e10vq
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2005
Commission file number: 0-27406
CONNETICS CORPORATION
(Exact name of registrant as specified in its charter)
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Delaware
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94-3173928 |
(State or other jurisdiction of
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(IRS Employer |
incorporation or organization)
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Identification Number) |
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3160 Porter Drive
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94304 |
Palo Alto, California
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(Zip Code) |
(Address of principal executive offices) |
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Registrants telephone number, including area code: (650) 843-2800
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 o No þ
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule
12b-2 of the Exchange Act). Yes þ No o
As of July 29, 2005, 34,972,877 shares of the Registrants common stock at $0.001 par
value were outstanding.
CONNETICS CORPORATION
TABLE OF CONTENTS
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONNETICS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
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June 30, |
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December 31, |
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2005 |
|
2004 |
ASSETS |
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Current assets: |
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Cash and cash equivalents |
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$ |
14,562 |
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$ |
18,261 |
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Marketable securities |
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|
237,649 |
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|
54,122 |
|
Restricted
cash current |
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|
1,000 |
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|
1,000 |
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Accounts receivable, net of allowances |
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|
15,914 |
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|
21,206 |
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Inventory, net |
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|
7,440 |
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|
5,020 |
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Prepaid expenses |
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|
8,879 |
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|
|
7,561 |
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Other current assets |
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|
2,168 |
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|
1,963 |
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|
|
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Total current assets |
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287,612 |
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|
109,133 |
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Property and equipment, net |
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14,045 |
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|
11,830 |
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Restricted cash long term |
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|
3,059 |
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|
2,963 |
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Debt issuance costs, deposits and other assets |
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|
11,462 |
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|
3,707 |
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Goodwill and other intangible assets, net |
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|
121,860 |
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|
128,659 |
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Total assets |
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$ |
438,038 |
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$ |
256,292 |
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LIABILITIES AND STOCKHOLDERS EQUITY |
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Current liabilities: |
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Accounts payable |
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$ |
15,120 |
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$ |
14,531 |
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Assumed liabilities related to acquisition of product rights |
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|
2,298 |
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|
2,710 |
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Accrued payroll and related expenses |
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|
4,876 |
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5,746 |
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Product rebate and coupon accruals |
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15,315 |
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10,564 |
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Accrued clinical trial costs |
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1,683 |
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|
751 |
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Other accrued liabilities |
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7,162 |
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3,650 |
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Total current liabilities |
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46,454 |
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37,952 |
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Convertible senior notes |
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290,000 |
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90,000 |
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Other non-current liabilities |
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471 |
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|
420 |
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Commitments and contingencies |
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Stockholders equity: |
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Preferred stock |
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Common stock |
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35 |
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36 |
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Additional paid-in capital |
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207,567 |
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|
237,666 |
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Deferred stock compensation |
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(4 |
) |
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(13 |
) |
Accumulated deficit |
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|
(107,630 |
) |
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|
(111,173 |
) |
Accumulated other comprehensive income |
|
|
1,145 |
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|
1,404 |
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Total stockholders equity |
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101,113 |
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|
127,920 |
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Total liabilities and stockholders equity |
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$ |
438,038 |
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$ |
256,292 |
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See accompanying notes to condensed consolidated financial statements.
3
CONNETICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
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Three Months Ended |
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Six Months Ended |
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June 30, |
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June 30, |
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2005 |
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2004 |
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2005 |
|
2004 |
Revenues: |
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|
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Product |
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$ |
45,239 |
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$ |
37,999 |
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$ |
87,429 |
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|
$ |
61,565 |
|
Royalty and contract |
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|
130 |
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|
254 |
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|
311 |
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1,670 |
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Total revenues |
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45,369 |
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|
38,253 |
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87,740 |
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63,235 |
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Operating costs and expenses: |
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Cost of product revenues |
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4,982 |
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3,578 |
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8,748 |
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|
5,146 |
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Amortization of intangible assets |
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3,400 |
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|
3,400 |
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6,799 |
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|
4,672 |
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Research and development |
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|
8,957 |
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|
5,096 |
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|
14,855 |
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|
9,537 |
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Selling, general and administrative |
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|
25,356 |
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|
17,467 |
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|
53,165 |
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|
32,760 |
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Total operating costs and expenses |
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|
42,695 |
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|
29,541 |
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|
83,567 |
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|
52,115 |
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Income from operations |
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|
2,674 |
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|
8,712 |
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|
4,173 |
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|
|
11,120 |
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Interest income |
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|
1,845 |
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|
|
152 |
|
|
|
2,322 |
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|
|
500 |
|
Interest expense |
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|
(1,860 |
) |
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|
(690 |
) |
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|
(2,631 |
) |
|
|
(1,381 |
) |
Other income (expense), net |
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|
(4 |
) |
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|
(70 |
) |
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|
(63 |
) |
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|
(19 |
) |
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Income before income taxes |
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|
2,655 |
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|
8,104 |
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|
3,801 |
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|
10,220 |
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Income tax provision |
|
|
153 |
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|
647 |
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|
258 |
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|
890 |
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Net income |
|
$ |
2,502 |
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|
$ |
7,457 |
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|
$ |
3,543 |
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|
$ |
9,330 |
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Net income per share: |
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Basic |
|
$ |
0.07 |
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$ |
0.21 |
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$ |
0.10 |
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$ |
0.27 |
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Diluted |
|
$ |
0.07 |
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$ |
0.19 |
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$ |
0.09 |
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$ |
0.25 |
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Shares used to calculate net income per share: |
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Basic |
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|
34,825 |
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|
|
35,242 |
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|
|
35,259 |
|
|
|
34,439 |
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Diluted |
|
|
37,093 |
|
|
|
41,627 |
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|
|
37,785 |
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|
36,722 |
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See accompanying notes to condensed consolidated financial statements.
4
CONNETICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
|
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Six Months Ended |
|
|
June 30, |
|
|
2005 |
|
2004 |
Cash flows from operating activities: |
|
|
|
|
|
|
|
|
Net income |
|
$ |
3,543 |
|
|
$ |
9,330 |
|
Adjustments to reconcile net income to net cash from operating activities: |
|
|
|
|
|
|
|
|
Depreciation |
|
|
772 |
|
|
|
744 |
|
Amortization of intangible assets |
|
|
6,799 |
|
|
|
4,672 |
|
Amortization of convertible senior notes offering costs |
|
|
550 |
|
|
|
368 |
|
Allowance for discounts, returns and chargebacks |
|
|
4,121 |
|
|
|
2,804 |
|
Stock compensation expense |
|
|
9 |
|
|
|
9 |
|
Changes in assets and liabilities: |
|
|
|
|
|
|
|
|
Accounts receivable |
|
|
1,174 |
|
|
|
(6,589 |
) |
Prepaids and other assets |
|
|
(3,819 |
) |
|
|
(1,485 |
) |
Inventory |
|
|
(2,375 |
) |
|
|
(3,290 |
) |
Accounts payable |
|
|
984 |
|
|
|
7,944 |
|
Product rebates and coupon accruals |
|
|
4,751 |
|
|
|
4,301 |
|
Accrued and other current liabilities |
|
|
3,200 |
|
|
|
920 |
|
Other non-current liabilities |
|
|
51 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net cash provided by operating activities |
|
|
19,760 |
|
|
|
19,728 |
|
|
|
|
|
|
|
|
|
|
Cash flows from investing activities: |
|
|
|
|
|
|
|
|
Purchases of marketable securities |
|
|
(238,682 |
) |
|
|
(22,578 |
) |
Sales and maturities of marketable securities |
|
|
54,981 |
|
|
|
85,809 |
|
Purchases of property and equipment |
|
|
(3,088 |
) |
|
|
(1,492 |
) |
Acquisition of patent and product rights |
|
|
|
|
|
|
(123,529 |
) |
|
|
|
|
|
|
|
|
|
Net cash used in investing activities |
|
|
(186,789 |
) |
|
|
(61,790 |
) |
|
|
|
|
|
|
|
|
|
Cash flows from financing activities: |
|
|
|
|
|
|
|
|
Transfer to restricted cash |
|
|
(96 |
) |
|
|
(2,696 |
) |
Proceeds from issuance of convertible senior notes, net of issuance costs |
|
|
193,625 |
|
|
|
|
|
Proceeds from issuance of common stock, net of issuance costs |
|
|
|
|
|
|
56,901 |
|
Repurchase of common stock |
|
|
(35,000 |
) |
|
|
|
|
Proceeds from exercise of stock options and employee stock purchase plan,
net of repurchases of unvested shares |
|
|
4,860 |
|
|
|
3,021 |
|
|
|
|
|
|
|
|
|
|
Net cash provided by financing activities |
|
|
163,389 |
|
|
|
57,226 |
|
|
|
|
|
|
|
|
|
|
Effect of foreign currency exchange rate changes on cash and cash equivalents |
|
|
(59 |
) |
|
|
(172 |
) |
|
|
|
|
|
|
|
|
|
Net change in cash and cash equivalents |
|
|
(3,699 |
) |
|
|
14,992 |
|
Cash and cash equivalents at beginning of period |
|
|
18,261 |
|
|
|
17,946 |
|
|
|
|
|
|
|
|
|
|
Cash and cash equivalents at end of period |
|
$ |
14,562 |
|
|
$ |
32,938 |
|
|
|
|
|
|
|
|
|
|
See accompanying notes to condensed consolidated financial statements.
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Note 1. Basis of Presentation and Policies
We prepared the accompanying unaudited condensed consolidated financial statements of
Connetics Corporation, or Connetics, in accordance with accounting principles generally accepted in
the United States for interim financial information and in compliance with the instructions to Form
10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include all of
the information and footnotes required by generally accepted accounting principles for complete
financial statements. We believe that we have included all adjustments, consisting of normal
recurring adjustments, considered necessary for a fair presentation.
Operating results for the three and six months ended June 30, 2005 are not necessarily
indicative of the results that may be expected for the year ending December 31, 2005. For a better
understanding of Connetics and its financial statements, we recommend reading these unaudited
condensed consolidated financial statements and notes in conjunction with the audited consolidated
financial statements and notes to those financial statements for the year ended December 31, 2004,
which are included in our Annual Report on Form 10-K as filed with the Securities and Exchange
Commission, or SEC.
Principles of Consolidation
The accompanying condensed consolidated financial statements include the accounts of Connetics
and its subsidiaries, Connetics Holdings Pty Ltd., and Connetics Australia Pty Ltd. We eliminated
all intercompany accounts and transactions in consolidation. We reclassified certain prior period
amounts and balances to conform to the current year presentation. On the condensed consolidated
balance sheets as of June 30, 2005, raw material inventory balances that were previously included
in prepaid expenses, other current assets, and other assets as of
December 31, 2004 and prior periods have been
reclassified to inventory; these reclassifications are reflected on
the condensed consolidated statements of cash flows for the six months
ended June 30, 2005 and 2004. Managed care and Medicaid rebates, or product rebates, and coupon
reserves were reclassified from an accounts receivable allowance to product rebates and coupon
accruals.
Use of Estimates
To prepare financial statements in conformity with accounting principles generally accepted in
the United States, management must make estimates and assumptions that affect the amounts reported
in the financial statements and accompanying notes. Actual results could differ from those
estimates based upon future events.
We evaluate our estimates on an on-going basis. In particular, we regularly evaluate estimates
related to recoverability of accounts receivable and inventory, revenue reserves, assumed
liabilities related to acquired product rights and accrued liabilities for clinical trial
activities and indirect promotional expense. We base our estimates on historical experience and on
various other specific assumptions that we believe to be reasonable under the circumstances. Those
estimates and assumptions form the basis for making judgments about the carrying value of assets
and liabilities that are not readily apparent from other sources.
Revenue Recognition
Product Revenues. We recognize revenue from product sales when there is persuasive evidence
that an arrangement exists, when title has passed, the price is fixed or determinable, and we are
reasonably assured of collecting the resulting receivable. We recognize product revenues net of
revenue reserves, which consist of allowances for discounts, returns, rebates, and chargebacks.
Management establishes revenue reserves using its best estimate at the time of sale based on
historical experience adjusted to reflect known changes in the factors that impact such reserves.
We accept from customers the return of products that are within six months before their expiration
date. We also authorize returns for damaged products and exchanges for expired products in
accordance with our return goods policy and procedures. We establish reserves for all such returns
at the time of sale. We include product shipping and handling costs in the cost of product
revenues. In connection with distribution service agreements, we recognize revenue net of fees
paid to the wholesalers for certain product distribution, inventory management, information, return
goods processing, and administrative services. Discounts, allowance for bad debt and chargebacks
are shown as a reduction to accounts receivable, and product rebates and coupon reserves are shown
as an addition to accrued expenses since these amounts are due to a party other than the direct
customer.
During the three months ended June 30, 2005, we experienced unexpected product returns related
to expiring and expired products at our wholesaler customers of OLUX® that were significantly
above historical levels. Based on our analysis, we recorded a charge to product revenues of $2.3 million in the three months ended June
30, 2005 for expired and estimated expiring products at our
customers associated with product sales recorded in prior periods. Our analysis considered
information contained in the reporting provided to us by wholesaler customers under the
distribution service
agreements; that type of information was not available to us before the second quarter of
2005. This charge resulted in a decrease in product revenues for the three months ended June 30,
2005.
6
Royalty Revenue. We collect royalties from our third-party licensees based on their sales. We
recognize royalties either in the quarter in which we receive the royalty payment from the licensee
or in the quarter in which we can reasonably estimate the royalty, which is typically one quarter
following the related sale by the licensee.
Contract Revenue. We record contract revenue for research and development, or R&D, and
milestone payments as earned based on the performance requirements of the contract. We recognize
non-refundable contract fees for which no further performance obligations exist, and for which
Connetics has no continuing involvement, on the date we receive the payments or the date when
collection is assured, whichever is earlier.
If, at the time an agreement is executed, there remains significant risk due to the incomplete
state of the products development, we recognize revenue from non-refundable upfront license fees
ratably over the period in which we have continuing development obligations. We recognize revenue
associated with substantial at risk performance milestones, as defined in the respective
agreements, based upon the achievement of the milestones. When we receive advance payments in
excess of amounts earned, we classify them as deferred revenue until they are earned.
Inventory
Inventory consists of raw materials and finished goods primarily related to currently marketed
products. In addition, inventory may include similar costs for product candidates awaiting
regulatory approval, which are capitalized based on managements judgment of probable near term
commercialization or alternative future uses. We state inventory at the lower of cost (determined
on a first-in first-out method) or market. If inventory costs exceed expected market value due to
obsolescence or lack of demand, we record reserves in an amount equal to the difference between the
cost and the market value. These reserves are based on significant estimates and assumptions by
management.
Stock-Based Compensation
We use the intrinsic-value method of accounting for stock-based awards granted to employees,
as allowed under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to
Employees, or APB 25, and related interpretations. Accordingly, we do not recognize any
compensation in our financial statements in connection with stock options granted to employees when
those options have exercise prices equal to or greater than fair market value of our common stock
on the date of grant. We also do not record any compensation expense in connection with our
Employee Stock Purchase Plan as long as the purchase price is not less than 85% of the fair market
value at the beginning or end of each offering period, whichever is lower.
For options granted to non-employees, we have determined compensation expense in accordance
with Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based
Compensation, or SFAS 123, as amended, and Emerging Issues Task Force No. 96-18, Accounting for
Equity Instruments That Are Issued to Other Than Employees for Acquiring, or in Conjunction with
Selling Goods or Services. By those criteria, we quantify compensation expense as the fair value
of the consideration received or the fair value of the equity instruments issued, whichever is more
reliably measured.
Although SFAS 123 allows us to continue to follow the APB 25 guidelines, we are required to
disclose pro forma net income (loss) and basic and diluted income (loss) per share as if we had
applied the fair value based method to all awards. Because the estimated value is determined as of
the date of grant, the actual value that the employee ultimately realizes may be significantly
different.
7
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
(in thousands except per share amounts): |
|
2005 |
|
2004 |
|
2005 |
|
2004 |
Net income, as reported |
|
$ |
2,502 |
|
|
$ |
7,457 |
|
|
$ |
3,543 |
|
|
$ |
9,330 |
|
Add: Stock-based employee compensation
expense, net of related tax effects |
|
|
5 |
|
|
|
4 |
|
|
|
9 |
|
|
|
8 |
|
Deduct: Total stock-based employee
compensation expense determined under
the fair value method for all awards,
net of related tax effects |
|
|
(4,330 |
) |
|
|
(2,617 |
) |
|
|
(9,651 |
) |
|
|
(5,301 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Pro forma net income (loss) |
|
$ |
(1,823 |
) |
|
$ |
4,844 |
|
|
$ |
(6,101 |
) |
|
$ |
4,037 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic net income as reported |
|
$ |
0.07 |
|
|
$ |
0.21 |
|
|
$ |
0.10 |
|
|
$ |
0.27 |
|
Diluted net income as reported |
|
$ |
0.07 |
|
|
$ |
0.19 |
|
|
$ |
0.09 |
|
|
$ |
0.25 |
|
Basic net income (loss) pro forma |
|
$ |
(0.05 |
) |
|
$ |
0.14 |
|
|
$ |
(0.17 |
) |
|
$ |
0.12 |
|
Diluted net income (loss) pro forma |
|
$ |
(0.05 |
) |
|
$ |
0.13 |
|
|
$ |
(0.16 |
) |
|
$ |
0.11 |
|
For purposes of this analysis, we estimate the fair value of each option grant on the date of
grant using the Black-Scholes option-pricing model. We used the following weighted average
assumptions in the model:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock Option Plans |
|
Stock Option Plans |
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
Expected stock volatility |
|
|
46.3 |
% |
|
|
55.8 |
% |
|
|
47.1 |
% |
|
|
56.6 |
% |
Risk-free interest rate |
|
|
3.9 |
% |
|
|
3.3 |
% |
|
|
3.6 |
% |
|
|
2.8 |
% |
Expected life (in years) |
|
|
4.0 |
|
|
|
3.4 |
|
|
|
4.0 |
|
|
|
3.4 |
|
Expected dividend yield |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock Purchase Plan |
|
Stock Purchase Plan |
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
Expected stock volatility |
|
|
54.5 |
% |
|
|
51.6 |
% |
|
|
50.2 |
% |
|
|
51.6 |
% |
Risk-free interest rate |
|
|
1.8 |
% |
|
|
3.8 |
% |
|
|
1.7 |
% |
|
|
3.8 |
% |
Expected life (in years) |
|
|
1.3 |
|
|
|
1.6 |
|
|
|
1.4 |
|
|
|
1.6 |
|
Expected dividend yield |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
0.0 |
% |
The Black-Scholes option valuation model was developed for use in estimating the fair value of
traded options that have no vesting restrictions and are fully transferable. This model also
requires us to make highly subjective assumptions, including the expected volatility of our stock.
Because our stock options have characteristics significantly different from those of traded
options, and because changes in the subjective input assumptions can materially affect the fair
value estimate, we do not believe that the existing models necessarily provide a reliable single
measure of the fair value of our options. The weighted average fair value of the options granted,
determined using the Black-Scholes model, was $9.80 for the six months ended June 30, 2005 and
$8.05 for the six months ended June 30, 2004.
The effects on pro forma disclosures of applying SFAS 123 are not likely to be representative
of the effects on reported results of future periods.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123
(revised 2004), Share-Based Payment, or SFAS 123R, which requires companies to measure and
recognize compensation expense for all stock-based awards at fair value. Stock-based awards include
grants of employee stock options. SFAS 123R replaces SFAS 123 and supersedes APB 25, which are
discussed above. SFAS 123R requires companies to recognize all stock-based awards to employees and
to reflect those awards in the financial statements based on the fair values of the awards. In
April 2005, the SEC modified the effective date for SFAS 123R, resulting in the pronouncement being
effective for all annual periods beginning after June 15, 2005. We are required to adopt SFAS 123R
in our fiscal year beginning January 1, 2006, after which the pro forma disclosures previously
permitted under SFAS 123 will no longer be an alternative to financial statement recognition. Under
SFAS 123R, we must determine the appropriate fair value model to be used for valuing share-based
awards, the amortization method for compensation cost, and the transition method to be used at date
of adoption. The transition methods permit companies to adopt the model retroactively or
prospectively. The prospective method would require that we record compensation expense for all
unvested stock options and restricted stock at the beginning of the year we adopt SFAS 123R. Under
the retroactive method, we would be permitted to restate prior periods either as of the beginning
of the year of adoption or for all periods presented, and we would record compensation expense for
all unvested
8
stock options and restricted stock beginning with the first period restated. We are evaluating
the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material
impact on our consolidated results of operations and earnings per share. We have not yet determined
which transition method we will use, the effect of adopting SFAS 123R, or whether the adoption will
result in amounts that are similar to the current pro forma disclosures under SFAS 123.
On September 30, 2004, the Emerging Issues Task Force, or EITF, reached a consensus on Issue
No. 04-8, The Effect of Contingently Convertible Debt on Diluted Earnings per Share, concluding
that contingently convertible debt instruments should be included in diluted earnings per share
computations (if dilutive) regardless of whether the market price trigger (or other contingent
feature) has been met. This consensus is effective for reporting periods ending after December 15,
2004, and requires companies to restate prior period earnings per share amounts presented for
comparative purposes utilizing a transition method. As of December 31, 2004, we had no outstanding
contingently convertible debt. In March 2005, we issued contingently convertible debt and adopted
the consensus. Our adoption of EITF No. 04-8 had no impact on diluted earnings per share for the
six months ended June 30, 2005 or for prior years.
Note 2. Net Income Per Share
To compute basic net income per share we divide net income by the weighted average number of
common shares outstanding during the period. To compute diluted net income per share, we divide net
income by the weighted average of all potential shares of common stock outstanding during the
period. For the three months ended June 30, 2004, we included all dilutive stock options, warrants,
and convertible debt in the calculation of diluted net income per share. As part of the dilutive
calculation we excluded interest expense related to the convertible debt, net of tax effect from
net income, to arrive at net income for the three months ended June 30, 2004. For the three and six
months ended June 30, 2005 and the six months ended June 30, 2004 the effect of the convertible
debt was not included in the calculation of diluted net income per share as it was anti-dilutive.
The calculation of basic and diluted net income per share is as follows (in thousands except
share amounts):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
Net income, as reported |
|
$ |
2,502 |
|
|
$ |
7,457 |
|
|
$ |
3,543 |
|
|
$ |
9,330 |
|
Add back: interest expense, net of tax effect |
|
|
|
|
|
|
649 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted income |
|
$ |
2,502 |
|
|
$ |
8,106 |
|
|
$ |
3,543 |
|
|
$ |
9,330 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding |
|
|
34,825 |
|
|
|
35,242 |
|
|
|
35,259 |
|
|
|
34,439 |
|
Effect of: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Dilutive stock options |
|
|
2,268 |
|
|
|
2,150 |
|
|
|
2,526 |
|
|
|
2,247 |
|
Dilutive warrants |
|
|
|
|
|
|
32 |
|
|
|
|
|
|
|
36 |
|
Convertible debt |
|
|
|
|
|
|
4,203 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted weighted-average shares outstanding |
|
|
37,093 |
|
|
|
41,627 |
|
|
|
37,785 |
|
|
|
36,722 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
0.07 |
|
|
$ |
0.21 |
|
|
$ |
0.10 |
|
|
$ |
0.27 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted |
|
$ |
0.07 |
|
|
$ |
0.19 |
|
|
$ |
0.09 |
|
|
$ |
0.25 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
9
In calculating diluted net income per share, we excluded the following weighted-average
options and convertible debt, as their effect would be anti-dilutive (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
Common stock equivalents: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options |
|
|
1,480 |
|
|
|
106 |
|
|
|
1,247 |
|
|
|
42 |
|
Convertible debt |
|
|
4,203 |
|
|
|
|
|
|
|
4,203 |
|
|
|
4,203 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total |
|
|
5,683 |
|
|
|
106 |
|
|
|
5,450 |
|
|
|
4,245 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
In 2005 and subsequent years, our dilutive securities may include incremental shares issuable
upon conversion of all or part of the $200 million in 2.00% convertible senior notes. Since the
$200 million principal amount can only be redeemed for cash, it has no impact on the diluted
earnings per share calculation. The conversion feature of these notes is triggered when our common
stock reaches a certain market price and, if triggered, may require us to pay a stock premium in
addition to redeeming the accreted principal amount for cash. In accordance with the consensus
from EITF No. 04-8, we will include the dilutive effect of the notes in our calculation of net
income per diluted share when the impact is dilutive. As of June 30, 2005, the conversion feature
of these notes did not have a dilutive effect because the weighted average market price of our
common stock did not exceed the initial conversion price of $35.46 to trigger any shares to be
issuable upon conversion. Therefore, the notes had no effect on our dilutive securities or our net
income per diluted share for the period ended June 30, 2005.
Note 3. Comprehensive Income
The components of comprehensive income are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
Net income |
|
$ |
2,502 |
|
|
$ |
7,457 |
|
|
$ |
3,543 |
|
|
$ |
9,330 |
|
Foreign currency translation adjustment |
|
|
48 |
|
|
|
(233 |
) |
|
|
(174 |
) |
|
|
(362 |
) |
Change in unrealized gain on
securities, net of reclassification
adjustments for realized gain (loss) |
|
|
(1 |
) |
|
|
(315 |
) |
|
|
(83 |
) |
|
|
(431 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Comprehensive income |
|
$ |
2,549 |
|
|
$ |
6,909 |
|
|
$ |
3,286 |
|
|
$ |
8,537 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated other comprehensive income recorded in stockholders equity included $103,000 of
net unrealized gains on investments and $1.0 million of foreign currency translation adjustments as
of June 30, 2005, and, as of December 31, 2004, included $276,000 of unrealized gains on
investments and $1.1 million of foreign currency translation adjustments.
4. Convertible Senior Notes and Stock Repurchase
On March 23, 2005, we issued $150 million of 2.00% convertible senior notes due March 30, 2015
to qualified institutional buyers in a private placement exempt from registration pursuant to Rule
144A of the Securities Act of 1933, as amended. The initial purchasers exercised in full an option
to purchase up to an additional $50 million principal amount of notes with the same terms, and the
sale was completed on March 30, 2005. The notes were sold at par and we received net cash proceeds
of $159 million after expenses of $6.8 million and net of $35.0 million used to repurchase our
common stock. We repurchased 1,332,300 shares of common stock at an average price of $26.27 per
share.
The notes are senior, unsecured obligations and rank equal in right of payment with all of our
existing and future unsecured and unsubordinated debt. The notes are convertible into cash or,
under certain circumstances, cash and shares of our common stock. The initial conversion rate of
the notes is 28.1972 shares of common stock per each $1,000 principal amount of notes, subject to
adjustment in certain circumstances, which represents a conversion price of approximately $35.46
per share. This conversion price is higher than the prices of our common stock on the dates the
notes were issued. The notes bear interest at a rate of 2.00% per annum for the initial five year
period, which is payable in arrears on March 30 and September 30 of each year until March 30, 2010.
The first interest payment will be made on September 30, 2005. For the remaining five-year period
commencing on March 30, 2010, we will pay contingent interest for six-month periods if the average
trading price of a note is above a specified level for a specified period prior to the six-month
period. In addition, beginning on March 30, 2010, the original principal amount shall be increased
at a rate that provides holders with an aggregate annual yield to maturity of 2.00%.
The holders may convert the notes under the following circumstances: (1) on or before March
30, 2009, if the closing sale price of our common stock is above a specified level, (2) at any time
after March 30, 2009, or (3) if a specified
10
fundamental change occurs, such as a merger or acquisition of the company. On or after March
30, 2010, holders of the notes may require us to repurchase all or a portion of their notes at 100%
of the principal amount of the notes plus accrued and unpaid interest. On or after April 4, 2010,
at our option, we may redeem all or a portion of the notes at a redemption price equal to the
accreted principal amount of the notes to be redeemed plus accrued and unpaid interest. If we
undergo a specified fundamental change, holders will have the right, at their option, except in
certain defined circumstances, to require us to purchase for cash all or any portion of their notes
at a price equal to the accreted principal amount plus accrued and unpaid interest. If a holder
elects to convert its notes in connection with the occurrence of a specified fundamental change,
the holder will be entitled to receive additional shares of common stock upon conversion in certain
circumstances.
At March 31, 2005, we did not have a sufficient number of shares of common stock to issue to
holders upon conversion of the notes. Pursuant to the exchange arrangement, if we did not have
enough common stock at the time of conversion, we would be permitted to issue shares of our newly
created Series C Preferred Stock in lieu of common stock. The Series C Preferred Stock was
convertible into shares of common stock at a rate of 1,000 shares of common stock for every 1.1
shares of Series C Preferred Stock. At our annual meeting held on April 22, 2005, our stockholders
approved an increase of our authorized shares of common stock from 50 million to 100 million
shares. As a result, we have a sufficient number of shares of common stock to issue to holders
upon conversion, and accordingly, we eliminated the Series C Preferred Stock.
Offering expenses of $6.8 million related to the issuance of these notes are included in debt
issuance costs, deposits, and other assets as of June 30, 2005. We are amortizing those expenses on
a straight-line basis over the ten year contractual term of the notes.
5. Inventory
The components of inventory are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
June 30, |
|
December 31, |
|
|
2005 |
|
2004 |
Raw materials |
|
$ |
2,107 |
|
|
$ |
677 |
|
Finished goods, net of allowance |
|
|
5,333 |
|
|
|
4,343 |
|
|
|
|
|
|
|
|
|
|
Total inventory |
|
$ |
7,440 |
|
|
$ |
5,020 |
|
|
|
|
|
|
|
|
|
|
As of June 30, 2005, inventory included $636,000 in raw materials for Velac®, a product
candidate for which we are seeking approval by the Food and Drug Administration, or FDA, for
commercial use.
Note 6. Goodwill and Purchased Intangible Assets
There were no changes in the carrying amount of goodwill during the six months ended June 30,
2005. The components of our other intangible assets at June 30, 2005 are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
June 30, 2005 |
|
December 31, 2004 |
|
|
Useful Life |
|
Gross Carrying |
|
Accumulated |
|
|
|
|
|
Gross Carrying |
|
Accumulated |
|
|
|
|
in Years |
|
Amount |
|
Amortization |
|
Net |
|
Amount |
|
Amortization |
|
Net |
Acquired product rights |
|
|
10 |
|
|
$ |
127,652 |
|
|
$ |
(17,021 |
) |
|
$ |
110,632 |
|
|
$ |
127,652 |
|
|
$ |
(10,638 |
) |
|
$ |
117,014 |
|
Existing technology |
|
|
10 |
|
|
|
6,810 |
|
|
|
(2,866 |
) |
|
|
3,944 |
|
|
|
6,810 |
|
|
|
(2,525 |
) |
|
|
4,285 |
|
Patents |
|
|
10 to 13 |
|
|
|
1,661 |
|
|
|
(648 |
) |
|
|
1,013 |
|
|
|
1,661 |
|
|
|
(572 |
) |
|
|
1,089 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total |
|
|
|
|
|
$ |
136,123 |
|
|
$ |
(20,535 |
) |
|
$ |
115,589 |
|
|
$ |
136,123 |
|
|
$ |
(13,735 |
) |
|
$ |
122,388 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Amortization expenses for our other intangible assets were $3.4 million for the three
months ended June 30, 2005 and $6.8 million for the six months ended June 30, 2005. For the same
reporting periods in 2004, amortization expenses were $3.4 million and $4.7 million, respectively.
The expected future amortization expense of our other purchased intangible assets is as
follows (in thousands):
|
|
|
|
|
|
|
Amortization |
|
|
Expense |
Remaining six months in 2005 |
|
$ |
6,799 |
|
For the year ending December 31, 2006 |
|
|
13,598 |
|
For the year ending December 31, 2007 |
|
|
13,598 |
|
For the year ending December 31, 2008 |
|
|
13,598 |
|
For the year ending December 31, 2009 |
|
|
13,598 |
|
For the year ending December 31, 2010 |
|
|
13,598 |
|
Thereafter |
|
|
40,800 |
|
|
|
|
|
|
Total |
|
$ |
115,589 |
|
|
|
|
|
|
11
Note 7. Guaranties and Indemnifications
In November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, including Indirect Guarantees of Indebtedness of Others,
or FIN No. 45. FIN No. 45 requires that upon issuance of a guarantee, the guarantor must recognize
a liability for the fair value of the obligations it assumes under that guarantee. FIN No. 45 also
requires the guarantor to make additional disclosures about the obligations associated with its
guarantees in its interim and annual financial statements.
We enter into indemnification provisions under our agreements with other companies in the
ordinary course of our business, typically with business partners, contractors, clinical sites,
insurers and customers. Under these provisions we generally indemnify and hold harmless the
indemnified party for losses suffered or incurred by the indemnified party as a result of our
activities. These indemnification provisions generally survive termination of the underlying
agreement. In some cases, the maximum potential amount of future payments we could be required to
make under these indemnification provisions is unlimited. The estimated fair value of the indemnity
obligations of these agreements is insignificant. Accordingly, we have not recorded liabilities for
these agreements as of June 30, 2005. We have not incurred material costs to defend lawsuits or
settle claims related to these indemnification provisions.
Note 8. Co-Promotion Agreements
In March 2004, we entered into an agreement with UCB Pharma Inc., or UCB, a subsidiary of UCB
Group Inc., pursuant to which we authorized UCB to promote OLUX® and Luxíq® to a segment of U.S.
primary care physicians, or PCPs. In July 2004, UCB acquired Celltech plc, and in connection with
other post-acquisition changes, UCB notified us that it intended to discontinue the co-promotion
agreement effective March 31, 2005. UCB continued to promote OLUX and Luxíq until that date. We
recorded 100% of the revenue from sales generated by promotional efforts of UCB and paid UCB a
portion of revenue as a promotional expense, which is included in selling, general and
administrative expense. UCB bore the marketing costs for promoting the products (including product
samples, marketing materials, etc.). We do not have any financial obligation to UCB on
prescriptions generated by PCPs after March 31, 2005.
In April 2005, we entered into an agreement with Ventiv Pharma Services, LLC, or VPS, a
subsidiary of Ventiv Health, Inc., under which VPS provides sales support for certain of our
products to primary care physicians and pediatricians. Product sales activities under this
agreement commenced in mid-April 2005. VPS promotes OLUX, Luxíq and Evoclin. We record 100% of
the revenue from product sales generated by promotional efforts of VPS, pay VPS a fee for the
personnel providing the promotional efforts, which are included in selling, general and
administrative expense, and bear the marketing costs for promoting the products, including product
samples and marketing materials.
Note 9. Commitments
Our commitments, including those disclosed in our Annual Report on Form 10-K for the year
ended December 31, 2004, and in our Quarterly Report on Form 10-Q for the three months ended March
31, 2005, consist primarily of operating lease agreements for our facilities as of March 31, 2005,
minimum purchase commitments under one of our contract manufacturing agreements, minimum royalty
commitments under one of our license agreements, and noncancellable purchase orders as of December
31, 2004.
In March 2005, we received landlord approval for a sublease signed in August 2004 for
approximately 19,500 square feet of office space in Palo Alto, California. Payments under the
sublease will commence on January 1, 2006.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
This discussion and analysis should be read in conjunction with the MD&A included in our
Annual Report on Form 10-K for the year ended December 31, 2004, and with the unaudited condensed
consolidated financial statements and notes to financial statements included in this Report. Our
disclosure and analysis in this Report, in other reports that we file with the Securities and
Exchange Commission, in our press releases and in public statements of our officers may contain
forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E
of the Securities Exchange Act. Forward-looking statements give our current expectations or
forecasts of future events. You can identify these statements by the fact that they do not relate
strictly to historical or current events. They use words such as
12
anticipate, estimate, expect, will, may, intend, plan, believe and similar
expressions in connection with discussion of future operating or financial performance. These
include statements relating to future actions, prospective products or product approvals, future
performance or results of current and anticipated products, sales efforts, expenses, the outcome of
contingencies such as legal proceedings, and financial results. Forward-looking statements may turn
out to be wrong. They can be affected by inaccurate assumptions or by known or unknown risks and
uncertainties. Many factors will be important in determining future results. No forward-looking
statement can be guaranteed, and actual results may vary materially from those anticipated in any
forward-looking statement. Some of the factors that, in our view, could cause actual results to
differ are discussed under the caption Factors Affecting Our Business and Prospects in our 2004
Annual Report on Form 10-K. Our historical operating results are not necessarily indicative of the
results to be expected in any future period.
Overview
We are a specialty pharmaceutical company that develops and commercializes innovative products
for the dermatology market. This market is characterized by a large patient population that is
served by relatively small, and therefore more accessible, groups of treating physicians. Our
products aim to improve the management of dermatological diseases and provide significant product
differentiation. We have branded our proprietary foam drug delivery vehicle, VersaFoam®.
We currently market four pharmaceutical products:
|
|
OLUX, a super high-potency topical steroid prescribed for the treatment of steroid responsive dermatological
diseases; |
|
|
|
Luxíq, a mid-potency topical steroid prescribed for scalp dermatoses such as psoriasis, eczema and seborrheic
dermatitis; |
|
|
|
Soriatane, an oral medicine for the treatment of severe psoriasis; and |
|
|
|
Evoclin, a topical treatment for acne vulgaris. |
We began selling Soriatane in March 2004 after we acquired the U.S. product rights from Roche.
We launched Evoclin commercially in December 2004 after we received product approval from the FDA.
Sales of these new products contributed significantly to our revenue growth in 2004 and into 2005.
In April 2005, we entered into an agreement with Ventiv Pharma Services, LLC, or VPS, a
subsidiary of Ventiv Health, Inc., under which VPS will provide sales support for OLUX, Luxíq and
Evoclin to primary care physicians and pediatricians. Product sales activities under this agreement
commenced in mid-April. We record 100% of the revenue from product sales generated by promotional
efforts of VPS, pay VPS a fee for the personnel providing the promotional efforts, and bear the
marketing costs for promoting the products, including product samples and marketing materials.
On June 10, 2005, the FDA issued a non-approvable letter for our product candidate Velac. The
FDA based its decision on the fact that a positive carcinogenicity signal was detected in a Tg.AC
mouse dermal carcinogenicity study. Based on our clinical trials and our analysis of the mouse
study, we had concluded that the mouse study was not predictive of human results. We expect to
continue working with the FDA to determine if and how Velac may be approved at some future date.
13
Critical Accounting Policies
We have made no material changes to our critical accounting policies, which are included in
our Annual Report on Form 10-K for the year ended December 31, 2004.
Results of Operations
Revenues
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Six Months Ended |
|
|
June 30, |
|
June 30, |
|
|
(In thousands) |
|
(In thousands) |
|
|
2005 |
|
2004 |
|
2005 |
|
2004 |
Product revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Soriatane |
|
$ |
18,334 |
|
|
$ |
17,154 |
|
|
$ |
35,915 |
|
|
$ |
20,794 |
|
OLUX |
|
|
14,033 |
|
|
|
15,223 |
|
|
|
29,825 |
|
|
|
29,593 |
|
Luxíq |
|
|
5,835 |
|
|
|
5,614 |
|
|
|
11,489 |
|
|
|
11,085 |
|
Evoclin |
|
|
7,037 |
|
|
|
|
|
|
|
10,104 |
|
|
|
|
|
Other |
|
|
|
|
|
|
8 |
|
|
|
96 |
|
|
|
93 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total product revenues |
|
|
45,239 |
|
|
|
37,999 |
|
|
|
87,429 |
|
|
|
61,565 |
|
Royalty and contract revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Royalty |
|
|
130 |
|
|
|
172 |
|
|
|
228 |
|
|
|
1,525 |
|
Contract |
|
|
|
|
|
|
82 |
|
|
|
83 |
|
|
|
145 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total royalty and contract revenues |
|
|
130 |
|
|
|
254 |
|
|
|
311 |
|
|
|
1,670 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total revenues |
|
$ |
45,369 |
|
|
$ |
38,253 |
|
|
$ |
87,740 |
|
|
$ |
63,235 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
We recorded product revenues of $45.2 million for the three months ended June 30, 2005,
compared to $38.0 million for the three months ended June 30, 2004, for an increase of $7.2
million or 19%. The increase in product revenues is primarily attributable to the introduction of
two new products, Soriatane in March 2004 and Evoclin in December 2004, which accounted for $1.2
million and $7.0 million of the incremental revenue, respectively. During the three months ended
June 30, 2005, we experienced unexpected product returns related to expired and expiring products
at our wholesaler customers of OLUX that were significantly above historical levels. Based on our
analysis, we recorded a charge to
product revenues of $2.3 million in the three months ended June 30, 2005 for expired and estimated expiring products at our customers, associated with product
sales recorded in prior periods. Our analysis considered information contained in the reporting
provided to us by our wholesaler customers under the distribution service agreements that became
available to us in the second quarter of 2005. This additional reserve was recorded as a decrease
in product revenues in the second quarter, which partially offset the increased sales from the new
products.
For the six months ended June 30, 2005, our product revenues were $87.4 million compared to
$61.6 million for the six months end June 30, 2004, for an
increase of $25.8 million or 42%. The increase
in product revenues is attributable to Soriatane and Evoclin, which accounted for $15.1 million and
$10.1 million of the increase, respectively, partially offset by the additional returns reserve
recorded in the second quarter as described above.
Royalty and contract revenues were $130,000 and $311,000 for the three and six months ended
June 30, 2005, compared to $254,000 and $1.7 million, for the comparable periods in 2004,
respectively. Royalty and contract revenues were lower for the first half of 2005 compared to the
same period in the prior year due to the final royalty payment of $1.2 million made by S.C. Johnson
in the first quarter of 2004.
Cost of Product Revenues
Our cost of product revenues includes the third party costs of manufacturing OLUX, Luxíq and
Evoclin, the cost of Soriatane inventory acquired from Roche, depreciation costs associated with
Connetics-owned equipment located at the DPT facility in Texas, allocation of overhead, royalty
payments based on a percentage of our product revenues, product freight and distribution costs from
our distributor in Tennessee and certain manufacturing support and quality assurance costs.
We recorded cost of product revenues of $5.0 million for the three months ended June 30, 2005,
compared to $3.6 million for the comparable periods in 2004, for an increase of $1.4 million or
39%. The increase was primarily due to $1.1 million of increased overhead costs allocated to cost
of finished goods sold and $0.4 million of increased production costs relating to our new products
Soriatane and Evoclin , partially offset by $0.6 million of decreased royalty payments due on
14
lower Soriatane sales to a U.S.-based distributor that exports branded pharmaceuticals to
select international markets in the three months ended June 30, 2005. In addition, we recorded a
reserve of $0.3 million in the three months ended June 30, 2005 for finished goods product that may
not be shipped because less than preferable dating at the time of shipment.
For the six months ended June 30, 2005 and 2004, our cost of product revenues were $8.7
million and $5.1 million, respectively, for an increase of $3.6 million or 71%. The increase was
primarily due to $1.9 million of increased production costs relating to our new products Soriatane
and Evoclin and $1.1 million of increased overhead costs allocated to cost of finished goods sold.
The increase also included the $0.3 million reserve for finished goods described above.
Amortization of Intangible Assets
Amortization expenses were $3.4 million for the three months ended June 30, 2005 and $6.8
million for the six months ended June 30, 2005, compared to $3.4 million and $4.7 million,
respectively, for the comparable periods in 2004. The $2.1 million increase for the six months
ended June 30, 2005 over the same period in 2004 is the result of four months amortization of the
Soriatane product rights acquired in March 2004 compared to two full quarters in 2005.
Research and Development
Our research and development, or R&D, expenses include costs of personnel to support our R&D
activities, costs of preclinical studies, costs of conducting our clinical trials (such as clinical
investigator fees, monitoring costs, data management and drug supply costs), external research
programs, and an allocation of facilities costs. Year to year changes in R&D expenses are primarily
due to the timing of and sample sizes required for particular trials.
R&D expenses were $9.0 million for the three months ended June 30, 2005, compared to $5.1
million for the three months ended June 30, 2004, for an increase of $3.9 million or 76%. For the
six months ended June 30, 2005 and 2004, R&D expenses were $14.9 million and $9.5 million,
respectively, for an increase of $5.4 million or 57%. The increased expenses are primarily
attributable to increased clinical trial activity in 2005 as compared to 2004 representing $2.8
million for the three months ended June 30, 2005 and $3.6 million for the six months ended June 30,
2005. The increase was also attributable to increased headcount costs of $0.5 million and $1.0
million, respectively, in the three and six months ended 2005 compared to the same periods in 2004.
Selling, General and Administrative Expenses
Our selling, general and administrative, or SG&A, expenses include sales and marketing
activities as well as expenses and costs associated with finance, legal, insurance, marketing,
sales, and other administrative matters.
We recorded SG&A expenses of $25.4 million for the three months ended June 30, 2005, compared
to $17.5 million for the comparable period in 2004, for an increase of $7.8 million or 45%. The
increase primarily consists of $3.5 million in increased direct and indirect promotional activities
costs, $1.9 million in marketing and sales expenses such as tradeshows, advertising and
conventions, and $1.2 million in increased product samples and market research costs. The
increased costs also included $0.5 million in increased headcount costs in the marketing, general
and administrative departments, and $0.4 million for increased legal and accounting fees.
We recorded SG&A expenses of $53.1 million for the six months ended June 30, 2005 compared to
$32.8 million for the comparable period in 2004 for an increase of $20.3 million or 62%. The
increase primarily consists of $8.7 million in increased direct and indirect promotional activities
costs, $4.8 million in marketing and sales expenses such as tradeshows, advertising and
conventions, $2.1 million in increased product samples and market research costs, $2.0 million in
increased headcount costs in the marketing, general and administrative departments and $1.0 million
for increased legal and accounting fees.
15
Interest and other income (expense), net
Interest income was $1.8 million for the three months ended June 30, 2005 and $2.3 million for
the six months ended June 30, 2005, compared to $152,000 and $500,000 for the three and six months
ended June 30, 2004, respectively. The increase in interest income during 2005 was the result of
higher average cash and investment balances in connection with the cash proceeds related to the
$200 million convertible senior notes issued in March 2005, as well as increased interest rates on
investments.
Interest expense was $1.9 million for the three months ended June 30, 2005, and $2.6 million
for the six months ended June 30, 2005, compared to $0.7 million and $1.4 million, respectively,
for the three and six months ended June 30, 2004. The increase in interest expense was primarily
due to the sale of convertible senior notes in March 2005.
Income Taxes
We recognized income tax expense of $0.2 million for the three months ended June 30, 2005, and
$0.3 million for the six months ended June 30, 2005, related to U.S. Federal alternate minimum
taxes and state income taxes, offset by foreign tax benefit related to our activities in Australia.
By comparison, we recognized income tax expense of $0.7 million for the three months ended June 30,
2004, and $0.9 million for the six months ended June 30, 2004. The tax provisions were primarily
for U.S. Federal alternative minimum tax. We also recorded foreign tax provisions in the three and
six months ended June 30, 2004 related to our Australian operations.
Liquidity and Capital Resources
Working Capital
We have financed our operations to date primarily through proceeds from equity and debt
financings, and product revenues. Cash, cash equivalents and
marketable securities totaled $252.2 million at June 30,
2005, up from $72.4 million at December 31, 2004. The
increase of $179.8 million was primarily due to receipt of the net cash proceeds of $194.0 million from the issuance
of convertible senior notes, partially offset by a $35.0 million repurchase of our common stock.
For a more complete description of the terms of the debt instruments and sales, refer to Note 4 in
the Notes to Condensed Consolidated Financial Statements elsewhere in this Report. Net operating
activities generated $19.8 million of cash for the six months ended June 30, 2005.
Working
capital at June 30, 2005 was $241.2 million compared to $71.2 million at December 31,
2004. In addition to the increased amounts identified above, the other significant change in
working capital during the first six months of 2005 was an increase of $2.4 million in inventory to
support increased product sales and the anticipated launch of Velac, a product candidate for which
we are seeking approval by the Food and Drug Administration, or FDA, for commercial use.
Capital Expenditures
We made capital expenditures of $3.1 million to purchase property and equipment for the six
months ended June 30, 2005 compared to $1.5 million for the same period in 2004. The expenditures
in 2005 were primarily for leasehold improvements on, and laboratory equipment purchased for, our
new corporate headquarters, which we occupied at the end of February 2005. In addition, in 2004 we
used $123.5 million in cash to acquire Soriatane product rights, including transaction-related
costs.
Capital Resources
We believe our existing cash, cash equivalents and marketable securities and cash generated
from product sales will be sufficient to fund our operating expenses, debt obligations and capital
requirements through at least the next 12 months. We cannot be certain of the amount of our future
product revenues. Our product sales may be impacted by patent risks and competition from new
products.
Products under development may not be safe and effective or approved by the FDA, or we may be
unable to produce them in commercial quantities at reasonable costs. Additionally, our products may
not gain satisfactory market acceptance. The amount of capital we require for operations in the
future depends on numerous factors, including the level of product revenues, the extent of
commercialization activities, the scope and progress of our clinical research and development
programs, the time and costs involved in obtaining regulatory approvals, the cost of filing,
prosecuting, and enforcing patent claims and other intellectual property rights, and competing
technological and market developments. If we need
16
funds in the future to in-license or acquire additional marketed or late-stage development
products, a portion of the funds may come from our existing cash, which will result in fewer
resources available to our current products and clinical programs. In order to take action on
business development opportunities we may identify in the future, we may need to use some of our
available cash, or raise additional cash by liquidating some of our investment portfolio and/or
raising additional funds through equity or debt financings.
We currently have no commitments for any additional financings. If we need to raise additional
money to fund our operations, funding may not be available to us on acceptable terms, or at all. If
we are unable to raise additional funds when we need them, we may not be able to market our
products as planned or continue development of potential products, or we could be required to
delay, scale back, or eliminate some or all of our research and development programs.
Contractual Obligations and Commercial Commitments
Our commitments, including those disclosed in our Annual Report on Form 10-K for the year
ended December 31, 2004, consist primarily of operating lease agreements for our facilities as well
as minimum purchase commitments under one of our contract manufacturing agreements, minimum royalty
commitments under one of our license agreements, and noncancellable purchase orders as of December
31, 2004.
In March 2005, we received landlord approval for a sublease signed in August 2004 for
approximately 19,500 square feet of office space in Palo Alto, California. Payments for the
sublease will commence on January 1, 2006.
As a result of this new leasing arrangement, our operating lease payments will increase as
follows (in thousands):
|
|
|
|
|
|
|
Increase in |
|
|
Operating Lease |
|
|
Payments |
For the year ending December 31, 2006 |
|
$ |
339 |
|
For the year ending December 31, 2007 |
|
|
303 |
|
For the year ending December 31, 2008 |
|
|
315 |
|
For the year ending December 31, 2009 |
|
|
338 |
|
For the year ending December 31, 2010 |
|
|
88 |
|
|
|
|
|
|
Total |
|
$ |
1,383 |
|
|
|
|
|
|
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board, or FASB, issued SFAS No. 123
(revised 2004), Share-Based Payment, or SFAS 123R, which requires companies to measure and
recognize compensation expense for all stock-based awards at fair value. Stock-based awards include
grants of employee stock options. SFAS 123R replaces Statement of Financial Accounting Standards
No. 123 Accounting for Stock-Based Compensation, or SFAS 123, and supersedes Accounting
Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. SFAS 123R requires
companies to recognize all stock-based awards to employees and to reflect those awards in the
financial statements based on the fair values of the awards. In April 2005, the SEC modified the
effective date for SFAS 123R, resulting in the pronouncement being effective for all annual periods
beginning after June 15, 2005. We are required to adopt SFAS 123R in our fiscal year beginning
January 1, 2006, after which the pro forma disclosures previously permitted under SFAS 123 will no
longer be an alternative to financial statement recognition. Under SFAS 123R, we must determine the
appropriate fair value model to be used for valuing share-based awards, the amortization method for
compensation cost, and the transition method to be used at date of adoption. The transition methods
permit companies to adopt the model retroactively or prospectively. The prospective method would
require that we record compensation expense for all unvested stock options and restricted stock at
the beginning of the year of we adopt of SFAS 123R. Under the retroactive method, we would be
permitted to restate prior periods either as of the beginning of the year of adoption or for all
periods presented, and we would record compensation expense for all unvested stock options and
restricted stock beginning with the first period restated. We are evaluating the requirements of
SFAS 123R and we expect that the adoption of SFAS 123R will have a material impact on our
consolidated results of operations and earnings per share. We have not yet determined which
transition method we will use, the impact of adopting SFAS 123R, or whether the adoption will
result in amounts that are similar to the current pro forma disclosures under SFAS 123.
Factors that May Affect Future Results, Financial Condition and the Market Price of Securities
Please also read Item 1 in our Annual Report on Form 10-K for the year ended December 31, 2004,
where we have described our business and the challenges and risks we may face in the future.
17
There are many factors that affect our business and results of operations, some of which are
beyond our control. In our Annual Report on Form 10-K we list some of the important factors that
may cause the actual results of our operations in future periods to differ materially from the
results currently expected or desired. Due to these factors, we believe that quarter-to-quarter
comparisons of our results of operations are not a good indication of our future performance. The
factors discussed in our reports filed with the Securities and Exchange Commission, including our
Annual Report on Form 10-K in particular under the caption Factors Affecting Our Business and
Prospects, should be carefully considered when evaluating our business and prospects.
Our Business Strategy May Cause Fluctuating Operating Results
Our operating results and financial condition may fluctuate from quarter to quarter and year
to year depending upon the relative timing of events or uncertainties that may arise. For example,
the following events or occurrences could cause fluctuations in our financial performance from
period to period:
|
|
changes in the levels we spend to develop new product lines, |
|
|
|
changes in the amounts we spend to promote our products, |
|
|
|
changes in treatment practices of physicians that currently prescribe our products, |
|
|
|
changes in reimbursement policies of health plans and other similar health insurers, including changes that
affect newly developed or newly acquired products, |
|
|
|
increasing regulatory requirements that may affect timing of new product development and ultimate
commercialization, |
|
|
|
the development of new competitive products by others, |
|
|
|
the mix of products that we sell during any time period, |
|
|
|
increases in the cost of raw materials used to manufacture our products, |
|
|
|
our responses to price competition, |
|
|
|
forward-buying patterns by wholesalers that may result in significant quarterly swings in revenue reporting, and |
|
|
|
fluctuations in royalties paid by third parties. |
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in the reported market risks or foreign currency exchange
risks from those we reported under Item 7A, Quantitative and Qualitative Disclosures About Market
Risk in our Annual Report on Form 10-K for the year ended December 31, 2004.
18
Item 4. Controls and Procedures
In
May 2005, we became aware that we had failed to file two Current Reports on Form 8-K in
connection with the creation (March 2005) and elimination (May 2005) of Series C Preferred Stock.
The Series C Preferred was created to be used for conversion of the convertible notes in the event
that we did not have sufficient common stock for that purpose. Because our stockholders authorized
an increase in our authorized common stock in April 2005, the Series C Preferred was no longer
necessary. Although we disclosed this issue in other filings with the SEC, most notably our Proxy
Statement, we did not timely file it on Form 8-K. As a result of our
failure to file these two Forms 8-K, Connetics is ineligible to register its securities on a
Registration Statement on Form S-3 until May 26, 2006.
Connetics disclosure controls and procedures are designed
with the objective of ensuring that information required to be disclosed in our reports filed under
the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time
periods specified in the SECs rules and forms. Our management, under the supervision and with the participation of our Chief Executive
Officer and Chief Financial Officer, undertook a re-evaluation of the effectiveness of the design
and operation of Connetics disclosure controls and procedures and made certain changes designed to
prevent similar omissions in the future. We have further educated our financial and legal reporting
personnel regarding items for which a Form 8-K is required, and have implemented additional
disclosure controls and procedures designed to avoid such inadvertent filing failures. This
evaluation was performed as of June 30, 2005.
Based on that re-evaluation, and taking into
account the modifications, our CEO and our CFO concluded that
Connetics disclosure controls and procedures (as defined in Rule 13a-15(e)
under the Securities Exchange Act of 1934)
were effective in timely alerting them to material information required to be included in our
periodic SEC reports. Notwithstanding the issues raised and discussed above, our
CEO and CFO also concluded that during the quarter ended June 30, 2005, there was no change in our
internal control over financial reporting (as defined in Rule
13a-15(f) under the Securities Exchange Act of 1934) that has materially affected, or is reasonably likely to
materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders
On April 22, 2005, we held our annual meeting of stockholders. At the meeting, the
stockholders acted on the following matters by the following votes:
1) Election of the following directors:
|
|
|
|
|
|
|
|
|
Name |
|
For |
|
Withheld |
Alexander E. Barkas, MD |
|
|
30,102,471 |
|
|
|
2,810,017 |
|
Eugene Bauer, M.D. |
|
|
18,678,008 |
|
|
|
14,234,479 |
|
Andrew Eckert |
|
|
22,765,545 |
|
|
|
10,146,942 |
|
Denise Gilbert, Ph.D. |
|
|
31,125,696 |
|
|
|
786,792 |
|
John C. Kane |
|
|
30,262,799 |
|
|
|
2,649,689 |
|
Thomas D. Kiley |
|
|
31,544,126 |
|
|
|
1,368,362 |
|
Leon E. Panetta |
|
|
20,638,966 |
|
|
|
12,273,521 |
|
G. Kirk Raab |
|
|
29,843,519 |
|
|
|
3,068,969 |
|
Thomas G. Wiggans |
|
|
31,466,209 |
|
|
|
1,466,279 |
|
2) Adoption of the 2005 Stock Plan (not approved):
|
|
|
|
|
|
|
|
|
For |
|
Against |
|
Abstain |
5,687,886 |
|
|
22,321,253 |
|
|
|
261,999 |
|
3) Approval of an amendment to the Companys Amended and Restated Certificate of Incorporation:
|
|
|
|
|
|
|
|
|
For |
|
Against |
|
Abstain |
28,468,459 |
|
|
4,281,306 |
|
|
|
162,723 |
|
4) Ratification of the appointment of Ernst & Young LLP to serve as the Companys independent
registered public accounting firm for the fiscal year ending December 31, 2005:
|
|
|
|
|
|
|
|
|
For |
|
Against |
|
Abstain |
32,667,617 |
|
|
244,361 |
|
|
|
513 |
|
19
Item 6. Exhibits
|
|
|
Exhibit |
|
|
Number |
|
Description |
|
|
|
3.1*
|
|
Amended and Restated Certificate of Incorporation (previously filed as an exhibit to the Companys Form
S-1 Registration Statement No. 33-80261) |
|
|
|
3.2*
|
|
Certificate of Amendment of the Companys Amended and Restated Certificate of Incorporation, as filed with
the Delaware Secretary of State on May 15, 1997 (previously filed as Exhibit 3.7 to the Companys Current
Report on Form 8-K dated and filed May 23, 1997) |
|
|
|
3.3*
|
|
Certificate of Designation of Rights, Preferences and Privileges of Series B
Participating Preferred Stock, as filed with the Delaware Secretary of State on May 15, 1997 (previously
filed as Exhibit A to Exhibit 1 to the Companys Form 8-A filed on May 23, 1997) |
|
|
|
3.4*
|
|
Certificate of Elimination of Rights, Preferences and Privileges of Connetics Corporation, as filed with
the Delaware Secretary of State on December 11, 2001 (previously filed as Exhibit 3.5 to the Companys
Annual Report on Form 10-K/ A for the year ended December 31, 2001) |
|
|
|
3.5*
|
|
Certificate of Designation of Rights, Preferences and Privileges of Series C Preferred
Stock, as filed with the Delaware Secretary of State on March 22, 2005 (previously filed
as Exhibit 3.1 to the Companys Current Report on Form 8-K filed on June 6, 2005) |
|
|
|
3.6*
|
|
Certificate of Elimination of Rights, Preferences and Privileges of Series C Preferred
Stock of Connetics Corporation, as filed with the Delaware Secretary of State on May 18, 2005
(previously filed as Exhibit 3.2 to the Companys Current Report on Form 8-K filed on June 6, 2005) |
|
|
|
3.7*
|
|
Certificate of Amendment of the Amended and Restated Certificate of Incorporation of Connetics
Corporation (previously filed as Exhibit 4.7 to the Companys Form S-1 Registration Statement filed
on June 20, 2005) |
|
|
|
10.1*
|
|
Form of Change in Control Agreement between the Company and outside directors
of the Company (previously filed as Exhibit 10.13 to the Companys Form S-1 Registration Statement
filed on June 20, 2005) |
|
|
|
10.2*
|
|
Change of Control Agreement dated January 1, 2002 between the Company and
Thomas G. Wiggans (previously filed as Exhibit 10.14 to the Companys Form S-1 Registration
Statement filed on June 20, 2005) |
|
|
|
10.3*
|
|
Change of Control Agreement dated January 1, 2002 between the Company and G. Kirk Raab
(previously filed as Exhibit 10.15 to the Companys Form S-1 Registration Statement filed on June 20, 2005) |
|
|
|
10.4*
|
|
Non-Qualified Stock Option Agreement between Connetics Corporation and James A. Trah (previously
filed as Exhibit 10.3 to the Companys Quarterly Report on Form 10-Q for the quarter ended March 31, 2005) |
|
|
|
10.5*
|
|
Non-Qualified Stock Option Agreement between Connetics Corporation and Michael Eison
(previously filed as Exhibit 10.25 to the Companys Form S-1 Registration Statement filed on June 20, 2005) |
|
|
|
10.6
|
|
Non-Qualified Stock Option Agreement between Connetics Corporation and Stefan Weiss |
|
|
|
10.7
|
|
1995 Directors Stock Option Plan (as amended through February 10, 2005),and forms of Option Agreement |
|
|
|
10.8
|
|
Description of Compensation Payable
to Non-Employee Directors |
|
|
|
31.1
|
|
Rule 13a-14(a) Certification of the Chief Executive Officer |
|
|
|
31.2
|
|
Rule 13a-14(a) Certification of the Chief Financial Officer |
|
|
|
32.1
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
32.2
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
* |
|
Incorporated by this reference to the previous filing, as indicated. |
|
|
|
The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly report on
Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are not to be
incorporated by reference into any filing of Connetics Corporation under the Securities Act of
1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or
after the date of this Form 10-Q, irrespective of any general incorporation language contained
in such filing. |
20
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
|
|
|
|
|
|
Connetics Corporation
|
|
|
By: |
/s/ John L. Higgins |
|
|
|
John L. Higgins |
|
|
|
Executive Vice President, Finance and Corporate Development and Chief Financial Officer (Principal Financial Officer and
Principal Accounting Officer and Duly Authorized Officer of the Registrant) |
|
|
Date:
August 5, 2005
21
INDEX TO EXHIBITS
|
|
|
Exhibit |
|
|
Number |
|
Description |
|
|
|
3.1*
|
|
Amended and Restated Certificate of Incorporation (previously filed as an exhibit to the Companys Form
S-1 Registration Statement No. 33-80261) |
|
|
|
3.2*
|
|
Certificate of Amendment of the Companys Amended and Restated Certificate of Incorporation, as filed with
the Delaware Secretary of State on May 15, 1997 (previously filed as Exhibit 3.7 to the Companys Current
Report on Form 8-K dated and filed May 23, 1997) |
|
|
|
3.3*
|
|
Certificate of Designation of Rights, Preferences and Privileges of Series B
Participating Preferred Stock, as filed with the Delaware Secretary of State on May 15, 1997 (previously
filed as Exhibit A to Exhibit 1 to the Companys Form 8-A filed on May 23, 1997) |
|
|
|
3.4*
|
|
Certificate of Elimination of Rights, Preferences and Privileges of Connetics Corporation, as filed with
the Delaware Secretary of State on December 11, 2001 (previously filed as Exhibit 3.5 to the Companys
Annual Report on Form 10-K/ A for the year ended December 31, 2001) |
|
|
|
3.5*
|
|
Certificate of Designation of Rights, Preferences and Privileges of Series C Preferred
Stock, as filed with the Delaware Secretary of State on March 22, 2005 (previously filed
as Exhibit 3.1 to the Companys Current Report on Form 8-K filed on June 6, 2005) |
|
|
|
3.6*
|
|
Certificate of Elimination of Rights, Preferences and Privileges of Series C Preferred
Stock of Connetics Corporation, as filed with the Delaware Secretary of State on May 18, 2005
(previously filed as Exhibit 3.2 to the Companys Current Report on Form 8-K filed on June 6, 2005) |
|
|
|
3.7*
|
|
Certificate of Amendment of the Amended and Restated Certificate of Incorporation of Connetics
Corporation (previously filed as Exhibit 4.7 to the Companys Form S-1 Registration Statement filed
on June 20, 2005) |
|
|
|
10.1*
|
|
Form of Change in Control Agreement between the Company and outside directors
of the Company (previously filed as Exhibit 10.13 to the Companys Form S-1 Registration Statement
filed on June 20, 2005) |
|
|
|
10.2*
|
|
Change of Control Agreement dated January 1, 2002 between the Company and
Thomas G. Wiggans (previously filed as Exhibit 10.14 to the Companys Form S-1 Registration
Statement filed on June 20, 2005) |
|
|
|
10.3*
|
|
Change of Control Agreement dated January 1, 2002 between the Company and G. Kirk Raab
(previously filed as Exhibit 10.15 to the Companys Form S-1 Registration Statement filed on June 20, 2005) |
|
|
|
10.4*
|
|
Non-Qualified Stock Option Agreement between Connetics Corporation and James A. Trah (previously filed as
Exhibit 10.3 to the Companys Quarterly Report on Form 10-Q for the quarter ended March 31, 2005) |
|
|
|
10.5*
|
|
Non-Qualified Stock Option Agreement between Connetics Corporation and Michael Eison
(previously filed as Exhibit 10.25 to the Companys Form S-1 Registration Statement filed on June 20, 2005) |
|
|
|
10.6
|
|
Non-Qualified Stock Option Agreement between Connetics Corporation and Stefan Weiss |
|
|
|
10.7
|
|
1995 Directors Stock Option Plan (as amended through February 10, 2005),and forms of Option Agreement |
|
|
|
10.8
|
|
Description of Compensation Payable
to Non-Employee Directors |
|
|
|
31.1
|
|
Rule 13a-14(a) Certification of the Chief Executive Officer |
|
|
|
31.2
|
|
Rule 13a-14(a) Certification of the Chief Financial Officer |
|
|
|
32.1
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
32.2
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
* |
|
Incorporated by this reference to the previous filing, as indicated. |
|
|
|
The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly report on
Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are not to be
incorporated by reference into any filing of Connetics Corporation under the Securities Act of
1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or
after the date of this Form 10-Q, irrespective of any general incorporation language contained
in such filing. |
22