incy_Current folio_10Q

Table of Contents

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended September 30, 2016

 

or

 

TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from             to            

 

Commission File Number: 001-12400

 

INCYTE CORPORATION

(Exact name of registrant as specified in its charter)

 

 

 

 

Delaware

 

94-3136539

(State or other jurisdiction of
incorporation or organization)

 

(IRS Employer
Identification No.)

 

 

 

1801 Augustine Cut-Off

Wilmington, DE  19803

 

19803

(Address of principal executive offices)

 

(Zip Code)

 

(302) 498-6700

(Registrant’s telephone number, including area code)

 

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  ☒ Yes  ☐ No

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  ☒ Yes  ☐ No

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.

 

 

 

 

Large accelerated filer ☒

 

Accelerated filer ☐

 

 

 

Non-accelerated filer ☐

 

Smaller reporting company ☐

(Do not check if a smaller reporting company)

 

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  ☐ Yes  ☒ No

 

The number of outstanding shares of the registrant’s Common Stock, $0.001 par value, was 188,385,146 as of October 25, 2016.

 

 

 

 


 

Table of Contents

INCYTE CORPORATION

 

INDEX

 

 

 

 

PART I:  FINANCIAL INFORMATION

    

 

 

 

 

Item 1. 

Financial Statements

 

 

 

 

 

 

Condensed Consolidated Balance Sheets

 

 

 

 

 

 

Condensed Consolidated Statements of Operations

 

 

 

 

 

 

Condensed Consolidated Statements of Comprehensive Income (Loss)

 

 

 

 

 

 

Condensed Consolidated Statements of Cash Flows

 

 

 

 

 

 

Notes to Condensed Consolidated Financial Statements

 

 

 

 

 

Item 2. 

Management’s Discussion and Analysis of Financial Condition and Results of Operations

 

31 

 

 

 

 

Item 3. 

Quantitative and Qualitative Disclosures about Market Risk

 

55 

 

 

 

 

Item 4. 

Controls and Procedures

 

55 

 

 

 

PART II:  OTHER INFORMATION

 

 

 

 

 

Item 1A. 

Risk Factors

 

56 

 

 

 

 

Item 6. 

Exhibits

 

74 

 

 

 

 

 

Signatures

 

75 

 

 

 

 

 

Exhibit Index

 

76 

 

 

 

2


 

Table of Contents

PART I:    FINANCIAL INFORMATION

Item 1.    Financial Statements

 

INCYTE CORPORATION

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except number of shares and par value)

 

 

 

 

 

 

 

 

 

 

September 30,

 

December 31,

 

 

    

2016

    

2015*

 

 

 

 

(unaudited)

 

 

 

 

ASSETS

 

 

 

 

 

 

 

Current assets:

 

 

 

 

 

 

 

Cash and cash equivalents

 

$

580,099

 

$

521,439

 

Marketable securities—available-for-sale

 

 

136,486

 

 

186,344

 

Restricted cash and investments

 

 

17

 

 

516

 

Accounts receivable

 

 

131,523

 

 

114,450

 

Inventory

 

 

4,078

 

 

1,783

 

Prepaid expenses and other current assets

 

 

34,457

 

 

17,843

 

Total current assets

 

 

886,660

 

 

842,375

 

 

 

 

 

 

 

 

 

Restricted cash and investments

 

 

932

 

 

13,977

 

Long term investment

 

 

55,745

 

 

35,248

 

Inventory

 

 

14,829

 

 

17,555

 

Property and equipment, net

 

 

151,942

 

 

86,006

 

Other intangible assets, net

 

 

263,821

 

 

 —

 

In-process research and development

 

 

12,000

 

 

 —

 

Goodwill

 

 

155,702

 

 

 —

 

Other assets, net

 

 

2,564

 

 

12,279

 

Total assets

 

$

1,544,195

 

$

1,007,440

 

 

 

 

 

 

 

 

 

LIABILITIES AND STOCKHOLDERS’ EQUITY

 

 

 

 

 

 

 

Current liabilities:

 

 

 

 

 

 

 

Accounts payable

 

$

57,524

 

$

30,085

 

Accrued compensation

 

 

47,414

 

 

38,117

 

Interest payable

 

 

2,285

 

 

762

 

Accrued and other current liabilities

 

 

112,600

 

 

86,531

 

Deferred revenue—collaborative agreements

 

 

2,868

 

 

12,512

 

Acquisition-related contingent consideration

 

 

17,854

 

 

 —

 

Total current liabilities

 

 

240,545

 

 

168,007

 

 

 

 

 

 

 

 

 

Convertible senior notes

 

 

643,434

 

 

619,893

 

Acquisition-related contingent consideration

 

 

280,146

 

 

 —

 

Other liabilities

 

 

10,084

 

 

48,385

 

Total liabilities

 

 

1,174,209

 

 

836,285

 

 

 

 

 

 

 

 

 

Stockholders’ equity:

 

 

 

 

 

 

 

Preferred stock, $0.001 par value; 5,000,000 shares authorized; none issued or outstanding as of September 30, 2016 and December 31, 2015

 

 

 —

 

 

 —

 

Common stock, $0.001 par value; 400,000,000 shares authorized; 188,258,973 and 186,650,249 shares issued and outstanding as of September 30, 2016 and December 31, 2015, respectively

 

 

188

 

 

187

 

Additional paid-in capital

 

 

2,053,046

 

 

1,950,764

 

Accumulated other comprehensive income (loss)

 

 

390

 

 

(809)

 

Accumulated deficit

 

 

(1,683,638)

 

 

(1,778,987)

 

Total stockholders’ equity

 

 

369,986

 

 

171,155

 

Total liabilities and stockholders’ equity

 

$

1,544,195

 

$

1,007,440

 


*   The condensed consolidated balance sheet at December 31, 2015 has been derived from the audited financial statements at that date.

See accompanying notes.

 

3


 

Table of Contents

INCYTE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited, in thousands, except per share amounts)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

    

2016

    

2015

    

2016

    

2015

 

Revenues:

 

 

 

 

 

 

 

 

 

 

 

 

 

Product revenues, net

 

$

236,623

 

$

161,259

 

$

632,006

 

$

418,994

 

Product royalty revenues

 

 

29,626

 

 

18,138

 

 

77,486

 

 

51,175

 

Contract revenues

 

 

3,214

 

 

8,214

 

 

69,643

 

 

39,643

 

Other revenues

 

 

6

 

 

 —

 

 

86

 

 

58

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total revenues

 

 

269,469

 

 

187,611

 

 

779,221

 

 

509,870

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Costs and expenses:

 

 

 

 

 

 

 

 

 

 

 

 

 

Cost of product revenues (including definite-lived intangible amortization)

 

 

20,205

 

 

8,040

 

 

38,577

 

 

17,268

 

Research and development

 

 

143,184

 

 

132,073

 

 

420,276

 

 

362,882

 

Selling, general and administrative

 

 

75,776

 

 

47,599

 

 

207,166

 

 

144,147

 

Change in fair value of acquisition-related contingent consideration

 

 

8,012

 

 

 —

 

 

10,283

 

 

 —

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Total costs and expenses

 

 

247,177

 

 

187,712

 

 

676,302

 

 

524,297

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) from operations

 

 

22,292

 

 

(101)

 

 

102,919

 

 

(14,427)

 

Interest and other income, net

 

 

1,188

 

 

3,026

 

 

3,818

 

 

5,800

 

Interest expense

 

 

(9,479)

 

 

(11,209)

 

 

(29,275)

 

 

(35,390)

 

Unrealized gain (loss) on long term investment

 

 

24,301

 

 

(31,289)

 

 

20,497

 

 

(4,115)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Income (loss) before provision for income taxes

 

 

38,302

 

 

(39,573)

 

 

97,959

 

 

(48,132)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Provision for income taxes

 

 

1,425

 

 

9

 

 

2,610

 

 

513

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss)

 

$

36,877

 

$

(39,582)

 

$

95,349

 

$

(48,645)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

$

0.20

 

$

(0.22)

 

$

0.51

 

$

(0.27)

 

Diluted

 

$

0.19

 

$

(0.22)

 

$

0.49

 

$

(0.27)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Shares used in computing  net income (loss) per share:

 

 

 

 

 

 

 

 

 

 

 

 

 

Basic

 

 

188,029

 

 

181,387

 

 

187,632

 

 

177,378

 

Diluted

 

 

194,265

 

 

181,387

 

 

193,754

 

 

177,378

 

 

See accompanying notes.

 

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Table of Contents

INCYTE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(unaudited)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

    

2016

    

2015

    

2016

    

2015

 

Net income (loss)

 

$

36,877

 

$

(39,582)

 

$

95,349

 

$

(48,645)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Other comprehensive income (loss):

 

 

 

 

 

 

 

 

 

 

 

 

 

Foreign currency translation

 

 

(18)

 

 

 —

 

 

(15)

 

 

 —

 

Unrealized gain (loss) on restricted investments and marketable securities, net of tax

 

 

(254)

 

 

(394)

 

 

1,036

 

 

(260)

 

Reclassification adjustment for realized (gain) loss on marketable securities

 

 

 —

 

 

(1,830)

 

 

178

 

 

(1,830)

 

Other comprehensive income (loss)

 

 

(272)

 

 

(2,224)

 

 

1,199

 

 

(2,090)

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Comprehensive income (loss)

 

$

36,605

 

$

(41,806)

 

$

96,548

 

$

(50,735)

 

 

See accompanying notes.

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Table of Contents

INCYTE CORPORATION

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

 

 

 

 

 

 

 

 

 

 

Nine Months Ended

 

 

 

September 30,

 

 

    

2016

    

2015

 

Cash flows from operating activities:

 

 

 

 

 

 

 

Net income (loss)

 

$

95,349

 

$

(48,645)

 

Adjustments to reconcile net income (loss) to net cash used in operating activities:

 

 

 

 

 

 

 

Depreciation and amortization

 

 

40,859

 

 

34,279

 

Stock-based compensation

 

 

68,598

 

 

52,775

 

Other, net

 

 

325

 

 

(1,830)

 

Unrealized (gain) loss on long term investment

 

 

(20,497)

 

 

4,115

 

Excess tax provision from stock-based compensation

 

 

 —

 

 

(2,094)

 

Change in fair value of acquisition-related contingent consideration

 

 

10,283

 

 

 —

 

Changes in operating assets and liabilities:

 

 

 

 

 

 

 

Accounts receivable

 

 

(6,712)

 

 

(29,033)

 

Prepaid expenses and other assets

 

 

(13,323)

 

 

(1,918)

 

Inventory

 

 

4,439

 

 

(830)

 

Accounts payable

 

 

25,683

 

 

2,904

 

Accrued and other liabilities

 

 

15,018

 

 

16,469

 

Deferred revenue—collaborative agreements

 

 

(9,644)

 

 

(9,665)

 

Net cash provided by operating activities

 

 

210,378

 

 

16,527

 

Cash flows from investing activities:

 

 

 

 

 

 

 

Acquisition of business, net of cash acquired

 

 

(142,965)

 

 

 —

 

Long term investment

 

 

 —

 

 

(39,829)

 

Capital expenditures

 

 

(104,405)

 

 

(19,107)

 

Purchases of marketable securities

 

 

(26,921)

 

 

(94,376)

 

Sale and maturities of marketable securities

 

 

77,815

 

 

52,831

 

Net cash used in investing activities

 

 

(196,476)

 

 

(100,481)

 

Cash flows from financing activities:

 

 

 

 

 

 

 

Restricted investments, net

 

 

13,976

 

 

(128)

 

Proceeds from issuance of common stock under stock plans

 

 

32,468

 

 

76,871

 

Direct financing arrangements repayments

 

 

(445)

 

 

(1,379)

 

Excess tax provision from stock-based compensation

 

 

 —

 

 

2,094

 

Payment of contingent consideration

 

 

(1,226)

 

 

 —

 

Net cash provided by financing activities

 

 

44,773

 

 

77,458

 

Effect of exchange rates on cash and cash equivalents

 

 

(15)

 

 

 —

 

Net increase (decrease) in cash and cash equivalents

 

 

58,660

 

 

(6,496)

 

Cash and cash equivalents at beginning of period

 

 

521,439

 

 

452,297

 

Cash and cash equivalents at end of period

 

$

580,099

 

$

445,801

 

Supplemental Schedule of Cash Flow Information

 

 

 

 

 

 

 

Interest paid

 

$

3,892

 

$

7,698

 

Income taxes paid

 

$

717

 

$

86

 

Reclassification to additional paid in capital in connection with conversions or exchange of 4.75% convertible senior notes due 2015

 

$

 —

 

$

88,962

 

Reclassification to common stock and additional paid in capital in connection with conversions of 0.375% convertible senior notes due 2018

 

$

5

 

$

 —

 

Reclassification to common stock and additional paid in capital in connection with conversions of 1.25% convertible senior notes due 2020

 

$

4

 

$

 —

 

 

See accompanying notes.

 

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Table of Contents

INCYTE CORPORATION

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

September 30, 2016

(Unaudited)

 

1.     Organization and business

 

Incyte Corporation (including its subsidiaries, “Incyte,” “we,” “us,” or “our”) is a biopharmaceutical company focused on developing and commercializing proprietary therapeutics. Our portfolio includes compounds in various stages, ranging from preclinical to late stage development, and commercialized products JAKAFI® (ruxolitinib) and ICLUSIG® (ponatinib). Our operations are treated as one operating segment.

 

2.     Summary of significant accounting policies

 

Basis of presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X.  The condensed consolidated balance sheet as of September 30, 2016 and the condensed consolidated statements of operations, and comprehensive income (loss) for the three and nine months ended September 30, 2016 and 2015, and the condensed consolidated statement of cash flows for the nine months ended September 30, 2016 and 2015 are unaudited, but include all adjustments, consisting only of normal recurring adjustments, which we consider necessary for a fair presentation of the financial position, operating results and cash flows for the periods presented.  The condensed consolidated balance sheet at December 31, 2015 has been derived from audited financial statements.

 

On June 1, 2016, we acquired (the “Acquisition”), pursuant to a Share Purchase Agreement dated as of May 9, 2016 (the “Share Purchase Agreement”), all of the outstanding shares of ARIAD Pharmaceuticals (Luxembourg) S.a.r.l., since renamed Incyte Biosciences Luxembourg S.a.r.l., the parent company of certain European subsidiaries of ARIAD Pharmaceuticals, Inc. (“ARIAD”).  Refer to Note 3 for further information regarding the Acquisition.

 

Although we believe that the disclosures in these financial statements are adequate to make the information presented not misleading, certain information and footnote information normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States (“U.S. GAAP”) have been condensed or omitted pursuant to the rules and regulations of the Securities and Exchange Commission.

 

Results for any interim period are not necessarily indicative of results for any future interim period or for the entire year. The accompanying financial statements should be read in conjunction with the financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2015.

 

Principles of Consolidation.  The condensed consolidated financial statements include the accounts of Incyte Corporation and our wholly owned subsidiaries. All inter-company accounts, transactions, and profits have been eliminated in consolidation.

 

Acquisitions.  Acquired businesses are accounted for using the acquisition method of accounting, which requires that assets acquired and liabilities assumed be recorded at fair value, with limited exceptions.  Any excess of the purchase price over the fair value of the net assets acquired is recorded as goodwill.  Transaction costs are expensed as incurred.  The operating results of the acquired business are reflected in our consolidated financial statements after the date of acquisition. Acquired in-process research and development (“IPR&D”) is recognized at fair value and initially characterized as an indefinite-lived intangible asset, irrespective of whether the acquired IPR&D has an alternative future use.

 

Foreign Currency Translation. Operations in non-U.S. entities are recorded in the functional currency of each entity. For financial reporting purposes, the functional currency of an entity is determined by a review of the source of an entity's most predominant cash flows. The results of operations for any non-U.S. dollar functional currency entities are translated from functional currencies into U.S. dollars using the average currency rate during each month. Assets and liabilities are translated using currency rates at the end of the period. Adjustments resulting from translating the financial statements of our foreign entities that use their local currency as the functional currency into U.S. dollars are reflected as a component of other comprehensive income (loss). Transaction gains and losses are recorded in interest and other income, net in the condensed consolidated statements of operations.  To date, both the translation gains or losses in other comprehensive income (loss) and the transaction gains or losses in foreign exchange gain (loss) have been immaterial.

 

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Table of Contents

Use of Estimates.  The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.

 

Concentrations of Credit Risk.  Cash, cash equivalents, marketable securities, trade receivables and restricted investments are financial instruments which potentially subject us to concentrations of credit risk. The estimated fair value of financial instruments approximates the carrying value based on available market information. We primarily invest our excess available funds in corporate debt securities and, by policy, limit the amount of credit exposure to any one issuer and to any one type of investment, other than securities issued or guaranteed by the U.S. government and money market funds that meet certain guidelines. Our receivables mainly relate to our product sales of JAKAFI, ICLUSIG and collaborative agreements with pharmaceutical companies. We have not experienced any significant credit losses on cash, cash equivalents, marketable securities, trade receivables or restricted investments to date and do not require collateral on receivables.

 

Cash and Cash Equivalents.  Cash and cash equivalents are held in banks or in custodial accounts with banks. Cash equivalents are defined as all liquid investments and money market funds with maturity from date of purchase of 90 days or less that are readily convertible into cash.

 

Marketable Securities—Available-for-Sale.  All marketable securities are classified as available-for-sale. Available-for-sale securities are carried at fair value, based on quoted market prices and observable inputs, with unrealized gains and losses, net of tax, reported as a separate component of stockholders’ equity. We classify marketable securities that are available for use in current operations as current assets on the condensed consolidated balance sheets. Realized gains and losses and declines in value judged to be other than temporary for available-for-sale securities are included in “Interest and other income, net.” The cost of securities sold is based on the specific identification method.

 

Accounts Receivable.  As of September 30, 2016 and December 31, 2015, we had no allowance for doubtful accounts. We provide an allowance for doubtful accounts based on experience and specifically identified risks. Accounts receivable are carried at fair value and charged off against the allowance for doubtful accounts when we determine that recovery is unlikely and we cease collection efforts.

 

Inventory.  Inventories are determined at the lower of cost or market value with cost determined under the specific identification method and may consist of raw materials, work in process and finished goods. We began capitalizing inventory in mid-November 2011 once the U.S. Food and Drug Administration (“FDA”) approved JAKAFI as the related costs were expected to be recoverable through the commercialization of the product. Costs incurred prior to approval of JAKAFI have been recorded as research and development expense in our statements of operations. As a result, cost of JAKAFI revenues for the next 3 to 6 months will reflect a lower average per unit cost of materials. The ICLUSIG inventories acquired on June 1, 2016 in connection with the Acquisition were recorded at fair value less costs to sell, which will result in a higher cost of ICLUSIG revenues for the next nine months. 

 

JAKAFI raw materials and work-in-process inventory is not subject to expiration and the shelf life of finished goods inventory is 36 months from the start of manufacturing of the finished goods. ICLUSIG finished goods inventory has a shelf life of 24 months from the start of manufacturing of the finished goods.  We evaluate for potential excess inventory by analyzing current and future product demand relative to the remaining product shelf life. We build demand forecasts by considering factors such as, but not limited to, overall market potential, market share, market acceptance and patient usage. We classify inventory as current on the condensed consolidated balance sheets when we expect inventory to be consumed for commercial use within the next twelve months.

 

Variable Interest Entities. We perform an initial and on-going evaluation of the entities with which we have variable interests, such as equity ownership, in order to identify entities (i) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support or (ii) in which the equity investors lack an essential characteristic of a controlling financial interest as variable interest entities (“VIE” or “VIEs”). If an entity is identified as a VIE, we perform an assessment to determine whether we have both (i) the power to direct activities that most significantly impact the VIE’s economic performance and (ii) have the obligation to absorb losses from or the right to receive benefits of the VIE that could potentially be significant to the VIE. If both of these criteria are satisfied, we are identified as the primary beneficiary of the VIE.  As of September 30, 2016, there were no entities in which we held a variable interest which we determined to be VIEs.

 

Equity Method Investments.  In circumstances where we have the ability to exercise significant influence over the operating and financial policies of a company in which we have an investment, the investment is accounted for either (i) under the equity method of accounting or (ii) at fair value by electing the fair value option under U.S. GAAP.   In assessing whether we exercise significant influence, we consider the nature and magnitude of our investment, any voting and protective rights we hold, any participation in the governance of the other company, and other relevant factors such as the presence of a collaboration or other business relationship. Under the equity method of accounting, we record

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within our results of operations our share of income or loss of the investee company.  Under the fair value option, our investment is carried at fair value on our condensed consolidated balance sheets as a long term investment and all changes in fair value are reported in our condensed consolidated statements of operations as an unrealized gain (loss) on long term investment.

 

Property and Equipment.  Property and equipment is stated at cost, less accumulated depreciation and amortization. Depreciation is recorded using the straight-line method over the estimated useful lives of the respective assets. Leasehold improvements are amortized over the shorter of the estimated useful life of the assets or lease term.

 

Management continually reviews the estimated useful lives of technologically sensitive equipment and believes that those estimates appropriately reflect the current useful life of our assets. In the event that a currently unknown significantly advanced technology became commercially available, we would re-evaluate the value and estimated useful lives of our existing equipment, possibly having a material impact on the financial statements.

 

Lease Accounting.  We account for operating leases by recording rent expense on a straight-line basis over the expected life of the lease, commencing on the date we gain possession of leased property. We include tenant improvement allowances and rent holidays received from landlords and the effect of any rent escalation clauses as adjustments to straight-line rent expense over the expected life of the lease.

 

Capital leases are reflected as a liability at the inception of the lease based on the present value of the minimum lease payments or, if lower, the fair value of the property. Assets under capital leases are recorded in property and equipment, net on the condensed consolidated balance sheets and depreciated in a manner similar to other property and equipment.

 

Certain construction projects may be accounted for as direct financing arrangements, whereby we record, over the construction period, the full cost of the asset in property and equipment, net on the condensed consolidated balance sheets. A corresponding liability is also recorded, net of leasehold improvements paid for by us, and is amortized over the expected lease term through monthly rental payments using the effective interest method.

 

In April 2016, we completed our purchase of the previously leased land and building of approximately 190,000 square feet of laboratory and office space in Wilmington, Delaware.  Refer to Note 7 for further information regarding the purchase.

 

Other Intangible Assets, net. Other intangible assets, net consist of licensed intellectual property rights acquired in business combinations, which are reported at fair value, less accumulated amortization. Intangible assets with finite lives are amortized over their estimated useful lives using the straight-line method.

 

In-Process Research and Development. The fair value of in-process research and development (“IPR&D”) acquired through business combinations is capitalized as an indefinite-lived intangible asset until the completion or abandonment of the related research and development activities.  When the related research and development is completed, the asset will be assigned a useful life and amortized. 

 

Impairment of Long-Lived Assets.  Long-lived assets with finite lives are tested for impairment whenever events or changes in circumstances indicate that the carrying value of an asset may not be recoverable.  If indicators of impairment are present, the asset is tested for recoverability by comparing the carrying value of the asset to the related estimated undiscounted future cash flows expected to be derived from the asset.  If the expected cash flows are less than the carrying value of the asset, then the asset is considered to be impaired and its carrying value is written down to fair value, based on the related estimated discounted future cash flows.

 

Indefinite-lived intangible assets, including IPR&D, are tested for impairment annually in the fourth quarter or more frequently if events or changes in circumstances between annual tests indicate that the asset may be impaired.  Impairment losses on indefinite-lived intangible assets are recognized based solely on a comparison of the fair value of the asset to its carrying value.

 

Goodwill.  Goodwill is calculated as the difference between the acquisition date fair value of the consideration transferred and the values assigned to the assets acquired and liabilities assumed.  Goodwill is not amortized but is tested for impairment at least annually in the fourth quarter at the reporting unit level.  A reporting unit is the same as, or one level below, an operating segment. Our operating segment is currently comprised of a single, entity wide reporting unit.

 

Income Taxes.  We account for income taxes using the asset and liability approach which requires the recognition of deferred tax assets and liabilities for the expected future tax consequences of temporary differences between the carrying amount of assets and liabilities for financial reporting purposes and amounts reportable for income tax purposes. In addition, we follow the guidance related to accounting for uncertainty in income taxes. This guidance

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creates a single model to address uncertainty in tax positions and clarifies the accounting for income taxes by prescribing the minimum recognition threshold a tax position is required to meet before it is recognized in the financial statements.

 

Financing Costs Related to Long-term Debt.  Costs associated with obtaining long-term debt are deferred and amortized over the term of the related debt using the effective interest method. Such costs are presented as a direct deduction from the carrying amount of the long-term debt liability, consistent with debt discounts, on the consolidated balance sheets.

 

Grant Accounting.  Grant amounts received from government agencies for operations are deferred and are amortized into income over the service period of the grant. Grant amounts received for purchases of capital assets are deferred and amortized into interest and other income, net over the useful life of the related capital assets. Such amounts are recorded in other liabilities on the condensed consolidated balance sheets.

 

Net Income (Loss) Per Share.  Our basic and diluted net income (loss) per share is calculated by dividing the net income (loss) by the weighted average number of shares of common stock outstanding during all periods presented. Options to purchase stock and shares issuable upon the conversion of convertible debt are included in diluted earnings per share calculations, unless the effects are anti-dilutive.

 

Accumulated Other Comprehensive Income (Loss).  Accumulated other comprehensive income (loss) consists of realized and unrealized gains or losses on marketable securities and restricted cash and investments, net of tax, and foreign currency translation gains or losses.

 

Revenue Recognition.  Revenues are recognized when (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services have been rendered, (3) the price is fixed or determinable and (4) collectability is reasonably assured. Revenues are deferred for fees received before earned or until no further obligations exist. We exercise judgment in determining that collectability is reasonably assured or that services have been delivered in accordance with the arrangement. We assess whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectability based primarily on the customer’s payment history and on the creditworthiness of the customer.

 

Product Revenues

 

Our product revenues consist of U.S. sales of JAKAFI and European sales of ICLUSIG.  Product revenues are recognized once we meet all four revenue recognition criteria described above. In November 2011, we began shipping JAKAFI to our customers in the U.S., which include specialty pharmacies and wholesalers. In June 2016, we acquired the right to and began shipping ICLUSIG to our customers in the European Union and certain other jurisdictions (Note 3), which include retail pharmacies, hospital pharmacies and distributors.

 

We recognize revenues for product received by our customers net of allowances for customer credits, including estimated rebates, chargebacks, discounts, returns, distribution service fees, patient assistance programs, and government rebates, such as Medicare Part D coverage gap reimbursements in the U.S. Product shipping and handling costs are included in cost of product revenues.

 

Customer Credits:  Our customers are offered various forms of consideration, including allowances, service fees and prompt payment discounts. We expect our customers will earn prompt payment discounts and, therefore, we deduct the full amount of these discounts from total product sales when revenues are recognized. Service fees are also deducted from total product sales as they are earned.

 

Rebates and Discounts:  Allowances for rebates include mandated discounts under the Medicaid Drug Rebate Program in the U.S. and mandated discounts in Europe in markets where government-sponsored healthcare systems are the primary payers for healthcare. Rebate amounts are based upon contractual agreements or legal requirements with public sector benefit providers. Rebates are amounts owed after the final dispensing of the product to a benefit plan participant and are based upon contractual agreements or legal requirements with public sector benefit providers. The accrual for rebates is based on statutory discount rates and expected utilization as well as historical data we have accumulated since product launches. Our estimates for expected utilization of rebates are based on data received from our customers. Rebates are generally invoiced and paid in arrears so that the accrual balance consists of an estimate of the amount expected to be incurred for the current quarter’s activity, plus an accrual balance for known prior quarters’ unpaid rebates. If actual future rebates vary from estimates, we may need to adjust prior period accruals, which would affect revenue in the period of adjustment.

 

Chargebacks:  Chargebacks are discounts that occur when certain contracted customers, which currently consist primarily of group purchasing organizations, Public Health Service institutions, non-profit clinics, and Federal government entities purchasing via the Federal Supply Schedule, purchase directly from our wholesalers. Contracted

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customers generally purchase the product at a discounted price. The wholesalers, in turn, charges back to us the difference between the price initially paid by the wholesalers and the discounted price paid by the contracted customers. In addition to actual chargebacks received, we maintain an accrual for chargebacks based on the estimated contractual discounts on the inventory levels on hand in our distribution channel.  If actual future chargebacks vary from these estimates, we may need to adjust prior period accruals, which would affect revenue in the period of adjustment.

 

Medicare Part D Coverage Gap:  Medicare Part D prescription drug benefit mandates manufacturers to fund 50% of the Medicare Part D insurance coverage gap for prescription drugs sold to eligible patients. Our estimates for the expected Medicare Part D coverage gap are based on historical invoices received and in part from data received from our customers. Funding of the coverage gap is generally invoiced and paid in arrears so that the accrual balance consists of an estimate of the amount expected to be incurred for the current quarter’s activity, plus an accrual balance for known prior quarters. If actual future funding varies from estimates, we may need to adjust prior period accruals, which would affect revenue in the period of adjustment.

 

Co-payment Assistance:  Patients who have commercial insurance and meet certain eligibility requirements may receive co-payment assistance. We accrue a liability for co-payment assistance based on actual program participation and estimates of program redemption using data provided by third-party administrators.

 

Product Royalty Revenues

 

Royalty revenues on commercial sales for ruxolitinib (marketed as JAKAVI® outside the United States) by Novartis Pharmaceutical International Ltd. (“Novartis”) are based on net sales of licensed products in licensed territories as provided by Novartis. We recognize royalty revenues in the period the sales occur.

 

Cost of Product Revenues

 

Cost of product revenues includes all JAKAFI related product costs as well as ICLUSIG related product costs. The acquired ICLUSIG inventories were recorded at fair value less costs to sell in connection with the Acquisition, and will result in a higher cost of ICLUSIG product revenues over the next nine months.  In addition, cost of product revenues include low single digit royalties under our collaboration and license agreement to Novartis on all future sales of JAKAFI in the United States. Subsequent to the Acquisition on June 1, 2016, cost of product revenues also includes the amortization of our licensed intellectual property for ICLUSIG using the straight-line method over the estimated useful life of 12.5 years.    

 

Contract and License Revenues

 

Under agreements involving multiple deliverables, services and/or rights to use assets that we entered into prior to January 1, 2011, the multiple elements are divided into separate units of accounting when certain criteria are met, including whether the delivered items have stand-alone value to the customer and whether there is objective and reliable evidence of the fair value of the undelivered items. When separate units of accounting exist, consideration is allocated among the separate elements based on their respective fair values. The determination of fair value of each element is based on objective evidence from historical sales of the individual elements by us to other customers. If such evidence of fair value for each undelivered element of the arrangement does not exist, all revenue from the arrangement is deferred until such time that evidence of fair value for each undelivered element does exist or until all elements of the arrangement are delivered. When elements are specifically tied to a separate earnings process, revenue is recognized when the specific performance obligation tied to the element is completed. When revenues for an element are not specifically tied to a separate earnings process, they are recognized ratably over the term of the agreement. We assess whether a substantive milestone exists at the inception of our agreements. For all milestones within our arrangements that are considered substantive, we recognize revenue upon the achievement of the associated milestone. If a milestone is not considered substantive, we would recognize the applicable milestone payment over the remaining period of performance under the arrangement. As of September 30, 2016, all remaining potential milestones under our collaborative arrangements are considered substantive.

 

On January 1, 2011, updated guidance on the recognition of revenues for agreements with multiple deliverables became effective and applies to any agreements we may enter into on or after January 1, 2011. This updated guidance (i) relates to whether multiple deliverables exist, how the deliverables in a revenue arrangement should be separated and how the consideration should be allocated; (ii) requires companies to allocate revenues in an arrangement using estimated selling prices of deliverables if a vendor does not have vendor-specific objective evidence or third-party evidence of selling price; and (iii) eliminates the use of the residual method and requires companies to allocate revenues using the relative selling price method. During the nine months ended September 30, 2016 and 2015, we did not enter into any agreements that are subject to this updated guidance. If we enter into an agreement with multiple deliverables after January 1, 2011 or amend existing agreements, this updated guidance could have a material effect on our financial statements.

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Our collaborations often include contractual milestones, which typically relate to the achievement of pre-specified development, regulatory and commercialization events. These three categories of milestone events reflect the three stages of the life-cycle of our drugs, which we describe in more detail in the following paragraphs.

 

The regulatory review and approval process, which includes preclinical testing and clinical trials of each drug candidate, is lengthy, expensive and uncertain. Securing approval by the FDA requires the submission of extensive preclinical and clinical data and supporting information to the FDA for each indication to establish a drug candidate’s safety and efficacy. The approval process takes many years, requires the expenditure of substantial resources, involves post-marketing surveillance and may involve ongoing requirements for post-marketing studies. Before commencing clinical investigations of a drug candidate in humans, we must submit an Investigational New Drug application (“IND”), which must be reviewed by the FDA.

 

The steps generally required before a drug may be marketed in the United States include preclinical laboratory tests, animal studies and formulation studies, submission to the FDA of an IND for human clinical testing, performance of adequate and well-controlled clinical trials in three phases, as described below, to establish the safety and efficacy of the drug for each indication, submission of a new drug application (“NDA”) or biologics license application (“BLA”) to the FDA for review and FDA approval of the NDA or BLA.

 

Similar requirements exist within foreign regulatory agencies as well. The time required satisfying the FDA requirements or similar requirements of foreign regulatory agencies may vary substantially based on the type, complexity and novelty of the product or the targeted disease.

 

Preclinical testing includes laboratory evaluation of product pharmacology, drug metabolism, and toxicity, which includes animal studies, to assess potential safety and efficacy as well as product chemistry, stability, formulation, development, and testing. The results of the preclinical tests, together with manufacturing information and analytical data, are submitted to the FDA as part of an IND. The FDA may raise safety concerns or questions about the conduct of the clinical trials included in the IND, and any of these concerns or questions must be resolved before clinical trials can proceed. We cannot be sure that submission of an IND will result in the FDA allowing clinical trials to commence. Clinical trials involve the administration of the investigational drug or the marketed drug to human subjects under the supervision of qualified investigators and in accordance with good clinical practices regulations covering the protection of human subjects. Clinical trials typically are conducted in three sequential phases, but the phases may overlap or be combined. Phase I usually involves the initial introduction of the investigational drug into healthy volunteers to evaluate its safety, dosage tolerance, absorption, metabolism, distribution and excretion. Phase II usually involves clinical trials in a limited patient population to evaluate dosage tolerance and optimal dosage, identify possible adverse effects and safety risks, and evaluate and gain preliminary evidence of the efficacy of the drug for specific indications. Phase III clinical trials usually further evaluate clinical efficacy and safety by testing the drug in its final form in an expanded patient population, providing statistical evidence of efficacy and safety, and providing an adequate basis for labeling. We cannot guarantee that Phase I, Phase II or Phase III testing will be completed successfully within any specified period of time, if at all. Furthermore, we, the institutional review board for a trial, or the FDA may suspend clinical trials at any time on various grounds, including a finding that the subjects or patients are being exposed to an unacceptable health risk.

 

Generally, the milestone events contained in our collaboration agreements coincide with the progression of our drugs from development, to regulatory approval and then to commercialization. The process of successfully discovering a new development candidate, having it approved and successfully commercialized is highly uncertain. As such, the milestone payments we may earn from our partners involve a significant degree of risk to achieve. Therefore, as a drug candidate progresses through the stages of its life-cycle, the value of the drug candidate generally increases.

 

Research and Development Costs.  Our policy is to expense research and development costs as incurred. We often contract with clinical research organizations (“CROs”) to facilitate, coordinate and perform agreed upon research and development of a new drug. To ensure that research and development costs are expensed as incurred, we record monthly accruals for clinical trials and preclinical testing costs based on the work performed under the contract.

 

These CRO contracts typically call for the payment of fees for services at the initiation of the contract and/or upon the achievement of certain clinical trial milestones. In the event that we prepay CRO fees, we record the prepayment as a prepaid asset and amortize the asset into research and development expense over the period of time the contracted research and development services are performed. Most professional fees, including project and clinical management, data management, monitoring, and medical writing fees are incurred throughout the contract period. These professional fees are expensed based on their percentage of completion at a particular date. Our CRO contracts generally include pass through fees. Pass through fees include, but are not limited to, regulatory expenses, investigator fees, travel costs, and other miscellaneous costs, including shipping and printing fees. We expense the costs of pass through fees under our CRO contracts as they are incurred, based on the best information available to us at the time. The estimates of the pass through fees incurred are based on the amount of work completed for the clinical trial and are monitored through

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correspondence with the CROs, internal reviews and a review of contractual terms. The factors utilized to derive the estimates include the number of patients enrolled, duration of the clinical trial, estimated patient attrition, screening rate and length of the dosing regimen. CRO fees incurred to set up the clinical trial are expensed during the setup period.

 

Under our clinical trial collaboration agreements we may be reimbursed for certain development costs incurred. Such costs are recorded as a reduction of research and development expense in the period in which the related expense is incurred.

 

Stock Compensation.  Share-based payment transactions with employees, which include stock options, restricted stock units (“RSUs”) and performance shares (“PSUs”), are recognized as compensation expense over the requisite service period based on their estimated fair values as well as expected forfeiture rates.  The stock compensation process requires significant judgment and the use of estimates, particularly surrounding Black-Scholes assumptions such as stock price volatility over the option term and expected option lives, as well as expected forfeiture rates and the probability of PSUs vesting.  The fair value of stock options, which are subject to graded vesting, are recognized as compensation expense over the requisite service period using the accelerated attribution method.  The fair value of RSUs that are subject to cliff vesting are recognized as compensation expense over the requisite service period using the straight line attribution method, and the fair value of RSUs that are subject to graded vesting are recognized as compensation expense over the requisite service period using the accelerated attribution method.  The fair value of PSUs are recognized as compensation expense beginning at the time in which the performance conditions are deemed probable of achievement, over the remaining requisite service period. We recorded $26.5 million and $68.6 million of stock compensation expense on our condensed consolidated statements of operations for the three and nine months ended September 30, 2016. We recorded $17.6 million and $52.8 million of stock compensation expense on our condensed consolidated statements of operations for the three and nine months ended September 30, 2015, respectively.

 

Acquisition-Related Contingent Consideration. Acquisition-related contingent consideration, which consists of our future royalty and certain potential milestone obligations to ARIAD, is recorded on the acquisition date at the estimated fair value of the obligation, in accordance with the acquisition method of accounting.  The fair value measurement is based on significant inputs that are unobservable in the market and thus represents a Level 3 measurement. The fair value of the acquisition-related contingent consideration is remeasured each reporting period, with changes in fair value recorded in the condensed consolidated statements of operations. 

 

Recent Accounting Pronouncements

 

In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update (“ASU”) No. 2014-09, “Revenue from Contracts with Customers,” which provides a five step approach to be applied to all contracts with customers. ASU No. 2014-09 also requires expanded disclosures about revenue recognition. This guidance is effective for annual reporting periods beginning after December 15, 2017 and interim periods therein.  Early adoption is permitted for reporting periods beginning after December 15, 2016.  We are currently analyzing the impact of ASU No. 2014-09 on our results of operations and, at this time, we are unable to determine the impact of the new standard, if any, on our condensed consolidated financial statements.

 

In August 2014, the FASB issued ASU No. 2014-15, “Presentation of Financial Statements—Going Concern,” to provide guidance on management’s responsibility in evaluating whether there is substantial doubt about a company’s ability to continue as a going concern and about related footnote disclosures. For each reporting period, management will be required to evaluate whether there are conditions or events that raise substantial doubt about our ability to continue as a going concern within one year from the date the financial statements are issued. This guidance is effective for the annual period ending after December 15, 2016, and for annual periods and interim periods thereafter. Early application is permitted. We do not believe the pending adoption of ASU No. 2014-15 will have a material impact on our condensed consolidated financial statements.

 

In February 2015, the FASB issued ASU No. 2015-02, “Amendments to the Consolidation Analysis,” which affects reporting entities that are required to evaluate whether they should consolidate certain legal entities.  The amendments place more emphasis in the consolidation evaluation on variable interests other than fee arrangements such as principal investment risk (including debt or equity interests), guarantees of the value of the assets or liabilities of the variable interest entity (“VIE”), written put options on the assets of the VIE, or similar obligations. Additionally, the amendments reduce the extent to which related party arrangements cause an entity to be considered a primary beneficiary. This guidance is to be applied using a modified retrospective approach by recording a cumulative-effect adjustment to equity as of the beginning of the fiscal year of adoption. The amendments are effective for fiscal years beginning after December 15, 2015, and interim periods therein. We have concluded ASU No. 2015-02 has no impact on our condensed consolidated financial statements. 

 

In February 2016, the FASB issued ASU No. 2016-02, “Leases,” that requires lessees to recognize assets and liabilities on the balance sheet for most leases including operating leases. Lessees now classify leases as either finance or

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operating leases and lessors classify all leases as sales-type, direct financing or operating leases.  The statement of operations presentation and expense recognition for lessees for finance leases is similar to that of capital leases under Accounting Standards Codification (“ASC”) 840 with separate interest and amortization expense with higher periodic expense in the earlier periods of a lease.  For operating leases, the statement of operations presentation and expense recognition is similar to that of operating leases under ASC 840 with single lease cost recognized on a straight-line basis. This guidance is to be applied using a modified retrospective approach at the beginning of the earliest comparative period presented in the financial statements and is effective for annual periods beginning after December 15, 2018 and interim periods therein.  Early adoption is permitted.  We are currently analyzing the impact of ASU No. 2016-02 and, at this time, are unable to determine the impact of the new standard, if any, on our condensed consolidated financial statements.

 

In March 2016, the FASB issued ASU No. 2016-09, “Improvements to Employee Share-Based Payment Accounting,” which changes the accounting for certain aspects of share-based payments to employees.  The new guidance requires excess tax benefits and tax deficiencies to be recorded in the statement of operations when the awards vest or are settled.  In addition, cash flows related to excess tax benefits will no longer be separately classified as a financing activity apart from other income tax cash flows.  The standard also clarifies that all cash payments made on an employee’s behalf for withheld shares should be presented as a financing activity on the statement of cash flows, and provides an accounting policy election to account for forfeitures as they occur.  The new standard is effective for our calendar year beginning January 1, 2017.  Early adoption is permitted however all of the guidance must be adopted in the same period. 

 

We elected to early adopt ASU No. 2016-09 as of the first quarter of 2016 which required us to reflect any adjustments as of January 1, 2016, the beginning of the annual period that includes the interim period of adoption.  The primary impact of adoption was the recognition of $325.6 million of accumulated excess tax benefits as deferred tax assets that under the previous guidance could not be recognized until the benefits were realized through a reduction in cash taxes paid.  This part of the guidance was applied using a modified retrospective method with a cumulative-effect adjustment to the accumulated deficit for the excess tax benefits not previously recognized. However, given the full valuation allowance placed on the additional $325.6 million of deferred tax assets, the recognition upon adoption had no impact to our accumulated deficit as of January 1, 2016.

 

Adoption of the standard also resulted in the recognition of excess tax benefits in our income tax provision rather than as paid-in capital. This guidance is to be applied prospectively and resulted in the recognition of $0.9 million of excess tax benefits in our income tax provision rather than paid-in capital for the nine months ended September 30, 2016.  Amendments to the minimum statutory withholding tax requirements had no impact to the accumulated deficit as of January 1, 2016. In addition, we have elected to continue to estimate forfeitures expected to occur when determining the amount of compensation cost to be recognized in each period.

 

We elected to apply the presentation requirements for cash flows related to excess tax benefits prospectively which resulted in classification within operating cash flows of the excess tax benefits recognized during the three months ended March 31, 2016.  This classification is now consistent with all other cash flow impacts from income taxes. In addition, the amendments to the cash flow statement presentation to classify cash payments made on behalf of employees for shares withheld as a financing activity had no impact on our previously reported cash flows, as this requirement is consistent with our previous presentation of these cash flows.

 

In August 2016, the FASB issued ASU No. 2016-15, “Classification of Certain Cash Receipts and Cash Payments,” which clarifies how entities should classify certain cash receipts and cash payments on the statement of cash flows to eliminate diversity in practice. Specifically relating to contingent consideration payments made after a business combination, an entity should classify cash payments that are not made within a relatively short period of time after a business combination to settle a contingent consideration liability as financing and operating activities.  The portion of cash payment up to the acquisition date fair value of the contingent consideration liability (including measurement period adjustments) is classified as a financing activity and the portion paid in excess of the acquisition date fair value is classified as an operating activity. The new standard is effective for fiscal years beginning after December 15, 2017 and interim periods therein. Early adoption is permitted however all of the amendments must be adopted in the same period and interim period adoption requires adjustments to be reflected as of the beginning of the fiscal year.   The guidance is to be applied on a retrospective basis with relevant disclosures under ASC 250. We elected to early adopt ASU No. 2016-15 as of the third quarter of 2016.  No retrospective adjustments were recorded as the first contingent consideration payment was made during the three months ended September 30, 2016.

 

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3.     Business combination

 

Description of the Transaction

 

On June 1, 2016, pursuant to the Share Purchase Agreement, we completed the Acquisition, and acquired all of the outstanding shares of ARIAD Pharmaceuticals (Luxembourg) S.a.r.l., since renamed Incyte Biosciences Luxembourg S.a.rl., the parent company of ARIAD’s European subsidiaries responsible for the development and commercialization of ICLUSIG (ponatinib) in the European Union (“EU”) and other countries including Switzerland, Norway, Turkey, Israel and Russia (the “Territory”) in exchange for an upfront payment of $147.5 million, including customary working capital adjustments (the “Upfront Payment”).  ICLUSIG is approved in Europe for the treatment of patients with chronic myeloid leukemia and Philadelphia-positive acute lymphoblastic leukemia who are resistant to or intolerant of certain second generation BCR-ABL inhibitors and all patients who have the T3151 mutation.  The acquisition of ARIAD Pharmaceuticals (Luxembourg) S.a.r.l. includes a fully integrated and established pan-European team including medical, sales and marketing personnel.  The existing platform and infrastructure acquired is expected to further our strategic plan and accelerate the establishment of our operations in Europe.   

 

Under the Share Purchase Agreement, and subject to certain limitations and exceptions, each party has also agreed to indemnify the other for breaches of representations and warranties and certain other matters to a maximum amount of $14.0 million. The Share Purchase Agreement also includes a standstill provision restricting our ability for a specified period of time to acquire shares of ARIAD’s common stock above a certain percentage or take certain other actions without ARIAD board approval, subject to certain customary exceptions.

 

In connection with the closing of the Acquisition, we entered into an Amended and Restated Buy-in License Agreement with ARIAD (the “License Agreement”).  Under the terms of the License Agreement, we were granted an exclusive license to develop and commercialize ICLUSIG in the Territory.  ARIAD is eligible to receive from us tiered royalties ranging between 32% and 50% on net sales of ICLUSIG in the Territory. The royalties are subject to reduction for certain events related to exclusivity and, if necessary, any third-party patent rights.  In addition, ARIAD is eligible to receive up to $135.0 million in potential future development and regulatory approval milestone payments for ICLUSIG in new oncology indications in the Territory (the “Milestones”), together with additional milestone payments for non-oncology indications, if approved, in the Territory.  Incyte will also be co-funding a portion of the ongoing ICLUSIG clinical studies OPTIC and OPTIC 2L, which are being conducted by ARIAD, by paying up to $7.0 million in both 2016 and 2017 (the “Development Costs”). 

 

The terms of the License Agreement also include a limited option for a potential future acquirer of ARIAD to purchase the European development and commercialization rights to ICLUSIG from us (the “Buy-Back Provision”). Under these purchase terms, we would retain all EU infrastructure and be financially compensated.  Our financial compensation would include the repayment of the Upfront Payment and any Milestone or Development Costs payments made by us to ARIAD and an additional payment based upon the last 12 months of ICLUSIG sales booked by us. We would also be eligible to receive royalties of between 20% to 25% from an ARIAD acquirer on future sales of ICLUSIG in the Territory. The Buy-Back Provision cannot be exercised before two years nor after the sixth year from the effective date of the License Agreement. Following exercise of the Buy-Back Provision, there is a further transition period of one year before the provision can be made effective.  We concluded the Buy-Back Provision is not a derivative as it does not provide for explicit or implicit net settlement, cannot be readily settled net by a means outside of the contract, and does not provide for delivery of an asset that puts the recipient in a position that is not substantially different from net settlement. We also consider the probability of a potential future buyer exercising the Buy-Back Provision to be near zero and have concluded that any value assigned to this provision is de minimis.

 

Unless terminated earlier in accordance with its provisions, our obligations to pay full royalties under the License Agreement will continue to be in effect on a country-by-country basis until the latest to occur of (1) the expiration date of the composition patent in the relevant country, (2) the expiration of any regulatory marketing exclusivity period or other statutory designation that provides similar exclusivity for the commercialization of ICLUSIG in such country and (3) the seventh anniversary of the first commercial sale of ICLUSIG in such country.  We will be obligated to pay royalties at a reduced rate for a specified period of time following such full royalty term. The License Agreement may be terminated in its entirety by us for convenience on 12 months’ notice after the third anniversary of the effective date of the License Agreement.  The License Agreement may also be terminated by either party under certain other circumstances, including material breach, as set forth in the License Agreement.

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Fair Value of Consideration Transferred

 

The preliminary fair value of consideration transferred totaled $440.5 million, which consisted of $147.5 million in cash pursuant to the Share Purchase Agreement, including net working capital adjustments, and $293.0 million of contingent consideration related to the License Agreement.  Contingent consideration includes the future payments that we may pay to ARIAD for our royalty obligations on future net sales of ICLUSIG, as well as for any future potential milestone payments related to new oncology or non-oncology indications for ICLUSIG.

 

The preliminary fair value of contingent consideration was determined using an income approach based on estimated ICLUSIG revenues in the Territory for both the approved third line treatment, as well as the second line treatment that is currently under development and is therefore contingent on future clinical results and European Medicines Agency (“EMA”) approval. The probability of technical success (“PTS”) of the second line indication was estimated at 25% based on the early stage of development and competitive market landscape, and the estimated future cash flows for the second line indication were probability weighted accordingly. The total projected cash flows of the third line and second line indications were estimated over 18 years, and discounted to present value using a discount rate of 10%. In addition, based on the believed limited effectiveness of ICLUSIG beyond the existing oncology indications, the fact that no development is currently ongoing for any new oncology or any non-oncology indications, and the lack of intention by us or ARIAD to develop ICLUSIG in additional oncology or non-oncology indications, the fair value of any cash flows for any new oncology or non-oncology indication was determined to be nil.  The present value of the contingent consideration was $293.0 million as of the Acquisition date.

 

Assets Acquired and Liabilities Assumed

 

The Acquisition has been accounted for as a business combination under the acquisition method of accounting.  The following table summarizes the estimated fair values of the assets acquired and liabilities assumed as of the acquisition date.  Due to the timing of the Acquisition, certain amounts are provisional and subject to change.  The provisional amounts consist primarily of the estimates of the fair value of intangible assets acquired, inventory, contingent consideration and income taxes.  We will finalize these amounts as we obtain the information necessary to complete the measurement process.  Any changes resulting from facts and circumstances that existed as of the acquisition date may result in adjustments to the provisional amounts recognized at the acquisition date.  These changes could be significant.  We will finalize these amounts no later than one year from the acquisition date.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Amounts

 

Measurement

 

Amounts

 

 

 

Recognized as of

 

Period

 

Recognized as of

 

(estimated in thousands)

 

Acquisition Date(a)

    

Adjustments(b)

    

September 30, 2016

 

Current assets

 

$

21,413

 

$

(159)

 

$

21,254

 

Property and equipment

 

 

850

 

 

 —

 

 

850

 

Restricted cash

 

 

432

 

 

 —

 

 

432

 

Intangible assets(c)

 

 

283,000

 

 

 —

 

 

283,000

 

Total identifiable assets

 

 

305,695

 

 

(159)

 

 

305,536

 

Current liabilities

 

 

(15,720)

 

 

182

 

 

(15,538)

 

Other long term liabilities

 

 

(5,226)

 

 

 —

 

 

(5,226)

 

Total liabilities assumed

 

 

(20,946)

 

 

182

 

 

(20,764)

 

Goodwill(d)

 

 

155,725

 

 

(23)

 

 

155,702

 

Total fair value of consideration transferred

 

$

440,474

 

$

 —

 

$

440,474

 

 

(a)As previously reported in our Quarterly Report on Form 10-Q for the quarter ended June 30, 2016. 

 

(b)The measurement period adjustments primarily reflect a change in working capital.  

 

(c)As of the effective date of the Acquisition, identifiable intangible assets are required to be measured at fair value.  The fair value measurement is based on significant inputs that are unobservable in the market and thus represents a Level 3 measurement. We used an income statement approach to estimate the preliminary fair value of the intangibles which includes licensed intellectual property and IPR&D. The assumptions used to estimate the cash flows of the licensed intellectual property included a discount rate of 15%, estimated gross margins of 98%, income tax rates ranging from 7.8% in periods in which we have established tax holidays to 13.8% thereafter, and operating expenses consisting of direct costs based on the anticipated level of revenues as well as the $7.0 million of research and development cost sharing payments we will owe in 2016 and 2017.  The assumptions used to estimate the cash flows of the IPR&D (which relates to the potential approval of ICLUSIG as a second line treatment) included a PTS of 25%, discount rate of 16%, estimated gross margins of 98%, income tax rates ranging from 7.8% in periods in which we have established tax

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holidays to 13.8% thereafter, and operating expenses consisting of direct costs based on the anticipated level of revenues as well as probability weighted milestone payments estimated for 2020 related to the clinical results and potential approval of ICLUSIG as a second line treatment. The licensed intellectual property has a weighted-average useful life of approximately 12.5 years and will be amortized using the straight-line method and the IPR&D is an indefinite-lived intangible and will not be amortized until the completion or abandonment of the related research and development activities. 

 

(d)Goodwill is calculated as the difference between the estimated acquisition date fair value of the consideration transferred and the estimated fair values of the assets acquired and liabilities assumed. The Goodwill is related to the existing platform, infrastructure, and workforce which is expected to generate synergies and further our strategic plan in Europe.  Goodwill is not amortized and none of the goodwill is expected to be deductible for tax purposes.

 

Acquisition-Related Costs

 

We have incurred to date $1.5 million of transaction costs directly related to the Acquisition, which includes expenditures for advisory, legal, valuation, accounting and other similar services.  These costs have been expensed in selling, general and administrative costs on the condensed consolidated statements of operations during the nine months ended September 30, 2016.

 

Revenue and Net Loss of ARIAD Pharmaceuticals (Luxembourg) S.a.r.l.

 

The revenues of ARIAD Pharmaceuticals (Luxembourg) S.a.r.l. for the period from the acquisition date to September 30, 2016 were $16.7 million and net loss was $28.2 million.  The net loss includes the effects of the Acquisition accounting adjustments and acquisition-related costs.

 

Pro Forma Impact of Business Combination

 

The following unaudited pro forma information presents condensed consolidated results of operations for the three and nine months ended September 30, 2016 and 2015, as if the Acquisition had occurred as of January 1, 2015 (in thousands).

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

For the Three Months Ended,

 

For the Nine Months Ended,

 

 

 

September 30,

 

September 30,

 

 

    

2016

    

2015

    

2016

    

2015

    

Pro forma revenues

    

$

269,469

    

$

194,866

 

$

821,743

    

$

528,711

 

Pro forma net income (loss)

 

$

36,877

 

$

(48,613)

 

$

91,248

 

$

(96,015)

 

 

The unaudited pro forma condensed consolidated results of operations were prepared using the acquisition method of accounting and are based on the historical financial information of our company and the acquired business which has been adjusted for events that are (1) directly attributable to the Acquisition, (2) factually supportable, and (3) expected to have continuing impact on the combined results.  The unaudited pro forma information reflects primarily the following adjustments:

 

·

To record amortization expense related to fair value adjustments recorded on the acquired definite lived intangibles;

 

·

To eliminate ARIAD Europe’s interest expense on the intercompany loan in accordance with the terms of the Acquisition;

 

·

To remove balances attributable to the ARIAD Australia entity which are not material. This entity was previously consolidated by ARIAD Europe; however it was not included in the Acquisition; and

 

·

To remove the recognition of revenue relating to distribution agreements in historic periods for those arrangements in which we have no continuing performance obligation and, therefore, the fair value of the assumed deferred revenue balance was zero.

 

The unaudited pro forma information is not necessarily indicative of the results that would have been obtained if the Acquisition had occurred as of the beginning of the period presented or that may occur in the future, and does not reflect future synergies, integration costs, or other such costs or savings.  The unaudited pro forma information for the nine months ended September 30, 2016 includes $24.4 million of revenue that had been deferred in historic periods relating to the conclusion of pricing and reimbursement negotiations with the French National Health Authority.

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4.     Fair value of financial instruments

 

FASB accounting guidance defines fair value as the price that would be received to sell an asset or paid to transfer a liability (“the exit price”) in an orderly transaction between market participants at the measurement date. The standard outlines a valuation framework and creates a fair value hierarchy in order to increase the consistency and comparability of fair value measurements and the related disclosures. In determining fair value we use quoted prices and observable inputs. Observable inputs are inputs that market participants would use in pricing the asset or liability based on market data obtained from sources independent of us. The fair value hierarchy is broken down into three levels based on the source of inputs as follows:

 

Level 1—Valuations based on unadjusted quoted prices in active markets for identical assets or liabilities.

 

Level 2—Valuations based on observable inputs and quoted prices in active markets for similar assets and liabilities.

 

Level 3—Valuations based on inputs that are unobservable and models that are significant to the overall fair value measurement.

 

Recurring Fair Value Measurements

 

Our marketable securities consist of investments in corporate debt securities that are classified as available-for-sale.

 

At September 30, 2016 and December 31, 2015, our Level 2 corporate debt securities were valued using readily available pricing sources which utilize market observable inputs, including the current interest rate and other characteristics for similar types of investments.

 

The following fair value hierarchy table presents information about each major category of our financial assets measured at fair value on a recurring basis as of September 30, 2016 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurement at Reporting Date Using:

 

 

 

 

 

 

Quoted Prices in

 

Significant Other

 

Significant

 

 

 

 

 

 

Active Markets for

 

Observable

 

Unobservable

 

 

 

 

 

 

Identical Assets

 

Inputs

 

Inputs

 

Balance as of

 

 

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

September 30, 2016

 

Cash and cash equivalents

 

$

580,099

 

$

 —

 

$

 —

 

$

580,099

 

Corporate debt securities

 

 

 —

 

 

136,486

 

 

 —

 

 

136,486

 

Long term investment (Note 9)

 

 

55,745

 

 

 —

 

 

 —

 

 

55,745

 

Total assets

 

$

635,844

 

$

136,486

 

$

 —

 

$

772,330

 

 

The following fair value hierarchy table presents information about each major category of our financial liabilities measured at fair value on a recurring basis as of September 30, 2016 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurement at Reporting Date Using:

 

 

 

 

 

Quoted Prices in

 

Significant Other

 

Significant

 

 

 

 

 

Active Markets for

 

Observable

 

Unobservable

 

 

 

 

 

Identical Assets

 

Inputs

 

Inputs

 

Balance as of

 

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

September 30, 2016

Contingent consideration (Note 3)

 

$

 —

 

$

 —

 

$

298,000

 

$

298,000

Total liabilities

 

$

 —

 

$

 —

 

$

298,000

 

$

298,000

 

The following is a rollforward of our Level 3 liabilities (in thousands):

 

 

 

 

 

 

Level 3

Balance at January 1, 2016

 

$

 —

Initial recognition of contingent consideration

 

 

293,000

Contingent consideration earned during the period but not yet paid

 

 

(4,012)

Payments made during the period

 

 

(1,271)

Change in fair value of contingent consideration

 

 

10,283

Balance at September 30, 2016

 

$

298,000

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The fair value of the contingent consideration was determined using an income approach based on estimated ICLUSIG revenues in the Territory for both the approved third line treatment, as well as the second line treatment that is currently under development and is therefore contingent on future clinical results and EMA approval.  The fair value of the contingent consideration is remeasured each reporting period, with changes in fair value recorded in the condensed consolidated statements of operations. The change in fair value of the contingent consideration during the period ending September 30, 2016 is due primarily to the passage of time, as there have been no significant changes to date in the key assumptions used in the fair value calculation at the date of acquisition as described in Note 3.

 

The following fair value hierarchy table presents information about each major category of our financial assets measured at fair value on a recurring basis as of December 31, 2015 (in thousands):

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Fair Value Measurement at Reporting Date Using:

 

 

 

 

 

 

Quoted Prices in

 

Significant Other

 

Significant

 

 

 

 

 

 

Active Markets for

 

Observable

 

Unobservable

 

 

 

 

 

 

Identical Assets

 

Inputs

 

Inputs

 

Balance as of

 

 

    

(Level 1)

    

(Level 2)

    

(Level 3)

    

December 31, 2015

 

Cash and cash equivalents

 

$

521,439

 

$

 —

 

$

 —

 

$

521,439

 

Corporate debt securities

 

 

 —

 

 

186,344

 

 

 —

 

 

186,344

 

Long term investment (Note 9)

 

 

35,248

 

 

 —

 

 

 —

 

 

35,248

 

Total assets

 

$

556,687

 

$

186,344

 

$

 —

 

$

743,031

 

 

The following is a summary of our marketable security portfolio as of September 30, 2016 and December 31, 2015, respectively.

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Net

 

Net

 

 

 

 

 

 

Amortized

 

Unrealized

 

Unrealized

 

Estimated

 

 

    

Cost

    

Gains

    

Losses

    

Fair Value

 

 

 

(in thousands)

 

September 30, 2016

    

 

 

    

 

 

    

 

 

    

 

 

 

Corporate debt securities

 

$

136,082

 

$

404

 

$

 —

 

$

136,486

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

December 31, 2015

 

 

 

 

 

 

 

 

 

 

 

 

 

Corporate debt securities

 

$

187,153

 

$

 —

 

$

(809)

 

$

186,344

 

 

Our corporate debt securities generally have contractual maturity dates of between 12 to 18 months.

 

Non-Recurring Fair Value Measurements

 

Non-recurring fair value measurements during the three and nine month periods ended September 30, 2016 relate to the fair value of intangible assets and inventory acquired in the Acquisition which are discussed in further detail in Note 3.

 

5.     Concentration of credit risk

 

In December 2009, we entered into a license, development and commercialization agreement with Eli Lilly and Company (“Lilly”). In November 2009, we entered into a collaboration and license agreement with Novartis. The concentration of credit risk related to our collaborative partners is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Percentage of Total

 

Percentage of Total

 

 

 

Contract Revenues for the

 

Contract Revenues for the

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

    

2016

    

2015

    

 

2016

    

2015

    

 

Collaboration Partner A

    

 —

%  

61

%  

    

7

%  

76

%  

 

Collaboration Partner B

 

100

%  

39

%  

 

93

%  

24

%  

 

 

Collaboration Partner A and Collaboration Partner B comprised in the aggregate 23% and 39% of the accounts receivable balance as of September 30, 2016 and December 31, 2015, respectively.

 

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In November 2011, we began commercialization and distribution of JAKAFI to a number of customers. Our product revenues are concentrated in a number of these customers. The concentration of credit risk related to JAKAFI product revenues is as follows:

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Percentage of Total Net

 

Percentage of Total Net

 

 

 

Product Revenues for the

 

Product Revenues for the

 

 

 

Three Months Ended

 

Nine Months Ended

 

 

 

September 30,

 

September 30,

 

 

    

2016

    

2015

    

 

2016

    

2015

    

 

Customer A

    

25

%  

29

%  

    

26

%  

28

%  

 

Customer B

 

19

%  

18

%  

 

18

%  

19

%  

 

Customer C

 

13

%  

13

%  

 

13

%  

13

%  

 

Customer D

 

8

%  

9

%  

 

8

%  

9

%  

 

 

We are exposed to risks associated with extending credit to customers related to the sale of products. Customer A, Customer B, Customer C and Customer D comprised in the aggregate 40% and 40% of the accounts receivable balance as of September 30, 2016 and December 31, 2015, respectively.

 

The concentration of credit risk relating to ICLUSIG product revenues or accounts receivable is not significant.

 

6.     Inventory

 

Our inventory balance consists of the following:

 

 

 

 

 

 

 

 

 

 

 

September 30,

 

December 31,

 

 

    

2016

    

2015

 

 

 

(in thousands)

 

Work-in-process

 

$

14,829

 

$

17,555

 

Finished goods

 

 

4,078

 

 

1,783

 

 

 

 

18,907

 

 

19,338

 

Inventories-current