Item 1. Business
OVERVIEW
SciClone Pharmaceuticals, Inc. is a biopharmaceutical company engaged in the development and commercialization of novel therapeutics to treat life-threatening diseases. Our strategy is to in-license products in the areas of cancer and viral infectious diseases, and to develop them for commercialization in the major pharmaceutical markets with a particular focus on China, one of the world’s fastest growing pharmaceutical markets. Our lead product ZADAXIN® (thymalfasin) is one of the largest selling imported drugs in China today, and currently is in late-stage clinical development in Europe for the treatment of malignant melanoma and hepatitis C virus (HCV). We expect that our proprietary in-licensed compound SCV-07 will enter phase 2 clinical development for viral infectious disease in the second quarter of 2007. In addition to our current product portfolio, we believe we are well-positioned to in-license additional therapeutics for both China and the significantly larger U.S. and European markets, in part because of our ability to rapidly and cost-effectively develop and commercialize these products in China. Also, we intend to use this clinical work to support and accelerate regulatory applications in the United States and Europe.
As part of our strategy, in June 2006 we in-licensed the Chinese marketing rights to DC Bead™, a product for the treatment of liver cancer or hepatocellular carcinoma (HCC), and submitted a regulatory application to the Chinese State Food and Drug Administration (SFDA) in December 2006. We are building upon our successful business in China by enhancing our clinical and regulatory capabilities. Concurrently, we intend to in-license or acquire additional products to expand our pipeline of development- and commercial-stage therapeutics for this market.
We and our European partner Sigma-Tau S.p.A are developing thymalfasin for the treatment of malignant melanoma and hepatitis C for the United States and European markets. Sigma-Tau is conducting a phase 2 malignant melanoma trial which includes 485 patients diagnosed with stage IV malignant melanoma, the most advanced form of the disease. Interim data from the first four arms of this five-arm trial showed that the addition of 3.2 mg of thymalfasin to standard dacarbazine (DTIC) chemotherapy increased patients’ median survival to 10.2 months, compared to 6.6 months for patients treated with DTIC chemotherapy with interferon alpha. In addition, such interim data showed that patients treated with thymalfasin and DTIC chemotherapy without interferon alpha achieved more than double the overall tumor response as compared to the control group treated with DTIC and low dose interferon alpha. We expect final survival and tumor response data to be reported in mid-2007. After the data are reported, SciClone and Sigma-Tau plan to share these data with the U.S. Food and Drug Administration (FDA) and European Agency for the Evaluation of Medical Products (EMEA) and
determine the optimal dose and design for a phase 3 clinical trial. In addition, Sigma-Tau is evaluating the triple therapy of thymalfasin, pegylated interferon alpha and ribavirin in hepatitis C patients through a phase 3 European clinical trial. Sigma-Tau completed the full enrollment of 553 HCV interferon alpha and ribavirin non-responder patients in December 2006 and we expect to report data from this trial in late 2008.
SciClone’s proprietary drug development candidate SCV-07 is planned to enter phase 2 clinical development in the U.S. for the treatment of viral infectious diseases in the second quarter 2007. In September 2006, we reported results from a phase 1 trial demonstrating SCV-07’s oral bioavailability, which broadens the compound’s therapeutic potential. In addition, we are conducting several ongoing animal model studies in a variety of disease indications.
SciClone Pharmaceuticals, Inc. was organized in 1990 as a California corporation and reincorporated in Delaware in 2003. Our corporate headquarters are located in San Mateo, California. For information about our revenues from external customers, measures of our profit and loss, our total assets and other financial matters, you should read our Consolidated Financial Statements provided in Part II, Item 8 of this Form 10-K.
STRATEGY
SciClone’s objective is to build a leading pharmaceutical business in China and develop and commercialize select products for the significantly larger United States and European markets. Over the last decade in China, we have established a successful sales and marketing organization and extensive importation and distribution channels. Through our dedicated sales force of more than 120 Chinese medical representatives, we have established a good reputation and relationships with physicians and administrators in over 500 hospitals in the major cities in China and have a strong commercial presence in liver disease, cancer and the intensive care setting. As a result of these efforts ZADAXIN is one of the top-selling imported pharmaceutical products in China. We actively are expanding our clinical development and regulatory capabilities in China to develop and commercialize additional products by working with established Contract Research Organizations (CROs) to conduct good clinical practice (GCP) and International Conference on Harmonization (ICH)-standard clinical trials and file regulatory documents with the SFDA. In 2006, we in-licensed the exclusive China marketing rights to DC Bead to complement our capabilities in the oncology sector. We expect to initiate a DC Bead liver cancer clinical trial in China in 2007.
Our current product development efforts in the U.S. and European markets are focused on the development of ZADAXIN for malignant melanoma (currently in a phase 2 trial) and hepatitis C (currently in a phase 3 trial). Trials for both indications are currently being conducted in Europe by Sigma-Tau, our partner for ZADAXIN for the European market. We expect to report results of the phase 2 malignant melanoma trial in mid-2007 and initiate a U.S. and European phase 3 trial for this indication in late 2007. We expect that our other proprietary drug development candidate SCV-07 will enter phase 2 clinical development in the United States for the treatment of viral infectious diseases in the second quarter of 2007. We intend to build on our experience developing therapeutics that target life-threatening diseases by focusing our in-licensing activities in the areas of cancer and viral infectious diseases.
A key factor in the successful execution of our strategy is the in-licensing of promising and attractive development-stage product candidates. Our targeted source of these potential products will be small- to mid-sized research-focused biotechnology companies based in the United States and Europe seeking to advance the development of their products rapidly and cost-effectively primarily for their home markets. We believe that one of our main competitive advantages in securing such licenses, for the U.S. or European markets in addition to the China market, is our proven ability to develop and commercialize novel biopharmaceutical products in China.
BUILDING A LEADING PHARMACEUTICAL BUSINESS IN CHINA
The China Pharmaceutical Market
According to IMS Health estimates, the pharmaceutical market in China in 2005 was approximately $12 billion, and it is estimated to grow at an average annual rate of 15% to 20% for the next several years. Consequently, although the China market is presently much smaller than the North American pharmaceutical market of $265 billion, the European market of $169 billion and the Japanese market of $60 billion, the Chinese market is expected to reach $90 billion by 2016, overtaking Japan and becoming the world’s third largest pharmaceutical market behind North America and all of Europe.
The rapid growth in the demand for pharmaceutical products in China is fueled by strong economic development, a growing urban middle class, and an aging population with related rising incidences of diseases such as cancer, diabetes, and heart disease. By 2010, approximately 170 million people in China are projected to be over 65 with increasing healthcare needs. Another significant change affecting medical care in China has been the deregulation of the healthcare system. This has resulted in a shift of responsibility for healthcare decisions from the government and the hospital to the physician and the patient, and has allowed patients greater access to healthcare services and novel therapeutic products. The increasing ability of patients to afford private pay healthcare options, those treatments and services not reimbursable under available insurance plans, also has broadened the market for new therapies.
The Chinese pharmaceutical market is dominated by generic products and traditional Chinese medicines (TCM) and is highly fragmented. According to the China Statistical Yearbook 2005 there are over 4,000 enterprises engaged in the manufacture of medicines in China. Many of the larger ones are state-owned or state-controlled chemical companies whose manufacture of bulk raw materials is a significant factor directing their focus on large volume in the low-cost generic market segment. Branded, and especially novel, biopharmaceutical products are produced and marketed by relatively few companies, many of which are large, western multinational pharmaceutical companies.
China’s entry into the World Trade Organization (WTO) has opened up certain aspects of the pharmaceutical industry to foreign enterprises. It has led to growing measures to protect the intellectual property rights of pharmaceutical products, lowered the tariff of imported pharmaceutical products, and opened up certain services in the pharmaceutical distribution business to foreign investment. As China seeks to be a global competitor in the pharmaceutical market, the government is increasing product requirements for marketing approval and adopting more manufacturing and clinical trial standards similar to those in the United States and in Europe. While low cost access to important resources, such as clinical trial development and manufacturing, is available to current and potential participants in the China pharmaceutical market, success is dependent on sales and marketing efforts and distribution capabilities.
Sales to hospitals account for approximately 80% to 85% of total pharmaceutical sales revenue in China. For sales of novel biopharmaceutical products, we believe that the share is even higher. For any pharmaceutical product to be successful, physicians must be familiar with its use, the national medical community must hold it in high regard, and the provider and manufacturer must have a good reputation with the medical community. The detailing of products to physicians and hospital administrators by company medical representatives and sales staff, supported by product focused medical education seminars, are critical for product launches and essential to gain and maintain market share. The acceptance rate of newly introduced pharmaceutical products is lower and longer than is typically observed in the U.S. or European markets. According to IMS Health data, in 2005, there were fewer than ten imported pharmaceutical products with sales in China of more than $25 million, and the top selling product had sales of $51 million.
Trusted relationships with effective distributors are also necessary for product success. Only registered distributors, by law, can arrange for the sale of pharmaceutical products to the hospitals. The distributors fulfill other key functions such as the storage and delivery of the product and receivable collection. Distribution
networks in China are tiered, which especially affects sales outside of the major metropolitan regions. The pharmaceutical distribution business is highly regulated, and companies without established networks or relationships with major distributors face significant market difficulties.
SciClone’s Established Sales and Marketing Organization
In China, we have a successful, established business as well as a strong commitment to introduce new pharmaceutical products to meet the country’s evolving healthcare needs. We launched ZADAXIN in China in 1996 and have established a strong commercial presence in liver disease, cancer and the intensive care setting. We employ a team of over 120 dedicated Chinese medical representatives who are well-trained regarding ZADAXIN’s attributes and understand the changing healthcare environment, the physician’s role and the patient’s needs in this unique culture. These representatives focus their efforts on building strong relationships with physicians and administrators in over 500 hospitals in the major cities in China. We are an active participant in, and sponsor of, regional and international medical conferences related to liver disease, and we endeavor to position ZADAXIN as a high-quality, imported, premium-priced product. Our sales and marketing capabilities and broad understanding of this market have made ZADAXIN, with 2006 sales in China of approximately $30 million, one of the top selling imported pharmaceutical products in this market.
Physician and hospital pharmacy orders for ZADAXIN are fulfilled exclusively through four licensed distributors, which were selected based on their capabilities, integrity, and strength in their regional marketplace. One each of three of the distributors covers the North, centered on Beijing; the East coast, centered on Shanghai; and the South, centered on Guang Dong. The fourth is the principal nationwide distributor to the military and most government service hospitals. Our licensed distributors purchase their ZADAXIN supplies from our selected importing agents. These well-established, government-licensed importing agents purchase ZADAXIN from us on a no-return basis, except under limited terms regarding product quality. Sales terms to the importing agents in China typically are for payment in six months to accommodate the importing agents’ costs of importation including duties and quality assurance testing fees and the long collection cycle associated with sales within the country.
China accounted for approximately 92%, 91%, and 91%, respectively, of our product sales for the years ended December 31, 2006, 2005 and 2004. ZADAXIN is approved in China for the treatment of hepatitis B virus (HBV) and for use as a vaccine adjuvant. However, physicians also have been using ZADAXIN increasingly in oncology and in intensive care cases.
In 2006, Shanghai Lingyun and China National Pharmaceutical Foreign Trade Corporation accounted for 66% and 15% of our sales, respectively, and two others accounted for a combined 11%. In 2005, Guang Dong South Pharmaceutical Foreign Trade Co., Ltd, Zhuhai Goldsn Medicine Co., Ltd and China National Pharmaceutical Foreign Trade Corporation accounted for 57%, 19%, and 15% of our sales, respectively. In 2004, China National Pharmaceutical Foreign Trade Corporation, China Meheco Corporation and Guang Dong South Pharmaceutical Foreign Trade Co., Ltd accounted for 32%, 29% and 23% of our sales, respectively. No other customers accounted for more than 10% of sales in those periods. As of December 31, 2006, approximately $12,562,000 or, 94% of our accounts receivable were attributable to three customers in China.
Broadening our Product Portfolio
To build on our successful sales and marketing business in China, we are actively seeking to in-license additional candidates for our product portfolio and drug candidate pipeline. We are in the process of expanding our clinical, regulatory and in-licensing capabilities with the objective of adding senior level executives who have successful clinical development experience, established relationships with CROs, deep understanding of the regulatory process, and in-licensing expertise targeting the unique needs of the patient population in China.
We believe that our proven capabilities in China are an advantage in our efforts to secure the marketing rights to development-stage products for either the U.S. or European markets in addition to the China market. Few biotechnology companies in the United States or Europe have efficient access to develop or commercialize their products for the China market. SciClone provides a significant value proposition to U.S. and European biotechnology companies as their collaborative partner for the development and commercialization of their products as we offer the following advantages:
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Significant time savings in obtaining regulatory approval for and launch of product into the major pharmaceutical markets and China. Our business in China offers access to large patient populations, providing for rapid enrollment of clinical trials.
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Dramatic cost savings in developing a product for the U.S. or European markets as clinical trials in China are cost-effective and SciClone provides license fees, milestone payments and royalty stream.
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Attractive opportunity for the biotechnology company to retain the product rights for its home market or until the product reaches a more advanced, and potentially more valuable, stage of development.
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GCP- and ICH-standard clinical trials conducted to meet the regulatory requirements of the SFDA and potentially to serve as one of the pivotal trials for FDA and EMEA filings.
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“First to market” potential advantage for new therapeutics in the rapidly growing Chinese pharmaceutical market.
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Highly experienced, well-trained and effective sales force providing high-level attention to a product’s rapid development, successful launch and strong promotion in China.
As the first of such in-license opportunities, in June 2006 we acquired the exclusive Chinese marketing rights to DC Bead and submitted a regulatory application to the SFDA in December 2006. Currently approved in Europe, we are targeting approval of DC Bead in China for the treatment of liver cancer. China accounts for one-half of the world’s liver cancer cases and in China more than 300,000 people die annually from this disease, making this an important unmet medical need and market opportunity.
Currently, we are actively evaluating opportunities to acquire or in-license the marketing rights to other products in China that can be effectively and efficiently marketed to physicians by our team of medical representatives. To maintain maximum efficiency in our existing operations, we plan to continue to focus on products in the areas of oncology, infectious disease and intensive care medicine.
SALES AND MARKETING
In addition to China, ZADAXIN is approved in over 34 countries, primarily in Asia, the Middle East and Latin America where our licensed distributors are largely responsible for the marketing and sales of the product. ZADAXIN’s approvals are principally for the treatment of HBV, with additional approvals in certain countries for the treatment of HCV, as a vaccine adjuvant, or as a chemotherapy adjuvant for cancer patients with weakened immune systems. We sell ZADAXIN in various international markets through our wholly owned subsidiary, SciClone Pharmaceuticals International Ltd. (SPIL).
SPIL is registered in the Cayman Islands and has its principal office in Hong Kong. SPIL orders ZADAXIN from our European manufacturer and contracts with a third party for the storage of our finished goods inventory at warehousing facilities in Hong Kong. SPIL then distributes our product worldwide from these warehousing facilities based on purchase orders from our customers. Under our established distribution arrangements, local importers and distributors are responsible for the importation, inventory, distribution and invoicing of ZADAXIN.
Product sales were $32,433,000, $27,842,000, and $22,765,000 for the years ended December 31, 2006, 2005 and 2004, respectively, and all were derived from sales of ZADAXIN.
SCICLONE’S LEAD PRODUCT ZADAXIN (thymalfasin)
ZADAXIN, generically referred to as thymalfasin or thymosin alpha 1, is SciClone’s brand of a pure synthetic preparation of thymalfasin, a substance which circulates in the blood naturally, and is instrumental in the immune response to certain cancers and viral infections. Published scientific and clinical studies have shown that thymalfasin helps stimulate and direct the body's immune response to eradicate certain cancers such as malignant melanoma as well as infectious diseases like HCV and HBV. Thymalfasin appears to be well tolerated with few reports of significant side effects or toxicities associated with its use.
Thymalfasin elicits a variety of immune system responses against cancer cells and viruses. One such response is an increase in production of certain subsets of white blood cells and their differentiation into CD-4 helper-cells, specifically towards differentiation into the Th1 subset of CD-4 helper cells (Th1 cells secrete cytokines such as interleukin-2 (IL-2) and gamma interferon that can help the immune response). Studies have shown that a Th1-directed immune response is fundamental to the eradication of certain cancers such as malignant melanoma as well as infectious diseases like HCV and HBV. Moreover, as thymalfasin increases differentiation into Th1 cells, it also results in decreased CD-4 cell differentiation into the Th2 subset of CD-4 helper cells that produce cytokines, such as IL-4, which are associated with persistence of viral infection.
Thymalfasin stimulates several other components of the immune response that help the body attack and kill certain cancer and/or virally-infected cells. It helps increase the production of CD-8 and NK, or natural killer, cells. It can stimulate the innate immune system through effects on Toll-like receptors (TLRs), specifically TLR2 and TLR9. Thymalfasin reduces apoptosis, or programmed death of T-cells, which allows these beneficial cells to circulate for a longer period of time. Thymalfasin enhances expression of surface-marker proteins (antigens) on certain cancer and virally-infected cells that enable the body’s immune system to more effectively recognize and target cancer and virally-infected cells for eradication.
CLINICAL DEVELOPMENT
ZADAXIN (thymalfasin) for Advanced-Stage Malignant Melanoma
The American Cancer Society estimates that in 2007 in the United States approximately 7,700 deaths will occur from melanoma. Melanoma is classified as stage IV, the most advanced form, once the cancer has spread beyond the skin to a distant site. Current therapies are ineffective at extending overall patient survival, which at this stage is typically only about six to nine months. Commonly used treatments for stage IV patients include chemotherapeutic agents, like dacarbazine (DTIC), and immunotherapeutics, including interferon alpha. Response to treatment largely depends upon the stage of melanoma, disease site and the extent to which the cancer has spread. Unfortunately, none of the current therapies have proven to be very effective at extending overall patient survival. Accordingly, many physicians believe that the best alternative for most stage IV melanoma patients is to enroll in a clinical trial in order to receive an investigational therapeutic.
Suppression of the growth of immune-sensitive tumors such as melanoma have been shown to be dependent on a strong immune response, including a large number of activated effectors such as natural killer (NK) cells and cytotoxic T lymphocytes (CTL). A broad immune response is beneficial, due to the extensive variation of different tumor cell types. In a recent article in the journal Cell it was suggested that it is important to increase the presentation of cancer-specific antigens to the immune system through sustained expression of Major Histocompatibility Complex (MHC) Class I, as cancers avoid the immune system by decreases in this presentation.
Thymalfasin's potential beneficial role in treatment of melanoma derives from its demonstrated broad activation of various arms of the immune system, including increases in NK cells, CTLs, and expression of MHC Class I. Thymalfasin's multiple activities arise through activation of Toll-like receptor 9 and signaling through increases in the nuclear factor NfKB through Myd88 and IKKb. Evaluation of thymalfasin's utility in melanoma animal models has confirmed effective anti-tumor activity in these models.
Our European partner, Sigma-Tau, is conducting a large, randomized, open-label phase 2 trial at 64 clinical sites throughout Europe evaluating different dose levels of thymalfasin in combination with DTIC chemotherapy with and without low-dose interferon alpha as a first-line treatment for patients with stage IV malignant melanoma. Most of these stage IV patients have visceral metastases and the remaining patients have lung metastases and skin or lymph node metastases. Patients are receiving six cycles of therapy for 6 months and will be observed for a period of 12 months after the end of therapy.
The trial's primary endpoint is overall tumor response. Secondary endpoints include overall survival, duration of response, time to disease progression and immunological response. The trial does not have a sufficiently large sample size to show statistical significance of the secondary endpoints, including survival. We intend to analyze the complete data to determine the significance of the final results regarding the secondary endpoints.
In December 2006, we reported preliminary survival data from 386 patients from the first four arms of this five-arm trial. When measured for survival, all patients in the treatment arms containing thymalfasin reached a longer median survival than those in the control arm. Patients treated with thymalfasin in combination with DTIC without interferon alpha reached a median survival of 10.2 months, compared to 6.6 months for patients in the control group treated with DTIC and interferon alpha, as shown in the table below.
In September 2006, we reported interim data from 463 patients showing that all patients in the treatment arms containing thymalfasin had a higher overall tumor response (complete and partial response) than those in the control arm, as shown in the table below. Importantly, the arm with thymalfasin 3.2 mg and DTIC performed better than any of the arms containing interferon alpha, which could suggest substituting thymalfasin for interferon alpha in treating malignant melanoma patients. The fifth arm of the clinical trial, treating patients with thymalfasin 6.4 mg plus DTIC and interferon alpha, was initiated later than the other arms. All patients in the fifth arm, treated with 6.4 mg of thymalfasin, DTIC and low-dose interferon, are expected to complete the treatment and follow up in the first half of 2007. To date, 75 patients in this arm have completed therapy and follow-up, and have shown an 8% overall response. The adverse events observed to date in this trial are consistent with those expected for this group of patients treated with DTIC and interferon alpha.
With the final data from this trial, we, together with Sigma-Tau, intend to share these data with the FDA and EMEA and to discuss with these regulatory agencies our plans to begin phase 3 trials. We expect these phase 3 trials to be multi-national with the majority of clinical trial sites located in the geographic areas with the highest prevalence of melanoma including the United States, Australia and Northern Europe.
Thymalfasin received Orphan Drug Status in the United States for stage IIb through stage IV malignant melanoma in March 2006.
ZADAXIN for Hepatitis C
HCV is a blood-borne viral disease which causes inflammation of the liver. The World Health Organization estimates that 170 million people worldwide are infected with HCV, and the Center for Disease Control estimates that approximately 8 to 10 million people are infected with HCV throughout the U.S. and Europe. Of these patients, approximately 85% are chronically infected, and the persistent liver inflammation in chronically infected patients can lead to serious complications including cirrhosis of the liver, liver failure and hepatocellular carcinoma or liver cancer. The markets for HCV therapeutics in the three major economic regions of the United States, Europe and Japan are estimated to total approximately $3 billion and are expected to grow to approximately $10.6 billion by 2014.
Our partner Sigma-Tau is conducting a triple combination therapy trial evaluating ZADAXIN, pegylated interferon alpha and ribavirin in non-responder patients who have failed to respond to a previous course of pegylated interferon alpha and ribavirin. Sigma-Tau completed full enrollment of 553 HCV non-responder patients in December 2006, and we expect to report data in late 2008.
This triple therapy phase 3 clinical trial is multi-center, double-blinded, randomized and placebo-controlled. Patients have been randomized to receive either ZADAXIN (1.6 mg, twice a week) or a placebo (twice a week) and all patients are receiving pegylated interferon alpha (180 mcg, once a week) and a standard dose of ribavirin (1,000 to 1,200 mg, daily, according to body weight). After completing 48 weeks of treatment, patients will be monitored for a 24-week observation period. The primary endpoint is sustained viral response (SVR) measured at week 72 at the end of the 24-week observation period. The secondary endpoints are normalization of the liver enzyme ALT measured at the end of weeks 48 and 72, absence of HCV RNA measured at week 48, and an improvement in the liver biopsy.
The design of the European phase 3 triple therapy clinical trial is supported by encouraging results achieved from a small, single-arm, non-blinded triple therapy pilot trial conducted in Mexico. Final endpoint results from this 25-patient trial were reported at the annual meeting of the American Association for the Study of Liver Diseases (AASLD) in October 2004 and showed that 19% of genotype 1 non-responder patients achieved an SVR. All of these patients were non-responders to previous therapy of interferon alpha with ribavirin. These data compare favorably to the 9% SVR reported from a separate, unrelated trial that treated genotype 1 non-responder patients with pegylated interferon and a low dose of ribavirin but without ZADAXIN. Although it is difficult to draw conclusions from two separate, unrelated trials, we believe the results achieved from this pilot triple therapy trial are encouraging.
In May 2006, we reported data from the second of our two double therapy phase 3 HCV clinical trials in the U.S. Non-responder patients in both trials received a 48-week course of therapy of either ZADAXIN (1.6 mg, twice a week) and pegylated interferon alpha (180 mcg, once a week) or placebo and pegylated interferon alpha followed by a 24-week observation period. Final results from both trials indicated that treatment with ZADAXIN and pegylated interferon alpha did not demonstrate a statistically significant benefit compared with treatment with pegylated interferon alone in sustained viral response or histologic improvement, the trial's co-primary endpoints. ZADAXIN was well tolerated with no treatment-related toxicities or side effects.
SCV-07
Our in-licensed proprietary drug development candidate SCV-07 is an orally available immune system modulator known to act on the TLR pathway. SCV-07 has shown broad applicability in viral infectious diseases in early preclinical testing. In September 2006, we reported phase 1 data indicating that SCV-07 taken orally was safe and led to circulating plasma concentrations similar to those obtained in previous phase 1 studies using a subcutaneous injection of SCV-07. Importantly, SCV-07 taken orally resulted in only 10% plasma level variability between all volunteers in the study, demonstrating highly predictable plasma concentrations after oral dosing of this drug. We expect SCV-07 to enter phase 2 clinical development in the U.S. for the treatment of viral infectious diseases in the second quarter 2007.
SCV-07 is a synthetic dipeptide that has demonstrated immunomodulatory activity by increasing T-cell differentiation and function, biological processes that are necessary for the body to fight off infection. SCV-07 specifically stimulates the immune system through its effects on CD-4 Th1 cells, which are essential for clearance of viral infections; and we have additional recent data that demonstrate apparent effects of SCV-07 involvement with TLR's of the innate immune system which could be part of its mechanism of action. SciClone acquired exclusive worldwide rights, outside of Russia, to SCV-07 from Verta, Ltd., a biotechnology company located in St. Petersburg, Russia.
In September 2002, we reported final results from a phase 2 clinical study conducted by Verta in Russia of SCV-07 in tuberculosis at the Interscience Conference on Antimicrobial Agents and Chemotherapy (ICAAC). After 3 months, 80% (35/44) of tuberculosis patients treated with a five-day regimen of SCV-07 therapy in combination with anti-tuberculosis chemotherapy were no longer contagious, as measured by negative sputum cultures, compared to 37% (10/27) of patients whose treatment did not include SCV-07.
DC Bead for Liver Cancer
In June 2006 we acquired the exclusive Chinese marketing rights from Biocompatibles International plc. (Biocompatibles) for the DC Bead embolizing and chemotherapy releasing device. The DC Bead is approved in Europe for use in the treatment of malignant hypervascularized tumors such as hepatocellular carcinoma (HCC), or primary liver cancer. In December 2006, we submitted a regulatory application to the SFDA for approval to market the DC Bead for the treatment of liver cancer.
The DC Bead is comprised of microscopic beads, which when administered by catheter into a blood vessel, block the supply of nutrients and blood to a tumor. While the blockage of the blood vessel itself can have an anti-tumor effect, chemotherapeutic agents can be added to the beads for a more targeted anti-tumor effect. This controlled delivery of an anti-tumor drug concentrates the toxic effect of the drug directly on the tumor and minimizes side effects throughout the rest of the body. The DC Bead is designed to deliver doxorubicin and potentially can deliver other chemotherapy drugs as well, such improvements which are available to us in our marketing agreement with Biocompatibles.
HCC is the fifth most common form of cancer worldwide, but represents the third most common cause of death from cancer. Over half of all worldwide cases of liver cancer occur in China with nearly 350,000 new cases and over 300,000 deaths each year, according to the GloboCan 2002 database (International Agency for Research on Cancer). The pervasiveness of liver cancer in China is principally due to the high prevalence of the HBV in that part of the world. Left untreated, HBV, like HCV, often leads to cirrhosis of the liver and liver cancer. Liver cancer that cannot be removed through surgery is frequently treated by transarterial chemoembolization (TACE). While TACE has shown efficacy in treating unresectable HCC, one of its drawbacks is the risk of systemic leakage of the chemotherapeutic drug throughout the body. The systemic exposure to the chemotherapeutic agent doxorubicin in particular is known to cause toxicity to the heart, including the risk of fatal congestive heart failure. DC Bead is designed to reduce this risk by delivering drugs directly to the tumor site.
INTELLECTUAL PROPERTY AND PROPRIETARY RIGHTS
Patents
We seek regulatory approval for our products in disease areas with unmet medical need, significant market potential and where we have a proprietary position through patents covering use, process, or composition of matter for our products. For our lead product ZADAXIN, we are the licensee or owner of patents relating to the use of thymosin alpha 1 for certain diseases and its process of manufacture.
We are the exclusive licensee or owner of patents relating to the use of thymalfasin as a therapy for HCV that do not expire until 2015 in the United States and until 2012 in Japan and the major commercial markets in
Europe. Our exclusivity to one license for the United States expires at the end of 2007, but we believe that it can be extended on acceptable terms to be negotiated. In addition, patents relating specifically to the use of thymalfasin in treating HCV in non-responders to interferon alpha treatment have been issued to us in the United States and various international markets. In the United States, certain European countries and Japan, the period of patent protection may be extended depending on the relevant dates of patent grant and market authorization, and we may, depending on the timing of any future approval, be eligible for such an extension.
We are the exclusive licensee or owners of patents that have been issued in the United States, Japan, China and other international markets relating to the treatment of HBV using thymalfasin. We are the licensee or owner of patents relating to the use of thymalfasin as a combination therapy for HBV that do not expire until 2019 in the United States and Europe and 2012 in Japan. We are also the exclusive licensee of patents that have been issued in the United States, a majority of European countries, Japan, and other international markets that relate to the use of thymalfasin to treat small cell and non-small cell lung cancer. Several corresponding additional patent applications have been issued or patent applications are pending in other countries for each of the above named indications. We have not been issued a patent with respect to the use of thymalfasin as a therapy for melanoma. However, thymalfasin marketing exclusivity for this indication is available to us under orphan drug designation in the United States.
We are either a patentee or exclusive licensee of use and process patents related to the method of making and therapeutic uses of thymalfasin. Our process patents are directed to methods of making thymalfasin and have been issued in the United States, a majority of European countries, Japan, Canada, Hong Kong, Taiwan and South Korea. Although the composition of matter patents related to thymalfasin have expired in the major pharmaceutical markets, we have several composition of matter patents and applications directed to analogues and derivatives of thymalfasin which have been granted in the United States and in important international markets. Our commercialized product, and the product we are using in our clinical trials, is thymalfasin and not an analogue or derivative. However, we continue to seek additional proprietary rights relating to the use of thymalfasin.
We are the exclusive licensee of an issued U.S. patent relating to the composition of matter of SCV-07 and related products, as well as similar pending foreign patent applications.
Proprietary Rights
In addition to our patent protection, we intend to use other means to protect our proprietary rights. We may pursue marketing exclusivity periods that are available under regulatory provisions in certain countries including the United States, Europe and Japan.
Orphan drug protection has been or may be sought where available if such protection also grants additional market exclusivity. We have obtained orphan drug designation for thymosin alpha 1 for the treatment of malignant melanoma in the United States and for the treatment of hepatocellular carcinoma in the United States and in Europe.
We have filed trademark applications worldwide for ZADAXIN and other trademarks that appear on our commercial packaging and promotional literature. Copyrights for the commercial packaging may prevent counterfeit products or genuine but unauthorized products from entering a particular country by parallel importation. We have implemented anti-counterfeiting measures on commercial packaging and we are registering the packaging with customs departments in countries where such procedures exist. We rely upon trade secrets, which we seek to protect in part by entering into confidentiality agreements with our employees, consultants, corporate partners, suppliers and licensees.
MANUFACTURING
ZADAXIN is manufactured for us by third parties under exclusive contract manufacturing and supply agreements. We closely monitor production runs of ZADAXIN and regularly conduct our own quality assurance audit programs. We believe the manufacturing facilities of our contract suppliers are in compliance with the FDA’s current Good Manufacturing Practices, and the Japanese or European equivalents of such standards.
Contract suppliers in the United States manufacture ZADAXIN for process validation and for our clinical trials in the United States. Contract suppliers in Europe manufacture ZADAXIN for our phase 2 and 3 clinical trials in Europe and for sale in other international markets where approved.
In the event of the termination of an agreement with any single supplier, we believe that we would be able to enter into arrangements with other suppliers with similar terms. We do not intend at this time to acquire or establish our own dedicated manufacturing facilities for any of our products. We believe that our current manufacturing partners have enough manufacturing capacity to meet potential market demand should ZADAXIN be approved in the major pharmaceutical markets of the United States, Europe and Japan.
COMPETITION
Our competitors include biopharmaceutical companies, biotechnology firms, universities and other research institutions, both in the United States and abroad, that are actively engaged in research and development or marketing of products in the therapeutic areas we are pursuing, particularly cancers such as malignant melanoma and certain infectious diseases such as HCV and HBV. Currently, competitors are marketing drugs for HCV, HBV and cancer, or have products in clinical trials. We believe that the principal competitive factors in this industry for a marketed drug include the efficacy, safety, price, therapeutic regimen, manufacturing, quality assurance and associated patents and the capabilities of its marketer.
In addition, most of our competitors, particularly large biopharmaceutical companies, have substantially greater financial, technical, regulatory, manufacturing, marketing and human resource capabilities than SciClone. Most of them also have extensive experience in undertaking the preclinical and clinical testing and in obtaining the regulatory approvals necessary to market drugs. Additional mergers and acquisitions in the pharmaceutical industry may result in even more resources being concentrated with our competitors.
In the United States and Europe, treatment options for late-stage melanoma are essentially limited to DTIC and interferon. In the United States, interleukin 2 (IL-2) is approved for late-stage melanoma, however due to its toxicity, therapy typically is limited to specialized treatment centers where patients must be monitored carefully for toxic side effects. No new therapies for late-stage melanoma have been approved within the last five years, and survival outcomes remain extremely poor for late-stage patients. For the treatment of cancer, many companies are researching, developing, or marketing other products for use alone or in combination with other therapies. In addition, we expect continuing advancements in and increasing awareness of the use of therapeutics which boost the immune system to fight cancer and infectious diseases. These developments may create new competitors.
For the treatment of HCV, the only products approved by the FDA are interferon alpha, in both standard and pegylated forms, and ribavirin, which is useful only in combination with interferon alpha. In addition, there are several other potential therapeutic products currently in clinical trials.
For the treatment of HBV, current therapies being marketed by competitors include interferon alpha, in both standard and pegylated forms, marketed primarily by Schering-Plough and Roche, nucleoside analogues such as lamivudine, marketed by GlaxoSmithKline, nucleotide analogue adefovir, marketed by GlaxoSmithKline and Gilead Sciences, and nucleoside analogue, entecavir, marketed by Bristol-Myers Squibb. In addition to these products, in our largest market China, ZADAXIN faces competition from other synthetic and generic biological extracts, which are locally manufactured and significantly lower priced.
Future clinical trials may or may not show ZADAXIN to have advantages or clinically significant synergistic value over such existing or future competitive products.
RESEARCH AND DEVELOPMENT
A major portion of our operating expenses to date is related to research and development (R&D). R&D expenses consist of independent R&D costs and costs associated with collaborative R&D and in-licensing arrangements. A substantial portion of our development expense is third party expense relating to the conduct of clinical trials. R&D expenses were $14,088,000, $14,406,000, and $17,994,000, for the years ended December 31, 2006, 2005, and 2004, respectively. We intend to maintain our strong commitment to R&D as an essential component of our product development effort. Licensed technology developed by outside parties is an additional source of potential products.
EMPLOYEES
As of December 31, 2006, we had 166 employees, 26 in the United States and 140 in foreign offices. From time to time, we engage the services of consultants worldwide with pharmaceutical and business backgrounds to assist in our product development and ZADAXIN commercialization activities. We plan to leverage our key personnel by continuing to make extensive use of clinical research organizations, contract laboratories, development consultants and collaborations with pharmaceutical companies to develop and market our products.
GOVERNMENT REGULATION
Regulation by governmental authorities in the United States and foreign countries is a significant factor in the manufacturing and marketing of our products, as well as in ongoing research and development activities and in pre-clinical and clinical trials and testing related to our products. When our products are manufactured, tested or sold in the United States, they will be regulated in accordance with the Federal Food, Drug, and Cosmetic Act, commonly referred to as the FD&C Act and the U.S. Public Health Service Act. In addition to obtaining FDA approval for each product, each manufacturing establishment must be registered with the FDA. Manufacturing establishments are subject to inspections by the FDA and by other federal, state and local agencies and must comply with current U.S. Good Manufacturing Practices (cGMP). In complying with cGMP standards, manufacturers must continue to expend time, money and effort in the area of production and quality assurance to ensure full technical compliance.
The steps required before a new drug or biological product may be distributed commercially in the United States generally include:
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conducting appropriate pre-clinical laboratory evaluations, including animal studies, in compliance with the FDA's Good Laboratory Practice (GLP) requirements, to assess the potential safety and efficacy of the product, and to characterize and document the product's chemistry, manufacturing controls, formulation and stability;
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submitting the results of these evaluations and tests to the FDA, along with manufacturing information and analytical data, in an Investigational New Drug Application (IND), and receiving approval from the FDA that the studies proposed under the IND are allowed to proceed;
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obtaining approval of Institutional Review Boards (IRBs) to introduce the drug into humans in clinical studies;
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conducting adequate and well-controlled human clinical trials in compliance with the FDA's Good Clinical Practice (GCP) requirements that establish the safety and efficacy of the drug product candidate for the intended use, typically in the following three sequential, or slightly overlapping stages:
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Phase 1: The drug is initially introduced into healthy human subjects or patients and tested for safety, dose tolerance, absorption, metabolism, distribution and excretion;
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Phase 2: The drug is studied in patients to identify possible adverse effects and safety risks, to determine dose tolerance and the optimal dosage and to collect initial efficacy data;
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Phase 3: The drug is studied in an expanded patient population at multiple clinical study sites, to confirm efficacy and safety at the optimized dose, by measuring a primary endpoint established at the outset of the study, and comparing it to that of established therapies, if any; and when required,
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Phase 4: The drug is studied in an expanded patient population in a post-approval setting for continued monitoring of safety and sometimes continued efficacy;
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submitting to the FDA the results of pre-clinical studies, clinical studies, and adequate data on chemistry, manufacturing and control information to ensure reproducible product quality batch after batch, in a New Drug Application (NDA) or Biologics License Application (BLA); and
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obtaining FDA approval of the NDA or BLA, including inspection and approval of the product manufacturing facility as compliant with cGMP requirements, prior to any commercial sale or shipment of the pharmaceutical agent.
When used in connection with trials and filings in other countries, terms such as “phase 1,” “phase 2,” “phase 3,” “phase 4,” “new drug application” and “marketing application” refer to what we believe are comparable trials and filings in these other countries.
The process of obtaining regulatory approval is lengthy, uncertain, and requires the expenditure of substantial resources. Each NDA or BLA must be accompanied by a user fee, pursuant to the requirements of the Prescription Drug User Fee Act, or PDUFA, and its amendments. The FDA adjusts the PDUFA user fees on an annual basis. According to the FDA’s fee schedule, effective through September 30, 2007, the user fee for an application requiring clinical data, such as an NDA or BLA, is $896,200. PDUFA also imposes an annual product fee for prescription drugs and biologics ($49,750), and an annual establishment fee ($313,100) on facilities used to manufacture prescription drugs and biologics. Fee waivers or reductions are available in certain circumstances, including a waiver of the application fee for the first application filed by a small business. Additionally, no user fees are assessed on NDAs or BLAs for products designated as orphan drugs, unless the drug also includes a non-orphan indication, and if a contract manufacturer is used, the contract manufacturer is responsible for the establishment fee.
After FDA approval has been obtained, the FDA will require post-marketing reporting to monitor the side effects of the drug. Further studies may be required to provide additional data on the product's risks, benefits, and optimal use, and will be required to gain approval for the use of the product as a treatment for clinical indications other than those for which the product was initially tested. Results of post-marketing programs may limit or expand the further marketing of the product. Further, if there are any modifications to the drug, including changes in indication, labeling, or a change in the manufacturing process or manufacturing facility, an NDA or BLA supplement may be required to be submitted to the FDA.
Additionally, after the FDA has authorized a drug product to enter commercial distribution, numerous regulatory requirements apply. These include, among others, the cGMPs, which require manufacturers to follow extensive design, testing, control, documentation and other quality assurance procedures during the manufacturing process; labeling regulations; the FDA's general prohibition against promoting drug products for unapproved or “off-label” uses; and adverse event reporting regulations, which require that manufacturers report to the FDA if their drug may have caused or contributed to a death or serious injury. The FDA and other regulatory agencies have broad post-market and regulatory and enforcement powers, and significant enforcement activity has occurred as to the sales and marketing practices of pharmaceutical companies. Failure to comply with the applicable U.S. drug regulatory requirements could result in, among other things, warning letters, fines,
injunctions, consent decrees, civil penalties, refunds, recalls or seizures of products (which would result in the cessation or reduction of production volume), total or partial suspension of production, withdrawals or suspensions of current product applications, and criminal prosecution. Adverse events related to a drug product in any existing or future markets could cause regulatory authorities to withdraw market approval for such product.
The FD&C Act includes provisions intended to facilitate and expedite the development and review of drugs and biological products intended for treatment of serious or life-threatening conditions that demonstrate the potential to address unmet medical needs for such conditions. These provisions set forth a procedure for designation of a drug and indication as a “fast track product.” Concurrent with or after an IND is filed, the sponsor may request designation as a fast track product, and the FDA is required to respond within 60 days.
An advantage of fast track designation is that sponsors may submit, and the FDA may commence review of, portions of an application before the complete application is submitted, provided that the FDA approves a schedule for submission of the completed application. The sponsor of a fast track product also may seek and obtain accelerated approval, whereby FDA approval is based upon a determination that the product has an effect on a clinical endpoint or on a surrogate endpoint that is reasonably likely to predict clinical benefit. A product approved on this basis is subject to rigorous postmarket compliance requirements, and the sponsor may be required to conduct post-approval studies to validate and/or confirm the endpoint. The FDA may withdraw accelerated approval if, for example, the sponsor fails to conduct required post-approval studies or disseminates false or misleading promotional materials. A fast track product also ordinarily would be eligible for priority review of an NDA or BLA, although fast track designation is not required to be eligible for priority review.
The Orphan Drug provisions of the FD&C Act provide incentives to drug and biologics suppliers to develop and supply drugs for the treatment of rare diseases, currently defined as diseases that affect fewer than 200,000 individuals in the United States or, for a disease that affects more than 200,000 individuals in the United States, where the sponsor does not realistically anticipate its product becoming profitable. Under these provisions, a supplier of a designated orphan product can seek tax benefits, and the holder of the first FDA approval of a designated orphan product will be granted a seven year period of marketing exclusivity for that product for the orphan indication. The marketing exclusivity of an orphan drug would prevent other sponsors from obtaining approval of the same drug for the same indication without a showing of clinical superiority. It would not prevent other types of drugs from being approved for the same use. We have pursued orphan drug designations where applicable for ZADAXIN (thymalfasin). Thymalfasin has been granted orphan designation by the FDA for the treatments of malignant melanoma and hepatocellular carcinoma.
In the European Union, incentives for suppliers to develop medicinal products for the treatment of rare diseases are provided pursuant to the Orphan Medicinal Products Regulation (Regulation (EC) 141/2000). Orphan medicinal products are those products designed to diagnose, treat or prevent a condition which occurs so infrequently that the cost of developing and bringing the product to the market would not be recovered by the expected sale of the product. In the EU, the criterion for designation is a prevalence of the relevant condition in no more than 5 per 10,000 of the population. The incentives include, amongst others, a reduction in the fees payable in respect of the marketing authorization application, protocol assistance for clinical trials in support of the application, and marketing exclusivity once the authorization is granted. In the EU, marketing exclusivity is granted to products with an orphan drug designation for a period of 10 years during which the EU will not accept another application for a marketing authorization for the same therapeutic indication in respect of a similar medicinal product, unless the second applicant can show its product is safer, more effective or otherwise clinically superior. A similar medicinal product is defined as a medicinal product containing a similar active substance as contained in the authorized orphan medicinal product.
Thymalfasin has been granted orphan designation throughout the EU for treatment of hepatocellular carcinoma. However, it should be noted that, as in the United States, the granting of orphan drug status in the EU does not affect the likelihood of success of obtaining regulatory approval or marketing authorization for the relevant product in any way.
Under the Drug Price Competition and Patent Term Restoration Act of 1984, or DPCPTRA, a sponsor may be granted marketing exclusivity for a period of time following FDA approval of certain drug applications, regardless of patent status, if the drug is a new chemical entity or new clinical studies were used to support the marketing application. This marketing exclusivity would prevent a third party from obtaining FDA approval for a similar or identical drug through an Abbreviated New Drug Application, or ANDA, which is the application form typically used by suppliers seeking approval of a generic drug, or 505(b)(2) application. The DPCPTRA also allows a patent owner to extend the term of the patent for a period equal to one-half the period of time elapsed between the filing of an IND and the filing of the corresponding NDA plus the period of time between the filing of the NDA and FDA approval with the maximum patent extension term being five years. The U.S. Patent and Trademark Office, in consultation with the FDA, reviews and approves the application for the patent term extension.
The Best Pharmaceuticals for Children Act provides an additional six months of marketing exclusivity for new or marketed drugs for certain pediatric testing conducted at the written request of the FDA. The Pediatric Research Equity Act authorizes the FDA to require pediatric studies for drugs and biological products to ensure the drugs’ or products’ safety and effectiveness in children. This Act required that new NDAs, BLAs or supplements to NDAs or BLAs contain data assessing the safety and effectiveness for the claimed indication in all relevant pediatric subpopulations. Dosing and administration must be supported for each pediatric subpopulation for which the drug is safe and effective. The FDA may grant deferrals for submission of data, or full or partial waivers.
We may seek the benefits of additional orphan, exclusivity, patent term extension, or fast track provisions, with respect to ZADAXIN but we cannot assure that we will be able to obtain any such benefits.
We are subject to foreign regulations governing human clinical trials and pharmaceutical sales. The requirements governing the conduct of clinical trials, product licensing, pricing and reimbursement vary widely from country to country. Whether or not FDA approval has been obtained, approval of a product by the comparable regulatory authorities of foreign countries is required prior to the commencement of marketing of our products in those countries. The approval process varies from country to country and the time required for approval may be longer or shorter than that required for FDA approval. In general, foreign countries use one of three forms of regulatory approval process. In one form, local clinical trials must be undertaken and the data must be compiled and submitted for review and approval. In Japan, for example, the process is time consuming and costly because certain pre-clinical studies and clinical trials must be conducted in Japan. A second form of approval process requires clinical trial submissions, but permits use of foreign clinical trials and typically also requires some form of local trial as well. A third form of approval process does not require local clinical trials, but rather contemplates submission of an application including proof of approval by countries that have clinical trial review procedures. Thus, a prior approval in one or more of the United States, Japan, most European Union countries or Australia, among others, is often sufficient for approval in countries using this third form of approval process.
The FDA regulates the export of drugs or bulk pharmaceuticals from the United States. In general, a drug that has been approved for commercial sale in the United States may be exported for commercial sale. An unapproved drug may be exported to a “listed country” (Australia, Canada, Israel, Japan, New Zealand, Switzerland, South Africa, and countries in the European Union and the European Economic Area) for investigational purposes without FDA authorization if exported in accordance with laws of the foreign country, and in accordance with the export requirements. Export of drugs to an unlisted country for clinical trial purposes continues to require FDA approval. An unapproved drug can be exported to any country for commercial purposes without prior FDA approval, provided that the drug (i) complies with the laws of that country, and (ii) has valid marketing authorization or the equivalent from the appropriate authority in a listed country. Export of drugs not approved in the United States that do not have marketing authorization in a listed country continue to require FDA export approval. We have obtained, where necessary, FDA approval for all exports of ZADAXIN from the United States for clinical trial purposes, and will seek to obtain FDA approval, where necessary, for any future shipments from the United States to any unlisted country.
We are also subject to various federal, state and local laws, regulations and recommendations relating to safe working conditions, laboratory and manufacturing practices, the experimental use of animals and the use and disposal of hazardous or potentially hazardous substances, including radioactive products and infectious disease agents, used in connection with research work and preclinical and clinical trials and testing. The extent of government regulation that might result from future legislation or administrative action in these areas cannot be accurately predicted and could prevent or delay regulatory approval of any of our products.
The level of revenues and profitability of pharmaceutical companies may be affected by the continuing efforts of governmental and third party payors to contain or reduce the costs of health care through various means, including the extent and availability of reimbursement. We are unable to predict when any proposed health care reforms will be implemented, if ever, or the effect of the implemented reforms on our business. Our ability to commercialize future products will depend in part on the extent to which coverage and reimbursement for the products will be available from government and health administration authorities, private health insurers, and other third-party payors.
THIRD-PARTY REIMBURSEMENT
Our ability to successfully commercialize our products may depend in part on the extent to which coverage and reimbursement to patients for our products will be available from government health care programs, private health insurers and other third-party payors or organizations. Significant uncertainty exists as to the reimbursement status of new therapeutic products, such as ZADAXIN. In most of the markets in which we are currently approved to sell ZADAXIN, reimbursement for ZADAXIN under government or private health insurance programs is not yet widely available, and in many of these countries government resources and per capita income may be so low that our products will be prohibitively expensive. We believe that most of the sales of ZADAXIN in China are made without third party reimbursement. In the United States, Europe and Japan, proposed health care reforms could limit the amount of governmental or third-party reimbursement available for our products should they be approved for sale in these markets. Various governments and third-party payors are trying to contain or reduce the costs of health care through various means. We expect that there will continue to be legislative efforts and proposals to implement such government controls.
AVAILABLE INFORMATION
We file electronically with the Securities and Exchange Commission (the Commission or the SEC) our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934. The public may read and copy any materials we file with the SEC at the SEC’s Public Reference Room at 100 F Street, NE, Washington, DC 20549. The public may obtain information on the operation of the Public Reference Room by calling the SEC at 1-800-SEC-0330. The SEC maintains an Internet site that contains reports, proxy and information statements, and other information regarding issuers that file electronically with the SEC. The address of that site is http://www.sec.gov.
You may obtain a free copy of our annual reports on Form 10-K, quarterly reports on Form 10-Q and current reports on Form 8-K and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (15 U.S.C. 78m(a) or 78o(d)), on the day of filing with the SEC on our website on the World Wide Web at http://www.sciclone.com, by contacting the Investor Relations Department at our corporate offices by calling 800-724-2566 or by sending an e-mail message to investorrelations@sciclone.com.
EXECUTIVE OFFICERS OF THE REGISTRANT
As of March 16, 2007, the executive officers of the Company, who are elected by and serve at the discretion of the Board of Directors, were as follows:
Friedhelm Blobel, Ph.D. has served as our President, Chief Executive Officer and as a Director since June 2006. From July 2000 to 2006, Dr. Blobel was President, CEO and a Director of Gryphon Therapeutics, Inc., a South San Francisco-based biopharmaceutical company. Prior to joining Gryphon Therapeutics in July 2000, Dr. Blobel spent more than 20 years as an executive with the Hoechst Group and the Boehringer Mannheim Group including responsibilities in the areas of diabetes and in vitro diagnostics. His roles at these companies included Group President of several product divisions, Chief Technology Officer, General Manager in Tokyo, Japan of a marketing and sales joint venture between Boehringer and Yamanouchi Pharmaceuticals (now Astellas), Senior Vice President of Research and Development Diabetes and Patient Care in Mannheim, Germany as well as in Indianapolis, USA. Dr. Blobel earned his doctorate degree (“Dr.rer.nat.”; a Ph.D. equivalent) with a dissertation in Biochemistry and Microbiology from the University of Hohenheim, Germany and holds an advanced degree in Chemistry from the University of Stuttgart, Germany.
Richard A. Waldron has served as our Executive Vice President, Chief Financial Officer and Secretary since 2007, and as our Chief Financial Officer and Secretary from 2001 until 2007. In July 2004, Mr. Waldron and the then Chief Operating Officer were appointed jointly to the Office of the President and served in that office until the appointment of Dr. Ira Lawrence as our President and Chief Executive Officer in April 2005. Mr. Waldron has over 20 years of experience in the finance and management of biotechnology companies. Prior to joining us in March 2001, he was Vice President and Chief Financial Officer from June 1999 to August 2000 for Genelabs Technologies, Inc. and from July 1995 through March 1999, he was Vice President and Chief Financial Officer of GeneMedicine, Inc. From 1990 to 1995, he was a managing director and the head of finance for technology-based companies at Rauscher Pierce Refsnes, Inc., an investment-banking firm. From 1985 to 1990, he was a senior vice president responsible for health care investment banking at Cowen & Company. Mr. Waldron received his M.B.A. degree with honors from Harvard University and his A.B. degree magna cum laude in Economics from Princeton University.
Hans P. Schmid has served as President and Managing Director for SciClone Pharmaceuticals International Ltd. since 2007, and as Managing Director for SciClone Pharmaceuticals International Ltd from July 2004 until 2007. He previously served as Vice President, Finance, Administration and Business Development since joining SciClone in May 2001. He has over 25 years of financial and pharmaceutical experience in the U.S. and international markets. Prior to joining SciClone, Mr. Schmid was Chief Financial Officer from December 1999 to April 2001 for Questcor Pharmaceuticals, Inc. and Senior Vice President, International Business Development from February 1997 to September 1999 for Oread, Inc., a contract pharmaceutical company. From 1985 to 1997 he worked at Syntex Corporation as Vice President of Finance and Administration for Pharmaceutical Operations Asia/Pacific region and at F. Hoffmann-LaRoche as Senior Vice President, Finance and Head of Administrative Services for Roche Bioscience. Previously he held financial and operational positions with Itel Corporation in Germany, Japan, England and the United States. He received his B.A. degree from the Commercial Trade School, Lucerne, Switzerland, and has studied International Business Management and Finance at San Francisco State University.
There are no family relationships among any of the directors or executive officers of the Company.
Item 1A.
Item 1A. Risk Factors
You should carefully consider the risks described below, in addition to the other information in this report on Form 10-K, before making an investment decision. Each of these risk factors could adversely affect our business, financial condition, and operating results as well as adversely affect the value of an investment in our common stock.
Our revenue is dependent on the sale of ZADAXIN in foreign countries, particularly China, and if we experience difficulties in our foreign sales efforts, our operating results and financial condition will be harmed.
Our product revenue is highly dependent on the sale of ZADAXIN in foreign countries. If we experience difficulties in our foreign sales efforts, our business will suffer and our operating results and financial condition will be harmed. For the years ended December 31, 2006, 2005 and 2004 approximately 92%, 91%, and 91%, respectively of our ZADAXIN sales were to customers in China. Sales of ZADAXIN in China may be limited due to the low average personal income, lack of patient cost reimbursement, poorly developed infrastructure and existing and potential competition from other products, including generics. ZADAXIN sales growth in recent years has benefited from the rapidly growing Chinese economy and growing personal disposable income. Sales of ZADAXIN in China could be adversely affected by a slowing or downturn of the Chinese economy. In China, ZADAXIN is approved only for the treatment of HBV and as a vaccine adjuvant. We face competition from certain large, global pharmaceutical companies who are aggressively marketing competing products for the treatment of HBV and other indications where ZADAXIN is used on an off-label basis. In addition, several local companies are selling lower priced locally manufactured generic thymosin, which is a competitive product and is selling in increasing quantities. We expect such competition to continue and there could be a negative impact on the price and the volume of ZADAXIN sold in China, which would harm our business. Our efforts to in-license other pharmaceutical products for marketing in China and other markets may be unsuccessful or may not have a meaningful effect on our dependence on ZADAXIN sales in those markets.
We do not have product sales in the United States, Europe or Japan with which to offset any decrease in our revenue from ZADAXIN sales in Asia, Latin America and the Middle East, and sales outside of China have not been substantial to date. Some countries in these regions, including China, regulate pharmaceutical prices and pharmaceutical importation. These regulations may reduce prices for ZADAXIN to levels significantly below those that would prevail in an unregulated market, limit the volume of product which may be imported and sold or place high import duties on the product, any of which may limit the growth of our revenues or cause them to decline. We believe that the Chinese government is increasing its efforts to reduce overall health care costs, including through pricing controls. Individual provinces in China and, in some cases, individual hospitals can and have established pricing requirements for a product to be included on formulary lists. These prices may be lower than our distributors have been selling ZADAXIN in which case we have been removed from formulary lists, which consequently has reduced sales to certain hospitals and could adversely affect our future sales.
Our ZADAXIN sales and operations in other parts of Asia, as well as in Latin America and the Middle East, are subject to a number of risks, including difficulties and delays in obtaining registrations, renewals of registrations, permits, pricing approvals and reimbursement, unexpected changes in regulatory requirements and political instability. We are also subject to the laws and regulations of other countries regarding the marketing, sale and distribution of our products in those countries where approvals have been obtained. We experience other issues with managing foreign sales operations including long payment cycles, potential difficulties in accounts receivable collection and, especially from significant customers, fluctuations in the timing and amount of orders. Operations in foreign countries also expose us to risks relating to difficulties in enforcing our proprietary rights, currency fluctuations and adverse or deteriorating economic conditions. If we experience problems with obtaining registrations, complying with reimbursement rules or compliance with other laws, or if we experience difficulties in payments or intellectual property matters in foreign jurisdictions, or if significant political, economic or regulatory changes occur, our results could be adversely affected.
Final results from our ongoing clinical trials for ZADAXIN and SCV-07 may differ materially from interim or pre-clinical trial results. These clinical trials could be affected by the future actions of our partners, unexpected delays, unanticipated patient drop out rates or adverse side effects, future actions by the U.S. Food and Drug Administration or equivalent regulatory authorities in Europe or additional expenses.
Clinical trials are inherently risky and may reveal that our product candidates are ineffective or have unanticipated drug interactions that may significantly decrease the likelihood of regulatory approval. The results of the Mexican triple therapy pilot trial using ZADAXIN to treat HCV do not necessarily predict that the phase 3 clinical trial using ZADAXIN as part of a triple therapy to treat HCV will be successful. The results of this trial may be different, or not statistically significant. Similarly, the results of our preclinical and earlier phase 2 clinical trial in tuberculosis for SCV-07 do not necessarily predict clinical or commercial success.
We may face numerous unforeseen events during, or as a result of, clinical trials that could delay or prevent commercialization of our product candidates including: our product candidates may not prove statistical significance; negative or inconclusive clinical trial results may require us to conduct further testing or we may choose to abandon projects that we had been expecting to complete; patient drop out rates in the HCV clinical trial may be higher than anticipated due to significant side effects associated with interferon alpha and ribavirin; the FDA, EMEA or SFDA may not approve our products for commercialization or may require additional clinical trial data prior to approving our products.
We rely on third parties to supply our clinical trial and commercial products. Deficiencies in their work could delay or harm one or more important areas of our business including our sales, clinical trials or the regulatory approval process.
We rely on third parties, who are subject to regulatory oversight, to supply our clinical and commercial products. The manufacturing of the raw material and the processing to finished product of ZADAXIN is done in few batches in any given three-month period. Manufacturing interruptions or failure or delay of product to meet quality assurance specifications could adversely affect shipments and recognition of sales of ZADAXIN in any period and impair our relationships with customers and our competitive position. During 2006 we have experienced failures and lower yields on production runs from our sole supplier of bulk product for the manufacture of ZADAXIN for our current markets including China and our current ZADAXIN clinical trials. We have taken and are taking various actions to ensure that our sales are not interrupted; to date during 2006, our planned inventory levels of finished product have been met by additional production runs and our sales of ZADAXIN and supply of clinical trial product have been unaffected. However, these efforts are not economical for our supplier. Accordingly, although currently we have inventory for the next few quarters, failure to remedy the production problem may cause future interruptions in product supply that may harm our business. In addition, if sales of ZADAXIN were to increase dramatically, our third-party suppliers may not be able to supply ZADAXIN quickly enough, which could limit our ability to satisfy increased demand or could adversely affect the ability of these suppliers to provide products for our clinical trials. In addition, Biocompatibles is the sole supplier of the DC Bead. If unanticipated deficiencies in these suppliers occur, we could experience delays in our ability to fulfill regulatory requirements which may adversely affect our sales or prospects for regulatory marketing approvals. We have an exclusive supplier of pegylated interferon alpha for our European phase 3 HCV clinical trial, who also supplied all of the pegylated interferon used in our U.S. phase 3 HCV clinical trials. Any recall of the manufacturing lots or similar action regarding the pegylated interferon alpha used in our clinical trials could detract from the integrity of the trial data and its potential use in future regulatory filings.
We rely on third parties and corporate collaborators to conduct clinical trials and these third parties may not perform satisfactorily.
We rely on third parties such as contract research organizations, medical institutions, clinical investigators, contract laboratories, and collaborative partners in the conduct of clinical trials for our product candidates. If
these parties, whom we do not control, do not successfully carry out their contractual duties or regulatory obligations or meet expected deadlines, if the third parties need to be replaced, or if the quality or accuracy of the data they obtain is compromised due to the failure to adhere to our clinical protocols or regulatory requirements or for other reasons, our preclinical or clinical activities may be extended, delayed, suspended or terminated, and we may not be able to obtain regulatory approval for, or successfully commercialize our product candidates.
If third-party reimbursement is not available or patients cannot otherwise pay for ZADAXIN or the DC Bead, we may not be able to successfully market them.
Significant uncertainty exists as to the reimbursement status of new therapeutic products, such as ZADAXIN and the DC Bead. We cannot assure you that third-party insurance coverage and reimbursement will be available for therapeutic products we might develop. We cannot assure you that we will be able to maintain or increase third-party payments for ZADAXIN or obtain third-party payments for the DC Bead in China. The failure to obtain or maintain third-party reimbursement for our products would harm our business. Further, we cannot assure you that additional limitations will not be imposed in the future in the United States or elsewhere on drug coverage and reimbursement due to proposed health care reforms. In many emerging markets where we have marketing rights to ZADAXIN, but where government resources and per capita income may be so low that our products will be prohibitively expensive, we may not be able to market our products on economically favorable terms, if at all.
Efforts by governmental and third-party payers to contain or reduce health care costs or the announcement of legislative proposals or reforms to implement government controls could cause us to reduce the prices at which we market our drugs, which would reduce our gross margins and may harm our business.
Additional clinical trials will be required for the successful U.S. and European commercialization of ZADAXIN and for the continued success of our commercialization efforts in China and other markets. If the results of clinical trials are not favorable, we will be unable to obtain regulatory approval for the intended indications we are evaluating and our sales efforts in China and other markets where ZADAXIN is approved will be harmed.
Our ability to achieve and sustain operating profitability depends in large part on our ability to commence, execute and complete clinical programs and obtain additional regulatory approvals for ZADAXIN and other drug candidates, particularly in the United States and Europe. We are also dependent on our ability to increase ZADAXIN sales in China and other markets. In particular, our ability to achieve and sustain profitability will depend in large part on our ability to commercialize ZADAXIN for the treatment of HCV or malignant melanoma in the United States and Europe.
To obtain regulatory approvals, we must, among other requirements, complete carefully controlled and well-designed clinical trials demonstrating that a particular drug is safe and effective for the applicable disease. We cannot depend on data from prior trial results to predict or demonstrate that our potential drug products are safe and efficacious under regulatory guidelines to qualify for commercial sale. In December 2005 and June 2006, we reported final results from our two U.S. phase 3 trials evaluating the double therapy combination of ZADAXIN and pegylated interferon alpha to treat HCV patients who had failed previous therapy. The results from these trials did not demonstrate that ZADAXIN in combination with pegylated interferon alpha provides a statistically significant clinical benefit when compared with pegylated interferon alpha alone. Although we do not believe that the news of these results had any significant effect on our sales to China in the following periods to date, we cannot assure you that our results will not be harmed if final data from current clinical trials are negative. Our European partner, Sigma-Tau, is conducting a triple therapy combination (ZADAXIN plus pegylated interferon alpha and ribavirin) trial in Europe. Enrollment of the 553 patients in this trial was completed in December 2006.
The current standard of care for HCV therapy is the combination of pegylated interferon alpha with ribavirin. This combination is not approved by the FDA or the EMEA for the treatment of non-responders,
however, in clinical practice pegylated interferon alpha with ribavirin is widely used for the treatment of both treatment naïve and non-responder HCV patients. The European HCV phase 3 clinical trial being conducted by Sigma-Tau has been designed to compare the efficacy of the triple combination of ZADAXIN, pegylated interferon alpha and ribavirin with the current standard of care. The final results of the European trial are not expected to be known until late 2008. As with the FDA, the EMEA generally requires two confirmatory phase 3 clinical trials to support their equivalent of an NDA. Therefore, results of the current triple therapy combination trial, even if positive and statistically significant, would by themselves be insufficient to support an NDA to the EMEA, and results from a second confirmatory phase 3 clinical trial would be needed. At this time, plans for such trial have not been made. We cannot assure you that we or our European partner, Sigma-Tau, will undertake such trial, that any clinical trial of the triple therapy combination will yield favorable results, that we will receive approval for ZADAXIN for the treatment of HCV in Europe or the United States or for the treatment of HCV in other countries, or that we will achieve significant levels of sales. If we are unable to do so, our business will be harmed.
In December 2006, we and Sigma-Tau announced positive interim survival data from a phase 2 trial in Europe evaluating ZADAXIN in combination with dacarbazine (DTIC) chemotherapy with and without low-dose interferon alpha to treat patients with stage IV, the most advanced and imminently fatal form of, malignant melanoma. Data from the first four arms of this ongoing five-arm trial showed that the addition of 3.2 mg of ZADAXIN to standard DTIC chemotherapy increased the median survival to 10.2 months. These data compare favorably to the median survival of 6.6 months for patients treated with DTIC chemotherapy with interferon alpha. DTIC is the only approved therapy in the United States for the treatment of advanced melanoma.
In September 2006, we reported overall tumor response data that showed a distinct ZADAXIN dose-dependent response in combination with DTIC chemotherapy at the 1.6 mg ZADAXIN dose with low-dose interferon and at the 3.2 mg ZADAXIN doses both with and without low-dose interferon alpha. Preliminary data showed that a lower percentage of evaluated patients in the 6.4 mg ZADAXIN dose with low-dose interferon arm achieved either complete or partial tumor response compared to the evaluated patients in either of the 3.2 mg ZADAXN arms. Preliminary survival data on the 6.4 mg ZADAXIN arm is expected to be available in late 2007 due to the later initiation of this treatment arm. The trial’s primary endpoint is overall tumor response.
With the final data from this trial, we, in collaboration with Sigma-Tau, intend to approach the FDA and the EMEA to share these data and to discuss our plans to initiate phase 3 registration trials. We cannot assure you that the final results of the phase 2 clinical trial will be favorable or support the design and initiation of phase 3 clinical trials, that we or Sigma-Tau will receive approval for the indication or that we will achieve significant levels of sales. If we are unable to do so, our business will be harmed.
Higher than anticipated patient drop out rates in our clinical trials could adversely affect trial results and make it more difficult to obtain regulatory approval.
In December 2005 and June 2006 we announced results from our two U.S. phase 3 HCV clinical trials. These clinical trials did not demonstrate that the combination of ZADAXIN and pegylated interferon alpha provides a statistically significant clinical benefit when compared to the use of pegylated interferon alpha alone in non-responder patients. These results may have made Sigma-Tau’s efforts to fully recruit patients for the currently ongoing ZADAXIN phase 3 HCV triple therapy combination trial more difficult and take longer than planned. Enrollment of the 553 patients in this trial was completed in December 2006. In addition, HCV clinical trials are lengthy. The trials require patient treatment for 48 weeks and a follow-up observation period for an additional 24 weeks. Patient dropouts are expected and each of our two phase 3 HCV clinical trials in the United States enrolled more than the planned number of 500 patients, but even then dropouts were higher than anticipated. A patient who drops out at any point in the 72 weeks of the trial is considered a “failure to respond” in results of the clinical trial. In general, the fewer patients who complete each trial, the higher the positive response rate for the group of remaining ZADAXIN treated patients in such trial needs to be in order to demonstrate statistical significance. Therefore, a higher than anticipated dropout rate lowers the chances of
proving statistical significance which could adversely affect clinical trial results. Dropouts did not prevent us from completing our U.S. phase 3 HCV clinical trials. However, dropouts may affect the final results of the European phase 3 HCV triple therapy combination trial.
We cannot predict the safety profile of the use of ZADAXIN when used in combination with other drugs.
Many of our trials involve the use of ZADAXIN in combination with other drugs. Some of these drugs, particularly pegylated interferon alpha, ribavirin, non-pegylated interferon alpha, lamivudine, and dacarbazine are known to cause adverse patient reactions. Even if ZADAXIN does not produce adverse side effects when used alone, we cannot predict how it will work with other drugs, including causing possible adverse side effects not directly attributable to the other drugs that could compromise the safety profile of ZADAXIN when used in certain combination therapies.
If we do not obtain regulatory approval for ZADAXIN for the intended indications that we are evaluating, our revenues will be limited and we may never become profitable.
Our ability to execute on our business strategy has been largely dependent on our ability to obtain regulatory approval for the use of ZADAXIN, particularly in the United States and Europe. The regulatory approval processes in the United States and Europe are demanding and typically require 12 months or more in the United States and 18 months or more in Europe from the date of submission of a New Drug Application (NDA). We have committed significant resources, including capital and time, to develop ZADAXIN, and intend to continue to do so, including the initiation and execution of additional clinical trials, with the goal of obtaining such approvals. If we do not obtain these approvals, we will be unable to achieve any substantial increase in our revenue from ZADAXIN and our ZADAXIN sales in other jurisdictions could decline.
All new drugs, including our products, which have been developed or are under development, are subject to extensive and rigorous regulation by the FDA and comparable agencies in state and local jurisdictions and in foreign countries. These regulations govern, among other things, the development, testing, manufacturing, labeling, storage, pre-market approval, importation, advertising, promotion, sale and distribution of our products. These regulations may change from time to time and new regulations may be adopted.
Obtaining regulatory approval in developing countries also is time-consuming and expensive. In some countries where we are contemplating marketing and selling ZADAXIN, the regulatory approval process often relies on prior approvals obtained in the United States or in Europe. Without such prior approvals, our ability to obtain regulatory approvals for ZADAXIN in these countries may be delayed or prevented. In addition, to secure these regulatory approvals, we will need, among other things, to demonstrate favorable results from additional clinical trials of ZADAXIN. Even if we are able to complete the clinical trials we have sponsored or are planning in a timely or cost-effective manner, these trials may not fulfill the applicable regulatory approval criteria, in which case we will not be able to obtain regulatory approval in these countries, and we have experienced such difficulties and have been unable to meet such regulatory filing requirements. We cannot assure you that we will ultimately obtain regulatory approvals in our targeted countries in a timely and cost-effective manner or at all. If we fail to obtain the required regulatory approvals to develop, market and sell ZADAXIN in countries where we currently do not have such rights, our revenues will be limited, and our future prospects will be dependent upon our ability to in-license or to bring earlier stage products to market, any of which will require substantial financial expenditures.
Satisfaction of government regulations may take several years and the time needed to satisfy them varies substantially based on the type, complexity and novelty of the pharmaceutical product. As a result, government regulation may cause us to delay the introduction of, or prevent us from marketing, our existing or potential products for a considerable period of time and impose costly procedures upon our activities. Even if we obtain regulatory approval for our products, such approval may impose limitations on the indicated uses for which our
products may be marketed. Unsatisfactory data resulting from clinical trials may also adversely affect our ability to market and sell ZADAXIN in markets where it is approved for sale.
Regulatory approval is necessary to permit us to market the DC Bead in China. If we are unable to secure regulatory approval in China, we will be unable to market the DC Bead in China and our future sales potential in this market could be harmed.
In June 2006, we announced our agreement with Biocompatibles International plc. (Biocompatibles) to become the exclusive distributor in China of the DC Bead, a chemotherapeutic drug delivery embolic agent designed to be used in the treatment of liver cancer. While the DC Bead is approved in Europe for the use in the treatment of malignant hypervascularized tumors, it has not yet received regulatory approval in China. Biocompatibles is responsible, with our assistance and financial support of 50% of all costs, for seeking and obtaining the regulatory approval for marketing the product in China. We, on behalf of Biocompatibles, filed a regulatory submission in China in December 2006; however, we cannot give assurance that such submission will be approved by the regulatory authorities. If clinical trials in China are required as part of the regulatory process, the regulatory submission for marketing approval could be delayed for a considerable period of time, and there can be no assurance that the results of clinical trials would support a regulatory submission or that the regulatory authorities would approve the product to be commercialized and sold in China. To the extent that additional information or clinical trials are required by the regulatory authorities, or we do not receive regulatory approval in China, our future sales potential in China could be harmed.
Our business strategy is dependent on our ability to in-license or otherwise acquire the rights to develop and commercialize products. If we fail to acquire such rights or are unsuccessful in our efforts to develop such products and obtain regulatory approval to market and successfully commercialize them, our business will suffer.
All of our products, including ZADAXIN, the only one for which we have sales revenue, have been in-licensed by us. We do not conduct product discovery and typically have in-licensed our products from third parties who have discovered the products and conducted at least some pre-clinical research on them. The competition for attractive products to in-license is intense, and we cannot assure you that we will be able to in-license products in the future on acceptable terms, if at all. In addition, we face the risks of developing the in-licensed products and the risks and uncertainties of conducting clinical trials and seeking regulatory approval to market the in-licensed products, all of which require years of effort and the commitment of significant financial resources. Our ability to grow our business requires the development and commercialization of additional products. If we are unable to in-license products on acceptable terms and successfully develop and commercialize them, our business could be harmed.
If we lose key personnel or are unable to attract and retain additional, highly skilled and experienced personnel required for the expansion of our activities, our business will suffer.
We are highly dependent upon our ability to attract and retain qualified personnel because of the specialized, scientific and worldwide nature of our business. There is intense competition for qualified management, scientific, clinical, regulatory, and sales and marketing personnel in the pharmaceutical industry, and we may not be able to attract and retain the qualified personnel we need to grow and develop our business globally. In particular, our efforts to in-license or acquire, develop and commercialize product candidates for China require the addition of clinical and regulatory personnel and the capabilities to expand our sales and marketing operation. In addition, we assign numerous key responsibilities to a limited number of individuals, and we would experience difficulty in finding immediate replacements for any of them. If we were unable to attract and retain qualified personnel as needed or promptly replace those employees who are critical to our product development and commercialization, the development and commercialization of our products would be adversely affected. At this time, we do not maintain “key person” life insurance on any of our personnel.
Because of China's tiered method of importing and distributing finished pharmaceutical products, our quarterly results may vary substantially from one period to the next.
China uses a tiered method to import and distribute finished pharmaceutical products. At each port of entry, and prior to moving the product forward to the distributors, government-licensed importing agents must process and evaluate each shipment to determine whether such shipment satisfies China's quality assurance requirements. In order to efficiently manage this process, the importing agents typically place large, and therefore relatively few, orders within any six month period. Therefore, our sales to an importing agent can vary substantially from quarter to quarter depending on the size and timing of the orders, which has in the past and may in the future cause our quarterly results to fluctuate. We rely on four to six importers, in any given quarter, to supply substantially all of our product in China. Because we use a small number of importing agents in China, our receivables from any one importing agent are material, and if we were unable to collect receivables from any importer, our business and cash-flow would be adversely affected.
Our sales of ZADAXIN may fluctuate due to seasonality of product orders and sales in any quarter may not be indicative of future sales.
Our sales for the quarter ended June 30, 2003 were greatly affected by the demand in China for ZADAXIN in connection with the treatment of SARS. To date, SARS has not re-emerged, like influenza, as a seasonal public health problem. However, if SARS or a similar epidemic were to emerge, it is not possible to predict what effect, if any, this would have on future sales of ZADAXIN. Although we do not market ZADAXIN for use in treating such epidemic diseases, if ZADAXIN is purchased in connection with future outbreaks of seasonal viral contagions, product sales could become more concentrated in certain quarters of the calendar year, quarterly sales levels could fluctuate and sales in any quarter may not be indicative of sales in future periods.
If we fail to protect our products, technologies and trade secrets, we may not be able to successfully use, manufacture, market or sell our products, or we may fail to advance or maintain our competitive position, and we have limited intellectual property protection in China.
Our success depends significantly on our ability to obtain and maintain meaningful patent protection for our products and technologies and to preserve our trade secrets. Our pending patent applications may not result in the issuance of patents in the future. Our patents or patent applications may not have priority over others' applications. Our existing patents and additional patents that may be issued, if any, may not provide a competitive advantage to us or may be invalidated or circumvented by our competitors. Others may independently develop similar products or design around patents issued or licensed to us. Patents issued to, or patent applications filed by, other companies could harm our ability to use, manufacture, market or sell our products or maintain our competitive position with respect to our products. Although many of our patents relating to ZADAXIN have expired, including composition of matter patents, we have rights to other patents and patent applications relating to ZADAXIN and ZADAXIN analogues, including method of use patents with respect to the use of ZADAXIN for certain indications. Additionally, we have received Orphan Drug designation in the United States for thymosin alpha 1, the chemical composition of ZADAXIN, for the treatment of stage IIb through stage IV malignant melanoma. If other parties develop generic forms of ZADAXIN for other indications, including conducting clinical trials for such indications, our patents and other rights might not be sufficient to prohibit them from marketing and selling such generic forms of ZADAXIN. If other parties develop analogues or derivatives of ZADAXIN, our patents and other rights might not be sufficient to prohibit them from marketing these analogues or derivatives.
Pharmaceutical products are either not patentable or have only recently become patentable in some of the countries in which we market or may market ZADAXIN. We do not have patent protection for ZADAXIN in China, our largest market. Other companies market generic thymosin alpha 1 in China, sometimes in violation of our trademark or other rights which we defend by informing physicians and hospitals of the practice as well as through the limited legal recourse. Past enforcement of intellectual property rights in many of these countries,
including China in particular, has been limited or non-existent. Future enforcement of patents and proprietary rights in many other countries will likely be problematic or unpredictable. Moreover, the issuance of a patent in one country does not assure the issuance of a similar patent in another country. Claim interpretation and infringement laws vary by nation, so the extent of any patent protection is uncertain and may vary in different jurisdictions.
If we are involved in intellectual property claims and litigation, the proceedings may divert our resources and subject us to significant liability for damages, substantial litigation expense and the loss of our proprietary rights.
Our commercial success depends in part on us not infringing valid, enforceable patents or proprietary rights of third parties, and not breaching any licenses that may relate to our technologies and products. We are aware of a third-party patent that may relate to our products and may cover a method of action used by ZADAXIN. We cannot assure you that our mechanism of action does not infringe on their claim. In addition, we may not be aware of all patents or patent applications that may impact our ability to make, use or sell any of our potential products. For example, U.S. patent applications may be kept confidential for 12 or more months while pending in the Patent and Trademark Office, and patent applications filed in foreign countries are often first published six months or more after filing. It is possible that we may unintentionally infringe these patents or other patents or proprietary rights of third parties. We may in the future receive notices claiming infringement from third parties as well as invitations to take licenses under third-party patents. Any legal action against us or our collaborative partners claiming damages and seeking to enjoin commercial activities relating to our products and processes affected by third-party rights may require us or our collaborative partners to obtain licenses in order to continue to manufacture or market the affected products and processes. Our efforts to defend against any of these claims, regardless of merit, would require us to devote resources and attention that could have been directed to our operations and growth plans. In addition, these actions may subject us to potential liability for damages. We or our collaborative partners may not prevail in a patent action and any license required under a patent may not be made available on commercially acceptable terms, or at all. Any conflicts resulting from the patent rights of others could significantly reduce the coverage of our patents and limit our ability to obtain meaningful patent protection.
If other companies obtain patents with conflicting claims, we may be required to obtain licenses to those patents or develop or obtain alternative technology to manufacture or market the affected products and processes. We may not be able to obtain any such licenses on acceptable terms or at all. Any failure to obtain such licenses could delay or prevent us from pursuing the development or commercialization of our potential products. Our efforts to defend against any of these claims would require us to devote resources and attention that could have been directed to our operations and growth plans.
We may need to initiate litigation, which could be time-consuming and expensive, to enforce our proprietary rights or to determine the scope and validity of others' rights. If litigation results, a court may find our patents or those of our licensors invalid or may find that we have infringed on a competitor's rights. If any of our competitors have filed patent applications in the United States which claim technology we also have invented, the Patent and Trademark Office may require us to participate in expensive interference proceedings to determine who has the right to a patent for the technology. These actions may subject us to potential liability for damages. We or our collaborative partners may not prevail in a patent action and any license required under a patent may not be made available on commercially acceptable terms, or at all.
If we are not able to establish and maintain adequate manufacturing relationships, the development and sale of our products could be impaired.
To be successful, our products must be manufactured in commercial quantities, in compliance with stringent regulatory requirements and at an acceptable cost. Typically we have at any time only one supplier for each phase of manufacturing of our product. At present, we are in the process of negotiating a new long-term supply
agreement with our sole supplier of bulk product for the manufacture of ZADAXIN for our current markets including China. Failure to secure such agreement, or on favorable terms, would harm our business. The manufacturing facilities of our suppliers are subject to inspection by regulatory authorities to ensure their compliance with regulatory requirements and standards. Manufacturing interruptions or failure to comply with regulatory requirements could significantly delay clinical development of potential products and reduce third-party or clinical researcher interest and support of proposed trials. These interruptions or failures could also impede commercialization of our products, including sales of ZADAXIN in approved markets, and impair our competitive position. Any of these developments would harm our business.
We are in the process of registering a new supplier for ZADAXIN with regulatory agencies in markets where ZADAXIN is approved for sale. We have received such registration in China. This process, quality assurance and other steps could cause delays or interruptions of supply in certain other markets. In some countries, a manufacturing change may require additional regulatory approvals that may delay ZADAXIN marketing approvals in new markets. In addition, manufacturing, supply and quality control problems may arise as we, either alone or with subcontractors, attempt to scale-up our manufacturing procedures. We may not be able to scale-up in a timely manner or at a commercially reasonable cost, either of which could cause delays or pose a threat to the ultimate commercialization of our products and harm our business.
We may not be able to successfully develop or commercialize our products. We may consider strategic alliances with other companies in efforts to broaden our product development pipeline.
While we have limited sales of ZADAXIN in certain markets, we do not yet have regulatory approval for ZADAXIN for the key markets of the United States, Europe and Japan and, in this respect, ZADAXIN is still being developed. We recently acquired the rights to distribute the DC Bead in China, but we must receive regulatory approval before we can commercialize this product. Our only other potential product presently is SCV-07, and it is in an earlier stage of development than ZADAXIN. We may consider and undertake various strategies to expand our portfolio of potential products, including acquiring product candidate rights through licenses or other relationships, or through other strategic relationships including acquisitions of other companies that may have proprietary rights to other development candidates or the capability to discover new drug candidates. Such transactions could require a substantial amount of our financial resources, or, if equity is involved, may result in substantial dilution to current stockholders. Strategic transactions also require substantial management time and effort and are subject to various risks that could adversely affect us or our financial results.
To fully develop our products, we will need to commit substantial resources to extensive research, development, pre-clinical testing, clinical trials, manufacturing scale-up and regulatory approval prior to the potential products being ready for sale. We cannot assure that our efforts will produce commercially viable products. We face significant technological risks inherent in developing these products. We may also abandon some or all of our proposed products before they become commercially viable. For the DC Bead, we are obligated to pay half of the costs in our efforts to obtain regulatory approval in China. If any of our products, even if developed and approved, cannot be successfully commercialized in a timely manner, our business will be harmed and the price of our stock may decline.
We have not yet sold any product other than ZADAXIN and our sales have been primarily in a single country, China. Our future revenue growth depends to a great extent on increased market acceptance and commercialization of ZADAXIN in additional countries, particularly in the United States, Europe and Japan. If we fail to successfully market ZADAXIN, or if we cannot commercialize this drug in the United States and other additional markets, our revenue and operating results will be limited. If unexpected and serious adverse events are reported, or if expected efficacy results are not achieved, it would have a material adverse effect on our business. Our future revenue will also depend in part on our ability to develop other commercially viable and accepted products, such as the DC Bead. Market acceptance of our products will depend on many factors, including our ability to convince prospective customers to use our products as an alternative to other treatments and therapies and to convince prospective strategic partners to market our products effectively and to
manufacture our products in sufficient quantities with acceptable quality and at an acceptable cost. In addition, doctors must opt to use treatments involving our products. If doctors elect to use a different course of treatment, demand for our drug products would be reduced. Failure to do any of the above will lead to an unfavorable outcome on the results of our operations.
We may need to obtain additional capital to support our long-term product development and commercialization programs.
We believe our existing resources will be sufficient to fund our operations, including anticipated clinical trials, through 2008. However, we cannot assure you that such funds will be sufficient, or that we will attain profitable operations in that period or in future periods. In addition to development plans for ZADAXIN, we intend to develop other products and we may need additional funds in the future to support such development and to support future growth and achieve profitability. If we need to raise additional funds in the future and such funds are not available on reasonable terms, if at all, our commercialization efforts may be impeded, our revenues may be limited and our operating results may suffer.
We have a history of operating losses and an accumulated deficit. We expect to incur losses in the near term and may not be profitable in the future.
Although we were profitable in 2006, we have experienced significant operating losses in the past, and as of December 31, 2006, we had an accumulated deficit of approximately $159 million. We expect our operating expenses to increase over the next several years as we plan to dedicate substantially all of our resources to expanding our development, testing and marketing capabilities, and these losses may increase if we cannot increase or sustain revenue. As a result, we may not achieve profitability in the future.
We have limited sales, marketing and distribution capabilities outside of China, which may adversely affect our ability to successfully commercialize our products.
Outside of our current principal market of China, we have limited sales, marketing and distribution capabilities, and we anticipate that we may be relying on third-party collaborators to sell, market and distribute our products for the foreseeable future particularly in the major pharmaceutical markets of the United States, Europe and Japan should we receive regulatory approval to market our products in those territories. If our arrangements with these third parties are not successful, or if we are unable to enter into additional third-party arrangements, we may need to substantially expand our sales, marketing and distribution force. Our efforts to expand may not succeed, or we may lack sufficient resources to expand in a timely manner, either of which will harm our future operating results. Moreover, if we are able to further expand our sales, marketing and distribution capabilities, we will begin competing with other companies that have experienced and well-funded operations. If we cannot successfully compete with these larger companies, our revenues may not grow and our business may suffer.
Commercialization of some of our products depends on collaborations with others. If our collaborators are not successful, or if we are unable to find future collaborators, we may not be able to properly develop and commercialize our products.
We depend in part on our distributors and business partners to develop or promote our drugs, and if they are not successful in their efforts or fail to do so, our business will suffer. For example, Sigma-Tau is responsible for the development and marketing of ZADAXIN in most of Europe and Biocompatibles is primarily responsible for the efforts to obtain regulatory approval in China for the DC Bead. We generally do not have control over the amount and timing of resources that our business partners devote to our collaborative efforts, and they have not always performed as or when expected. If they do not perform their obligations as we expect, particularly obligations regarding clinical trials, our development expenses would increase and the development or sale of our products could be limited or delayed, which could hurt our business and cause our stock price to decline. In
addition, our relationships with these companies may not be successful. Disputes may arise with our collaborators, including disputes over ownership rights to intellectual property, know-how or technologies developed with our collaborators. We may not be able to negotiate similar additional arrangements in the future to develop and commercialize ZADAXIN or other products.
We may be subject to product liability lawsuits, and our insurance may be inadequate to cover damages.
Clinical trials or marketing of any of our current and potential products may expose us to liability claims from the use of these products. We currently carry product liability insurance. However, we cannot be certain that we will be able to maintain insurance on acceptable terms, if at all, for clinical and commercial activities or that the insurance would be sufficient to cover any potential product liability claim or recall. If we fail to have sufficient coverage, our business, results of operations and cash flows could be adversely affected.
We depend on international sales, and global conditions could negatively affect our operating results.
A large majority of our sales are in China. Heightened tensions resulting from the current geopolitical conditions in the Middle East, North Korea and elsewhere could worsen, causing disruptions in foreign trade, which would harm our sales. In particular, our commercial product is manufactured in Europe and distributed by us from our operations in Hong Kong. Any disruption of our supply and distribution activities due to geopolitical conditions could decrease our sales and harm our operating results.
If we are unable to comply with environmental and other laws and regulations, our business may be harmed.
We are subject to various federal, state and local laws, regulations and recommendations relating to the use, manufacture, storage, handling and disposal of hazardous materials and waste products (including radioactive compounds and infectious disease agents), as well as safe working conditions, laboratory and manufacturing practices and the experimental use of animals. The extent of government regulation that might result from future legislation or administrative action in these areas cannot be accurately predicted.
We do not currently maintain hazardous materials at our facilities. While we outsource our research and development programs involving the controlled use of biohazardous materials, if in the future we conduct these programs ourselves, we might be required to incur significant cost to comply with environmental laws and regulations. Further, in the event of an accident, we would be liable for any damages that result, and the liability could exceed our resources.
We may lose market share or otherwise fail to compete effectively in the intensely competitive biopharmaceutical industry.
Competition in the biopharmaceutical industry is intense, and we expect that competition will increase. Our success depends on our ability to compete in this industry, but we cannot assure you that we will be able to successfully compete with our competitors. Increased competitive pressure could lead to intensified price-based competition resulting in lower prices and margins, which would hurt our operating results. We cannot assure you that we will compete successfully against our competitors or that our competitors, or potential competitors, will not develop drugs or other treatments for our targeted indications that will be superior to ours.
Our stock price may be volatile, and an investment in our stock could suffer a decline in value.
The market price of our common stock has experienced, and may continue to experience, substantial volatility due to many factors, some of which we have no control over, including:
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progress and results of clinical trials involving ZADAXIN and SCV-07;
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progress of ZADAXIN through the regulatory process, especially regulatory actions and the adequacy of clinical data and documentation for regulatory purposes in the United States, Europe and Japan;
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progress of the DC Bead through the regulatory process, especially regulatory actions and the adequacy of clinical data and documentation for regulatory purposes in China;
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timing and achievement of milestones;
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announcements of technological innovations or new products by us or our competitors;
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announcement and completion of corporate acquisition, merger, licensing or marketing arrangements, or sales of assets;
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government regulatory action affecting our drug products or our competitors' drug products in both the United States and foreign countries;
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developments or disputes concerning patent or proprietary rights;
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changes in the composition of our management team or board of directors;
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changes in company assessments or financial estimates by securities analysts;
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actual or anticipated fluctuations in our quarterly operating results;
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changes in assessments of our internal controls over financial reporting;
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general stock market conditions and fluctuations for the emerging growth and biopharmaceutical market sectors;
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economic conditions in the United States or abroad; and
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broad financial market fluctuations in the United States, Europe or Asia.
In the past, following periods of large price declines in the public market price of a company's securities, securities class action litigation has often been initiated against that company. Litigation of this type could result in substantial costs and diversion of our attention and resources, which would hurt our business. Any adverse determination in litigation could also subject us to significant liabilities.
Substantial sales of our stock or the exercise or conversion of options or convertible securities may impact the market price of our common stock.
Our collaborative partner Sigma-Tau and affiliates hold a substantial amount of our stock. The stock is freely tradeable and Sigma-Tau is not under any obligation to SciClone which would prevent it from selling some or all of the stock it holds.
Future sales of substantial amounts of our common stock could adversely affect the market price of our common stock. Similarly, if we raise additional funds through the issuance of common stock or securities convertible into or exercisable for common stock, the percentage ownership of our present stockholders will be reduced and the price of our common stock may fall.
Sales of our common stock by officers and directors could affect our stock price.
Our board of directors has approved an amendment to our trading policy that permits officers and directors to enter into trading plans that comply with the requirements of Rule 10b5-1 of the Securities Exchange Act of 1934, as amended. Rule 10b5-1 allows corporate officers and directors to adopt written, pre-arranged stock trading plans when they do not have material, non-public information. Using these plans, officers and directors can gradually diversify their investment portfolios, can spread stock trades out over an extended period of time to reduce any market impact and can avoid concerns about initiating stock transactions at a time when they might
be in possession of material, non-public information. As of December 31, 2006, one director has adopted such a plan, and other directors or officers may do so in the future. We expect future sales by officers and directors either under 10b5-1 plans or otherwise as a result of their personal financial planning. We do not believe the volume of such sales would affect our trading price; however, the market could react negatively to sales by our officers and directors, which could affect the trading price of our stock.
Anti-takeover provisions in our charter documents and under Delaware law may make an acquisition of us, which may be beneficial to our stockholders, more difficult.
Certain anti-takeover provisions of Delaware law and our charter documents as currently in effect may make a change in control of our company more difficult, even if a change in control would be beneficial to our stockholders. Our charter documents contain certain anti-takeover provisions, including provisions in our certificate of incorporation providing that stockholders may not cumulate votes, stockholders' meetings may be called by stockholders only if they hold 25% or more of our common stock and provisions in our bylaws providing that the stockholders may not take action by written consent. Additionally, our board of directors has the authority to issue 10 million shares of preferred stock and to determine the terms of those shares of stock without any further action by the stockholders. The rights of holders of our common stock are subject to the rights of the holders of any preferred stock that may be issued. The issuance of preferred stock could make it more difficult for a third-party to acquire a majority of our outstanding voting stock. Delaware law also prohibits corporations from engaging in a business combination with any holders of 15% or more of their capital stock until the holder has held the stock for three years unless, among other possibilities, the board of directors approves the transaction. Our board of directors may use these provisions to prevent changes in the management and control of our company. Also, on December 18, 2006, our Board of Directors declared a dividend distribution of one Preferred Stock Purchase Right (collectively, the “Rights”) for each outstanding share of our Common Stock, each Right which entitles the registered holder to purchase from the Company one one-thousandth of a share of the Company’s Series D Preferred Stock, $0.001 par value, at a price of $25.00 pursuant to a Rights Agreement dated as of December 19, 2006, between the Company and Mellon Investor Services LLC. The Rights have certain anti-takeover effects. Under certain circumstances the Rights could cause substantial dilution to a person or group who attempts to acquire the Company on terms not approved by our Board of Directors. Although the Rights should not interfere with an acquisition of the Company approved by the Board, the Rights may have the effect of delaying and perhaps improving the terms of an acquisition for our stockholders, or deterring an acquisition of the Company. Also, under applicable Delaware law, our board of directors may adopt additional anti-takeover measures in the future.
If we fail to maintain an effective system of internal controls, we may not be able to accurately report our financial results. As a result, current and potential stockholders could lose confidence in our financial reporting, which would harm our business and the trading price of our stock.
Effective internal controls are necessary for us to provide reliable financial reports. If we cannot provide reliable financial reports, our business and operating results could be harmed. We have in the past discovered, and may in the future discover, areas of our internal controls that need improvement. For example, in the quarter ended June 30, 2005, we identified a material weakness in our internal controls over financial reporting as defined in Public Company Accounting Oversight Board (PCAOB) Standard No. 2. This material weakness related to our failure, due to our lack of familiarity with certain technical stock option accounting matters, to evaluate the correct accounting effect of a stock price performance based option granted to our Chief Executive Officer on June 1, 2005, the date he commenced his employment. Due to the terms of this option, Accounting Principles Board Opinion No. 25 (APB 25) required the application of variable accounting and specifically required the recognition of non-cash expense in the period that portions of the option vested or were deemed probable of vesting at the end of the reporting period. The vesting of this option is directly determined by the price level of trading activity in our stock, and the conditions required to recognize a related non-cash expense did not occur in the interim period ended June 30, 2005. However, had the conditions required the recognition of a non-cash expense related to this option under APB 25, our accounting procedures at June 30, 2005 would not have correctly applied APB 25. Because of the material weakness described above, management concluded that
the Company did not maintain effective internal control over financial reporting as of June 30, 2005. The Company’s management identified the steps necessary to address the material weakness described above, and executed remediation plans, as discussed in “Item 4. Controls and Procedures” of our September 30, 2005 quarterly report on Form 10-Q, which is incorporated herein by reference.
Any failure to implement and maintain the improvements in the controls over our financial reporting, or difficulties encountered in the implementation of these improvements in our controls, could cause us to fail to meet our reporting obligations. Any failure to improve our internal controls to address these identified weaknesses could also cause investors to lose confidence in our reported financial information, which could have a negative impact on the trading price of our stock.
New accounting pronouncements may impact our financial position or results of operations.
Future changes in financial accounting standards may cause adverse, unexpected fluctuations in the timing of the recognition of revenues or expenses and may affect our financial position or results of operations. New pronouncements and varying interpretations of pronouncements have occurred with frequency and may occur in the future and this may lead to changes in our accounting policies in the future. One such new pronouncement issued in December 2004 by the Financial Accounting Standards Board (FASB) is FASB Statement No. 123 (revised 2004), “Share-Based Payment” (FAS 123R). FAS 123R requires share-based payments to employees and directors, including grants of stock options, to be recognized in the statement of operations based on their fair values. We adopted FAS 123R on January 1, 2006. Accordingly, the adoption of FAS 123R's fair value method is having a significant impact on our results of operations, although it has had no impact on our cash or overall financial position. For the year ended December 31, 2006, we recognized $2,446,000 of stock-based compensation expense relating to the adoption of FAS 123R.
New legislation may impact our financial position or results of operations.
Compliance with changing regulations concerning corporate governance and public disclosure has resulted in and may continue to result in additional expenses. Changing laws, regulations and standards relating to corporate governance and public disclosure, including the Sarbanes-Oxley Act of 2002, new SEC regulations and The NASDAQ Stock Market LLC rules, are creating uncertainty for companies such as ours and costs are increasing as a result of this uncertainty and other factors. We are committed to maintaining high standards of corporate governance and public disclosure. As a result, we intend to invest all reasonably necessary resources to comply with evolving standards, and this investment has and may continue to result in increased general and administrative expenses and a diversion of management time and attention from revenue-generating activities to compliance activities.
We may be subject to currency exchange rate fluctuations, which could adversely affect our financial performance.
Substantially all of our product sales are denominated in U.S. dollars. Fluctuation in the U.S. dollar exchange rate with local currency directly affects the customer's cost for our product. In particular, a stronger U.S. dollar vis-à-vis the local currency would tend to have an adverse effect on sales and potentially on collection of accounts receivable. The Chinese currency is no longer pegged to the U.S. dollar and, we are subject to currency exchange rate fluctuations as a result of expenses incurred by our foreign operations. In particular, one of our supply arrangements under which we purchase finished products is denominated in euros and costs of our operations in China are paid in local currency. Consequently, changes in exchange rates could unpredictably and adversely affect our operating results and could result in exchange losses. To date, we have not hedged against the risks associated with fluctuations in exchange rates and, therefore, exchange rate fluctuations could have a material adverse impact on our future operating results and stock price.
Item 1B.
Item 1B. Unresolved Staff Comments
None
Item 2.
Item 2. Properties
We currently lease approximately 24,000 square feet of office space including our headquarters in San Mateo, California and limited office space in Beijing, Hong Kong, Shanghai, Singapore, Tokyo and Sao Paulo. We believe that our existing facilities will be adequate for our current needs and that additional space will be available as needed.
Item 3.
Item 3. Legal Proceedings
None
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders
No matter was submitted to a vote of security holders during the fourth quarter of the fiscal year ended December 31, 2006.
PART II
Item 5.
Item 5. Market for the Registrant’s Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Our Common Stock trades on The NASDAQ Stock Market LLC under the symbol “SCLN.”
The following table sets forth the high and low sales prices per share for the quarterly periods indicated, as reported by The NASDAQ Stock Market LLC (formerly The NASDAQ National Market). The quotations shown represent inter-dealer prices without adjustment for retail markups, markdowns, or commissions, and may not necessarily reflect actual transactions.
Stockholders
As of March 9, 2007, there were approximately 369 holders of record of our common stock and 46,083,749 shares of common stock issued and outstanding.
Dividends
We have not paid any dividends on our common stock during the fiscal years ended December 31, 2006, 2005, and 2004 and currently intend to retain any future earnings for use in our business.
Securities Authorized for Issuance Under Equity Compensation Plans
The information required by Item 201(d) of Regulation S-K is incorporated by reference from the section entitled “Securities Authorized for Issuance under Equity Compensation Plans” in Part III, Item 12 of this Form 10-K.
Item 6.
Item 6. Selected Consolidated Financial Data
This section presents selected historical financial data for each of the last five fiscal years and is qualified by reference to and should be read in conjunction with the consolidated financial statements and notes thereto included elsewhere in this Annual Report on Form 10-K.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations
This Management’s Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the “Selected Consolidated Financial Data” and our consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. This Management’s Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Annual Report on Form 10-K contain forward-looking statements which involve risks and uncertainties. See “Note Regarding Forward-Looking Statements” and “Risk Factors” contained in this Annual Report on Form 10-K.
Overview
We are a biopharmaceutical company engaged in the development and commercialization of novel therapeutics to treat life-threatening diseases. Our strategy is to in-license products in the areas of cancer and viral infectious diseases, and to develop them for commercialization in the major pharmaceutical markets with a particular focus on China, one of the world’s fastest growing pharmaceutical markets. ZADAXIN is one of the largest selling imported drugs in China today, and currently is in late-stage clinical development in Europe for the treatment of malignant melanoma and hepatitis C virus (HCV). During the periods encompassed by this Annual Report on Form 10-K, we devoted substantially all of our resources to our lead product ZADAXIN® (thymalfasin or thymosin alpha 1) clinical trials and our ZADAXIN commercialization activities, and our primary focus was the clinical development of ZADAXIN as a part of a new combination therapy for the treatment of HCV. We expect our proprietary compound SCV-07 will enter phase 2 clinical development for viral infectious disease in the second quarter of 2007. We also submitted a regulatory application to the Chinese State Food and Drug Administration (SFDA) in December 2006 related to our June 2006 in-licensing of the Chinese marketing rights to DC Bead™, a product for the treatment of liver cancer, or hepatocellular carcinoma (HCC). In addition to our current product portfolio, we believe we are well-positioned to in-license additional therapeutics for both China and potentially the significantly larger U.S. and European markets, in part because of our ability to rapidly and cost-effectively develop and commercialize these products in China. Also, we intend to use this clinical work to support and accelerate regulatory applications in the United States and Europe.
In December 2005 and June 2006, we reported results from the first of our two U.S. phase 3 trials evaluating the double therapy combination of ZADAXIN and pegylated interferon alpha to treat HCV patients who had failed previous therapy. The results from these trials did not demonstrate that ZADAXIN in combination with pegylated interferon alpha provides a statistically significant clinical benefit when compared with pegylated interferon alpha alone. Our European partner, Sigma-Tau, is conducting a triple therapy combination (ZADAXIN plus pegylated interferon alpha and ribavirin) trial in Europe and enrollment for this trial was completed in December 2006. Also in December 2006, we reported positive interim survival data from a phase 2 trial treating patients with stage IV malignant melanoma indicating that the addition of 3.2 mg of ZADAXIN to standard dacarbazine (DTIC) chemotherapy increased the median survival to 10.2 months. In addition, such data show patients treated with thymalfasin and DTIC chemotherapy without interferon alpha achieved more than double the overall tumor response as compared to the control group.
We manufacture ZADAXIN for sale, and for our clinical trials, through third party contract manufacturers, and we conduct our research and development efforts principally through arrangements with clinical research sites, contract research organizations and universities.
From commencement of operations through December 31, 2006, we have an accumulated deficit of approximately $159,000,000. At least over the next few years, we expect net losses due to increased operating expenses as we expand our research and development, clinical testing and sales and marketing capabilities. Our ability to achieve and sustain operating profitability is dependent on expansion of sales of ZADAXIN in China and securing regulatory approval for SCV-07 and DC Bead in China or the execution and successful completion of ZADAXIN, SCV-07 and DC Bead clinical trials and securing regulatory approvals for these products in the major pharmaceutical markets of the United States, Europe and Japan. If regulatory approval is secured in those
countries, our ability to achieve and sustain operating profitability will depend on the successful commercialization and marketing of these products. In addition, other factors may also impact our ability to achieve and sustain operating profitability, including the pricing of ZADAXIN and its manufacturing and marketing costs, our ability to compete in pharmaceutical markets, the cost of product development and commercialization programs including SCV-07 and DC Bead, the timing and costs of acquiring rights to additional drugs, our ability to fund our operations and the entrance into and extension of agreements for product development and commercialization, where appropriate.
We expect net sales to increase in 2007 due to increased sales to China. Primarily due to the level of research and development activities and other operations, we expect a net loss and a reduction in cash, cash equivalents and short-term investments for 2007.
Our operating results may fluctuate from quarter to quarter and these fluctuations may be substantial as a result of, among other factors, the number, timing, costs and results of preclinical and clinical trials of our products, market acceptance of ZADAXIN, SCV-07 and DC Bead and the timing of orders for our products from international markets, particularly China, the regulatory approval process, the timing of FDA or international regulatory approvals, and the acquisition of additional product rights and the funding, if any, provided as a result of corporate partnering arrangements.
Critical Accounting Policies
General
We have identified the policies below as critical to our business operations and the understanding of our results of operations. The impact and any associated risks related to these policies on our business operations is discussed throughout “Management’s Discussion and Analysis of Financial Condition and Results of Operations” where such policies affect our reported and expected financial results. For a detailed discussion on the application of these and other accounting policies, see Note 1 in the “Notes to our Consolidated Financial Statements” in Part II, Item 8 of this Annual Report on Form 10-K. The Consolidated Financial Statements have been prepared in accordance with accounting principles generally accepted in the United Sates, which requires us to make estimates and assumptions that affect the reported amount of assets and liabilities, disclosure of contingent assets and liabilities at the date of our financial statements, and the reported amounts of revenue and expenses during the reporting period. On an on-going basis, we evaluate the relevance of our estimates. We base our estimates on historical experience and on various other market specific assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. There can be no assurance that actual results will not differ from those estimates.
Revenue Recognition
We recognize revenue from product sales at the time of shipment. There are no significant customer acceptance requirements or post-shipment obligations on our part. Sales to importing agents or distributors are recognized at time of shipment when title to the product is transferred to them. Importing agents or distributors do not have contractual rights of return except under limited terms regarding product quality. However, we intend to replace products that have expired or are deemed to be damaged or defective when delivered. We exercise judgment in estimating return reserves. Payments by the importing agents and distributors are not contingent upon sale to the end user by the importing agents or distributors.
Contract revenue for research and development is recorded as earned based on the performance requirements of the contract. We exercise judgment in determining the period over which our performance obligations have been fulfilled which can have an impact on the timing and amount of revenue that is recognized in a particular reporting period. Nonrefundable contract fees for which no further performance obligations exist, and for which there is no continuing involvement by us, are recognized on the earlier of when the payments are received or when collection is assured.
Revenue associated with substantive performance milestones is recognized based on the achievement of the milestones, as defined in the respective agreements and provided that (i) the milestone event is substantive and its achievement is not reasonably assured at the inception of the agreement and (ii) there are no future performance obligations associated with the milestone payment. We exercise judgment in our determination of the achievement of milestones which can have an impact on the timing and amount of revenue recognized in a particular reporting period.
Amounts invoiced relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized as the applicable revenue recognition criteria are satisfied.
Accounts Receivable
We are required to estimate the collectibility of our trade receivables. We maintain reserves for credit losses, and such losses have been within our expectations. We recognize reserves for bad debts ranging from 25% to 100% of past due accounts receivable based on the length of time the receivables are past due and our collectibility experience. A considerable amount of judgment is required in assessing the ultimate realization of these receivables including, but not limited to, an analysis of the historical payment patterns of our customers, individual customer circumstances and their geographic region including a review of the local economic environment. Our ability to collect outstanding receivables from our customers is critical to our operating performance and cash flows. We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. If the financial condition of our customers or the economic environment in which they operate were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required which would increase our general and administrative expenses. Conversely, if actual credit losses are significantly less than expected, this would decrease our general and administrative expenses.
Inventories
Our inventories are stated at the lower of cost or realizable market value. In assessing the ultimate realization of inventories, we are required to make judgments as to future demand requirements and compare that with the current inventory levels. If our current assumptions about future production or inventory levels and demand were to change or if actual market conditions are less favorable than those projected by management, inventory write-downs may be required which could negatively impact our gross margins and results of operations.
Impairment of Intangible Assets
At December 31, 2006, we had net intangible assets of $402,000 related to ZADAXIN product rights and have never recorded any impairment losses related to intangible assets. In assessing the recoverability of our intangible assets we must make assumptions regarding estimated future cash flows and other factors. If these estimates or their related assumptions change in the future, we may be required to record impairment charges for these assets.
Research and Development Expenses
Our research and development expenses are principally incurred for our clinical trials including cost sharing of Sigma-Tau’s large clinical trial in Europe using ZADAXIN as part of a novel triple therapy combination for the treatment of hepatitis C virus (HCV), and our large phase 3 clinical trials that took place in the United States, primarily in 2005 and 2004. Research and development expenses are charged to operations as incurred. Our cost accruals for clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with numerous institutions that conduct the clinical trials on our behalf. The financial terms of these agreements are subject to negotiation and vary from contract to contract and may result in uneven payment flows.
Payments under the contracts depend on factors such as the achievement of certain events, the successful enrollment of patients, and the completion of portions of the clinical trial or similar conditions. The objective of our accrual policy is to match the recording of expenses in our financial statements to the actual services received and efforts expended. Expenses related to grants to the institutions for our U.S. HCV clinical trials were accrued based on the level of patient enrollment and activity according to the protocol. In general, for these clinical trials, these expenses were higher for the initial and final months of a patient's scheduled 18 months of treatment and observation. Expenses relating to clinical research organizations or other entities managing the trials and laboratory and other direct expenses are recognized in the period they are estimated to be incurred and the services performed. We monitor active patient enrollment levels and related activity to the extent possible and adjust our estimates accordingly; however, if management has underestimated activity levels associated with various studies at a given point in time, we could underestimate our actual research and development expenses, requiring the recording of additional expenses and an increase in net loss in the future.
Stock Option Valuation
Effective January 1, 2006, we adopted the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), Share-Based Payment, (“FAS 123R”). Prior to January 1, 2006, we accounted for share-based payments under the recognition and measurement provisions of Accounting Principles Board Opinion 25 (“APB 25”) and related Interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation (“FAS 123”). Accordingly, we did not recognize compensation expense in accounting for our employee stock purchase plan or our stock option plans for options to employees and directors granted with exercise prices at fair market value.
We adopted FAS 123R using the modified-prospective transition method. Under this method, compensation cost recognized for the year ended December 31, 2006 includes compensation cost for share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123. Compensation cost also includes all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123R. Compensation cost is calculated on the date of grant using the fair value of the option as determined using the Black Scholes option valuation model and the single option approach. The Company amortizes the compensation cost over the vesting period, which is generally four years, using the straight line attribution method. Results for prior periods have not been restated to reflect the impact of FAS 123R.
Determining the fair value of each option award under FAS 123R using the Black Scholes option valuation model requires the use of certain subjective assumptions. We determined weighted-average valuation assumptions as follows:
Volatility-We believe the historical volatility of our stock price is indicative of expectations about expected future stock price volatility. We estimated volatility using the historical share price performance for a time period equivalent to the expected term of the option. We also considered the implied volatility of market traded puts and calls on our common stock, however, since these puts and calls are thinly traded, the information was not considered representative of their future estimated volatility.
Expected term-When establishing an estimate of the expected term of an award, we consider the vesting period for the option and our historical experience of employee stock option exercises (including forfeitures).
Risk-Free Interest rate-The risk free interest rate is based on the U.S. treasury constant maturity rates with similar terms to the expected term of the option.
Dividend Yield-The expected dividend yield is 0% as we have not paid and do not expect to pay dividends in the foreseeable future.
Expected Forfeitures - We use historical data regarding forfeitures of our options to estimate pre-vesting option forfeitures. We record stock-based compensation only for those awards that are expected to vest.
The most significant assumptions are our estimates of the expected volatility and the expected term of the award. In addition, judgment is also required in estimating the amount of share-based awards that are expected to be forfeited. If actual conditions, events or amounts differ significantly from any of these estimates, stock-based compensation expense and its non-cash effect on our results of operations could be materially impacted. As of December 31, 2006, unamortized compensation expense related to unvested options was approximately $4,000,000. The weighted average period over which compensation expense related to these options will be recognized is 2.09 years.
Results of Operations
Product sales were $32,433,000, $27,842,000, and $22,765,000 for the years ended December 31, 2006, 2005 and 2004, respectively, and all were derived from sales of ZADAXIN. Sales to customers in China accounted for approximately 92%, 91% and 91% of this revenue for the years ended December 31, 2006, 2005 and 2004, respectively. Product prices have remained stable throughout this three year period.
For the years ended December 31, 2006, 2005 and 2004, sales in each year to three or four importing agents in China accounted for approximately 92%, 91%, and 91%, respectively of our product sales. In 2006, Shanghai Lingyun and China National Pharmaceutical Foreign Trade Corporation accounted for 66% and 15% of our sales, respectively, and two others accounted for a combined 11%. In 2005, Guang Dong South Pharmaceutical Foreign Trade Co., Ltd, Zhuhai Goldsn Medicine Co., Ltd and China National Pharmaceutical Foreign Trade Corporation accounted for 57%, 19%, and 15% of our sales, respectively. In 2004, China National Pharmaceutical Foreign Trade Corporation, China Meheco Corporation and Guang Dong South Pharmaceutical Foreign Trade Co., Ltd accounted for 32%, 29% and 23% of our sales, respectively. No other customers accounted for more than 10% of sales in those periods. As of December 31, 2006, approximately $12,562,000 or, 94% of our accounts receivable were attributable to three customers in China. We perform on-going credit evaluations of our customers’ financial condition, and generally do not require collateral from our customers.
Contract revenue was $229,000, $492,000, and $1,631,000 for the years ended December 31, 2006, 2005 and 2004, respectively. The contract revenue for 2004 includes a $1,000,000 milestone payment we received from Sigma-Tau relating to the completion of enrollment of our U.S. phase 3 HCV clinical trials. The remaining contract revenue recognized in 2004, 2005 and 2006 is in connection with the $2,685,000 payment we received from Sigma-Tau in January 2002 and a $50,000 payment we received from Sigma-Tau in December 2006. This revenue is recognized as contract revenue over the course of the ZADAXIN HCV U.S. clinical program and the period of sharing the clinical data from this program with Sigma-Tau in accordance with the performance requirements under our contract with Sigma-Tau.
Gross margin was 79%, 83%, and 81% in 2006, 2005 and 2004, respectively. The decrease in gross margin in 2006 was primarily due to an increase of $929,000 in royalty expense recorded in December 2006 related to annual minimum royalties due to sales of product from 1997 through 2006 according to our license agreement with Wayne State University (WSU). An increase in gross margin percentage from the 2004 to 2005 period was due to lower average cost of product sold in the 2005 period. We expect cost of product sales and hence gross margin to vary from year to year, depending upon the level of ZADAXIN sales, the absorption of product-related fixed costs, and any charges associated with excess or expiring finished product inventory.
Research and development (R&D) expenses were $14,088,000, $14,406,000, and $17,994,000 and represented approximately 41%, 45%, and 53% of our total costs and expenses for the years ended December 31, 2006, 2005, and 2004, respectively. R&D expenses in 2006 included stock-based compensation expense of $771,000 following the adoption of FAS 123R. The decrease in R&D expenses over the years from 2004 to 2006 was primarily related to the U.S. phase 3 HCV clinical trials completed in mid-2006. During 2006, we recorded
approximately $1,000,000 of expenses related to the U.S. phase 3 HCV trial. This compares to expenses in 2005 of approximately $3,400,000 and approximately $8,600,000 in 2004. The major components of R&D expenses consist of clinical studies performed by clinical trial institutions and contract research organizations, related materials and supplies, preclinical work, pharmaceutical development, personnel costs, including salaries and benefits, third party research funding, and overhead allocations consisting of various support and facilities related costs. Our research and development activities are also separated into three main categories: research, clinical development and pharmaceutical development. Research costs typically consist of preclinical and toxicology work. Clinical development costs primarily relate to clinical trials. Pharmaceutical development costs consist of product formulation and chemical analysis. During 2006, we recorded approximately $5,400,000 of research, $6,900,000 of clinical development, and $1,800,000 of pharmaceutical development activities. This compares to expenses in 2005 of approximately $4,300,000 of research, $8,300,000 of clinical development, and $1,800,000 of pharmaceutical development activities and expenses in 2004 of approximately $4,100,000 of research, $11,800,000 of clinical development, and $2,100,000 of pharmaceutical development activities.
The initiation and continuation of our current clinical development programs has had and is expected to continue to have a significant effect on our research and development expenses. In general, we expect research and development expenses to vary substantially from quarter to quarter as we pursue our strategy of initiating additional preclinical and clinical trials and testing, acquiring product rights, and expanding regulatory activities. An expansion or significant extension of our clinical development programs may require us to seek additional capital resources.
Sales and marketing expenses were $11,569,000, $10,237,000, and $9,665,000 for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in sales and marketing expenses in 2006 was primarily due to a $639,000 increase in stock-based compensation expense following the adoption of FAS 123R, increases in other compensation expenses of approximately $364,000 and expenses related to conferences of $100,000, and increased rent of approximately $116,000. The increase in sales and marketing expenses in 2005 was primarily due to an increase in expenses related to conferences of $244,000 and an increase in expenses associated with the expansion of our marketing efforts of approximately $208,000. We expect sales and marketing expenses for 2007 to be higher than those incurred in 2006 due to increased sales efforts.
General and administrative expenses were $9,040,000, $7,457,000, and $6,311,000 for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in 2006 was primarily related to an increase in salary related expenses of $410,000, increased consulting fees of $656,000, and an increase in stock-based compensation expense of $564,000 following the adoption of FAS 123R. The increase in 2005 was primarily related to increased legal fees of approximately $625,000 to support increased legal and regulatory activities, increased accounting fees of approximately $237,000 associated with increased securities regulation requirements and approximately $472,000 related to non-cash stock-price performance based option expenses. For 2007, we expect increased general and administrative expenses as we increase our general and administrative activities to support increased expenditures on business development, legal and regulatory activities.
Interest and investment income was approximately $1,764,000, $1,273,000, and $1,285,000 for the years ended December 31, 2006, 2005 and 2004, respectively. Interest and investment income in 2004 included a gain from the sale of equity securities in the amount of approximately $697,000. Excluding this gain in 2004, the increase in interest and investment income in 2005 and 2006 is primarily due to cash balances earning higher interest rates in those periods. Interest and investment expense primarily relating to convertible notes payable was $94,000, $345,000, and $361,000 for the years ended December 31, 2006, 2005 and 2004, respectively. The Company repaid $4,000,000 and $1,600,000 of convertible notes in December 2005 and March 2006, respectively, resulting in the decrease in interest expense for those periods.
Other income (expense), net was $7,981,000, $0, and ($51,000) for the years ended December 31, 2006, 2005 and 2004, respectively. The increase in other income for the 2006 period was primarily due to $8,000,000 received in April 2006 for the resolution of our dispute with Schering Plough KK.
Net income (loss) for the years ended December 31, 2006, 2005 and 2004 was $727,000, ($7,713,000), and ($13,278,000), respectively. The increase in net income in 2006 was primarily due to $8,000,000 we received in April 2006 for the resolution of our dispute with Schering Plough KK. Net loss was lower in 2005 than in 2004 principally due to higher net sales and gross margin and lower operating expenses. Basic and diluted net income (loss) per share for the years ended December 31, 2006, 2005 and 2004 was $0.02, ($0.17), and ($0.30), respectively. Weighted average shares outstanding used in computing basic net income (loss) per share for the years ended December 31, 2006, 2005 and 2004 were 45,901,015, 45,328,714, and 44,626,337, respectively. Weighted average shares outstanding used in computing diluted net income (loss) per share for the years ended December 31, 2006, 2005 and 2004 were 46,072,027, 45,328,714, and 44,626,337, respectively.
Income Taxes
We have not recorded any federal or state income tax expense for the years ended December 31, 2006, 2005 and 2004. Undistributed earnings of our foreign subsidiaries amounted to approximately $6,126,000, $6,673,000, and $4,155,000 at December 31, 2006, 2005 and 2004, respectively. These earnings are considered to be permanently reinvested and accordingly, no deferred U.S. income taxes have been provided thereon.
At December 31, 2006, we had net operating loss carryforwards for federal income tax purposes of approximately $123,000,000 which expire in the years 2007 through 2026. The difference between the cumulative losses for financial reporting purposes and federal income tax purposes is primarily attributable to losses incurred by our foreign subsidiaries. At December 31, 2006, we had federal tax credit carryforwards of approximately $7,000,000 which expire in the years 2009 through 2026.
Because of the “change in ownership” provisions of the Internal Revenue Code, a portion of our net operating loss carryforwards and tax credit carryforwards may be subject to an annual limitation regarding their utilization against taxable income in future periods. As a result of the annual limitation, a portion of these carryforwards may expire before ultimately becoming available to reduce future income tax liabilities.
Liquidity and Capital Resources
At December 31, 2006, 2005 and 2004, we had $42,592,000, $42,256,000, and $51,299,000, respectively, in cash, cash equivalents and short-term investments. In each of these years, the principal factors affecting these balances were the net income (loss) and cash used in financing activities. We currently estimate cash, cash equivalents and short-term investments at December 31, 2007 will be lower than the balance at December 31, 2006. The expected decrease in this balance is primarily attributable to further expected net loss. The short-term investments consist primarily of highly liquid marketable securities. We have two letters of credit each secured by a certificate of deposit. At December 31, 2006, the letters of credit totaled $698,000, one for $633,000 under our lease agreement, the other for $65,000 to facilitate our value added tax filings in Europe.
Net cash provided by (used in) operating activities totaled $1,720,000, ($8,091,000), and ($12,335,000) for the years ended December 31, 2006, 2005 and 2004, respectively. Net cash provided by operating activities for the year ended December 31, 2006 was primarily due to the net income of $727,000, a non-cash expense related to employee stock options of $2,446,000 due to the adoption of FAS 123R, an increase in accounts payable and other accrued expenses of $1,137,000 primarily related to an increase in the royalty accrual, and a decrease in prepaid expenses and other assets of $644,000 primarily related to a reduction in prepaid royalties and a reduction in the value added tax receivable, offset partially by an increase in net accounts receivable of $3,576,000 due to an increase in sales year over year. Net cash used in operating activities for the year ended December 31, 2005 was primarily due to the net loss of $7,713,000. Net cash used in operating activities for the year ended December 31, 2004 was less than the net loss primarily due to a $1,599,000 decrease in inventory levels.
Net cash used by us in investing activities amounted to $615,000 for the year ended December 31, 2006 and $6,434,000 for the year ended December 31, 2005, compared to net cash provided by investing activities of $351,000 for the year ended December 31, 2004. Cash used in 2006 of $615,000 was primarily due to increased holdings in U.S. Treasury Securities of $4,369,000, offset partially by a decrease in municipal securities holdings of $3,850,000, and due to purchases of property and equipment of $75,000. The increase in cash used in 2005 was primarily due to the purchase of U.S. Treasury Securities in the amount of $6,034,000 in 2005.
Net cash used in financing activities totaled $1,335,000 for the year ended December 31, 2006 as compared to net cash used in financing activities in the amount of $834,000 for the year ended December 31, 2005, and net cash provided by financing activities of $289,000 for the year ended December 31, 2004. Net cash used in financing activities for the year ended December 31, 2006 consisted of the repayment of a $1,600,000 convertible note, partially offset by proceeds received of approximately $221,000 related to exercises of outstanding options under our employee stock option plans and $44,000 from the issuance of common stock under our employee stock purchase plan. Net cash used in financing activities for the year ended December 31, 2005 consisted of the repayment of a $4,000,000 convertible note partially offset by proceeds received of approximately $3,003,000 related to exercises of outstanding options under our employee and director stock option plans and $163,000 from the issuance of common stock under our employee stock purchase plan. Net cash provided by financing activities for the year ended December 31, 2004 consisted of approximately $12,000 related to exercises of outstanding options under our employee and director stock option plans and $277,000 from the issuance of common stock under our employee stock purchase plan.
The following table summarizes our contractual obligations and other commitments as of December 31, 2006.
(1) These are future minimum rental commitments for office space and copiers leased under non-cancelable operating lease arrangements.
(2) This includes approximately $1,198,000 in minimum purchase requirements from a contract manufacturer, and approximately $2,486,000 payable to our European marketing and development partner, Sigma-Tau, to conduct and complete an HCV clinical trial in Europe.
(3) This includes minimum royalty payments to the U.S. Army through 2010 and to Wayne State University (“WSU”) through 2012. Additionally upon regulatory approval of ZADAXIN and commercialization of the product in certain countries, the Company is obligated to pay the U.S. Army and WSU the greater of the respective minimum annual royalty or a royalty based on a percentage of ZADAXIN sales. See note 11 of the Notes to Consolidated Financial Statements.
(4) This amount represents a discretionary accrued long-term bonus payable to our CEO as of December 31, 2006 based on performance targets over the years 2006-2008.
Our existing capital resources and funds from product sales are sufficient to finance our operations for the immediate future but are not sufficient to complete our current plans to conduct and complete clinical trials with SCV-07 and ZADAXIN, and, if we proceed with all the development efforts we are planning, we would need to raise additional financing. The unavailability or the inopportune timing of any financing could prevent or delay our long-term product development and commercialization programs, either of which would severely hurt our
business. We cannot assure you that funds from financings will be sufficient to complete our current plans to conduct and complete clinical trials. The need, timing and amount of any such financing would depend upon numerous factors, including the level of ZADAXIN sales, the timing and amount of manufacturing costs related to ZADAXIN, the availability of complementary products, technologies and businesses, the initiation and continuation of preclinical and clinical trials and testing, the timing of regulatory approvals, developments in relationships with existing or future collaborative parties, the status of competitive products, and the condition of the capital markets and the availability of financing for SciClone in particular.
There are no officers or directors that were involved in related party transactions in 2006.
Off-Balance Sheet Arrangements
There were no off-balance sheet arrangements in 2006, 2005 or 2004.
Recent Accounting Pronouncement
In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim period guidance, among other provisions. FIN 48 is effective for the Company’s first quarter of calendar year 2007. The Company does not anticipate FIN 48 having a material impact on its consolidated financial position, results of operations, and cash flows.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The primary objective of our investment activities is to preserve principal while at the same time maximizing yields without significantly increasing risk. To achieve this objective, we invest our cash solely in U.S. Treasury or U.S. government agency notes and highly rated, highly liquid short-term municipal securities. Our investments in these notes are subject to interest rate risk. To minimize the exposure due to an adverse shift in interest rates, we invest in short-term notes and maintain an average maturity of less than one year. A hypothetical 60 basis point increase in interest rates would result in an approximate $136,575 decrease (0.6%) in fair value of our available-for-sale and held-to-maturity securities. This potential change is based on sensitivity analyses performed on our financial position at December 31, 2006. Actual results may differ materially.
Substantially all our sales and most of our manufacturing costs to date have been in U.S. dollars. However, our purchases from one of our contract manufacturers are denominated in euros and costs of our marketing efforts in China are paid in local currency. This exposes us to foreign currency exchange rate fluctuations. Losses related to foreign currency exchange rate fluctuations have been insignificant to date.
Item 8.
Item 8. Financial Statements and Supplementary Data
SCICLONE PHARMACEUTICALS, INC.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
Page
Report of Independent Registered Public Accounting Firm
Consolidated Balance Sheets
Consolidated Statements of Operations
Consolidated Statement of Stockholders’ Equity
Consolidated Statements of Cash Flows
Notes to Consolidated Financial Statements
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of SciClone Pharmaceuticals, Inc.
We have audited the accompanying consolidated balance sheets of SciClone Pharmaceuticals, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006. Our audits also included the financial statement schedule listed at Item 15(a). These financial statements and schedule are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of SciClone Pharmaceuticals, Inc. at December 31, 2006 and 2005, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles. Also, in our opinion, the related financial statement schedule, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein.
As discussed in Note 1 to the consolidated financial statements, in 2006, SciClone Pharmaceuticals, Inc. changed its method of accounting for stock-based compensation in accordance with guidance provided in Statement of Financial Accounting Standards No. 123(R), “Share-Based Payment”.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of SciClone Pharmaceuticals, Inc.’s internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated March 15, 2007 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Palo Alto, California
March 15, 2007
SCICLONE PHARMACEUTICALS, INC.
CONSOLIDATED BALANCE SHEETS
See notes to consolidated financial statements.
SCICLONE PHARMACEUTICALS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
See notes to consolidated financial statements.
SCICLONE PHARMACEUTICALS, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS’ EQUITY
See notes to consolidated financial statements.
SCICLONE PHARMACEUTICALS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
See notes to consolidated financial statements.
SCICLONE PHARMACEUTICALS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
Note 1 - The Company and Summary of Significant Accounting Policies
The Company
SciClone Pharmaceuticals, Inc. (“SciClone” or the “Company”) is a biopharmaceutical company engaged in the development and commercialization of therapeutics to treat life-threatening diseases. The Company’s lead product ZADAXIN® is currently being evaluated in melanoma and hepatitis C virus (“HCV”) clinical trials and is currently approved for sale in certain international locations, and is sold primarily in China through the Company’s wholly-owned subsidiary SciClone Pharmaceuticals International Ltd. (“SPIL”). During 2006, the Company in-licensed the Chinese marketing rights to DC BeadTM, a product for the treatment of liver cancer or hepatocellular carcinoma, and submitted a regulatory application to the Chinese State Food and Drug Administration related to this product.
Basis of Presentation
The consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, SPIL, SciClone Italy S.R.L., SciClone Japan K.K., SciClone do Brasil-Produtos Farmaceuticos Ltda, SciClone Pharmaceuticals International Holding Ltd and SciClone Pharmaceuticals (China) Ltd. SPIL is registered in the Cayman Islands with its principal office located in Hong Kong. SciClone Italy S.R.L. is registered in Italy with its principal office located in Rome. SciClone Japan K.K. is registered in Japan with its principal office located in Tokyo. SciClone do Brasil is registered in Brazil with its principal office located in Sao Paulo. SciClone Pharmaceuticals International Holding Ltd. is registered in Cayman Islands with its principal office located in Hong Kong. SciClone Pharmaceuticals (China) Ltd. is registered in China with its principal office located in Shanghai. All significant intercompany accounts and transactions have been eliminated.
Revenue Recognition
The Company recognizes revenue from product sales at the time of delivery. There are no significant customer acceptance requirements or post shipment obligations on the part of the Company. Sales to importing agents or distributors are recognized at time of shipment when title to the product is transferred to them, and they do not have contractual rights of return except under limited terms regarding product quality. However, the Company is expected to replace products that have expired or are deemed to be damaged or defective when delivered. Payments by the importing agents and distributors are not contingent upon sale to the end user by the importing agents or distributors.
Contract revenue for research and development is recorded as earned based on the performance requirements of the contract. Nonrefundable contract fees for which no further performance obligations exist, and there is no continuing involvement by the Company, are recognized on the earlier of when the payments are received or when collection is assured.
Revenue associated with substantive performance milestones is recognized based on the achievement of the milestones, as defined in the respective agreements and provided that (i) the milestone event is substantive and its achievement is not reasonably assured at the inception of the agreement, and (ii) there are no future performance obligations associated with the milestone payment.
Amounts invoiced relating to arrangements where revenue cannot be recognized are reflected on our balance sheet as deferred revenue and recognized as the applicable revenue recognition criteria are satisfied.
Use of Estimates
The preparation of financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
Cash Equivalents and Investments
Cash equivalents consist of highly liquid investments with maturities of three months or less on the date of purchase.
The Company classifies its investment portfolio as available-for-sale and held-to-maturity. The Company records the available-for-sale investments at fair value, as determined by available market information, on the balance sheet. The portfolio primarily consists of U.S. Government securities and short-term municipal securities. Unrealized gains or losses are included in accumulated other comprehensive income on the consolidated balance sheet. Realized gains or losses and declines in value judged to be other than temporary are determined on the basis of specific identification and included in interest and investment income. The Company also has held-to-maturity investments and records them at amortized cost. The Company does an assessment each reporting period to determine whether any investment is impaired. Management believes the credit risk associated with these investments is limited due to the nature of the investments.
The Company is required by its lease agreement to have a letter of credit secured by a certificate of deposit of $633,000 at December 31, 2006. Under its European value added tax filing arrangement, the Company has a letter of credit secured by a certificate of deposit of $65,000 at December 31, 2006. These amounts are recorded as restricted short-term investments on the accompanying balance sheets.
For the years ended December 31, 2006, 2005 and 2004, net unrealized gains (losses) of approximately $25,000, $15,000, and $(138,000), respectively, were included in accumulated other comprehensive income (loss). For the years ended December 31, 2006 and 2005, there were no realized gains or losses. For the year ended December 31, 2004, a net realized gain of approximately $697,000 was recognized primarily in connection with the sale of equity securities.
Fair Value of Financial Instruments
The fair value of our cash equivalents and available-for-sale marketable securities are based on quoted market prices and the carrying amounts are equal to their respective fair values at December 31, 2006 and 2005. The amortized cost of the held-to-maturity securities approximates their fair value at December 31, 2006 and 2005.
Other financial instruments, including accounts receivable, accounts payable and accrued liabilities, are carried at cost, which the Company believes approximates fair value because of the short-term maturity of these instruments.
Inventories
Inventories consist principally of raw materials, work in progress and finished goods products. Inventories are stated at the lower of cost or market, with cost determined on a first-in, first-out basis. We periodically review the inventory in order to identify obsolete items. If obsolete items are observed and there are no alternate uses for the inventory, we will record a write-down to net realizable value in the period that the impairment is first recognized.
Property and Equipment
Property and equipment is stated at cost, less accumulated depreciation. Depreciation is recorded over the estimated useful lives of the respective assets (three to five years) on the straight-line basis. Leasehold improvements are amortized over the shorter of the estimated useful life or lease term on the straight-line basis.
Intangible Assets
Intangible assets with definite lives are amortized over their estimated useful lives and are reviewed for impairment when facts or circumstances suggest that the carrying value of these assets may not be recoverable. The Company's policy is to identify and record impairment losses, if necessary, on intangible product rights when events and circumstances indicate that the assets might be impaired and the undiscounted cash flows estimated to be generated by those assets are less than the carrying amounts of those assets. The Company to date has not identified any impairment losses on these assets. Although the Company has a history of operating losses and negative cash flow, the Company believes that there is no impairment to the intangible assets because ZADAXIN has been approved for sale in several countries, principally as a treatment for hepatitis B virus. Based on the Company's anticipated financial results for future ZADAXIN sales, it has been determined that the expected future cash flows exceed the carrying amount of the assets.
Foreign Currency Translation
The Company translates the assets and liabilities of its foreign subsidiaries stated in local functional currencies to U.S. dollars at the rates of exchange in effect at the end of the period. Revenues and expenses are translated using rates of exchange in effect during the period. Gains and losses from the translation of financial statements denominated in foreign currencies, if material, would be included as a separate component of other comprehensive income (loss) in the statement of stockholders' equity.
The Company records foreign currency transactions at the exchange rate prevailing at the date of the transaction with resultant gains and losses being included in results of operations. Foreign currency transaction gains and losses have not been significant for any period presented.
Research and Development Expenses
Research and development expenditures are charged to operations as incurred. Major components of research and development expenses consist of clinical development performed on the Company’s behalf by institutions and contract research organizations, sharing of certain costs of Sigma-Tau’s clinical development of ZADAXIN, personnel costs, including salaries and benefits, preclinical work, pharmaceutical development, materials and supplies, third party research funding and overhead allocations consisting of various administrative and facilities related costs. SciClone’s research and development activities are also separated into three main categories: research, clinical development and pharmaceutical development. Research costs typically consist of preclinical and toxicology work. Clinical development costs primarily relate to clinical trials. Pharmaceutical development costs consist of product formulation and chemical analysis.
ZADAXIN clinical trials have the largest and most significant impact on the Company’s research and development expenses. Cost accruals for clinical trials are based on estimates of the services received and efforts expended pursuant to contracts with numerous institutions that conduct the clinical trials on the Company's behalf. The financial terms of these agreements are subject to negotiation and vary from contract to contract and may result in uneven payment flows. Payments under the contracts depend on factors such as the achievement of certain events, the successful enrollment of patients and the completion of portions of the clinical trial or similar conditions. The objective of the accrual policy is to match the recording of expenses to the actual services received and efforts expended. Expenses related to grants to institutions that conduct the clinical trials on the Company’s behalf are accrued based on the level of patient enrollment and activity according to the protocol. In
general, for our U.S. HCV clinical trials, these expenses were higher for the initial and final months of a patient's scheduled 18 months of treatment and observation. Expenses relating to the clinical research organization and other entities managing the trials and laboratory and other direct expenses are recognized in the period they are estimated to be incurred and the services performed. The Company monitors active patient enrollment levels and related activity to the extent possible and adjusts estimates accordingly.
Shipping and Handling Costs
Costs related to shipping and handling are included in cost of sales for all periods presented.
Advertising Expenses
The Company expenses advertising costs as incurred and these costs are included in sales and marketing expenses for all periods presented. Advertising expenses for the years ended December 31, 2006, 2005 and 2004 were $221,000, $150,000, and $235,000, respectively.
Income Taxes
Income taxes are accounted for under the liability method. Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax basis, and operating loss and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period that includes the enactment date. Deferred tax assets are reduced by a valuation allowance when, in the opinion of management, it is more likely than not that some or all of the deferred tax assets may not be realized. Accordingly, the net deferred tax assets have been fully offset by a valuation allowance.
Net Income (Loss) Per Share
Basic net income (loss) per share has been computed by dividing net income (loss) by the weighted-average number of shares of common stock outstanding for the period. Diluted net income (loss) per share is computed by dividing net income (loss) by the weighted-average number of common equivalent shares outstanding for the period. Diluted net income (loss) per share includes any dilutive impact from stock options outstanding using the treasury stock method.
The following is a reconciliation of the numerator and denominators of the basic and diluted net income (loss) per share computations:
For the years ended December 31, 2006, 2005 and 2004, approximately 6,903,336, 7,080,186, and 8,979,653 shares, respectively, related to convertible notes payable and outstanding options were excluded from the calculation of diluted net income (loss) per share because their inclusion would have been anti-dilutive.
Accounting for Stock-Based Compensation
Effective January 1, 2006, the Company adopted the fair value recognition provisions of Financial Accounting Standards Board (“FASB”) Statement No. 123(R), Share-Based Payment, (“FAS 123R”). Prior to January 1, 2006, the Company accounted for share-based payments under the recognition and measurement provisions of Accounting Principles Board Opinion 25 (“APB 25”) and related Interpretations, as permitted by FASB Statement No. 123, Accounting for Stock-Based Compensation (“FAS 123”). Accordingly, the Company did not recognize compensation expense in accounting for its employee stock purchase plan or its stock option plans for options to employees and directors granted with exercise prices at fair market value.
The Company adopted FAS 123R using the modified-prospective transition method. Under this method, compensation cost recognized during the year ended December 31, 2006 includes compensation cost for share-based payments granted prior to, but not yet vested as of January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123. Compensation cost also includes all share-based payments granted subsequent to January 1, 2006, based on the grant-date fair value estimated in accordance with the provisions of FAS 123R. Compensation cost is calculated on the date of grant using the fair value of the option as determined using the Black Scholes option valuation model and the single option approach. The Company amortizes the compensation cost over the vesting period, which is generally four years, using the straight line attribution method. Results for prior periods have not been restated to reflect the impact of FAS 123R.
In November 2005, the FASB issued FASB Staff Position No. 123R-3, “Transition Election Related to Accounting for the Tax Effects of Share-Based Payment Awards”. The Company has adopted the simplified method to calculate the beginning balance of the additional paid-in-capital (or “APIC”) pool of excess tax benefit, and to determine the subsequent effect on the APIC pool and the Consolidated Statements of Cash Flows of the tax effects of stock-based compensation awards that were outstanding upon our adoption of FAS 123R.
Stock-based compensation expense recognized in the Consolidated Statement of Operations for the year ended December 31, 2006 is based on awards ultimately expected to vest. FAS 123R requires forfeitures to be estimated at the time of grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those estimates. We use historical data to estimate pre-vesting option forfeitures. In the Company’s pro forma information required under FAS 123 for periods prior to January 1, 2006, the Company accounted for forfeitures as they occurred.
We have not recognized, and do not expect to recognize in the near future, any tax benefit related to employee stock-based compensation cost.
The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee and director stock awards have characteristics significantly different from those of traded options, and because changes in subjective input assumptions can materially affect the fair value estimate, in the Company's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its stock options and stock purchases.
Our former Chief Executive Officer (“CEO”) was granted a target stock price award (see note 13, CEO Agreements) and, therefore, the grant date fair values related to each of the four vesting portions of this award have been calculated and the related expense included in the SFAS 123 pro forma expense disclosure over their derived service periods. For the years ended December 31, 2005 and 2004, approximately $232,000 and $0, respectively is included in the SFAS 123 pro forma expense below related to this award.
The following table illustrates the effect on net loss and net loss per share for the years ended December 31, 2005 and 2004, had compensation expense for the Company’s stock option and employee stock purchase plans been determined based on the fair value at the grant date consistent with the provisions of FAS 123:
Warrants issued in connection with equity and debt arrangements and equity instruments issued to non-employees are valued using the Black-Scholes option valuation model. Warrants issued to placement agents and similar parties in connection with equity financing are accounted for as stock issuance costs with an equal amount recorded as additional paid-in capital. Warrants issued to purchasers of the Company's equities are not separately included in the financial statements as their value is a sub-component of additional paid-in capital. The fair value of warrants issued in connection with debt arrangements, if material, is accounted for as a debt discount and amortized as additional interest expense over the term of the related debt.
Comprehensive Income (Loss)
Comprehensive income (loss) is comprised of net income (loss) and other comprehensive income (loss). Accumulated other comprehensive income (loss) includes net unrealized gains and losses on our available-for-sale securities at the balance sheet dates.
Segment Information
The Company operates in one segment (see note 16).
Concentration of Credit Risk
The People's Republic of China, like Japan and certain other Asian markets, uses a tiered method to import and distribute products. The distributors make the sales in the country, but the product is imported for them by licensed importers. For the year ended December 31, 2006, sales to four importing agents in China accounted for 92% of the Company’s product sales. For the year ended December 31, 2005, sales to three importing agents in China accounted for 91% of the Company’s product sales and sales to four importing agents in China accounted for 91% of the Company’s product sales for the year ended December 31, 2004. In 2006, the two largest customers accounted for 66% and 15% of sales, respectively. No other customer accounted for more than 10% of sales in 2006. In 2005, the three largest customers accounted for 57%, 19% and 15% of sales, respectively. No other customer accounted for more than 10% of sales in 2005. In 2004, the three largest customers accounted for 32%, 29% and 23% of sales, respectively. No other customer accounted for more than 10% of sales in 2004. As of December 31, 2006, approximately $12,562,000, or 94% of the Company's accounts receivable were attributable to three importing agents in China. The Company performs on-going credit evaluations of its customers' financial condition, and generally does not require collateral from its customers. The Company maintains reserves for credit losses, and such losses have been within management's expectation. The Company recognizes reserves for bad debts ranging from 25% to 100% based on the length of time the receivables are past contractual payment due dates and the Company's collection experience.
Recently Issued Accounting Pronouncement
In July 2006, the FASB issued Financial Interpretation No. 48, “Accounting for Uncertainty in Income Taxes-an interpretation of FASB Statement No. 109” (“FIN 48”), which is a change in accounting for income taxes. FIN 48 specifies how tax benefits for uncertain tax positions are to be recognized, measured, and derecognized in financial statements; requires certain disclosures of uncertain tax matters; specifies how reserves for uncertain tax positions should be classified on the balance sheet; and provides transition and interim period guidance, among other provisions. FIN 48 is effective for the Company’s first quarter of calendar year 2007. The Company does not anticipate FIN 48 having a material impact on its consolidated financial position, results of operations, and cash flows.
Reclassifications
The Company has made a classification change between short-term and long-term liabilities in the consolidated balance sheet as of December 31, 2005 to conform to the current period presentation. As of December 31, 2005, $68,000 was reclassified from accrued compensation and employee benefits to other long-term liabilities.
Note 2 - Marketable Securities
The following is a summary of available-for-sale and held-to maturity securities:
As of December 31, 2006, there was $698,000 in restricted short-term investments and $5,876,000 in other short-term investments held in available-for sale securities. As of December 31, 2005, there was $692,000 in restricted short-term investments and $9,685,000 in other short-term investments held in available-for sale securities. As of December 31, 2006 and 2005 all available-for sale securities excluding the short-term municipal securities had maturities of 12 months or less. The short-term municipals are auction rate securities which have long final maturities, however, because they are highly rated, highly liquid and their interest rate is reset at
auction every 30 days, they are included as available-for-sale securities. The Company’s interest rate risk associated with these securities is limited due to this interest rate reset mechanism.
As of December 31, 2006 and 2005, there was $10,403,000 and $6,034,000, respectively, in other short-term investments classified as held-to-maturity securities. These securities are U.S. Treasury bills which will mature in February, May and June 2007. The fair value of the investments at December 31, 2006 and 2005, respectively, approximated their cost.
Note 3 - Prepaid Expenses and Other Current Assets
The following is a summary of prepaid expenses and other current assets:
Note 4 - Inventories
Inventories consisted of the following:
Note 5 - Property and Equipment
Property and equipment consisted of the following:
Depreciation expense for the years ended December 31, 2006, 2005 and 2004 was $157,000, $133,000, and $115,000, respectively.
Note 6 - Intangible Assets
Intangible assets include the following:
In December 1997 the Company entered into an agreement with Alpha 1 Biomedicals, Inc. (“A1B”) to acquire the worldwide rights, except in Italy, Spain and Portugal, where Sclavo S.p.A. (“Sclavo”), an international pharmaceutical entity, owned exclusive marketing rights, to ZADAXIN, which rights A1B had licensed from Hoffmann-LaRoche, Inc. and F. Hoffmann-LaRoche AG, for approximately $1,800,000. The transaction closed in July 1998 and eliminated the Company's royalty obligation to A1B with respect to all sales of ZADAXIN after the acquisition date. In April 1998, the Company entered into an agreement with Sclavo to acquire ZADAXIN rights for Italy, Spain and Portugal from Sclavo for approximately $1,400,000.
In connection with the foregoing transactions with Sclavo and A1B, the Company estimated the fair market value of the intangible assets purchased to be approximately $2,456,000 and wrote off the remaining $700,000 related to HCV in-process technology.
Acquired ZADAXIN product rights are being amortized on a straight-line basis over their estimated useful lives. Amortization expense for the years ended December 31, 2006, 2005 and 2004 was $70,000 per year and for the years 2007 through 2012 is expected to be $70,000 per year. Based upon the progress in the ZADAXIN clinical trials and the Company’s actual experience of product sales, the Company assessed that the acquired product rights will be useful to the Company through 2012 when the European patent for the use of ZADAXIN in the treatment of hepatitis C expires. The Company reassesses the useful life of these assets in accordance with current facts and circumstances.
Note 7 - Other Accrued Expenses
The following is a summary of other accrued expenses:
Note 8 - Collaborative Agreements
In May 2004, the Company entered into an agreement with Sigma-Tau, whereby Sigma-Tau is conducting a multi-center phase 3 hepatitis C triple therapy clinical trial in Europe with approximately 550 patients. The objective of the European trial is to provide data on ZADAXIN’s use as part of a triple therapy in treating HCV
patients. The Company is providing Sigma-Tau approximately $2,500,000 of funding support during the course of patient enrollment and trial period of which $1,523,000 has been paid as of December 31, 2006, and a $1,500,000 milestone payment at the completion of the study. Based on the level of activity in this trial, the Company has recorded approximately $1,750,000 and $1,203,000 of research and development expense related to this trial in the years ended December 31, 2006 and 2005, respectively.
In October 2003, the Company and Wayne State University (“WSU”) amended a license agreement that WSU and A1B had entered into in 1994 that was subsequently assigned by A1B to SciClone. The 2003 amendment allows the Company to maintain an exclusive license to certain WSU patents regarding the use of thymosin alpha 1 in the treatment of hepatitis B and hepatitis C. In addition to certain minimum royalty payments following sales of ZADAXIN in certain territories, the Company paid WSU a total of $1,400,000 in non-refundable pre-paid royalties. The Company can offset the annual minimum royalties due on sales of ZADAXIN with these pre-paid royalties to the extent of 50% of the annual royalties in any one year. As of December 31, 2006, $1,000,000 of these royalties were included in other assets on the accompanying balance sheet.
In April 1999, the Company licensed to Sigma-Tau semi-exclusive ZADAXIN development and marketing rights in Italy and Spain, and exclusive rights in Switzerland. In March 2000, this license was expanded and amended to include all of the countries then in the European Union and Sigma-Tau was made exclusive licensee in these countries. In December 2001, this license was further amended to define the scope of clinical development for ZADAXIN that Sigma-Tau would undertake in Europe. Under the terms of the December 2001 amendment, the Company received $2,685,000 in the first quarter of 2002. This contract revenue was recognized over the estimated time to complete the ZADAXIN U.S. phase 3 HCV clinical trials and deliver the clinical data, the substantive performance requirements under the contract amendment. For the year ended December 31, 2006, 2005 and 2004, the Company recognized $229,000, $492,000, and $537,000, respectively. Additionally, in the second quarter of 2004, the Company recognized a $1,000,000 milestone payment from Sigma-Tau for the full enrollment of the Company’s current phase 3 U.S. clinical trials as there are no future performance obligations associated with the milestone payment.
In August 1997 the Company entered into a ZADAXIN Patent License Agreement with The Fitzsimons Army Medical Center of the U.S. Army (the “U.S. Army”). The Company is obligated to pay the U.S. Army a minimum annual royalty and a royalty based on a percentage of ZADAXIN net sales revenue upon commercialization of ZADAXIN for treatment of chronic hepatitis C in certain countries, including the U.S., the European Union and Japan, but not including China.
Note 9 - Other Long-term Liabilities
Other long-term liabilities consisted of $68,000 of accrued compensation and employee benefits at December 31, 2006 and 2005.
Note 10 - Income Taxes
The Company has not recorded any federal or state income tax expense for the years ended December 31, 2006, 2005 and 2004. Undistributed earnings of the Company’s foreign subsidiaries amounted to approximately $6,126,000, $6,673,000, and $4,155,000 at December 31, 2006, 2005 and 2004, respectively. These earnings are considered to be permanently reinvested and accordingly, no deferred U.S. income taxes have been provided thereon.
The domestic and foreign components of pre tax income (loss) for the years ended December 31 are as follows:
A reconciliation of the statutory federal income tax rate of 34% to the actual tax rate for the years ended December 31 is as follows:
Significant components of the Company's deferred tax assets at December 31 are as follows:
The valuation allowance increased by approximately $3,353,000, $5,818,000, and $6,349,000 in the years ended December 31, 2006, 2005 and 2004, respectively. Deferred tax assets relating to net operating loss carryforwards as of December 31, 2006 include approximately $3,014,000 associated with stock option activity for which any subsequently recognized tax benefits will be credited directly to stockholders' equity. The Company did not have any deferred tax liabilities at December 31, 2006 or 2005.
At December 31, 2006, the Company has net operating loss carryforwards for federal income tax purposes of approximately $123,000,000 which expire in the years 2007 through 2026. At December 31, 2006, the Company has federal tax credit carryforwards of approximately $7,000,000 which expire in the years 2007 through 2026.
At December 31, 2006, the Company has state net operating loss carryforwards of approximately $17,000,000 available to reduce future taxable income. The carryforwards begin to expire in 2007, if not utilized. In addition, the Company has research and development tax credit carryforwards of approximately $1,000,000 for state tax purposes at December 31, 2006. The tax credit carryforwards will be carried forward indefinitely until utilized.
Because of the “change in ownership” provisions of the Internal Revenue Code, a portion of the Company's net operating loss carryforwards and tax credit carryforwards may be subject to an annual limitation regarding their utilization against taxable income in future periods. As a result of the annual limitation, a portion of these carryforwards may expire before ultimately becoming available to reduce future income tax liabilities.
Note 11 - Commitments and Contingencies
Leases
The Company leases its main office facility under a non-cancelable operating lease agreement which expires in August 2007. The lease requires the Company to pay insurance and taxes and its pro-rata share of operating expenses. The Company also leases various office facilities abroad under non-cancelable lease agreements. The Company expenses rent as incurred and these costs are included in operating expenses. Rent expense in 2006, 2005, and 2004 was $1,625,000, $1,458,000, and $1,393,000, respectively. Minimum future rental payments under facility and equipment operating lease agreements amount to a total of $1,469,000, which consists of $1,209,000 in 2007, $197,000 in 2008 and $63,000 in 2009.
Purchase Obligations
For the years ended December 31, 2006, 2005 and 2004, the Company had purchase obligation requirements in the amounts of $3,684,000, $4,749,000, and $6,456,000, respectively. At December 31, 2006 the purchase obligations consist of minimum purchase requirements from a contract manufacturer in the amount of $1,198,000. In addition, there were research and development fees payable in the amount of $2,486,000 to Sigma-Tau to conduct and complete an HCV clinical trial in Europe.
Royalties
Under the October 2003 amendment to the Patent License Agreement with WSU, the Company is obligated to pay WSU a royalty, subject to minimum amounts, on a percentage of ZADAXIN net sales revenue for the treatment of hepatitis B and hepatitis C in certain countries including the United States, the European Union and Japan, but not including China. In the year ended December 31, 2006, 2005 and 2004, the Company paid WSU $500,000, $400,000, and $300,000, respectively, of non-refundable pre-paid royalties and the Company has certain rights to offset annual minimum royalties due on sales of ZADAXIN with these pre-paid royalties. Minimum annual royalties of up to $500,000 will be due each year through 2012.
Under the August 1997 ZADAXIN Patent License Agreement with the U.S. Army, the Company is obligated to pay the U.S. Army minimum annual royalty payments through 2010 and a royalty based on a percentage of ZADAXIN net sales revenue upon commercialization of ZADAXIN for treatment of chronic hepatitis C in certain countries including the U.S., the European Union and Japan, but not including China. During 2006, 2005 and 2004 the Company paid $20,000 per year to the U.S. Army related to the minimum annual royalty.
Convertible Notes Payable
In March 2001, the Company issued a $1,600,000 convertible note to an investment affiliate of UBS AG. The $1,600,000 note was convertible into 276,530 shares of common stock at a fixed conversion price of $5.7860 per share. In March 2006, the $1,600,000 note was repaid.
In December 2000, the Company issued a $4,000,000 convertible note to an investment affiliate of UBS AG. The $4,000,000 note was convertible into 407,610 shares of common stock at a fixed conversion price of $9.8133 per share. In December 2005, the $4,000,000 note was repaid.
Note 12 - Stockholders’ Equity
On July 18, 2003, the Company reincorporated from a California corporation to a Delaware corporation by merging the Company, then a California corporation, with and into SciClone Pharmaceuticals Inc., a Delaware corporation and wholly-owned subsidiary of the Company. Each share of outstanding stock of the California corporation was automatically exchanged for a like share of stock of the Delaware corporation.
Common Stock and Warrants
In July 2004 when a former CEO left the Company, his outstanding unvested options to purchase 253,541 shares of the Company’s common stock became fully vested and all of his outstanding options to purchase 1,615,454 shares became exercisable for a one or two year period. These changes to the former CEO’s options did not result in any stock-based compensation as the changes were effected in accordance with the original terms of the option grants.
In January 1999, the Company issued warrants to purchase a total of 150,000 shares of common stock to Cato Research Ltd. as part of a settlement agreement. Of this total, warrants to purchase 50,000 shares of common stock were exercised at a price of $1.225 for proceeds of $61,250 in March 2000. In January 2004, the remaining warrants to purchase 100,000 shares of common stock were exercised at a price of $2.25 for 65,753 shares of common stock.
Stock Award Plans
In August 1991, the Board of Directors and stockholders of the Company approved the 1991 Stock Plan (the “1991 Plan”) and reserved 1,300,000 shares for issuance thereunder. In May 1993, the Board of Directors and stockholders of the Company approved a 2,150,000 increase in the shares reserved under the 1991 Plan. The 1991 Plan permits the award of incentive or nonqualified stock options and shares of common stock under restricted stock purchase agreements.
In January 1992, the Board of Directors and stockholders of the Company approved the 1992 Stock Plan (the “1992 Plan”) and reserved 240,000 shares for issuance thereunder. The 1992 Plan permits the award of incentive or nonqualified stock options which must be exercised in cash.
In June 1995, the Board of Directors and the stockholders of the Company approved the 1995 Equity Incentive Plan (the “1995 Plan”) and reserved 1,250,000 shares for issuance thereunder. The 1995 Plan permits the award of incentive or nonqualified stock options and shares of common stock under restricted stock awards. In May 1997, the Board of Directors and stockholders of the Company approved a 750,000 increase in the shares reserved under the 1995 Plan. In June 1998, June 2000 and June 2002 the Board of Directors and stockholders of the Company approved increases of 1,500,000, 1,250,000 and 1,350,000, respectively, in the shares reserved under the 1995 Plan.
In May 2004, the Board of Directors and the stockholders of the Company approved the 2004 Stock Option Plan (the “2004 Plan”) and reserved 2,500,000 shares for issuance thereunder. The 2004 Plan permits the award of incentive stock options or nonstatutory stock options. In June 2005, the Board of Directors and stockholders of the Company approved an increase in the maximum number of shares issuable under the 2004 Plan by 2,300,000 shares to a total of 4,800,000 shares. The Board of Directors and stockholders also approved amendments to the 2004 Plan to expand the types of stock-based incentives authorized under the 2004 Plan and to restate the 2004 Plan as the 2005 Equity Incentive Plan (the “2005 Plan”). The 2005 Equity Incentive Plan permits the grant of incentive stock options, nonstatutory stock options, stock appreciation rights, stock purchase rights, stock bonuses, restricted stock units, performance shares and performance units. The options are granted at fair market value on the date of grant and expire ten years from the date of grant.
Under the 1991, 1992, 1995 and 2005 Plans, options are exercisable upon conditions determined by the Board of Directors and expire ten years from the date of grant. Options are generally granted at fair market value on the date of grant and vest over time, generally four years. Although the 1991, 1992 and 1995 Plans have expired, the outstanding options relating to them are fully valid.
In June 1995, the Board of Directors and the stockholders of the Company approved the 1995 Nonemployee Director Stock Option Plan (the “Nonemployee Director Plan”) and reserved 250,000 shares for issuance
thereunder. In June 2000 and June 2002 the Board of Directors and stockholders of the Company approved an increase of 250,000 in the shares reserved for issuance under the Nonemployee Director Plan. In May 2004, the Board of Directors and stockholders of the Company approved the 2004 Outside Directors Stock Option Plan and reserved 465,000 shares for issuance thereunder and the Nonemployee Director Stock Option Plan was canceled. The 2004 Outside Directors Stock Option Plan automatically grants nonqualified stock options to nonemployee directors upon their appointment or first election to the Company’s Board of Directors (“Initial Grant”) and annually upon their reelection to the Board of Directors at the Company’s Annual Meeting of Stockholders (“Annual Grant”). The options are granted at fair market value on the date of grant and expire ten years from the date of grant. Initial Grants become exercisable in three equal annual installments beginning on the first anniversary of the date of grant, and Annual Grants become exercisable in twelve equal monthly installments from the date of grant, subject in each case to the Outside Director’s continuous service on our Board of Directors. In June 2005, the Board of Directors and stockholders of the Company approved an increase in the maximum number of shares issuable under the 2004 Outside Directors Stock Option Plan by 550,000 shares to a total of 1,015,000 shares.
The following table summarizes the stock option activity under the 1991, 1992, 1995 and 2005 Stock Option Plans, the Nonemployee Director Plan and the 2004 Outside Director Stock Option Plan:
The aggregate intrinsic value in the table above represents the value of the Company’s closing stock price on the last trading day of the fiscal year in excess of the exercise price multiplied by the number of options outstanding or exercisable. The intrinsic value of options at time of exercise was $112,000, $1,668,000, and $2,000 for the years ended December 31, 2006, 2005 and 2004, respectively. The estimated fair value of shares vested for the years ended December 31, 2006, 2005, and 2004 was $2,674,000, $2,744,000, and $4,373,000, respectively.
The following table summarizes information concerning outstanding and exercisable options as of December 31, 2006:
The following table illustrates the allocation of compensation cost related to stock options and employee stock purchases to the income statement line items each year as of December 31:
As result of adopting FAS 123R as of January 1, 2006, our income from operations and net income for the year ended December 31, 2006 is approximately $2,446,000 lower than if we had continued to account for share-based compensation under APB 25. Basic and diluted income per share for year ended December 31, 2006 are each $0.07 lower than if the Company had continued to account for share-based compensation under APB 25. The total compensation cost capitalized in inventory was approximately $108,000 for the year ended December 31, 2006.
The weighted-average assumptions used in the Black-Scholes option valuation model to calculate the estimated fair values at the date of grant for 2006, 2005 and 2004 and the resulting weighted-average expected life and weighted-average fair value of stock options granted and for stock purchases during those periods are as follows:
The expected term of options granted is derived from historical data on employee exercises and terminations. The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant. Expected volatility is based on the historical volatility of our stock. The expected dividend assumption is based on the Company’s history and expectations of no dividend payouts.
In July 1996, the Board of Directors and stockholders of the Company approved the 1996 Employee Stock Purchase Plan (the “ESPP”) and reserved 500,000 shares for issuance thereunder. In June 2003, the Board of Directors and stockholders of the Company approved an increase of 500,000 in the shares reserved for issuance under the 1996 Employee Stock Purchase Plan. All full-time employees are eligible to participate in the ESPP. Under the terms of the ESPP, employees could choose to have up to 15% of their salary withheld to purchase the Company's common stock. The purchase price of the stock was 85% of the lower of the fair market value as of the first and last trading day of each quarterly participation period. In January 2006, the Board of Directors amended the ESPP to provide that, for each Offering Period commencing after January 31, 2006, the purchase price of the stock shall be equal to 95% of the fair market value of a share of the Company’s Common Stock on the Purchase Date (or such other amount as may be established by the Board). Accordingly, no fair value calculation was performed for purchases subsequent to January 31, 2006 because the amended plan is non-compensatory under FAS 123R. Under the ESPP, the Company sold 22,454, 80,113 and 124,798 shares to employees in 2006, 2005 and 2004, respectively.
As of December 31, 2006, unamortized compensation expense related to unvested options was approximately $4,000,000. The weighted average period over which compensation expense related to these options will be recognized is 2.09 years.
Reserved Shares
As of December 31, 2006, the Company had reserved shares of common stock for future issuance as follows:
Stockholder Rights Agreement
On December 18, 2006, the Company’s Board of Directors declared a dividend distribution of one Preferred Stock Purchase Right (collectively, the “Rights”) for each outstanding share of the Company’s Common Stock, each Right which entitles the registered holder to purchase from the Company one one-thousandth of a share of the Company’s Series D Preferred Stock, $0.001 par value, at a price of $25.00 pursuant to a Rights Agreement dated as of December 19, 2006, between the Company and Mellon Investor Services LLC (the “Rights Agreement”). The Rights, which will initially trade with the Common Stock, become exercisable when a person or group acquires 15% or more of the Company’s Common Stock without prior Board approval. In that event, the Rights permit the Company’s stockholders, other than the acquiror, to purchase the Company’s Common Stock having a market value of twice the exercise price of the Rights, in lieu of the Preferred Stock.
Alternatively, when the Rights become exercisable, the Company’s Board of Directors may authorize the issuance of one share of the Company’s Common Stock in exchange for each Right that is then exercisable. In addition, in the event of certain business combinations, the Rights permit the purchase of the Common Stock of an acquiror at a 50% discount. Rights held by the acquiror will become null and void in each case. Prior to a person or group acquiring 15%, the Rights can be redeemed for $0.001 each by action of the Board. The Rights Agreement contains an exception to the 15% ownership threshold for shares currently beneficially owned by Sigma-Tau Finanziaria S.p.A. The Rights expire on December 19, 2016. The Rights Agreement includes a requirement that a committee of independent directors evaluate the Rights Agreement at least every three years (a “TIDE” provision).
Note 13 - CEO Agreements
On June 2, 2006, Dr. Friedhelm Blobel became our President and CEO and joined our Board of Directors, and Dr. Ira Lawrence resigned as President and CEO and became a consultant to the Company. Dr. Lawrence also continues to serve as a Director of the Company and serves as a member of the Business Development Committee and the Medical Review Committee of the Board of Directors. In accordance with Dr. Lawrence’s separation agreement, his unvested stock options were cancelled. His options to purchase 200,000 shares that vested during his time of services as CEO will be exercisable for their term provided that Dr. Lawrence continues his service as a consultant or Director of the Company.
The Company had entered into an employment agreement with Dr. Lawrence effective June 1, 2005. The employment agreement included the award of an option to purchase 400,000 shares of the Company’s common stock at $2.97 per share, the closing price on The NASDAQ Stock Market LLC (formerly the NASDAQ National Market) of a share of the Company’s common stock on June 1, 2005. This option had a term of 10 years and 25% of such second option would vest upon the Company’s common stock trading after June 1, 2005 for at least 30 consecutive calendar days at or greater than a target closing stock price, as reported on The NASDAQ Stock Market LLC, of (a) $4.50 on or before June 1, 2008, (b) $6.00 on or before June 1, 2009, (c) $8.00 on or before June 1, 2010, and (d) $10.00 on or before June 1, 2011, each price as adjusted for stock dividends, stock splits or similar changes in the Company’s capital structure.
Under APB 25, the Company recognized non-cash expense related to the stock price performance based option granted to Dr. Lawrence on June 1, 2005, the date he commenced his employment. The terms of this option required the application of variable accounting, and the related non-cash expense to be recognized is effected by the price level of trading activity in our stock. The Company recognized non-cash expense when the vesting of a portion of the option was determined to be probable. During the year ended December 31, 2005, the market price of the Company’s common stock price had closed above $4.50 for at least 30 consecutive calendar days thus triggering the vesting of 25% of the shares underlying the option. Therefore, the Company recognized a $423,000 non-cash expense attributable to this vesting in 2005. For the year ended December 31, 2006, no expense related to this option was recognized by the Company as the remaining unvested shares were forfeited upon Dr. Lawrence’s departure from the Company.
Under SFAS 123, the option is considered a target stock price award and, therefore, the grant date fair values related to each of the four vesting portions of this award have been calculated and the related expense included in the SFAS 123 pro forma expense disclosure over the derived service periods for each of the four vesting portions of the award. The aggregate fair value of the award was estimated to be $691,000 at the date of grant using a Monte Carlo simulation option pricing model with the following assumptions, risk-free interest rate of 4.097%; dividend yield of 0%; volatility factor of 74% and expected life of 10 years. The fair values of the four vesting portions of the awards of $186,000, $173,000, $166,000 and $166,000 were to be amortized over their related derived service periods of 13, 21, 28, and 36 months, respectively. For the years ended December 31, 2005 and 2004, approximately $232,000 and $0, respectively, of such expense is included in the SFAS 123 pro forma expense (see note 1, Significant Accounting Policies, Accounting for Stock-Based Compensation).
Under the new CEO agreement with Dr. Blobel, effective June 2, 2006, the Board of Directors is obligated in 2008 to consider an award to Dr. Blobel of a special cash bonus of up to $300,000, based on his achievement of the previously agreed upon performance targets over the years 2006-2008. The Company will estimate the probable amount of this long-term incentive bonus on a quarterly basis in order to accrue the bonus over the related performance period. For the year ended December 31, 2006, the Company accrued approximately $68,000 relating to the special cash bonus. All expenses related to the agreement with Dr. Blobel will be recorded to general and administrative expenses.
The employment agreement with Dr. Blobel also includes two option awards. The first option award is to purchase 400,000 shares of the Company’s common stock at an exercise price per share equal to the closing price on The NASDAQ Stock Market LLC of a share of the Company’s common stock on June 2, 2006. The option has a term of ten years and will vest in annual installments on each of the first four anniversaries of June 2, 2006. The Company is recognizing compensation cost for these options based on the grant-date fair value estimated in accordance with the provision of FAS 123R. The Company is amortizing the compensation cost over the vesting period, which is four years, using the straight line attribution method.
The second option award granted to Dr. Blobel is to purchase 600,000 shares of the Company’s common stock at an exercise price per share equal to the closing price on The NASDAQ Stock Market LLC of a share of the Company’s common stock on June 2, 2006. This option has a term of 10 years and shares of such option will vest upon the Company’s common stock trading after June 2, 2006 for at least 30 consecutive calendar days at or greater than a target closing stock price as reported on The NASDAQ Stock Market LLC, of (a) $4.50 on or before June 2, 2009 for 100,000 shares, (b) $6.00 on or before June 2, 2010 for 100,000 shares, (c) $8.00 on or before June 2, 2011 for 100,000 shares, (d) $10.00 on or before June 2, 2012 for 100,000 shares, (e) $12.00 on or before June 2, 2013 for 100,000 shares, and (f) $14.00 on or before June 2, 2014 for 100,000 shares, each price as adjusted for stock dividends, stock splits or similar changes in the Company’s capital structure. The second option grant is considered an award with market service conditions. The market conditions are not considered performance conditions and therefore, compensation expense is recognized for the option with market conditions as long as service requirements are met, even if the market condition is not reached. Therefore, the grant date fair values related to each of the six vesting portions of this award have been calculated and the related compensation costs are being expensed over the service periods for each of the six vesting portions of the award. For the year ended December 31, 2006, the Company recorded $265,000 of compensation expense related to this award.
Note 14 - 401k Plan
The Company has a pre-tax savings plan covering substantially all U.S. employees, which qualifies under Section 401(k) of the Internal Revenue Code. Under the plan, eligible employees may contribute a portion of their pre-tax salary, subject to certain limitations. The Company contributes and matches 50% of the employee contributions, up to 15% of an employee's salary. Company contributions, which can be terminated at the Company's discretion, were approximately $200,000, $170,000, and $161,000 for the years ended December 31, 2006, 2005 and 2004, respectively.
Note 15 - Other Income
On April 3, 2006, the Company announced the resolution of its dispute with Schering Plough KK (SPKK) concerning clinical trials conducted in Japan with ZADAXIN. Under the terms of the settlement, SPKK paid SciClone $8,000,000 on April 18, 2006 which was recorded as other income for the year ended December 31, 2006.
Note 16 - Significant Geographic Information
The Company operates in one business segment, the development and commercialization of novel therapeutics to treat chronic and life threatening diseases. Through December 31, 2006, all of the Company’s revenues were generated from the sale of ZADAXIN.
The President and CEO has been identified as the Chief Operating Decision Makers (“CODM”) because he has final authority over resource allocation decisions and performance assessment. The CODM does not receive discrete financial information at a level below that of the business segment.
The Company's domestic operations primarily consist of product development. The Company's wholly owned international subsidiary, SciClone Pharmaceuticals International Ltd., is engaged in sales and marketing and product distribution worldwide.
Information regarding geographic areas is as follows:
Two customers accounted for 10% or more of total revenues (66% and 15%) for an aggregate of 81% of total revenues for the year ended December 31, 2006. Three customers accounted for 10% or more of total revenues (57%, 19% and 15%) for an aggregate of 91% of total revenues for the year ended December 31, 2005. Three customers accounted for 10% or more of total revenues (32%, 29% and 23%) for an aggregate of 84% of total revenues for the year ended December 31, 2004. No other customer accounted for more than 10% of total revenues during these years.
Note 17 - Selected Quarterly Financial Data (unaudited)
(1) During the three months ended December 31, 2006, the Company recorded $929,000 of royalty expense related to a license agreement.
(2) In April 2006, the Company received $8,000,000 for the resolution of its dispute with Schering Plough KK.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure
Not applicable
Item 9A.
Item 9A. Controls and Procedures
Disclosure Controls and Procedures
As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of its management, including our President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures in ensuring that material information required to be disclosed in the Company’s reports filed or submitted under the Securities Exchange Act of 1934, as amended, has been made known to them in a timely fashion. Based on this evaluation, our President and Chief Executive Officer and our Executive Vice President and Chief Financial Officer concluded that the Company’s disclosure controls and procedures are effective in reaching a reasonable level of assurance that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms.
Management's Annual Report on Internal Control over Financial Reporting; Attestation Report of the Registered Public Accounting Firm
Management of the Company is responsible for establishing and maintaining adequate internal control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Securities Exchange Act of 1934, as amended. The Company’s internal control over financial reporting is designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. The Company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of the assets of the Company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the Company are being made only in accordance with authorizations of management and directors of the Company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the Company’s assets that could have a material effect on the consolidated financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. All control systems have inherent limitations so that no evaluation of controls can provide absolute assurance that all control issues are detected. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
Under the supervision and with the participation of our management, we assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, based on the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on this assessment and those criteria, management believes that the Company maintained effective internal control over financial reporting as of December 31, 2006.
Ernst & Young LLP, an independent registered public accounting firm, has audited and issued an attestation report on management’s assessment of the effectiveness of the Company’s internal control over financial reporting as of December 31, 2006, as stated in their report which is included below.
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders of SciClone Pharmaceuticals, Inc.
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting, that SciClone Pharmaceuticals, Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (the COSO criteria). SciClone Pharmaceuticals, Inc.’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
A company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that SciClone Pharmaceuticals, Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the COSO criteria. Also, in our opinion, SciClone Pharmaceuticals, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the COSO criteria.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of SciClone Pharmaceuticals, Inc. as of December 31, 2006 and 2005, and the related consolidated statements of operations, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2006 and our report dated March 15, 2007 expressed an unqualified opinion thereon.
/s/ Ernst & Young LLP
Palo Alto, California
March 15, 2007
Changes in Internal Control over Financial Reporting
There has been no change in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Securities Act of 1934, as amended) that was identified in connection with the evaluation thereof that occurred during the fourth quarter of 2006 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information
Not applicable
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant
The information required by Item 401 of Regulation S-K is incorporated by reference from the Proxy Statement under the caption “ELECTION OF DIRECTORS - Nominees,” and “ELECTION OF DIRECTORS - Board Meetings and Committees - Audit Committee.” Information relating to the executive officers of the Company is set forth in Item 1 in Part I of this Report under the caption “Executive Officers of the Registrant.”
The information required by Item 405 of Regulation S-K is incorporated by reference from the Proxy Statement under the caption “EXECUTIVE COMPENSATION AND OTHER MATTERS - Compliance with Section 16(a) of the Exchange Act.”
Code of Ethics
We have adopted a code of business conduct and ethics, and a policy providing for the reporting of potential violations of the code, for directors, officers (including our principal executive officer, principal financial officer, principal accounting officer and controller) and employees, known as the Corporate Code of Conduct and Reporting (‘Whistle Blowing’) of Perceived or Alleged Violations (the “Code of Conduct”). The Code of Conduct is available on our website at http://phx.corporate-ir.net/phoenix.zhtml?c=103184&p=irol-govConduct. Additionally, stockholders may request a free copy of the Code of Conduct by contacting the Investor Relations Department at our corporate offices by calling 800-724-2566 or by sending an e-mail message to investorrelations@sciclone.com.
Item 11.
Item 11. Executive Compensation
The information required by this Item 11 is incorporated by reference from the Proxy Statement under the captions “EXECUTIVE COMPENSATION AND OTHER MATTERS” and “ELECTION OF DIRECTORS - Compensation of Directors.”
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Securities Authorized for Issuance under Equity Compensation Plans
As of December 31, 2006, the Company maintained seven compensation plans that provide for the issuance of common stock to officers and other employees, directors and consultants. These consist of the 1991 Stock Plan, the 1992 Stock Plan, the 1995 Equity Incentive Plan, the 1995 Nonemployee Director Stock Option Plan, the 1996 Employee Stock Purchase Plan, the 2004 Outside Directors Stock Option Plan and the 2005 Equity Incentive Plan, which plans have all been approved by the Company’s stockholders. The Company does not currently maintain any compensation plans that have not been approved by the Company’s stockholders. The following table sets forth information regarding outstanding options and shares reserved for future issuance under the foregoing plans as of December 31, 2006:
(1) 1996 Employee Stock Purchase Plan is a voluntary plan open to all employees. This plan allows employees to elect payroll deductions which are used to purchase SciClone’s common stock directly from the Company.
The information required by Item 403 of Regulation S-K is incorporated by reference from the Proxy Statement under the caption “SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.”
Item 13.
Item 13. Certain Relationships and Related Transactions
The information required by this Item is incorporated by reference from the Proxy Statement under the captions “EXECUTIVE COMPENSATION AND OTHER MATTERS - Certain Relationships and Related Transactions” and “ELECTION OF DIRECTORS - Director Independence.”
Item 14.
Item 14. Principal Accountant Fees and Services
The information required by this Item 14 is incorporated by reference from the Proxy Statement under the caption “RATIFICATION OF APPOINTMENT OF INDEPENDENT AUDITORS - Principal Accountant Fees.”
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
Item 15 (a). The following documents are filed as part of this Annual Report on Form 10-K:
(1) Financial Statements. The following financial statements of the Company are contained in Item 8, Part II on pages 47 - 71 of this Annual Report on Form 10-K:
Report of Independent Registered Public Accounting Firm.
Consolidated Balance Sheets at December 31, 2006 and 2005.
Consolidated Statements of Operations for each of the three years in the period ended December 31, 2006.
Consolidated Statement of Stockholders’ Equity for the three years ended December 31, 2006.
Consolidated Statements of Cash Flows for each of the three years in the period ended December 31, 2006.
Notes to Consolidated Financial Statements.
(2) Financial Statement Schedules
The following schedule required to be filed by Item 8 of this form and Item 15(d) is contained on page 83 of this Report:
Schedule II - Valuation and Qualifying Accounts for each of the three years in the period ended December 31, 2006.
All other schedules have been omitted because they are either inapplicable or the required information has been given in the consolidated financial statements or the notes thereto.
(3) Exhibits.
Refer to Item 15(b) below.
Item 15 (b). Exhibits.
Exhibits (numbered in accordance with Item 601 of Regulation S-K):
* Certain information in this exhibit has been omitted and filed separately with the Securities and Exchange Commission pursuant to a confidential treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83 and 230.46.
** Management compensatory plan or arrangement.
(1) Incorporated by reference from the Company’s Current Report on 8-K filed on July 28, 2003.
(2) Incorporated by reference from the Company’s Registration Statement on Form S-l (No. 33-45446), declared effective by the Commission on March 17, 1992.
(3) Incorporated by reference from the Company’s Registration Statement on Form S-8 (No. 33-66832) filed with the Commission on August 3, 1993.
(4) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 1994.
(5) Incorporated by reference from the Company’s Registration Statement on Form S-8 (No. 33-80911) filed with the Commission on December 28, 1995.
(6) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 1995.
(7) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1996.
(8) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1996.
(9) Incorporated by reference from the Company’s Current Report on Form 8-K filed on October 14, 1997.
(10) Incorporated by reference from the Company’s Current Report on Form 8-K filed on January 26, 1998.
(11) Incorporated by reference from the Company’s Current Report on Form 8-K filed on April 20, 2000.
(12) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998.
(13) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.
(14) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2001.
(15) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
(16) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
(17) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003.
(18) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2003.
(19) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
(20) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004.
(21) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2004.
(22) Incorporated by reference from the Company’s Current Report on Form 8-K filed on September 15, 2004.
(23) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
(24) Incorporated by reference from the Company’s Current Report on Form 8-K filed on April 29, 2005.
(25) Incorporated by reference from the Company’s Current Report on Form 8-K filed on June 1, 2005.
(26) Incorporated by reference from the Company’s Current Report on Form 8-K filed on June 20, 2005.
(27) Incorporated by reference from the Company’s Current Report on Form 8-K filed on February 28, 2006.
(28) Incorporated by reference from the Company’s Current Report on Form 8-K filed on April 25, 2006.
(29) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006.
(30) Incorporated by reference from the Company’s Current Report on Form 8-K filed on November 27, 2006.
(31) Incorporated by reference from the Company’s Current Report on Form 8-K filed on December 22, 2006.
(32) Incorporated by reference from the Company’s Current Report on Form 8-K filed on December 28, 2006.
(33) Filed herewith.
Item 15 (c). See Item 15(a) above.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
SCICLONE PHARMACEUTICALS, INC.
By:
/S/ FRIEDHELM BLOBEL, PH.D.
Friedhelm Blobel, Ph.D.
President and Chief Executive Officer
(Principal Executive Officer)
Date: March 16, 2007
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Friedhelm Blobel, Ph.D. and Richard A. Waldron, and each of them, his attorneys-in-fact and agents, each with the power of substitution and resubstitution, for him in any and all capacities, to sign this Report on Form 10-K, and to file the same, with exhibits thereto and other documents in connection therewith, with the Securities and Exchange Commission, granting to said attorneys-in-fact and agents, and each of them, full power and authority to do and perform each and every act and thing requisite and necessary, to be done in connection therewith, as fully as to all intents and purposes as he might or could do in person, hereby ratifying and confirming all that said attorneys-in-fact and agents, or either of them, or their or his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this Report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
SCICLONE PHARMACEUTICALS, INC.
INDEX TO EXHIBITS
* Certain information in this exhibit has been omitted and filed separately with the Securities and Exchange Commission pursuant to a confidential treatment request under 17 C.F.R. Sections 200.80(b)(4), 200.83 and 230.46.
** Management compensatory plan or arrangement.
(1) Incorporated by reference from the Company’s Current Report on 8-K filed on July 28, 2003.
(2) Incorporated by reference from the Company’s Registration Statement on Form S-l (No. 33-45446), declared effective by the Commission on March 17, 1992.
(3) Incorporated by reference from the Company’s Registration Statement on Form S-8 (No. 33-66832) filed with the Commission on August 3, 1993.
(4) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 1994.
(5) Incorporated by reference from the Company’s Registration Statement on Form S-8 (No. 33-80911) filed with the Commission on December 28, 1995.
(6) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 1995.
(7) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 1996.
(8) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1996.
(9) Incorporated by reference from the Company’s Current Report on Form 8-K filed on October 14, 1997.
(10) Incorporated by reference from the Company’s Current Report on Form 8-K filed on January 26, 1998.
(11) Incorporated by reference from the Company’s Current Report on Form 8-K filed on April 20, 2000.
(12) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 1998.
(13) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2000.
(14) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended March 31, 2001.
(15) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2001.
(16) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2002.
(17) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2003.
(18) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2003.
(19) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
(20) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2004.
(21) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended September 30, 2004.
(22) Incorporated by reference from the Company’s Current Report on Form 8-K filed on September 15, 2004.
(23) Incorporated by reference from the Company’s Annual Report on Form 10-K for the year ended December 31, 2004.
(24) Incorporated by reference from the Company’s Current Report on Form 8-K filed on April 29, 2005.
(25) Incorporated by reference from the Company’s Current Report on Form 8-K filed on June 1, 2005.
(26) Incorporated by reference from the Company’s Current Report on Form 8-K filed on June 20, 2005.
(27) Incorporated by reference from the Company’s Current Report on Form 8-K filed on February 28, 2006.
(28) Incorporated by reference from the Company’s Current Report on Form 8-K filed on April 25, 2006.
(29) Incorporated by reference from the Company’s Quarterly Report on Form 10-Q for the quarterly period ended June 30, 2006.
(30) Incorporated by reference from the Company’s Current Report on Form 8-K filed on November 27, 2006.
(31) Incorporated by reference from the Company’s Current Report on Form 8-K filed on December 22, 2006.
(32) Incorporated by reference from the Company’s Current Report on Form 8-K filed on December 28, 2006.
(33) Filed herewith.