ZymoGenetics 10-Q 2005
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2005
FOR THE TRANSITION PERIOD FROM TO
Commission File Number: 0-33489
(exact name of registrant as specified in its charter)
(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 ¨
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).
Yes x No ¨
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).
Yes ¨ No x
Indicate the number of shares outstanding of each of the issuers classes of common stock, as of the latest practicable date.
Common stock outstanding at October 28, 2005: 65,629,048 shares.
Quarterly Report on Form 10-Q
For the quarterly period ended September 30, 2005
The accompanying notes are an integral part of these financial statements.
STATEMENTS OF OPERATIONS
(in thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
NOTES TO FINANCIAL STATEMENTS
The accompanying unaudited financial statements of ZymoGenetics, Inc. (the Company) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. In the opinion of management, the financial statements reflect all normal recurring adjustments necessary to present fairly the Companys financial position and results of operations as of and for the periods indicated. Operating results for such periods are not necessarily indicative of the results that may be expected for the full year or for any future period.
The balance sheet at December 31, 2004 has been derived from the audited financial statements at that date but does not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. These financial statements should be read in conjunction with the audited financial statements and related footnotes included in the Companys Annual Report filed on Form 10-K for the year ended December 31, 2004.
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 and disclosure of contingent assets and liabilities at the date of the financial statements and that affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
Basic and diluted net loss per share has been computed based on net loss and the weighted-average number of common shares outstanding during the applicable period. The Company has excluded all outstanding options to purchase common stock as such shares are antidilutive for all periods presented.
The following table presents the calculation of basic and diluted net loss per share (in thousands, except per share data):
Short-term investments consisted of the following at September 30, 2005 (in thousands):
The Companys management has concluded that unrealized losses are temporary, as the duration of the decline in the value of the investments has been short; the extent of the decline, both in dollars and percentage of cost is not severe; and the Company has the ability and intent to hold the investments until at least substantially all of the cost of the investments is recovered.
As permitted by the provisions of Statement of Financial Accounting Standards No. 123, Accounting for Stock Based Compensation (SFAS 123) as amended by Statement of Financial Accounting Standards No. 148, Accounting for Stock-Based Compensation Transition and Disclosure (SFAS 148), the Company has elected to follow Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees (APB 25), in accounting for employee stock option grants and apply the disclosure-only provisions of SFAS 123. Under APB 25, compensation expense is based on the excess, if any, of the estimated fair value of its stock at the date of grant over the exercise price of the option. Deferred compensation is amortized over the vesting period of the individual options, using the straight-line method.
The following table illustrates the effect on net loss and loss per share as if the fair value based method prescribed by SFAS 123 had been applied to all outstanding and unvested awards for the three and nine-month periods ended September 30 (in thousands, except per share data):
For the three and nine months ended September 30, 2005, total comprehensive loss was $20.8 million and $63.1 million, respectively. For the three and nine months ended September 30, 2004, total comprehensive loss was $21.7 million and $66.8 million, respectively. Comprehensive loss is composed of net loss and unrealized gains and losses on short-term investments. The net change in accumulated other comprehensive loss for the nine months ended September 30, 2005 was $153,000, reflecting a increase in net unrealized losses on short-term investments due to increasing interest rates.
In August 2005, the Company issued 7.5 million shares of common stock, raising net proceeds of $126.6 million.
Certain amounts in the financial statements have been reclassified to conform to the current periods presentation. The reclassifications had no impact on net loss, shareholders equity or cash flows as previously reported.
In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. Disclosure of the effect of expensing the fair value of equity compensation is currently required under existing literature (see Note 4 to the financial statements). In March 2005, the Securities and Exchange Commission (SEC) released Staff Accounting Bulletin No. 107, Share-Based Payment, which expresses views of the SEC Staff about the application of SFAS 123(R). In April 2005, the SEC adopted a new rule that amends the compliance date for SFAS 123(R) to the beginning of the next fiscal year that begins after June 15, 2005. Accordingly, the Company will be required to begin expensing amounts related to employee stock options effective January 1, 2006. The adoption of SFAS 123(R) will have a material impact on the Companys results of operations. The process of evaluating the option valuation methods and adoption transition alternatives available under SFAS 123(R) has begun, but is not completed. Accordingly, the Company is not able to provide an estimate of the amount by which its net loss will increase after SFAS 123(R) is adopted.
In June 2005, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 154 (SFAS 154), Accounting Changes and Error Corrections-a replacement of APB No.20 and FAS No.3. SFAS 154 changes the requirements for the accounting for and reporting of a change in accounting principle and applies to all voluntary changes in accounting principle. It also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. SFAS 154 is effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. The Company will apply the provisions of this statement effective January 1, 2006.
The following discussion and analysis should be read in conjunction with the financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This report contains, in addition to historical information, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. This Act provides a safe harbor for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in the section entitled Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price as well as those discussed elsewhere in this report. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. When used in this document, the words believes, expects, anticipates, intends, plans and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Readers are urged to carefully review and consider the various disclosures made in this report and in our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and factors that may affect our business, prospects and results of operations.
We are a biopharmaceutical company focused on discovering, developing and commercializing therapeutic protein based products for the treatment of human diseases. The process for taking one of our discoveries to the marketplace is long, complex and very costly. It is difficult to predict the time it will take to commercialize any given product candidate, but it would not be unusual to span ten years or more and cost hundreds of millions of dollars. It is also a business of attrition; it is expected that, for the industry as a whole, less than 20% of the drug candidates entering human clinical trials will actually make it to the marketplace. For the products that do make it, particularly for those that address previously unmet medical needs, the markets can be significant, with a number of successful products selling in excess of $1 billion per year.
An important element of our strategy is that we intend to maintain all or a significant share of the commercial rights to a number of our products in North American markets. As a result, we will be required to pay a significant portion of the development costs for these product candidates. A second important element of our strategy is that we are developing a broad portfolio of product candidates to give our company more opportunities to be successful. We currently have three product candidates in clinical development and expect to add additional proteins to this portfolio in the future. Thus, we are paying a significant portion of development costs for several potential products. Assuming these product candidates progress through clinical development successfully, the cost of clinical trials are expected to increase significantly.
Our most significant financial challenges are to obtain adequate funding to cover the cost of product development, and to control spending and direct it toward product candidates that will create the most value for the companys shareholders over the long term. It can be a complex and highly subjective process to establish the appropriate balance between cash conservation and value generation. There are a number of important factors that we consider in addressing these challenges, including the following:
We expect that it will be several years or more before we can generate enough product-related revenues to reach cash flow breakeven. In the interim, revenues from existing relationships will help to defray our expenses, but additional funding will be required, the amount of which could be significant. We may decide to enter into additional product development collaborations, which would reduce our funding requirements. We may also generate funding through licensing of patents that are not relevant to our product development programs.
It is likely that we will continue to look for opportunities to raise equity capital as a primary means of funding our company over the next several years. The equity markets for biotechnology stocks have tended to experience long cycles during which the sale of equity securities has been extremely difficult. It is not possible to predict the timing or length of these cycles. As a result, many biotechnology companies, including ours, have adopted an opportunistic strategy of raising equity capital when it is available. We believe this strategy is important to minimizing the financial risks to our company and our shareholders. Consistent with our strategy, in August 2005, we issued 7.5 million shares of common stock raising net proceeds of $126.6 million.
Results of Operations
Our revenues consist of royalties, option fees, license fees and milestone payments. The recognition of these revenues, in particular license fees and milestone payments, can fluctuate significantly from quarter to quarter. For the year 2005, we continue to expect that our total revenues will slightly exceed those reported for the year 2004. However, certain milestones could be achieved by licensees in the fourth quarter of 2005 that would result in our total revenues increasing by up to 20% for the full year.
Royalties. We earn royalties on sales of certain products subject to license agreements with Novo Nordisk, our former parent and current owner of approximately 33% of our outstanding common stock, and several other companies. Royalties generated from underlying human insulin sales have decreased in 2005 to $667,000 and $2.7 million for the three and nine-month periods ended September 30, 2005, respectively, as compared to $2.1 million and $4.9 million for the corresponding periods in 2004, due to patent expirations in certain countries and unfavorable changes in foreign exchange rates. We expect this trend to continue, and expect total 2005 royalty revenue to be in the range of $7 million to $8 million. We have opportunities to earn royalties in the future under other existing license agreements, but we cannot be certain when, or if, products will be sold subject to those licenses.
Option fees. We recognized $2.7 million and $8.0 million of option fee revenues for the three and nine-month periods ended September 30, 2005, respectively, as compared to $1.9 million and $5.6 million for the corresponding periods in 2004. The increases represent the recognition of deferred revenue related to a strategic alliance with Serono entered into during the fourth quarter of 2004. The $1.9 million per quarter recorded in both years represents the annual option fee of $7.5 million from Novo Nordisk under an option and license agreement, pursuant to which we have granted an option to license certain rights to proteins that we discover. We will receive the final payment under the agreement in November 2005.
License fees and milestone payments. Revenues from license fees and other up-front payments are recognized over the period we are contractually required to provide other rights or services that represent continuing obligations. From period to period, license fees and milestone payments can fluctuate substantially based on the completion of new licensing or collaborative agreements and the achievement of development related milestones. The decrease of $3.5 million for the quarter ended September 30, 2005, as compared to the corresponding period in 2004, is primarily due to the recognition of revenue for several milestone payments earned in the prior year period. The effect of this decline in milestone revenue was partially offset by the recognition of deferred revenue related to the licenses of rFXIII to Novo Nordisk and certain other proteins to Serono, all of which were entered into during the fourth quarter of 2004.
The increase for the nine-month period ended September 30, 2005, as compared to the nine-month period in 2004, is primarily due to a one-time, lump sum license fee received and earned from Eli Lilly and Company in the first quarter of 2005 for a license to certain Protein C patents, and the recognition of deferred revenue related to the Novo Nordisk and Serono licenses. This increase was partially offset by the decline in milestone payments described above.
Research and development. Research and development expense has been our most significant expense to date, consisting primarily of salaries and benefit expenses, costs of consumables, facility costs and contracted services. Research and development expense, net of cost reimbursements, decreased by 18% for the quarter ended September 30, 2005 compared to the corresponding quarter in 2004, but has increased 1% for the nine-month period ended September 30, 2005 as compared to the corresponding period in 2004. The decrease for the three-month period largely resulted from a significant reduction in rhThrombin contract manufacturing costs. In the third quarter of 2004, there was an ongoing campaign to adapt the manufacturing process to commercial scale and supply product for Phase 3 clinical testing. The next rhThrombin manufacturing campaign, in support of the planned product license application and commercial launch, is not scheduled to begin until late 2005. The addition of approximately 50 employees between September 30, 2004 and September 30, 2005 who are focused on product development led to higher salaries and benefits costs for both the three and nine-month periods. In addition, we have experienced a significant increase in consumable costs in the nine-month period to supply our recently completed pilot-scale manufacturing facility. These trends are shown in the following table (in thousands):
We anticipate that research and development expense will increase in the foreseeable future as we continue to advance, and potentially expand, our internal product development programs. For the full year 2005, we expect that our research and development expenses will increase by less than 10% compared to 2004.
General and administrative. General and administrative expense consists primarily of salaries and benefit expenses, professional fees and other corporate costs. Expense increased 11% and 2% for the three
and nine months ended September 30, 2005, respectively, as compared to the corresponding periods in 2004. The increases were primarily due to increased head count and external costs partially offset by a decrease in noncash stock-based compensation. A significant part of the expense increases related to increased strategic marketing activities in support of our product development programs, especially rhThrombin. General increases in headcount costs and professional fees also contributed to the expense increases. We anticipate that our general and administrative requirements will continue to increase to support our development programs as they advance towards commercialization. For the full year 2005, we expect an increase in general and administrative expense; however, net of the decline in noncash stock-based compensation, 2005 expense is only expected to be slightly higher than in 2004.
Noncash stock-based compensation. In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)), Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprises equity instruments or that may be settled by the issuance of such equity instruments. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. Disclosure of the effect of expensing the fair value of equity compensation is currently required under existing literature (see Note 4 to the financial statements). SFAS 123(R) will become effective for fiscal years beginning after June 15, 2005. Accordingly, we will be required to begin expensing amounts related to employee stock options effective January 1, 2006. The adoption of SFAS 123(R) will have a material impact on our results of operations. We have begun, but not completed, the process of evaluating the option valuation methods and adoption transition alternatives available under SFAS 123(R). Accordingly, we are not able to provide an estimate of the amount by which our net loss will increase after SFAS 123(R) is adopted.
Other income (expense)
Investment income. Investment income is generated primarily from investment of our cash reserves in investment grade, fixed-income securities. There are three primary factors affecting the amount of investment income that we report: amount of cash reserves invested, the effective interest rate, and the amount of gains or losses recognized. Investment income increased significantly for the three and nine-month periods ended September 30, 2005 as compared to the corresponding periods in 2004, largely due to increases in the effective interest rate realized and higher average amounts of cash reserves invested. The following table shows how each of these factors affected investment income for the following (in thousands):
Interest expense. We have accounted for a sale-leaseback transaction completed in October 2002 as a financing transaction. Under this method of accounting, an amount equal to the net proceeds of the sale is considered a long-term interest bearing liability. Rent payments under the leases are considered to be payments toward the liability and are allocated to principal and interest. Interest expense was relatively constant for the three-month period in 2005 and 2004, but increased to $5.7 million for the nine-month period ended September 30, 2005 as compared to $5.0 million for the corresponding period in 2004. The increase resulted from additional lease obligations of approximately $15 million effective upon completion of our facility expansion project in mid-2004.
Liquidity and Capital Resources
As of September 30, 2005, we had cash, cash equivalents and short-term investments of $378.1 million, which we intend to use to fund our operations and capital expenditures over the next several years. These cash reserves are held in a variety of investment-grade, fixed-income securities, including corporate bonds, commercial paper and money market instruments. We believe that our existing cash resources should provide sufficient funding for the next several years. If we complete additional collaborative development transactions, which would generate both revenues and cost reductions, these cash resources would fund our company over a longer period of time.
Cash flows from operating activities. The amount of cash used to fund our operating activities generally tracks our net losses, with the following exceptions:
Generally, with the exception of changes in deferred revenue, we do not expect these items to generate material year-to-year fluctuations in the relationship between our net loss and the amount of net cash used in operating activities. Substantial license or upfront fees may be received upon the date we enter into new licensing or collaborative agreements and be recorded as deferred revenue. For example, in 2004 upon the execution of a strategic alliance agreement with Serono and a license agreement with Novo Nordisk, we recorded $36.2 million of deferred revenue, which will be recognized as revenue over the next approximately five years. For the nine months ended September 30, 2005, we recognized $17.7 million of deferred revenue from these and other transactions, causing our cash used in operating activities to be higher than our corresponding net loss. The timing of additional deferred revenue transactions is expected to be irregular and, thus, has the potential to create fluctuations in the relationship between our net loss and the amount of cash used in operating activities.
Cash flows from investing activities. Our most significant use of cash in investing activities is for capital expenditures. We expend a certain amount each year on routine items to maintain the effectiveness of our business, e.g., to adopt newly developed technologies, expand into new functional areas, adapt our facilities to changing needs and/or replace obsolete assets. In addition, we have used cash to purchase land and expand our facilities. The following table shows the amount of cash going toward each of these types of capital expenditures for the nine months ended September 30 (in thousands):
The R&D facility expansion project was partially funded by an allowance from our landlord, which is reflected as cash flow from financing activities. The project began in April 2003 and construction was completed in mid-2004. We expect to spend approximately $6 million in 2005 on routine capital equipment and facility projects.
Cash flows from investing activities also reflect large amounts of cash used to purchase short-term investments and received from the sale and maturity of short-term investments. These amounts primarily relate to shifts between cash and cash equivalents and short-term investments. Because we manage our cash usage with respect to our total cash, cash equivalents and short-term investments, we do not consider these cash flows to be important to an understanding of our liquidity and capital resources.
Cash flows from financing activities. In August 2005, we received net proceeds of $126.6 million from a follow-on offering of 7.5 million shares of common stock. In May 2004, we entered into a stock purchase agreement with Amgen, Inc. under which we received net proceeds of approximately $10 million. As part of the agreement for the expansion of our R&D facility, our landlord provided us an allowance of approximately $15 million to be applied toward the cost of this project. We received $6.9 million through the quarter ended June 2004, which represented the final installment of construction advance payments from our landlord.
We expect to incur substantial additional costs as we continue to advance and expand our product development programs. We expect these expenditures to increase over the next several years, particularly if the outcomes of clinical trials are successful and our product candidates continue to advance. Our plans include the internal development of selected product candidates and the co-development of product candidates with collaborators where we would assume a percentage of the overall product development costs. If, at any time, our prospects for financing these programs decline, we may decide to reduce our ongoing investment in our development programs. We could reduce our investment by discontinuing our funding under existing co-development arrangements, establishing new co-development arrangements for other product candidates to provide additional funding sources or out-licensing product candidates that we might otherwise develop internally. Additionally, we could consider delaying or discontinuing development of product candidates to reduce the level of our related expenditures.
Our long-term capital requirements and the adequacy of our available funds will depend on several factors, many of which may not be in our control, including:
Over the next several years we expect to seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements sooner than we expect. However, financing may be unavailable when we need it or may not be available on acceptable terms. If we raise additional funds by issuing equity or equity-based securities, the percentage ownership of our existing shareholders would be reduced, and these securities could have rights superior to those of our common stock. If we are unable to raise additional funds when we need them, we could be required to delay, scale back or eliminate
expenditures for some of our development programs or expansion plans, or grant rights to third parties to develop and market product candidates that we would prefer to develop and market internally, with license terms that are not favorable to us.
At September 30, 2005 we are contractually obligated to make payments as follows (in thousands):
The building lease obligations, which resulted from the sale-leaseback financing transaction, reflect the reset of the lease terms to 15 years beginning May 2004. Operating lease terms range from one to ten years. We have certain renewal provisions at our option, which are not reflected in the above table, for the building leases and the operating leases. In September 2005, we entered into two additional operating leases for office space within the same building as our previous operating leases. The lease terms expire in January 2012. The development contracts include the production of registration lots of rhThrombin, which may also be used for commercial purposes.
Our Senior Vice President of Technical Operations, Mark D. Young, recently announced his intention to retire effective April 1, 2006. We have begun the process to recruit and hire his replacement. In September 2005, Nicole Onetto joined the Company as our Senior Vice President and Chief Medical Officer.
Important Factors That May Affect Our Business, Our Results of Operations and Our Stock Price
A summary of important factors that may affect our business, our results of operations and our stock price follows. You should refer to our Annual Report or Form 10-K for the year ended December 31, 2004 for a more thorough discussion of these factors. The risks and uncertainties identified below are not the only ones we face. Additional risks and uncertainties not presently known to us or that we currently deem immaterial also may impair our business operations. If any of the risks identified in the factors below actually occur, our business, financial condition and operating results could be materially adversely affected.
Product Development Risks
Intellectual Property Risks
General Business Risks
Financial and Market Risks
Our exposure to market risk is primarily limited to interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because the majority of our investments are in short-term debt securities. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive without significantly increasing risk. To minimize risk, we maintain our portfolio of cash, cash equivalents and short-term investments in a variety of interest-bearing instruments, including United States government and agency securities, high-grade United States corporate bonds, asset-backed securities, commercial paper and money market funds. Due to the nature of our short-term investments, all of which mature within three years, we believe that we are not subject to any material market risk exposure. We have no material foreign currency exposure, nor do we hold derivative financial instruments.
Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report, have concluded that as of such date our disclosure controls and procedures were effective. No change in our internal control over financial reporting occurred during the quarter ended September 30, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
(b) Use of Proceeds from Sale of Registered Securities
Our Registration Statement under the Securities Act of 1933 (File No. 333-69190) relating to our initial public offering, was declared effective by the SEC on January 31, 2002. From the effective date of the offering through September 30, 2005, we have invested the net proceeds from the offering in a variety of investment grade, fixed income securities, including corporate bonds, commercial paper and money market instruments.
Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.