SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
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 NUMBER 0-18962
CYGNUS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-2978092
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
400 PENOBSCOT DRIVE, REDWOOD CITY, CALIFORNIA 94063-4719
(Address of principal executive offices and zip code)
Registrant's telephone number, including area code: (650) 369-4300
---------------
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
------ -----
Number of shares outstanding of each of the registrant's classes of common stock
as of NOVEMBER 9, 1998:
Common Stock - 20,592,613 shares
CYGNUS, INC.
INDEX
PART I. FINANCIAL INFORMATION PAGE NO.
--------
Item 1: Financial Statements
Condensed Consolidated Statements of Operations for the three and nine month
periods ended September 30, 1998 and 1997 (unaudited).......................2
Condensed Consolidated Balance Sheets at September 30,1998 (unaudited) and
December 31, 1997...........................................................3
Condensed Consolidated Statements of Cash Flows for the nine month periods
ended September 30, 1998 and 1997 (unaudited)...............................4
Notes to Condensed Consolidated Financial Statements (unaudited)..............5
Item 2: Management's Discussion and Analysis of Financial Condition and
Results of Operations.......................................................9
PART II. OTHER INFORMATION
Item 1: Legal Proceedings...........................................................32
Item 6: Exhibits and Reports on Form 8-K............................................33
SIGNATURES...........................................................................34
1
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CYGNUS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(unaudited)
(In thousands, except per share data)
Three months ended Nine months ended
September 30, September 30,
1998 1997 1998 1997
-------- -------- ------ --------
Product revenues $ -- $ 1,770 $ 587 $ 3,470
Contract revenues 2,463 3,528 7,822 10,984
Royalty and other revenues 319 139 714 8,516
-------- -------- ------ --------
TOTAL REVENUES 2,782 5,437 9,123 22,970
Costs and expenses:
Costs of products sold 741 3,062 2,701 7,071
Research and development 7,859 5,381 22,665 16,353
Marketing, general and administrative 3,634 2,240 8,350 6,103
Arbitration settlement -- 39,633 -- 39,633
-------- -------- -------- --------
TOTAL COSTS AND EXPENSES 12,234 50,316 33,716 69,160
LOSS FROM OPERATIONS (9,452) (44,879) (24,593) (46,190)
Interest income (expense), net (171) 272 (227) 910
-------- -------- -------- --------
NET LOSS $ (9,623) $(44,607) $(24,820) $(45,280)
-------- -------- -------- --------
-------- -------- -------- --------
NET LOSS PER SHARE $ (0.48) $ (2.36) $ (1.23) $ (2.41)
-------- -------- -------- --------
-------- -------- -------- --------
Shares used in computation of basic and
diluted net loss per share 20,241 18,879 20,107 18,818
-------- -------- -------- --------
-------- -------- -------- --------
(See accompanying notes.)
2
CYGNUS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
ASSETS: SEPTEMBER 30, December 31,
- ------- 1998 1997
------------- ------------
(unaudited)
Current assets:
Cash and cash equivalents $ 18,708 $ 20,669
Short-term investments 36,539 14,163
Trade accounts receivable, net of allowance 1,313 2,040
Inventories 770 924
Prepaid expenses and other current assets 1,049 1,988
--------- ---------
TOTAL CURRENT ASSETS 58,379 39,784
Equipment and improvements, at cost 18,766 15,741
Less accumulated depreciation and amortization (12,618) (11,145)
--------- ---------
Net equipment and improvements 6,148 4,596
Deferred compensation and other assets 7,440 4,897
--------- ---------
TOTAL ASSETS $ 71,967 $ 49,277
--------- ---------
--------- ---------
LIABILITIES AND STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICIENCY):
Current liabilities:
Accounts payable $ 1,278 $ 1,294
Current portion of arbitration obligation 2,352 16,223
Accrued compensation 3,465 3,298
Accrued professional services 1,057 842
Other accrued liabilities 1,971 1,263
Customer advances 232 624
Current portion of deferred revenue 1,207 1,846
Current portion of long term debt 2,762 3,767
Current portion of capital lease obligations 338 686
--------- ---------
TOTAL CURRENT LIABILITIES 14,662 29,843
Long-term portion of deferred revenue 237 1,188
Long-term debt, non-current portion 9,330 3,812
Long-term portion of capital lease obligations 787 390
Long-term portion of arbitration obligations 23,000 23,000
Deferred compensation and other long-term liabilities 5,331 4,844
Convertible subordinated debt 43,000 --
Stockholders' equity (net capital deficiency):
Common stock 136,921 122,728
Accumulated deficit (161,301) (136,528)
--------- ---------
TOTAL STOCKHOLDERS' EQUITY (NET CAPITAL DEFICIENCY) (24,380) (13,800)
--------- ---------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY
(NET CAPITAL DEFICENCY) $ 71,967 $ 49,277
--------- ---------
--------- ---------
Note: The condensed consolidated balance sheet at December 31, 1997 has been
derived from the audited financial statements at that date but does not include
all of the information and footnotes required by generally accepted accounting
principles for complete financial statements.
(See accompanying notes.)
3
CYGNUS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
Increase/(Decrease) in Cash and Cash Equivalents
(unaudited)
(In thousands)
NINE MONTHS ENDED SEPTEMBER 30,
1998 1997
-------------- ---------------
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss $ (24,820) $ (45,280)
Adjustments to reconcile net loss to cash
(used in)/provided by operating activities:
Depreciation and amortization 1,391 3,108
Decrease/(increase) in assets 1,726 3,812
Increase/(decrease) in liabilities (421) (11,861)
Increase/(decrease) in arbitration liability (13,871) 39,633
-------------- ---------------
NET CASH (USED IN)/PROVIDED BY OPERATING ACTIVITIES (35,995) (10,588)
-------------- ---------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital expenditures (2,590) (2,588)
Decrease/(increase) in short-term investments (22,057) (5,048)
-------------- ---------------
NET CASH (USED IN)/PROVIDED BY INVESTING ACTIVITIES (24,647) (7,636)
-------------- ---------------
CASH FLOWS FROM FINANCING ACTIVITIES:
Issuance of common stock 14,193 4,273
Principal payments of long-term debt (1,598) (1,813)
Payment of capital lease obligations (375) (1,042)
Issuance of convertible subordinated debt, net 40,351 --
Issuance of long-term debt, net 6,110 1,331
-------------- ---------------
NET CASH (USED IN)/PROVIDED BY FINANCING ACTIVITIES 58,681 2,749
-------------- ---------------
NET INCREASE /(DECREASE) IN CASH AND CASH EQUIVALENTS (1,961) (15,475)
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 20,669 33,148
-------------- ---------------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 18,708 $ 17,673
-------------- ---------------
-------------- ---------------
(See accompanying notes.)
4
CYGNUS, INC.
September 30, 1998
NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS (UNAUDITED)
1. BASIS OF PRESENTATION
The condensed consolidated financial statements of Cygnus, Inc. (the
"Company" or "Cygnus") as of and for the nine month periods ended September
30, 1998 and 1997 included herein are unaudited, but include all adjustments
(consisting only of normal recurring adjustments) which the management of
Cygnus, Inc. believes necessary for a fair presentation of the financial
position as of the reported dates and the results of operations for the
respective periods presented. Interim financial results are not necessarily
indicative of results for a full year. The consolidated financial statements
should be read in conjunction with the audited financial statements and
related notes for the year ended December 31, 1997 included in the Company's
1997 Annual Report on Form 10-K.
2. NET LOSS PER SHARE
In 1997, the Financial Accounting Standards Board issued Statement No.
128, EARNINGS PER SHARE ("Statement 128"). Statement 128 replaced the
calculation of primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options, warrants, and convertible
securities. Diluted earnings per share is very similar to the previously
reported fully diluted earnings per share. All earnings per share amounts for
all periods have been presented and where appropriate restated to conform to
the Statement 128 requirements.
Currently, basic and diluted net loss per share is computed using the
weighted average number of shares of common stock outstanding. Shares
issuable from stock options, warrants and convertible debt outstanding are
excluded from the diluted earnings per share computation, as their effect is
anti-dilutive.
3. COMPREHENSIVE INCOME (LOSS)
As of January 1, 1998, the Company adopted the provisions of SFAS No. 130,
"Reporting Comprehensive Income" ("SFAS 130"). SFAS 130 establishes new rules
for the reporting and display of comprehensive income and its components;
however, the adoption of SFAS 130 had no impact on the Company's net loss or
shareholders' equity. Comprehensive income (loss) has not been presented
separately herein as it approximates the Company's net loss.
5
CYGNUS, INC.
September 30, 1998
4. INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out method)
or market, after appropriate consideration has been given to obsolescence and
inventories in excess of anticipated future demand. Net inventories consist
of the following (in thousands):
SEPTEMBER 30, December 31,
1998 1997
------------- -------------
Raw materials $ 770 $ 787
Work in process 0 86
Finished goods 0 51
------- -------
$ 770 $ 924
------- -------
------- -------
Inventories at September 30, 1998 and December 31, 1997 relate to the
Company's estradiol transdermal product, the FemPatch -Registered
Trademark-system (Warner-Lambert Co., Morris Plains, NJ).
5. DEBT AND EQUITY ISSUANCES
In February 1998, the Company entered into Note Purchase Agreements with
certain institutional investors to issue and sell approximately $43 million
of 4% Senior Subordinated Convertible Notes due 2005 (the "Notes"). On
October 28, 1998, the Company restructured the Notes. Key provisions in the
restructured Notes include the repayment of $18.5 million in principal
reducing the principal balance from $43 million to $24.5 million, a delay in
the convertibility of the majority of the Notes to June 30, 1999,
modification of conversion prices of the Notes, the ability of the Company to
redeem at par at any time all or part of the new principal amount of the
Notes, an increase in the interest rate to 5.5% paid annually on the new
principal balance, and the change in the final maturity of the Notes to
October 1, 2000.
On October 28, 1998 Cygnus redeemed $18.5 million of the original
principal amount of the Notes. Under the terms of the restructured Notes, all
of the remaining $24.5 million principal amount of the Notes are redeemable
by the Company at par with accrued interest. In addition, $18.5 million of
the Notes will not be convertible into Common Stock by the Note holders until
June 30, 1999 and after, effectively a five-month delay from the original
terms of the Note. The restructured Notes are divided into three tranches.
The first tranche has an original principal amount of $6 million and is
convertible in whole or in part into Common Stock at any time, at $3.5375
until June 30, 1999, subject to a potential upward adjustment on February 1,
1999, based on certain market formulas. On and after July 1, 1999, the
conversion price will be based on other market based pricing formulas. The
second tranche also has an original principal amount of $6 million but cannot
be converted into Common Stock until June 30, 1999, at which time the second
tranche becomes convertible in whole or in part at a price of the average of
closing bid prices using a fifteen trading day look-back from February 1,
1999. The third tranche of the restructured Notes has an original principal
amount of $12.5 million and cannot be converted into Common Stock until on or
after July 1, 1999.
6
CYGNUS, INC.
September 30, 1998
Beginning July 1, 1999, no more than 15% of the second and third tranches may
be converted per calendar month, at conversion prices which reflect certain
market formulas. Such formulas include components based on various averages
of closing bid prices and low trading prices during fifteen or ten, as the
case may be, trading day look-back periods from various dates. Any portions
of the 15% monthly amounts of the second and third tranches that are not
converted in the relevant month may be rolled over for conversion in future
months. If the Company calls the second tranche of Notes ($6 million) for
redemption before February 1, 1999, the Note holders will be entitled to
convert not more than 50% of such Notes called before the redemption occurs.
If the Company calls the third tranche of Notes ($12.5 million) for
redemption before July 1, 1999, the Note holders will not be entitled to
convert any portion of such tranche so called. The Note holders will
otherwise be entitled to convert Notes called for redemption before the
redemption occurs, at conversion prices based on market formulas, which, in
the case of Notes that would otherwise be convertible in the absence of such
redemption, are the same that would be applicable to such conversion.
The restructured Notes contain a beneficial conversion feature related
to the first tranche which will result in a non-cash charge to interest
expense of $4.2 million on the date of the restructuring . Additional debt
restructuring costs of $1.4 million (including a $1.0 million write-off
relating to prior debt issuance costs associated with the $18.5 million debt
paid down) will be charged to interest expense. The Company will record total
charges related to the restructuring of the Notes of $5.6 million in the
quarter ended December 31, 1998.
On February 4, 1998, the Company completed a direct public offering of
905,740 shares of its Common Stock for net proceeds to the Company of
approximately $13.3 million. The Common Stock was sold at a discount from the
market price.
7
CYGNUS, INC.
September 30, 1998
6. LEGAL PROCEEDINGS
In May 1997 Cygnus reported it had initiated arbitration proceedings
against Pharmacia & Upjohn ("Pharmacia") relating to the Nicotrol-Registered-
patch (Pharmacia AB, Stockholm, Sweden), Cygnus' smoking cessation patch. In
March of 1997, Cygnus announced that Pharmacia exercised its option to
purchase the U.S. manufacturing rights for the Nicotrol patch. The agreement
between Cygnus and Pharmacia provided that Pharmacia would be obligated to
pay Cygnus for, among other things, existing inventory costs and certain
purchase order commitments. Pharmacia disputes their obligations regarding
certain of the inventory costs and certain purchase order commitments. The
arbitration is intended to resolve these matters. In March 1998, Pharmacia
added a counterclaim against Cygnus in the arbitration, seeking approximately
$1.5 million in reimbursement for an alleged overpayment in royalties for
Nicotrol units shipped in 1996 and 1997. Cygnus disputes this counterclaim.
The arbitration hearing on both Cygnus' claim and Pharmacia's counterclaim
commenced on June 15, 1998 before a panel of the American Arbitration
Association. Testimony concluded on June 24, 1998, at which time the panel
heard argument and scheduled post-hearing briefings. Both sides submitted
their post-hearing briefs on July 17, 1998. The panel has not yet closed the
hearing proceedings and still has the option to request more evidence or
argument. Once the proceedings are closed, a decision is expected within 30
days of that date. See the Company's quarterly reports on Form 10-Q for the
quarter ended March 31, 1998 and June 30, 1998, filed with the Securities and
Exchange Commission ("SEC") on May 15, 1998 and August 4, 1998, respectively,
and the Company's annual report on Form 10-K for the year ended December 31,
1997, filed with the SEC on February 6, 1998.
8
CYGNUS, INC.
September 30, 1998
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS REPORT ON FORM 10-Q CONTAINS FORWARD-LOOKING STATEMENTS, INCLUDING
BUT NOT LIMITED TO THOSE SPECIFICALLY IDENTIFIED AS SUCH, THAT INVOLVE RISKS
AND UNCERTAINTIES. THE STATEMENTS CONTAINED IN THIS REPORT ON FORM 10-Q THAT
ARE NOT PURELY HISTORICAL ARE FORWARD-LOOKING STATEMENTS WITHIN THE MEANING
OF SECTION 27A OF THE SECURITIES ACT AND SECTION 21E OF THE EXCHANGE ACT,
INCLUDING WITHOUT LIMITATION STATEMENTS REGARDING THE COMPANY'S EXPECTATIONS,
BELIEFS, INTENTIONS OR STRATEGIES REGARDING THE FUTURE. ALL FORWARD-LOOKING
STATEMENTS INCLUDED IN THIS REPORT ON FORM 10-Q ARE BASED ON INFORMATION
AVAILABLE TO THE COMPANY ON THE DATE HEREOF, AND THE COMPANY ASSUMES NO
OBLIGATION TO UPDATE ANY SUCH FORWARD-LOOKING STATEMENTS. THE COMPANY'S
ACTUAL RESULTS COULD DIFFER MATERIALLY FROM THOSE ANTICIPATED IN THESE
FORWARD-LOOKING STATEMENTS AS A RESULT OF A NUMBER OF FACTORS, INCLUDING, BUT
NOT LIMITED TO, THOSE SET FORTH IN THE "RISK FACTORS" BEGINNING ON PAGE 16
AND ELSEWHERE IN THIS REPORT ON FORM 10-Q.
GENERAL
Cygnus is engaged in the development and manufacture of diagnostic and
drug delivery systems, utilizing proprietary technologies to satisfy unmet
medical needs cost-effectively. The Company's current efforts are primarily
focused on two core areas: a continuous and automatic glucose monitoring
device (the GlucoWatch-Registered- system) and transdermal drug delivery
systems.
The Company's product development efforts have been and are expected to
continue to be either self-funded, funded by licensees or distributors, or
both. In general, the Company's agreements provide that Cygnus will
manufacture its products and receive manufacturing revenues from sales of
these products to its licensees or distributors. Cygnus may also receive
royalties based on certain of its licensees' or distributors' product sales.
In certain circumstances, the Company may elect to license manufacturing
rights for a product to its licensee in exchange for a technology transfer
fee and/or a higher royalty rate.
In 1996, the Company entered into a collaboration with Becton Dickinson
& Company ("Becton Dickinson") for the commercialization of the GlucoWatch
monitor, a continuous and automatic glucose monitoring system that painlessly
extracts and measures glucose levels for people with diabetes. Under the
Becton Dickinson agreement, the Company had granted Becton Dickinson
exclusive worldwide marketing and distribution rights, with the exception of
Japan and Korea. The agreement was amended in June 1997 to grant Becton
Dickinson worldwide marketing rights, with the exception of Japan and Korea,
for the Company's second generation glucose monitor. On March 31, 1998, the
Company announced that the agreement it had with Becton Dickinson had been
terminated. Consequently, the Company will not receive any future milestone
payments under the Becton Dickinson agreement and will not be obligated to
share future revenue, if any, associated with commercialization of the
GlucoWatch monitor. The Company is currently involved in discussions with
other companies with regard to the collaboration for the sales and
distribution of the GlucoWatch monitor in the United States and Europe. There
can be no assurance that the Company will be able to enter into new
collaborative arrangements.
In July 1998, the Company was notified by American Home Products
Corporation (AHP), the licensee for two of the Company's transdermal hormone
replacement products, that AHP
9
CYGNUS, INC.
September 30, 1998
wanted to discuss the status of its agreement with the Company. Cygnus was
notified by AHP that it intended to exercise its right under the agreement to
seek a sublicensee for these products and is now actively involved in doing
so. AHP and Cygnus have negotiated an amendment to the agreement that
provides Cygnus immediate ownership of the regulatory filing packages for the
two products and the right to co-promote the two products as well. The
amendment also provides that if AHP is unable to sign an agreement with a
sublicensee within six months, the rights to the two products will revert to
Cygnus and AHP will be obligated to continue development activities for the
two products for an additional six months. There can be no assurance that AHP
will find a sublicensee. Furthermore, if AHP is unsuccessful in finding a
sublicensee, it is uncertain what course of action the Company will take with
regard to these two products, although it is expected the Company will seek a
new collaboration for the distribution and marketing of the products.
The Company received notification from Warner-Lambert and Sanofi that
Warner-Lambert was terminating its FemPatch system agreement with Sanofi.
Pursuant to the Company's agreement with Warner-Lambert, the termination of
the agreement between Warner- Lambert and Sanofi also terminates the supply
agreement between the Company and Warner- Lambert. The effective date of
termination was November 7, 1998. As a result of this termination the Company
does not expect any future revenues from Warner-Lambert related to the
FemPatch system. The Company and Sanofi are currently discussing potential
alternative marketing arrangements for the FemPatch system. However, there
can be no assurance that the Company will be successful in these discussions
or in its efforts to establish alternative marketing arrangements for the
FemPatch system.
The Company's results of operations vary significantly from year to year
and depend on, among other factors, the signing of new product development
agreements and the timing of recognizing payment amounts specified
thereunder, the timing of recognizing license or distribution fees and cost
reimbursement payments made by pharmaceutical licensees, and the demand for
the Nicotrol patch. Up-front and interim milestone payments from contracts
are generally earned and recognized based on the percentage of actual efforts
expended compared to total expected efforts during the development period for
each contract. However, contract revenues are not always aligned with the
timing of related expenses. To date, research and development expenses have
generally exceeded contract revenue in any particular period and the Company
expects the same situation to continue for the next few years. In addition,
the level of revenues in any given period is not necessarily indicative of
expected revenues in future periods. The Company has incurred net losses each
year since its inception and does not believe it will achieve profitability
in 1998. At September 30, 1998, the Company's accumulated deficit and net
capital deficiency were approximately $161.3 million and $24.4 million,
respectively.
RESULTS OF OPERATIONS:
COMPARISON FOR THE QUARTERS ENDED SEPTEMBER 30, 1998 AND 1997
PRODUCT REVENUES for the quarter ended September 30, 1998 were $0.0
million, compared to $1.8 million for the quarter ended September 30, 1997.
Product revenues were $0.6 million for the nine months ended September 30,
1998 compared to $3.5 million for the nine months ended September 30, 1997.
Product revenue for the nine months ended September 30, 1998 resulted from
the shipments of the FemPatch system. Product revenues for the comparable
1997 period resulted
10
from shipments of the FemPatch system and the Nicotrol patch. As a result of
the termination of the agreement between Warner-Lambert and Sanofi and the
supply agreement between the Company and Warner-Lambert in November 1998, the
Company does not expect any further product revenue related to the FemPatch
system. The reduction in total product revenue for the nine months ended
September 30, 1998 resulted primarily from reduced shipments of the FemPatch
system in the second half of 1998 and from the discontinuation of Nicotrol
patch manufacturing in the first quarter of 1997. Included in third quarter
1997 product revenue were the initial shipments of FemPatch systems.
Due to the discontinuation of Nicotrol patch manufacturing and the
termination of the FemPatch system, the Company does not expect any further
product revenues until new products are commercialized. The Company does,
however, expect to continue to receive royalty revenues from the manufacture
and sale of the Nicotrol Patch by the Company's licensee. There can be no
assurance that the Company will be successful in its efforts to commercialize
any future products.
Due to the above factors and the uncertainty regarding when and if
additional products will obtain approval from the FDA and when and if
licensees will sell and market such products, the Company believes that the
level of product revenues experienced to date is not indicative of future
results and may fluctuate from period to period.
CONTRACT REVENUES for the quarter ended September 30, 1998 were $2.5
million compared to $3.5 million for the quarter ended September 30, 1997 and
were $7.8 million for the nine months ended September 30, 1998 compared to
$11.0 million for the nine months ended September 30, 1997. Contract revenues
primarily reflect labor and material cost reimbursements associated with the
development of certain transdermal delivery systems and the amortization of
milestone payments relating to certain transdermal delivery systems and the
glucose monitoring device. The decrease in contract revenues for the quarter
and nine months ended September 30, 1998 as compared to the comparable 1997
periods is primarily due to a payment of $1.0 million received from
Pharmacia & Upjohn in June 1997 for the exercise of its option to purchase
the manufacturing rights for the Nicotrol patch, a reduction in clinical
billings related to one of the Company's hormone replacement products and
reduced milestone amortization related to the GlucoWatch monitor.
In July 1996, the Company entered into an agreement with Tokyo-based
Yamanouchi Pharmaceutical Co., Ltd. ("Yamanouchi") for the marketing and
distribution of the GlucoWatch monitor. Under the terms of this agreement,
Yamanouchi has exclusive marketing and distribution rights in Japan and
Korea. Cygnus will have primary responsibility for completing product
development and for manufacturing. In the third quarter of 1996, Cygnus
received an up-front, non-refundable payment from Yamanouchi and is eligible
to receive milestone payments as well as a percentage of the product's future
commercial sales. In July 1996, the Company also entered into a development
and marketing agreement with Yamanouchi for a 7-day transdermal product to
deliver a proprietary Yamanouchi compound. In July 1998, Yamanouchi
discontinued the agreement related to the 7-day transdermal product.
Contract revenues are expected to fluctuate from quarter to quarter and
from year to year, and future contract revenues cannot be reasonably predicted.
The contributing factors to achieving contract revenues include, but are not
limited to, future successes in finalizing new collaborative
11
CYGNUS, INC.
September 30, 1998
agreements, timely achievement of milestones under current contracts, and
strategic decisions on self-funding certain projects. The Company is unable
to predict to what extent the termination of existing contracts by current
partners, or new collaborative agreements, if any, will impact overall
contract revenues in the remainder of 1998 and subsequent future periods.
ROYALTY AND OTHER REVENUES for the quarter ended September 30, 1998 were
$0.3 million compared to $0.1 million for the quarter ended September 30,
1997 and were $0.7 million for the nine months ended September 30, 1998
compared to $8.5 million for the nine months ended September 30, 1997. The
net decrease in royalty and other revenues for the nine months ended
September 30, 1998 compared to the nine months ended September 30, 1997 is
primarily due to the 1996 launch in the United States of the non-prescription
Nicotrol patch. The nine months ended September 30, 1997 included the
recognition of previously deferred royalty payments associated with this
launch, whereas no such amortization was included in the nine months ended
September 30, 1998.
Royalty revenue will fluctuate from period to period, since it is
primarily based upon sales by the Company's licensees. The level of royalty
income for a product also depends on various external factors, including the
size of the market for the product, product pricing levels and the ability of
the Company's licensee to market the product. Therefore, the level of royalty
revenue for any given period is not indicative of the expected royalty
revenue for future periods.
COSTS OF PRODUCTS SOLD for the quarter ended September 30, 1998 were
$0.7 million compared to $3.1 million for the quarter ended September 30,
1997 and were $2.7 million for the nine months ended September 30, 1998
compared to $7.1 million for the nine months ended September 30, 1997. Costs
of products sold primarily include direct and indirect production, facility
and personnel costs required to meet future anticipated production levels.
Costs of products sold for the quarter and nine months ended September 30,
1998 include shipments of the FemPatch system. The decrease in costs of
products sold for the quarter and nine months ended September 30, 1998 is
primarily due to the reduced shipments of the FemPatch system. The Company
experienced negative product margins for the quarter and nine months ended
September 30, 1998 and September 30, 1997 due to low production volumes that
prevented the Company from absorbing all of its fixed manufacturing costs.
Because the Company is not currently manufacturing any commercial products,
the Company expects that fixed manufacturing costs will continue to result in
negative product margins for the foreseeable future.
RESEARCH AND DEVELOPMENT EXPENSES for the quarter ended September 30,
1998 were $7.9 million compared to $5.4 million for the quarter ended
September 30, 1997 and were $22.7 million for the nine months ended September
30, 1998 compared to $16.4 million for the nine months ended September 30,
1997. The increase in research and development expenses for the quarter and
nine months ended September 30, 1998 is due primarily to the Company's
accelerated level of clinical activities associated with the GlucoWatch
system. Research and development and clinical activities primarily include
support and development for the glucose monitoring program, the Company's
hormone replacement therapy products and a contraception product. Cygnus
anticipates that the development of new products, continued research of new
technologies and preparation for regulatory filings and clinical trials will
result in an increase in its overall research and development expenses in
future periods.
12
CYGNUS, INC.
September 30, 1998
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the quarter ended
September 30, 1998 were $3.6 million compared to $2.2 million for the quarter
ended September 30, 1997 and were $8.3 million for the nine months ended
September 30, 1998 compared to $6.1 million for the nine months ended
September 30, 1997. While current levels are higher than the prior year,
Cygnus anticipates that marketing, general and administrative expenses may
increase in the future as the Company expands its operations.
ARBITRATION SETTLEMENT EXPENSE for the quarter ended September 30, 1997 of
$39.6 million represents a non-recurring arbitration settlement expense with
Sanofi. As of September 30, 1998, the Company had accrued liabilities related
to the arbitration settlement of $25.4 million. Of the total accrued
liability of $25.4 million, $23.0 million is long-term. Under the terms of
the settlement, Cygnus (i) paid Sanofi $14.0 million in cash in January 1998,
(ii) will make royalty payments of between 6.5% and 8.5% of any and all net
sales of two products, which are subject to minimum payments in an aggregate
amount equal to $17.0 million, commencing in 2001 and ending in 2005, whether
or not any net sales of the two products have occurred, and (iii) issued in
December 1997, a convertible promissory note in the principal amount of $6.0
million, payable in full at the end of four years and bearing interest at
6.5% per annum. The note will be convertible into the Company's Common Stock
at Sanofi's option, exercisable at any time during the four year term, at a
conversion rate of $21.725 per share.
INTEREST INCOME(EXPENSE), NET OF INTEREST AND OTHER EXPENSE for the
quarter ended September 30, 1998 were $(0.2) million compared to $0.3 million
for the quarter ended September 30, 1997 and were $(0.2) million for the nine
months ended September 30, 1998 compared to $0.9 million for the nine months
ended September 30, 1997. The decrease for the quarter and nine months ended
September 30, 1998 is due primarily to higher interest expense associated
with the Company's issuance of the convertible debt, the amortization of the
financing fees related to this debt and the interest related to the
additional long-term debt incurred in the second quarter of 1998.
13
CYGNUS, INC.
September 30, 1998
LIQUIDITY AND CAPITAL RESOURCES
Through December 1997, the Company received net proceeds of
approximately $82.1 million from public offerings of its Common Stock. In
February 1998, the Company received net proceeds of approximately $13.3
million (net of issuance costs of approximately $0.5 million) from a direct
public offering of its Common Stock.
Through 1997, the Company financed approximately $9.7 million of
manufacturing and research equipment under capital loan and lease
arrangements. In the second quarter of 1998, the Company entered into a new
loan agreement for $1.4 million to finance additional capital equipment.
Borrowings under this agreement are secured by specific Company assets.
In April of 1998, the Company consolidated its two outstanding bank
loans into an expanded credit facility with the same bank. An additional $4.7
million was borrowed, increasing the total outstanding under the new
agreement to $10.0 million. This balance will be repaid through October 2001,
with monthly interest-only payments through October 1998, and monthly
principal-and-interest installments thereafter. As of September 30, 1998
there is $10.0 million outstanding under this agreement.
In February 1998, the Company entered into Note Purchase Agreements with
certain institutional investors to issue and sell approximately $43 million
of 4% Senior Subordinated Convertible Notes due 2005 (the "Notes"). On
October 28, 1998, the Company restructured the Notes. Key provisions in the
restructured Notes include the October 1998 repayment of $18.5 million in
principal (reducing the principal balance from $43 million to $24.5 million),
a delay in the convertibility of the majority of the Notes to June 30, 1999,
modification of conversion prices of the notes, the ability of the Company to
redeem at par at any time all or part of the new principal amount of the
Notes, an increase in the interest rate to 5.5% paid annually on the new
principal balance and the change in the final maturity of the Notes to
October 1, 2000 (see Note 5, "Debt and Equity Issuances" in the Notes to the
Condensed Consolidated Financial Statements).
Net cash used in operating activities for the nine months ended
September 30, 1998 was $36.0 million, compared with net cash used of $10.6
million for the nine months ended September 30, 1997. Cash used in operating
activities during the nine months ended September 30, 1998 was primarily due
to the Company's net loss of $24.8 million and a $14.0 million cash payment
made in January 1998 to Sanofi under the terms of the arbitration settlement,
offset by an increase in accounts payable and other accrued liabilities of
$0.7 million, a decrease in notes receivable, prepaid expenses and other
current assets of $0.8 million and a decrease in accounts receivable of $0.7
million. Cash used in operating activities during the nine months ended
September 30, 1997 was primarily due to the Company's net loss of $45.3
million, a decrease of $10.0 million in deferred revenue and an increase of
$3.3 million in notes receivable, prepaid expenses and other current assets.
This was offset by the $39.6 million increase in accrued Sanofi obligations
and a decrease of $7.0 million in accounts receivable.
In addition to the cash received from the public offerings, equipment
lease and short-term working capital financing, the Company has been
financing its operations through revenues and interest income.
14
CYGNUS, INC.
September 30, 1998
The current level of cash used in operating activities is not
necessarily indicative of the level of future cash usage. As a result of
expected increased expenditures for the development of new products,
preparation for regulatory filings and clinical trials and the expected
reduction in product revenues, the Company anticipates an increase in cash
usage for 1998 and future operating activities.
Net cash used in investing activities of $24.6 million for the nine
months ended September 30, 1998 resulted primarily from net purchases of
short-term investments of $22.0 million and capital expenditures of $2.6
million. Net cash used in investing activities of $7.6 million for the nine
months ended September 30, 1997 resulted primarily from net purchases of
short-term investments of $5.0 million and capital expenditures of $2.6
million.
Net cash provided by financing activities of $58.7 million for the nine
months ended September 30, 1998 includes, as mentioned above, net proceeds of
$40.4 million and $13.3 million from the Company's February 1998 issuance of
Senior Subordinated Convertible Notes and from a direct public offering of
its Common Stock, respectively, additional stock proceeds of $0.9 million and
$6.1 million from the issuance of long-term debt, offset by long-term debt
and capital lease repayments of $1.6 million and $0.4 million, respectively.
Net cash provided by financing activities of $2.7 million for the nine months
ended September 30, 1997 includes $2.5 million from the exercise of warrants
to purchase common stock, $1.7 million of common stock issuance proceeds and
$1.3 million received from the Company's capital equipment loan, offset by
long-term debt and capital lease repayments of $1.8 million and $1.0 million,
respectively.
The Company's long-term capital expenditure requirements will depend
upon numerous factors, including: the progress of the Company's research and
development programs; the time required to obtain regulatory approvals; the
resources that the Company devotes to the development of self-funded
products, proprietary manufacturing methods and advanced technologies; the
ability of the Company to obtain additional licensing arrangements and to
manufacture products under those arrangements; the additional expenditures to
support the manufacture of new products, if and when approved; and possible
acquisitions of products, technologies and companies. As the Company
evaluates the progress of its development projects, in particular the
GlucoWatch system, its commercialization plans and the lead time to set up
manufacturing capabilities, Cygnus may commence long-term planning for
another manufacturing site. Nevertheless, the Company believes that such
long-term planning will not result in any material impact on cash flows and
liquidity for 1999.
Based upon current expectations for operating losses, payment of the
$18.5 million related to the restructured Notes in October 1998, arbitration
settlement payments, and projected short-term capital expenditures, the
Company believes that its existing cash, cash equivalents and short-term
investments of $55.2 million as of September 30, 1998 (reduced to $36.7
million as a result of the October 28, 1998 $18.5 million subordinated debt
principal payment), when coupled with cash from revenues and earnings from
investments, will be sufficient to meet its operating expenses and capital
expenditure requirements at least through September 30, 1999. However, there
can be no assurance that the Company will not require additional financing,
depending upon future business strategies, results of clinical trials and
management decisions to accelerate certain research and development programs
and other factors.
15
CYGNUS, INC.
September 30, 1998
RISK FACTORS
POTENTIAL DELISTING OF SECURITIES FROM THE NASDAQ MARKET; LIMITED LIQUIDITY OF
TRADING MARKET
Shares of the Company's Common Stock are quoted on the Nasdaq National
Market. On February 23, 1998 Nasdaq promulgated new rules (the "New Nasdaq
Listing Requirements") that make continued listing of companies on the Nasdaq
National Market more difficult and has significantly increased its
enforcement efforts with regard to the Nasdaq standards for such listing.
Nasdaq's rules as applied to the Company require a $5.00 minimum closing bid
price. On September 30, 1998, the Company received correspondence from Nasdaq
stating that if the Company is unable to demonstrate compliance with the
minimum bid price requirement for continued listing on the Nasdaq National
Market on or before the end of the ninety day period ended December 29, 1998,
the Company's securities will be delisted at the opening of business on
January 2, 1999. The Company can demonstrate compliance with this requirement
by maintaining a $5.00 minimum closing bid price for ten consecutive trading
days. The Company plans to request a hearing with Nasdaq to discuss the
listing requirements. No potential delisting action would take place until
after the hearing.
If the Company is delisted from the Nasdaq National Market, the Company
will be in default under certain material contracts, including certain
subordinated debt arrangements. Such a default under such subordinated debt
arrangements could obligate the Company to redeem such debt at an amount
equal to 110% of the principal amount thereof plus accrued interest.
Furthermore, if the Company is delisted from the Nasdaq National Market,
trading, if any, in the Common Stock would be conducted in the
over-the-counter market on an electronic bulletin board established for
securities that do not meet the Nasdaq National Market or Nasdaq SmallCap
Market listing requirements, or in what are commonly referred to as the
"pinksheets." As a result, an investor would find it more difficult to
dispose of, or to obtain accurate quotations of the price of, the Company's
Common Stock. In addition, if the Company's Common Stock were removed from
the Nasdaq National Market, the Company's Common Stock would be subject to
so-called "penny stock" rules that impose additional sales practice and
market making requirements on broker-dealers who sell and/or make a market in
such securities. Consequently, removal from the Nasdaq National Market, if
it were to occur, could affect the ability or willingness of broker-dealers
to sell and/or make a market in the Company's Common Stock and the ability of
purchasers of the Company's Common Stock to sell their securities in the
secondary market. In addition, if the market price of the Company's Common
Stock is less than $5.00 per share, the Company may become subject to certain
penny stock rules even if still quoted on the Nasdaq National Market. Such
rules may further limit the market liquidity of the Company's Common Stock
and the ability of purchasers to sell such Common Stock in the secondary
market.
The Board of Directors of the Company has approved a proposal (the
"Reverse Stock Split Proposal") to amend the Company's Certificate of
Incorporation to effect a one-for-three reverse stock split of the Company's
outstanding Common Stock, each share having a par value of one-tenth of one
cent (the "Common Stock"), subject to the approval by the stockholders of the
Company. The Reverse Stock Split Proposal provides for the combination and
reclassification of the presently issued and outstanding shares of Common
Stock into a smaller number of shares of identical Common Stock, on the basis
of one share of Common Stock for each three shares of Common Stock previously
issued and outstanding (the "Reverse Stock Split"). Except as may result from
the payment of cash for fractional shares as described below, each
stockholder will hold the same percentage of Common Stock outstanding
immediately following the Reverse Stock Split as each stockholder did
immediately prior to the Reverse Stock Split. If approved by the stockholders
of the Company as provided herein, the Reverse Stock Split will be effected
by an amendment and restatement of the Company's Certificate of Incorporation
(the "Reverse Stock Split Amendment"), and will become effective upon the
filing of the Reverse Stock Split Amendment with the Secretary of State of
Delaware (the "Effective Time"). The following discussion is qualified in its
entirety by the full text of the Reverse Stock Split Amendment, which is
incorporated by reference herein.
At the Effective Time, each share of Common Stock issued and outstanding
will automatically be reclassified and converted into one-third of a share of
Common Stock. Fractional shares of Common Stock will not be issued as a
result of the Reverse Stock Split. Stockholders entitled to receive a
fractional share of Common Stock as a consequence of the Reverse Stock Split
will, instead, receive from the Company a cash payment in U.S. dollars equal
to such fraction multiplied by three times the arithmetic mean average
closing bid price per share of the Common Stock on the Nasdaq Stock Market,
Inc. ("Nasdaq") for the five trading days immediately preceding the Effective
Date.
The primary purpose of the Reverse Stock Split is to increase the per
share price in order to meet the New Nasdaq Listing Requirements. The Company
believes that maintaining the listing of the Common Stock on Nasdaq is in the
best interests of the Company and its stockholders. Inclusion on Nasdaq
increases liquidity and may potentially minimize the spread between the "bid"
and "asked" prices quoted by market makers. Further, continued Nasdaq listing
will avoid the Company being in default under certain material contracts,
including certain debt arrangements, and may enhance the Company's access to
capital and increase the Company's flexibility in responding to anticipated
capital requirements. The Company believes that prospective investors will
view an investment in the Company more favorably if its shares qualify for
listing on Nasdaq.
For the above reasons, the Company believes that the Reverse Stock Split
is in the best interests of the Company and its stockholders, if needed to
remain listed on the Nasdaq National Market. However, there can be no
assurance that the Reverse Stock Split will have the desired consequences.
The Company anticipates that, following the consummation of the Reverse Stock
Split, the Common Stock will trade at a price per share that is significantly
higher than the current market price of the Common Stock. Additionally, the
Company believes that a higher quoted market price per share may encourage
potential new investors, decrease market price volatility and increase the
liquidity of the Common Stock. However, there can be no assurance that,
following the Reverse Stock Split, the Common Stock will trade at three times
the market price of the Common Stock prior to the Reverse Stock Split or will
have the other desired market effects.
If the Reverse Stock Split Proposal is approved by the stockholders at
the Special Meeting, the Board of Directors of the Company may elect not to
file, or to delay the filing of, the Reverse Stock Split Amendment, if it is
not needed for continued Nasdaq listing or if the Board of Directors
determines that filing the Reverse Stock Split Amendment would not be in the
best interest of the Company's stockholders at such time. Factors leading to
such a determination could include, without limitation, any possible effect
on Nasdaq listing or future securities offerings.
DEPENDENCE ON NEW PRODUCTS; UNCERTAINTY OF MARKET ACCEPTANCE
For the Company to be successful, it will need to develop, license, or
acquire new products. Several products based on the Company's technologies
are currently under development by Cygnus and its licensees. Many of these
products (including the GlucoWatch monitor) will require significant
additional development and investment, including preclinical and clinical
testing, prior to their commercialization. From time to time the Company has
experienced delays or setbacks in the development of certain of its products.
For example, the Company experienced development delays in the
miniaturization of the GlucoWatch monitor. There can be no assurance that
the Company will be able to successfully address the problems that may arise
during the development and commercialization process. In addition, there can
be no assurance that such products or future products (including the
GlucoWatch monitor) can or will be successfully developed, prove to be safe
and effective in clinical trials, meet applicable regulatory standards, be
capable of being manufactured in commercial quantities at reasonable cost, be
marketed successfully or achieve market acceptance. Product development
efforts can be terminated by the Company or its licensees and there can be no
assurance that initial product development efforts or third party
collaborations will be successful. If any of the Company's development
programs are not successfully completed, required regulatory approvals or
clearances are not obtained, or products for which approvals or clearances
are obtained are not commercially successful, the Company's business,
financial condition and results of operations would be materially and
adversely affected.
The Company's business is subject to the risks inherent in the
development of new products using new technologies and approaches. There can
be no assurance that unforeseen problems will not develop with these
technologies or applications, that the Company will be able to successfully
address technological challenges it encounters in its research and
development programs or that commercially feasible products will ultimately
be developed by the Company.
Before the Company can market the GlucoWatch monitor, it must first
conduct registration clinical trials using a version of the product designed
for commercial sale, prepare a submission to the FDA and obtain clearance or
approval from the FDA. Approval from other U.S. or foreign government
regulatory agencies may also be required. Each of these stages will involve
certain risks and challenges. The Company has completed research clinical
studies using a commercial version of the product and will be conducting
registration clinical trials for submission to the FDA. There can be no
assurance that the commercial product will produce results that are
substantially equivalent to FDA-approved glucose monitoring products or that
will support the necessary regulatory filings and approvals. In addition, if
the Company receives the necessary regulatory approvals for the GlucoWatch
monitor, there can be no assurance that unforeseen problems will not occur in
product manufacturing and commercial scale-up or marketing or product
distribution. Any such occurrence could significantly delay the
commercialization of the GlucoWatch monitor or prevent its market
introduction entirely. Furthermore, if the GlucoWatch monitor is
successfully developed, the commercial success of the GlucoWatch monitor will
depend on its acceptance in the market.
16
CYGNUS, INC.
September 30, 1998
HISTORY OF OPERATING LOSSES; FUTURE CAPITAL REQUIREMENTS
The Company has a limited operating history upon which its prospects can
be evaluated. Such prospects must be considered in light of the substantial
risks, expenses and difficulties encountered by entrants into the medical
device and drug delivery industry. The Company reported a net loss of $9.6
million for the third quarter of 1998 and has experienced annual operating
losses since inception. The Company expects to continue to incur operating
losses at least until significant sales, if any, of the GlucoWatch monitor or
the contraceptive patch (which is in phase III clinical trails and is
currently in development with Johnson & Johnson) commence. There can be no
assurance that the Company will generate significant revenues or achieve
profitability. The Company has, and expects to have, fluctuations in
quarterly results based on recognition of collaborative and contract revenues
and expenses. Some of these fluctuations could be significant.
To date the Company has generated limited revenues from product sales
and does not have significant experience in manufacturing, marketing or
selling its products. There can be no assurance that the Company's future
development efforts will result in commercially viable products, that the
Company will be successful in introducing its products, or that required
regulatory clearances or approvals will be obtained in a timely manner, or at
all. There can be no assurance that the Company's products will ever gain
market acceptance or that the Company will continue to generate revenues or
achieve profitability.
The Company's revenues to date have been derived primarily from product
development and licensing fees related to its products under development, as
well as from manufacturing and royalty revenues from the Nicotrol patch and
the FemPatch system. The Company will no longer receive manufacturing revenue
from the Nicotrol patch or the FemPatch system. The Company will, however,
continue to receive royalty payments for the Nicotrol patch. The Company
expects that a substantial portion of its future revenues will be derived, if
regulatory approvals are obtained, from sales of the GlucoWatch and other
products currently under development.
The continued development of the Company's products will require the
commitment of substantial resources to conduct the research, preclinical
development and clinical trials necessary to bring such products to market
and to establish production and marketing capabilities. The Company may seek
additional funding through public or private financings, including debt or
equity financings, and through other arrangements, including collaborative
arrangements. Any additional equity financings may be dilutive to
stockholders and debt financing, if available, may involve restrictions on
dividends and other restrictions on the Company. Adequate funds, whether
through financial markets or collaborative or other arrangements with
corporate partners or from other sources, may not be available when needed
or, if available, on terms acceptable to the Company. Lack of sufficient
additional funds may require the Company to delay, scale back or eliminate
some or all of its research and product development programs or to license
others to commercialize products or technologies that the Company would
otherwise seek to develop itself.
The Company believes that its existing cash, cash equivalents and short-
term investments, when coupled with cash from revenues and earnings from
investments, will be sufficient to meet its operating expenses, dept repayment
and capital expenditure requirements at least through September 30, 1999. The
amounts and timing of expenditures will depend on the progress of ongoing
research and development, the results of preclinical testing and clinical
trials, the rate at
17
CYGNUS, INC.
September 30, 1998
which operating losses are incurred, the execution of any development and
licensing agreements with corporate partners, the Company's development of
products, the FDA regulatory process and other factors, many of which are
beyond the Company's control.
GOVERNMENT REGULATION; NO ASSURANCE OF REGULATORY APPROVALS
The design, manufacturing, labeling, distribution and marketing of the
Company's products will be subject to extensive and rigorous government
regulation in the United States and certain other countries where the process
of obtaining and maintaining required regulatory clearance or approvals is
lengthy, expensive and uncertain. In order for the Company to market its
products in the United States, the Company must obtain clearance or approval
from the Untied States Food and Drug Administration ("FDA"). To date, the
Company has two products which have received FDA approval, the Nicotrol patch
and the FemPatch system. Before a regulatory submission can be filed with the
FDA, a product must undergo extensive clinical trials. The Company's drug
delivery systems require the filing of a New Drug Application ("NDA") with
the FDA, and the FDA's approval of the NDA. Devices such as the GlucoWatch
monitor under development by the Company will require the filing and FDA
clearance or approval of a medical device submission. The time required for
regulatory approval of the Company's products after a filing is uncertain.
There can be no assurance that problems will not arise that could delay or
prevent the commercialization of the Company's products or that the FDA and
foreign regulatory agencies will be satisfied with the results of clinical
trials or approve the marketing of any products. Moreover, even if regulatory
approval is granted, such approval may include significant limitations on
indicated uses for which any such products could be marketed.
Based on discussions with the FDA to date, the Company believes that the
submission to the FDA for the GlucoWatch monitor will be in the form of a
premarket notification (a "510(k) notification"), although the final
determination of the type of submission will not be made until FDA submission.
There can be no assurance that the FDA will act favorably or quickly on the
Company's 510(k) submission, or that significant difficulties and costs will
not be encountered during efforts to obtain FDA clearance or approval.
Specifically, the FDA may request additional data or require additional
clinical studies be conducted to obtain 510(k) clearance for one or more of the
Company's products. In addition, there can be no assurance that the FDA will
not require the submission of a premarket approval ("PMA") application to
obtain FDA approval to market one or more of the Company's products. The PMA
process is more rigorous and potentially lengthier than the supporting data and
clinical information, which could materially delay the introduction of the
GlucoWatch monitor. In addition, there can be no assurance that the FDA will
not impose strict labeling or other requirements as a condition of its 510(k)
clearance or PMA, any of which could limit the Company's ability to market its
products. Further, if the Company wishes to modify a product after FDA
clearance of a 510(k) premarket notification or approval of a PMA application,
including changes in indications or other modifications that could affect
safety and efficacy, additional clearances or approvals will be required from
the FDA. Any request by the FDA for additional data or any requirement by the
FDA that the Company conduct additional clinical studies or submit to the more
rigorous and lengthier PMA process could result in a significant delay in
bringing the Company's products to market and substantial additional research
and other expenditures by the Company. Similarly, any labeling or other
conditions or restrictions imposed by the FDA on the marketing of the Company's
products could hinder the Company's ability to effectively market its products.
Any of the foregoing actions by the FDA could delay or prevent
18
CYGNUS, INC.
September 30, 1998
altogether the Company's ability to market and distribute its products and
could have a material adverse effect on the Company's business, financial
condition and results of operations.
A drug or medical device and its manufacturer are subject to continual
review after approval, and later discovery of previously unknown problems
with a product or the manufacturing process may result in restrictions on
such product or the manufacturer, including withdrawal of the product or
products from the market. Failure to comply with applicable regulatory
requirements may, among other things, result in fines, suspensions of
regulatory approvals, product recalls, operating restrictions and criminal
prosecution. In addition, new government regulations may be established that
could delay or prevent regulatory approval of the Company's potential
products. Cygnus is also subject to federal, state and local regulations
regarding work place safety, environmental protection and hazardous and
controlled substance controls, among others.
In order for the Company to market its products under development in
Europe and certain other foreign jurisdictions, the Company and its
distributors and agents must obtain required regulatory registrations or
approvals and otherwise comply with extensive regulations regarding safety,
efficacy and quality in those jurisdictions. Specifically, certain foreign
regulatory bodies have adopted various regulations governing product
standards, packaging requirements, labeling requirements, import
restrictions, tariff regulations, duties and tax requirements. These
regulations vary from country to country. In order to commence sales of the
GlucoWatch monitor in Europe, the Company must receive CE mark certification,
which is an international symbol of quality and compliance with applicable
European medical device directives. To obtain CE certification the Company
must pass a review of the GlucoWatch monitor technical file by a European
Community notified body. Failure to receive CE mark certification or other
foreign regulatory approvals could have a material adverse effect on the
Company's business, financial condition and results of operations. There can
be no assurance that the Company will obtain any other required regulatory
registrations or approvals in such countries or that it will not be required
to incur significant costs in obtaining or maintaining such regulatory
registrations or approvals. Delays in obtaining any registrations or
approvals required to market the Company's products, failure to receive these
registrations or approvals, or future loss of previously obtained
registrations or approvals could have a material adverse effect on the
Company's business, financial condition and results of operations.
DEPENDENCE ON LICENSEES, DISTRIBUTORS AND COLLABORATIVE ARRANGEMENTS
The Company's business strategy for the development, clinical testing,
regulatory approval, manufacturing and commercialization of its products
depends, in large part, upon the Company's ability to selectively enter into
and maintain collaborative arrangements with licensees and distributors. If
the GlucoWatch monitor is commercialized, the Company will be dependent upon
Yamanouchi Pharmaceutical Co., Ltd. for marketing and distribution of the
GlucoWatch monitor in Japan and Korea. The Company does not currently have
any marketing or distribution agreements for the GlucoWatch monitor other
than the Yamanouchi collaboration. However, the Company is currently involved
in discussions with other companies with regard to the collaboration for the
sales and distribution of the GlucoWatch monitor in the United States and
Europe. The Company's licensees and distributors generally have the right to
terminate a product development effort at any time prior to regulatory
approval for any reason without significant penalty. Such cancellations may
result in delays, suspension or abandonment of clinical testing, the
preparation and processing of
19
CYGNUS, INC.
September 30, 1998
regulatory filings and product development and commercialization efforts.
Licensees have exercised this right in the past, and there can be no
assurance that current and future licensees or distributors will not exercise
this right in the future.
Since all payments to the Company under its licensing and distribution
agreements following their execution are contingent on the occurrence of
future events or sales levels, and the agreements are terminable by the
licensee or distributor, no assurance can be given as to whether the Company
will receive any particular payment thereunder or as to the amount or timing
of any such payment. In the past some of the Company's licensees,
distributors and collaborators have approached the Company requesting
modification of the terms of existing agreements. If a licensee or
distributor were to cease funding one of the Company's products, Cygnus would
either self-fund development efforts, identify and enter into an agreement
with an alternative licensee or distributor, or suspend further development
work on the product. Additionally, the Company may choose to self-fund
certain research and development projects in order to exploit its
technologies. However, should such Company-sponsored research and development
activities result in a commercial product, the long-term effect on the
Company's results of operations could be favorable. There can be no assurance
that, if necessary, the Company would be able to negotiate an agreement with
an alternative licensee or distributor on acceptable terms. Any increase in
Company-sponsored research and development or sales and marketing activities
will have an immediate adverse effect on the Company's results of operations.
Furthermore, the resources and attention a licensee or distributor
devotes to a product are not within the Company's control. As a result,
there may be delays in clinical testing, the preparation and processing of
regulatory filings and commercialization efforts conducted by the Company's
licensees or distributors. There can be no assurance that one or more of the
Company's licensees or distributors will not, for competitive reasons,
support, directly or indirectly, a company or product that competes with the
Company's product that is the subject of its license or distributor agreement
with the Company. Furthermore, any dispute between the Company and one of its
licensees or distributors might require the Company to initiate or defend
against expensive litigation or arbitration proceedings.
Any termination of any license or distributor arrangement by one of the
Company's licensees or distributors, any inability of a licensee or
distributor to fund or otherwise satisfy its obligations under its
arrangements with the Company and any significant dispute with, or breach of
a contractual commitment by, a licensee or distributor, would likely require
the Company to seek and reach agreement with another licensee or distributor
or to assume, to the extent possible and at its own expense, all the
responsibilities being undertaken by the licensee or distributor. There can
be no assurance that the Company would be able to reach agreement with a
replacement licensee or distributor. If the Company were not able to find a
replacement licensee or distributor, there can be no assurance that the
Company would be able to perform or fund the activities for which such
licensee or distributor is currently responsible. Even if the Company were
able to perform and fund these activities, the Company's capital requirements
would increase substantially. In addition, the further development and the
clinical testing, regulatory approval process, marketing, distribution and
sale of the product covered by such licensee or distributor would be
significantly delayed. See "Risk Factors - Limited Marketing and Sales
Experience."
20
CYGNUS, INC.
September 30, 1998
For the Company to be competitive, it will need to develop, in-license
or acquire new diagnostic and drug delivery products. Furthermore, the
Company's ability to develop and commercialize products in the future will
depend, in part, on its ability to enter into collaborative arrangements with
additional licensees on favorable terms. There can be no assurance that the
Company will be able to enter into new collaborative arrangements on such
terms, if at all. Additionally, there can be no assurance that existing or
future collaborative arrangements will be successful.
Any of the foregoing circumstances could have a material adverse effect
upon the Company's business, financial condition, and results of operations.
DEPENDENCE ON LICENSED PATENT APPLICATIONS AND PROPRIETARY TECHNOLOGY
The Company's success depends in large part on its ability to obtain
patent protection for its products, preserve its trade secrets and operate
without infringing the proprietary rights of others, both in the U.S. and in
other countries. Patent applications in the U.S. are maintained in secrecy
until patents are issued, and since publication of discoveries in the
scientific or patent literature tends to lag behind actual discovery by
several months, Cygnus cannot be certain that it was the first to file patent
applications on such inventions or that it will not infringe third party
patents once issued. No assurance can be made that patents will be issued
with respect to any of the Company's patent applications or that any patents
will provide competitive advantages for its products or will not be
challenged or circumvented by competitors. Cygnus also relies on trade
secrets and proprietary know-how that it seeks to protect, in part, by
confidentiality agreements with its licensees, employees and consultants.
There can be no assurance that these agreements will not be breached, that
the Company would have adequate remedies for any breach or that the Company's
trade secrets will not otherwise become known or be independently developed
by its competitors.
Any litigation, in the U.S. or abroad, as well as foreign opposition
and/or domestic interference proceedings, could result in substantial expense
to the Company and significant diversion of effort by the Company's technical
and management personnel. Litigation may be necessary to enforce patents
issued to the Company or to protect trade secrets or know-how owned by the
Company as well at to defend against infringement charges. A negative
determination in such proceedings in which the Company is a party could
subject the Company to significant liabilities to third parties or require
the Company to seek licenses from third parties. Although patent and
intellectual property disputes in the pharmaceutical product area have often
been settled through licensing or similar arrangements, costs associated with
such arrangements may be substantial and could include ongoing royalties.
Furthermore, there can be no assurance that necessary licenses would be
available to the Company on satisfactory terms, if at all. Accordingly, an
adverse determination in a judicial or administrative proceeding or failure
to obtain necessary licenses could prevent the Company from manufacturing and
selling certain of its products, which would have a material adverse effect
on the Company.
21
CYGNUS, INC.
September 30, 1998
HIGHLY LEVERAGED; ABILITY TO SERVICE DEBT
As of September 30, 1998, prior to the $18.5 million reduction in
convertible debt pursuant to the debt restructuring agreement concluded on
October 28,1998 (see Note 5 "Debt and Equity issuances"), the Company had
indebtedness of $81.6 million, including $43.0 million resulting from the
issuance by the Company of its 4% Senior Subordinated Convertible Notes due
2005 (the "Notes") in February 1998. The October restructuring agreement
mentioned above, among other things, accelerated the due date to October 1,
2000. The degree to which the Company is leveraged could materially adversely
affect the Company's ability to obtain financing for working capital,
acquisitions or other purposes and could make it more vulnerable to industry
downturns and competitive pressures. The Company's ability to meet its debt
service obligations will be dependent upon the Company's future performance,
which will be subject to financial, business and other factors affecting the
operations of the Company, many of which are beyond its control. Although the
Company believes its cash flows will be adequate to meet its interest
payments, there can be no assurance that the Company will continue to
generate cash flows in the future sufficient to cover its fixed charges or to
permit the Company to satisfy any redemption obligations pursuant to the
Notes (see below). If the Company is unable to generate cash flows in the
future sufficient to cover its fixed charges or to permit the Company to
satisfy any redemption obligations pursuant to the Notes, and the Company is
unable to borrow sufficient funds either under its credit facilities or from
other sources, it may be required to refinance all or a portion of its
existing debt, to sell all or a portion of its assets, or to sell equity
securities. There can be no assurance that a refinancing would be possible,
nor can there be any assurance as to the timing of any asset sales or sales
of equity securities or the proceeds which the Company could realize
therefrom.
The Notes are subordinate in right of payment to all existing and future
Senior Debt (as defined in the First Supplemental Indenture). By reason of
such subordination of the Notes, in the event of insolvency, bankruptcy,
liquidation, reorganization, dissolution or winding up of the business of the
Company or upon default in payment with respect to any Senior Debt of the
Company or an event of default with respect to such indebtedness resulting in
the acceleration thereof, the assets of the Company will be available to pay
the amounts due on the Notes only after all Senior Debt of the Company has
been paid in full. Moreover, holders of Common Stock would only receive the
assets remaining after payment of all indebtedness and preferred stock, if
any.
The Notes are obligations exclusively of the Company. Although the Company
does not currently conduct operations through subsidiaries, it may elect to do
so as products become commercialized. In such event, the cash flow and the
consequent ability to service debt, including the Notes, of the Company, will
be partially dependent upon the earnings of its subsidiaries and the
distribution of those earnings to, or upon loans or other payments of funds by
those subsidiaries to, the Company. The payment of dividends and the making of
loans and advances to the Company by its subsidiaries would be subject to
statutory or contractual restrictions, would be dependent upon the earnings of
those subsidiaries and would be subject to various business considerations.
Any right of the Company to receive assets of any of its subsidiaries upon
their liquidation or reorganization (and the consequent right of the holders of
the Notes (the "Holder(s)") to participate in those assets) would be effectively
subordinated to the claims of that subsidiary's creditors (including trade
creditors), except to the extent that the Company is itself recognized as a
creditor of such subsidiary, in which case the claims of the Company would
still be subordinate to any
22
CYGNUS, INC.
September 30, 1998
security interests in the assets of such subsidiary and any indebtedness of
such subsidiary senior to that held by the Company. Under certain
circumstances, including the delisting of the Company's securities from the
Nasdaq National Market, each holder of Notes will have the right, at the
Holder's option, to require the Company to repurchase all or a portion of
such Holder's Notes at a purchase price equal to 110% of the principal amount
thereof plus accrued interest thereon to the repurchase date.
COMPETING PRODUCTS AND CHANGES IN TECHNOLOGY
A large number of companies are involved or are becoming involved in the
development and commercialization of products incorporating diagnostic and
drug delivery systems. This field is highly competitive, and Cygnus believes
that competition will substantially increase in the future. A number of
companies have invested, and are continuing to invest, significant resources
in the development of diagnostic and drug delivery systems. Many of these
companies have greater financial, research and development and other
resources than Cygnus, as well as more experience than Cygnus in
commercializing diagnostic and transdermal drug delivery products. Such
companies may improve existing drug formulations and products more
efficiently than Cygnus or may design and develop new diagnostic and
transdermal drug delivery products which are more accepted in the marketplace
than the Company's products.
The Company's primary competitors in the glucose monitoring industry are
expected to be companies that currently market finger stab method products.
These companies have established products and distribution channels. In
addition, a number of companies are engaged in the development of products
using technology that is different than that used by Cygnus, but that are also
intended to permit less painful or painless glucose monitoring. These
technologies include infrared spectroscopy, which uses radiation to measure
glucose levels, and a variety of methods (including, in one case, transdermal
technology) to extract interstitial fluid and measure the glucose concentration
therein. The Company is not aware of any products under development that offer
the range of benefits of the GlucoWatch monitor. However, there can be no
assurance that these products will not be more accepted in the marketplace than
the GlucoWatch monitor or will not render the Company's glucose monitor
uncompetitive or obsolete. A number of companies have developed or are seeking
to develop new drugs to treat diabetes that could reduce demand for glucose
monitoring systems. In addition, many of the Company's competitors and
potential competitors have substantially greater resources, research and
development staffs and facilities than the Company and have significantly
greater experience than the Company in developing, manufacturing and marketing
glucose monitoring devices. Competition within the glucose monitoring industry
could also result in price reductions for glucose monitoring devices such that
the Company may not be able to sell the GlucoWatch monitor at a price level
adequate for the Company to realize a return on its investment.
The drug delivery industry is a rapidly evolving field. A number of other
companies, including major pharmaceutical companies, are also developing and
marketing transdermal and other similar systems for the controlled delivery of
drugs. Products currently on the market or under development by competitors
deliver the same drugs or other drugs to treat the same indications as many of
the products under development by the Company. The first pharmaceutical product
to reach the market in a therapeutic area often obtains and maintains
significant market share relative to later entrants to the market. The
Company's transdermal products will also compete with drugs
23
CYGNUS, INC.
September 30, 1998
marketed not only in similar drug delivery systems but also in traditional
dosage forms such as oral administration, bolus injection and continuous
infusion. New drugs, new therapeutic approaches or future developments in
alternative drug delivery technologies, such as time-release capsules,
liposomes, inhalants, and implants, may provide therapeutic or cost
advantages over the drug delivery systems being developed by the Company.
MANUFACTURING; DEPENDENCE ON THIRD PARTY SUPPLIERS
Any manufacture of the Company's products is subject to current good
manufacturing practices ("cGMP") requirements prescribed by the FDA or other
standards prescribed by the appropriate regulatory agency in the country of
use. Additionally, the Company's agreements with licensees either specify
pricing formulas for products manufactured and sold by Cygnus to its
licensees or specify that prices will be negotiated in the future. There can
be no assurance that prices for the Company's products will cover the
manufacturing costs for these products in light of the Company's limited
manufacturing experience and general supply and demand conditions in the
marketplace.
The Company's GlucoWatch monitor has not yet been manufactured for
commercial sale, and the Company has no experience manufacturing the
GlucoWatch monitor in the volumes that would be necessary for the Company to
achieve significant commercial sales. To successfully commercialize the
GlucoWatch monitor, the device will have to be manufactured in compliance
with regulatory requirements, in a timely manner and in sufficient quantities
while maintaining product performance, quality and acceptable manufacturing
costs. There can be no assurance that the Company will be able to establish
and maintain reliable, full scale manufacturing of the GlucoWatch monitor at
commercially reasonable prices. Manufacturers often encounter difficulties in
scaling up production of new products, including problems involving product
performance, production yields, quality control and assurance and shortages
of personnel. In addition, manufacturing facilities will be subject to GMP
regulations, including possible preapproval inspection, international quality
standards and other regulatory requirements. Difficulties encountered by the
Company in manufacturing scale-up or failure by the Company to implement and
maintain manufacturing facilities in accordance with GMP regulations,
international quality standards or other regulatory requirements could result
in a delay or termination of production, which could have a material adverse
effect on the Company's business, financial condition and results of
operations.
In the past, the Company has experienced these problems in scaling up its
products for commercial launch. There can be no assurance that similar
problems will not be encountered in the future. In addition, there can be no
assurance that the Company will be able to achieve and maintain product
performance quality and reliability if and when producing the GlucoWatch
monitor in the quantities required for commercialization, nor that the
GlucoWatch monitor can be assembled and manufactured at an acceptable cost.
The GlucoWatch monitor will be manufactured from components to be
purchased from outside suppliers, most of which are the Company's single source
for such components. In the event the Company is unable to obtain these
components from its suppliers, the Company would be required to obtain
components from alternate suppliers. Any interruption in the supply of
24
CYGNUS, INC.
September 30, 1998
GlucoWatch monitor components could have a material adverse effect on the
Company's business, financial condition and results of operations.
Several materials used in the Company's transdermal products are
currently obtained from single sources. Although the Company has not
experienced difficulty acquiring these materials for the manufacture of its
products for sale or clinical trials, there can be no assurance that supply
interruptions will not occur or that the Company will not have to obtain
substitute vendors, if such vendors are available, which could require
additional regulatory submissions and approvals. Any such interruption of
supplies could have a material adverse effect on the Company's ability to
develop, manufacture and sell its transdermal products.
LIMITED MARKETING AND SALES EXPERIENCE
The Company has limited experience in marketing or selling medical
device products. In order to successfully market and sell the GlucoWatch
monitor or the Company's other products under development, the Company must
either develop a more extensive marketing and sales force or enter into
arrangements with third parties to market and sell such products. There can
be no assurance that the Company will be able to successfully develop a more
extensive marketing and sales force or that it will be able to enter into
marketing and sales agreements with third parties on acceptable terms, if at
all. If the Company maintains its own marketing and sales capabilities, it
will compete with other companies that have experienced and well-funded
marketing and sales operations. If the Company enters into a marketing
arrangement with a third party for the marketing and sales of the Company's
products, any revenues to be received by the Company from such products will
be dependent on the third party, and the Company will likely be required to a
pay a sales commission or similar amount to such party.
THIRD-PARTY REIMBURSEMENT
Successful commercialization of certain of the Company's products may
depend in part on the availability of reimbursement from third-party health
care payors, such as private insurance plans and the government. There can be
no assurance that such reimbursement will be available. Third-party payors
are increasingly attempting to contain health care costs by limiting both
coverage and the level of reimbursement for new therapeutic and diagnostic
products. There can be no assurance that adequate levels of reimbursement
will be available to enable the Company to achieve market acceptance of the
GlucoWatch monitor or other new products under development or to maintain
price levels sufficient to realize an appropriate return on its investment.
In certain international countries, the period of time needed to obtain such
reimbursement can be lengthy. The Company may delay the launch of its
products into certain countries until eligibility for reimbursement is
established. This could potentially have an adverse effect on the Company.
PRODUCT LIABILITY
The design, development, manufacture and use of the Company's products
involve an inherent risk of product liability claims and associated adverse
publicity. Producers of medical products may face substantial liability for
damages in the event of product failure or if it is alleged the product caused
harm. The Company currently maintains product liability insurance. Such
insurance is expensive and difficult to obtain and may not be available in the
future on acceptable
25
CYGNUS, INC.
September 30, 1998
terms or at all. There can be no assurance, however, that the Company will
not be subject to product liability claims, that the Company's current
insurance would cover such claims, or that adequate insurance will continue
to be available on acceptable terms to the Company in the future. In the
event the Company is held liable for damages in excess of the limits of its
insurance coverage, or if any claim or product recall results in significant
adverse publicity against the Company, the Company's business, financial
condition and results of operations could be materially and adversely
affected.
ATTRACTING AND RETAINING KEY EMPLOYEES
The Company's ability to operate successfully and manage its potential
future growth depends in significant part upon the continued service of
certain key scientific, technical, managerial and finance personnel, and its
ability to attract and retain additional highly qualified scientific,
technical, managerial and finance personnel. The Company faces intense
competition for qualified personnel in these areas, many of whom are often
subject to competing employment offers, and there can be no assurance that
the Company will be able to attract and retain such personnel. The loss of
key personnel or inability to hire and retain additional qualified personnel
in the future could have a material adverse effect on the Company's business,
financial condition and results of operations.
VOLATILITY OF STOCK PRICE
The trading price of the Company's Common Stock is subject to
substantial fluctuations in response to factors such as announcements by the
Company or its competitors of results of regulatory approval filings or
clinical trials or testing, developments or disputes governing proprietary
rights, technological innovations or new commercial products, government
regulatory action, general conditions in the medical technology industry,
changes in securities analysts' recommendations, or other events or factors,
many of which are beyond the Company's control. In addition, the stock market
in general has experienced extreme price and volume fluctuations in recent
years which have particularly affected the market prices of many medical
technology companies and which have been unrelated to the operating
performance of such companies. Fluctuations or decreases in the trading
price of the Company's Common Stock may adversely affect the market for the
Company's Common Stock. In the past, following periods of volatility in the
market price for a company's securities, securities class action litigation
often has been instituted. Such litigation could result in substantial costs
and a diversion of management attention and resources, which could have a
material adverse effect on the Company's business, financial condition and
operating results.
If all the first tranche Notes (see Note 5 "Debt and Equity issues")
convert at $3.5375 before January 31, 1999, an additional 1.7 million shares
will be issued resulting in a substantial dilution of the Company's Common
Stock. Conversion of the remaining $18.5 million outstanding principal
balance of the Notes will have an additional dilutive effect. However,
because the conversion prices of the second and third tranches will be
established based on future market prices that cannot be predicted, and
because the Company has the right to redeem the $18.5 million outstanding
principal of the Note subject to the preemptive conversion right of the Note
holders, the Company is unable to predict the extent of this dilution. For
further details on the formulas used in determining conversion prices refer
to the Second Supplemental Indenture incorporated by reference in the Form
8-K filed on October 30, 1998.
26
CYGNUS, INC.
September 30, 1998
ABSENCE OF DIVIDENDS
The Company has never declared or paid cash dividends on its Common
Stock. The Company's current bank term loan precludes it from paying
dividends to stockholders. The Company currently intends to retain any
earnings for use in its business and therefore does not anticipate paying any
dividends in the future.
CERTAIN CHARTER AND BYLAW PROVISIONS AND DELAWARE ANTI-TAKEOVER STATUTE
On September 21,1993, while a California Corporation, the company
adopted a Shareholder Rights Agreement. In November 1998, as a result of the
Company's reincorporation in Delaware and the passage of time, the Company
adopted a revised Stockholder Rights Plan (the "Rights Plan") with provisions
very similar to those in the 1993 agreement. Such provisions provide for a
dividend distribution of one Preferred Share Purchase Right (a "Right") on
each outstanding share of the Common Stock. Each Right entitles stockholders
to buy 1/1000th of a share (a "Unit") of the Company's Series A Junior
Participating Preferred Stock at an exercise price of $40.00 per Unit. The
Rights will become exercisable upon the earlier of (i) the close of business
on the first date of a public announcement that a person or a group acquires
20 percent or more of the outstanding Common Stock or (ii) ten business days
(or such later date as may be determined by the Board of Directors) after a
person or group commences or announces the intention to commence a tender or
exchange offer, the consummation of which would result in ownership by the
person or group of 20 percent or more of the Common Stock. The Company will
be entitled to redeem all, but not less than all, the outstanding Rights at
$0.01 per Right at any time prior to the earlier of (i) the first date of a
public announcement of an acquisition by a person or group of 20 percent or
more of the Company's Common Stock or (ii) the close of business on the tenth
anniversary of the Rights Plan.
The Stockholder Rights Plan and certain provisions of the Company's
Amended and Restated Certificate of Incorporation ( the "Restated Certificate")
and the Company's Bylaws may have the effect of making it more difficult for a
third party to acquire, or of discouraging a third party from attempting to
acquire control of the Company. Such provisions could limit the price that
certain investors might be willing to pay in the future for shares of Common
Stock. The Company's Restated Certificate allows the Company to issue Preferred
Stock without the vote of or further action by the stockholders and certain
provisions of the Restated Certificate and the Bylaws eliminate the right of
stockholders to act by written consent without a meeting, specify procedures
for director nominations by stockholders and submission of other proposals for
consideration at stockholder meetings, and eliminate cumulative voting in the
election of directors. These provisions and the Stockholder Rights Plan may
make it more difficult for stockholders to take certain corporate actions and
could have the effect of delaying or preventing a change in control of the
Company. In addition, the Company is subject to Section 203 of the Delaware
General Corporation Law which, subject to certain exceptions, prohibits a
Delaware corporation from engaging in any business combination with any
interested stockholder for a period of three years following the date that such
stockholder became an interested stockholder, unless (1) prior to such date,
the Board of Directors of the corporation approved either the business
combination or the transaction which resulted in the stockholder becoming an
interested stockholder, or (2) upon consummation of the transaction which
resulted in the stockholder becoming an interested
27
CYGNUS, INC.
September 30, 1998
stockholder, the interested stockholder owned at least 85% of the voting
stock of the corporation outstanding at the time the transaction commenced,
excluding for purposes of determining the number of shares outstanding of
those shares owned (i) by persons who are directors and also officers and
(ii) employee stock plans in which employee participants do not have the
right to determine confidentially whether shares held subject to the plan
will be tendered in a tender or exchange offer, or (iii) on or subsequent to
such time the business combination is approved by the board of directors and
authorized at an annual or special meeting of stockholders, and not by
written consent, by the affirmative vote of at least 66 2/3% of the
outstanding voting stock which is not owned by the interested stockholder.
28
CYGNUS, INC.
September 30, 1998
YEAR 2000 COMPLIANCE
The Year 2000 ("Y2K") program at the Company is comprised of the following
major phases:
1. Awareness
2. Inventory
3. Assessment
4. Correction and Testing
5. Implementation
The Company expects to complete the awareness, inventory and most of the
assessment phases by the end of 1998
Y2K issues pertaining to Information Technology ("IT") systems are
expected to be minor due to the newness of the core systems and the relative
simplicity of their application today. Certain externally provided systems
and services are non-compliant. Renovating/replacement, testing, and
implementation of these systems are not expected to be a major risk.
Due to the regulatory requirements placed on the pharmaceutical and
medical device industry by the FDA, the Company has placed appropriate
attention on the non-IT systems. For the Company, this specifically covers
all areas governed by current Good Manufacturing Practice ("cGMP") guidelines
and include but are not limited to environmental monitoring/control systems,
laboratory instrumentation and their sub-systems, production equipment, and
materials handling equipment.
The Company has identified several providers of products and services
that are critical to its operations. The Company is working with these
providers to ensure that these critical products and services are available
for continued operations after January 1, 2000. At this time the Company is
not aware of any issues relating to these providers.
There is currently no reliable estimate of the total Y2K remediation
costs. This will be available by the end of December 1998, and will be
published in the 1998 SEC 10-K filing.
29
CYGNUS, INC.
September 30, 1998
Direct costs planned in 1998 for completion up to the Assessment phase are
approximately $100,000.
The preliminary perspective on the anticipated Y2K risks for the Company
is at a low level of risk on the IT side, and at a higher risk level with
several critical materials and services and their respective providers. Full
detail on these will not be known until the end of 1998.
At this time, the Company has not identified any Y2K items requiring a
contingency plan.
30
CYGNUS, INC.
September 30, 1998
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
In May 1997 Cygnus reported it had initiated arbitration proceedings against
Pharmacia & Upjohn ("Pharmacia") relating to the Nicotrol-Registered
Trademark- patch (Pharmacia AB, Stockholm, Sweden), Cygnus' smoking cessation
patch. In March of 1997, Cygnus announced that Pharmacia exercised its option
to purchase the U.S. manufacturing rights for the Nicotrol patch. The
agreement between Cygnus and Pharmacia provided that Pharmacia would be
obligated to pay Cygnus for, among other things, existing inventory costs and
certain purchase order commitments. Pharmacia disputes their obligations
regarding certain of the inventory costs and certain purchase order
commitments. The arbitration is intended to resolve these matters. In March
1998, Pharmacia added a counterclaim against Cygnus in the arbitration,
seeking approximately $1.5 million in reimbursement for an alleged
overpayment in royalties for Nicotrol units shipped in 1996 and 1997. Cygnus
disputes this counterclaim. The arbitration hearing on both Cygnus' claim and
Pharmacia's counterclaim commenced on June 15, 1998 before a panel of the
American Arbitration Association. Testimony concluded on June 24, 1998, at
which time the panel heard argument and scheduled post-hearing briefings.
Both sides submitted their post-hearing briefs on July 17, 1998. The panel
has not yet closed the hearing proceedings and still has the option to
request more evidence or argument. Once the proceedings are closed, a
decision is expected within 30 days of that date. See the Company's quarterly
reports on Form 10-Q for the quarter ended March 31, 1998 and June 30, 1998,
filed with the Securities and Exchange Commission ("SEC") on May 15, 1998 and
August 4, 1998, respectively, and the Company's annual report on Form 10-K
for the year ended December 31, 1997, filed with the SEC on February 6, 1998.
31
CYGNUS, INC.
September 30, 1998
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
a) EXHIBITS
The following exhibits are filed herewith or incorporated by reference:
4.8 Second Supplemental Indenture, dated as of October 28, 1998, to
the Indenture dated as of February 3, 1998 and the First
Supplemental Indenture dated as of February 3, 1998, incorporated
by reference to Exhibits 4.8 of the Company's Form 8-K filed on
October 30, 1998.
10.37 1994 Stock Option/Award Plan (As Amended and Restated as of
February 24, 1998), incorporated by reference to Exhibit 99.1 of
the Company's Form S-8 filed on November 16, 1998.
10.38 Amended 1991 Employee Stock Purchase Plan (As Amended and
Restated as of February 24, 1998), incorporated by reference to
Exhibit 99.6 of the Company's Form S-8 filed on November 16, 1998.
10.39 Plan Amendment Cygnus, Inc. 1994 Stock Option/Award Plan,
incorporated by reference to Exhibit 99.2 of the Company's Form
S-8 filed on November 16, 1998.
10.40 Form of Special Addendum to Stock Option Agreement (Change in
Control), incorporated by reference to Exhibit 99.3 of the
Company's Form S-8 filed on November 16, 1998.
10.41 Form of Special Addendum to Stock Option Agreement (Termination
of Employment Without Cause - Officers), incorporated by
reference to Exhibit 99.4 of the Company's Form S-8 filed on
November 16, 1998.
10.42 Form of Special Addendum to Stock Option Agreement (Termination
of Employment Without Cause - Key Employee), incorporated by
reference to Exhibit 99.5 of the Company's Form S-8 filed on
November 16, 1998.
10.43 Written Compensation Agreement between Registrar and Mr. Marion,
incorporated by reference to Exhibit 99.7 of the Company's Form
S-8 filed on November 16, 1998.
10.44 Stock Option Agreement between Registrar and Mr. Marion,
incorporated by reference to Exhibit 99.8 of the Company's Form
S-8 filed on November 16, 1998.
10.45 Amended and Restated Loan and Security Agreement between the
Registrant and Silicon Valley Bank entered into as of April 30,
1998.
10.46 Form of Agreement between the Company and each of the Executive
Officers with respect to post-employment benefits.
10.47 Form of Agreement between the Company and each of the Executive
Officers with respect to post-employment benefits relating to
change of control.
32
CYGNUS, INC.
September 30, 1998
27.1 Financial Data Schedule.
b) REPORTS ON FORM 8-K
The Company has recently filed three current Reports on Form 8-K.
The first Report on Form 8-K was dated August 11, 1998 regarding the
Company's press release announcing the resignation of Gregory B. Lawless
as President, Chief Executive Officer and a Director of the Company and
the appointment of John C. Hodgman as President, Chief Executive Officer
and a Director of the Company and the naming of Andre F. Marion as Vice
Chairman, as filed with the Securities and Exchange Commission on August
21, 1998.
The second Report on Form 8-K was dated October 22, 1998 regarding the
Company's press release announcing its earnings for the quarter ended
September 30, 1998, as filed with the Securities and Exchange Commission
on October 28, 1998.
The third Report on Form 8-K was dated October 30, 1998 regarding the
restructuring of the Company's 4% Senior Subordinated Convertible Notes
due 2005, as filed with the Securities and Exchange Commission on October
30, 1998.
33
CYGNUS, INC.
September 30, 1998
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.
CYGNUS, INC.
Date: November 16, 1998 By: /s/ John C. Hodgman
------------------------------ -------------------------------
John C. Hodgman
President, Chief Executive Officer
and Chief Financial Officer
(and Principal Accounting Officer)
34
CYGNUS, INC.
September 30, 1998
INDEX OF EXHIBITS
The following exhibits are included herein:
Exhibit 10.45 Amended and Restated Loan and Security Agreement between the
Registrant and Silicon Valley Bank entered into as of April 30,
1998.
Exhibit 10.46 Form of Agreement between the Company and each of the Executive
Officers with respect to post-employment benefits.
Exhibit 10.47 Form of Agreement between the Company and each of the Executive
Officers with respect to post-employment benefits relating to
change of control.
Exhibit 27 Financial Data Schedule.