UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
(MARK ONE)
[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 1998
or
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE TRANSITION PERIOD FROM _________________TO ______________.
COMMISSION FILE NO. 0-20966
CATALYTICA, INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)
DELAWARE 94-2262240
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER
INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
430 FERGUSON DRIVE
MOUNTAIN VIEW, CALIFORNIA 94043
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES)
(650) 960-3000
(REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filing requirements for the past 90 days. Yes [X] No [_]
As of November 7, 1998, there were outstanding 28,199,084 shares of the
registrant's Common Stock, par value $.001, which is the only class of common
stock of the registrant registered under Section 12(g) of the Securities Act of
1933. The Company also has outstanding 13,270,000 shares of Class A Common
Stock and 11,730,000 shares of Class B Common Stock which are convertible into
an equal number of shares of Common Stock.
CATALYTICA, INC.
FORM 10-Q
TABLE OF CONTENTS
SEPTEMBER 30, 1998
PAGE NO.
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS (UNAUDITED)
Unaudited Condensed Consolidated Balance Sheets as of September 30, 1998 and December 31, 1997 3
Unaudited Condensed Consolidated Statements of Operations for the three and nine months ended
September 30, 1998 and September 30, 1997 4
Unaudited Condensed Consolidated Statements of Cash Flows for the nine months ended September 30,
1998 and September 30, 1997 5
Notes to Unaudited Condensed Consolidated Financial Statements 6
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K 24
SIGNATURES 25
2
PART I--FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CATALYTICA, INC.
UNAUDITED CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS)
SEPTEMBER 30, DECEMBER 31,
1998 1997
-------- --------
ASSETS
Current assets:
Cash and cash equivalents $ 30,689 $ 35,149
Short-term investments 5,172 11,918
Accounts receivable, net 28,294 12,640
Accounts receivable from joint venture 217 967
Notes receivable from employees 293 405
Inventory:
Raw materials 41,926 52,648
Work in process 45,306 54,883
Finished goods 11,761 6,714
-------- --------
98,993 114,245
Deferred tax asset 166 166
Prepaid expenses and other assets 2,219 1,939
-------- --------
Total current assets 166,043 177,429
Property, plant and equipment:
Land 5,391 5,391
Equipment 116,287 99,744
Buildings and leasehold improvements 66,873 65,744
-------- --------
188,551 170,879
Less accumulated depreciation and amortization (24,669) (15,075)
-------- --------
163,882 155,804
Other assets 3,279 2,040
-------- --------
$333,204 $335,273
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 16,119 $ 23,281
Accrued payroll and related expenses 14,162 5,768
Deferred revenue 1,574 1,848
Other accrued liabilities 6,719 8,250
Current portion of long-term debt 305 50,332
Income taxes payable 661 525
-------- --------
Total current liabilities 39,540 90,004
Long-term debt 77,709 75,069
Non-current deferred revenue 2,559 3,611
Other accrued liabilities 6,400 6,400
Minority interest 41,000 11,000
Class A and B common stock 97,079 97,079
Stockholders' equity:
Common stock 32 28
Additional paid-in capital 102,156 100,375
Deferred compensation (312) (406)
Accumulated deficit (32,959) (47,887)
-------- --------
Total stockholders' equity 68,917 52,110
-------- --------
$333,204 $335,273
======== ========
See accompanying notes.
3
CATALYTICA, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1998 1997 1998 1997
------- ------- -------- -------
Revenues:
Product sales $86,072 $66,699 $270,118 $76,020
Research revenues 2,115 1,606 6,280 4,832
------- ------- -------- -------
88,187 68,305 276,398 80,852
Costs and expenses:
Cost of sales 67,896 60,223 222,703 69,310
Research and development 6,351 2,470 16,446 6,909
Selling, general and administrative 5,545 2,139 12,801 4,130
------- ------- -------- -------
Total costs and expenses 79,792 64,832 251,950 80,349
Operating income 8,395 3,473 24,448 503
Interest income 616 303 2,171 808
Interest expense (1,960) (1,881) (6,980) (2,119)
Loss on joint venture (745) (1,150) (3,052) (2,600)
------- ------- -------- -------
Income (loss) before income taxes 6,306 745 16,587 (3,408)
Provision for income taxes (662) (2) (1,659) (2)
------- ------- -------- -------
Net income (loss) $ 5,644 $ 743 $ 14,928 $(3,410)
======= ======= ======== =======
Net income (loss) per share:
Basic $0.10 $0.02 $0.26 $(0.13)
======= ======= ======== =======
Diluted $0.09 $0.02 $0.24 $(0.13)
======= ======= ======== =======
Number of shares used in computing net
income (loss) per share:
Basic 53,176 40,914 53,054 26,896
======= ======= ======== -------
Diluted 59,238 44,753 59,044 26,896
======= ======= ======== -------
See accompanying notes.
4
CATALYTICA, INC.
UNAUDITED CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS
(IN THOUSANDS)
NINE MONTHS ENDED SEPTEMBER 30,
1998 1997
-------- ---------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) $ 14,928 $ (3,410)
Adjustments to reconcile net income (loss) to net cash provided by (used in)
operating activity:
Depreciation and amortization 9,383 2,552
Deferred income taxes -- --
Losses in affiliated company 3,052 2,600
Changes in:
Accounts receivable (15,654) (17,038)
Accounts receivable from joint venture 750 545
Inventory 15,252 11,027
Prepaid expenses and other current assets (988) (721)
Accounts payable (7,162) 14,651
Accrued payroll and related expenses 8,394 3,465
Deferred revenue (1,326) (1,344)
Accrued acquisition costs (70) 285
Other accrued liabilities (1,325) 6,359
-------- ---------
Net cash provided by operating activities 25,234 18,971
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchases of investments (28,906) (13,184)
Maturities of investments 36,089 21,532
Investment in affiliate company (3,052) (2,600)
Disposition of property and equipment 189 --
Acquisition of property and equipment (17,881) (3,651)
Acquisition of Glaxo inventory -- (117,500)
Acquisition of Glaxo property, plant and equipment -- (130,497)
-------- ---------
Net cash used in investing activities (13,561) (245,900)
CASH FLOWS FROM FINANCING ACTIVITIES:
Net receipts on (issuance of) notes receivable from employees (531) 73
Additions to debt obligations 2,700 137,726
Payments on debt obligations (50,087) (5,551)
Minority investment 30,000 --
Issuance of Class A and B common stock, net -- 117,679
Issuance of stock, net of issuance costs 1,785 5,790
-------- ---------
Net cash provided by (used in) financing activities (16,133) 255,717
-------- ---------
Net increase (decrease) in cash and cash equivalents (4,460) 28,788
Cash and cash equivalents at beginning of period 35,149 15,540
-------- ---------
Cash and cash equivalents at end of period $ 30,689 $ 44,328
======== =========
Non cash financing activities:
Issuance of warrants in conjunction with the Glaxo Wellcome facility acquisition -- $ 6,500
======== =========
Issuance of Catalytica Pharmaceutical's Junior Preferred Stock in conjunction with
the Glaxo Wellcome facility acquisition -- $ 3,000
======== =========
Assumption of liability in conjunction with Glaxo Wellcome facility acquisition -- $ 6,400
======== =========
See accompanying notes.
5
NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. BASIS OF PRESENTATION
The accompanying unaudited condensed consolidated financial statements have
been prepared in accordance with generally accepted accounting principles for
interim financial information and with the instructions to Form 10-Q and Article
10 of Regulation S-X. Accordingly, they do not include all of the information
and footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments (consisting
of normal recurring accruals) considered necessary for a fair presentation have
been included. Operating results for the nine-month period ended September 30,
1998, are not necessarily indicative of the results that may be expected for the
year ended December 31, 1998. For further information, refer to the consolidated
financial statements and footnotes thereto included in the Catalytica, Inc.
Annual Report on Form 10-K for the year ended December 31, 1997.
2. EARNINGS (LOSS) PER SHARE
Earnings (loss) per share is presented in accordance with Financial Accounting
Standards Board (FASB) Statement of Financial Accounting Standards (SFAS) No.
128, "Earnings Per Share" (EPS). This statement requires the presentation of EPS
to reflect both "Basic EPS" and "Diluted EPS" on the face of the statement of
operations. For the nine months ended September 30, 1997, the inclusion of
common stock equivalents and the reduction of Catalytica Pharmaceuticals income
due to holders of subsidiary stock options is antidilutive, therefore loss per
share is computed based on the weighted average number of common shares
outstanding excluding common stock equivalents for this period. Weighted average
shares outstanding for the three and nine months ended September 30, 1998, and
the three months ended September 30, 1997 includes Class A and B common shares
as Catalytica, Inc. ("the Company") considers Class A and B to be the equivalent
of common stock. The periods presented herein have been adjusted to reflect the
calculation of EPS in accordance with SFAS No. 128.
6
A reconciliation of the numerators and denominators for the Basic and Diluted
EPS calculations follows:
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1998 1997 1998 1997
------- ------- ------- -------
NUMERATOR:
Numerator for basic earnings per share: Income (loss)
available to common shareholders $ 5,644 $ 743 $14,928 (3,410)
Less: Reduction of Catalytica Pharmaceuticals income
attributable to holders of subsidiary stock options (384) (25) (940) --
------- ------- ------- -------
Numerator for diluted earnings (loss) per share $ 5,260 $ 718 $13,988 (3,410)
------- ------- ------- -------
DENOMINATOR:
Denominator for basic earnings per share
Weighted-average shares 53,176 40,914 53,054 26,896
------- ------- ------- -------
Effect of dilutive securities:
Catalytica, Inc. employee stock options 798 624 764 --
Catalytica Pharmaceuticals Convertible Preferred Stock 1,668 1,483 1,681 --
Catalytica Pharmaceuticals Convertible Junior
Preferred Stock 563 500 567 --
Catalytica Combustion Systems, Inc. Convertible
Preferred Stock 2,645 -- 2,664 --
Catalytica, Inc. warrants issued to common shareholders -- 1,187 -- --
Catalytica, Inc. warrants issued to Glaxo Wellcome,
Inc. 388 45 314 --
------- ------- ------- -------
Dilutive potential common shares 6,062 3,839 5,990 --
Denominator for diluted earnings (loss) per share
Adjusted weighted-average shares and assumed
conversions 59,238 44,753 59,044 26,896
------- ------- ------- -------
Basic earnings (loss) per share $0.10 $0.02 $0.26 $ (0.13)
======= ======= ======= =======
Diluted earnings (loss) per share $0.09 $0.02 $0.24 $ (0.13)
======= ======= ======= =======
3. IMPACT OF STATEMENT OF FINANCIAL ACCOUNTING STANDARDS NO. 130
Effective January 1, 1998, the Company adopted Statement of Financial
Accounting Standards No. 130, "Reporting Comprehensive Income." This Statement
requires that all items recognized under accounting standards as components of
comprehensive earnings be reported in an annual financial statement that is
displayed with the same prominence as other annual financial statements. This
Statement also requires that an entity classify items of other comprehensive
earnings by their nature in an annual financial statement. For example, other
comprehensive earnings may include foreign currency translation adjustments,
minimum pension liability adjustments, and unrealized gains and losses on
marketable securities classified as available-for-sale. Annual financial
statements for prior periods will be reclassified, as required. The Company has
no comprehensive earnings adjustments for the three and nine months ended
September 30, 1998 and 1997, thus total comprehensive earnings is equal to net
earnings (loss).
7
4. FINANCIAL INSTRUMENTS
For the purposes of the consolidated cash flows, all investments with
maturities of three months or less at the date of purchase held as available-
for-sale are considered to be cash and cash equivalents; instruments with
maturities of three months or less at the date of purchase that are planned to
be held-to-maturity ($5,171,860 at September 30, 1998) and investments with
maturities greater than three months that are available-for-sale (none at
September 30, 1998) are considered to be short-term investments; investments
with maturities greater than one year are considered to be long-term investments
and are available-for-sale (none at September 30, 1998). All investments at
September 30, 1998, were carried at amortized cost, which approximated fair
market value (quoted market price). The classification of investments is made
at the time of purchase with classification for held-to-maturity made when the
Company has the positive intent and ability to hold the investments to maturity.
5. USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions that
affect the reported amounts of assets and liabilities and disclosure of
contingent assets and liabilities at the date of financial statements and the
reported amounts of revenues and expenses during the reporting period. Actual
results could differ from those estimates.
6. REVENUE RECOGNITION
In connection with the purchase of the Glaxo Wellcome, Inc. ("Glaxo Wellcome")
facility in Greenville, North Carolina ("Greenville Facility") by the Company on
July 31, 1997, Glaxo Wellcome entered into a Supply Agreement under which
Catalytica Pharmaceuticals, Inc., a subsidiary of the Company ("Catalytica
Pharmaceuticals"), has been and will continue to manufacture products for Glaxo
Wellcome. During the quarter ended June 30, 1998, the original Supply Agreement
was amended to expand production of Glaxo Wellcome products at the Greenville
Facility in 1998 and 1999. Glaxo Wellcome has guaranteed that revenues paid to
Catalytica Pharmaceuticals will meet a specified level of minimum revenue or
that Glaxo Wellcome will pay Catalytica Pharmaceuticals any shortfall.
The Company recognizes revenue under the Supply Agreement with Glaxo Wellcome
based upon the minimum revenues under this agreement. All other product
revenues are recorded upon shipment. During the three and nine months ended
September 30, 1998, the Company recorded $77 and $244 million, respectively, of
revenue derived from sales to Glaxo Wellcome.
As of September 30, 1998, a receivable in the amount of $17.6 million was
outstanding from Glaxo Wellcome.
7. DEBT
In conjunction with the acquisition of the Greenville Facility, the Company
entered into a Credit Agreement pursuant to which a syndicate of banks led by
Chase Securities, Inc. ("Chase") agreed to lend Catalytica Pharmaceuticals an
aggregate of up to $200,000,000 (the "Debt Facilities"). The Debt Facilities
consisted of a senior secured term loan facility (the "Term Debt Facility") in
an aggregate principal amount of $125,000,000 and a senior secured revolving
facility (the "Revolving Debt Facility") in an aggregate principal amount of
$75,000,000. In the quarter ended June 30, 1998, this Credit Agreement was
amended to increase the Revolving Debt Facility from $75,000,000 million to
$100,000,000. In addition, the Term Debt Facility was reduced from its original
balance of $125,000,00 million to $75,000,000. Up to $20,000,000 of the
Revolving Debt Facility is available for the issuance of letters of credit. The
Term Debt Facility, which originally matured December 31, 2001, will now mature
December 31, 2002 and will amortize in quarterly installments commencing on
December 31, 1999. The Credit Agreement, which is guaranteed by the Company,
requires that the Company maintain certain financial ratios and levels of
tangible net worth, profitability, and liquidity and implements restrictions on
the Company's ability to declare and pay dividends. The senior secured facility
interest rate is a variable interest rate tied to LIBOR. This interest rate was
6.06% as of September 30, 1998. As of September 30, 1998, nothing was
outstanding under the Revolving Debt Facility and $75,000,000 was outstanding
under the Term Debt Facility.
8
In addition to the restrictions above, the Credit Agreement contains various
covenants restricting further indebtedness, issuance of preferred stock by the
Company or its subsidiaries, liens, acquisitions, asset sales, and capital
expenditures. At September 30, 1998, the Company and Catalytica Pharmaceuticals,
Inc. were in compliance with the covenants.
In the second quarter of 1998 following the restructuring of the Credit
Agreement, the Company entered into a $50,000,000 interest rate swap,
derivative transaction to reduce the Company's exposure to fluctuations in
short-term interest rates. This interest rate swap transaction effectively
fixed the LIBOR benchmark rate used to calculate the Company's borrowing cost at
5.59% for 4 years on $50,000,000 of the Term Debt Facility. The Company
accounts for this interest rate swap as a hedge, and accrues the interest rate
differential as interest expense on a monthly basis.
During the second quarter of 1998, the Company received a $2.7 million non-
interest bearing loan from a customer to be used to finance special equipment
requirements. The loan is payable in aggregate annual amounts of (i) $.7
million on December 31, 1999; (ii) $1 million on December 31, 2000; and (iii)
$ 1 million on December 31, 2001.
8. FORMATION OF GENXON/(TM)/ JOINT VENTURE WITH WOODWARD GOVERNOR COMPANY
On October 15, 1996 Catalytica's subsidiary Catalytica Combustion Systems,
Inc. ("Combustion Systems") and Woodward Governor Company formed a Delaware
limited liability company in connection with a 50/50 joint venture to serve the
gas turbine retrofit market for installed, out-of-warranty engines. The new
company, GENXON/(TM)/ Power Systems, LLC, was formed to upgrade the combustion
systems of installed turbines with XONON, which is designed to reduce emissions
and permit greater asset utilization for both power generation and mechanical
drive markets.
Subsequent to the initial funding of $10 million, which was completed during
the quarter ended September 30, 1997, continued funding of the joint venture
beyond the initial commitment has occurred on a 50/50 basis with each joint
venture partner contributing an equal amount quarterly. For the three and nine
months ended September 30, 1998, each partner contributed $1.7 and $3.35
million, respectively, bringing the total combined investment in the joint
venture to $21.4 million to date. Although the Company believes that Combustion
Systems and Woodward intend to continue the funding of this joint venture,
neither joint venture partner is contractually required to make further capital
infusions.
Combustion Systems recognized its 50% share of GENXON losses of $1.5 million,
of which $.7 million was Combustion Systems' 50% of GENXON's loss for the three
months ended September 30, 1998, and $6.1 million, of which $3.0 million was
Combustion Systems' 50% of GENXON's loss for the nine months ended September
30, 1998. Accordingly, losses on the joint venture were recognized in the
results of operations.
As of September 30, 1998, an account receivable for $217,000 existed from the
joint venture for costs incurred by Combustion Systems. Accordingly these costs
have not been included in the consolidated entity.
9. INCOME TAXES
The provision for income taxes for the three and nine months ended September
30, 1998 was approximately 10%, for each period, as compared to 0% for the
corresponding periods in 1997. The increase in the estimated annual tax rate is
due primarily to state income taxes relating to the Greenville facility coupled
with the federal alternative minimum tax.
9
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Overview
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act and Section 21E of the Exchange Act, which
involve risks and uncertainties including but not limited to those statements
that have been identified by an asterisk ("*") and other statements regarding
the Company's strategy, financial performance and revenue sources. The Company's
actual results could differ materially from the results anticipated in these
forward-looking statements as a result of certain factors including those set
forth under "Risk Factors" and elsewhere in this Report.
The Company is creating new businesses that leverage the Company's
proprietary catalytic technologies to yield economic and environmental benefits
by lowering manufacturing costs and reducing hazardous byproducts.* Catalytica
currently is focused on applying its capabilities to two primary areas: (i)
production of pharmaceutical components and products; (ii) developing advanced
combustion systems to reduce toxic emissions generated by natural gas turbines.
To pursue these opportunities, the Company has created two operating
subsidiaries, Catalytica Pharmaceuticals, Inc. ("Catalytica Pharmaceuticals")
and Catalytica Combustion Systems, Inc. ("Combustion Systems"). In addition to
market focus, the formation of subsidiaries provides greater flexibility for
strategic financial arrangements and business partnerships. A third subsidiary,
Catalytica Advanced Technologies ("Advanced Technologies"), is exploring new
business opportunities and markets for the Company's technologies.
On July 31, 1997, Catalytica Pharmaceuticals, Inc. (formerly Catalytica
Fine Chemicals, Inc.), a subsidiary of the Company, acquired from Glaxo
Wellcome, Inc. a pharmaceutical manufacturing facility (the "Greenville
Facility") located in Greenville, North Carolina (the "Acquisition"), in
exchange for (i) $244.7 million in cash (after certain post closing
adjustments); (ii) 250,000 shares of Junior Preferred Stock of Catalytica
Pharmaceuticals; (iii) warrants to purchase 2,000,000 shares of the Company's
Common Stock at an exercise price of $12.00 per share and (iv) 10% of the
earnings before interest and taxes prior to July 31, 2007, in excess of an
aggregate cumulative amount of $10 million attributable to the Sterile Product
Operations ("SPO") portion of the Greenville Facility, up to an aggregate
cumulative payment to Glaxo Wellcome of an additional $25.0 million.
To raise the cash needed to complete the Acquisition, the Company used a
combination of equity and debt financing. With the closing of the Acquisition,
the Company completed the sale of 13,270,000 shares of its Class A Common Stock
and 16,730,000 shares of its Class B Common Stock to Morgan Stanley Capital
Partners III, L.P. and two affiliated funds ("MSCP") (collectively, the "Stock
Sale"), at a price of $4.00 per share, for an aggregate of $120,000,000. The
Class A and B stock are convertible into common stock of the Company on a share
for share basis. In November of 1997, the Company repurchased 5,000,000 of the
Class B MSCP shares at $4.75 per share with the proceeds from the issuance of a
warrant dividend granted to its stockholders in connection with the financing of
the acquisition.
In addition to the equity investment by MSCP, the Company, The Chase
Manhattan Bank ("Chase") and Chase Securities Inc. ("CSI") entered into a Credit
Agreement pursuant to which a syndicate of banks led by Chase agreed to lend
Catalytica Pharmaceuticals an aggregate of up to $200,000,000 (the "Debt
Facilities"). The Debt Facilities consisted of a senior secured term loan
facility (the "Term Debt Facility") in an aggregate principal amount of
$125,000,000 and a senior secured revolving facility (the "Revolving Debt
Facility") in an aggregate principal amount of $75,000,000. In the quarter ended
June 30, 1998, this Credit Agreement was amended to increase the Revolving Debt
Facility from $75,000,000 million to $100,000,000. In addition, the Term Debt
Facility was reduced from its original balance of $125,000,00 million to
$75,000,000. In the second quarter of 1998, the Company also entered into an
interest rate swap, derivative transaction which fixed the LIBOR benchmark rate
used to calculate the Company's borrowing cost at 5.59% plus the spread in the
Credit Agreement for 4 years on $50,000,000 of the Term Debt Facility. As of
September 30, 1998, nothing was outstanding under the revolving debt facility
and $75,000,000 was outstanding under the Term Debt Facility. (See Note 7 to
Unaudited Condensed Consolidated Financial Statements).
10
The additional facilities, employees and business volumes resulting from
the Acquisition have substantially increased the expenses and working capital
requirements and placed increased burdens on the Company's management resources.
Furthermore, the success of the Company's future results depends, in significant
part, on the levels of new manufacturing business developed by Catalytica
Pharmaceuticals.* In the event Catalytica Pharmaceuticals does not continue to
obtain additional new customers, which could involve additional business from
Glaxo Wellcome, on terms sufficient to offset the costs associated with
operating and maintaining the Greenville Facility, and with servicing the debt
incurred in connection with the acquisition of the Greenville Facility, the
Company's consolidated results of operations and financial condition would be
materially adversely affected.
Due to the size of the Acquisition, the results of operations of Catalytica
Pharmaceuticals have a material affect on the consolidated results of operations
of the Company, and the results of operations of the Company's other businesses
are expected to only modestly impact consolidated results for fiscal year 1998.*
The anticipated revenues from the Supply Agreement with Glaxo Wellcome are
expected to allow the Company to achieve continued profitable operations for
Catalytica Pharmaceuticals throughout 1998, and the consolidated parent Company
as well, offsetting losses arising from continued investments in the Company's
Combustion Systems and Advanced Technologies businesses.* After 1998, Catalytica
Pharmaceuticals' profitability will depend on its success and timing in
continuing to obtain additional new customers, including possible new agreements
with Glaxo Wellcome.* Profitability on a consolidated basis will depend on the
operating results of each of the Company's subsidiaries, particularly the rate
of commercial success of Catalytica Combustion Systems.*
Manufacturing at the Greenville Facility is conducted in three district
operations: Chemical Manufacturing Operations ("CMO"), Pharmaceutical Product
Operations ("PPO"), and Sterile Product Operations ("SPO"). There is
substantial underutilization of manufacturing capacity at the PPO and SPO
facilities, but because of the long lead times required to obtain necessary
regulatory approvals to manufacture final dosage products at these facilities,
Catalytica Pharmaceuticals does not anticipate additional significant revenue
from such facilities until 1999 at the earliest.* The inability of Catalytica
Pharmaceuticals to fill additional available capacity or to reduce costs in
conjunction with lower levels of capacity utilization would have a material
adverse effect on the Company's results of operations and financial condition.
Catalytica Pharmaceuticals also owns and operates a flexible, multi-
purpose, commercial scale manufacturing plant in East Palo Alto, California,
which has approximately 12,000 gallons of reactor capacity set up in a wide
range of reactor sizes ("Bayview Facility"). The Bayview Facility includes a
pilot plant used for scaling up manufacturing processes and a solids handling
facility that operates under current Good Manufacturing Practices ("cGMP").
This facility was acquired in 1993 from Novartis (formerly Sandoz).
On May 8, 1996, Catalytica Pharmaceuticals, announced that Pfizer Inc.
("Pfizer") had signed an agreement to invest $15 million in Catalytica
Pharmaceuticals. These funds originally provided Pfizer a 15% interest in
Catalytica Pharmaceuticals and a five-year research and development ("R&D")
commitment by Catalytica Pharmaceuticals to develop new processes and technology
for the manufacture of Pfizer products. Prior to this investment, Catalytica
Pharmaceuticals was a wholly-owned subsidiary of Catalytica, Inc. Pursuant to
the terms of the Greenville Acquisition, Glaxo Wellcome received approximately a
1.5% equity interest in Catalytica Pharmaceuticals and the Company purchased
additional shares of Catalytica Pharmaceuticals, which resulted in Pfizer's
ownership interest decreasing to approximately 4.4%. The Company owns the
remaining 94.1% outstanding equity interest in Catalytica Pharmaceuticals.
During the past four years, Catalytica Pharmaceuticals and Pfizer have
collaborated on the development of proprietary processes for key intermediate
products for several of Pfizer's promising new pharmaceuticals. During the first
quarter of 1998, Catalytica Pharmaceuticals and Pfizer signed a new
collaborative agreement to begin research and development into new drug
formulations. Under the new agreement, Catalytica Pharmaceuticals through it's
Greenville Facility, will now provide expertise in development of innovative
processes for the manufacture of tablets, capsules, injectable products, and
other formulations for releasing medications internally. The new agreement with
Pfizer extends the aforementioned existing R&D relationship between the two
companies, established in 1996, under which Catalytica Pharmaceuticals has
focused on the development of new processes for synthesizing chemical compounds
for the production of Pfizer drugs. The Pfizer drugs are at varying stages of
approval by the Food and Drug Administration ("FDA"), ranging from Phase II
clinical trials through the New Drug
11
Application stage. Catalytica Pharmaceuticals currently manufactures
intermediates for certain Pfizer drugs and anticipates becoming a supplier of
intermediates to Pfizer for other pharmaceutical products in the future.* There
can be no assurance, however, that orders will be forthcoming from Pfizer.
On October 15, 1996 Catalytica's subsidiary Catalytica Combustion Systems
Inc. ("Combustion Systems") and Woodward Governor Company formed a Delaware
limited liability company in connection with a 50/50 joint venture to serve the
gas turbine retrofit market for installed, out-of-warranty engines. The new
company, GENXON/(TM)/ Power Systems, LLC, was formed to upgrade the combustion
systems of installed turbines with XONON which is designed to reduce emissions
and permit greater asset utilization for both power generation and mechanical
drive markets.
Subsequent to the initial funding of $10 million, which was completed
during the quarter ended September 30, 1997, continued funding of the joint
venture beyond the initial commitment has occurred on a 50/50 basis with each
joint venture partner contributing an equal amount quarterly. For the three and
nine months ended September 30, 1998, each partner contributed $1.7 and $3.35
million, respectively, bringing the total combined investment in the joint
venture to $21.4 million to date. Although the Company believes that Combustion
Systems and Woodward intend to continue the funding of this joint venture,
neither joint venture partner is contractually required to make further capital
infusions.*
On January 14, 1998, Enron Ventures Corporation, a wholly-owned subsidiary
of Enron Corporation ("Enron"), purchased a 15% minority interest in Catalytica
Combustion Systems for $30 million. The Company owns the remaining 85%
outstanding equity interest in Catalytica Combustion Systems. In addition, Enron
also received a three-year option to purchase an additional 5% of Combustion
Systems for $14.4 million. In connection with the Stock Purchase agreement, the
Company entered into a Share Exchange agreement, providing Enron the right to
exchange the Series B Preferred Stock of Combustion Systems for Catalytica, Inc.
Common Stock. After the five year anniversary of the agreement, if Combustion
Systems has not undertaken a public offering, in which Combustion Systems
receives proceeds of at least $20 million, Enron shall have the right to require
the Company to exchange all of the outstanding shares of Series B Preferred
Stock for that number of shares of Catalytica, Inc. Common Stock based upon a
determined exchange rate. The exchange rate is based upon the fair value of the
Series B Preferred Stock and the market value of Catalytica's Common Stock at
the time of conversion. Upon consolidation of Combustion Systems into
Catalytica, Inc., the Series B Preferred Stock issued to Enron is reflected as
$30 million of minority interest.
The Company's business had not been profitable until the second half of
1997, and as of September 30, 1998, the Company had an accumulated deficit of
$32.9 million. To achieve continued profitable operations, the Company must
successfully manage the operations of its Greenville Facility and develop
additional business with Glaxo and other customers, and, to a lesser extent,
successfully develop, manufacture, introduce and market or license its
combustion systems and catalytic processes.* The Company's success will depend
on its ability to complete the transition from emphasizing research and
development to full commercialization and sale of its products.* The Company
began manufacturing, marketing and selling pharmaceutical intermediates in 1994
with the acquisition of the Bayview Facility, and substantially increased its
manufacturing and marketing of pharmaceutical products in 1997 with the
acquisition of the Greenville Facility.
Results of Operations
Net revenues for the three and nine months ended September 30, 1998
increased by 29% and 242% respectively, compared to the same quarter in fiscal
1997 due to an increase in product sales attributable to the July 31, 1997
acquisition of the Greenville Facility and the related Supply Agreement with
Glaxo Wellcome. The Greenville Facility acquisition contributed to two of the
three months of revenue in the third quarter of 1997 which reflects the 29%
increase in 1998 third quarter revenue. During the three and nine months ended
September 30, 1998, 90% and 91%, respectively, of the Company's pharmaceutical
product revenues were derived from sales to Glaxo Wellcome. As part of the
Supply Agreement, Glaxo Wellcome guarantees a specified minimum level of
revenues in each year of the agreement. To the extent the minimum level of
revenues exceeds revenues due as a result of product shipments, the Company
receives additional payments from Glaxo Wellcome which help offset
12
fixed manufacturing costs associated with manufacturing capacity reserved for
Glaxo Wellcome as required in the long term Supply Agreement (See Note 6 to
Unaudited Condensed Consolidated Financial Statements). There was a 32% and 30%
increase, respectively, in research revenues for the three and nine months of
1998 reflecting an increase in funded research associated with Advanced
Technologies and Combustion Systems and a milestone payment from GENXON to
Combustion Systems in the second quarter.
Interest income increased 103% and 169% for the three and nine months ended
September 30, 1998, respectively, when compared to the same period in 1997.
Cash and investments increased due to an increase in product sales and the Enron
cash investment in Catalytica Combustion Systems. The Enron cash investment has
restrictions related to its use such that these funds cannot be used to retire
debt in other Catalytica subsidiaries such as Catalytica Pharmaceuticals.
Cost of sales increased 13% and 221% for the three and nine months of 1998.
The increase in cost of sales reflects increased physical volume of product
sales primarily due to an increase in sales attributable to the July 31, 1997
acquisition of the Greenville Facility and the related Supply Agreement with
Glaxo Wellcome. The Greenville Facility acquisition contributed to two of the
three months of cost of sales in the third quarter of 1997 which reflects the
13% increase in third quarter cost of sales. Operating margins in the third
quarter of 1998 were favorably influenced by product mix. Margins on the
pharmaceutical products are subject to fluctuations from quarter to quarter due
to various factors including the mix of products being manufactured,
manufacturing efficiencies achieved on production runs, the length of down-time
associated with setting up new productions runs, and numerous other variables
present in the chemical and dosage form manufacturing environment.
Research and development expenses increased 157% and 138% for the three and
nine months ended September 30, 1998, as compared to the same periods in 1997.
This increase is largely attributable to research and development expenses
associated with the Greenville Facility coupled with increased R&D activity
associated with Combustion Systems and Advanced Technologies. Research and
development expenses may fluctuate from quarter to quarter.
Selling, general and administrative expenses ("SG&A") increased 159% and
210% for the three and nine months ended 1998 compared to the same periods of
1997 largely due to SG&A costs incurred by the addition of SG&A employees at the
Greenville Facility. SG&A expenses have increased as the Company has expanded
it's sales and marketing personnel to sell the available capacity in the
Facility.* SG&A expenses also increased during the third quarter of 1998 due
to management incentive accruals related to above plan performance.
Net interest expense increased 4% for the third quarter of 1998 and
increased 229% for the first nine months of 1998 when compared to the same
periods last year due to debt associated with the July 31, 1997 acquisition of
the Greenville Facility.
Combustion Systems recognized its 50% share of GENXON losses of $1.5
million, of which $.7 million was Combustion Systems' 50% of GENXON's loss for
the three months ended September 30, 1998, and $6.1 million, of which $3.0
million was Combustion Systems' 50% of GENXON's loss for the nine months ended
September 30, 1998. The Company's capital contribution for the three and nine
months ended 1998 was $.7 and $3.3 million, respectively. The Company estimates
it may make additional capital contributions to the joint venture during the
remainder of 1998.* The Company anticipates GENXON will continue to generate
losses during this time frame, and accordingly the Company will record its share
of these losses to the extent of its capital contribution.*
The provision for income taxes for the three and nine months ended
September 30, 1998 was approximately 10% as compared to 0% for the corresponding
periods in 1997. The increase in the estimated annual tax rate is due primarily
to the Company's recent profitability resulting in state income taxes relating
to the Greenville Facility coupled with the federal alternative minimum tax.
13
Liquidity and Capital Resources
Total cash and cash equivalents plus short-term investments decreased to
$35.9 million at September 30, 1998, compared to $47.1 million at December 31,
1997. The decrease in cash was primarily due to early payments of $50 million on
the Chase Term Debt Facility (See Note 7 to Unaudited Condensed Consolidated
Financial Statements), coupled with a net increase in various working capital
items associated with the Pharmaceutical business, largely offset by a $30
million investment in Combustion Systems by Enron Ventures Corporation for a 15%
ownership in Combustion Systems. During the quarter ended September 30, 1998,
the Company made early payments of $10 million on the Chase Term Debt Facility.
During the past several years, the Company has obtained various term loans
and lines of credit to fund capital purchases and working capital needs. On July
31, 1997 in conjunction with the acquisition of the Greenville Facility, the
Company and a syndicate of Banks led by Chase Manhattan Bank ("Chase") entered
into a Credit Agreement. In the second quarter of 1998 this Credit Agreement
was amended, pursuant to which Catalytica Pharmaceuticals could borrow up to an
aggregate of $175,000,000 (the "Debt Facilities"). The Debt Facilities consisted
of a senior secured term loan facility (the "Term Debt Facility") in an
aggregate principal amount of $75,000,000 and a senior secured revolving
facility (the "Revolving Debt Facility") in an aggregate principal amount of
$100,000,000. The Term Debt Facility will mature on December 31, 2002, and
amortizes in quarterly installments commencing on December 31, 1999 in aggregate
annual amounts of (i) $10,000,000 in the fourth quarter of 1999, (ii)
$15,000,000 in the year 2000, (iii) $20,000,000 in the year 2001, and (iv)
$30,000,000 in the year 2002. The Revolving Debt Facility matures on December
31, 2002. As of September 30, 1998, nothing was outstanding under the
Revolving Debt Facility and $75,000,000 was outstanding under the Term Debt
Facility. In the first three quarters of 1998, the Company made early payments
of $50 million on the original Chase Term Debt Facility. During the quarter
ended September 30, 1998, the Company made early payments of $10 million on the
original Chase Term Debt Facility. Because of these early payments and the
amendment of the Debt Facilities which includes changes to the amortization
schedule, there are no remaining amounts owed in 1998. As of September 30,
1998, the Company was in compliance with various covenants and other
restrictions contained in the Chase Debt Agreement and believes that it will
remain in compliance.*
In the second quarter of 1998, the Company entered into an interest rate
swap, derivative transaction in order to better match the Company's floating-
rate interest income on its cash equivalents and short-term investments with its
fixed-rate interest expense on its long-term debt, and to diversify a portion of
the Company's exposure away from fluctuations in short-term interest rates.
The net effect of the interest rate swap was to fix the LIBOR benchmark rate
used to calculate the Company's borrowing cost at 5.9% for 4 years on
$50,000,000 of the Term Debt Facility.
The Company's operations to date have required substantial amounts of cash.
As part of the financing of the acquisition of the Greenville Facility,
Catalytica Pharmaceuticals incurred approximately $125 million of long-term
indebtedness, of which $75 million was outstanding as of September 30, 1998. The
Company and its subsidiary Catalytica Advanced Technology have guaranteed this
indebtedness. As a result of this increased leverage, Catalytica
Pharmaceuticals' principal and interest obligations have increased
substantially. The degree to which Catalytica Pharmaceuticals is leveraged could
adversely affect Catalytica Pharmaceuticals' and the Company's ability to obtain
additional financing for working capital, acquisitions or other purposes and
could make Catalytica Pharmaceuticals and the Company more vulnerable to
economic downturns and competitive pressures. The Company's future capital
requirements will depend on many factors, including Catalytica Pharmaceuticals
level of business beyond the Supply Agreement with Glaxo Wellcome, the rate of
commercialization of the Company's catalytic combustion systems, and the need to
expand manufacturing capacity for pharmaceutical or combustion systems
business.* The Company expects to spend approximately $30 million during 1998
for capital expenditures primarily at Catalytica Pharmaceuticals.* Because of
its cash position of $35.9 million (including short-term investments) and its
available line of credit of $100 million as of September 30, 1998 coupled with
the anticipated cash flow from operations in 1998, the Company believes that it
has adequate funds to meet its working capital needs and debt repayment
obligations for at least the next 12 months.*
14
RISK FACTORS
Year 2000 Computer Systems Compliance. Many computer systems, software,
and electronic products require valid dates to work acceptably but are coded to
accept only two-digit entries in the date code field. These systems will need
to be changed to distinguish 21st century dates from 20th century dates. In
addition, certain systems and products do not correctly process "leap year"
dates. As a result, in the next 15 months, computer systems, software ("IT
Systems"), and other equipment, such as elevators, phones, office equipment, and
manufacturing equipment used by many companies may need to be upgraded,
repaired, or replaced to comply with "Year 2000" and "leap year" requirements.
The Company's existing systems are not yet completely Year 2000 compliant. As a
result, the Company is continuing to modify the systems.
The Company has conducted an internal review of most of its internal
systems, including inventory, manufacturing, planning, finance, human resources,
payroll, automation, laboratory, and embedded systems. The systems affected by
the Year 2000 problem are divided into three categories. BUSINESS INFORMATION
TECHNOLOGY SYSTEMS comprise any mainframe, midrange, or PC based computer system
used in corporate operations. These systems generally involve application code
supported by internal staff. MANUFACTURING AUTOMATION SYSTEMS are specific
computer and process control systems used in production processes, including
programmable logic controllers. These systems generally involve application
code that is supported by internal staff or directly by the vendor. EMBEDDED
SYSTEMS may comprise any system or device that includes an intelligent processor
or chip that is not programmable or cannot be modified without hardware changes.
These systems are generally supported by the vendor and are not maintained by
internal staff, other than for routine calibration or adjustment (e.g. stand-
alone controllers, intelligent field devices, laboratory instruments,
telecommunications devices).
Set forth below is a chart showing the Company's present status of
compliance (at September 30, 1998) and internal target dates for compliance.
The Company has prioritized the remediation effort to fix critical business
systems first, non-critical systems second, and cosmetic changes to reports and
displays last. Key critical business systems, such as Financials (General
Ledger, Purchasing, Accounts Payable, Accounts Receivable, and Fixed Assets) and
Material Requirements Planning, are currently 100% compliant. Remaining
critical and non-critical business systems are expected to be completed by mid-
1999 and cosmetic changes to reports and displays are anticipated to be
completed in fourth quarter 1999. *
PRESENT YEAR 2000 STATUS AS OF SEPTEMBER 30, 1998
- -------------------------------------------------
RESOLUTION PHASES
- ----------------------------------------------------------------------------------------------
EXPOSURE TYPE ASSESSMENT REMEDIATION TESTING IMPLEMENTATION
- ----------------------------------------------------------------------------------------------
BUSINESS INFORMATION 100% Complete 71 % Complete 61% Complete 51% Complete
TECHNOLOGY SYSTEMS
Expected Completion November 1999 November 1999 December 1999
- ----------------------------------------------------------------------------------------------
MANUFACTURING 87% Complete 82% Complete 77% Complete 63% Complete
AUTOMATION SYSTEMS
Expected Completion December 1998 July 1999 July 1999 September 1999
- ----------------------------------------------------------------------------------------------
EMBEDDED SYSTEMS 78% Complete 63% Complete 63% Complete 63% Complete
Expected Completion December 1998 September 1999 September 1999 September 1999
- ----------------------------------------------------------------------------------------------
15
Assessment of potential problems in business information technology systems
is complete; assessment of manufacturing automation systems and embedded systems
is in progress and is expected to be complete in the fourth quarter of 1998.*
Testing and remediation of Business Information Technology Systems,
Manufacturing Automation Systems, and Embedded Systems is in progress. All
phases of these efforts are expected to be successfully completed during 1999.*
As part of the Company's review to assure compliance with Year 2000, the
Company has formed a task force (the "Task Force") to oversee Year 2000 and leap
year issues.* The Task Force has reviewed all IT Systems and Non-IT Systems
that have been determined not to be Year 2000 and leap year compliant and has
identified and begun implementation of solutions to ensure such compliance.* The
Company has evaluated its systems for Year 2000 and leap year compliance.
Remediation of problems discovered will be corrected through internal efforts,
vendor upgrades, replacement, or decommissioning of obsolete systems and
equipment.* External and internal costs associated with these efforts are
currently expected to be approximately $7 million.* In conjunction with the
purchase of the Greenville site, Glaxo Wellcome has agreed to reimburse
Catalytica for $4 million of these costs. As of September 30, 1998, the Company
had spent $3.4 million on costs associated with the Year 2000 effort of which
$2.5 million is to be reimbursed by Glaxo Wellcome.* Catalytica does
not expect the costs relating to Year 2000 remediation to have a material effect
on results of operations or financial condition.*
The Company has contacted its major customers, vendors, and service
suppliers whose systems failures potentially could have a significant impact on
the Company's operations to verify their Year 2000 readiness to determine
potential exposure to Year 2000 issues. The Company has been informed by 65 per
cent of its major customers, vendors, and service suppliers that such suppliers
will be Year 2000 compliant by the Year 2000.
Failure of these third parties systems to timely achieve Year 2000
compliance could have a material adverse effect on the business, financial
condition, results of operation and prospects of the Company. Year 2000
problems could affect many of the Company's production, distribution, plant
equipment, financial, and administrative operations. Systems critical to the
business which have been identified as non-Year 2000 compliant are either being
replaced or corrected through programming modifications.
As part of contingency planning, Catalytica is developing procedures for
those areas that are critical to its business. These plans will be designed to
mitigate serious disruptions to the business beyond the end of 1999.* The major
efforts in contingency planning will occur in the last quarter of 1998 and the
first half of 1999, with the expectation that contingency plans will be in place
by the end of the second quarter of 1999.* Based on current plans and efforts
to date, the Company does not anticipate that Year 2000 problems will have a
material effect on results of operations or financial condition.*
The Company has not determined the state of compliance of certain third-
party suppliers of services such as phone companies, long distance carriers,
financial institutions and electric companies, the failure of any one of which
could severely disrupt the Company's ability to carry on its business as well as
disrupt the business of the Company's customers.
Failure to provide Year 2000 and leap year compliant business solutions to
customers or to receive such business solutions from its suppliers could result
in liability to the Company or otherwise have a material adverse effect on the
Company's business, results of operations, financial condition and prospects.
The Company could be affected through disruptions in the operation of the
enterprises with which the Company interacts or from general widespread problems
or an economic crisis resulting from non-compliant Year 2000 systems. Despite
the Company's efforts to address the Year 2000 effect on its internal systems
and business operations, such effect could result in a material disruption of
its business or have a material adverse effect on the Company's business,
financial condition or results of operations.
UNCERTAINTY OF FUTURE RESULTS. To achieve continued profitable operations,
Catalytica must successfully manage the operations of the pharmaceutical
manufacturing facility located in Greenville, North Carolina (the "Greenville
16
Facility"), and, to a lesser extent, successfully develop, manufacture,
introduce and market or license its combustion systems and catalytic processes.*
The Company began manufacturing, marketing and selling pharmaceutical
intermediates in 1994. As a result of the acquisition of the Greenville
Facility in 1997, it has substantially increased its manufacturing of
pharmaceutical products. The Company's business first achieved profitability
in the quarter ended September 30, 1997.
The Company's profitability is dependent on the continued profitability of
Catalytica Pharmaceuticals and the extent of the losses in its other operating
subsidiaries.* Catalytica Pharmaceuticals' profitability will depend on its
success and timing in continuing to obtain new customers, including possible
new agreements with Glaxo Wellcome.* In the event Catalytica Pharmaceuticals
does not continue to obtain additional new customers, which could involve
additional business from Glaxo Wellcome, on terms sufficient to offset the
costs associated with operating and maintaining the Greenville Facility, and
with servicing the debt incurred in connection with the acquisition of the
Greenville Facility, the Company's consolidated results of operations and
financial condition would be materially adversely affected. Manufacturing at
the Greenville Facility is conducted in three distinct operations: Chemical
Manufacturing Operations ("CMO"), Pharmaceutical Product Operations ("PPO")
and Sterile Product Operations ("SPO"). There is substantial underutilization
of manufacturing capacity at the PPO and SPO facilities, and because of the
long lead times required to obtain necessary regulatory approvals to
manufacture pharmaceutical and sterile products at these facilities,
Catalytica Pharmaceuticals does not anticipate additional significant revenue
from such facilities until 1999 at the earliest.* See "Management's Discussion
and Analysis of Financial Condition and Results of Operations."
The Company anticipates its operating results will fluctuate from quarter
to quarter as a result of differences in the amount and timing of expenses
incurred and revenues received. In particular, the Company's operating results
are affected by the size and timing of receipt of orders for and shipments of
its pharmaceuticals products coupled with changes in product mix, as well as the
amount and timing of payments and expenses under the Company's research and
development contracts.
RELIANCE ON RELATIONSHIP WITH GLAXO WELLCOME. Catalytica Pharmaceuticals
estimates that aggregate payments by Glaxo Wellcome under the Supply Agreement,
as amended, which commenced on August 1, 1997, and was expanded in the second
quarter of 1998, will total approximately $850 million, which include guaranteed
minimum payments plus the cost of raw materials.* The annual level of minimum
payments declines significantly after 1998, but is expected to continue to
represent a significant source of revenue for Catalytica Pharmaceuticals.*
Results for Catalytica Pharmaceuticals business is substantially dependent on
its Supply Agreement with Glaxo Wellcome during 1998 and 1999, and will continue
to be dependent on Glaxo Wellcome in part thereafter until the end of the term
of the Supply Agreement.* Catalytica Pharmaceuticals' business and the
Company's consolidated results of operations would be adversely affected if
Catalytica Pharmaceuticals does not successfully perform its
17
obligations under the Supply Agreement. This could result in increased costs to
the Company or in possible termination of the Supply Agreement by Glaxo
Wellcome.*
DEPENDENCE ON KEY PERSONNEL. The Company's success is dependent on the
retention of principal members of its management and scientific staff and on the
ability to continue to attract, motivate and retain additional key personnel.*
Competition for such key personnel is intense, and the loss of the services of
key personnel or the failure to recruit necessary additional personnel could
have a material adverse effect on the Company's operations and on its research
and development efforts. The Company does not have non-competition agreements
with any of its key employees. The Company's expansion into areas and
activities requiring additional expertise, such as manufacturing, marketing and
distribution, have placed increased demands on the Company's resources. These
activities require the addition of new personnel with expertise in these areas
and the development of additional expertise by existing personnel. Any failure
on the part of Catalytica Pharmaceuticals to attract or retain necessary
personnel would have a material adverse effect on the Company's consolidated
results of operations.
UNCERTAINTIES RELATED TO COMBUSTION SYSTEMS BUSINESS. The Company, through
its subsidiary Catalytica Combustion Systems, Inc. ("Combustion Systems"), and
the GENXON joint venture, is still conducting research and development on its
combustion systems. Prior to commercialization of its combustion systems, the
Company's products will be required to undergo rigorous testing by turbine
manufacturers. Ultimate sales of the Company's combustion system products will
depend upon the acceptance and use of the Company's technology by a limited
number of turbine manufacturers and the Company's ability to enter into
commercial relationships with these manufacturers.* The Company's subsidiary,
Combustion Systems, is currently working with leading turbine manufacturers,
including: Pratt & Whitney Canada, Inc., General Electric, Allison Engine Co., a
subsidiary of Rolls Royce, and Solar, a subsidiary of Caterpillar, Inc. In
addition, through its joint venture company GENXON, Combustion Systems is
developing complete combustor systems for AGC, to be used on small Kawasaki
Heavy Industries turbines for mobile cogeneration applications.* GENXON is
also developing complete combustor systems utilizing Catalytica's combustion
technology for end users to be retrofitted on older out-of-warranty turbines no
longer supported by OEM's.* Neither the Company, its subsidiary Combustion
Systems, nor the joint venture company GENXON have formal long-term agreements
in place with many of these companies. The Company's ability to complete
research and development and introduce commercial systems for these markets
could be adversely affected if any of these companies terminated its
relationship with the Company or GENXON. If such terminations occurred, there
is no assurance as to whether the Company could enter into a similar
relationship with another manufacturer.
The Company currently has limited manufacturing and marketing capability
for its combustion products, and to the extent that the Company's existing
facilities are inadequate, the Company will be required to develop or acquire
manufacturing capability. In order to market any of its combustion system
products, the Company will be required to develop marketing capability, either
on its own or in conjunction with others. There can be no assurance that the
Company will be able to manufacture its products successfully or develop an
effective marketing and sales organization. In addition, some of the Company's
combustion systems and processes are expected to be sold as components of large
systems such as natural gas turbines for electric power plants.* Accordingly,
the rate of adoption of the Company's systems and processes may depend in part
on economic conditions that affect capital investment decisions, as well as the
regulatory environment.* There can be no assurance that the Company's
combustion products will be economically attractive when compared to competitive
products.
In October 1996 Combustion Systems and Woodward Governor Company formed a
Delaware limited liability company in connection with a 50/50 joint venture to
serve the gas turbine retrofit market for installed, out-of-warranty engines.
The new company, GENXON/(TM)/ Power Systems, LLC ("GENXON"), was formed to
upgrade the combustion systems of installed turbines with XONON which is
designed to reduce emissions and permit greater asset utilization for both power
generation and mechanical drive markets. GENXON plans to deliver an integrated
product which includes Combustion Systems' system for ultra low NOx emissions
and Woodward's control systems.* Unlike Catalytica Combustion Systems' efforts
to date, which have focused only on the design of the catalyst assembly, GENXON
is developing entire combustion systems. The development of complete combustion
systems by GENXON to serve the retrofit market will require the design of new
combustion chambers to be retrofitted on existing turbines. This new combustion
chamber will incorporate a XONON catalyst.* There can be no assurance
18
that GENXON will be successful in developing new combustion chambers that will
work in lieu of the current design that does not incorporate a catalyst. There
can be no assurance that GENXON's products will be economically attractive when
compared to competitive products.
The initial capital commitment of the GENXON joint venture partners was $10
million--$2 million from Combustion Systems and $8 million from Woodward--
payable over time as the funds were required by the joint venture. This initial
capital commitment of $10 million was reached during the third quarter of 1997.
Continued funding of the joint venture beyond the initial $10 million commitment
has occurred on a 50/50 basis with each joint venture partner contributing $1.7
and $3.35 million, respectively, for the three and nine months ended September
30, 1998, bringing the total investment in the joint venture to $21.4 million to
date. Combustion Systems recognized its 50% share of GENXON losses, of $1.5
million, of which $.7 million was Combustion Systems 50% of GENXON's loss for
the three months ended September 30, 1998, and $6.1 million, of which $3.0
million was Combustion Systems 50% of GENXON's loss for the nine months ended
September 30, 1998. Accordingly, losses on the joint venture were recognized in
the results of operations. The Company expects to make additional capital
contributions to the joint venture during the remainder of fiscal 1998 and
anticipates GENXON will incur additional losses.* The Company will record its
share of these losses to the extent of its capital contribution. Although
Combustion Systems and Woodward intend to continue the funding of this joint
venture, neither joint venture partner is contractually required to make further
capital infusions. If the Company desired to complete any projects being
developed by the joint venture, the Company could be required to fund the
projects itself if Woodward decides not to make any additional capital
contributions to GENXON.* If such an event were to occur, it could have an
adverse effect on the Company's results of operations and financial condition.
See "Management's Discussion and Analysis of Financial Condition and Results of
Operations."
RISK OF PRODUCT LIABILITY. Although Catalytica Pharmaceuticals intends to
seek indemnification from its customers for any product liability claims that
may result from the pharmaceutical products it produces, there can be no
assurance that Catalytica Pharmaceuticals will not ultimately be found liable
for any product liability claims regarding products it manufactures. Catalytica
Pharmaceuticals expects it will be required to indemnify its customers for
product liability claims if a manufacturing defect results in injury. There can
be no assurance that Catalytica Pharmaceuticals will be able to obtain or
maintain product liability insurance in the future on acceptable terms or with
adequate coverage against potential liabilities. If Catalytica Pharmaceuticals
is found liable in a product liability claim and the Company does not have
adequate product liability insurance or indemnification, the Company's
consolidated results of operations could be materially adversely effected.
Additionally, under the Supply Agreement, Catalytica Pharmaceuticals is
obligated to maintain $100,000,000 of product liability insurance. If
Catalytica Pharmaceuticals does not meet this requirement, it would be
considered a default under the Supply Agreement.
HAZARDOUS MATERIALS AND ENVIRONMENTAL MATTERS. The Company's research and
development activities and fine chemicals manufacturing involve the use of many
hazardous chemicals. The use of such chemicals has significantly increased as a
result of the acquisition of the Greenville Facility. The Company is subject to
extensive federal, state and local laws and regulations governing the use,
manufacture, storage, handling and disposal of such materials and associated
waste products. The Company believes that its properties and operations comply
in all material respects with applicable environmental laws; however, the risk
of environmental liabilities cannot be completely eliminated. Public awareness
of environmental issues has increased the impact of such laws on the conduct of
manufacturing operations and ownership of property. Any failure by the Company
to comply with present or future environmental laws could result in cessation of
portions or all of the Company's operations, impositions of fines, restrictions
on the Company's ability to carry on or expand its operations, significant
expenditures by the Company to comply with environmental laws and regulations,
and/or liabilities in excess of the resources of the Company. The Company has
environmental impairment insurance with regard to first party and third party
liability in the amount of $25,000,000 (with a $1,000,000 retention) with
respect to the Greenville Facility only. There can be no assurance that the
Company will not be required to make renovations or improvements to comply with
environmental laws and regulations in the future. The Company's operations,
business or assets could be materially adversely affected in the event such
environmental laws or regulations require the Company to modify current
facilities substantially or otherwise limit the Company's ability to conduct or
expand its operations.
19
Catalytica Pharmaceuticals expects that significant expenditures may be
incurred at the Greenville Facility as a result of new environmental
regulations.* As of September 21, 1998, the United States Environmental
Protection Agency (the "EPA") has issued, new regulations for the
pharmaceutical industry under the authority of the federal Clean Air Act and
Clean Water Act. These proposed regulations will require the installation of
"Maximum Achievable Control Technology" for certain hazardous air pollutant
emissions sources ("Pharmaceutical MACT") and could potentially require the
installation of additional pretreatment systems for wastewater discharges.* The
EPA is also considering changes to its particulate matter emissions regulations
as well as regulation of certain ozone precursor emissions.* As these rules are
in the early stages of consideration by the EPA, and as there can be no
assurance of their adoption, the additional cost of complying with such
regulations cannot be determined at this time. There can be no assurance that
Catalytica Pharmaceuticals will not be required to make additional renovations
or improvements to comply with environmental laws and regulations in the future.
Catalytica Pharmaceuticals' operations, business and assets could be materially
adversely affected in the event such environmental laws or regulations require
Catalytica Pharmaceuticals to modify the current Greenville Facility
substantially or otherwise limit Catalytica Pharmaceuticals' ability to conduct
or expand its operations.
CURRENT AND POTENTIAL ENVIRONMENTAL CONTAMINATION AT CATALYTICA
PHARMACEUTICALS' TWO SITES. Glaxo Wellcome has been working with the EPA and
the North Carolina Department of Environment and Natural Resources (the
"NCDENR") to investigate, identify and remediate contamination in the soil and
groundwater at the Greenville Facility now owned by Catalytica Pharmaceuticals.
This investigation, carried out pursuant to the federal Resource Conservation
and Recovery Act, has identified 17 different areas of the Greenville Facility
where contamination has or may have occurred. Of these 17 areas, at least six
have been identified as requiring further investigation and remediation by
NCDENR ("Site Contamination"). Contaminants found in the soil and groundwater
at the Greenville Facility include solvents, petroleum hydrocarbons and
pesticides. As the new owner of the Greenville Facility, Catalytica
Pharmaceuticals has become legally liable for such contamination.
Notwithstanding such legal liability, Glaxo Wellcome has agreed to be primarily
liable for and to perform, at its cost, the remediation required by law for
contamination of the soil and groundwater existing at the Greenville Facility as
of the Closing. The cost and extent of remediation to be required at the
Greenville Facility is currently unknown. The Environmental Agreement with
Glaxo Wellcome also requires Catalytica Pharmaceuticals to provide access to the
Greenville Facility and certain facility services as required for the
remediation, subject to reimbursement by Glaxo Wellcome. However, there can be
no assurance that the Company or Catalytica Pharmaceuticals will not incur
unreimbursed costs or suffer an interference with ongoing operations as a result
of Glaxo Wellcome's remediation activities or the existence of contamination at
the Greenville Facility. In addition, the Company's future development of the
Greenville Facility may be limited by the existence of contamination or Glaxo
Wellcome's remediation activities. There also can be no assurance that
Catalytica Pharmaceuticals' ongoing operations at the Greenville Facility will
not cause additional contamination. The determination of the existence and cost
of any such additional contamination contributed by Catalytica Pharmaceuticals
of the Company could involve costly and time-consuming negotiations and
litigation. Furthermore, any such contamination caused by Catalytica
Pharmaceuticals or the Company could materially adversely affect the business,
results of operations and financial condition of Catalytica Pharmaceuticals and
the consolidated results of operations and financial condition of the Company.
In addition, a moderate amount of asbestos containing material ("ACM") is
present at the Greenville Facility. Catalytica Pharmaceuticals believes that
the ACM, in its present condition, does not require abatement. Abatement will
only be required if and as renovations are performed in those areas containing
ACM. Catalytica Pharmaceuticals cannot presently predict whether, when or to
what extent it may need or desire to renovate areas of the Greenville Facility
containing ACM. However, should such renovations be necessary, the additional
costs could be substantial.
The Company through a subsidiary leases the land on which its Bayview
facility in East Palo Alto, California is located from Rhone Poulenc, Inc.,
("Rhone Poulenc"). The past activities of Rhone Poulenc's predecessor caused
significant soil and groundwater contamination of the facility and a down
gradient area located along the San Francisco Bay. Consequently, the site is
subject to a clean up and abatement order issued by the Bay Area Regional Water
Quality Control Board ("RWQCB") which currently requires stabilization,
containment and monitoring of the arsenic and volatile organic contamination at
the site and surrounding areas. The ground lease between Rhone Poulenc and the
Company includes an indemnity by Rhone Poulenc against any costs and liabilities
that the Company might incur to fulfill the RWQCB order and to otherwise address
the contamination that is the
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subject of the order. The Company also has obtained an indemnification from
Novartis (the immediately preceding owner/operator of the facility) against any
costs and liability the Company may incur with respect to any contamination
caused by Novartis' operations. However, there can be no assurance that the
Company will not be held responsible with respect to the existing contamination
or named in an action brought by a governmental agency or a third party because
of such contamination. If the Company is held responsible and it has contributed
to the contamination, it will be liable for any damage to third parties, and
will be required to indemnify Rhone Poulenc and Novartis for any additional
clean up costs or liability they may incur, with respect to the contamination
caused by the Company. The determination of the existence and additional cost of
any such incremental contamination contribution by the Company could involve
costly and time-consuming negotiations and litigation. Further, any such
incremental contamination by the Company or the unenforceability of either of
the indemnity agreements described above could materially adversely affect the
Company's business and results of operations.
CATALYTICA PHARMACEUTICALS' COMPLIANCE WITH FDA REGULATIONS. Many of the
fine chemicals products Catalytica Pharmaceuticals manufactures, or will
manufacture in the future, and the final drug products in which they are used
are subject to regulation for safety and efficacy by the FDA and foreign
regulatory authorities before such products can be commercially marketed. The
process of obtaining regulatory clearances for marketing is uncertain, costly
and time consuming. Catalytica Pharmaceuticals cannot predict how long the
necessary regulatory approvals will take or if its customers will ever obtain
such approval for their products. To the extent Catalytica Pharmaceuticals'
customers do not obtain the necessary regulatory approvals for marketing new
products, Catalytica Pharmaceuticals' fine chemicals product sales will be
adversely affected.
Products manufactured by Catalytica Pharmaceuticals at the Greenville
Facility require Catalytica Pharmaceuticals to comply with the FDA's current
Good Manufacturing Practices ("cGMP") regulations, and certain of Catalytica
Pharmaceuticals' customers, including Glaxo Wellcome, also require Catalytica
Pharmaceuticals to adhere to cGMP regulations, even if not required by the FDA.
In complying with cGMP regulations, manufacturers must continue to expend time,
money and effort in production, record keeping and quality control to ensure
that the product meets applicable specifications and other requirements. The
FDA periodically inspects drug-manufacturing facilities to ensure compliance
with applicable cGMP requirements. Failure to comply subjects the manufacturer
to possible FDA action, such as suspension of manufacturing. The FDA also may
require the submission of any lot of the product for inspection and may restrict
the release of any lot that does not comply with FDA regulations, or may
otherwise order the suspension of manufacture, recall or seizure. Failure of
Catalytica Pharmaceuticals' customers to obtain and to maintain FDA clearance
for marketing of the products manufactured by Catalytica Pharmaceuticals, or
failure of Catalytica Pharmaceuticals to comply with cGMP regulations as
required by the FDA or Catalytica Pharmaceuticals' customers, would have a
material adverse effect on the Company's results of operations.
INFLUENCE OF ENVIRONMENTAL REGULATIONS ON RATE OF COMMERCIALIZATION. The
rate at which industrial companies adopt the Company's catalytic combustion
systems will be heavily influenced by the enactment and enforcement of
environmental regulations at the federal, state and local levels.* Current
federal law governing air pollution generally does not mandate the specific
means for controlling emissions, but instead, creates ambient air quality
standards for individual geographic regions to attain through individualized
planning on a regional basis in light of the general level of air pollution in
the region. Federal law requires state and local authorities to determine
specific strategies for reducing emissions or specific pollutants. Among other
strategies, state and local authorities in all areas which do not meet ambient
air quality standards must adopt performance standards for all major new and
modified sources of air pollution. The more polluted the air in a particular
region has become, the more stringent such controls must be. The Company's
revenues will depend, in part, on the standards, permit requirements and
programs these state and local authorities promulgate for reducing emissions
(including emissions of NOx) addressed by the Company's combustion systems.*
Demand for the Company's systems and processes will be affected by how quickly
the standards are implemented and the level of reductions required.* Certain
industries or companies may successfully delay the implementation of existing or
new regulations or purchase or acquire emissions credits from other sources,
which could delay or eliminate their need to purchase the Company's systems and
processes. Moreover, new environmental regulations may impose different
requirements which may not be met by the systems and processes being developed
by Catalytica or which may require costly modifications of the Company's
products. The United States Congress is currently reviewing existing
environmental regulations. There can be no certainty as to whether Congress
will amend or modify existing regulations in a manner that could have an adverse
effect on demand for the Company's combustion system products.
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COMPETITION AND TECHNOLOGICAL CHANGE. There are numerous competitors in a
variety of industries in the United States, Europe and Japan that have
commercialized and are working on technologies that could be competitive with
those under development by the Company, including both catalytic and other
technological approaches. The Company's competitors may develop technologies and
systems and processes that are more effective than those being developed by the
Company or that would render the Company's technology and systems and processes
less competitive or obsolete. In the market for fine chemicals used in
pharmaceutical products and in the market for final dosage form of
pharmaceutical products, the Company faces its primary competition from
pharmaceutical companies that manufacture their own products and from other fine
chemicals manufacturers such as Lonza AG and DSM Fine Chemicals. In the
combustion systems market, the Company faces its primary competition from large
gas turbine power generation manufacturers, such as General Electric Co.
("General Electric"), Allison Engine Company ("Allison") and Solar Turbines
Incorporated ("Solar"), each of which is developing competing DLN systems for
their own turbines. Many of the Company's competitors in the combustion systems
market are also potential customers of the Company, and the Company expects to
rely on these potential customers to help commercialize its products.* Most of
these competitors have greater research and development capabilities, financial
resources, managerial resources, marketing experience and manufacturing
experience than the Company. If these companies are successful in developing
such products, the Company's ability to sell its systems and processes would be
materially adversely affected. Further, since many of the Company's competitors
are existing or potential customers, the Company's ability to gain market share
may be limited.
PATENTS AND INTELLECTUAL PROPERTY. The Company has an active program of
pursuing patents for its inventions in the United States and in markets
throughout the world relevant to its business areas. The Company has at least
37 United States patents and 14 pending United States patent applications, and
at least 91 foreign patents and patent applications.
The Company's success will depend on the ability to continue to obtain
patents, protect trade secrets and operate without infringing on the proprietary
rights of others in the United States and other countries. There can be no
assurance that the Company's patent applications will result in the issuance of
any patent, that any of the Company's existing patents or any patents that may
be issued in the future will provide significant proprietary protection, that
any such patents will be sufficiently broad to protect the Company's technology,
or that any such patents will not be challenged, circumvented or invalidated.
There can also be no assurance that the patents of others will not have an
adverse effect on the Company. Others may independently develop similar systems
or processes or design around patents issued to the Company. In addition, the
Company may be required to obtain licenses to patents or other proprietary
rights. The Company cannot assure that any licenses required under any such
patents or proprietary rights would be made available on terms acceptable to the
Company, if at all. If Catalytica requires and does not obtain such licenses,
it could encounter delays in system or process introductions while it attempts
to design around such patents, or it could find that the development,
manufacture, sale or licensing of systems or processes requiring such licenses
could be foreclosed. The Company could incur substantial costs in defending
itself or its licensees in litigation brought by others or prosecuting
infringement claims against third parties. The Company could incur substantial
costs in interference proceedings declared by the United States Patent and
Trademark Office in connection with one or more of the Company's or third
parties' patents or patent applications, and those proceedings could also result
in an adverse decision as to the priority of the Company's inventions. The
Company also protects its proprietary technology and processes in part by
confidentiality agreements with its collaborative partners, employees and
consultants. There can be no assurance that these agreements will not be
breached, that the Company will have adequate remedies for any breach, or that
the Company's trade secrets will not otherwise become known or be independently
discovered by competitors.
CONCENTRATION OF OWNERSHIP. Morgan Stanley Capital Partners III, L.P. and
two affiliated funds (collectively, "MSCP") beneficially own approximately 32%
of the voting control of the Company and 47% of the outstanding capital stock of
the Company as of September 30, 1998. As a result, MSCP is able to exercise
significant influence over all matters requiring stockholder approval, including
the election of directors and approval of all significant corporate transactions
such as any merger, consolidation or sale of all or substantially all of the
Company's assets. The Company has granted to MSCP certain contractual rights,
including representation on the Company's Board of Directors and committees of
the Board of Directors, that will give MSCP additional rights to participate in
certain actions to be taken by the Company. Such concentration of ownership and
contractual rights
22
may have the effect of delaying, deferring or preventing a change of control of
the Company. The sale by MSCP of shares of the Company's capital stock could
constitute a change of control under the Company's credit agreement, which would
trigger a default of the agreement. MSCP has agreed not to trigger a change of
control under the credit agreement. In addition, such concentration of ownership
and contractual rights could allow MSCP to prevent significant corporate
transactions.
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PART II--OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
10.1 Catalytica Combustion Systems, Inc. 1995 Stock Plan, as
amended, and related form of Stock Option Agreement
10.2 Catalytica Pharmaceuticals, Inc. 1995 Stock Plan, as
amended, and related form of Stock Option Agreement
27.1 Financial Data Schedule
(b) Reports on Form 8-K
The Company filed no reports on Form 8-K during the quarter
ended September 30, 1998.
All information required by other items in Part II is omitted because the
items are inapplicable, the answer is negative or substantially the same
information has been previously reported by the registrant.
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CATALYTICA, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: November 13, 1998
CATALYTICA, INC.
(Registrant)
BY: /S/ LAWRENCE W. BRISCOE
---------------------------------
Lawrence W. Briscoe
Vice President and Chief
Financial Officer
Signing on behalf of the
registrant and as principal
financial officer
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