<PAGE> 1
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, 1998
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)
3400 WEST BAYSHORE ROAD
PALO ALTO, CALIFORNIA 94303
(Address of principal executive offices)
Registrant's 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 at least the past 90 days. Yes [X] No [ ]
As of October 30, 1998, 17,276,793 shares of the Registrant's common stock were
outstanding, at $0.001 par value.
<PAGE> 2
CONNETICS CORPORATION
QUARTERLY REPORT ON FORM 10-Q
FOR THE PERIOD ENDED SEPTEMBER 30, 1998
TABLE OF CONTENTS
<TABLE>
<CAPTION>
Page
----
<S> <C>
PART I. FINANCIAL INFORMATION
Item 1. Condensed Financial Statements
Condensed Balance Sheets at September 30, 1998 and
December 31, 1997 ...................................... 3
Condensed Statements of Operations for the three and
nine months ended September 30, 1998 and 1997........... 4
Condensed Statements of Cash Flows for the nine
months ended September 30, 1998 and 1997................ 5
Notes to Condensed Financial Statements................. 6
Item 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations..................... 10
Item 3. Quantitative and Qualitative Disclosures About
Market Risks............................................ 15
PART II. OTHER INFORMATION
Item 6. Exhibits and Reports on Form 8-K........................ 16
Exhibits................................................ 16
Reports on Form 8-K..................................... 16
SIGNATURE .................................................................... 17
</TABLE>
<PAGE> 3
PART I. FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
CONNETICS CORPORATION
CONDENSED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
-------- --------
(UNAUDITED)
ASSETS
<S> <C> <C>
Current assets:
Cash and cash equivalents $ 6,279 $ 8,452
Short-term investments 4,624 5,894
Accounts and other receivables 921 1,527
Other current assets 219 158
-------- --------
Total current assets 12,043 16,031
Property and equipment, net 1,290 1,663
Restricted cash 1,874 --
Notes receivable from related parties 374 333
Deposits and other assets 103 160
License agreements and product rights 7,840 12,881
-------- --------
$ 23,524 $ 31,068
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 1,201 $ 1,492
Accrued and other current liabilities 1,238 1,100
Accrued process development expenses 612 586
Accrued payroll and related expenses 885 536
Current portion of notes payable and other liabilities 6,912 2,884
Current portion of capital lease obligations, capital loans
and long-term debt 957 2,746
-------- --------
Total current liabilities 11,805 9,344
Noncurrent portion of capital lease obligations, capital loans
and long-term debt 1,867 649
Other long-term liabilities 4,509 9,666
Redeemable convertible preferred stock, Series A -- 600
Stockholders' equity:
Common stock and additional paid-in capital 92,334 77,566
Notes receivable from stockholders (65) (75)
Deferred compensation, net (392) (763)
Accumulated deficit (86,474) (65,873)
Treasury stock, at cost (60) (46)
-------- --------
Total stockholders' equity 5,343 10,809
======== ========
$ 23,524 $ 31,068
======== ========
</TABLE>
See notes to condensed financial statements.
-3-
<PAGE> 4
CONNETICS CORPORATION
CONDENSED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
(UNAUDITED)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
------------------------- -------------------------
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues:
Product $ 2,209 $ 2,006 $ 5,380 $ 5,053
License -- -- 1,648 --
-------- -------- -------- --------
Total revenues 2,209 2,006 7,028 5,053
Operating cost and expenses:
Cost of product revenue 419 332 1,026 815
License amortization 1,680 1,782 5,040 5,344
Research and development 3,185 3,834 8,468 14,731
Selling, general and administrative 3,162 2,559 8,667 6,599
Charge for acquired in-process technology -- -- 4,000 --
-------- -------- -------- --------
Total operating cost and expenses 8,446 8,507 27,201 27,489
Interest income 193 245 604 714
Interest expense (292) (423) (1,031) (1,318)
-------- -------- -------- --------
Net loss $ (6,336) $ (6,679) $(20,600) $(23,040)
======== ======== ======== ========
Basic and diluted net loss per share $ (0.37) $ (0.61) $ (1.30) $ (2.31)
======== ======== ======== ========
Shares used to calculate net loss per share 17,207 11,016 15,790 10,034
======== ======== ======== ========
</TABLE>
See notes to condensed financial statements.
-4-
<PAGE> 5
CONNETICS CORPORATION
CONDENSED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED
SEPTEMBER 30,
-------------------------
1998 1997
-------- --------
<S> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $(20,600) $(23,040)
Adjustments to reconcile net loss to net cash used by
operating activities:
Depreciation and amortization 5,654 5,909
Technology acquired in exchange for common stock 4,010 --
Amortization of deferred compensation 441 378
Accrued interest on notes payable 389 830
Changes in assets and liabilities:
Current and other long-term assets (1,374) (1,478)
Current and other liabilities 222 (3,077)
Other long-term liabilities 582 1,252
-------- --------
Net cash used in operating activities (10,676) (19,226)
-------- --------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of short-term investments (5,280) (12,169)
Sales and maturities of short-term investments, net 6,553 13,798
Capital expenditures (186) (808)
Licensed assets and product rights (308) --
-------- --------
Net cash provided by (used in) investing activities 779 821
-------- --------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from bank loan 1,500 --
Payment of notes payable (2,100) --
Proceeds from capital loans and long-term debt 2 333
Payments of obligations under capital leases and capital loans (2,071) (1,693)
Proceeds from issuance of common stock, net of issuance costs 10,393 10,977
-------- --------
Net cash provided by financing activities 7,724 9,617
-------- --------
Net change in cash and cash equivalents (2,173) (8,788)
Cash and cash equivalents at beginning of period 8,452 14,555
======== ========
Cash and cash equivalents at end of period $ 6,279 $ 5,767
======== ========
SUPPLEMENTARY INFORMATION:
Interest paid $ 534 $ 488
</TABLE>
See notes to condensed financial statements.
-5-
<PAGE> 6
CONNETICS CORPORATION
NOTES TO CONDENSED FINANCIAL STATEMENTS
SEPTEMBER 30, 1998
(UNAUDITED)
1. BASIS OF PRESENTATION
The accompanying unaudited condensed financial statements of Connetics
Corporation (the "Company" or "Connetics") have been prepared in accordance with
generally accepted accounting principles for interim financial information and
pursuant to the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, such financial statements do not include all of the information and
footnotes required by generally accepted accounting principles for complete
financial statements. In the opinion of management, all adjustments, consisting
of normal recurring accrual adjustments, considered necessary for a fair
presentation have been included. Operating results for the three and nine month
periods ended September 30, 1998 are not necessarily indicative of the results
that may be expected for the year ending December 31, 1998.
These financial statements and notes should be read in conjunction with the
Company's audited financial statements and notes thereto for the year ended
December 31, 1997 included in the Company's Annual Report on Form 10-K.
2. NET LOSS PER SHARE
In February 1997, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 128, "Earnings Per Share" (SFAS
128), which requires the Company to simplify the calculation of earnings per
share ("EPS") and achieve comparability with the recently issued International
Accounting Standard No. 33, "Earnings Per Share." Statement No. 128 replaced the
calculation of primary and fully diluted earnings per share with basic and
diluted earnings per share. Unlike primary earnings per share, basic earnings
per share excludes any dilutive effects of options, warrants and convertible
securities. Diluted earnings per share is very similar to the previously
reported fully diluted earnings per share. Earnings per share amounts for all
periods presented have been restated, where appropriate, to conform to the
Statement 128 requirements.
The following table sets forth the computation of basic and diluted earnings per
share:
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
------------------------- -------------------------
(In thousands except per share amounts) 1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Numerator:
Net loss $ (6,336) $ (6,679) $(20,600) $(23,040)
Preferred stock dividends -- (29) (1) (110)
-------- -------- -------- --------
Numerator for basic and diluted earnings per share -- (6,336) (6,708) (20,601) (23,150)
loss attributable to common stockholders
Denominator:
Denominator for basic and diluted earnings per share --
weighted-average shares 17,207 11,016 15,790 10,034
Basic and diluted net loss per share $ (0.37) $ (0.61) $ (1.30) $ (2.31)
======== ======== ======== ========
</TABLE>
Options to purchase 2,098,293 shares of common stock at exercise prices ranging
from $0.4448 to $11.00, warrants to purchase 1,289,193 shares of common stock at
exercise prices ranging from $4.89 to
-6-
<PAGE> 7
$11.00 were outstanding at September 30, 1998 but were not included in the
computation of diluted earnings per share as their effect would be antidilutive.
3. COMPREHENSIVE INCOME
As of January 1, 1998, the Company adopted Statement No. 130, "Reporting
Comprehensive Income" (SFAS 130). Statement 130 establishes new rules for the
reporting and display of comprehensive income and its components; however, the
adoption of this Statement had no impact on the Company's net income or
shareholders' equity. Statement 130 requires unrealized gains or losses on the
Company's available-for-sale securities and foreign currency translation
adjustments, which prior to adoption were reported separately in shareholders'
equity to be included in other comprehensive income. Prior year financial
statements have been reclassified to conform to the requirements of Statement
130.
During the three and nine months ended September 30, 1998, total comprehensive
income (loss) amounted to $(6.3) million and $(20.6) million, respectively,
compared to $(6.7) million and $(23.0) million for the same periods in 1997,
respectively. The components of comprehensive income, net of related tax, for
the three and nine month periods ended September 30, 1998 and 1997 are as
follows:
<TABLE>
<CAPTION>
Three months ended Nine months ended
September 30, September 30,
------------------------- -------------------------
(In thousands) 1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Net loss $ (6,336) $ (6,679) $(20,600) $(23,040)
Unrealized gains on securities 4 1 3 4
Foreign currency translation adjustment -- -- -- --
-------- -------- -------- --------
Comprehensive income (loss) $ (6,332) $ (6,678) $(20,597) $(23,036)
======== ======== ======== ========
</TABLE>
The components of accumulated other comprehensive income, net of related tax, at
September 30, 1998 and December 31, 1997 are as follows:
<TABLE>
<CAPTION>
(In thousands) 1998 1997
---- ----
<S> <C> <C>
Unrealized gains on securities $5 $2
Foreign currency translation adjustments - -
--- ---
Accumulated comprehensive income $5 $2
=== ===
</TABLE>
4. LICENSED ASSETS AND PRODUCT RIGHTS
Pursuant to its equity and asset purchase agreements with SmithKline Beecham
Properties, Inc. ("SBP"), the Company guaranteed a total value of the common
shares issued to SBP of $8,000,000 on April 1, 1998. As of April 1, 1998, the
aggregate fair market value of the shares previously issued under the agreement
was less than $8,000,000 and, as a result, the Company was required to issue
additional shares. On April 10, 1998, the Company issued 1,037,779 shares of its
Common Stock to SBP in fulfillment of such obligation. The issuance completed
the Company's obligation to issue equity to SBP under its Stock Issuance
Agreement with SBP. The Company also paid SBP approximately $308,000 in cash on
May 4, 1998 in conjunction with the transaction to fulfill its obligation to SBP
related to the
-7-
<PAGE> 8
equity agreement. (See Note 5 of Notes to Financial Statements for the year
ended December 31, 1997 in the Company's Annual Report on Form 10-K)
On April 28, 1998, the Company entered into a Second Omnibus Amendment with
SmithKline Beecham Corporation, SBP and related entities (collectively
"SmithKline"). Under this Amendment, the Company restructured its payment
obligations under a promissory note issued to SmithKline in connection with the
Ridaura acquisition. This amendment adjusted the December 18, 1997 amended note
repayments for the remaining principal payments of $10.0 million (originally due
in October 1998 and January 1999 with payments of $1.0 million and $9.0 million,
respectively) to SmithKline as follows:
<TABLE>
<CAPTION>
Payment Due Date Amount Due Payment Due Date Amount Due
<S> <C> <C> <C>
July 1, 1998 $1,100,000 July 1, 1999 $ 800,000
October 1, 1998 $1,100,000 October 1, 1999 $ 700,000
January 4, 1999 $2,500,000 January 3, 2000 $1,500,000
April 1, 1999 $ 800,000 April 1, 2000 $1,500,000
</TABLE>
The Company is required to pay interest on the principal amount outstanding of
$4.7 million from April 8, 1998 through January 4, 1999 at prime rate plus 2%
per year, and on the principal amount outstanding of $5.3 million from January
5, 1999 through April 1, 2000 at prime rate plus 3% per year. The Company paid
SmithKline $1.2 million in principal and interest on July 1, 1998 and October 1,
1998, respectively.
5. FINANCING ARRANGEMENT
On September 24, 1998, the Company entered into a term Loan and Security
Agreement (the "Term Loan") with a bank (the "Lender") under which the Company
borrowed $1,500,000. The Term Loan bears interest at prime rate plus 1.25%
(currently 9.75%), with interest only payments for the first twelve months, and
to be repaid thereafter in forty eight (48) equal monthly installments of
principal plus accrued interest. On the anniversary of the loan, the Company has
the right to elect whether the aggregate Term Loan outstanding will bear
interest at (i) a floating rate equal to prime rate plus 1.25% or (ii) a fixed
rate equal to 4.5 percentage points above the yield of the 48 month Treasury
Bill (fixed at the time of election). In conjunction with the Term Loan, the
Company granted the lender a first priority security interest in its presently
existing Intellectual Property Collateral. Covenants governing the Term Loan
require the maintenance of certain financial ratios, and if the Company does not
meet the covenants during the loan period, a restricted cash pledge must be made
against 100% of the outstanding loan balance. At September 30, 1998, the Company
had $1.5 million pledged in restricted cash pertaining to the Term Loan.
In December 1995, the Company consummated a $5,000,000 term Loan and Security
Agreement with a bank consortium. Under the terms of the loan, the Company is
required to maintain certain financial ratios and meet certain covenants during
the loan period or else the Company would be required to pledge restricted cash
of 65% of the outstanding loan. At September 30, 1998, the Company pledged
$374,000 in restricted cash pertaining to this loan.
6. LIQUIDITY AND FINANCIAL VIABILITY
In the course of its development activities, the Company has sustained
continuing operating losses and expects such losses to continue over at least
the next few years. The Company plans to continue to finance its operating
activities with a combination of stock sales, through public offerings and
self-managed private financings, payments from corporate partnering
arrangements, product revenue, bank loans and/or debt financing. Ultimately, the
Company's ability to continue as a going concern in the
-8-
<PAGE> 9
future is dependent upon obtaining additional financings.
7. OTHER MATTERS
In April 1998, the Company entered into an agreement with Alta BioPharma
Partners, L.P. ("Alta") and certain funds affiliated with Alta (collectively the
"Investors"), to sell an aggregate of 2,162,163 shares of the Company's Common
Stock at a price of $4.625 per share, for an aggregate purchase price of
approximately $10 million. The financing closed on April 10, 1998 and the
Company filed a registration statement on Form S-3 covering the resale of the
shares of Common Stock purchased by the Investors in June, 1998.
On April 27, 1998, the Company entered into a development, commercialization and
supply agreement with Suntory Pharmaceuticals, a division of Suntory Limited, of
Osaka, Japan for ConXn(R) for the treatment of scleroderma. Under the terms of
the agreement, Suntory will pay approximately $14 million in license fees and
milestone payments to the Company, be responsible for all development and
commercialization expenses in Japan, and pay royalties on sales in Japan for the
treatment of scleroderma. The Company has retained rights to all other
indications in Japan for ConXn. Suntory will purchase relaxin materials from the
Company and make milestone payments based upon development progress in the
United States and Japan. On April 30, 1998, Suntory paid an up-front license fee
of $1.5 million (net of $165,000 international withholding tax) to the Company.
On May 5, 1998, the Company entered into a license agreement with Genentech,
Inc. ("Genentech") under which the Company received an exclusive license under
certain patent rights and know-how to Actimmune(R) (gamma interferon) for the
treatment of chronic granulomatous disease ("CGD") and several additional
indications (non-cancer dermatological diseases, infectious diseases,
osteopetrosis, pulmonary fibrosis and asthma) in the United States. Under the
terms of the agreement, the Company issued Genentech 340,048 shares of its
common stock valued at $2.0 million at the time of closing with a guaranteed
value of $4.0 million at December 28, 1998. In the event that the value of the
initial shares issued is less than $4.0 million on December 28, 1998, the
Company will either issue additional shares or pay cash to Genentech. The
Company will also be required to pay certain development and commercialization
milestones and royalties on sales. The parties also entered into a Supply
Agreement under which Genentech will manufacture and supply gamma interferon, in
bulk product or finished product, with a termination date on the earlier of May
5, 2001 or the date on which a third party manufacturer, approved by the
parties, enters into a supply agreement with the Company. Because the
realizability of the license is largely uncertain and dependent on additional
research and development related to gamma interferon, the Company recorded a
$4.0 million noncash one-time license fee charge during the quarter ended June
30, 1998. In October 1998, the Company formed a wholly-owned subsidiary
corporation, InterMune Pharmaceuticals, Inc., to further develop and market
gamma interferon.
-9-
<PAGE> 10
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
SPECIAL NOTE: EXCEPT FOR THE HISTORICAL INFORMATION, THE FOLLOWING MANAGEMENT'S
DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
("MD&A") CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES. THE COMPANY'S ACTUAL RESULTS OF OPERATIONS COULD DIFFER
MATERIALLY FROM THOSE ANTICIPATED IN SUCH FORWARD-LOOKING STATEMENTS AS A RESULT
OF VARIOUS FACTORS, INCLUDING THOSE IDENTIFIED BELOW. POTENTIAL RISKS AND
UNCERTAINTIES INCLUDE, WITHOUT LIMITATION, UNCERTAINTY OF PRODUCT DEVELOPMENT
AND MARKET ACCEPTANCE OF A PRODUCT ONCE DEVELOPED; UNCERTAINTY OF FUTURE
RIDAURA(R) REVENUES AND COSTS; UNCERTAINTY OF CLINICAL TRIALS RESULTS;
UNCERTAINTY OF FUTURE PROFITABILITY; FUTURE CAPITAL REQUIREMENTS AND UNCERTAINTY
OF FUTURE FUNDING; AND RISKS ASSOCIATED WITH POSSIBLE FUTURE PRODUCT
ACQUISITIONS. IN PARTICULAR, THE FACTORS SET FORTH IN THE COMPANY'S ANNUAL
REPORT ON FORM 10-K FOR THE FISCAL YEAR ENDED DECEMBER 31, 1997, COMMENCING ON
PAGE 20 UNDER THE HEADING "ADDITIONAL FACTORS THAT MAY AFFECT FUTURE RESULTS,"
MAY CAUSE THE COMPANY'S ACTUAL RESULTS TO VARY FROM THOSE CONTEMPLATED BY
CERTAIN FORWARD-LOOKING STATEMENTS SET FORTH IN THIS REPORT AND SHOULD BE
CONSIDERED CAREFULLY IN ADDITION TO OTHER INFORMATION PRESENTED IN THIS REPORT.
This MD&A should be read in conjunction with the MD&A included in the Company's
1997 Annual Report on Form 10-K, and with the unaudited condensed financial
statements and notes to financial statements included in Part I, Item 1 of this
Quarterly Report. Results of operations in the current or any prior fiscal
period should not be considered as indicative of results to be expected for any
future fiscal period.
OVERVIEW
Connetics Corporation acquires, develops and markets products in the areas of
rheumatology and dermatology. The Company acquired the U.S. and Canadian rights
to Ridaura(R) (auranofin), a treatment for rheumatoid arthritis, froM SmithKline
Beecham Corporation and related entities ("SmithKline") in December 1996, and in
December 1997 the Company re-sold its Canadian rights to Ridaura. The Company's
products under development include LUXIQ(TM) (betamethasone valerate 0.1%) for
the treatment of scalp psoriasis and other dermatoses; Olux(TM) (clobetasOl
propionate 0.05%) for the treatment of severe scalp dermatoses; ConXn(R)
(relaxin) for the treatment oF scleroderma, infertility and other fibrotic
disorders; gamma interferon for the treatment of chronic granulomatous disease,
dermatological diseases, infectious diseases, osteopetrosis, pulmonary fibrosis
and asthma; and T-cell receptor (TCR) peptide vaccines for the treatment of
multiple sclerosis and rheumatoid arthritis.
During the quarter ended September 30, 1998, the Company initiated and completed
treatment in a Phase III clinical trial of Olux intended for the treatment of
severe scalp psoriasis and other corticosteroid-responsive dermatoses of the
scalp. The Phase III trial was a multicenter, randomized, double-blind study of
approximately 190 scalp psoriasis patients which compared Olux to a currently
approved clobetasol solution and to placebo during a two week treatment regimen.
The primary endpoints for the trial included changes in the clinical signs of
psoriasis: plaque thickness scaling, erythema (redness), and the global response
to treatment as judged by the investigator. Decreases in itching and the
patient's assessment of improvement were also evaluated. On November 11, 1998,
the Company announced that the outcome of the trial was positive and that the
Company anticipates filing a New Drug Application ("NDA") in 1999.
There can be no assurance that any of the Company's potential products will be
successfully developed, receive the necessary regulatory approvals or be
successfully commercialized.
RESULTS OF OPERATIONS
The Company's product revenues are derived from the sales of Ridaura and were
$2.2 million and $5.4 million for the three and nine months ended September 30,
1998, respectively, compared to $2.0 million
-10-
<PAGE> 11
and $5.1 million for the same periods in 1997, respectively. In December 1997,
the Company sold the Canadian rights to Ridaura to Pharmascience, Inc., a
Canadian corporation. Revenue on an adjusted basis to reflect the disposition of
Ridaura rights in Canada for the three and nine months ended September 30, 1997
were $1.9 million and $4.8 million, respectively. In connection with an
agreement with Suntory Pharmaceuticals, the Company also recorded $1.6 million
licensing revenue for the nine months ended September 30, 1998. The Company
believes the increase in product revenue for the three and nine months ended
September 30, 1998 as compared to the same periods in 1997 resulted in part from
the increased promotion efforts of the Company's sales organization.
Pursuant to agreements between SmithKline and the Company, SmithKline will
manufacture and supply Ridaura in final package form through December 2001.
SmithKline also managed distribution of the product, with no additional
consideration, through December 1997, at which time CORD Logistics, Inc.
("CORD") began managing customer orders and distribution of Ridaura. As a
result, the Company began incurring distribution costs of approximately 3% of
net revenue. Under a distribution arrangement, CORD will also manage customer
orders and distribution of future products of the Company.
The Company's cost of product revenues includes the cost of Ridaura purchased
from SmithKline, a percentage royalty cost based on product revenues, and
distribution costs from CORD. For the three and nine months ended September 30,
1998, the Company recorded $0.4 million and $1.0 million, respectively, in cost
of product revenues compared to $0.3 million and $0.8 million for the same
periods in 1997. Amortization expense associated with the acquisition of product
rights to Ridaura were $1.7 million and $5.0 million compared to $1.8 million
and $5.3 million for the same periods in 1998 and 1997, respectively.
Research and development expenses were $3.2 million and $8.5 million for the
three and nine months ended September 30, 1998, compared to $3.8 and $14.7
million for the same periods in 1997. The decrease in research and development
expenses of $0.6 million and $6.2 million, respectively was primarily due to
lower clinical trial expenses. For the first nine months of 1998, the Company's
clinical trial activities consisted of a 13 patient open label clinical trial of
ConXn for the treatment of scleroderma, a 41 patient Phase II clinical trial of
gamma interferon for the treatment of keloids, a 190 patient Phase III clinical
trial of Olux and contract manufacturing scale-up expenses associated with LUXIQ
compared with two Phase III, two Phase II and one Phase I/II clinical trials
during the same period in 1997. Research and development expenses are expected
to decrease over the next quarter due to the completion of current clinical
trial activities. However the decrease could be offset by the initiation of an
expected pivotal trial of ConXn for the treatment of scleroderma and possible
acquisition of new technologies and products.
Selling, general and administrative expenses increased to $3.2 million and $8.7
million for the three and nine months ended September 30, 1998, respectively,
compared to $2.6 million and $6.6 million for the same periods in 1997,
respectively. The increases in expenses were primarily due to increased
activities of an established sales and marketing organization including the
hiring of additional sales staff in the third quarter, costs associated with the
promotion and marketing of Ridaura and increases in personnel in the general and
administrative functions. Selling, general and administrative expenses are
expected to increase primarily due to further staffing up of the sales
organization, costs associated with marketing Ridaura and possible launching of
new approved or acquired products.
Pursuant to the gamma interferon license agreement with Genentech in May 1998,
the Company recorded a $4.0 million noncash one-time license fee charge in the
quarter ended June 30, 1998. The Company determined that the realizability of
the license is largely uncertain and dependent on additional research and
development of gamma interferon, and as a result, has expensed the full purchase
amount in the quarter ended June 30, 1998.
Interest income was $193,000 and $604,000 in the three and nine months ended
September 30, 1998,
-11-
<PAGE> 12
compared with $245,000 and $714,000 for the corresponding periods in 1997,
respectively. The decrease in interest income during the nine months of 1998 was
due to a lower average cash and investment balance, offset in part by the
Company's self-managed private placement in April 1998, which raised $10.0
million. Interest earned in the future will depend on Company funding cycles and
prevailing interest rates. Interest expense decreased to $292,000 and $1,031,000
for the three and nine months ended September 30, 1998, compared with $423,000
and $1,318,000 for the corresponding periods in 1997. The decrease in interest
expense during the nine months of 1998 was due to lower imputed interest
expense, $389,000 in 1998 compared to $830,000 in 1997, attributable to a
non-interest bearing $11.0 million promissory note payable to SmithKline as
partial consideration for the acquisition of U.S. and Canadian rights to
Ridaura, and lower interest expense associated with lower balances outstanding
for obligations under capital leases and loans, and notes payable. The decrease
was offset in part by $383,000 in accrued interest payable pursuant to the
amended repayment terms of the SmithKline note by which the Company is required
to pay interest on the principal amount outstanding at prime rate plus 2% per
annum.
Net losses for the three and nine months ended September 30, 1998 were $6.3
million and $20.6 million, respectively, compared to $6.7 million and $23.0
million for the corresponding periods in 1997, respectively. Other than the $4.0
million one-time licensing charge in connection with the license of gamma
interferon (discussed above), the decrease of $2.4 million in net losses for the
nine months ended September 30, 1998 from the same period in 1997 was primarily
due to a decrease of approximately $6.2 million in development activities, lower
amortization costs due to the sale of Canadian rights to Ridaura and an
additional $1.6 million in licensing revenue in connection with the agreement
with Suntory Pharmaceuticals for ConXn. These decreases were offset in part by
higher selling, general and administrative expenses. The Company expects to
incur additional losses over the next few years and losses are expected to
fluctuate from period to period based on timing of product revenues, clinical
material purchases, possible acquisitions of new products and technologies,
scale-up activities and clinical activities.
LIQUIDITY AND CAPITAL RESOURCES
The Company has financed its operations to date primarily through private sales
of equity securities, proceeds from its initial public offering in February 1996
and five self-managed financings, two in 1996, two in 1997 and one in 1998. At
September 30, 1998, cash, cash equivalents, short-term investments, and
long-term restricted cash totaled $12.8 million, a decrease of $1.5 million from
$14.3 million at December 31, 1997. In 1998, the Company has generated cash of
$11.5 million through sales of the Company's common stock ($10.0 million) and an
up-front license fee payment from Suntory Limited ($1.5 million).
Cash used in operations for the nine months ended September 30, 1998 was $10.7
million compared with $19.2 million for the same period in 1997. Net loss for
the first nine months of 1998 was affected by a number of charges that did not
use cash, including a $4.0 million technology licensed in exchange for common
stock, and $5.0 million of amortization expense and $389,000 imputed interest
expense associated with the acquisition of Ridaura. Cash outflow for the quarter
was primarily for operating activities. Receivables at September 30, 1998 were
$0.9 million compared with $1.5 million for the same period in 1997 due to a
shorter collection cycle as product sales in 1998 are direct to wholesalers with
payment terms of 2% discount, net 30 days. In 1997, the Company's sole customer
was SmithKline who in turn distributed Ridaura under a Transitional Services
Agreement with the Company. Payment terms under this arrangement were on a
quarterly basis, thirty days after the end of each quarter.
Investing activities, other than the changes in the Company's short-term
investments, consumed $0.5 million in cash during the nine month period ended
September 30, 1998, of which $186,000 was for equipment expenditures required
for operations and $308,000 was for fulfillment of obligation under the equity
and asset purchase agreements with SmithKline (see Note 4 of Notes to Condensed
Financial Statements).
-12-
<PAGE> 13
Cash provided by financing activities was $7.7 million for the nine months ended
September 30, 1998 compared with $9.6 million for the same period in 1997. The
Company raised $10.0 million in April through private sales of its common stock
and $1.5 million in a bank loan in September. These proceeds were offset in part
by $2.1 million in payments on obligations under capital leases and loans, and
$2.1 million in principal payment to SmithKline for obligations under a
promissory note in connection with the Ridaura acquisition.
Working capital decreased by $4.6 million to $2.1 million at September 30, 1998
from $6.7 million at December 31, 1997. The decrease in working capital resulted
primarily from the reclassification of the note payable due to SmithKline in
1999 for rights to Ridaura to current liabilities and the lower cash balances.
On April 28, 1998, the Company entered into a second omnibus amendment with
SmithKline and restructured its payment obligations under the promissory note
such that $5.3 million of payments previously due within 1998 are now due after
January 1999 (see Note 4 of Notes to Condensed Financial Statements).
At September 30, 1998, the Company had an aggregate of $14.2 million in future
obligations of principal payments under capital leases, loans, long-term debt
and other obligations, of which $7.9 million is to be paid within the next year
The Company has an equity line agreement with an investor that may potentially
provide the Company access to capital through sales of its Common Stock. The
equity line is available for a three-year term beginning June 26, 1998. During
the three year term, if the stock meets certain volume restrictions and trades
above $10.00, then up to $500,000 may be drawn approximately every three months
in exchange for the sale of stock at an approximate minimum price of $10.00.
The Company believes that its existing cash, cash equivalents and short-term
investments along with cash generated from the sales of Ridaura and from
financings, will be sufficient to fund the Company's operating expenses, debt
obligations and capital requirements through 1999. The Company's future capital
uses and requirements depend on numerous factors, including the progress of its
research and development programs, the progress of clinical and advanced-stage
clinical testing, the time and costs involved in obtaining regulatory approvals,
the cost of filing, prosecuting, and enforcing patent claims and other
intellectual property rights, competing technological and market developments,
the ability of the Company to establish collaborative arrangements, the level of
product revenues, the possible acquisition of new products and technologies, and
the development of commercialization activities, and therefore such capital uses
and requirements may increase in future periods. As a result, the Company will
require substantial additional funds prior to reaching profitability and may
attempt to raise additional funds through equity or debt financings,
collaborative arrangements with corporate partners or from other sources. There
can be no assurance that additional funding will be available for the Company to
finance its ongoing operations when needed or, if available, that the terms for
obtaining such funds will be favorable to the Company or will not result in
dilution to the Company's stockholders.
IMPACT OF YEAR 2000
Certain currently installed computer systems and software programs were written
to accept only two digit entries in the date fields rather than four digit
entries. In particular, some of the Company's older computer programs were
written using two digits rather than four to define the applicable year.
Beginning in the year 2000, these date code fields will need to accept four
digits entries to distinguish 21st century dates from 20th century dates or they
could cause a system failure or miscalculations causing disruptions of
operations, including, among other things, a temporary inability to process
transactions, send invoices, or engage in similar normal business activities. As
a result, during the next year, computer systems and/or software used by many
companies, including Connetics, may need to be upgraded to comply with such
"Year 2000" requirements.
-13-
<PAGE> 14
Based on recent assessments, the Company determined that it will be required to
modify or replace portions of its software and certain hardware so that those
systems will properly recognize dates beyond December 31, 1999. The Company
presently believes that with modifications or replacement of existing software
and certain hardware, the Year 2000 Issue can be mitigated. However, if such
modifications and replacements are not made, or are not completed by the end of
1999, the Year 2000 Issue may potentially have a material impact on the
operations of the Company.
The Company's plan to resolve the Year 2000 Issue involves the following four
phases: assessment, remediation, testing, and implementation. To date, the
Company has completed its assessment of all systems that could be significantly
affected by the Year 2000. The assessment indicated that most of the Company's
significant information technology could be affected, particularly the general
ledger, payable and fixed asset systems. Based on a review of its product line,
the Company has determined that most of the products it has sold and will
continue to sell do no require remediation to be Year 2000 compliant.
Accordingly, the Company does not believe that the Year 2000 presents a material
exposure as it relates to the Company's products. In addition, the Company has
gathered information about the Year 2000 compliance status of its significant
service providers and suppliers and continues to monitor their compliance.
For its information technology exposures, to date the Company has completed 75%
of the remediation phase and expects to complete software replacement no later
than December 31, 1998. Once software is replaced for a system, the Company
begins testing and implementation. These phases run concurrently for different
systems. To date, the Company has completed testing and implementation of
approximately 50% of its remediated systems. The Company expects to have all
remediated systems fully tested and implemented by March 31, 1999.
The remediation of operating equipment is more difficult than the remediation of
the information technology systems. The Company is 55% complete with the
remediation phase of its operating equipment and is 10% complete with the
testing of its remediated operating equipment. Once testing is complete, the
operating equipment will be ready for immediate use. The Company expects to
complete its remediation efforts by March 31, 1999, and testing and
implementation of affected equipment is expected to be fully completed by June
30, 1999.
The Company has on-line access to its third party distribution service system
that includes customer orders, billing, shipping and inventory management. This
vendor has made its distribution system Year 2000 compliant, and the Company is
scheduled for a system compliant conversion by November 30, 1998.
The Company has queried its significant suppliers, service providers and
subcontractors that do not share information systems with the Company (external
agents). To date, the Company is not aware of any external agent with a Year
2000 issue that would materially impact the Company's results of operations,
liquidity, or capital resources. However, the Company has no means of ensuring
that external agents will be Year 2000 compliant. The inability of external
agents to complete their Year 2000 resolution process in a timely fashion could
materially impact the Company. The effect of non-compliance by external agents
is not determinable.
The Company will utilize both internal and external resources to replace, test,
and implement the software and operating equipment for Year 2000 modifications.
The total cost of the Year 2000 project is estimated to be less than $50,000 and
is being funded through operating cash flows. To date, the Company has incurred
and expensed approximately $10,000 related to all phases of the Year 2000
project. Of the total remaining project costs, approximately $20,000 is
attributable to the purchase of new software and operating equipment, which will
be capitalized. Additional expenditures will cover the repair of hardware and
software and will be expensed as incurred.
-14-
<PAGE> 15
Management of the Company believes it has an effective program in place to
resolve the Year 2000 issue in a timely manner. As noted above, the Company has
not yet completed all necessary phases of the Year 2000 program. In the event
that the Company does not complete any additional phases, the progress of the
Company's research and development projects could be delayed. In addition,
disruptions in the economy generally resulting from Year 2000 issues may also
material adversely affect the Company, and the amount of potential liability and
lost revenue cannot be reasonably estimated at this time.
The Company currently has no contingency plan in place in the event it does not
complete all phases of the Year 2000 program. The Company plans to evaluate the
status of completion in March 1999 and determine whether such a plan is
necessary.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
Not Applicable.
-15-
<PAGE> 16
PART II. OTHER INFORMATION
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits.
27.1 Financial Data Schedule (EDGAR - filed version only)
(b) Reports on Form 8-K.
None.
-16-
<PAGE> 17
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
Vice President, Finance and
Administration and Chief Financial
Officer
Date: November 13, 1998
-17-
<PAGE> 18
INDEX TO EXHIBITS
<TABLE>
<CAPTION>
Exhibit
Number Description
- ------ -----------
<S> <C>
27.1 Financial Data Schedule
</TABLE>
<TABLE> <S> <C>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 6,279
<SECURITIES> 4,624
<RECEIVABLES> 921
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 12,043
<PP&E> 3,590
<DEPRECIATION> 2,300
<TOTAL-ASSETS> 23,524
<CURRENT-LIABILITIES> 11,805
<BONDS> 0
0
0
<COMMON> 17
<OTHER-SE> 5,326
<TOTAL-LIABILITY-AND-EQUITY> 23,524
<SALES> 5,380
<TOTAL-REVENUES> 7,028
<CGS> 1,026
<TOTAL-COSTS> 1,026
<OTHER-EXPENSES> 26,175
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 1,031
<INCOME-PRETAX> (20,600)
<INCOME-TAX> 0
<INCOME-CONTINUING> 0
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (20,600)
<EPS-PRIMARY> (1.30)<F1>
<EPS-DILUTED> (1.30)
<FN>
<F1>For purposes of this exhibit, Primary means Basic.
</FN>
</TABLE>
