ITEM 1 - BUSINESS
Overview
Encysive Pharmaceuticals Inc. is a global biopharmaceutical company that engages in the discovery, development and commercialization of novel, synthetic, small molecule compounds to address unmet medical needs. We focus our research and development programs predominantly on the treatment and prevention of interrelated diseases of the vascular endothelium and exploit our expertise in the area of the intravascular inflammatory process, referred to as the inflammatory cascade, and vascular diseases. We have successfully developed one FDA approved drug, Argatroban, for the treatment of heparin-induced thrombocytopenia, or HIT, which is licensed to and marketed by GlaxoSmithKline plc, or GSK in the U.S. and Canada. Our lead drug candidate, Thelin™ (sitaxsentan sodium), is an endothelin receptor antagonist we developed for the treatment of pulmonary arterial hypertension, or PAH. Thelin™ has received marketing authorization in the EU and Australia and is under review by the FDA in the United States and by national regulatory authorities in Canada.
We have three additional compounds in clinical development: the next generation endothelin receptor antagonist, TBC3711; TBC4746, a very late antigen-4, or VLA-4, antagonist licensed to Schering Corporation and Schering-Plough Ltd., or collectively, Schering-Plough; and bimosiamose, a selectin antagonist licensed to Revotar Biopharmaceuticals AG, or Revotar, our former majority-owned German subsidiary.
Our executive offices are located at 4848 Loop Central Drive, Suite 700, Houston, Texas 77081. Our telephone number is (713) 796-8822.
As used in this Form 10-K, the words “we,” “our,” “us,” “Encysive,” and the “Company” refer to Encysive Pharmaceuticals Inc., its predecessors and subsidiaries, except as otherwise specified. This Form 10-K may contain trademarks and service marks of other companies.
Marketed Products
Thelin™
Pulmonary Arterial Hypertension
PAH is a chronic, life-threatening disease characterized by vasoconstriction (narrowing of blood vessels) leading to the lungs, which results in very high blood pressure in the pulmonary arteries as the heart struggles to pump blood to the lungs. PAH patients suffer from a variety of symptoms, including shortness of breath and fatigue and, as the disease progresses, are less able to perform simple activities of living such as walking short distances or up a flight of stairs. In addition, the long-term chronic increase in pulmonary blood pressure often leads to an inability of the heart to pump blood adequately throughout the lungs and body, frequently resulting in death. PAH may be a primary condition, perhaps caused by genetic factors or unknown causes, or secondary to other diseases like autoimmune diseases (such as scleroderma or lupus), congenital heart disease, HIV infection or cirrhosis of the liver. Based on both industry research and our internal market research, we estimate that PAH afflicts approximately 100,000 to 200,000 individuals, mostly women, in the United States, Canada and Europe.
The Role of Endothelin Antagonists in PAH
Endothelin is a substance produced in humans that is believed to play a critical role in the control of blood flow. The action of endothelin can be explained by its interactions on cell surfaces with two distinct receptor subtypes, the endothelin-A, or ETA, and endothelin-B, or ETB, receptors. In general, ETA receptors are associated with vasoconstriction, while ETB receptors are primarily associated with vasodilation (widening of blood vessels). There is substantial evidence that endothelin is involved in a variety of other diseases where blood flow is important. These include diseases that result from severe vasoconstriction, congestive heart failure and certain types of hypertension.
Our research program has developed small molecules that inhibit the binding of endothelin to its cell surface receptors. Our scientists believe that agents which specifically block ETA receptors may provide the best clinical utility and safety versus those non-specific agents which block both ETA and ETB receptors.
Thelin™ (sitaxsentan sodium) is a highly-selective oral ETA receptor antagonist dosed once a day for the treatment of PAH. In August 2006, Thelin™ was approved by the European Commission, or EC, for use in patients with pulmonary arterial hypertension classified as World Health Organization, or WHO, functional class III, to improve exercise capacity, as well as in primary pulmonary hypertension and in pulmonary hypertension associated with connective tissue disease. After the EC approved Thelin™ for marketing
and sale in the EU, we started to build the necessary commercial infrastructure, including the establishment of country sales organizations and the negotiation of third party distributor relationships, to promote and sell Thelin™ in various countries of the EU. The centralized licensing procedure of the European Agency for the Evaluation of Medicinal Products, or EMEA, permits us to market Thelin™ in all 27 member states of the EU, however in most of the EU countries we must negotiate pricing and reimbursement prior to commercial launch. In the fourth quarter of 2006, we made Thelin™ commercially available in the United Kingdom, or U.K., and Germany. We anticipate subsequent product launches of Thelin™ in other EU countries, including Ireland, the Netherlands, Spain, France and Italy, as their respective national governments approve pricing and reimbursement. On March 7, 2007, we announced that the Australian Therapeutic Goods Administration, or TGA, had granted marketing approval for ThelinTM 100 mg tablets as a once daily oral treatment for patients with PAH. Our next step will be to apply for reimbursement in Australia and make a final decision on whether or not to add our own commercial infrastructure or commercialize through a third party.
Thelin™ is also under review by the FDA in the United States and by the Therapeutic Products Directorate, or TPD, of Health Canada. In March 2006, we received an Approvable Letter from the FDA, or the March Approvable Letter, pursuant to which the FDA identified several concerns and observations that were required to be resolved before the drug could be approved, including the option of conducting additional clinical trial work. In May 2006, the FDA accepted for review our complete response to the concerns and observations noted in the March Approvable Letter, and designated the submission as a Class 1 review. A new Prescription Drug User Fee Act, or PDUFA, target action date of July 24, 2006, was established. On July 24, 2006, we received a second Approvable Letter, or the July Approvable Letter, pursuant to which the FDA identified one of the substantive items raised in the March Approvable Letter as remaining unresolved. The FDA again offered the alternative of conducting additional clinical work. Following discussions with the FDA, we submitted a complete response to the July Approvable Letter, which was accepted by the FDA on December 28, 2006. Our resubmission was designated by the FDA as a Class 2 review, and assigned a new PDUFA target action date of June 15, 2007. On October 10, 2005, we submitted an NDA for Thelin™ in Canada that is currently under active review. We cannot assure you that Thelin™ will be approved for marketing in the U.S. or Canada.
During 2004, we obtained orphan drug designation for Thelin™ from both the FDA and the EC. Orphan drug designation grants exclusivity to Thelin™ upon product approval for seven years in the U.S. and ten years in the EU. We anticipate that patent protection for Thelin™ may extend beyond expiration of orphan drug exclusivity in the U.S. and the EU. During 2006, the EMEA requested additional information from us to support the orphan drug designation for Thelin™ and we have responded to that request. At this time, we cannot assure you that Thelin™ will maintain orphan drug designation and its associated exclusivity in the EU for the full 10 year period.
We have established central EU commercial operations near London, England, with regional sales offices established in Germany, France and Italy. We will evaluate the need to add additional infrastructure and commercial support as reimbursement is obtained in countries where Thelin™ is approved. We will also evaluate the need for commercial infrastructure and support worldwide if Thelin™ receives regulatory approval and reimbursement in other countries. In some markets, we may choose to use third parties to distribute Thelin™, or to provide other services such as reimbursement and/or sales support.
In anticipation of approval of Thelin™ by the FDA, we have hired and trained a U.S. sales force, formed a commercialization infrastructure and initiated other market launch preparation activities in the U.S. If Thelin™ is approved in the U.S., we will rely on a network of third party logistics providers and specialty pharmacies to distribute Thelin™ to patients. This network will require significant coordination with our sales and marketing, third party reimbursement, medical affairs and finance organizations, and will provide services such as reimbursement assistance, patient education and counseling to monitor compliance. In anticipation of marketing approval of Thelin™ by the Canadian TPD, we have started to build a commercial presence in Canada.
Argatroban
Argatroban, licensed from Mitsubishi Pharma Corporation, or Mitsubishi, and developed in North America by us, is a synthetic direct thrombin inhibitor that was approved by the FDA in 2000. It is indicated as an anticoagulant for prophylaxis or treatment of thrombosis in patients with HIT, and as an anticoagulant in patients with or at risk for HIT undergoing percutaneous coronary intervention, or PCI. Argatroban was approved in Canada in 2001 for use as an anticoagulant therapy in patients with HIT syndrome. We have licenses to a formulation patent, which expires in 2014, and a manufacturing process patent that expires in 2017. The composition of matter patent has expired. We are not aware of any regulatory submissions by other parties for generic compounds that could compete with Argatroban. Argatroban is marketed and sold by GSK in the U.S. and Canada under a license agreement whereby our subsidiary described below receives royalties on sales. In 2006, we earned royalties from the sales of Argatroban totaling $17.4 million. See “Collaborations and License Agreements - GlaxoSmithKline.”
On February 6, 2007, our wholly owned subsidiary, Argatroban Royalty Sub LLC, or Royalty Sub, closed a private placement of $60 million in aggregate principal amount of promissory notes, or the Argatroban Notes, to institutional investors. The Argatroban Notes are secured by royalties to be paid from sales of Argatroban and by a pledge by us of the stock of Royalty Sub. All interest and principal payments on the Argatroban Notes will be made solely from royalties and other payments payable under the license agreement with GSK, all of which have been transferred to Royalty Sub. The Argatroban Notes are non-recourse and non-convertible
and have not been guaranteed by us. Royalty Sub will receive all royalties on the sales of Argatroban until the Argatroban Notes have been repaid in full; therefore, future royalties will not be available to fund our operations.
The Argatroban Notes bear interest at 12% per annum payable quarterly beginning March 30, 2007. If the Argatroban royalties received for any quarter exceed the interest payments and expenses due for that quarter, the excess will be applied to the repayment of principal of the Argatroban Notes until the Argatroban Notes have been paid in full. Any portion of the principal amount of the Argatroban Notes not repaid on or before the legal final maturity date of September 30, 2014, will be payable on that date. In addition, the Argatroban Notes may be redeemed at our option on any quarterly payment date, subject to the payment of a make-whole payment (if the redemption occurs on or before December 30, 2007) or a redemption premium (if repaid after December 30, 2007, and before March 30, 2010). On and after March 30, 2010, the Argatroban Notes may be redeemed without premium. Once the Argatroban Notes are repaid in full, Royalty Sub will retain all royalty and other payments due under the license agreement with GSK.
Net proceeds to us from the financing were approximately $56 million after deducting transaction costs, of which $10 million was withheld from us pending confirmation of treaty relief from U.K. withholding tax obligations. Once tax treaty relief is confirmed, the amount withheld will be released to us. If tax treaty relief is not received by March 23, 2008, the amount withheld will be used to pay interest on and principal of the Argatroban Notes. See Note 2 to the Consolidated Financial Statements included herein for a more complete description of the terms of the Argatroban Notes.
Research and Development
Clinical Development Programs
To date, we have conducted clinical studies with Thelin™ in three diseases - congestive heart failure, essential hypertension and PAH. Our current clinical development programs for Thelin™ include plans to develop oral Thelin™ more broadly in PAH and to explore other indications for both intravenous and oral Thelin™. We continue to study oral Thelin™ in PAH in the STRIDE-3 continuation trial, and in March 2006, we initiated a trial to study oral Thelin™ as a treatment for diastolic heart failure. We will also be conducting additional clinical trials with oral Thelin™ as part of our post approval commitments to the EMEA. These trials will include a study of PAH combination therapy involving Thelin™ and sildenafil, and a pediatric clinical trial for Thelin™ in PAH. In November 2006, we presented data for an intravenous formulation of Thelin™ being studied in patients undergoing cardiac bypass procedures. The trial demonstrated that intravenous Thelin™ prevented the post-operative increase in pulmonary arterial pressure that is believed to be associated with increased morbidity and mortality in patients shortly after cardiac bypass surgery.
TBC3711 is our second-generation endothelin antagonist and next clinical candidate. We believe TBC3711 is more selective and more potent than Thelin™, with the potential to treat PAH and other diseases. TBC3711 has completed two Phase I clinical studies. In January 2006, we announced the initiation of a 12-week, multi-center, randomized, double-blind, placebo controlled Phase II dose ranging study to evaluate four once-daily, oral doses of TBC3711 in patients with diagnosed resistant hypertension. On March 23, 2006, the FDA placed the study on clinical hold and all clinical trials for TBC3711 were suspended. The clinical hold resulted from a finding in an earlier animal study involving dosing with intravenous TBC3711. The finding occurred in a single rat that displayed abnormalities at baseline. On December 7, 2006, we received clearance from the FDA to resume clinical testing with TBC3711, including its oral and intravenous formulations. We expect to resume Phase II clinical testing in the second quarter of 2007, and are evaluating the study of TBC3711 in several potential indications.
In 2000, we entered into a worldwide research collaboration and license agreement with Schering-Plough to discover, develop and commercialize VLA-4 antagonists. Schering-Plough has completed pre-clinical development with TBC4746, an oral VLA-4 antagonist, and has informed us that they have initiated studies in human volunteers. VLA-4 is a potential target in the inflammatory cascade taking place within the vasculature. TBC4746 has the potential to address a number of diseases, including asthma and multiple sclerosis. We could receive development milestone payments if this compound progresses through the clinical trial phases and will receive royalties on product sales should TBC4746 reach the market. In March 2005, the initiation of clinical studies of TBC4746 by Schering-Plough triggered a milestone payment to us that together with previously received upfront license fees and milestone payments aggregate to $6 million. See “Collaborations and License Agreements - Schering-Plough.”
We have licensed to Revotar all rights to bimosiamose, a selectin antagonist discovered by us. Bimosiamose is designed to block inflammatory cells from leaving the vascular space to travel to tissue sites of inflammation. In April 2005, the stockholders of Revotar agreed to restructure Revotar’s capitalization in an arrangement referred to as the “Restructuring.” As a result, we are no longer funding any drug development activities at Revotar. For additional information about the Restructuring, see Note 14 to the Consolidated Financial Statements included herein.
Research Programs
Our research efforts are concentrated on targets within the vasculature, and the potential indications of our drug candidates include cardiovascular diseases and a potentially wide variety of inflammatory diseases involving two complementary sets of targets. The first set of targets relate to G protein-coupled receptors, or GPCRs. Historically, GPCRs have been some of the most amenable
targets for developing commercially successful pharmaceuticals, such as beta-blockers, antihistamines, and most anti-psychotics and anti-depressants. Endothelin receptors, targeted by Thelin™ and TBC3711, are examples of GPCRs.
We have also developed expertise in pharmacologically intervening in the intravascular inflammatory cascade, representing a second set of intravascular targets. Bimosiamose and TBC4746 are examples of drug candidates that we designed to target two distinct steps in this cascade, the selectins and VLA-4, respectively. Some of the targets in this cascade are GPCRs. Thus, we believe that our focus on endothelial cell and related vascular biology has opened up a broad range of disease targets with high unmet medical need.
We are also studying three new compounds in oral microdosing studies in humans to assess pharmacokinetics. An intravenous form of one of these compounds is expected to enter Phase I trials in 2007. In addition, we are conducting final preclinical toxicology testing of our Chemokine C-motif Receptor 9, or CCR9 receptor antagonist, and anticipate the submission of an Investigational New Drug, or IND, application in 2007.
Collaborations and Licensing Agreements
We have established collaborations with a number of corporations, research institutions and scientists to further our research and development objectives and expedite the commercialization of our products. Our major licensing and collaboration agreements are summarized below.
Mitsubishi Pharma Corporation
We entered into an agreement in 1993 to license Mitsubishi’s rights and technology relating to Argatroban and to license Mitsubishi’s own proprietary technology developed with respect to Argatroban. The agreement provides us an exclusive license to use and sell Argatroban in the U.S. and Canada for all cardiovascular, renal, neurological and immunological purposes other than use for the coating of stents. We are required to pay Mitsubishi specified royalties on net sales of Argatroban by us and our sub licensees after its commercial introduction in the U.S. and Canada. GSK is also obligated to pay Mitsubishi royalties on sales of Argatroban. As of December 31, 2006, we had paid Mitsubishi approximately $2,385,000 in royalty payments under the agreement. We have also paid Mitsubishi a $500,000 milestone payment in 1997 under the agreement and no additional milestone payments are payable to Mitsubishi under the agreement. We have agreed to pay a consultant involved in the negotiation of this agreement a royalty based on net sales of Argatroban. During 1997, we signed an additional agreement with Mitsubishi that provides us with royalties on sales of Argatroban in certain European countries and in 2006 we began receiving royalties from Mitsubishi based on European sales. Either party may terminate the agreement if the other party defaults in its material obligations under the agreement or becomes insolvent, or if a substantial portion of its property is subject to levy, and such default or event of default is not cured in 60 days. Unless terminated sooner, the agreement expires on the later of termination of patent rights in a particular country or 20 years after first commercial sale of products in a particular country. If our agreement with Mitsubishi is terminated, we and Royalty Sub would lose all rights to Argatroban, including the right to receive revenues from the sale of Argatroban. The Mitsubishi composition of matter patent on Argatroban has expired. Under the agreement, we have access to a formulation patent granted in the U.S. in 1993, which has been extended and now expires in 2014 and a process patent that expires in 2017. Argatroban received FDA approval on June 30, 2000, and enjoyed market exclusivity under the Hatch-Waxman Act until June 30, 2005. Since we no longer have the protection of a composition of matter patent or Hatch-Waxman market exclusivity, it is possible that generic manufacturers may be able to produce Argatroban without violating Argatroban’s formulation or process patents.
GlaxoSmithKline
In connection with our development and commercialization of Argatroban, in August 1997, we entered into an agreement with GSK whereby GSK was granted an exclusive sublicense in the U.S. and Canada for the indications of Argatroban that we have licensed from Mitsubishi. GSK paid $8.5 million in upfront license fees and $12.5 million in milestone payments, all of which were reported as revenues in the years prior to and including 2000. No additional license fees or milestone payments are payable to us by GSK under the agreement. As of December 31, 2006, we had received approximately $48.2 million in royalty payments from GSK.
The agreement with GSK provides for the formation of a joint development committee to analyze the development of additional Argatroban indications (such as PCI) covered by our license from Mitsubishi. The joint development is to be funded 60% by GSK, except that costs of Phase IV trials are paid 100% by GSK. Except as discussed below, GSK has the exclusive right to commercialize all products arising out of the collaboration, subject to the obligation to pay royalties on net sales to us and our rights to co-promote these products through our own sales force in certain circumstances. We will retain the rights to any indications that GSK determines it does not wish to pursue, provided that we do not grant marketing rights to any third parties, and that we use our own sales force to commercialize any such indications. Any indications that GSK and Encysive elect not to develop will be returned to Mitsubishi, subject to the rights of GSK and Encysive to commercialize these indications at Encysive’s election, with GSK having the first opportunity to commercialize. Mitsubishi may also request the joint development committee to develop new indications inside or outside the licensed field of use and, if the joint development committee determines that it does not want to proceed with any such
indication, all rights under the agreement with Mitsubishi regarding such indication will revert to Mitsubishi subject to our and GSK’s right to commercialize the indication, with GSK having the first opportunity to commercialize. We do not presently plan to develop Argatroban for any additional indications. In connection with the issuance of the Argatroban Notes, we agreed not to submit any proposals to the joint development committee or exercise any of our co-promotion rights under the agreement with GSK.
The agreement with GSK generally terminates on a country-by-country basis upon the earlier of the termination of our rights under the agreement with Mitsubishi, the expiration of applicable patent rights, or in the case of certain royalty payments, the commencement of substantial third-party competition. GSK also has the right to terminate the agreement on a country-by-country basis by giving us at least three months written notice that the commercial profile of the product in question would not justify continued development or marketing in that country. In addition, either party may terminate the agreement on 60 days notice if the other party defaults in its obligations under the agreement or becomes insolvent. If our agreement with GSK is terminated, Royalty Sub would no longer receive royalties from GSK’s sales of Argatroban and we may experience delays and incur expenses in attempting to commercialize Argatroban.
At present, Mitsubishi is the only manufacturer of Argatroban’s active pharmaceutical ingredient, or API, and has entered into an agreement with GSK to supply Argatroban API in bulk to meet GSK’s needs in the production of the Argatroban finished product. GSK has informed us that they have begun supplying Argatroban finished product from their manufacturing facility in the United Kingdom. Should Mitsubishi fail during any consecutive nine-month period to supply GSK at least 80% of its requirements, and such requirements cannot be satisfied by existing inventories, the agreement provides for the nonexclusive transfer of the production technology for API to GSK.
Schering-Plough
In June 2000, we and Schering-Plough entered into a worldwide research collaboration and license agreement to discover, develop and commercialize VLA-4 antagonists. In addition to funding research costs, Schering-Plough paid us an aggregate of $6 million in upfront license fees and milestone payments, and may pay us additional development milestones of $37 million for the development of VLA-4 antagonists. Schering-Plough will also pay us royalties if product sales result from the agreement. We have received approximately $13.3 million in research payments from Schering-Plough under the agreement. Subsequently, during 2005, the research phase was completed and a VLA-4 antagonist, TBC4746, moved into clinical development. See Note 13 to the Consolidated Financial Statements included herein for a discussion of this transaction. Under the terms of the agreement, Schering-Plough is responsible for further development of VLA-4 antagonists, and in 2005 initiated a study of TBC4746 in human volunteers, for which we received a milestone payment. If this agreement is terminated, we will lose Schering-Plough’s funding for development milestones and royalties on product sales resulting from the agreement.
Revotar Biopharmaceuticals, AG
During September 2000, Revotar was formed and we transferred to Revotar certain development and commercialization rights to our bimosiamose selectin antagonist program as well as rights to other proprietary technology. In April 2005, the stockholders of Revotar agreed to the Restructuring. As a result, we are no longer funding any drug development activities at Revotar. Revotar will likely need to obtain additional capital resources or enter into a collaboration to complete development of bimosiamose. For additional information about the Restructuring, see Note 14 to the Consolidated Financial Statements included herein.
Patents and Proprietary Rights
Because of the substantial length of time and expense associated with developing new pharmaceutical products, we place considerable importance on intellectual property protection for new technologies, compounds, products and processes. Our policy is to actively seek patent protection both in the United States and internationally and to file additional patent applications, when appropriate, to cover improvements to our compounds, products and processes. We also rely on trade secrets, internal know-how, technological innovations and agreements with third parties to develop, maintain and protect our competitive position and to develop our business.
We in-licensed the U.S. and Canadian rights to Argatroban in 1993, which included a formulation patent granted in 1993 that has been extended and now expires in 2014, and a process patent that expires in 2017. The Mitsubishi composition of matter patent on Argatroban has expired. Argatroban received FDA approval on June 30, 2000, and enjoyed market exclusivity under the Hatch-Waxman Act until June 30, 2005. Since we no longer have the protection of a composition of matter patent or Hatch-Waxman market exclusivity, it is possible that generic manufacturers may be able to produce Argatroban without violating Argatroban’s formulation or process patents.
We have a number of U.S. and foreign patent and patent applications related to our compounds, products and technologies, but we cannot be certain that issued patents will be enforceable or provide adequate protections or that pending patent applications will result in issued patents.
The following table shows the primary patents relevant to our products and programs:
The patent positions of biopharmaceutical firms, including us, are uncertain and involve complex legal and factual questions. Consequently, we do not know whether any of our applications will result in the issuance of patents or, if any patents are issued, whether they will provide significant proprietary protection or will be circumvented or invalidated or held unenforceable. Since publication of discoveries in the scientific or patent literature often lags behind actual discoveries, we cannot be certain that we were the first creator of inventions covered by our pending patent applications or that we were the first to file patent applications for such inventions. Moreover, we may have to participate in interference proceedings declared by the U.S. Patent and Trademark Office, or PTO, to determine priority of invention, which could result in substantial cost to us, even if the eventual outcome is favorable to us, or in the loss of patent rights. We cannot assure you that our patents, if issued, would be held valid by a court of competent jurisdiction.
The development of therapeutic products for cardiovascular applications is intensely competitive. Many pharmaceutical companies, biotechnology companies, universities and research institutions have filed patent applications or received patents in this field. Some of these applications or patents may be competitive with our applications or conflict in certain respects with claims made under our applications. Such conflict could result in a significant reduction of the coverage of our patents, if issued. In addition, if patents are issued to other companies that contain competitive or conflicting claims and such claims are ultimately determined to be valid, we could be subject to significant liabilities to third parties, required to license disputed rights from third parties or required to cease using such technology. We cannot assure you that we would be able to obtain licenses to these patents at a reasonable cost, if at all, or develop or obtain alternative technology.
It is also very important that we do not infringe patents or proprietary rights of others and that we do not violate the agreements that grant proprietary rights to us. If we do infringe patents or violate these agreements, we could be prevented from developing or commercializing products or from using the processes covered by those patents or agreements, or we could be required to obtain a license from the third party allowing us to use their technology. We cannot be certain that, if required, we could obtain a license to any third-party technology or that we could obtain one at a reasonable cost. If we were not able to obtain a required license, we could be adversely affected. Because patent applications are confidential for at least some period of time until a patent issues, we may not know if our competitors filed patent applications for technology covered by our pending applications, or used by us in our commercialization efforts, or if we were the first to invent the technology that is the subject of our patent applications. Competitors may have filed patent applications or received patents and may obtain additional patents and proprietary rights that block us from developing or commercializing our technology or compete with our patents. If competitors file patent applications covering our technology, we may have to participate in interference proceedings or litigation to determine the right to a patent. Litigation and interference proceedings are expensive even if we are ultimately successful.
Patents relating to pharmaceutical, biopharmaceutical and biotechnology products, compounds and processes such as those that cover our existing compounds, products and processes and those that we will likely file in the future, do not always provide complete or adequate protection. Litigation or opposition or reexamination proceedings regarding the enforcement or validity of our existing patents or any future patents could invalidate our patents or substantially reduce their protection. In addition, our pending patent applications and patent applications filed by our collaborative partners may not result in the issuance of any patents or may result in patents that do not provide adequate protection. As a result, we may not be able to prevent third parties from developing the same compounds and products that we have developed or are developing.
We also rely upon unpatented trade secrets and improvements, internal know-how, technological innovations and other confidential and proprietary information. We cannot assure you that others will not independently develop substantially equivalent proprietary information and techniques or otherwise gain access to our trade secrets or disclose such technology, or that we can meaningfully protect our trade secrets.
We require our employees, consultants, members of our scientific advisory board, vendors, outside scientific collaborators and sponsored researchers, advisors and other entities to enter into confidentiality agreements. These agreements provide that all confidential information developed or made known to the entity during the course of its relationship with us is to be kept confidential and not used or disclosed to third parties, except in specific circumstances. In the case of our employees, the agreements further provide that all inventions conceived by the employee are our exclusive property. We cannot assure you, however, that these agreements will provide meaningful protection or adequate remedies for our trade secrets and improvements, internal know-how and other technologies in the event of unauthorized use or disclosure of such information. Under some of our research and development agreements, inventions discovered in certain cases become jointly owned by us and our collaboration partners, and in other cases, become the exclusive property of one of us. It can be difficult to determine who owns a particular invention and disputes could arise regarding those inventions.
Government Regulation
Domestic Regulation of Drug Companies
The research, testing, manufacture and marketing of pharmaceutical drug products are extensively regulated by numerous governmental authorities in the United States and other countries. In the United States, pharmaceutical drugs are subject to rigorous regulation by the FDA. The Federal Food, Drug and Cosmetic Act, and other federal and state statutes and regulations, govern, among other things, the research, development, testing, manufacture, storage, record keeping, labeling, promotion and marketing and distribution of pharmaceutical products. Failure to comply with applicable regulatory requirements may subject a company to administrative or judicially imposed sanctions.
Clinical trials involve the administration of the investigational new drug to healthy volunteers or patients under the supervision of a qualified principal investigator. Clinical trials are conducted in accordance with Good Clinical Practice guidelines, and under protocols detailing the objectives of the trial, the parameters to be used in monitoring safety and the effectiveness criteria to be evaluated. Each protocol must be submitted to the FDA as part of the IND application. The study protocol and informed consent information for patients in clinical trials must also be approved by the institutional review board at each institution where the trials will be conducted.
Clinical trials to support NDAs are typically conducted in three sequential phases which may overlap. In Phase I, the initial introduction of the drug into healthy human subjects or patients, the drug is tested to assess metabolism, pharmacokinetics and pharmacological actions and safety, including side effects associated with increasing doses. Phase II usually involves trials in a limited patient population to:
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determine dosage tolerance and optimal dosage;
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identify possible adverse effects and safety risks; and
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preliminarily support the efficacy of the drug in specific, targeted indications.
If a compound is found to be effective and to have an acceptable safety profile in Phase II evaluation, Phase III trials are undertaken to further evaluate clinical efficacy and to further test for safety within an expanded patient population at geographically dispersed clinical trial sites. There can be no assurance that Phase I, Phase II or Phase III testing of our product candidates will be completed successfully within any specified time period, if at all.
After completion of successful clinical testing, generally an NDA is prepared and submitted to the FDA. FDA approval of the NDA is required before marketing may begin in the United States. The NDA must include the results of extensive clinical and other testing and the compilation of data relating to the product’s chemistry, pharmacology and manufacture. The cost of an NDA is substantial.
We also rely on FDA regulated third parties to study, manufacture, package and test our clinical and commercial products. If the FDA evaluation of our NDA submissions, including the information provided by these other FDA regulated entities, is favorable, the FDA may issue either an Approvable Letter or an Approval Letter. The Approvable Letter may contain a number of conditions that must be met in order to secure final approval of the NDA. When and if those conditions have been met to the FDA’s satisfaction, the FDA will issue an Approval Letter. The Approval Letter authorizes commercial marketing of the drug for specific labeled indications in the U.S. As a condition of NDA approval, the FDA may require post-marketing testing and surveillance to monitor the drug’s safety or efficacy, or impose other conditions, commonly referred to as Phase IV commitments.
If the FDA’s evaluation of either the NDA submission or the facilities of the third parties we use to study, manufacture, package and test our products is not favorable, the FDA may refuse to approve the NDA and issue a Not Approvable Letter. The Not Approvable Letter outlines the deficiencies in the submission and often requires additional testing or information. Notwithstanding the submission of any requested additional data or information in response to an Approvable or Not Approvable Letter, the FDA ultimately may decide that the application does not satisfy the regulatory criteria for approval. Once granted, product approvals may
be withdrawn if compliance with regulatory standards is not maintained or problems occur following the initial marketing of the pharmaceutical drug product.
As described above, the associated third parties must pass a pre-approval inspection of their facilities by the FDA before obtaining marketing approval of any products. To supply products for use in the United States, foreign establishments must comply with current Good Manufacturing Practices, or cGMP, and are subject to periodic inspection by the FDA or corresponding regulatory agencies in countries under reciprocal agreements with the FDA. We use and intend to use third parties to produce and test our products in clinical and commercial quantities. There can be no guarantee that future FDA inspections will proceed without any compliance issues requiring the expenditure of money or other resources.
Foreign Regulation of Drug Compounds
The approval of foreign governments is necessary before pharmaceuticals products may be marketed and sold in those countries, whether or not FDA approval has been obtained. The approval procedures vary among countries and can involve the submission of information and the completion of testing which are in addition to those required by the FDA. Therefore, there can be substantial delays in obtaining required approvals from foreign regulatory authorities after the relevant regulatory applications are filed. Also, if a product is approved for marketing in a foreign country, it is possible that it may not be sold until the applicable regulatory body approves the product’s pricing and reimbursement.
In Europe, an application for marketing authorization may be submitted as a centralized procedure providing for the grant of a single marketing authorization, which is valid in all 27 member states of the European Union. A mutual recognition procedure is also available, at the request of the applicant for all medicinal products, which are not subject to the centralized procedure. Thelin’s Marketing Authorization Application, or MAA, was granted by the EC in August 2006 through the centralized procedure. The EC’s approval for Thelin™ included a requirement that we conduct certain additional clinical work post approval. These are typically called Phase IV commitments. We are moving forward to complete the European Phase IV commitments, which include a combination clinical trial involving Thelin™ and sildenafil, and a pediatric clinical trial with Thelin™. Failure to complete these European Phase IV commitments can lead to negative regulatory action, which can include withdrawal of the approval of our MAA.
Hazardous Materials
Our research and development processes involve the controlled use of hazardous materials, chemicals, radioactive materials and produce waste products. We are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of hazardous materials and waste products. Although we have not had any claims to date on our general liability insurance relative to hazardous materials and although we believe that our safety procedures for handling and disposing of hazardous materials comply with the standards prescribed by laws and regulations, the risk of accidental contamination or injury from these materials cannot be eliminated completely. In the event of an accident, we could be held liable for any damages that result. This liability could exceed our financial resources or not be covered by our general liability insurance, which has a policy limit of $7 million. Although we believe that we are in compliance in all material respects with applicable environmental laws and regulations, there can be no assurance that we will not be required to incur significant costs to comply with environmental laws and regulations in the future. There can also be no assurance that our operations, business or assets will not be materially adversely affected by current or future environmental laws or regulations.
Competition
The development and sale of new pharmaceutical drugs for the treatment of vascular and inflammatory diseases is highly competitive and we will face intense competition from global pharmaceutical companies and biotechnology companies. Competition is likely to increase as a result of advances made in the commercial application of new therapy technologies and heightened interest in the commercial potential of treating PAH and other diseases. Companies that successfully complete clinical trials, obtain required regulatory approvals in a timely manner, initiate commercial sales of their products before their competitors and can demonstrate significant differentiation in terms of safety and efficacy may achieve a significant competitive advantage. In addition, significant research in biotechnology and vascular medicine may occur in universities and other nonprofit research institutions. These entities have become increasingly active in seeking patent protection and licensing revenues for their research results. They also compete with us in recruiting talented scientists and business professionals.
We believe that our ability to compete successfully will depend on our ability to create, develop and commercialize scientifically advanced and differentiated medical products, attract and retain qualified scientific, medical, operational and commercial talent, obtain patent or other legal protection for our compounds, products and processes, obtain required regulatory approvals in a timely manner and successfully commercialize our products. Many of our competitors have substantially greater research, development, financial, marketing, sales and human resources than we do. As such, we expect to encounter significant competition in commercializing our products. See Item 1A
ITEM 1A - RISK FACTORS
Stockholders and potential investors in shares of our stock should carefully consider the following risk factors, in addition to other information in this Form 10-K. We are identifying these risk factors as important factors that could cause our actual results to differ materially from those contained in any written or oral forward-looking statements made by or on behalf of us. We are relying upon the safe-harbor for forward-looking statements and any such statements made by or on behalf of us are qualified by reference to the following cautionary statements, as well as to those set forth elsewhere in this Form 10-K.
Risks Related to Our Business, Industry and Strategy
If we are unable to raise additional capital, we will not be able to continue to operate as a going concern.
At December 31, 2006, we had an accumulated deficit of approximately $422.3 million, and for the fiscal years ended December 31, 2006, 2005 and 2004, we have incurred net losses of approximately $109.3 million, $74.9 million and $54.7 million, respectively. As a result, the amount of our cash and cash equivalents was approximately $71.9 million at March 1, 2007. While our Consolidated Financial Statements included herein have been prepared assuming that we will continue as a going concern, because of our losses and need for additional financing to execute our business strategy, our independent auditor’s report on the Consolidated Financial Statements contains a statement relating to their substantial doubt about our ability to continue as a going concern.
Although we have recently received additional funds from our equity financing line with an institutional investor, Azimuth Opportunity Ltd., or Azimuth, and from the sale by Royalty Sub of the Argatroban Notes, we will require additional funding to continue to operate as a going concern, whether Thelin™ is approved by the FDA or not. Subject to certain conditions, we may issue and sell up to 8,780,500 shares of our common stock to Azimuth under the equity financing line and may receive $10 million upon the confirmation of treaty relief from U.K. withholding obligations pursuant to the terms of the Argatroban Notes. We could also issue common stock, debt, or other securities for gross aggregate proceeds of $95.5 million pursuant to our effective shelf registration statement. We cannot assure you that such funding will be available under commercially acceptable terms, if at all.
We have a history of losses and we may never become profitable.
We have been unprofitable to date and may continue to be unprofitable for the foreseeable future. Until recently, the majority of our financial resources have been dedicated to the research and development of Argatroban, Thelin™ and other drug compounds. Beginning in 2005, we have spent an increasing percentage of our financial resources on preparations for the anticipated commercial launch of Thelin™ in the U.S., and more recently, in building the commercial infrastructure necessary to successfully launch Thelin™ in Europe. This trend is expected to continue as we expand our commercial organization in Europe and continue to invest in U.S. launch preparations for Thelin™. While we continue to invest in developing several new drug compounds, we currently do not have any drug candidates that are likely to be commercialized in the near future other than Thelin™.
We have just started to commercialize Thelin™ in Europe, and as such, cannot make any projections or financial forecasts of sales or operating expenses. We believe, however, that the commercial launch of Thelin™ in Europe and the anticipated launch of Thelin™ in the U.S. and other countries will require additional funding due to higher levels of sales and marketing expenditures, particularly in Europe, than in recent periods. As the outcomes of our regulatory filings with the FDA and other regulatory authorities are uncertain, we are unable to project revenues for Thelin™ in the U.S. and other countries. Even though we have received regulatory approval to market Thelin™ in Europe, significant uncertainties make it difficult to forecast or predict future sales. These uncertainties include the market acceptance of Thelin™, the reimbursement policies of third-party payors, the speed with which government or other third-party payors grant pricing and reimbursement approvals, competitive activity, the timing of competitive product approvals, and other factors impacting the timing and speed of our product launch, all of which could materially affect any revenue projections.
Even if we receive regulatory approval for Thelin™ in the U.S., we may not be able to achieve profitability for the foreseeable future. If we do not receive regulatory approval for Thelin™ in the U.S., to achieve profitability, we will need to restructure the organization to reduce expenses. The commercial launch of Thelin™ in Europe, the potential commercial launch of Thelin™ in the U.S. and other countries, and the realization of our research and development pipeline of potential new drug compounds, will require substantial incremental investment over the next several years. This increased level of investment will include higher levels of spending in research, development, preclinical and clinical testing and regulatory related activities, both foreign and domestic, to advance our pipeline of new products, as well as higher levels of spending for sales and marketing activities related to Thelin™ , the establishment of a commercial infrastructure in Europe and the maintenance of our commercial infrastructure in the U.S.
We cannot assure you that we will be able to develop, produce at reasonable cost, obtain regulatory approvals, or market successfully, any of our product candidates, including Thelin™. All of our products will require regulatory approval before they may be commercialized. Products, if any, resulting from our research and development programs other than Argatroban and Thelin™, or the use of our products in new indications, may not be commercially available for a number of years, if at all, and we cannot assure you that any successfully developed products will generate substantial revenues or that we will ever be profitable.
If we are unable to raise additional capital, we will be unable to conduct our operations and develop our potential products.
As of March 1, 2007, after our receipt of net proceeds from the sale by Royalty Sub of the Argatroban Notes, we had cash and cash equivalents of approximately $71.9 million. We expect to continue to incur substantial research and development expenditures as we design and develop new drug candidates, and continue to invest in the development and commercialization of Thelin™. We also anticipate that our operating expenses will continue to increase due to the following factors:
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We have incurred and will continue to incur significant commercialization-related expenses for Thelin™. These costs include:
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maintaining a commercial infrastructure in the U.S. and building a commercial infrastructure in Europe and other key geographic areas;
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investing in market launch and market development activities;
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expenses related to reimbursement submissions and approvals;
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market research;
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building the necessary infrastructure in our support services functions, such as finance, human resources and legal;
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building the depth and breadth of our management team;
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preparing and producing educational and promotional materials; and
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establishing additional contractual relationships with manufacturing, distribution and specialty pharmacy providers to ensure the successful commercialization of Thelin™.
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We expect to incur significant expenses in conjunction with additional clinical trial costs for Thelin™ and are incurring costs for clinical trials related to additional drug compounds. These costs include:
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hiring personnel to direct and execute clinical trials;
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costs incurred by clinical investigators;
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services of contract research organizations; and
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purchasing and formulating quantities of drug compound to be used in such clinical trials.
Notwithstanding revenues that may be produced through potential sales of Thelin™, we will need to secure additional financing to continue our current operations, including the required levels of research and development to reach our long-term goals. Estimates of our future cash requirements will depend on many factors, including:
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the outcome and timing of regulatory approvals for Thelin™, including breadth of approved product label;
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our ability to secure necessary reimbursement approvals for Thelin™;
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competitive activity, including the timing of regulatory approvals for competitive products;
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our success in commercializing Thelin™;
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continued scientific progress in our drug discovery programs;
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the number and magnitude of these research and development programs;
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progress with preclinical testing and clinical trials of new drug compounds;
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the costs and our success in filing, prosecuting and enforcing patent claims;
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competing technological and market developments and changes in our existing research relationships;
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administrative costs and costs to commercialize our products as new product compounds are further developed and marketed;
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working capital requirements to support inventory and accounts receivable;
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our ability to maintain and establish additional collaborative arrangements; and
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effective and sustained commercialization activities and arrangements.
To date, we have financed our research and development activities and other operations primarily through public and private offerings of common stock, including an equity financing line with Azimuth; proceeds from the issuance and sale in March 2005 of our 2.5% Convertible Senior Notes due 2012, or the Convertible Notes; funds received through collaborations, research agreements, licenses and partnerships; royalty revenue from sales of Argatroban; and the recent sale by Royalty Sub of the Argatroban Notes. Subject to certain conditions, we may issue and sell up to 8,780,500 shares of our common stock to Azimuth under the equity financing line and may receive $10 million upon the confirmation of treaty relief from U.K. withholding obligations pursuant to the terms of the Argatroban Notes. We may also issue common stock, debt, or other securities for gross aggregate proceeds of $95.5 million pursuant to our effective shelf registration statement. However, we cannot assure you that such funding will be available under commercially acceptable terms.
Based upon our current cash position and expected future cash requirements, we will require additional external funding in 2007 in order to continue our ongoing research and development programs, and to fund the commercial launch of Thelin™ in Europe, whether Thelin™ is approved in the U.S. by the FDA or not. Because the FDA has designed Thelin™ as a Class 2 resubmission and assigned a new PDUFA action date of June 15, 2007, we believe that additional funding will be significantly more difficult to obtain on commercially acceptable terms, if at all. We are considering various alternatives to reduce our expenses in order to sustain our cash resources. Those measures include scaling back personnel and expenses, delaying or terminating research and development programs, curtailing capital expenditures, and reducing other operating expenses. We may also consider relinquishing, licensing or otherwise disposing of rights to technologies or product candidates that we could otherwise seek to develop or commercialize ourselves on terms that are less favorable than might otherwise be available or at an earlier stage than would otherwise be desirable, including the possibility of licensing rights to Thelin™ outside North America and Europe. Even if Thelin™ is approved by the FDA, we believe that we will require additional funding for increased spending required to commercially launch Thelin™ in the U.S.
If we receive approval by the FDA to market Thelin™ in the U.S., and if we are successful in obtaining additional funding, we believe that our operating expenses will exceed those incurred in 2006. If we do not receive approval by the FDA, we may be required to restructure our operations to significantly reduce our operating expenses. In any event, we anticipate that we will continue to incur operating losses throughout 2007.
We may experience significant fluctuations in our operating results.
We have historically experienced, and expect to continue to experience for the foreseeable future, significant fluctuations in our operating results. These fluctuations are due to a number of factors, many of which are outside of our control, and may result in volatility of our stock price. Future operating results will depend on many factors, including:
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demand for our products;
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cost of product sales;
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achievement and timing of research and development milestones;
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cost and timing of clinical trials and regulatory approvals for our products;
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marketing and other expenses;
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manufacturing or supply disruptions;
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the timing of the introduction and market acceptance of new products by us or competing companies; and
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the timing and magnitude of certain research and development expenses.
We face substantial competition that may result in other companies developing and commercializing products more successfully than we do.
The biopharmaceutical industry is highly competitive. Our success will depend on our ability to develop safe, efficacious and cost-effective products, apply technology, and establish and maintain a market for our products. Our competitors may be either global or regional companies. Potential competitors in the U.S. and other countries include major pharmaceutical and chemical companies, specialized biotechnology firms, universities and other research institutions. Many of our competitors have substantially greater research and development capabilities and experience, and greater manufacturing, marketing and financial resources. Accordingly, our competitors may develop products or other novel technologies that are more effective, safer or less costly than any that have been or are being developed by us. In addition, our competitors may be successful in obtaining FDA and other applicable regulatory approval for products more rapidly than we are able to.
Our competition for Thelin™ includes prostacyclin analogues as well as other endothelin antagonists. In earlier years, the standard treatment for PAH consisted of intravenous systemic prostacyclin. Today prostacyclin can be administered intravenously, subcutaneously or via inhalation. Epoprostenol, sold under the trade name Flolan® is marketed by Gilead in the U.S., and GSK outside the U.S. Flolan® is administered intravenously via continuous infusion through a central venous catheter and special infusion pump. As a competitive therapy, it is costly, associated with significant adverse events including those related to its delivery and typically reserved by clinicians for patients with the most severe symptoms, WHO or New York Heart Association, or NYHA, functional class IV status. Treprostinil, sold under the trade name Remodulin®, is marketed worldwide by Lung Rx, a division of United Therapeutics. Remodulin® is a prostaglandin analog that is required to be administered subcutaneously or intravenously through an infusion pump. It is also being studied for potential use through inhalation. Iloprost, sold under the trade name Ventavis®, is marketed in the U.S. by Actelion. Ventavis® is a synthetic analogue of prostacyclin and is delivered via inhalation for the treatment of PAH in patients classified as WHO Group I with NYHA Class III or IV symptoms. During clinical trials, Ventavis® was administered six to nine times a day.
In terms of endothelin antagonists, Bosentan, sold under the trade name Tracleer®, is marketed worldwide by Actelion Ltd. Tracleer® is a twice daily, orally administered, non- selective ET-1 receptor antagonist. It was the first oral agent approved for the treatment of PAH and is indicated in patients with moderate to severe NYHA/WHO functional class III and IV symptoms. Tracleer® is also associated with significant potential for hepatotoxicity and teratogenicity. Ambrisentan, which does not yet have a trade name,
will be distributed by Gilead Sciences in the U.S. and GSK in geographies outside the U.S. Ambrisentan is a once daily orally administered endothelin antagonist being developed by Gilead for the treatment of PAH. In December 2006, Gilead submitted an NDA to the FDA seeking approval for ambrisentan as a treatment for PAH, and on February 16, 2007, Gilead announced that the FDA had granted Priority Review status and was assigned a PDUFA date of June 18, 2007.
Another category of treatment options are Phosphodiesterase Type-5, or PDE5, inhibitors. These include sildenafil citrate, sold under the trade name Revatio®, which is marketed worldwide by Pfizer. Revatio® is a specific PDE5 inhibitor indicated for the treatment of PAH (WHO Group I). Sildenafil is also the active ingredient in Viagra®, Pfizer’s erectile dysfunction medication. Sildenafil is an oral agent that is administered three times daily in the treatment of PAH. We believe that PDE5 inhibitors such as sildenafil may be used as first-line and as additive therapy with endothelin antagonists. Tadalafil, sold under the trade name Cialis®, is marketed worldwide by Lilly-ICOS. Cialis® is another PDE5 inhibitor approved for erectile dysfunction that is also being studied in PAH. Its development status in PAH is unknown at this time.
We may have competition for TBC3711 in PAH as well as other indications. A number of companies, including Abbott Laboratories, Gilead and Speedel, have ETA receptor antagonist compounds that have begun clinical trials in areas other than PAH. Abbott is studying atrasentan in studies of several types of prostate cancer. Gilead announced positive Phase IIb trial results of darusentan in resistant hypertension patients and Speedel started Phase III clinical development for SPP301 in diabetic nephropathy.
Our direct competition for Argatroban in the treatment of HIT is lepirudin, a recombinant hirudin analog sold under the trade name Refludan® and is marketed by Berlex. Argatroban and Refludan® are potent and selective inhibitors of thrombin with a predictable dose-response effect. A third direct thrombin inhibitor, bivalirudin, which is sold under the trade name Angiomax® and is marketed by Medicines Company, is currently approved in the U.S. and other countries for use in patients undergoing PCI and in patients with or at risk for HIT and/or HITTS undergoing PCI.
We make business decisions based on forecasts of future sales of Thelin™ that may be inaccurate.
Our market estimates are based on many assumptions, including, but not limited to, reliance on external primary and secondary market research, our own internal research, population estimates, disease diagnostic rates, treatment trends, sales of similar products and market estimates by third parties. Any of these assumptions can materially impact our forecasts and we cannot assure you that the assumptions are accurate. In addition, our commercial forecasts include the transition of our current clinical trial patients to Thelin™ commercial supply. We cannot assure you that patients currently receiving Thelin™ in our clinical trials will be prescribed Thelin™ when the clinical trials are terminated.
Historically, we have been dependent on third parties to fund, market and develop our products.
Historically, we relied on strategic relationships with our corporate partners to provide the financing, marketing and technical support and, in certain cases, the technology necessary to develop and commercialize certain of our product candidates. We have entered into an agreement with Mitsubishi to license rights and technology relating to Argatroban in the U.S. and Canada for specified therapeutic indications. Either party may terminate the Mitsubishi agreement on 60 days notice if the other party defaults on its material obligations under the agreement or becomes insolvent, or if a substantial portion of its property is subject to levy. Unless terminated sooner due to the above-described termination provisions, the agreement with Mitsubishi expires on the later of the termination of patent rights in a particular country or 20 years after the first commercial sale of products in a particular country. If our agreement with Mitsubishi is terminated, we and Royalty Sub will lose all rights to Argatroban, including the right to receive revenues from the sale of Argatroban, which would have a material adverse effect on our business and financial condition.
We also entered into an agreement with GSK in 1997 whereby we granted an exclusive sublicense to GSK relating to the continued development and commercialization of Argatroban. This agreement provides for the payment of royalties and certain milestone payments upon the completion of various regulatory filings and receipt of regulatory approvals. The agreement generally terminates on a country-by-country basis upon the earlier of the termination of our rights under the agreement with Mitsubishi, the expiration of applicable patent rights, or in the case of certain royalty payments, the introduction of a substantial competitor for Argatroban by another pharmaceutical company. GSK also has the right to terminate the agreement on a country-by-country basis by giving us at least three months written notice based on a reasonable determination by GSK that the commercial profile of the therapeutic indication in question would not justify continued development or marketing in that country. In addition, either we or GSK may terminate our agreement if the other party defaults on its obligations under the agreement or becomes insolvent, and such default or event of default is not cured in 60 days. If our agreement with GSK is terminated, Royalty Sub will no longer receive royalties from GSK’s sales of Argatroban and we may experience delays and incur expenses in attempting to commercialize Argatroban.
In 2000, we entered into a worldwide research collaboration and license agreement to discover, develop and commercialize VLA4 antagonists with Schering-Plough. Under the terms of the agreement, Schering-Plough obtained the exclusive worldwide rights to develop, manufacture and market all compounds from our library of VLA-4 antagonists, as well as the rights to a second integrin antagonist. We were responsible for optimizing a lead compound and additional follow-on compounds. Schering-Plough supported our research and reimburses us for costs associated with the worldwide product development program and commercialization of the compound. On June 30, 2004, the research program being conducted by us was completed and Schering-Plough ended their funding of our research on a follow-on compound pursuant to the research agreement. Under the terms of the agreement, Schering-Plough is
responsible for further development of VLA-4 antagonists, and in 2005 initiated a study of TBC4746 in human volunteers. In addition to reimbursing research costs, Schering-Plough paid an upfront license fee, paid us development milestones and could pay additional development milestones and royalties on product sales resulting from the agreement. If this agreement is terminated, we will lose Schering-Plough’s funding for development milestones and royalties on product sales resulting from the agreement.
We cannot assure you that we will satisfy the conditions required to obtain additional research or milestone payments under the existing agreements or that we can prevent the termination of these agreements. We also cannot assure you that we will be able to enter into future strategic alliances on acceptable terms, or that we will choose to do so.
Use of our net operating losses for reducing our income tax expenses may be limited.
At December 31, 2006, we had net operating loss carry forwards for federal income tax purposes of approximately $405 million, all of which are currently subject to a valuation allowance such that no deferred tax asset is reflected on our balance sheet with respect to such amounts. Such net operating losses expire during the years 2007 through 2026, of which approximately $4 million will expire in 2007.
The use of such net operating loss carry forwards and other tax attributes can be subject to an annual limitation if we experience an “ownership change” under Section 382 of the Internal Revenue Code, which generally occurs if we have a more than 50 percentage point change in the ownership of our stock in any rolling three-year period. The annual limitation is equal to our market value at the time of any such ownership change multiplied by the applicable long-term, tax-exempt rate which is published monthly by the Internal Revenue Service. Any such limitation could materially limit the use of our net operating loss carry forwards and other tax attributes, perhaps causing them to expire unused.
Based on our review, we do not believe that any of our net operating loss carry forwards or other tax attributes are currently subject to this limitation or that the issuance or conversion of our Convertible Notes will trigger such a limitation at this time. However, such a determination is complex and we cannot assure you that the Internal Revenue Service could not successfully challenge our conclusion. Future events including shifts in our stock ownership could trigger such a limitation which could have the effect of materially increasing our income tax expense and cash costs for income taxes.
We would expect that future operating profits earned on sales of Thelin™ in Europe, as well as potential future profits realized on the sale of Thelin™ in the U.S., may allow us to utilize this net operating loss carry forward in future periods.
Even if our net operating losses are not subject to the limitations discussed above, we may be subject to the alternative minimum tax due to statutory limitations on the use of such net operating losses in computing this tax.
We may not be able to pay principal or interest on our outstanding Convertible Notes.
As of December 31, 2006, we had $130 million of our Convertible Notes outstanding, with stated conversion prices higher than our current stock price. The terms of our Convertible Notes do not restrict our use of existing cash, cash equivalents or investments, however we cannot assure you that funds will be available or sufficient in the future to allow payment of interest on our Convertible Notes. Interest is payable on the Convertible Notes semi-annually totaling approximately $3.2 million per year. Currently, our cash, cash equivalents and investments are not sufficient to repay the principal amount of the debt. There are a number of factors that could prevent us from making future interest payments or debt repayment obligations. Some of these factors include, but are not limited to, the following:
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We may not be able to generate cash flow from operations or financing activities to meet our future repayment obligations on the Convertible Notes.
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The Convertible Notes might not be converted into common stock, which would require that we repay the principal amount at the maturity date of the Convertible Notes, March 15, 2012.
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Our financial condition and other factors in the financial markets may prevent us from refinancing the Convertible Notes in the future, should we desire to do so.
In certain circumstances, we may lose the potential to receive future royalty payments after the Argatroban Notes are repaid in full or we may be required to pay liquidated damages equal to the then outstanding balance of the Argatroban Notes plus accrued unpaid interest thereon.
In February 2007, Royalty Sub issued $60 million in aggregate principal amount of the Argatroban Notes, which are secured by, among other things, royalty payments from future sales of Argatroban and by a pledge by us of the equity interest of Royalty Sub. If the royalty payments are insufficient to repay the Argatroban Notes and an event of default occurs under the indenture governing the Argatroban Notes, in certain circumstances, the royalty payments and the equity interest of Royalty Sub may be foreclosed upon and we could lose the potential to receive future royalty payments after the Argatroban Notes are repaid in full. In addition, in connection with the issuance of the Argatroban Notes, we have made certain covenants to Royalty Sub. If we breach an applicable covenant, we have agreed to pay liquidated damages to the holders of the Argatroban Notes equal to the then outstanding balance of the Argatroban Notes plus accrued unpaid interest thereon. See Note 2 to the Consolidated Financial Statements included herein for a more complete description of the terms of the Argatroban Notes.
We are the subject of securities class action and shareholder derivative lawsuits that may result in substantial expenditures, and divert management’s attention.
On September 26, 2006, a purported class action complaint (the “Massachusetts Laborers complaint”) was filed in the United States District Court for the Southern District of Texas by Massachusetts Laborers’ Annuity Fund, on behalf of itself and all other similarly situated investors against the Company, Bruce D. Given, M.D. (the Company’s President and Chief Executive Officer), Richard A.F. Dixon (the Company’s Senior Vice President, Research and Chief Scientific Officer) and Stephen L. Mueller (the Company’s former Vice President, Finance and Administration, Secretary and Treasurer). The complaint alleges violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5, and focuses on statements that are claimed to be false and misleading regarding our drug sitaxsentan sodium. The plaintiffs seek unspecified damages on behalf of a purported class of purchasers of our securities during the period from February 19, 2004 through March 24, 2006.
In addition, on October 10, 2006, a second purported class action complaint was filed in the United States District Court for the Southern District of Texas by Gustav R. Bastian, on behalf of himself and all other similarly situated investors against the Company, Dr. Given, Mr. Dixon and Mr. Mueller. The complaint asserts substantially the same factual allegations and legal claims as the Massachusetts Laborers complaint on behalf of the same putative class. A third substantially similar purported class action complaint was filed on October 20, 2006 by Steven O. Scott, and a fourth substantially similar purported class action complaint was filed on November 1, 2006 by Cami Janzen-Guare. These complaints assert substantially the same factual allegations and legal claims as the Massachusetts Laborers’ complaint and were filed in the same court on behalf of the same putative class.
It is possible that additional complaints regarding the same subject matter may be filed in the future. The Court has consolidated the four existing lawsuits into a single civil action, and we expect that any future purported class action lawsuits involving the same subject matter as the existing lawsuits, will likewise be consolidated into this action. Although we believe that the allegations in these cases are without merit and intend to defend all such litigation vigorously, litigation is subject to inherent uncertainties, and an adverse result in these or other matters that may arise from time to time could have a material adverse effect on our business, results of operations and financial condition.
On November 22, 2006, an individual claiming to be a shareholder of the Company filed a purported shareholder derivative complaint in the United States District Court for the Southern District of Texas. The complaint names the Company as a nominal defendant and certain of the Company’s current and former officers and all of the Company’s current directors as defendants. The suit asserts claims for breach of fiduciary duty, abuse of control, insider selling, misappropriation of information, gross mismanagement, and waste of corporate assets, and seeks contribution and indemnification against the individual defendants. The lawsuit seeks damages on behalf of the Company against the individual defendants, as well as a constructive trust over the individual defendants’ assets or trading activities; restitution and disgorgement of all profits, benefits, and compensation obtained by the individual defendants and the costs of attorneys’ fees expended by the plaintiff in litigating the derivative action.
We anticipate that additional shareholder derivative lawsuits regarding the same subject matter may be filed in federal and/or state court during the upcoming weeks or months. Any litigation to which we are subject may be costly and, further, could require significant involvement of our senior management and may divert management’s attention from our business and operations.
If Revotar, our former majority-owned German subsidiary, is unable to obtain additional funding, bimosiamose may not be commercialized.
Revotar is developing a selectin antagonist, bimosiamose, for the treatment of asthma and psoriasis. In April 2005, we entered into an agreement with the other Revotar stockholders whereby we would no longer be obligated to fund any drug development activities, in exchange for eliminating our ownership interest and licensing our worldwide rights to bimosiamose and certain follow-on compounds to Revotar. See Note 14 to the Consolidated Financial Statements included herein. Revotar will likely need to obtain additional capital or resources, or enter into a collaboration to complete development of bimosiamose. If Revotar is unable to obtain additional funding or enter into a development collaboration, Revotar will no longer be able to continue its operations and may have to consider various methods of maximizing shareholder value, including the sale or liquidation of its assets to its stockholders or third parties.
Risks Relating To Clinical and Regulatory Matters
The regulatory approval process is costly and lengthy and we may not be able to successfully obtain all required regulatory approvals.
The preclinical development, clinical trials, manufacturing, marketing and labeling of pharmaceuticals are all subject to extensive regulation by numerous governmental authorities and agencies in the U.S. and other countries. We must obtain regulatory approval for each of our product candidates before marketing or selling any of them. The process of obtaining and maintaining regulatory approvals is lengthy, expensive and uncertain. It can also vary substantially, based on the type, complexity and novelty of the product. It is not possible to predict how long the approval processes of the FDA or any other applicable federal, state or foreign regulatory authority or agency for any of our products will take, or whether any such approvals ultimately will be granted. Positive results in preclinical testing and/or early phases of clinical studies offer no assurance of success in later phases of the approval process.
Generally, preclinical and clinical testing of products can take many years, and require the expenditure of substantial resources, and the data obtained from these tests and trials can be susceptible to varying interpretation that could delay, limit or prevent regulatory approval. For example, we licensed rights to Argatroban in 1993, and incurred costs, including preclinical research studies and clinical trials costs of approximately $43 million prior to its approval by the FDA in June 2000 for the treatment of thrombosis in patients with HIT. We are still incurring costs for the development of Thelin™, and our costs have already significantly exceeded the cost of developing Argatroban. To obtain regulatory approvals, we must, among other requirements, complete carefully controlled and well-designed clinical trials demonstrating that a particular product candidate is safe and effective for the applicable disease. Several biotechnology companies have failed to obtain regulatory approvals because regulatory agencies were not satisfied with the structure or conduct of clinical trials or the ability to interpret the data from the trials. Similar problems could delay or prevent us from obtaining approvals. Any delay in obtaining, or failure to obtain, approvals could adversely affect the marketing of our products and our ability to generate product revenue.
Delays or rejections in the regulatory approval process based on the failure of clinical or other data to meet expectations, or the failure of the product to meet a regulatory agency’s requirements for safety, efficacy and quality may jeopardize the commercial launch of Thelin™ or other future products of ours, which would have a materially adverse impact on our ability to generate revenue and our ability to secure additional funding. Additionally, regulatory approval, if obtained, may significantly limit the indicated uses for which a product may be marketed.
In addition, we, or the FDA or other applicable regulatory agencies, might delay or halt our clinical trials for various reasons, including but not limited to:
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we may fail to comply with extensive FDA or other applicable regulatory agency regulations;
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a product candidate may not appear to be more effective than current therapies;
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a product candidate may have unforeseen or significant adverse side effects or other safety issues;
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the time required to determine whether a product candidate is effective may be longer than expected;
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we may be unable to adequately follow or evaluate patients after treatment with a product candidate;
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patients may die or experience other significant adverse effects during a clinical trial because their disease is too advanced or because they experience medical problems that may not be related to the product candidate;
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sufficient numbers of patients may not enroll in our clinical trials; or
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we may be unable to produce sufficient quantities of a product candidate to complete the trial.
Any delays or difficulties in obtaining regulatory approvals or clearances for our product candidates may:
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adversely affect the marketing of any products we develop;
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impose significant additional costs on us;
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diminish any competitive advantages that we may attain; and
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limit our ability to receive royalties and generate revenue and profits.
Legislative or regulatory changes could harm our business.
The FDA has designated ThelinTM as an orphan drug under the Orphan Drug Act. The Orphan Drug Act provides incentives to manufacturers to develop and market drugs for rare diseases, generally by entitling the first developer that receives FDA marketing approval for an orphan drug to at least a seven-year exclusive marketing period in the United States for that product. In recent years, Congress has considered legislation to change the Orphan Drug Act to shorten the period of automatic market exclusivity and to grant marketing rights to simultaneous developers of a drug. If the Orphan Drug Act is amended in this manner, ThelinTM could face increased competition, which may result in lower sales.
In addition, the United States government and other governments have shown significant interest in pursuing healthcare reform. Any government-adopted reform measures could adversely impact:
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the pricing of therapeutic products and medical devices in the United States or internationally;
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our ability to protect the United States market from the purchase by consumers of therapeutic products and medical devices that have been imported from manufacturers and distributors located outside of the United States;
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the amount of reimbursement available from governmental agencies or other third-party payers; and
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Medicare and Medicaid reimbursement of pharmaceutical products.
New laws, regulations and judicial decisions, or new interpretations of existing laws, regulations and decisions, which relate to health care availability, methods of delivery or payment for products and services, or sales, marketing or pricing may cause our revenue to decline, and necessitate revision of our research and development programs.
Legislative changes or regulatory decisions in Europe may adversely impact our orphan drug status which may result in loss of revenues in the European Union.
The EC has designated Thelin™ as an orphan drug. Orphan drug status precludes European regulators from approving marketing applications in the EU for medicinal products that are chemically similar to Thelin™ for a period of ten years. We have been requested to provide information to support the designation of Thelin™ as an orphan drug in the EU and have responded to this request. If the EC amends its decision designating Thelin™ as an orphan drug, or if the EC decides not to renew the orphan drug designation of Thelin™ after the first five years following marketing approval, Thelin™ will lose its orphan drug status and European regulators may approve medicinal products that are chemically similar to Thelin™. In such case, we would need to rely on our existing patent protection to prevent the commercialization of competing products in the EU. This protection presently extends to 2016, subject to any available extensions, and may be broader or narrower than that offered by orphan drug status, depending on the scope of patent claims applicable to Thelin™. If Thelin™ loses its orphan drug status in the EU, and existing patent claims applicable to Thelin™ cannot prevent commercialization of competing products, Thelin™ will face increased competition, which may decrease the amount of revenue we receive from Thelin™.
We depend on third parties in the conduct of our clinical trials for our product candidates and any failure of those parties to fulfill their obligations could adversely affect our development plans.
We depend on independent clinical investigators, contract research organizations, hospitals and other third party service providers and our collaborators in the conduct of our clinical trials for our product candidates. We rely on these parties for successful execution of our clinical trials but do not control many aspects of their activities. For example, the investigators are not our employees. However, as the sponsor of these trials we are responsible for ensuring that each of our clinical trials is conducted in accordance with the clinical investigational plan, protocols for each clinical trial, good clinical practices and other regulatory requirements. Third parties may not complete activities on schedule or may not conduct our clinical trials in accordance with regulatory requirements or our stated protocols. The failure of these third parties to carry out their obligations could delay or prevent the development, approval and commercialization of our product candidates.
Our clinical trials could take longer to complete and cost more than we expect, which may result in our development plans being significantly delayed.
We will need to conduct clinical studies of all of our product candidates; these studies are costly, time consuming and unpredictable. Any unanticipated costs or delays in our clinical studies could cause us to expend substantial additional funds or to delay or modify our plans significantly, which would harm our business, financial condition and results of operations. The factors that could contribute to such cost, delays or modifications include:
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the cost of conducting human clinical trials for any potential product. These costs can vary dramatically based on a number of factors, including the order and timing of clinical indications pursued and the development and financial support from corporate partners; and
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intense competition in the pharmaceutical market, which may make it difficult for us to obtain sufficient patient populations or clinician support to conduct our clinical trials as planned.
Many factors affect patient enrollment, including the size of the patient population, the proximity of patients to clinical sites, the eligibility criteria for the trial, competing clinical trials and new drugs approved for the conditions we are investigating. Other companies are conducting clinical trials and have announced plans for future trials that are seeking or likely to seek patients with the same diseases as those we are studying. Competition for patients in cardiovascular disease trials is particularly intense because of the limited number of leading cardiologists and the geographic concentration of major clinical centers. As a result of all of these factors, our trials may take longer to enroll patients than we anticipate.
Even if we obtain marketing approval, our products will be subject to ongoing regulatory oversight, which may affect the success of our products.
Any regulatory approvals that we receive for a product may be subject to limitations on the indicated uses for which the product may be marketed, or may contain requirements for potentially costly follow-up Phase IV clinical studies. Failure to complete Phase IV requirements can lead to negative regulatory action which can include withdrawal of regulatory approval. After we obtain marketing approval for any product, the manufacturer and the manufacturing and testing facilities for that product will be subject to continual review and periodic inspections by the FDA and other regulatory authorities. The subsequent discovery of previously unknown problems with the product or with the manufacturer or facility may result in restrictions on the product or manufacturer, including withdrawal of the product from the market. We have not incurred any material expenses related to the post-marketing review of Argatroban; however, post-marketing review and surveillance expenses for Thelin™ will be more significant than those incurred with Argatroban.
If we fail to comply with applicable regulatory requirements, we may be subject to fines, suspension or withdrawal of regulatory approvals, withdrawal of product, product recalls, seizure of products, operating restrictions and criminal prosecution.
Risks Related To Ongoing Operations
We may not be able to retain our personnel.
Our success depends largely upon the continued service of our management and scientific staff and our ability to attract, retain and motivate qualified scientific, management, sales and marketing and professional support staff personnel. The loss of the services of the principal members of our management and scientific staff may impede our ability to bring products to market. Certain members of our management team and scientific staff, have employment agreements with us, which provide for initial one-year terms that renew automatically for successive additional one-year periods, unless either party provides notice at least 60 days before the scheduled expiration. We do not maintain key person insurance on any members of our management team and scientific staff. Our success is also dependent on our maintaining and expanding our personnel as needs arise in the areas of research, clinical trial management, manufacturing, sales and marketing, and professional support staff, in order to commercialize our products. In anticipation of receiving regulatory approval to market Thelin™ in the U.S., we have hired marketing personnel, a U.S. field sales force, and related management and conducted training in preparation to launch Thelin™ in the U.S.
After we received marketing clearance for Thelin™ from the EC, we began to establish sales operations and hire sales representatives in certain countries of the EU. We may also need to hire and train other qualified personnel in order to successfully commercialize Thelin™ in the EU. We face intense competition for such personnel from other companies, academic institutions, government entities and other organizations. We cannot assure you that we will be successful in hiring or retaining qualified personnel. Managing the integration of new personnel, and our growth in general, could pose significant risks to our development and progress in achieving our goals.
We also rely on consultants and advisors to assist us in formulating our research and development strategy. All our consultants and advisors are either self-employed or employed by other organizations and they may have other commitments, such as consulting or advisory contracts with other organizations that may affect their ability to contribute to us.
We may be sued for product liability, which may prevent or interfere with the development or commercialization of our products.
Because our products and product candidates are new treatments, with limited, if any, past use on humans, serious undesirable and unintended side effects, including death, may arise. We may be subject to product liability claims that are inherent in the testing, manufacturing, marketing and sale of pharmaceutical products. These claims could expose us to significant liabilities that could prevent or interfere with the development or commercialization of our products and seriously impair our financial position. Product liability insurance is generally expensive for biopharmaceutical companies such as ours. Under the agreements with Mitsubishi and GSK, we also maintain product liability insurance to cover claims that may arise from the sale of Argatroban. Our existing coverage has policy limits of up to $15 million for claims arising from clinical trials or from the sale of Argatroban or Thelin™. However, we cannot provide any assurance that this coverage will be sufficient to satisfy any liabilities that may arise. If we receive regulatory approval to sell Thelin™ in the U.S. and other countries, we will need additional product liability insurance coverage, which may not be available on commercially reasonable terms. We cannot assure you that we will be able to maintain our existing insurance coverage or obtain additional coverage on commercially reasonable terms for liability arising from the use or sale of our other products, including Thelin™, in the future. Also, this insurance coverage and our resources may not be sufficient to satisfy any loss related to product liability claims.
Endothelin antagonists as a class may generate liver and fetal abnormalities.
Liver and fetal abnormalities have been recognized as complications related to the endothelin antagonist class of drugs. In a follow-on extension of the Phase II study for Thelin™, two patients developed treatment-related hepatitis and one of these patients died. Fetal abnormalities with respect to this class of drug have also been detected in animal studies. Thelin™ may produce birth defects if used by pregnant women, as this effect has been seen when it is administered to animals.
Because of potential liver injury and in an effort to minimize the possibility of fetal exposure, the distribution of Thelin™ in the EU has been restricted, and it is likely that Thelin™ distribution will be restricted elsewhere, if approved, to physicians, patients and caregivers who have been provided education on these risks. If we are unable to clearly demonstrate that Thelin™ provides an acceptable risk-benefit profile as compared to currently approved therapies, we are not likely to receive regulatory approval to market Thelin™, which would have a material adverse affect on our ability to generate meaningful revenue or achieve profitability.
Tracleer® (bosentan), a product of Actelion, Inc., also belongs to the endothelin antagonist class of drugs. The FDA, as a condition for the approval of Tracleer®, required that Actelion distribute Tracleer® via a limited access program. A limited access program is a distribution system that seeks to manage the post-marketing risk of an approved medication through: (i) limited distribution of the medication through a number of specialty pharmacy distributors; (ii) registration of all practitioners prescribing the medication; (iii) registration of all patients receiving the medication; (iv) written certification by the practitioner that the medication is being prescribed for a medically appropriate use; (v) review of safety warnings with the patient by the practitioner; and (vi) an ongoing comprehensive program to monitor, collect, track and report adverse event and other safety related information from patients receiving the medication. We believe that since Thelin™ belongs to the same class of drug as Tracleer®, the FDA will require that Thelin™ be distributed though a limited access program that may make physician acceptance, patient access and product reimbursement more difficult.
As a condition for marketing Thelin™ in the EU, the EMEA imposed conditions regarding the supply and the safe and effective use of Thelin™ in the EU. These conditions include:
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establishment of a surveillance program and safety database to collect information on patient demographics, adverse reaction and treatment discontinuations; and
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a controlled distribution system that ensures physicians are provided with information stating that Thelin™: (i) is teratogenic, therefore pregnancy should be avoided; (ii) requires monitoring of liver function and other blood parameters, and (iii) interacts with other medications, specifically vitamin K antagonists and cyclosporin A.
Our corporate compliance program cannot guarantee that we are in compliance with all potentially applicable regulations.
The development, manufacturing, pricing, sales, and reimbursement of our products, together with our general operations, are subject to extensive regulation by federal, state and other authorities within the United States and numerous entities outside of the United States. As a publicly traded company we are subject to significant regulations, some of which have either only recently been adopted or are currently proposals subject to change. While we have developed and instituted a corporate compliance program and continue to update the program in response to newly implemented or changing regulatory requirements, we cannot assure that we are or will be in compliance with all potentially applicable regulations. If we fail to comply with any of these regulations, we could be subject to a range of regulatory actions, including suspension or termination of clinical trials, the failure to approve a product candidate, restrictions on our products or manufacturing processes, withdrawal of products from the market, significant fines, or other sanctions or litigation
In connection with our management’s assessment of the effectiveness of our internal control over financial reporting as of the end of the fiscal year ended December 31, 2006, and the corresponding audit of that assessment by KPMG LLP, our independent registered public accounting firm, KPMG identified one significant deficiency in our internal control over financial reporting. This deficiency was not determined to be a “material weakness” in our controls, however. An internal control material weakness is defined as a significant deficiency, or aggregation of deficiencies, that does not reduce to a relatively low level the risk that material misstatements in financial statements will not be prevented or detected on a timely basis by employees in the normal course of their work. An internal control significant deficiency, or aggregation of deficiencies, is one that could result in a misstatement of the financial statements that is more than inconsequential. We have taken what we believe to be the necessary steps to remedy such deficiencies in our internal control over financial reporting within the required time periods and our management and KPMG concluded that as of December 31, 2006, they believed that our internal control over financial reporting was effective. However, we cannot assure you that these measures or any future measures will enable us to avoid other significant deficiencies or material weaknesses in the future.
Risks Relating to Product Manufacturing, Distribution and Sales
We have very limited manufacturing, marketing and sales experience.
We have very limited manufacturing, marketing and product sales experience. If we develop commercially marketable products, and receive regulatory approval for those products, we cannot assure you that contract manufacturing services will be available in sufficient capacity to supply our product needs on a timely basis. If we decide to build or acquire commercial scale manufacturing capabilities, we will require additional management and technical personnel, as well as significant additional financial resources. The manufacture of pharmaceutical products, both inside and outside the United States, is highly regulated and complex. We, and the third parties we rely upon for the manufacture of our products, must comply with all applicable regulatory requirements of the FDA and foreign authorities, including current Good Manufacturing Practice regulations. The facilities used to manufacture, store and distribute our products also are subject to inspection by regulatory authorities at any time to determine compliance with regulations. These regulations are complex, and any failure to comply with them could lead to remedial action, civil and criminal penalties and delays in production or distribution of material. The process of changing or adding a manufacturer or changing a formulation requires prior approval from regulatory authorities and is very time-consuming. If we are unable to manage this process effectively or if an unforeseen event occurs at any facility, we could face supply disruptions that would result in significant costs and delays, undermine goodwill established with physicians and patients, damage commercial prospects for our products and adversely affect operating results.
We intend to commercialize Thelin™ in the EU and, upon receipt of FDA approval, in the U.S. through our own specialty sales force. As a result, we would face a number of additional risks, including:
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we may not be able to attract, and retain an experienced marketing or sales force;
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the costs of establishing and maintaining a sales force, and the associated direct and indirect commercial infrastructure costs, may not be justifiable in light of product revenues; and
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our direct sales and marketing efforts may not be successful.
We cannot assure you that the raw materials necessary for the manufacture of our products will be available in sufficient quantities or at a reasonable cost.
Complications or delays in obtaining raw materials or in product manufacturing could delay the submission of products for regulatory approval, the initiation of new development programs and the availability of a sufficient commercial supply of our products to meet demand, each of which could materially impair our competitive position and potential profitability. We cannot assure you that we will be able to enter into any other supply arrangements on acceptable terms, if at all.
We are dependent on a single supplier of Argatroban.
At present, Mitsubishi is the only manufacturer of Argatroban API and has entered into an agreement with GSK to supply Argatroban API in bulk to meet GSK’s needs in the production of Argatroban finished product. GSK has informed us that they have begun supplying Argatroban finished product from their manufacturing facility in the United Kingdom. Should Mitsubishi fail during any consecutive nine-month period to supply GSK at least 80% of its requirements, and such requirements cannot be satisfied by existing inventories, the agreement provides for the nonexclusive transfer of the production technology for API to GSK. However, in the event Mitsubishi terminates supplying Argatroban API or defaults in its supply commitment, we cannot assure you that GSK will be able to commence manufacturing of Argatroban API in a timely manner or that alternate sources of Argatroban API will be available at reasonable cost, if at all.
We are dependent on a single supplier of Thelin™.
At the present time, we have contracted with a single supplier for the supply of Thelin™ API. Although the supplier has two manufacturing sites capable of producing Thelin™ API, we cannot assure you that this will be adequate to insure uninterrupted supply to satisfy our needs for clinical trials and commercialization. Any disruption in supply could adversely affect our ability to conduct clinical trials or meet commercialization needs. Additionally, we have contracted with a single supplier for tableting and packaging Thelin™ and although we have an alternate supplier capable of these services, we cannot assure you that there will not be a disruption in supply.
We will be dependent on third parties to distribute Thelin™.
In the EU markets where we intend to commercialize Thelin™, we will rely on third parties for importation, warehousing, distribution and other distribution related services. If Thelin™ is approved in the U.S., we will rely on a network of third party specialty pharmacies to distribute Thelin™ to patients. This network will require significant coordination with our sales and marketing, medical affairs and finance organizations, and will provide services such as reimbursement assistance, patient education and counseling to monitor compliance. We believe these services will help patients successfully use Thelin™. Failure to successfully establish and maintain our contracts with these third parties, or the inability or failure of any of them to adequately perform as agreed under their respective contracts with us could harm our business. We do not have our own warehouse or distribution capabilities, and we lack the resources and experience to establish any of these functions and do not intend to do so in the foreseeable future. Any failure by these third parties to pay us for purchases of Thelin™ on a timely basis or at all could have a material adverse effect on our financial position, results of operations and cash flows. Our sales could fluctuate from quarter to quarter based on the buying patterns of these third parties.
We would be unable to replace some or all of these third parties in a timely manner in the event of a natural disaster, failure to meet regulatory requirements, business failure, strike or other distribution failure. If any of these third parties did not perform for any reason under their respective contracts with us, the distribution of Thelin™ could be interrupted, damaging our results of operations and market position. Since we would be dependent on these third parties for information regarding Thelin™ sales, shipments and inventory, failure of their financial systems could also harm our ability to accurately report and forecast product sales and fulfill our regulatory obligations.
Our products, even if approved by the FDA or foreign regulatory agencies, may not be accepted by health care providers, insurers or patients.
If any of our products, including Thelin™, after receiving FDA or other foreign regulatory approval, fail to achieve or maintain market acceptance, our ability to become profitable or maintain profitability in the future will be adversely affected. We believe that market acceptance will depend on our ability to provide and maintain acceptable evidence of safety, efficacy and cost effectiveness. In addition, market acceptance depends on the effectiveness of our marketing strategy and the availability of reimbursement by government and private third-party payers for our products.
The successful commercialization of our products is dependent on pharmaceutical pricing and third-party reimbursement.
In recent years, there have been numerous proposals to change the health care system in the United States. Some of these proposals have included measures that would limit or eliminate payments for medical procedures and treatments or subject the pricing of pharmaceuticals to government control. In addition, government and private third-party payers are increasingly attempting to contain health care costs by limiting both the coverage and the level of reimbursement of drug products. Consequently, the reimbursement status of newly approved health care products is highly uncertain and we cannot assure you that third-party coverage will be available, or that available third-party coverage will enable us to maintain price levels sufficient to realize an appropriate return
on our investment in product development. Our long-term ability to market products successfully may depend in part on the extent to which reimbursement for the cost of such products and related treatment will be available. Third-party payers are increasingly challenging the prices of medical products and services. Furthermore, inadequate third-party coverage may reduce market acceptance of our products. Significant changes in the health care system in the United States or elsewhere could have a material adverse effect on our business and financial performance.
The hazardous material we use in our research and development could result in significant liabilities, which may exceed our insurance coverage.
Our research and development activities involve the use of hazardous materials. While we believe that we are currently in substantial compliance with federal, state, foreign and local laws and regulations governing the use of these materials, accidental injury or contamination may occur. Any such accident or contamination could result in substantial liabilities, which could exceed our financial resources or not be covered by our general liability insurance, which has a policy limit of $7 million. We do not carry specific insurance coverage for environmental contamination. Additionally, the cost of compliance with environmental and safety laws and regulations may increase in the future.
Risks Relating to Intellectual Property
We may not be able to protect proprietary information and obtain patent protection.
We actively seek patent protection for our proprietary technology, both in the U.S. and in other areas of the world. However, the patent positions of pharmaceutical and biotechnology companies, including us, are generally uncertain and involve complex legal, scientific and factual issues. Intellectual property is an uncertain and developing area of the law that is potentially subject to significant change. Our success will depend significantly on our ability to:
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obtain and maintain and enforce patent protection for our products and product candidates and for those of our collaborative partners;
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protect and enforce our trade secrets;
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operate without infringing upon the proprietary rights of others; and
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prevent others from infringing on our proprietary rights.
We cannot assure you that patents issued to or licensed by us will not be challenged, invalidated or circumvented, or that the rights granted will provide competitive advantages to us. We cannot assure you that our patent applications or pending or future patent applications, if and when issued, will be valid and enforceable and withstand litigation. We cannot assure you that others will not independently develop substantially equivalent, generic equivalent or superseding proprietary technology or that an equivalent or superior product will not be marketed in competition with our products, thereby substantially reducing the value of our proprietary rights. We may experience a significant delay in obtaining patent protection for our products as a result of a substantial backlog of pharmaceutical and biotechnology patent applications at the U.S. Patent and Trademark Office, or PTO. Other competitors may have filed or maintained patent applications of which we may not be aware for technology used by us or covered by our pending applications. In addition, patent protection, even if obtained, is affected by the limited period of time for which a patent is effective.
Patent protection only provides rights of exclusivity for the term of the patent. We will be able to protect our proprietary rights from unauthorized use by third parties only to the extent that our proprietary rights are covered by valid and enforceable patents or are effectively maintained as trade secrets, and then only to the extent that we are able, financially and otherwise, to enforce such proprietary rights.
Argatroban is currently marketed in a formulation that is covered under a formulation patent that was extended and now expires in 2014 and a process patent that expires in 2017. Hatch-Waxman protection has expired and it is possible that generic manufacturers may be able to produce Argatroban without violating the formulation or process patents. In addition, Thelin™ is covered under a composition of matter patent that expires in 2013.
We could also incur substantial costs in filing and prosecuting patent claims, in defending any patent infringement suits or in asserting any patent rights, including those granted by third parties, in a suit with another party. The PTO could institute interference proceedings involving us in connection with one or more of our patents or patent applications, and such proceedings could result in an adverse decision resulting in loss of patent rights as to priority of invention. The PTO or a comparable agency in a foreign jurisdiction could also institute re-examination or opposition proceedings against us in connection with one or more of our patents or patent applications and such proceedings could result in an adverse decision as to the validity or scope of the patents. Further, third parties may obtain a declaratory judgment, or other opinion, from a court of competent jurisdiction declaring one or more of our patents invalid, unenforceable, and/or not infringed by competing products.
We may be required to obtain licenses to patents or other proprietary rights from third parties. We cannot assure you that any licenses required under any patents or proprietary rights would be made available on acceptable terms, if at all. If we are unable to
obtain required licenses, we could encounter delays in product introductions while we attempt to design around blocking patents, or we could find that the development, manufacture or sale of products requiring such licenses could be foreclosed.
Termination of our license of Argatroban from Mitsubishi would result in the loss of significant rights.
We entered into an agreement in 1993 to license Mitsubishi’s rights and technology relating to Argatroban and to license Mitsubishi’s own proprietary technology developed with respect to Argatroban. Under the agreement, Mitsubishi has the right to bring any suit or action for infringement of the patent rights granted thereunder; provided, however, if Mitsubishi fails to take action with respect to any infringement, we have the right the bring any appropriate suit or action against the infringer based upon any patent with the patent rights granted thereunder that has a claim that specifically covers a licensed product. The agreement provides us an exclusive license to use and sell Argatroban in the U.S. and Canada for all cardiovascular, renal, neurological and immunological purposes other than use for the coating of stents. We are required to pay Mitsubishi specified royalties on net sales of Argatroban by us and our sublicensees after its commercial introduction in the U.S. and Canada. During 2000, we signed an additional agreement with Mitsubishi that provides us with royalties on sales of Argatroban in certain European countries, up to a total of $5.0 million in milestones for the development of ischemic stroke and certain other provisions. During 2001, we received $2.0 million of these milestones less certain Japanese withholding taxes. Additional milestones are dependent on further development of Argatroban in the indication of ischemic stroke. During 2002, we completed a Phase II human clinical trial for Argatroban as a monotherapy treatment for acute ischemic stroke. The clinical trial met the primary safety endpoint and showed positive results in the secondary safety endpoint. In light of a lack of an overall efficacy trend and the high risk and high costs associated with stroke trials, it is unlikely that we will proceed independently with a full Phase III program. Either party may terminate the agreement with Mitsubishi on 60 days notice if the other party defaults in its material obligations under the agreement, or becomes insolvent, or if a substantial portion of its property is subject to levy. We are currently in compliance with respect to the material obligations under the agreement. Unless terminated sooner, the agreement with Mitsubishi expires on the later of termination of patent rights in a particular country or 20 years after first commercial sale of products in a particular country. If our agreement with Mitsubishi is terminated, we and Royalty Sub will lose the rights to Argatroban, including the right to receive revenues from the sale of Argatroban, which would have a material adverse effect on our business and financial condition.
If we are unable to keep our trade secrets confidential, our technology and information may be used by others to compete against us.
We rely significantly on trade secrets, know-how and continuing technological advancement to maintain our competitive position. We try to protect this information by entering into confidentiality agreements with our employees and consultants, which contain assignment of invention provisions. Notwithstanding these agreements, others may gain access to these trade secrets, such agreements may not be honored and we may not be able to protect effectively our rights to our unpatented trade secrets. Moreover, our trade secrets may otherwise become known or independently developed by our competitors, thereby resulting in our loss of rights in the trade secrets.
Failure to avoid infringement of others’ intellectual property rights could impair our ability to manufacture and market our products.
We cannot guarantee that our products or product candidates will be free of claims by third parties alleging that we have infringed their intellectual property rights. Any such claim could be expensive and time-consuming to defend, and an adverse litigation result or a settlement of litigation could require us to pay damages, obtain a license from the complaining party or a third party, develop non-infringing alternatives or cease using the asserted intellectual property right. Any such result could adversely affect our ability to operate profitably.
We cannot assure you that we would prevail in any intellectual property infringement action, will be able to obtain a license to any third-party intellectual property on commercially reasonable terms, if at all, successfully develop non-infringing alternatives on a timely basis, or license non-infringing alternatives, if any exist, on commercially reasonable terms, if at all. Any significant intellectual property impediment to our ability to develop or commercialize our products could significantly harm our business and prospects.
Risks Related to Our Common Stock
Our stock price is volatile.
The stock market has from time to time experienced significant price and volume fluctuations that may be unrelated to the operating performance of particular companies. In particular, the market price of our common stock, like that of the securities of other biopharmaceutical companies, has been and may be highly volatile. During the period from January 1, 2004, to December 31, 2006, our stock price has ranged from a low of $3.29 per share (on May 19, 2006) to a high of $13.29 per share (on September 7, 2005). Further information regarding the trading price of our common stock is included herein in Item 5. The following factors, among others, may affect the price of the common stock:
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governmental regulations and regulatory developments in both the U.S. and foreign countries affecting us or our competitors;
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fluctuations in our financial results;
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announcements of technological innovations, clinical trial results, regulatory filings, regulatory approvals, expanded product indications, or the launch of new commercial products by us or our competitors;
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announcements of actual or potential medical results or risks relating to products either under development or being commercialized by us or our competitors;
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disputes relating to patents or other proprietary rights affecting us or our competitors;
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public concern as to the safety of products developed by us or other biotechnology and pharmaceutical companies;
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general market conditions;
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fluctuations in price and volume in the stock market in general, or in the trading of the stock of biopharmaceutical and biotechnology companies in particular, that are unrelated to our operating performance;
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issuances of securities in equity, debt or other financings;
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trading and possible arbitrage activity related to our outstanding Convertible Notes;
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sales of common stock by existing stockholders; and
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the perception that such issuances or sales could occur.
Issuance of shares in connection with financing transactions or under stock plans will dilute current stockholders.
We issued $130 million of our Convertible Notes, which are convertible into approximately 9.3 million shares of our common stock. We have also entered into an equity financing line with Azimuth pursuant to which we may sell to Azimuth up to $75,000,000 of our common stock, or 11,866,851 shares of common stock, whichever occurs first, at a discount of 2.875% to 5.875% to be determined based on our market capitalization at the start of each sale period. At our request and upon the approval of our Board of Directors, Azimuth will purchase a certain dollar amount of shares, with the exact number of shares to be determined based on the per share market price of our common stock over the draw-down period for such purchase. To date, we have issued an aggregate of 3,086,351 shares of our common stock to Azimuth pursuant to two draw down requests. In addition, pursuant to our stock plans, our management, upon approval by our Compensation and Corporate Governance Committee, is authorized to grant stock awards to our employees, directors and consultants. Stockholders will incur dilution upon the conversion of the Convertible Notes, the sale of shares of our common stock to Azimuth or the exercise of any outstanding stock awards. In addition, if we raise additional funds by issuing additional common stock, or securities convertible into or exchangeable or exercisable for common stock, further dilution to our existing stockholders will result and new investors could have rights superior to existing stockholders.
The number of shares of our common stock eligible for future sale could adversely affect the market price of our stock.
As of February 2, 2007, we have reserved approximately 5.6 million shares of common stock for issuance upon exercise of outstanding options issued under our stock option plans and approximately 9.3 million shares issuable upon conversion of our Convertible Notes. In addition, we may issue up to a maximum 8,780,500 shares of common stock to Azimuth pursuant to our equity financing line. All of these shares of common stock are registered or will be registered for sale or resale on currently effective registration statements. The issuance of a significant number of shares of common stock upon the exercise of stock options or the sale of a substantial number of shares of common stock under Rule 144 or otherwise could adversely affect the market price of the common stock.
We do not intend to pay cash dividends on our common stock in the foreseeable future.
We have never declared or paid any cash dividends on our common stock and we currently do not anticipate paying any cash dividends in the foreseeable future. Because we do not anticipate paying cash dividends for the foreseeable future, holders of shares of our common stock will not realize a return on their investment unless the trading price of our common stock appreciates, which we cannot assure.
Certain anti-takeover provisions in our certificate of incorporation and Delaware law, our rights plan, and severance provisions of our employment agreements, may deter or prevent a change in control of our company and result in the entrenchment of management, even if that change would be beneficial to our stockholders.
Our certificate of incorporation and Section 203 of the Delaware General Corporation Law contain certain provisions that may delay or prevent an attempt by a third party to acquire control of us. These provisions in our certificate of incorporation include:
•
authorizing the issuance of “blank check” preferred stock;
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limiting the ability of stockholders to call a special meeting of stockholders by requiring the written request of the holders of at least 51% of our outstanding common stock; and
•
establishing advance notice requirements for nominations for election to the Board of Directors or for proposing matters that can be acted upon at stockholder meetings.
We are subject to Section 203 of the Delaware General Corporation Law which generally prohibits a Delaware corporation from engaging in any of a broad range of business combinations with an interested stockholder for a period of three years following the date on which the stockholder became an interested stockholder.
In January 2002, we adopted a rights plan that may delay or prevent such attempt by a third party to acquire control of us without obtaining our agreement to redeem the rights. If our agreement to redeem the rights is not obtained, the third party would suffer substantial dilution. In addition, the severance provisions of employment agreements with certain members of management could impede an attempted change of control by a third party and result in the entrenchment of management. These provisions include:
•
the lump-sum payment to certain members of our management team of up to three years annual base salary and a pro rata bonus in the event of a termination by us without “cause” or by the management team member for “good reason; “
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the continued vesting and exercisability of all stock options and restricted stock during specified periods after the termination by us without “cause” or by the management team member for “good reason;”
•
the lump-sum payment to certain members of our management team of up to three years’ annual base salary and bonus in the event of a termination by us without “cause” or by the management team member for “good reason” within two years of a “change in control” of us;
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gross-up payments for certain income taxes on lump-sum payments; and
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the continuation of certain other benefits for periods of up to three years.
In the event of the termination by us without “cause” or by the management team member for “good reason” of all of these members of management within two years of a “change in control” of us, the base salary and annual bonus portions of these employment agreements would aggregate approximately $10 million at the rate of compensation in effect at December 31, 2006.
ITEM 1B
ITEM 1B - UNRESOLVED STAFF COMMENTS
None.
ITEM 2
ITEM 2 - PROPERTIES
In November 2004, we leased 40,730 square feet of office space in Houston, Texas, for our administrative, marketing, clinical development and regulatory departments. The lease expires on December 31, 2008, and can be extended at our option to December 31, 2009. Our prior lease of 15,490 square feet of office space in Bellaire, Texas, which housed our administrative, marketing, clinical development and regulatory departments, expired July 31, 2005.
We also lease 31,359 square feet of office and laboratory space in a building in Houston, Texas, for our research department, including a 21,621 square foot laboratory facility The remaining area is being used for clinical development, computer modeling, storage space and additional offices for scientists. This lease expires in December 2008, and can be extended at our option to December 31, 2009.
We lease office space for our European operations in Uxbridge, U.K., Munich, Germany, Milan, Italy and Paris, France. The agreements are of varying term, and may be extended at our option upon prior written notice.
We may require additional space to accommodate future research and laboratory needs as necessary to bring products into development and clinical trials. In addition, we may require additional office space to support the commercial launch of Thelin™ in Europe.
In general, our properties are well maintained, adequate and suitable to their purposes. See Note 11 to our Consolidated Financial Statements, Equipment and Leasehold Improvements, which discloses amounts invested in buildings and equipment, is incorporated by reference. See also the discussion about lease agreements under Note 17 to our Consolidated Financial Statements, Commitments and Contingencies, which also is incorporated herein by reference.
ITEM 3
ITEM 3 - LEGAL PROCEEDINGS
On September 26, 2006, a purported class action complaint (the “Massachusetts Laborers complaint”) was filed in the United States District Court for the Southern District of Texas by Massachusetts Laborers’ Annuity Fund, on behalf of itself and all other similarly situated investors against the Company, Bruce D. Given, M.D. (the Company’s President and Chief Executive Officer), Richard A.F. Dixon (the Company’s Senior Vice President, Research and Chief Scientific Officer) and Stephen L. Mueller (the Company’s former Vice President, Finance and Administration, Secretary and Treasurer). The complaint alleges violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5, and focuses on statements that are claimed to be false and misleading regarding our drug sitaxsentan sodium. The plaintiffs seek unspecified damages on behalf of a purported class of purchasers of our securities during the period from February 19, 2004 through March 24, 2006.
In addition, on October 10, 2006, a second purported class action complaint was filed in the United States District Court for the Southern District of Texas by Gustav R. Bastian, on behalf of himself and all other similarly situated investors against the Company,
Dr. Given, Mr. Dixon and Mr. Mueller. The complaint asserts substantially the same factual allegations and legal claims as the Massachusetts Laborers complaint on behalf of the same putative class. A third substantially similar purported class action complaint was filed on October 20, 2006 by Steven O. Scott, and a fourth substantially similar purported class action complaint was filed on November 1, 2006 by Cami Janzen-Guare. These complaints assert substantially the same factual allegations and legal claims as the Massachusetts Laborers’ complaint and were filed in the same court on behalf of the same putative class.
It is possible that additional complaints regarding the same subject matter may be filed in the future. The Court has consolidated the four existing putative class action lawsuits into a single civil action, and we expect that any future purported class action lawsuits involving the same subject matter as the existing lawsuits will likewise be consolidated into this action. Although we believe that the allegations in these cases are without merit and intend to defend all such litigation vigorously, litigation is subject to inherent uncertainties, and an adverse result in these or other matters that may arise from time to time could have a material adverse effect on our business, results of operations and financial condition.
On November 22, 2006, John Jadelis, an individual claiming to be a shareholder of the Company, filed a purported shareholder derivative complaint in the United States District Court for the Southern District of Texas. The complaint names the Company as a nominal defendant Bruce D. Given, the Company’s President and CEO, Richard A.F. Dixon, the Company’s Senior Vice President of Research and Chief Scientific Officer, Stephen L. Mueller, the Company’s former Vice President, Finance and Administration, Secretary and Treasurer, Ron Anderson, Director, J. Kevin Buchi, Director, John H. Dillon, II, Director, John M. Pietruski, Director, James A Thomson, Director, Suzanne Oparil, Director, James T. Willerson, Director and Robert J. Cruikshank, Director, as defendants. The suit asserts claims for breach of fiduciary duty, abuse of control, insider selling, misappropriation of information, gross mismanagement, and waste of corporate assets, and seeks contribution and indemnification against the individual defendants. The lawsuit seeks damages on behalf of the Company against the individual defendants, as well as a constructive trust over the individual defendants’ assets or trading activities; restitution and disgorgement of all profits, benefits, and compensation obtained by the individual defendants; and the costs of attorneys’ fees expended by the plaintiff in litigating the derivative action.
We anticipate that additional shareholder derivative lawsuits regarding the same subject matter may be filed in federal and/or state court during the upcoming months.
ITEM 4
ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of our stockholders during the fourth quarter of our fiscal year ended December 31, 2006.
PART II
ITEM 5
ITEM 5 - MARKET FOR REGISTRANT’S COMMON EQUITY, RELATED STOCKHOLDER MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
The following is a line graph presentation comparing our common stock’s cumulative five-year return with various indices, including broad market indices. In May 2003, our name changed from Texas Biotechnology Corporation to Encysive Pharmaceuticals Inc. As a result, our common stock traded on The Nasdaq National Market System as “TXBI” until May 18, 2003, when it began trading as “ENCY.”
Our common stock trades on The NASDAQ Global Market under the symbol “ENCY.” The following table sets forth, for the periods indicated, the high and low sale prices for the common stock as reported by the consolidated transaction reporting system.
As of February 23, 2007, there were approximately 608 holders of record of our common stock and approximately 24,600 beneficial owners.
DIVIDEND POLICY
We have never declared or paid dividends on our common stock. We do not anticipate paying any cash dividends in the foreseeable future. We intend to retain any future earnings to finance our growth strategy and ongoing business. Payment of future dividends, if any, will be at the discretion of the Board of Directors after reviewing various factors, including our financial condition and operating results, current and anticipated cash needs and restrictions which may be in effect in any future financing agreement.
RECENT SALES OF UNREGISTERED SECURITIES
None.
REPURCHASES OF EQUITY SECURITIES
None.
ITEM 6
ITEM 6 - SELECTED FINANCIAL DATA
(In thousands, except per share amounts)
The selected financial data set forth below for each of the years in the five-year period ended December 31, 2006, are derived from our audited consolidated financial statements. The selected financial data set forth below should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and our 2006, 2005 and 2004 financial statements and notes thereto included elsewhere in this Form 10-K.
ITEM 7
ITEM 7 - MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
The following discussion of our financial condition and results of operations should be read in conjunction with our consolidated financial statements and the related notes to the financial statements included elsewhere in this Form 10-K. This discussion contains forward-looking statements based on current expectations that are subject to risks and uncertainties, such as statements of our plans, objectives, expectations and intentions. Our actual results and the timing of events could differ materially from those anticipated or implied by the forward-looking statements discussed here as a result of various factors, including, among others, those set forth under the “Cautionary Note Regarding Forward-Looking Statements” herein. You should not place undue reliance on these forward-looking statements, which speak only as of the date of this report. You should also consider the items discussed in Item 1A - Risk Factors, included in this Form 10-K. Except as required by law, we undertake no obligation to update any of the forward-looking statements in this discussion after the date of this report.
Encysive Pharmaceuticals Inc. is a biopharmaceutical company that engages in the discovery, development and commercialization of novel, synthetic, small molecule compounds to address unmet medical needs. We focus our research and development programs predominantly on the treatment and prevention of interrelated diseases of the vascular endothelium and exploit our expertise in the area of the intravascular inflammatory process, referred to as the inflammatory cascade, and vascular diseases. We are a multinational company with revenues from an approved product in the EU, and sales and marketing operations in several EU countries. We have successfully developed one FDA, approved drug, Argatroban, for the treatment of HIT, which is licensed to and marketed by GSK. Our lead drug candidate, Thelin™ (sitaxsentan sodium) is an endothelin receptor antagonist for the treatment of PAH. Thelin™ has received marketing authorization in the EU and Australia, and is under review by the FDA in the United States and by regulatory authorities in Canada.
Critical Accounting Policies
Revenue Recognition
We recognize royalty revenue as a licensee sells products and we have received sufficient information to record a receivable. Our royalty revenue is based on net sales of product, that is, sales net of discounts, returns and allowances. Argatroban is licensed to GSK, which distributes and sells the product, and from which Royalty Sub receives a quarterly royalty payment. At the time of each payment, GSK provides us with limited quarterly data related to the product’s gross sales, sales returns, discounts and allowances. While we are informed of the amount of product returns recorded each quarter, we do not have information necessary to identify the period or periods to which such returns correspond. We believe that substantially all discounts and allowances pertain to current period sales. We also believe that a portion of sales recorded in each period will ultimately be returned, and therefore estimate future returns and their impact on royalty revenues. In the pharmaceutical industry, product returns are primarily influenced by remaining or expired shelf life, product withdrawals or recalls, significant price changes from competitors or the introduction of generic products or other new competition. We are not aware of any pending product recalls or withdrawals, significant price fluctuations or generic or new competition. Accordingly, we have estimated only the impact of product dating on returns.
Since we do not manufacture, sell or distribute Argatroban, we do not have information related to levels of inventory in the distribution channels. However, due to the cost of the drug and pressures on hospitals to minimize operating expenditures, we believe inventory levels are maintained at a minimally acceptable level. Inventory level is therefore not a part of our estimate process.
We have estimated remaining shelf life, which is an important reason for product returns, based upon the fact that Argatroban has an expiration date of two years from manufacture. Common industry practice is that prescription drugs can be returned to the manufacturer at any time; however, product is normally returned when the remaining shelf life is reduced to six months or less. Our reserve is therefore based upon an estimate of the percentage of sales made in the preceding 18-month period that may be returned in future periods. Initially, lacking any historical sales data for Argatroban and based upon management’s experience with other pharmaceutical products in the industry, management estimated that four percent of gross sales of Argatroban would be returned during future periods. Based upon subsequent analysis of historical sales data, we believe that differences between estimated and actual future returns will not have a material effect upon our results of operations or financial condition.
•
Revenue from collaborative research and development activities is recognized as services are performed.
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We defer the recognition of milestone payments related to contractual agreements that are still in the development stage. Such deferred revenues are amortized into income over the estimated remaining development period. Milestone payments received under contractual agreements which have completed the development stage are evaluated, and either recognized into income when earned, or amortized over a future period, depending upon whether we continue to have obligations under the terms of the arrangement.
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License fees received under the terms of licensing agreements for our intellectual property are deferred and amortized into income over the estimated development period of the licensed item or items.
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Revenue from grants is recognized as earned under the terms of the related grant agreements, typically as expenses are incurred.
•
Revenue from sales of Thelin™ is recognized when product is shipped and title transfers to the customer. Sales revenue is reported net of discounts, allowances, and returns, but included VAT charged to customers.
Amounts received in advance of services being performed under contracts are recorded as deferred revenue, and recognized as services are performed. We periodically evaluate our estimates of remaining development periods, and adjust the recognition of remaining deferred revenues over the adjusted development period remaining. At December 31, 2006, remaining deferred revenue was approximately $1.3 million, which we expect to recognize over the next 12 months. A future change in our estimate of development periods could accelerate or decelerate the timing of future recognition of deferred revenue.
Cost of goods sold
We began pre-license sales of Thelin™ in the U.K. in July 2006 utilizing the services of a third party. After receipt of marketing approval by EMEA in August 2006, Thelin™ became commercially available through third party distributors in the U.K. and in Germany during late 2006. Cost of goods sold is comprised of the direct cost of inventory consumed, along with the fees associated with the third party.
Share-Based Payments
At December 31, 2006, we had five stock-based compensation plans for employees and non-employee directors. Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB25”). Share-based employee compensation expense related to stock options was not recognized in the Company’s consolidated statements of earnings prior to January 1, 2006, as all stock option awards granted under the plans had an exercise price equal to the market value of the common stock on the date of the grant. Effective January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”) using the modified prospective transition method. Under this transition method, compensation expense recognized during year 2006, included: (i) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation” (“FAS 123”), and (ii) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with FAS 123R. In accordance with the modified prospective transition method, results for prior periods have not been restated. The adoption of FAS 123R resulted in a reduction of net earnings of $5,294,000, or $0.09 per share basic and diluted, in year 2006, arising from unvested stock options. See Note 9 to the Consolidated Financial Statements included herein for further detail on the impact of FAS 123R on the Company’s Consolidated Financial Statements.
Drug Manufacturing and Packaging
Costs arising from the manufacturing and packaging of drug product, which is intended for use in clinical trials, are recognized as incurred and included in research and development expenses. We capitalize inventory costs associated with certain products prior to regulatory approval and product launch, based on management’s judgment of probable future commercial use and net realizable value. We could be required to expense previously capitalized costs related to pre-approval or pre-launch inventory upon a change in such judgment, due to a denial or additional delays of approval by regulatory bodies, additional delays in commercialization, or other potential factors. At December 31, 2006, we determined, based upon inventory production plans, expiration dates of product on hand and projected future sales, that we should record a reserve for inventory obsolescence of approximately $496,000. At December 31, 2006, we had $2.3 million of capitalized inventory costs, net of the reserve for obsolescence.
Costs Related to Issue of Long-Term Debt
Costs incurred in the issuance of the Convertible Notes, primarily comprised of initial purchasers’ discounts, legal and other professional fees have been deferred, and will be amortized and reported as a component of interest expense during the periods beginning with the issuance date of the Convertible Notes to the date that we have the ability to call the debt.
Results of Operations
The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires us to make estimates and assumptions that affect the reported amounts of assets, liabilities, disclosures of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Our operating results have fluctuated significantly during each quarter and year, and we anticipate that such fluctuations, which are largely attributable to increasing commercialization expenditures, will continue for the next several years. We have been
unprofitable to date and expect to make substantial expenditures during the next several years as we invest in launching Thelin™ in Europe, and maintenance of the commercial infrastructure necessary to launch Thelin™ in the U.S.
We have sustained net losses of approximately $422.3 million from the date of our inception to December 31, 2006. We have primarily financed our operations to date through a series of private placements and public offerings of our common stock and convertible debt, debt issued by our subsidiary that is secured by royalties on Argatroban and from funds received through our collaborations, research agreements and partnerships. See discussion of “Liquidity and Capital Resources” below.
In April 2005, the stockholders of Revotar, our former majority-owned German subsidiary, agreed to restructure Revotar’s capitalization. Following the completion of the Restructuring, our Consolidated Financial Statements no longer include the results of Revotar. We recorded a gain of approximately $1.7 million upon its disposal of Revotar, which is included in the amount reported under the caption “Gain (loss) from discontinued operations” in our financial statements for year 2005. For additional information about Revotar, see Note 14 to the Consolidated Financial Statements included herein. Results for years 2004 and 2003 have been restated to reflect the classification of Revotar as a discontinued operation during 2005, with no change in reported net loss.
Year ended December 31, 2006, Compared with Year ended December 31, 2005
Revenues
Revenues in year 2006 increased $5.0 million, to $19.0 million from $14.0 million in year 2005. The increase is primarily due to higher royalties earned on higher sales of Argatroban by GSK in year 2006. Royalties increased to $17.4 million, from $12.9 million in 2005. As a result of the recent sale of the Argatroban Notes by our subsidiary, future royalty revenues from sales of Argatroban will be used to pay interest and to repay the Argatroban Notes, and will not be available to fund our operations until the Argatroban Notes are repaid in full.
We began pre-license sales of Thelin™ in the U.K. in July 2006 utilizing the services of a third party. After receipt of marketing approval by EMEA in August 2006, Thelin™ became commercially available through third party distributors in the U.K. and in Germany during late 2006. We reported sales of Thelin™ of approximately $0.3 million in 2006.
We have just started to commercialize Thelin™ in Europe, and as such, cannot make any sales projections or financial forecasts. As the outcome of our regulatory filings with the FDA and other regulatory authorities is uncertain, we are unable to project revenues for Thelin™ in the U.S. and other countries. Even though we have received regulatory approval to market Thelin™ in Europe, and are hopeful that we may receive regulatory approval to market Thelin™ in the U.S., significant uncertainties make it difficult to forecast or predict future sales. These uncertainties include the market acceptance of Thelin™, reimbursement policies of third-party payers and the speed with which government or other third-party payers grant pricing and reimbursement approvals, competitive activity, the timing of competitive product approvals, and other factors impacting the timing and speed of our product launch, could materially affect any revenue projections
Cost of Goods Sold
Cost of goods sold in 2006 of approximately $0.1 million was primarily comprised of the cost to manufacture, finish and package Thelin™ sold in Europe.
Research and Development Expenses
Research and development expense in 2006 was comparable to 2005, and was primarily comprised of the costs of ongoing long-term safety studies of Thelin™, and with expenses related to various regulatory submissions for Thelin™. As discussed below, we have restricted research and development activities to those necessary to maintain our existing programs, and have deferred additional projects until the second half of 2007. If we do not receive FDA approval to sell Thelin™ in the U.S., we may be required to make further reductions in our research and development activities. If we do receive FDA approval and are successful in obtaining additional funding, research and development activities in 2007 would remain significant as we would expect to continue to invest in our research pipeline.
Sales and Marketing Expenses
Sales and marketing expenses increased to $41.4 million in 2006 from $16.0 million in 2005. The increase was primarily due to costs associated with preparation for the commercial launch in the EU and the anticipated commercial launch of Thelin™ in the U.S. This included the addition of a U.S. sales force and related sales launch preparation activities. We have made Thelin™ commercially available in the U.K. and Germany, are actively preparing for the commercial launch of Thelin™ throughout Europe, having added a vice president of European sales and marketing and a European headquarters staff. We have hired a sales force in the U.K. and in Germany. We expect sales and marketing expenses in 2007 to continue to increase over 2006, as we commercially launch Thelin™ in Europe. As discussed in Liquidity and Capital Resources below, our current liquidity position will limit our commercialization activities in the U.S. to those that we deem necessary to maintain the ability to commercially launch Thelin™ in the U.S. if we receive FDA approval. If we do receive FDA approval and are successful in obtaining additional funding, sales and marketing expenses in
2007 would reflect additional expenditures necessary to commercially launch Thelin™ in the U.S. If we do not receive FDA approval, we may be required to make significant reductions in our commercial infrastructure in the U.S.
General and Administrative Expense
General and administrative expense increased to $22.3 million in 2006, from $12.3 million in 2005. The increase is primarily due to costs associated with the anticipated commercial launch of Thelin™, including increases in staff, in the U.S. and Europe, travel, consulting, legal and other professional services. We expect general and administrative expenses in 2007 to increase over 2006 as we continue to build the infrastructure to commercially operate in Europe. As discussed in Liquidity and Capital Resources below, we will restrict general and administrative activities in the U.S. to those that we deem essential to maintain our operations. If we do not receive FDA approval, however, we may be required to make significant reductions in our administrative infrastructure in the U.S.
Total Operating Expenses
Total operating expenses increased $36.5 million in 2006, compared with 2005. The increase is primarily due to preparations for the commercial launch of Thelin™ in Europe and in the U.S., if we receive regulatory approval.
Operating loss
Operating loss increased by $31.5 million in 2006 compared with 2005, primarily due to increased operating expenses in 2006.
Investment Income
Investment income in 2006 declined $0.9 million in 2006 compared with 2005, primarily due to reduced levels of funds available for investment.
Interest Expense
Interest expense is primarily comprised of interest on the Convertible Notes. Interest expense increased $0.8 million in 2006 compared with 2005, as the Convertible Notes were outstanding for the entire year of 2006 and for nine months in 2005.
Loss from Continuing Operations
Loss from continuing operations increased $33.2 million in 2006 compared with 2005, primarily due to expenses incurred in 2006 for the anticipated commercial launch of Thelin™ in Europe and in the U.S., if we receive regulatory approval.
Gain from Discontinued Operations
We recorded a gain from discontinued operations in 2005 due to the Restructuring of Revotar. For additional information on the Restructuring, see Note 14 to the Consolidated Financial Statements included herein. In 2005 and 2004, Revotar lost, net of minority interest, $0.4 million and $0.9 million, respectively.
Net Loss Before Cumulative Effect of Accounting Principle
Net loss before cumulative effect of accounting principle increased $34.5 million compared with 2005, primarily due to expenses incurred in 2006 for the anticipated commercial launch of Thelin™ in Europe and the U.S., if we receive regulatory approval.
Cumulative effect of Change in Accounting Principle
Prior to the Company’s adoption of FAS 123R, if unvested shares of restricted common stock were forfeited, the Company reversed any compensation expense that it had previously recorded on those shares at the time of forfeiture. Upon the adoption of FAS 123R, the Company will adjust the amount of expense recorded each period, based upon its estimate of future forfeitures. The cumulative effect of estimating future forfeitures of unvested restricted common shares granted before January 1, 2006, was $107,000, which is reported as a cumulative effect of change in accounting principle during 2006.
Net Loss
Net loss increased $34.4 million compared with 2005, primarily due to expenses incurred in 2006 for the anticipated commercial launch of Thelin™ in Europe and the U.S., if we receive regulatory approval.
Year ended December 31, 2005, Compared with Year ended December 31, 2004
Revenues
Revenues in year 2005 increased $1.2 million, to $14.0 million from $12.8 million in year 2004. The increase is primarily due to higher royalties earned on higher sales of Argatroban by GSK in year 2005. Royalties increased to $12.9 million, from $10.6 million in 2004. License fees, milestones and grants increased $0.4 million in year 2005, due to receipt of an additional milestone payment from Schering-Plough in March 2005. The increased royalties and license fees, milestones and grants were partially offset by the end
of research support from Schering-Plough, which terminated June 30, 2004. In 2004, we received $1.5 million in research support from Schering-Plough.
Research and Development Expenses
Research and development expenses increased $7.0 million, to $63.5 million in 2005 from $56.4 million in 2004. The increase is primarily related to Thelin™ clinical trials, and expenses associated with regulatory submissions for Thelin™.
Sales and Marketing Expenses
Sales and marketing expenses increased $12.8 million in 2005 to $16.0 million, compared with $3.1 million in 2004. During 2005, we began building the commercial infrastructure to support the commercial launch of Thelin™ in the U.S. Such costs include the addition of a vice president of sales, a U.S. sales force, and support staff.
General and Administrative Expenses
General and administrative expenses increased to $12.3 million in 2005 from $8.4 million in 2004. The increased expense in year 2005 resulted from costs associated with building the commercial infrastructure to support the anticipated commercial launch of Thelin™ in 2006. Such costs include the addition of several key management appointments, including a chief financial officer, chief operating officer, general counsel and additional support staff.
Operating Loss
Operating loss increased $22.6 million, to $77.8 million in 2005 from $55.2 million in 2004. The increased operating loss is primarily due to costs associated with building the commercial infrastructure to support the anticipated commercial launch of Thelin™, and higher research and development expenses discussed above, partially offset by higher revenues in 2005.
Investment Income
Investment income increased to $4.7 million in 2005, from $1.5 million in 2004, as we invested proceeds from the sale of $130 million in Convertible Notes in March 2005.
Interest Expense
Interest expense of $3.1 million in 2005 is comprised of interest and amortized debt issue costs on the Convertible Notes. For additional information on the Convertible Notes, see Note 7 to the consolidated financial statements, included herein.
Loss from Continuing Operations
Loss from continuing operations of $76.2 million in 2005 and $53.7 million in 2004 is comprised of the operating loss, discussed above, and interest expense, partially offset by investment income.
Gain (Loss) from Discontinued Operations
We recorded a gain from discontinued operations in 2005 due to the Restructuring of Revotar. For additional information on the Restructuring, see Note 14 to the consolidated financial statements. In 2005 and 2004, Revotar lost, net of minority interest, $0.4 million and $0.9 million, respectively.
Net Loss
Net loss increased to $74.9 million in 2005, from $54.7 million in 2004, due to higher interest and operating expenses in 2005, partially offset by higher revenues and a gain on the disposition of Revotar.
Liquidity and Capital Resources
While the Consolidated Financial Statements included herein have been prepared assuming that we will continue as a going concern, because of our losses and need for additional financing to execute our business strategy, our independent auditor’s report on our Consolidated Financial Statements contains a statement relating to their substantial doubt about our ability to continue as a going concern. At December 31 2006, we had cash and investments of $43.8 million, and at March 1, 2007, after the receipt of net proceeds from the sale by Royalty Sub of the Argatroban Notes described below, we had cash and cash equivalents of approximately $71.9 million. To date, we have financed our research and development activities and other operations primarily through public and private offerings of common stock, including an equity financing line with Azimuth; proceeds from the issuance and sale of our Convertible Notes; funds received through collaborations, research agreements, licenses and partnerships; royalty revenue from sales of Argatroban; and the recent sale by Royalty Sub of the Argatroban Notes. Although, we have recently received additional funds from our equity financing line with Azimuth described below and from the sale by Royalty Sub of the Argatroban Notes, we will require additional funding to continue to operate as a going concern, whether or not Thelin™ is approved in the U.S. by the FDA, as described
in more detail below. Subject to certain conditions, we may issue and sell up to 8,780,500 shares of our common stock to Azimuth under the equity financing line and may receive $10 million upon the confirmation of treaty relief from U.K. withholding obligations pursuant to the terms of the Argatroban Notes. We may also issue common stock, debt, or other securities for gross aggregate proceeds of $95.5 million pursuant to our effective shelf registration statement. However, we cannot assure you that such funding will be available under commercially acceptable terms.
Outlook for 2007
Until recently, the majority of our financial resources have been dedicated to the research and development of Argatroban, Thelin™ and other drug compounds. Beginning in 2005, we have spent an increasing percentage of our financial resources on preparations for the anticipated commercial launch of Thelin™ in the U.S., and more recently, in building the commercial infrastructure necessary to successfully launch Thelin™ in Europe. As described below, this trend is expected to continue as we expand our commercial organization in Europe and continue to invest in U.S. launch preparations for Thelin™. While we continue to invest in developing several new drug compounds, we currently do not have any drug candidates that are likely to be commercialized in the near future other than Thelin™.
We have just started to commercialize Thelin™ in Europe, and as such, cannot make any projections or financial forecasts of sales or operating expenses. We believe, however, that the commercial launch of Thelin™ in Europe and the anticipated launch of Thelin™ in the U.S. and other countries will require additional funding due to higher levels of sales and marketing expenditures, particularly in Europe, than in recent periods. As the outcomes of our regulatory filings with the FDA and other regulatory authorities are uncertain, we are unable to project revenues for Thelin™ in the U.S. and other countries. Even though we have received regulatory approval to market Thelin™ in Europe, significant uncertainties make it difficult to forecast or predict future sales. These uncertainties include the market acceptance of Thelin™, the reimbursement policies of third-party payors, the speed with which government or other third-party payors grant pricing and reimbursement approvals, competitive activity, the timing of competitive product approvals, and other factors impacting the timing and speed of our product launch, all of which could materially affect any revenue projections.
Based upon our current cash position of $71.9 million as of March 1, 2007 and expected future cash requirements, we will require additional funding in 2007 in order to continue our ongoing research and development programs, and to fund the commercial launch of Thelin™ in Europe, whether Thelin™ is approved in the U.S. by the FDA or not. Because the FDA has designed Thelin™ as a Class 2 resubmission and assigned a new PDUFA action date of June 15, 2007, we believe that additional funding will be significantly more difficult to obtain on commercially acceptable terms, if at all. We are considering various alternatives to reduce our expenses in order to sustain our cash resources. Those measures include scaling back personnel and expenses, delaying or terminating research and development programs, curtailing capital expenditures, and reducing other operating expenses. We may also consider relinquishing, licensing or otherwise disposing of rights to technologies or product candidates that we could otherwise seek to develop or commercialize ourselves on terms that are less favorable than might otherwise be available or at an earlier stage than would otherwise be desirable, including the possibility of licensing rights to Thelin™ outside North America and Europe. Even if Thelin™ is approved by the FDA, we believe that we will require additional funding for increased spending required to commercially launch Thelin™ in the U.S.
If we receive approval by the FDA to market Thelin™ in the U.S., and if we are successful in obtaining additional funding, we believe that our operating expenses will exceed those incurred in 2006. If we do not receive approval by the FDA, we may be required to restructure our operations to significantly reduce our operating expenses. In any event, we anticipate that we will continue to incur operating losses throughout 2007.
Years 2006 and 2005
Cash Flows from Operating Activities
At December 31, 2006, we had cash, cash equivalents and investment securities of $43.8 million compared with $127.9 million at December 31, 2005. We used $100.5 million in cash from operating activities in year 2006 compared to cash used by operating activities of $66.1 million in 2005. The primary operating uses of cash in 2006 were to fund the building of a corporate infrastructure to support the anticipated commercial launch of Thelin™, pay interest on to the Convertible Notes, fund our general operating expenses and the ongoing research and development programs, reduced by cash received from investment income.
Cash Flows from Investing Activities
Investing activities are primarily comprised of our investments in debt securities. Cash is generated from investment activities when marketable securities mature, the resulting cash is utilized primarily to fund operating activities. Investing activities in 2006 consisted of purchases of equipment of $2.1 million. To maximize liquidity in 2006, we invested our available funds in cash equivalent securities, having original maturities of less than 90 days. In 2005, we generated $20.8 million in investing activities, reflecting the maturities of marketable debt securities, partially offset by purchases of equipment and leasehold improvements of $2.1 million.
Cash Flows from Financing Activities
Cash provided by financing activities in year 2006 was $18.4 million, compared with $127.1 million in 2005. Financing activities in 2006 consisted of net proceeds from two draw-downs under our equity financing line with Azimuth described below totaling $17.8 million, and $0.6 million proceeds from the exercise of employee stock options. Financing activities in year 2005 primarily consisted of net proceeds from the sale of the Convertible Notes, and proceeds from the exercise of employee stock options of $1.7 million. See Note 7 to our Consolidated Financial Statements included herein for additional information on the Convertible Notes.
On October 19, 2006, we entered into an equity financing line with Azimuth pursuant to which Azimuth is committed to purchase up to $75 million shares of our common stock or 11,866,851 shares of our common stock, whichever occurs first, over the 18-month term of the financing line, subject to certain conditions. To date, we have closed two draw-down requests under the financing line pursuant to which we received aggregate net proceeds of approximately $17.8 million, after deducting estimated offering expenses, and issued an aggregate of 3,086,351 shares of our common stock. We can sell and issue up to 8,780,500 additional shares to Azimuth prior to the expiration of the financing line, subject to certain conditions.
On February 6, 2007, our wholly owned subsidiary, Royalty Sub, issued the Argatroban Notes, for which we received approximately $56 million of net proceeds, after deducting transaction costs, of which $10 million was withheld from us pending confirmation of treaty relief from U.K. withholding tax obligations. Once tax treaty relief is confirmed, the amount withheld will be released to us. If tax treaty relief is not received by March 23, 2008, the amount withheld will be used to pay interest on and principal of the Argatroban Notes. See Note 2 to the Consolidated Financial Statements included herein for a more complete description of the terms of the Argatroban Notes.
We also have an effective shelf registration statement, under which we could be eligible to issue common stock, debt, or other securities for gross aggregate proceeds of up to $95.5 million. We cannot assure you whether any of these financing arrangements will be available under commercially acceptable terms, if at all.
Contractual Obligations
At December 31, 2006, our material contractual obligations were comprised of (i) $130 million in 2.5% Convertible Senior Notes, (ii) obligations under our operating lease agreements (see Note 17 to the Consolidated Financial Statements included herein), and (iii) under one research agreement, we could be obligated to pay the other party a termination fee in the event that we elect to terminate the project prior to completion (see Note 17 to the Consolidated Financial Statements). In addition, we are obligated to make semi-annual interest payments on the Convertible Notes of totaling approximately $3.2 million per year.
As of December 31, 2006, the Company had contractual obligations as follows (in thousands):.
In addition to the above, Royalty Sub is obligated to repay $60 million in Argatroban Notes, which were issued in February 2007. See Note 2 to the Consolidated Financial Statements included herein for a more complete description of the terms of the Argatroban Notes.
Off-Balance Sheet Arrangements
We do not engage in off-balance sheet financing arrangements.
Impact of Inflation and Changing Prices
The pharmaceutical research industry is labor intensive and wages and related expenses increase in inflationary periods. The lease of space and related building services for the Houston facility contains a clause that escalates rent and related services each year based on the increase in building operating costs and the increase in the Houston Consumer Price Index, respectively. To date, inflation has not had a significant impact on our operations.
ITEM 7A
ITEM 7A - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Foreign Currency Exchange Risk
We are exposed to market risk primarily from changes in foreign currency exchange rates. We have contracts with entities in other areas outside the U.S. that are denominated in a foreign currency. To date, these currencies have not fluctuated materially.
ITEM 8
ITEM 8 - FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The financial statements we are required to include in this Item 8 are set forth in Item 15 of this Form 10-K and are incorporated by reference.
ITEM 9
ITEM 9 - CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
Not applicable.
ITEM 9A
ITEM 9A - CONTROLS AND PROCEDURES
Controls and Procedures
As of the end of the period covered by this report, our management carried out an evaluation, with the participation of our principal executive officer (the “CEO”) and our principal financial officer (the “CFO”), of the effectiveness of our disclosure controls and procedures pursuant to Rule 13a-15 of the Securities Exchange Act of 1934. Based on those evaluations, the CEO and CFO believe:
(i) that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including the CEO and CFO, as appropriate to allow timely decisions regarding required disclosure; and
(ii) that our disclosure controls and procedures are effective.
Management’s Report on Internal Control over Financial Reporting
Our management is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934, as amended). Our management assessed the effectiveness of our internal control over financial reporting as of December 31, 2006. In making this assessment, our management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (“COSO”) in Internal Control-Integrated Framework. Based on the assessment, our management believes that as of December 31, 2006, our internal control over financial reporting is effective based on these criteria. Our independent registered public accounting firm, KPMG LLP, has issued an audit report on our assessment of our internal control over financial reporting that is included herein at page.
Our management, including our CEO and CFO, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints and the benefit of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Encysive have been 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.
Changes in Internal Control Over Financial Reporting
There were no changes in our internal control over financial reporting during the quarter ended December 31, 2006, that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.
ITEM 9B
ITEM 9B - OTHER INFORMATION
None.
PART III
ITEM 10
ITEM 10 - DIRECTORS, EXECUTIVE OFFICERS AND CORPORATE GOVERNANCE
Incorporated herein by reference to Encysive’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 9, 2007.
ITEM 11
ITEM 11 - EXECUTIVE COMPENSATION
Incorporated herein by reference to Encysive’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 9, 2007.
ITEM 12
ITEM 12 - SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDER MATTERS
Incorporated herein by reference to Encysive’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 9, 2007.
ITEM 13
ITEM 13 - CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS, AND DIRECTOR INDEPENDENCE
Incorporated herein by reference to Encysive’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 9, 2007.
ITEM 14
ITEM 14 - PRINCIPAL ACCOUNTING FEES AND SERVICES
Incorporated herein by reference to Encysive’s definitive Proxy Statement for the Annual Meeting of Stockholders to be held on May 9, 2007.
PART IV
ITEM 15
ITEM 15 - EXHIBITS, FINANCIAL STATEMENT SCHEDULES
(a) 1. Index to Consolidated Financial Statements
Reference is made to the Consolidated Financial Statements, the reports thereon, and the notes thereto commencing at Page of this Annual Report on Form 10-K. Set forth below is an index to such Financial Statements.
2. Financial Statement Schedules
All other schedules have been omitted since the information is not required or is not material to require submission of the schedule, or because the information is included in the financial statements or the notes thereto.
3. Index to Exhibits
Information with respect to this Item is contained in the attached Index to Exhibits which is incorporated herein by reference.
The Company will furnish a copy of any one or more of these exhibits to a shareholder who so requests upon receipt of payment for the costs of duplication and mailing the requested item.
(b) Exhibits
See Item 15(a)(3) above.
(c) Financial Statement Schedules
None.
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, in the City of Houston and State of Texas on the 15th day of March, 2007.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below on behalf of the registrant and in the capacities indicated on the 15th day of March, 2007.
Signature
Title
/s/ John M. Pietruski
John M. Pietruski
Chairman of the Board of Directors
/s/ Bruce D. Given
Bruce D. Given, M.D.
Director, President and Chief Executive Officer
(Principal Executive Officer)
/s/ Richard A.F. Dixon
Richard A.F. Dixon, Ph.D.
Director and Senior Vice President, Research and
Chief Scientific Officer
/s/ Gordon H. Busenbark
Gordon H. Busenbark
Chief Financial Officer
(Principal Financial and Accounting Officer)
/s/ Ron J. Anderson
Ron J. Anderson, M.D.
Director
/s/ J. Kevin Buchi
J. Kevin Buchi
Director
/s/ Robert J. Cruikshank
Robert J. Cruikshank
Director
/s/ John H. Dillon II
John H. Dillon II
Director
/s/ Suzanne Oparil, M.D.
Suzanne Oparil, M.D.
Director
/s/ James A. Thomson
James A. Thomson, Ph.D.
Director
/s/ James T. Willerson
James T. Willerson, M.D.
Director
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Encysive Pharmaceuticals Inc.:
We have audited the accompanying consolidated balance sheets of Encysive Pharmaceuticals Inc. and subsidiaries (the Company) as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive loss, stockholders’ equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2006. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements 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 consolidated financial statements referred to above present fairly, in all material respects, the financial position of Encysive Pharmaceuticals Inc. and subsidiaries as of December 31, 2006 and 2005, and the results of their operations and their cash flows for each of the years in the three-year period ended December 31, 2006, in conformity with U.S. generally accepted accounting principles.
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of Encysive Pharmaceuticals Inc.’s internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 15, 2007 expressed an unqualified opinion on management’s assessment of, and the effective operation of, internal control over financial reporting.
The accompanying consolidated financial statements have been prepared assuming that the Company will continue as a going concern. As discussed in Note 1 to the financial statements, the Company has suffered recurring losses from operations and has a net capital deficiency that raise substantial doubt about its ability to continue as a going concern. Management’s plans in regard to these matters are also described in Note 1. The consolidated financial statements do not include any adjustments that might result from the outcome of this uncertainty.
As discussed in Notes 3 and 9 to the consolidated financial statements, effective January 1, 2006, the Company adopted the fair value method of accounting for stock-based compensation as required by Statement of Financial Accounting Standards No. 123(R), Share-Based Payment.
Houston, Texas
March 15, 2007
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
Encysive Pharmaceuticals Inc.:
We have audited management’s assessment, included in the accompanying Management’s Report on Internal Control over Financial Reporting appearing under Item 9A, that Encysive Pharmaceuticals Inc. maintained effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSCO). Encysive 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 Encysive Pharmaceuticals Inc. maintained effective internal control over financial reporting as of December 31, 2006, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Also, in our opinion, Encysive Pharmaceuticals Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2006, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated balance sheets of Encysive Pharmaceuticals Inc. and subsidiaries as of December 31, 2006 and 2005, and the related consolidated statements of operations and comprehensive loss, stockholders’ equity (deficit), and cash flows for each of the years in the three-year period ended December 31, 2006, and our report dated March 15, 2007 expressed an unqualified opinion on those consolidated financial statements.
Houston, Texas
March 15, 2007
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED BALANCE SHEETS
($ in thousands, except share data)
See accompanying Notes to Consolidated Financial Statements.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF OPERATIONS
AND COMPREHENSIVE LOSS
($ in thousands, except per share data)
See accompanying Notes to Consolidated Financial Statements.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
For the years ended December 31, 2006, 2005 and 2004
($ in thousands)
See accompanying Notes to Consolidated Financial Statements.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY (DEFICIT)
For the years ended December 31, 2006, 2005 and 2004
($ in thousands)
See accompanying Notes to Consolidated Financial Statements.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
CONSOLIDATED STATEMENTS OF CASH FLOWS
($ in thousands)
See accompanying Notes to Consolidated Financial Statements.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) Liquidity and Management’s Plans
The accompanying consolidated financial statements have been prepared assuming that Encysive Pharmaceuticals Inc. (the “Company” or “Encysive”), a Delaware corporation, will continue to operate as a going concern. The Company has sustained losses since its formation, and at December 31, 2006 had a stockholder’s deficit of $93,717,000. In order to continue as a going concern, the Company will need to receive additional funding, whether Thelin™ is approved by the U.S. Food and Drug Administration (“FDA”) or not. Management has entered into two financing arrangements, discussed below, to providing additional liquidity, however the Company will require additional funding, reduce its operating expenses, or both in order to continue to operate. There can be no assurance that such additional funding will be available on commercially acceptable terms.
On October 19, 2006, the Company entered into a Common Stock Purchase Agreement, (the “Azimuth Agreement”) with Azimuth Opportunity Ltd. (“Azimuth”), which provides that, upon the terms and subject to the conditions set forth therein, Azimuth is committed to purchase up to $75,000,000 of common stock, or 11,866,851 shares of the Company’s common stock as of October 19, 2006, whichever occurs first, over the 18-month term of the Azimuth Agreement. To date, the Company has closed two draw down requests under the Azimuth Agreement and has received aggregate gross proceeds of approximately $18 million and net proceeds of approximately $17.8 million after deducting estimated offering expenses. The Company has issued an aggregate of 3,086,351 shares of the Company’s common stock to Azimuth from the two draw down requests, and could issue up to an additional 8,780,500 shares under the terms of the Azimuth Agreement.
On February 6, 2007, the Company’s wholly owned subsidiary, Argatroban Royalty Sub LLC, closed a private placement of $60 million in aggregate principal amount of promissory notes, to institutional investors. Net proceeds from the financing were approximately $56.6 million after transaction costs, of which $10 million was withheld from pending confirmation of treaty relief from U.K. withholding tax obligations. Once tax treaty relief is confirmed, the amount withheld will be released to the Company. If tax treaty relief is not received by March 23, 2008, the withheld amount will be used to pay interest on and principal of the promissory notes. For additional information, refer to Note 2, below.
The Company has an effective shelf registration statement on Form S-3, under which it could issue additional common stock, debt, or other securities for gross aggregate proceeds of up to $95.5 million.
These matters raise substantial doubt about the Company’s ability to continue as a going concern. These consolidated financial statements do not include the adjustments that would be necessary should the Company be unable to continue as a going concern.
(2) Subsequent Event
On February 6, 2007, the Company, pursuant to the terms of a purchase and sale agreement, sold, assigned and contributed to Argatroban Royalty Sub LLC, a Delaware limited liability company and newly formed, wholly owned subsidiary of the Company (“Royalty Sub”), the rights of the Company to collect the Royalty Payments (defined below) payable to the Company under the Principal Documents (defined below), in exchange for approximately $56.6 million in cash, of which $10.0 million was deposited into a “Holdback Account” pending receipt of the U.K. Tax Confirmation (defined below), and a capital contribution by the Company to Royalty Sub in an amount equal to the excess of the agreed fair market value of the Royalty Payments over the amount of the cash portion of the purchase price. Also on February 6, 2007, Royalty Sub issued an aggregate principal amount of $60.0 million of its Argatroban PhaRMASM Secured 12% Notes due 2014 (the “Argatroban Notes”) to certain institutional investors in a private placement pursuant to Section 4(2) of the Securities Act of 1933, as amended (the “Securities Act”).
The Royalty Payments arise under the (i) Product Development, License and Copromotion Agreement dated as of August 5, 1997, as amended (the “GSK License Agreement”), between GlaxoSmithKline plc, a public limited company organized in England (“GSK”), and the Company, (ii) Mitsubishi-TBC-SB Agreement dated as of August 5, 1997 (the “Three-Party Agreement”), among the Company, Mitsubishi Pharma Corporation, a Japanese corporation, and GSK and (iii) other related agreements (collectively with the GSK License Agreement and the Three-Party Agreement, the “Principal Documents”), and include the right to receive royalties and certain other payments (the “Royalty Payments”) from sales in the United States (including Puerto Rico and its other territories and possessions) and Canada (collectively, the “Territory”) of Argatroban. Argatroban is marketed and sold in the Territory by GSK. The purchase and sale agreement includes typical provisions regarding representations and warranties, affirmative and negative covenants consistent with the Company’s obligations under the Principal Documents, indemnification and other matters typically addressed in similar agreements.
The Argatroban Notes are subject to an Indenture, dated as of February 6, 2007 (the “Indenture”), between Royalty Sub and U.S. Bank National Association, as Trustee (the “Trustee”). The Indenture provides for $60 million in aggregate principal amount of the Argatroban Notes. Except as described below, the Royalty Payments are the sole source of payment for the Argatroban Notes, and the Company is not an obligor or guarantor of the Argatroban Notes. Principal on the Argatroban Notes must be paid in full by the final legal maturity date of September 30, 2014, unless redeemed earlier. The interest rate applicable to the Argatroban Notes is 12% per annum (calculated on the basis of a 360-day year consisting of twelve 30-day months) and is payable quarterly in arrears on March 30, June 30, September 30 and December 30 each year, beginning on March 30, 2007 (each, a “Payment Date”). The calculation date for
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
each such Payment Date will be the fifth business day immediately preceding such Payment Date (the “Calculation Date”). Non-payment of principal will not be an event of default prior to September 30, 2014.
Funds in the Holdback Account will be used to pay interest on and principal of the Argatroban Notes (without any premium or penalty) if (x) by March 23, 2008, Royalty Sub has not obtained a confirmation from Her Majesty’s Revenue & Customs of the United Kingdom (“HMRC”) that, under the income tax treaty presently in force between the United Kingdom and the United States, either (i) no United Kingdom income tax is required to be withheld at source on the royalties in respect of sales of Argatroban in the Territory or (ii) if United Kingdom income tax is required to be withheld at source on such royalties, the Company or Royalty Sub is entitled to repayment from HMRC of such tax (the “U.K. Tax Confirmation”), or (y) prior to March 23, 2008, the Company furnishes an officer’s certificate to the Trustee evidencing that the HMRC has declined to furnish the U.K. Tax Confirmation. If United Kingdom income tax is withheld on the royalties paid, neither the Company nor Royalty Sub expects to recognize any reduction in U.S. income tax as a result of such United Kingdom income tax. If the HMRC declines to furnish the U.K. Tax Confirmation, Royalty Sub expects that GSK will withhold United Kingdom income tax on all Royalty Payments to Royalty Sub, including recovery or offset for taxes that should have been withheld from prior payments to Royalty Sub.
The Royalty Payments, together with any funds made available from an account into which capital contributions will be made by the Company, if any, to Royalty Sub (the “Capital Account”) or the Holdback Account in limited circumstances, will be the sole source of payment of principal of, and interest on, the Argatroban Notes.
The Argatroban Notes will be subject to redemption at the option of Royalty Sub on any Payment Date specified by Royalty Sub as provided below, upon payment of the redemption price of the Argatroban Notes to be redeemed (the “Redemption Price”), together with accrued and unpaid interest through the redemption date. The Redemption Price will be calculated as follows. If the applicable redemption of the Argatroban Notes occurs on or prior to December 30, 2007, the Redemption Price will be equal to the greater of (x) the outstanding principal balance of the Argatroban Notes being redeemed and (y) the present value, discounted at the rate on U.S. Treasury obligations with a comparable maturity to the remaining weighted average life of the Argatroban Notes plus 1.0%, of the principal payment amounts and interest at the rate applicable to the Argatroban Notes on the outstanding principal balance of the Argatroban Notes. If the applicable redemption of the Argatroban Notes occurs after December 30, 2007, the Redemption Price will be equal to the percentage of the outstanding principal balance of the Argatroban Notes being redeemed specified below for the period in which the redemption occurs:
See Item 2.03 of the Company’s Current Report on Form 8-K, the contents of which are incorporated herein by reference, filed with the Securities and Exchange Commission on February 8, 2007 for a more complete description of the terms of the Indenture and the Argatroban Notes.
(3) Organization and Significant Accounting Policies
(a) Organization
The Company is a biopharmaceutical company focused on the discovery, development and commercialization of novel synthetic small molecule compounds for the treatment of a variety of cardiovascular, vascular and related inflammatory diseases. Since its formation in 1989, the Company has been engaged principally in research and drug discovery programs and clinical development of certain drug compounds. During the third quarter of 2000, Encysive formed Revotar Biopharmaceuticals AG (“Revotar”), a German corporation, to conduct research and development for novel small molecule compounds and to develop and commercialize Encysive’s selectin antagonists. In May 2005, the Company and the other shareholders of Revotar consummated a restructuring (the “Restructuring”) whereby the Company’s ownership of Revotar was initially reduced to approximately 14%. Subsequently, Revotar’s other stockholders purchased the Company’s remaining Revotar shares for nominal consideration. Financial statements included in this annual report on Form 10-K for prior-year periods have been reclassified to reflect the Restructuring, and report the results of Revotar under the caption “Gain (loss) on discontinued operations.” For additional information about the Restructuring, see Note 14. In 2004, the Company established Encysive (UK) Limited, a private company located in the United Kingdom (UK). In 2006, the Company established Encysive Germany GmbH, a private company located in Germany, Encysive Canada Inc., a private company formed in Canada, and Royalty Sub.
The Company is presently working on a number of long-term development projects that involve experimental and unproven technology, which may require many years and substantial expenditures to complete, and which may or may not be successful. Sales of the Company’s first product, Argatroban, for which royalty income now goes to Royalty Sub, began during November 2000. Sales of Thelin™ (sitaxsentan sodium) in the U.K. and Germany began in the fourth quarter of 2006.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(b) Basis of Consolidation
The Company’s consolidated financial statements include the accounts of the Company and its wholly owned subsidiaries, ImmunoPharmaceutics, Inc. (“IPI”), Encysive, L.P. (“ELP”), EP-ET, LLC, Encysive (UK) Limited, Encysive Germany GmbH, Encysive Canada, Inc. and Royalty Sub. All material intercompany balances and transactions have been eliminated.
(c) Use of Estimates
Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities, revenues and expenses, and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with accounting principles generally accepted in the United States of America. Actual results could differ from these estimates.
(d) Cash, Cash Equivalents and Short-Term Investments
Cash equivalents are considered to be those securities or instruments with original maturities, when purchased, of three months or less and are recorded at cost. Short-term investments consist of debt securities with original maturities of less than one year and greater than three months at the purchase date. The Company classifies all short-term investments as held-to-maturity. Held-to-maturity securities are those securities in which the Company has the ability and intent to hold the security until maturity. Short-term investments are stated at amortized cost plus accrued interest. Interest income is accrued as earned. Investments made at a discount or premium from their stated par values are accreted or amortized to their stated par values over the time remaining until maturity. The Company evaluates the carrying value of its securities by comparing the carrying values of the securities to their market values. In the event that the fair value of a security were to decline below its carrying cost, and in the opinion of management such decline were other than temporary, the Company would record a loss and reduce the carrying value of such instrument to its fair value. Composition of cash and investments was as follows (in thousands):
(e) Equipment and Leasehold Improvements
Equipment and leasehold improvements are stated at cost less accumulated depreciation and amortization. Depreciation of furniture and equipment is provided on the straight-line method over the estimated useful lives of the respective assets (three to ten years). Amortization of leasehold improvements is provided on the straight-line method over the remaining minimum lease term.
(f) Inventory
The Company capitalizes inventory costs associated with certain products prior to regulatory approval and product launch, based on management’s judgment of probable future commercial use and net realizable value. The Company could be required to expense previously capitalized costs related to pre-approval or pre-launch inventory upon a change in such judgment, due to a denial or delay of approval by regulatory bodies, a delay in commercialization, or other potential factors. Inventory balances are relieved by the First-in First-out method. At December 31, 2006, the Company had $2.3 million of capitalized inventory costs, net of a reserve for obsolescence of $0.5 million.
(g) Research and Development Costs
All research and development costs are expensed as incurred and include salaries of research and development employees, certain rent and related building services, research supplies and services, clinical trial expenses and other associated costs. Salaries and benefits in the years ended December 31, 2006, 2005 and 2004, of approximately $20,977,000, $12,723,000, and $9,457,000, respectively, were charged to research and development expenses. Payments related to the acquisition of in-process research and development are expensed as incurred.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(h) Net Loss Per Common Share
Basic net loss per common share is calculated by dividing the net loss applicable to common shares by the weighted average number of common and common equivalent shares outstanding during the period. For the years 2006, 2005 and 2004, there were no potential common equivalent shares used in the calculation of weighted average common shares outstanding as the effect would be antidilutive due to net losses.
(i) Revenue Recognition
Revenue from service contracts is recognized as services are performed. Royalty revenue is recognized as products are sold by a licensee and the Company has received sufficient information to record a receivable. The Company defers the recognition of milestone payments related to contractual agreements that are still in the development stage. Such deferred revenues are amortized into income over the estimated remaining development period. Milestone payments received under contractual agreements which have completed the development stage are evaluated, and either recognized into income when earned, or amortized over a future period, depending upon whether the Company continues to have obligations under the terms of the arrangement. License fees received under the terms of licensing agreements for the Company’s intellectual property are similarly deferred and amortized into income over the estimated development period of the licensed item or items. The Company periodically evaluates its estimates of remaining development periods and adjusts the recognition of remaining deferred revenues over the adjusted development period remaining. Revenue from grants is recognized as earned under the terms of the related grant agreements, typically as expenses are incurred. Amounts received in advance of services being performed under contracts are recorded as deferred revenue and recognized as services are performed. Revenue from sales of Thelin™ is recognized when product is shipped and title transfers to the customer. Sales revenue is reported net of discounts, allowances, and returns.
(j) Debt Issue Costs
The Company incurred costs, principally comprised of initial purchasers’ discounts and various legal and professional fees, of approximately $4,663,000 related to the issue of its 2.50% Convertible Senior Notes due 2012 (the “Convertible Notes”) in March 2005. Debt issue costs are deferred, and recognized from the issuance of the Convertible Notes through the date that the Company has the ability to call the Convertible Notes, March 20, 2010. Interest expense in the years ended December 31, 2006 and 2005, includes approximately $664,000 and $538,000, respectively in amortized debt issue costs. Remaining unamortized debt issue costs were approximately $3,461,000 at December 31, 2006. For additional information about the Convertible Notes, see Note 7.
(k) Patent Application Costs
Costs incurred in filing for, defending and maintaining patents are expensed as incurred.
(l) Intangible and Other Assets
Intangible and other assets primarily consists of an amount paid for a product approved by the United States Food and Drug Administration (“FDA”), which is being amortized on a straight-line basis over its estimated useful life. The Company periodically reviews the useful lives of its intangible and long-lived assets, which may result in future adjustments to the amortization periods. Related amortization expense was approximately $106,000 in each of the years ended December 31, 2006,
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
2005 and 2004, and management expects it to be approximately $106,000 per year through 2009. Amortization of intangible assets is included in research and development expenses in the consolidated statements of operations and comprehensive loss.
(m) Treasury Stock
Treasury stock is recorded at cost. On May 3, 2001, the Company announced a stock repurchase program to buy up to 3 million shares, or approximately 7 percent of the Company’s outstanding Common Stock over an 18-month period. Pursuant to the stock repurchase program, the Company repurchased 213,000 shares for net payments of approximately $1,602,000 during the year ended December 31, 2001. No shares were repurchased during the years ended December 31, 2006, 2005 and 2004.
(n) Stock-based Compensation
At December 31, 2006, the Company had five stock-based compensation plans for employees and non-employee directors. Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement principles of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees,” and related interpretations (“APB25”). Share-based employee compensation expense related to stock options was not recognized in the Company’s consolidated statements of earnings prior to January 1, 2006, as all stock option awards granted under the plans had an exercise price equal to the market value of the common stock on the date of the grant. Effective January 1, 2006, the Company adopted the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”), using the modified prospective transition method. Under this transition method, compensation expense recognized during the year ended December 30, 2006 included: (i) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (“FAS 123”), and (ii) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with FAS 123R. In accordance with the modified prospective transition method, results for prior periods have not been restated. The adoption of FAS 123R resulted in a reduction of net earnings of $5,294,000, or $ $0.09 per share basic and diluted, for the year ended December 31, 2006. See Note 9 for further detail on the impact of FAS 123R on the Company’s condensed consolidated financial statements.
Prior to the Company’s adoption of FAS 123R, if unvested shares of common stock were forfeited, the Company reversed any compensation expense that it had previously recorded on those shares at the time of forfeiture. Upon the adoption of FAS 123R, the Company will adjust the amount of expense recorded each period, based upon its estimate of future forfeitures. The cumulative effect of estimating future forfeitures of unvested common shares granted before January 1, 2006, was $107,000, which is reported as a cumulative effect of change in accounting principle during the year ended December 31, 2006.
The following table illustrates the effect on net loss and loss per share in 2005 and 2004 if the Company had applied the fair value recognition provisions of FASB Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation,” (FAS 123) to stock-based employee compensation ($ in thousands, except for per share data).
(o) Income Taxes
The Company uses the asset and liability method of accounting for income taxes. Under the asset and 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 bases and operating loss and tax credit carry-forwards.
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.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(p) Impairment of Long-lived Assets
As circumstances dictate, the Company evaluates the recoverability of its long-lived tangible and intangible assets by comparing the projected undiscounted net cash flows associated with such assets against their respective carrying values. Impairment, if any, is based on the excess of the carrying value over the fair value.
(q) Leases
Certain of the Company’s lease agreements contain periods of rent abatement. The Company amortizes the effect of any such rent abatements over the term of the lease, using the straight-line method.
(r) New Accounting Pronouncements
In June 2006, the FASB issued FASB Interpretation No. 48, “Accounting for Uncertainty in Income Taxes - an interpretation of FASB Statement No. 109 (“FIN 48”). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a company’s financial statements. FIN 48 requires companies to determine whether it is “more likely than not” that a tax position will be sustained upon examination by the appropriate taxing authorities before any part of the benefit can be recorded in the financial statements. It also provides guidance on the recognition, measurement and classification of income tax uncertainties, along with any related interest and penalties. Previously recorded income tax benefits that no longer meet this standard are required to be charged to earnings in the period that such determination is made. FIN 48 will also require significant additional disclosures. FIN 48 is effective for fiscal years beginning after December 15, 2006. The Company intends to adopt the new standard during the first quarter of 2007 as required. The effect of adoption of FIN 48 is not currently expected to be material.
In September 2006, the SEC issued Staff Accounting Bulletin No. 108, “Considering the Effects of Prior Year Misstatements when Quantifying Misstatements in Current Year Financial Statements (“SAB 108”). SAB 108 provides guidance on how prior year misstatements should be considered when quantifying misstatements in current year financial statements for purposes of assessing materiality. SAB 108 requires that registrants quantify errors using both a balance sheet and income statement approach and evaluate whether either approach results in quantifying a misstatement that, when relevant quantitative and qualitative factors are considered, are material. SAB 108 is effective for fiscal years ending after November 15, 2006. SAB 108 permits companies to initially apply its provisions by either restating prior financial statements or recording a cumulative effect adjustment to the carrying values of assets and liabilities as of January 1, 2006 with an offsetting adjustment to retained earnings for errors that were previously deemed immaterial but are material under the guidance of SAB 108. The adoption of this bulletin did not have a material effect upon the Company’s consolidated financial statements.
In September 2006, the FASB issued Statement of Financial Standards No. 157, “Fair Value Measurements (“FAS 157”). FAS 157 defines fair value, establishes a framework for measuring fair value, and requires enhanced disclosures about fair value measurements. FAS 157 does not require any new fair value measurements. FAS 157 is effective for fiscal years beginning after November 15, 2007. The guidance in FAS 157 will be applied prospectively with the exception of (i) block discounts of financial instruments; and (ii) certain financial and hybrid instruments measured at initial recognition under FAS 133, which are to be applied retrospectively as of the beginning of initial adoption (a limited form of retrospective adoption). The Company intends to adopt the new standard during the first quarter of 2008. The Company is currently evaluating the impact of FAS 157 and does not expect that the adoption of FAS 157 will have a material impact on the Company’s consolidated financial statements.
(4) Receivables
Accounts receivable at December 31, 2006 and 2005 primarily consisted of royalties receivable from GSK on sales of Argatroban. Royalty receivables are recorded at the invoiced amount and do not bear interest.
(5) Inventory
Based on management’s judgment of probable future commercial use and net realizable value, costs related to the production of work-in-process inventory of Thelin™ have been capitalized as inventory. The Company could be required to expense these costs upon a change in such judgment, due to a denial or delay of approval by regulatory bodies, a delay in commercialization, or other potential factors.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(6) Accrued Expenses
At December 31, accrued expenses consisted of the following:
(7) Long-Term Debt
In March 2005, the Company issued $130,000,000 in Convertible Notes. The Company will pay 2.50% interest per annum on the Convertible Notes on March 15 and September 15 of each year, beginning September 15, 2005.
Holders of the Convertible Notes may convert the Convertible Notes into shares of common stock at any time prior to the maturity date of the Convertible Notes at a conversion rate of 71.7077 shares of common stock per $1,000 principal amount of Convertible Notes, which is equal to an initial conversion price of approximately $13.95 per share, subject to adjustment as set forth in the indenture governing the Convertible Notes. In the event of certain types of fundamental changes, the Company will increase the number of shares issuable upon conversion or, in lieu thereof, the Company may in certain circumstances elect to adjust the conversion rate and related conversion obligation so that the Convertible Notes are convertible into shares of the acquiring or surviving company, or at the option of the Company, the Company may elect to pay the additional value represented by an increase in the conversion rate in cash to holders electing to convert their Convertible Notes. On or after March 20, 2010, the Company may redeem some or all of the Convertible Notes for cash at 100% of the principal amount plus accrued interest, if the trading price of the Company’s common stock exceeds 140% of the conversion price of the Convertible Notes then in effect for at least 20 trading days within a period of 30 consecutive trading days ending on the trading day prior to the date on which the redemption notice is mailed. Upon the occurrence of a fundamental change meeting certain conditions, holders of the Convertible Notes may require the Company to repurchase for cash all or part of their Convertible Notes.
The Convertible Notes are senior unsecured obligations and rank equally in right of payment with any senior unsecured indebtedness that the Company may incur in the future. The Convertible Notes will be effectively subordinated to all future secured indebtedness and all existing and future liabilities of the Company’s subsidiaries, including trade payables and senior in right of payment to any future subordinated indebtedness that the Company may incur.
(8) Capital Stock
On October 19, 2006, the Company entered into the Azimuth Agreement with Azimuth, which provides that, upon the terms and subject to the conditions set forth therein, Azimuth is committed to purchase up to $75,000,000 of the Company’s common stock, or 11,866,851 shares of the Company’s common stock, whichever occurs first, over the 18-month term of the Azimuth Agreement. As of December 19, 2006, the Company had closed two draw-down requests under the Azimuth Agreement and had received aggregate gross proceeds of approximately $18,000,000, and net proceeds of approximately $17,750,000 after deducting estimated offering expenses. The Company has issued an aggregate of 3,086,351 shares of the Company’s common stock to Azimuth pursuant to the two draw-down requests.
In March 2005, the Company issued the Convertible Notes in the principal amount of $130,000,000. As the Convertible Notes are convertible into the Company’s common stock, the Company has reserved 9,322,001 shares for issuance upon conversion, including 213,000 treasury shares. For additional information about the Convertible Notes, see Note 7.
In September 2004, the Company sold 4,600,000 shares of common stock for $7.94 per share in an underwritten public offering. The net proceeds to the Company from this offering were approximately $35.6 million after deducting selling commissions and expenses of approximately $1.0 million related to the offering.
The Company has reserved common stock for issuance as of December 31, 2006, as follows:
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(a) Shareholders’ Rights Plan
In January 2002, the Company adopted a shareholder rights plan under which the Board of Directors declared a dividend of one preferred stock purchase right (“Right”) for each outstanding share of the Company’s common stock held of record as of the close of business on January 22, 2002. Each Right initially entitles a shareholder to purchase a one one-thousandth fraction of a share of Preferred Stock - Junior Participating Series A (the “Preferred Stock”) for $55.00. Each such fraction of a share of Preferred Stock has terms designed to make it essentially equivalent to one share of Common Stock. The Rights will become exercisable only in the event a person or group acquires 15% or more of the Company’s Common Stock or commences a tender or exchange offer which, if consummated, would result in that person or group owning 15% of the Common Stock. Prior to such an event, the Rights will be evidenced by and traded in tandem with the Common Stock.
If a person or group acquires a 15% or larger position in the Company, each Right (except those held by the acquiring party) will then entitle its holder to purchase, fractional shares of Preferred Stock having twice the value of the $55 exercise price, with each fractional Preferred Share valued at the market price of the Common Stock. Also, if following an acquisition of 15% or more of the Company’s Common Stock, the Company is acquired by that person or group in a merger or other business combination transaction, each Right would then entitle its holder to purchase Common Stock of the acquiring company having a value of twice the $55.00 exercise price. The effect would be to entitle the Company’s shareholders to buy stock in the acquiring company at 50% of its market price.
The Company may redeem the Rights at $.001 per Right at any time on or prior to the tenth business day following the acquisition of 15% or more of its Common Stock by a person or group or commencement of a tender offer for such 15% ownership. The Rights expire on January 2, 2012.
(9) Share-Based Payments
The Company has in effect the following stock option plans:
The Amended and Restated 1990 Incentive Stock Option Plan (“1990 Plan”) allows for the issuance of incentive and non-qualified options to employees, directors, officers, non-employee independent contractors and non-employee directors, pursuant to which 43,750 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1990 Plan.
The Amended and Restated 1992 Incentive Stock Option Plan (“1992 Plan”) allows for the issuance of incentive and non-qualified options to employees, directors, officers, non-employee independent contractors and non-employee directors, pursuant to which 115,133 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1992 Plan.
The Amended and Restated 1995 Stock Option Plan (“1995 Plan”) allows for the issuance of incentive and non-qualified options, shares of restricted stock, phantom units and stock bonuses to employees, officers, and non-employee independent contractors, pursuant to which 731,703 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1995 Plan.
The Amended and Restated 1995 Non-Employee Director Stock Option Plan (“1995 Director Plan”) allows for the issuance of non-qualified options to non-employee directors, pursuant to which 382,500 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company. No new issuances are being made under the 1995 Director Plan.
The Amended and Restated 1999 Stock Incentive Plan (“1999 Plan”) allows for the issuance of incentive and non-qualified options, shares of restricted stock and stock bonuses to directors, employees, officers and non-employee independent contractors, pursuant to which 6,440,965 shares of Common Stock are reserved for issuance out of authorized but unissued shares of the Company.
Prior to January 1, 2006, the Company accounted for those plans under the recognition and measurement principles of APB25. Share-based employee compensation expense related to stock options was not recognized in the Company’s consolidated statements of earnings prior to January 1, 2006, as all stock option awards granted under the plans had an exercise price equal to the market value of the common stock on the date of the grant. Effective January 1, 2006, the Company adopted the provisions of FAS 123R using the modified prospective transition method. Under this transition method, compensation expense recognized in 2006, included: (i) compensation expense for all share-based awards granted prior to, but not yet vested as of January 1, 2006, based on the grant date fair value estimated in accordance with the original provisions of FAS 123, and (ii) compensation expense for all share-based awards granted subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with FAS 123R. In accordance with the modified prospective transition method, results for prior periods have not been restated.
As a result of adopting FAS 123R, the charge to earnings from continuing operations and net earnings related to stock option grants in 2006, was $5,294,000. The impact of adopting FAS 123R on both basic and diluted earnings per share in 2006 was $0.09.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The following table summarizes share-based compensation recorded in 2006, 2005 and 2004 ($ in thousands):
The fair value of the Company’s stock option awards is estimated on the date of grant using a Black-Scholes option-pricing model that uses the assumptions in the table below. The fair value of the Company’s stock option awards, which are subject to graded vesting, is expensed over the vesting life of the stock options using the straight-line method. Expected volatility is based on an average of (i) historical volatility of the Company’s stock, (ii) implied volatility from the Company’s convertible debt and (iii) implied volatility from traded options on the Company’s stock. The risk-free rate for periods within the contractual life of the stock option award is based on the yield curve of a zero-coupon U.S. Treasury bond for the month during which the stock option award is granted with a maturity equal to the expected term of the stock option award granted. The Company uses historical data to estimate stock option exercises and forfeitures within its valuation model. The expected term of stock option awards granted is derived from historical exercise experience under the Company’s share-based payment plans and represents the period of time that stock option awards granted are expected to be outstanding. Share-based awards generally vest over a three-year period, and stock options have a contractual life of ten years.
The per-share weighted average fair value of stock options granted during 2006, 2005 and 2004 was $4.34, $6.35 and $5.95, respectively, on the grant date using the Black-Scholes option pricing model with the following assumptions:
A summary of the Company’s stock option activity for years 2006, 2005 and 2004, was as follows:
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The weighted average grant date fair value of options granted and total intrinsic value of options exercised during year 2006, 2005 and 2004, was as follows:
The fair value of unvested shares of restricted common stock is determined based on the closing trading price of the Company’s common stock on the day before the grant date. A summary of the Company’s unvested restricted share activity for year 2006, 2005 and 2004 was as follows:
The Company began granting phantom units in 2006 to certain of its non-U.S. employees. The fair value of unvested phantom units is determined based on the closing trading price of the Common Stock on the day before the grant date. A summary of the Company’s unvested phantom unit activity for the year ended December 31, 2006, was as follows:
At December 31, 2006, there was $9.4 million of unrecognized compensation expense related to unvested share-based awards granted under the Company’s share-based payment plans of which $5.0 million relates to stock options expected to be recognized over a weighted-average period of 1.2 years, and $4.4 million relates to unvested restricted shares and phantom units expected to be recognized over a weighted average period of 2.0 years.
(10) Income Taxes
The Company did not incur any tax expense in any year due to operating losses and the related increase in the valuation allowance.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The reconciliation of income taxes at the statutory rate of 35% applied to income before taxes is as follows ($ in thousands):
The tax effects of the temporary differences that give rise to significant portions of the deferred tax assets as of December 31, 2006 and 2005, are as follows ($ in thousands):
At December 31, 2006 and 2005, the Company had net operating loss carryforwards of $404.9 million and $310.4 million, respectively. The Company has established a valuation allowance for the full amount of the resulting deferred tax assets as management does not believe that it is more likely than not that the Company will recover these assets. Utilization of the Company's net operating loss carryforwards is subject to certain limitations due to specific stock ownership changes which have occurred or may occur. Approximately $2 million of our loss carryforwards expired in 2006. To the extent not utilized, the carryforwards will expire during the years beginning 2007 through 2026, of which approximately $4 million will expire in 2007.
The difference between the increase in valuation allowance reported above, and the change in valuation allowance between December 31, 2006 and 2005, reflects the utilization of net operating losses from stock options. Approximately $5.9 million and $5.8 million of the total valuation allowance for years 2006 and 2005, respectively, relate to stock option compensation deductions. The tax benefits associated with stock option compensation deductions will be credited to equity when realized.
In 2005 the Company cancelled its loan to Revotar in the amount of approximately $3.7 million, including accrued interest. This cancellation was treated as a capital loss in the 2005 provision resulting in a deferred tax asset of $1.9 million; however, when the tax return was filed, it was determined that the cancellation of this loan, and accrued interest, was an ordinary loss. The remaining $.036 million of capital loss resulted from the disposition of stock in subsidiaries.
The $2.73 million increase in the Deferred Compensation component of the Company's deferred tax asset is a result of the Company's adoption of the provisions of Statement of Financial Accounting Standards No. 123R, “Share-Based Payment” (“FAS 123R”).
The Accrued Liabilities component of the Company's Deferred Tax Asset includes an adjustment for accrued liabilities relating to clinical trials for 2006 in the amount of approximately $3.7 million, resulting in a deferred tax asset of $1.3 million. There was not an adjustment in 2005 for clinical trials.
(11) Equipment and Leasehold Improvements
Equipment and leasehold improvements consist of the following ($ in thousands):
Depreciation and amortization expense related to equipment and leasehold improvements was $1,015,000, $1,113,000, and $626,000 in years 2006, 2005 and 2004, respectively.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(12) Entity-Wide Geographic Data
The Company operates in a single business segment that includes research and development of pharmaceutical products. As a result of the Restructuring, revenues from Germany have been included in the gain or loss from discontinued operations on the Company’s statements of operations. The following table summarizes the Company’s long-lived assets in different geographic locations ($ in thousands):
The following table summarizes the Company’s revenues in different geographic locations ($ in thousands):
The Company’s revenues are primarily derived from several customers, each of whom represents a significant percentage of total revenues. The following table summarizes the Company’s sources of revenues from its principal customers ($ in thousands):
(13) Research and License Agreements
Under the terms of the Company’s agreement with ELP prior to the Acquisition, the Company provided, and was reimbursed for, research and development activities conducted on behalf of Encysive, L.P.
The Company also received reimbursement for certain research costs pursuant to its agreements with GlaxoSmithKline, plc (“GSK”) (Note 15), Schering-Plough Ltd. and Schering Corporation (collectively “Schering-Plough”) and Revotar (Note 14).
(a) Mitsubishi-Pharma Agreement
Encysive has entered into an agreement with Mitsubishi Pharma Corporation, formerly Mitsubishi-Tokyo Pharmaceuticals, Inc. (“Mitsubishi”), to license Mitsubishi’s rights and technology relating to Argatroban and to license Mitsubishi’s own proprietary technology developed with respect to Argatroban (the “Mitsubishi Agreement”). Under the Mitsubishi Agreement, the Company has an exclusive license to use and sell Argatroban in the U.S. and Canada for all specified indications. The Company is required to pay Mitsubishi specified royalties on net sales of Argatroban by the Company and its sublicensees after its commercial introduction in the U.S. and Canada. GSK is also obligated to pay Mitsubishi royalties on sales of Argatroban. As of December 31, 2006, the Company had paid Mitsubishi approximately $2,385,000 in royalty payments under the Mitsubishi Agreement. The Company has also paid Mitsubishi a $500,000 milestone payment under the Mitsubishi Agreement. No additional milestone payments are payable to Mitsubishi under the Mitsubishi Agreement.
Either party may terminate the Mitsubishi Agreement on 60 days notice if the other party defaults in its material obligations under the agreement, or is insolvent, or if a substantial portion of its property is subject to levy. Unless terminated sooner pursuant to the above-described termination provisions, the Mitsubishi Agreement expires on the later of termination of patent rights in a particular country or 20 years after first commercial sale of products. If the Mitsubishi Agreement is terminated, the Company and Royalty Sub would lose all rights to Argatroban, including the right to receive revenues from the sale of Argatroban. Under the Mitsubishi Agreement, Encysive has access to a formulation patent granted in 1993, which expires in 2014 and a process patent that expires in 2017. The Mitsubishi composition of matter patent on Argatroban has expired.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
During 2000, Encysive signed an additional agreement with Mitsubishi that provides Encysive with royalties on sales of Argatroban in certain European countries, up to a total of $5.0 million in milestones for the development of ischemic stroke and certain other provisions. The Company began enrolling patients in a clinical trial for ischemic stroke in April 2001, and received a $2.0 million milestone payment in May 2001, which was being recognized as revenues over the expected development period and, accordingly, revenues in 2002 included approximately $382,000 related to such milestone payment. In light of a lack of a positive overall efficacy trend and the high risk and high costs associated with stroke trials, management determined that it was unlikely that the Company would proceed independently with a full Phase III program and, accordingly, recognized the remaining deferred revenue related to the milestone payment from Mitsubishi during 2003. License fees, milestones and grants in 2003 includes $1,143,000 related to the milestone payment from Mitsubishi. In conjunction with the Mitsubishi Agreement, a consulting firm involved in negotiations related to the agreement will receive a percentage of net sales received as a result of the agreement.
Mitsubishi further agreed to supply the Company with its requirements of Argatroban Active Pharmaceutical Ingredient (“API”) throughout the term of the Mitsubishi Agreement for the Company’s clinical testing and commercial sales of Argatroban in the U.S. and Canada. In the event Mitsubishi should discontinue the manufacture of Argatroban API, Mitsubishi and Encysive have agreed to discuss in good faith the means by which, and the party to whom, Argatroban API production technology will be transferred. The transferee may be a person or entity other than the Company. At present, Mitsubishi is the only manufacturer of Argatroban API. See Note 15.
During the third quarter of 1997, the Company sublicensed certain rights to Argatroban to GSK. In conjunction with this agreement, the Company agreed to make certain payments to Mitsubishi, which are included in selling, general and administrative expenses, to pay an additional royalty to Mitsubishi, beginning January 1, 2002, and to provide access to certain Argatroban clinical data to Mitsubishi. In certain circumstances, Mitsubishi and Encysive will share equally in all upfront payments and royalties should Mitsubishi use Encysive’s regulatory documents and data for registration in certain territories. See Note 15.
(b) Schering-Plough Research Collaboration and License Agreement
On June 30, 2000, Encysive and Schering-Plough entered into a worldwide research collaboration and license agreement to discover, develop and commercialize VLA-4 antagonists. VLA-4 antagonists represent a new class of compounds that has shown promise in multiple preclinical animal models of asthma. The primary focus of the collaboration will be to discover orally available VLA-4 antagonists as treatments for asthma.
Under the terms of the agreement, Schering-Plough obtains the exclusive worldwide rights to develop, manufacture and market all compounds from Encysive’s library of VLA-4 antagonists, as well as the rights to a second integrin antagonist. Encysive will be responsible for optimizing a lead compound and additional follow-on compounds. Schering-Plough supported research at Encysive until June 30, 2004, and will be responsible for all costs associated with the worldwide product development program and commercialization of the compound. In addition to funding research costs, Schering-Plough paid Encysive an aggregate of $4 million in upfront license fees and milestone payments, and will pay the Company additional development milestones of $39 million regarding the development of VLA-4 antagonists, and $38 million regarding the development of a second integrin antagonist. The Company is not currently developing the second integrin antagonist. Schering-Plough will also pay the Company royalties on product sales resulting from the agreement. The upfront license fee is being amortized into revenue over the expected development period which is estimated to be through December 31, 2007, and the Company recognized $382,000 of the license fee as revenues in each of the years 2006, 2005 and 2004, respectively. On June 30, 2004 Schering-Plough ended their funding of our research on a follow-on compound pursuant to the research agreement, prior to which the Company had received approximately $13.3 million in research payments from Schering-Plough under the agreement. Schering-Plough can terminate the agreement upon 180 days written notice to the Company. If the agreement is terminated, Encysive will lose Schering-Plough’s funding for future development milestones and royalties on product sales resulting from the agreement.
In June 2002, the Company achieved a milestone under the Schering-Plough agreement as a result of the nomination of an initial candidate for Schering-Plough’s further development. This milestone payment will be recognized into revenue over the expected development period, and approximately $179,000 was recognized as revenue during each of 2006, 2005 and 2004.
In March 2005, the Company achieved a $2 million milestone under the Schering-Plough agreement, which will be recognized into revenue over the expected development period, of which approximately $727,000 and $545,000 was recognized during 2006 and 2005, respectively.
(14) Discontinued Foreign Subsidiary
Encysive formed Revotar in 2000 to conduct research and development of novel small molecule compounds and to develop and commercialize selectin antagonists, including bimosiamose. In April 2005, the stockholders of Revotar agreed to restructure Revotar’s capitalization. Under the terms of the Restructuring, Revotar’s stockholders other than the Company contributed additional funds to Revotar, and the Company’s ownership was reduced to approximately 14% of the outstanding common stock of Revotar. Revotar’s other stockholders subsequently purchased the remaining shares of Revotar common stock owned by the Company for
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NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
nominal consideration. Upon the funding of Revotar by the other stockholders, the Company licensed its worldwide rights to bimosiamose and certain follow-on compounds to Revotar for which it could receive substantial future royalty payments from Revotar in the event that these compounds are subsequently approved and commercialized, or licensed to a third party. Further, the Company agreed to cancel its outstanding loan, and accrued interest thereon, of approximately $3.7 million. The transaction became effective in May 2005, upon contribution of the additional capital by Revotar’s other stockholders. Following the completion of the Restructuring, the Company’s consolidated financial statements no longer include the results of Revotar. The Company recorded a gain of approximately $1.7 million upon its disposal of Revotar, which is included in the amount reported under the caption “Gain (loss) from discontinued operations” in the Company’s financial statements for 2005.
Prior to the Restructuring, Revotar had assets of approximately $1.0 million, and liabilities, not including the note payable to Encysive, of approximately $2.5 million. Revotar’s revenues and pretax losses (net of minority interest), reported in discontinued operations for years 2005, 2004 and 2003 were as follow ($ in thousands):
(15) Commercialization Agreement
In connection with Encysive’s development and commercialization of Argatroban, in August 1997, Encysive entered into a Product Development, License and CoPromotion Agreement with GSK (the “GSK Agreement”) whereby GSK was granted exclusive rights to work with Encysive in the development and commercialization of Argatroban in the U.S. and Canada for specified indications. GSK paid $8.5 million in upfront license fees during August 1997, a $5 million milestone payment in October 1997, and a $7.5 million milestone payment in June 2000. Additional milestone payments may be earned upon the clinical development and FDA approval for the acute myocardial infarction indication. Future milestone payments for the acute myocardial infarction indication are subject to GSK’s agreement to market Argatroban for such indication. The parties have also formed a joint development committee to analyze the development of additional Argatroban indications to be funded 60% by GSK except for certain Phase IV trials which shall be funded entirely by GSK. At this time, GSK has no plans to conduct development work for the acute myocardial infarction and stroke indications. GSK has the exclusive right to commercialize all products arising out of the collaboration, subject to the obligation to pay royalties on net sales to Encysive and to the rights of Encysive to co-promote these products through its own sales force in certain circumstances. As of December 31, 2006, the Company had received approximately $48.2 million in royalty payments from GSK under the GSK Agreement. Encysive will retain the rights to any indications which GSK determines it does not wish to pursue (such as ischemic stroke), subject to the requirement that Encysive must use its own sales force to commercialize any such indications. Any indications which Encysive elects not to pursue will be returned to Mitsubishi. In conjunction with the GSK Agreement, a consulting firm involved in negotiations related to the agreement will receive a percentage of all consideration received by Encysive as a result of the agreement.
At present, Mitsubishi is the only manufacturer of Argatroban API, and has entered into the Mitsubishi Supply Agreement with GSK to supply Argatroban API in order to meet GSK and Encysive’s needs for the production of Argatroban finished product. GSK has informed the Company that they have begun supplying Argatroban finished product from a manufacturing facility in the United Kingdom. Should Mitsubishi fail during any consecutive nine-month period to supply GSK at least 80% of its requirements, and such requirements cannot be satisfied by existing inventories, the Mitsubishi Supply Agreement provides for the nonexclusive transfer of the production technology for API to GSK. If GSK cannot commence manufacturing of Argatroban API or alternate sources of supply are unavailable or uneconomic, the Company’s results of operations would be materially and adversely affected.
The GSK Agreement generally terminates on a country-by-country basis upon the earlier of the termination of Encysive’s rights under the Mitsubishi Agreement, the expiration of applicable patent rights or, in the case of royalty payments, the commencement of substantial third-party competition. GSK also has the right to terminate the agreement on a country-by-country basis by giving Encysive at least three months written notice at any time before GSK first markets products in that country based on a reasonable determination by GSK that the commercial profile of the product in question would not justify continued development in that country. GSK has similar rights to terminate the GSK Agreement on a country-by-country basis after marketing has commenced. In addition, either party may terminate the GSK Agreement on 60 days notice if the other party defaults in its obligations under the agreement or is insolvent. If the GSK Agreement is terminated, Royalty Sub would no longer receive royalties from GSK’s sales of Argatroban.
In December 2006, the Company sold its right to receive royalties on sales of Argatroban by GSK to Royalty Sub. GSK will pay all future royalties to Royalty Sub until the Argatroban Notes and accrued interest are repaid.
(16) 401(k) Plan
The Company adopted a 401(k) plan which became effective on September 1, 1993. Under the plan, all employees with three months of service are eligible to participate in the plan and may contribute up to 60% of their compensation, with a maximum of $15,000 per employee in 2006 The Compensation Committee of the Board of Directors approved an employer matching contribution of $0.50 for each dollar of employee contributions up to 6% of salaries and the 401(k) plan was amended effective January 1, 2001.
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
The Compensation Committee approved matching contributions on the catch-up contribution made by employees 50 years of age or older by the end of the plan year and the 401(k) plan was amended effective January 1, 2002. Total cost of the employer match was $542,000 and $218,000 in 2006, 2005 and 2004, respectively.
(17) Commitments and Contingencies
(a) Employment agreements
The Company has entered into employment agreements with certain officers and key employees. Additionally, the Company has signed agreements with 12 of its officers and key employees to provide certain benefits in the event of a “change of control” as defined in these agreements and the occurrence of certain other events. The agreements provide for a lump-sum payment in cash equal to 12 months to three years of annual base salary and annual cash bonus, if any. The base salary and annual bonus portion of the agreements would aggregate approximately $9.1 million at the rate of compensation in effect at December 31, 2006. In addition, the agreements provide for gross-up for certain taxes on the lump-sum payment, continuation of certain insurance and other benefits for periods of 12 months to three years and reimbursement of certain legal expenses in conjunction with the agreements.
(b) Lease Agreements
In November 2004, the Company leased 40,730 square feet of office space in Houston, Texas, for the Company’s administrative, marketing, clinical development and regulatory departments. The lease expires on December 31, 2008, and can be extended at the Company’s option to December 31, 2009. The Company’s prior lease of 15,490 square feet of office space in Bellaire, Texas, which housed its administrative, marketing, clinical development and regulatory departments, expired July 31, 2005.
The Company also leases 31,359 square feet of office and laboratory space in a building in Houston, Texas, for its research department, including a 21,621 square foot laboratory facility. The remaining area is being used for clinical development, computer modeling, storage space and additional offices for scientists. This lease expires in December 2008, and can be extended at the Company’s option to December 31, 2009.
In 2006, the Company signed agreements to lease office space for its European operations in Uxbridge, U.K. and Munich, Germany, and subsequently leased office space in Milan, Italy and Paris, France. The agreements are of varying terms, and may be extended at the Company’s option upon prior written notice.
The Company may require additional space to accommodate future research and laboratory needs as necessary to bring products into development and clinical trials. In addition, the Company may require additional office space to support the commercial launch of Thelin™ in Europe.
For the years ended December 31, 2006, 2005 and 2004, rent and related building services totaled approximately $1,613,000, $1,686,000 and $1,310,000, respectively.
At December 31, 2006, the Company’s minimum aggregate commitments under long-term, non-cancelable operating leases are as follows ($ in thousands):
(c) Litigation
On September 26, 2006, a purported class action complaint (the “Massachusetts Laborers action”) was filed in the United States District Court for the Southern District of Texas by Massachusetts Laborers’ Annuity Fund, on behalf of itself and all other similarly situated investors against the Company, Bruce D. Given, M.D. (the Company’s President and Chief Executive Officer), Richard A.F. Dixon (the Company’s Senior Vice President, Research and Chief Scientific Officer) and Stephen L. Mueller (the Company’s former Vice President, Finance and Administration, Secretary and Treasurer). The complaint alleges violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5, and focuses on statements that are claimed to be false and misleading regarding the Company’s drug sitaxsentan sodium. The
ENCYSIVE PHARMACEUTICALS INC. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
plaintiffs seek unspecified damages on behalf of a purported class of purchasers of the Company’s securities during the period from February 19, 2004 through March 24, 2006. Three additional substantially similar putative class action lawsuits were filed in the weeks following September 26, 2006 and have since been consolidated with the Massachusetts Laborers action. It is possible that additional class action complaints regarding the same subject matter may be filed in the future. The Company expects that any future such complaints will be consolidated with the Massachusetts Laborers action.
In addition, on November 22, 2006, a putative shareholder derivative action captioned Jadelis v. Given et al., Case No. 2006-CV-3713 was filed in the United States District Court for the Southern District of Texas, Houston Division (the “Jadelis action”). The Jadelis action contains essentially the same factual allegations as in the Massachusetts Laborers action, but purports to assert claims derivatively on behalf of the Company for breach of fiduciary duty, corporate waste, gross mismanagement, abuse of control, insider selling, contribution, and indemnification against Bruce D. Given, Richard A.F. Dixon, Stephen L. Mueller, John M. Pietruski, James T. Willerson, Ron J. Anderson, J. Kevin Buchi, Robert J. Cruikshank, John H. Dillon, II, Suzanne Oparil, and James A. Thompson. It is possible that additional shareholder derivative complaints regarding the same subject matter may be filed in the future. While the Jadelis action does not assert claims or seek damages against the Company itself, it does seek recovery of the plaintiff’s attorneys’ fees from the Company in the event the plaintiff’s lawsuit is successful.
These litigation matters are in their early stages, and discovery has not yet begun. While we believe that the claims against the Company are without merit, litigation is subject to inherent uncertainties, and an adverse result in these matters could have a material adverse effect on our business, results of operations and financial condition. Any litigation to which we are subject may be costly and, further, could require significant involvement of our senior management and may divert management’s attention from our business and operations. The Company also has indemnification obligations to some or all of the individual defendants identified above. The Company is currently unable to estimate the likelihood of an unfavorable result in the above-mentioned litigation matters or the maximum potential amount of future payments under the indemnifications or otherwise in connection with liability under the purported shareholder class action lawsuits or shareholder derivative lawsuits due to the inherent uncertainties involved in such litigation. The Company maintains insurance that may limit its financial exposure for defense costs and liability for an unfavorable outcome in these matters, should it not prevail, for claims covered by the insurance coverage.
The Company anticipates that additional shareholder derivative lawsuits regarding the same subject matter may be filed in federal and/or state court during the upcoming months.
The Consolidated Financial Statements do not include a contingency related to the ongoing litigation, as it is not possible to estimate the Company’s damages, if it were to be found liable.
(d) Foreign Currency Exchange Risk
The Company is exposed to market risk primarily from changes in foreign currency exchange rates. We have contracts with entities in other areas outside the U.S. that are denominated in a foreign currency. To date, these currencies have not fluctuated materially.
(e) Other Contingencies
Like other biopharmaceutical companies, the Company is subject to other contingencies, including legal proceedings and claims arising out of its business that cover a wide range of matters, including, among others, environmental matters, contract and employment claims, and product liability. The Company may be involved in legal actions from time to time. The Company has used various substances in its research and development which have been or may be deemed to be hazardous or dangerous, and the extent of its potential liability, if any, under environmental, product liability and workers’ compensation statutes, rules, regulations and case law is unclear.
(18) Quarterly Financial Data (Unaudited)
The following is a summary of the unaudited quarterly results of operations (in thousands, except per share data):
Because of the method used in calculating per share data, the quarterly per share data will not necessarily total to the per share data as computed for the year. Periods prior to the Restructuring have been restated to reflect the status of Revotar as a discontinued operation, with no change in reported net loss.
INDEX TO EXHIBITS
*
The Company has omitted certain portions of these agreements in reliance on Rule 24b-2 under the Securities Exchange Act of 1934, as amended.
+
Management contract or compensatory plan or arrangement.

Filed herewith.