UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549
FORM 10-Q
(Mark One)
X Quarterly report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934. For the quarterly period ended March 31, 1998.
Transition report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934. For the transition period from to .
Commission File Number
1-9813
GENENTECH, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-2347624
(State or other jurisdiction of (I.R.S. employer
incorporation or organization) identification number)
1 DNA Way, South San Francisco, California 94080
(Address of principal executive offices and zip code)
(650) 225-1000
(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. Yes X No
Indicate the number of shares outstanding of each of the issuer's classes of
common stock, as of the latest practicable date.
Class Number of Shares Outstanding
- ----- ----------------------------
Common Stock $.02 par value 76,621,009
(Common Stock) Outstanding at March 31, 1998
Callable Putable Common Stock $.02 par value 48,539,376
(Special Common Stock) Outstanding at March 31, 1998
GENENTECH, INC.
INDEX
PART I. FINANCIAL INFORMATION PAGE NO.
Condensed Consolidated Statements of Income -
for the three months ended March 31, 1998 and 1997 3
Condensed Consolidated Statements of Cash Flows -
for the three months ended March 31, 1998 and 1997 4
Condensed Consolidated Balance Sheets -
March 31, 1998 and December 31, 1997 5
Notes to Condensed Consolidated Financial Statements 6-9
Independent Accountants' Review Report 10
Financial Review 11-19
PART II. OTHER INFORMATION 20
SIGNATURES 21
2
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
GENENTECH, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(thousands, except per share amounts)
(unaudited)
Three Months
Ended March 31,
----------------------
1998 1997
---------- ----------
<S> <C> <C>
Revenues:
Product sales (including amounts from related parties:
1998-$6,607; 1997-$4,494) $ 164,719 $ 154,213
Royalties (including amounts from related parties:
1998-$7,129; 1997-$6,798) 64,493 65,312
Contract and other (including amounts from
related parties: 1998-$7,798; 1997-$15,706) 14,865 21,409
Interest 20,623 16,351
---------- ----------
Total revenues 264,700 257,285
Costs and expenses:
Cost of sales (including amounts from related parties:
1998-$6,025; 1997-$3,899) 33,621 27,685
Research and development (including contract
related: 1998-$9,062; 1997-$15,706) 98,202 122,743
Marketing, general and administrative 74,950 61,981
Interest 959 988
---------- ----------
Total costs and expenses 207,732 213,397
Income before taxes 56,968 43,888
Income tax provision 15,951 12,289
---------- ----------
Net income $ 41,017 $ 31,599
========== ==========
Earnings per share:
Basic $ 0.33 $ 0.26
========== ==========
Diluted $ 0.32 $ 0.25
========== ==========
Weighted average shares used to
compute diluted earnings per share 128,807 125,258
========== ==========
<FN>
See Notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
3
<TABLE>
<CAPTION>
GENENTECH, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(thousands)
(unaudited)
Three Months
Ended March 31,
----------------------
1998 1997
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 41,017 $ 31,599
Adjustments to reconcile net income to net cash
provided by (used in) operating activities:
Depreciation and amortization 17,936 16,481
Deferred income taxes 4,386 (2,583)
Gain on sales of securities available-for-sale (5,835) (1,992)
Loss on sales of securities available-for-sale 376 997
Write down of securities available-for-sale 2,555 -
Loss on fixed asset dispositions - 31
Changes in assets and liabilities:
Investments in trading securities 25,290 (97,585)
Receivables and other current assets 15,071 (11,850)
Inventories (1,685) (1,724)
Accounts payable, other current liabilities
and other long-term liabilities (30,252) 6,170
---------- ----------
Net cash provided by (used in) operating activities 68,859 (60,456)
Cash flows from investing activities:
Purchases of securities held-to-maturity (128,731) (138,090)
Proceeds from maturities of securities held-to-maturity 102,874 185,096
Purchases of securities available-for-sale (177,731) (136,994)
Proceeds from sales of securities available-for-sale 96,636 114,885
Capital expenditures (21,002) (45,711)
Change in other assets 1,336 (3,435)
---------- ----------
Net cash used in investing activities (126,618) (24,249)
Cash flows from financing activities:
Stock issuances 34,578 27,258
---------- ----------
Net cash provided by financing activities 34,578 27,258
---------- ----------
Net decrease in cash and cash equivalents (23,181) (57,447)
Cash and cash equivalents at beginning of period 244,469 207,264
---------- ----------
Cash and cash equivalents at end of period $ 221,288 $ 149,817
========== ==========
<FN>
See Notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
4
<TABLE>
<CAPTION>
GENENTECH, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(thousands)
(unaudited)
March 31, December 31,
1998 1997
------------ ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 221,288 $ 244,469
Short-term investments 663,793 588,853
Accounts receivable, net (including amounts
from related party: 1998-$34,620;
1997-$44,386) 175,285 189,245
Inventories 117,711 116,026
Prepaid expenses and other current assets 54,214 55,325
------------ ------------
Total current assets 1,232,291 1,193,918
Long-term marketable securities 487,867 453,188
Property, plant and equipment, less accumulated
depreciation (1998-$392,034; 1997-$376,091) 688,363 683,304
Other assets 165,000 177,202
------------ ------------
Total assets $2,573,521 $2,507,612
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 41,621 $ 48,992
Income taxes payable 55,091 40,293
Accrued liabilities - related party 12,017 15,427
Other accrued liabilities 164,645 184,845
------------ ------------
Total current liabilities 273,374 289,557
Long-term debt 150,000 150,000
Other long-term liabilities 38,229 36,830
------------ ------------
Total liabilities 461,603 476,387
Commitments and contingencies
Stockholders' equity:
Preferred stock - -
Special Common Stock 971 952
Common Stock 1,532 1,532
Additional paid-in capital 1,498,327 1,463,768
Retained earnings 552,159 511,141
Net unrealized gain on securities
available-for-sale 58,929 53,832
------------ ------------
Total stockholders' equity 2,111,918 2,031,225
------------ ------------
Total liabilities and stockholders' equity $2,573,521 $2,507,612
============ ============
<FN>
See Notes to Condensed Consolidated Financial Statements.
</FN>
</TABLE>
5
GENENTECH, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 1. Statement of Accounting Presentation
In the opinion of Genentech, Inc. (the Company), the accompanying unaudited
condensed consolidated financial statements have been prepared in accordance
with generally accepted accounting principles for interim financial
information and with the instructions to Form 10-Q and Article 10 of
Regulation S-X. Accordingly, they 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 only of adjustments of a normal recurring nature) considered
necessary for a fair presentation have been included. Operating results for
the three-month periods ended March 31, 1998 and 1997 are not necessarily
indicative of the results that may be expected for the year ending December
31, 1998. The condensed consolidated balance sheet as of December 31, 1997
has been derived from the audited financial statements as of that date. For
further information, refer to the consolidated financial statements and
notes thereto included in the Company's Annual Report to Stockholders for
the year ended December 31, 1997.
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
Note 2. New Accounting Standards
The Company adopted Statement of Financial Accounting Standards (FAS) No.
128, "Earnings Per Share" for the year ended December 31, 1997. All
earnings per share (EPS) and share amounts for all periods presented have
been restated to comply with FAS 128. The following is a reconciliation of
the numerator and denominators of the basic and diluted EPS computations for
the quarter ended March 31, 1998 and 1997 (in thousands).
1998 1997
-----------------------
Numerator:
Net income - numerator for
basic and diluted EPS: $ 41,017 $ 31,599
--------- ---------
Denominator:
Denominator for basic EPS--
weighted-average shares 124,758 121,969
Effect of dilutive securities:
Stock options 4,049 3,289
--------- ---------
Denominator for diluted EPS
--adjusted weighted-average
shares and assumed conversions 128,807 125,258
========= =========
Options to purchase 2,850,050 shares of Special Common Stock at $67.31 per
share and 28,200 shares of Special Common Stock at $55.38 per share were
outstanding in the first quarter of 1998 and the comparable period in 1997,
6
respectively, but were not included in the computation of diluted EPS
because the options were anti-dilutive.
In the first quarter of 1998 and the comparable period in 1997, the Company
had convertible subordinated debentures that were convertible to 1,013,514
shares of Special Common Stock, but were not included in the computation of
diluted EPS because they were anti-dilutive.
The Financial Accounting Standards Board issued FAS 130, "Reporting
Comprehensive Income," and FAS 131, "Disclosures about Segments of an
Enterprise and Related Information," in June 1997, which require additional
disclosures to be adopted on December 31, 1998. Under FAS 130, the Company
is required to display comprehensive income and its components as part of
the Company's full set of financial statements. Comprehensive income is
comprised of net income and other comprehensive income. The measurement and
presentation of net income will not change. Other comprehensive income
includes certain changes in equity of the Company that are excluded from net
income. Specifically, FAS 130 requires unrealized holding gains and losses
on the Company's available-for-sale securities, which are currently reported
separately in stockholders' equity, to be included in other comprehensive
income. During the first quarter of 1998 and the comparable period in 1997,
total comprehensive income amounted to $46.1 million and $25.7 million,
respectively.
FAS 131 requires that the Company report financial and descriptive
information about its reportable operating segments. The Company is
evaluating the impact on its disclosures, if any.
Note 3. Relationship with Roche Holdings, Inc.
On October 25, 1995, the Company and Roche Holdings, Inc. (Roche) entered into
a new agreement (the Agreement) to extend until June 30, 1999, Roche's option
to cause the Company to redeem (call) the outstanding Special Common Stock of
the Company at predetermined prices. Should the call be exercised, Roche will
concurrently purchase from the Company a like number of shares of Common Stock
for a price equal to the Company's cost to redeem the Special Common Stock.
During the quarter beginning April 1, 1998, the call price is $76.50 per share
and increases by $1.50 per share each quarter through the end of the option
period on June 30, 1999, on which date the price will be $82.50 per share. If
Roche does not cause the redemption as of June 30, 1999, the Company's
stockholders will have the option (the put) to cause the Company to redeem
none, some or all of their shares of Special Common Stock at $60.00 per share
(and Roche will concurrently provide the necessary redemption funds to the
Company by purchasing a like number of shares of Common Stock at $60.00 per
share) within thirty business days commencing July 1, 1999. Roche Holding
Ltd, a Swiss corporation, has guaranteed Roche's obligation under the put.
In the event of the put, wherein sufficient shares of the Company's Special
Common Stock are tendered to result in Roche owning at least 85% of the
total outstanding shares of the Company's outstanding equity, the Company
has in place an Incentive Units Program (the Program) that would result in
amounts becoming payable to eligible employees if specified performance
benchmarks are achieved by the Company during the term of the Program.
These amounts would vary depending on which benchmarks are achieved. At
March 31, 1998, no such amounts were payable under the Program.
In conjunction with the Agreement and revisions agreed upon in principle in
the second quarter of 1997, F. Hoffmann-La Roche Ltd (HLR) was granted an
option for ten years for licenses to use and sell certain of the Company's
7
products in non-U.S. markets (the License Agreement). Under the License
Agreement, HLR may exercise its option to license any such future product of
the Company either when the Company determines to move such product into
development or at the end of Phase II clinical trials. The License
Agreement provides that the Company and HLR will share the U.S. and European
development costs regardless of the location or purpose of studies.
Under the Agreement, independent of its right to cause the Company to redeem
the Special Common Stock, Roche may increase its ownership of the Company up
to 79.9% by making purchases on the open market. Roche held approximately
66.4% of the outstanding common equity of the Company as of March 31, 1998.
Contract revenue for the reimbursement of ongoing development expenses for
nerve growth factor (NGF), for which HLR exercised its development option
under the License Agreement in 1996, was $4.5 million for the first quarter
of 1998.
Note 4. Legal Proceedings
The Company is a party to various legal proceedings, including patent
infringement cases involving human growth hormone products and Activase,
registered trademark, product liability cases involving Protropin,
registered trademark, and other matters. In addition, in July 1997, an
action was filed in the U.S. District Court for the Northern District of
California alleging that the Company's manufacture, use and sale of its
Nutropin, registered trademark, human growth hormone products infringed a
patent (the Goodman Patent) owned by the Regents of the University of
California (UC). This action is substantially the same as a previous action
filed in 1990 against the Company by UC alleging that the Company's
manufacture, use and sale of its Protropin human growth hormone products
infringed the Goodman Patent, and the new action has been consolidated with
that prior case. The case is expected to commence trial on June 29, 1998.
In October 1997, the Company was named, along with several other
pharmaceutical companies, in a lawsuit brought by Novo Nordisk A/S (Novo) in
the U.S. District Court for the District of New Jersey alleging infringement
of a patent held by Novo relating to the Company's manufacture, use and sale
of its Nutropin human growth hormone products. Novo seeks to permanently
enjoin the Company from the alleged patent infringement and also seeks
compensatory and enhanced damages from the Company. In addition, in 1995
the Company received and responded to grand jury document subpoenas from the
U.S. District Court for the Northern District of California for documents
relating to the Company's past clinical, sales and marketing activities
associated with human growth hormone. In February 1997 and February 1998,
the Company received grand jury document subpoenas from the same court
related to the same subject matter. The government is investigating this
matter, and the Company believes that it is a subject of that investigation.
Based upon the nature of the claims made and the investigations completed to
date by the Company and its counsel, the Company believes the outcome of
these actions will not have a material adverse effect on the financial
position, results of operations or cash flows of the Company. However, were
an unfavorable ruling to occur in any quarterly period, there exists the
possibility of a material impact on the net income of that period.
8
Note 5. Inventories
Inventories are summarized below:
March 31, December 31,
1998 1997
------------ ------------
(thousands)
Raw materials and supplies $ 17,576 $ 17,544
Work in process 87,333 84,831
Finished goods 12,802 13,651
--------- ---------
Total $ 117,711 $ 116,026
========= =========
9
INDEPENDENT ACCOUNTANTS' REVIEW REPORT
The Board of Directors and Stockholders
Genentech, Inc.
We have reviewed the accompanying condensed consolidated balance sheet of
Genentech, Inc. as of March 31, 1998, and the related condensed consolidated
statements of income and cash flows for the three-month periods ended March
31, 1998 and 1997. These financial statements are the responsibility of the
Company's management.
We conducted our reviews in accordance with standards established by the
American Institute of Certified Public Accountants. A review of interim
financial information consists principally of applying analytical procedures
to financial data, and making inquiries of persons responsible for financial
and accounting matters. It is substantially less in scope than an audit
conducted in accordance with generally accepted auditing standards, which
will be performed for the full year with the objective of expressing an
opinion regarding the financial statements taken as a whole. Accordingly,
we do not express such opinion.
Based on our reviews, we are not aware of any material modifications that
should be made to the accompanying condensed consolidated financial
statements referred to above for them to be in conformity with generally
accepted accounting principles.
We have previously audited, in accordance with generally accepted auditing
standards, the consolidated balance sheet of Genentech, Inc. as of December
31, 1997, and the related consolidated statements of income, stockholders'
equity, and cash flows for the year then ended (not presented herein) and in
our report dated January 20, 1998, we expressed an unqualified opinion on
those consolidated financial statements. In our opinion, the information
set forth in the accompanying condensed consolidated balance sheet as of
December 31, 1997, is fairly stated, in all material respects, in relation
to the consolidated balance sheet from which it has been derived.
ERNST & YOUNG LLP
San Jose, California
April 9, 1998
10
GENENTECH, INC.
FINANCIAL REVIEW
RELATIONSHIP WITH ROCHE HOLDINGS, INC.
On October 25, 1995, Genentech, Inc. (the Company) and Roche Holdings, Inc.
(Roche) entered into a new agreement (the Agreement) to extend until June
30, 1999, Roche's option to cause the Company to redeem (call) the
outstanding callable putable common stock (Special Common Stock) of the
Company at predetermined prices. Should the call be exercised, Roche will
concurrently purchase from the Company a like number of shares of the
Company's common stock (the Common Stock) for a price equal to the Company's
cost to redeem the Special Common Stock. If Roche does not cause the
redemption as of June 30, 1999, the Company's stockholders will have the
option to cause the Company to redeem none, some or all of their shares of
Special Common Stock at $60.00 per share (and Roche will concurrently
provide the necessary redemption funds to the Company by purchasing a like
number of shares of Common Stock at $60.00 per share) within thirty business
days commencing July 1, 1999.
In conjunction with the Agreement and revisions agreed upon in principle in
the second quarter of 1997, F. Hoffmann-La Roche Ltd (HLR) was granted an
option for ten years for licenses to use and sell certain of the Company's
products in non-U.S. markets (the License Agreement). The License Agreement
provides that the Company and HLR will share the U.S. and European
development costs regardless of the location or purpose of studies. Under
the License Agreement, HLR may exercise its option to license any such
future products of the Company either when the Company determines to move
such product into development or at the end of Phase II clinical trials.
See the Relationship with Roche Holdings, Inc. note in the Notes to
Condensed Consolidated Financial Statements for further information.
As a result of the License Agreement, contract revenue in the quarter ended
March 31, 1998, totaled $4.5 million for the reimbursement of ongoing
development expenses related to nerve growth factor (NGF), for which HLR
exercised its development option under the License Agreement in 1996.
RESULTS OF OPERATIONS
(dollars in millions, except per share amounts)
Three Months Ended
March 31,
------------------
REVENUES 1998 1997 % Change
- --------- ------- ------- --------
Revenues $ 264.7 $ 257.3 3 %
======= ======= ========
PRODUCT SALES
- -----------------------------------
Activase $ 55.7 $ 75.0 (26)%
Protropin, Nutropin and Nutropin AQ 50.9 55.9 (9)
Pulmozyme 19.5 22.3 (13)
Rituxan 37.7 - -
Actimmune 0.9 1.0 (10)
------- ------- --------
Total product sales $ 164.7 $ 154.2 7 %
======= ======= ========
11
Net sales of Activase, registered trademark, (Alteplase, recombinant), a
tissue plasminogen activator (t-PA), decreased 26% in the first quarter of
1998 from the comparable period in 1997. This decrease was primarily due to
a decline in market share as a result of competition from Centocor, Inc.'s
(Centocor) Retavase, registered trademark. The decrease also resulted, to a
lesser extent, from a decline in the size of the thrombolytic market due to
increasing use of mechanical reperfusion and from a decrease in the
available commercial market due to patients receiving therapy through two
large ongoing Phase III clinical trials.
In March 1998, the Company received two new patents related to variant forms
of t-PA. Based on these patents, the Company filed an infringement action
against Centocor in the Northern District of California which alleges that
Centocor's sale, offer for sale, use and importation of Retavase (Reteplase,
recombinant), a t-PA, in the U.S. infringes these two new patents of the
Company. The Company is seeking a permanent injunction and damages.
Net sales of the Company's three growth hormone products - Protropin,
registered trademark, (somatrem for injection), Nutropin, registered
trademark, [somatropin (rDNA origin) for injection] and Nutropin AQ,
trademark, [somatropin (rDNA origin) injection] - decreased 9% in the first
quarter of 1998 from the comparable period in 1997. This decrease primarily
reflects fluctuations in distributor ordering patterns.
Net sales of Pulmozyme, registered trademark, (dornase alfa) decreased 13%
in the first quarter of 1998 from the comparable period in 1997 due
primarily to fluctuations in ordering patterns. In February 1998, the
Company received approval from the U.S. Food and Drug Administration (FDA)
for a label extension for Pulmozyme. With this revised labeling, Pulmozyme
may now also be used to treat very young children with cystic fibrosis, ages
three months to four years, adding to the product's previous approvals for
patients five years of age and older.
Rituxan, trademark, (Rituximab) was approved by the FDA in November 1997 for
the treatment of patients with relapsed or refractory low-grade or
follicular, CD20-positive B-cell non-Hodgkin's lymphoma, a cancer of the
immune system. Net sales of Rituxan were $37.7 million in the first quarter
of 1998, however, not enough time has passed for these figures to be
indicative of the future trend of Rituxan sales. Rituxan was co-developed
by the Company and IDEC Pharmaceuticals Corporation (IDEC), from whom the
Company licenses Rituxan. During the first quarter of 1998, the Company
received FDA approval for the large-scale (12,000-liter) manufacture of
Rituxan. The Rituxan that the Company manufactures will supplement the
Rituxan manufactured by IDEC.
Three Months Ended
March 31,
ROYALTIES, CONTRACT AND ------------------
OTHER, AND INTEREST INCOME 1998 1997 % Change
- ---------------------------- ------- ------- --------
Royalties $64.5 $65.3 (1)%
Contract and other 14.9 21.4 (30)
Interest income 20.6 16.4 26
Royalty income in the first quarter of 1998 was equivalent to the comparable
period in 1997. Although royalty income in the first quarter of 1998 was
higher than the comparable period of last year due to higher licensee sales,
this increase was offset by the reversal of reserves against certain royalty
revenues in the first quarter of 1997.
12
Contract and other revenue decreased 30% in the first quarter of 1998 from
the comparable period in 1997 primarily as a result of fluctuations in
contract revenues from HLR. Two projects, Rituxan and IGF-I, for which HLR
exercised its development option in 1996, have been winding down. Rituxan
was commercialized in the fourth quarter of 1997 and IGF-I in Type I and II
diabetes mellitus was discontinued in September 1997.
Interest income increased 26% in the first quarter of 1998 from the
comparable period in 1997 due to a higher portfolio balance and an increase
in the average yield on the portfolio. The total investment portfolio,
consisting of cash and cash equivalents, and short- and long-term marketable
securities, increased to $1,372.9 million as of March 31, 1998 from $1,166.1
million as of March 31, 1997 and from $1,286.5 million as of December 31,
1997.
Three Months Ended
March 31,
------------------
COSTS AND EXPENSES 1998 1997 % Change
- -------------------------- ------- ------- --------
Cost of sales $ 33.6 $ 27.7 21 %
Research and development 98.2 122.7 (20)
Marketing, general and
administrative 74.9 62.0 21
Interest expense 1.0 1.0 -
------- ------- --------
Total costs and expenses $207.7 $213.4 (3)%
======= ======= ========
Cost of sales as a percent of product sales increased 21% in the first
quarter of 1998 from the comparable period in 1997 primarily as a result of
a product mix shift, including the introduction of Rituxan.
Research and development (R&D) expenses decreased 20% in the first quarter
of 1998 from the comparable period in 1997. The decrease was largely due to
the completion, discontinuation and wind-down of large-scale clinical
trials. For the first quarter of 1998, the Company invested approximately
37% of revenues into R&D compared to 48% in the comparable period in 1997.
This percentage decrease reflects the Company's goal to decrease R&D
spending as a percent of revenues as products progress through late-stage
clinical trials and revenues increase.
Marketing, general and administrative (MG&A) expenses increased 21% in the
first quarter of 1998 from the comparable period in 1997 due to higher
marketing and sales (M&S) expenses related to the introduction of Rituxan
and the resultant profit sharing with IDEC and as a result of competitive
conditions in the thrombolytic market.
Three Months Ended
March 31,
------------------
INCOME TAXES 1998 1997 % Change
- ------------- ------- ------- --------
Income taxes $16.0 $12.3 30%
The Company's effective income tax rate for the first quarter of 1998 and
the comparable period in 1997 was 28%. The effective tax rate in each period
was less than the U.S. statutory rate of 35% primarily due to research and
development tax credits.
13
Three Months Ended
March 31,
------------------
NET INCOME 1998 1997 % Change
- ------------------- ------- ------- --------
Net income $ 41.0 $ 31.6 30%
Earnings per share:
Basic $ 0.33 $ 0.26
Diluted $ 0.32 $ 0.25
The 30% increase in net income in the first quarter of 1998 from the
comparable period in 1997 was driven primarily by sales of Rituxan, higher
interest income and lower R&D; partially offset by a decrease in sales of
other products, lower contract and other revenue, higher M&S expenses and
higher cost of sales.
LIQUIDITY AND CAPITAL
RESOURCES March 31, 1998 December 31, 1997
- --------------------------- ------------------- -------------------
Cash and cash equivalents, $ 1,372.9 $ 1,286.5
short-term investments
and long-term marketable
securities
Working capital 958.9 904.4
Cash generated from operations, maturities of investments and stock
issuances were used to make investments in marketable securities and capital
additions.
Cash and cash equivalents at March 31, 1998, were lower by $23.2 million
compared to December 31, 1997 and working capital increased by $54.5 million
in the first quarter of 1998.
Capital expenditures totaled $21.0 million in the first quarter of 1998
compared to $45.7 million in the comparable period in 1997. The decrease in
the first quarter of 1998 was due to higher construction activity in the
comparable period in 1997 related to improvements to existing manufacturing
and office facilities.
FORWARD-LOOKING STATEMENTS
The following section contains forward-looking statements that are based on
the Company's current expectations. Because the Company's actual results
may differ materially from these and any other forward-looking statements
made by or on behalf of the Company, this section also includes a discussion
of important factors that could affect the Company's actual future results,
including its product sales, royalties, contract revenues, expenses and net
income.
Product Sales: The Company's product sales may vary from period to period
for several reasons including, but not limited to: the overall competitive
environment for the Company's products, the amount of sales to customers in
the U.S., the amount and timing of the Company's sales to HLR, the timing
and volume of bulk shipments to licensees, the availability of third-party
reimbursements for the cost of therapy, the effectiveness and safety of the
products, the rate of adoption and use of the Company's products for
14
approved indications and additional indications, and the potential
introduction of new products and additional indications for existing
products in 1998 and beyond.
Competition: The Company faces growing competition in two of its
therapeutic markets. Activase lost market share and could lose additional
market share in the thrombolytic market to Centocor's Retavase and such
adverse effect on sales could be material. Retavase received FDA approval
in October 1996 for the treatment of acute myocardial infarction (AMI). In
addition, there is an increasing use of angioplasty in lieu of thrombolytic
therapy for the treatment of AMI, which is expected to continue. In the
growth hormone market, the Company continues to face increased competition
from five other companies with growth hormone products. Three of these
competitors have also received approval to market their existing human
growth hormone products for additional indications. The Company expects
that such competition could have an adverse effect on its sales of
Protropin, Nutropin and Nutropin AQ and such effect could be material.
Other competitive factors affecting the Company's product sales include, but
are not limited to: the timing of FDA approval, if any, of additional
competitive products, pricing decisions made by the Company, the degree of
patent protection afforded to particular products, the outcome of litigation
involving the Company's patents and patents of competing companies for
products and processes related to production and formulation of those
products, the increasing use and development of alternate therapies, and the
rate of market penetration by competing products.
Royalty and Contract Revenues: Royalty and contract revenues in future
periods could vary significantly from 1997 levels. Major factors affecting
these revenues include, but are not limited to: HLR's decisions to exercise
or not to exercise its option to develop and sell the Company's future
products in non-U.S. markets and the timing and amount of related
development cost reimbursements, if any; variations in HLR's sales and other
licensees' sales of licensed products; the expiration of royalties from
Lilly beginning in August 1998, which contribute substantially to current
royalty revenues; fluctuations in foreign currency exchange rates; the
initiation of other new contractual arrangements with other companies; the
timing of non-U.S. approvals, if any, for products licensed to HLR; whether
and when contract benchmarks are achieved; and the conclusion of existing
arrangements with other companies and HLR.
R&D: The Company intends to continue to develop new products and is
committed to aggressive R&D investment. Successful pharmaceutical product
development is highly uncertain and is dependent on numerous factors, many
of which are beyond the Company's control. Products that appear promising in
the early phases of development may fail to reach the market for numerous
reasons: they may be found to be ineffective or to have harmful side effects
in preclinical or clinical testing; they may fail to receive necessary
regulatory approvals; they may turn out to be uneconomical because of
manufacturing costs or other factors; or they may be precluded from
commercialization by the proprietary rights of others or by competing
products or technologies for the same indication. Success in preclinical
and early clinical trials does not ensure that large scale clinical trials
will be successful. Clinical results are frequently susceptible to varying
interpretations that may delay, limit or prevent regulatory approvals. The
length of time necessary to complete clinical trials and to submit an
application for marketing approval for a final decision by a regulatory
authority varies significantly and may be difficult to predict.
The Company currently has several products in late-stage clinical testing
and anticipates that its R&D expenses will continue at a high percentage of
15
revenues over the short-term though they are expected to decline in 1998
from 1997 levels. Over the long-term, however, as revenues increase, R&D as
a percent of revenues should decrease to the 20% to 25% range. Factors
affecting the Company's R&D expenses include, but are not limited to: the
outcome of clinical trials currently being conducted, the number of products
entering into development from late-stage research, in-licensing activities,
including the timing and amount of related development funding or milestone
payments, and future levels of revenues.
In December 1997, the Company and Alteon Inc. (Alteon) entered into a
collaborative agreement to develop and market pimagedine, an advanced
glycosylation end-product formation inhibitor. Based on the recommendations
of an External Safety Monitoring Committee, with which the FDA and the
Company concurred, in the first quarter of 1998, Alteon discontinued a Phase
III clinical trial of pimagedine in Type 2 diabetics with progressive kidney
disease and is continuing a Phase III trial of pimagedine in Type 1
diabetics with progressive kidney disease. A third Phase III trial in
diabetic patients with end-stage renal disease is ongoing.
Income Tax Provision: The Company expects its effective tax rate to be
approximately 28% in 1998 and continue at or near 35% for the next several
years dependent upon several factors. These factors include, but are not
limited to, changes in tax laws and rates, future levels of R&D spending,
the outcome of clinical trials of certain development products, the
Company's success in commercializing such products, and potential
competition regarding the products.
Uncertainties Surrounding Proprietary Rights: The patent positions of
pharmaceutical and biotechnology companies can be highly uncertain and
involve complex legal and factual questions. Accordingly, the breadth of
claims allowed in such companies' patents cannot be predicted. Patent
disputes are frequent and can preclude commercialization of products. The
Company has in the past been, is currently, and may in the future be
involved in material patent litigation. Such litigation is costly in its
own right and could subject the Company to significant liabilities to third-
parties and, if decided adversely, the Company may need to obtain third-
party licenses at a material cost or cease using the technology or product
in dispute. The presence of patents or other proprietary rights belonging
to other parties may lead to the termination of R&D of a particular product.
The Company believes it has strong patent protection or the potential for
strong patent protection for a number of its products that generate sales
and royalty revenue or that the Company is developing; however, the courts
will determine the ultimate strength of patent protection of the Company's
products and those on which the Company earns royalties.
Year 2000: Some of the Company's older computer software programs were
written using two digit fields rather than four digit fields to define the
applicable year (i.e., "98" in the computer code refers to the year "1998").
As a result, time-sensitive functions of those software programs may
misinterpret dates after January 1, 2000, to refer to the twentieth century
rather than the twenty-first century (i.e., "02" could be interpreted as
"1902" rather than "2002"). This could cause system failures or
miscalculations resulting in inaccuracies in computer output or disruptions
of operations, including, among other things, inaccurate processing of
financial information and/or temporary inabilities to process transactions,
manufacture products, or engage in similar normal business activities.
The Company has developed plans to address the potential exposures related
to the impact on its computer systems for the Year 2000 and beyond. An
assessment of key financial, informational and operational systems to
determine if they are Year 2000 compliant has been completed. Detailed
16
plans and timelines for implementation and testing of modifications and
corrections to these key computer systems have been or are in process of
being developed to address computer system problems as required by December
31, 1999. The Company believes that with these detailed plans and completed
modifications, the Year 2000 issue will not pose significant operational
problems for its computer systems. However, if such modifications and
conversions are not made, or are not completed in a timely fashion, the Year
2000 issue could have a material impact on the operations of the Company.
In addition to risks associated with the Company's own computer systems, the
Company has relationships with, and is to varying degrees dependent upon, a
large number of third parties that provide information, goods and services
to the Company. These include financial institutions, suppliers, vendors,
research partners and governmental entities. If large numbers of these
third parties experience failures in their computer systems due to Year 2000
non-compliance, it could affect the Company's ability to process
transactions, manufacture products, or engage in similar normal business
activities. While some of these risks are outside the control of the
Company, the Company has instituted a program to identify key third parties,
update contracts and address any non-compliance issues.
The total cost of the Year 2000 systems assessments and conversions is
funded through operating cash flows and the Company is expensing these
costs. The financial impact of making the required systems changes cannot
be known precisely at this time, but is not expected to be material to the
Company's financial position, results of operations or cash flows.
Liquidity: The Company believes that its cash, cash equivalents and short-
term investments, together with funds provided by operations and leasing
arrangements, will be sufficient to meet its foreseeable operating cash
requirements. In addition, the Company believes it could access additional
funds from the capital and debt markets. Factors affecting the Company's
cash position include, but are not limited to, future levels of the
Company's product sales, royalty and contract revenues, expenses, in-
licensing activities, including the timing and amount of related development
funding or milestone payments, and capital expenditures.
Roche Holdings, Inc.: At March 31, 1998, Roche held approximately 66.4% of
the Company's outstanding common equity. The Company expects to continue to
have material transactions with Roche, including royalty and contract
revenues, product sales and joint product development costs.
Market Risk: The Company is exposed to market risk, including changes to
interest rates, foreign currency exchange rates and equity investment
prices. To reduce the volatility related to these exposures, the Company
enters into various derivative transactions pursuant to the Company's
investment and risk management policies and procedures in areas such as
hedging and counterparty exposure practices. The Company does not use
derivatives for speculative purposes.
The Company maintains risk management control systems to monitor the risks
associated with interest rates, foreign currency exchange rates and equity
investment price changes, and its derivative and financial instrument
positions. The risk management control systems use analytical techniques,
including sensitivity analysis, and market values. Though the Company
intends for its risk management control systems to be comprehensive, there
are inherent risks which may only be partially offset by the Company's
hedging programs should there be unfavorable movements in interest rates,
foreign currency exchange rates or equity investment prices.
17
Interest Rates - The Company's interest income is sensitive to changes
in the general level of U.S. interest rates. In this regard, changes in
U.S. interest rates affect the interest earned on the Company's cash
equivalents, short-term investments, convertible equity loans, preferred
stock investments and long-term investments. To mitigate the impact of
fluctuations in U.S. interest rates, the Company may enter into swap
transactions, which involve the receipt of fixed rate interest and the
payment of floating rate interest without the exchange of the underlying
principal. By investing the Company's cash in an amount equal to the
notional amount of the swap contract, with a maturity date equal to the
maturity date of the floating rate obligation, the Company hedges itself
from any potential earnings impact due to changes in interest rates.
Foreign Currency Exchange Rates - The Company receives royalty
revenues from licensees selling products in countries throughout the world.
As a result, the Company's financial results could be significantly affected
by factors such as changes in foreign currency exchange rates or weak
economic conditions in the foreign markets in which the Company's licensed
products are sold. The Company is exposed to changes in exchange rates in
Europe, Asia and Canada. The Company's exposure to foreign exchange rates
primarily exists with the German Mark. When the U.S. dollar strengthens
against the currencies in these countries, the U.S. dollar value of non-U.S.
dollar-based revenue decreases; when the U.S. dollar weakens, the U.S.
dollar value of the non-U.S. dollar-based revenues increases. Accordingly,
changes in exchange rates, and in particular a strengthening of the U.S.
dollar, may adversely affect the Company's royalty revenues as expressed in
U.S. dollars. In addition, as part of its overall investment strategy, the
Company has three portfolios that are managed by external money managers.
These portfolios consist primarily of non-dollar denominated investments.
As a result, the Company is exposed to changes in the exchanges rates of the
countries in which these non-dollar denominated investments are made.
To mitigate this risk, the Company hedges certain of its anticipated
revenues by purchasing option contracts with expiration dates and amounts of
currency that are based on 25% to 90% of probable future revenues so that
the potential adverse impact of movements in currency exchange rates on the
non-dollar denominated revenues will be at least partly offset by an
associated increase in the value of the option. The duration of these
options is generally one to four years. The Company may also enter into
foreign currency forward contracts (forward contracts) to lock in the dollar
value of a portion of these anticipated revenues. The duration of these
forward contracts is generally less than one year. Also, to hedge the non-
dollar denominated investments in the externally managed portfolios, the
external money managers also enter into forward contracts.
Equity Investment Securities - As part of its strategic alliance
efforts, the Company invests in equity securities of biotechnology companies
that are subject to fluctuations from market value changes in stock prices.
To mitigate this risk, certain equity securities are hedged with costless
collars. A costless collar is a purchased put option and a written call
option in which the cost of the purchased put and the proceeds of the
written call offset each other; therefore, there is no initial cost or cash
outflow for these instruments at the time of purchase. The purchased put
protects the Company from a decline in the market value of the security
below a certain minimum level (the put "strike" level); while the call
effectively limits the Company's potential to benefit from an increase in
the market value of the security above a certain maximum level (the call
"strike" level). In addition, as part of its strategic alliance efforts,
the Company has made interest bearing loans that are convertible into
equity.
18
Credit Risk of Counterparties: The Company could be exposed to losses
related to the above financial instruments should one of its counterparties
default. This risk is mitigated through credit monitoring procedures.
Legal Proceedings: The Company is a party to various legal proceedings,
including patent infringement cases and various cases involving product
liability and other matters. See the Legal Proceedings note in the Notes to
Condensed Consolidated Financial Statements for further information.
19
GENENTECH, INC.
PART II. OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
Previously reported.
See Item 3 of the Company's report on Form 10-K for the period ended
December 31, 1997.
See also Note 4 "Legal Proceedings" in Part I "Notes to Condensed
Consolidated Financial Statements."
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
15.1 Letter re: Unaudited Interim Financial Information
27.1 Financial Data Schedule
(b) Reports on Form 8-K
There were no reports on Form 8-K filed during the quarter
ended March 31, 1998.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's market risk disclosures set forth in the 1997 Annual Report to
Stockholders have not changed significantly.
20
GENENTECH, INC.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
Date: May 11, 1998 GENENTECH, INC.
/S/ARTHUR D. LEVINSON /S/LOUIS J. LAVIGNE, JR.
------------------------------------- ----------------------------
Arthur D. Levinson, Ph.D. Louis J. Lavigne, Jr.
President and Chief Executive Officer Executive Vice President and
Chief Financial Officer
/S/JOHN M. WHITING
----------------------------
John M. Whiting
Controller and
Chief Accounting Officer
21
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS INCLUDED IN THE COMPANY'S FORM
10-Q FOR THE PERIOD ENDED MARCH 31, 1998, AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS AND THE NOTES THERETO.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 3-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> MAR-31-1998
<CASH> 221,288
<SECURITIES> 1,151,660
<RECEIVABLES> 175,285<F1>
<ALLOWANCES> 0<F1>
<INVENTORY> 117,711
<CURRENT-ASSETS> 1,232,291
<PP&E> 1,080,397
<DEPRECIATION> 392,034
<TOTAL-ASSETS> 2,573,521
<CURRENT-LIABILITIES> 273,374
<BONDS> 150,000
0
0
<COMMON> 2,503
<OTHER-SE> 2,109,415
<TOTAL-LIABILITY-AND-EQUITY> 2,573,521
<SALES> 164,719
<TOTAL-REVENUES> 264,700
<CGS> 33,621
<TOTAL-COSTS> 33,621
<OTHER-EXPENSES> 98,202
<LOSS-PROVISION> 0<F1>
<INTEREST-EXPENSE> 959
<INCOME-PRETAX> 56,968
<INCOME-TAX> 15,951
<INCOME-CONTINUING> 41,017
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 41,017
<EPS-PRIMARY> .33<F2>
<EPS-DILUTED> .32
<FN>
<F1>ACCOUNTS RECEIVABLE ARE PRESENTED NET OF ALLOWANCE FOR DOUBTFUL ACCOUNTS
IN THE CONDENSED CONSOLIDATED BALANCE SHEET. THE PROVISION FOR LOSSES ON
DOUBTFUL ACCOUNTS IS NOT REPORTED AS A SEPARATE LINE IN THE CONDENSED
CONSOLIDATED STATEMENT OF INCOME OR STATEMENT OF CASH FLOWS.
<F2>REPRESENTS BASIC EARNINGS PER SHARE
</FN>
</TABLE>
Exhibit 15.1
May 11, 1998
The Board of Directors and Stockholders
Genentech, Inc.
We are aware of the incorporation by reference in the Registration
Statements pertaining to the 1991 Employee Stock Plan, the 1996 Stock
Option/Stock Incentive Plan, the 1994 Stock Option Plan, the 1990 Stock
Option/Stock Incentive Plan, the 1984 Incentive Stock Option Plan and the
1984 Non-Qualified Stock Option Plan, the shares issuable to certain
convertible subordinated debenture holders, the Genentech, Inc. Tax
Reduction Investment Plan and in the related prospectuses, as applicable,
contained in such Registration Statements of our report dated April 9, 1998
relating to the unaudited condensed consolidated interim financial
statements of Genentech, Inc. which are included in its Form 10-Q for the
quarter ended March 31, 1998.
Pursuant to Rule 436(c) of the Securities Act of 1933 our report is not a
part of the registration statement prepared or certified by accountants
within the meaning of Section 7 or 11 of the Securities Act of 1933.
Very truly yours,
ERNST & YOUNG LLP
