<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 September 30,
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)
1 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 128,338,296
Outstanding at September 30, 1999
<PAGE>
GENENTECH, INC.
INDEX
PART I. FINANCIAL INFORMATION PAGE NO.
Condensed Consolidated Statements of Operations -
for the three months and nine months ended
September 30, 1999 and 1998 3
Condensed Consolidated Statements of Cash Flows -
for the nine months ended September 30, 1999 and 1998 4
Condensed Consolidated Balance Sheets -
September 30, 1999 and December 31, 1998 5
Notes to Condensed Consolidated Financial Statements 6-17
Independent Accountants' Review Report 18
Financial Review 19-42
PART II. OTHER INFORMATION 43
SIGNATURES 44
In this report, "Genentech," "we," "us" and "our" refer to Genentech, Inc.
We own or have rights to various copyrights, trademarks and trade names used
in our business including the following: Actimmune, registered trademark,
interferon gamma-1b; Activase, registered trademark, (alteplase, recombinant)
tissue plasminogen activator; Herceptin, registered trademark, (trastuzumab)
anti-HER2 antibody; Nutropin, registered trademark, (somatropin (rDNA origin)
for injection) growth hormone; Nutropin AQ, registered trademark, (somatropin
(rDNA origin) injection) liquid formulation growth hormone; Nutropin Depot,
trademark, encapsulated sustained-release growth hormone; Protropin,
registered trademark, (somatrem for injection) growth hormone; Pulmozyme,
registered trademark, (dornase alfa, recombinant) inhalation solution;
Rituxan, registered trademark, (rituximab) antibody; TNKase, trademark,
(tenecteplase) second generation tissue plasminogen activator; and Xubix,
trademark, (sibrafiban) oral IIb/IIIa antagonist. This report also includes
trademarks, service marks and trade names of other companies.
Page 2
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PART I. FINANCIAL INFORMATION
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(thousands, except per share amounts)
(unaudited)
<TABLE>
<CAPTION>
Three Months Nine Months
Ended September 30, Ended September 30,
---------------------- ----------------------
1999 1998 1999 1998
---------- --------- ---------- ---------
<S> <C> <C> <C> <C>
Revenues:
Product sales (including amounts
from related parties, three months -
1999-$7,371; 1998-$8,122; nine
months - 1999-$34,369; 1998-$21,295) $ 266,968 $ 163,100 $ 770,392 $ 504,082
Royalties (including amounts from
related parties: three months -
1999-$11,768; 1998-$9,167; nine
months - 1999-$31,879; 1998-$25,048) 46,128 60,725 138,732 182,606
Contract and other (including
amounts from related parties:
three months - 1999-$0;
1998-$43,010; nine months -
1999-$19,944; 1998-$58,658) 7,503 66,113 84,684 95,034
Interest 24,729 23,992 69,114 64,920
---------- --------- ---------- ---------
Total revenues 345,328 313,930 1,062,922 846,642
Costs and expenses:
Cost of sales (including amounts
from related parties: three months -
1999-$6,056; 1998-$5,596; nine
months - 1999-$27,987; 1998-$17,368) 92,750 35,351 191,154 106,122
Research and development (including
contract related: three months -
1999-$2,451; 1998-$6,825; nine
months - 1999-$16,877; 1998-$26,566) 84,629 99,862 269,580 291,013
Marketing, general and administrative 113,613 89,544 328,186 245,137
Special charges:
Legal settlement - - 50,000 -
Related to redemption 57,800 - 1,205,104 -
Recurring charges related to redemption 98,986 - 98,986 -
Interest 1,326 1,148 4,045 3,302
---------- --------- ---------- ---------
Total costs and expenses 449,104 225,905 2,147,055 645,574
Income (loss) before taxes (103,776) 88,025 (1,084,133) 201,068
Income tax (benefit) provision (40,931) 24,647 (112,511) 56,299
---------- --------- ---------- ---------
Net income (loss) $ (62,845) $ 63,378 $ (971,622) $ 144,769
========== ========= ========== =========
Earnings (loss) per share:
Basic $ (0.49) $ 0.50 $ (7.59) $ 1.15
========== ========= ========== =========
Diluted $ (0.49) $ 0.49 $ (7.59) $ 1.12
========== ========= ========== =========
Weighted average shares used to
compute earnings (loss) per share:
Basic 127,854 126,080 128,013 125,480
========== ========= ========== =========
Diluted 127,854 129,948 128,013 129,510
========== ========= ========== =========
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
Page 3
<PAGE>
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(thousands)
(unaudited)
<TABLE>
<CAPTION>
Nine Months
Ended September 30,
----------------------
1999 1998
---------- ----------
<S> <C> <C>
Cash flows from operating activities:
Net (loss) income $ (971,622) $ 144,769
Adjustments to reconcile net (loss) income to net
cash provided by (used in) operating activities:
Depreciation and amortization 162,634 57,417
In-process research and development 752,500 -
Amortization of inventory write-up 46,814 -
Non-cash compensation related to stock options,
net of tax 96,033 -
Write-up of securities available-for-sale (20,337) -
Deferred income taxes (99,544) (4,677)
Gain on sales of securities available-for-sale (12,283) (5,839)
Loss on sales of securities available-for-sale 921 669
Write down of securities available-for-sale 8,467 14,550
Write down of non-marketable equity securities 432 -
Loss on fixed asset dispositions 155 730
Changes in assets and liabilities:
Investments in trading securities (7,525) (23,028)
Receivables and other current assets (32,747) 59,116
Inventories 3,021 (7,860)
Accounts payable, other current liabilities
and other long-term liabilities 50,430 43,334
---------- ----------
Net cash (used) provided by operating activities (22,651) 279,181
Cash flows from investing activities:
Purchases of securities held-to-maturity (186,612) (327,690)
Proceeds from maturities of securities held-to-maturity 286,497 353,029
Purchases of securities available-for-sale (506,876) (586,328)
Proceeds from sales of securities available-for-sale 379,849 321,573
Purchases of non-marketable equity securities (39,990) (13,575)
Capital expenditures (65,347) (61,740)
Change in other assets (17,370) (11,291)
Transfer to restricted cash included in other assets (56,179) -
---------- ----------
Net cash used in investing activities (206,028) (326,022)
Cash flows from financing activities:
Stock issuances 120,131 81,638
---------- ----------
Net cash provided by financing activities 120,131 81,638
---------- ----------
Net (decrease) increase in cash and cash equivalents (108,548) 34,797
Cash and cash equivalents at beginning of period 281,162 244,469
---------- ----------
Cash and cash equivalents at end of period $ 172,614 $ 279,266
========== ==========
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
Page 4
<PAGE>
CONDENSED CONSOLIDATED BALANCE SHEETS
(thousands)
(unaudited)
<TABLE>
<CAPTION>
September 30, December 31,
1999 1998
------------ ------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 172,614 $ 281,162
Short-term investments 516,272 606,544
Accounts receivable, net (including amounts
from related party: 1999-$36,612; 1998-$22,850) 185,220 149,741
Inventories 284,972 148,626
Prepaid expenses and other current assets 13,740 55,885
------------ ------------
Total current assets 1,172,818 1,241,958
Long-term marketable securities 918,569 716,888
Property, plant and equipment, less accumulated
depreciation (1999-$499,534; 1998-$445,215) 721,990 700,249
Goodwill 1,667,382 -
Other intangible assets 1,506,478 65,033
Other assets 182,158 131,274
------------ ------------
Total assets $ 6,169,395 $ 2,855,402
============ ============
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 50,819 $ 40,895
Accrued liabilities - related party 14,087 10,945
Other accrued liabilities 290,540 239,487
------------ ------------
Total current liabilities 355,446 291,327
Long-term debt 149,708 149,990
Other long-term liabilities 437,139 70,240
------------ ------------
Total liabilities 942,293 511,557
Commitments and contingencies
Stockholders' equity:
Preferred stock - -
Special Common Stock - 1,010
Common stock 2,594 1,532
Additional paid-in capital 7,159,783 1,588,990
Retained earnings (accumulated deficit) (2,000,716) 693,050
Accumulated other comprehensive income 65,441 59,263
------------ ------------
Total stockholders' equity 5,227,102 2,343,845
------------ ------------
Total liabilities and stockholders' equity $ 6,169,395 $ 2,855,402
============ ============
</TABLE>
See Notes to Condensed Consolidated Financial Statements.
Page 5
<PAGE>
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
Note 1. Statement of Accounting Presentation and Significant Accounting
Policies
In the opinion of management, 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- and nine-
month periods ended September 30, 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 our Annual Report to Stockholders for the year ended
December 31, 1998.
The unaudited condensed consolidated financial statements give effect to our
June 30, 1999 redemption of all of our outstanding callable putable common
stock, par value $.02 per share (referred to as our "Special Common Stock")
held by stockholders other than Roche Holdings, Inc., commonly known as
Roche, at a price of $82.50 per share in cash with funds deposited by Roche
for such purpose (the "Redemption"), resulting in Roche owning 100% of our
common stock. Roche accounted for the Redemption as a purchase of a business
and we were required to push down the effect of the Redemption and Roche's
1990 through 1997 purchases of our Common Stock and Special Common Stock into
our consolidated financial statements.
Use of Estimates: 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.
Other Assets: Under certain lease agreements, we may be required from time
to time to set aside cash as collateral. These amounts are included in other
assets.
Long-Lived Assets: The carrying value of our long-lived assets is reviewed
for impairment whenever events or changes in circumstances indicate that the
asset may not be recoverable. An impairment loss would be recognized when
estimated future cash flows expected to result from the use of the asset and
its eventual disposition is less than its carrying amount.
New Accounting Standards: In July 1999, the Financial Accounting Standards
Board (FASB) announced the delay of the effective date of Statement of
Financial Accounting Standards (FAS) 133, "Accounting for Derivative
Instruments and Hedging Activities," for one year, to the first quarter of
2001. 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
Page 6
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under FAS 133. We are currently evaluating the impact of FAS 133 on our
financial position and results of operations.
At the end of March 1999, the FASB issued a proposed Interpretation of
Accounting Principles Board Opinion number 25, "Accounting for Certain
Transactions involving Stock Compensation" (proposal). This proposal would
be effective upon issuance of the final interpretation, which is expected in
the first quarter of 2000, but generally would cover events that occur after
December 15, 1998. To the extent that events covered by this proposal occur
during the period after December 15, 1998, but before issuance of the final
interpretation, the effects of applying this proposal would be recognized on
a prospective basis from the effective date. The potential impact of this
proposal may be significant in relation to stock option repricings. We are
currently evaluating the impact of this proposal on our financial position
and results of operations.
Reclassifications: Certain reclassifications of prior year amounts have
been made to conform with the current year presentation.
Note 2. Redemption of Genentech's Special Common Stock
Basis of Presentation
Roche will account for the Redemption as a purchase of a business. As a
result, we were required to push down the effect of the Redemption and
Roche's 1990 through 1997 purchases of our Common and Special Common Stock
into our consolidated financial statements at the date of the Redemption.
Under this method of accounting, Genentech's assets and liabilities,
including intangible assets, were recorded at their fair values not to exceed
the aggregate purchase price plus Roche's transaction costs at June 30, 1999.
In 1990 and 1991 through 1997 Roche purchased 60% and 5%, respectively, of
the outstanding stock of Genentech. In June 1999, we redeemed all of our
Special Common Stock held by stockholders other than Roche resulting in Roche
owning 100% of our common stock. The push-down effect of Roche's aggregate
purchase price and the Redemption price in our consolidated balance sheet as
of June 30, 1999 was allocated based on Roche's ownership percentages as if
the purchases occurred at the original purchase dates for the 1990 and 1991
through 1997 purchases, and at June 30, 1999 for the Redemption. Management
of Genentech determined the values of tangible and intangible assets,
including in-process research and development, used in allocating the
purchase prices. The aggregate purchase prices for the acquisition of all of
Genentech's outstanding shares, including Roche's estimated transaction costs
of $10.0 million, was $6,604.9 million, consisting of approximately $2,843.5
million for the 1990 and 1991 through 1997 purchases and approximately
$3,761.4 million for the Redemption.
The following table shows details of the excess of purchase price over net
book value (in millions):
<TABLE>
<CAPTION>
Purchase Period
--------------------
1990-1997 1999 Total
--------- --------- ---------
<S> <C> <C> <C>
Total purchase price $ 2,843.5 $ 3,761.4 $ 6,604.9
Less portion of net book value purchased 566.6 836.4 1,403.0
--------- --------- ---------
Excess of purchase price over net book value $ 2,276.9 $ 2,925.0 $ 5,201.9
========= ========= =========
</TABLE>
Page 7
<PAGE>
The following table shows the allocation of the excess of the purchase price
over net book value (in millions):
Purchase Period
--------------------
1990-1997 1999 Total
--------- --------- ---------
Inventories $ 102.0 $ 186.2 $ 288.2
Land - 16.6 16.6
In-process research and development 500.5 752.5 1,253.0
Developed product technology 429.0 765.0 1,194.0
Core technology 240.5 203.0 443.5
Developed license technology 292.5 175.0 467.5
Trained and assembled workforce 32.5 49.0 81.5
Tradenames 39.0 105.0 144.0
Key distributor relationships 6.5 73.5 80.0
Goodwill 1,091.2 1,228.4 2,319.6
Deferred tax liability (456.8) (629.2) (1,086.0)
--------- --------- ---------
Total $ 2,276.9 $ 2,925.0 $ 5,201.9
========= ========= =========
PUSH-DOWN ACCOUNTING ADJUSTMENTS
The following is a description of accounting adjustments and related useful
lives that reflect push-down accounting in our financial statements. These
adjustments were based on management's estimates of the value of the tangible
and intangible assets acquired:
- - We recorded charges of $1,147.3 million in the second quarter and $57.8
million in the third quarter of 1999. These charges include: a non-cash
charge of $752.2 million for in-process research and development in the
second quarter; $284.5 million of compensation expense related to
Genentech's early cash settlement of certain employee stock options in the
second quarter; and an aggregate of approximately $102.3 million in the
second quarter and $57.8 million in the third quarter of non-cash
compensation expense in connection with the modification and
remeasurement, for accounting purposes, of continuing employee stock
options, which represents the difference between each applicable option
exercise price and the redemption price of the Special Common Stock. (You
should read "Stock Option Changes" note for further information on these
charges.) In addition, we recorded adjustments of $20.3 million related
to the write-up of marketable securities as a result of push-down
accounting in the second quarter.
- - We recorded an income tax benefit of $177.8 million related to the above
early cash settlement and non-cash compensation related to certain
employee stock options. The income tax benefit reduced the current tax
payable in other accrued liabilities by $56.9 million and reduced long-
term deferred income taxes by $120.9 million.
- - The estimated useful life of the inventory adjustment to fair value
resulting from the Redemption is approximately one year based upon the
expected time to sell inventories on hand at June 30, 1999. In the third
quarter of 1999, we recorded amortization expense of $46.8 million related
to the inventory adjustment. The entire inventory adjustment related to
Roche's 1990 through 1997 purchases was reflected as a charge to retained
earnings.
- - An adjustment was made to record the fair value of land as a result of the
Redemption. There were no such adjustments for the purchase periods from
1990 through 1997.
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- - $1,091.2 million of goodwill, which reflects Roche's 1990 through 1997
purchases, less related accumulated amortization of $613.6 million
through June 30, 1999, which was recorded as a charge to retained
earnings. Included in goodwill is $456.8 million related to the recording
of deferred tax liabilities. Deferred taxes were recorded for the
adjustment to fair value for other intangible assets and inventories as a
result of Roche's 1990 through 1997 purchases. The deferred tax liability
was calculated based on a marginal tax rate of 40%. The goodwill related
to the 1990 through 1997 purchases is amortized over 15 years.
- - $1,228.4 million of goodwill was recorded as a result of the Redemption.
Included in goodwill is $629.2 million related to the recording of
deferred tax liabilities. Deferred taxes were recorded for the adjustment
to fair value for other intangible assets, inventories and land. The
deferred tax liability was calculated based on a marginal tax rate of 40%
and has been allocated between short- and long-term classifications to
match the asset classifications. The goodwill related to the Redemption
is amortized over 15 years.
- - In the third quarter of 1999, we recorded amortization expense of $95.6
million related to goodwill and other intangible assets.
- - The existing deferred tax asset valuation allowance of $62.8 million
related to the tax benefits of stock option deductions which have been
realized and credited to paid-in capital as a result of establishing
deferred tax liabilities under push-down accounting was eliminated at June
30, 1999.
- - The redemption of our Special Common Stock and the issuance of new shares
of common stock to Roche resulted in substantially the same number of
total shares outstanding as prior to the Redemption.
- - The excess of purchase price over net book value of $2,276.9 million for
1990 through 1997 and $2,925.0 million in 1999, and $160.1 million for
the remeasurement of continuing employee stock options at the
remeasurement date was recorded in paid-in capital.
- - The following adjustments were made to retained earnings for the 1990
through 1997 purchase period (in millions):
1990-1997
Purchases
----------
In-process research and development $ (500.5)
Amortization of goodwill, intangibles and fair
value adjustment to inventories, net of tax (1,221.8)
----------
Total adjustment to retained earnings $ (1,722.3)
==========
- - The tax provision benefit of $40.9 million for the third quarter and
$112.5 million for the first nine months ended September 30, 1999 consists
of tax expense of $32.9 million and $97.8 million, respectively, on pretax
income excluding the income and deductions attributable to push-down
accounting and legal settlement, and tax benefits of $73.8 million for the
third quarter and $210.3 million for the first nine months ended September
30, 1999 related to the income and deductions attributable to push-down
accounting and legal settlement.
- - $1,040.0 million of other intangible assets, which reflects Roche's 1990
through 1997 purchases, less related accumulated amortization of $911.5
million of those assets through June 30, 1999, which was recorded as a
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charge to retained earnings. The components of other intangible assets
related to these purchases and their estimated lives are as follows (in
millions):
Fair Accumulated Estimated
Value Amortization Life
-------- ------------ ----------
Developed product technology $ 429.0 $ 361.8 10
Core technology 240.5 202.9 10
Developed license technology 292.5 286.9 6
Trained and assembled workforce 32.5 31.6 7
Tradenames 39.0 21.9 15
Key distributor relationships 6.5 6.4 5
-------- --------
$1,040.0 $ 911.5
======== ========
- - $1,370.5 million of other intangible assets was recorded as a result of
the Redemption. The components of other intangible assets related to the
Redemption and their estimated lives are as follows (in millions):
Fair Estimated
Value Life
-------- -----------
Developed product technology $ 765.0 10
Core technology 203.0 10
Developed license technology 175.0 6
Trained and assembled workforce 49.0 7
Tradenames 105.0 15
Key distributor relationships 73.5 5
--------
$1,370.5
========
- - $500.5 million and $752.5 million of in-process research and
development was recorded as a result of Roche's 1990 through 1997
purchases and the Redemption, respectively. At the date of each purchase,
Genentech concluded that technological feasibility of the acquired in-
process technology was not established and that the in-process technology
had no future alternative uses. The amount related to the 1990 through
1997 purchases was charged to retained earnings at June 30, 1999. The
amount related to the Redemption was charged to operations at June 30,
1999.
The amounts assigned to in-process research and development were
determined based upon an analysis employing the risk-adjusted cash flows
expected to be generated by the products that result from the in-process
projects. The analyses performed included forecasting future cash flows
that was expected to result from the progress made on each of the in-
process projects prior to the purchase dates. These cash flows were
estimated by first forecasting, on a product-by-product basis, total
revenues expected to result from sales of the first generation of each in-
process product. From this amount, a portion of the gross in-process
product revenues was removed to account for the contribution provided by
any core technology, which was considered to benefit the in-process
products. The net in-process revenue was then multiplied by the project's
estimated percentage of completion as of the purchase dates to arrive at a
forecast of net in-process research and development revenues attributable
to projects completed prior to the purchase dates. From this forecast,
appropriate operating expenses, cash flow adjustments and contributory
asset returns were deducted to arrive at a forecast of net returns on the
completed portion of the in-process technology. Finally, these net
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returns were discounted to a present value at discount rates that
incorporate both the weighted average cost of capital (relative to the
biotech industry and Genentech) as well as the product-specific risk
associated with the purchased in-process research and development
products. The product specific risk factors considered include where each
product is in each phase of development, type of molecule under
development, likelihood of regulatory approval, manufacturing process
capability, scientific rationale, pre-clinical safety and efficacy data,
target product profile and development plan. The discount rates employed
ranged from 16% to 19% for the 1999 valuation and 20% to 28% for the 1990
purchase valuation, all of which represent a significant risk premium to
Genentech's weighted average cost of capital.
The forecast data employed in the analyses was based upon internal product
level forecast information maintained by Genentech management in the
ordinary course of managing its business. The inputs used by Genentech in
analyzing in-process research and development were based upon assumptions,
which Genentech believes to be reasonable but which are inherently
uncertain and unpredictable. These assumptions may be incomplete or
inaccurate, and no assurance can be given that unanticipated events and
circumstances will not occur.
Note 3. Relationship with Roche Holdings, Inc.
On June 30, 1999, Roche exercised its option to cause us to redeem all of our
Special Common Stock held by stockholders, other than Roche, at a price of
$82.50 per share in cash with funds deposited by Roche for such purpose and
we retired all of the shares of Special Common Stock including those held by
Roche. As a result, Roche owned 100% of our outstanding common stock. On
July 23, 1999, Roche completed a public offering of 22,000,000 shares of our
common stock. Roche received the proceeds from the offering. As a result,
Roche's percentage ownership of our outstanding common stock was reduced from
100% to approximately 82.1% at September 30, 1999. Our common stock began
trading on the New York Stock Exchange under the symbol "DNA" on July 20,
1999. See "Subsequent Events" note below for information on Roche's second
public offering.
In July 1999, we entered into certain affiliation arrangements with Roche,
amended our licensing and marketing agreement with F. Hoffmann-La Roche Ltd,
an affiliate of Roche commonly known as Hoffmann-La Roche, and entered into a
tax sharing agreement with Roche.
AFFILIATION ARRANGEMENTS
In July 1999, we amended our certificate of incorporation and bylaws and
entered into an affiliation agreement with Roche. As a result, our board
changed to consist of two Roche directors, three independent directors
nominated by a nominating committee currently controlled by Roche, and one
Genentech employee. However, under the affiliation agreement, Roche has the
right to obtain proportional representation on our board at any time. Roche
intends to continue to allow our current management to conduct our business
and operations as we have done in the past. However, we cannot ensure that
Roche will not implement a new business plan in the future.
LICENSING AGREEMENT
In 1995, we entered into a licensing and marketing agreement with Hoffmann-La
Roche and its affiliates granting it a ten-year option to license to use and
sell products in non-U.S. markets. In July 1999, we amended that agreement,
the major provisions of which include:
- - extended Hoffmann-La Roche's option until at least 2015;
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- - Hoffmann-La Roche may exercise its option to license our products upon the
occurrence of any of the following: (1) our decision to file an
Investigational New Drug exemption application, or IND, for a product, (2)
completion of a Phase II trial for a product or (3) if Hoffmann-La Roche
previously paid us a fee of $10 million to extend its option on a
product, completion of a Phase III trial for that product;
- - we have agreed, in general, to manufacture for and supply to Hoffmann-La
Roche its clinical requirements of our products at cost, and its
commercial requirements at cost plus a margin of 20%; however, Hoffmann-La
Roche will have the right to manufacture our products under certain
circumstances;
- - Hoffmann-La Roche has agreed to pay, for each product for which Hoffmann-
La Roche exercises its option upon either a decision to file an IND with
the U.S. Food and Drug Administration, or FDA, or completion of the Phase
II trials, a royalty of 12.5% on the first $100 million on its aggregate
sales of that product and thereafter a royalty of 15% on its aggregate
sales of that product in excess of $100 million until the later in each
country of the expiration of our last relevant patent or 25 years from the
first commercial introduction of that product; and
- - Hoffmann-La Roche will pay, for each product for which Hoffmann-La Roche
exercises its option after completion of the Phase III trials, a royalty
of 15% on its sales of that product until the later in each country of the
expiration of our relevant patent or 25 years from the first commercial
introduction of that product; however, $5 million of any option extension
fee paid by Hoffmann-La Roche will be credited against royalties payable
to us in the first calendar year of sales by Hoffmann-La Roche in which
aggregate sales of that product exceed $100 million.
TAX SHARING AGREEMENT
Since the redemption of our Special Common Stock, we have been included in
Roche's U.S. federal consolidated income tax group. As a result, our tax
liability will be included in the consolidated federal income tax liability
of Roche and its subsidiaries. We also will be included with Roche and/or
one or more Roche subsidiaries in consolidated or combined income tax groups
for certain state and local tax jurisdictions. Accordingly, we have entered
into a tax sharing agreement with Roche. Pursuant to the tax sharing
agreement, we and Roche will make payments so that the net amount paid by us
on account of Roche's consolidated or combined taxes will be determined as
though Genentech had filed separate, stand-alone income tax returns as the
common parent of a group of corporations rather than a consolidated
subsidiary of Roche. (See "Subsequent Events" note below for a description
of the changes to our tax status with respect to Roche as a result of Roche's
second public offering of Genentech's common stock).
ROCHE'S RIGHT TO MAINTAIN ITS PERCENTAGE OWNERSHIP INTEREST IN OUR STOCK
We expect from time to time to issue additional shares of common stock in
connection with our stock option and stock purchase plans, and we may issue
additional shares for other purposes. The affiliation agreement requires us
to, among other things, establish a stock repurchase program designed to
maintain Roche's percentage ownership interest in our common stock. In
addition, Roche will have a continuing option to buy stock from us at
prevailing market prices to maintain its percentage ownership interest.
Roche's percentage ownership interest at September 30, 1999 was approximately
82.1%.
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Note 4. Stock Option Changes
In connection with the redemption of our Special Common Stock, the following
changes occurred with respect to our stock options that were outstanding as
of June 30, 1999:
- - Options for the purchase of approximately 6.8 million shares of Special
Common Stock were canceled in accordance with the terms of the applicable
stock option plans, and the holders received cash payments in the amount
of $82.50 per share, less the exercise price;
- - Options for the purchase of approximately 4.0 million shares of Special
Common Stock were converted into options to purchase a like number of
shares of common stock at the same exercise price; and
- - Options for the purchase of approximately 4.9 million shares of Special
Common Stock were canceled, in accordance with the terms of our 1996 Stock
Option/Stock Incentive Plan (the "1996 Plan"). With certain exceptions,
we granted new options for the purchase of 1.333 times the number of
shares under the previous options with an exercise price of $97 per share,
which was the public offering price of the common stock. The number of
shares that were the subject of these new options, which were issued under
our 1999 Stock Plan (the "1999 Plan"), was approximately 5.0 million.
Alternative arrangements were provided for certain holders of some of the
unvested options under the 1996 Plan.
Of the approximately 4.0 million shares of converted options, options with
respect to approximately 2.9 million shares were outstanding at September 30,
1999, all of which are currently exerciseable except for options with respect
to approximately 201,000 shares. These outstanding options are held by 2,200
employees; no non-employee directors hold these options.
Our board of directors and Roche, then our sole stockholder, approved the
1999 Plan on July 16, 1999. Under the 1999 Plan, we granted new options to
purchase approximately 6.5 million shares (including the 5.0 million shares
referred to above) of common stock to approximately 2,400 employees at an
exercise price of $97 per share, with the grant of such options made
effective as of July 16, 1999. Of the options to purchase these 6.5 million
shares, options to purchase approximately 6.4 million shares were outstanding
at September 30, 1999, of which options to purchase approximately 300,000
shares are currently exerciseable.
In connection with these stock option transactions, we recorded or expect to
record:
- - In the quarter ended June 30, 1999, (1) cash compensation expense of
approximately $284.5 million associated with the cash-out of such stock
options and (2) non-cash compensation expense of approximately $102.3
million associated with the remeasurement, for accounting purposes, of the
converted options, which non-cash amount represents the difference between
each applicable option exercise price and the redemption price of the
Special Common Stock;
- - In the quarter ended September 30, 1999, non-cash compensation expense of
$57.8 million associated with the remeasurement, for accounting purposes,
of the converted options, which non-cash amount represents the difference
between the $82.50 redemption price of the Special Common Stock and the
$97 July 1999 public offering price of the common stock; and
- - Over a two-year period beginning July 1, 1999, an aggregate of
approximately $27.4 million of deferred cash compensation available to be
earned by a limited number of employees who elected the alternative
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arrangements described above. In the third quarter of 1999, we recorded
compensation expense of $3.4 million related to these alternative
arrangements.
Note 5. Related Party Transactions
In the second quarter of 1999, we entered into a license agreement with
Immunex Corporation that grants rights under our immunoadhesin patent
portfolio to Immunex for its product Enbrel, registered trademark,
(etanercept) biologic response modifier. In exchange for a worldwide, co-
exclusive license covering fusion proteins such as Enbrel, Immunex paid
Genentech an initial non-refundable license fee which was recorded in
contract revenues net of a portion to be paid to Roche pursuant to an
agreement between Roche and us.
Note 6. Long-term Debt
Our long-term debt consists of $149.7 million of convertible subordinated
debentures, with interest payable at 5%, due in 2002. Prior to the
redemption of our Special Common Stock, the debentures were convertible, at
the option of the holder, into one-half share of our Special Common Stock and
$18 in cash, for each $74 in principal amount of debenture converted. As a
result of the redemption of our Special Common Stock, upon conversion, the
holder receives, for each $74 in principal amount of debenture converted,
$59.25 in cash, which represents one-half of the $82.50 redemption price and
$18 in cash. The $18 in cash is reimbursed by Roche to us. Generally, we
may redeem the debentures until maturity.
Note 7. 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 three- and
nine-month periods ended September 30, 1999 and 1998 (in thousands).
Three Months Nine Months
Ended September 30, Ended September 30,
------------------- -------------------
1999 1998 1999 1998
--------- -------- --------- --------
Numerator:
Net (loss) income - numerator
For basic and diluted EPS: $ (62,845) $ 63,378 $(971,622) $144,769
--------- -------- --------- --------
Denominator:
Denominator for basic EPS--
weighted-average shares 127,854 126,080 128,013 125,480
Effect of dilutive securities:
Stock options - 3,868 - 4,030
--------- -------- --------- --------
Denominator for diluted EPS
--adjusted weighted-average
shares and assumed conversions 127,854 129,948 128,013 129,510
========= ======== ========= ========
Options to purchase 1,563,950 shares of Special Common Stock between $68.19
per share and $68.38 per share were outstanding in the nine-month period
ended September 30, 1998, but were not included in the computations of
diluted EPS because the options were anti-dilutive.
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In the three- and nine-month periods ended September 30, 1998, we had
convertible subordinated debentures that were convertible to 1,013,514
shares of Special Common Stock. These were not included in the computations
of diluted EPS because they were anti-dilutive. As a result of the
Redemption, the convertible subordinated debentures are no longer
convertible to Special Common Stock. For further information, you should
read the "Long-term Debt" note above.
Note 8. Comprehensive Income
We adopted FAS 130, "Reporting Comprehensive Income," in 1998. Comprehensive
income is comprised of net income and other comprehensive income. Our other
comprehensive income includes unrealized holding gains and losses on our
available-for-sale securities, which were reported separately in
stockholders' equity, and included in accumulated other comprehensive income.
Comprehensive income (loss) was $(35.2) million for the quarter ended
September 30, 1999 and $68.9 million for the comparable period in 1998.
Comprehensive income (loss) was $(965.4) million for the nine months ended
September 30, 1999, and $135.2 million for the comparable period in 1998.
Note 9. Legal Proceedings
We are a party to various legal proceedings, including patent infringement
cases involving human growth hormone products, antibody products and other
matters.
In July 1997, an action was filed in the U.S. District Court for the Northern
District of California alleging that our manufacture, use and sale of
Nutropin human growth hormone products infringes a patent known as the
"Goodman Patent," owned by the Regents of the University of California, or
UC. This action is substantially the same as a previous action filed in 1990
against us by UC alleging that our manufacture, use and sale of Protropin
recombinant human growth hormone infringes the Goodman Patent. The 1997 case
had been stayed until recently, as described below.
In May 1999, the 1990 case was submitted to the jury and, on June 2, 1999,
the jury announced its findings. While the jury found that the Goodman
Patent was valid, the jurors could not agree among themselves whether our
manufacture, use or sale of Protropin infringed the Goodman Patent, although
the jury publicly reported that it voted 8-1 in favor of UC. Because the
jury could not reach a unanimous decision, no finding of infringement was
made and there is no current legal basis for us to be held liable to UC for
any claim of damages. On June 22, 1999, the judge held a hearing known as a
status conference to discuss further proceedings relating to the 1990 and
1997 cases. At that time, Genentech renewed its request that the judge hold
a non-jury trial and decide whether UC defrauded the U.S. Patent and
Trademark Office when obtaining the Goodman Patent. The judge has previously
denied a request by UC that this defense be thrown out of the case for lack
of merit. A favorable ruling by the judge in any such trial would render the
Goodman Patent unenforceable. On July 1, 1999, the judge issued a written
decision setting the schedule for further proceedings. The judge
consolidated the 1990 and 1997 cases for a jury trial to begin on January 3,
2000. The issues of infringement and willfulness will be tried to the jury
first, and only if the jury finds liability would the issue of damages be
tried. Pursuant to the judge's decision, that jury trial is to be followed
immediately by a court trial of Genentech's fraud (inequitable conduct) claim
against UC. In addition, UC made a motion for entry of a judgment as a
matter of law (a "directed verdict") that Genentech's manufacture, use or
sale of Protropin infringes the Goodman Patent notwithstanding the lack of
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unanimous jury verdict on that issue. The judge scheduled a hearing for July
23, 1999 to discuss that motion. On July 15, 1999, the judge issued a
written decision denying UC's motion for a directed verdict, and the judge
canceled the July 23, 1999 hearing.
On May 28, 1999, Glaxo Wellcome Inc. filed a patent infringement lawsuit
against us in the U.S. District Court in Delaware. That suit asserts that we
infringe four U.S. patents owned by Glaxo Wellcome. Two of the patents
relate to the use of specific kinds of monoclonal antibodies for the
treatment of human disease, including cancer. The other two patents asserted
against us relate to preparations of specific kinds of monoclonal antibodies
which are made more stable and the methods by which such preparations are
made. We have been served with the complaint. The complaint fails to
specify which of our products or methods of manufacture are allegedly
infringing the four patents at issue. However, we believe that the suit
relates to the manufacture, use and sale of our Herceptin and Rituxan
antibody products. On July 19, 1999, we filed our answer to Glaxo Wellcome's
complaint, and in our answer we also stated counterclaims against Glaxo
Wellcome. The judge has scheduled the trial of this suit to begin January
29, 2001.
We and the City of Hope Medical Center are parties to a 1976 agreement
relating to work conducted by two City of Hope employees, Arthur Riggs and
Keiichi Itakura, and patents resulting therefrom ("Riggs/Itakura Patents").
Since that time, Genentech has entered into license agreements with various
companies to make, use and sell the products covered by the Riggs/Itakura
Patents. On August 13, 1999 the City of Hope filed a complaint against us in
the Superior Court in Los Angeles County, California alleging that we owe
royalties to the City of Hope in connection with these license agreements, as
well as product license agreements that involve the grant of licenses under
the Riggs/Itakura Patents. The complaint states claims for declaratory
relief, breach of contract, breach of implied covenant of good faith and fair
dealing, and breach of fiduciary duty. We have not yet filed our answer to
the compliant.
Based upon the nature of the claims made and the information available to
date to us and our counsel through investigations and otherwise, we believe
the outcome of these actions is not likely to have a material adverse effect
on our financial position, result of operations or cash flows. 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.
In addition to the above, in April 1999, we agreed to make a $50 million
payment to settle a federal investigation relating to our past clinical,
sales and marketing activities associated with human growth hormone.
Note 10. Inventories
As a result of push-down accounting, we wrote-up inventory at June 30, 1999
by $186.2 million of which $170.3 million was allocated to work in process
and $15.9 million was allocated to finished goods. In the third quarter of
1999, we recorded amortization expense of $46.8 million related to the
inventory write-up. Inventories are summarized below (in thousands):
September 30, December 31,
1999 1998
------------- ------------
Raw materials and supplies $ 18,507 $ 21,414
Work in process 244,604 106,383
Finished goods 21,861 20,829
----------- ---------
Total $ 284,972 $ 148,626
=========== =========
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Note 11. Subsequent Events
On October 26, 1999, Roche completed its second public offering of 20,000,000
shares of our common stock. Roche received the proceeds from the offering.
As a result, Roche's percentage ownership of our outstanding common stock was
reduced to approximately 66.3%.
Effective with the consummation of the second public offering on October
26, 1999, Genentech ceased to be a member of the consolidated federal income
tax group (and certain consolidated or combined state and local income tax
groups) of which Roche is the common parent. Accordingly, our tax sharing
agreement with Roche now pertains only to the state and local tax returns in
which we will be consolidated or combined with Roche. We will continue to
calculate our tax liability or refund with Roche for these state and local
jurisdictions as if we were a stand-alone entity.
Genentech announced in October 1999 that its board of directors approved a 2-
for-1 split of its common stock to be effective in the form of a stock
dividend. All shareholders of record of Genentech common stock at the close
of business on October 29, 1999 will receive one additional share for each
share held. The additional shares will be distributed beginning November 2,
1999. Genentech stock will trade on a split-adjusted basis on November 3,
1999. The accompanying financial statements have not been adjusted to
reflect this stock split.
In October 1999, CuraGen Corporation exercised its right under an existing
agreement with Genentech to borrow $16.0 million. Simultaneously, with this
draw down, CuraGen repaid the loan by issuing 977,636 shares of CuraGen stock
valued at $16.37 per share at such issuance, or an aggregate of $16.0
million.
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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 September 30, 1999, and the related condensed
consolidated statements of operations for the three-month and nine-month
periods ended September 30, 1999 and 1998 and the condensed consolidated
statements of cash flows for the nine-month periods ended September 30, 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 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
October 7, 1999
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GENENTECH, INC.
FINANCIAL REVIEW
OVERVIEW
Genentech is a leading biotechnology company that uses human genetic
information to discover, develop, manufacture and market human
pharmaceuticals for significant unmet medical needs. Thirteen of the
approved products of biotechnology stem from our science. Science at
Genentech focuses primarily on two areas of medicine: cardiovascular and
oncology. We also pursue projects where there exists a significant
opportunity to fill a therapeutic void in other important areas of medicine,
such as with our growth hormone products.
We manufacture and market the following seven products directly in the United
States:
- - Herceptin antibody for the treatment of certain patients with metastatic
breast cancer whose tumors overexpress the human epidermal growth factor
receptor2, or HER2, protein;
- - Rituxan (rituximab) antibody for the treatment of patients with relapsed
or refractory low-grade or follicular, CD20-positive B-cell non-Hodgkins
lymphoma;
- - Activase tissue plasminogen activator, or t-PA, for the treatment of heart
attack, acute ischemic stroke within three hours of the onset of symptoms,
and acute massive pulmonary embolism;
- - Protropin growth hormone for the treatment of lack of adequate endogenous
growth hormone secretion, or growth hormone deficiency, in children;
- - Nutropin growth hormone for the treatment of growth hormone deficiency in
children and adults, growth failure associated with chronic renal
insufficiency prior to kidney transplantation and short stature associated
with Turner syndrome;
- - Nutropin AQ liquid formulation growth hormone for the same indications as
Nutropin; and
- - Pulmozyme inhalation solution for the management of cystic fibrosis.
We receive royalties on sales of products in Canada, on sales of Pulmozyme
outside of the United States and on sales of rituximab outside of the United
States (excluding Japan) from F. Hoffmann-La Roche Ltd, an affiliate of Roche
Holdings, Inc., that is commonly known as Hoffmann-La Roche. We receive
royalties on sales of growth hormone products and t-PA outside of the United
States and Canada through other licensees. We also receive worldwide
royalties on five additional licensed products that originated from our
technology and are marketed by other companies.
REDEMPTION OF OUR SPECIAL COMMON STOCK
On June 30, 1999, we redeemed all of our outstanding Special Common Stock
held by stockholders other than Roche Holdings, Inc., commonly known as
Roche, at a price of $82.50 per share in cash with funds deposited by Roche
for that purpose. As a result, Roche's percentage ownership of our
outstanding common stock increased from 65% to 100%. Consequently, push-down
accounting is required under U.S. generally accepted accounting principles to
reflect in our financial statements the amounts paid for our stock in excess
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of our net book value. Push-down accounting required us to record goodwill
and other intangible assets of $1,706.0 million and $1,499.0 million,
respectively, onto our balance sheet in the second quarter of 1999. The
amortization of this goodwill and other intangible assets will have a
significant negative impact on our financial results in future years. In
addition, we will continuously evaluate whether events and circumstances have
occurred that indicate any portion of the remaining balance of these
intangible assets may not be recoverable. When factors indicate that assets
should be evaluated for possible impairment, we may be required to reduce the
carrying value of our intangible assets, which could have a material adverse
effect on our financial condition and results of operations during the
periods in which such a reduction is recognized. Also, as a result of push-
down accounting, we recorded charges of $1,147.3 million in the second
quarter and $57.8 million in the third quarter of 1999. These charges
include a non-cash charge of $752.2 million for in-process research and
development, $284.5 million of compensation expense related to Genentech's
early cash settlement of certain employee stock options and an aggregate of
approximately $102.3 million in the second quarter and $57.8 million in the
third quarter as a non-cash charge for the remeasurement of the value of
continuing employee stock options. For more information about push-down
accounting, you should read "Redemption of Genentech's Special Common Stock"
note in the Notes to Condensed Consolidated Financial Statements above.
Stock Options Changes
In connection with the redemption of our Special Common Stock, the following
changes occurred with respect to our stock options that were outstanding as
of June 30, 1999:
- - Options for the purchase of approximately 6.8 million shares of Special
Common Stock were canceled in accordance with the terms of the applicable
stock option plans, and the holders received cash payments in the amount
of $82.50 per share, less the exercise price;
- - Options for the purchase of approximately 4.0 million shares of Special
Common Stock were converted into options to purchase a like number of
shares of common stock at the same exercise price; and
- - Options for the purchase of approximately 4.9 million shares of Special
Common Stock were canceled, in accordance with the terms of our 1996 Stock
Option/Stock Incentive Plan (the "1996 Plan"). With certain exceptions,
we granted new options for the purchase of 1.333 times the number of
shares under the previous options with an exercise price of $97 per share,
which was the public offering price of the common stock. The number of
shares that were the subject of these new options, which were issued under
our 1999 Stock Plan (the "1999 Plan"), was approximately 5.0 million.
Alternative arrangements were provided for certain holders of some of the
unvested options under the 1996 Plan.
Of the approximately 4.0 million shares of converted options, options with
respect to approximately 2.9 million shares are currently outstanding, all of
which are currently exerciseable except for options with respect to
approximately 201,000 shares. These outstanding options are held by 2,200
employees; no non-employee directors hold these options.
Our board of directors and Roche, then our sole stockholder, approved the
1999 Plan on July 16, 1999. Under the 1999 Plan, we granted new options to
purchase approximately 6.5 million shares (including the 5.0 million shares
referred to above) of common stock to approximately 2,400 employees at an
exercise price of $97 per share, with the grant of such options made
effective as of July 16, 1999. Of the options to purchase these 6.5 million
shares, options to purchase approximately 6.4 million shares are currently
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outstanding, of which options to purchase approximately 300,000 shares are
currently exerciseable.
In connection with these stock option transactions, we recorded or expect to
record:
- - In the quarter ended June 30, 1999, (1) cash compensation expense of
approximately $284.5 million associated with the cash-out of such stock
options and (2) non-cash compensation expense of approximately $102.3
million associated with the remeasurement, for accounting purposes, of the
converted options, which non-cash amount represents the difference between
each applicable option exercise price and the redemption price of the
Special Common Stock;
- - In the quarter ended September 30, 1999, non-cash compensation expense of
$57.8 million associated with the remeasurement, for accounting purposes,
of the converted options, which non-cash amount represents the difference
between the $82.50 redemption price of the Special Common Stock and the
$97 July 1999 public offering price of the common stock; and
- - Over a two-year period beginning July 1, 1999, an aggregate of
approximately $27.4 million of deferred cash compensation available to be
earned by a limited number of employees who elected the alternative
arrangements described above.
PUBLIC OFFERINGS
On July 23, 1999, and October 26, 1999, Roche completed public offerings of
our common stock. As a result of the public offerings, Roche's percentage
ownership of our outstanding common stock was reduced to approximately 66.3%.
We had 128,711,638 shares of common stock outstanding at October 26, 1999.
We did not receive any of the net proceeds from the offerings. Our common
stock began trading on the New York Stock Exchange under the symbol DNA on
July 20, 1999. We currently intend to retain all future income for use in
the operation of our business and to fund future growth and, therefore, we do
not intend to declare or pay any cash dividends on our common stock in the
forseeable future.
In July 1999, we amended our certificate of incorporation and bylaws and
entered into certain affiliation arrangements with Roche, amended our
licensing and marketing agreement with Hoffmann-La Roche, and entered into a
tax sharing agreement with Roche.
Relationship with Roche Holdings, Inc.
As a result of the redemption of our Special Common Stock, the then-existing
governance agreement between us and Roche terminated, except for provisions
relating to indemnification and stock options, warrants and convertible
securities. In July 1999, we entered into certain affiliation arrangements
with Roche, amended our licensing and marketing agreement with Hoffmann-La
Roche, and entered into a tax sharing agreement with Roche as follows:
Affiliation Arrangements
Our board of directors consists of two Roche directors, three independent
directors nominated by a nominating committee currently controlled by Roche,
and one Genentech employee. However, under the affiliation agreement, Roche
has the right to obtain proportional representation on our board at any time.
Roche intends to continue to allow our current management to conduct our
business and operations as we have done in the past. However, we cannot
ensure that Roche will not implement a new business plan in the future.
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Except as follows, the affiliation arrangements do not limit Roche's ability
to buy or sell our common stock. If Roche and its affiliates sell their
majority ownership of shares of our common stock to a successor, Roche has
agreed that it will cause the successor to purchase all shares of our common
stock not held by Roche as follows:
- - with consideration, if that consideration is composed entirely of either
cash or equity traded on a U.S. national securities exchange, in the same
form and amounts per share as received by Roche and its affiliates; and
- - in all other cases, with consideration that has a value per share not less
than the weighted average value per share received by Roche and its
affiliates as determined by a nationally recognized investment bank.
If Roche owns more than 90% of our common stock for more than two months,
Roche has agreed that it will, as soon as reasonably practicable, effect a
merger of Genentech with Roche or an affiliate of Roche.
Roche has agreed, as a condition to any merger of Genentech with Roche or the
sale of our assets to Roche, that either:
- - the merger or sale must be authorized by the favorable vote of a majority
of non-Roche stockholders, provided no person will be entitled to cast
more than 5% of the votes at the meeting; or
- - in the event such a favorable vote is not obtained, the value of the
consideration to be received by non-Roche stockholders would be equal to
or greater than the average of the means of the ranges of fair values for
the common stock as determined by two nationally recognized investment
banks.
We have agreed not to approve, without the prior approval of the directors
designated by Roche:
- - any acquisition, sale or other disposal of all or a portion of our
business representing 10% or more of our assets, net income or revenues;
- - any issuance of capital stock except under certain circumstances; or
- - any repurchase or redemption of our capital stock other than a redemption
required by the terms of any security and purchases made at fair market
value in connection with any of our deferred compensation plans.
Licensing Agreement
In 1995, we entered into a licensing and marketing agreement with Hoffmann-La
Roche and its affiliates granting it a ten-year option to license to use and
sell products in non-U.S. markets. In July 1999, we amended that agreement,
the major provisions of which include:
- - extending Hoffmann-La Roche's option until at least 2015;
- - Hoffmann-La Roche may exercise its option to license our products upon the
occurrence of any of the following: (1) our decision to file an
Investigational New Drug exemption application, or IND, for a product, (2)
completion of a Phase II trial for a product or (3) if Hoffmann-La Roche
previously paid us a fee of $10 million to extend its option on a product,
completion of a Phase III trial for that product;
- - we agreed, in general, to manufacture for and supply to Hoffmann-La Roche
its clinical requirements of our products at cost, and its commercial
requirements at cost plus a margin of 20%; however, Hoffmann-La Roche will
have the right to manufacture our products under certain circumstances;
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- - Hoffmann-La Roche has agreed to pay, for each product for which Hoffmann-
La Roche exercises its option upon either a decision to file an IND with
the U.S. Food and Drug Administration, or FDA, or completion of the Phase
II trials, a royalty of 12.5% on the first $100 million on its aggregate
sales of that product and thereafter a royalty of 15% on its aggregate
sales of that product in excess of $100 million until the later in each
country of the expiration of our last relevant patent or 25 years from the
first commercial introduction of that product; and
- - Hoffmann-La Roche will pay, for each product for which Hoffmann-La Roche
exercises its option after completion of the Phase III trials, a royalty
of 15% on its sales of that product until the later in each country of the
expiration of our relevant patent or 25 years from the first commercial
introduction of that product; however, $5 million of any option extension
fee paid by Hoffmann-La Roche will be credited against royalties payable
to us in the first calendar year of sales by Hoffmann-La Roche in which
aggregate sales of that product exceed $100 million.
Tax Sharing Agreement
Since the redemption of our Special Common Stock, we have been included in
Roche's U.S. federal consolidated income tax group. As a result, our tax
liability was included in the consolidated federal income tax liability of
Roche and its subsidiaries. We were also included with Roche and/or one or
more Roche subsidiaries in consolidated or combined income tax groups for
certain state and local tax jurisdictions. Accordingly, we entered into a
tax sharing agreement with Roche. Pursuant to the tax sharing agreement, we
and Roche are to make payments such that, with respect to the period during
which Genentech is a member of a Roche consolidated or combined group, the
net amount paid by us on account of consolidated or combined income taxes
(including any amounts determined to be due as a result of a redetermination
of the consolidated or combined income tax liability of a Roche group by
reason of an audit) will be determined as if we had filed separate, stand-
alone federal, state and local income tax returns as the common parent of an
affiliated group of corporations filing consolidated or combined federal,
state and local returns rather than a consolidated subsidiary of Roche.
Effective with the consummation of the second public offering on October 26,
1999, Genentech ceased to be a member of the consolidated federal income tax
group (and certain consolidated or combined state and local income tax
groups) of which Roche is the common parent. Accordingly, our tax sharing
agreement with Roche now pertains only to the state and local tax returns in
which we will be consolidated or combined with Roche. We will continue to
calculate our tax liability or refund with Roche for these state and local
jurisdictions as if we were a stand-alone entity.
Roche's Right to Maintain its Percentage Ownership Interest in Our Stock
We expect from time to time to issue additional shares of common stock in
connection with our stock option and stock purchase plans, and we may issue
additional shares for other purposes. The affiliation agreement requires us
to, among other things, establish a stock repurchase program designed to
maintain Roche's percentage ownership interest in our common stock. In
addition, Roche will have a continuing option to buy stock from us at
prevailing market prices to maintain its percentage ownership interest.
Roche's ownership interest in our common stock was approximately 66.3% at
October 26, 1999.
STOCK SPLIT
Genentech announced in October 1999 that its board of directors approved a 2-
for-1 split of its common stock to be effective in the form of a stock
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<PAGE>
dividend. All shareholders of record of Genentech common stock at the close
of business on October 29, 1999 will receive one additional share for each
share held. The additional shares will be distributed beginning November 2,
1999. Genentech stock will trade on a split-adjusted basis on November 3,
1999. The accompanying financial statements have not been adjusted to
reflect this stock split.
RESULTS OF OPERATIONS
(dollars in millions, except per share amounts)
<TABLE>
<CAPTION>>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------- --------------------------------------
1999 1999
------------------ 1998 Pro Forma ------------------ 1998 Pro Forma
NET INCOME (LOSS) Actual Pro Forma Actual % Change Actual Pro Forma Actual % Change
- ------------------- ------- --------- ------ --------- ------- --------- ------ ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Net income (loss) $ (62.8) $ 66.9 $ 63.4 6% $(971.6) $ 198.6 $144.8 37%
Earnings (loss)
per share:
Basic $ (0.49) $ 0.52 $ 0.50 $ (7.59) $ 1.55 $ 1.15
Diluted $ (0.49) $ 0.51 $ 0.49 $ (7.59) $ 1.50 $ 1.12
</TABLE>
Net Income (Loss): The net loss for the quarter and nine months ended
September 30, 1999 reflects the Redemption in the second quarter and the
related effect of push-down accounting. (For further information, read
"Redemption of Genentech's Special Common Stock" note in the Notes to
Condensed Consolidated Financial Statements.) In addition, the net loss for
the first nine months of 1999 also reflects the legal settlement recorded in
the first quarter.
Pro forma net income, which excludes special and recurring charges
related to the Redemption and push-down accounting, for the third quarter of
1999 was $66.9 million, a 6% increase from the comparable period in 1998.
Pro forma net income, excluding special and recurring charges related to the
Redemption and a special charge related to the legal settlement, for the
first nine months of 1999 was $198.6 million, a 37% increase from the
comparable period in 1998. These increases represent revenue growth
primarily driven by sales of our oncology products, Rituxan and Herceptin,
and lower research and development expenses. These increases were offset in
part by lower contract and other income, the expiration of royalties from Eli
Lilly and Company, commonly known as Lilly, in August 1998 and higher
marketing, general and administrative expenses. See below for further
information on the components of operations.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------- --------------------------------------
1999 1999
------------------ 1998 Pro Forma ------------------- 1998 Pro Forma
REVENUES Actual Pro Forma Actual % Change Actual Pro Forma Actual % Change
- ------------------- ------- --------- ------ --------- -------- --------- ------ ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Revenues $ 345.3 $ 345.3 $313.9 10% $1,062.9 $ 1,042.5 $846.6 23%
======= ========= ====== ========= ======== ========= ====== =========
PRODUCT SALES
- -------------------
Herceptin $ 47.9 $ 47.9 - - $ 134.0 $ 134.0 - -
Rituxan 72.6 72.6 $ 39.4 84% 204.1 204.1 $111.9 82%
Activase 59.2 59.2 45.1 31 169.3 169.3 154.9 9
Protropin, Nutropin
and Nutropin AQ 59.9 59.9 52.9 13 175.5 175.5 166.1 6
Pulmozyme 27.0 27.0 24.7 9 85.7 85.7 68.3 25
Actimmune 0.4 0.4 1.0 (60) 1.8 1.8 2.9 (38)
------- --------- ------ --------- -------- --------- ------- --------
Total product sales $ 267.0 $ 267.0 $163.1 64% $ 770.4 $ 770.4 $504.1 53%
======= ========= ====== ========= ======== ========= ======= ========
</TABLE>
Page 24
<PAGE>
Herceptin: Net sales of Herceptin, indicated for the treatment of certain
patients with metastatic breast cancer who have tumors that overexpress the
human epidermal growth factor receptor (HER2) protein, were $47.9 million in
the third quarter of 1999. We recorded $46.2 million in net sales of
Herceptin in the second quarter of 1999 and $39.9 million in the first
quarter of 1999. An increase in physician acceptance of Herceptin has
contributed to a positive sales trend and successful penetration into the
breast cancer market. Herceptin was first marketed in September 1998.
Rituxan: Net sales of Rituxan, indicated 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, increased 84% in the third
quarter of 1999 and 82% in the first nine months of 1999 from the comparable
periods in 1998. These increases were primarily due to increased market
penetration for the treatment of B-cell non-Hodgkin's lymphoma. We co-
developed Rituxan with IDEC Pharmaceuticals Corporation, commonly known as
IDEC, from whom we license Rituxan.
Activase: Net sales of Activase tissue plasminogen activator (t-PA)
increased 31% in the third quarter of 1999 and 9% in the first nine months of
1999 from the comparable periods in 1998. These increases were largely due
to usage in peripheral indications previously served by another company's
thrombolytic currently in short supply in the marketplace. These increases
were offset in part by a continued decline in the overall size of the
thrombolytic therapy market due to mechanical reperfusion and continued
competition from Centocor, Inc.'s Retavase, registered trademark.
In connection with the acquisition by Roche of Corange Limited in 1998,
Roche entered into a consent decree with the Federal Trade Commission.
Pursuant to the consent decree, with Roche's acquisition of 100% of our
stock, Roche shall cause us to dismiss, with prejudice, all pending
litigation we have against Centocor regarding the rights for the research,
development, manufacture or sale of Centocor's Retavase product, and we shall
refrain from instituting any new litigation against Centocor challenging or
seeking to render invalid any of the patents divested or licensed to Centocor
pursuant to the terms of the decree. Roche has requested that we proceed
with dismissing such litigations as required under the consent decree, and we
are in process of discussing and resolving with Roche and Centocor how to
implement those dismissals.
Protropin, Nutropin and Nutropin AQ: Net sales of our three growth hormone
products - Protropin, Nutropin, and Nutropin AQ, - increased 13% in the third
quarter of 1999 and 6% in the first nine months of 1999 from the comparable
periods in 1998. These increases primarily reflect fluctuations in
distributor ordering patterns.
Pulmozyme: Net sales of Pulmozyme increased 9% in the third quarter of 1999
and 25% in the first nine months of this year from the comparable periods in
1998. We continue to increase our market penetration in the early and mild
patient populations for the management of cystic fibrosis.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------- --------------------------------------
ROYALTIES, CONTRACT, 1999 1999
AND OTHER, AND ------------------ 1998 Pro Forma ------------------ 1998 Pro Forma
INTEREST INCOME Actual Pro Forma Actual % Change Actual Pro Forma Actual % Change
- ------------------- ------- --------- ------ --------- ------- --------- ------ ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Royalties $ 46.1 $ 46.1 $ 60.7 (24)% $ 138.7 $ 138.7 $182.6 (24)%
Contract and other 7.5 7.5 66.1 (89) 84.7 64.3 95.0 (32)
Interest income 24.7 24.7 24.0 3 69.1 69.1 64.9 6
</TABLE>
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<PAGE>
Royalty Income: Royalty income decreased 24% in the third quarter and in the
nine-month period ended September 30, 1999 from the comparable periods in
1998. These decreases primarily relate to the expiration of royalties from
Lilly in August 1998, partly offset by higher royalties from various
licensees, including retroactive royalties in the second quarter from Immunex
Corporation pursuant to the licensing agreement for Enbrel, registered
trademark, (etanercept) biologic response modifier.
Contract and Other Revenues: Contract and other revenues were down 89% in
the third quarter and 11% in the nine months ended September 30, 1999 from
the comparable periods in 1998. These declines, which are further explained
below, were partly offset by adjustments of $20.3 million related to the
write-up of marketable securities on June 30, 1999 as a result of push-down
accounting.
Pro forma contract and other revenues, which excludes the effect of
push-down accounting, decreased 89% and 32% in the third quarter and first
nine months of 1999, respectively. These decreases resulted primarily from
higher revenues in the third quarter of last year related to the contract
payment from Hoffmann-La Roche for Herceptin marketing rights and the patent
infringement settlement with Novo Nordisk A/S. These decreases were offset
in part by higher revenues in 1999 from our strategic alliances, including an
initial license fee from Immunex for Enbrel, a milestone payment from Schwarz
Pharma AG related to a U.S. Food and Drug Administration (FDA) filing for
Nutropin Depot sustained-release growth hormone and higher gains from the
sale of biotechnology equity securities.
Interest Income: Interest income increased 3% in the third quarter and 6% in
the nine months ended September 30, 1999 from the comparable periods in 1998
primarily due to a higher portfolio balance. The total investment portfolio,
consisting of cash and cash equivalents, and short- and long-term marketable
securities, decreased to $1,607.5 million at September 30, 1999 from $1,721.0
million at June 30, 1999, and is comparable to the portfolio of $1,604.6
million at December 31, 1998.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
--------------------------------------- --------------------------------------
1999 1999
------------------ 1998 Pro Forma ------------------ 1998 Pro Forma
COST AND EXPENSES Actual Pro Forma Actual % Change Actual Pro Forma Actual % Change
- ------------------------ -------- --------- ------ --------- -------- --------- ------ ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Cost of sales $ 92.8 $ 46.0 $ 35.3 30% $ 191.2 $ 144.3 $106.1 36%
Research and development 84.6 84.6 99.9 (15) 269.6 269.6 291.0 (7)
Marketing, general and
administrative 113.6 113.6 89.6 27 328.2 328.2 245.1 34
Special charges:
Legal settlement - - - - 50.0 - - -
Related to redemption 57.8 - - - 1,205.1 - - -
Recurring charges related
to redemption 98.9 - - - 98.9 - - -
Interest expense 1.3 1.3 1.1 18 4.0 4.0 3.3 21
-------- --------- ------ --------- -------- --------- ------ ---------
Total costs and expenses $ 449.0 $ 245.5 $225.9 9% $2,147.0 $ 746.1 $645.5 16%
======== ========= ====== ========= ======== ========= ====== =========
</TABLE>
Cost of Sales: Cost of sales increased 163% in the third quarter and 80% in
the nine months ended September 30, 1999 from the comparable periods in 1998.
These increases largely reflect the amortization of the inventory write-up as
a result of push-down accounting, which is expected to continue into next
year. Exclusive of the amortization expense, cost of sales increased 30% in
the third quarter and 36% in the first nine months of 1999 from the
comparable periods in 1998. Cost of sales as a percent of net sales,
exclusive of amortization expense, decreased to 17% in the third quarter and
19% in the first nine months of 1999 from 22% and 21%, respectively, in the
comparable periods of 1998. These decreases were primarily driven by higher
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<PAGE>
volume coupled with productivity improvements and a more favorable product
mix.
Research and Development: Research and development expenses in the third
quarter and first nine months of 1999 decreased from the comparable periods
in 1998. For the third quarter and first nine months of 1999, we invested
25% and 26%, respectively, of pro forma revenues into research and
development compared to 32% and 34%, respectively, from a year ago. The
decrease in expenses and the lower ratios reflect our long-range plan to
reduce research and development spending as a percent of revenues as products
progress through late-stage clinical trials and revenues increase.
Marketing, General and Administrative: Marketing, general and administrative
expenses increased 27% in the third quarter and 34% in the first nine months
of 1999 from the comparable periods in 1998. These increases were driven
mainly by the growth of Rituxan sales and the resultant profit sharing
expense and the introduction of Herceptin. The first nine months of 1999
also reflect higher legal expenses and the write-down of certain
biotechnology investments.
Special Charges: The first nine months of 1999 included a $1,205.1 million
special charge related to the Redemption and the application of push-down
accounting. This charge included a non-cash charge of $752.5 million in the
second quarter for in-process research and development, $284.5 million in the
second quarter for the cash-out of Special Common Stock options, and $102.3
million in the second quarter and $57.8 million in the third quarter as a
non-cash charge for the remeasurement of the value of continuing employee
stock options. The first nine months of 1999 also included a $50.0 million
legal settlement in the first quarter related to a federal investigation of
our past clinical, sales and marketing activities associated with human
growth hormone. (See Redemption of Genentech's Special Common Stock and
Legal Proceedings notes in the Notes to Condensed Consolidated Financial
Statements for further information regarding these special charges.)
At the Redemption date, we determined the acquired in-process technology was
not technologically feasible and the in-process technology had no future
alternative uses. As a result, $500.5 million of in-process research and
development related to Roche's 1990 through 1997 purchases of our common
stock was charged to retained earnings; and $752.5 million of in-process
research and development related to the Redemption was charged to operations
at June 30, 1999.
The amounts of in-process research and development were determined based on
an analysis utilizing the risk-adjusted cash flows expected to be generated
by the products that result from the in-process projects. The analysis
included forecasted future cash flows that were expected to result from the
progress made on each of the in-process projects prior to the purchase dates.
These cash flows were estimated by first forecasting, on a product-by-product
basis, total revenues expected from sales of the first generation of each in-
process product. A portion of the gross in-process product revenues was then
removed to account for the contribution provided by any core technology,
which was considered to benefit the in-process products. The net in-process
revenue was then multiplied by the project's estimated percentage of
completion as of the purchase dates to determine a forecast of net in-process
research and development revenues attributable to projects completed prior to
the purchase dates. Appropriate operating expenses, cash flow adjustments
and contributory asset returns were deducted from the forecast to establish a
forecast of net returns on the completed portion of the in-process
technology. Finally, these net returns were discounted to a present value at
discount rates that incorporate both the weighted average cost of capital
(relative to the biotech industry and us) as well as the product-specific
risk associated with the purchased in-process research and development
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<PAGE>
products. The product specific risk factors included each product in each
phase of development, type of molecule under development, likelihood of
regulatory approval, manufacturing process capability, scientific rationale,
pre-clinical safety and efficacy data, target product profile and development
plan. The discount rates ranged from 16% to 19% for the 1999 valuation and
20% to 28% for the 1990 purchase valuation, all of which represent a
significant risk premium to our weighted average cost of capital.
The forecast data in the analyses was based on internal product level
forecast information maintained by our management in the ordinary course of
managing the business. The inputs used by us in analyzing in-process
research and development were based on assumptions, which we believed to be
reasonable but which were inherently uncertain and unpredictable. These
assumptions may be incomplete or inaccurate, and no assurance can be given
that unanticipated events and circumstances will not occur.
A brief description of in-process research and development projects is set
forth below including an estimated percentage of completion of products
within each project at the Redemption date of when products within each
project will be substantially complete. Except as otherwise noted below,
there have been no significant changes to the projects since the Redemption
date. We do not track all costs associated with research and development on
a project-by-project basis. Therefore, we believe a calculation of cost
incurred as a percentage of total incurred project cost as of FDA approval is
not possible. We estimated, however, that the research and development
expenditures that will be required to complete the in-process projects will
total approximately $700 million.
We have estimated percentage completion data for each project based on an
equal weighting of three indicators, as follows:
PTS: Probability of technical success ("PTS") is a project level statistic
maintained by us on an ongoing basis, which is intended to represent the
current likelihood of project success, i.e., FDA approval. This is a
quantitative calculation based on the stage of development and the complexity
of the project, and it is highly correlated with the project's phase of
development. PTS is periodically adjusted to reflect actual experiences over
a reasonable period of time.
Status compared to Baseline Model: We developed a baseline model which
allocated percentages of a standard development project to each major phase
of the project based upon our experience. We then overlaid the time-based
status of each project to this baseline model, in order to calculate a
percentage of completion for each project.
Management's Estimate of Percentage Complete: Our senior product development
management representatives provided an estimate of the percentage complete,
on a technological basis, of each project.
Nutropin Depot sustained-release growth hormone - A sustained release version
of human growth hormone based on Alkermes' ProLease sustained release drug
delivery system, which is designed to deliver human growth hormone by monthly
or semi-monthly injections. This product is being developed in collaboration
with Alkermes. On June 25, 1999, we made U.S. regulatory filings seeking
marketing approval for Nutropin Depot, and we are currently awaiting
regulatory clearance. We estimate that the initial indication on this
project will be substantially complete by the year 2000, and that it was
approximately 85% complete at the Redemption date.
TNKase second generation t-PA - A second generation t-PA that is a
selectively mutated version of a wild-type t-PA. This t-PA version may be
faster acting and easier to administer, and may restore blood flow faster.
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<PAGE>
On July 30, 1999, we made U.S. regulatory filings seeking marketing approval
for TNKase, and we are currently awaiting regulatory clearance. This product
is being developed in collaboration with Boehringer Ingelheim International
GmbH. We estimate that this project will be substantially complete by the
year 2000, and that it was approximately 90% complete at the Redemption date.
Anti-IgE antibody - An anti-IgE monoclonal antibody designed to interfere
early in the process that leads to symptoms of allergic asthma and seasonal
allergic rhinitis. This product is being developed in collaboration with
Tanox, Inc. and Novartis Pharmaceuticals Corporation. Phase III trials are
ongoing in patients with allergic asthma. Phase III trials have been
completed in patients with seasonal allergic rhinitis and the results have
been analyzed. We estimated that this project was approximately 75% complete
at the Redemption date.
Pulmozyme inhalation solution - A recombinant human protein that is an
approved treatment for the management of cystic fibrosis. We are conducting
a trial to determine the effect of Pulmozyme on pulmonary function in
patients with early-stage cystic fibrosis. We estimated this project to be
approximately 75% complete at the Redemption date. We are also preparing to
begin clinical testing of Pulmozyme delivery via Aradigm Corporation's AERx,
trademark, delivery system. We estimated that this project was approximately
45% complete at the Redemption date. We estimate that these projects will be
substantially complete by the year 2003.
Rituxan antibody - A monoclonal antibody approved for the treatment of
relapsed or refractory low-grade or follicular, CD20-positive B-cell non-
Hodgkin's lymphoma, a cancer of the immune system. We are in Phase III
clinical trials for the treatment of intermediate- and high-grade non-
Hodgkin's lymphoma. This product is being developed in collaboration with
IDEC Pharmaceuticals, Inc., or IDEC. We estimate that this project will be
substantially complete by the year 2004 and that it was approximately 60%
complete at the Redemption date.
Xubix (sibrafiban) oral IIb/IIIa antagonist - An orally administered
inhibitor of platelet aggregation that may be useful in the prevention of
unwanted clotting in certain cardiovascular conditions, including acute
coronary syndrome. Hoffmann-La Roche Ltd was conducting global development
of this molecule, and we had certain opt-in rights with respect to the United
States. We estimated that this project was approximately 65% complete at the
Redemption date. On August 6, 1999, Hoffmann-La Roche announced that the
preliminary results from its Phase III trial of Xubix had not shown that
Xubix was better than aspirin in preventing recurrent ischemic events in
patients suffering from acute coronary syndrome. Hoffmann-La Roche has
terminated its development of Xubix based on the unsuccessful results.
Activase t-PA - A protein that is an approved treatment for heart attack,
acute ischemic stroke within three hours of symptom onset, and acute massive
pulmonary embolism. We are preparing for Phase III trials of this product
for intravenous catheter clearance. We estimate that this project will be
substantially complete in 2000 and that it was approximately 90% complete at
the Redemption date.
Anti-CD11a antibody - An antibody (also known as hu1124) designed to block
certain immune cells as a potential treatment of psoriasis. We are currently
preparing for Phase III trials of this product, which we are developing in
collaboration with Xoma Corporation. We estimate that this project will be
substantially complete by the year 2003 and that it was approximately 50%
complete at the Redemption date.
Herceptin antibody - An antibody that is an approved treatment for metastatic
breast cancer. In collaboration with Hoffmann-La Roche and U.S. national
Page 29
<PAGE>
cooperative groups, we are preparing for Phase III trials for adjuvant
treatment of early-stage breast cancer in patients who overexpress the HER2
protein. We estimate that this project will be substantially complete by the
year 2007, and that it was approximately 45% complete at the Redemption date.
Thrombopoietin (TPO) - A protein that is being studied for treatment of
thrombocytopenia, a reduction in clot-inducing platelets, in cancer patients
treated with chemotherapy. This molecule has been exclusively licensed to
Pharmacia & Upjohn. We estimate that this project will be substantially
complete by the year 2002, and that it was approximately 55% complete at the
Redemption date.
Anti-CD18 antibody - An antibody designed to block certain immune cells that
may impact blood flow. We are conducting Phase II clinical trials aimed at
increasing blood flow in patients with acute myocardial infarction. We
estimate that this project will be substantially complete by the year 2004,
and that it was approximately 55% complete at the Redemption date.
Anti-VEGF antibody - An antibody developed to inhibit angiogenesis (the
formation of new blood vessels) as a potential treatment for several types of
solid-tumor cancers. In pre-clinical studies the anti-VEGF antibody resulted
in decreased vascularization and a decline in growth and metastasis of a
variety of solid tumors. Phase II studies are ongoing in prostate cancer,
breast cancer, renal cell carcinoma, lung cancer and colorectal cancer. We
estimate these projects will be substantially complete by the year 2003, and
that they were 35% to 40% complete at the Redemption date.
Herceptin antibody - An antibody that is an approved treatment for metastatic
breast cancer. Herceptin will also be evaluated for broader application in
other tumor types in which the HER2 protein is overexpressed. We are
conducting and are planning to conduct additional Phase II studies alone or
in collaboration with Hoffmann-La Roche, the National Cancer Institute or
other clinical research groups. We estimate that the initial indications on
this project will be substantially complete by the year 2004. These broader
applications have projects that were estimated to be 40% to 45% complete at
the Redemption date.
AMD Fab - A customized fragment of an anti-VEGF antibody for the potential
treatment of age-related macular degeneration (AMD). In this condition,
excessive blood vessel growth in the retina of the eye can lead to blindness.
We are currently preparing for Phase I clinical trials. We estimate that
this project will be substantially complete by the year 2004, and that it was
approximately 20% complete at the Redemption date.
LDP-02 - A monoclonal antibody for the treatment of inflammatory bowel
disease. This product is licensed from and being developed in collaboration
with LeukoSite, Inc. This compound is currently in Phase Ib/IIa clinical
trials in Canada and the United Kingdom. We estimate that this project will
be substantially complete by the year 2005, and that it was approximately 30%
complete at the Redemption date.
We also have identified five additional product programs that were at
different stages of in-process research and development. We expect these
projects to be substantially complete in years 1999 through 2004. The
percent completion for these additional programs ranged from an estimated 35%
to 90%. These projects did not receive material allocations of the purchase
price.
In addition, our in-process research and development included a process
technology program. The process technology program included the research and
development of ideas and techniques that should improve the bulk production
of antibodies, including cell culture productivity, and streamlined and
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<PAGE>
improved recovery processes, and improvements in various areas of
pharmaceutical manufacturing. We estimated that the process technology
program was approximately 50% complete at the Redemption date.
Recurring Charges Related to Redemption: We began recording recurring
charges related to the Redemption and push-down accounting in the third
quarter of 1999. These charges were $98.9 million in the quarter and were
comprised of the amortization of intangibles and goodwill, and compensation
expense related to alternative arrangements provided at the time of the
Redemption for certain holders of some of the unvested options under the 1996
Plan.
<TABLE>
<CAPTION>
Three Months Ended Nine Months Ended
September 30, September 30,
-------------------------------------- --------------------------------------
1999 1999
------------------ 1998 Pro Forma ------------------ 1998 Pro Forma
INCOME TAXES Actual Pro Forma Actual % Change Actual Pro Forma Actual % Change
- --------------------- ------- --------- ------ --------- ------- --------- ------ ---------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Income taxes (benefit)
provision $ (40.9) $ 32.9 $ 24.6 34% $ (112.5) $ 97.8 $ 56.3 74%
</TABLE>
The tax provision benefit of $40.9 million for the third quarter and $112.5
million for the first nine months ended September 30, 1999 consists of tax
expense of $32.9 million and $97.8 million, respectively, on pretax income
excluding the income and deductions attributable to push-down accounting and
legal settlement, and tax benefits of $73.8 million for the third quarter and
$210.3 million for the first nine months ended September 30, 1999 related to
the income and deductions attributable to push-down accounting and legal
settlement. The effective tax rate on pretax income excluding non-recurring
special charges and legal settlement is 41% for the third quarter and nine
months ended September 30, 1999, which reflects the anticipated impact of
non-deductible goodwill amortization on the full year 1999 effective tax
rate.
The expected full year 1999 effective tax rate is 41%, which is higher than
the 1998 effective tax rate of 28% because of the goodwill amortization and
reduced benefits from research and development tax credits and the
realization of foreign losses.
The pro forma tax provision of $32.9 million for the third quarter and
$97.8 million for the first nine months ended September 30, 1999 was based on
a tax rate of 33% on pro forma pretax income, which excludes the effects of
push-down accounting in the second and third quarter of 1999 and the legal
settlement in the first quarter of 1999. The full year 1999 pro forma
effective tax rate is expected to remain at 33%.
LIQUIDITY AND CAPITAL
RESOURCES September 30, 1999 December 31, 1998
- --------------------------- ------------------ -----------------
Cash and cash equivalents, $ 1,607.5 $ 1,604.6
short-term investments
and long-term marketable
securities
Working capital $ 817.4 950.6
We used cash generated from operations, maturities of investments and stock
issuances to make investments in marketable securities and capital additions.
Cash and cash equivalents, short-term investments and long-term marketable
securities at September 30, 1999, were comparable to December 31, 1998.
Working capital decreased by $133.2 million in the first nine months of 1999
Page 31
<PAGE>
from December 31, 1998 primarily due to the effects of push-down accounting
and the transfer of funds to restricted cash.
Capital expenditures totaled $65.3 million in the first nine months of 1999
compared to $61.7 million in the comparable period of 1998. The slight
increase in 1999 compared to 1998 was primarily due to an increase in
equipment purchases.
We believe that our cash, cash equivalents and short-term investments,
together with funds provided by operations and leasing arrangements, will be
sufficient to meet our foreseeable operating cash requirements. In addition,
we believe we could access additional funds from the debt and, under certain
circumstances, capital markets. Factors that could negatively affect our
cash position include, but are not limited to, future levels of our product
sales, royalty and contract revenues, expenses, in-licensing activities,
including the timing and amount of related development funding or milestone
payments, acquisitions, capital expenditures and the amount of any stock
repurchased under any stock repurchase program. The affiliation agreement
with Roche requires us to, among other things, establish a stock repurchase
program designed to maintain Roche's percentage ownership interest in our
common stock. While the dollar amounts associated with these future
purchases cannot currently be estimated, such stock repurchases could have a
material adverse impact on our liquidity.
Our long-term debt consists of $149.7 million of convertible subordinated
debentures, with interest payable at 5%, due in 2002. Prior to the
redemption of our Special Common Stock, the debentures were convertible, at
the option of the holder, into one-half share of our Special Common Stock and
$18 in cash, for each $74 in principal amount of debenture converted. As a
result of the redemption of our Special Common Stock, upon conversion, the
holder receives, for each $74 in principal amount of debenture converted,
$59.25 in cash, which represents one-half of the $82.50 redemption price and
$18 in cash. The $18 in cash will be reimbursed by Roche to us. Generally,
we may redeem the debentures until maturity.
Forward-Looking Information and Cautionary Factors that May Affect Future
Results
The following section contains forward-looking information based on our
current expectations. Because our actual results may differ materially from
this and any other forward-looking statements made by or on behalf of
Genentech, this section also includes a discussion of important factors that
could affect our actual future results, including our product sales,
royalties, contract revenues, expenses and net income.
Our Operating Results May Fluctuate
Our operating results may vary from period to period for several reasons
including, but not limited to:
- - the overall competitive environment for our products;
- - the amount and timing of sales to customers in the United States;
- - the amount and timing of our sales to Hoffmann-La Roche and the amount and
timing of its sales to its customers;
- - 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 our products;
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- - the rate of adoption and use of our products for approved indications and
additional indications;
- - the potential introduction of new products and additional indications for
existing products in 1999 and beyond; and
- - the ability to manufacture sufficient quantities of any particular
marketed product.
The Results of Our Research and Development Are Unpredictable
Successful pharmaceutical product development is highly uncertain and is
dependent on numerous factors, many of which are beyond our control.
Products that appear promising in the early phases of development may fail to
reach the market for numerous reasons, including, but not limited to:
- - 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 our research and development expenses include, but are not
limited to:
- - the number of and the outcome of clinical trials currently being conducted
by us and/or our collaborators;
- - the number of products entering into development from late-stage research;
- - Hoffmann-La Roche's decisions whether to exercise its options to develop
and sell our future products in non-U.S. markets and the timing and amount
of any related development cost reimbursement;
- - in-licensing activities, including the timing and amount of related
development funding or milestone payments; and
- - future levels of revenues.
Roche, Our Controlling Stockholder, May Have Interests That Are Adverse to
Other Stockholders
At the completion of the October 1999 offering, Roche owned approximately
66.3% of our outstanding common stock. Roche may in the future, through open
market purchases or otherwise, acquire additional shares of our common stock.
As our majority stockholder, Roche controls the outcome of actions requiring
the approval of our stockholders. Our bylaws provide, among other things,
that the composition of our board of directors shall consist of two Roche
directors, three independent directors nominated by a nominating committee
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and one Genentech employee nominated by the nominating committee. As long as
Roche owns in excess of 50% of our common stock, Roche directors will
comprise two of the three members of the nominating committee. However, at
any time until Roche owns less than 5% of our stock, Roche will have the
right to obtain proportional representation on our board. Roche intends to
continue to allow our current management to conduct our business and
operations as we have done in the past. However, we cannot assure you that
Roche will not institute a new business plan in the future. The interests of
Roche may conflict with the interests of other holders of common stock. You
should also read "Relationship with Roche Holdings, Inc." above for further
information.
The affiliation agreement between us and Roche requires the approval of the
directors designated by Roche to make any acquisition or any sale or disposal
of all or a portion of our business representing 10% or more of our assets,
net income or revenues. Moreover, the affiliation agreement also contains
provisions that are designed to enable Roche to maintain a certain percentage
ownership interest in our common stock. These provisions may have the effect
of limiting our ability to make acquisitions.
Our certificate of incorporation includes provisions relating to competition
by Roche with us, allocations of corporate opportunities, transactions with
interested parties and intercompany agreements and provisions limiting the
liability of certain people. Our certificate of incorporation provides that
any person purchasing or acquiring an interest in shares of our capital stock
shall be deemed to have consented to the provisions in the certificate of
incorporation relating to competition with Roche, conflicts of interest,
corporate opportunities and intercompany agreements, and such consent may
restrict such person's ability to challenge transactions carried out in
compliance with such provisions. Persons who are directors and/or officers
of ours and who are also directors and/or officers of Roche may choose to
take action in reliance on such provisions rather than act in a manner that
might be favorable to us but adverse to Roche. Two of our directors
currently serve as directors, officers and employees of Roche Holding Ltd and
its affiliates.
We Depend on Skilled Personnel and Key Relationships
The success of our business depends, in large part, on our continued ability
to attract and retain highly qualified management, scientific, manufacturing
and sales and marketing personnel, and on our ability to develop and maintain
important relationships with leading research institutions and key
distributors. Competition for such personnel and relationships is intense.
In connection with the redemption of our Special Common Stock, two of our
existing employee stock option plans terminated and a number of employee
options, including many of those held by senior management, were canceled.
We have issued new employee stock options to attract and retain employees.
However, certain provisions of our affiliation agreement with Roche are
designed to enable Roche to maintain its percentage ownership interest in our
common stock, which may limit our flexibility as to the number of shares we
are able to grant under our stock option plans. We cannot assure you that we
will be able to attract or retain such personnel or maintain such
relationships.
We Face Growing and New Competition
We face growing competition in two of our therapeutic markets and expect new
competition in a third market. First, in the thrombolytic market, Activase
has lost market share and could lose additional market share to Centocor's
Retavase, registered trademark; the resulting adverse effect on sales could
be material. Retavase received approval from the FDA in October 1996 for the
treatment of acute myocardial infarction. In addition, Bristol-Myers Squibb
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recently completed a Phase III trial for another competitive product for the
treatment of acute myocardial infarction and it may file for product approval
in the near future. There is also an increasing use of mechanical
reperfusion in lieu of thrombolytic therapy for the treatment of acute
myocardial infarction, which we expect to continue.
Second, in the growth hormone market, we continue 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, we have 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. As a
result of this competition, our sales of Protropin, Nutropin and Nutropin AQ
may decline, perhaps significantly.
Third, in the non-Hodgkin's lymphoma market, Coulter Pharmaceuticals Inc., or
Coulter, has filed a Biologics License Application, or BLA, for a product
that may compete with our product Rituxan. We are also aware of other
potentially competitive biologic therapies for non-Hodgkin's lymphoma in
development.
Other Competitive Factors Could Affect Our Product Sales
Other competitive factors that could affect our product sales include, but
are not limited to:
- - the timing of FDA approval, if any, of competitive products;
- - our pricing decisions and the pricing decisions of our competitors;
- - the degree of patent protection afforded to particular products;
- - the outcome of litigation involving our patents and patents of other
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.
In Connection with the Redemption of Our Special Common Stock We Recorded
Substantial Goodwill and Other Intangibles, the Amortization of Which Will
Adversely Affect Our Earnings
As a result of the redemption of our Special Common Stock, Roche owned all of
our outstanding stock, requiring push-down accounting under generally
accepted accounting principles. Push-down accounting required us to
establish a new accounting basis for our assets and liabilities, based on
Roche's cost in acquiring all of our stock. In other words, Roche's cost of
acquiring Genentech was "pushed down" to us and reflected in our financial
statements. Push-down accounting required us to record goodwill and other
intangible assets of approximately $1,706.0 million and $1,499.0 million,
respectively, during the second quarter of 1999. The amortization of this
goodwill and other intangible assets will have a significant negative impact
on our financial results in future years. In addition, we will continuously
evaluate whether events and circumstances have occurred that indicate the
remaining balance of this and other intangible assets may not be recoverable.
When factors indicate that assets should be evaluated for possible
impairment, we may be required to reduce the carrying value of our intangible
assets, which could have a material adverse effect on our financial condition
and results of operations during the periods in which such a reduction is
recognized. We may be required to write down intangible assets in future
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periods. For more information about push-down accounting, see the
"Redemption of Genentech's Special Common Stock" note in the Notes to
Condensed Consolidated Financial Statements.
Our Royalty and Contract Revenues Could Decline
Royalty and contract revenues in future periods could vary significantly.
Major factors affecting these revenues include, but are not limited to:
- - Hoffmann-La Roche's decisions whether to exercise its options to develop
and sell our future products in non-U.S. markets and the timing and amount
of any related development cost reimbursements;
- - variations in Hoffmann-La Roche's sales and other licensees' sales of
licensed products;
- - the conclusion of existing arrangements with other companies and Hoffmann-
La Roche;
- - the timing of non-U.S. approvals, if any, for products licensed to
Hoffmann-La Roche and other licensees;
- - fluctuations in foreign currency exchange rates;
- - the initiation of new contractual arrangements with other companies;
- - whether and when contract benchmarks are achieved;
- - the failure of or refusal of a licensee to pay royalties; and
- - the expiration or invalidation of patents or other licensed intellectual
property.
Protecting Our Proprietary Rights is Difficult and Costly
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 these companies' patents cannot
be predicted. Patent disputes are frequent and can preclude
commercialization of products. We have in the past been, are currently, and
may in the future be involved in material patent litigation. Patent
litigation is costly in its own right and could subject us to significant
liabilities to third-parties and, if decided adversely, we 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 the research and
development of a particular product. We believe that we have strong patent
protection or the potential for strong patent protection for a number of our
products that generate sales and royalty revenue or that we are developing.
However, the courts will determine the ultimate strength of patent protection
of our products and those on which we earn royalties. You should read the
"Legal Proceedings" note in the Notes to Condensed Consolidated Financial
Statements.
We May Incur Material Litigation Costs
We are subject to legal proceedings, including those matters described in the
"Legal Proceedings" note in the Notes to Condensed Consolidated Financial
Statements. Litigation to which we are currently or have been subjected
relates to, among other things, our patent and intellectual property rights,
licensing arrangements with other persons, product liability and financing
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activities. We cannot predict with certainty the eventual outcome of pending
litigation, and we could be required to incur substantial expense in
defending these lawsuits. We have in the past taken substantial special
charges relating to certain litigation, including a special charge of $50
million in the first quarter of 1999.
We May Incur Material Product Liability Costs
The testing and marketing of medical products entail an inherent risk of
product liability. We maintain limited product liability insurance coverage.
Our business may be materially and adversely affected by a successful product
liability claim in excess of our insurance coverage. We cannot assure you
that product liability insurance coverage will continue to be available to us
in the future on reasonable terms or at all.
Our Products Are Subject to Governmental Regulations and Approvals
The pharmaceutical industry is subject to stringent regulation with respect
to product safety and efficacy by various federal, state and local
authorities. Of particular significance are the FDA's requirements covering
research and development, testing, manufacturing, quality control, labeling
and promotion of drugs for human use. A pharmaceutical product cannot be
marketed in the United States until it has been approved by the FDA, and then
can only be marketed for the indications and claims approved by the FDA. As
a result of these requirements, the length of time, the level of expenditures
and the laboratory and clinical information required for approval of a New
Drug Application, or NDA, or a BLA, are substantial and can require a number
of years. We cannot be sure that we can obtain necessary regulatory
approvals on a timely basis, if at all, for any of the products we are
developing, and all of the following could have a material adverse effect on
our business:
- - significant delays in obtaining or failing to obtain required approvals;
- - loss of or changes to previously obtained approvals; and
- - failing to comply with existing or future regulatory requirements.
Moreover, it is possible that the current regulatory framework could change
or additional regulations could arise at any stage during our product
development, which may affect our ability to obtain approval of our products.
A Variety of Factors Could Affect Our Liquidity
We believe that our cash, cash equivalents and short-term investments,
together with funds provided by operations and leasing arrangements, will be
sufficient to meet our foreseeable operating cash requirements. In addition,
we believe we could access additional funds from the debt and, under certain
circumstances, capital markets. Factors that could negatively affect our
cash position include, but are not limited to, future levels of our product
sales, royalty and contract revenues, expenses, in-licensing activities,
including the timing and amount of related development funding or milestone
payments, acquisitions, capital expenditures and the amount of any stock
repurchased under any stock repurchase program. The affiliation agreement
with Roche requires us to, among other things, establish a stock repurchase
program designed to maintain Roche's percentage ownership interest in our
common stock. While the dollar amounts associated with these future
purchases cannot currently be estimated, such stock repurchases could have a
material adverse impact on our liquidity.
We Are Subject to a Tax Sharing Agreement with Roche, and a Variety of
Factors Could Affect Our Income Tax Rate
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Since the redemption of our Special Common Stock, we have been included in
Roche's U.S. federal consolidated income tax group. Accordingly, we entered
into a tax sharing agreement with Roche. Pursuant to the tax sharing
agreement, we and Roche are to make payments such that, with respect to the
period during which Genentech is a member of a Roche consolidated or combined
group, the net amount paid by us on account of consolidated or combined
income taxes (including any amounts determined to be due as a result of a
redetermination of the consolidated or combined income tax liability of a
Roche group by reason of an audit) will be determined as if we had filed
separate, stand-alone federal, state and local income tax returns as the
common parent of an affiliated group of corporations filing consolidated or
combined federal, state and local returns rather than a consolidated
subsidiary of Roche.
Effective with the consummation of the second public offering on October 26,
1999, Genentech ceased to be a member of the consolidated federal income tax
group (and certain consolidated or combined state and local income tax
groups) of which Roche is the common parent. Accordingly, our tax sharing
agreement with Roche now pertains only to the state and local tax returns in
which we will be consolidated or combined with Roche. We will continue to
calculate our tax liability or refund with Roche for these state and local
jurisdictions as if we were a stand-alone entity.
We expect our effective tax rate to increase in 1999 from 1998 as a result of
non-deductible goodwill amortization and a charge for in-process research and
development and beyond 1999 for goodwill amortization.
Our effective tax rate is dependent upon several factors including, but not
limited to, changes in tax laws and rates, interpretation of existing tax
laws, future levels of research and development spending, the outcome of
clinical trials of certain development products, our success in
commercializing such products, and potential competition regarding the
products.
We May Lose Revenue or Incur Significant Costs if Year 2000 Compliance Issues
Are Not Properly Addressed
We use and rely 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 our 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.
We have a Year 2000 Project in place to address the potential exposures
related to the impact on our computer systems and scientific and
manufacturing equipment containing computer-related components for the Year
2000 and beyond. More than 75% of our Year 2000 scheduled work is complete.
The remaining work is scheduled to be completed before December 31, 1999.
The Year 2000 Project phases include: (1) inventorying and prioritizing
business critical systems; (2) Year 2000 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 completed.
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Compliance analysis is approximately 95% complete for these systems.
Remediation activities vary by department; however, on the average,
remediation activities are approximately 95% complete. Testing of our
information technology infrastructure is approximately 100% complete.
Testing of business critical application programs is approximately 85%
complete and is scheduled for completion by the end of November 1999.
Contingency planning for business critical processes, which will include
provisions such as identifying alternate sources for materials and services
and if necessary reverting to non-computerized systems for processing
information, was initiated in March 1999, is approximately 80% complete and
is scheduled for completion by the end of November 1999. We believe that
with the completed modifications, the Year 2000 issue will not pose
significant operational problems for our computer systems and equipment.
However, if such modifications and conversions are not made, or are not
completed in a timely fashion, Year 2000-related problems could have a
material impact on our operations, the precise degree of which cannot be
known at this time.
In addition to risks associated with our own computer systems and equipment,
we have relationships with, and are to varying degrees dependent upon, a
large number of third parties that provide us with information, goods and
services. These include financial institutions, suppliers, vendors, research
and business 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 our ability to
process transactions, manufacture products, or engage in similar normal
business activities. While some of these risks are outside our control, we
have 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 we are expensing these costs as they are
incurred. We have created a mechanism to trace costs directly related to the
Year 2000 issue and have 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.
We Are Exposed to Market Risk
We are 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, we enter into various derivative
investment transactions pursuant to our investment and risk management
policies and procedures in areas such as hedging and counterparty exposure
practices. We do not use derivatives for speculative purposes.
We maintain risk management control systems to monitor the risks associated
with interest rates, foreign currency exchange rates and equity investment
price changes, and our derivative and financial instrument positions. The
risk management control systems use analytical techniques, including
sensitivity analysis and market values. Though we intend for our risk
management control systems to be comprehensive, there are inherent risks that
may only be partially offset by our hedging programs should there be
unfavorable movements in interest rates, foreign currency exchange rates or
equity investment prices.
The estimated exposures discussed below are intended to measure the maximum
amount we could lose from adverse market movements in interest rates, foreign
currency exchange rates and equity investment prices, given a specified
confidence level, over a given period of time. Loss is defined in the value
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at risk estimation as fair market value loss. The exposures to interest
rate, foreign currency exchange rate and equity investment price changes are
calculated based on proprietary modeling techniques from a Monte Carlo
simulation value at risk model using a 30-day holding period and a 95%
confidence level. The value at risk model assumes non-linear financial
returns and generates potential paths various market prices could take and
tracks the hypothetical performance of a portfolio under each scenario to
approximate its financial return. The value at risk model takes into account
correlations and diversification across market factors, including interest
rates, foreign currencies and equity prices. Market volatilities and
correlations are based on J.P. Morgan Riskmetrics, trademark, dataset as of
December 31, 1998.
Our Interest Income is Subject to Fluctuations in Interest Rates
Our 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 our 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, we 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 our 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, we hedge
ourselves from any potential earnings impact due to changes in interest
rates.
Based on our overall interest rate exposure at September 30, 1999 and
December 31, 1998, including derivative and other interest rate sensitive
instruments, a near-term change in interest rates, within a 95% confidence
level based on historical interest rate movements, would not materially
affect the fair value of interest rate sensitive instruments.
We Are Exposed to Risks Relating to Foreign Currency Exchange Rates and
Foreign Economic Conditions
We receive royalty revenues from licensees selling products in countries
throughout the world. As a result, our 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
our licensed products are sold. We are exposed to changes in exchange rates
in Europe, Asia (primarily Japan) and Canada. Our 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 our royalty revenues as expressed in
U.S. dollars. In addition, as part of our overall investment strategy, a
portion of our portfolio is primarily in non-dollar denominated investments.
As a result, we are exposed to changes in the exchange rates of the countries
in which these non-dollar denominated investments are made.
To mitigate this risk, we hedge certain of our 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. Currently, the duration of these
options is generally one to four years. We may also enter into foreign
currency forward contracts to lock in the dollar value of a portion of these
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anticipated revenues. The duration of these forward contracts is generally
less than one year. Also, to hedge the non-dollar denominated investments in
the portfolio, we also enter into forward contracts.
Based on our overall currency rate exposure at September 30, 1999 and
December 31, 1998, including derivative and other foreign currency sensitive
instruments, a near-term change in currency rates within a 95% confidence
level based on historical currency rate movements, would not materially
affect the fair value of foreign currency sensitive instruments.
Our Investments in Equity Securities Are Subject to Market Risks
As part of our strategic alliance efforts, we invest 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 us from a decline in the market value of the
security below a certain minimum level (the put "strike" level); while the
call effectively limits our 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 our strategic alliance efforts, we hold
dividend-bearing convertible preferred stock and have made interest-bearing
loans that are convertible into the equity securities of the debtor.
Based on our overall exposure to fluctuations from market value changes in
marketable equity prices at September 30, 1999 and December 31, 1998, a near-
term change in equity prices within a 95% confidence level based on historic
volatilities could result in a potential loss in fair value of the equity
securities portfolio of $10.6 million.
New Accounting Standards Could Impact Our Financial Position and Results of
Operations
In July 1999, the Financial Accounting Standards Board announced the delay of
the effective date of Statement of Financial Accounting Standards (FAS) 133,
"Accounting for Derivative Instruments and Hedging Activities," for one year,
to the first quarter of 2001.
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. We are currently evaluating the impact of FAS 133 on our
financial position and results of operations.
At the end of March 1999, the Financial Accounting Standards Board issued a
proposed Interpretation of Accounting Principles Board Opinion number 25,
"Accounting for Certain Transactions involving Stock Compensation"
(proposal). This proposal would be effective upon issuance of the final
interpretation, which is expected in the fourth quarter of 1999, but
generally would cover events that occur after December 15, 1998. To the
extent that events covered by this proposal occur during the period after
December 15, 1998, but before issuance of the final interpretation, the
effects of applying this proposal would be recognized on a prospective basis
from the effective date. The potential impact of this proposal may be
significant in relation to non-employee director stock options and stock
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option repricings. We are currently evaluating the impact of this proposal
on our financial position and results of operations.
We Are Exposed to Credit Risk of Counterparties
We could be exposed to losses related to the financial instruments described
above under "We are Exposed to Market Risk" should one of our counterparties
default. We attempt to mitigate this risk through credit monitoring
procedures.
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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 Item 1 of the Company's report on Form 10-Q for the periods ended
June 30, 1999 and March 31, 1999.
See also the Legal Proceedings note in the Notes to Condensed Consolidated
Financial Statements of Part I.
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
(a) Exhibits
3.1 Amended and Restated Certificate of Incorporation
(incorporated by reference to our Current Report on
Form 8-K filed with the Commission on July 28, 1999).
3.2 Bylaws (incorporated by reference to Amendment No. 3
to our Registration Statement (No. 333-80601) on Form
S-3 filed with the Commission on July 16, 1999).
15.1 Letter re: Unaudited Interim Financial Information
27.1 Financial Data Schedule
(b) Reports on Form 8-K
On July 28, 1999, we filed a Current Report on Form 8-K
attaching our Amended and Restated Certificate of
Incorporation as filed with the Secretary of State of
Delaware on July 22, 1999.
There were no other reports on Form 8-K filed during the
quarter ended September 30, 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: October 28, 1999 GENENTECH, INC.
/S/ARTHUR D. LEVINSON /S/LOUIS J. LAVIGNE, JR.
------------------------------------- ----------------------------
Arthur D. Levinson, Ph.D. Louis J. Lavigne, Jr.
Chairman and Chief Executive Officer Executive Vice President and
Chief Financial Officer
/S/JOHN M. WHITING
----------------------------
John M. Whiting
Controller and
Chief Accounting Officer
Page 44
EXHIBIT 15.1
October 26, 1999
The Board of Directors and Stockholders
Genentech, Inc.
We are aware of the incorporation by reference in the Registration Statements
pertaining to the 401k Plan, the 1999 Stock Option/Stock Incentive Plan, the
1996 Stock Option/Stock Incentive Plan, the 1994 Stock Option Plan, the 1990
Stock Option/Stock Incentive Plan in the related prospectuses, as applicable,
contained in such Registration Statements of our report dated October 7, 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
September 30, 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,
/S/ERNST & YOUNG LLP
- --------------------------
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 SEPTEMBER 30, 1999, AND IS QUALIFIED IN ITS ENTIRETY
BY REFERENCE TO SUCH FINANCIAL STATEMENTS AND THE NOTES THERETO. AMOUNTS IN
THOUSANDS.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1999
<PERIOD-END> SEP-30-1999
<CASH> 172,614
<SECURITIES> 1,434,841
<RECEIVABLES> 185,220<F1>
<ALLOWANCES> 0<F1>
<INVENTORY> 284,972
<CURRENT-ASSETS> 1,172,818
<PP&E> 1,221,524
<DEPRECIATION> 499,534
<TOTAL-ASSETS> 6,169,395
<CURRENT-LIABILITIES> 355,446
<BONDS> 149,708
0
0
<COMMON> 2,594
<OTHER-SE> 5,224,508
<TOTAL-LIABILITY-AND-EQUITY> 6,169,395
<SALES> 770,392
<TOTAL-REVENUES> 1,062,922
<CGS> 191,154
<TOTAL-COSTS> 191,154
<OTHER-EXPENSES> 269,580
<LOSS-PROVISION> 0<F1>
<INTEREST-EXPENSE> 4,045
<INCOME-PRETAX> (1,084,133)
<INCOME-TAX> (112,511)
<INCOME-CONTINUING> (971,622)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (971,622)
<EPS-BASIC> (7.59)
<EPS-DILUTED> (7.59)
<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.
</FN>
</TABLE>
