1
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, 2001
Commission file number: 0-27406
CONNETICS CORPORATION
(Exact name of registrant as specified in its charter)
DELAWARE 94-3173928
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification Number)
3400 WEST BAYSHORE ROAD
PALO ALTO, CALIFORNIA 94303
(Address of principal executive offices)
Registrant's 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 at least the past 90 days. Yes [X] No [ ]
As of August 7, 2001, 29,976,173 shares of the Registrant's common stock
were outstanding, at $0.001 par value.
2
CONNETICS CORPORATION
TABLE OF CONTENTS
Page
----
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets at June 30, 2001 and December 31, 2000 3
Condensed Consolidated Statements of Operations for the three months and the
six months ended June 30, 2001 and 2000 4
Condensed Consolidated Statements of Cash Flows for the six months ended
June 30, 2001 and 2000 5
Notes to Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and
Results of Operations 12
Item 3. Quantitative and Qualitative Disclosures About Market Risks 26
PART II. OTHER INFORMATION
Item 4. Submission of Matters to a Vote of Security Holders 27
Item 6. Exhibits and Reports on Form 8-K 27
(a) Exhibits 27
(b) Reports on Form 8-K 27
3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONNETICS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
June 30, December 31,
2001 2000
--------- ------------
(unaudited) (Note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 12,158 $ 58,577
Short-term investments 43,611 21,607
Accounts receivable 3,953 2,749
Other current assets 1,071 545
--------- ---------
Total current assets 60,793 83,478
Property and equipment, net 2,261 1,807
Deposits and other assets 326 428
Goodwill and other purchased intangibles, net 14,404 --
--------- ---------
Total assets $ 77,784 $ 85,713
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 3,610 $ 5,115
Accrued liabilities 2,244 2,715
Accrual for Relaxin related liabilities 5,795 --
Current portion of deferred revenue 332 132
Accrued process development expenses 1,094 1,389
Accrued payroll and related expenses 1,582 1,797
Current portion of notes payable -- 750
Other current liabilities 158 513
Current portion of capital lease obligations 12 37
--------- ---------
Total current liabilities 14,827 12,448
Deferred revenue 593 659
Stockholders' equity:
Preferred stock -- --
Common stock and additional paid-in capital 161,427 159,242
Deferred compensation (12) (21)
Accumulated deficit (103,778) (92,756)
Accumulated other comprehensive income 4,727 6,141
--------- ---------
Total stockholders' equity 62,364 72,606
--------- ---------
Total liabilities and stockholders' equity $ 77,784 $ 85,713
========= =========
See accompanying notes to condensed consolidated financial statements.
- 3 -
4
CONNETICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
Three Months Ended Six Months Ended
June 30, June 30,
----------------------- -----------------------
2001 2000 2001 2000
-------- -------- -------- --------
Revenues:
Product $ 6,577 $ 3,793 $ 14,232 $ 9,460
Royalty 123 -- 123 --
Contract and other 863 6,729 1,667 14,665
-------- -------- -------- --------
Total revenues 7,563 10,522 16,022 24,125
-------- -------- -------- --------
Operating costs and expenses:
Cost of product revenues 603 461 1,708 2,260
Research and development 5,621 3,983 9,973 10,128
Selling, general and administrative 9,698 6,046 17,310 11,565
Acquired in-process research and development 1,080 -- 1,080 --
Charge for Relaxin program 5,976 -- 5,976 --
-------- -------- -------- --------
Total operating costs and expenses 22,978 10,490 36,047 23,953
-------- -------- -------- --------
Income (loss) from operations (15,415) 32 (20,025) 172
Interest and other income 1,530 349 2,531 646
Gain on sale of investments -- 255 122 703
Gain on sale of Ridaura product line 8,055 -- 8,055 --
Interest and other expense (305) (69) (1,706) (169)
-------- -------- -------- --------
Income (loss) before cumulative effect of change in
accounting principle $ (6,135) $ 567 $(11,023) $ 1,352
Cumulative effect of change in accounting principle -- -- -- (5,192)
-------- -------- -------- --------
Net income (loss) $ (6,135) $ 567 $(11,023) $ (3,840)
======== ======== ======== ========
Basic earnings per share
Income (loss) per share before cumulative effect
of change in accounting principle $ (0.21) $ .02 $ (0.37) $ 0.05
Cumulative effect of change in accounting principle -- -- -- $ (0.19)
-------- -------- -------- --------
Net income (loss) per share $ (0.21) $ .02 $ (0.37) $ (0.14)
======== ======== ======== ========
Diluted earnings per share
Income (loss) per share before cumulative effect
of change in accounting principle $ (0.21) $ .02 $ (0.37) $ 0.05
Cumulative effect of change in accounting principle -- -- -- $ (0.18)
-------- -------- -------- --------
Net income (loss) per share $ (0.21) $ .02 $ (0.37) $ (0.13)
======== ======== ======== ========
Basic shares used to calculate net income (loss) 29,777 27,481 29,741 27,295
======== ======== ======== ========
Diluted shares used to calculate net income (loss) 29,777 28,704 29,741 28,558
======== ======== ======== ========
See accompanying notes to condensed consolidated financial statements.
- 4 -
5
CONNETICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
Six Months Ended
June 30,
-----------------------
2001 2000
-------- --------
Cash flows from operating activities:
Net loss $(11,023) $ (3,840)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization 742 361
Gain on sale of investment (122) (703)
Gain on sale of Ridaura product line (8,055) --
Stock compensation expense 1,267 1,008
In-process research and development 1,080 --
Amortization of deferred compensation 9 9
Loss on foreign exchange forward contract 555 --
Changes in assets and liabilities, excluding effects of acquisition -- --
Accounts receivable 348 257
Current and other assets (449) (518)
Accounts payable (1,671) (3,299)
Current other liabilities 1,882 (1,337)
Deferred revenue 134 4,821
-------- --------
Net cash used in operating activities (15,303) (3,241)
-------- --------
Cash flows from investing activities:
Purchases of short-term investments (35,815) (1,989)
Sales and maturities of short-term investments 12,521 9,557
Purchases of property and equipment (332) (387)
Proceeds from sale of Ridaura product line 8,979 --
Acquisition of a business, net of cash acquired (16,611) --
-------- --------
Net cash provided by (used in) investing activities (31,258) 7,181
-------- --------
Cash flows from financing activities:
Payment of notes payable (750) (2,114)
Payments on obligations under capital leases and capital loans (25) (113)
Proceeds from issuance of common stock, net of issuance costs 918 21,407
-------- --------
Net cash provided by financing activities 143 19,180
Effect of foreign currency exchange rates on cash and cash equivalents (1) --
-------- --------
Net change in cash and cash equivalents (46,419) 23,120
Cash and cash equivalents at beginning of period 58,577 8,460
-------- --------
Cash and cash equivalents at end of period $ 12,158 $ 31,580
======== ========
Supplementary information:
Interest paid $ 12 $ 197
Financing activity:
Issuance of common stock as payment on accrued liabilities $ 888
See accompanying notes to condensed consolidated financial statements.
- 5 -
6
CONNETICS CORPORATION
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2001
(UNAUDITED)
1. BASIS OF PRESENTATION AND POLICIES
We have prepared the accompanying unaudited condensed consolidated
financial statements of Connetics Corporation ("Connetics") in accordance with
generally accepted accounting principles for interim financial information and
pursuant to 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. In our opinion, all adjustments, consisting of normal
recurring adjustments, considered necessary for a fair presentation have been
included. Operating results for the six months ended June 30, 2001 are not
necessarily indicative of the results that may be expected for the year ended
December 31, 2001. Certain prior year balances have been reclassified for
comparative purposes.
These condensed, consolidated financial statements and notes should be
read in conjunction with audited financial statements and notes to those
financial statements for the year ended December 31, 2000 included in our Annual
Report on Form 10-K as filed with the Securities and Exchange Commission.
Principles of Consolidation
The accompanying unaudited condensed consolidated financial statements
include the accounts of Connetics and its wholly-owned subsidiary, Soltec
Research Pty Ltd. ("Soltec"). All significant intercompany accounts and
transactions are eliminated in consolidation.
Revenue Recognition
Product Sales and Royalty Revenue. We recognize revenue from product
sales when there is persuasive evidence that an arrangement exists, when title
has passed upon shipment, the price is fixed or determinable, and collectibility
is reasonably assured. We recognize product revenue net of allowances for
estimated returns, rebates, and chargebacks. We are obligated to accept from
customers the return of pharmaceuticals that have reached their expiration date.
To date we have not experienced significant returns of expired product.
Royalties from licensees are based on third-party sales and are recognized in
the quarter in which the royalty payment is either received from the licensee or
may be reasonably estimated, which is typically one quarter following the
related sale of the licensee.
- 6 -
7
Contract revenue. We record contract revenue for research and development
as it is earned based on the performance requirements of the contract.
We recognize non-refundable contract fees for which no further
performance obligation exists, and for which Connetics has no continuing
involvement, on the earlier of when the payments are received or when collection
is assured.
We recognize revenue from non-refundable upfront license fees under
collaborative agreements ratably over the development period when, at the time
the agreement is executed, the development period involves significant risk due
to the incomplete stage of the product's development.
Revenue associated with substantial "at risk" performance milestones, as
defined in the respective agreements, is recognized based upon the achievement
of the milestones.
Royalty expense directly related to product sales is classified in cost
of sales.
Foreign Currency Translation
The functional currency of Connetics' Australian subsidiary is the local
currency. The translation of the Australian currency into U.S. dollars is
performed for balance sheet accounts using the exchange rates in effect at the
balance sheet date and for revenue and expense accounts using a weighted average
exchange rate during the period. Foreign currency translation adjustments are
recorded in comprehensive income (loss).
Goodwill and Purchased Intangible Assets
Goodwill and purchased intangibles are amortized on a straight-line basis
over 10 year lives (see note 4).
We periodically perform reviews to determine if the carrying value of
assets is impaired. The reviews look for the existence of facts or
circumstances, either internal or external, which indicate that the carrying
value of the asset cannot be recovered. No such impairment has been indicated to
date. If in the future, management determines the existence of impairment
indicators, we would use undiscounted cash flows to initially determine whether
an impairment should be recognized. If necessary, we would perform subsequent
calculation to measure the amount of impairment loss based on the excess of the
carrying value over the fair value of the impaired assets. If quoted market
prices for the assets are not available, the fair value would be calculated
using the present value of estimated expected future cash flows or other
appropriate valuation methodologies. The cash flow calculation would be based on
management's best estimates, using appropriate assumptions and projections at
the time.
Recent Accounting Pronouncements
As of January 1, 2001, Connetics adopted Financial Accounting Standards
Board Statement No. 133, "Accounting for Derivative Instruments and Hedging
Activities."
As a result of the adoption of SFAS 133, we recognize derivative
financial instruments in our financial statements at their fair value,
regardless of the purpose or intent for holding the instrument. Changes in the
fair value of derivative financial instruments are either recognized
- 7 -
8
periodically in income or in stockholders' equity as a component of
comprehensive income (loss) depending on whether the derivative financial
instrument qualifies for hedge accounting, and if so, whether it qualifies as a
fair value hedge or cash flow hedge.
Connetics entered into a foreign exchange forward contract related to our
acquisition of Soltec. That contract was entered into in relation to a business
combination and does not qualify as a hedge under SFAS 133. The purpose of the
contract was to lock in to the purchase price paid for Soltec. As of the closing
date, April 20, 2001, we incurred a loss of $0.6 million on this contract. The
foreign exchange forward contract was terminated on the closing date of the
acquisition of Soltec.
In June 2001, the FASB issued Statement of Financial Accounting Standards
No. 141, Business Combinations ("SFAS 141"). SFAS 141 establishes new standards
for accounting and reporting for business combinations and will require that the
purchase method of accounting be used for all business combinations initiated
after June 30, 2001. We will adopt this statement in the third quarter of fiscal
2001.
In June 2001, the FASB issued Statement of Financial Accounting Standards
No. 142, Goodwill and Other Intangible Assets ("SFAS 142"), which establishes
new standards for goodwill and other intangible assets, including the
elimination of goodwill amortization, to be replaced with periodic evaluation of
goodwill for impairment. SFAS 142 is effective for fiscal years ending after
December 15, 2001, but any goodwill and intangible assets resulting from a
business combination after July 1, 2001 will be accounted for under SFAS 142.
Goodwill and intangible assets from business combination before July 1, 2001
will continue to be amortized prior to the adoption of SFAS 142.
Connetics will adopt SFAS 142 on January 1, 2002. Upon the adoption of
SFAS 142, we are required to evaluate our existing goodwill and intangibles
assets from business combinations completed before July 1, 2001 and make any
necessary reclassifications in order to comply with the new criteria in SFAS 141
for recognition of intangible assets.
At June 30, 2001, Connetics has goodwill and intangible assets of $14.4
million subject to SFAS 141 and SFAS 142. Amortization expense for goodwill and
intangible assets amounted to $0.4 million for the six months ended June 30,
2001. Due to the extensive efforts needed to comply with the adoption of SFAS
142, it is not practical to reasonably estimate the impact of adoption of theses
statements on our financial statements at the date of this report, including
whether any transitional impairment losses will be required to be recognized as
a cumulative effect of a change in accounting principle.
2. NET INCOME (LOSS) PER SHARE
We compute basic net income (loss) per common share using the weighted
average number of shares outstanding during the period. We compute diluted net
income per share using the weighted average of common and diluted equivalent
stock options and warrants outstanding during the period. We excluded all stock
option and warrants from the calculation of diluted loss
- 8 -
9
per common share for the six months ended June 30, 2001 because these securities
are anti-dilutive during this period. The following table sets forth the
computations for basic and diluted earnings per share.
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2001 2000 2001 2000
-------- -------- -------- --------
(In thousand, except per share amounts)
Numerator for basic and diluted earnings-
per share-
Net income (loss) $ (6,135) $ 567 $(11,023) $ (3,840)
Denominator for basic earnings per share
Weighted average shares 29,777 27,481 29,741 27,295
Effect of dilutive securities --
Stock options and warrants -- 1,223 -- 1,263
-------- -------- -------- --------
Denominator for diluted earnings per share 29,777 28,704 29,741 28,558
Net income (loss) per share:
Basic $ (0.21) $ .02 $ (0.37) $ (0.14)
======== ======== ======== ========
Diluted $ (0.21) $ .02 $ (0.37) $ (0.13)
======== ======== ======== ========
3. COMPREHENSIVE INCOME (LOSS)
During the three and six month periods ended June 30, 2001, total
comprehensive loss amounted to $4.0 million and $12.4 million, respectively,
compared to a comprehensive income of $22.7 million and $39.2 million for the
comparable periods in 2000. The components of comprehensive income (loss) for
the three and six month period ended June 30, 2001 and June 30, 2000 are as
follows:
Three months ended Six months ended
June 30, June 30,
----------------------- -----------------------
2001 2000 2001 2000
-------- -------- -------- --------
(In thousands)
Net income (loss) $ (6,135) $ 567 $(11,023) $ (3,840)
Cumulative translation adjustment (1) -- (1) --
Unrealized gain (loss) on securities 2,156 22,118 (1,412) 43,038
-------- -------- -------- --------
Comprehensive income (loss) $ (3,980) $ 22,685 $(12,436) $ 39,198
======== ======== ======== ========
4. ACQUISITION OF SOLTEC
In April 2001, Connetics completed its acquisition of Soltec, a division
of Australia-based F.H. Faulding & Co Limited. Connetics' two marketed
dermatology products and current product development programs are based on
technology developed by Soltec. The acquisition was accounted for using the
purchase method of accounting and accordingly, the purchase price was allocated
to the assets acquired and liabilities assumed based on their estimated fair
values on the acquisition date. Since April 19, 2001, Soltec's results of
operations have been included in the Connetics' consolidated statements of
operations. The fair value of the intangible assets was determined based upon an
independent valuation using a combination of methods, including an income
approach for the in-process research and development and existing technology, a
cost approach for the assembled workforce and the royalty savings approach for
the patents and core technology.
- 9 -
10
Connetics purchased all of the shares of Soltec's capital stock for a
purchase price of approximately $16.9 million. The purchase price was allocated,
based on an independent valuation, to goodwill of $6.4 million, patents and core
technology of $1.2 million, existing technology of $6.8 million, acquired
in-process research and development of $1.1 million, assembled workforce of $0.1
million and tangible net assets assumed of $1.3 million.
The value of the acquired in-process technology was computed using a
discounted cash flow analysis with a discount rate of 20% on the anticipated
income stream and the expected completion stage of the related product revenues.
The acquired in-process research and development programs are in early stages of
development, have not reached technological feasibility, and have no foreseeable
alternative future uses. The value of the existing technology was computed using
a discounted cash flow analysis with a discount rate of 15%. The discounted cash
flow analysis was based on management's forecast of future revenues, cost of
revenues and operating expenses related to the products and technologies
purchased from Soltec. Amortization of the acquired intangibles and goodwill
associated with this acquisition totaled $0.3 million for the three and six
months ended June 30, 2001.
The following unaudited pro forma results of operation are as if the
Soltec acquisition had been consummated as of January 1, 2000. The pro forma
information has been prepared for comparative purposes only and is not
indicative of what operating results would have been if the acquisition had
taken place at the beginning of fiscal 2000 or of future operating results.
Six months ended
June 30,
---------------------------
2001 2000
---------- ----------
(In thousands)
(Unaudited)
Pro forma revenue $ 17,947 $ 25,505
========== ==========
Pro forma income (loss) before cumulative effect of change in
accounting principle $ (8,775) $ 2,285
Cumulative effect of change in accounting principle -- $ (5,192)
---------- ----------
Pro forma net loss $ (8,775) $ (2,907)
========== ==========
BASIC PRO FORMA EARNINGS PER SHARE:
Pro forma income loss before cumulative effect of change in
accounting principle $ (0.30) $ 0.08
Cumulative effect of change in accounting principle -- $ (0.19)
========== ==========
Pro forma net loss per share $ (0.30) $ (0.11)
DILUTED PRO FORMA EARNINGS PER SHARE:
Pro forma income (loss) before cumulative effect of change in
accounting principle $ (0.30) $ 0.08
Cumulative effect of change in accounting principle -- $ (0.18)
========== ==========
Pro forma net loss per share $ (0.30) $ (0.10)
========== ==========
The pro forma income (loss) amounts shown above exclude the charge for
in-process research and development because of its non-recurring nature.
- 10 -
11
5. REDUCTION IN RELAXIN PROGRAM
In May 2001, Connetics announced its decision to pursue a license partner
or other strategic alternative for its relaxin program. As a result, Connetics
has reduced its investment in the development of relaxin in favor of focusing
its resources on expanding its dermatology business. During the second quarter,
Connetics reduced its workforce from 182 people to 155 people by eliminating
positions related to relaxin. Connetics took a one-time charge of approximately
$6.0 million in the second quarter of 2001, which represents $0.5 million
accrued in connection with the reduction in workforce as well as $5.5 million
for the wind down of relaxin development contracts.
Boehringer Ingelheim, or BIA, manufactures relaxin for us for clinical
uses under a long-term contract. In July 2000, in anticipation of successful
results in our relaxin clinical trial for scleroderma, we submitted a purchase
order to BIA for product to be used for commercial supply. The purchase order
was for a price to be negotiated. We have been in discussion with BIA since the
beginning of 2001 regarding whether any additional monies are owed under the
contract in view of the failure of the clinical trial. In July 2001, following
our May 2001 announcement about downsizing the relaxin program, BIA notified us
that BIA believes we are in breach of the relaxin manufacturing agreement and
that BIA intends to terminate the agreement and seek remedies if Connetics does
not remedy the alleged breach. We disagree with BIA's allegation that we have
breached the contract. Nevertheless, consistent with other reserves taken in
connection with the Company's downsizing of the relaxin program, we have
recorded a reserve for our estimate of our potential exposure in the dispute
with BIA. There can be no guarantee, however, that the actual resolution of this
dispute will not result in charges in excess of the reserve we have recorded.
6. SALE OF RIDAURA
In April 2001, Connetics sold its rights to Ridaura(R) including
inventory and identified liabilities to Prometheus Laboratories Inc. for $9.0
million in cash plus a royalty on annual sales in excess of $4.0 million for the
next five years. Ridaura(R) is a prescription pharmaceutical product for the
treatment of rheumatoid arthritis. Connetics accrued approximately $0.9 million
for transaction related costs and contractual liabilities incurred as of the
date of the sale. After recognizing the above amounts, Connetics recorded a gain
of $8.1 million on this transaction.
7. LICENSE OF LIQUIPATCH(TM) TECHNOLOGY
In June 2001, Connetics announced a global licensing agreement between
Soltec and a major international healthcare company for Soltec's innovative
Liquipatch multi-polymer gel delivery system. The agreement follows successful
pilot development work and gives the licensee exclusive global right to use the
Liquipatch technology in a field in dermatology, particularly for the delivery
of a topical over-the-counter product. The licensee will be responsible for all
development costs, and will be obligated to pay license fees, milestone
payments, and royalties on future product sales. As of June 30, 2001, there was
no financial statement impact as a result of this agreement.
- 11 -
12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
This MD&A should be read in conjunction with the MD&A included in our
Annual Report on Form 10-K for the year ended December 31, 2000, and with the
unaudited condensed consolidated financial statements and notes to financial
statements included in this report and in the report on Form 10-Q for the
quarter ended March 31, 2001. Except for historical information, the discussion
in this report contains forward-looking statements that involve risks and
uncertainties. When used in this report, the words "anticipate," "believe,"
"estimate," "will," "intend" and "expect" and similar expressions identify
forward-looking statements. Although we believe that our plans, intentions and
expectations reflected in these forward-looking statements are reasonable, these
plans, intentions, or expectations may not be achieved. Some of the factors
that, in our view, could cause actual results to differ are discussed under the
caption "Factors That May Affect Future Results, Financial Condition and the
Market Price of Securities" and in our 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 currently market two pharmaceutical products, OLUX(TM) Foam
(clobetasol propionate), 0.05% for the treatment of moderate to severe scalp
dermatoses, and Luxiq(R) (betamethasone valerate) Foam, 0.12%, for the treatment
of mild to moderate scalp dermatoses. We launched OLUX on November 6, 2000. Our
commercial business is focused on the dermatology marketplace, which is
characterized by a large patient population that is served by relatively small,
and therefore more accessible, groups of treating physicians. Our two
dermatology products have clinically proven therapeutic advantages and we
provide quality customer service to physicians through our experienced sales and
marketing staff. As we are now focusing on our dermatology business, we sold our
rights to Ridaura(R) including inventory to Prometheus Laboratories Inc. for
$9.0 million in cash plus a royalty on annual sales in excess of $4.0 million
for the next five years. Ridaura(R) is a prescription pharmaceutical product for
the treatment of rheumatoid arthritis.
In addition to our commercial business, we hold the rights to a
biotechnology product that has the potential to treat multiple diseases, a
recombinant form of a natural hormone called relaxin. Relaxin reduces the
hardening, or fibrosis, of skin and organ tissue, dilates existing blood vessels
and stimulates new blood vessel growth. On May 23, 2001, we announced our
decision to reduce our investment in the development of relaxin and to search
for licensing opportunities or other strategic alternatives for the product. We
reduced our work force from 182 people to 155 people by eliminating positions
related to relaxin. The one-time charge in the second quarter of 2001 represents
amounts accrued in connection with the reduction in workforce as well as a wind
down of relaxin development contracts. Boehringer Ingelheim, or BIA,
manufactures relaxin for us for clinical uses under a long-term contract. In
July 2000, in anticipation of successful results in our relaxin clinical trial
for scleroderma, we submitted a purchase order to BIA for product to be used for
commercial supply. The purchase order was for a price to be negotiated. We have
been in discussions with BIA since the beginning of 2001 regarding whether any
additional monies are owed under the contract in view of the failure of the
clinical trial. In July 2001, following our May 2001 announcement about
downsizing the relaxin program, BIA notified us that BIA believes we are in
breach of the relaxin manufacturing agreement and that BIA intends to terminate
the agreement and seek remedies if Connetics does not remedy the alleged breach.
We disagree with BIA's allegation that we have breached the contract.
Nevertheless, consistent with other reserves taken in connection with the
Company's downsizing of the relaxin program, we have recorded a reserve for our
estimate of our potential exposure in the dispute with BIA. There can be no
guarantee, however, that the actual resolution of this dispute will not result
in charges in excess of the reserve we have recorded.
In April 2001, we completed the acquisition of Soltec Research Pty Ltd, a
division of Australia-based F.H. Faulding & Co Limited for approximately $16.9
million. $1.1 million of the purchase price was allocated, based on an
independent valuation, to in-process research and development, with the balance
to the tangible assets of Soltec, existing technology and goodwill. Connetics'
two marketed dermatology products and current development programs are based on
technology developed by Soltec. Soltec has been developing innovative delivery
systems for new dermatology products for over 10 years, and has leveraged its
broad range of drug delivery technologies by entering into license agreements
with dermatology companies around the world. Those license agreements bear
royalties payable to Soltec for currently marketed products, as well as
potential future royalties for products under development.
- 12 -
13
RESULTS OF OPERATIONS
REVENUES
Three Months Ended Six Months Ended
June 30, June 30,
--------------------- --------------------
Revenues 2001 2000 2001 2000
------- ------- ------- -------
(In thousands)
Product:
Luxiq(R) $ 3,399 2,588 $ 7,294 $ 4,847
OLUX(TM) 3,184 -- 4,923 --
Ridaura (6) 1,064 2,015 2,715
Actimmune -- 141 -- 1,898
------- ------- ------- -------
Total product revenues 6,577 3,793 14,232 9,460
Contract and royalty:
Celltech 756 1,125 756 7,252
Suntory Ltd. -- 47 -- 93
F.H. Faulding & Co., Ltd. 20 25 39 25
Paladin Labs, Inc. 13 264 27 477
InterMune -- -- -- 1,500
Immune Response Corp. -- 50 -- 100
Other contract 74 -- 74 --
Royalty 123 -- 123 --
------- ------- ------- -------
Total contract & royalty revenues 986 1,511 1,019 9,447
------- ------- ------- -------
Sale of InterMune Revenue Rights -- 5,218 771 5,218
------- ------- ------- -------
Total revenues $ 7,563 $10,522 $16,022 $24,125
======= ======= ======= =======
Our product revenues for the three and six month periods ended June 30,
2001, were $6.6 million and $14.2 million, respectively, compared to $3.8
million and $9.5 million for the three and six months ended June 30, 2000. The
increase in total product revenues for the three and six months ended June 30,
2001 was due to continued sales growth of Luxiq and OLUX, which we began
marketing in April 1999 and November 2000, respectively, offset by lower sales
of Ridaura(R) and Actimmune. As part of the June 27, 2000 agreement with
InterMune, we did not record Actimmune sales beginning with the second quarter
of 2000. Ridaura sales, which were minimal, for April 2001 were netted with
chargebacks and returns resulting in a negative amount. As part of the April 30,
2001 sale agreement to Prometheus we did not record Ridaura sales beginning with
May 2001.
Contract and royalty revenues for the three and six month periods ended
June 30, 2001 was $1.0 million, compared to $1.5 million and $9.4 million for
the three and six months ended June 30, 2000. The decrease in total contract and
royalty revenue for the six month period ended June 30, 2001, is mainly due to
the receipt of a one-time license payment in the first quarter of 2000, a
milestone payment of $5.0 million in the first quarter of 2000 from a former
collaborative partner for relaxin, and $1.5 million paid by InterMune, for
Actimmune in the first quarter of 2000 in conjunction with our sublicense
agreement. We had no royalty revenue in 2000. We expect contract revenues to
fluctuate significantly depending on our remaining partners achieving milestones
under existing agreements, and on new business opportunities.
- 13 -
14
InterMune purchased the remaining United States commercial rights and
revenue to Actimmune on June 23, 2000. As part of the transaction, InterMune
paid $5.2 million in 2000 which included the prepayment of a $1.0 million
obligation owed in 2002. In March 2001 Intermune made a final payment on this
arrangement to Connetics in the amount $ 0.9 million which has been offset by
related rebates and chargebacks of $0.1 million.
Our cost of product revenues for 2001 includes the costs of Luxiq, OLUX
and Ridaura, royalty payments on these products based on a percentage of our
product revenues, and product freight and distribution costs from our
distributor. We recorded cost of product revenues of $0.6 million and $1.7
million, respectively, for the three and six months ended June 30, 2001,
compared to $0.5 million and $2.3 million, respectively, for the three and six
months ended June 30, 2001. The cost of product revenues for the first six
months of 2001 decreased compared to the first six months of 2000 primarily
because in 2001 We did not recognize Actimmune revenue and its associated cost
of sales under the revenue rights agreement, and did not recognize Ridaura
revenue and its associated cost of sales following the sale of Ridaura(R) in
April 2001.
RESEARCH AND DEVELOPMENT
Research and development expenses were $5.6 million and $10.0 million for
the three month and six month periods ended June 30, 2001, compared to $4.0 and
$10.1 million for the comparable periods in 2000. The increase in expenses for
the three months ended June 30, 2001 was due to increased dermatology product
development activity.
We expect research and development expenses to remain consistent over the
next few quarters. In May 2001, Connetics announced its decision to pursue a
license partner or other strategic alternative for its Relaxin program. As a
result, we have reduced our investment in the development of Relaxin in favor of
focusing our resources on expanding our dermatology business. The reduction in
expenses related to relaxin clinical work, manufacturing and overhead, will be
offset by the increase in expenditures for dermatology research, development and
marketing.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES
Selling, general and administrative expenses were $9.7 million and $17.3
million for the three and six month periods June 30, 2001, compared to $6.0
million and $11.6 million for the comparable periods in 2000. The increase in
expenses was due to increased headcount and increased market research and sales
promotions costs related to the OLUX launch, a one-time non-cash compensation
charge, as well as the amortization of intangibles associated with the
acquisition of Soltec. We expect selling, general and administrative expenses to
remain consistent or be slightly lower due to non-recurring charges incurred in
the second quarter of 2001.
ACQUIRED IN-PROCESS RESEARCH AND DEVELOPMENT
We recorded a charge of $1.1 million for acquired in-process research and
development associated with the acquisition of Soltec, during the three month
period ended June 30, 2001.
Acquired in-process research and development consists of several
projects which involve the use of novel technologies to improve the delivery of
drugs. Several of these projects are being developed in connection with other
companies who own rights to the drugs. We may earn milestone and other fees
under these arrangements and, if the drugs are successfully developed, will be
entitled to royalties based on net sales. The projects are in various stages of
development and are subject to substantial risks. We currently estimate that
completion of the first projects will occur in the period from 2001 to 2002 and
we expect to incur research and development expenses of up to $1.4 million,
assuming all drugs are successfully developed (before considering any research
funding from our partners). The value of the in-process research and
development was determined by an independent valuation expert using a
discounted cash flow analysis with a rate of 20%. In addition, the stage of
completion of each project was considered in determining the value.
There is no assurance that the projects will meet either technological or
commercial success. The products under development have no foreseeable
alternative future use. The estimates used by Connetics in valuing in-process
research and development were based on assumptions we believe to be reasonable,
but which are inherently uncertain and unpredictable. Our assumption may be
incomplete or inaccurate, and no assurance can be given that unanticipated
events and circumstances will not occur. Accordingly, actual results may vary
from the results projected for purposes of determining the fair value of the
acquired in-process research and development.
- 14 -
15
CHARGE FOR RELAXIN PROGRAM
During the three month period ended June 30, 2001, we recorded a
one-time charge of $6.0 million, related to the relaxin program following our
May 2001 decision to strategically reduce the program. The charge included
amounts related to severance and costs associated with winding down contracts.
INTEREST INCOME (EXPENSE)
Interest and other income were $1.5 million and $2.5 million for the
three month and six month periods ended June 30, 2001, compared with $0.3
million and $0.6 million for the comparable periods in 2000. The increase in
interest income was due to higher cash and short-term investment balances for
the period ended June 30, 2001 compared to the same period in 2000.
Additionally, there was an increase in other income, which was primarily related
to a gain in the second quarter of 2001 of $0.8 million on the foreign exchange
forward contract that was entered into in February 2001 in connection with the
Soltec acquisition. The gain on this foreign exchange forward contract in the
second quarter of 2001 was the result of an improvement of relative exchange
rates between the first and second quarters of 2001. During the first quarter of
2001 a loss on this same contract of $1.4 million had been recorded and included
in other expense in that quarter. This loss accounted for the majority of the
increase in interest and other expense for the six months ended June 30, 2001
compared to the same period in 2000.
NET LOSS
We expect to incur losses for the remainder of 2001 and the foreseeable
future. These losses are expected to fluctuate from period to period based on
timing of product revenues, sales and marketing expenses, clinical material
purchases, clinical trial expenses, and possible acquisitions of new products
and technologies.
- 15 -
16
LIQUIDITY AND CAPITAL RESOURCES
We have financed our operations to date primarily through proceeds from
equity financings, collaborative arrangements with corporate partners and bank
loans. At June 30, 2001, cash, cash equivalents and short-term investments
totaled $55.8 million compared to $80.2 million at December 31, 2000. Our
investments are held in a variety of interest-bearing instruments including
high-grade corporate bonds, commercial paper and money market accounts.
Cash flows from operating activities. Cash used in operations for the six
month period ended June 30, 2001 and 2000, was $15.3 million and $3.2 million,
respectively. Net loss of $11.0 million for the first six months of 2001 was
affected by non-cash charges of $0.7 million of depreciation and amortization
expense and $0.6 million in other expense related to the Soltec foreign exchange
forward contract, a one time in-process research and development charge of $1.1
million related to the Soltec acquisition, a one-time $6.0 million charge
related to the reduction in the relaxin program, and a compensation charge in
the amount of $1.1 million, partially offset by the $8.1 million gain on the
sale of Ridaura(R).
Cash flows from investing activities. Investing activities used $31.3
million in cash during the six month period ended June 30, 2001, due in part to
sales of $12.5 million of short-term investments offset by $35.8 million of
short term investment purchases, as well as the acquisition of Soltec in the
amount of $16.6 (net of cash acquired), which is partially offset by the
proceeds from the sale of Ridaura in the amount of $9.0 million.
Cash flows from financing activities. Cash provided by financing
activities of $0.1 million for the six months ended June 30, 2001 included a
$0.8 million bank loan payment, offset by $0.9 million in proceeds from issuance
of common stock.
Working Capital. Working capital decreased by $25.0 million to $46.0
million at June 30, 2001 from $71.0 million at December 31, 2000. The decrease
in working capital was due to use of our cash in operations, payment of debt
obligations, and the acquisition of Soltec, which was partially offset by the
sale of Ridaura.
We believe our existing cash, cash equivalents and short-term investments
generated from product sales and collaborative arrangements with corporate
partners, will be sufficient to fund our operating expenses, debt obligations
and capital requirements through at least the next 12 months.
FACTORS THAT MAY AFFECT FUTURE RESULTS, FINANCIAL CONDITION AND THE MARKET PRICE
OF SECURITIES
Please also read Item 1 in our 2000 Annual Report on Form 10-K where we
have described our business and the challenges and risks we may face in the
future.
Our results of operation have varied widely in the past, and they could
continue to vary significantly from quarter to quarter due to a number of
factors, including those listed below. Any shortfall in revenues would have an
immediate impact on our earnings per share, which could adversely affect the
market price of our common stock. Our operating expenses, which include sales
and marketing, research and development and general and administrative expenses,
are based on our expectations of future revenues and are relatively fixed in the
short term. Accordingly, if revenues fall below our expectations, we will not be
able to reduce our spending
- 16 -
17
rapidly in response to such a shortfall. Due to the foregoing factors, we
believe that quarter-to-quarter comparisons of our results of operations are not
a good indication of our future performance.
RISKS RELATED TO OUR BUSINESS
We incurred losses in every year since inception, except for fiscal year 2000.
If we do not achieve profitability, stockholders may lose their investment.
Except for fiscal year 2000, we have lost money every year since our
inception. We had net losses of $27.3 million in 1999 and net income of $27.0
million in 2000. If we exclude a gain of $43.0 million on sales of stock we held
in InterMune, and the associated income tax, our net loss for 2000 would have
been $15.0 million. We had a net loss of $11.0 million for the six months ended
June 30, 2001. Our accumulated deficit was $103.8 million at June 30, 2001. We
may incur additional losses during the next few years. If we do not achieve and
maintain profitability, our stock price may decline.
If we do not obtain the capital necessary to fund our operations, we will be
unable to develop or market our products.
We currently believe that our available cash resources will be sufficient
to fund our operating and working capital requirements for the next 18 months.
If in the future, our product revenue does not continue to grow or we are unable
to raise additional funds when needed, we may not be able to market our products
as planned or continue development of our other products.
If we fail to protect our proprietary rights, competitors may be able to use our
technologies, which would weaken our competitive position, reduce our revenues
and increase our costs.
Our commercial success depends in part on our ability and the ability of
our licensors to protect our technology and processes. The foam technology used
in our Luxiq(R) and OLUX(TM) products is covered by one issued patent.
We are pursuing several U. S. and foreign patent applications, although
we cannot be sure that any of these patents will ever be issued. We and Soltec
also have acquired rights under certain patents and patent applications in
connection with our licenses to distribute products and from the assignment of
rights to patents and patent applications from certain of our consultants and
officers. These patents and patent applications may be subject to claims of
rights by third parties. If there are conflicting claims to the same patent or
patent application, we may not prevail and, even if we do have some rights in a
patent or application, those rights may not be sufficient for the marketing and
distribution of products covered by the patent or application.
The patents and applications in which we have an interest may be
challenged as to their validity or enforceability. Challenges may result in
potentially significant harm to our business. The cost of responding to these
challenges and the inherent costs to defend the validity of our patents,
including the prosecution of infringements and the related litigation, could be
substantial whether or not we are successful. Such litigation also could require
a substantial commitment of management's time. A judgment adverse to us in any
patent interference, litigation or other proceeding arising in connection with
these patent applications could materially harm our business.
- 17 -
18
The ownership of a patent or an interest in a patent does not always
provide significant protection. Others may independently develop similar
technologies or design around the patented aspects of our technology. We only
conduct patent searches to determine whether our products infringe upon any
existing patents, when we think such searches are appropriate. If we are
unsuccessful in any challenge to the marketing and sale of our products or
technologies, we may be required to license the disputed rights, if the holder
of those rights is willing, or to cease marketing the challenged products, or to
modify our products to avoid infringing upon those rights. Under these
circumstances, we may not be able to obtain a license to such intellectual
property on favorable terms, if at all. We may not succeed in any attempt to
redesign our products or processes to avoid infringement.
Our current product revenue will not cover the cost of fully developing and
commercializing new products.
Product revenue from sales of our marketed products does not currently
cover the full cost of developing products in our pipeline. Historically, we
have depended on licensing agreements with our corporate partners to
successfully develop and commercialize our products. We also generate revenue by
licensing our products to third parties for specific territories and
indications. Our reliance on licensing arrangements with third parties carries
several risks, including the possibilities that:
- a product development contract may expire or a relationship may be
terminated, and we will not be able to attract a satisfactory
alternative corporate partner within a reasonable time;
- we may be contractually bound to terms that, in the future, are
not commercially favorable to us; and
- royalties generated from licensing arrangements may be
insignificant.
If any of these risks occurs, we may not be able to successfully develop our
products.
If we do not successfully partner or commercialize relaxin, we will lose
fundamental intellectual property rights to the product.
Licenses with Genentech, Inc. and The Howard Florey Institute of
Experimental Physiology and Medicine require us to use our best efforts to
commercialize relaxin. If we fail to successfully commercialize relaxin, our
rights under these licenses may revert to Genentech and the Florey Institute.
The termination of these agreements and subsequent reversion of rights could
prevent us from leveraging our additional patents and know-how by securing a
partnership arrangement for the relaxin program.
We are subject to foreign exchange risks which may increase our operational
expenses.
We make payments to Miza Pharmaceuticals for the production of Luxiq and
OLUX in pounds sterling. If the U.S. dollar depreciates against the pound, the
payments that we must make will increase, which will increase our expenses. We
do not currently hedge our foreign currency exposure related to our agreement
with Miza.
- 18 -
19
We rely on our employees and consultants to keep our trade secrets confidential.
We rely on trade secrets and unpatented proprietary know-how and
continuing technological innovation in developing and manufacturing our
products. We require each of our and Soltec's employees, consultants and
advisors to enter into confidentiality agreements prohibiting them from taking
our proprietary information and technology or from using or disclosing
proprietary information to third parties except in specified circumstances. The
agreements also provide that all inventions conceived by an employee, consultant
or advisor, to the extent appropriate for the services provided during the
course of the relationship, shall be our exclusive property, other than
inventions unrelated to us and developed entirely on the individual's own time.
Nevertheless, these agreements may not provide meaningful protection of our
trade secrets and proprietary know-how if they are used or disclosed. Despite
all of the precautions we may take, people who are not parties to
confidentiality agreements may obtain access to our trade secrets or know-how.
In addition, others may independently develop similar or equivalent trade
secrets or know-how.
Our use of hazardous materials exposes us to the risk of environmental
liabilities, and we may incur substantial additional costs to comply with
environmental laws.
Our research and development activities involve the controlled use of
hazardous materials, chemicals and various radioactive materials. We are subject
to laws and regulations governing the use, storage, handling and disposal of
these materials and certain waste products. In the event of accidental
contamination or injury from these materials, we could be liable for any damages
that result and any liability could exceed our resources. We may also be
required to incur significant costs to comply with environmental laws and
regulations as our research activities increase.
RISKS RELATED TO OUR PRODUCTS
Manufacturing difficulties could delay commercialization of our products or
future revenues from product sales.
We depend on third parties to manufacture our products, and each product
is manufactured by a sole source manufacturer. Currently, Miza Pharmaceuticals
is our sole source manufacturers for Luxiq and OLUX. All of our contractors must
comply with the applicable FDA good manufacturing practice regulations, which
include quality control and quality assurance requirements as well as the
corresponding maintenance of records and documentation. Manufacturing facilities
are subject to ongoing periodic inspection by the FDA and corresponding state
agencies, including unannounced inspections, and must be licensed before they
can be used in commercial manufacturing of our products. If our sole source
manufacturers cannot provide us with our product requirements in a timely and
cost-effective manner, if the product they are able to supply cannot meet
commercial requirements for shelf life, or if they are not able to comply with
the applicable good manufacturing practice regulations and other FDA regulatory
requirements, our sales of marketed products could be reduced and we could
suffer delays in the progress of clinical trials for products under development.
We do not have control over our third-party manufacturers' compliance with these
regulations and standards. In addition, any commercial dispute with any of our
sole source suppliers could result in delays in the manufacture of product, and
affect our ability to commercialize our products.
- 19 -
20
\
If we are unable to contract with third parties to manufacture and distribute
our products in sufficient quantities, on a timely basis, or at an acceptable
cost, we may be unable to meet demand for our products and may lose potential
revenues.
We have no manufacturing or distribution facilities for any of our
products. Instead, we contract with third parties to manufacture our products
for us. We have manufacturing agreements with the following companies:
- Miza Pharmaceuticals, a U.K. corporation, for Luxiq and OLUX; and
- Boehringer Ingelheim Austria GmbH for relaxin.
Boehringer Ingelheim, or BIA, manufactures relaxin for us for clinical
uses under a long-term contract. In July 2000, in anticipation of successful
results in our relaxin clinical trial for scleroderma, we submitted a purchase
order to BIA for product to be used for commercial supply. The purchase order
was for a price to be negotiated. We have been in discussions with BIA since the
beginning of 2001 regarding whether any additional monies are owed under the
contract in view of the failure of the clinical trial. In July 2001, following
our May 2001 announcement about downsizing the relaxin program, BIA notified us
that BIA believes we are in breach of the relaxin manufacturing agreement and
that BIA intends to terminate the agreement and seek remedies if Connetics does
not remedy the alleged breach. We disagree with BIA's allegation that we have
breached the contract. Nevertheless, consistent with other reserves taken in
connection with the Company's downsizing of the relaxin program, we have
recorded a reserve for our estimate of our potential exposure in the dispute
with BIA. There can be no guarantee, however, that the actual resolution of this
dispute will not result in charges in excess of the reserve we have recorded.
Typically, these manufacturing contracts are short-term. We are dependent
upon renewing agreements with our existing manufacturers or finding replacement
manufacturers to satisfy our requirements. As a result, we cannot be certain
that manufacturing sources will continue to be available or that we can continue
to out-source the manufacturing of our products on reasonable or acceptable
terms.
Any loss of a manufacturer or any difficulties, which could arise in the
manufacturing process, could significantly affect our inventories and supply of
products available for sale. If we are unable to supply sufficient amounts of
our products on a timely basis, our market share could decrease and,
correspondingly, our profitability could decrease.
If our contract manufacturers fail to comply with cGMP regulations, we may be
unable to meet demand for our products and may lose potential revenue.
The FDA requires that all manufacturers used by pharmaceutical companies
comply with the FDA's regulations, including those cGMP regulations applicable
to manufacturing processes. The cGMP validation of a new facility and the
approval of that manufacturer for a new drug product may take a year or more
before manufacture can begin at the facility. Delays in obtaining FDA validation
of a replacement manufacturing facility could cause an interruption in the
supply of our products. Although we have business interruption insurance
covering the loss of income for up to $8.0 million, which may mitigate the harm
to our business from the interruption of the manufacturing of products caused by
certain events, the loss of a manufacturer could still have a negative effect on
our sales, margins and market share, as well as our overall business and
financial results.
If our supply of finished products is interrupted, our ability to maintain our
inventory levels could suffer.
We try to maintain inventory levels that are no greater than necessary to
meet our current projections. Any interruption in the supply of finished
products could hinder our ability to timely distribute finished products. If we
are unable to obtain adequate product supplies to satisfy our customers' orders,
we may lose those orders and our customers may cancel other orders and stock and
sell competing products. This in turn could cause a loss of our market share and
negatively affect our revenues.
We cannot be certain that supply interruptions will not occur or that our
inventory will always be adequate. Numerous factors could cause interruptions in
the supply of our finished products
- 20 -
21
including shortages in raw material required by our manufacturers, changes in
our sources for manufacturing, our failure to timely locate and obtain
replacement manufacturers as needed and conditions effecting the cost and
availability of raw materials.
If we do not obtain and maintain governmental approvals for our products, we
cannot sell these products for their intended diseases.
Pharmaceutical companies are subject to heavy regulation by a number of
national, state and local agencies. Of particular importance is the FDA in the
United States. It has jurisdiction over all of our business and administers
requirements covering testing, manufacture, safety, effectiveness, labeling,
storage, record keeping, approval, advertising and promotion of our products.
Failure to comply with applicable regulatory requirements could, among other
things, result in fines; suspensions of regulatory approvals of products;
product recalls; delays in product distribution, marketing and sale; and civil
or criminal sanctions.
The process of obtaining and maintaining regulatory approvals for
pharmaceutical and biological drug products, and obtaining and maintaining
regulatory approvals to market these products for new indications, is lengthy,
expensive and uncertain. The manufacturing and marketing of drugs are subject to
continuing FDA and foreign regulatory review, and later discovery of previously
unknown problems with a product, manufacturing process or facility may result in
restrictions, including withdrawal of the product from the market. Our products
receive FDA review regarding their safety and effectiveness. However, the FDA is
permitted to revisit and change its prior determinations and we cannot be sure
that the FDA will not change its position with regard to the safety or
effectiveness of our products. If the FDA's position changes, we may be required
to change our labeling or formulations, or cease to manufacture and market the
challenged products. Even before any formal regulatory action, we could
voluntarily decide to cease distribution and sale or recall any of our products
if concerns about the safety or effectiveness develop.
To market our products in countries outside of the United States, we and
our partners must obtain similar approvals from foreign regulatory bodies. The
foreign regulatory approval process includes all of the risks associated with
obtaining FDA approval, and approval by the FDA does not ensure approval by the
regulatory authorities of any other country. The process of obtaining these
approvals is time consuming and requires the expenditure of substantial
resources.
In recent years, various legislative proposals have been offered in
Congress and in some state legislatures that include major changes in the health
care system. These proposals have included price or patient reimbursement
constraints on medicines and restrictions on access to certain products. We
cannot predict the outcome of such initiatives, and it is difficult to predict
the future impact of the broad and expanding legislative and regulatory
requirements affecting us.
We may spend a significant amount of money to obtain FDA and other regulatory
approvals, which may never be granted.
The process of obtaining FDA and other regulatory approvals is lengthy
and expensive. To obtain approval, we must show in preclinical and clinical
trials that our products are safe and effective, and the marketing and
manufacturing of pharmaceutical products are subject to rigorous testing
procedures. The FDA approval processes require substantial time and effort, the
FDA continues to modify product development guidelines, and the FDA may not
grant approval on a timely basis or at all. Clinical trial data can be the
subject of differing interpretation, and the
- 21 -
22
FDA has substantial discretion in the approval process. The FDA may not
interpret our clinical data the way we do. The FDA may also require additional
clinical data to support approval. The FDA can take between one and two years to
review new drug applications and biologics license applications, or longer if
significant questions arise during the review process. We may not be able to
obtain FDA approval to conduct clinical trials or to manufacture and market any
of the products we develop, acquire or license. Moreover, the costs to obtain
approvals could be considerable and the failure to obtain or delays in obtaining
an approval could have a significant negative effect on our business performance
and financial results. Even if we obtain approval from the FDA, the FDA is
authorized to impose post-marketing requirements such as:
- testing and surveillance to monitor the product and its continued
compliance with regulatory requirements;
- submitting products for inspection and, if any inspection reveals
that the product is not in compliance, the prohibition of the sale
of all products from the same lot;
- suspending manufacturing;
- recalling products; and
- withdrawing marketing clearance.
In its regulation of advertising, the FDA from time to time issues
correspondence to pharmaceutical companies alleging that some advertising or
promotional practices are false, misleading or deceptive. The FDA has the power
to impose a wide array of sanctions on companies for such advertising practices,
and the receipt of correspondence from the FDA alleging these practices can
result in the following:
- incurring substantial expenses, including fines, penalties, legal
fees and costs to comply with the FDA's requirements;
- changes in the methods of marketing and selling products;
- taking FDA-mandated corrective action, which may include placing
advertisements or sending letters to physicians rescinding
previous advertisements or promotion; and
- disruption in the distribution of products and loss of sales until
compliance with the FDA's position is obtained.
If Luxiq and OLUX do not achieve or sustain market acceptance, our revenues will
not increase and may not cover our operating expenses.
Our future revenues will depend upon dermatologist and patient acceptance
of Luxiq and OLUX. Factors that could affect acceptance of Luxiq and OLUX
include:
- satisfaction with existing alternative therapies;
- the effectiveness of our sales and marketing efforts;
- undesirable and unforeseeable side effects; and
- 22 -
23
- the cost of the product as compared with alternative therapies.
Since we have only had approval to sell Luxiq for two years, and we only
began selling OLUX in November 2000, we cannot predict the potential long-term
patient acceptance of either product.
We rely on third parties to conduct clinical trials for our products, and those
third parties may not perform satisfactorily.
We do not have the ability to independently conduct clinical studies, and
we rely on third parties to perform this function. If these third parties do not
perform satisfactorily, we may not be able to locate acceptable replacements or
enter into favorable agreements with them, if at all. If we are unable to rely
on clinical data collected by others, we could be required to repeat clinical
trials, which could significantly delay commercialization and require
significantly greater capital.
If we are unable to develop new products, our expenses may increase without any
immediate return on the investment.
We currently have a variety of new products in various stages of research
and development and are working on possible improvements, extensions and
reformulations of some existing products. These research and development
activities, as well as the clinical testing and regulatory approval process,
which must be completed before commercial quantities of these developments can
be sold, will require significant commitments of personnel and financial
resources. Delays in the research, development, testing or approval processes
will cause a corresponding delay in revenue generation from those products.
Regardless of whether they are ever released to the market, the expense of such
processes will have already been incurred.
We reevaluate our research and development efforts regularly to assess
whether our efforts to develop a particular product or technology are
progressing at a rate that justifies our continued expenditures. On the basis of
these reevaluations, we have abandoned in the past, and may abandon in the
future, our efforts on a particular product or technology. There can be no
certainty that any product we are researching or developing will ever be
successfully released to the market. If we fail to take a product or technology
from the development stage to market on a timely basis, we may incur significant
expenses without a near-term financial return.
If we do not successfully integrate new products, we may not be able to sustain
revenue growth and we may not be able to compete effectively.
When we acquire or develop new products and product lines, we must be
able to integrate those products and product lines into our systems for
marketing, sales and distribution. If these products or product lines are not
integrated successfully, the potential for growth is limited. The new products
we acquire or develop could have channels of distribution, competition, price
limitations or marketing acceptance different from our current products. As a
result, we do not know whether we will be able to compete effectively and obtain
market acceptance in any new product categories. After acquiring or developing a
new product, we may need to significantly increase our sales force and incur
additional marketing, distribution and other operational expenses. These
additional expenses could negatively affect our gross margins and operating
results. In addition, many of these expenses could be incurred prior to the
actual distribution of new products. Because of this timing, if the new products
are not accepted by the market or if
- 23 -
24
they are not competitive with similar products distributed by others, the
ultimate success of the acquisition or development could be substantially
diminished.
RISKS RELATED TO OUR INDUSTRY
We face intense competition, which may limit our commercial opportunities and
our ability to become profitable.
The pharmaceutical industry is highly competitive. Competition in our
industry occurs on a variety of fronts, including developing and bringing new
products to market before others, developing new technologies to improve
existing products, developing new products to provide the same benefits as
existing products at less cost and developing new products to provide benefits
superior to those of existing products.
Most of our competitors are large, well-established companies in the
fields of pharmaceuticals and health care. Many of these companies have
substantially greater financial, technical and human resources than we have to
devote to marketing, sales, research and development and acquisitions. Some of
these competitors have more collective experience than we do in undertaking
preclinical testing and human clinical trials of new pharmaceutical products and
obtaining regulatory approvals for therapeutic products. As a result, they have
a greater ability to undertake more extensive research and development,
marketing and pricing policy programs. It is possible that our competitors may
develop new or improved products to treat the same conditions as our products
treat or make technological advances reducing their cost of production so that
they may engage in price competition through aggressive pricing policies to
secure a greater market share to our detriment. Our commercial opportunities
will be reduced or eliminated if our competitors develop and market products
that are more effective, have fewer or less severe adverse side effects or are
less expensive than our products. These competitors also may develop products
that make our current or future products obsolete. Any of these events could
have a significant negative impact on our business and financial results,
including reductions in our market share and gross margins.
Physicians may not adopt our products over competing products, and our
products may not offer an economically feasible alternative to existing modes of
therapy.
Our products compete with generic pharmaceuticals, which claim to offer
equivalent benefit at a lower cost. In some cases, insurers and other health
care payment organizations try to encourage the use of these less expensive
generic brands through their prescription benefits coverages and reimbursement
policies. These organizations may make the generic alternative more attractive
to the patient by providing different amounts of reimbursement so that the net
cost of the generic product to the patient is less than the net cost of our
prescription brand product. Aggressive pricing policies by our generic product
competitors and the prescription benefits policies of insurers could cause us to
lose market share or force us to reduce our margins in response.
If third party payors will not provide coverage or reimburse patients for the
use of our products, our revenues and profitability will suffer.
Our products' commercial success is substantially dependent on whether
third-party reimbursement is available for the use of our products by hospitals,
clinics and doctors.
- 24 -
25
Medicare, Medicaid, health maintenance organizations and other third-party
payors may not authorize or otherwise budget for the reimbursement of our
products. In addition, they may not view our products as cost-effective and
reimbursement may not be available to consumers or may not be sufficient to
allow our products to be marketed on a competitive basis. Likewise, legislative
proposals to reform health care or reduce government programs could result in
lower prices for or rejection of our products. Changes in reimbursement policies
or health care cost containment initiatives that limit or restrict reimbursement
for our products may cause our revenues to decline.
If managed care organizations and other third-party reimbursement policies do
not cover our products, we may not increase our market share and our revenues
and profitability will suffer.
Our operating results and business success depends in large part on the
availability of adequate third-party payor reimbursement to patients for our
prescription-brand products. These third-party payors include governmental
entities (such as Medicaid), private health insurers and managed care
organizations. Over 70% of the U.S. population now participates in some version
of managed care. Because of the size of the patient population covered by
managed care organizations, marketing of prescription drugs to them and the
pharmacy benefit managers that serve many of these organizations has become
important to our business. Managed care organizations and other third-party
payors try to negotiate the pricing of medical services and products to control
their costs. Managed care organizations and pharmacy benefit managers typically
develop formularies to reduce their cost for medications. Formularies can be
based on the prices and therapeutic benefits of the available products. Due to
their lower costs, generics are often favored. The breadth of the products
covered by formularies varies considerably from one managed care organization to
another, and many formularies include alternative and competitive products for
treatment of particular medical conditions. Exclusion of a product from a
formulary can lead to its sharply reduced usage in the managed care organization
patient population. Payment or reimbursement of only a portion of the cost of
our prescription products could make our products less attractive, from a
net-cost perspective, to patients, suppliers and prescribing physicians. We
cannot be certain that the reimbursement policies of these entities will be
adequate for our products to compete on a price basis. If our products are not
included within an adequate number of formularies or adequate reimbursement
levels are not provided, or if those policies increasingly favor generic
products, our market share and gross margins could be negatively affected, as
could our overall business and financial condition.
If product liability lawsuits are brought against us, we may incur substantial
costs.
Our industry faces an inherent risk of product liability claims from
allegations that our products resulted in adverse effects to the patient or
others. These risks exist even with respect to those products that are approved
for commercial sale by the FDA and manufactured in facilities licensed and
regulated by the FDA. Our insurance may not provide adequate coverage against
potential product liability claims or losses. We also cannot be certain that our
current coverage will continue to be available in the future on reasonable
terms, if at all. Even if we are ultimately successful in product liability
litigation, the litigation would consume substantial amounts of our financial
and managerial resources, and might create adverse publicity, all of which would
impair our ability to generate sales. If we were found liable for any product
liability claims in excess of our coverage or outside of our coverage, the cost
and expense of such liability could severely damage our business, financial
condition and profitability.
- 25 -
26
RISKS RELATED TO OUR STOCK
Our stock price is volatile and the value of your investment in our stock could
decline in value.
The market prices for securities of specialty pharmaceutical companies
like our company have been and are likely to continue to be highly volatile. As
a result, investors in these companies often buy at very high prices only to see
the price drop substantially a short time later, resulting in an extreme drop in
value in the stock holdings of these investors. In addition, the volatility
could result in securities class action litigation. Any litigation would likely
result in substantial costs, and divert our management's attention and
resources. Our charter documents and Delaware law contain provisions that could
delay or prevent an acquisition of us, even if the acquisition would be
beneficial to our stockholders.
Our certificate of incorporation authorizes our board of directors to
issue undesignated preferred stock and to determine the rights, preferences,
privileges and restrictions of the preferred stock without further vote or
action by our stockholders. The issuance of preferred stock could make it more
difficult for third parties to acquire a majority of our outstanding voting
stock. We also have a stockholder rights plan, which entitles existing
stockholders to rights, including the right to purchase shares of preferred
stock, in the event of an acquisition of 15% or more of our outstanding common
stock, or an unsolicited tender offer for such shares. The existence of the
rights plan could delay, prevent, or make more difficult a merger or tender
offer or proxy contest involving us. Other provisions of Delaware law and of our
charter documents, including a provision eliminating the ability of stockholders
to take actions by written consent, could also delay or make difficult a merger,
tender offer or proxy contest involving us. Further, our stock option and
purchase plans generally provide for the assumption of such plans or
substitution of an equivalent option of a successor corporation or,
alternatively, at the discretion of the board of directors, exercise of some or
all of the option stock, including non-vested shares, or acceleration of vesting
of shares issued pursuant to stock grants, upon a change of control or similar
event.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
There have been no material changes in the reported market risks since
December 31, 2000 except for the foreign currency exchange risk related to the
foreign currency exchange contract Connetics entered into during the quarter
ended March 31, 2001. The contract was cancelled in April 2001 in conjunction
with the acquisition of Soltec.
- 26 -
27
PART II. OTHER INFORMATION
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
On May 17, 2001, we held our annual meeting of stockholders. At the
meeting, the stockholders approved the following matters by the following votes:
1) Election of the following directors:
FOR WITHHELD
Alexander E. Barkas, MD 23,918,656 168,842
Eugene Bauer, MD 20,321,552 3,765,946
John C. Kane 23,921,757 165,741
Thomas D. Kiley 23,918,457 169,041
Glenn A. Oclassen 23,924,157 163,341
Leon E. Panetta 23,917,176 170,322
G. Kirk Raab 23,621,842 465,656
Thomas G. Wiggans 23,109,248 978,250
2) Approval of Amendment to the 1995 Directors' Stock Option Plan
FOR AGAINST ABSTAIN
23,323,241 704,493 58,764
3) Ratification of the appointment of Ernst & Young LLP to serve as
the Company's independent auditors for the fiscal year ended
December 31, 2001
FOR AGAINST ABSTAIN
24,011,333 40,611 35,554
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits. None
(b) Reports on Form 8-K.
We filed the following Current Reports on Form 8-K during the quarter
ended June 30, 2001:
(i) We filed a Current Report on Form 8-K dated March 20, 2001, with
the Securities and Exchange Commission on April 2, 2001, under
Item 5. Other Events, and Item 7. Exhibits
(ii) We filed a Current Report on Form 8-K dated April 10, 2001, with
the Securities and Exchange Commission on May 4, 2001, under Item
2. Acquisition of Disposition of Assets, and Item 7. Financial
Statements, Pro Forma Financial Information and Exhibits.
- 27 -
28
(iii) We filed a Current Report on Form 8-K dated April 30, 2001, with
the Securities and Exchange Commission on May 11, 2001, under Item
2. Acquisition or Disposition of Assets, and Item 7. Financial
Statements, Pro Forma Financial Information and Exhibits.
(iv) We filed a Current Report on Form 8-K dated May 23, 2001, with the
Securities and Exchange Commission on May 23, 2001, under Item 5.
Other Events, and Item 7. Exhibits.
- 28 -
29
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
Exec. Vice President, Finance
and Administration
and Chief Financial Officer
Date: August 14, 2001
- 29 -