
A summary of our stock option activity for the period is presented below:
In April 2008, we declared a special cash dividend of $4.25 per share, payable to each holder of our common stock as of May 5, 2008. In accordance with the 2005 Equity Incentive Plan (2005 Plan), the exercise price of all options outstanding under the 2005 Plan was decreased to adjust for the impact of this special dividend. As of May 5, 2008, there were approximately 2.0 million shares outstanding under the 2005 Plan with original exercise prices ranging from $11.41 to $32.49, all of which were decreased by $4.25 to adjust for the cash dividend. See Note 5 for further details regarding the cash dividend.
Total unrecognized compensation cost related to unvested stock options outstanding as of June 30, 2008, excluding forfeitures, was $31 million, which we expect to recognize over a weighted-average period of 2.6 years.
Restricted Stock Activity
A summary of our restricted stock activity for the period is presented below:
Total unrecognized compensation cost related to unvested restricted stock outstanding as of June 30, 2008, excluding potential forfeitures, was $3.1 million, which we expect to recognize over a weighted-average period of 1.5 years.
Employee Stock Purchase Plan (ESPP)
Stock-based compensation expense recognized in connection with our ESPP for the three-month periods ended June 30, 2008 and 2007 was $0 and $0.4 million, respectively, and such expense for the six-month periods ended June 30, 2008 and 2007 was $0.3 million and $0.8 million, respectively.
3. Net Income (Loss) Per Share
In accordance with SFAS No. 128, Earnings per Share (SFAS 128), we compute basic net income (loss) per share using the weighted-average number of shares of common stock outstanding during the periods presented, less the weighted-average number of shares of restricted stock that are subject to repurchase. We compute diluted net income (loss) per share for our continuing operations using the sum of the weighted-average number of common and common equivalent shares outstanding. Common equivalent shares used in the computation of diluted net income per share result from the assumed exercise of stock options, the issuance of restricted stock, the assumed issuance of common shares under our ESPP using the treasury stock
method, and the assumed conversion of our 2.00%, $250.0 million Convertible Senior Notes due 2012 (the 2005 Notes) and our 2.75%, $250.0 million Convertible Subordinated Notes due 2023 (the 2003 Notes), including both the effect on interest expense and the inclusion of the underlying shares using the if-converted method. For the three and six months ended June 30, 2007, we also included the release of the contingent shares remaining in escrow from the ESP Pharma, Inc acquisition, prior to their release from escrow in April 2007.
The following is a reconciliation of the numerators and denominators of the basic and diluted net income (loss) per share computations for the three and six months ended June 30, 2008 and 2007:
We excluded from our earnings per share calculation 10.6 million and 11.6 million shares for the three and six months ended June 30, 2008, respectively, and 4.2 million and 7.1 million shares, for the three months and six months ended June 30, 2007, respectively, relating to outstanding stock options and restricted stock as such amounts would have been antidilutive. Although we generated net income for the three and six months ended June 30, 2007, we did not include the effect of the assumed conversion of the 2005 Notes the 2003 Notes, including both the effect on interest expense and the inclusion of the underlying shares, as it would have been anti-dilutive.
4. Comprehensive Income (Loss)
Comprehensive income (loss) is comprised of net income (loss) and other comprehensive income (loss). Specifically, we include in other comprehensive loss the changes in unrealized gains and losses on our holdings of available-for-sale securities and the liability that has not yet been recognized as net periodic benefit cost for our postretirement benefit plan. The following table presents the calculation of our comprehensive loss:
5. Cash Dividend
In April 2008, we declared a special cash dividend of $4.25 per share (the Dividend), payable to each holder of our common stock as of May 5, 2008 (the Record Date). We paid $506.4 million of the Dividend in May 2008 using proceeds from the sales of the Commercial and Cardiovascular Assets and the Manufacturing Assets. In addition to the $506.4 million paid in May 2008, we recorded an additional $0.6 million as a dividend payable related to future distributions of the Dividend to holders of unvested restricted stock awards, which amount would be paid upon the vesting of these equity awards.
In connection with the Dividend, the conversion rates for the 2003 Notes and the 2005 Notes were adjusted, effective May 6, 2008, based on the amount of the Dividend and the trading price of our common stock in certain periods pursuant to the terms of the applicable indenture. For the 2023 Notes, the conversion rate increased from 49.6618 shares of common stock per $1,000 principal amount of notes to 72.586 shares of common stock per $1,000 principal amount of notes. For the 2012 Notes, the conversion rate increased from 42.219 shares of common stock per $1,000 principal amount of notes to 61.426 shares of common stock per $1,000 principal amount of notes.
6. Discontinued Operations
In 2007, we publicly announced our intent to seek to divest certain portions of our operations and potentially to sell the entire Company. In the fourth quarter of 2007, we decided to pursue a sale of the Commercial and Cardiovascular Assets on a discreet basis and, as a result, we classified the Commercial and Cardiovascular Assets, excluding goodwill, as held for sale in our Consolidated Balance Sheet as of December 31, 2007. As we will not have significant or direct involvement in the future operations related to the Commercial and Cardiovascular Assets, we have presented the results of the Commercial and Cardiovascular Operations as discontinued operations in the Consolidated Statement of Operations for the current and comparative periods in accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-lived Assets (SFAS No. 144). As of December 31, 2007, goodwill related entirely to the Commercial and Cardiovascular Operations.
In March 2008, we closed the sales of the Commercial and Cardiovascular Assets. We sold the rights to IV Busulfex, including trademarks, patents, intellectual property and related assets, to Otsuka Pharmaceutical Co., Ltd. (Otsuka) for $200 million in cash and an additional $1.4 million for the IV Busulfex inventories. We also sold the rights to Cardene, Retavase and ularitide, including all trademarks, patents, intellectual property, inventories and related assets (together, our Cardiovascular Assets), to EKR Therapeutics, Inc. (EKR) in March 2008. In consideration for the Cardiovascular Assets sold to EKR, we received upfront proceeds of $85.0 million, $6.0 million of which was placed in an escrow account for a period of approximately one year to cover certain product return related costs under the purchase agreement. In addition, the purchase agreement includes contingent consideration of up to $85.0 million in potential future milestone payments as well as potential future royalties on certain Cardene and ularitide product sales.
We recognized a pre-tax loss of $64.6 million in connection with the sale of the Commercial and Cardiovascular Assets during the first quarter of 2008. This loss was comprised of the total upfront consideration from the sales of the Commercial and Cardiovascular Assets of $280.4 million plus the write-off of $10.6 million in net liabilities, less the book values of intangible assets and inventories of $268.2 million, the write-off of goodwill of $81.7 million and transaction fees of $5.7 million.
In connection with the sale of the Commercial and Cardiovascular Assets, we entered into agreements with both Otsuka and EKR to provide certain transition services. We expect to provide these transition services to Otsuka and EKR through 2008 and mid-2009, respectively. Any fees or cost reimbursements received for transition services are reflected as discontinued operations.
The results of our discontinued operations for the three and six months ended June 30, 2008 and 2007 were as follows:
(1) Included within total costs and expenses for the three and six months ended June 30, 2008 is $2.5 million that we recognized in connection with certain contingent Retavase manufacturing costs obligations for which we are required to reimburse EKR. At the time of sale, the likelihood of such reimbursements being required was not deemed probable and therefore no liability was initially recorded.
(2) Income tax expense attributable to our discontinued operations during the six months ended June 30, 2008 was primarily related to the tax gain on the sale of the Commercial and Cardiovascular Assets. Although we recognized a loss on the sale of these assets for financial reporting purposes, for tax purposes, we included the fair value of the contingent consideration from EKR in our proceeds, which included potential future milestone payments as well as potential future royalties on certain Cardene and ularitide product sales. In addition, the tax basis in the Commercial and Cardiovascular Assets was less than the book value recorded for financial reporting purposes. Therefore, we recognized a taxable gain and incurred alternative minimum tax on the sale of the Commercial and Cardiovascular Assets. The income tax payable attributable to our discontinued operations for the second quarter of 2008 was $5.4 million. The $34.6 million difference between the income tax payable and the income tax expense represents the tax benefit of certain tax deductions in connection with stock-based compensation, and such difference has been credited to additional paid-in capital. The tax expense allocated to discontinued operations during the six months ended June 30, 2008 was determined by subtracting from the year-to-date provision for the total company the year-to-date provision for continuing operations.
In connection with the divesture of the Commercial and Cardiovascular Assets, we committed in the first quarter of 2008 to provide certain severance benefits to those employees whose employment positions we likely would eliminate in connection with the transactions (the Commercial Employees). Under SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities (SFAS No. 146), we recognized expenses for these severance benefits of $1.8 million during the first quarter of 2008 which was included within discontinued operations. Our liability was $0.2 million at the end of the second quarter of 2008, and we expect to pay all amounts by the end of the third quarter of 2008.
During the fourth quarter of 2007, the Compensation Committee of our Board of Directors approved a modification to the existing terms of outstanding stock options held by our Commercial Employees to accelerate the vesting of up to 25% of the original grant amount upon termination of such employees, if the sale of the Commercial and Cardiovascular Assets occurred prior to a change in control of the Company. During the three and six months ended June 30, 2008, we recognized $0.3 million and $3.6 million, respectively, of stock based compensation expense related to such modification.
7. Sale of Manufacturing Assets
In March 2008, we sold our Manufacturing Assets to an affiliate of Genmab A/S (Genmab), for total cash proceeds of $240 million. Under the terms of the purchase agreement, Genmab acquired our manufacturing and related administrative facilities in Brooklyn Park, Minnesota, and related assets therein, and assumed certain of our lease obligations related to our facilities in Plymouth, Minnesota (together, the Manufacturing Assets). We recognized a pre-tax gain of $49.7 million upon the close of the sale in March 2008. Such gain represents the $240 million in gross proceeds, less the net book value of the underlying assets transferred of $185.4 million and $4.9 million in transaction costs and other charges.
In connection with the sale of the Manufacturing Assets, we entered into an agreement with Genmab under which we and Genmab will each provide transition services to the other over a maximum period of 12 months, or through March 2009. In addition, to fulfill our clinical manufacturing needs in the near-term, we entered into a clinical supply agreement with Genmab that became effective upon the close of the transaction. Under the terms of the clinical supply agreement, Genmab agreed to produce clinical trial material for certain of our pipeline products until March 2010, and we have minimum purchase commitments of approximately $21.6 million for a certain number of production lots by the end of 2009.
8. Restructuring and Other Charges
In an effort to reduce our operating costs to a level more consistent with a biotechnology company focused on antibody discovery and development, in March 2008 we commenced a restructuring plan pursuant to which we eliminated approximately 120 employment positions during the first quarter of 2008 and would eliminate approximately 130 additional
employment positions over the subsequent 12 months (the Transition Employees). All impacted employees were notified in March 2008. Subsequent to the completion of the restructuring, we expect to have approximately 300 employees.
Employees terminated in connection with the restructuring are eligible for a package consisting of severance payments of generally 12 weeks of salary and medical benefits along with up to three months of outplacement services. We are recognizing severance charges for Transition Employees over their respective estimated service periods. During the three and six months ended June 30, 2008, we recognized restructuring charges of $2.9 million and $8.4 million, respectively, consisting of post-termination severance costs as well as salary accruals relating to the portion of the 60-day notice period over which the terminated employees would not be providing services to the Company. These restructuring charges include those employees terminated immediately as well as the Transition Employees.
Facilities Related Restructuring
During the third quarter of 2007, we initiated our move from Fremont, California to our current location in Redwood City, California. In connection with this move, we ceased use of a portion of our leased property in Fremont, California and, as a result, we recognized idle facilities charges during 2007. The leases on these facilities terminated at the end of first quarter of 2008, and all related obligations were fully paid by June 30, 2008.
During the second quarter of 2007, we ceased use of one of our leased facilities in Plymouth, Minnesota. We recognized idle facilities charges, classified as restructuring expenses during the second quarter of 2007, of $1.6 million related to this facility. We expect to pay all obligations accrued relating to the lease by the end of the first quarter of 2009.
During the fourth quarter of 2007, we ceased use of a second facility in Plymouth. However, in connection with the sale of our Manufacturing Assets, Genmab assumed our obligations under the lease for this facility in March 2008.
The following table summarizes the restructuring activity discussed above, as well as the remaining restructuring accrual balance at June 30, 2008:
* Excludes restructuring charges for employees terminated in connection with the sale of the Commercial and Cardiovascular Assets as those amounts are reflected as part of discontinued operations. See Note 6 for further information.
In connection with our restructuring efforts, we have offered, and we continue to offer, retention bonuses and other incentives to two employee groups: (1) ongoing employees that we hope to retain after the restructuring, and (2) Transition Employees that we hope to retain through a transition period. This is in addition to the retention programs that we implemented during the fourth quarter of 2007, under which we recognized $1.1 million in expenses in 2007. We are recognizing the expenses for these retention programs over the period from the respective dates the programs were approved through the estimated service period for Transition Employees or until the expected pay-out date for ongoing employees. We recognized $3.4 million and $6.0 million in expenses under these retention programs during the three and six months ended June 30, 2008, respectively, which have been classified as research and development expenses and general and administrative expenses in the financial statements. As of June 30, 2008, we had accrued $5.7 million related to these retention bonuses, which is included in accrued compensation on the Condensed Consolidated Balance Sheet.
9. Asset Impairment Charges
Total asset impairment charges recognized in continuing operations for the three months ended June 30, 2008 and 2007 were $0.3 million and $5.0 million, respectively. The $0.3 million charge recognized during the second quarter of 2008 represented the cost of an information technology project that was terminated and which had no future benefit to us as a result of our restructuring activities. The $5.0 million charge recognized during the second quarter of 2007 related to two
buildings that comprised part of our prior corporate headquarters in Fremont, California. On June 30, 2007, management committed to a plan to sell these two buildings and, based on market value information we had at the time, we concluded that the net carrying value of the assets was impaired as of June 30, 2007. We recognized an impairment charge of $5.0 million to reduce the net carrying value of the assets to $20.6 million, which was our estimate of fair value, less cost to sell. The sale of these two buildings closed in October 2007 on terms consistent with those expected and, as a result, no significant gain or loss on the sale was recognized at the time of sale.
Asset impairment charges recognized in continuing operations for the six months ended June 30, 2008 and 2007 were $3.8 million and $5.0 million, respectively. The $3.8 million charge recognized during the first half of 2008 primarily represented the costs of certain research equipment that is expected to have no future useful life and certain information technology projects that were terminated and have no future benefit to us, in each case, as a result of our restructuring activities. The $5.0 million impairment charges related to the impairment of our former Fremont, California facilities, as discussed above.
10. Non-Monetary Transaction
In January 2008, we and Biogen Idec entered into an exclusive worldwide licensing agreement with Ophthotech Corp. (Ophthotech), a privately held company, for an anti-angiogenesis antibody to treat Age-Related Macular Degeneration (AMD). Under the terms of the agreement, we and Biogen Idec have granted Ophthotech worldwide development and commercial rights to all ophthalmic uses of volociximab (M200). In addition, we and Biogen Idec have an obligation to supply both clinical and commercial M200 product to Ophthotech. In connection with this agreement, we received an equity position in Ophthotech, and we are entitled to receive a combination of development and commercial milestone payments and royalties on future product sales.
We have estimated the fair value of the nonmarketable equity instruments received based predominately upon the price of similar Ophthotech equity instruments that Ophthotech had recently sold to independent parties for cash consideration. Based on this approach, we have estimated the fair value of our equity position to be $1.8 million, which is included in other assets on the Condensed Consolidated Balance Sheet as of June 30, 2008.
For the purposes of revenue recognition, we are treating the grant of the license and the manufacturing obligation to provide M200 product to Ophtotech as a single unit of accounting. Because we were, and we continue to be, unable to estimate the time period over which we are obligated to supply the M200 product, we have not recognized any revenue under the agreement. The fair value of the consideration that we received from Ophthotech continues to be classified as long-term deferred revenue as of June 30, 2008. We do not intend to recognize any revenue related to this agreement until we are able to reasonably estimate the date at which our obligations will end.
11. Restricted Cash
As of June 30, 2008 and December 31, 2007, we had a total of $18.3 million and $28.3 million, respectively, of restricted cash. As of June 30, 2008 and December 31, 2007, $15.0 million and $25.0 million, respectively, of the restricted cash supported letters of credit on which our landlord and construction contractor could draw if we did not fulfill our obligations with respect to the construction of our leasehold improvements to our Redwood City, California, facility. All of the work underlying the $15 million letter of credit that was outstanding at June 30, 2008 has been performed, and the construction contractor is no longer able to draw on the letter of credit. The remaining $3.3 million of long-term restricted cash supports letters of credit serving as a security deposit for obligations under our Redwood City leases.
12. Other Accrued Liabilities
Other accrued liabilities consisted of the following:
13. Income Taxes
Income tax expense attributable to our continuing operations during the three and six months ended June 30, 2008 was $1.4 million and $2.4 million, respectively, which was related primarily to federal and state alternative minimum taxes as well as foreign taxes on income earned by our foreign operations. As a result of the sale of our Commercial and Cardiovascular Assets in March 2008, we no longer have deferred tax liabilities, and due to our lack of earnings history, the gross deferred tax assets have been fully offset by a valuation allowance and no longer appear on our Consolidated Balance Sheet as of June 30, 2008.
The income tax expense for our continuing operations was $0.4 million for the three and six months ended June 30, 2007, which was related primarily to federal and state alternative minimum taxes and foreign taxes on income earned by our foreign operations.
During the three months ended June 30, 2008 we recorded an $8.3 million increase in our liabilities related to prior year uncertain tax positions in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes, an interpretation of SFAS 109, Accounting for Income Taxes. This increase is a result of the Company refining its position for prior year uncertain tax positions. We do not anticipate any additional unrecognized benefits in the next 12 months that would result in a material change to our financial position.
14. Fair Value Measurements
As of January 1, 2008, we adopted FASB Statement No. 157, Fair Value Measurements (FAS 157). FAS 157 established a framework for measuring fair value in GAAP and clarified the definition of fair value within that framework. FAS 157 does not require any new fair value measurements in GAAP. FAS 157 introduced, or reiterated, a number of key concepts which form the foundation of the fair value measurement approach to be utilized for financial reporting purposes. The fair value of our financial instruments reflect the amounts that would be received if we were to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price). FAS 157 also established a fair value hierarchy that prioritizes the use of inputs used in valuation techniques into the following three levels:
· Level 1quoted prices in active markets for identical assets and liabilities
· Level 2observable inputs other than quoted prices in active markets for identical assets and liabilities
· Level 3unobservable inputs
At June 30, 2008, we determined the fair values of our financial assets using Level 1 and Level 2 inputs, as reflected in the table below:
The following table presents the classification of our financial assets on our Consolidated Balance Sheet as of June 30, 2008:
We have excluded from the tables above $0.8 million of accrued interest, which has been recorded as part of marketable securities, and $11.9 million of cash, which is included in the cash and cash equivalents caption, in the Consolidated Balance Sheet.
15. Subsequent Events
In August 2008, EKR received from the U.S. Food and Drug Administration (FDA) approval for a pre-mixed bag formulation of nicardipine hydrochloride. Under the terms of the purchase agreement with EKR, we are entitled to a $25 million milestone payment from EKR as a result of this approval.
This report includes forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities and Exchange Act of 1934, as amended. All statements other than statements of historical facts are forward looking statements for purposes of these provisions, including any projections of earnings, revenues or other financial items, any statements of the plans and objectives of management for future operations, any statements concerning proposed new products or licensing or collaborative arrangements, any statements regarding future economic conditions or performance, and any statement of assumptions underlying any of the foregoing. In some cases, forward-looking statements can be identified by the use of terminology such as believes, may, will, expects, plans, anticipates, estimates, potential, or continue or the negative thereof or other comparable terminology. Although we believe that the expectations reflected in the forward-looking statements contained in this report are reasonable, there can be no assurance that such expectations or any of the forward-looking statements will prove to be correct, and actual results could differ materially from those projected or assumed in the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to inherent risks and uncertainties, including the risk factors set forth below, and for the reasons described elsewhere in this report. All forward-looking statements and reasons why results may differ included in this report are made as of the date hereof, and we assume no obligation to update these forward-looking statements or reasons why actual results might differ.
We are a biotechnology company focused on the discovery and development of novel antibodies in oncology and immunologic diseases. We receive royalties and other revenues through licensing agreements with biotechnology and pharmaceutical companies based on our proprietary antibody humanization technology platform. The technology subject to these licensing agreements has contributed to the development by our licensees of 10 marketed products. We currently have several investigational compounds in clinical development for oncology and immunologic diseases, two of which we are developing in collaboration with Biogen Idec MA, Inc. (Biogen Idec). Our research platform is focused on the discovery of novel antibodies for the treatment of cancer and immunologic diseases.
During the period from March 2005 through early March 2008, we marketed and sold acute-care products in the hospital setting in the United States and Canada. We acquired the rights to three of these products, Cardene IV®, IV Busulfex® and Retavase®, which are non-antibody-based products, in connection with our acquisitions of ESP Pharma, Inc. as well as the rights to Retavase in March 2005. We subsequently acquired the rights to Cardene SR® in September 2006. These
commercial products (together, the Commercial and Cardiovascular Assets) and the related operations (the Commercial and Cardiovascular Operations) were fully divested during the first quarter of 2008. We recognized a pre-tax loss of $64.6 million in connection with the sale of the Commercial and Cardiovascular Assets, which is presented within discontinued operations, during the six months ended June 30, 2008.
In March 2008, we sold our Minnesota manufacturing facility and related operations to an affiliate of Genmab A/S (Genmab), for total cash proceeds of $240 million. Under the terms of this agreement, Genmab acquired our manufacturing and related administrative facilities in Brooklyn Park, Minnesota, and related assets therein, and assumed certain of our lease obligations related to our facilities in Plymouth, Minnesota (together, the Manufacturing Assets). In connection with this transaction, under the terms of a clinical supply agreement, Genmab agreed to produce clinical material for certain of our pipeline products until March 2010.
Also during March 2008, in an effort to reduce our operating costs to a level more consistent with a biotechnology company focused on antibody discovery and development, we commenced a restructuring plan pursuant to which we eliminated approximately 120 employment positions in the first quarter of 2008 and would eliminate approximately 130 additional employment positions over the subsequent 12 months (the Transition Employees). We offered these 130 Transition Employees and the approximately 300 employees that we expect to retain after the restructuring, retention bonuses and other incentives to encourage these employees to stay with the Company until the Spin-off of our biotechnology assets (see below) or with the Spin-off company after the separation transaction. In connection with this overall restructuring effort, we expect to incur significant transition-related expenses through March 2009, a portion of which will be recognized as restructuring charges.
In April 2008, we announced our intent to spin off our biotechnology assets and related operations (the Biotechnology Business) into a separate publicly traded entity apart from our antibody humanization royalty assets (the Spin-off) by the end of 2008. In the event that the Spin-off does occur, we expect to retain the rights to antibody humanization royalty revenues from all current and future licensed products and plan to distribute this income to our stockholders, net of any operating expenses, debt service and income taxes. Subsequent to the potential Spin-off, we plan to have only a nominal number of employees to support our intellectual properties, manage our related licensing operations and provide for certain essential reporting and management functions of a public company. In connection with this process, we expect to cause a wholly owned subsidiary to file a registration statement on Form 10 with the Securities and Exchange Commission (SEC) subsequent to the filing of this Form 10-Q. We would transfer our biotechnology assets to this wholly owned subsidiary at the time of the Spin-off. Assuming the Spin-off does occur, we expect to capitalize the new biotechnology Spin-off company with approximately $375 million in cash at the completion of the Spin-off transaction, which amount will be increased by any milestone or similar payments received by PDL on or prior to the spin-off date related to the Biotechnology Business. We expect that this initial capitalization, as well as future payments from our collaboration agreement with Biogen Idec and from the asset purchase agreement with EKR, each of which is being assigned to the Biotechnology Business, would fund the biotechnology Spin-offs operations and working capital requirements for approximately three years after the closing of the Spin-off based on current operating plans. While we pursue the Spin-off, we continue to explore the possible sale or securitization of all or part of our antibody humanization royalty assets. We plan to continue to pursue both the Spin-off and a potential royalty assets monetization transaction in parallel. As the Companys goal is to separate its biotechnology assets from its antibody humanization royalty assets, a royatly transaction could be in lieu of the Spin-off.
In April 2008 we declared a special cash dividend of $4.25 per share of common stock (the Dividend), which was paid in May 2008 using the proceeds from the sale of the Commercial and Cardiovascular Assets and the Manufacturing Assets. Based on the total shares outstanding as of the May 5, 2008 record date, the total Dividend is expected to be $507.0 million, of which $506.4 million was paid in May 2008. The remaining $0.6 million unpaid portion of the Dividend relates to the Dividend payable on employee restricted stock awards that were unvested as of the date of the Dividend and would be paid to employees when and if they vest in the underlying restricted stock awards.
In August 2008, EKR Therapeutics, Inc., which acquired certain of our Commercial and Cardiovascular Assets, received approval from the U.S. Food and Drug Administration (FDA) for a pre-mixed bag formulation of nicardipine hydrochloride. Under the terms of the purchase agreement with EKR, we are entitled to a $25 million milestone payment from EKR as a result of this approval.
We were organized as a Delaware corporation in 1986 under the name Protein Design Labs, Inc. In 2006, we changed our name to PDL BioPharma, Inc.
Research and Development Programs
We have several investigational antibody-based compounds in various stages of development for cancer and immunologic diseases, two of which we are developing in collaboration with Biogen Idec. The table below lists various investigational
compounds for which we are pursuing development activities either on our own or in collaboration. Not all clinical trials for each product candidate are listed below. As part of our transition services agreement with EKR, which purchased the rights to Cardene, Retavase and ularitide, including all trademarks, patents, intellectual property, inventories and related assets in March 2008, we continue to provide research and development services for certain life cycle management activities for Cardene. Under this agreement, EKR reimburses us for all costs and expenses incurred in connection with these activities, all of which have been reflected as discontinued operations. As this is no longer an on-going PDL-sponsored program, we have excluded Cardene from the table below. The development and commercialization of our product candidates are subject to numerous risks and uncertainties, as noted in our Risk Factors in this Quarterly Report.
Daclizumab. Daclizumab is a humanized monoclonal antibody that binds to the alpha chain (CD25) of the interleukin-2 (IL-2) receptor on activated T cells, which are white blood cells that play a role in inflammatory and immune-mediated processes in the body.
Daclizumab in Multiple Sclerosis:
We and our partner, Biogen Idec, are currently testing daclizumab as a monotherapy for relapsing multiple sclerosis in a phase 2 study. In 2007, we and Biogen Idec announced that the CHOICE trial, a phase 2, randomized, double-blind, placebo-controlled trial of daclizumab conducted in 270 patients, met its primary endpoint in relapsing MS patients being treated with interferon beta. These data showed daclizumab administered at 2 mg/kg every two weeks as a subcutaneous injection added to interferon beta therapy significantly reduced new or enlarged gadolinium-enhancing lesions at week 24 compared to interferon beta therapy alone. We and Biogen Idec continue to evaluate the results of the CHOICE study to help further inform the development of daclizumab for multiple sclerosis.
In the first quarter of 2008, we and Biogen Idec initiated a phase 2 monotherapy trial of daclizumab, the SELECT trial, to advance the overall clinical development program in relapsing MS. This trial is currently ongoing. Results of this study will further guide the potential later stage development of daclizumab in which we anticipate Biogen Idec will play a lead role, leveraging their experience in the commercialization of treatments for multiple sclerosis.
We have previously conducted a double-blind placebo controlled clinical trial for daclizumab in patients with moderate to severe asthma. This study demonstrated a statistically significant benefit in the primary and several secondary endpoints encouraging us to continue to pursue this indication. We are currently proposing additional testing for daclizumab in this area and we are in the process of outlining an appropriate development plan in discussions with the FDA.
Daclizumab in Transplant Maintenance: A potential extension of daclizumab clinical use is in transplant maintenance. Data from various studies have suggested a role for daclizumab in this indication, and we are evaluating opportunities and next steps for this program.
Daclizumab is the active component of the approved drug Zenapax, which has been marketed worldwide by Hoffmann La-Roche (Roche) for acute transplant rejection.
Volociximab (M200). Volociximab is a chimeric monoclonal antibody that inhibits the functional activity of a5ß1 integrin, a protein found on activated endothelial cells. Blocking the activity of a5ß1 integrin has been found to prevent angiogenesis, which is the formation of new blood vessels that feed tumors and allow them to grow and metastasize.
We believe that volociximab may have potential in treating a range of solid tumors and that its role in angiogenesis may also aid in the treatment of age related macular degeneration (AMD). Currently, we have a worldwide strategic development partnership with Biogen Idec for volociximab in oncology, and, with them, we have an out-licensing agreement with Ophthotech Corporation for its development in AMD.
Volociximab in Solid Tumors: We and our partner, Biogen Idec, are currently investigating volociximab in various open-label clinical trials in patients with advanced solid tumors. This includes phase 1-2 and phase 1 clinical trials in ovarian and non-small cell lung cancer. Previously, we had conducted studies of voloxicimab in third-line ovarian cancer, pancreatic cancer, renal cell carcinoma and melanoma. These data and associated analyses have contributed to our understanding of the mechanism and safety profile of voloxicimab, and we are applying this knowledge to our ongoing programs. We plan to continue to evaluate the data from our ongoing studies in ovarian and non-small cell lung cancer and collaborate with Biogen Idec on the future development plans for this antibody.
Volociximab in Eye Disorders: We and Biogen Idec have licensed voloxicimab for ophthalmic indications to Ophthotech for various milestones and eventual royalties on potential product sales.
Elotuzumab (HuLuc63). Elotuzumab is a humanized monoclonal antibody that binds to CS1, a cell surface glycoprotein that is highly expressed on myeloma cells but minimally expressed on normal human cells. Based upon preclinical studies elotuzumab may also induce anti-tumor effects through antibody-dependent cellular cytotoxicity (ADCC) activity on myeloma cells. Elotuzumab is currently in phase 1 clinical studies as both a monotherapy in relapsed refractory patients and combination therapy as a second line treatment in patients with multiple myeloma. We have previously published early results from the ongoing monotherapy study reflecting early pharmacokinetic (PK) and tolerance data. We also published strong preclinical data supporting the use of elotuzamab in combination with other agents. In July 2008, we initiated a phase 1 combination trial of elotuzumab with Revlimid® (lenalidomide) in patients with multiple myeloma. Two additional trials are ongoing, one of elotuzumab in combination with Velcade® (bortezomib) and a second trial of elotuzumab as a monotherapy in this same patient population.
Preclinical data from our elotuzumab program are suggestive of the anitibodys biologic activity. Our scientific rationale supporting the development of this antibody includes potent reduction of human multiple myeloma tumors in animal models, destruction of multiple myeloma cells directly from patients, and an extensive analysis of the target for elotuzumab, CS1, which is highly expressed in almost all cases of multiple myeloma independent of stage of prior therapy.
PDL192. PDL192 is a humanized monoclonal antibody that binds to the TWEAK (tumor necrosis factor-like weak inducer of apoptosis) receptor (TweakR), also known as Fn14 or TNFRSF12A, a cell surface protein with homology to the family of tumor necrosis factor (TNF) receptors. PDL192 appears to have dual mechanisms of action, where the binding to the target results in a biological signal detrimental to the cancer cell. In addition, PDL192 may be able to recruit the immune system to also mediate ADCC activity to help destroy the tumor. Our scientists have demonstrated that TweakR is over-expressed in a number of solid tumor indications including pancreatic, colon, lung, renal, breast and head and neck cancers, and ongoing scientific work will help prioritize those tumors for therapeutic testing. In preclinical studies, PDL192 also has been shown to significantly inhibit tumor growth of various models of human cancer in mice. We filed the IND for PDL192 in the second quarter of 2008 and have initiated a phase 1 dose escalation program in solid tumors.
PDL241. PDL241 is a novel humanized monoclonal antibody that we believe may have potential in immunologic diseases. We are currently conducting preclinical toxicology and IND-enabling studies for this lead preclinical candidate which we hope to advance into the clinic. Preclinical data including its target and potential mechanism will be made available in conjunction with any future IND filing for this antibody.
Preclinical research candidates. We are currently evaluating a series of discovery-stage antibody and target combinations, as well as multiple next-generation antibodies, for their suitability to progress into the clinic. Our goal is to continue to characterize a pool of novel and next generation antibodies, from which we can advance the most promising candidates into clinical development.
Technology Outlicense Agreements
We have licensed and will continue to offer to license our humanization patents in return for license fees, annual maintenance payments and royalties on product sales. The 10 humanized antibody products listed below are currently approved for use by the FDA and are licensed under our patents.
(1) Cimzia was approved for marketing by the FDA in April 2008. We expect to receive and recognize royalty revenues on sales of Cimzia beginning in the third quarter of 2008.
(2) Roche is obligated to pay us royalties on Zenapax only once product sales have reached a certain threshold; we have not received royalties on sales of Zenapax since the first quarter of 2006 and we do not expect to receive royalty revenue from Roches sales of Zenapax in the future.
Collaborative and Strategic Agreement
We have a collaboration agreement with Biogen Idec for the joint development, manufacture and commercialization of daclizumab in MS and indications other than transplant and respiratory diseases, and for shared development and commercialization of volociximab (M200) in all indications. Under our collaboration agreement with Biogen Idec, we share equally the costs of all development activities. This agreement requires each party to undertake extensive efforts in support of the collaboration and requires the performance of both parties to be successful. We anticipate recognizing an increasing amount of revenue and expenses as we progress with this collaboration.
We continue to actively evaluate potential opportunities to partner certain programs with or out-license certain of our technologies to other pharmaceutical or biotechnology companies and expect that we will enter into other collaboration or other agreements in the future.
Summary of Second Quarter of 2008
In the second quarter of 2008, we recognized revenues from continuing operations of $111.9 million, a 26% increase from $89.1 million in the comparable period in 2007. Our revenue growth was driven by increases in royalties, primarily due to higher royalties related to our license agreements with Genentech.
Our total expenses from continuing operations in the second quarter of 2008 were $60.2 million, a significant decrease from $78.7 million in the second quarter of 2007 due largely to the reduction in operating costs resulting from the sale of our manufacturing facility in the first quarter of 2008 and our restructuring that was initiated in the first half of 2008. Total costs and expenses in the second quarter of 2008 also included restructuring charges of $3.0 million and asset impairment charges of $0.3 million, compared to asset impairment charges of $5.0 million during the second quarter of 2007. Our income from continuing operations for the second quarter of 2008 was $50.8 million, compared to $11.5 million in the prior-year comparable period. In the first six months of 2008, net cash provided by operating activities was $7.5 million, a decrease from $45.9 million provided by operating activities in the comparable period in 2007. At June 30, 2008, we had cash, cash equivalents, marketable securities and restricted cash of $493.7 million, compared to $440.8 million at December 31, 2007. As of June 30, 2008, we had $526.5 million in total debt outstanding, which included $500.0 million in convertible notes.
We expect that in the foreseeable future, our revenue growth will be generated primarily by increases in our royalties, with some potential increase in our collaboration and related milestone revenues if we are successful in the development of our products currently under collaboration agreements or if we are successful in entering into new collaboration agreements. We expect that our operating expenses in the near term will decrease significantly relative to recent historical expense levels due to the sales of the Commercial and Cardiovascular Assets and the Manufacturing Assets in March 2008, and the restructuring
activities that are in process and that will continue over the next several quarters. However, we expect to incur additional charges and expenses during 2008 and into 2009 related to the restructuring, including severance payments to terminated employees and retention incentives we have offered to ongoing employees and Transition Employees. We also expect to incur significant costs in the next few quarters to prepare for and implement the Spin-off of our Biotechnology Business. In addition, we are actively seeking to sublease excess capacity in our Redwood City facilities. If we are able to sublease any of this excess capacity, our lease expenses would decline. The process of subleasing office space can be a lengthy and uncertain process and we cannot assure if and when we may sublease any of our excess capacity or the amount of excess capacity that we may ultimately be able to sublease. In the future, after we complete our restructuring plans, we would expect our operating expense increases or decreases to correlate generally with the development of our potential products. Our total operating expenses will also fluctuate depending on the outcome of our efforts to sublease some or all of our corporate headquarters facility. New collaboration or out-licensing agreements, and receipt of potential contingent consideration as described below also would have an impact on our future financial results.
Economic and Industry-wide Factors
Various economic and industry-wide factors are relevant to us and could affect our business, including the factors set forth below.
· Our business will depend in significant part on our ability to develop innovative new drugs. Drug development, however, is highly uncertain and very expensive, typically requiring tens to hundreds of millions of dollars invested in research, development and manufacturing elements. Identifying drug candidates to study in clinical trials requires significant investment and may take several years. In addition, the clinical trial process for drug candidates is usually lengthy, expensive and subject to high rates of failure throughout the development process. As a result, a majority of the clinical trial programs for drug candidates are terminated prior to applying for regulatory approval. Even if a drug receives FDA or other regulatory approval, such approval could be conditioned on the need to conduct additional trials, or we or our licensees could be required to or voluntarily decide to suspend marketing of a drug as a result of safety or other events.
· Our industry is subject to extensive government regulation, and we must make significant expenditures to comply with these regulations. For example, the FDA regulates, among other things, the development, testing, research, manufacture, safety, efficacy, record-keeping, labeling, storage, approval, quality control, adverse event reporting, advertising, promotions, sale and distribution of our products. The development and marketing of our products outside of the United States is subject to similar extensive regulation by foreign governments, which regulations are not harmonized with the regulations of the United States.
· The manufacture of drugs and antibodies for use as therapeutics in compliance with regulatory requirements is complex, time-consuming and expensive. If our contract manufacturers are unable to manufacture product or product candidates in accordance with FDA and European good manufacturing practices, we may not be able to obtain or retain regulatory approval for our products. We are currently reliant on third-party manufacturers for all of our products.
· Our business success is dependent in significant part on our success in establishing intellectual property rights, either internally or through in-license of third-party intellectual property rights, and protecting our intellectual property rights. If we are unable to protect our intellectual property, we may not be able to compete successfully and our sales and royalty revenues and operating results would be adversely affected. Our pending patent applications may not result in the issuance of valid patents or our issued patents may not provide competitive advantages or may be reduced in scope. Proceedings to assert and defend our intellectual property rights are expensive, can, and have, continued over many years and could result in a significant reduction in the scope or invalidation of our patents, which could adversely affect our results of operations.
· To be successful, we must retain qualified clinical, scientific, marketing, administrative and management personnel. We face significant competition for experienced personnel and have experienced significant attrition in late 2007 and early 2008 as a result of the uncertainty created by the strategic initiatives we undertook during this period. We also implemented a restructuring in March 2008, which includes a significant reduction in force, and we expect to continue to face challenges in retaining qualified personnel as we transition to a more streamlined organization. In addition, we are currently searching for a Chief Executive Officer, and we believe our ability to attract and retain a qualified individual in that role will be critical to our success going forward.
See also the Risk Factors section of this quarterly report for additional information on these economic and industry-wide and other factors and the impact they could have on our business and results of operations.
CRITICAL ACCOUNTING POLICIES AND THE USE OF ESTIMATES
The preparation of our financial statements in conformity with accounting principles generally accepted in the United States (GAAP) requires management to make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. Actual results could differ materially from those estimates. For a description of the critical accounting policies that affect our more significant judgments and estimates used in the preparation of our condensed consolidated financial statements, refer to our Annual Report on Form 10-K for the year ended December 31, 2007, filed with the SEC. Except as noted below, there have been no changes to our critical accounting policies since December 31, 2007.
We enter into patent license, collaboration and humanization agreements that may contain multiple elements, such as upfront license fees, reimbursement of research and development expenses, milestones related to the achievement of particular stages in product development and royalties. Under our collaboration arrangements, we may receive nonrefundable upfront fees, time-based licensing fees and reimbursement for all or a portion of certain predefined research and development or post-commercialization expenses, and our licensees may make milestone payments to us when they or we achieve certain levels of development with respect to the licensed technology. Generally, when there is more than one deliverable under the agreement, we account for the revenue as a single unit of accounting under Emerging Issues Task Force (EITF) Issue No. 00-21, Revenue Arrangement with Multiple Deliverables, for revenue recognition purposes. As a combined unit of accounting, the up-front payments are recognized ratably as the underlying services are provided under the arrangement. We recognize at-risk milestone payments upon achievement of the underlying milestone event and when they are due and payable under the arrangement. Milestones are deemed to be at risk when, at the onset of an arrangement, management believes that they will require a reasonable amount of effort to be achieved and are not simply reached by the lapse of time or perfunctory effort. We currently determine attribution methods for each payment stream based on the specific facts and circumstances of the arrangement. The EITF may provide additional guidance on the topic of Revenue Recognition for a Single Deliverable for a Single Unit of Accounting (with Multiple Deliverables) That Have Multiple Payment Streams, which could change our method of revenue recognition in future periods.
In December 2007, the Financial Accounting Standards Board (FASB) ratified the final consensuses in EITF Issue No. 07-1, Accounting for Collaborative Arrangements (EITF 07-1), which requires certain income statement presentation of transactions with third parties and of payments between the parties to the collaborative arrangement, along with disclosure about the nature and purpose of the arrangement. We are required to adopt EITF 07-1 on or before January 1, 2009. With respect to the reimbursement of development costs, each quarter, we and our collaborator(s) reconcile what each party has incurred in terms of development costs, and we record either a net receivable or a net payable in our combined financial statements. For each quarterly period, if we have a net receivable from a collaborator, we recognize revenues by such amount, and if we have a net payable to our collaborator, we recognize additional research and development expenses by such amount. Therefore, our revenues and research and development expenses may fluctuate depending on which party in the collaboration is incurring the majority of the development costs in any particular quarterly period.
In addition, we occasionally enter into non-monetary transactions in connection with our patent licensing arrangements. Management must use estimates and judgments when considering the fair value of the technology rights acquired and the patent licenses granted under these arrangements. The fair value of the technology right(s) acquired from the licensee is typically based on the fair value of the patent license and other consideration we exchange with the licensee.
Clinical Trial Expenses
We base our cost accruals for clinical trials on estimates of the services received and efforts expended pursuant to contracts with numerous clinical trial centers and clinical research organizations (CROs). In the normal course of business, we contract with third parties to perform various clinical trial activities in the ongoing development of potential drugs. The financial terms of these agreements vary from contract to contract, are subject to negotiation and may result in uneven payment flows. Payments under the contracts depend on factors such as the achievement of certain events, the successful accrual of patients or the completion of portions of the clinical trial or similar conditions. The objective of our accrual policy is to match the recording of expenses in our financial statements to the actual services received and efforts expended. As such, we recognize direct expenses related to each patient enrolled in a clinical trial on an estimated cost-per-patient basis as services are performed. In addition to considering information from our clinical operations group regarding the status of our clinical trials,
we rely on information from CROs, such as estimated costs per patient, to calculate our accrual for direct clinical expenses at the end of each reporting period. For indirect expenses, which relate to site and other administrative costs to manage our clinical trials, we rely on information provided by the CRO, including costs incurred by the CRO as of a particular reporting date, to calculate our indirect clinical expenses. In the event of early termination of a clinical trial, we accrue and recognize expenses in an amount based on our estimate of the remaining non-cancelable obligations associated with the winding down of the clinical trial, which we confirm directly with the CRO.
If our CROs were to either under or over report the costs that they have incurred or if there is a change in the estimated per patient costs, it could have an impact on our clinical trial expenses during the period in which they report a change in estimated costs to us. Adjustments to our clinical trial accruals primarily relate to indirect costs, for which we place significant reliance on our CROs for accurate information at the end of each reporting period. Based upon the magnitude of our historical adjustments, we believe that it is reasonably possible that a change in estimate related to our clinical accruals could be approximately 1% of our annual research and development expenses.
Employee Stock-Based Compensation
Under the provisions of Statement of Financial Accounting Standards (SFAS) No. 123(R), Stock-Based Compensation (SFAS No. 123(R)), we estimate the fair value of our employee stock awards at the date of grant using the Black-Scholes option-pricing model, which requires the use of certain subjective assumptions. The most significant of these assumptions are our estimates of the expected volatility of the market price of our stock and the expected term of the award. When establishing an estimate of the expected term of an award, we consider the vesting period for the award, our recent historical experience of employee stock option exercises (including forfeitures), the expected volatility, and a comparison to relevant peer group data. As required under the accounting rules, we review our valuation assumptions at each grant date and, as a result, our valuation assumptions used to value employee stock-based awards granted in future periods may change.
Further, SFAS No. 123(R) requires that employee stock-based compensation costs be recognized over the requisite service period, or the vesting period, in a manner similar to all other forms of compensation paid to employees. The allocation of employee stock-based compensation costs to each operating expense line are estimated based on specific employee headcount information at each grant date and estimated stock option forfeiture rates and revised, if necessary, in future periods if actual employee headcount information or forfeitures differ materially from those estimates. As a result, the amount of employee stock-based compensation costs we recognize in each operating expense category in future periods may differ significantly from what we have recorded in the current period. During the second quarter of 2008, we increased our estimated forfeiture rate from 10.8% to approximately 19.5%, which was based on historical forfeiture rates adjusted for certain one-time events and the impact of more recent trends on our future forfeitures, resulting in a decrease to stock-based compensation expense during the quarter of $1.7 million. In future periods, we will continue to revise our estimated forfeiture rates. A hypothetical seven percentage point change in the rate of estimated stock option forfeitures could result in an increase or decrease to stock-based compensation expense of approximately $1.0 million.
Our income tax provision is based on income before taxes and is computed using the liability method in accordance with SFAS No. 109, Accounting for Income Taxes. Deferred tax assets and liabilities are determined based on the difference between the financial statement and tax basis of assets and liabilities using tax rates projected to be in effect for the year in which the differences are expected to reverse. Significant estimates are required in determining our provision for income taxes. Some of these estimates are based on interpretations of existing tax laws or regulations, or the expected results from any future tax examinations. Various internal and external factors may have favorable or unfavorable effects on our future income provision for income taxes. These factors include, but are not limited to, changes in tax laws, regulations and/or rates, the results of any future tax examinations, changing interpretations of existing tax laws or regulations, changes in estimates of prior years items, past and future levels of R&D spending, acquisitions, changes in our corporate structure, and changes in overall levels of income before taxes all of which may result in periodic revisions to our provision for income taxes. Uncertain tax positions are accounted for in accordance with FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes. We accrue tax related interest and penalties related to uncertain tax positions and include these with income tax expense in the Condensed Consolidated Statements of Income.
The income tax provision for the quarter was calculated based on the results of operations for the three and six months ended June 31, 2008 and does not reflect an annual effective rate. Since we cannot consistently predict our future operating income or in which jurisdiction it will be located, we are not using an annual effective tax rate to apply to the operating income for the quarter.
Valuation and Impairment of Long-Lived Assets
In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, we periodically evaluate whether current facts or circumstances indicate that the carrying value of our depreciable assets held and to be used may not be recoverable. If such circumstances are determined to exist, an estimate of undiscounted future cash flows produced by the long-lived asset, or the appropriate grouping of assets, is compared to the carrying value to determine whether impairment exists. If an asset is determined to be impaired, the loss is measured based on the difference between the assets fair value and its carrying value. We report an asset to be disposed of at the lower of its carrying value or its estimated net realizable value.
RESULTS OF OPERATIONS
Three and Six Months Ended June 30, 2008 and 2007
Our total revenues from continuing operations increased by $22.8 million, or 26%, and $21.3 million, or 14%, in the three and six months ended June 30, 2008, respectively, from the comparable periods in 2007 for reasons discussed below.
Royalty revenues increased by $24.8 million and $26.2 million, or 31% and 20%, in the three and six months ended June 30, 2008, respectively, from the comparable periods in 2007. These increases were primarily due to higher reported product sales of Avastin, Herceptin and Lucentis, which are marketed by Genentech, and Tysabri, which is marketed by Elan.
Under most of the agreements for the license of rights under our antibody humanization patents, we receive a flat-rate royalty based upon our licensees net sales of covered products. Royalty payments are generally due one quarter in arrears; that is, generally in the second month of the quarter after the licensee has sold the royalty-bearing product. However, our master patent license agreement with Genentech provides for a royalty fee structure that has four tiers, under which the royalty rate Genentech must pay on royalty-bearing products sold in the United States or manufactured in the United States and sold anywhere (U.S.-based Sales) in a given calendar year decreases during that year on incremental U.S.-based Sales above the net sales thresholds. As a result, Genentechs average annual royalty rate during a year declines as Genentechs cumulative U.S.-based Sales increase during that year. Because we receive royalties in arrears, the average royalty rate for the payments we receive from Genentech in the second calendar quarter, which would be for Genentechs sales from the first calendar quarter, is higher than the average royalty rate for following quarters. The average royalty rate for payments we receive from Genentech is lowest in the first calendar quarter, which would be for Genentechs sales from the fourth calendar quarter, when more of Genentechs U.S.-based Sales bear royalties at lower royalty rates. With respect to royalties that fall under the tiered fee structure, we allocate the royalty revenues among the different products based on the relative underlying net product sales reported to us by Genentech. With respect to royalty-bearing products that are both manufactured and sold outside of the United States (ex-U.S.-based Sales), the royalty rate that we receive from Genentech is a fixed rate based on a percentage of the underlying ex-U.S.-based Sales. The mix of U.S.-based Sales and ex-U.S.-based Sales and the manufacturing location are outside of our control and have fluctuated in the past and may continue to fluctuate in future periods.
Royalties from licensed product sales exceeding more than 10% of our total royalty revenues are set forth below (by licensee and product, as a percentage of total royalty revenues):
License, Collaboration and Other
License, collaboration and other revenues recognized during the three and six months ended June 30, 2008 and 2007 primarily consisted of revenues recognized under our collaboration agreements, upfront licensing and patent rights fees, milestone payments related to licensed technology and license maintenance fees. License, collaboration and other revenues decreased 22% and 25% in the three and six months ended June 30, 2008, respectively, in comparison to the same 2007 periods primarily due to the accelerated recognition of deferred revenue in 2007 resulting from the April 2007 termination of our agreement with Roche to co-develop daclizumab for transplant maintenance. Such decreases in revenues were partially offset by $2.0 million in milestone payments, reflected as license and other revenues, that we received in the first quarter of 2008 from certain of our licensees.
We continue to actively evaluate potential opportunities to partner certain programs with or out-license certain of our technologies to other pharmaceutical or biotechnology companies and expect that we will enter into other collaboration or other agreements in the future.
Costs and Expenses
* not meaningful
Certain expenses related to the Commercial and Cardiovascular Operations, which in prior periods were presented as cost of product sales, research and development expenses and general and administrative expenses, have been presented as discontinued operations for all periods presented in the current financial statements.
Research and Development
Our research and development activities include research, process development, pre-clinical development, manufacturing and clinical development, which activities generally include regulatory, safety, medical writing, biometry, U.S. and European clinical operations, compliance, quality and program management. Research and development expenses consist primarily of costs of personnel to support these research and development activities, as well as outbound milestone payments and technology licensing fees, costs of preclinical studies, costs of conducting our clinical trials, such as fees to CROs and clinical investigators, monitoring costs, data management and drug supply costs, research and development funding provided to third parties, stock-based compensation expense accounted for under SFAS No. 123(R) and an allocation of facility and overhead costs, principally information technology.
The table below reflects the development for each of our products in clinical development and the research and development expenses recognized in connection with each product.