ZymoGenetics 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008
FOR THE TRANSITION PERIOD FROM TO
Commission File Number: 0-33489
(exact name of registrant as specified in its charter)
1201 Eastlake Avenue East, Seattle, Washington 98102
(Address of principal executive offices) (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, and (2) has been subject to such filing requirements for the past 90 days. Yes x No ¨
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See definition of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the 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 31, 2008: 68,735,062 shares.
Quarterly Report on Form 10-Q
For the quarterly period ended September 30, 2008
PART I FINANCIAL INFORMATION
CONSOLIDATED BALANCE SHEETS
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
The accompanying notes are an integral part of these consolidated financial statements.
CONSOLIDATED STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The accompanying unaudited consolidated 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.
These unaudited interim 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, 2007.
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 periods. Actual results could differ from those estimates.
There are several factors that will significantly impact the Companys cash requirements during the next twelve months, including the amount of revenue generated from RECOTHROM sales, proceeds from new license and collaboration transactions, amounts the Company may draw under the debt financing arrangement, and reductions in its expense run rate, including the restructuring of agreements with Merck Serono and other cost saving measures it may implement. The Company believes that its existing cash resources, supplemented by activities described above will be sufficient to fund its operations for at least the next twelve months and possibly much longer. In addition, the Company may raise additional funds through one or more financing transactions, which would help fund it over an even longer period. If, despite the existing contractual commitment, funding under the $100.0 million debt financing arrangement were not made available when requested, the Companys continued operations would be dependent on the completion of new licenses, collaborations or financing transactions and it would likely need to significantly curtail existing operations. The degree of success in raising cash through these other sources would directly impact the Companys prospective cash requirements and if these activities were not successful, its existing cash resources would likely be exhausted in 2009.
Basic and diluted net loss per share have been computed based on net loss and the weighted-average number of common shares outstanding during the applicable period. The Company has excluded 14.0 and 13.0 million outstanding options to purchase common stock for the periods ended September 30, 2008 and 2007, respectively, and 588,500 restricted stock units for the period ended September 30, 2008 as such potential shares are antidilutive for all periods presented. Additionally, the Company is obligated to issue warrants pursuant to a debt financing arrangement with Deerfield Management (See Note 6). No warrants have been issued as of September 30, 2008.
Short-term investments consisted of the following at September 30, 2008 (in thousands):
During the third quarter of 2008, the Company recorded an other-than-temporary impairment loss of $400,000 on one of its asset-backed security investments. The security was downgraded to a BB rating due to concerns regarding the quality of the underlying collateral and the insurance put in place to enhance the credit quality of the instrument.
The Companys management has concluded that all other unrealized losses are temporary and the Company has the ability and intent to hold the investments until at least substantially all of the cost of the investments is expected to be recovered. As of September 30, 2008, the weighted average expected maturity dates for all securities did not exceed three years.
Included in other assets is a long-term investment in common shares of BioMimetic Therapeutics, Inc. (BMTI), a company that licensed certain technologies from the Company and made certain payments in shares of common stock. These shares became publicly traded in 2006 and, as a result, are adjusted to fair value, with the unrealized gain reported as a separate component of shareholders equity. For the three and nine months ended September 30, 2008, the unrealized gain on the investment decreased by $65,000 and $1.1 million, respectively. As of September 30, 2008, the unrealized gain on the investment was $856,000.
Fair value measurements
Effective January 1, 2008, the Company adopted Financial Accounting Standards Board (FASB) Statement No. 157, Fair Value Measurements (FAS 157). FAS 157 establishes that fair value is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date (exit price) and establishes a fair value hierarchy based on the inputs used to measure fair value. The three levels of the fair value hierarchy defined by FAS 157 are as follows:
As required by FAS 157, financial assets and liabilities are classified in their entirety based on the lowest level of input that is significant to the fair value measurement. The Companys assessment of the significance of a particular input to the fair value measurement requires judgment and may affect the valuation of fair value assets and liabilities and their placement within the fair value hierarchy levels. The Companys short-term and long-term investments accounted for at fair value as of September 30, 2008 are summarized below (in thousands):
Inventory is stated at the lower of cost or market. Cost includes amounts related to materials, labor and overhead, and is determined on a specific identification basis in a manner which approximates the first-in, first-out (FIFO) method. Prior to FDA approval of RECOTHROM®, recombinant thrombin on January 17, 2008, all manufacturing related costs were expensed as research and development. The inventory balances reflect the cost of post-approval manufacturing activities. Inventory consisted of the following at September 30, 2008 (in thousands):
In August 2008, the Company sold land located near its corporate headquarters for $11.8 million and recognized a gain of $7.1 million. The gain is included in other income (expense) on the consolidated statement of operations as gain (loss) on sale of fixed assets.
In June 2008, the Company entered into a financing arrangement with Deerfield Management (Deerfield), whereby the Company can borrow up to $100.0 million in four draws of $25.0 million each until January 2010. Interest will accrue on amounts outstanding at a rate of 4.9% per annum, compounded quarterly, and will be due, along with outstanding principal, in June 2013. Each $25.0 million draw entitles Deerfield to a royalty equal to 2% of RECOTHROM net sales in the U.S. The cumulative royalty will not exceed $45.0 million assuming the Company draws the entire $100.0 million. The cumulative limit on royalties will be lower if the Company borrows less than $100.0 million. In addition, the Company is obligated to issue Deerfield warrants to purchase 1.5 million shares of common stock at $10.34 per share at the earlier of the first draw or January 2010, and warrants to purchase 1.0 million shares each upon the second, third and fourth draws exercisable at a 25% premium to the average sale price of the Companys common stock for the 15 trading days prior to the draw. All warrants will have a six-year term and the Company is obligated to register with the Securities and Exchange Commission the common stock issuable under the warrants. The Company can repay borrowed amounts in whole or in part at any time, without penalty, and all associated interest and royalty obligations will cease.
The Company has calculated the fair value of the initial 1.5 million warrants to be $6.2 million using the Black Scholes option pricing model with the following assumptions: expected volatility of 55.2%; expected dividend yield of 0.0%; risk free rate of 3.503%; and a contractual life of six years. The amount has been recorded as deferred financing costs and warrants issuable.
Deferred financing costs, consisting of a $1.0 million loan issuance fee paid to Deerfield, $299,000 of other costs associated with the transaction, and the $6.2 million fair value of warrants issuable, will be amortized to interest expense through June 2013.
In October 2008, the Company requested the first draw of $25.0 million under the Deerfield financing arrangement and received it in November 2008.
RECOTHROM was approved by the FDA on January 17, 2008. Sales of RECOTHROM are recognized as revenue when the product is shipped and title and risk of loss have passed. Product sales are recorded net of provisions for estimated discounts, rebates, chargebacks, and returns. Prior to FDA approval, all third party manufacturing costs and an allocation of Company labor and overhead associated with the manufacturing of RECOTHROM for commercial sale were expensed as research and development costs as incurred. Subsequent to RECOTHROM approval, these costs are recorded as inventory. Costs of product sales includes the inventory and distribution costs associated with RECOTHROM product sales revenue and a $400,000 charge in the third quarter of 2008 for final packaging costs incurred subsequent to FDA approval for product that is not expected to be sold.
On August 28, 2008, the Company exercised its right under the Collaborative Development and Marketing Agreement with Ares Trading S.A. (Merck Serono), to discontinue its co-development and co-funding obligations relating to atacicept and convert to an exclusive license. Accordingly, the Company is no longer responsible for funding product development costs after June 1, 2008. Merck Serono will pay the Company milestone fees and royalties on worldwide net sales, and the Company will continue to be responsible for certain transitional activities and will have its expenses reimbursed by Merck Serono.
The Company and Serono Technologies S.A. (Merck Serono) also amended the Strategic Alliance Agreement which expires on October 12, 2009. Under the revised terms, the Company and Merck Serono have alternating options through October 12, 2009, to obtain an exclusive, worldwide, royalty bearing license to product candidates jointly researched pursuant to the strategic alliance, with Merck Serono having the option for the first product candidate. Each party will have opt-in rights based on pre-negotiated terms if the other party seeks a partner for the applicable product candidate, which include retroactive and prospective cost sharing, royalties and milestone fees. In addition to its co-development and co-commercialization rights within the U.S., Merck Serono will have an exclusive license outside of the United States whether Merck Serono opts-in to develop a product candidate of the Company or the Company opts in to develop a product candidate of Merck Serono.
In addition to the foregoing agreements, the Company is a party to certain other licensing agreements with Merck Serono and its affiliates with regard to earlier stage product candidates. In connection with the restructuring of the Companys relationship with Merck Serono, the parties also converted their co-development/co-commercialization agreements for IL-17RC and IL-31 to licenses comparable to those contained in the amended Strategic Alliance Agreement with Merck Serono receiving an exclusive license and all rights to IL-17RC and the Company receiving an exclusive license and all rights to IL-31.
As part of the revised agreements with Merck Serono, the Company will no longer have to pay $9.8 million of development costs that were required to be reimbursed to Merck Serono under the prior agreements. The development costs had been previously expensed as research and development costs in the period June 1, 2008 to August 28, 2008. The forgiveness of these expenses was determined to be consideration for the licenses granted to Merck Serono and therefore the Company has considered the $9.8 million to be incremental revenue which is being deferred and recognized as license fee revenue on a straight-line basis through October 2009, the Companys remaining obligated performance period under the Strategic Alliance Agreement.
In January 2008, the Company issued a total of 57,200 unrestricted shares of common stock to employees of the Company in recognition of FDA approval of RECOTHROM. The share price used to determine compensation was $13.05, based on the closing price on the date the compensation committee of the Companys board of directors approved the distribution. Additionally, the compensation amount was increased to include payroll taxes paid on behalf of the employees. The entire $1.1 million of costs related to the issuance were expensed in January 2008.
In February 2008, the Company granted 620,500 restricted stock units to non-officer employees under the Companys 2001 Stock Incentive Plan. These shares will vest over a three-year period with one-third vesting on each anniversary of the grant date. The grant date fair value for the restricted stock unit awards was the closing market price of the Companys common stock on the date of grant, which was $9.26 per share. As of September 30, 2008, total unrecognized compensation costs related to unvested restricted stock units was $4.3 million, which is expected to be recognized on a straight-line basis through February 2011.
The following table shows stock-based compensation expense by type of award for the periods presented (in thousands):
The following table shows stock-based compensation expense by expense classification for the periods presented (in thousands):
No income tax benefit has been recorded for stock option exercises as the Company has a full valuation allowance and management has concluded it is more likely than not that the net deferred tax asset will not be realized.
For the three and nine months ended September 30, 2008, total comprehensive loss was $29.4 million and $109.7 million, respectively. For the three and nine months ended September 30, 2007, total comprehensive loss was $38.9 million and $109.1 million, respectively. Comprehensive loss is composed of net loss and unrealized gains and losses on short-term and long-term investments. The net change in accumulated other comprehensive income for the nine months ended September 30, 2008 was a $2.6 million reduction, reflecting a $1.5 million decrease in net unrealized gains on short-term investments and a decrease of $1.1 million in unrealized gain on long-term investments.
Novo Nordisk owned approximately 30% and 31% of the Companys outstanding common stock at September 30, 2008 and 2007, respectively. The following table summarizes revenue earned from Novo Nordisk for the periods presented (in thousands):
The Company earned royalties on two products marketed and sold by Novo Nordisk, recombinant insulin and recombinant glucagon. These royalties have ceased due to patent expiration with the final payment received for recombinant insulin during the third quarter of 2008 of $290,000.
Collaborations and Licenses
The Company has licensed rights to Novo Nordisk to commercialize the Companys IL-20 intellectual property. Novo Nordisk is responsible for all development activities and the Company has no significant continuing obligations under the license agreements. In January 2007, the Company received and recorded as revenue a milestone payment of $1.0 million for the advancement of IL-20 to development lead status within Novo Nordisk. In February 2008, the Company received and recorded as revenue a milestone payment of $2.0 million for a Novo Nordisk Investigational New Drug filing related to IL-20.
The Company has licensed the rights to IL-21 to Novo Nordisk for territories outside of North America. Novo Nordisk is obligated to make milestone payments based on the achievement of development milestones and royalties on sales of any resulting products. In the third quarter of 2007, the Company received a milestone payment of $3.5 million and recognized the payment as revenue as the Company had no other significant rights or obligations under the agreement. In January 2008, Novo Nordisk announced that it was discontinuing its oncology research and development program and intends to out license its rights to IL-21.
The Company has licensed rights to Novo Nordisk to commercialize the Companys IL-31 intellectual property outside of North America. The Company does not have any significant continuing obligations under the license agreement. In June 2007, the Company received a $1.0 million milestone payment for advancement to development lead status. Effective June 2008, Novo Nordisk terminated the IL-31 license agreement.
The Company has licensed rights to Novo Nordisk who will independently develop and commercialize recombinant Factor XIII on a worldwide basis. The Company does not have any significant continuing obligations under the license agreement. In February 2008 and May 2008, the Company received and recorded as revenue milestone payments of $2.5 million each related to Novo Nordisks achievement of certain manufacturing targets for rFactor XIII.
Amounts receivable from Novo Nordisk totaled $92,000 at September 30, 2008.
In November 2007, the Emerging Issues Task Force (EITF) reached a final consensus on EITF Issue No. 07-1, Accounting for Collaborative Arrangements Related to the Development and Commercialization of Intellectual Property (EITF 07-1). EITF 07-1 will require the Company to disclose the nature and purpose of its collaborative arrangements in its annual financial statements, its rights and obligations under the collaborative arrangements, the stage of the underlying endeavors life cycle, the Companys accounting policies for the arrangements and the income statement classification and amount of significant financial statement amounts related to the collaborative arrangements. EITF 07-1 will be effective for fiscal years beginning after December 15, 2008 and will require the Company to apply it as a change in accounting principle through retrospective application to all prior periods for all collaborative arrangements existing as of the effective date. The Company is currently assessing the impact of EITF 07-1 on its results of operations, cash flows and financial condition.
In February 2008, the Financial Accounting Standards Board (FASB) issued FASB FSP 157-2, Effective Date of FASB Statement No. 157 (FSP 157-2), which delays the effective date of FAS 157 for all nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. These nonfinancial items include assets and liabilities such as reporting units measured at fair value in a goodwill impairment test and nonfinancial assets acquired and liabilities assumed in a business combination. Effective January 1, 2008, the Company adopted FAS 157 for financial assets and liabilities recognized at fair value on a recurring basis. The partial adoption of FAS 157 for financial assets and liabilities did not have a material impact on the Companys results of operations, cash flows or financial condition. See Note 3 for information and related disclosures regarding fair value measurements.
FASB statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities (Statement No. 159) became effective on January 1, 2008. Statement No. 159 permits an instrument by instrument irrevocable election to account for selected financial assets and financial liabilities at fair value. The Company did not elect to apply the fair value option to any eligible financial assets or financial liabilities on January 1, 2008 or during the first three quarters of 2008. Subsequent to the initial adoption, the Company may elect to account for selected financial assets and financial liabilities at fair value. Such an election could be made at the time an eligible financial asset, financial liability or firm commitment is recognized or when certain specified reconsideration events occur.
The Company has a license agreement with a third party under which the Company is obligated to pay royalties based upon the application of an agreed-upon formula, which contains certain variables that are subject to interpretation. Through September 30, 2008, the Company has recorded approximately $285,000 in royalty expense, which it believes fully satisfied its obligation under the license agreement. During the third quarter of 2008, the other party claimed that the Company owes a total of $4.5 million under its interpretation of the royalty formula. The Company continues to believe that its method of calculating the amount of royalties due is valid and intends to vigorously defend its position. The Company has applied SFAS No. 5, Accounting for Contingencies, to this matter and has concluded that it is not required to record a liability.
In October 2008, the Company entered into a binding, nonexclusive, worldwide license with Bristol-Myers Squibb Company (BMS) to the Companys patents related to immunoglobulin fusion proteins and has agreed to terminate the related patent infringement lawsuit filed in August 2006 against BMS. In return, BMS will pay the Company a one-time license payment of $21.0 million. The Company has no future performance obligations under this arrangement and accordingly, expects to record the entire amount as license fee revenue in October 2008.
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, risks associated with our unproven marketing and sales capabilities, preclinical and clinical development, manufacturing of products, product safety, regulatory oversight, relationships with third parties, intellectual property claims and litigation and other risks detailed in our public filings with the Securities and Exchange Commission, including those risks described in Item 1A. of our Annual Report on Form 10-K for the year ended December 31, 2007. 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 other factors that may affect our business, prospects, results of operations and financial condition.
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 a significant share of the commercial rights to our products in the U.S. For our commercial product, RECOTHROM, which was approved by the FDA on January 17, 2008, we have maintained full U.S. rights. As a result, we have paid and will continue to pay the commercialization and development costs for RECOTHROM in the U.S. 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 we expect to add additional product candidates to this portfolio in the future. Therefore, we are paying and expect to pay a significant portion of development costs for several potential product candidates. Assuming these product candidates progress through clinical development successfully, the costs of clinical trials are expected to increase significantly.
One of our most significant challenges is to appropriately invest our operating funds. Our goal is to maximize the value of our RECOTHROM asset, while developing valuable additional product candidates that will generate value for our 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 before we can generate enough product-related revenues for our company to reach net income or cash flow breakeven, if ever. For the foreseeable future, we expect to continue to use significant amounts of cash to develop our business. Revenues from our existing relationships and the access to $100.0 million in debt financing obtained in June 2008 improve our overall financial position, but additional funding may still be required, the amount of which could be significant, and difficult to obtain. We may decide to enter into additional product development collaborations, which would reduce our funding requirements. We may also generate funding through licensing of our patents, as was recently done with our licensing agreement with Bristol-Myers Squibb Company.
In late 2006, we began preparations for the launch of rThrombin (which we now market in the U.S. as RECOTHROM), which was approved by the FDA on January 17, 2008. In June 2007, we entered into a global collaboration with Bayer for development and commercialization of rThrombin. Bayer has agreed to commercialize rThrombin in countries outside the United States and will co-promote the product with us in the United States for three years. As part of those efforts, Bayer submitted marketing authorization applications to the European Medicines Agency in September 2008 and to Health Canada in November 2008. We have hired approximately 60 field personnel and additional headquarters-based personnel to support the operations related to the commercialization of RECOTHROM. We are also incurring launch and commercialization related marketing costs to support the selling effort. In addition, we are building inventory to ensure we can meet the expected demand for the product and minimize the risk of product shortages. These launch and commercialization related activities require additional funding over and above that related to our development pipeline. We anticipate significant revenue generation from RECOTHROM sales over time; however, we cannot be certain of the rate of market penetration or when, if ever, our revenues will exceed our related costs.
We will continue to look for opportunities to raise capital, either in the form of debt, equity or equity-related capital as a means of funding our company. These opportunities may arise at any time, depending on things such as overall market conditions; dynamics in the biotechnology sector of the market; investor appetite for certain types of companies; and fundamental characteristics of our business. At other times, it may be difficult to raise capital on terms favorable to our company, if at all. Accordingly, we expect to raise capital when it is available, not when there is an immediate need. We believe this strategy is important to minimize the financial risks to our company and our shareholders.
Results of Operations
Product sales. On January 17, 2008, the FDA granted marketing approval of RECOTHROM (for the 5,000 IU vial configuration) and on May 27, 2008 granted marketing approval of the larger 20,000 IU RECOTHROM vial configuration, both with and without a spray kit. Sales of RECOTHROM are recognized as revenue when the product is shipped and title and risk of loss have passed. Product sales are recorded net of provisions for estimated discounts, rebates, chargebacks, and returns. We recognized net product sales revenue of $1.8 million and $4.1 million for the three and nine-month periods ended September 30, 2008.
Royalties. Royalties increased by $285,000 for the three-month period ended September 30, 2008 as compared to the corresponding period in 2007. The increase was primarily related to the final payment of insulin royalties from Novo Nordisk. Royalties decreased by $183,000 for the nine-month period ended September 30, 2008 as compared to the corresponding period in 2007. The primary reason for the decrease was reduced insulin and glucagon royalties from Novo Nordisk due to patent expirations. This decrease was partially offset by increased royalties from sales of GEM 21S, a product of BioMimetic Therapeutics, Inc., and BeneFIX, a product of Wyeth Pharmaceuticals Inc.
Collaborations and licenses. We enter into various collaborative agreements that may generate significant license, option or other upfront fees with subsequent milestone payments earned upon completion of development milestones. Where we have no continuing performance obligations under an arrangement, we recognize such payments as revenue when contractually due and payment is reasonably assured, as these payments represent the culmination of a separate earnings process. Where we have continuing performance obligations under an arrangement, revenue is recognized using one of two methods. Where we are able to estimate the total amount of services under the arrangement, revenue is recognized using a proportional performance model. Costs incurred to date compared to total expected costs are used to determine proportional performance, as this is considered to be representative of the delivery of outputs under the arrangement. Revenue recognized at any point in time is limited to cash received and amounts contractually due. Changes in estimates of total expected performance are accounted for prospectively as a change in estimate. Where we cannot estimate the total amount of service that is to be provided, a time-based method is used to recognize revenue. Under the time-based method, revenue is recognized over the arrangements estimated performance period, starting with the contracts commencement, but not before the removal of any contingencies for each milestone. Proportional performance is determined based on the elapsed time compared to the total estimated performance period. Revenue recognized at any point in time is limited to the cash received and amounts contractually due. 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.
On August 28, 2008, we amended the Strategic Alliance Agreement with Serono S.A. (Merck Serono) and simultaneously exercised our right under the atacicept Collaborative Development and Marketing Agreement to discontinue our co-development and co-funding obligations and convert our position to an exclusive milestone and royalty bearing license. Based on these actions, our responsibility for funding atacicept product development costs ended June 1, 2008 and all significant continuing obligations under the agreements will end in October 2009. Since the agreements were negotiated in tandem, we are considering them as a single agreement for revenue recognition purposes. We have recorded our share of the collaboration expenses from January 1, 2008 to August 28, 2008 of $24.7 million as research and development expense. Additionally, as part of the revised agreements with Merck Serono, we will no longer have to pay $9.8 million of development costs that were required to be reimbursed to Merck Serono under the prior agreements. The development costs had been previously expensed as research and development costs in the period June 1, 2008 to August 28, 2008. The forgiveness of these expenses was determined to be consideration for the licenses granted to Merck Serono and therefore we have considered the $9.8 million to be incremental revenue which is being deferred and recognized as license fee revenue on a straight-line basis through October 2009, our remaining obligated performance period under the Strategic Alliance Agreement.
Collaboration and license revenue was $8.5 million for the three-month period ended September 30, 2008, an increase of $1.3 million as compared to the corresponding period in 2007. The increase primarily resulted from license fees earned under the RECOTHROM (rThrombin) agreement with Bayer, which became effective in June 2007, and milestone revenue earned in September 2008 under the BioMimetic Therapeutics Inc. license agreement. Partially offsetting this increase is a $3.5 million milestone earned in the third quarter of 2007 under the IL-21 license agreement with Novo Nordisk for which no comparable amount was earned in the third quarter of 2008. Collaboration and license revenue was $29.0 million for the nine-months ended September 30, 2008, an increase of $16.1 million as compared to the corresponding period in 2007. The improvement primarily resulted from an $11.9 million increase in license fees earned under the RECOTHROM agreement with Bayer, and milestone revenue of $5.0 million earned in 2008 under the rFactor XIII license agreement with Novo Nordisk. These increases were partially offset by the aforementioned decline related to the $3.5 million earned under the IL-21 agreement with Novo Nordisk in 2007.
In addition, collaboration and license revenue related to Merck Serono agreements was $2.8 million and $1.5 million for the three-month periods ended September 30, 2008 and 2007, respectively, and $6.4 million and $4.3 million for the nine-months ended September 30, 2008 and 2007, respectively. The increases for both periods resulted from the increased amortization associated with the restructuring of our agreements with Merck Serono, as described above. As of September 30, 2008, the deferred revenue related to the Merck Serono agreements totaled $22.2 million.
Costs and expenses
Costs of product sales. Prior to FDA approval of RECOTHROM in January 2008, all third party manufacturing costs and an allocation of our labor and overhead associated with the manufacturing of RECOTHROM for commercial sale were expensed as research and development costs as incurred. Subsequent to approval, third party manufacturing costs and labor and overhead associated with the commercial manufacturing of RECOTHROM are recorded as inventory. Accordingly, we expect that costs of product sales will be lower during the time we are selling product manufactured prior to approval. Costs of product sales includes the inventory and distribution costs associated with RECOTHROM product revenue. Additionally, we recorded a $400,000 charge to cost of product sales in the three-month period ended September 30, 2008 for final packaging costs incurred subsequent to FDA approval for product that is not expected to be sold. For the three- and nine-month periods ended September 30, 2008, we recognized $695,000 and $994,000, respectively, as total costs of product sales.
Research and development. Research and development expense consists primarily of salaries and benefit expenses, costs of consumables, contracted services and stock-based compensation. Our research and development activities have generally been expanding over the past several years, particularly related to our recently approved commercial product, RECOTHROM, and clinical-stage product candidates, atacicept, IL-21 and PEG-IFN-. Research and development expense has been partially offset by cost reimbursements from collaborators for work performed on various co-development programs. These trends for the periods presented are shown in the following table (in thousands):
Salaries and benefits, consumables and facility costs, generally track with changes in our employee base from year to year; however, in February 2008, we terminated 37 research and development employees and recorded a severance related charge of $2.0 million in the first quarter of 2008. In addition, costs related to RECOTHROM manufacturing have been reclassified from salaries and benefits and added to inventory. As a result of these events, salaries and benefits decreased in the three- and nine- month periods ended September 30, 2008 as compared to the same periods in 2007.
Contracted services include the cost of items such as contract research, contract manufacturing, clinical trials, non-clinical studies and payments to collaborators. These costs relate primarily to clinical development programs and can fluctuate substantially from period-to-period depending on the stage of our various programs. Generally, these external costs increase as a program advances toward commercialization, but there can be periods between major clinical trials or manufacturing campaigns during which costs decline. Our clinical trial costs increased by $965,000 and $4.5 million in the three- and nine-month periods ended September 30, 2008, respectively, as compared to the corresponding periods in 2007, primarily reflecting the costs incurred for the atacicept lupus nephritis clinical trial that began in late 2007. Payments to collaborators also increased by $3.0 million and $15.4 million for the three- and nine-month periods ended September 30, 2008, respectively, as compared to the corresponding periods in 2007, primarily reflecting our portion of atacicept development costs under our collaboration with Merck Serono. In August 2008, we amended our collaboration with Merck Serono whereby Merck Serono will be responsible for all development costs associated with atacicept subsequent to August 28, 2008. For the periods January through August 2008, we recorded contract service costs of approximately $24.7 million related to the Merck Serono agreements. Contract manufacturing costs decreased by approximately $5.9 million and $8.2 million for the three- and nine-month periods ended September 30, 2008, respectively, as compared to the corresponding periods in 2007, reflecting the discontinued expensing of pre-approval manufacturing of rThrombin bulk drug and finished product inventory after FDA approval in January 2008.
To date, our business needs have not required us to fully allocate all research and development costs among our various programs. However, we track direct labor, contracted services and certain consumable costs by program, which we monitor to ensure appropriate utilization of our company resources. We also incur indirect costs that are not allocated to specific programs. These costs include indirect labor, certain consumable costs, facility costs, and depreciation and amortization, all of which benefit all of our research and development programs. The following table presents our research and development costs allocated to clinical development, preclinical and research programs, together with the unallocated costs that benefit all programs for the periods presented (in thousands):
The major trends in research and development program costs for the periods presented in the table were as follows:
Selling, general and administrative. Selling, general and administrative expense, which consists primarily of salaries and benefit expenses, professional fees and other corporate costs, increased 10% and 36% for the three and nine-month periods ended September 30, 2008, respectively as compared to the corresponding periods in 2007. The increases were primarily due to increased sales and marketing activities and the hiring our sales force early in the third quarter of 2007 to support the launch and commercialization of RECOTHROM in 2008.
Stock-based compensation. Stock-based compensation expense decreased $363,000 for the three-month period ended September 30, 2008 and increased $269,000 for the nine-month period ended September 30, 2008 as compared to the corresponding periods in 2007. The following amounts of stock-based compensation expense were recorded for the periods presented (in thousands):
Other income (expense)
Investment income. Investment income is generated primarily from investment of our cash reserves in investment grade, fixed-income securities. There are four primary factors affecting the amount of investment income that we report: the amount of cash reserves invested, the effective interest rate, the amount of realized gains or losses on investments sold during the period and the amount of other-than-temporary impairment recorded in the period. The following table shows how each of these factors affected investment income for the periods presented (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 increased by $316,000 and $292,000 in the three and nine-month periods ended September 30, 2008, respectively, as compared to the corresponding periods in 2007, primarily reflecting the amortization of deferred financing costs.
Gain (loss) on sale of fixed assets. In August of 2008, we sold undeveloped land near our corporate headquarters for $11.8 million and recognized a gain of $7.1 million.
Liquidity and Capital Resources
As of September 30, 2008, we had cash, cash equivalents and short-term investments of $81.1 million, which we intend to use to fund our operations and capital expenditures. These cash reserves are held in a variety of investment-grade, fixed-income securities, including corporate bonds, commercial paper and money market instruments. We continue to monitor our investments closely and, based on market conditions, recorded an other-than-temporary impairment loss of $400,000 on one security in the third quarter of 2008. We consider all other unrealized losses totaling $1.6 million to be temporary.
In June 2008, we completed a debt financing arrangement enabling us to draw up to $100.0 million in $25.0 million increments until January 2010. Interest will accrue on amounts outstanding at a rate of 4.9% per annum, compounded quarterly, and will be due, along with outstanding principal, in June 2013. Each $25.0 million draw entitles the lender to a royalty equal to 2% of RECOTHROM net sales in the U.S. The cumulative royalty will not exceed $45.0 million assuming we draw the entire $100.0 million. In addition, we are obligated to issue between 1.5 million and 4.5 million in six-year warrants depending on the amount drawn. In October 2008, we requested our first draw of $25.0 million under the debt financing arrangement and received it in November 2008.
There are several factors that will significantly impact our cash requirements during the next twelve months, including the amount of revenue generated from RECOTHROM sales, proceeds from new license and collaboration transactions, amounts we may draw under the debt financing arrangement, and reductions in our expense run rate, including the restructuring of our agreements with Merck Serono and other cost saving measures we may implement. We believe that our existing cash resources, supplemented by activities described above will be sufficient to fund our operations for at least the next 12 months and possibly much longer. In addition, we may raise additional funds through one or more financing transactions, which would help fund our company over an even 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 certain noncash items, changes in deferred revenue and RECOTHROM inventory increases, 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, we received milestone payments from Bayer relating to the rThrombin collaboration of $30.0 million in July 2007 and $40.0 million in February 2008 that have been recorded as deferred revenue and are being recognized as revenue through the first quarter of 2013. For the nine-month periods ended September 30, 2008 and 2007, we recognized $19.7 million and $6.6 million, respectively, of previously deferred revenue relating to Bayer and other collaborations. The timing of additional deferred revenue transactions is expected to be irregular and, accordingly, 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 or replace obsolete assets. In addition, we have used cash at various times to purchase land and expand facilities. In August 2008, we sold land that we purchased in 2001 and 2002 for $11.8 million. Cash flows from investing activities also reflect large amounts of cash used to purchase short-term investments and receipts 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. We paid $1.3 million in costs related to the $100.0 million debt financing arrangement in the nine-month period ended September 30, 2008 and received $513,000 and $4.3 million of proceeds from the exercise of stock options for the nine-month periods ended September 30, 2008 and 2007, respectively.
We expect to incur substantial additional costs as we continue to advance and expand our product development programs, as well as continue to commercialize RECOTHROM. 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. We also expect to incur substantial costs during the remainder of 2008 and in 2009 supporting the commercialization of RECOTHROM. Although we remain optimistic regarding its commercial prospects and its potential peak market share, it might be quite some time, if ever, before our RECOTHROM revenues exceed our expenses. If at any time our prospects for financing these various initiatives decline, we may decide to look for ways to reduce our ongoing investment. In such event, we might consider 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 or certain rights related to product candidates that we might otherwise develop and commercialize 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 fully in our control, including:
Over the next several years we expect to seek additional funding through public or private financings, including debt or 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, 2008, we were contractually obligated to make payments as follows (in thousands):
The building lease obligations resulted from our 2002 sale-leaseback financing transaction and run until May 2019. The operating leases relate to the office space near our corporate headquarter buildings and in March 2008, we entered into a master lease agreement which extended the lease term for all leased floors to April 2019. We have certain renewal provisions at our option, which are not reflected in the above table, for the building leases and the operating leases. RECOTHROM manufacturing contracts include the manufacture of rThrombin bulk drug and RECOTHROM finished product for commercial sale.
Until recently, our exposure to market risk has been 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, which may include United States government and agency securities, high-grade United States corporate bonds, asset-backed securities, commercial paper and money market funds.
In 2008, due to deteriorating conditions in the debt markets, our exposure to market risk has increased and has impacted our investment portfolio. Overall liquidity for many debt issues has declined substantially, meaning that we may realize losses if we are required to liquidate securities upon short notice. Additionally, the credit quality of certain issues has declined substantially, causing ratings downgrades and in some cases uncertainty regarding the ability of issuers to repay principal amounts. Also, with respect to asset backed securities, overall economic conditions have generated concerns about the value of underlying assets held as collateral, and highlighted risks associated with insurance policies used to enhance the credit of the related debt issues. To date, we have not experienced defaults on any of our investment securities. We continue to monitor our investments closely and, based on market conditions, recorded an other-than-temporary impairment loss of $400,000 on one security in the third quarter of 2008.
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, 2008 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II OTHER INFORMATION
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I., Item 1A. Risk Factors in our Annual Report on Form 10-K for the year ended December 31, 2007, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
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.