<PAGE>
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, 1999.
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)
One DNA Way, South San Francisco, California 94080-4990
(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, 1999
Callable Putable Common Stock $.02 par value 51,346,989
(Special Common Stock) Outstanding at March 31, 1999
<PAGE>
GENENTECH, INC.
INDEX
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION PAGE NO.
<S> <C>
Condensed Consolidated Statements of Income -
for the three months ended March 31, 1999 and 1998 3
Condensed Consolidated Statements of Cash Flows -
for the three months ended March 31, 1999 and 1998 4
Condensed Consolidated Balance Sheets -
March 31, 1999 and December 31, 1998 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
</TABLE>
Page 2
<PAGE>
PART I. FINANCIAL INFORMATION
GENENTECH, INC.
CONDENSED CONSOLIDATED STATEMENTS OF INCOME
(thousands, except per share amounts)
(unaudited)
<TABLE>
<CAPTION>
Three Months
Ended March 31,
--------------------
1999 1998
--------- ---------
<S> <C> <C>
Revenues:
Product sales (including amounts from related parties:
1999-$13,624; 1998-$6,607) $ 234,069 $ 164,719
Royalties (including amounts from related parties:
1999-$11,241; 1998-$7,129) 46,618 64,493
Contract and other (including amounts from
related parties: 1999-$4,269; 1998-$7,798) 19,266 14,865
Interest 22,399 20,623
--------- ---------
Total revenues 322,352 264,700
Costs and expenses:
Cost of sales (including amounts from related parties:
1999-$10,786; 1998-$6,025) 45,723 33,621
Research and development (including contract
related: 1999-$7,860; 1998-$8,562) 90,740 98,202
Marketing, general and administrative 97,201 74,950
Legal settlement 50,000 -
Interest 1,363 959
--------- ---------
Total costs and expenses 285,027 207,732
Income before taxes 37,325 56,968
Income tax provision 22,910 15,951
--------- ---------
Net income $ 14,415 $ 41,017
========= =========
Earnings per share:
Basic $ 0.11 $ 0.33
========= =========
Diluted $ 0.11 $ 0.32
========= =========
Weighted average shares used to
compute diluted earnings per share 132,522 128,807
========= =========
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
Page 3
<PAGE>
GENENTECH, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(thousands)
(unaudited)
<TABLE>
<CAPTION>
Three Months
Ended March 31,
---------------------
1999 1998
--------- ---------
<S> <C> <C>
Cash flows from operating activities:
Net income $ 14,415 $ 41,017
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation and amortization 21,912 17,936
Deferred income taxes (924) 4,386
Gain on sales of securities available-for-sale (12,259) (5,835)
Loss on sales of securities available-for-sale 30 376
Write-down of securities available-for-sale 914 2,555
Write down of nonmarketable securities 432 -
Changes in assets and liabilities:
Investments in trading securities (2,772) 25,290
Receivables and other current assets (10,503) 15,071
Inventories 1,914 (1,685)
Accounts payable, other current liabilities
and other long-term liabilities 40,466 (30,252)
--------- ---------
Net cash provided by operating activities 53,625 68,859
Cash flows from investing activities:
Purchases of securities held-to-maturity (126,981) (128,731)
Proceeds from maturities of securities held-to-maturity 112,357 102,874
Purchases of securities available-for-sale (220,652) (177,731)
Proceeds from sales of securities available-for-sale 113,533 96,636
Purchases of non-marketable equity securities (2,317) -
Capital expenditures (18,209) (21,002)
Change in other assets (14,148) 1,336
--------- ---------
Net cash used in investing activities (156,417) (126,618)
Cash flows from financing activities:
Stock issuances 35,190 34,578
--------- ---------
Net cash provided by financing activities 35,190 34,578
--------- ---------
Net decrease in cash and cash equivalents (67,602) (23,181)
Cash and cash equivalents at beginning of period 281,162 244,469
--------- ---------
Cash and cash equivalents at end of period $ 213,560 $ 221,288
========= =========
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
Page 4
<PAGE>
GENENTECH, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(thousands)
(unaudited)
<TABLE>
<CAPTION>
March 31, December 31,
1999 1998
------------ ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 213,560 $ 281,162
Short-term investments 681,410 606,544
Accounts receivable, net (including amounts
from related party: 1999-$32,522;
1998-$22,850) 168,816 149,741
Inventories 146,712 148,626
Prepaid expenses and other current assets 51,940 55,885
------------ ------------
Total current assets 1,262,438 1,241,958
Long-term marketable securities 767,450 716,888
Property, plant and equipment, less accumulated
depreciation (1999-$464,749; 1998-$445,215) 698,887 700,249
Other assets 197,333 196,307
------------ ------------
Total assets $2,926,108 $2,855,402
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 31,576 $ 40,895
Accrued liabilities - related party 12,778 10,945
Other accrued liabilities 275,422 239,487
------------ ------------
Total current liabilities 319,776 291,327
Long-term debt 149,990 149,990
Other long-term liabilities 66,638 70,240
------------ ------------
Total liabilities 536,404 511,557
Commitments and contingencies
Stockholders' equity:
Preferred stock - -
Special Common Stock 1,027 1,010
Common Stock 1,532 1,532
Additional paid-in capital 1,630,326 1,588,990
Retained earnings 707,465 693,050
Accumulated other comprehensive income 49,354 59,263
------------ ------------
Total stockholders' equity 2,389,704 2,343,845
------------ ------------
Total liabilities and stockholders' equity $2,926,108 $2,855,402
============ ============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
Page 5
<PAGE>
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, 1999 and 1998 are not necessarily
indicative of the results that may be expected for the year ending December
31, 1999. The condensed consolidated balance sheet as of December 31, 1998
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, 1998.
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
In June 1998, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards (FAS) 133, "Accounting for Derivative
Instruments and Hedging Activities," effective beginning in the first quarter
of 2000. FAS 133 establishes accounting and reporting standards for
derivative instruments, including certain derivative instruments embedded in
other contracts, and for hedging activities. It requires companies to
recognize all derivatives as either assets or liabilities on the balance
sheet and measure those instruments at fair value. Gains or losses resulting
from changes in the values of those derivatives would be accounted for
depending on the use of the derivative and whether it qualifies for hedge
accounting under FAS 133. The Company is currently evaluating the impact of
FAS 133 on its financial position and results of operations.
Note 3. Earnings Per Share
The following is a reconciliation of the numerator and denominators of the
basic and diluted earnings per share (EPS) computations for the quarter ended
March 31, 1999 and 1998 (in thousands).
1999 1998
-----------------------
Numerator:
Net income - numerator for
basic and diluted EPS: $ 14,415 $ 41,017
--------- ---------
Denominator:
Denominator for basic EPS--
weighted-average shares 127,704 124,758
Page 6
<PAGE>
Effect of dilutive securities:
Stock options 4,818 4,049
--------- ---------
Denominator for diluted EPS
--adjusted weighted-average
shares and assumed conversions 132,522 128,807
========= =========
In the first quarter of 1999, all options outstanding were dilutive. In
the first quarter of 1998, options to purchase 2,850,050 shares of Special
Common Stock at $67.31 per share were outstanding, but were not included in
the computation of diluted EPS. These options' exercise price was greater
than the average market price of the Special Common Stock and therefore, the
effect would be anti-dilutive.
The Company had convertible subordinated debentures that were
convertible to 1,013,447 shares of Special Common Stock in the first quarter
of 1999 and had convertible subordinated debentures that were convertible to
1,013,514 shares of Special Common Stock in the comparable period in 1998,
but were not included in the computation of diluted EPS because they were
anti-dilutive.
Note 4. Comprehensive Income
The Company adopted FAS 130, "Reporting Comprehensive Income," in 1998.
Comprehensive income is comprised of net income and other comprehensive
income. The Company's other comprehensive income includes unrealized holding
gains and losses on its available-for-sale securities, which were reported
separately in stockholders' equity, and included in accumulated other
comprehensive income. Comprehensive income was $4.5 million for the quarter
ended March 31, 1999 and $46.1 million for the comparable period in 1998.
Note 5. Relationship with Roche Holdings, Inc.
On June 30, 1999, Roche Holdings, Inc.'s (Roche) option to cause the Company
to redeem (call) the outstanding Callable Putable Common Stock (Special
Common Stock) of the Company at $82.50 will expire. This arrangement was the
result of the October 1995 agreement (the Agreement) between the Company and
Roche. 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. If Roche does not cause
the redemption as of June 30, 1999, for thirty business days commencing July
1, 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). Roche Holding Ltd, a Swiss corporation,
has guaranteed Roche's obligation under the put.
In the event that sufficient shares of the Company's Special Common
Stock are tendered pursuant to the put 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. In event of the put, at March 31, 1999, $14.7 million is
contingently payable under the Program.
Page 7
<PAGE>
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 64.9% of the outstanding common equity of the Company as of
March 31, 1999.
In conjunction with the Agreement, the Company and F. Hoffmann-La Roche
Ltd (HLR) entered into an agreement (the License Agreement), pursuant to
which 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. In the second quarter
of 1997 and the second and fourth quarters of 1998, the Company and HLR
agreed in principle to changes to the License Agreement. As so revised,
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.
Also, as part of this Agreement, the Company receives royalties on sales of
certain of its products in Canada, on sales of Pulmozyme, registered
trademark, outside of the U.S. and on sales of rituximab outside of the U.S.,
excluding Japan.
Contract revenue from HLR for the reimbursement of ongoing development
expenses was $4.3 million for the first quarter of 1999 and $7.8 million for
the comparable period in 1998.
In addition, on July 6, 1998, the Company entered into an agreement
with HLR to provide HLR exclusive marketing rights outside of the U.S. for
Herceptin, registered trademark, (trastuzumab). Under the agreement, HLR
paid $40.0 million and has agreed to pay cash milestones tied to future
product development activities, to contribute equally with the Company up to
a maximum of $40.0 million on global development costs and to make royalty
payments on product sales. As of March 31, 1999, no additional amounts have
been paid.
Note 6. 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 and other matters.
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, registered trademark,
human growth hormone products infringed the Goodman Patent. The 1997 case
has been stayed pending the conclusion of the 1990 case, which is now in
trial. UC has publicly stated that it is seeking $400 million in damages
from the Company pursuant to the 1990 case.
In the 1990 case, UC contends that the Protropin production plasmid,
developed and used by the Company, infringes the claims of the Goodman Patent
under the doctrine of equivalents. UC contends that UC human growth hormone
cDNA brought to Genentech by an ex-employee of UC, Peter Seeburg, was used in
the construction of the Company's Protropin production plasmid, and that such
use, if it occurred, constitutes some evidence of infringement under the
Page 8
<PAGE>
doctrine of equivalents. The Company vigorously and emphatically denies that
the UC human growth hormone cDNA brought to Genentech by Mr. Seeburg was used
in the construction of Genentech's human growth hormone production plasmid.
Rather, the Company's records demonstrate that the plasmid was developed
internally by Dr. David Goeddel without any use of the UC cDNA. In addition,
the Company believes the evidence in the case strongly supports its position
that there is no infringement of the Goodman Patent under the doctrine of
equivalents. The Company also believes that UC committed fraud upon the U.S.
Patent and Trademark Office in obtaining the Goodman Patent when it was
originally issued to UC in 1982, and that the Goodman Patent is therefore
invalid because of UC's inequitable conduct.
Based upon the nature of the claims made and the information available
to date to the Company and its counsel through investigations and otherwise,
the Company believes the outcome of these actions is not likely to 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.
The Company has entered into a settlement agreement with the U.S.
Department of Justice and the U.S. Attorney for the Northern District of
California concerning an investigation, ongoing since 1995, into the
Company's past promotional practices with respect to human growth hormone.
As part of the settlement agreement, the Company will pay a criminal fine and
restitution in the amount of $50 million and will plead guilty to a felony of
promoting Protropin for medical uses for which it was not approved. The
Company recorded a $50 million charge in the first quarter of 1999 related to
the settlement.
Note 7. Inventories
Inventories are summarized below:
March 31, December 31,
1999 1998
------------ ------------
(thousands)
Raw materials and supplies $ 21,700 $ 21,414
Work in process 102,520 106,383
Finished goods 22,492 20,829
--------- ---------
Total $ 146,712 $ 148,626
========= =========
Page 9
<PAGE>
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, 1999, and the related condensed consolidated
statements of income and cash flows for the three-month periods ended March
31, 1999 and 1998. 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 an 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, 1998, 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, 1999, 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, 1998, 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, 1999
Page 10
<PAGE>
GENENTECH, INC.
FINANCIAL REVIEW
RELATIONSHIP WITH ROCHE HOLDINGS, INC.
On June 30, 1999, Roche Holdings, Inc.'s (Roche) option to cause Genentech,
Inc. (the Company) to redeem (call) the outstanding Callable Putable Common
Stock (Special Common Stock) of the Company at $82.50 will expire. This
arrangement was the result of the October 1995 agreement (the Agreement)
between the Company and Roche. 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. If Roche does not cause the redemption as of June 30, 1999, for
thirty business days commencing July 1, 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).
In conjunction with the Agreement, the Company and F. Hoffmann-La Roche
Ltd (HLR) entered into an agreement (the License Agreement), pursuant to
which 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. In the second quarter
of 1997 and the second and fourth quarters of 1998, the Company and HLR
agreed in principle to changes to the License Agreement. As so revised,
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.
Also, as part of this Agreement, the Company receives royalties on sales of
certain of its products in Canada, on sales of Pulmozyme, registered
trademark, outside of the U.S. and on sales of rituximab outside of the U.S.,
excluding Japan.
Contract revenue from HLR for the reimbursement of ongoing development
expenses was $4.3 million for the first quarter of 1999 and $7.8 million for
the comparable period in 1998.
In addition, on July 6, 1998, the Company entered into an agreement with
HLR to provide HLR exclusive marketing rights outside of the U.S. for
Herceptin, registered trademark, (trastuzumab). Under the agreement, HLR
paid $40.0 million and has agreed to pay cash milestones tied to future
product development activities, to contribute equally with the Company up to
a maximum of $40.0 million on global development costs and to make royalty
payments on product sales. As of March 31, 1999, no additional amounts have
been paid.
RESULTS OF OPERATIONS
(dollars in millions, except per share amounts)
Three Months Ended
March 31,
------------------
REVENUES 1999 1998 % Change
- --------- ------- ------- --------
Revenues $ 322.4 $ 264.7 22%
======= ======= ========
Page 11
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PRODUCT SALES
- -----------------------------------
Herceptin $ 39.9 $ - -%
Rituxan 57.1 37.7 51
Activase 52.0 55.7 (7)
Protropin, Nutropin and Nutropin AQ 56.2 50.9 10
Pulmozyme 28.2 19.5 45
Actimmune 0.7 0.9 (22)
------- ------- --------
Total product sales $ 234.1 $ 164.7 42%
======= ======= ========
Sales of Herceptin, indicated for the treatment of certain patients with
metastatic breast cancer, in the first quarter of 1999 were $39.9 million.
The Company recorded $30.5 million of initial sales of Herceptin in the
fourth quarter of 1998. While the Company is encouraged by these sales
figures, not enough time has passed for these figures to be indicative of
future sales. An increase of physician acceptance of Herceptin, as an
important therapy for women with metastatic breast cancer who have tumors
that overexpress the human epidermal growth factor receptor (HER2) protein,
has contributed to a positive sales trend and successful initial penetration
into the breast cancer market.
Sales of Rituxan, registered trademark, (Rituximab), indicated for the
treatment of patients with relapsed or refractory low-grade or follicular,
CD20-positive, B-cell non-Hodgkin's lymphoma,(B-cell NHL), a cancer of the
immune system, increased 51% in the first quarter of 1999 from the comparable
period in 1998. This sales increase is primarily due to increased market
penetration for the treatment of B-cell NHL. Rituxan was co-developed by the
Company and IDEC Pharmaceuticals Corporation (IDEC), from whom the Company
licenses Rituxan.
Net sales of Activase, registered trademark, (Alteplase, recombinant), a
tissue plasminogen activator (t-PA), decreased 7% in the first quarter of
1999 from the comparable period in 1998. The decrease is due to a continued
decline in the overall size of the thrombolytic therapy market due to
mechanical reperfusion and continued competition from Centocor, Inc.'s
(Centocor) Retavase, registered trademark.
In February 1999, the Company received a new patent related to variant
forms of t-PA. Based on this patent, the Company filed a second infringement
suit against Centocor, Inc. in the U.S. District Court for the Northern
District of California which alleges that Centocor's sale, offer for sale,
and use and importation of Retavase, a t-PA product, in the U.S. infringes
this new patent of the Company. Last year, the Company brought suit against
Centocor in the same court above alleging infringement of two related
Genentech patents. The suits have been consolidated and are pending.
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,
registered trademark, [somatropin (rDNA origin) injection], a liquid
formulation of Nutropin - increased 10% in the first quarter of 1999 from the
comparable period in 1998. This increase primarily reflects fluctuations in
distributor ordering patterns.
Net sales of Pulmozyme (dornase alfa) increased 45% in the first quarter of
1999 from the comparable period in 1998 primarily due to increased sales to
Roche and increased market penetration for the treatment of cystic fibrosis.
Page 12
<PAGE>
Three Months Ended
March 31,
ROYALTIES, CONTRACT AND ------------------
OTHER, AND INTEREST INCOME 1999 1998 % Change
- ---------------------------- ------- ------- --------
Royalties $46.6 $64.5 (28)%
Contract and other 19.3 14.9 30
Interest income 22.4 20.6 9
Royalty income decreased by 28% in the first quarter of 1999 from the
comparable period in 1998. The decrease primarily relates to the expiration
of royalties from Eli Lilly and Company in August 1998.
Contract and other revenue increased 30% in the first quarter of 1999 from
the comparable period in 1998 primarily due to higher gains on the sale of
biotechnology equity securities and higher revenues from strategic alliances,
partly offset by lower contract revenues from Roche.
Interest income increased 9% in the first quarter of 1999 from the comparable
period in 1998 due to a higher portfolio balance. The total investment
portfolio, consisting of cash and cash equivalents, and short- and long-term
marketable securities, increased to $1,662.4 million as of March 31, 1999
from $1,372.9 million as of March 31, 1998 and from $1,604.6 million as of
December 31, 1998.
Three Months Ended
March 31,
------------------
COSTS AND EXPENSES 1999 1998 % Change
- -------------------------- ------- ------- --------
Cost of sales $ 45.7 $ 33.6 36%
Research and development 90.7 98.2 (8)
Marketing, general and
administrative 97.2 74.9 30
Legal settlement 50.0 - -
Interest expense 1.4 1.0 40
------- ------- --------
Total costs and expenses $285.0 $207.7 37%
======= ======= ========
Cost of sales as a percent of product sales was 20% in the first quarter of
1999 and 1998.
Research and development (R&D) expenses decreased 8% in the first quarter of
1999 from the comparable period in 1998. For the first quarter of 1999, the
Company invested approximately 28% of revenues into R&D compared to 37% in
the comparable period in 1998. 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 30% in the
first quarter of 1999 from the comparable period in 1998 due to higher
marketing and sales (M&S) expenses in support of oncology products and higher
profit sharing with IDEC related to higher sales of Rituxan.
Three Months Ended
March 31,
------------------
INCOME TAXES 1999 1998 % Change
- ------------- ------- ------- --------
Income taxes $22.9 $16.0 43%
Page 13
<PAGE>
The Company's effective income tax rate for the first quarter of 1999 was 61%
compared to 28% in the first quarter of 1998. The 61% tax rate in the first
quarter of 1999 reflects the nature of the $50 million legal settlement
expense as well as an increase in the income tax rate due to reduced benefits
from both R&D tax credits and realization of foreign losses. Excluding the
legal settlement expense, the Company's effective tax rate would have been
33%.
Three Months Ended
March 31,
------------------
NET INCOME 1999 1998 % Change
- ------------------- ------- ------- --------
Net income $ 14.4 $ 41.0 (65)%
Earnings per share:
Basic $ 0.11 $ 0.33
Diluted $ 0.11 $ 0.32
The 65% decrease in net income in the first quarter of 1999 from the
comparable period in 1998 was due to the legal settlement as discussed in
note 6 of the Notes to the Condensed Consolidated Financial Statements.
Exclusive of the legal settlement, net income in the first quarter of 1999
would have been $58.5 million, an increase of 43% over the first quarter of
1998. This increase was driven by higher product sales, primarily related to
new sales of Herceptin and higher sales of Rituxan. This increase was partly
offset by lower royalties and higher M&S expenses and cost of sales.
LIQUIDITY AND CAPITAL
RESOURCES March 31, 1999 December 31, 1998
- --------------------------- ------------------- -------------------
Cash and cash equivalents, $ 1,662.4 $ 1,604.6
short-term investments
and long-term marketable
securities
Working capital 942.7 950.6
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, short-term investments and long-term marketable
securities at March 31, 1999, increased by $57.8 million compared to December
31, 1998 and working capital decreased by $7.9 million in the first quarter
of 1999.
Capital expenditures totaled $18.2 million in the first quarter of 1999
compared to $21.0 million in the comparable period in 1998. The decrease in
the first quarter of 1999 was primarily due to a decrease in construction
activity related to existing manufacturing facilities, partly offset by an
increase in equipment purchases.
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.
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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 approved
indications and additional indications; and the potential introduction of new
products and additional indications for existing products in 1999 and beyond.
Competition: The Company faces growing competition in two of its therapeutic
markets and expects new competition in a third. First, Activase lost market
share and could lose additional market share in the thrombolytic market to
Centocor's Retavase and the resulting 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 mechanical reperfusion in lieu of thrombolytic therapy for the
treatment of AMI, which is expected to continue. Second, in the growth
hormone market, the Company continues to face increased competition from five
other companies with growth hormone products, although one company has been
preliminarily enjoined from selling its product. As a result of this
competition, the Company has experienced a loss in new patient market share.
Four 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. Third, in the B-cell NHL market, Coulter Pharmaceuticals Inc. has
recently filed for approval with the FDA with respect to an antibody product
for a similar indication for which Rituxan is approved. Genentech is aware
of other potentially competitive biologic therapies in development.
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 1998 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; 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 and
other licensees; whether and when contract benchmarks are achieved; and the
conclusion of existing arrangements with other companies and HLR.
During the quarter, the Company entered into an agreement with Schwarz
Pharma AG for the development and distribution of Nutropin AQ and the
sustained-release Nutropin Depot, trademark, [somatropin (rDNA origin for
depot suspension] for the treatment of certain pediatric and adult growth
disorders in Europe and certain other countries outside of the U.S., Canada
and Japan. Under the terms of the agreement, the Company will receive an
upfront payment and additional benchmark payments upon Schwarz Pharma's
achievements of development milestones. In addition, Schwarz Pharma will
contribute to future development of these products. As of March 31, 1999, no
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amounts have been received. The Company and partner Alkermes, Inc. will
manufacture the products for sale by Schwarz Pharma. The Company and
Alkermes are currently preparing U.S. regulatory filings seeking marketing
approval for Nutropin Depot.
R&D: The Company is committed to aggressive R&D investment to discover and
develop new products. 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 revenues over the short-term. Over the long-term, as
revenues increase, R&D as a percent of revenues is expected to decrease.
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. Factors affecting the Company's R&D expenses include, but are
not limited to: the number of and the outcome of clinical trials currently
being conducted by the Company and/or its collaborators; 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.
Income Tax Provision: The Company expects its effective tax rate to be 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,
interpretation of existing tax laws, 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.
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<PAGE>
Year 2000: The Company uses and relies on a wide variety of information
technologies, computer systems and scientific and manufacturing equipment
containing computer related components (such as programmable logic
controllers and other embedded systems). Some of the Company's older
computer software programs and equipment are unable to distinguish between
the year 1900 and the year 2000. As a result, time-sensitive functions of
those software programs and equipment may misinterpret dates after January 1,
2000, to refer to the twentieth century rather than the twenty-first century.
This could cause system or equipment shutdowns, 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 a Year 2000 Project (Y2K Project) in place to address
the potential exposures related to the impact on its computer systems and
scientific and manufacturing equipment containing computer related components
for the Year 2000 and beyond. Approximately half of the Company's Year 2000
(Y2K) scheduled work is complete. The remaining work is scheduled to be
completed by the end of the third quarter of 1999. The Y2K Project phases
include: (1) inventorying and prioritizing business critical systems; (2)
Y2K compliance analysis; (3) remediation activities including repairing or
replacing identified systems; (4) testing; and (5) developing contingency
plans.
An inventory of business critical financial, informational and
operational systems, including manufacturing control systems, has been
essentially completed. Compliance analysis is approximately 85% complete for
these systems. Remediation activities vary by department, however, on the
average, remediation activities are approximately 60% complete. Testing of
the Company's information technology infrastructure is 80% complete. Testing
of business critical application programs began in the third quarter of 1998,
and is scheduled to be complete by the third quarter of 1999. Contingency
planning for business critical processes, which will include provisions such
as identifying alternative sources for materials and services and if
necessary reverting to non-computerized systems for processing information,
was initiated in March 1999 and these plans are scheduled for completion in
September 1999. The Company believes that with the completed modifications,
the Y2K issue will not pose significant operational problems for its computer
systems and equipment. 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, the precise degree
of which cannot be known at this time.
In addition to risks associated with the Company's own computer systems
and equipment, 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, governmental entities and customers.
If significant numbers of these third parties experience failures in their
computer systems or equipment due to Year 2000 noncompliance, 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 programs,
including internal records review and use of external questionnaires, to
identify key third parties, assess their level of Year 2000 compliance,
update contracts and address any noncompliance 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
as they are incurred. The Company has created a mechanism to trace costs
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directly related to the Year 2000 issue and has budgeted funds to address the
issues of assessment and conversion. The financial impact of making the
required systems changes cannot be known precisely at this time, but it is
currently expected to be less than $10.0 million. The actual financial
impact could, however, exceed this estimate.
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, 1999, Roche held approximately 64.9% 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. See also
Relationship with Roche Holdings, Inc. note in Notes to Condensed
Consolidated Financial Statements for a discussion of the terms of the put
and call pursuant to the Agreement.
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 relating to these exposures, the Company enters into
various derivative investment 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.
Interest Rates - The Company's interest income is sensitive to changes
in the general level of interest rates, primarily 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 preferred
stock investments, convertible loans 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
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<PAGE>
are sold. The Company is exposed to changes in exchange rates in Europe,
Asia (primarily Japan) and Canada. The Company's exposure to foreign
exchange rates primarily exists with the Euro. 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 a portion of its portfolio primarily in nondollar
denominated investments. As a result, the Company is exposed to changes in
the exchange rates of the countries in which these nondollar 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 currently based on 25% to 90% of probable future revenues
so that the potential adverse impact of movements in currency exchange rates
on the nondollar denominated revenues will be at least partly offset by an
associated increase in the value of the option. Currently, the duration of
these options is generally one to three 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
nondollar denominated investments in the portfolio, the Company also enters
into forward contracts.
Equity Investment Securities - As part of its strategic alliance
efforts, the Company invests in equity instruments 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
holds dividend bearing convertible preferred stock and has made interest
bearing loans that are convertible into the equity securities of the debtor.
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.
New Accounting Standard: In June 1998, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standards (FAS) 133,
"Accounting for Derivative Instruments and Hedging Activities," effective
beginning in the first quarter of 2000. FAS 133 establishes accounting and
reporting standards for derivative instruments, including certain derivative
instruments embedded in other contracts, and for hedging activities. Based
on the requirements of FAS 133, there may be changes to the balance sheet and
reported assets and liabilities. The Company is currently evaluating the
impact of FAS 133 on its financial position and results of operations.
Legal Proceedings: The Company is a party to various legal proceedings
including patent infringement cases and other matters. See the Leases,
Commitments and Contingencies note in the Notes to Consolidated Financial
Statements for further information.
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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, 1998.
See also Note 6 "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, 1999.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The Company's market risk disclosures set forth in the 1998 Annual Report to
Stockholders have not changed significantly.
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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, 1999 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
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Exhibit 15.1
May 11, 1999
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, 1999
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, 1999.
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
<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, 1999, AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS AND THE NOTES THERETO.
</LEGEND>
<S> <C>
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<F1>ACCOUNTS RECEIVABLE ARE PRESENTED NET OF ALLOWANCE FOR DOUBTFUL ACCOUNTS
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<F2>REPRESENTS BASIC EARNINGS PER SHARE
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