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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(MARK ONE)
x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 |
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2006
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: 0-33489
ZYMOGENETICS, INC.
(exact name of registrant as specified in its charter)
Washington | 91-1144498 | |
(State or other jurisdiction of incorporation or organization) | (I.R.S. Employer Identification No.) |
1201 Eastlake Avenue East, Seattle, Washington 98102
(Address of principal executive offices) (Zip Code)
(206) 442-6600
(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, and (2) has been subject to such filing requirements for the past 90 days. Yes x. No ¨.
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act. (Check one):
Large accelerated filer ¨ Accelerated filer x Non-accelerated filer ¨.
Indicate by check mark whether the Registrant is a shell company (as defined in Rule 12b-2 of the Act). Yes ¨ No x.
Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.
Common stock outstanding at October 30, 2006: 67,390,432 shares.
Table of Contents
Quarterly Report on Form 10-Q
For the quarterly period ended September 30, 2006
TABLE OF CONTENTS
Page No. | ||||||
PART I | FINANCIAL INFORMATION | |||||
Item 1. | Financial Statements (unaudited) | |||||
a) | Balance Sheets | 3 | ||||
b) | Statements of Operations | 4 | ||||
c) | Statements of Cash Flows | 5 | ||||
d) | Notes to Financial Statements | 6 | ||||
Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations | 11 | ||||
Item 3. | Quantitative and Qualitative Disclosures About Market Risk | 17 | ||||
Item 4. | Controls and Procedures | 17 | ||||
PART II | OTHER INFORMATION | |||||
Item 1A. | Risk Factors | 18 | ||||
Item 6. | Exhibits | 18 | ||||
SIGNATURE | 19 |
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PART I FINANCIAL INFORMATION
Item 1. | Financial Statements |
ZYMOGENETICS, INC.
(in thousands)
(unaudited)
September 30, 2006 | December 31, 2005 | |||||||
Assets | ||||||||
Current assets | ||||||||
Cash and cash equivalents | $ | 24,815 | $ | 122,322 | ||||
Short-term investments | 264,879 | 243,989 | ||||||
Receivables | ||||||||
Related party | 854 | 962 | ||||||
Trade | 3,045 | 2,366 | ||||||
Interest and other | 1,939 | 1,775 | ||||||
Prepaid expenses | 2,967 | 3,781 | ||||||
Total current assets | 298,499 | 375,195 | ||||||
Property and equipment, net | 71,021 | 71,803 | ||||||
Other assets | 6,547 | 6,355 | ||||||
Total assets | $ | 376,067 | $ | 453,353 | ||||
Liabilities and Shareholders’ Equity | ||||||||
Current liabilities | ||||||||
Accounts payable | $ | 4,205 | $ | 3,897 | ||||
Accrued liabilities | 14,987 | 11,911 | ||||||
Deferred revenue | 6,703 | 15,928 | ||||||
Total current liabilities | 25,895 | 31,736 | ||||||
Lease obligations | 67,063 | 66,754 | ||||||
Deferred revenue | 13,099 | 17,070 | ||||||
Other noncurrent liabilities | 4,322 | 4,130 | ||||||
Commitments and contingencies | ||||||||
Shareholders’ equity | ||||||||
Preferred stock, no par value, 30,000 shares authorized | — | — | ||||||
Common stock, no par value, 150,000 shares authorized, 67,335 and 65,935 issued and outstanding at September 30, 2006 and December 31, 2005, respectively | 727,015 | 702,957 | ||||||
Non-voting common stock, no par value, 30,000 shares authorized | — | — | ||||||
Accumulated deficit | (460,669 | ) | (367,816 | ) | ||||
Accumulated other comprehensive loss | (658 | ) | (1,478 | ) | ||||
Total shareholders’ equity | 265,688 | 333,663 | ||||||
Total liabilities and shareholders’ equity | $ | 376,067 | $ | 453,353 | ||||
The accompanying notes are an integral part of these financial statements.
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ZYMOGENETICS, INC.
(in thousands, except per share data)
(unaudited)
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Revenues | ||||||||||||||||
Royalties | ||||||||||||||||
Related party | $ | 660 | $ | 732 | $ | 2,081 | $ | 3,129 | ||||||||
Other | 1,047 | 932 | 3,214 | 2,753 | ||||||||||||
Option fees | ||||||||||||||||
Related party | 1,903 | 1,875 | 5,667 | 5,625 | ||||||||||||
Other | 784 | 784 | 2,352 | 2,353 | ||||||||||||
License fees and milestone payments | ||||||||||||||||
Related party | 8 | 2,268 | 5,262 | 7,805 | ||||||||||||
Other | 1,150 | 907 | 2,434 | 5,802 | ||||||||||||
Total revenues | 5,552 | 7,498 | 21,010 | 27,467 | ||||||||||||
Operating expenses | ||||||||||||||||
Research and development | 30,296 | 22,979 | 94,621 | 73,398 | ||||||||||||
General and administrative | 8,028 | 5,646 | 24,132 | 17,490 | ||||||||||||
Total operating expenses | 38,324 | 28,625 | 118,753 | 90,888 | ||||||||||||
Loss from operations | (32,772 | ) | (21,127 | ) | (97,743 | ) | (63,421 | ) | ||||||||
Other income (expense) | ||||||||||||||||
Investment income | 3,444 | 2,671 | 10,604 | 6,120 | ||||||||||||
Interest expense | (1,909 | ) | (1,895 | ) | (5,718 | ) | (5,668 | ) | ||||||||
Other, net | 12 | — | 4 | 27 | ||||||||||||
Net other income | 1,547 | 776 | 4,890 | 479 | ||||||||||||
Net loss | $ | (31,225 | ) | $ | (20,351 | ) | $ | (92,853 | ) | $ | (62,942 | ) | ||||
Basic and diluted net loss per share | $ | (0.47 | ) | $ | (0.33 | ) | $ | (1.39 | ) | $ | (1.06 | ) | ||||
Weighted-average number of shares used in computing net loss per share | 67,124 | 62,371 | 66,749 | 59,317 | ||||||||||||
The accompanying notes are an integral part of these financial statements.
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ZYMOGENETICS, INC.
(in thousands)
(unaudited)
Nine Months Ended September 30, | ||||||||
2006 | 2005 | |||||||
Operating activities | ||||||||
Net loss | $ | (92,853 | ) | $ | (62,942 | ) | ||
Adjustments to reconcile net loss to net cash used in operating activities | ||||||||
Depreciation and amortization | 4,987 | 4,720 | ||||||
Net gain on disposition of property and equipment | (11 | ) | (29 | ) | ||||
Noncash milestone revenue | — | (500 | ) | |||||
Stock-based compensation | 13,986 | 2,726 | ||||||
Net realized loss on short-term investments | 106 | 446 | ||||||
Net (accretion) amortization of (discount) premium on short-term investments | (412 | ) | 960 | |||||
Changes in operating assets and liabilities | ||||||||
Receivables | (735 | ) | 2,882 | |||||
Prepaid expenses | 814 | 555 | ||||||
Other assets | (192 | ) | 79 | |||||
Accounts payable | 308 | (565 | ) | |||||
Accrued liabilities | 3,076 | (1,249 | ) | |||||
Deferred revenue | (13,196 | ) | (17,676 | ) | ||||
Lease obligations | 309 | 419 | ||||||
Other noncurrent liabilities | 192 | 51 | ||||||
Net cash used in operating activities | (83,621 | ) | (70,123 | ) | ||||
Investing activities | ||||||||
Purchases of property and equipment | (4,195 | ) | (4,297 | ) | ||||
Purchases of short-term investments | (177,611 | ) | (206,582 | ) | ||||
Proceeds from sale of property and equipment | — | 4 | ||||||
Proceeds from sale and maturity of short-term investments | 157,848 | 204,665 | ||||||
Net cash used in investing activities | (23,958 | ) | (6,210 | ) | ||||
Financing activities | ||||||||
Net proceeds from issuance of common stock | — | 126,614 | ||||||
Proceeds from exercise of stock options | 10,072 | 2,421 | ||||||
Net cash provided by financing activities | 10,072 | 129,035 | ||||||
Net (decrease) increase in cash and cash equivalents | (97,507 | ) | 52,702 | |||||
Cash and cash equivalents at beginning of period | 122,322 | 117,308 | ||||||
Cash and cash equivalents at end of period | $ | 24,815 | $ | 170,010 | ||||
The accompanying notes are an integral part of these financial statements.
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ZYMOGENETICS, INC.
(unaudited)
1. | Basis of presentation |
The accompanying unaudited financial statements of ZymoGenetics, Inc. (the “Company”) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial information and the instructions to Form 10-Q. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been omitted pursuant to such rules and regulations. In the opinion of management, the financial statements reflect all normal recurring adjustments necessary to present fairly the Company’s financial position and results of operations as of and for the periods indicated. Operating results for such periods are not necessarily indicative of the results that may be expected for the full year or for any future period.
The December 31, 2005 balance sheet data was derived from the audited financial statements at that date but does not include all the information and footnotes required by generally accepted accounting principles for complete financial statements. These unaudited interim financial statements should be read in conjunction with the audited financial statements and related footnotes included in the Company’s Annual Report filed on Form 10-K for the year ended December 31, 2005.
The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and that affect the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.
2. | Net loss per share |
Basic and diluted net loss per share has been computed based on net loss and the weighted-average number of common shares outstanding during the applicable period. The Company has excluded 12.0 million outstanding options to purchase common stock as such shares are antidilutive for all periods presented.
3. | Short-term investments |
Short-term investments consisted of the following at September 30, 2006 (in thousands):
Amortized Cost | Gross Unrealized Gain | Gross Unrealized Loss | Estimated Fair Value | ||||||||||
Type of security: | |||||||||||||
Commercial paper and money market | $ | 4,000 | $ | — | $ | — | $ | 4,000 | |||||
Corporate debt securities | 78,806 | 121 | (101 | ) | 78,826 | ||||||||
Asset-backed securities | 139,978 | 117 | (715 | ) | 139,380 | ||||||||
U.S. government and agency securities | 42,750 | 27 | (104 | ) | 42,673 | ||||||||
$ | 265,534 | $ | 265 | $ | (920 | ) | $ | 264,879 | |||||
Maturity date: | |||||||||||||
Less than one year | $ | 151,454 | $ | 150,978 | |||||||||
Due in 1-3 years | 114,080 | 113,901 | |||||||||||
$ | 265,534 | $ | 264,879 | ||||||||||
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The Company’s management has concluded that unrealized losses are temporary, as the duration of the decline in the value of the investments has been relatively short; the extent of the decline, both in dollars and percentage of cost is not severe; and the Company has the ability and intent to hold the investments until at least substantially all of the cost of the investments is recovered.
4. | Stock compensation |
In March 2000, the Company adopted the 2000 Stock Incentive Plan (the 2000 Plan). Upon completion of the Company’s initial public offering in February 2002, the 2000 Plan was suspended and the 2001 Stock Incentive Plan (the 2001 Plan) became effective. Both Plans provide for the issuance of incentive stock options and nonqualified stock options to employees, directors, consultants and other independent contractors who provide services to the Company. The Company’s board of directors is responsible for administration of the Plans and determines the term of each option, exercise price and the vesting terms. The 2001 Plan provides for an annual increase in authorized shares effective the first day of each year equal to the least of (i) 2,700,000 shares; (ii) 5% of the outstanding common stock as of the end of the Company’s preceding fiscal year; and (iii) a lesser amount as determined by the Board of Directors. The first annual increase under the 2001 Plan occurred upon completion of the Company’s initial public offering. Any shares from the 2000 Plan that are not actually issued shall continue to be available for issuance under the 2001 Plan. The Company has reserved a total of 19,738,650 shares of common stock for issuance under the Plans, of which 3,091,328 are available for future grant at September 30, 2006. Options granted to employees under the Plans generally vest over a four-year period and expire ten years from the date of grant. Options to purchase 747,085 shares have been granted to board members, of which 144,000 options were immediately exercisable and 351,085 options vest over approximately one year.
A summary of stock option activity under the Plans for the nine months ended September 30, 2006 is presented below (shares and aggregate intrinsic value in thousands):
Shares | Weighted- Average Exercise Price | Weighted- Average Remaining Contractual Term (Years) | Aggregate Intrinsic Value | ||||||||
Balance, January 1, 2006 | 11,470 | $ | 10.88 | ||||||||
Granted | 1,565 | 20.60 | |||||||||
Exercised | (629 | ) | 6.35 | ||||||||
Forfeited | (90 | ) | 16.42 | ||||||||
Expired | (3 | ) | 15.92 | ||||||||
Balance, March 31, 2006 | 12,313 | $ | 12.30 | 7.2 | $ | 114,725 | |||||
Granted | 646 | 18.65 | |||||||||
Exercised | (473 | ) | 7.06 | ||||||||
Forfeited | (265 | ) | 17.95 | ||||||||
Expired | — | — | |||||||||
Balance, June 30, 2006 | 12,221 | $ | 12.72 | 7.0 | $ | 82,180 | |||||
Granted | 180 | 18.69 | |||||||||
Exercised | (297 | ) | 9.26 | ||||||||
Forfeited | (50 | ) | 18.45 | ||||||||
Expired | (48 | ) | 20.54 | ||||||||
Balance, September 30, 2006 | 12,006 | $ | 12.84 | 6.9 | $ | 62,479 | |||||
Exercisable, September 30, 2006 | 7,190 | $ | 8.84 | 5.6 | $ | 60,586 | |||||
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A summary of stock option value under the Plans is presented below (in thousands, except per stock option share data):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||
Weighted average grant-date fair value per stock option share granted | $ | 10.82 | $ | 8.81 | $ | 11.55 | $ | 10.39 | ||||
Total intrinsic value of stock options exercised | 2,657 | 2,360 | 18,026 | 7,170 | ||||||||
Total fair value of stock options vested | 3,914 | 3,905 | 15,141 | 13,644 |
Effective January 1, 2006, the Company adopted Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)),Share-Based Payment, that addresses the accounting for share-based payment transactions in which an enterprise receives employee services in exchange for (a) equity instruments of the enterprise or (b) liabilities that are based on the fair value of the enterprise’s equity instruments or that may be settled by the issuance of such equity instruments. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25,Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. The Company has adopted the modified prospective transition method and determines fair value using the Black-Scholes valuation method. Accordingly, prior periods have not been restated to reflect stock-based compensation under SFAS 123(R). The Company recorded the following amounts of stock-based compensation expense for the periods presented (in thousands):
Three Months Ended September 30, 2006 | Nine Months Ended September 30, 2006 | |||||
Research and development expense | $ | 2,892 | $ | 8,924 | ||
General and administrative expense | 1,692 | 5,030 | ||||
Total | $ | 4,584 | $ | 13,954 | ||
The Company has capitalized $32,000 of stock-based compensation cost to its internal software development project in the nine months ended September 30, 2006. No income tax benefit has been recorded as the Company has a full valuation allowance and management has concluded it is more likely than not that the net deferred tax asset will not be realized. As of September 30, 2006, there was $44.8 million of total unrecognized compensation costs related to stock options. These costs are expected to be recognized over a weighted average period of approximately three years.
Estimated fair values of stock options granted have been determined using the Black-Scholes option pricing model with the following assumptions:
Three Months Ended September 30, 2006 | Nine Months Ended September 30, 2006 | |||||
Expected stock price volatility | 56 | % | 56 | % | ||
Risk-free interest rate | 4.66 | % | 4.57 | % | ||
Expected life of options | 6.1years | 6.1years | ||||
Expected dividend yield | 0 | % | 0 | % |
The Company does not have historical trading information for its common stock for a long enough period to calculate historical volatility solely based on the trading of its common stock. Furthermore, the market for options on the Company’s common stock is illiquid and cannot be relied upon as a source of implied volatility. Accordingly, the Company has estimated the volatility of its common stock by augmenting its historical volatility with that of other similar companies, and blending it with the implied volatility of market traded options of similar companies. The risk-free interest rate used in the option valuation model is based on U.S. Treasury zero-coupon issues with remaining terms similar to the expected term of the options. The Company has estimated the expected life of its stock options using the simplified
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method for determining the expected term as prescribed by the Securities and Exchange Commission’s Staff Accounting Bulletin 107,Share-based Payment. The Company does not anticipate paying any cash dividends in the foreseeable future and therefore an expected dividend yield of zero is used in the option valuation model. Forfeitures are estimated at the time of grant and revised in subsequent periods if actual forfeitures differ from those estimates. Accordingly, stock-based compensation expense is recorded only for those awards that vest. All stock-based payment awards are amortized on a straight-line basis over the requisite service periods of the awards, which are generally the vesting periods.
The following table illustrates the effect on net loss and loss per share for the periods presented as if the fair value based method prescribed by SFAS 123 had been applied to all outstanding and unvested awards (in thousands, except per share data):
Three Months Ended September 30, 2005 | Nine Months Ended September 30, 2005 | |||||||
Net loss, as reported | $ | (20,351 | ) | $ | (62,942 | ) | ||
Add: employee stock-based compensation under APB 25 included in reported net loss | 527 | 2,726 | ||||||
Deduct: employee stock-based compensation expense determined under the fair value method | (4,578 | ) | (14,117 | ) | ||||
Net loss, pro forma | $ | (24,402 | ) | $ | (74,333 | ) | ||
Basic and diluted net loss per share, as reported | $ | (0.33 | ) | $ | (1.06 | ) | ||
Basic and diluted net loss per share, pro forma | $ | (0.39 | ) | $ | (1.25 | ) | ||
5. | Comprehensive loss |
For the three and nine months ended September 30, 2006, total comprehensive loss was $30.0 million and $92.0 million, respectively. For the three and nine months ended September 30, 2005, total comprehensive loss was $20.8 million and $63.1 million, respectively. Comprehensive loss is composed of net loss and unrealized gains and losses on short-term investments. The net change in accumulated other comprehensive loss for the nine months ended September 30, 2006 was a decrease of $820,000, reflecting a decrease in net unrealized losses on short-term investments due to decreasing interest rates.
6. | Recent accounting pronouncements |
In July 2006, the Financial Accounting Standards Board (FASB) issued FASB Interpretation No. 48Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109 (FIN 48). FIN 48 prescribes a comprehensive model for how a company should recognize, measure, present and disclose in its financial statements uncertain tax positions that the company has taken or expects to take on a tax return, including a decision whether to file or not to file a return in a particular jurisdiction. Under FIN 48, the financial statements will reflect expected future tax consequences of such positions presuming the taxing authorities’ full knowledge of the position and all relevant facts, but without considering time values. The new accounting model for uncertain tax positions in FIN 48 is effective for annual periods beginning after December 15, 2006. The Company is currently assessing the impact of FIN 48 on its results of operations, cash flows and financial condition.
In September 2006, the Financial Accounting Standards Board (FASB) issued FASB Statement No. 157Accounting for Fair Value Measurements(FAS 157). FAS 157 defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles (GAAP), and expands disclosures about fair value measurements. FAS 157 applies under other accounting pronouncements that require or permit fair value measurements, the FASB having previously concluded in those accounting pronouncements that fair value is the relevant measurement attribute. Accordingly, FAS 157 does not require any new fair value measurements. The Company is currently assessing the impact of FAS 157 on its results of operations, cash flows and financial condition.
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In September 2006, the Securities and Exchange Commission (SEC) issued Staff Accounting Bulletin No. 108 (SAB 108). SAB 108 allows for the adjustment of the cumulative effect of prior year immaterial errors in assets and liabilities as of the beginning of the fiscal year with an offsetting adjustment to the opening balance of retained earnings. There have been two common approaches used to quantify such errors. Under one approach, the error is quantified as the amount by which the current year income statement is misstated. The other approach quantifies the error as the cumulative amount by which the current year balance sheet is misstated. The Company does not expect the adoption of SAB 108 to have a material impact on its financial statements.
7. | Contingencies |
The Company has a license agreement with a third party under which the Company is obligated to pay royalties based upon the application of an agreed-upon formula, which contains certain variables that are subject to interpretation. As of September 30, 2006, the Company has recorded approximately $212,000 in royalty expense, which it believes fully satisfied its obligation under the license agreement. The other party has claimed that the Company owes an additional $1.8 million under its interpretation of the royalty formula. The Company continues to believe that its method of calculating the amount of royalties due is valid and intends to vigorously defend its position. The Company has applied SFAS No. 5, Accounting for Contingencies, to this matter and has concluded that it is not required to record a liability.
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Item 2. | Management’s Discussion and Analysis of Financial Condition and Results of Operations |
Forward-Looking Statements
The following discussion and analysis should be read in conjunction with the financial statements and related notes thereto included elsewhere in this Quarterly Report on Form 10-Q. This report contains, in addition to historical information, forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995 that involve risks and uncertainties. This Act provides a “safe harbor” for forward-looking statements to encourage companies to provide prospective information about themselves so long as they identify these statements as forward-looking and provide meaningful cautionary statements identifying important factors that could cause actual results to differ from the projected results. Factors that could cause or contribute to such differences include, but are not limited to, risks associated with our preclinical and clinical development, regulatory oversight, intellectual property claims and litigation and other risks detailed in our public filings with the Securities and Exchange Commission, including those risks described in Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2005. All statements other than statements of historical fact, including statements regarding industry prospects and future results of operations or financial position, made in this Quarterly Report on Form 10-Q are forward looking. When used in this document, the words “believes,” “expects,” “anticipates,” “intends,” “plans” and similar expressions, are intended to identify certain of these forward-looking statements. However, these words are not the exclusive means of identifying such statements. In addition, any statements that refer to expectations, projections or other characterizations of future events or circumstances are forward-looking statements. The cautionary statements made in this document should be read as being applicable to all related forward-looking statements wherever they appear in this document. Readers are cautioned not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Readers are urged to carefully review and consider the various disclosures made in this report and in our other reports filed with the Securities and Exchange Commission that attempt to advise interested parties of the risks and other factors that may affect our business, prospects and results of operations.
Business Overview
We are a biopharmaceutical company focused on discovering, developing and commercializing therapeutic protein-based products for the treatment of human diseases. The process for taking one of our discoveries to the marketplace is long, complex and very costly. It is difficult to predict the time it will take to commercialize any given product candidate, but it is not unusual for such commercialization to span ten years or more and cost hundreds of millions of dollars. It is also a business of attrition; it is expected that, for the industry as a whole, less than 20% of the drug candidates entering human clinical trials will actually make it to the marketplace. For the products that do make it, particularly for those that address previously unmet medical needs, the markets can be significant, with a number of successful products selling in excess of $1 billion per year.
An important element of our strategy is that we intend to maintain all or a significant share of the commercial rights to a number of our product candidates in North American markets. As a result, we will be required to pay a significant portion of the development costs for these product candidates. A second important element of our strategy is that we are developing a broad portfolio of product candidates to give our company more opportunities to be successful. We currently have three product candidates in clinical development and expect to add additional proteins to this portfolio in the future. Thus, we are paying a significant portion of development costs for several potential products. Assuming these product candidates progress through clinical development successfully, the costs of clinical trials are expected to increase significantly.
Our most significant financial challenges are to obtain adequate funding to cover the cost of product development, and to control spending and direct it toward product candidates that will create the most value for our shareholders over the long term. It can be a complex and highly subjective process to establish the
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appropriate balance between cash conservation and value generation. There are a number of important factors that we consider in addressing these challenges, including the following:
• | the nature, timing and magnitude of financing transactions, which would typically involve issuance of equity or equity-based securities; |
• | the nature and timing of product development collaborations, which would typically provide for funding of a portion of the respective product development costs, as well as bring in near-term potential revenues in the form of upfront fees and milestone payments; |
• | the breadth of product development programs, i.e. the number of potential disease indications for which a product candidate is tested in clinical trials; |
• | the number of products in our development portfolio and the decision to move new product candidates into clinical development; and |
• | periodic assessments of the relative capital requirements, risk and value of each of our product candidates. |
We expect that it will be several years or more before we can generate enough product-related revenues to reach net income or cash flow breakeven. For example, we currently estimate that in 2006 our net loss will be within the range of $125-135 million, and that we will use net cash of $110-120 million. Revenues from existing relationships help to defray our expenses, but additional funding will be required, the amount of which could be significant. We may decide to enter into additional product development collaborations, which would reduce our funding requirements. We may also generate funding through licensing of patents that are not relevant to our product development programs.
It is likely that we will continue to look for opportunities to raise equity capital as a primary means of funding our company over the next several years. The equity markets for biotechnology stocks have tended to experience long cycles during which the sale of equity securities has been extremely difficult. It is not possible to predict the timing or length of these cycles. As a result, many biotechnology companies, including ours, have adopted an opportunistic strategy of raising equity capital when it is available. We believe this strategy is important to minimizing the financial risks to our company and our shareholders. Consistent with our strategy, in August 2005, we issued 7.5 million shares of common stock raising net proceeds of approximately $126 million.
Results of Operations
Revenues
Royalties. We earn royalties on sales of certain products subject to license agreements with Novo Nordisk, our former parent and current owner of approximately 31% of our outstanding common stock, and several other companies. Royalties have decreased for both the three and nine-month periods ended September 30, 2006 compared to the corresponding periods in 2005, primarily due to insulin and glucagon patent expiration in certain countries. Insulin and glucagon royalties declined to 39% of our total royalty for both the three and nine-month periods ended September 30, 2006, from 44% and 53% for the corresponding periods in 2005. This downward trend is expected to continue and, in 2007, royalties for both insulin and glucagon in the remaining major markets will end. Royalties earned on sales of GEM 21S, a product of BioMimetic Therapeutics, Inc., have partially offset this decrease.
Option fees. In the three and nine-month periods ended September 30, 2006 and 2005, we recognized option fee revenue of $1.9 million and $5.7 million, respectively, under an Option and License Agreement with Novo Nordisk, pursuant to which we have granted an option to license certain rights to proteins that we discover. The initial term of this agreement expired in November 2004; however, Novo Nordisk exercised its right to extend the agreement to November 2006 and has paid us $7.5 million per year for those two additional years. We received the final payment from Novo Nordisk in November 2005, of which $833,000 was recorded as deferred revenue at September 30, 2006 and will be recognized as option fee revenue in the fourth quarter of 2006.
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In September 2004, we signed a five-year strategic alliance agreement with Serono S.A. under which Serono may acquire rights and licenses to certain leads and targets from our research and development pipeline. In the three and nine-month periods ended September 30, 2006 and 2005, we recognized revenue of $784,000 and $2.4 million, respectively, from this agreement. At September 30, 2006, $9.5 million was recorded as deferred revenue, which will be recognized at a rate of $3.1 million per year.
License fees and milestone payments. Revenues from license fees and other up-front payments are recognized over the period we are contractually required to provide other rights or services that represent continuing obligations. From period to period, license fees and milestone payments can fluctuate substantially based on the completion of new licensing or collaborative agreements and the achievement of development-related milestones. The decrease of $2.0 million for the three-month period ended September 30, 2006, versus the comparable period in 2005, was primarily due to the reduction of license fee revenue recognized for recombinant Factor XIII from Novo Nordisk. This revenue was recognized evenly over the period October 2004 through May 2006. For the nine month period, in addition to the decrease related to the recombinant Factor XIII license, a one-time, lump sum license fee from Eli Lilly was earned in the 2005 period for which no comparable amount was earned in the corresponding 2006 period.
Operating expenses
Research and development. Research and development expense has been our most significant expense to date, consisting primarily of salaries and benefit expenses, costs of consumables, contracted services and stock-based compensation. Our research and development activities have expanded in the past year, particularly related to our clinical-stage product candidates, rhThrombin, atacicept and IL-21. In addition, the impact of recognizing stock-based compensation cost in 2006 with the adoption of SFAS 123(R) has increased research and development expenses. Research and development expense in both periods was slightly offset by cost reimbursements from Novo Nordisk and Serono for work performed on various development programs. These trends for the three and nine-month periods ended September 30 are shown in the following table (in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Salaries and benefits | $ | 12,995 | $ | 11,040 | $ | 39,004 | $ | 32,917 | ||||||||
Consumables | 2,640 | 2,685 | 8,525 | 9,785 | ||||||||||||
Facility costs | 1,950 | 1,570 | 5,650 | 4,682 | ||||||||||||
Contracted services | 9,338 | 6,604 | 31,318 | 22,539 | ||||||||||||
Depreciation and amortization | 1,321 | 1,295 | 4,032 | 3,864 | ||||||||||||
Stock-based compensation | 2,892 | 477 | 8,924 | 2,224 | ||||||||||||
Subtotal | 31,136 | 23,671 | 97,453 | 76,011 | ||||||||||||
Cost reimbursement from collaborators | (840 | ) | (692 | ) | (2,832 | ) | (2,613 | ) | ||||||||
Net research and development expense | $ | 30,296 | $ | 22,979 | $ | 94,621 | $ | 73,398 | ||||||||
Salaries and benefits, consumables and facility costs, as shown in the table above, have tended to track fairly consistently with increases in our employee base from year to year. Between September 30, 2005 and September 30, 2006, we added approximately 32 full-time equivalent employees who are involved in product development activities. Contrary to this trend, in the nine months ended September 30, 2006, we experienced a reduction in consumable costs related to manufacturing IL-29 product in 2005 for use in toxicology studies and clinical trials, for which there were no comparable costs during the same period in 2006.
Contracted services include the cost of items such as contract manufacturing, clinical trials, non-clinical studies and payments to collaborators. These costs relate primarily to clinical development programs and can fluctuate substantially from period-to-period depending on the stage of our various programs. Generally, these external costs increase as a program advances toward commercialization, but there can be periods between major clinical trials during which costs decline. Our clinical trial costs
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increased in the three and nine-month periods ended September 30, 2006, as compared to the corresponding periods in 2005, reflecting the costs of rhThrombin Phase 3 clinical trials. Also, contract manufacturing costs tend to be incurred irregularly over the course of a development program, with relatively short manufacturing campaigns that may provide enough product to supply multiple years of clinical trial activity. Our contract manufacturing costs increased for the three and nine-month periods ended September 30, 2006 as compared to the same periods in 2005, reflecting on-going process development and manufacturing campaigns for rhThrombin to support the anticipated filing of a license application with the FDA in late 2006.
To date, our business needs have not required us to fully allocate all research and development costs among our various programs. However, we track direct labor, contracted services and certain consumable costs by program, which we monitor to ensure appropriate utilization of company resources. We also incur indirect costs that are not allocated to specific programs. These costs include indirect labor, certain consumable costs, facility costs, and depreciation and amortization, all of which benefit all of our research and development programs.
The following table presents our research and development costs allocated to clinical development, pre-development and discovery research programs, together with the unallocated costs that benefit all programs for the three and nine-month periods ended September 30 (in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||
Clinical development programs: | ||||||||||||
Hemostasis | $ | 10,152 | $ | 4,653 | $ | 32,486 | $ | 14,802 | ||||
Autoimmunity and oncology | 3,659 | 4,429 | 12,275 | 13,906 | ||||||||
Antiviral | 1,332 | 1,397 | 4,070 | 1,397 | ||||||||
Pre-development programs | 3,015 | 1,316 | 6,309 | 7,647 | ||||||||
Discovery research programs | 1,230 | 2,146 | 6,119 | 6,728 | ||||||||
Unallocated indirect costs | 10,908 | 9,038 | 33,362 | 28,918 | ||||||||
Total | $ | 30,296 | $ | 22,979 | $ | 94,621 | $ | 73,398 | ||||
The following summarizes the reasons for significant changes in research and development program costs for the periods presented in the table:
• | Hemostasis clinical development program costs increased substantially from 2005 to 2006 for both the three and nine-month periods ended September 30 reflecting the production of rhThrombin bulk drug validation lots and Phase 3 clinical trial costs in 2006. |
• | Autoimmunity and oncology clinical development program (atacicept and IL-21) costs decreased from 2005 to 2006 for both the three and nine-month periods ended September 30 primarily due to completion of the atacicept and IL-21 clinical trials in late 2005 and the first half of 2006. Additional studies for both programs are expected to begin in the fourth quarter of 2006. |
• | Antiviral clinical development program costs in 2006 reflect activities associated with preparing for clinical testing of IL-29. |
• | Pre-development program costs declined in the nine-month period primarily due to the transition of IL-29 to development in mid-2005. The increase for the three-month period was due to added pre-development programs. |
• | Unallocated indirect costs increased from 2005 to 2006 for both the three and nine-month periods ended September 30 primarily due to the impact of recording stock-based compensation expense pursuant to SFAS 123(R). |
General and administrative. General and administrative expense, which consists primarily of salaries and benefit expenses, professional fees and other corporate costs, increased 42% and 38% for the three and
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nine-month periods ended September 30, 2006, respectively, as compared to the corresponding periods in 2005. The increase was primarily due to the impact of recording stock-based compensation expense in accordance with SFAS 123(R). Stock-based compensation expense of $1.7 million and $5.0 million was recorded for the three and nine-month periods ended September 30, 2006, respectively. Higher personnel, patent and recruitment costs also contributed to the increase.
Stock-based compensation.Effective January 2006, we adopted Statement of Financial Accounting Standards No. 123(R) (SFAS 123(R)),Share-Based Payment. The Statement eliminates the ability to account for share-based compensation transactions using APB Opinion No. 25 (APB 25),Accounting for Stock Issued to Employees, and generally requires instead that such transactions be accounted for using a fair-value-based method. We have adopted the modified prospective transition method and determine fair value using the Black-Scholes valuation method. Accordingly, we recorded stock-based compensation expense of $4.6 million and $14.0 million for the three and nine-month periods ended September 30, 2006, respectively. Stock-based compensation of $527,000 and $2.7 million for the respective periods in 2005 was recorded pursuant to APB 25. We have estimated that the financial impact for the full year 2006 will be to increase our operating expenses by approximately $19 million.
Other income (expense)
Investment income. Investment income is generated primarily from investment of our cash reserves in investment grade, fixed-income securities. There are three primary factors affecting the amount of investment income that we report: amount of cash reserves invested, the effective interest rate, and the amount of gains or losses recognized. Investment income increased significantly for the three and nine-month periods ended September 30, 2006 as compared to the corresponding periods in 2005, largely due to increases in the effective interest rate realized. The following table shows how each of these factors affected investment income for the three and nine months ended September 30 (in thousands):
Three Months Ended September 30, | Nine Months Ended September 30, | |||||||||||||||
2006 | 2005 | 2006 | 2005 | |||||||||||||
Weighted average amount of cash reserves | $ | 298,749 | $ | 343,462 | $ | 321,136 | $ | 311,570 | ||||||||
Effective interest rate | 1.18 | % | 0.80 | % | 3.33 | % | 2.11 | % | ||||||||
Investment income before gains and losses | 3,520 | 2,737 | 10,710 | 6,566 | ||||||||||||
Net losses on sales of investments | (76 | ) | (66 | ) | (106 | ) | (446 | ) | ||||||||
Investment income, as reported | $ | 3,444 | $ | 2,671 | $ | 10,604 | $ | 6,120 | ||||||||
Interest expense. We have accounted for a sale-leaseback transaction completed in October 2002 as a financing transaction. Under this method of accounting, an amount equal to the net proceeds of the sale is considered a long-term interest bearing liability. Rent payments under the leases are considered to be payments toward the liability and are allocated to principal and interest. Interest expense was $1.9 and $5.7 million for the three and nine-month periods, respectively, for both 2006 and 2005.
Liquidity and Capital Resources
As of September 30, 2006, we had cash, cash equivalents and short-term investments of $289.7 million, which we intend to use to fund our operations and capital expenditures over the next several years. These cash reserves are held in a variety of investment-grade, fixed-income securities, including corporate bonds, commercial paper and money market instruments. We believe that our existing cash resources should provide sufficient funding for at least two years. If we complete additional collaborative development transactions, which could generate both revenues and cost reductions, these cash resources could extend the period of time over which these funds would cover our operating costs.
Cash flows from operating activities. The amount of cash used to fund our operating activities generally tracks our net losses, with the following exceptions:
• | noncash expenses, such as depreciation and amortization, gain or loss on sale or disposal of assets, and stock-based compensation, which do not result in uses of cash; |
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• | net realized gains and losses and accretion and amortization of discounts and premiums on short-term investments, which are reflected as sources of cash from investing activities upon maturity or sale of the respective investments; |
• | changes in receivables, which generally represent temporary timing differences between the recognition of certain revenues and the subsequent receipt of cash payments; |
• | changes in deferred revenue, which reflect the difference in timing between the receipt of cash from option fees, license fees and other upfront payments and the subsequent recognition of these amounts as revenue over the period we are contractually required to provide other rights or services that represent continuing obligations; and |
• | changes in other assets and liabilities, which generally represent temporary timing differences between the recognition of certain expenses and their payment. |
Generally, with the exception of changes in deferred revenue, we do not expect these items to generate material year-to-year fluctuations in the relationship between our net loss and the amount of net cash used in operating activities. Substantial license or upfront fees may be received upon the date we enter into new licensing or collaborative agreements and be recorded as deferred revenue. For example, in 2004 upon the execution of a strategic alliance agreement with Serono and a license agreement with Novo Nordisk, we recorded $36.2 million of deferred revenue, which is being recognized as revenue over approximately five years. For the nine-month periods ended September 30, 2006 and 2005, we recognized $13.2 million and $17.7 million, respectively, of previously deferred revenue from these and other transactions. The timing of additional deferred revenue transactions is expected to be irregular and, thus, has the potential to create fluctuations in the relationship between our net loss and the amount of cash used in operating activities.
Cash flows from investing activities. Our most significant use of cash in investing activities is for capital expenditures. We expend a certain amount each year on routine items to maintain the effectiveness of our business, e.g., to adopt newly developed technologies, expand into new functional areas, adapt our facilities to changing needs and/or replace obsolete assets. In addition, at various times we have used cash to purchase land and expand facilities. Cash flows from investing activities also reflect large amounts of cash used to purchase short-term investments and received from the sale and maturity of short-term investments. These amounts primarily relate to shifts between cash and cash equivalents and short-term investments. Because we manage our cash usage with respect to our total cash, cash equivalents and short-term investments, we do not consider these cash flows to be important to an understanding of our liquidity and capital resources.
Cash flows from financing activities. We received $10.1 million and $2.4 million of proceeds from the exercise of stock options for the nine-month periods ended September 30, 2006 and 2005, respectively. In August 2005, we received net proceeds of $126.6 million from a follow-on offering of 7.5 million shares of common stock.
We expect to incur substantial additional costs as we continue to advance and expand our product development programs. We expect these expenditures to increase over the next several years, particularly if the outcomes of clinical trials are successful and our product candidates continue to advance. Our plans include the internal development of selected product candidates and the co-development of product candidates with collaborators where we would assume a percentage of the overall product development costs. If, at any time, our prospects for financing these programs decline, we may decide to reduce our ongoing investment in our development programs. We could reduce our investment by discontinuing our funding under existing co-development arrangements, establishing new co-development arrangements for other product candidates to provide additional funding sources or out-licensing product candidates that we might otherwise develop internally. Additionally, we could consider delaying or discontinuing development of product candidates to reduce the level of our related expenditures.
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Our long-term capital requirements and the adequacy of our available funds will depend on several factors, many of which may not be in our control, including:
• | results of research and development programs; |
• | cash flows under existing and potential future arrangements with licensees, collaborators and other parties; |
• | costs involved in filing, prosecuting, enforcing and defending patent claims; and |
• | costs associated with the expansion of our facilities. |
Over the next several years we expect to seek additional funding through public or private financings, including equity financings, and through other arrangements, including collaborative arrangements. Poor financial results, unanticipated expenses or unanticipated opportunities that require financial commitments could give rise to additional financing requirements sooner than we expect. However, financing may be unavailable when we need it or may not be available on acceptable terms. If we raise additional funds by issuing equity or equity-based securities, the percentage ownership of our existing shareholders would be reduced, and these securities could have rights superior to those of our common stock. If we are unable to raise additional funds when we need them, we could be required to delay, scale back or eliminate expenditures for some of our development programs or expansion plans, or grant rights to third parties to develop and market product candidates that we would prefer to develop and market internally, with license terms that are not favorable to us.
Contractual Obligations
At September 30, 2006 we are contractually obligated to make payments as follows (in thousands):
Payments Due by Period | |||||||||||||||
Total | Less than 1 Year | 1-3 Years | 3-5 Years | More than 5 Years | |||||||||||
Building lease obligations | $ | 117,614 | $ | 7,544 | $ | 15,890 | $ | 17,021 | $ | 77,159 | |||||
Operating leases | 10,526 | 2,151 | 4,229 | 3,545 | 601 | ||||||||||
Development contracts | 24,479 | 23,208 | 683 | 428 | 160 | ||||||||||
Total | $ | 152,619 | $ | 32,903 | $ | 20,802 | $ | 20,994 | $ | 77,920 | |||||
The building lease obligations, which resulted from our sale-leaseback financing transaction, reflect the lease term through May 2019. Operating lease terms range from one to seven years and generally relate to leased office space nearby our corporate headquarter buildings. We have certain renewal provisions at our option, which are not reflected in the above table, for the building leases and the operating leases. The development contracts largely reflect the production of rhThrombin for commercial purposes.
Item 3. | Quantitative and Qualitative Disclosures About Market Risk |
Our exposure to market risk is primarily limited to interest income sensitivity, which is affected by changes in the general level of United States interest rates, particularly because the majority of our investments are in short-term debt securities. The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive without significantly increasing risk. To minimize risk, we maintain our portfolio of cash, cash equivalents and short-term investments in a variety of interest-bearing instruments, including United States government and agency securities, high-grade United States corporate bonds, asset-backed securities, commercial paper and money market funds. Due to the nature of our short-term investments, all of which mature within three years, we believe that we are not subject to any material market risk exposure. We have no material foreign currency exposure, nor do we hold derivative financial instruments.
Item 4. | Controls and Procedures |
Our principal executive officer and principal financial officer, after evaluating the effectiveness of our disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) as of the end of the period covered by this report, have concluded that as of such date our disclosure controls and
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procedures were effective. No change in our internal control over financial reporting occurred during the quarter ended September 30, 2006 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II OTHER INFORMATION
Item 1A. | Risk Factors |
In addition to the other information set forth in this report, you should carefully consider the factors discussed in Part I, “Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2005, which could materially affect our business, financial condition or future results. The risks described in our Annual Report on Form 10-K are not the only risks facing our Company. Additional risks and uncertainties not currently known to us or that we currently deem to be immaterial also may materially adversely affect our business, financial condition and/or operating results.
Item 6. | Exhibits |
Exhibit Number | ||
31.1 | Certification of Chief Executive Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
31.2 | Certification of Chief Financial Officer Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. | |
32.1 | Certification of Chief Executive Officer and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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Pursuant to the requirements of the Securities Exchange Act of 1934, as amended, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
ZYMOGENETICS, INC. | ||||||||
Date: November 1, 2006 | By: | /s/ James A. Johnson | ||||||
James A. Johnson | ||||||||
Senior Vice President and Chief Financial Officer | ||||||||
(Principal Financial Officer and Authorized Officer) |
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