UNITED STATES SECURITIES AND EXCHANGE COMMISSION
FORM 10-Q/A
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended June 30, 2003
Commission file number: 0-27406
CONNETICS CORPORATION
| Delaware | 94-3173928 | |
| (State or other jurisdiction of incorporation or organization) | (IRS Employer Identification Number) | |
| 3290 West Bayshore Road Palo Alto, California (Address of principal executive offices) | 94303 (Zip Code) |
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 the past 90 days. Yes [X] No [ ]
Indicate by check mark whether the registrant is an accelerated filer (as defined in Exchange Act Rule 12b-2). Yes [X] No [ ]
As of August 8, 2003, 31,692,935 shares of the Registrant’s common stock were outstanding, at $0.001 par value.
| Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations | ||||||||
| SIGNATURE | ||||||||
| INDEX TO EXHIBITS | ||||||||
| EXHIBIT 31.1 | ||||||||
| EXHIBIT 31.2 | ||||||||
| EXHIBIT 32.1 | ||||||||
| EXHIBIT 32.2 | ||||||||
We are filing this Amendment No. 1 (“Amendment No. 1”) to our quarterly report on Form 10-Q for the quarter ended June 30, 2003, as filed with the Securities and Exchange Commission on August 14, 2003 (the “Original Form 10-Q”), to reflect certain revisions in Item 2 of Part I. This Amendment No. 1 speaks as of the date of the Original Form 10-Q, except for the certifications, which speak as of their respective dates and the filing date of this Amendment No. 1. This Amendment No. 1 does not reflect events occurring after the filing of the Original Form 10-Q, nor does it modify or update the disclosure in the Original Form 10-Q except as specifically set forth herein.
Item 2.Management’s Discussion and Analysis of Financial Condition and Results of Operations
This discussion and analysis should be read in conjunction with the MD&A included in our Annual Report on Form 10-K/A for the year ended December 31, 2002, and with the unaudited condensed consolidated financial statements and notes to financial statements included in this Report. Our disclosure and analysis in this Report, in other reports that we file with the Securities and Exchange Commission, in our press releases and in public statements of our officers contain forward-looking statements within the meaning of Section 27A of the Securities Act, and Section 21E of the Securities Exchange Act. Forward-looking statements give our current expectations or forecasts of future events. You can identify these statements by the fact that they do not relate strictly to historical or current events. They use words such as “anticipate,” “estimate,” “expect,” “will,” “may,” “intend,” “plan,” “believe” and similar expressions in connection with discussion of future operating or financial performance. These include statements relating to future actions, prospective products or product approvals, future performance or results of current and anticipated products, sales efforts, expenses, the outcome of contingencies such as legal proceedings, and financial results. Forward-looking statements may turn out to be wrong. They can be affected by inaccurate assumptions or by known or unknown risks and uncertainties. Many factors will be important in determining future results. No forward-looking statement can be guaranteed, and actual results may vary materially from those anticipated in any forward-looking statement. Some of the factors that, in our view, could cause actual results to differ are discussed under the caption “Factors That May Affect Future Results, Financial Condition and the Market Price of Securities” and in our Annual Report on Form 10-K/A. Our historical operating results are not necessarily indicative of the results to be expected in any future period.
Overview
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. We currently market two pharmaceutical products, OLUX® and Luxíq®. Both products have clinically proven therapeutic advantages and we are providing quality customer service to physicians through our experienced sales and marketing professionals. In December 2002, we received approval from the U.S. Food and Drug Administration, or FDA, to sell OLUX for the treatment of non-scalp psoriasis.
In addition to revenue from product sales, we receive royalties on sales of RID®, Actimmune® and Ridaura® in the U.S., and internationally on sales of Banlice®, Milice®, Bettamousse®, and on a super-concentrated aerosol spray licensed worldwide. We have licenses with Novartis and Pharmacia Corporation, which have the potential to bear royalties in the future depending on approval of their products for sale.
During the first half of 2003, we had three product candidates in Phase III clinical trials: Extina™, a foam formulation of a 2% concentration of the antifungal drug ketoconazole, for the treatment of seborrheic dermatitis; Actiza™, a formulation of 1% clindamycin in our proprietary foam delivery system for the treatment of acne; and Velac ® Gel (a first-in-class combination of 1% clindamycin and 0.025% tretinoin) for the treatment of acne.
In April 2003, we announced the outcome of a Phase III clinical trial evaluating Extina. The four-week, double-blinded active- and placebo-controlled trial included 619 patients at 25 centers. As designed, the trial results demonstrated that Extina was not inferior to Nizoral® (ketoconazole) 2% Cream as measured by the primary endpoint of Investigator’s Static Global Assessment (ISGA). The trial was also designed to compare Extina to placebo foam per the ISGA. The result, although in favor of Extina™, did not achieve statistical significance. On all other endpoints, statistical significance was achieved; therefore we believe that the totality of the data demonstrated that Extina was clinically superior to placebo foam. On July 2, 2003 we announced we had submitted a New Drug Application (NDA) with the FDA for Extina.
In June 2003, we announced the completion of patient enrollment in our Phase III clinical trial for Actiza, a formulation of 1% clindamycin delivered in our proprietary foam delivery system, for the treatment of acne. The Phase III trial includes 1,026 patients at 18 centers, in which patients are treated for 12 weeks in a double-blinded, placebo and active controlled design. We anticipate data from the trial will be available in the fall of 2003.
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In May 2003 we issued $90 million of convertible senior notes in a private placement pursuant to Rule 144A of the Securities Act of 1933. The notes bear an interest rate of 2.25% per year and have a five-year term. The notes are convertible into Connetics common stock at a price equal to approximately $21.41 per share, subject to adjustment in certain circumstances, which represents a 35% premium over the closing price on the date the offering was announced. We will use the proceeds from the offering to augment our cash reserves for general corporate purposes, including potential future product or company acquisitions, capital expenditures and working capital.
Critical Accounting Policies
There have been no material changes to our critical accounting policies, from those reported in the section entitled “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in our annual report on Form 10-K/A for the year ended December 31, 2002.
Results of Operations
Revenues
| Three Months Ended | Six Months Ended | ||||||||||||||||||
| June 30, | June 30, | ||||||||||||||||||
| (in thousands) | (in thousands) | ||||||||||||||||||
| 2003 | 2002 | 2003 | 2002 | ||||||||||||||||
| Revenues Product: | |||||||||||||||||||
| OLUX® | $ | 11,004 | $ | 7,728 | $ | 20,879 | $ | 14,526 | |||||||||||
| Luxíq® | 4,491 | 3,653 | 8,879 | 6,975 | |||||||||||||||
| Other | 33 | 42 | 81 | 62 | |||||||||||||||
| Total product revenues | 15,528 | 11,423 | 29,839 | 21,563 | |||||||||||||||
| Royalty, license and contract: | |||||||||||||||||||
| Royalty | 4,384 | 766 | 5,320 | 1,416 | |||||||||||||||
| Novartis | — | — | — | 580 | |||||||||||||||
| Pharmacia | 25 | 375 | 56 | 500 | |||||||||||||||
| Other contract | 33 | 62 | 66 | 98 | |||||||||||||||
| Total royalty, license and contract revenues | 4,442 | 1,203 | 5,442 | 2,594 | |||||||||||||||
| Total revenues | $ | 19,970 | $ | 12,626 | $ | 35,281 | $ | 24,157 | |||||||||||
Our product revenues were $15.5 million for the three months ended June 30, 2003 and $29.8 million for the six months ended June 30, 2003, compared to $11.4 million and $21.6 million for the three and six months ended June 30, 2002. Total net product sales increased 36% in the second quarter and 38% in the first six months of 2003 as compared to the same periods in the prior year. Increased sales volumes accounted for a 26% increase in the net product sales in the second quarter of 2003 and a 25% increase in the net product sales in the six months ended June 30, 2003 compared to the same periods in 2002. Higher sales prices for our dermatology products accounted for the remainder of the increases in net product sales in the three and six months ended June 30, 2003 compared to the same periods in 2002.
Royalty, license and contract revenues were $4.4 million and $5.4 million for the three and six months ended June 30, 2003, compared to $1.2 million and $2.6 million for the three and six months ended June 30, 2002. Royalty, license and contract revenue was higher for the second quarter of 2003 compared to the second quarter of 2002 primarily due to a one-time royalty payment made by a third party in the amount of $2.9 million in connection with Connetics’ aerosol spray technology, as well as an increase year over year in the quarterly royalties paid by the same party of approximately $654,000 in the second quarter of 2003 and an increase in royalty revenues of $51,000 related to the sales of Actimmune.
We have an agreement with Prometheus Laboratories, Inc. pursuant to which we receive a royalty on Prometheus’ annual sales of Ridaura in excess of $4.0 million, in any calendar year through March 2006. We recognize royalty revenue in the quarter in which the royalty payment is either received or may be reasonably estimated. We recognized $0 and $133,000 of royalty revenue in the three and six months ended June 30, 2003 and $0 in both of the comparable periods for 2002 in conjunction with this agreement.
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We have an agreement with InterMune, Inc. pursuant to which we receive a royalty on InterMune’s sales of Actimmune in the United States. We recognized $95,000 and $187,000 of royalty revenue for the three and six months ended June 30, 2003, and $44,000 of royalty revenue for both of the three and six months ended June 30, 2002, in connection with this agreement.
Cost of Product Revenues
Our cost of product revenues includes the third party costs of manufacturing OLUX and Luxíq, depreciation costs associated with Connetics owned equipment located at the DPT facility in Texas, royalty payments based on a percentage of our product revenues, and product freight and distribution costs from Cardinal Health Specialty Pharmaceutical Services (formerly CORD Logistics, Inc.), the third party that handles all of our product distribution activities. Currently, DPT Laboratories, Ltd., AccraPac Group, Inc., and InyX Pharma, Ltd. (formerly Miza Pharmaceuticals) manufacture commercial supplies of OLUX and Luxíq. We recorded costs of product revenues of $1.2 million for the three months ended June 30, 2003 and $2.3 million for the six months ended June 30, 2003, compared to $973,000 and $1.6 million for the three and six months ended June 30, 2002. The increase in the cost of product revenues in the three and six month periods ended June 30, 2003 compared to the same periods in 2002 is directly attributable to the increase in sales volume of our products.
Research and Development
Research and development expenses include costs of personnel to support our research and development activities, costs of preclinical studies, costs of conducting our clinical trials, such as clinical investigator fees, monitoring costs, data management and drug supply costs, external research programs, and an allocation of facilities costs, salaries and benefits, and overhead costs such as rent, supplies and utilities. In the six months ended June 30, 2003 we incurred costs associated with ten clinical trials in various stages of completion, compared to four clinical trials in various stages of completion in the six months ended June 30, 2002. There was also a significant increase in the number of patients enrolled in the clinical trial work performed during the six months ended June 30, 2003 compared to the same six month period in 2002. As of June 30 2003, we were still conducting concurrent Phase III clinical trials for Velac and Actiza.
Research and development expenses were $8.6 million and $5.6 million for the three months ended June 30, 2003 and 2002, respectively. The increase is primarily due to increased clinical trial costs of $2.2 million as well as increased employee and travel related costs of $576,000 associated with the increased headcount needed to support the increased activities in the clinical trial area as well as other R&D activities.
Research and development expenses were $17.2 million and $10.7 million for the six months ended June 30, 2003 and 2002, respectively. The increase is due primarily to increased clinical trial costs of $5.6 million as well as increased employee & travel related costs of $877,000 associated with the increased headcount needed to support the increased activities in the clinical trial area as well as other R&D activities.
Selling, General and Administrative Expenses
Selling, general and administrative expenses were $10.8 million for the three months ended June 30, 2003 and $21.9 million for the six months ended June 30, 2003, compared to $10.7 million and $20.3 million for the comparable periods in 2002. Although expenditures were relatively flat for the three months ended June 30, 2003 compared with the same period in 2002, there was some fluctuation in the areas of expenditures between the periods. For the three months ended June 30, 2003 there was an overall increase of $569,000 in employee-related costs due to increased headcount, an increase of $288,000 in miscellaneous selling, general and administrative expenses, partially offset by a decrease in consulting and outside services of $820,000, compared with the same period in 2002.
For the six months ended June 30, 2003 there was an overall increase of $985,000 in employee-related costs due to increased headcount, an increase of $288,000 in miscellaneous selling, general and administrative expenses, an increase of $588,000 in consulting and outside service expenses, partially offset by a decrease in travel expenses of $291,000 compared with the same period in 2002.
Interest and other income (expense), net
Interest income was $169,000 and $294,000 for the three and six months ended June 30, 2003 and $217,000 and $496,000 for the three and six months ended June 30, 2002. The decrease in interest income during the first six months of 2003 compared to the same period in 2002 was the result of lower cash and investment balances for the majority of the period, combined with a decrease in market interest rates on investments.
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Interest expense was $230,000 and $231,000 for the three and six months ended June 30, 2003 and $4,000 and $6,000 for the three and six months ended June 30, 2002. The increase in interest expense during the first six months of 2003 compared to the same period in 2002 was directly related to the interest expense associated with the convertible senior notes issued in the second quarter of 2003.
Other income, net, was $33,000 and $87,000 for the three and six months ended June 30, 2003 and $93,000 and $171,000 for the three and six months ended June 30, 2002. The decrease in other income during the six months ended June 30, 2003 compared to the same period in 2002 is directly related to the decrease in income related to a facility sublease, which ended in January 2003.
Income Taxes
We recognized income tax expense of $1.2 million for the three months ended June 30, 2003 and $1.3 million for the six months ended June 30, 2003, related to a foreign tax provision recorded by Connetics Australia. We recognized income tax expense of $161,000 and a net income tax benefit of $63,000 for the three and six months ended June 30, 2002. The net income tax benefit reflects a U.S. tax benefit of $540,000 partially reduced by a foreign tax provision recorded by Connetics Australia of $477,000. The U.S. tax benefit arose principally because of the provisions of the U.S. Job Creation and Worker Assistance Act of 2002 enacted on March 9, 2002, which allows taxpayers to carry back net operating losses generated in 2001 and 2002 to offset alternative minimum tax paid in the last five years.
Liquidity and Capital Resources
Sources and Use of Cash.We have financed our operations to date primarily through proceeds from equity and debt financings, collaborative arrangements with corporate partners, bank loans, and product revenues. At June 30, 2003, cash, cash equivalents and short-term investments totaled $113.5 million compared to $33.1 million at December 31, 2002. Our cash balances are held in a variety of interest-bearing instruments including high-grade corporate bonds, commercial paper, U.S. Government agencies papers, and money market accounts.
Cash used in operating activities.Cash used in operations for the six months ended June 30, 2003 was $7.9 million compared to $7.5 million for the six month period ended June 30, 2002. Net loss of $7.2 million for the six months ended June 30, 2003 was affected by non-cash charges of $1.1 million of depreciation and amortization expense and $2.2 million of increased reserves related to product returns, chargebacks, rebates and coupon programs. Cash usage was primarily offset by a decrease in accounts receivable of approximately of $1.9 million related to the timing of sales and collection of outstanding amounts, an increase in other assets of $2.4 million primarily related to various prepaid activities, a decrease in accounts payable and other accrued and current liabilities of $3.4 million primarily related to the timing of payments and activities related to development and other business activity.
Net loss of $8.5 million for the six-month period ending June 30, 2002 was affected by non-cash charges of $1.0 million of depreciation and amortization expense and a $1.6 million gain on the sale of investments. Cash usage was partially offset by a decrease in accounts receivable of $840,000 relating to the timing of sales and collection of outstanding amounts, an increase in reserves related to product returns, chargebacks, and rebates of $448,000, an increase of $778,000 in various prepaid activities, and an increase in accounts payable and other accrued and current liabilities of $1.4 million related to increased business and development activities.
Cash flows provided by (used in) investing activities.Cash flows used in investing activities was $42.7 million for the six month period ended June 30, 2003, compared to cash flows provided by investing activities of $8.5 million for the six months ended June 30, 2002. The increase in cash used in investing activities is due primarily to the net result of an increase in purchasing activity of short-term investments of $40.6 million primarily related to the proceeds from the convertible debt financing in the second quarter of 2003, as well as a decrease in sales activity of short-term investments of $12.5 million. We had only moderate increases in operating expenses in the six month period ended June 30, 2003 compared to the same period in 2002, but our property and equipment expenditures decreased by $2.0 million for the six month period ended June 30, 2003 compared to the same period last year. Of the $2.0 million, $1.5 million is related to the DPT facility build-out which occurred in 2002, $185,000 related to leasehold improvements and other costs in connection with moving our offices to 3290 West Bayshore in 2002, and the balance represented higher regular business equipment and property purchases in the first six months of 2002 compared to the same period in 2003.
Cash flows from financing activities.Financing activities provided $89.5 million and $4.3 million for the six month periods ended June 30, 2003 and 2002, respectively. This increase is primarily due to the $86.5 million of
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net proceeds from the issuance of convertible senior notes in the second quarter of 2003. The increase due to the financing was partially offset by the decrease of $1.1 million in restricted cash activity in 2003 compared to the same time frame in 2002. During the first six months of 2002, $1.4 million of previously restricted certificates of deposits related to our controlled disbursements account, security deposit on facility, and collateral on certain officers’ personal bank loans were released. For the same period in 2003, $312,000 of a previously restricted certificate of deposit related to a security deposit on our facility was released.
Working Capital.Working capital increased by $81.1 million to $106.3 million at June 30, 2003 from $25.2 million at December 31, 2002, primarily due to the convertible debt financing which we completed in the second quarter of 2003.
Contractual Obligations and Commercial Commitments.There have been no material changes in our contractual obligations and commercial commitments since December 31, 2002. Our commitments, including those disclosed in the Annual Report on Form 10-K/A for the year ended December 31, 2002, consist primarily of operating lease agreements for our facilities as well as minimum purchase commitments under one of our contract manufacturing agreements.
Restricted Cash and Cash Equivalents.In the six months ended June 30, 2003, $312,000 was released from previously restricted certificates of deposit related to security for our facilities rent. As of June 30, 2003, $411,000 of our total cash and cash equivalents balance was restricted cash, held in various certificates of deposit, for specific purposes.
We believe our existing cash, cash equivalents and short-term investments, cash 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. Our future capital uses and requirements depend on numerous factors, including the progress of our research and development programs, the progress of clinical testing, the time and costs involved in obtaining regulatory approvals, the cost of filing, prosecuting, and enforcing patent claims and other intellectual property rights, competing technological and market developments, the level of product revenues, and the possible acquisition of new products and technologies. A key element of our strategy is to in-license or acquire additional marketed or late-stage development products. A portion of the funds needed to acquire, develop and market any new products may come from our existing cash, which will result in fewer resources available to our current products and clinical programs. We continually evaluate various business development opportunities, including the possibility of acquiring or in-licensing other products. If we successfully reach agreements with third parties, these transactions may require us to use some of our available cash, or to raise additional cash by liquidating some of our investment portfolio and/or raising additional funds through equity or debt financings in connection with the transaction.
Factors that May Affect Future Results, Financial Condition and the Market Price of Securities
Please also read Item 1 in our 2002 Annual Report on Form 10-K/A where we have described our business and the challenges and risks we may face in the future.
There are many factors that affect our business and results of operations, some of which are beyond our control. In our Annual Report on Form 10-K/A for the year ended December 31, 2002 we list some of the important factors that may cause the actual results of our operations in future periods to differ materially from the results currently expected or desired. Due to these factors, we believe that quarter-to-quarter comparisons of our results of operations are not a good indication of our future performance. The factors discussed in our reports filed with the Securities and Exchange Commission, including our Annual Report on Form 10-K/A for the year ended December 31, 2002, in particular under the caption “Factors That May Affect Future Results, Financial Condition and the Market Price of Securities,” should be carefully considered when evaluating our business and prospects.
Our Business Strategy May Cause Fluctuating Operating Results
Our operating results and financial condition may fluctuate from quarter to quarter and year to year depending upon the relative timing of events or uncertainties that may arise. For example, the following events or occurrences could cause fluctuations in our financial performance from period to period:
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| • | changes in the levels we spend to develop new product lines, | ||
| • | changes in the amount we spend to promote our products, | ||
| • | changes in treatment practices of physicians that currently prescribe our products, | ||
| • | changes in reimbursement policies of health plans and other similar health insurers, including changes that affect newly developed or newly acquired products, | ||
| • | forward-buying patterns by wholesalers that may result in significant quarterly swings in revenue reporting, | ||
| • | increases in the cost of raw materials used to manufacture our products, | ||
| • | the development of new competitive products by others, | ||
| • | the mix of products that we sell during any time period, and | ||
| • | our responses to price competition, and | ||
| • | fluctuations in royalties paid by third parties. |
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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 Corporate Development and Chief Financial Officer | ||||||
| Date: December 2, 2003 | ||||||
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INDEX TO EXHIBITS
| Exhibit | ||
| Number | Description | |
| 4.1* | Indenture, dated as of May 28, 2003, between the Company and J.P. Morgan Trust Company, National Association, including therein the forms of the notes. | |
| 4.2* | Registration Rights Agreement, dated as of May 28, 2003, between the Company and Goldman, Sachs & Co., C.E. Unterberg, Towbin (a California Limited Partnership), CIBC World Markets Corp., Thomas Weisel Partners LLC and U.S. Bancorp Piper Jaffray Inc., as representatives. | |
| 31.1 | Certification by Chief Executive Officer pursuant to Rule 13a-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002. | |
| 31.2 | Certification by Chief Financial Officer pursuant to Rule 13a-14(a) and Section 302 of the Sarbanes-Oxley Act of 2002. | |
| 32.1 | Certification by Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. 1350. | |
| 32.2 | Certification by Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, 18 U.S.C. 1350. |
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| * | Previously filed with and incorporated by reference to the Registrant’s original Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003, filed with the Securities and Exchange Commission on August 14, 2003. |
