Isolagen, Inc.
(A Development Stage Company)
Notes to Unaudited Consolidated Financial Statements
Note 1—Basis of Presentation, Business and Organization
Isolagen, Inc. f/k/a American Financial Holding, Inc., a Delaware corporation (“Isolagen” or the “Company”) is the parent company of Isolagen Technologies, Inc., a Delaware corporation (“Isolagen Technologies”). Isolagen Technologies is the parent company of Isolagen Europe Limited, a company organized under the laws of the United Kingdom (“Isolagen Europe”), Isolagen Australia Pty Limited, a company organized under the laws of Australia (“Isolagen Australia”), and Isolagen International, S.A., a company organized under the laws of Switzerland (“Isolagen Switzerland”). The common stock of the Company, par value $0.001 per share, (“Common Stock”) is traded on the American Stock Exchange (“AMEX”) under the symbol “ILE.”
The following unaudited financial statements have been prepared pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures normally included in the annual financial statements prepared in accordance with generally accepted accounting principles in the United States of America have been condensed or omitted pursuant to those rules and regulations, although the Company believes that the disclosures made are adequate to make the information not misleading. In the opinion of management, all adjustments necessary for the fair presentation for the periods presented have been reflected as required by Regulation S-X, Rule 10-01. These financial statements should be read in conjunction with the financial statements and the notes thereto included in the Company’s latest Annual Report on Form 10-K filed with the Securities and Exchange Commission.
Isolagen specializes in the development and commercialization of autologous cellular therapies for soft tissue regeneration. Autologous cellular therapy is the process whereby a patient’s own cells are extracted, allowed to multiply and then injected into the patient for applications such as skin rejuvenation and correction and reduction of the normal effects of aging like wrinkles and nasolabial folds. The procedure is minimally invasive and non-surgical.
Commencing in 1995, a predecessor of our Isolagen Process was used to correct facial defects, such as wrinkles, depressions and scars. From 1995 to 1999, approximately 200 physicians utilized this process on approximately 1,000 patients, for a total of approximately 4,000 injections. The physicians who used this process during this period did not document any significant adverse reactions.
In May 1996, the Food and Drug Administration, or FDA, in response to the increasing use of cellular therapy to treat serious illness, released draft regulation for public comment to regulate cellular therapy. In May 1998, this regulation was passed, and in 1999, the FDA notified the Company that the Isolagen Process would require FDA approval as a regulated biologic product. In October 1999, the Company filed an investigational new drug application, or “IND”, which was accepted by the FDA. In November 1999, the Company’s IND was placed on clinical hold while it established a cGMP facility and standard operating procedures, including quality control release criteria. The clinical hold was released in May 2002. From June 2002, the Company assembled its management and scientific team and improved its Isolagen Process. These improvements included the introduction of an improved transport medium to extend cell viability, the standardization of the injection technique and the standardization of the Company’s manufacturing and laboratory techniques. The Company commenced clinical trials in January 2003 upon completion of its previous cGMP facility.
The Company is developing its lead product candidate for the correction and reduction of the normal effects of aging, such as wrinkles and creases. In March 2004, the Company announced positive results of its first Phase III exploratory clinical trial for its lead product candidate. In July 2004, the Company announced the commencement of a pivotal Phase III trial consisting of two identical trials, Study A and Study B, conducted in different geographic and demographic populations in the United States. The results of the two studies were mixed; only Study B achieved statistical significance. As a result, the data from this Trial was inadequate to support a Biologics License Application. The Company used the information derived from the Company’s post hoc statistical analysis and the input of the Company’s clinical advisors to develop a Phase III confirmatory study. However, more recently the Company determined to conduct a full Phase III pivotal trial as opposed to a confirmatory trial which would consist of 400 subjects. In June of 2006, the Company filed a request for a Special Protocol Assessment relating to the Company’s Phase III dermal trial. On August 3, 2006, the FDA advised the Company that the FDA required a number of amendments to the request. All of the requested changes are acceptable to the Company and the Company will file these amendments during the month of August 2006. The FDA has 45 days to respond to a request or amendment to a request for a Special Protocol Assessment.
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The Company’s goal is to become a leading commercial autologous cell therapy company for soft tissue regeneration. The Company currently sells its dermal product primarily in the United Kingdom. The Company plans to further expand sales of its dermal product to other parts of Europe, Asia and the Americas.
Through June 30, 2006, the Company has been primarily engaged in developing its initial product technology, recruiting personnel, and continuing its United Kingdom operations. In the course of its development activities, the Company has sustained losses and expects such losses to continue through at least 2007. The Company expects to finance its operations primarily through its existing cash and future financing.
The Company’s ability to operate profitably is largely contingent upon its success in obtaining regulatory approval to sell its products, upon its successful development of markets for its products and upon its development of profitable manufacturing processes. The Company may be required to obtain additional capital in the future to expand its operations. No assurance can be given that the Company will be able to obtain such regulatory approvals, successfully develop the markets for its products or develop profitable manufacturing methods, or obtain any such additional capital as it might need, either through equity or debt financing, on satisfactory terms or at all. Additionally, no assurance can be given that any such financing, if obtained, will be adequate to meet the Company’s ultimate capital needs and to support the Company’s growth. If adequate capital cannot be obtained on satisfactory terms, the Company’s operations could be negatively impacted.
If the Company achieves growth in its operations in the next few years, such growth could place a strain on its management, administrative, operational and financial infrastructure. The Company may find it necessary to hire additional management, financial and sales and marketing personnel to manage the Company’s expanding operations. In addition, the Company’s ability to manage its current operations and future growth requires the continued improvement of operational, financial and management controls, reporting systems and procedures. If the Company is unable to manage this growth effectively and successfully, the Company’s business, operating results and financial condition may be materially adversely affected.
At June 30, 2006 and December 31, 2005, the Company had cash, cash equivalents, restricted cash and available-for-sale investments of $49.2 and $67.0 million, respectively. The Company believes that its existing capital resources are adequate to finance its operations through at least June 30, 2007; however, its long-term viability is dependent upon successful operation of its business, its ability to improve its manufacturing process, the approval of its products and the ability to raise additional debt and equity to meet its business objectives.
Acquisition and merger and basis of presentation
On August 10, 2001, Isolagen Technologies consummated a merger with American Financial Holdings, Inc. (“AFH”) and Gemini IX, Inc. (“Gemini”). Pursuant to an Agreement and Plan of Merger, dated August 1, 2001, by and among AFH, ISO Acquisition Corp, a Delaware corporation and wholly-owned subsidiary of AFH (“Merger Sub”), Isolagen Technologies, Gemini, a Delaware corporation, and William J. Boss, Jr., Olga Marko and Dennis McGill, stockholders of Isolagen Technologies (the “Merger Agreement”), AFH (i) issued 5,453,977 shares of its common stock, par value $0.001 to acquire, in a privately negotiated transaction, 100% of the issued and outstanding common stock (195,707 shares, par value $0.01, including the shares issued immediately prior to the Merger for the conversion of certain liabilities, as discussed below) of Isolagen Technologies, and (ii) issued 3,942,400 shares of its common stock to acquire 100% of the issued and outstanding common stock of Gemini. Pursuant to the terms of the Merger Agreement, Merger Sub, together with Gemini, merged with and into Isolagen Technologies (the “Merger”), and AFH was the surviving corporation. AFH subsequently changed its name to Isolagen, Inc. on November 13, 2001.
Prior to the Merger, Isolagen Technologies had no active business and was seeking funding to begin FDA trials of the Isolagen Process. AFH was a non-operating, public shell company with limited assets. Gemini was a non-operating private company with limited assets and was unaffiliated with AFH.
Since AFH and Gemini had no operations and limited assets at the time of the Merger, the merger has been accounted for as a recapitalization of Isolagen Technologies and an issuance of common stock by Isolagen Technologies for the net assets of AFH and Gemini. In the recapitalization, Isolagen Technologies is treated as having affected (i) a 27.8694 for 1 stock split, whereby the 195,707 shares of its common stock outstanding immediately prior to the merger are converted into the 5,453,977 shares of common stock received and held by the Isolagen Technologies
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stockholders immediately after the merger, and (ii) a change in the par value of its common stock, from $0.01 per share to $0.001 per share. The stock split and change in par value have been reflected in the accompanying consolidated financial statements by retroactively restating all share and per share amounts. The stock issuances are accounted for as the issuance of (i) 3,942,400 shares for the net assets of Gemini, recorded at their book value, and (ii) the issuance of 3,899,547 shares (the number of shares AFH had outstanding immediately prior to the Merger) for the net assets of AFH, recorded at their book value.
Immediately prior to and as a condition of the Merger, Isolagen Technologies issued an aggregate of 2,328,972 shares (post split) of its common stock to convert to equity an aggregate of $2,075,246 of liabilities, comprised of (i) accrued salaries of $328,125, (ii) convertible debt and related accrued interest of $1,611,346, (iii) convertible shareholder notes and related accrued interest of $135,667 and (iv) bridge financing costs of $108. Simultaneous with the Merger, the Company sold 1,346,669 shares of restricted common stock to certain accredited investors in a private placement transaction. The consideration paid by such investors for the shares of common stock aggregated $2,020,000 in transactions exempt from the registration requirements of the Securities Act. The net cash proceeds of this private placement were used to fund Isolagen’s research and development projects and the initial FDA trials of the Isolagen Process, to explore the viability of entering foreign markets, to provide working capital and for general corporate purposes.
The financial statements presented include Isolagen, Inc. and its wholly-owned subsidiaries. All significant intercompany transactions and balances have been eliminated. Isolagen Technologies was, for accounting purposes, the surviving entity of the Merger, and accordingly for the periods prior to the Merger, the financial statements reflect the financial position, results of operations and cash flows of Isolagen Technologies. The assets, liabilities, operations and cash flows of AFH and Gemini are included in the consolidated financial statements from August 10, 2001 onward.
Note 2—Summary of Significant Accounting Policies
Use of estimates
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenue and expenses during the reporting period. Examples include provisions for bad debts and inventory obsolescence, useful lives of property and equipment and intangible assets, impairment of property and equipment and intangible assets, deferred taxes, and the provision for and disclosure of litigation and loss contingencies (see Note 4). Actual results may differ materially from those estimates.
Foreign currency translation
The financial position and results of operations of the Company’s foreign subsidiaries are determined using the local currency as the functional currency. Assets and liabilities of these subsidiaries are translated at the exchange rate in effect at each period-end. Income statement accounts are translated at the average rate of exchange prevailing during the period. Adjustments arising from the use of differing exchange rates from period to period are included in accumulated other comprehensive income in shareholders’ equity. Gains and losses resulting from foreign currency transactions are included in earnings and have not been material in any one period.
Balances of related after-tax components comprising accumulated other comprehensive income included in shareholders’ equity, at June 30, 2006 and December 31, 2005 are as follows:
| | June 30, | | December 31, | |
| | 2006 | | 2005 | |
| | | | | |
Foreign currency translation adjustment | | $ | (299,240 | ) | $ | (784,644 | ) |
Accumulated other comprehensive loss | | $ | (299,240 | ) | $ | (784,644 | ) |
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Statement of cash flows
For purposes of the statements of cash flows, the Company considers all highly liquid investments (investments which, when purchased, have original maturities of three months or less) to be cash equivalents. At June 30, 2006 and December 31, 2005, the Company had $2.0 million and $2.5 million, respectively, of cash restricted for the payment of the non-cancelable portion of the Exton, Pennsylvania facility lease, due monthly through March 2008.
Concentration of credit risk
The Company maintains its cash primarily with major U.S. domestic banks. The amounts held in these banks generally exceed the insured limit of $100,000. The terms of these deposits are on demand to minimize risk. The Company has not incurred losses related to these deposits. Cash equivalents are maintained with two financial institutions. The Company invests these funds primarily in government securities and/or mortgage-backed securities.
The Company’s available-for-sale investments, as set forth below, subject it to certain credit risk that is concentrated in securities issued by U.S. government sponsored mortgage entities, and various U.S. states. Due to the credit ratings of these issuers, the Company does not believe that the credit risk is significant.
Available-for-Sale investments
At June 30, 2006 and December 31, 2005, the Company held certain investments in marketable debt securities as a means of temporarily investing remaining proceeds from its issuance of shares of common stock and 3.5% Convertible Subordinated Notes until the funds are needed for operating purposes. These investments are being accounted for as “available-for-sale” investments under Statement of Financial Accounting Standards (“SFAS”) No. 115, “Accounting for Certain Investments in Debt and Equity Securities.” As a result, the investments are reflected at their fair value, based on quoted market prices, with unrealized gains and losses recorded in accumulated other comprehensive income until the investments are sold, at which time the realized gains and losses are included in the results of operations.
Allowance for Doubtful Accounts
The Company maintains an allowance for doubtful accounts related to its accounts receivable that have been deemed to have a high risk of collectibility. Management reviews its accounts receivable on a monthly basis to determine if any receivables will potentially be uncollectible. Management analyzes historical collection trends and changes in its customer payment patterns, customer concentration, and creditworthiness when evaluating the adequacy of its allowance for doubtful accounts. In its overall allowance for doubtful accounts, the Company includes any receivable balances that are determined to be uncollectible. Based on the information available, management believes the allowance for doubtful accounts is adequate; however, actual future write-offs may exceed the recorded allowance.
Inventory
Inventory consists of raw materials used in the Isolagen Process. Inventory is stated at the lower of cost or market and cost is determined by the weighted average method. Costs of sales include labor, material and overhead associated with the manufacturing process. Those costs, except for the costs of raw materials that have not been used, are expensed as incurred.
Assets held for sale
In April 2005, the Company acquired land and a two-building, 100,000 square foot corporate campus in Bevaix, Canton of Neuchâtel, Switzerland for $10 million. The Company subsequently spent approximately $1.8 million on the first phase of a renovation. In April 2006, management decided to place the corporate campus on the market for sale in order to consolidate European operations into one location and to conserve capital. The Company commenced its selling efforts during June of 2006 at which time the carrying amount of the campus was reclassified as an asset held for sale, as reflected on the accompanying June 30, 2006 consolidated balance sheet. The net book value of the corporate campus at June 30, 2006 was $10.6 million, reflecting management’s estimate of the realizable value of
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the corporate campus. The carrying amount of the campus as of December 31, 2005 has also been reclassified to conform to this presentation.
Although the campus was not being actively marketed for sale as of March 31, 2006 and therefore had not been reclassified as held for sale, as of March 31, 2006, management at that date assessed whether the book value of the corporate campus was impaired based on its estimate of the realizable value of the corporate campus, and made a determination to write down the corporate campus by $0.7 million, which charge was reflected in selling, general and administrative expenses in the consolidated statement of operations for the three months ended March 31, 2006 and six months ended June 30, 2006.
Property and equipment
Property and equipment is carried at cost less accumulated depreciation and amortization. Generally, depreciation and amortization for financial reporting purposes is provided by the straight-line method over the estimated useful life of three years, except for leasehold improvements which are amortized using the straight-line method over the remaining lease term or the life of the asset, whichever is shorter. The cost of repairs and maintenance is charged as an expense as incurred.
Debt issue costs
The costs incurred in issuing the Company’s 3.5% Convertible Subordinated Notes, including placement agent fees, legal and accounting costs and other direct costs are included in Other Assets and are being amortized to expense using the effective interest method over five years, through November 2009. Debt issuance costs, net of amortization, were approximately $2.5 million at June 30, 2006 and $2.9 million at December 31, 2005, respectively.
Treasury stock
The Company utilizes the cost method for accounting for its treasury stock acquisitions and dispositions.
Revenue recognition
The Company recognizes revenue over the period the service is performed in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” (“SAB 104”). In general, SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable and (4) collectibility is reasonably assured.
The Isolagen Process is administered to each patient using a recommended regimen of injections. Due to the short shelf life, each injection is cultured on an as needed basis and shipped prior to the individual injection being administered by the physician. The Company believes each injection has stand alone value to the patient. The Company invoices the attending physician when the physician sends his or her patient’s tissue sample to the Company which creates a contractual arrangement between the Company and the medical professional. The amount invoiced varies directly with the dose and number of injections requested. Generally, orders are paid in advance by the physician prior to the first injection. There is no performance provision under any arrangement with any physician, and there is no right to refund or returns for unused injections.
As a result, the Company believes that the requirements of SAB 104 are met as each injection is shipped, as the risk of loss transfers to our physician customer at that time, the fee is fixed and determinable and collection is reasonably assured. Advance payments are deferred until shipment of the injection(s). The amount of the revenue deferred represents the fair value of the remaining undelivered injections measured in accordance with Emerging Issues Task Force Issue (“EITF”) 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” which addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. Should the physician discontinue the regimen prematurely all remaining deferred revenue is recognized.
The Company also offers a service whereby it stores a patient’s cells for later use in the preparation of injections. In accordance with EITF 00-21, the fee charged for this service is recognized as revenue ratably over the
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length of the storage agreement. Revenue related to this service was approximately $0.1 million and $0.2 million, respectively, for the three months and six months ended June 30, 2006 and less than $0.1 million for both the three and six months ended June 30, 2005.
Promotional incentives
The Company periodically offers promotional incentives to physicians on a case-by-case basis. Promotional incentives are provided to physicians in the form of “at no charge” Isolagen treatments and Isolagen treatments offered at a discount from the suggested price list. The Company does not receive any identifiable benefit from the physicians in exchange for any promotional incentives granted.
In accordance with EITF 01-09, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendor’s Products),” the Company does not record any revenue related to “at no charge” Isolagen treatments and the estimated cost to provide such treatments is expensed as selling, general and administrative expense at the time the promotion is granted. The Company records discounts granted as a reduction in revenue (i.e., net revenue after discount) from that specific transaction.
Shipping and handling costs
The Company typically does not charge customers for shipping and handling costs for shipments within the United Kingdom. These costs are included in selling, general and administrative expenses. For shipments outside of the United Kingdom, the Company charges the customer for shipping and handling. Such charges to customers are presented net of the costs of shipping and handling, as selling, general and administrative expense, and are not significant to the consolidated statements of operations.
Research and development expenses
Research and development costs are expensed as incurred and include salaries and benefits, costs paid to third party contractors to perform research, conduct clinical trials, develop and manufacture drug materials and delivery devices, and a portion of facilities cost. Research and development costs also include costs to develop improved manufacturing, cell collection and logistical process improvements. It is anticipated that such improvements would eliminate several of the steps and materials involved in the current system, which the Company expects would lead to significant cost reductions in both skilled labor and materials and will enable scalable mass production. However, the commercial viability of the improvements under consideration is uncertain, and the Company does not know whether it will be successful in its implementation.
Clinical trial costs are a significant component of research and development expenses and include costs associated with third-party contractors. Invoicing from third-party contractors for services performed can lag several months. The Company accrues the costs of services rendered in connection with third-party contractor activities based on its estimate of management fees, site management and monitoring costs and data management costs. Actual clinical trial costs may differ from estimated clinical trial costs and are adjusted for in the period in which they become known.
Costs of exit activities
Houston, Texas. On March 28, 2006, the Company’s board of directors approved the shut-down of the Houston, Texas facility. The Houston, Texas facility was used primarily for research and development purposes and is maintained under an operating lease which ends on April 30, 2008. The research and development activities will be conducted at the Company’s facilities located in Exton, Pennsylvania. An exit plan was communicated to the affected employees during the three months ended June 30, 2006. There were approximately 15 employees at the Houston, Texas facility at March 31, 2006 and the large majority of these employees had been terminated by June 30, 2006 at a severance cost of less than $0.1 million. The Company will use its best efforts to negotiate an exit from the lease with the lessor, however, there is no assurance that such negotiations will be successful. As of June 30, 2006, the remaining lease payments and common operating expenses due under the Houston, Texas lease agreement was approximately $0.3 million.
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Australian facilities. In September 2004, the Company approved a plan for the closure of its Australian facilities and the servicing of Australia from the Company’s London, England facility. The Company adopted this plan because it believed that anticipated processing enhancements and improved delivery logistics will eliminate the need for an Australian laboratory. During 2005, all Australian fixed assets were sold or disposed of and the lease related to the Australian facility was terminated. Included in the results of operations for both the three and six months ended June 30, 2005 are exit costs of less than $0.1 million related to the exit from the Australian facilities.
Share-based compensation
Effective January 1, 2006 the Company adopted the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and amends SFAS No. 95, “Statement of Cash Flows.” SFAS No. 123(R) requires entities to recognize compensation expense for all share-based payments to employees and directors, including grants of employee stock options, based on the grant-date fair value of those share-based payments, adjusted for expected forfeitures. The Company adopted SFAS No. 123(R) using the modified prospective application method. Under the modified prospective application method, the fair value measurement requirements of SFAS No. 123(R) is applied to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that were outstanding as of January 1, 2006 is recognized as the requisite service is rendered on or after January 1, 2006. The compensation cost for that portion of awards is based on the grant-date fair value of those awards as calculated for pro forma disclosures under SFAS No. 123. Changes to the grant-date fair value of equity awards granted before January 1, 2006 are precluded.
Prior to the adoption of SFAS No. 123(R), the Company followed the intrinsic value method in accordance with APB No. 25 to account for its employee stock options. Historically, substantially all stock options have been granted with an exercise price equal to the fair market value of the common stock on the date of grant. Accordingly, no compensation expense was recognized from option grants to employees and directors. Compensation expense was recognized in connection with the issuance of stock options to non-employee consultants in accordance with EITF 96-18, “Accounting for Equity Instrument That are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services.” SFAS No. 123(R) did not change the accounting for stock-based compensation related to non-employees in connection with equity based incentive arrangements.
As a result of adopting Statement 123(R) on January 1, 2006, the Company’s loss before income taxes and net loss for the three and six months ended June 30, 2006 was $0.3 million and $0.4 million higher, respectively, than if it had continued to account for share-based compensation under APB No. 25. Basic and diluted loss per share for the three and six months ended June 30, 2006 were $0.01 greater than if the Company had continued to account for share-based compensation under APB No. 25 (see Note 5).
Income taxes
An asset and liability approach is used for financial accounting and reporting for income taxes. Deferred income taxes arise from temporary differences between income tax and financial reporting and principally relate to recognition of revenue and expenses in different periods for financial and tax accounting purposes and are measured using currently enacted tax rates and laws. In addition, a deferred tax asset can be generated by net operating loss carryforwards (“NOLs”). If it is more likely than not that some portion or all of a deferred tax asset will not be realized, a valuation allowance is recognized.
Loss per share data
Basic loss per share is calculated based on the weighted average common shares outstanding during the period, after giving effect to the manner in which the merger was accounted for as described in Note 1, except that it does not include unvested common shares subject to cancellation. Excluded from the computation of basic loss per share at June 30, 2006 were approximately 17,100 shares of outstanding, but unvested employee restricted stock awards. As these awards vest and are no longer subject to cancellation, they are then included in the calculation of basic loss per share. Diluted earnings per share also gives effect to the dilutive effect of stock options, warrants (calculated
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based on the treasury stock method), restricted stock, convertible notes and convertible preferred stock. The Company does not present diluted earnings per share for periods in which it incurred net losses as the effect is antidilutive.
At June 30, 2006, options and warrants to purchase 11.2 million shares of common stock at exercise prices ranging from $1.50 to $11.38 per share, and the aforementioned 17,100 shares of outstanding but unvested employee restricted stock awards, were outstanding but were not included in the computation of diluted earnings per share as their effect would be antidilutive. Also, 9.8 million shares issuable upon the conversion of the Company’s convertible notes, at a conversion price of approximately $9.16, were not included as their effect would be antidilutive.
At June 30, 2005, options and warrants to purchase 8.7 million shares of common stock at exercise prices ranging from $1.50 to $11.38 per share were outstanding, but were not included in the computation of diluted earnings per share as their effect would be antidilutive, and 9.8 million shares issuable upon the conversion of the Company’s convertible notes, at a conversion price of approximately $9.16, were not included as their effect would be antidilutive.
Comprehensive loss
Comprehensive loss encompasses all changes in equity other than those with shareholders and consists of net loss and foreign currency translation adjustments and unrealized gains and losses on available-for-sale marketable debt securities. The Company does not provide for U.S. income taxes on foreign currency translation adjustments since it does not provide for such taxes on undistributed earnings of foreign subsidiaries.
| | Three Months
Ended June 30,
2006 | | Three Months
Ended June 30,
2005 | |
Net loss | | $ | (8,131,714 | ) | $ | (9,989,213 | ) |
Other comprehensive income (loss), foreign currency translation adjustment | | 424,352 | | (703,141 | ) |
Comprehensive loss | | $ | (7,707,362 | ) | $ | (10,692,354 | ) |
| | Six Months
Ended June 30,
2006 | | Six Months
Ended June 30,
2005 | |
Net loss | | $ | (18,049,165 | ) | $ | (16,420,419 | ) |
Other comprehensive income (loss), foreign currency translation adjustment | | 485,404 | | (745,289 | ) |
Other comprehensive loss, net unrealized loss on available-for-sale securities | | — | | (10,005 | ) |
Comprehensive loss | | $ | (17,563,761 | ) | $ | (17,175,713 | ) |
Fair value of financial instruments
The Company’s financial instruments consist of accounts receivable, marketable debt securities, accounts payable and convertible subordinated debentures. The fair values of the Company’s accounts receivable and accounts payable approximate, in the Company’s opinion, their respective carrying amounts. The Company’s marketable debt security investments are carried at fair value. The Company’s convertible subordinated debentures were quoted at approximately 75% of par value at June 30, 2006. Accordingly, the fair value of our convertible subordinated debentures is approximately $67.5 million at June 30, 2006.
Recently issued accounting standards not yet effective
In March 2006, the Financial Accounting Standards Board (“FASB”) issued SFAS No. 156, “Accounting for Servicing of Financial Assets—an amendment of FASB Statement No. 140,” that provides guidance on accounting for separately recognized servicing assets and servicing liabilities. In accordance with the provisions of SFAS No. 156, separately recognized servicing assets and servicing liabilities must be initially measured at fair value, if practicable. Subsequent to initial recognition, the Company may use either the amortization method or the fair value measurement method to account for servicing assets and servicing liabilities within the scope of this Statement. The Company will
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adopt SFAS No. 156 in fiscal year 2007. The adoption of this Statement is not expected to have a material effect on the Company’s Consolidated Financial Statements.
In April 2006, the FASB issued FASB Staff Position (FSP) FIN 46(R)-6, “Determining the Variability to Be Considered in Applying FASB Interpretation No. 46(R)”, that will become effective beginning third quarter of 2006. FSP FIN No. 46(R)-6 clarifies that the variability to be considered in applying Interpretation 46(R) shall be based on an analysis of the design of the variable interest entity. The adoption of this FSP is not expected to have a material effect on the Company’s Consolidated Financial Statements.
In February 2006, the FASB issued SFAS No. 155, “Accounting for Certain Hybrid Financial Instruments—an amendment of FASB Statements No. 133 and 140,” to permit fair value remeasurement for any hybrid financial instrument that contains an embedded derivative that otherwise would require bifurcation in accordance with the provisions of SFAS No. 133, “Accounting for Derivative Instruments and Hedging Activities.” The Company will adopt SFAS No. 155 in fiscal year 2007. The adoption of this Statement is not expected to have a material effect on the Company’s Consolidated Financial Statements.
Note 3—Available-for-Sale Investments
The following sets forth information concerning marketable debt securities as of June 30, 2006:
Type of issue | | Maturity | | Face
amount | | Cost | | Gross
unrealized
gains | | Gross
unrealized
losses | | Fair
value | |
State and local government | | 2021-2043 | | $ | 9,000,000 | | $ | 9,000,000 | | — | | — | | $ | 9,000,000 | |
| | | | | | $ | 9,000,000 | | | | | | $ | 9,000,000 | |
| | | | | | | | | | | | | | | | |
The following sets forth information concerning marketable debt securities as of December 31, 2005:
Type of issue | | Maturity | | Face
amount | | Cost | | Gross
unrealized
gains | | Gross
unrealized
losses | | Fair
value | |
State and local government | | 2012-2043 | | $ | 23,000,000 | | $ | 23,000,000 | | — | | — | | $ | 23,000,000 | |
| | | | | | $ | 23,000,000 | | — | | — | | $ | 23,000,000 | |
| | | | | | | | | | | | | | | | |
The Company’s investments in state and local government and corporate issues are investments in Auction Rate Securities (“ARS”), for which the interest rates are reset periodically through a Dutch auction process. The following sets forth the aggregate maturities of the Company’s investments in marketable debt securities at June 30, 2006, without regard to the dates at which the interest rates for ARS investments reset:
Maturity | | Cost | | Fair
Value | |
2006 | | $ | — | | $ | — | |
2007-2011 | | — | | — | |
2012-2016 | | — | | — | |
2017 and after | | 9,000,000 | | 9,000,000 | |
| | $ | 9,000,000 | | $ | 9,000,000 | |
Proceeds from the sale of available-for-sale marketable debt securities were $4.5 million and $16.7 million for the three and six months ended June 30, 2006, respectively, and no realized gains and losses based on specific identification, were included in the results of operations upon those sales.
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Note 4—Commitments and Contingencies
Federal Securities Litigation
The Company and certain of its current and former officers and directors are defendants in class action cases pending in the United States District Court for the Eastern District of Pennsylvania.
In August and September, 2005, various lawsuits were filed alleging securities fraud and asserting claims on behalf of a putative class of purchasers of publicly traded Isolagen securities between March 3, 2004 and August 1, 2005. These lawsuits were Elliot Liff v. Isolagen, Inc. et al., C.A. No. H-05-2887, filed in the United States District Court for the Southern District of Texas; Michael Cummisky v. Isolagen, Inc. et al., C.A. No. 05-cv-03105, filed in the United States District Court for the Southern District of Texas; Ronald A. Gargiulo v. Isolagen, Inc. et al., C.A. No. 05-cv-4983, filed in the United States District Court for the Eastern District of Pennsylvania, and Gregory J. Newman v. Frank M. DeLape, et al., C.A. No. 05-cv-5090, filed in the United States District Court for the Eastern District of Pennsylvania.
The Liff and Cummiskey actions were consolidated on October 7, 2005. The Gargiolo and Newman actions were consolidated on November 29, 2005. On November 18, 2005, the Company filed a motion with the Judicial Panel on Multidistrict Litigation (the “MDL Motion”) to transfer the Federal Securities Actions and the Keene derivative case (described below) to the United States District Court for the Eastern District of Pennsylvania. The Liff and Cummiskey actions were stayed on November 23, 2005 pending resolution of the MDL Motion. The Gargiulo and Newman actions were stayed on December 7, 2005 pending resolution of the MDL Motion. On February 23, 2006, the MDL Motion was granted and the actions pending in the Southern District of Texas were transferred to the Eastern District of Pennsylvania, where they have been captioned In re Isolagen, Inc. Securities & Derivative Litigation, MDL No. 1741 (the “Federal Securities Litigation”).
On April 4, 2006, the United States District Court for the Eastern District of Pennsylvania appointed Silverback Asset Management, LLC, Silverback Master, Ltd., Silverback Life Sciences Master Fund, Ltd., Context Capital Management, LLC and Michael F. McNulty as Lead Plaintiffs, and the law firms of Bernstein Litowitz Berger & Grossman LLP and Kirby McInerney & Squire LLP as Lead Counsel in the Federal Securities Litigation.
On July 14, 2006, Lead Plaintiffs filed a Consolidated Class Action Complaint in the Federal Securities Litigation on behalf of a putative class of persons or entities who purchased or otherwise acquired Isolagen common stock or convertible debt securities between March 3, 2004 and August 9, 2005. The complaint purports to assert claims for securities fraud in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Isolagen and certain of its former officers and directors. The complaint also purports to assert claims for violations of Section 11 and 12 of the Securities Act of 1933 against the Company and certain of its current and former directors and officers in connection with the registration and sale of certain shares of Isolagen common stock and certain convertible debt securities. The complaint also purports to assert claims against CIBC World Markets Corp., Legg Mason Wood Walker, Inc., Canaccord Adams, Inc. and UBS Securities LLC as underwriters in connection with an April, 2004 public offering of Isolagen common stock and a 2005 sale of convertible notes. The Company intends to defend these lawsuits vigorously. However, the Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received.
Derivative Actions
The Company is the nominal defendant in derivative actions (the “Derivative Actions”) pending in State District Court in Harris County, Texas, the United States District Court for the Eastern District of Pennsylvania, and the Court of Common Pleas of Chester County, Pennsylvania.
On September 28, 2005, Carmine Vitale filed an action styled, Case No. 2005-61840, Carmine Vitale v. Frank DeLape, et al. in the 55th Judicial District Court of Harris County, Texas and in February 2006 Mr. Vitale filed an amended complaint. In this action, the plaintiff purports to bring a shareholder derivative action on behalf of the Company against certain of the Company’s current and former officers and directors. The Plaintiff alleges that the individual defendants breached their fiduciary duties to the Company and engaged in other wrongful conduct. Certain individual defendants are accused of improper trading in Isolagen stock. The plaintiff did not make a demand on the Board of Isolagen prior to bringing the action and plaintiff alleges that a demand was excused under the law as futile.
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On December 2, 2005, the Company filed its answer and special exceptions pursuant to Rule 91 of the Texas Rules of Civil Procedure based on pleading defects inherent in the Vitale complaint. The plaintiff filed an amended complaint on February 15, 2006. The plaintiff has served a discovery request on the Company, to which the Company has objected as premature. The defendants have filed renewed special exceptions to the amended complaint. A hearing on the special exceptions is scheduled to be held in August.
On October 8, 2005, Richard Keene, filed an action styled, C.A. No. H-05-3441, Richard Keene v. Frank M. DeLape et al., in the United States District Court for the Southern District of Texas. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
The Company sought to transfer the Keene action to the United States District Court for the Eastern District of Pennsylvania as part of the MDL Motion. On January 21, 2006, the court stayed the Keene action pending resolution of the MDL Motion. On February 23, 2006, the Keene action was transferred with the Federal Securities Actions from the Southern District of Texas to the Eastern District of Pennsylvania. Thereafter, the plaintiff filed an amended complaint, and the defendants moved to dismiss the amended complaint. Briefing on that motion is complete.
On October 31, 2005, William Thomas Fordyce filed an action styled, C.A. No. GD-05-08432, William Thomas Fordyce v. Frank M. DeLape, et al., in the Court of Common Pleas of Chester County, Pennsylvania. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
On January 20, 2006, the Company filed its preliminary objections to the complaint. The Company filed a memorandum of law in support of its objections on February 23, 2006. The plaintiff filed his response to the Company’s preliminary objections on March 14, 2006. Oral argument on the Company’s preliminary objections was held on July 6, 2006.
The Derivative Actions are purportedly being prosecuted on behalf of the Company and any recovery obtained, less any attorneys’ fees awarded, will go to the Company. The Company is advancing legal expenses to certain current and former directors and officers of the Company who are named as defendants in the Derivative Actions and expects to receive reimbursement for those advances from its insurance carriers. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received. The Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements.
Other Litigation
The Company is involved in various other legal matters that are being defended and handled in the ordinary course of business. Although it is not possible to predict the outcome of these matters, management believes that the results will not have a material impact on the Company’s financial statements.
United Kingdom Customer Settlement
During 2005, the Company began an informal study and surveyed a number of patients who had previously received the Isolagen treatment to assess patient satisfaction. Some patients surveyed reported sub-optimal results from treatment. One hundred forty-nine patients who claimed to have received sub-optimal results were retreated for the purpose of determining the reasons for sub-optimal results. Only those patients who completed the survey, provided adequate medical records including before and after photographs and who were deemed both to have received a sub-optimal result from a first treatment administered according to the Isolagen protocol and who were considered to be appropriate patients for treatment with the Isolagen Process received re-treatment. No one completing the survey was offered re-treatment unless they agreed to these conditions. Following re-treatment, a number of patients reported better results than first obtained through the initial treatment by their initial treating physician.
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During the first quarter of 2006, the Company received a number of complaints from certain patients who had learned of the limited re-treatment program and also learned that a number of physicians with dissatisfied patients were generating public ill-will as a result of the Company’s decision to limit the number of patients offered re-treatment and were encouraging dissatisfied patients to seek recourse against the Company. In response, in March 2006 the Company decided that it was in its best interest to address these complaints to foster goodwill in the marketplace and avoid the cost of any potential patient claims. Accordingly, the Company agreed to resolve any properly documented and substantiated patient complaints by offering to retreat the patient pursuant to the same criteria stated above or pay £1,000 (approximately US$1,750) to the patients identified to the Company as having received a sub-optimal result. In order to qualify for re-treatment and in addition to the criteria set forth above, the patient will be treated by a physician identified by the Company who will treat these patients pursuant to a protocol. In addition, these patients must agree to follow-up visits and assessments of their response to treatment. No patient unlikely to benefit from Isolagen therapy will be retreated.
The Company made this offer to approximately 290 patients during late March 2006. Accordingly, the Company believed its range of liability was between £290,000 (or approximately $0.5 million), assuming all 290 patients were to choose the £1,000 payment, and approximately £580,000 (or approximately $1.0 million), assuming all 290 patients elected to be retreated. The estimated costs for retreatment include the cost of treatment, physician fees and other ancillary costs. The Company estimated that 60% of the patients will elect the £1,000 offer and 40% will elect to be retreated. Accordingly, the Company recorded a charge to selling, general and administrative expense for the three months ended March 31, 2006 of $0.7 million. As of March 31, 2006, no amounts had been expended related to this settlement and the $0.7 million liability was included in accrued expenses in the consolidated balance sheet.
During the three months ended June 30, 2006, an additional 31 patients were entered into the settlement program, resulting in an additional charge to selling, general and administrative expense of $0.1 million. Also during the three months ended June 30, 2006, the £1,000 payments to patients, discussed above, reduced the liability by $0.2 million. As of June 30, 2006, the liability included in accrued expenses in the consolidated balance sheet was $0.6 million. The estimates of the factors which will affect the actual cost of this program may change in future periods and the effects of any changes in these estimates will be accounted for in the period in which the estimate changes.
Note 5—Equity and Stock-Based Compensation
In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123(R)”). SFAS No. 123(R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation”, supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and amends SFAS No. 95, “Statement of Cash Flows.” SFAS No. 123(R) requires entities to recognize compensation expense for all share-based payments to employees and directors, including grants of employee stock options, based on the grant-date fair value of those share-based payments, adjusted for expected forfeitures. The Company adopted SFAS No. 123(R) as of January 1, 2006 using the modified prospective application method. Under the modified prospective application method, the fair value measurement requirements of SFAS No. 123(R) is applied to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that were outstanding as of January 1, 2006 is recognized as the requisite service is rendered on or after January 1, 2006. The compensation cost for that portion of awards is based on the grant-date fair value of those awards as calculated for pro forma disclosures under SFAS No. 123. Changes to the grant-date fair value of equity awards granted before January 1, 2006 are precluded.
Prior to the adoption of SFAS No. 123(R), the Company followed the intrinsic value method in accordance with APB No. 25 to account for its employee stock options. Historically, substantially all stock options have been granted with an exercise price equal to the fair market value of the common stock on the date of grant. Accordingly, no compensation expense was recognized from option grants to employees and directors. Compensation expense was recognized in connection with the issuance of stock options to non-employee consultants in accordance with EITF 96-18, “Accounting for Equity Instrument That are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services.” SFAS No. 123(R) did not change the accounting for stock-based compensation related to non-employees in connection with equity based incentive arrangements.
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The Company utilizes the straight-line attribution method for recognizing stock-based compensation expense under SFAS No. 123(R). The Company recorded $0.3 million and $0.4 million of compensation expense, net of tax, during the three and six months ended June 30, 2006, respectively, for stock option awards to employees and directors based on the estimated fair values at the grant dates of the awards.
As a result of adopting Statement 123(R) on January 1, 2006, the Company’s loss before income taxes and net loss for the three and six months ended June 30, 2006 was $0.3 million and $0.4 million higher, respectively, than if it had continued to account for share-based compensation under APB No. 25. Basic and diluted loss per share for the three and six months ended June 30, 2006 was $0.01 greater than if the Company had continued to account for share-based compensation under APB No. 25.
Results for the three and six months ended June 30, 2005 have not been restated. Had compensation expense for employee and director stock options been determined based on fair value at the grant date consistent with SFAS No. 123(R), with stock options expensed using the straight-line attribution method, the Company’s net loss and loss per share would have been increased to the pro forma amounts indicated below:
| | Three Months
Ended June 30, | | Six Months Ended
June 30, | |
| | 2005 | | 2005 | |
Net loss—as reported | | $ | (9,989,213 | ) | $ | (16,420,419 | ) |
Plus: stock-based employee compensation expense included in reported net loss, net of related tax effects of $0 | | 979 | | 26,708 | |
Less: total stock based employee compensation determined under fair value based method for all awards granted to employees, net of related tax effect of $0 | | 103,775 | | (1,431,970 | ) |
Net loss—pro forma | | $ | (9,884,459 | ) | $ | (17,825,681 | ) |
Net loss per share—as reported | | | | | |
Basic and diluted | | $ | (0.33 | ) | $ | (0.54 | ) |
Net loss per share—pro forma | | | | | |
Basic and diluted | | $ | (0.33 | ) | $ | (0.59 | ) |
The weighted average fair market value using the Black-Scholes option-pricing model of the options granted was $1.33 for the six months ended June 30, 2006 and $3.20 for the six months ended June 30, 2005. The fair market value of the stock options at the date of grant was estimated using the Black-Scholes option-pricing model with the following weighted average assumptions:
| | Six Months Ended | |
| | June 30, | | June 30, | |
| | 2006 | | 2005 | |
Expected life (years) | | 5.5 years | | 5.0 years | |
Interest rate | | 4.9 | % | 4.0 | % |
Dividend yield | | — | | — | |
Volatility | | 80 | % | 78 | % |
The risk-free interest rate is based on U.S. Treasury interest rates at the time of the grant whose term is consistent with the expected life of the stock options. Expected volatility is based on the Company’s historical experience. Expected life represents the period of time that options are expected to be outstanding and is based on the Company’s historical experience or the simplified method, as permitted by SEC Staff Accounting Bulletin No. 107 where appropriate. Expected dividend yield was not considered in the option pricing formula since the Company does not pay dividends and has no current plans to do so in the future. The forfeiture rate used was based upon historical experience. As required by SFAS No. 123(R), the Company will adjust the estimated forfeiture rate based upon actual experience.
During December 2005, the Company’s Board of Directors approved the full vesting of all unvested, outstanding stock options issued to current employees and directors. The Board decided to take this action (“the
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acceleration event”) in anticipation of the adoption of SFAS No. 123 (Revised 2004). As a result of this acceleration event, approximately 1.4 million stock options were vested that would have otherwise vested during 2006 and later periods. At the time of the acceleration event, the unamortized grant date fair value of the affected options was approximately $3.6 million (for SFAS No. 123 and SFAS No. 148 pro forma disclosure purposes), which was charged to pro forma expense in the fourth quarter of 2005. As the Company accelerated the vesting of outstanding employee and director stock options during December 2005, there was no remaining expense related to such options to be recognized in the Company’s statements of operations in future periods.
There were 10,000 stock options exercised during the six months ended June 30, 2006, resulting in cash proceeds to the Company of $16,500. These exercised options had an intrinsic value of $25,400. A summary of option activity for the six months ended June 30, 2006 is as follows:
| | Shares | | Weighted
Average
Exercise
Price | | Weighted
Average
Remaining
Contractual
Term | | Aggregate
Intrinsic
Value | |
| | | | | | | | | |
Outstanding at January 1, 2006 | | 6,912,683 | | $ | 5.66 | | | | | |
Granted | | 3,956,500 | | 1.89 | | | | | |
Exercised | | (10,000 | ) | 1.65 | | | | | |
Forfeited | | (356,250 | ) | 5.87 | | | | | |
Outstanding at June 30, 2006 | | 10,502,933 | | 4.23 | | 5.15 | | $ | 8,646,860 | |
Options exercisable at June 30, 2006 | | 6,756,432 | | $ | 5.51 | | 3.04 | | $ | 990,084 | |
The following table summarizes the status of the Company’s non-vested stock options since January 1, 2006:
| | Non-vested Options | |
| | Number of
Shares | | Weighted-
Average Fair
Value | |
Non-vested at January 1, 2006 | | 116,667 | | $ | 1.12 | |
Granted | | 3,956,500 | | 1.33 | |
Vested | | (316,666 | ) | 1.45 | |
Forfeited | | (10,000 | ) | 1.01 | |
Non-vested at June 30, 2006 | | 3,746,501 | | 1.34 | |
| | | | | | |
The total fair value of shares vested during the six months ended June 30, 2006 was $0.5 million. As of June 30, 2006, there was $3.4 million of total unrecognized compensation cost related to non-vested director and employee stock options. That cost is expected to be recognized over a weighted-average period of 2.9 years.
2001 Stock Option and Stock Appreciation Rights Plan
Effective August 10, 2001, the Company adopted the Isolagen, Inc. 2001 Stock Option and Stock Appreciation Rights Plan (the “2001 Stock Plan”). The 2001 Stock Plan is discretionary and allows for an aggregate of up to 5,000,000 shares of the Company’s common stock to be awarded through incentive and non-qualified stock options and stock appreciation rights. The 2001 Stock Plan is administered by the Company’s Board of Directors, who has exclusive discretion to select participants who will receive the awards and to determine the type, size and terms of each award granted.
During the three months ended March 31, 2006, the Company issued to four independent Board of Director members, under the 2001 Stock Plan, a total of 120,000 options to purchase its common stock with an exercise price of $2.14 per share and a ten year maximum contractual life. The options vest over four fiscal quarters during 2006. Also during the three months ended March 31, 2006, the Company issued, under the 2001 Stock Plan, a total of 10,000
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options to purchase its common stock with an exercise price of $1.84 per share to one employee with a five year maximum contractual life. These options vested over a three year period from the date of grant, and were forfeited during the three months ended June 30, 2006.
During the three months ended June 30, 2006, the Company issued, under the 2001 Stock Plan, (1) a total of 91,500 options to eight employees to purchase its common stock at exercise prices ranging from $1.89 to $2.06 per share, which have a five year maximum contractual life and which vest annually over a three year period from the date of grant, (2) 160,000 options to purchase its common stock with an exercise price of $1.89 per share to the Company’s President, which have a ten year maximum contractual life and which vest each fiscal quarter end over a three year period from the date of grant and (3) 50,000 options to purchase its common stock with an exercise price of $1.89 per share to a non-employee service provider, which have a five year maximum contractual life and which fully vest after one year from the date of grant.
Also during the three months ended June 30, 2006, the Company modified 100,000 stock options previously granted to the former CFO of the Company during 2005, such that the options will expire five years from the date of grant, as opposed to 90 days after termination. In connection with this modification, the Company recorded a charge of $0.1 million to selling, general and administrative expenses in the consolidated statement of operations for the three and six months ended June 30, 2006.
2003 Stock Option and Stock Appreciation Rights Plan
On January 29, 2003, the Company’s Board of Directors approved the 2003 Stock Option and Appreciation Rights Plan (the “2003 Stock Plan”). The 2003 Stock Plan is discretionary and allows for an aggregate of up to 2,250,000 shares of the Company’s common stock to be awarded through incentive and non-qualified stock options and stock appreciation rights. The 2003 Stock Plan is administered by the Company’s Board of Directors, who has exclusive discretion to select participants who will receive the awards and to determine the type, size and terms of each award granted. No options were granted under the 2003 Stock Plan during the six months ended June 30, 2006.
2005 Equity Incentive Plan
On April 26, 2005, the Company’s Board of Directors approved the 2005 Equity Incentive Plan (the “2005 Stock Plan”). The 2005 Stock Plan is discretionary and allows for an aggregate of up to 2,100,000 shares of the Company’s common stock to be awarded through incentive and non-qualified stock options, stock units, stock awards, stock appreciation rights and other stock-based awards. The 2005 Stock Plan is administered by the Compensation Committee of the Company’s Board of Directors, who has exclusive discretion to select participants who will receive the awards and to determine the type, size and terms of each award granted.
Restricted Stock: During the three months ended March 31, 2006, the Company issued 126,750 shares of restricted stock awards to various employees. The restricted common stock vested quarterly over three years, beginning on March 31, 2006 and ending on December 31, 2008. Compensation expense related to restricted stock for the three months ended March 31, 2006 was $23,497. On March 31, 2006, 10,557 shares of the 126,750 shares of restricted stock vested.
During the three months ended June 30, 2006, 2,752 shares of the restricted stock were cancelled due to terminations, 94,648 shares of restricted stock were cancelled in a Board approved exchange for 206,500 stock options (which were issued under the 2001 Plan) and 3,707shares of restricted stock vested. Compensation expense related to the restricted stock was less than $5,000 for the three months ended June 30, 2006. As of June 30, 2006, 17,086 shares of unvested restricted stock were outstanding, which vest quarterly through March 31, 2009.
Stock Options: No stock options were issued under the 2005 Stock Plan during the three months ended March 31, 2006. During the three months ended June 30, 2006, the Company issued 400,000 options to purchase its common stock with an exercise price of $1.88 per share to the Company’s President. These options have a ten year maximum contractual life and the options shall vest, and no longer be subject to forfeiture, upon the occurrence of any of the following events: (i) upon the closing of the sale of substantially all of the assets of the Company or the reorganization, consolidation or the merger of the Company; provided that the event results in the payment or distribution of
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consideration valued in good faith by the Board of Directors at $25 per share or more; or (ii) upon the closing of a tender offer or exchange offer to purchase 50% or more of the issued and outstanding shares of common stock of the Company at a price per share valued in good faith by the Board of Directors at $25 or more; or (iii) immediately following a “Stock Acquisition Date,” as that term is defined in the Rights Plan adopted by the Company on May 12, 2006 (provided that said rights are not subsequently redeemed by the Company or that the Rights Plan is not subsequently amended to preclude exercise of the rights issued thereunder, prior to the Distribution Date, as that term is defined in the Rights Pan), or (iv) at such other time as the Board of Directors, in its sole discretion, deems appropriate; provided in each case that the President is employed by the Company at the time of said event.
The 400,000 share option grant is considered a grant of a performance stock option. No compensation cost has been recorded for this grant (the “Performance Stock Option Grant”) as the Company does not currently believe that the vesting events are probable of occurrence. The grant date fair value of the award was approximately $0.6 million. This fair value of $0.6 million, or any portion thereof, will not be recognized as compensation expense until the vesting of the Performance Stock Option Grant becomes probable.
Other Stock Options
During the three months ended March 31, 2006, the Company did not issue any options outside the 2001 Stock Plan, the 2003 Stock Plan or the 2005 Stock Plan. During the three months ended June 30, 2006, the Company issued (1) 2,000,000 options to purchase its common stock with an exercise price of $1.88 per share to the Company’s CEO, which have a ten year maximum contractual life and which vest each fiscal quarter end over a three year period from the date of grant, (2) 325,000 options to purchase its common stock with an exercise price of $1.87 per share to the Company’s CFO, which have a five year maximum contractual life and vest annually over a three year period from the date of grant and (3) 200,000 options to purchase its common stock with an exercise price of $1.87 per share to a separate employee, which have a five year maximum contractual life and vest annually over a three year period from the date of grant.
In addition, during the three months ended June 30, 2006 the Company issued 500,000 options to purchase its common stock with an exercise price of $1.88 per share to the Company’s CEO. These options have a ten year maximum contractual life and the options have identical vesting terms to the Performance Stock Option Grant issued under the 2005 Stock Plan discussed above. No compensation cost has been recorded for this grant as the Company does not currently believe that the vesting events are probable of occurrence. The grant date fair value of the award was approximately $0.7 million. This fair value of $0.7 million, or any portion thereof, will not be recognized as compensation expense until the vesting of the award becomes probable.
Stock Options Issued for Services
As of June 30, 2006, the Company has outstanding 691,100 options issued to non-employees under consulting and distribution agreements. The following sets forth certain information concerning these options:
| | Vested | | Unvested | |
Warrants and options outstanding | | 537,766 | | 153,334 | |
Vesting period | | n/a | | 6-10 mos. | |
Range of exercise prices | | $ | 1.50-10.49 | | $ | 1.89-6.00 | |
Weighted average exercise price | | $ | 5.29 | | $ | 3.84 | |
Expiration dates | | 2006-2013 | | 2009-2013 | |
Expense related to these contracts was less than $0.1 million and approximately $0.1 million for the three and six months ended June 30, 2006, respectively. Expense related to these contracts was less than $0.1 million for both the three and six months ended June 30, 2005. The expense was calculated using the Black Scholes option-pricing model based on the following weighted average assumptions for the six months ended June 30, 2006 and six months ended June 30, 2005:
Expected life (years) | | 5-10 Years | |
Interest rate | | 4.0-4.97% | |
Dividend yield | | — | |
Volatility | | 83.0-83.1% | |
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Further, there were 688,256 warrants outstanding as of June 30, 2006 and December 31, 2005. None of these warrants were converted or forfeited during the six months ended June 30, 2006.
Stockholder Rights Plan
In May 2006, the Board of Directors of the Company adopted a Stockholder Rights Plan, as set forth in the Rights Agreement, dated as of May 12, 2006, by and between the Company and American Stock Transfer & Trust Company, a trust company organized under the laws of the State of New York (the “Rights Agent”). Pursuant to the Rights Agreement, stockholders of record at the close of business on May 22, 2006 received one right (“Right”) for each share of Isolagen common stock held on that date. The Rights, which will initially trade with the common stock and represent the right to purchase one ten-thousandth of a share of the Company’s newly created Series C Preferred Stock at $35 per Right, become exercisable when a person or group acquires 15% or more of the Company’s common stock (20% in the case of certain institutional stockholders) or announces a tender offer for 15% or more of the common stock. In that event, in lieu of purchasing the Series C Preferred Stock, the Rights permit the Company’s stockholders, other than the acquiror, to purchase Isolagen common stock having a market value of twice the exercise price of the Rights. In addition, in the event of certain business combinations, the Rights permit holders to purchase the common stock of the acquiror at a 50% discount. Rights held by the acquiror will become null and void in each case.
The Rights have certain anti-takeover effects, in that they would cause substantial dilution to a person or group that attempts to acquire a significant interest in the Company on terms not approved by the Board of Directors. In the event that the Board of Directors determines a transaction to be in the best interests of the Company and its stockholders, the Board of Directors will be entitled to redeem the Rights for $.001 per Right at any time before the tenth business day after the Company’s announcement that a person or group has acquired ownership of 15% or the tenth business day after commencement of a tender or exchange offer for more than 15% of the outstanding common stock. The Rights expire on May 12, 2016.
Note 6—Geographical Information
The Company operates its business on the basis of a single reportable segment. The Company markets its products on a global basis. The Company’s principal markets are the United States, the United Kingdom and Europe. While no commercial operations have commenced in the United States, the United States is presented separately as it is the Company’s headquarters.
Geographical information concerning the Company’s reportable segment is as follows:
| | Revenue
Three months ended June 30, | |
| | 2006 | | 2005 | |
| | | | | |
United States | | $ | — | | $ | — | |
United Kingdom | | 1,376,103 | | 2,111,806 | |
Other | | 267,643 | | 234,707 | |
| | $ | 1,643,746 | | $ | 2,346,513 | |
| | Revenue
Six months ended June 30, | |
| | 2006 | | 2005 | |
| | | | | |
United States | | $ | — | | $ | — | |
United Kingdom | | 2,887,636 | | 4,533,097 | |
Other | | 555,680 | | 479,950 | |
| | $ | 3,443,316 | | $ | 5,013,047 | |
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| | Property and Equipment, net | |
| | June 30, | | December 31, | |
| | 2006 | | 2005 | |
| | | | | |
United States | | $ | 4,589,579 | | $ | 4,602,417 | |
United Kingdom | | 1,774,755 | | 1,868,592 | |
Switzerland | | — | | 68,952 | |
| | $ | 6,364,334 | | $ | 6,539,961 | |
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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS.
The following discussion and analysis should be read in conjunction with our consolidated financial statements, including the notes thereto.
Forward-Looking Information
This report contains certain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, as well as information relating to Isolagen that is based on management’s exercise of business judgment and assumptions made by and information currently available to management. When used in this document and other documents, releases and reports released by us, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “the facts suggest” and words of similar import, are intended to identify any forward-looking statements. You should not place undue reliance on these forward-looking statements. These statements reflect our current view of future events and are subject to certain risks and uncertainties as noted below. Should one or more of these risks or uncertainties materialize, or should underlying assumptions prove incorrect, our actual results could differ materially from those anticipated in these forward-looking statements. Actual events, transactions and results may materially differ from the anticipated events, transactions or results described in such statements. Although we believe that our expectations are based on reasonable assumptions, we can give no assurance that our expectations will materialize. Many factors could cause actual results to differ materially from our forward looking statements. Several of these factors include, without limitation:
· our ability to develop autologous cellular therapies that have specific applications in cosmetic dermatology, and our ability to explore (and possibly develop) applications for periodontal disease, reconstructive dentistry and other health-related markets;
· whether our clinical human trials relating to autologous cellular therapy applications for the treatment of dermal defects or gingival recession can be conducted within the timeframe that we expect, whether such trials will yield positive results, or whether additional applications for the commercialization of autologous cellular therapy can be identified by us and advanced into human clinical trials;
· whether the FDA accepts our proposed protocol relating to our dermal Phase III study;
· whether the results of such Phase III study will support a successful BLA filing;
· our ability to provide and deliver any autologous cellular therapies that we may develop, on a basis that is cost competitive with other therapies, drugs and treatments that may be provided by our competitors;
· our ability to finance our business;
· our ability to improve our current pricing model;
· our ability to decrease our cost of goods sold through the improvement and/or automation of our manufacturing process, which we believe will eliminate several of the steps and materials involved in our current system and will lead to significant cost reductions in both skilled labor and materials and will enable scalable mass production;
· whether we can successfully transfer the technology relating to our process in Exton into our UK operations;
· our ability to reduce our need for fetal bovine calf serum by improved use of less expensive media combinations and different media alternatives;
· a stable currency rate environment in the world, and specifically the countries we are doing business in or plan to do business in;
· our ability to meet requisite regulations or receive regulatory approvals in the United States, Europe, Asia and the Americas, and our ability to retain the licenses that we have obtained and may obtain; and the absence of adverse regulatory developments in the United States, Europe, Asia and the Americas or any other country where we plan to conduct commercial operations;
· continued availability of supplies at satisfactory prices;
· no new entrance of competitive products or further penetration of existing products in our markets;
· no adverse publicity related to our products or the Company itself;
· no adverse claims relating to our intellectual property;
· the adoption of new, or changes in, accounting principles; and/or legal proceedings;
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· | | our ability to maintain compliance with the AMEX requirements for continued listing of our common stock; |
· | | the costs inherent with complying with statutes and regulations applicable to public reporting companies, such as the Sarbanes-Oxley Act of 2002; |
· | | our ability to efficiently integrate future acquisitions, if any; |
· | | our ability to successfully integrate other new lines of business that we may enter in the future, if any; and |
· | | our dependence on our physician customers to correctly follow our established protocols for the safe administration of the Isolagen Process; and |
· | | other risks referenced from time to time elsewhere in this report and in our filings with the SEC, including, without limitation, the risks and uncertainties described in Item 1A of our Form 10-K for the year ended December 31, 2005 as well as Part II, Item 1A of this report. |
These factors are not necessarily all of the important factors that could cause actual results of operations to differ materially from those expressed in these forward-looking statements. Other unknown or unpredictable factors also could have material adverse effects on our future results. We undertake no obligation and do not intend to update, revise or otherwise publicly release any revisions to these forward-looking statements to reflect events or circumstances after the date hereof or to reflect the occurrence of any unanticipated events. We cannot assure you that projected results will be achieved.
General
We specialize in the development and commercialization of autologous cellular therapies for soft tissue regeneration. Our two product candidates, which are being evaluated for the aesthetic and dental markets, utilize our proprietary Isolagen Process. Our ability to operate profitably is largely contingent upon our success in obtaining regulatory approval to sell our products, upon our successful development of markets for our products, and upon our development of profitable manufacturing processes. We may be required to obtain additional capital in the future to support these efforts or expand our operations. No assurance can be given that we will be able to obtain such regulatory approvals, successfully develop the markets for our products or develop profitable manufacturing methods, or obtain such additional capital as we might need, either through equity or debt financing, on satisfactory terms or at all. Additionally, no assurance can be given that any such financing, if obtained, will be adequate to meet our ultimate capital needs and to support our growth. If adequate capital cannot be obtained on satisfactory terms, our operations could be negatively impacted.
If we achieve growth in our operations in the next few years, such growth could place a strain on our management, administrative, operational and financial infrastructure. We may find it necessary to hire additional management, financial, sales and marketing personnel to manage our expanding operations. In addition, our ability to manage future operations and growth may require the continued improvement of operational, financial and management controls, reporting systems and procedures. If we are unable to manage this growth effectively and successfully, our business, operating results and financial condition may be materially adversely affected.
Conversely, the business operation could be adversely affected by the departure of key management personnel and our inability to replace that management expeditiously.
The focus of our efforts has been and will continue to be the development, testing and approval of the Isolagen Process, and the evaluation of researching other applications. As a result of this uncertainty, we are still considered to be a “development stage” enterprise. We have, since 2002, made the Isolagen Process available to physicians primarily in the United Kingdom. Revenue was approximately $1.6 million and $3.4 million for the three and six months ended June 30, 2006, respectively. We continue to generate negative gross margins, as discussed under “Results of Operations—Comparison of the three months ended June 30, 2006 and 2005” and “Results of Operations—Comparison of the six months ended June 30, 2006 and 2005.” In addition, in the market of the United Kingdom, we have decided to place a great deal of emphasis on the training and proctoring of our customers in order to ensure that they are administering the Isolagen process appropriately. This retraining effort has resulted in the contraction of our physician customer base, which is likely to continue for the immediate future. As a result, it is highly likely that sales in the United Kingdom in the near future will reflect a declining trend. Our goal is to assure a positive outcome for our physicians and their patients, achieve a positive gross margin on the sale of our product, and create a profitable Company.
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At June 30, 2006 and December 31, 2005, we had cash, cash equivalents, restricted cash and available-for-sale investments of $49.2 million and $67.0 million, respectively. The causes of our decrease in cash, cash equivalents, restricted cash and available-for-sale investments are discussed under “Liquidity and Capital Resources.” We believe our existing capital resources are adequate to finance our operations through at least June 30, 2007; however, our long-term viability is dependent upon successful operation of our business, which includes our ability to improve our manufacturing process, the approval of our products and the ability to raise additional debt and equity to meet our business objectives.
Recent Developments
Clinical
We are developing our lead dermal product candidate for the correction and reduction of the normal effects of aging, such as wrinkles and nasolabial folds. In March 2004, we announced positive results of our first Phase III exploratory clinical trial for our lead product candidate. In July 2004, we announced the commencement of two pivotal Phase III trials, which were being conducted in two different geographic and demographic populations in the United States as two identical trials for the treatment of facial wrinkles. These trials, which were concluded during the second half of 2005, were randomized, double blind and placebo-controlled and were conducted at various sites in the United States. The trials, which were conducted simultaneously, each had in excess of 100 subjects split evenly between the treatment group and the placebo group.
We announced on August 1, 2005 the results of our pivotal Phase III dermal studies. The dermal studies met three of the four primary endpoints and achieved statistical significance when combined. The studies’ primary endpoints were based on blinded physician visual assessment using a six-point scale with a two-point positive move required to meet the endpoint and subject assessment using a visual analog scale. Trial B of the study proved to be clinically and statistically significant with both the subject and physician assessment achieving positive results. Trial A results were mixed with only a positive assessment from the subjects. In addition, there was a wide variance in results from site to site with a range of response rates from 73.3% to 7.6%, where a “response” represents the improvement of at least two points, on a six point scale, based on a visual assessment performed by the physician. We believe that this range of outcomes suggests that results are dependent on, among other things, injection technique. We conducted a post hoc statistical analysis and a thorough review of the results of the Phase III studies that suggested trial results were negatively impacted by two factors in addition to injection technique. First, our statistical analysis included all subjects who were randomized to the study. The statistical analysis did not exclude subjects who received neither our product nor placebo; these subjects were deemed to have failed the study. Second, our study population included a number of subjects with a baseline assessment of two (of their wrinkles) on the six-point scale. A two point improvement for these subjects would have required an assessment of zero on the six-point scale. After consultation with our clinical advisors familiar with utilizing the six-point scale, we believe subjects with an initial assessment of two on the scale should have been excluded from participation in the studies because of investigator reluctance to make a final assessment of zero (equivalent to no wrinkles) at the endpoint. Our future protocols will exclude subjects with a baseline assessment of two.
We used the information derived from our post hoc statistical analysis and the input of our clinical advisors to develop a Phase III confirmatory study. However, more recently we determined to conduct a full Phase III pivotal trial, as opposed to a confirmatory trial, which would consist of 400 subjects. In June of 2006, we filed a request for a Special Protocol Assessment relating to our Phase III Dermal Trial. On August 3, 2006, the FDA advised us that it required a number of amendments to the request. All of the requested changes are acceptable to us and we will file these amendments during the month of August 2006. The FDA has 45 days to respond to a request or amendment to a request for a Special Protocol Assessment. However, we anticipate a response prior to the expiration of that time period.
We completed a Phase I clinical trial for our second product candidate for the treatment of periodontal disease in late 2003. In the second quarter of 2004, we initiated a Phase II clinical trial for the cosmetic, or “black triangle,” application of this product candidate. This Phase II clinical trial concluded during the second quarter of 2005. The analysis of the investigator and subject visual analog scale assessment demonstrated that the Isolagen Process was statistically superior to placebo at four months after treatment. Although results of the investigator and subject assessment demonstrated that the Isolagen Process was statistically superior to placebo, an analysis of objective linear measurements did not yield statistically significant results despite a positive change observed as a
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result of treatment with the Isolagen Process. Clinical advisors believe that current measurement techniques are not precise enough to accurately record the positive change. We are investigating alternative measurement techniques to assess change in future trials.
Switzerland
In April 2005, we acquired land and a two-building, 100,000 square foot corporate campus in Bevaix, Canton of Neuchâtel, Switzerland for $10 million. We spent approximately $1.8 million to date on the first phase of a renovation. During April 2006, management decided to place the corporate campus on the market for sale in order to consolidate European operations into one location and to conserve capital. We commenced selling efforts during the second quarter of 2006, and as such, the carrying amount of the campus was reclassified as an asset held for sale. The net book value of the corporate campus at June 30, 2006 was $10.6 million, reflecting management’s estimate of the realizable value of the corporate campus. The carrying amount of the campus as of December 31, 2005 has also been reclassified to conform to this presentation.
Although the campus was not being actively marketed for sale as of March 31, 2006, management at that date assessed whether the book value of the corporate campus was impaired based on its estimate of the realizable value of the corporate campus and made a determination to write down the corporate campus by $0.7 million, which charge is reflected in selling, general and administrative expenses in the consolidated statement of operations for the six months ended June 30, 2006. The net book value of the corporate campus at June 30, 2006 was $10.6 million, reflecting management’s estimate of the realizable value of the corporate campus. This estimate may change in future periods. At June 30, 2006, the Swiss corporate campus is classified as held for sale on the consolidated balance sheet, and prior period amounts have been reclassified to conform to this presentation.
Houston, Texas
On March 28, 2006, our board of directors approved the shut-down of the Houston, Texas facility. The Houston, Texas facility was used primarily for research and development purposes and is maintained under an operating lease which ends on April 30, 2008. The research and development activities will be conducted at our facilities located in Exton, Pennsylvania. An exit plan was communicated to the affected employees during the three months ended June 30, 2006. There were approximately 15 employees at the Houston, Texas facility at March 31, 2006 and the large majority of these employees had been terminated by June 30, 2006 at a severance cost of less than $0.1 million. We will use our best efforts to negotiate an exit from the lease with the lessor, however, there is no assurance that such negotiations will be successful. As of June 30, 2006, the remaining lease payments and common operating expenses due under the Houston, Texas lease agreement was approximately $0.3 million.
United Kingdom Customer Settlement
During 2005, we began an informal study and surveyed a number of patients who had previously received the Isolagen treatment to assess patient satisfaction. Some patients surveyed reported sub-optimal results from treatment. One hundred forty-nine patients who claimed to have received sub-optimal results were retreated for the purpose of determining the reasons for sub-optimal results. Only those patients who completed the survey, provided adequate medical records including before and after photographs and who were deemed both to have received a sub-optimal result from a first treatment administered according to the Isolagen protocol and who were considered to be appropriate patients for treatment with the Isolagen Process received re-treatment. No one completing the survey was offered re-treatment unless they agreed to these conditions. Following re-treatment, a number of patients reported better results than first obtained through the initial treatment by their initial treating physician.
During the first quarter of 2006, we received a number of complaints from certain patients who had learned of the limited re-treatment program and also learned that a number of physicians with dissatisfied patients were generating public ill-will as a result of the Company’s decision to limit the number of patients offered re-treatment and were encouraging dissatisfied patients to seek recourse against us. In response, in March 2006 we decided that it was in our best interest to address these complaints to foster goodwill in the marketplace and avoid the cost of any potential patient claims. Accordingly, we agreed to resolve any properly documented and substantiated patient complaints by offering to retreat the patient pursuant to the same criteria stated above or pay £1,000 (approximately US$1,750) to the patients identified to us as having received a sub-optimal result. In order to qualify for re-treatment
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and in addition to the criteria set forth above, the patient will be treated by a physician identified by us who will treat these patients pursuant to a protocol. In addition, these patients must agree to follow-up visits and assessments of their response to treatment. No patient unlikely to benefit from Isolagen therapy will be retreated.
We made this offer to approximately 290 patients during late March 2006. Accordingly, we believed our range of liability was between £290,000 (or approximately $0.5 million), assuming all 290 patients were to choose the £1,000 payment, and approximately £580,000 (or approximately $1.0 million), assuming all 290 patients elected to be retreated. The estimated costs for re-treatment include the cost of treatment, physician fees and other ancillary costs. We currently estimate that 60% of the patients will elect the £1,000 offer and 40% will elect to be retreated. The Company has recorded a charge to selling, general and administrative expense for the three months ended March 31, 2006 of $0.7 million. As of March 31, 2006, no amounts had been expended related to this settlement and the $0.7 million liability was included in accrued expenses in the consolidated balance sheet. During the three months ended June 30, 2006, an additional 31 patients were entered into the settlement program, resulting in an additional charge to selling, general and administrative expense of $0.1 million. Also during the three months ended June 30, 2006, the £1,000 payments to patients, discussed above, reduced the liability by $0.2 million. As of June 30, 2006, the liability included in accrued expenses in the consolidated balance sheet was $0.6 million. The estimates of the factors which will affect the actual cost of this program may change in future periods and the effects of any changes in these estimates will be accounted for in the period in which the estimate changes.
Stockholder Rights Plan
In May 2006, the Board of Directors adopted a Stockholder Rights Plan, as set forth in the Rights Agreement, dated as of May 12, 2006, by and between the Isolagen, Inc. and American Stock Transfer & Trust Company, a trust company organized under the laws of the State of New York (the “Rights Agent”). Pursuant to the Rights Agreement, stockholders of record at the close of business on May 22, 2006 received one Right for each share of Isolagen common stock held on that date. The Rights, which will initially trade with the common stock and represent the right to purchase one ten-thousandth of a share of the Company’s newly created Series C Preferred Stock at $35 per Right, become exercisable when a person or group acquires 15% or more of our common stock (20% in the case of certain institutional stockholders) or announces a tender offer for 15% or more of the common stock. In that event, in lieu of purchasing the Series C Preferred Stock, the Rights permit our stockholders, other than the acquiror, to purchase Isolagen common stock having a market value of twice the exercise price of the Rights. In addition, in the event of certain business combinations, the Rights permit holders to purchase common stock of the acquiror at a 50% discount. Rights held by the acquiror will become null and void in each case.
The Rights have certain anti-takeover effects, in that they would cause substantial dilution to a person or group that attempts to acquire a significant interest in us or on terms not approved by the Board of Directors. In the event that the Board of Directors determines a transaction to be in our best interests and its stockholders, the Board of Directors will be entitled to redeem the Rights for $.001 per Right at any time before the tenth business day after an announcement that a person or group has acquired ownership of 15% or the tenth business day after commencement of a tender or exchange offer for more than 15% of the outstanding common stock. The Rights expire on May 12, 2016.
Management
As previously announced, on June 5, 2006 we named Nicholas L. Teti, Jr., as Chairman and Chief Executive Officer. Also on June 5, 2006, we named Declan Daly as Executive Vice President-Europe and Chief Financial Officer. Refer to Part I, Note 5 of Notes to the Unaudited Consolidated Financial Statements found elsewhere in this report, for further information related to equity awards granted to these new officers.
Critical Accounting Policies
The following discussion and analysis of financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in conformity with accounting principles generally accepted in the United States of America. Our significant accounting policies are more fully described in Note 2 of Notes to the Consolidated Financial Statements. However, certain accounting policies and estimates are particularly important to the understanding of our financial position and results of operations and require the application of
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significant judgment by our management or can be materially affected by changes from period to period in economic factors or conditions that are outside the control of management. As a result they are subject to an inherent degree of uncertainty. In applying these policies, our management uses their judgment to determine the appropriate assumptions to be used in the determination of certain estimates. Those estimates are based on our historical operations, our future business plans and projected financial results, the terms of existing contracts, our observance of trends in the industry, information provided by our customers and information available from other outside sources, as appropriate. The following discusses our significant accounting policies and estimates.
Revenue Recognition: We recognize revenue over the period the service is performed in accordance with SEC Staff Accounting Bulletin No. 104, “Revenue Recognition in Financial Statements” (“SAB 104”). In general, SAB 104 requires that four basic criteria must be met before revenue can be recognized: (1) persuasive evidence of an arrangement exists, (2) delivery has occurred or services rendered, (3) the fee is fixed and determinable and (4) collectibility is reasonably assured.
The Isolagen Process is administered to each patient using a recommended regimen of injections. Due to the short shelf life, each injection is cultured on an as needed basis and shipped prior to the individual injection being administered by the physician. The Company believes each injection has stand alone value to the patient. The Company invoices the attending physician when the physician sends his or her patient’s tissue sample to us, which creates a contractual arrangement between us and the medical professional. The amount invoiced varies directly with the dose and number of injections requested. Generally, orders are paid in advance by the physician prior to the first injection. There is no performance provision under any arrangement with any physician, and there is no right to refund or returns for unused injections.
As a result, we believe that the requirements of SAB 104 are met as each injection is shipped, as the risk of loss transfers to our physician customer at that time, the fee is fixed and determinable and collection is reasonably assured. Advance payments are deferred until shipment of the injection(s). The amount of the revenue deferred represents the fair value of the remaining undelivered injections measured in accordance with Emerging Issues Task Force Issue (“EITF”) 00-21, “Accounting for Revenue Arrangements with Multiple Deliverables,” which addresses the issue of accounting for arrangements that involve the delivery of multiple products or services. Should the physician discontinue the regimen prematurely all remaining deferred revenue is recognized.
We also offer a service whereby we store a patient’s cells for later use in the preparation of injections. In accordance with EITF 00-21, the fee charged for this service is recognized as revenue ratably over the length of the storage agreement.
Cost of Sales, Selling, General and Administrative Expenses and Research and Development Expenses: Our Exton, Pennsylvania facility is used to conduct research on the development, testing and approval of the Isolagen Process. In addition, our Exton facility serves as our corporate headquarters. Our London facility is engaged in the commercialization of our process (for which revenue is earned from the sale of Isolagen Process injections) as a means to improve manufacturing technologies that would be used to produce commercial quantities of injections on a profitable basis in the future. Therefore, we classify as cost of sales the costs (except for costs related to marketing, sales and general corporate administration) incurred in operating our London facility, while the costs incurred in operating our Exton, Pennsylvania facilities (except for costs related to general corporate administration) are classified as research and development expenses.
Costs of sales includes salaries and benefits, costs paid to third-party contractors to develop and manufacture drug materials and delivery devices, inventory used in the manufacturing process, a portion of facilities cost and other indirect manufacturing costs. Those costs, except for the costs of raw materials that have not been used, are expensed as incurred.
Historically, autologous cell companies have been hampered by manufacturing technologies that use traditional methodology for culturing cells through the utilization of plastic flasks. This methodology is labor intensive, slow, involves many sterile interventions and is costly. The use of this process to produce Isolagen Process injections in commercial quantities would not, over time, be profitable. We have been using the commercialization of our process as a means of researching and developing manufacturing technologies which therefore could be used to produce commercial quantities of injections on a profitable basis. Through June 30, 2006, our cost of sales has exceeded our
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revenue. This reflects the fact that the level of our sales from our commercialization efforts, primarily in the United Kingdom, have not yet reached the levels necessary for profitable operations, and the development and implementation of improved processes has not yet achieved all of the cost efficiencies we hope to achieve in the future.
If, in the future, the purposes for which we operate our Exton, Pennsylvania or London facilities, or any new facilities we open, changes, the allocation of the costs incurred in operating that facility between cost of sales and research and development expenses could change to reflect such operational changes.
Research and Development Expenses: Research and development costs are expensed as incurred and include salaries and benefits, costs paid to third-party contractors to perform research, conduct clinical trials, develop and manufacture drug materials and delivery devices, and a portion of facilities cost. Clinical trial costs are a significant component of research and development expenses and include costs associated with third-party contractors. Invoicing from third-party contractors for services performed can lag several months. We accrue the costs of services rendered in connection with third-party contractor activities based on our estimate of management fees, site management and monitoring costs and data management costs. Actual clinical trial costs may differ from estimated clinical trial costs and are adjusted for in the period in which they become known.
Stock-Based Compensation: In December 2004, the Financial Accounting Standards Board (“FASB”) issued Statement of Financial Accounting Standards (“SFAS”) No. 123 (revised 2004), “Share-Based Payment” (“SFAS No. 123 (R)”). SFAS No. 123 (R) replaces SFAS No. 123, “Accounting for Stock-Based Compensation,” supersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees” (“APB No. 25”), and amends SFAS No. 95, “Statement of Cash Flows.” SFAS No. 123 (R) requires entities to recognize compensation expense for all share-based payments to employees and directors, including grants of employee stock options, based on the grant-date fair value of those share-based payments, adjusted for expected forfeitures.
We adopted SFAS No. 123(R) as of January 1, 2006 using the modified prospective application method. Under the modified prospective application method, the fair value measurement requirements of SFAS No. 123(R) is applied to new awards and to awards modified, repurchased, or cancelled after January 1, 2006. Additionally, compensation cost for the portion of awards for which the requisite service has not been rendered that were outstanding as of January 1, 2006 is recognized as the requisite service is rendered on or after January 1, 2006. The compensation cost for that portion of awards is based on the grant-date fair value of those awards as calculated for pro forma disclosures under SFAS No. 123. Changes to the grant-date fair value of equity awards granted before January 1, 2006 are precluded.
The fair value of stock options is determined using the Black-Scholes valuation model, which is consistent with our valuation techniques previously utilized for awards in footnote disclosures required under SFAS No. 123. Prior to the adoption of SFAS No. 123(R), we followed the intrinsic value method in accordance with APB No. 25 to account for our employee and director stock options. Historically, substantially all stock options have been granted with an exercise price equal to the fair market value of the common stock on the date of grant. Accordingly, no compensation expense was recognized from option grants to employees and directors. However, compensation expense was recognized in connection with the issuance of stock options to non-employee consultants in accordance with EITF 96-18, “Accounting for Equity Instrument That are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services.” SFAS No. 123(R) did not change the accounting for stock-based compensation related to non-employees in connection with equity based incentive arrangements.
The adoption of SFAS No. 123(R) requires additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangement. This change in accounting resulted in the recognition of compensation expense of $0.3 and $0.4 million for the three and six months ended June 30, 2006, respectively, related to our employee and director stock options. Basic and diluted loss per share for the three and six months ended June 30, 2006 was $0.01 greater than if we had continued to account for share-based compensation under APB No. 25. During the three months ended June 30, 2006, we granted 3.8 million stock options, of which 3.0 million stock options were granted to three new officers on their employee commencement dates. As of June 30, 2006, there was $3.4 million of total unrecognized compensation cost related to non-vested stock options to employees and directors; the cost of which is expected to be recognized over a weighted-average period of 2.86 years. For additional information related to our stock-based compensation during the first and second quarters of 2006, see Note 5 — Share-Based Compensation.
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During December 2005, the board of directors approved the full vesting of all unvested, outstanding stock options issued to current employees and directors. The board decided to take this action (“the acceleration event”) in anticipation of the adoption of SFAS No. 123 (R). As a result of this acceleration event, approximately 1.4 million stock options were vested that would have otherwise vested during 2006 and later periods. At the time of the acceleration event, the unamortized grant date fair value of the affected options was approximately $3.6 million (for SFAS No. 123 and SFAS No. 148 pro forma disclosure purposes), which was charged to pro forma expense in the fourth quarter of 2005. Substantially all of the unvested employee stock options that were subject to the acceleration event had exercise prices above market price of our common stock at the time the board approved the acceleration event. However, in accordance with SFAS 123 (R) if we had not completed this acceleration event in December 2005, the majority of the $3.6 million amount discussed above would have been charged against the future results of operations, beginning in the first quarter of fiscal 2006 and continuing through later periods as the options vested. As discussed above, substantially all of the unvested employee stock options which were accelerated had exercise prices above market price at the time of acceleration. For the purposes of applying APB No. 25 to such stock options in the statement of operations for the year ended December 31, 2005, the acceleration event was treated as the acceleration of the vesting of employee and director options that otherwise would have vested as originally scheduled, and accordingly was not a modification requiring the remeasurement of the intrinsic value of the options, or the application of variable option accounting, under APB No. 25. For stock options that had exercise prices below market price at the time of acceleration and that would not have vested originally, a charge of approximately $15,000 was recorded in the statement of operations for the year ended December 31, 2005.
Federal Securities and Derivative Actions: As discussed in Note 4 of Notes to Consolidated Financial Statements and Part II, Item 1, Legal Proceedings, set forth elsewhere in this Report, we are currently defending ourselves against various class and derivative actions. We intend to defend ourselves vigorously against these actions. We cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in our consolidated financial statements. Generally, a loss must be both reasonably estimable and probable in order to record a provision for loss. We will expense our legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received. Although we have not recorded a provision for loss regarding these matters, a loss could occur in a future period.
We are involved in various other legal matters that are being defended and handled in the ordinary course of business. Although it is not possible to predict the outcome of these matters, management believes that the results will not have a material impact on our financial statements.
Results of Operations
Comparison of the three months ended June 30, 2006 and 2005
REVENUE. Revenue decreased $0.7 million to $1.6 million for the three months ended June 30, 2006, as compared to $2.3 million for the three months ended June 30, 2005. The decrease in revenue is primarily due to the contraction of our physician customer base in the United Kingdom as a result of our decision to place a great deal of emphasis on the training and proctoring of our physician customers in order to ensure that they are administering the Isolagen process appropriately. This retraining effort has resulted in the contraction of our physician customer base which is likely to continue for the immediate future. As a result, it is highly likely that sales in the United Kingdom in the near future will reflect a declining trend.
As discussed above, our London facility is engaged in the commercialization of our process (for which they earn revenue from the sale of Isolagen Process injections) as a means to improve manufacturing technologies that would be used to produce commercial quantities of injections on a profitable basis in the future. We are working to reduce our costs through the pursuit of an optimized manufacturing process and other efficiencies. However, through June 30, 2006 we continued to experience a negative gross margin. As such, we did not believe that we should drive demand if we were manufacturing our product at negative margins, and as a result in the recent periods we have not attempted to increase our revenue stream.
Sales measured by product volumes, as measured by milliliter of product, decreased by approximately 27% during the three months ended June 30, 2006, as compared to the three months ended June 30, 2005. Average selling price per milliliter of treatment decreased approximately 18% during the three months ended June 30, 2006,
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as compared to the three months ended June 30, 2005. The average selling price has fluctuated as we continue to investigate various price points in the United Kingdom market. In addition, our average selling price per milliliter has declined due to the increase in six milliliter treatment programs sold in the three months ended June 30, 2006 as compared to four and six milliliter treatments sold during the three months ended June 30, 2005. Generally, higher milliliter treatments carry a higher total price but a lower price per milliliter of treatment.
In addition, after the completion of a standard treatment, a patient may request and pay for an additional one to three milliliters of treatment. Such additional treatment volumes increased by approximately 121% during the quarter ended June 30, 2006, as compared to the quarter ended June 30, 2005. This increase in volume was offset by a decrease in average selling price of approximately 23%.
From time to time, we provide promotional incentives, or no charge treatments, to doctors utilizing the Isolagen Process. Such promotional incentives are not reflected as revenue, but rather, are reflected as marketing expense in selling, general and administrative expenses. We expect to continue, on a reduced basis in 2006, providing such promotional incentives to doctors during the introduction phase of the Isolagen Process in the United Kingdom and elsewhere.
We also offer a service whereby we store a patient’s cells for later use in the preparation of injections. The fees charged for this service are recognized as revenue ratably over the length of the storage agreement. Revenue from this service in each of the quarters ended June 30, 2006 and 2005 was less than $0.1 million.
COST OF SALES. Costs of sales decreased $0.8 million to $2.0 million for the three months ended June 30, 2006, as compared to $2.8 million for the three months ended June 30, 2005. For the three months ended June 30, 2006, our cost of sales exceeded revenue as the development and implementation of our processes has not yet achieved all of the cost efficiencies we anticipate.
As a percentage of revenue, cost of sales were approximately 120% for the three months ended June 30, 2006, which reflected no significant change from the approximately 118% for the three months ended June 30, 2005. Since 2002 we have made our Isolagen Process available to physicians in the United Kingdom. The Company has been using the commercialization of the Isolagen Process in this market as a means of researching and developing manufacturing technologies and, therefore, we believe could be used to produce commercial quantities of injections on a profitable basis. As the London facility operations continue to develop and mature, resulting in significant changes to its stage of commercial development, large fluctuations in the percentage of cost of sales to revenue are experienced.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses decreased $0.2 million, or 4%, to $5.6 million for the three months ended June 30, 2006, as compared to $5.9 million for the three months ended June 30, 2005. The fluctuation in selling, general and administrative expenses are primarily due to the following:
a) Salaries, bonuses and payroll taxes increased by approximately $0.7 million to $2.2 million for the three months ended June 30, 2006 compared to $1.5 million for three months ended June 30, 2005 due to an increase of $0.5 million in non-cash stock compensation related to stock options issued and $0.3 million of signing bonuses paid to new officers during the three months ended June 30, 2006. This increase was offset by a reduction of $0.1 million in salaries due to a reduction in number of employees as a result of closing our Houston, Texas facility.
b) Legal expenses increased by approximately $0.4 million to $0.6 million for the three months ended June 30, 2006, as compared to $0.2 million for three months ended June 30, 2005 due primarily to increased litigation related to the class action and derivative action matters.
c) Travel and entertainment expense decreased by approximately $0.2 million to $0.2 million for the three months ended June 30, 2006, as compared to $0.4 million for the three months ended June 30, 2005 due to less travel between our Houston, Texas and Exton, Pennsylvania facilities as a result of our closing the Houston office.
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d) Marketing expense decreased by approximately $0.1 million to $0.8 million for the three months ended June 30, 2006, as compared to $0.9 million for three months ended June 30, 2005 due to decreased marketing and promotional efforts related to negative gross margins in our operations in the United Kingdom.
e) Consulting fees increased by approximately $0.2 million to $0.4 million for the three months ended June 30, 2006, as compared to $0.2 million for the three months ended June 30, 2005 primarily due to increased costs related to the Switzerland campus which is currently held for sale.
f) Other general and administrative operating costs decreased by approximately $1.1 million to $1.2 million for the three months ended June 30, 2006, as compared to $2.3 million for three months ended June 30, 2005 due to decreased accounting fees of $0.3 million, decreased facility expenses of $0.2 million (as a result of the completion of our Exton laboratory and allocation of rent and utilities between selling, general and administrative expenses and research and development expenses); decreased corporate expenses of $0.1 million and decreased office expenses and other corporate expenses of $0.5 million.
RESEARCH AND DEVELOPMENT. Research and development expenses decreased by approximately $1.6 million during the three months ended June 30, 2006 to $1.8 million, as compared to $3.4 million for the three months ended June 30, 2005. Research and development costs are composed primarily of costs related to our efforts to gain FDA approval for the Isolagen Process for specific dermal applications in the United States and also include costs to develop manufacturing, cell collection and logistical process improvements. Our initial pivotal Phase III dermal studies and our Phase II dental studies concluded during the three months ended June 30, 2005. We subsequently commenced preparations for a Phase III dermal trial during the fourth quarter of 2005. Such costs primarily include personnel and laboratory costs related to these FDA trials and certain consulting costs. The total inception to date cost of research and development as of June 30, 2006 was $28.3 million. The FDA approval process is extremely complicated and is dependent upon our study protocols and the results of our studies. In the event that the FDA requires additional studies for dermal applications or requires changes in our study protocols or in the event that the results of the studies are not consistent with our expectations, as occurred during 2005 with respect to our first pivotal Phase III dermal trial (see Recent Developments section), the process will be more expensive and time consuming. Due to the complexities of the FDA approval process, we are unable to predict what the cost of obtaining approval for the dermal applications will be at this time. We have other research projects currently underway. However, research and development costs related to these projects were not material during the three months ended June 30, 2006 and 2005. The major changes in research and development expense are due to the following: a) consulting expense decreased by approximately $1.9 million to $0.5 million for the three months ended June 30, 2006, as compared to $2.4 million for the three months ended June 30, 2005; b) laboratory costs have decreased by $0.1 million for the three months ended June 30, 2006, to $0.2 million for the three months ended June 30, 2006; c) salaries and payroll taxes decreased by approximately $0.3 million to $0.5 million for the three months ended June 30, 2006, as compared to $0.8 million for the three months ended June 30, 2005; d) depreciation and rent and utilities increased by approximately $0.7 million for the three months ended June 30, 2006 due to the Exton, Pennsylvania research and development facility and related allocation of expenses to research and development expenses.
INTEREST INCOME. Interest income remained constant at $0.6 million for the three months ended June 30, 2006, as compared to the three months ended June 30, 2005. The interest income has remained constant primarily as a result of rising interest rates, which has offset our decreasing cash, restricted cash and short-term investment balances.
INTEREST EXPENSE. Interest expense remained constant at $1.0 million for three months ended June 30, 2006, as compared to the three months ended June 30, 2005. The interest expense is related to the interest expense associated with the issuance on November 1, 2004 of $90 million in principal amount of 3.5% convertible subordinated debt, as well as the related amortization of deferred debt issuance costs of $0.2 million for the three months ended June 30, 2006.
NET LOSS. Net loss for the three months ended June 30, 2006 was $8.1 million, as compared to a net loss of $10.0 million for the three months ended June 30, 2005. This decrease in net loss primarily represents the effects
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of the decreases in our research and development expenses and selling, general and administrative expenses as discussed above.
Comparison of the six months ending June 30, 2006 and 2005
REVENUE. Revenue decreased $1.6 million, to $3.4 million for the six months ended June 30, 2006, as compared to $5.0 million for the six months ended June 30, 2005. The decrease in revenue is primarily due to the contraction of our physician customer base in the United Kingdom as a result of our decision to place a great deal of emphasis on the training and proctoring of our physician customers in order to ensure that they are administering the Isolagen process appropriately. This retraining effort has resulted in the contraction of our physician customer base which is likely to continue for the immediate future. As a result, it is highly likely that sales in the United Kingdom in the near future will reflect a declining trend.
As discussed above, our London facility is engaged in the commercialization of our process (for which they earn revenue from the sale of Isolagen Process injections) as a means to improve manufacturing technologies that would be used to produce commercial quantities of injections on a profitable basis in the future. We are working to reduce and stabilize our costs through the pursuit of an optimized manufacturing process and other efficiencies. However, through June 30, 2006 we continued to experience a negative gross margin. As such, we did not believe that we should drive demand if we were manufacturing our product at negative margins, and as a result in the recent periods we have not attempted to increase our revenue stream.
Sales measured by product volumes, as measured by milliliter of product, decreased by approximately 20% during the six months ended June 30, 2006, as compared to the six months ended June 30, 2005. Average selling price per milliliter of treatment decreased approximately 27% during the six months ended June 30, 2006, as compared to the six months ended June 30, 2005. The average selling price has fluctuated as we continue to investigate various price points in the United Kingdom market. In addition, our average selling price per milliliter has declined due to the increase in six milliliter treatment programs sold in the six months ended June 30, 2006 as compared to four and six milliliter treatments sold during the six months ended June 30, 2005. Generally, higher milliliter treatments carry a higher total price but a lower price per milliliter of treatment.
In addition, after the completion of a standard treatment, a patient may request and pay for an additional one to three milliliters of treatment. Such additional treatment volumes increased by approximately 135% during the six months ended June 30, 2006, as compared to the six months ended June 30, 2005. This increase in volume was offset by a decrease in average selling price of approximately 30%.
From time to time, we provide promotional incentives, or no charge treatments, to doctors utilizing the Isolagen Process. Such promotional incentives are not reflected as revenue, but rather, are reflected as marketing expense in selling, general and administrative expenses. We expect to continue, on a reduced basis in 2006, providing such promotional incentives to doctors during the introduction phase of the Isolagen Process in the United Kingdom and elsewhere.
We also offer a service whereby we store a patient’s cells for later use in the preparation of injections. The fees charged for this service are recognized as revenue ratably over the length of the storage agreement. Revenue from this service in each of the six month periods ended June 30, 2006 and 2005 was less than $0.2 million.
COST OF SALES. Costs of sales decreased to $3.9 million for the six months ended June 30, 2006, as compared to $5.2 million for the six months ended June 30, 2005. For the six months ended June 30, 2006, our cost of sales exceeded revenue as the development and implementation of our processes has not yet achieved all of the cost efficiencies we anticipate.
As a percentage of revenue, cost of sales were approximately 114% for the six months ended June 30, 2006 and approximately 103% for the six months ended June 30, 2005. The change in this percentage is primarily the result of the lower level of sales activity during 2006, given the reduction of marketing and promotional efforts as a result of negative gross margins in our operations in the United Kingdom. Since 2002 we have made our Isolagen Process available to physicians in the United Kingdom. The Company has been using the commercialization of the Isolagen Process in this market as a means of researching and developing manufacturing
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technologies and, therefore, we believe could be used to produce commercial quantities of injections on a profitable basis. As the London facility operations continue to develop and mature, resulting in significant changes to its stage of commercial development, large fluctuations in the percentage of cost of sales to revenue are experienced.
SELLING, GENERAL AND ADMINISTRATIVE EXPENSES. Selling, general and administrative expenses increased $0.6 million, or 6%, to $11.3 million for the six months ended June 30, 2006, as compared to $10.7 million for the six months ended June 30, 2005. The increase in selling, general and administrative expense is primarily due to the following:
a) Salaries, bonuses and payroll taxes increased by approximately $1.1 million to $3.5 million for the six months ended June 30, 2006 compared to $2.4 million for six months ended June 30, 2005 due to a $0.5 million increase in non-cash stock compensation related to stock options issued, $0.3 million signing bonuses paid to new officers during the second quarter of 2006 and $0.3 million in additional salaries and related payroll taxes due to increased headcount.
b) Legal expenses increased by approximately $0.8 million to $1.3 million for the six months ended June 30, 2006, as compared to $0.5 million for six months ended June 30, 2005 due to increased litigation related to the class action and derivative action matters.
c) Consulting fees increases by approximately $0.1 million to $0.6 million for the six months ended June 30, 2006, as compared to $0.5 million or six months ended June 30, 2005 primarily due to increased costs related to the Switzerland campus which is currently held for sale.
d) Travel and entertainment expense decreased by approximately $0.4 million to $0.4 million for the six months ended June 30, 2006, as compared to $0.8 million for the six months ended June 30, 2005 due to less travel between our Houston, Texas and Exton, Pennsylvania facilities as a result of our closing of the Houston office.
e) Marketing expenses decreased by approximately $0.2 million to $1.3 million for the six months ended June 30, 2006, as compared to $1.5 million for six months ended June 30, 2005 due to decreased marketing and promotional efforts related to negative gross margins in our operations in the United Kingdom.
f) Depreciation expense decreased by approximately $0.1 million to $0.4 million for the six months ended June 30, 2006, as compared to $0.5 million for six months ended June 30, 2005 primary due to the closure of our Australian facility during the second quarter of 2005.
g) Other general and administrative costs decreased by approximately $0.5 million to $3.6 million for the six months ended June 30, 2006, as compared to $4.1 million for six months ended June 30, 2005 due to decreased accounting fees of $0.4 million and due to decreased office and other corporate costs of $0.8 million. These decreases were offset by an asset impairment charge on the Switzerland facility of $0.7 million during the second quarter of 2006.
RESEARCH AND DEVELOPMENT. Research and development expenses remained consistent with the prior year compared period, decreasing approximately $0.1 million during the six months ended June 30, 2006 to $4.9 million, as compared to $5.0 million in the six months ended June 30, 2005. Research and development costs are composed primarily of costs related to our efforts to gain FDA approval for the Isolagen Process for specific dermal applications in the United States and also include costs to develop manufacturing, cell collection and logistical process improvements. Our initial pivotal Phase III dermal studies and our Phase II dental studies concluded during the six months ended June 30, 2005. We subsequently commenced preparations for a new Phase III dermal trial during the fourth quarter of 2005. Such costs include personnel and laboratory costs related to these FDA trials and certain consulting costs. The total inception to date cost of research and development as of June 30, 2006 was $28.3 million. The FDA approval process is extremely complicated and is dependent upon our study protocols and the results of our studies. In the event that the FDA requires additional studies for dermal applications or requires changes in our study protocols or in the event that the results of the studies are not consistent with our expectations, as occurred during 2005 with respect to our first pivotal Phase III dermal trial (see the Recent
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Developments section), the process will be more expensive and time consuming. Due to the complexities of the FDA approval process, we are unable to predict what the costs of obtaining approval for the dermal applications will be at this time. Also, during the third quarter of 2005, we began an investigational study related to patients subjectively considered to be poor responders to the Isolagen Process (or the “suboptimal program”). 149 patients were ultimately included in the suboptimal program and the program was completed during the first half of 2006. We have other research projects currently underway. However, research and development costs related to these projects were not material during 2006 and 2005.
UNITED KINGDOM CUSTOMER SETTLEMENT. During 2005, the Company began an informal study and surveyed a number of patients who had previously received the Isolagen treatment to assess patient satisfaction. Some patients surveyed reported sub-optimal results from treatment. One hundred forty-nine patients who claimed to have received sub-optimal results were retreated for the purpose of determining the reasons for sub-optimal results. Only those patients who completed the survey, provided adequate medical records including before and after photographs and who were deemed both to have received a sub-optimal result from a first treatment administered according to the Isolagen protocol and who were considered to be appropriate patients for treatment with the Isolagen Process received re-treatment. No one completing the survey was offered re-treatment unless they agreed to these conditions. Following re-treatment, a number of patients reported better results than first obtained through the initial treatment by their initial treating physician.
During the first quarter of 2006, the Company received a number of complaints from certain patients who had learned of the limited re-treatment program and also learned that a number of physicians with dissatisfied patients were generating public ill-will as a result of the Company’s decision to limit the number of patients offered re-treatment and were encouraging dissatisfied patients to seek recourse against the Company. In response, in March 2006 the Company decided that it was in its best interest to address these complaints to foster goodwill in the marketplace and avoid the cost of any potential patient claims. Accordingly, the Company agreed to resolve any properly documented and substantiated patient complaints by offering to retreat the patient pursuant to the same criteria stated above or pay £1,000 (approximately US$1,750) to the patients identified to the Company as having received a sub-optimal result. In order to qualify for re-treatment and in addition to the criteria set forth above, the patient will be treated by a physician identified by the Company who will treat these patients pursuant to a protocol. In addition, these patients must agree to follow-up visits and assessments of their response to treatment. No patient unlikely to benefit from Isolagen therapy will be retreated.
The Company made this offer to approximately 290 patients during late March 2006. Accordingly, the Company believed its range of liability was between £290,000 (or approximately $0.5 million), assuming all 290 patients were to choose the £1,000 payment, and approximately £580,000 (or approximately $1.0 million), assuming all 290 patients elected to be retreated. The estimated costs for retreatment include the cost of treatment, physician fees and other ancillary costs. The Company estimates that 60% of the patients will elect the £1,000 offer and 40% will elect to be retreated. Accordingly, the Company recorded a charge to selling, general and administrative expense for the three months ended March 31, 2006 of $0.7 million. As of March 31, 2006, no amounts had been expended related to this settlement and the $0.7 million liability was included in accrued expenses in the consolidated balance sheet.
During the three months ended June 30, 2006, an additional 31 patients were entered into the settlement program, resulting in an additional charge to selling, general and administrative expense of $0.1 million. Also during the three months ended June 30, 2006, the £1,000 payments to patients, discussed above, reduced the liability by $0.2 million. As of June 30, 2006, the liability included in accrued expenses in the consolidated balance sheet was $0.6 million. The estimates of the factors which will affect the actual cost of this program may change in future periods and the effects of any changes in these estimates will be accounted for in the period in which the estimate changes.
INTEREST INCOME. Interest income decreased $0.1 million to $1.3 million for the six months ended June 30, 2006 as compared to $1.4 million for the six months ended June 30, 2005. The decrease in interest income resulted principally from a decrease in the amount of cash, restricted cash and short-term investment balances, as a result of our normal operating activities related to our efforts to gain FDA approval for the Isolagen Process for specific dermal applications in the United States. The decrease in the amount of cash, restricted cash and short-term investment balances is offset by rising interest rates established by the Federal Reserve.
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INTEREST EXPENSE. Interest expense remained constant at $2.0 million for six months ended June 30, 2006, as compared to the six months ended June 30, 2005. The interest expense is related to the interest expense associated with the issuance on November 1, 2004 of $90 million in principal amount of 3.5% convertible subordinated debt, as well as the related amortization of deferred debt issuance costs of $0.2 million for the three months ended June 30, 2006.
NET LOSS. Net loss for the six months ended June 30, 2006 was $18.0 million as compared to a net loss of $16.4 million for the six months ended June 30, 2005. This increase in net loss primarily represents the effects of the increases in selling, general and administrative expenses, and the United Kingdom Customer Settlement discussed above.
LIQUIDITY AND CAPITAL RESOURCES
Operating Activities
Cash used in operating activities during the six months ended June 30, 2006 amounted to $16.5 million, as compared to the $15.5 million of cash used in operating activities during the six months ended June 30, 2005. The increase in the cash used in operations of $1.0 million is due to the changes in our net operating assets, which negatively impacted cash flows by $1.3 million, offset by our reduction in net loss (as adjusted for non-cash expenditures) of $0.3 million. During the six months ended June 30, 2006, the changes in our net operating assets resulted in a cash outflow of $1.2 million, primarily due to a significant reduction in our accounts payable and accrued expenses. During the six months ended June 30, 2005, our changes in net operating assets resulted in a cash inflow of $0.1 million. For the six months ended June 30, 2006, we financed our operating cash flow needs from our cash on hand at the beginning of the period. Those cash balances were the result of debt and equity offerings we completed in 2004 and 2003.
Investing Activities
Cash provided by investing activities during the six months ended June 30, 2006 amounted to $13.2 million as compared to cash used in investing activities of $14.5 million during the six months ended June 30, 2005; a positive change of $27.7 million. This increase in cash provided by investing activities is due to the increase in net cash flows from the investment in or sale of available-for-sale investments, net of reinvestments, of $16.0 million. Further, cash expended on capital expenditures during the six months ended June 30, 2006 of $0.8 million decreased by $11.7 million as compared to the six months ended June 30, 2005. The large majority of the $12.5 million in capital expenditures during the six months ended June 30, 2005 related to our April 2005 acquisition of the Switzerland campus for $10.0 million and purchases related to our 2005 Exton, Pennsylvania facility, including production equipment.
Financing Activities
Cash from financing activities was less than $0.1 million during both the six months ended June 30, 2006 and 2005. These cash inflows were the result of stock option exercises.
Working Capital
As of June 30, 2006, we had cash, cash equivalents, restricted cash and available-for-sale investments of $49.2 million and working capital of $45.1 million (including our cash, cash equivalents, restricted cash and available-for-sale investments). We believe our existing capital resources are adequate to finance our operations through at least June 30, 2007; however, our long-term viability is dependent upon successful operation of our business, our ability to improve our manufacturing process, the approval of our products and the ability to raise additional debt and equity to meet our business objectives.
In November 2004, we issued $90.0 million in principal amount of 3.5% convertible subordinated notes due November 1, 2024. These notes could be due sooner, as discussed below.
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The notes are our general, unsecured obligations. The notes are subordinated in right of payment, which means that they will rank in right of payment behind other indebtedness of ours. In addition, the notes are effectively subordinated to all existing and future liabilities of our subsidiaries. We will be required to repay the full principal amount of the notes on November 1, 2024 unless they are previously converted, redeemed or repurchased.
The notes bear interest at an annual rate of 3.5% from the date of issuance of the notes. We will pay interest twice a year, on each May 1 and November 1, until the principal is paid or made available for payment or the notes have been converted. Interest will be calculated on the basis of a 360-day year consisting of twelve 30-day months.
The note holders may convert the notes into shares of our common stock at any time before the close of business on November 1, 2024, unless the notes have been previously redeemed or repurchased as discussed below. The initial conversion rate (which is subject to adjustment) for the notes is 109.2001 shares of common stock per $1,000 principal amount of notes, which is equivalent to an initial conversion price of approximately $9.16 per share. Holders of notes called for redemption or submitted for repurchase will be entitled to convert the notes up to and including the business day immediately preceding the date fixed for redemption or repurchase.
At any time on or after November 1, 2009, we may redeem some or all of the notes at a redemption price equal to 100% of the principal amount of such notes plus accrued and unpaid interest (including additional interest, if any) to, but excluding, the redemption date.
The note holders will have the right to require us to repurchase their notes on November 1 of 2009, 2014 and 2019. In addition, if we experience a fundamental change (which generally will be deemed to occur upon the occurrence of a change in control or a termination of trading of our common stock), note holders will have the right to require us to repurchase their notes. In the event of certain fundamental changes that occur on or prior to November 1, 2009, we will also pay a make-whole premium to holders that require us to purchase their notes in connection with such fundamental change.
Factors Affecting Our Capital Resources
In April 2005, we acquired land and a two-building, 100,000 square foot corporate campus in Bevaix, Canton of Neuchâtel, Switzerland for $10 million. We spent approximately $1.8 million to date on the first phase of a renovation. During April 2006, management decided to place the corporate campus on the market for sale in order to consolidate European operations into one location and to conserve capital. As of March 31, 2006, management assessed whether the book value of the corporate campus was impaired and made a determination to write down the corporate campus by $0.7 million, which is reflected in selling, general and administrative expenses in the consolidated statement of operations for the three months ended March 31, 2006. We commenced selling efforts during the second quarter of 2006. The net book value of the corporate campus at June 30, 2006 was $10.6 million, reflecting management’s estimate of the realizable value of the corporate campus.
The European Union has introduced new legislation, Directive 2004/23/EC relating to human tissue and cells for human application and the facilities in which they are manufactured, which was to be effective April 7, 2006. The European Commission has not yet developed or adopted required technical guidelines relating to this Directive. We believe that implementation of the Directive is unlikely until these guidelines are developed and adopted both by the European Commission and by the member states of the European Union. We currently estimate that if we are required to comply with the Directive, such compliance will require less than $1 million in renovations to our United Kingdom facility.
Inflation did not have a significant impact on the Company’s results during the three and six months ended June 30, 2006.
OFF-BALANCE SHEET TRANSACTIONS
We do not engage in material off-balance sheet transactions.
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ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Our market risk relates to foreign currency transactions and the potential effects of changes in exchange rates. Such market risks have not changed materially from those described in our Annual Report on Form 10-K for the year ended December 31, 2005 filed with the SEC on March 14, 2006. Our foreign assets and liabilities are translated into U.S. dollars each accounting period and the effect of such translation is reflected as a separate component of consolidated stockholders’ equity. Our consolidated stockholders’ equity fluctuates depending on the weakening or strengthening of the U.S. dollar against the foreign currency in which foreign assets and liabilities are denominated.
As a result of increasing foreign currency exchange rates since December 31, 2005, specifically as it relates to the British pound and the Swiss franc, our accumulated other comprehensive loss of $0.8 million at December 31, 2005 has decreased to an accumulated other comprehensive loss of $0.3 million at June 30, 2006; or a change of $0.5 million. However, our accumulated other comprehensive loss is considered unrealized and is reflected in the Consolidated Balance Sheet. Accordingly, this unrealized loss may increase or decrease in the future, based on the movement of foreign currency exchange rates, but will not have an impact on net income (loss) until the related foreign capital investments are sold or otherwise realized.
ITEM 4. CONTROLS AND PROCEDURES
(a) Disclosure Controls and Procedures. The Company’s management, with the participation of the Company’s Chief Executive Officer, and the Company’s Chief Financial Officer (the “Certifying Officers”), has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on that evaluation, the Certifying Officers have concluded that the Company’s disclosure controls and procedures were effective for the purpose of ensuring that material information required to be in this quarterly report is made known to them by others on a timely basis and that information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.
(b) Changes in Internal Controls. There has been no change in the Company’s internal control over financial reporting that occurred during the Company’s most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
PART II - OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Federal Securities Litigation
The Company and certain of its current and former officers and directors are defendants in class action cases pending in the United States District Court for the Eastern District of Pennsylvania.
In August and September, 2005, various lawsuits were filed alleging securities fraud and asserting claims on behalf of a putative class of purchasers of publicly traded Isolagen securities between March 3, 2004 and August 1, 2005. These lawsuits were Elliot Liff v. Isolagen, Inc. et al., C.A. No. H-05-2887, filed in the United States District Court for the Southern District of Texas; Michael Cummisky v. Isolagen, Inc. et al., C.A. No. 05-cv-03105, filed in the United States District Court for the Southern District of Texas; Ronald A. Gargiulo v. Isolagen, Inc. et al., C.A. No. 05-cv-4983, filed in the United States District Court for the Eastern District of Pennsylvania, and Gregory J. Newman v. Frank M. DeLape, et al., C.A. No. 05-cv-5090, filed in the United States District Court for the Eastern District of Pennsylvania.
The Liff and Cummiskey actions were consolidated on October 7, 2005. The Gargiolo and Newman actions were consolidated on November 29, 2005. On November 18, 2005, the Company filed a motion with the Judicial
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Panel on Multidistrict Litigation (the “MDL Motion”) to transfer the Federal Securities Actions and the Keene derivative case (described below) to the United States District Court for the Eastern District of Pennsylvania. The Liff and Cummiskey actions were stayed on November 23, 2005 pending resolution of the MDL Motion. The Gargiulo and Newman actions were stayed on December 7, 2005 pending resolution of the MDL Motion. On February 23, 2006, the MDL Motion was granted and the actions pending in the Southern District of Texas were transferred to the Eastern District of Pennsylvania, where they have been captioned In re Isolagen, Inc. Securities & Derivative Litigation, MDL No. 1741 (the “Federal Securities Litigation”).
On April 4, 2006, the United States District Court for the Eastern District of Pennsylvania appointed Silverback Asset Management, LLC, Silverback Master, Ltd., Silverback Life Sciences Master Fund, Ltd., Context Capital Management, LLC and Michael F. McNulty as Lead Plaintiffs, and the law firms of Bernstein Litowitz Berger & Grossman LLP and Kirby McInerney & Squire LLP as Lead Counsel in the Federal Securities Litigation.
On July 14, 2006, Lead Plaintiffs filed a Consolidated Class Action Complaint in the Federal Securities Litigation on behalf of a putative class of persons or entities who purchased or otherwise acquired Isolagen common stock or convertible debt securities between March 3, 2004 and August 9, 2005. The complaint purports to assert claims for securities fraud in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 against Isolagen and certain of its former officers and directors. The complaint also purports to assert claims for violations of Section 11 and 12 of the Securities Act of 1933 against the Company and certain of its current and former directors and officers in connection with the registration and sale of certain shares of Isolagen common stock and certain convertible debt securities. The complaint also purports to assert claims against CIBC World Markets Corp., Legg Mason Wood Walker, Inc., Canaccord Adams, Inc. and UBS Securities LLC as underwriters in connection with an April, 2004 public offering of Isolagen common stock and a 2005 sale of convertible notes. The Company intends to defend these lawsuits vigorously. However, the Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received.
Derivative Actions
The Company is the nominal defendant in derivative actions (the “Derivative Actions”) pending in State District Court in Harris County, Texas, the United States District Court for the Eastern District of Pennsylvania, and the Court of Common Pleas of Chester County, Pennsylvania.
On September 28, 2005, Carmine Vitale filed an action styled, Case No. 2005-61840, Carmine Vitale v. Frank DeLape, et al. in the 55th Judicial District Court of Harris County, Texas and in February 2006 Mr. Vitale filed an amended complaint. In this action, the plaintiff purports to bring a shareholder derivative action on behalf of the Company against certain of the Company’s current and former officers and directors. The Plaintiff alleges that the individual defendants breached their fiduciary duties to the Company and engaged in other wrongful conduct. Certain individual defendants are accused of improper trading in Isolagen stock. The plaintiff did not make a demand on the Board of Isolagen prior to bringing the action and plaintiff alleges that a demand was excused under the law as futile.
On December 2, 2005, the Company filed its answer and special exceptions pursuant to Rule 91 of the Texas Rules of Civil Procedure based on pleading defects inherent in the Vitale complaint. The plaintiff filed an amended complaint on February 15, 2006. The plaintiff has served a discovery request on the Company, to which the Company has objected as premature. The defendants have filed renewed special exceptions to the amended complaint. A hearing on the special exceptions is scheduled to be held in August.
On October 8, 2005, Richard Keene, filed an action styled, C.A. No. H-05-3441, Richard Keene v. Frank M. DeLape et al., in the United States District Court for the Southern District of Texas. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
The Company sought to transfer the Keene action to the United States District Court for the Eastern District of Pennsylvania as part of the MDL Motion. On January 21, 2006, the court stayed the Keene action pending
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resolution of the MDL Motion. On February 23, 2006, the Keene action was transferred with the Federal Securities Actions from the Southern District of Texas to the Eastern District of Pennsylvania. Thereafter, the plaintiff filed an amended complaint, and the defendants moved to dismiss the amended complaint. Briefing on that motion is complete.
On October 31, 2005, William Thomas Fordyce filed an action styled, C.A. No. GD-05-08432, William Thomas Fordyce v. Frank M. DeLape, et al., in the Court of Common Pleas of Chester County, Pennsylvania. This action makes substantially similar allegations as the original complaint in the Vitale action. The plaintiff also alleges that his failure to make a demand on the Board prior to filing the action is excused as futile.
On January 20, 2006, the Company filed its preliminary objections to the complaint. The Company filed a memorandum of law in support of its objections on February 23, 2006. The plaintiff filed his response to the Company’s preliminary objections on March 14, 2006. Oral argument on the Company’s preliminary objections was held on July 6, 2006.
The Derivative Actions are purportedly being prosecuted on behalf of the Company and any recovery obtained, less any attorneys’ fees awarded, will go to the Company. The Company is advancing legal expenses to certain current and former directors and officers of the Company who are named as defendants in the Derivative Actions and expects to receive reimbursement for those advances from its insurance carriers. The Company will expense its legal costs as they are incurred and will record any insurance recoveries on such legal costs in the period the recoveries are received. The Company cannot currently estimate the amount of loss, if any, that may result from the resolution of these actions, and no provision has been recorded in the consolidated financial statements.
Other
We are involved in various other legal matters that are being defended and handled in the ordinary course of business. Although it is not possible to predict the outcome of these matters, management believes that the results will not have a material impact on the Company’s financial statements.
ITEM 1A. RISK FACTORS
We have included in Part I, Item 1A of our Annual Report on Form 10-K for the year ended December 31, 2005, a description of certain risks and uncertainties that could affect our business, future performance or financial condition. These risks and uncertainties are hereby incorporated in Part II, Item 1A of this Form 10-Q. Investors should consider these risks and uncertainties prior to making an investment decision with respect to our securities. In addition, the following risk factors should be carefully considered by current investors and any potential investor prior to making any investment decisions regarding our securities:
We have issued certain rights to our shareholders that may have anti-takeover effects.
In May 2006, our board of directors declared a dividend of one right for each share of our common stock to purchase our newly created Series C participating preferred stock in connection with the adoption of a stockholder rights plan. These rights may have certain anti-takeover effects. For example, the rights may cause substantial dilution to a person or group that attempts to acquire us in a manner which causes the rights to become exercisable. As such, the rights may have the effect of rendering more difficult or discouraging an acquisition of our company which is deemed undesirable by our board of directors.
We have established protocols for the safe administration of our Isolagen Process, but are dependent on our physician customers to correctly follow our protocols.
Each patient’s cells are delivered to the treating physician in a vial identifying the patient by name, date of birth and a unique identification number. The treatment protocol requires each physician to verify the patient’s name and date of birth with the patient and the patient records immediately prior to injection. In the event more than one patient’s cells are delivered to a physician or we deliver the wrong patient’s cells to the physician, it is the physician’s obligation to follow the treatment protocol and assure that the patient is treated with the correct cells. On at least one occasion we delivered the wrong patient’s cells to the physician. In such an event, we notify the physician of the wrong delivery.
ITEM 2. UNREGISTERED SALES OF EQUITY SECURITIES AND USE OF PROCEEDS
During the quarter ended June 30, 2006, we issued, outside of our registered stock option plans, 3,025,000 stock options, as described in our Form 8-K filed June 9, 2006.
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ITEM 6. EXHIBITS
(a) | Exhibits | |
| | |
| EXHIBIT NO. | | IDENTIFICATION OF EXHIBIT |
| | | |
| 31.1 | | Certification of Chief Executive Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 31.2 | | Certification of Chief Financial Officer pursuant to Rule 13a-14(a) under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 32.1 | | Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
| | | |
| 32.2 | | Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |
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