e10vq
UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the Quarterly Period Ended September 30, 2006
Commission file number: 0-27406
CONNETICS CORPORATION
(Exact name of registrant as specified in its charter)
|
|
|
Delaware
|
|
94-3173928 |
(State or other jurisdiction of
|
|
(IRS Employer |
incorporation or organization)
|
|
Identification Number) |
|
|
|
3160 Porter Drive |
|
|
Palo Alto, California
|
|
94304 |
(Address of principal executive offices)
|
|
(Zip Code) |
Registrants telephone number, including area code: (650) 843-2800
Indicate by check mark whether the registrant (1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such shorter period that the registrant was required to file such reports), and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated
filer or a non-accelerated filer. See definition of accelerated filer and large accelerated filer
in Rule 12b-2 of the Exchange Act.
Large Accelerated Filer o Accelerated Filer þ Non-Accelerated Filer o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of
the Exchange Act). Yes o No þ
As of October 31, 2006, 34,525,850 shares of the Registrants common stock at $0.001 par
value, were outstanding.
CONNETICS CORPORATION
TABLE OF CONTENTS
2
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
CONNETICS CORPORATION
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands)
(Unaudited)
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
ASSETS |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Current assets: |
|
|
|
|
|
|
|
|
Cash and cash equivalents |
|
$ |
42,338 |
|
|
$ |
29,988 |
|
Marketable securities |
|
|
187,154 |
|
|
|
241,108 |
|
Restricted cash current |
|
|
1,421 |
|
|
|
1,000 |
|
Accounts receivable, net of cash discounts and allowances |
|
|
10,132 |
|
|
|
11,100 |
|
Inventory |
|
|
9,476 |
|
|
|
7,485 |
|
Other current assets |
|
|
22,682 |
|
|
|
21,938 |
|
|
|
|
|
|
|
|
Total current assets |
|
|
273,203 |
|
|
|
312,619 |
|
Long-term investments |
|
|
12,274 |
|
|
|
|
|
Property and equipment, net |
|
|
14,874 |
|
|
|
14,438 |
|
Restricted cash long term |
|
|
2,533 |
|
|
|
3,059 |
|
Goodwill |
|
|
6,271 |
|
|
|
6,271 |
|
Other intangibles, net |
|
|
109,213 |
|
|
|
108,789 |
|
Other assets |
|
|
9,413 |
|
|
|
12,313 |
|
|
|
|
|
|
|
|
|
|
$ |
427,781 |
|
|
$ |
457,489 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
LIABILITIES AND STOCKHOLDERS EQUITY |
|
|
|
|
|
|
|
|
Current liabilities: |
|
|
|
|
|
|
|
|
Accounts payable |
|
$ |
17,046 |
|
|
$ |
16,609 |
|
Product-related liabilities |
|
|
28,109 |
|
|
|
35,371 |
|
Other accrued liabilities |
|
|
13,845 |
|
|
|
15,075 |
|
|
|
|
|
|
|
|
Total current liabilities |
|
|
59,000 |
|
|
|
67,055 |
|
|
|
|
|
|
|
|
Convertible senior notes |
|
|
290,000 |
|
|
|
290,000 |
|
Other non-current liabilities |
|
|
590 |
|
|
|
517 |
|
Commitments and contingencies |
|
|
|
|
|
|
|
|
Stockholders Equity: |
|
|
|
|
|
|
|
|
Common stock |
|
|
35 |
|
|
|
37 |
|
Treasury stock |
|
|
(62,603 |
) |
|
|
(60,447 |
) |
Additional paid-in-capital |
|
|
256,060 |
|
|
|
247,880 |
|
Accumulated deficit |
|
|
(116,130 |
) |
|
|
(88,080 |
) |
Accumulated other comprehensive income |
|
|
829 |
|
|
|
527 |
|
|
|
|
|
|
|
|
Total stockholders equity |
|
|
78,191 |
|
|
|
99,917 |
|
|
|
|
|
|
|
|
Total liabilities and stockholders equity |
|
$ |
427,781 |
|
|
$ |
457,489 |
|
|
|
|
|
|
|
|
See accompanying notes to condensed consolidated financial statements.
3
CONNETICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share amounts)
(Unaudited)
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
|
|
|
|
2005 |
|
|
|
|
|
|
2005 |
|
|
|
2006 |
|
|
(restated) |
|
|
2006 |
|
|
(restated) |
|
Net revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product |
|
$ |
18,836 |
|
|
$ |
50,788 |
|
|
$ |
109,405 |
|
|
$ |
136,331 |
|
Royalty and contract |
|
|
849 |
|
|
|
158 |
|
|
|
1,255 |
|
|
|
469 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total net revenues |
|
|
19,685 |
|
|
|
50,946 |
|
|
|
110,660 |
|
|
|
136,800 |
|
Operating costs and expenses: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of product revenues (excluding amortization of acquired
product rights) |
|
|
1,668 |
|
|
|
4,183 |
|
|
|
9,226 |
|
|
|
12,931 |
|
Amortization of intangible assets |
|
|
4,059 |
|
|
|
3,399 |
|
|
|
12,114 |
|
|
|
10,198 |
|
Research and development |
|
|
10,035 |
|
|
|
8,381 |
|
|
|
26,237 |
|
|
|
23,236 |
|
Selling, general and administrative |
|
|
31,578 |
|
|
|
23,703 |
|
|
|
92,980 |
|
|
|
76,868 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating costs and expenses |
|
|
47,340 |
|
|
|
39,666 |
|
|
|
140,557 |
|
|
|
123,233 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) from operations |
|
|
(27,655 |
) |
|
|
11,280 |
|
|
|
(29,897 |
) |
|
|
13,567 |
|
Interest and other income (expense): |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest income |
|
|
3,046 |
|
|
|
2,130 |
|
|
|
8,046 |
|
|
|
4,452 |
|
Interest expense |
|
|
(3,215 |
) |
|
|
(2,008 |
) |
|
|
(6,945 |
) |
|
|
(4,639 |
) |
Other income (expense), net |
|
|
179 |
|
|
|
38 |
|
|
|
213 |
|
|
|
(25 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before income taxes |
|
|
(27,645 |
) |
|
|
11,440 |
|
|
|
(28,583 |
) |
|
|
13,355 |
|
Income tax provision (benefit) |
|
|
(274 |
) |
|
|
470 |
|
|
|
(533 |
) |
|
|
728 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) |
|
$ |
(27,371 |
) |
|
$ |
10,970 |
|
|
$ |
(28,050 |
) |
|
$ |
12,627 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
(0.81 |
) |
|
$ |
0.31 |
|
|
$ |
(0.83 |
) |
|
$ |
0.36 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted |
|
$ |
(0.81 |
) |
|
$ |
0.29 |
|
|
$ |
(0.83 |
) |
|
$ |
0.34 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares used to compute basic and diluted net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
|
33,836 |
|
|
|
35,075 |
|
|
|
33,741 |
|
|
|
35,197 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted |
|
|
33,836 |
|
|
|
40,812 |
|
|
|
33,741 |
|
|
|
37,462 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
See accompanying notes to condensed consolidated financial statements.
4
CONNETICS CORPORATION
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
|
|
|
|
|
|
|
|
|
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
|
|
|
|
|
2005 |
|
|
|
2006 |
|
|
(restated) |
|
Cash flows from operating activities: |
|
|
|
|
|
|
|
|
Net income (loss) |
|
$ |
(28,050 |
) |
|
$ |
12,627 |
|
Adjustments to reconcile net income (loss) to net cash from operating activities: |
|
|
|
|
|
|
|
|
Depreciation |
|
|
1,891 |
|
|
|
1,260 |
|
Amortization of intangible assets |
|
|
12,114 |
|
|
|
10,199 |
|
Amortization of convertible senior notes offering costs |
|
|
1,076 |
|
|
|
911 |
|
Allowance for cash discounts and doubtful accounts |
|
|
(62 |
) |
|
|
28 |
|
Stock compensation expense |
|
|
3,756 |
|
|
|
13 |
|
Changes in assets and liabilities: |
|
|
|
|
|
|
|
|
Accounts receivable |
|
|
1,030 |
|
|
|
2,038 |
|
Other assets |
|
|
1,091 |
|
|
|
(5,705 |
) |
Inventory |
|
|
(1,936 |
) |
|
|
(336 |
) |
Accounts payable |
|
|
574 |
|
|
|
1,622 |
|
Product-related accruals |
|
|
(7,262 |
) |
|
|
11,428 |
|
Other current liabilities |
|
|
(924 |
) |
|
|
2,088 |
|
Other non-current liabilities |
|
|
(233 |
) |
|
|
126 |
|
|
|
|
|
|
|
|
Net cash (used in) provided by operating activities |
|
|
(16,935 |
) |
|
|
36,299 |
|
|
|
|
|
|
|
|
Cash flows from investing activities: |
|
|
|
|
|
|
|
|
Purchases of marketable securities |
|
|
(108,152 |
) |
|
|
(300,033 |
) |
Sales and maturities of marketable securities |
|
|
150,175 |
|
|
|
114,772 |
|
Transfer to restricted cash |
|
|
105 |
|
|
|
(96 |
) |
Purchases of property and equipment |
|
|
(2,496 |
) |
|
|
(3,873 |
) |
Acquisition of sales force |
|
|
(12,537 |
) |
|
|
|
|
|
|
|
|
|
|
|
Net cash provided by (used in) investing activities |
|
|
27,095 |
|
|
|
(189,230 |
) |
|
|
|
|
|
|
|
Cash flows from financing activities: |
|
|
|
|
|
|
|
|
Proceeds from issuance of convertible senior notes, net of issuance costs |
|
|
|
|
|
|
192,625 |
|
Repurchases of common stock |
|
|
(2,156 |
) |
|
|
(35,000 |
) |
Proceeds from exercise of stock options and employee stock purchase plan, net
of repurchases of unvested shares |
|
|
4,422 |
|
|
|
7,135 |
|
|
|
|
|
|
|
|
Net cash provided by financing activities |
|
|
2,266 |
|
|
|
164,760 |
|
|
|
|
|
|
|
|
Effect of foreign currency exchange rate changes on cash and cash equivalents |
|
|
(76 |
) |
|
|
(72 |
) |
|
|
|
|
|
|
|
Net change in cash and cash equivalents |
|
|
12,350 |
|
|
|
11,757 |
|
Cash and cash equivalents at beginning of period |
|
|
29,988 |
|
|
|
18,261 |
|
|
|
|
|
|
|
|
Cash and cash equivalents at end of period |
|
$ |
42,338 |
|
|
$ |
30,018 |
|
|
|
|
|
|
|
|
See accompanying notes to condensed consolidated financial statements.
5
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
Recent Transaction
On October 22, 2006, Connetics Corporation, or Connetics entered into a definitive merger
agreement with Stiefel Laboratories, Inc., or Stiefel, for Stiefel to acquire Connetics. Unless
otherwise indicated, the discussions in this document relate to Connetics as a standalone entity
and do not reflect the impact of the proposed merger with Stiefel. See Note 13 for further
discussion of this proposed transaction.
1. Basis of Presentation
Interim Financial Information
We prepared the accompanying unaudited condensed consolidated financial statements of
Connetics Corporation, or Connetics, in accordance with U.S. generally accepted accounting
principles, or GAAP, for interim financial information and in compliance with the instructions to
Form 10-Q and Article 10 of Regulation S-X. Accordingly, the financial statements do not include
all of the information and footnotes required by U.S. generally accepted accounting principles for
complete financial statements. We believe that we have included all adjustments, consisting of
normal recurring adjustments, considered necessary for a fair presentation. The balance sheet as
of December 31, 2005 has been derived from audited financial statements.
Operating results for the three and nine months ended September 30, 2006 are not necessarily
indicative of the results that may be expected for the year ending December 31, 2006. For a better
understanding of Connetics and its financial statements, we recommend reading these unaudited
condensed consolidated financial statements and notes in conjunction with the audited consolidated
financial statements and notes to those financial statements for each of the three years in the
period ended December 31, 2005, as restated, which are included in our Annual Report on Form 10-K/A
as filed with the Securities and Exchange Commission, or SEC.
Principles of Consolidation
The accompanying condensed consolidated financial statements include the accounts of Connetics
and its subsidiaries, Connetics Holdings Pty Ltd., and Connetics Australia Pty Ltd. We have
eliminated all intercompany accounts and transactions in consolidation.
Use of Estimates
We have prepared our condensed consolidated financial statements in conformity with GAAP.
Such preparation requires management to make estimates and assumptions that affect the amounts
reported in the financial statements and accompanying notes. Actual results could differ from
those estimates based upon future events.
We evaluate our estimates on an on-going basis. In particular, we regularly evaluate
estimates related to revenue reserves, recoverability of accounts receivable and inventory,
intangible assets, and assumed liabilities related to acquired product rights, accrued liabilities
for clinical trial activities and indirect promotional expenses. We base our estimates on
historical experience and on various other specific assumptions that we believe to be reasonable
under the circumstances. Those estimates and assumptions form the basis for making judgments about
the carrying value of assets and liabilities that are not readily apparent from other sources.
Actual results could differ from those estimates depending on the outcome of future events,
although we believe that the estimates and assumptions upon which we rely are reasonable based on
information available to us at the time they are made. To the extent there are material
differences between these estimates, judgments or assumptions and actual results, our financial
statements will be affected.
6
Restatement of Prior Period Information
Financial results for the three and nine months ended September 30, 2005 have been restated to
correct errors in our estimated accruals for rebates, chargebacks and returns. Refer to our Annual
Report on Form 10-K/A for the year ended December 31, 2005 for a detailed discussion of the
restatement.
Adjustment to Quarterly Financial Statements
In order to facilitate improved management of wholesaler inventory levels of all of our
products, we have shipped below estimated prescription demand during 2006 with the goal of reducing
average wholesaler inventory levels to less than two months on-hand by the end of 2006. In
connection with this effort, on June 30, 2006 we halted an in-transit shipment to one of our
wholesalers; the product was brought back to our warehouse and the wholesaler never received
delivery. We properly reversed the revenue and accounts receivable related to this shipment, and
those amounts were not included in the June 30, 2006 Form 10-Q financial statements. However,
during our third quarter 2006 close procedures we noted that the financial statements in the June
30, 2006 Form 10-Q did not reflect the reversal of the cost of product revenues and increase in
inventory associated with the halted shipment. Therefore, our June 30, 2006 results overstated
cost of product revenues by $368,000 and understated inventory by the same amount. In accordance
with Accounting Principles Board Opinion 28, Interim Financial Reporting, or APB 28, paragraph 29
because the amount is not material to our full year results we have recorded the $368,000 reversal
of cost of product revenues as an adjustment in June 2006 by amending the year-to-date amounts in
the September 30, 2006 financial information included in this Report. The table below sets forth
the effect of the adjustment on the Condensed Consolidated Statement of Operations as of June 30,
2006 (in thousands except per share amounts):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended June 30, 2006 |
|
|
Six Months Ended June 30, 2006 |
|
|
|
(unaudited) |
|
|
(unaudited) |
|
|
|
As |
|
|
|
|
|
|
|
|
|
|
As |
|
|
|
|
|
|
|
|
|
Previously |
|
|
Inventory |
|
|
As |
|
|
Previously |
|
|
Inventory |
|
|
As |
|
|
|
Reported |
|
|
Adjustment |
|
|
Restated |
|
|
Reported |
|
|
Adjustment |
|
|
Restated |
|
Net revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Product revenues |
|
|
43,620 |
|
|
|
|
|
|
|
43,620 |
|
|
|
90,569 |
|
|
|
|
|
|
|
90,569 |
|
Royalty and contract |
|
|
222 |
|
|
|
|
|
|
|
222 |
|
|
|
406 |
|
|
|
|
|
|
|
406 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total net revenues |
|
|
43,842 |
|
|
|
|
|
|
|
43,842 |
|
|
|
90,975 |
|
|
|
|
|
|
|
90,975 |
|
Operating costs and expenses: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Cost of product revenues
(excluding amortization of
acquired product rights) |
|
|
4,007 |
|
|
|
(368 |
) |
|
|
3,639 |
|
|
|
7,926 |
|
|
|
(368 |
) |
|
|
7,558 |
|
Amortization of intangible assets |
|
|
4,153 |
|
|
|
|
|
|
|
4,153 |
|
|
|
8,055 |
|
|
|
|
|
|
|
8,055 |
|
Research and Development |
|
|
8,020 |
|
|
|
|
|
|
|
8,020 |
|
|
|
16,202 |
|
|
|
|
|
|
|
16,202 |
|
Selling, general and
administrative |
|
|
31,037 |
|
|
|
|
|
|
|
31,037 |
|
|
|
61,402 |
|
|
|
|
|
|
|
61,402 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total operating costs
and expenses |
|
|
47,217 |
|
|
|
(368 |
) |
|
|
46,849 |
|
|
|
93,585 |
|
|
|
(368 |
) |
|
|
93,217 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) from operations |
|
|
(3,375 |
) |
|
|
368 |
|
|
|
(3,007 |
) |
|
|
(2,610 |
) |
|
|
368 |
|
|
|
(2,242 |
) |
Interest and other income (expense): |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Interest income |
|
|
2,758 |
|
|
|
|
|
|
|
2,758 |
|
|
|
5,000 |
|
|
|
|
|
|
|
5,000 |
|
Interest expense |
|
|
(1,865 |
) |
|
|
|
|
|
|
(1,865 |
) |
|
|
(3,730 |
) |
|
|
|
|
|
|
(3,730 |
) |
Other income (expense), net |
|
|
(19 |
) |
|
|
|
|
|
|
(19 |
) |
|
|
33 |
|
|
|
|
|
|
|
33 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Income (loss) before income taxes |
|
|
(2,501 |
) |
|
|
368 |
|
|
|
(2,133 |
) |
|
|
(1,307 |
) |
|
|
368 |
|
|
|
(939 |
) |
Income tax provision (benefit) |
|
|
(340 |
) |
|
|
|
|
|
|
(340 |
) |
|
|
(259 |
) |
|
|
|
|
|
|
(259 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) |
|
$ |
(2,161 |
) |
|
$ |
368 |
|
|
$ |
(1,793 |
) |
|
$ |
(1,048 |
) |
|
$ |
368 |
|
|
$ |
(680 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
(0.06 |
) |
|
|
|
|
|
$ |
(0.05 |
) |
|
$ |
(0.03 |
) |
|
|
|
|
|
$ |
(0.02 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted |
|
$ |
(0.06 |
) |
|
|
|
|
|
$ |
(0.05 |
) |
|
$ |
(0.03 |
) |
|
|
|
|
|
$ |
(0.02 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Shares used to compute basic and diluted
net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
|
33,740 |
|
|
|
|
|
|
|
33,740 |
|
|
|
33,693 |
|
|
|
|
|
|
|
33,693 |
|
Diluted |
|
|
33,740 |
|
|
|
|
|
|
|
33,740 |
|
|
|
33,693 |
|
|
|
|
|
|
|
33,693 |
|
7
Recent Accounting Pronouncements
In July 2006 the Financial Accounting Standards Board, or the FASB, issued FASB Interpretation
No. 48, Accounting for Uncertainty in Income Taxes, or FIN 48. FIN 48 is an interpretation of
Statement of Financial Accounting Standards No. 109, Accounting for Income Taxes, or SFAS 109. FIN
48 clarifies the accounting for uncertainty in income taxes recognized in an enterprises financial
statements in accordance with SFAS 109 and prescribes a recognition threshold and measurement
attribute for the financial statement recognition and measurement of a tax position taken or
expected to be taken in a tax return. FIN 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods, disclosure, and transition.
The provisions of FIN 48 are required to be applied to all tax positions upon initial adoption.
The cumulative effect of applying the provisions of FIN 48 are required to be reported as an
adjustment to the opening balance of retained earnings in the year of adoption. FIN 48 will be
effective beginning with the first annual period after December 15, 2006. We are still evaluating
what impact, if any, the adoption of this standard will have on our financial position or results
of operations.
In September 2006 the FASB issued FASB Statement No. 157, Fair Value Measurements, or SFAS
157. The standard provides guidance for using fair value to measure assets and liabilities. The
standard also responds to investors requests for expanded information about the extent to which
companies measure assets and liabilities at fair value, the information used to measure fair value,
and the effect of fair value measurements on earnings. The standard applies whenever other
standards require or permit assets or liabilities to be measured at fair value. The standard does
not expand the use of fair value in any new circumstances. SFAS 157 must be adopted prospectively
as of the beginning of the year it is initially applied. SFAS 157 is effective for financial
statements issued for fiscal years beginning after November 15, 2007, and interim periods within
those fiscal years. We are still evaluating what impact, if any, the adoption of this standard
will have on our financial position or results of operations.
2. Significant Accounting Policies
Revenue Recognition
Our revenue recognition policy is in accordance with SEC Staff Accounting Bulletin No. 104, or
SAB 104, Revenue Recognition. We recognize revenue for sales when substantially all the risks
and rewards of ownership have transferred to the customer, which generally occurs on the date of
shipment. Our revenue recognition policy has a substantial impact on our reported results and
relies on certain estimates that require difficult, subjective and complex judgments on the part of
management.
We recognize product revenues net of allowances and accruals for estimated returns, rebates,
chargebacks and discounts. We estimate allowances and accruals based primarily on our past
experience. We also consider the volume and price mix of products in the retail channel, trends in
distributor inventory, trends in patient mix, economic trends that might impact patient demand for
our products (including competitive environment) and other factors. In addition, in December 2005
we began to use information about products in the wholesaler channel furnished to us in connection
with distribution service agreements entered into in late 2004 and 2005. The sensitivity of our
estimates can vary by program, type of customer and geographic location. In addition, estimates
associated with U.S. Medicaid and contract rebates and returns are subject to adjustments based on
new and updated business factors, in part due to the time delay between the recording of the
accrual and its ultimate settlement, an interval that can range up to one year for rebates and up
to several years for returns. Because of this time lag, in any given quarter our estimates of
returns, rebates and chargebacks recorded in prior periods may be adjusted to reflect current
business factors.
8
Gross-to-Net Sales Adjustment
The following significant categories of gross-to-net sales adjustments impact our reporting:
product returns, managed care rebates, Medicaid rebates, chargebacks, cash discounts, and other
adjustments, most of which involve significant estimates and judgments and require us to use
information from external sources. We account for these gross-to-net sales adjustments in
accordance with Emerging Issues Task Force Issue No. 01-9, or EITF 01-9, Accounting for
Consideration Given by a Vendor to a Customer (Including a Reseller of the Vendors Products), and
Statement of Financial Accounting Standard No. 48, or FAS 48, Revenue Recognition When Right of
Return Exists, as applicable.
Returns
Our product returns accrual is primarily based on estimates of future product returns over the
period during which wholesalers have a right of return, which in turn is based in part on estimates
of the remaining shelf life of the products. We allow wholesalers and pharmacies to return unused
product stocks that are within six months before and up to one year after their expiration date for
a credit at the then-current wholesale price less five percent. As a general practice, we do not
ship product that has less than 15 months until its expiration date. We also authorize returns for
damaged products and credits for expired products in accordance with our returned goods policy and
procedures. At the time of sale, we estimate the quantity and value of goods that may ultimately
be returned pursuant to these rights.
We estimate the rate of future product returns based on our historical experience using the
most recent three years data, the relative risk of return based on expiration date and other
qualitative factors that could impact the level of future product returns, such as competitive
developments, product discontinuations and our introduction of new products. We assess the risk of
return on a production lot basis and apply our estimated return rate to the units at risk for
return. Beginning in the first quarter of 2006, as a result of more extensive revenue forecasting,
we revalued our estimate of product returns using current and anticipated price increases. This
resulted in an increase to our returns reserve of $1.1 million and an increase in our net loss per
share of $0.03 for the nine months ended September 30, 2006. We monitor inventories held by our
distributors as well as prescription trends to help us assess the rate of return. In situations
where we are aware of products in the distribution channel nearing their expiration date, we
analyze the situation and if the analysis indicates that product returns will be larger than
previously expected, we adjust the product return accrual in which our analysis indicates the
adjustment is necessary. If a product begins to face significant competition from generic
products, we will give particular attention to the possible level of returns. To date, none of our
products has direct generic competition.
Due to the significant reduction of inventory held by our distributors during the third
quarter of 2006, our accrual for product returns of $14.4 million as of September 30, 2006
represented a significant amount of the value of the inventory in the distribution channel. We
believe this reduction of wholesaler inventory will correlate to a lower amount of product returns
in the future. We believe the methodology we utilize to calculate our returns reserve continues to
be appropriate; however, we do not have adequate information at the end of the third quarter to
determine a more appropriate estimated rate of return than the rate indicated by our most recent
three years data. During the fourth quarter of 2006, we will attempt to obtain additional
information on the inventory held by our largest wholesalers in order to determine the potential
return profile of the existing channel inventory. If, as anticipated, the return rate profile
supported by the information and our on-going returns experience indicate a significantly lower
rate for future returns, we will have a basis for determining a more appropriate accrual for
returns, at which time we could potentially release a substantial portion of our returns reserve.
Even if we release a significant amount of the accrual in the fourth quarter of 2006, we expect
that over the next one to several quarters our estimated return rate, and therefore our product
returns accrual, will continue to decrease at a more modest rate over time as a result of our
target wholesaler inventory levels.
9
It is more difficult for us to estimate returns from new products than returns for established
products. We estimate the product return accrual for new products primarily based on our
historical product returns experience with similar products, products that have similar
characteristics at various stages of their life cycle, and other available information pertinent to
the intended use and marketing of the new product.
Our actual experience and the qualitative factors that we use to determine the necessary
accrual for future product returns are susceptible to change based on unforeseen events and
uncertainties. We assess the trends that could affect our estimates and make changes to the
accrual quarterly.
Managed Care Rebates
We offer rebates to key managed care and other direct and indirect customers. Several of
these arrangements require the customer to achieve certain performance targets relating to value of
product purchased, formulary status or pre-determined market shares relative to competitors in
order to earn such rebates.
We establish an accrual in an amount equal to our estimate of managed care rebates
attributable to our sales in the period in which we record the sale as revenue. We estimate the
managed care rebates accrual primarily based on the specific terms in each agreement, current
contract prices, historical and estimated future usage by managed care organizations, and levels of
inventory in the distribution channel. We analyze the accrual at least quarterly and adjust the
balance as needed.
Medicaid Rebates
We participate in the Federal Medicaid rebate program, as well as several state
government-managed supplemental Medicaid rebate programs, which were developed to provide
assistance to certain vulnerable and needy individuals and families. Under the Medicaid rebate
program, we pay a rebate to each participating state and local government for our products that
their programs reimburse. Federal law also requires that any company that participates in the
Medicaid program must extend comparable discounts to qualified purchasers under the Public Health
Services, or PHS, pharmaceutical pricing program. The PHS pricing program extends discounts
comparable to the Medicaid rebate to a variety of community health clinics and other entities that
receive health services grants from the PHS, as well as hospitals that serve a disproportionate
share of Medicare and Medicaid beneficiaries. For purposes of this discussion, discounts and
rebates provided through these programs are considered Medicaid rebates and are included in our
Medicaid rebate accrual.
We establish an accrual in the amount equal to our estimate of Medicaid rebates attributable
to our sales in the period in which we record the sale as revenue. Although we accrue a liability
for estimated Medicaid rebates at the time we record the sale, the actual Medicaid rebate related
to that sale is typically not billed to us for up to one year after the sale, when a prescription
is filled that is covered by that program. We analyze the accrual at least quarterly and adjust
the balance as needed. In determining the appropriate accrual amount we consider the then-current
Medicaid rebate laws and interpretations; the historical and estimated future percentage of our
products that are sold to Medicaid recipients by pharmacies, hospitals, and other retailers that
buy from our customers; our product pricing and current rebate and/or discount contracts; and the
levels of inventory in the distribution channel. We analyze the accrual at least quarterly and
adjust the balance as needed.
Medicare Part D programs offered by managed care organizations, which began to provide
prescription drug benefit coverage effective January 1, 2006, were expected by us to reduce the
number of Medicaid eligible prescriptions processed by state Medicaid programs. Accordingly, our
rebate reserves for 2005 and the first quarter of 2006 were established based on our estimate of
the pending impact of these programs. Based on Medicaid claims recently received attributable to
prescriptions filled for the first three months of 2006, the reduction in prescriptions processed
by state Medicaid programs was significantly greater than the reduction we
had originally estimated. In late July and August, we conducted a review of the impact of the
Medicare Part D
10
programs on claims activity including discussions with all significant state
programs to ensure all of the claims relating to the first three months had been received. We
anticipate that Medicare Part D programs will continue to reduce the prescriptions processed by,
and therefore rebates to, state Medicaid programs in the future relative to prior years. Based on
this review we revised our estimate of the impact of these programs and as a result during the
second quarter we released approximately $2.9 million of Medicaid rebate reserves accrued at March
31, 2006. This change in estimate and related adjustment resulted in corresponding positive
contribution to our net product revenues for the nine months ended September 30, 2006 and decreased
our net loss by $0.09 per share for the nine months ended September 30, 2006. The impact of
Medicare Part D programs will continue to be evaluated and as additional market, data and rebate
claims activity become known the estimated rebate claims reserve will be adjusted accordingly.
Chargebacks
We also make our products available to authorized users of the Federal Supply Schedule, or
FSS, of the General Services Administration under an FSS contract negotiated by the Department of
Veterans Affairs. The Veterans Health Care Act of 1992, or VHCA, establishes a price cap, known as
the federal ceiling price for sales of covered drugs to the Veterans Administration, the
Department of Defense, the Coast Guard, and the PHS. Specifically, our sales to these federal
groups are discounted by a minimum of 24% off the average manufacturer price charged to non-federal
customers. These groups purchase product from the wholesalers, who then charge back to Connetics
the difference between the current retail price and the price the federal entity paid them for the
product.
We establish an accrual in the amount equal to our estimate of chargeback claims attributable
to our sales in the period in which we record the sale as revenue. Although we accrue a liability
for estimated chargebacks at the time we record the sale, the actual chargeback related to that
sale is not processed until the federal group purchases the product from the wholesaler. We
estimate the rate of chargebacks based on historical experience and changes to current contract
prices. We also consider our claim processing lag time and the level of inventory held at
wholesalers. We analyze the accrual at least quarterly and adjust the balance as needed. The
inventory at retail pharmacies, which represents the rest of the distribution channel, is not
considered in this accrual, as the entities eligible for chargebacks buy directly from wholesalers.
Cash Discounts
We offer cash discounts to our customers, generally 2% of the sales price, as an incentive for
prompt payment. We account for cash discounts by reducing accounts receivable by the full amount
of the discounts we expect our customers to take. We consider payment performance and adjust the
allowance to reflect actual experience and our current expectations about future activity.
Other Adjustments
In addition to the significant gross-to-net sales adjustments described above, we periodically
make other sales adjustments. For example, we may offer sales discounts to our customers and
discounts and coupons to patients. Other adjustments also includes payments owing to
distributors pursuant to distribution services agreements. We generally account for these other
gross-to-net adjustments by establishing an accrual in the amount equal to our estimate of the
adjustments attributable to the sale. We estimate the accruals for these other gross-to-net sales
adjustments primarily based our historical experience, and other relevant factors, including levels
of inventory in the distribution channel, if relevant, and adjust the accruals periodically
throughout the quarter to reflect the actual experience.
In 2004, the Department of Defense, or DOD, took the position that the Federal Supply Schedule
discounted price extends to retail pharmacy transactions through the DODs TRICARE Retail
Pharmacy program,
11
or TRRx. The intention was to obtain refunds for the government on retail
pharmacy utilization based on the difference between wholesaler pricing and Federal Ceiling Prices
as defined under the Veterans Health Care Act of 1992. The refund requirement was announced to us
and other manufacturers in an October 2004 letter. Based on the receipt of rebate invoices, we
began to reserve for an estimated liability for prescriptions filled under the TRRx program
beginning in the third quarter of 2005 and had reserved $1.4 million through June 30, 2006 for
potential liability under the TRRx program. That accrual is part of product-related accruals on
the Balance Sheet. A trade association challenged the legality of the TRRx program in Federal
court, and on September 11, 2006 the U.S. Court of Appeals for the Federal Circuit struck down the
TRRx program. We now believe that, as a result of the Federal Court of Appeals decision, it is
unlikely that the TRRx Program, even if ultimately implemented, will be made retroactive. As a
result, we released the $1.4 million accrual in September 2006, which decreased our net loss per
share by $0.04 for the three month and nine month periods ended September 30, 2006.
Use of Information from External Sources
We use information from external sources to estimate our significant gross-to-net sales
adjustments. Our estimates of inventory in the distribution channel are based on the projected
prescription demand-based sales for our products and historical inventory experience, as well as
our analysis of third-party information, including written and oral information obtained from
certain wholesalers with respect to their inventory levels and sell-through to customers,
third-party market research data, and our internal information. The inventory information received
from wholesalers is a product of their record-keeping process and excludes inventory held by
intermediaries to whom they sell, such as retailers and hospitals. Prior to December 31, 2005, we
estimated inventory in the distribution channel using historical shipment and return information
from our accounting records and data on prescriptions filled, which we purchase from Per-Se
Technologies, formerly NDC Health Corporation, one of the leading providers of prescription-based
information. In April 2005, we began to receive weekly reporting of inventory on hand and sales
information under the distribution service agreements from our two largest customers. We
identified errors in the reported information that impaired the accuracy and, as a result,
usefulness of this reporting. These errors were not corrected until December 2005. In December
2005 we also began to receive weekly reporting of inventory on hand and sales information for two
other customers. As a result of the improved accuracy and increased scope of our inventory
reporting, we began to use the reported inventory on hand information to estimate inventory in the
distribution channel as of December 31, 2005.
We use the information from Per-Se Technologies to project the prescription demand for our
products. Our estimates are subject to inherent limitations pertaining to reliance on third-party
information, as certain third-party information is itself in the form of estimates. In addition,
our estimates reflect other limitations including lags between the date as of which third-party
information is generated and the date on which we receive the third-party information.
Use of Estimates in Reserves
We believe that our allowances and accruals for items that are deducted from gross revenues
are reasonable and appropriate based on current facts and circumstances. It is possible, however,
that other parties applying reasonable judgment to the same facts and circumstances could develop
different allowance and accrual amounts for items that are deducted from gross revenues.
Additionally, changes in actual experience or changes in other qualitative factors could cause our
allowances and accruals to fluctuate, particularly with newly launched or acquired products. We
review the rates and amounts in our allowance and accrual estimates on a quarterly basis. If
future estimated rates and amounts are significantly greater than those reflected in our recorded
reserves, the resulting adjustments to those reserves would decrease our reported net revenues;
conversely, if actual returns, rebates and chargebacks are significantly less than those reflected
in our recorded reserves, the resulting adjustments to those reserves would increase our reported
net revenue. If we changed our assumptions and
estimates, our revenue reserves would change, which would impact the net revenues we report.
12
Royalty Revenues
We collect royalties from our third-party licensees based on their sales. We recognize
royalties either in the quarter in which we receive the royalty payment from the licensee or in the
period in which we can reasonably estimate the royalty, which is typically one quarter following
the related sale by the licensee.
Contract Revenues
We record contract revenue for research and development, or R&D, and milestone payments as
earned based on the performance requirements of the contract. We recognize non-refundable contract
fees for which no further performance obligations exist, and for which Connetics has no continuing
involvement, on the date we receive the payments or the date when collection is assured, whichever
is earlier.
We recognize revenue from non-refundable upfront license fees ratably over the period in which
we have continuing development obligations. We recognize revenue associated with substantial at
risk performance milestones, as defined in the respective agreements, based upon the achievement
of the milestones. When we receive advance payments in excess of amounts earned, we classify them
as deferred revenue until they are earned.
Stock-Based Compensation
On January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards
No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, requiring us to recognize expense
related to the fair value of our stock-based compensation awards. We elected to use the modified
prospective transition method as permitted by SFAS 123R and therefore have not restated our
financial results for prior periods. Under this transition method, stock-based compensation
expense for the three and nine months ended September 30, 2006 includes compensation expense for
all stock-based compensation 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, or
SFAS 123. Stock-based compensation expense for all stock-based compensation awards granted
subsequent to January 1, 2006 was based on the grant-date fair value estimated in accordance with
the provisions of SFAS 123R.
We use the Black-Scholes option-pricing model which requires the input of highly subjective
assumptions, including the options expected life and the price volatility of the underlying stock.
We record stock-based compensation expense net of expected forfeitures. The estimation of stock
awards that will ultimately vest requires judgment, and to the extent actual results or updated
estimates differ from our current estimates, such amounts will be recorded as a cumulative
adjustment in the period estimates are revised. We use a blend of historical volatility of our
common stock and implied volatility of tradable forward call and put options to purchase and sell
shares of our common stock. Changes in the subjective input assumptions can materially affect the
estimate of fair value of options granted and our results of operations could be materially
impacted.
We recognize stock-based compensation as expense over the requisite service periods in our
Condensed Consolidated Statements of Operations, using a graded vesting expense attribution
approach for unvested stock option awards granted before we adopted SFAS 123R and using the
straight-line expense attribution approach for stock option awards granted after we adopted SFAS
123R.
3. Net Income (Loss) Per Share
We compute basic net income (loss) per common share by dividing net income (loss) by the
weighted
average number of unrestricted common shares outstanding during the period.
13
The calculation of basic and diluted net income (loss) per share is as follows:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
|
|
|
|
2005 |
|
|
|
|
|
|
2005 |
|
(in thousands, except per share amounts) |
|
2006 |
|
|
(restated) |
|
|
2006 |
|
|
(restated) |
|
Net income (loss), as reported |
|
$ |
(27,371 |
) |
|
$ |
10,970 |
|
|
$ |
(28,050 |
) |
|
$ |
12,627 |
|
Add: interest on convertible note, net of tax effect |
|
|
|
|
|
|
669 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss), diluted |
|
$ |
(27,371 |
) |
|
$ |
11,639 |
|
|
$ |
(28,050 |
) |
|
$ |
12,627 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average shares outstanding |
|
|
34,436 |
|
|
|
35,075 |
|
|
|
34,243 |
|
|
|
35,197 |
|
Weighted-average restricted shares subject to repurchase |
|
|
(600 |
) |
|
|
|
|
|
|
(502 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic weighted-average shares outstanding |
|
|
33,836 |
|
|
|
35,075 |
|
|
|
33,741 |
|
|
|
35,197 |
|
Dilutive stock options |
|
|
|
|
|
|
1,534 |
|
|
|
|
|
|
|
2,265 |
|
Convertible debt |
|
|
|
|
|
|
4,203 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted weighted-average shares outstanding |
|
|
33,836 |
|
|
|
40,812 |
|
|
|
33,741 |
|
|
|
37,462 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income (loss) per share: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Basic |
|
$ |
(0.81 |
) |
|
$ |
0.31 |
|
|
$ |
(0.83 |
) |
|
$ |
0.36 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Diluted |
|
$ |
(0.81 |
) |
|
$ |
0.29 |
|
|
$ |
(0.83 |
) |
|
$ |
0.34 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
In calculating diluted net income (loss) per share, we excluded the following shares, as
the effect would be anti-dilutive (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
Nine Months Ended |
|
|
September 30, |
|
September 30, |
|
|
2006 |
|
2005 |
|
2006 |
|
2005 |
Options |
|
|
6,219 |
|
|
|
3,053 |
|
|
|
4,833 |
|
|
|
1,456 |
|
Restricted stock |
|
|
615 |
|
|
|
|
|
|
|
615 |
|
|
|
|
|
Convertible debt |
|
|
4,203 |
|
|
|
|
|
|
|
4,203 |
|
|
|
4,203 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total |
|
|
10,441 |
|
|
|
3,053 |
|
|
|
9,651 |
|
|
|
5,659 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
In 2006 and subsequent years, our dilutive securities may include incremental shares
issuable upon conversion of all or part of the $200 million in 2.00% convertible senior notes
currently outstanding. The conversion feature of these notes is triggered when our common stock
reaches a certain market price and, if triggered, may require us to pay a stock premium in addition
to redeeming the accreted principal amount for cash. The $200 million principal amount can only be
redeemed for cash, and therefore, has no impact on the diluted earnings per share calculation. In
accordance with the consensus from EITF No. 04-8, The Effect of Contingently Convertible
Instruments on Diluted Earnings per Share, we will include the dilutive effect of the notes in our
calculation of net income per diluted share when the impact is dilutive. The conversion feature of
these notes was not included as the notes had no dilutive effect on our computation of net income
(loss) per share for any period since issuance in March 2005.
4. Stock-Based Compensation
On January 1, 2006, we adopted the provisions of SFAS 123R, requiring us to measure and
recognize compensation expense for all stock-based awards at fair value. We elected to use the
modified prospective transition method as permitted by SFAS 123R and therefore have not restated
our financial results for the impact of SFAS 123R on prior periods. Under this transition method,
stock-based compensation expense for the three and nine months ended September 30, 2006 includes
compensation expense for all stock-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
SFAS 123. Stock-based compensation expense for all stock-based compensation awards granted
subsequent to January 1, 2006 was based on the grant-date fair value estimated in accordance with
the provisions of SFAS 123R.
14
Stock-based compensation is recognized as expense over the requisite service periods in our
Condensed Consolidated Statement of Operations for the three and nine month periods ended September
30, 2006 using a graded vesting expense attribution approach for unvested stock option awards
granted prior to the adoption of SFAS 123R and using the straight-line expense attribution approach
for stock option awards granted after the adoption of SFAS 123R. We record stock-based
compensation expense net of expected forfeitures. The following table sets forth the total
stock-based compensation expense resulting from stock options, non-vested stock awards and our
Employee Stock Purchase Plan, or Purchase Plan, included in our Condensed Consolidated Statement
of Operations.
|
|
|
|
|
|
|
|
|
|
|
Three Months |
|
|
Nine Months |
|
|
|
Ended |
|
|
Ended |
|
|
|
September 30, |
|
|
September 30, |
|
(in thousands, except per share amounts) |
|
2006 |
|
|
2006 |
|
Cost of product revenues |
|
$ |
|
|
|
$ |
|
|
Research and development |
|
|
307 |
|
|
|
867 |
|
Selling, general and administrative |
|
|
964 |
|
|
|
2,989 |
|
|
|
|
|
|
|
|
Stock-based compensation expense before income tax provision |
|
|
1,271 |
|
|
|
3,856 |
|
Income tax provision |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total stock-based compensation expense after income tax provision |
|
$ |
1,271 |
|
|
$ |
3,856 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock-based compensation expense per share: |
|
|
|
|
|
|
|
|
Basic and diluted |
|
$ |
0.04 |
|
|
$ |
0.11 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Weighted average shares outstanding: |
|
|
|
|
|
|
|
|
Basic and diluted |
|
|
33,836 |
|
|
|
33,741 |
|
|
|
|
|
|
|
|
The fair value of the options vested for the nine months ended September 30, 2006 was
$2.4 million. As of September 30, 2006, there was $9.5 million (before any related tax benefit) of
total unrecognized compensation cost related to unvested stock-based compensation that is expected
to be recognized over a weighted-average period of approximately 1.9 years.
We received net cash from the exercise of stock options of $385,000 for the three months ended
September 30, 2006, and $3.6 million for the nine months ended September 30, 2006. Net cash
proceeds from the exercise of stock options were $2.2 million and $7.1 million for the three and
nine months ended September 30, 2005, respectively. We did not realize any income tax benefit from
stock option exercises during the three and nine months ended September 30, 2006 and 2005. In
accordance with SFAS 123R, we present excess tax benefits from the exercise of stock options, if
any, as financing cash flows rather than operating cash flows.
Prior to the adoption of SFAS 123R, we applied SFAS 123, amended by SFAS 148, which allowed
companies to apply the existing accounting rules under APB 25 and related Interpretations.
Accordingly, we did not recognize any compensation expense in our financial statements in
connection with stock options granted to employees when those options had exercise prices equal to
or greater than fair market value of our common stock on the date of grant. We also did not record
any compensation expense in connection with our Purchase Plan as long as the purchase price was not
less than 85% of the fair market value at the beginning or end of each offering period, whichever
was lower. As required by SFAS 148 prior to the adoption of SFAS 123R, we provided pro forma net
income (loss) and pro forma net income (loss) per share disclosures for stock-based awards, as if
the fair-value-based method defined in SFAS 123 had been applied.
15
The following table illustrates the effect on net income after tax and net income per share as
if we had applied the fair value recognition provisions of SFAS 123 to stock-based compensation
during the three and nine months ended September 30, 2005:
|
|
|
|
|
|
|
|
|
|
|
Three Months |
|
|
Nine Months |
|
|
|
Ended |
|
|
Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2005 |
|
|
2005 |
|
(in thousands, except per share amounts) |
|
(restated) |
|
|
(restated) |
|
Net income, as reported |
|
$ |
10,970 |
|
|
$ |
12,627 |
|
Add: interest on convertible note, net of tax effect |
|
|
669 |
|
|
|
|
|
|
|
|
|
|
|
|
Net income, diluted |
|
$ |
11,639 |
|
|
$ |
12,627 |
|
|
|
|
|
|
|
|
Add: Stock-based compensation expense, net of related tax effects |
|
|
5 |
|
|
|
13 |
|
Deduct: Total stock-based employee compensation expense
determined under the fair value method for all awards, net of
related tax effects |
|
|
(4,010 |
) |
|
|
(12,288 |
) |
|
|
|
|
|
|
|
Pro forma net income |
|
$ |
7,634 |
|
|
$ |
352 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Net income per share: |
|
|
|
|
|
|
|
|
Basic, as reported |
|
$ |
0.31 |
|
|
$ |
0.36 |
|
Diluted, as reported |
|
$ |
0.29 |
|
|
$ |
0.34 |
|
Basic, pro forma |
|
$ |
0.20 |
|
|
$ |
0.01 |
|
Diluted, pro forma |
|
$ |
0.19 |
|
|
$ |
0.01 |
|
The pro forma stock-based compensation expense determined under the fair value method for
the nine months ended September 30, 2005 of $12.3 million, as reported above, differs from the
previously reported pro forma amount of $13.7 million. The previously reported amount erroneously
included the expense related to our Purchase Plan for the full year of 2005 rather than only the
nine month period ended September 30, 2005.
The weighted average fair value of options granted, based on the assumptions and criteria
discussed below, was $4.95 and $6.37 per share for the three and nine months ended September 30,
2006, respectively; and $7.28 and $9.53 per share for the three and nine months ended September 30,
2005, respectively.
The fair value of stock-based awards was estimated using the Black-Scholes model with the
following weighted-average assumptions:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Stock Option Plans |
|
Stock Option Plans |
|
|
Three Months Ended |
|
Nine Months Ended |
|
|
September 30, |
|
September 30, |
|
|
2006 |
|
2005 |
|
2006 |
|
2005 |
Expected stock volatility |
|
|
53.7 |
% |
|
|
47.1 |
% |
|
|
51.9 |
% |
|
|
47.1 |
% |
Risk-free interest rate |
|
|
4.7 |
% |
|
|
3.9 |
% |
|
|
4.7 |
% |
|
|
3.6 |
% |
Expected life (in years) |
|
|
4.5 |
|
|
|
4.0 |
|
|
|
4.2 |
|
|
|
4.0 |
|
Expected dividend yield |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
0.0 |
% |
|
|
|
|
|
|
|
|
|
|
|
Stock Purchase Plan |
|
|
Three Months |
|
Nine Months |
|
|
Ended |
|
Ended |
|
|
September 30, |
|
September 30, |
|
|
2005 |
|
2005 |
Expected stock volatility |
|
|
55.9 |
% |
|
|
52.1 |
% |
Risk-free interest rate |
|
|
1.5 |
% |
|
|
1.6 |
% |
Expected life (in years) |
|
|
1.4 |
|
|
|
1.4 |
|
Expected dividend yield |
|
|
0.0 |
% |
|
|
0.0 |
% |
We estimated the fair value of each option grant on the date of the grant using the
Black-Scholes valuation model. The expected life of the options represents the weighted average
period of time that options granted are expected to be outstanding giving consideration to vesting
schedules, option cancellations and the historical exercise patterns we have experienced. For the
three and nine month periods ended September 30, 2006, we estimate the expected stock price
volatility based on a combination of our common stocks historical
volatility and the implied volatility of tradable forward call and put options to purchase and
sell shares of our
16
stock. For the three and nine month periods ended September 30, 2005, we
estimated expected stock volatility primarily using a combination of the historical volatility of
our stock and our peers stock, and to a lesser extent, the implied volatility as described above.
The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of
grant. In 2006, we have reduced gross compensation expense to account for estimated forfeitures,
because the expense related to stock option awards recognized on adoption of SFAS 123R is based on
awards ultimately expected to vest. SFAS 123R requires forfeitures to be estimated at the time of
grant and revised, if necessary, in subsequent periods if actual forfeitures differ from those
estimates. We estimated forfeitures based on our historical experience.
Through November 30, 2005, our Purchase Plan permitted eligible employees to purchase our
common stock through payroll deductions at a price equal to the lower of 85% of the fair market
value at the beginning or end of the offering period, which was two years. On December 1, 2005, we
modified the Purchase Plan so that employee purchases were made at 85% of the fair market value of
our common stock at the end of each six month offering period. The elimination of the look back
period as well as a decrease in employee participation in the Purchase Plan has resulted in a
significant decrease of the expense related to the Purchase Plan in 2006 and simplified the
calculation of the related stock-based compensation to represent 15% of the contributions to the
Purchase Plan. We recognized $81,000 and $226,000 in stock-based compensation expense related to
the Purchase Plan during the three and nine months ended September 30, 2006, respectively.
Stock-based compensation expense related to the Purchase Plan recognized in our pro forma
disclosure was $749,000 and $1,472,000 for the three and nine month periods ended September 30,
2005, respectively.
On January 27, 2006, we granted 475,000 shares of restricted stock in lieu of option grants to
members of our executive management. Of the total awards, 50% are subject to time-based vesting
and the remaining 50% are subject to both performance-based and time-based vesting with certain
2006 performance goals determined by the Compensation Committee. For all of the shares subject to
time-based vesting and the shares ultimately issued based on performance, the vesting restriction
for one-half will lapse on February 1, 2008 and the remaining one-half will lapse February 1, 2009.
Through September 30, 2006 we have not recorded compensation expense for the restricted stock
grants which have performance-based criteria due to the probability that the performance criteria
will not be met; however, the Compensation Committee will make a final assessment in late 2006 or
the first quarter of 2007, at which time they will consider business conditions and other factors. On February 1, 2006, we also granted 58,000 shares of
restricted stock in lieu of option grants to certain management individuals; all of those shares
are subject only to time-based vesting. Of the total awards, the restriction for one-third lapses
on the first anniversary and one-sixth each six months thereafter. On May 22, 2006 we granted an
additional 60,000 shares of restricted stock in lieu of annual option grants to our Board of
Directors. The restriction on these awards lapses one year from the date of grant. We did not
grant restricted stock prior to January 1, 2006. We recognized approximately $568,000 and
$1,240,000 of compensation expense during the three and nine month periods ended September 30,
2006, respectively. The weighted average fair value of restricted stock granted, determined using
the Black-Scholes model, was $10.44 per share for the three months ended September 30, 2006 and
$14.75 per share for the nine months ended September 30, 2006, respectively.
Stock Plans
We have seven plans pursuant to which we have granted stock options to employees, directors,
and consultants. In general, all of the plans authorize the grant of stock options vesting at a
rate to be set by the Board or the Compensation Committee. Generally, stock options under all of
our employee stock plans become exercisable at a rate of 25% per year for a period of four years
from date of grant. The plans require that the options be exercisable at a rate no less than 20%
per year. The exercise price of stock options under the employee stock plans generally meets the
following criteria: exercise price of incentive stock options must be at least 100% of the fair
market value on the grant date, exercise price of non-statutory stock
options must be at least 85% of the fair market value on the grant date, and exercise price of options granted to 10% (or greater)
stockholders must be
17
at least 110% of the fair market value on the grant date. The 1995 Directors
Plan expired on January 1, 2006. The 2000 Non- Officer Stock Plan, the 2002 Employee Stock Plan
and the International Stock Incentive Plan do not permit the grant of incentive stock options. The
weighted stock options under all of our employee stock plans have a term of ten years from date of
grant. Below is a general description of the plans from which we are currently granting stock
options.
2000 Stock Plan. Our 2000 Stock Plan (the 2000 Plan) was approved by the Board and our
stockholders in 1999. The 2000 Plan became available on January 1, 2000, and was initially funded
with 808,512 shares. On the first day of each new calendar year during the term of the 2000 Plan,
the number of shares available will be increased (with no further action needed by the Board or the
stockholders) by a number of shares equal to the lesser of three percent (3%) of the number of
shares of common stock outstanding on the last preceding business day, or an amount determined by
the Board.
Non-Officer Stock Option Plans. The 2000 Non-Officer Stock Plan was funded with 500,000
shares. No additional shares will be added to this plan, although shares may be granted if they
become available through cancellation. The 2002 Employee Stock Plan was initially funded with
500,000 shares. In 2003, the 2002 Employee Stock Plan was amended to increase the shares available
for issuance by 750,000 shares, for a total of 1,250,000 shares, and to permit the issuance of
options under the plan to officers of Connetics who are not executive officers within the meaning
of Section 16 of the Securities Exchange Act of 1934. Our stockholders approved those amendments
in 2003. The options granted under both plans are nonstatutory stock options.
International Stock Incentive Plan. In 2001, the Board approved an International Stock
Incentive Plan, which provided for the grant of Connetics stock options to employees of Connetics
or its subsidiaries where the employees are based outside of the United States. The plan was
funded with 250,000 shares. The options granted under the plan are nonstatutory stock options.
Inducement Stock Option Grants. In 2005, the Compensation Committee of the Board of Directors
approved a pool of 600,000 shares to be granted to certain employees. Pursuant to NASDAQ
Marketplace Rule 4350(i)(1)(A)(IV), we issue a press release for all inducement grants disclosing
the grants and their material terms.
Summary of All Option Plans and Non-Plan Grants. The following table summarizes information
concerning stock options outstanding under all of our stock option plans and certain grants of
shares and options outside of our plans. Options canceled under terminated plans are no longer
available for grant.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options Outstanding |
|
|
|
Shares |
|
|
|
|
|
|
Weighted |
|
|
|
Available |
|
|
Number |
|
|
Average |
|
|
|
for |
|
|
of |
|
|
Exercise |
|
|
|
Grant |
|
|
Shares |
|
|
Price |
|
Balance, December 31, 2004 |
|
|
372,082 |
|
|
|
6,837,909 |
|
|
$ |
12.64 |
|
|
|
|
|
|
|
|
|
|
|
|
Additional shares authorized |
|
|
1,675,356 |
|
|
|
|
|
|
|
|
|
Options granted |
|
|
(1,730,887 |
) |
|
|
1,730,887 |
|
|
|
22.05 |
|
Options exercised |
|
|
|
|
|
|
(713,747 |
) |
|
|
8.93 |
|
Options canceled, expired or forfeited |
|
|
474,797 |
|
|
|
(474,797 |
) |
|
|
18.90 |
|
|
|
|
|
|
|
|
|
|
|
|
Balance, December 31, 2005 |
|
|
791,348 |
|
|
|
7,380,252 |
|
|
$ |
14.80 |
|
Additional shares authorized |
|
|
1,277,543 |
|
|
|
|
|
|
|
|
|
Options granted |
|
|
(1,008,068 |
) |
|
|
1,008,068 |
|
|
|
13.85 |
|
Restricted shares granted |
|
|
(615,120 |
) |
|
|
|
|
|
|
|
|
Options exercised |
|
|
|
|
|
|
(424,032 |
) |
|
|
8.90 |
|
Options canceled, expired or forfeited (1) |
|
|
456,076 |
|
|
|
(456,076 |
) |
|
|
18.19 |
|
Options canceled due to an expired plan (2) |
|
|
(70,000 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Balance, September 30, 2006 |
|
|
831,779 |
|
|
|
7,508,212 |
|
|
$ |
14.80 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
(1) |
|
During the nine months ended September 30, 2006 we had 49,000 canceled, expired or
forfeited |
18
|
|
|
|
|
options related to stock option plans that expired before January 1, 2006. As these
options expire or are forfeited they are not added back to the pool of options available for
grant. |
|
(2) |
|
On January 1, 2006 our 1995 Directors Plan expired, with the result that 70,000
options expired that had never been granted. |
The aggregate intrinsic value of options exercised during the three and nine months ended
September 30, 2006 was $373,000 and $2.4 million, respectively. The aggregate intrinsic value of
options exercised during the three and nine months ended September 30, 2005 was $2.4 million and
$8.9 million, respectively.
The following table summarizes information concerning outstanding and exercisable options at
September 30, 2006:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Options Outstanding |
|
Options Exercisable |
|
|
|
|
|
|
Weighted |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Average |
|
Weighted |
|
|
|
|
|
Weighted |
Range |
|
|
|
|
|
Remaining |
|
Average |
|
|
|
|
|
Average |
of |
|
Number of |
|
Life (in |
|
Exercise |
|
Number of |
|
Exercise |
Exercise Prices |
|
Shares |
|
years |
|
Price |
|
Shares |
|
Price |
$ 0.00 $5.84
|
|
|
488,005 |
|
|
|
3.30 |
|
|
$ |
4.48 |
|
|
|
488,005 |
|
|
$ |
4.48 |
|
$ 5.85 $8.75
|
|
|
1,062,756 |
|
|
|
2.90 |
|
|
|
7.61 |
|
|
|
1,026,256 |
|
|
|
7.60 |
|
$ 8.76 $11.67
|
|
|
488,419 |
|
|
|
7.40 |
|
|
|
10.34 |
|
|
|
246,688 |
|
|
|
10.53 |
|
$11.68 $14.59
|
|
|
1,757,109 |
|
|
|
5.65 |
|
|
|
12.29 |
|
|
|
1,468,325 |
|
|
|
12.20 |
|
$14.60 $17.51
|
|
|
898,468 |
|
|
|
8.62 |
|
|
|
15.82 |
|
|
|
241,032 |
|
|
|
16.30 |
|
$17.52 $20.43
|
|
|
1,320,559 |
|
|
|
6.81 |
|
|
|
18.28 |
|
|
|
1,237,098 |
|
|
|
18.32 |
|
$20.44 $23.34
|
|
|
282,146 |
|
|
|
7.72 |
|
|
|
21.88 |
|
|
|
282,146 |
|
|
|
21.88 |
|
$23.35 $26.26
|
|
|
950,500 |
|
|
|
7.68 |
|
|
|
23.76 |
|
|
|
950,500 |
|
|
|
23.76 |
|
$26.27 $29.18
|
|
|
260,250 |
|
|
|
7.77 |
|
|
|
27.32 |
|
|
|
260,250 |
|
|
|
27.32 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
$ 0.00 $29.18
|
|
|
7,508,212 |
|
|
|
6.19 |
|
|
|
14.80 |
|
|
|
6,200,300 |
|
|
|
14.99 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The aggregate intrinsic value of options outstanding and options exercisable at September
30, 2006 was $6.9 million and $6.6 million, respectively. Options exercisable at September 30,
2006 had a weighted-average remaining contractual life of 5.63 years.
5. Comprehensive Income
The components of comprehensive income (loss) are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
|
|
|
|
2005 |
|
|
|
|
|
|
2005 |
|
|
|
2006 |
|
|
(restated) |
|
|
2006 |
|
|
(restated) |
|
Net income (loss) |
|
$ |
(27,371 |
) |
|
$ |
10,970 |
|
|
$ |
(28,050 |
) |
|
$ |
12,627 |
|
Foreign currency translation adjustment |
|
|
(95 |
) |
|
|
(9 |
) |
|
|
(41 |
) |
|
|
(92 |
) |
Change in unrealized gain (loss) on securities |
|
|
720 |
|
|
|
(362 |
) |
|
|
343 |
|
|
|
(536 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Comprehensive income (loss) |
|
$ |
(26,746 |
) |
|
$ |
10,599 |
|
|
$ |
(27,748 |
) |
|
$ |
11,999 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Accumulated other comprehensive income recorded in stockholders equity included $105,000
of net unrealized losses on investments and $934,000 of foreign currency translation unrealized
gains as of September 30, 2006 and, as of December 31, 2005, included $447,000 of net unrealized
losses on investments and $974,000 of foreign currency translation unrealized gains.
6. Inventory
Inventory consists of raw materials and finished goods costs primarily related to our marketed
products.
We state inventory at the lower of cost (determined on a first-in first-out method) or market.
If inventory costs
19
exceed expected market value due to obsolescence, expiration or lack of demand
for the product, we record reserves in an amount equal to the difference between the cost and the
estimated market value. These reserves are based on estimates and assumptions made by management.
These estimates and assumptions can have a significant impact on the amounts of reserves.
The components of inventory are as follows (in thousands):
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
|
December 31, |
|
|
|
2006 |
|
|
2005 |
|
Raw materials |
|
$ |
4,054 |
|
|
$ |
1,649 |
|
Finished goods |
|
|
5,422 |
|
|
|
5,836 |
|
|
|
|
|
|
|
|
Total inventory |
|
$ |
9,476 |
|
|
$ |
7,485 |
|
|
|
|
|
|
|
|
Inventory may also include similar costs for product candidates awaiting regulatory
approval to be sold upon receipt of approval. We capitalize those costs based on managements
judgment of probable near-term commercialization or alternative future uses for the inventory. If
not approved, we assess the realizability of the asset based on several factors including
managements estimates of future regulatory work required, alternative uses, and potential resale
value. We included $1.9 million of product packaging material and equipment costs related to Velac
Gel in the other assets line item on our balance sheet at December 31, 2005. After completion of
certain studies in the third quarter of 2006 and communications with the FDA in September 2006, our
management team reassessed the realizability of these assets based on future regulatory work
required, the potential resale value and other relevant factors. We determined these assets were
impaired and expensed $1.9 million to the research and development line item on our statement of
operations for the three and nine month periods ended September 30, 2006. Connetics remains
committed to bringing the product to market and development activities are ongoing.
7. PediaMed Sales Organization Acquisition
Effective February 1, 2006, we acquired the sales organization of PediaMed Pharmaceuticals,
Inc., a privately-held pharmaceutical company specializing in the pediatric market, for cash of
$12.5 million plus transaction costs of approximately $37,000. We recorded an intangible asset for
the assembled workforce and trademark rights acquired in connection with this acquisition of
approximately $12.5 million based on a cost approach. We are amortizing the assembled workforce
over an estimated useful life of five years. The acquired sales force is promoting our products to
selected pediatricians nationwide. We added Verdeso, our first product with a pediatric label
approved by the FDA, to the groups portfolio in October 2006. The FDA approved Verdeso on
September 19, 2006. The PediaMed acquisition did not include any commercial products historically
sold by the PediaMed sales organization, or rights to any products developed by PediaMed. The
$12.5 million included $0.3 million for trademark rights acquired in connection with the
acquisition which were amortized over six months.
8. Goodwill and Other Intangible Assets
There was no change in the carrying amount of goodwill of $6.3 million during the three and
nine months ended September 30, 2006. The components of our intangible assets are as follows (in
thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, 2006 |
|
|
December 31, 2005 |
|
|
|
Useful Life |
|
|
Gross Carrying |
|
|
Accumulated |
|
|
|
|
|
|
Gross Carrying |
|
|
Accumulated |
|
|
|
|
|
|
in Years |
|
|
Amount |
|
|
Amortization |
|
|
Net |
|
|
Amount |
|
|
Amortization |
|
|
Net |
|
Acquired product rights |
|
|
10 |
|
|
$ |
127,652 |
|
|
$ |
(32,977 |
) |
|
$ |
94,675 |
|
|
$ |
127,652 |
|
|
$ |
(23,403 |
) |
|
$ |
104,249 |
|
Existing technology |
|
|
10 |
|
|
|
6,810 |
|
|
|
(3,717 |
) |
|
|
3,093 |
|
|
|
6,810 |
|
|
|
(3,206 |
) |
|
|
3,604 |
|
Patents |
|
|
10-13 |
|
|
|
1,661 |
|
|
|
(838 |
) |
|
|
823 |
|
|
|
1,661 |
|
|
|
(725 |
) |
|
|
936 |
|
Assembled workforce |
|
|
5 |
|
|
|
12,248 |
|
|
|
(1,626 |
) |
|
|
10,622 |
|
|
|
|
|
|
|
|
|
|
|
|
|
Other PediaMed assets |
|
|
0.5 |
|
|
|
289 |
|
|
|
(289 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total |
|
|
|
|
|
$ |
148,660 |
|
|
$ |
(39,447 |
) |
|
$ |
109,213 |
|
|
$ |
136,123 |
|
|
$ |
(27,334 |
) |
|
$ |
108,789 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
20
Amortization expenses for our other intangible assets were $4.1 million and $12.1 million
during the three and nine months ended September 30, 2006, respectively. Amortization expenses for
our other intangible assets were $3.4 million and $10.2 million during the three and nine months
ended September 30, 2005, respectively.
The expected future amortization expense of our other intangible assets is as follows (in
thousands):
|
|
|
|
|
|
|
Amortization |
|
|
|
Expense |
|
Remaining three months in 2006 |
|
$ |
4,011 |
|
For the year ending December 31, 2007 |
|
|
16,049 |
|
For the year ending December 31, 2008 |
|
|
16,049 |
|
For the year ending December 31, 2009 |
|
|
16,049 |
|
For the year ending December 31, 2010 |
|
|
16,049 |
|
For the year ending December 31, 2011 |
|
|
13,232 |
|
Thereafter |
|
|
27,774 |
|
|
|
|
|
Total |
|
$ |
109,213 |
|
|
|
|
|
9. Guaranties and Indemnifications
Pursuant to FASB Interpretation No. 45, Guarantors Accounting and Disclosure Requirements
for Guarantees, including Indirect Guarantees of Indebtedness of Others, or FIN No. 45, upon
issuance the guarantor must recognize a liability for the fair value of the obligations it assumes
under that guarantee. We enter into indemnification provisions under our agreements with certain
key employees and other companies in the ordinary course of our business, typically with business
partners, contractors, clinical sites, insurers, and customers. Under these provisions we
generally indemnify and hold harmless the indemnified party for losses suffered or incurred by the
indemnified party as a result of our activities. These indemnification provisions generally
survive termination of the underlying agreement. In some cases, the maximum potential amount of
future payments Connetics could be required to make under these indemnification provisions is
unlimited. The estimated fair value of the indemnity obligations of these agreements is
insignificant. Accordingly, we have not recorded liabilities for these agreements as of September
30, 2006. We have not incurred material costs to defend lawsuits or settle claims related to these
indemnification provisions.
10. Co-Promotion Agreement
In April 2005, we entered into an agreement with Ventiv Pharma Services, LLC, or VPS, a
subsidiary of Ventiv Health, Inc., under which VPS provided sales support for certain of our
products to primary care physicians and pediatricians. Product sales activities under this
agreement commenced in mid-April 2005. We recorded 100% of the revenue from product sales of OLUX
Foam, Luxíq Foam, and Evoclin Foam generated by promotional efforts of VPS; paid VPS a fee for the
personnel providing the promotional efforts, which are included in selling, general and
administrative expense; and bore the marketing costs for promoting the products, including product
samples and marketing materials. In January 2006, the parties mutually agreed to discontinue
the agreement, and the agreement terminated effective February 10, 2006.
11. Stock Repurchase Program
On October 31, 2005, our Board of Directors authorized the repurchase of up $50 million of our
common
stock. As of December 31, 2005, we had repurchased 1.8 million shares of our common stock at
a cost of $24.4 million. During the nine months ended September 30, 2006, we repurchased an
additional 143,000 shares at a cost of $2.2 million.
21
12. SEC Investigation
As
previously disclosed, the SEC is conducting an investigation into
potential securities law violations by the Company and/or current and
former officers, directors and employees. The Company has received
and responded to multiple subpoenas and requests for information,
most recently a document subpoena dated October 6, 2006, to
which the Company has responded. The SEC investigation is ongoing.
13. Subsequent Events Proposed Merger with Stiefel Laboratories, Inc.
On October 22, 2006, Connetics entered into a definitive merger agreement (Merger Agreement)
with Stiefel Laboratories, Inc., or Stiefel, for Stiefel to acquire Connetics. This transaction is
subject to certain closing conditions, including (i) approval by at least a majority of the voting
power of the shares of the Companys common stock outstanding, and (ii) the termination or
expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.
Upon the closing of the merger:
|
|
|
each issued and outstanding share of the Companys common stock (including shares of
restricted common stock whose vesting will accelerate upon the closing of the merger,
as discussed below), will be converted into a right to receive $17.50 in cash, without
interest; |
|
|
|
|
all of the Companys outstanding stock options and shares of restricted stock, to
the extent not vested, will accelerate in full; and |
|
|
|
|
each outstanding stock option will be terminated and converted into a right to
receive a cash payment equal to the product of (i) the amount, if any, that $17.50
exceeds the exercise price per share of such option, multiplied by (ii) the number of
shares underlying such option. |
22
In connection with the Merger Agreement, the directors and executive officers of Connetics,
concurrently with the execution and delivery of the Merger Agreement, entered into Voting
Agreements with Stiefel (Voting Agreements), pursuant to which they each agreed, among other
things, to vote the shares of Connetics common stock held by them in favor of the Merger and
against any other proposal or offer to acquire Connetics. If the Merger Agreement is terminated for
any reason, the Voting Agreements will also terminate. The directors and executive officers who
have entered into Voting Agreements own, in the aggregate, 1,033,051 shares of Connetics common
stock as of October 22, 2006, representing approximately three percent of Connetics outstanding
common stock.
Immediately prior to the execution of the Merger Agreement, the Company and Computershare
Trust Company, N.A. entered into an amendment (Rights Agreement Amendment) to the Companys Rights
Agreement dated as of November 21, 2001 (Rights Agreement). The purpose and effect of the Rights
Agreement Amendment is to make the Rights Agreement inapplicable to the announcement, approval,
execution, delivery or performance of the Merger Agreement or the Voting Agreements, or the
consummation of the Merger or any of the other transactions contemplated by the Merger Agreement,
so that these events will not trigger the separation or exercise of the Rights (as defined in the
Rights Agreement).
Connetics and Stiefel also entered into a Distribution and Supply Agreement (Distribution and
Supply Agreement) in which they agreed that if a third party should begin selling a generic version
of Connetics Soriatane® product, Stiefel would be authorized to also sell a generic version of
Soriatane in the United States, Connetics would supply Stiefel with its requirements of the product
(subject to certain limitations) and Connetics would not supply any other party with a generic
version of Soriatane. If the Merger Agreement is terminated, then Connetics would be entitled to
terminate the Distribution and Supply Agreement.
The Company currently expects the transaction to close in late 2006 or early 2007, although
there can be no assurances that it will close. Under terms specified in the merger agreement,
Connetics or Stiefel may terminate the agreement, and, in connection with a termination under
certain specified circumstances, Connetics may be required to pay a $19.1 million termination fee
to Stiefel.
As a result of the merger, each holder of the convertible notes shall have the right to
require Connetics to repurchase any or all of the holders notes for cash at 100% of the principal
amount plus accrued and unpaid interest on such amount to the applicable repurchase date.
Furthermore, each holder of the notes shall have the right to convert all of such holders notes
into shares of the Connetics Common Stock pursuant to the conversion ratio set forth in the
respective indenture agreements.
For more information about the proposed transaction, refer to the Current Report on Form 8-K
filed by the Company on October 24, 2006.
23
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
This discussion and analysis should be read in conjunction with the MD&A included in our
Annual Report, as amended, on Form 10-K /A for the year ended December 31, 2005 and with the
unaudited condensed consolidated financial statements and notes to financial statements included in
this Report. Our disclosure and analysis in this Report, in other reports that we file with the
Securities and Exchange Commission, in our press releases and in public statements of our officers
may contain forward-looking statements within the meaning of Section 27A of the Securities Act, and
Section 21E of the Securities Exchange Act. Forward-looking statements give our current
expectations or forecasts of future events. You can identify these statements by the fact that
they do not relate strictly to historical or current events. They use words such as anticipate,
estimate, expect, will, may, intend, plan, believe and similar expressions in
connection with discussion of future operating or financial performance. These include statements
relating to future actions, prospective products or product approvals, future performance or
results of current and anticipated products, sales efforts, expenses, the outcome of contingencies
such as legal proceedings, and financial results. Forward-looking statements may turn out to be
wrong. They can be affected by inaccurate assumptions or by known or unknown risks and
uncertainties. Many factors will be important in determining future results. No forward-looking
statement can be guaranteed, and actual results may vary materially from those anticipated in any
forward-looking statement. Some of the factors that, in our view, could cause actual results to
differ are discussed under the caption Risk Factors in our 2005 Annual Report, as amended, on
Form 10-K/A for the year ended December 31, 2005, as amended. Our historical operating results are
not necessarily indicative of the results to be expected in any future period.
Proposed Merger With Stiefel
On October 22, 2006, Connetics entered into a definitive merger agreement (Merger Agreement)
with Stiefel Laboratories, Inc., or Stiefel, for Stiefel to acquire Connetics. This transaction is
subject to certain closing conditions, including (i) approval by at least a majority of the voting
power of the shares of the Companys common stock outstanding, and (ii) the termination or
expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.
Upon the closing of the merger:
|
|
|
each issued and outstanding share of the Companys common stock (including shares of
restricted common stock whose vesting will accelerate upon the closing of the merger,
as discussed below), will be converted into a right to receive $17.50 in cash, without
interest; |
|
|
|
|
all of the Companys outstanding stock options and shares of restricted stock, to
the extent not vested, will accelerate in full; and |
|
|
|
|
each outstanding stock option will be terminated and converted into a right to
receive a cash payment equal to the product of (i) the amount, if any, that $17.50
exceeds the exercise price per share of such option, multiplied by (ii) the number of
shares underlying such option. |
This Managements Discussion and Analysis of Financial Condition and Results of Operations
section is intended to help the reader understand our historical results and anticipated outlook
prior to the close of the proposed merger. We currently expect the transaction to close in late
2006 or early 2007, although we cannot assure you that it will close. Under terms specified in the
merger agreement, Connetics or Stiefel may terminate the agreement, and, in connection with a
termination under certain specified circumstances, Connetics may be required to pay a $19.1 million
termination fee to Stiefel. For more information about the proposed transaction, refer to the
Current Report on Form 8-K filed by the Company on October 24, 2006. We intend to file a proxy
statement with the SEC that, when final, will detail a meeting of our stockholders to enable our
stockholders to vote to adopt the merger agreement. The proxy statement will be sent to all our
stockholders and will contain
24
important information about us, the merger, risks relating to the merger and related matters.
We strongly encourage our stockholders to read this proxy statement when available.
Restatement of Consolidated Financial Statements
We restated our consolidated financial statements to correct for errors in our estimated
accruals for rebates, chargebacks and returns. Please refer to our Annual Report, as amended, on
Form 10-K/A for the year ended December 31, 2005 for a detailed discussion.
Overview
We are a specialty pharmaceutical company that develops and commercializes innovative products
for the medical dermatology market. This market is characterized by a large patient population that
is served by relatively small, and therefore more accessible, groups of treating physicians. Our
products are designed to improve the management of dermatological diseases and provide significant
product differentiation. We have branded our proprietary foam drug delivery vehicle, VersaFoam(R).
We market five prescription pharmaceutical products:
|
§ |
|
OLUX (clobetasol propionate) Foam, 0.05%, a super high-potency topical steroid
prescribed for the treatment of steroid responsive dermatological diseases of the scalp
and mild to moderate plaque-type psoriasis of non-scalp regions excluding the face and
intertriginous areas; |
|
|
§ |
|
Luxíq (betamethasone valerate) Foam, 0.12%, a mid-potency topical steroid prescribed
for scalp dermatoses such as psoriasis, eczema and seborrheic dermatitis; |
|
|
§ |
|
Soriatane (acitretin), an oral medicine for the treatment of severe psoriasis; and |
|
|
§ |
|
Evoclin (clindamycin phosphate) Foam, 1%, a topical treatment for acne vulgaris. |
|
|
§ |
|
Verdeso (desonide) Foam, 0.05%, a low-potency topical steroid and is the first
approved product formulated in Connetics proprietary VersaFoam(R)-EF emulsion
formulation foam vehicle for the treatment of mild-to-moderate atopic dermatitis. |
On April 3, 2006, we announced that we had filed a Citizen Petition with the FDA to request
that any generic products that reference Soriatane(R) (acitretin) meet several criteria in addition
to rigorous bio-equivalency testing prior to approval. We believe that the criteria outlined in
the citizen petition will ensure that patients are adequately protected from generic versions of
acitretin that might not be comparable in safety and efficacy to the branded product. Subtle
differences between Soriatane and a generic acitretin that change the extent or route of
metabolism, absorption, distribution or elimination of acitretin can significantly increase the
risks associated with the well-known conversion of acitretin to the potent teratogen, etretinate,
and therefore reduce the effectiveness of current safeguards to manage these risks. The Citizen
Petition outlines several ways in which the FDA can confirm that a generic acitretin is in every
way the same as Soriatane, in order to ensure that the labeling instructions and other safeguards
put in place for Soriatane are sufficient to give the same level of protection to patients who
receive generic acitretin.
The projects currently in our research and development pipeline in 2006 include Extina(R)
(ketoconazole) Foam, 2%, a potential new treatment for seborrheic dermatitis and Velac(R) Gel for
the treatment of acne, as well as other programs in the preclinical development stage. We also
have one New Drug Application, or NDA, under review by the FDA. In January 2006, we submitted an
NDA for Primolux(
tm) Foam, a super high-potency topical steroid, formulated with 0.05%
clobetasol propionate in our proprietary emollient foam delivery vehicle,
25
which has been accepted for filing and assigned a user fee date of January 2007.
As
previously disclosed, the SEC is conducting an investigation into
potential securities law violations by the Company and/or current and
former officers, directors and employees. The Company has received
and responded to multiple subpoenas and requests for information,
most recently a document subpoena dated October 6, 2006, to
which the Company has responded. The SEC investigation is ongoing.
On August 28, 2006 we announced the positive outcome of our Phase III clinical trial
evaluating Extina® (ketoconazole) Foam, 2%, formulated in VersaFoam-HF, for the treatment of
seborrheic dermatitis. The Extina Phase III clinical study was a four-week, double-blinded,
active- and placebo-controlled trial that included 1,162 patients at 24 centers in the United
States. The trial was designed to demonstrate that Extina is superior to placebo foam as measured
by the primary endpoint of Investigators Static Global Assessment, or ISGA. The ISGA for this
trial was an overall assessment of the severity of seborrheic dermatitis with respect to the
clinically relevant signs of the disease. Adverse events with Extina were mild to moderate in
nature and were related primarily to burning and stinging at the application site.
On September 19, 2006, the FDA approved Verdeso (desonide) Foam, 0.05%, for the treatment of
mild-to-moderate atopic dermatitis. Verdeso, formerly referred to as Desilux, is a low-potency
topical steroid and is the first approved product formulated in Connetics proprietary
VersaFoam®-EF emulsion formulation foam vehicle. Verdeso is also our first product approved for
pediatric use. Connetics began marketing Verdeso to physicians in the late October 2006.
On October 22, 2006, upon Board of Directors authorization, we signed a definitive merger
agreement with Stiefel Laboratories, Inc., a privately held company based in Coral Gables, Florida.
Upon the closing of the transaction, holders of Connetics common stock will receive $17.50 per
share in cash. The closing is subject to approval by holders of a majority of Connetics
outstanding common stock, antitrust clearance and other customary closing conditions. We
anticipate closing the merger in late 2006 or early 2007.
Critical Accounting Policies and Estimates
We made no material changes to our critical accounting policies and estimates included in our
Annual
Report on Form 10-K/A for the year ended December 31, 2005, except as noted below.
27
Revenue Recognition
Historically we have recognized revenue based on a sell-in model for new products. Starting
in the fourth quarter of 2006, our policy will be to recognize revenue for new products based on
estimated units filled in prescriptions until our wholesalers establish consistent ordering and
inventory levels that are consistent with our targeted wholesaler inventory stocking levels
(generally between four and six weeks of sales). This is the policy we are following with sales of
Verdeso , which we launched in October 2006. We will estimate units filled in prescriptions using
prescription data we purchase from Per-Se Technologies, formerly NDC Health Corporation, one of the
leading providers of prescription-based information. When wholesalers have established consistent
ordering and inventory levels consistent with our targeted wholesaler inventory stocking levels, we
will recognize product revenue upon shipment. Regardless of the timing of recognition, we
recognize product revenues net of applicable estimated allowances and product-related accruals.
Stock-Based Compensation
On January 1, 2006, we adopted the provisions of Statement of Financial Accounting Standards
No. 123 (revised 2004), Share-Based Payment, or SFAS 123R, requiring us to recognize expense
related to the fair value of our stock-based compensation awards. We elected to use the modified
prospective transition method as permitted by SFAS 123R and therefore have not restated our
financial results for prior periods. Under this transition method, stock-based compensation
expense for the three and nine months ended September 30, 2006 includes compensation expense for
all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006.
Compensation expense is 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, or SFAS 123. Stock-based compensation expense for all stock-based
compensation awards granted on or after January 1, 2006 is based on the grant-date fair value
estimated in accordance with the provisions of SFAS 123R.
We use the Black-Scholes option-pricing model, which requires the input of highly subjective
assumptions, including the options expected life, the price volatility of the underlying stock,
and the estimated forfeiture rate. The estimation of stock awards that will ultimately vest
requires judgment, and to the extent actual results or updated estimates differ from our current
estimates, such amounts will be recorded as a cumulative adjustment in the period estimates are
revised. We use a blend of historical volatility of our common stock and implied volatility of
tradable forward call and put options to purchase and sell shares of our common stock. Changes in
the subjective input assumptions can materially affect the estimate of fair value of options
granted and our results of operations could be materially impacted.
We recognize stock-based compensation as expense over the requisite service periods in our
Condensed Consolidated Statements of Operations, using a graded vesting expense attribution
approach for unvested stock option awards granted before we adopted SFAS 123R and using the
straight-line expense attribution approach for stock option awards granted after we adopted SFAS
123R.
27
Results of Operations
Net Revenues
The following table summarizes our gross-to-net sales deductions (in thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Gross product revenues |
|
$ |
21,968 |
|
|
$ |
58,848 |
|
|
$ |
134,836 |
|
|
$ |
174,019 |
|
Product returns |
|
|
(1,708 |
) |
|
|
965 |
|
|
|
(9,294 |
) |
|
|
(8,001 |
) |
Managed care and Medicaid rebates |
|
|
(798 |
) |
|
|
(5,484 |
) |
|
|
(6,969 |
) |
|
|
(17,062 |
) |
Chargebacks |
|
|
(764 |
) |
|
|
(1,889 |
) |
|
|
(3,833 |
) |
|
|
(5,776 |
) |
Cash discounts and other |
|
|
138 |
|
|
|
(1,652 |
) |
|
|
(5,335 |
) |
|
|
(6,849 |
) |
|
|
|
|
|
|
|
|
|
|
|
|
|
Net product revenues |
|
$ |
18,836 |
|
|
$ |
50,788 |
|
|
$ |
109,405 |
|
|
$ |
136,331 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
The following table summarizes our net product and royalty and contract revenues (in
thousands):
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Three Months Ended |
|
|
Nine Months Ended |
|
|
|
September 30, |
|
|
September 30, |
|
|
|
2006 |
|
|
2005 |
|
|
2006 |
|
|
2005 |
|
Net product revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Soriatane |
|
$ |
10,411 |
|
|
$ |
20,804 |
|
|
$ |
44,867 |
|
|
$ |
54,911 |
|
OLUX Foam |
|
|
4,317 |
|
|
|
15,879 |
|
|
|
31,362 |
|
|
|
45,276 |
|
Evoclin Foam |
|
|
2,255 |
|
|
|
7,519 |
|
|
|
19,459 |
|
|
|
17,517 |
|
Luxiq Foam |
|
|
1,843 |
|
|
|
6,541 |
|
|
|
13,620 |
|
|
|
18,486 |
|
Other |
|
|
10 |
|
|
|
45 |
|
|
|
97 |
|
|
|
141 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total net product revenues |
|
|
18,836 |
|
|
|
50,788 |
|
|
|
109,405 |
|
|
|
136,331 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Royalty and contract revenues: |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Royalty |
|
|
475 |
|
|
|
158 |
|
|
|
881 |
|
|
|
386 |
|
Contract |
|
|
374 |
|
|
|
|
|
|
|
374 |
|
|
|
83 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total royalty and contract revenues |
|
|
849 |
|
|
|
158 |
|
|
|
1,255 |
|
|
|
469 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total net revenues |
|
$ |
19,685 |
|
|
$ |
50,946 |
|
|
$ |
110,660 |
|
|
$ |
136,800 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Our net product revenues were $18.8 million for the three months ended September 30, 2006
and $50.8 million for the three months ended September 30, 2005, representing a decrease of $32.0
million or 63%. The decrease in net product revenues is primarily attributable to the reduction of
inventory levels of our products at our major wholesalers, which resulted in shipment of units to
the wholesalers below unit demand. We estimate that we shipped approximately $31.4 million less
than unit demand during the third quarter resulting in a decrease in the estimated months of demand
in the distribution channel of 3.6 months at June 30, 2006 to 1.5 months at September 30, 2006 (see
further discussion below). This $32.0 million decrease in net revenues was partially offset by a
$1.4 million release for accruals related to the TRICARE Retail Pharmacy Program, or TRRx.
In 2004, the Department of Defense, or DOD, took the position that the Federal Supply Schedule
discounted price extends to retail pharmacy transactions through the DODs TRRx. The intention was
to obtain refunds for the government on retail pharmacy utilization based on the difference between
wholesaler pricing and Federal Ceiling Prices as defined under the Veterans Health Care Act of
1992. The refund requirement was announced to us and other manufacturers in an October 2004
letter. Based on the receipt of rebate invoices, we began to reserve for an estimated liability
for prescriptions filled under the TRRx program beginning in the third quarter of 2005 and had
reserved $1.4 million through June 30, 2006 for potential liability under the TRRx program. That
accrual is part of product-related accruals on the Balance Sheet. A trade association challenged
the legality of the TRRx program in Federal court, and on September 11, 2006 the U.S. Court of
Appeals for the Federal Circuit struck down the TRRx program. We now believe that, as a result of
the Federal Court of Appeals decision, it is unlikely that the TRRx Program, even if ultimately
implemented will be made retroactive to 2004. As a result, we released the $1.4 million accrual in
September 2006, which decreased our net loss per share by $0.04 for the three
month and nine month periods ended September 30, 2006.
28
Our net product revenues were $109.4 million for the nine months ended September 30, 2006 and
$136.3 million for the nine months ended September 30, 2005, representing a decrease of $26.9
million or 20%. The decrease in net product revenues is primarily attributable to the reduction of
inventory levels of our products at our major wholesalers of $38.6 in the second and third quarters
of 2006. This decrease is slightly offset by a $1.4 million release of a reserve for TRRx in the
third quarter, which decreased our net loss per share by $0.04 for the nine months ended September
30, 2006. The decrease is also partially offset by a $2.9 million release of Medicaid reserves in
the second quarter discussed below which decreased our net loss by $0.09 per share for the nine
months ended September 30, 2006 (see Medicare Part D discussion below).
We expected Medicare Part D programs to reduce the number of Medicaid eligible prescriptions
processed by state Medicaid programs. Medicare Part D programs are offered by managed care
organizations and began to provide prescription drug benefit coverage effective January 1, 2006.
Based, however, on the Medicaid claims we have recently received attributable to prescriptions
filled for the first three months of 2006, the reduction in prescriptions processed by, and
therefore the reduction in rebates due to, state Medicaid programs was significantly greater than
we anticipated. Because of this discrepancy, in late July and August, we conducted a review of the
claims activity including calls to all of the significant state programs we contract with, to
ensure that we had actually received all of the claims relating to the first three months of 2006.
We anticipate that Medicare Part D programs will continue to reduce the prescriptions processed by,
and therefore rebates to, state Medicaid programs in the future, which would be partially offset by
rebates due to Medicare Part D programs. Based on this review we revised our estimate of the
impact of these programs and as a result, during the second quarter we released approximately $2.9
million of Medicaid rebate reserves accrued at March 31, 2006, which resulted in a corresponding
positive contribution to our net product revenues for the nine months ended September 30, 2006.
The impact of Medicare Part D programs will continue to be evaluated and as additional market data
and rebate claims activity become known the estimated rebate claims reserve will be adjusted
accordingly.
We estimate inventory in the distribution channel using reports we receive from wholesalers
and we calculate months supply on a weighted average basis by product relative to unit demand.
Our estimated levels of inventory in the distribution channel as of December 31, 2005, March 31,
2006, June 30, 2006, and September 30, 2006 are approximately the following months of estimated
unit demand:
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
September 30, |
|
June 30, |
|
March 31, |
|
December 31, |
Product |
|
2006 |
|
2006 |
|
2006 |
|
2005 |
|
Soriatane |
|
|
1.5 |
|
|
|
3.2 |
|
|
|
3.9 |
|
|
|
4.2 |
|
OLUX Foam |
|
|
1.5 |
|
|
|
3.6 |
|
|
|
3.9 |
|
|
|
4.6 |
|
Evoclin Foam |
|
|
1.3 |
|
|
|
3.7 |
|
|
|
4.0 |
|
|
|
4.3 |
|
Luxíq Foam |
|
|
1.6 |
|
|
|
4.0 |
|
|
|
4.4 |
|
|
|
5.4 |
|
Weighted
average for
all products |
|
|
1.5 |
|
|
|
3.6 |
|
|
|
4.0 |
|
|
|
4.6 |
|
The decrease in the estimated levels of inventory in the first quarter of 2006 was
primarily a function of increased unit demand experienced by the wholesalers while the decrease in
the second and third quarter of 2006 was principally the result of shipment of units to the
wholesalers below unit demand.
In order to facilitate improved management of wholesale inventory levels of all of our
products, at the end of 2005 we announced our intention to reduce wholesale inventory levels of our
products. On July 10, 2006, we announced that we intend to continue to ship below estimated
prescription demand during the remainder of 2006 at a greater rate than originally planned for the
year, with a goal of reducing average wholesaler inventory levels to approximately two months
on-hand by the end of 2006. In September 2006, based on the logistical efficiencies gained in the
distribution system, we reduced the goal of average wholesaler inventory levels to between four and
six weeks. The rate at which we continue to reduce inventory is subject to many variables,
however, including
29
estimates of the amounts currently in inventory at each wholesaler and predictions of end-user
prescription demand for our products.
Because shipments to our wholesalers have been and, to a lesser extent, will continue to be
below levels indicated by prescription demand, our net product revenues under U.S. GAAP reported in
our quarterly and annual financial statements have been and, to a lesser extent, will continue to
be lower than the actual prescription demand levels for our products would suggest. These actions
have resulted in lower levels of accounts receivable due to the reductions in shipments, slower
increases and even decreases in returns and chargeback accruals and accruals for rebates reserves
on our balance sheet, and modest write-offs of excess finished goods inventory balances, all of
which have affected and could continue to affect our liquidity. We also have minimum production
obligations with DPT Laboratories, Ltd., or DPT, and may be required to pay fees to DPT if we do
not order as much product as projected. Any future changes in prescription demand will impact the
amount of inventory reductions necessary to achieve desired levels of inventory in the distribution
channel. We believe that our reduction of inventory levels in the distribution channel is
consistent with improved wholesaler reporting, improved distribution logistics under centralized
warehousing offerings from our two largest wholesalers, and the relative maturity of most of our
products.
We estimate the rate of future product returns based on our historical experience using the
most recent three years data, the relative risk of return based on expiration date and other
qualitative factors that could impact the level of future product returns, including monitoring
inventories held by our distributors. Due to the significant reduction of inventory held by our
distributors during 2006, our accrual for product returns of $14.4 million as of September 30, 2006
represented a significant amount of the retail value of the inventory in the distribution channel.
We believe this reduction of wholesaler inventory will correlate to a lower amount of product
returns in the future. We believe the methodology we utilize to calculate our returns reserve
continues to be appropriate; however, we do not have adequate information at the end of the third
quarter to determine a more appropriate estimated rate of return than the rate indicated by our
most recent three years data. During the fourth quarter of 2006, we will attempt to obtain
additional information on the inventory held by our largest wholesalers in order to determine the
potential return profile of the existing channel inventory. If, as anticipated, the return rate
profile supported by the information and our on-going returns experience indicate a significantly
lower rate for future returns, we will have a basis for determining a more appropriate accrual for
returns, at which time we could potentially release a substantial portion of our returns reserve.
Even if we release a significant amount of the accrual in the fourth quarter of 2006, we expect
that over the next one to several quarters our estimated return rate, and therefore our product
returns accrual, will continue to decrease at a more modest rate over time as a result of our
target wholesaler inventory levels.
Cost of Product Revenues
Our cost of product revenues includes the third party costs of manufacturing OLUX, Luxíq and
Evoclin, the cost of Soriatane inventory supplied from Hoffmann-La Roche, Inc., or Roche,
depreciation costs associated with Connetics-owned equipment located at the DPT facility in Texas,
allocation of overhead, royalty payments based on a percentage of our net product revenues, product
freight and distribution costs from Cardinal Health Specialty Pharmaceutical Services, or SPS, and
certain manufacturing support and quality assurance costs.
Our cost of product revenues were $1.7 million and $4.2 million for the three months ended
September 30, 2006 and 2005, respectively, representing a decrease of $2.5 million or 60%, and $9.2
million and $12.9 million for the nine months ended September 30, 2006 and 2005, respectively,
representing a decrease of $3.7 million or 29%. The decrease in both periods was principally due
to significantly lower shipments of product to the wholesalers as a result of the reduction of
inventory levels of our products at our major wholesalers. This decrease is also attributable to
reduced royalty payments paid on Soriatane sales to a U.S.-based distributor that exports branded
pharmaceutical products to select international markets in 2006 as compared to 2005 of $0.5 million
and $1.6 million in the three and nine months ended September 30, 2006, respectively.
30
In order to facilitate improved management of wholesaler inventory levels of all of our
products, we have shipped below estimated prescription demand during 2006 with the goal of reducing
average wholesaler inventory levels to less than two months on-hand by the end of 2006. In
connection with this effort, on June 30, 2006 we halted an in-transit shipment to one of our
wholesalers; the product was brought back to our warehouse and the wholesaler never received
delivery. We properly reversed the revenue and accounts receivable related to this shipment, and
those amounts were appropriately not reflected in the June 30, 2006 Form 10-Q financial statements.
However, during our third quarter 2006 close procedures we noted that the Form 10-Q did not
reflect the reversal of the cost of product revenues and increase in inventory associated with the
halted shipment. Therefore, our June 30, 2006 results overstated cost of product revenues by
$368,000 and understated inventory by the same amount. We have recorded the $368,000 reversal of
cost of product revenues as an adjustment in June 2006 by amending the year-to-date amounts in the
September 30, 2006 financial information included in Note 1 to this Report.
Amortization of Intangible Assets
We recorded amortization expenses of $4.1 million and $12.1 million for the three and nine
months ended September 30, 2006, compared to $3.4 million and $10.2 million for the comparable
periods in 2005. The increase in amortization expense was attributable to amortization of
identified intangibles recorded from the acquisition of the pediatric sales force from PediaMed.
Research and Development
R&D expenses include costs of personnel to support our research and development activities,
costs of preclinical studies, costs of conducting our clinical trials (such as clinical
investigator fees, monitoring costs, data management and drug supply costs), external research
programs and an allocation of facilities costs. Year to year changes in R&D expenses are primarily
due to the timing and size of particular clinical trials, as well as the recognition of stock-based
compensation in the current year due to the adoption of SFAS 123(R).
R&D expenses were $10.0 million for the three months ended September 30, 2006, compared to
$8.4 million for the three months ended September 30, 2005, representing an increase of $1.6
million or 19%. The increase is primarily due to $1.9 million of expense recorded for product
packaging material and equipment costs related to Velac Gel that we had previously capitalized.
After completion of certain studies in the third quarter of 2006 and communications with the FDA in
September 2006, our management team reassessed the realizability of these assets based on future
regulatory work required, the potential resale value and other relevant factors. We determined
these assets were impaired and expensed $1.9 million to the research and development line item on
our statement of operations for the three and nine month periods ended September 30, 2006.
Connetics remains committed to bringing the product to market and development activities are
ongoing.
For the nine months ended September 30, 2006 and 2005, R&D expenses were $26.2 million and
$23.2 million, respectively, representing an increase of $3.0 million or 13%. The increase was
partially attributable to $1.9 million of expense recognized for inventory and equipment costs
related to Velac Gel as discussed in the preceding paragraph. We determined these assets were
impaired and expensed $1.9 million to the research and development line item on our statement of
operations in September 2006. The increase is also attributable to the $0.8 million filing fee for
the Primolux(TM) Foam NDA in January 2006 and expense resulting from the recognition of stock-based
compensation due to the adoption of SFAS 123R of $0.9 million in the nine months ended September
30, 2006.
Selling, General and Administrative Expenses
Selling, general and administrative expenses include expenses and costs associated with
finance, legal,
31
insurance, marketing, sales, and other administrative matters.
Selling,
general and administrative expenses were $31.6 million for the three months ended
September 30, 2006, compared to $23.7 million for the three months ended September 30, 2005,
representing an increase of $7.9 million or 33%. The increase
primarily consists of $4.9 million
for increased legal, audit, tax and other administrative expenses primarily driven by our recent
restatement and our pending SEC investigation, $3.8 million in increased personnel costs driven by
our sales department due to the purchase of the PediaMed sales organization, $1.0 million resulting
from the recognition of stock-based compensation in 2006, $600,000 in consulting and recruiting
fees, partially offset by $2.0 million in decreased direct and indirect promotional activities.
For the nine
months ended September 30, 2006 and 2005, selling, general and administrative
expenses were $93.0 million and $76.9 million,
respectively, representing an increase of $16.1
million or 21%. The increase primarily consists of $9.0 million for increased legal, audit, tax
and other administrative expenses primarily driven by our recent restatement and our pending SEC
investigation, $9.1 million in increased personnel costs primarily driven by our sales department
due to the purchase of the PediaMed sales organization, $3.0 million resulting from the recognition
of stock-based compensation in 2006, $1.0 million in consulting and recruiting fees partially
offset by $6.7 million in decreased direct and indirect promotional activities.
Stock-based Compensation
On January 1, 2006, we adopted the provisions of SFAS 123R requiring us to recognize expense
related to the fair value of our stock-based compensation awards. Total stock-based compensation
expense was $1.3 million for the three months ended September 30, 2006 and $3.9 million for nine
months ended September 30, 2006.
Prior to the adoption of SFAS 123R, we approved the acceleration of vesting for
out-of-the-money unvested incentive and non-qualified stock options previously awarded to
employees and outside directors with option exercise prices equal to or greater than $18.00
effective November 7, 2005. We took this action to reduce the impact of compensation expense that
we would otherwise be required to recognize in our consolidated statements of operations pursuant
to SFAS 123R beginning January 1, 2006. As a result of the acceleration, our pro forma stock-based
employee compensation expense for the fourth quarter of 2005 increased $8.5 million, which
represents the amount by which we reduced the stock-based compensation expense we would otherwise
have been required to recognize on a pre-tax basis over fiscal years 2006, 2007 and 2008.
Prior to the adoption of SFAS 123R, we applied SFAS 123, amended by SFAS 148, which allowed
companies to apply the existing accounting rules under Accounting Principles Board Opinion 25, or
APB 25, and related Interpretations. Accordingly, we did not recognize any compensation in our
financial statements in connection with stock options granted to employees when those options had
exercise prices equal to or greater than the fair market value of our common stock on the date of
grant.
As of September 30, 2006, there was $9.5 million (before any related tax benefit) of total
unrecognized compensation cost related to non vested stock-based compensation that is expected to
be recognized over a weighted-average period of approximately 1.9 years.
On January 27, 2006, we granted 475,000 shares of restricted stock in lieu of option grants to
members of our executive management. Of the total awards, 50% are subject to time-based vesting
and the remaining 50% are subject to both performance-based and time-based vesting with certain
2006 performance goals determined by the Compensation Committee. For all of the shares subject to
time-based vesting and the shares ultimately issued based on performance, the vesting restriction
for one-half will lapse on February 1, 2008 and the remaining one-half will lapse February 1, 2009.
Through September 30, 2006 we have not recorded compensation expense
for the restricted stock grants which will have performance-based
criteria due to the probability that the performance criteria will
not be met; however, the Compensation Committee will make a final
assessment in late 2006 or the first quarter of 2007, at which time
they will consider business conditions and other factors.
32
On February 1, 2006, we also granted 58,000
shares of restricted stock in lieu of option grants to certain management individuals; all of those
shares are subject only to time-based vesting. Of the total awards, the restriction for one-third
lapses on the first anniversary and one-sixth each six months thereafter. On May 22, 2006 we
granted an additional 60,000 shares of restricted stock in lieu of annual option grants to our
Board of Directors. The restriction on these awards lapses one year from the date of grant. We
did not grant restricted stock before January 1, 2006. We recognized approximately $568,000 and
$1,240,000 of compensation expense for the grants subject to time-based vesting criteria during the
three and nine month periods ended September 30, 2006, respectively. The weighted average fair
value of restricted stock granted, determined using the Black-Scholes model, was $10.44 per share
for the three months ended September 30, 2006 and $14.75 per share for the nine months ended
September 30, 2006.
Interest and other income (expense), net
Interest income was $3.0 million and $8.0 million for the three and nine months ended
September 30, 2006, respectively, compared to $2.1 million and $4.5 million for the comparable
periods in 2005. The increase in interest income was the result of higher interest rates and yield
on our investments in 2006 coupled with a full nine months in 2006 of interest earned on our
investments that were a result of the issuance of the $200 million in notes in March 2005.
Interest
expense was $3.2 million and $6.9 million for the three and nine months ended
September 30, 2006, respectively, compared to $2.0 million and $4.6 million for the comparable
periods in 2005. The increase in interest expense is primarily due to the $1.4 million we paid in
the third quarter of 2006 to the consenting holders of the 2003 Notes in consideration for the
amendments and waivers which provided us with additional time to file our first quarter Form 10-Q.
The increase in interest expense during the nine month period September 30, 2006 is also due to a
full nine months of interest expense in 2006 related to the sale of 2005 Notes.
Provision (Benefit) for Income Taxes
We recognized an income tax benefit of $274,000 and $533,000 for the three and nine months
ended September 30, 2006, respectively, primarily related to a tax asset recorded for losses
generated by our foreign operations which we believe is more likely than not to be realized. This
benefit has been partially offset by withholding taxes. We recognized income tax expense of
$470,000 and $728,000 for the three and nine months ended September 30, 2005, respectively, related
to U.S. Federal alternative minimum taxes and state income taxes, offset by foreign tax benefit
related to our activities in Australia.
Liquidity and Capital Resources
Working Capital
We have financed our operations to date primarily through proceeds from equity and debt
financings, and net product revenues. Cash, cash equivalents, marketable securities and long-term
investments totaled $241.8 million at September 30, 2006, down from $271.1 million at December 31,
2005. Of the $29.3 million decrease, $12.5 million is related to the acquisition of the PediaMed
sales organization, $6.0 million is related to legal, audit, tax, banking and other administrative
expenses driven by our recent restatement and our pending SEC investigation and $2.2 million is
related to the repurchase of 143,000 shares of our stock.
Working capital at September 30, 2006 was $214.2 million compared to $245.6 million at
December 31, 2005 representing a $39.4 million decrease in current assets and an $8.1 million
decrease in current liabilities. Significant changes in working capital during 2006 can be
summarized as follows:
33
|
|
|
Fluctuation in Current Assets |
|
Explanation |
|
|
|
$41.6 million decrease cash, cash
equivalents and marketable securities
|
|
In addition to the items
noted above, at September 30,
2006 $12.3 million of
investments were classified
as long-term assets, whereas,
at December 31, 2005 all of
our investments were
classified as current assets. |
|
|
|
Fluctuation in Current Liabilities |
|
Explanation |
|
|
|
$7.3 million decrease product-related
accrued liabilities
|
|
Decrease is primarily driven
by lower costs related to
fewer units in our
distribution channel
resulting from the reduction
of inventory levels of our
products at our major
wholesalers. |
Capital Expenditures
We made capital expenditures of $2.5 million for the nine months ended September 30, 2006
compared to $3.9 million for the same period in 2005. The expenditures in 2006 were primarily for
laboratory equipment and computer software and equipment. The expenditures in 2005 were primarily
for leasehold improvements on, and laboratory equipment purchased for, our new corporate
headquarters, which we occupied at the end of February 2005.
On February 1, 2006, we acquired the sales organization of PediaMed Pharmaceuticals, Inc., a
privately-held pharmaceutical company specializing in the pediatric market, which resulted in a
cash payment of $12.5 million in the first quarter of 2006.
Capital Resources
We believe our existing cash, cash equivalents, marketable securities and long-term
investments and cash generated from product sales will be sufficient to fund our operating
expenses, debt obligations and capital requirements through at least the foreseeable future. We
have classified $12.3 million of our investments as long-term at September 30, 2006. We cannot be
certain what our future net product revenues will be. Our product sales may be impacted by patent
risks and competition from new products.
The amount of capital we require for operations in the future depends on numerous factors,
including the level of net product revenues, the extent of commercialization activities, the scope
and progress of our clinical research and development programs, the time and costs involved in
obtaining regulatory approvals, the cost of filing, prosecuting, and enforcing patent claims and
other intellectual property rights, and competing technological and market developments. If we
need funds in the future to in-license or acquire additional marketed or late-stage development
products, a portion of the funds may come from our existing cash, which will result in fewer
resources available to our current products and clinical programs. In order to take action on
business development opportunities we may identify in the future, we may need to use some of our
available cash, or raise additional cash by liquidating some of our investment portfolio and/or
raising additional funds through equity or debt financings.
We currently have no commitments for any additional financings. If we need to raise
additional money to fund our operations, funding may not be available to us on acceptable terms, or
at all. If we are unable to raise additional funds when we need them, we may not be able to market
our products as planned or continue development of potential products, or we could be required to
delay, scale back, or eliminate some or all of our research and development programs.
On October 31, 2005, our Board of Directors authorized the repurchase of up $50 million of our
common stock. As of December 31, 2005, we had repurchased 1.8 million shares of our common stock
at a cost of $24.4 million. During the nine months ended September 30, 2006, we repurchased an
additional 143,000 shares at a
34
cost of $2.2 million.
Contractual Obligations and Commercial Commitments
Our commitments, including those disclosed in our Annual Report on Form 10-K/A for the year
ended December 31, 2005, consist primarily of operating lease agreements for our facilities as well
as minimum purchase commitments under one of our contract manufacturing agreements, minimum royalty
commitments under one of our license agreements, and non-cancelable purchase orders. As of
December 31, 2005, our non-cancelable purchase orders totaled $19.0 million. As of the date of this
report, we canceled and renegotiated purchase orders with one of our suppliers, which reduced our
total obligations due to them by $4.5 million.
Recent Accounting Pronouncements
In July 2006 the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income
Taxes, or FIN 48, an interpretation of Statement of Financial Accounting Standards No. 109,
Accounting for Income Taxes, or SFAS 109. FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in an enterprises financial statements in accordance with SFAS 109 and prescribes
a recognition threshold and measurement attribute for the financial statement recognition and
measurement of a tax position taken or expected to be taken in a tax return. FIN 48 also provides
guidance on derecognition, classification, interest and penalties, accounting in interim periods,
disclosure, and transition. The provisions of FIN 48 are required to be applied to all tax
positions upon initial adoption. The cumulative effect of applying the provisions of FIN 48 are
required to be reported as an adjustment to the opening balance of retained earnings in the year of
adoption. FIN 48 will be effective beginning with the first annual period after December 15, 2006.
We are still evaluating what impact, if any, the adoption of this standard will have on our
financial position or results of operations.
In September 2006 the FASB issued FASB Statement No. 157, Fair Value Measurements, or SFAS
157. The standard provides guidance for using fair value to measure assets and liabilities. The
standard also responds to investors requests for expanded information about the extent to which
companies measure assets and liabilities at fair value, the information used to measure fair value,
and the effect of fair value measurements on earnings. The standard applies whenever other
standards require or permit assets or liabilities to be measured at fair value. The standard does
not expand the use of fair value in any new circumstances. SFAS 157 requires prospective adoption
as of the beginning of the year of adoption. SFAS 157 is effective for financial statements issued
for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years.
We are still evaluating what impact, if any, the adoption of this standard will have on our
financial position or results of operations.
Item 3. Quantitative and Qualitative Disclosures About Market Risk
There have been no material changes in the reported market risks or foreign currency exchange
risks from those reported under Item 7A, Quantitative and Qualitative Disclosures About Market Risk
in our Annual Report on Form 10-K/A for the year ended December 31, 2005.
Item 4. Controls and Procedures
Disclosure Controls and Procedures
We maintain disclosure controls and procedures that are designed to ensure that information
required to be disclosed in our filings with the SEC is recorded, processed, summarized and
reported within the time period specified in the SECs rules and forms, and that such information
is accumulated and communicated to management, including our Chief Executive Officer and Chief
Financial Officer, as appropriate, to allow timely decisions regarding required disclosure based on
the definition of disclosure controls and procedures as defined
35
in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the
Exchange Act). In designing and evaluating our disclosure controls and procedures, we have
recognized that any controls and procedures, no matter how well designed and operated, can provide
only reasonable assurance of achieving the desired control objectives, and management is required
to apply judgment in evaluating its controls and procedures.
In connection with the restatement of our financial statements, we reevaluated our disclosure
controls and procedures. The evaluation was performed under the supervision and with the
participation of Company management, including the Chief Executive Officer (CEO) and the Chief
Financial Officer (CFO), to assess the effectiveness of the design and operation of our disclosure
controls and procedures (as defined under the Exchange Act). Based on that evaluation, our
management, including the CEO and the CFO, has concluded that Connetics disclosure controls and
procedures were not effective as of December 31, 2005 or as of March 31, 2006 because of material
weaknesses in our internal control over financial reporting. We have made changes in our
disclosure controls and procedures since we filed our Form 10-Q for the quarter ended June 30,
2006, and we believe that those changes are reasonably designed to ensure that all information we
are required to disclose is recorded, processed, summarized and reported within the requisite
periods.
Managements Report on Internal Control Over Financial Reporting
Connetics management is responsible for establishing and maintaining adequate internal
control over financial reporting as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange
Act. Our internal control over financial reporting is designed, under the supervision of our CEO
and CFO, to provide reasonable assurance regarding the reliability of financial reporting and the
preparation of financial statements for external purposes in accordance with U.S. generally
accepted accounting principles (GAAP). Our internal control over financial reporting includes
those policies and procedures that: (a) pertain to the maintenance of records that, in reasonable
detail, accurately and fairly reflect the transactions and dispositions of our assets; (b) provide
reasonable assurance that transactions are recorded as necessary to permit preparation of financial
statements in accordance with GAAP, and that our receipts and expenditures are being made only in
accordance with authorizations of management and directors of the Company; and (c) provide
reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or
disposition of our assets that could have a material effect on the financial statements.
We based our evaluation on the framework in Internal Control Integrated Framework issued
by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). All internal
control systems, no matter how well designed, have inherent limitations. Therefore, even those
systems determined to be effective can provide only reasonable assurance regarding the reliability
of financial reporting and the preparation of financial statements for external purposes in
accordance with GAAP.
In connection with the restatement of our financial statements on Form 10-K/A for the year
ended December 31, 2005, we identified errors in our accruals that we determined were the result of
material weaknesses in our internal control over financial reporting related to the processes for
establishing those accruals, specifically: (a) insufficient controls over the design of the
methodology, development of the assumptions, and corroboration of the inputs used in estimating
accruals for rebates, chargebacks and product returns, and (b) insufficient involvement of and
communication between relevant finance and operational personnel in the estimation processes.
A material weakness is defined as a significant deficiency or a combination of significant
deficiencies which results in more than a remote likelihood that material misstatement of our
annual or interim financial statements would not be prevented or detected by company personnel in
the normal course of performing their assigned functions. Due to the material weaknesses described
above, we have concluded that the Company did not maintain effective internal control over
financial reporting as of December 31, 2005. We believe the changes we
36
have made in our disclosure controls and procedures since we filed our Form 10-Q for the quarter
ended June 30, 2006 are reasonably designed to ensure that all information we are required to
disclose is recorded, processed, summarized and reported within the requisite periods. However, as
of September 30, 2006 these controls have not been in place long enough for management to conclude
on their operating effectiveness and we therefore, do not believe we have remediated the material
weaknesses described above as of September 30, 2006.
Changes in Internal Control over Financial Reporting
There have been no significant changes in our internal control over financial reporting during
the quarter ended September 30, 2006, except for the implementation of measures described below
under Remediation of Material Weaknesses.
Remediation of Material Weaknesses
Since March 31, 2006, we have implemented, or plan to implement, certain measures to remediate
the identified material weaknesses and to enhance our internal control over financial reporting.
As of the date of the filing of this Quarterly Report on Form 10-Q, we have implemented the
following measures:
|
§ |
|
modified the methodology used to estimate accruals for rebates and chargebacks to
fully capture the future liability related to product inventory in the distribution
channel and other factors, including anticipated price increases for our products and
estimated future usage of our products by patients enrolled in Medicaid programs and
contracted managed care organizations; |
|
|
§ |
|
revised our methodology used to estimate the accrual for product returns to (a)
estimate the return rate on our most recent three years data, resulting in an
estimated rate that is more responsive to current return trends, (b) apply the rate to
production lots, (c) consider the relevant risk of return, and (d) take into account
current price and anticipated price increases; |
|
|
§ |
|
assigned an individual with significant industry experience as our Senior Revenue
Manager and increased the involvement of our Vice-President, Finance and Administration
in the estimation process; |
|
|
§ |
|
engaged external consultants to assist us in revising our methodologies to ensure
all relevant factors were considered and the computational aspects of the models were
appropriate; |
|
|
§ |
|
established formal intradepartmental communication between the finance function and
other departments, including, but not limited to, commercial operations, specifically
personnel involved in our sales operations, managed care and manufacturing activities
involving monthly forecast meetings and a central, shared location on our internal
network for the sharing of information; |
|
|
§ |
|
established formal coordination related to assumptions used in our quarterly revenue
reserves including meetings with relevant operational personnel at the start of the
quarterly close and written confirmations of the final assumptions used in our
financial statements from those same operational personnel upon the completion of the
quarterly close; |
|
|
§ |
|
developed a checklist used by finance personnel to ensure all quarterly activities
related to revenue reserves are completed on a timeline basis; and |
|
|
§ |
|
hired an individual with significant industry experience as our Senior Financial
Analyst to assist in |
37
|
|
|
and support our revenue-reserves estimation process; and |
In addition to the measures noted above, we are considering or in the process of implementing
the following additional remediation actions:
|
§ |
|
development of processes for the periodic regular reconciliation of our inventory
data with third party wholesalers inventory reports; and |
|
|
§ |
|
training of all relevant finance and commercial operations personnel regarding the
new revenue-reserves methodologies and the controls and procedures surrounding channel
inventory and product returns; |
|
|
§ |
|
hiring of additional finance and commercial personnel with specific, relevant
industry experience to manage the more sophisticated methodologies adopted in
connection with the restatement of our financial statements. |
We anticipate that the improvements noted above will be ongoing improvement measures.
Furthermore, while we have taken steps to remediate the material weaknesses, these steps may not be
adequate to fully remediate those weaknesses, and additional measures may be required. The
effectiveness of our remediation efforts will not be known until we can test those controls in
connection with the pending management tests of internal controls as of December 31, 2006.
38
PART II. OTHER INFORMATION
Item 1. Legal Proceedings
1. SEC Investigation. As
previously disclosed, the SEC is conducting an investigation into
potential securities law violations by the Company and/or current and
former officers, directors and employees. The Company has received
and responded to multiple subpoenas and requests for information,
most recently a document subpoena dated October 6, 2006, to
which the Company has responded. The SEC investigation is ongoing.
2. Purported Class Action Litigation.
(a) Plumbers & Pipefitters Local #562 Pension Fund vs.
Connetics Corporation, Thomas G. Wiggans, C.
Gregory Vontz, and Alexander J. Yaroshinsky (N.D. Cal. Case No. 06-5691 PJH). On September 18,
2006, a purported shareholder class action complaint was filed on behalf of stockholders who
purchased common stock of the Company between June 28, 2004 and May 3, 2006, alleging violations of
Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The
complaint names the Company and
certain of its current and former officers and directors as defendants, and is pending in the United
States District Court, Northern District of California.
(b) Almar T. Widiger Living Trust vs. Connetics Corporation, Thomas G. Wiggans, C. Gregory Vontz,
and Alexander J. Yaroshinsky (N.D. Cal. Case No. 06-06250 VRW). On October 4, 2006, a purported
shareholder class action complaint was filed on behalf of stockholders who purchased common stock
of the Company between June 28, 2004 and July 9, 2006, alleging violations of Sections 10(b) and
20(a) of the Securities Exchange Act of 1934. The complaint names the Company and certain of its
current and former officers and directors as defendants, and is pending in the United States District
Court, Northern District of California.
(c) Fishbury, Limited vs. Connetics Corporation, Thomas G. Wiggans, C. Gregory Vontz, and Alexander
J. Yaroshinsky (S.D. N.Y. Case No. 06-CV-11496). On October 31, 2006, a purported shareholder
class action complaint was filed on behalf of stockholders who purchased common stock of the
Company between June 28, 2004 and July 9, 2006, alleging violations of Sections 10(b) and 20(a) of
the Securities Exchange Act of 1934. The complaint names the Company and certain of its current and
former officers and directors as defendants, and is pending in the United States District Court,
Southern District of New York.
(d) Bruce Gallant vs. Connetics Corporation, Thomas G. Wiggans, C. Gregory Vontz, and Alexander J.
Yaroshinsky (S.D. N.Y. Case No. 06-CV-12875). On November 2, 2006, a purported shareholder class
action complaint was filed on behalf of stockholders who purchased common stock of the Company
between June 28, 2004 and July 9, 2006, alleging violations of Sections 10(b) and 20(a) of the
Securities Exchange Act of 1934. The complaint names the Company and certain of its current and former
officers and directors as defendants, and is
39
pending in the United States District Court, Southern District of New York.
3. Shareholder Derivative Actions. Rosenberg v. Wiggans et al. (Santa Clara County Case No.
1-06-CV-071778, and Spiegal v. Wiggans et al. (Santa Clara County Case No. 1-06-CV-071776. On
September 25, 2006, two separate shareholder derivative actions were filed in Santa Clara Superior
Court against certain officers and directors, and a former officer, of the Company, alleging, among
other things, breach of fiduciary duty, abuse of control, gross mismanagement, waste of corporate
assets, unjust enrichment and violations of the California Corporations Code. These matters have
been consolidated, but additional similar state actions may be filed. The complaint was amended on
October 23, 2006, to include claims related to the merger agreement between the Company and Stiefel
Laboratories, Inc., which was announced on October 23rd.
Item 1A. Risk Factors
Please also read Item 1 in our Annual Report on Form 10-K/A for the year ended December 31,
2005 where we have described our business and the challenges and risks we may face in the future.
There are many factors that affect our business and results of operations, some of which are
beyond our control. In our Annual Report on Form 10-K/A we list some of the important factors that
may cause the actual results of our operations in future periods to differ materially from the
results currently expected or desired. Due to these factors, we believe that quarter-to-quarter
comparisons of our results of operations are not a good indication of our future performance. The
factors discussed in our reports filed with the Securities and Exchange Commission, including our
Annual Report on Form 10-K/A in particular under the Risk Factors section, should be carefully
considered when evaluating our business and prospects. Material changes to our Risk Factors since
the filing of our Annual Report on Form 10-K for the year ended December 31, 2005, as amended, are
required to be disclosed in this filing.
Our Business Strategy May Cause Fluctuating Operating Results
Our operating results and financial condition may fluctuate from quarter to quarter and year
to year depending upon the relative timing of events or uncertainties that may arise. For example,
the following events or occurrences could cause fluctuations in our financial performance from
period to period:
|
|
|
the pending SEC investigation, |
|
|
|
|
quarterly variations in results, |
|
|
|
|
the timing of new product introductions, |
|
|
|
|
clinical trial results and regulatory developments, |
|
|
|
|
competition, including both branded and generic, |
|
|
|
|
business and product market cycles, |
|
|
|
|
fluctuations in customer requirements, |
|
|
|
|
the availability and utilization of manufacturing capacity, |
|
|
|
|
the timing and amounts of royalties paid to us by third parties, and |
|
|
|
|
issues with the safety or effectiveness of our products. |
40
We face additional risks and costs as a result of the delayed filing of our quarterly report
on Form 10-Q for the quarter ended March 31, 2006 and our recent financial restatement.
As a result of the delayed filing of our Form 10-Q for the quarter ended March 31, 2006, and
the restatement of our historical financial statements we have experienced additional risks and
costs. The restatement was completed with the filing of an amendment to our Form 10-K for the year
ended December 31, 2005 on July 25, 2006. This restatement was time-consuming, required us to incur
additional expenses and has affected managements attention and resources. Further, the measures to
strengthen internal controls being implemented may require greater management time and company
resources to implement and monitor. In addition, measures being implemented as a result of this
examination, described in Item 4 Controls and Procedures of this Form 10-Q, may not be sufficient
to fully remediate the material weaknesses in our internal controls that are described in that
item.
As a result of our delayed filing of our Form 10-Q, we are ineligible to register our
securities on Form S-3 for sale by us or resale by others until we have timely filed all periodic
reports under the Exchange Act for one year. If we have to use Form S-1 to raise capital or
complete acquisitions, that could increase transaction costs and adversely affect our ability to
raise capital or complete acquisitions of other companies during this period.
Item 2. Purchase of Equity Securities by the Issuer
On October 31, 2005, our Board of Directors authorized the repurchase of up $50 million of our
common stock. The authorization expires at the earlier of December 31, 2006 or when we have
purchased $50 million of our common stock. As of December 31, 2005, we had repurchased 1.8 million
shares of our common stock at an average price paid per share of $13.51. During the nine months
ended September 30, 2006, we repurchased an additional 143,000 shares at an average price per share
of $15.02. Certain information regarding our purchases of common stock under our repurchase
program during the nine months ended September 30, 2006 is set forth in the table below.
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total Number of |
|
|
Approximate Dollar |
|
|
|
|
|
|
|
|
|
|
|
Shares Purchased as |
|
|
Value of Shares |
|
|
|
|
|
|
|
|
|
|
|
Part of Publicly |
|
|
That May Yet Be |
|
|
|
Total Number of |
|
|
Average Price Paid |
|
|
Announced Plans or |
|
|
Purchased Under the |
|
Period |
|
Shares Purchased |
|
|
Per Share |
|
|
Programs |
|
|
Plans or Programs |
|
January 1 31, 2006 |
|
|
|
|
|
$ |
|
|
|
|
|
|
|
$ |
25,700,000 |
|
February 1 28, 2006 |
|
|
143,104 |
|
|
|
15.02 |
|
|
|
143,104 |
|
|
|
23,500,000 |
|
March 1 31, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
23,500,000 |
|
April 1 30, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
23,500,000 |
|
May 1 31, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
23,500,000 |
|
June 1 30, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
23,500,000 |
|
July 1 31, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
23,500,000 |
|
August 1 31, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
23,500,000 |
|
September 1 30, 2006 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
23,500,000 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Total |
|
|
143,104 |
|
|
$ |
15.02 |
|
|
|
143,104 |
|
|
$ |
23,500,000 |
|
|
|
|
|
|
|
|
|
|
|
|
|
|
Item 5. Other Information
Unresolved Staff Comments
On June 2, 2006, we received a letter from the staff of the SECs Division of Corporation
Finance, notifying us that they had reviewed our Annual Report filed on Form 10-K for the fiscal
year ended December 31, 2005 and requesting that we provide the SEC with additional information.
One of the comments in the SECs
41
letter suggests we could enhance our disclosure regarding product returns, rebates and
chargebacks, and accordingly relates to the same matters that are the subject of the restatement of
our financial statements. On June 20, 2006, we provided the SEC with the analyses and information
requested by the SEC staff. On August 14, 2006, we provided additional information to the SEC in a
supplemental response letter.
On September 15, 2006, we received a second letter from the staff of the SECs Division of
Corporation Finance with some follow-up questions to their original queries. We filed a response
to this letter on October 6, 2006. As of the date of the filing of this Form 10-Q, the staff
continues to review our responses and, therefore, these comments remain unresolved.
42
Item 6. Exhibits
|
|
|
Exhibit |
|
|
Number |
|
Description |
|
|
|
10.1
|
|
Letter of Agreement with Dr. Lincoln Krochmal |
|
|
|
31.1
|
|
Rule 13a-14(a) Certification of the Chief Executive Officer |
|
|
|
31.2
|
|
Rule 13a-14(a) Certification of the Chief Financial Officer |
|
|
|
32.1
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
32.2
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
* |
|
Portions of this exhibit have been omitted and filed separately with the Commission. Confidential treatment has been requested with respect to the omitted portions. |
|
|
|
The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly report on
Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are not to be
incorporated by reference into any filing of Connetics Corporation under the Securities Act of
1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or
after the date of this Form 10-Q, irrespective of any general incorporation language contained in
such filing. |
43
SIGNATURE
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly
caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.
|
|
|
|
|
|
Connetics Corporation
|
|
|
By: |
/s/ John L. Higgins
|
|
|
|
John L. Higgins |
|
|
|
Chief Financial Officer
Executive Vice President, Finance
and Corporate Development |
|
|
Date:
November 8, 2006
44
INDEX TO EXHIBITS
|
|
|
Exhibit |
|
|
Number |
|
Description |
|
|
|
10.1
|
|
Letter of Agreement with Dr. Lincoln Krochmal |
|
|
|
31.1
|
|
Rule 13a-14(a) Certification of the Chief Executive Officer |
|
|
|
31.2
|
|
Rule 13a-14(a) Certification of the Chief Financial Officer |
|
|
|
32.1
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
32.2
|
|
Section 1350 Certification of the Chief Executive Officer |
|
|
|
* |
|
Portions of this exhibit have been omitted and filed separately with the Commission.
Confidential treatment has been requested with respect to the omitted portions. |
|
|
|
The certifications attached as Exhibits 32.1 and 32.2 that accompany this quarterly report on
Form 10-Q, are not deemed filed with the Securities and Exchange Commission and are not to be
incorporated by reference into any filing of Connetics Corporation under the Securities Act of
1933, as amended, or the Securities Exchange Act of 1934, as amended, whether made before or
after the date of this Form 10-Q, irrespective of any general incorporation language contained in
such filing. |