UNITED STATES SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K/A
Amendment No. 1
(MARK ONE)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
FOR THE YEAR ENDED DECEMBER 31, 1998
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE SECURITIES
EXCHANGE ACT OF 1934
COMMISSION FILE NUMBER 0-016607
---------------------
ADVANCED TISSUE SCIENCES, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 14-1701513
- --------------------------------- ----------------------
(STATE OR OTHER JURISDICTION (I.R.S. EMPLOYER
OF INCORPORATION OR ORGANIZATION) IDENTIFICATION NUMBER)
10933 NORTH TORREY PINES ROAD, LA JOLLA, CALIFORNIA 92037
- ---------------------------------------------------- ----------
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICES) (ZIP CODE)
REGISTRANT'S TELEPHONE NUMBER, INCLUDING AREA CODE: (619) 713-7300
SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.01 PAR VALUE
----------------------------
(TITLE OF CLASS)
----------------
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
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
--- ---
As of March 24, 1999 there were 41,330,719 shares of Common Stock
outstanding.
The aggregate market value of the Common Stock of the Registrant held by
non-affiliates on March 24, 1999 was approximately $80,357,180.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Company's Proxy Statement for the Annual Meeting of
Stockholders to be held on May 25, 1999, as filed with the Commission pursuant
to Regulation 14A, are incorporated by reference into Part III of this report.
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
ADVANCED TISSUE SCIENCES, INC.
Date: September 15, 1999 By: /s/ Arthur J. Benvenuto
------------------ -------------------------
Arthur J. Benvenuto
Chairman of the Board of Directors
and Chief Executive Officer
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been executed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
SIGNATURE TITLE DATE
--------- ----- ----
/s/ Arthur J. Benvenuto Chairman of the Board of September 15,
- ----------------------- Directors and Chief 1999
Arthur J. Benvenuto Executive Officer
(principal executive officer)
/s/ Dr. Gail K. Naughton Director, President and Chief September 15,
- ------------------------ Operating Officer 1999
Dr. Gail K. Naughton
/s/ Michael V. Swanson Vice President, Finance and September 15,
- ---------------------- Administration (principal 1999
Michael V. Swanson financial and accounting officer)
/s/ Jerome E. Groopman, M.D. Director September 15,
- ---------------------------- 1999
Jerome E. Groopman, M.D.
/s/ Jack L. Heckel Director September 15,
- ------------------ 1999
Jack L. Heckel
/s/ Ronald L. Nelson Director September 15,
- -------------------- 1999
Ronald L. Nelson
/s/ Dayton Ogden Director September 15,
- ---------------- 1999
Dayton Ogden
/s/ David S. Tappan, Jr. Director September 15,
- ------------------------ 1999
David S. Tappan, Jr.
/s/ Dr. Gail R. Wilensky Director September 15,
- ------------------------ 1999
Dr. Gail R. Wilensky
1
<PAGE>
Index
-----------------
Page
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Selected Financial Data................................... F-1
Management's Discussion and Analysis of Financial
Condition and Results of Operations..................... F-2 to F-8
Consolidated Financial Statements of Advanced
Tissue Sciences, Inc.:
Consolidated Balance Sheets as of December 31,
1998 and 1997..................................... F-9
Consolidated Statements of Operations for the
Years Ended December 31, 1998, 1997 and 1996...... F-10
Consolidated Statements of Cash Flows for the
Years Ended December 31, 1998, 1997 and 1996...... F-11
Consolidated Statements of Stockholders' Equity
for the Years Ended December 31, 1998,
1997 and 1996..................................... F-12
Notes to the Consolidated Financial Statements....... F-13 to F-26
Report of Ernst & Young LLP, Independent Auditors.... F-27
Combined Financial Statements of the Dermagraft
Joint Venture:
Combined Balance Sheets as of December 31,
1998 and 1997..................................... F-28
Combined Statements of Operations for the
Years Ended December 31, 1998 and 1997
and for the Period April 29, 1996 (inception)
to December 31, 1996.............................. F-29
Combined Statements of Cash Flows for the
Years Ended December 31, 1998 and 1997
and for the Period April 29, 1996 (inception)
to December 31, 1996.............................. F-30
Combined Statements of Partners' Capital for
the Years Ended December 31, 1998 and 1997
and for the Period April 29, 1996 (inception)
to December 31, 1996.............................. F-31
Notes to the Combined Financial Statements........... F-32 to F-34
Report of Ernst & Young LLP, Independent Auditors.... F-35
2
<PAGE>
SELECTED FINANCIAL DATA
See Note 1 to the accompanying consolidated financial statements for a
discussion of the basis of presentation. This summary of selected financial
data should be read in conjunction with the consolidated financial statements
and notes presented on pages F-9 to F-26.
<TABLE>
<CAPTION>
Year Ended December 31,
----------------------------------------------------------
1998 1997 1996 1995 1994
---------- ---------- ---------- ---------- ----------
(In thousands, except per share amounts)
<S> <C> <C> <C> <C> <C>
Revenues:
Product sales (1) $ 11,962 $ 2,166 $ 1,018 $ 1,177 $ 1,042
Contracts and fees (2) (3) 8,519 10,985 13,574 2,388 923
Research and development
expenses 14,398 17,984 23,699 18,498 16,459
Equity in losses of joint
ventures (3) (17,628) (11,990) -- -- --
Net loss (43,285) (36,089) (22,401) (23,125) (22,775)
Net loss applicable to common
stock (43,863) (36,089) (22,401) (23,125) (22,775)
Basic and diluted loss per
common share $ (1.11) $ (.96) $ (.61) $ (.72) $ (.75)
Weighted average shares used in
the calculation of basic and
diluted loss per common share 39,373 37,548 36,556 33,266 30,250
</TABLE>
<TABLE>
<CAPTION>
December 31,
-----------------------------------------------------------
1998 1997 1996 1995 1994
---------- ---------- ---------- ---------- ----------
(In thousands)
<S> <C> <C> <C> <C> <C>
Cash, cash equivalents and
short-term investments (4) $ 23,054 $ 17,086 $ 40,217 $ 18,929 $ 22,033
Working capital 20,442 13,216 35,984 15,747 19,037
Total assets 53,985 50,460 56,501 31,141 33,426
Long-term debt, capital lease
obligations and redeemable
preferred stock 32,260 26,157 61 25 36
Accumulated deficit (218,456) (175,171) (139,082) (116,681) (93,556)
Stockholders' equity (4) 12,527 13,966 48,380 25,900 28,350
</TABLE>
- ----------
(1) Product sales for the year ended December 31, 1998 include sales of
TransCyte(TM) (formerly Dermagraft-TC(R)) to unrelated customers of
$1,035,000 and sales of TransCyte and Dermagraft(R) at cost to a related
party in the amount of $10,927,000. Product sales for the year ended
December 31, 1997 include sales of TransCyte of $976,000 and sales of
Dermagraft at cost to a related party in the amount of $1,190,000.
Product sales in 1996 and prior years are for sales of the Company's
Skin2(R) laboratory testing kits. The Company discontinued sales
of its Skin2 laboratory testing kits in October 1996.
(2) Contracts and fees for the year ended December 31, 1996 include a $10
million up front payment from Smith & Nephew plc upon the formation of a
joint venture for the commercialization of Dermagraft for the treatment
of diabetic foot ulcers.
(3) In April 1996, the Company formed a joint venture (the "Dermagraft
Joint Venture") with Smith & Nephew for the commercialization of
Dermagraft for the treatment of diabetic foot ulcers. The Company had
formed a separate joint venture for the commercialization of tissue-
engineered cartilage for orthopedic applications in April 1994.
Contracts and fees include revenues for research and development,
marketing and other activities performed for the joint ventures.
Advanced Tissue Sciences and Smith & Nephew began sharing in the
revenues and expenses of the joint ventures in January 1997.
(4) In January 1999, the Company received $15 million from Smith & Nephew,
through the Dermagraft Joint Venture, in connection with a 1998
expansion of the Dermagraft Joint Venture to include Dermagraft for
venous and pressure ulcers and the marketing of TransCyte outside the
United States.
F-1
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS
Advanced Tissue Sciences, Inc. (the "Company" or "Advanced Tissue
Sciences") is engaged in the development and manufacture of human-based tissue
products for tissue repair and transplantation using its proprietary tissue
engineering technology. The Company's leading therapeutic products are tissue-
engineered skin products, TransCyte(TM) (formerly Dermagraft-TC(R)) for the
temporary covering of severe and partial-thickness burns and Dermagraft(R)
for the treatment of severe skin ulcers. In addition to its TransCyte and
Dermagraft skin products, the Company is focusing its resources on the
development of tissue-engineered cartilage and cardiovascular products.
In March 1997, the Company received marketing approval in the United States
from the U.S. Food and Drug Administration (the "FDA") for its first therapeutic
product, TransCyte, as a temporary covering for severe, full-thickness, or
third degree burns. In addition, in October 1997, the Company received FDA
approval to market TransCyte for partial-thickness, or second degree burns in
the United States. Through September 1998, TransCyte was marketed for burns
by Advanced Tissue Sciences through a direct sales force in the United States.
As of October 1998, TransCyte is being marketed in the United States and
throughout the rest of the world for burn and wound care applications under a
recently expanded joint venture with Smith & Nephew plc ("Smith & Nephew").
Dermagraft for the treatment of diabetic foot ulcers was approved for
sale in Canada in August 1997, and was introduced in the United Kingdom and
several other European countries late in 1997 through the joint venture with
Smith & Nephew. The Company also submitted a Premarket Approval (PMA)
application to the FDA for approval to market Dermagraft for the treatment of
diabetic foot ulcers in the United States. In January 1998, an FDA advisory
panel recommended approval of Dermagraft with the condition that the Company
perform a post-marketing study to confirm efficacy and provide physician
training. However, in June 1998, the FDA decided the PMA application was not
approvable without supportive data from an additional controlled clinical
trial. The Company has received approval from the FDA and has begun the
requested clinical trial. Based on the clinical plan, the Company believes
the additional data could be available for submission in twelve to eighteen
months after trial initiation, assuming a reasonable rate of patient
enrollment and data consistent with its previous PMA submission.
In October 1998, the FDA approved the Company's application for a Treatment
Investigational Device Exemption (IDE) for Dermagraft, allowing the Company to
make Dermagraft for the treatment of diabetic foot ulcers available to
selected centers in the United States under an approved clinical protocol.
The Treatment IDE is a new regulatory provision for devices that (1) permits
companies to make available promising new products to patients with serious
diseases for which there is no satisfactory alternative, and (2) allows
companies to recover the costs of manufacturing and distributing the product.
The Treatment IDE is being conducted concurrently with the ongoing clinical
trial of Dermagraft in the treatment of diabetic foot ulcers in the United
States.
In April 1996, the Company entered into an agreement with Smith & Nephew to
form a joint venture (the "Dermagraft Joint Venture") for the worldwide
commercialization of Dermagraft in the treatment of diabetic foot ulcers. Under
the joint venture agreement, all expenses and revenues associated with the
development and commercialization of Dermagraft for diabetic foot ulcers from
January 1997 are shared equally by the joint venture partners. In January 1998,
Advanced Tissue Sciences and Smith & Nephew expanded the Dermagraft Joint
Venture to include additional technology for the treatment of skin tissue wounds
and applications such as venous ulcers, pressure ulcers and burns. In August
1998, the Company and Smith & Nephew expanded the Dermagraft Joint Venture
further to include exclusive rights to TransCyte for full and partial-
thickness burns in the United States effective October 1998. Under the
expanded joint venture, Advanced Tissue Sciences and Smith & Nephew will
continue to share equally in the expenses and revenues of the Dermagraft
Joint Venture, except the Company will fund the first $6 million in expense
for conducting clinical trials and regulatory support of Dermagraft and
TransCyte in the treatment of venous ulcers and pressure ulcers. In addition,
the Company will fund certain manufacturing and distribution costs and
certain costs related to post-market studies of TransCyte through December
1999. See Note 3 to the consolidated financial statements.
In May 1994, the Company and Smith & Nephew entered into a separate joint
venture (the "Cartilage Joint Venture") for the worldwide development,
manufacture and marketing of human tissue-engineered cartilage for
F-2
<PAGE>
orthopedic applications. In January 1997, the joint venture partners began
sharing equally in the Cartilage Joint Venture's expenses. See Note 3 to the
consolidated financial statements.
In October 1997, the Company was awarded a $2 million Advanced Technology
Program grant from the National Institute of Standards and Technology to fund
collaborative cardiovascular research with the University of California, San
Diego over a three-year period. Funding under the grant began in 1998. From
1993 through 1997, the Company sponsored at least $1 million annually in early
stage research programs at the Massachusetts Institute of Technology ("MIT")
and Children's Hospital in Boston ("Children's Hospital") directed toward the
tissue engineering of cartilage, liver and numerous other tissues and several
polymer technologies. The Company substantially reduced its commitment to
MIT and Children's Hospital in 1998; however, additional research is being
sponsored at several other academic institutions.
The Company has incurred, and expects to continue to incur, substantial
expenditures in support of the commercialization, development and clinical
trials of its TransCyte and Dermagraft products for burn and skin ulcer
applications, for manufacturing systems and in advancing other applications of
the Company's core technology. In particular, the Company will incur, either
directly or through the Dermagraft Joint Venture, substantial and increasing
costs for the additional clinical trial of Dermagraft in the treatment of
diabetic foot ulcers and in support of clinical trials and post-market studies
of Dermagraft and TransCyte in venous, pressure and diabetic foot ulcers and for
full and partial-thickness burns.
RESULTS OF OPERATIONS
Year Ended December 31, 1998 as Compared to the Year Ended December 31, 1997
Product sales totaled $11,962,000 in 1998, as compared to $2,166,000 in
1997. Product sales include sales to related parties of $10,927,000 and
$1,190,000 and to others of $1,035,000 and $976,000 in 1998 and 1997,
respectively.
Product sales to related parties reflect sales of Dermagraft and TransCyte
to the Dermagraft Joint Venture at cost. See Notes 3 and 17 to the consolidated
financial statements. The Company manufactures Dermagraft and TransCyte to meet
the Dermagraft Joint Venture's forecasted requirements for sales, marketing and
clinical trials. Increased product sales to the Dermagraft Joint Venture in
1998 reflect increased manufacturing costs as discussed with respect to cost of
goods sold below and the fact that commercial sales to the Dermagraft Joint
Venture did not begin until the second quarter of 1997. In addition to product
attributes and competition, growth in sales in 1999 and beyond will continue to
be sensitive to the Dermagraft Joint Venture's success in obtaining
regulatory approvals and product reimbursement from both national healthcare
systems and private insurers.
As discussed above, TransCyte sales and marketing were transferred from the
Company to the Dermagraft Joint Venture effective October 1998. As a result,
product sales to others include sales of TransCyte in the United States from
January through September 1998. Product sales in 1997 reflect sales for the
period April through December 1997. There were no sales to outside customers in
the first quarter of 1997, as TransCyte was first introduced in April 1997 for
full-thickness burns and in October 1997 for partial-thickness burns.
Revenues from contracts and fees were $8,519,000 for 1998, compared to
$10,985,000 in 1997. Contract revenues decreased $2,466,000 for 1998 reflecting
lower contract revenues recognized for research and development and clinical
activities performed for the Dermagraft and the Cartilage Joint Ventures and for
associated administrative costs. See Notes 3 and 17 to the consolidated
financial statements. Future contract revenues will include costs associated
with clinical trials and post-market studies of Dermagraft in venous, pressure
and diabetic foot ulcers and TransCyte for full and partial-thickness burns.
Cost of goods sold for 1998 represents the cost of the Company's TransCyte
product sold domestically and the cost of TransCyte and Dermagraft sold to the
Dermagraft Joint Venture. Cost of goods sold in 1997 represents costs to
manufacture TransCyte since its introduction in April 1997 and sales to the
Dermagraft Joint Venture beginning in the second quarter of 1997. Products are
being sold to the Dermagraft Joint Venture at cost to manufacture including
period costs. The Company initiated production of Dermagraft in its commercial
facility in January 1998
F-3
<PAGE>
and, accordingly, cost of goods sold has reflected costs associated with that
facility such as depreciation and overhead since that date. As a result of
the FDA's decision to require additional clinical data for Dermagraft in the
treatment of diabetic foot ulcers, the Company expects to continue to incur
significant costs associated with excess production capacity within its
manufacturing facility. Due to the costs related to such excess production
capacity, the Dermagraft Joint Venture immediately writes the inventory down
to estimated market value at the date of purchase, which is the net
realizable value at which the joint venture believes it will be able to sell
the products to its customers. During the years ended December 31, 1998 and
1997, such write downs by the Dermagraft Joint Venture totaled $8,267,000
and $491,000, respectively. To the extent the Company does not sell such
products to the Dermagraft Joint Venture, it will be required to write such
inventories down to net realizable value.
Research and development expenditures decreased 20% to $14,398,000 for
1998, compared to $17,984,000 in 1997. The decrease in research and development
costs primarily reflects lower costs for sponsored research programs, for both
clinical trials and production for clinical trials of TransCyte and Dermagraft
and for the development of commercial manufacturing processes. Research and
development costs are expected to increase during 1999 reflecting clinical
trials and post-market studies of Dermagraft in venous, pressure and diabetic
foot ulcers and TransCyte for full and partial-thickness burns.
Selling, general and administrative costs were $13,409,000 in 1998, a
decrease of $655,000 from $14,064,000 in 1997. The decrease primarily reflects
lower expenditures for selling and marketing costs related to the
commercialization of products partially offset by higher compensation costs.
Selling and marketing costs decreased during the fourth quarter of 1998 due
to the transfer of sales and marketing of TransCyte to the Dermagraft Joint
Venture effective October 1998.
Professional and consulting costs for legal, accounting and other
consulting services incurred in 1998 were $2,263,000, compared to $2,941,000 in
1997. The decrease in professional and consulting fees in 1998 principally
reflects lower legal and recruiting fees and lower costs for Dermagraft-related
marketing consultants partially offset by higher costs in preparation for the
reinspection of the Company's manufacturing facility.
Equity in losses of joint ventures was $17,628,000 in 1998, as compared to
$11,990,000 in 1997. These amounts represent the Company's share of the
losses of the Dermagraft and Cartilage Joint Ventures. The equity in losses
of joint ventures includes costs incurred by the Company and charged to the
Dermagraft and Cartilage Joint Ventures totaling $9,547,000 and $5,899,000 in
the years ended December 31, 1998 and 1997, respectively (see Note 17 to the
consolidated financial statements). The increase in 1998 primarily reflects
increased manufacturing costs and selling, general and administrative
expenses in the Dermagraft Joint Venture. As the Company sells products to
the Dermagraft Joint Venture at its cost to manufacture, costs of the
commercial facility began to be recognized in cost of goods sold for the
Dermagraft Joint Venture in January 1998. Selling, general and
administrative expenses in the Dermagraft Joint Venture have increased to
support the commercial introduction of Dermagraft and TransCyte in certain
markets. The joint ventures' losses are expected to continue in 1999 as
Dermagraft and TransCyte are commercially introduced in certain markets, as
these products are manufactured in support of clinical trials and as
orthopedic cartilage research and development efforts continue.
Interest income and other was $1,320,000 in 1998, which compared to
$1,252,000 in 1997 as higher cash balances in the second half of 1998 from a
$25 million private placement of Convertible Series B Preferred Stock offset
lower cash balances in the first half of the year as compared to 1997.
Interest expense was $2,343,000 in 1998, compared to $877,000 in 1997. The
increase in 1998 principally reflects interest on notes payable to Smith &
Nephew and The Chase Manhattan Bank (see Note 8 to the consolidated financial
statements).
Year Ended December 31, 1997 as Compared to the Year Ended December 31, 1996
Product sales totaled $2,166,000 in 1997, as compared to $1,018,000 in
1996. Product sales to related parties reflect sales of Dermagraft to the
Dermagraft Joint Venture at cost (see Note 3 to the consolidated financial
statements). Sales to outside customers of $976,000 in 1997 are from sales of
TransCyte for full-thickness burns introduced in April and for partial-thickness
burns introduced in October, following marketing approvals from the FDA. Sales
in 1996 were from the Company's Skin product line which was discontinued in
October 1996 (see Note 4 to the consolidated financial statements).
F-4
<PAGE>
Sales of TransCyte fluctuated from quarter to quarter in 1997. Although
sales of $173,000 were down in the third quarter as compared to sales of
$450,000 in the introductory second quarter, sales increased to $353,000 in the
fourth quarter primarily driven by approval of the partial-thickness indication.
The Company focused its efforts during 1997 on educating the market as to the
benefits and attributes of TransCyte and in having additional burn centers trial
the product.
Revenues from related parties for contracts and fees were $10,975,000 in
1997, as compared to $13,564,000 in 1996. Revenues reported for 1996 included a
$10 million up front fee from Smith & Nephew upon signing an agreement to enter
into the Dermagraft Joint Venture. Contract revenues, excluding the $10 million
payment, increased $7,411,000 in 1997, principally reflecting contract revenues
recognized for research and development and other activities performed for the
Dermagraft Joint Venture. Such funding began in January 1997. See Note 3 to
the consolidated financial statements. 1997 and 1996 also include revenues
recognized for research and development performed for the Cartilage Joint
Venture.
Cost of goods sold in 1997 represents the cost of the Company's TransCyte
product since its introduction in April 1997 and the cost of Dermagraft sold to
the Dermagraft Joint Venture. Products are being sold to the Dermagraft Joint
Venture at cost to manufacture including period costs (see Note 3 to the
consolidated financial statements). Cost of goods sold in 1996 represents the
cost of the Company's Skin2 laboratory testing kits. As noted above, the
Company discontinued its Skin2 business in October 1996.
Research and development expenditures decreased 24% to $17,984,000 in 1997,
from $23,699,000 in 1996. The decrease in research and development costs
primarily reflects lower costs for both clinical trials and production for
clinical trials of TransCyte and Dermagraft and for the development of
commercial manufacturing processes. These decreases were partially offset by
increased research and development costs to support the development of tissue-
engineered cartilage.
Selling, general and administrative costs increased 37% to $14,064,000 in
1997, as compared to $10,260,000 in 1996. The increase in selling, general and
administrative expenses principally reflects higher selling and marketing costs
related to the commercialization of TransCyte and costs associated with
supporting the Dermagraft and Cartilage Joint Ventures. These increases are
reflected primarily in higher costs for selling and promotional materials, and
personnel and associated costs.
Professional and consulting costs for legal, accounting and other
consulting services incurred in 1997 were $2,941,000 as compared to $3,378,000
in 1996. The decrease in professional and consulting fees in 1997 principally
reflects the absence of fees paid to financial advisors related to the
Dermagraft Joint Venture and the Company's In Vitro Laboratory Testing business
in 1996 and lower fees for regulatory consultants. This was partially offset by
increased costs for marketing consultants and for the recruitment of personnel.
Equity in losses of joint ventures was $11,990,000 in 1997, and represents
the Company's share of the losses of the Dermagraft and Cartilage Joint
Ventures. The Company began sharing in such costs in January 1997 (see Note 3
to the consolidated financial statements).
Interest and other income decreased to $1,252,000 in 1997 from $1,719,000
in 1996. The decrease primarily reflects a decline in interest income from
lower average cash balances in 1997 as compared to 1996. The decrease was
partially offset by interest charged to the Dermagraft Joint Venture for capital
employed.
Interest expense was $877,000 for 1997, as compared to $6,000 in 1996. The
increase reflects interest expense on borrowings from Smith & Nephew and The
Chase Manhattan Bank during 1997. See Note 8 to the consolidated financial
statements.
LIQUIDITY AND CAPITAL RESOURCES
As of December 31, 1998, the Company had available working capital of
$20,442,000, an increase of $7,226,000 from December 31, 1997. In addition, the
Company received a payment of $15 million in January 1999 from Smith & Nephew,
through the Dermagraft joint venture, in connection with the January 1998
expansion of
F-5
<PAGE>
the Dermagraft Joint Venture discussed above. The increase in working
capital from 1997 principally reflects the effect of the $20 million
sale of Common Stock to Smith & Nephew in January 1998, the $25 million
Convertible Series B Preferred Stock private placement in July 1998 (see
Note 12 to the consolidated financial statements), $4 million in
borrowings, including $1.4 million from The Chase Manhattan Bank and $2.3
million from Smith & Nephew, during the year (see Note 8 to the consolidated
financial statements), and $1.5 million in lease financing (see Note 9 to the
consolidated financial statements) offset by the use of funds for operations,
capital expenditures, and debt payments, and to support the Dermagraft and
Cartilage Joint Ventures. Capital expenditures of $3,740,000 for 1998 relate
primarily to the Company's manufacturing facility and related process
equipment and furniture and equipment for research and administration.
The Company expects to use working capital as it continues to incur
substantial research and development expenses; additional costs in support of
clinical trials; selling, general and administrative costs in support of product
commercialization; and additional expenditures for capital equipment and patents
both directly and in support of the Dermagraft and Cartilage Joint Ventures.
These increases are expected to be only partially offset by revenues received
from the Dermagraft and Cartilage Joint Ventures with Smith & Nephew. If, for
any reason, Smith & Nephew were to terminate the Dermagraft Joint Venture or,
to a lesser extent, the Cartilage Joint Venture, the Company would experience
a substantial increase in the need for and use of its working capital to
support the commercialization and manufacture of its Dermagraft and
TransCyte products or the development of its orthopedic cartilage products.
In addition to available working capital, the Company has entered into an
equity line with an investor group which could provide up to $50 million in
funding through the sale of Common Stock pursuant to drawings made from time to
time by the Company. Subject to certain conditions, the equity line is
available through February 2000 (see Note 12 to the consolidated financial
statements). Any drawing by the Company under the equity line may not exceed
$15 million and, in any event, the investor group may, in its sole discretion,
refuse to fund any drawing if such drawing, when aggregated with other drawings
within the preceding three months and other Company securities held by the
investor group, would result in the investor group owning more than 4.9% of
the outstanding shares of Common Stock. Any shares sold under the equity line
will be sold at a 5% discount to the average low trading price of the Company's
Common Stock over a specified period as determined by market volume. A drawing
cannot be made during the pricing period for an earlier drawing under the
equity line. In addition, the Company may not effect a drawing under the
equity line if the Common Stock is trading at less than $2 per share, trading
of the Common Stock on the Nasdaq National Market has been suspended or the
Common Stock has been delisted from the Nasdaq National Market, or there is
not in effect a registration statement under the Securities Act of 1933 covering
the issuance and resale of the Common Stock to be issued pursuant to the
drawing. Subject to the foregoing, any decision to draw any funds under the
equity line and the timing of any such draw are solely at the Company's
discretion.
The Company currently believes it has sufficient funds, including those
available under the equity line and from borrowings through its joint venture
arrangements, to support its operations through 1999. To the extent necessary,
further sources of funds may include existing or future strategic alliances or
other joint venture arrangements which provide funding to the Company, and
additional public or private offerings of debt or equity securities, among
others. There can be no assurance, however, that funds from these sources or
those outlined above will be available when needed or on terms favorable to the
Company, under existing arrangements or otherwise, or that the Company will be
successful in entering into any other strategic alliances or joint ventures.
The Company continually reviews its product development activities in an
effort to allocate its resources to those products the Company believes have the
greatest commercial potential. Factors considered by the Company in determining
the products to pursue include projected markets and need, potential for
regulatory approval and reimbursement under the existing healthcare system as
well as anticipated healthcare reforms, technical feasibility, expected and
known product attributes and estimated costs to bring the product to market.
Based on these and other factors which the Company considers relevant, the
Company may from time to time reallocate its resources among its product
development activities. Additions to products under development or changes in
products being pursued can substantially and rapidly change the Company's
funding requirements.
F-6
<PAGE>
FINANCIAL CONDITION
Cash, cash equivalents and short-term investments as of December 31, 1998
increased by $5,968,000 from December 31, 1997 reflecting principally the effect
of the $20 million sale of Common Stock to Smith & Nephew in January 1998, the
$25 million Convertible Series B Preferred Stock private placement in July 1998
(see Note 12 to the consolidated financial statements), $4 million in
borrowings (see Note 8 to the consolidated financial statements) and $1.5
million from the operating lease financing of certain equipment (see Note 9
to the consolidated financial statements) partially offset by the use of cash
to fund operations, to support the Dermagraft and Cartilage Joint Ventures
and for capital expenditures and the payment of debt. Accrued expenses at
December 31, 1998 declined from year-end 1997 primarily due to reductions in
amounts accrued for sponsored research, clinical studies and payroll costs,
partially offset by an increase in joint venture obligations. Preferred
stock at December 31, 1998 reflects the private placement of the Convertible
Series B Preferred Stock in July 1998.
MARKET RISK
The Company is exposed to changes in interest rates primarily from its
long-term debt arrangements and, secondarily, its investments in certain
securities. Under its current policies, the Company does not use interest
rate derivative instruments to manage exposure to interest rate changes. The
Company believes that a hypothetical 100 basis point adverse move in interest
rates along the entire interest rate yield curve would not materially affect
the fair value of the Company's interest sensitive financial instruments at
December 31, 1998.
YEAR 2000 COMPLIANCE
The Year 2000 ("Y2K") issue is a situation which results from computer
systems and software products being coded using two digits rather than four to
define the applicable years. The Company's computer systems and software
products utilize embedded technology that is time-sensitive and may recognize
a date as the year 1900 rather than the year 2000 which could cause computer
system failures and errors leading to a disruption in business operations.
The Y2K issue could affect not only the Company's operations but also the
operations of its business partners, customers, suppliers and regulatory
agencies among others.
In response to the risks presented by the Y2K issue, the Company developed
and is currently implementing a Y2K compliance plan. A multi-disciplinary team
was established with responsibility to (i) identify Y2K problems, (ii) set
timetables for correcting Y2K problems, (iii) establish a new procurement policy
which addresses the Y2K issue, (iv) determine the criticality of equipment to
the business process, (v) identify critical suppliers and verify their Y2K
compliance status, (vi) assess the potential impact of Y2K problems on partners,
customers, vendors and regulatory agencies, (vii) review the solution process,
(viii) develop and perform testing plans and procedures, (ix) verify corrective
action, and (x) formulate the backup strategy for critical processes that might
fail and establish critical date contingencies.
The Company has approached the Y2K issue in two specific phases. Phase I
involves the review and analysis of computer systems, software products,
equipment and vendor relationships considered critical to the Company's
operations to (i) determine Y2K compliance or non-compliance, and (ii) take
corrective action to the extent possible to assure compliance in areas of
non-compliance. Phase II involves the review and analysis of computer systems,
software products, equipment and vendor relationships not considered critical to
the Company's operations. In both phases, qualified independent consultants are
being utilized to achieve compliance goals. The Company currently estimates
that the cost of Phase I and II activities to be approximately $175,000 and
$100,000, respectively, exclusive of internal manpower costs. These estimated
costs are primarily for consulting services and equipment upgrades and are
not material to the Company's financial condition or results of operations.
With respect to Phase I, all required system modifications have been made
to computer servers, operating systems and telecommunication network equipment.
Major application software has been tested and verified for Y2K compliance. All
other software has been identified and compliance documentation has been
obtained from the software vendors. Each computer workstation has been tested
for its ability to successfully roll over the date on January 1, 2000, and each
workstation is currently being updated with the latest modifications to ensure
Y2K compliance for operating systems. The Company has identified several pieces
of manufacturing and laboratory
F-7
<PAGE>
equipment and facility access control systems which still need to be upgraded.
These upgrades should be in place by mid-year 1999 and the cost of upgrades
is included in the cost estimate for Phase I presented above. The Company
believes that all significant Y2K problems relating to computer systems,
product software and vendor relationships considered critical to the Company's
operations have been identified and specific plans are in place to assure Y2K
compliance by mid-year 1999 thus reducing the risk of a critical Y2K failure
or error. As noted above, the Phase I cost to the Company to assure Y2K
compliance of these systems, software and vendor relationships is not expected
to have a material impact on the Company's financial condition or operating
results.
In Phase II, the Company has identified approximately 150 non-critical
items to be tested for Y2K compliance, and will need to assess approximately 260
vendor relationships. While these systems and relationships are not considered
critical to the Company's business operations, every reasonable effort will be
made to identify and correct those that are not Y2K compliant. The Company
expects to complete Phase II by mid-year 1999 utilizing both independent
consultants and Advanced Tissue Sciences personnel. As noted above, the Phase
II cost to the Company to assure Y2K compliance of these systems and
relationships is not expected to have a material impact on the Company's
financial condition or operating results.
The Company has not yet completed its formal contingency plan relative to
undetected Y2K problems; however, at the current time, there does not appear to
be any critical piece of equipment for which backup cannot be provided. The
worst case scenario would likely involve adding additional short-term labor to
perform repetitive manufacturing tasks. There could also be some incremental
costs of replacing current testing capabilities if the Company's on-site test
equipment should fail. While these extra costs have not yet been estimated by
the Y2K team, they would not be expected to have a material impact on the
Company's financial condition or operating results.
The foregoing Y2K discussion contains forward-looking statements within the
meaning of the Private Securities Litigation Reform Act of 1995. Such
statements, including, without limitation, estimated costs and timelines to
complete certain actions, are based on management's best current estimates,
which were derived utilizing numerous assumptions about future events,
including the continued availability of certain resources, representations
received from third parties and other factors. However, there can be no
guarantee that these estimates will be achieved, and actual results could
differ materially from those anticipated. Specific factors that might cause
such material differences include, but are not limited to, the ability to
identify and remediate all relevant Y2K issues, results of Y2K testing,
adequate resolution of Y2K issues by third-party vendors and suppliers of
goods and services to the Company, unanticipated system costs, the adequacy
of and ability to develop and implement contingency plans and similar
uncertainties.
OTHER INFORMATION
THE DISCUSSIONS IN THIS ANNUAL REPORT ON FORM 10-K, PARTICULARLY THOSE
RELATING TO STRATEGIC ALLIANCES (INCLUDING POTENTIAL REVENUES FROM CERTAIN
EXISTING JOINT VENTURES), THE USE OF WORKING CAPITAL, THE SUFFICIENCY AND
AVAILABILITY OF FUNDS TO SUPPORT OPERATIONS, ADDITIONAL CLINICAL TRIALS, Y2K
READINESS AND COMMERCIALIZATION OF THE COMPANY'S PRODUCTS, ARE FORWARD-LOOKING
STATEMENTS INVOLVING RISKS AND UNCERTAINTIES WITHIN THE MEANING OF THE
SECURITIES ACT OF 1933 AND THE SECURITIES EXCHANGE ACT OF 1934. NO ASSURANCE
CAN BE GIVEN THAT THE COMPANY WILL SUCCESSFULLY COMPLETE CLINICAL TRIALS, OBTAIN
U.S. FOOD AND DRUG ADMINISTRATION APPROVAL, SCALE UP MANUFACTURING PROCESSES,
SUCCESSFULLY MARKET SUCH PRODUCTS, ACHIEVE THE MILESTONES REQUIRED TO RECEIVE
ADDITIONAL FUNDING, IDENTIFY AND CORRECT ALL Y2K ISSUES, OR ENTER INTO NEW
STRATEGIC ALLIANCES. THESE AND OTHER RISKS ARE DETAILED IN THE COMPANY'S
PUBLICLY AVAILABLE FILINGS WITH THE SECURITIES AND EXCHANGE COMMISSION,
INCLUDING THIS ANNUAL REPORT ON FORM 10-K FOR THE YEAR ENDED DECEMBER 31, 1998.
THE FORWARD-LOOKING STATEMENTS ARE QUALIFIED IN THEIR ENTIRETY BY REFERENCE TO
THE RISKS AND RISK FACTORS DESCRIBED IN SUCH REPORTS.
F-8
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED BALANCE SHEETS
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
December 31,
------------------------
1998 1997
---------- ----------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 16,551 $ 15,086
Short-term investments 6,503 2,000
Inventory 3,364 4,643
Other current assets 2,412 1,395
---------- ----------
Total current assets 28,830 23,124
Property - net 20,624 23,190
Patent costs - net 1,846 1,608
Other assets 2,685 2,538
---------- ----------
Total assets $ 53,985 $ 50,460
========== ==========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 894 $ 958
Accrued expenses 4,805 7,011
Current portion of long-term debt
and capital lease obligations 2,689 1,939
---------- ----------
Total current liabilities 8,388 9,908
Long-term debt and capital lease obligations 27,260 26,157
Other long-term liabilities 558 245
Minority interest in consolidated subsidiary 252 184
---------- ----------
Total liabilities 36,458 36,494
---------- ----------
Redeemable Convertible Series B Preferred Stock,
$.01 par value; 1,000 shares authorized, 100
shares issued and outstanding at December 31,
1998 and none at December 31, 1997 (aggregate
redemption and liquidation value of $5,119 at
December 31, 1998) 5,000 --
---------- ----------
Commitments and contingencies (Notes 9, 10 and 11)
Stockholders' equity:
Convertible Series B Preferred Stock; $.01 par
value; 350 shares issued and outstanding at
December 31, 1998 and none at December 31, 1997
(aggregate liquidation value of $17,917 at
December 31, 1998). -- --
Accrued cumulative preferred stock dividends 536 --
Common Stock, $.01 par value; 100,000,000 shares
authorized; issued and outstanding, 40,353,524
shares at December 31, 1998 and 37,673,983
shares at December 31, 1997 403 377
Additional paid-in capital 230,963 189,679
Accumulated deficit (218,456) (175,171)
---------- ----------
13,446 14,885
Less note received in connection with the
sale of Common Stock (919) (919)
---------- ----------
Total stockholders' equity 12,527 13,966
---------- ----------
Total liabilities and stockholders' equity $ 53,985 $ 50,460
========== ==========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-9
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
<TABLE>
<CAPTION>
Year Ended December 31,
--------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Revenues:
Product sales -
Related parties $ 10,927 $ 1,190 $ --
Others 1,035 976 1,018
Contracts and fees -
Related parties 7,935 10,975 13,564
Others 584 10 10
----------- ---------- ----------
Total revenues 20,481 13,151 14,592
----------- ---------- ----------
Costs and expenses:
Research and development 14,398 17,984 23,699
Selling, general and administrative 13,409 14,064 10,260
Cost of goods sold 15,045 2,636 1,369
Professional and consulting 2,263 2,941 3,378
----------- ---------- ----------
Total costs and expenses 45,115 37,625 38,706
----------- ---------- ----------
Loss from operations before equity
in losses of joint ventures (24,634) (24,474) (24,114)
Equity in losses of joint ventures (17,628) (11,990) --
----------- ---------- ----------
Loss from operations (42,262) (36,464) (24,114)
Other income (expense):
Interest income and other 1,320 1,252 1,719
Interest expense (2,343) (877) (6)
----------- ---------- ----------
Net loss (43,285) (36,089) (22,401)
Dividends on preferred stock (578) -- --
----------- ---------- ----------
Net loss applicable to common stock $ (43,863) $ (36,089) $ (22,401)
=========== ========== ==========
Basic and diluted loss per
common share $ (1.11) $ (.96) $ (.61)
=========== ========== ==========
Weighted average number of common
shares used in the computation
of basic and diluted loss per
common share 39,373 37,548 36,556
=========== ========== ==========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-10
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
Year Ended December 31,
------------------------------------
1998 1997 1996
---------- ---------- ----------
<S> <C> <C> <C>
Operating activities:
Net loss $ (43,285) $ (36,089) $ (22,401)
Adjustments to reconcile net loss to
cash used in operating activities:
Depreciation and amortization 4,756 2,120 1,774
Compensation for services paid in
stock options or warrants 1,092 438 976
Equity in losses of joint ventures 17,628 11,990 --
Other adjustments to net loss 162 366 66
Changes in assets and liabilities:
Inventory 1,279 (3,364) (761)
Other current assets (1,017) 1,153 (1,032)
Accounts payable (64) (1,274) 1,049
Accrued expenses (2,206) 1,206 1,783
----------- ---------- ----------
Net cash used in operating
activities (21,655) (23,454) (18,546)
----------- ---------- ----------
Investing activities:
Purchases of short-term investments (17,449) (6,234) (45,730)
Maturities and sales of short-term
investments 12,946 16,544 33,420
Acquisition of property (3,740) (15,567) (3,104)
Proceeds from sale of furniture
and equipment 1,502 -- --
Investment in joint ventures (23,436) (11,040) --
Distributions from joint ventures 3,909 605 --
Patent application costs (284) (439) (356)
Other long-term assets 1,739 (3,118) (114)
----------- ---------- ----------
Net cash used in investing
activities (24,813) (19,249) (15,884)
----------- ---------- ----------
Financing activities:
Proceeds from borrowings 3,993 28,000 --
Payments of borrowings (2,140) (38) (12)
Net proceeds from sale of Preferred
Stock 24,915 -- --
Net proceeds from sale of Common Stock 20,000 -- 40,253
Options and warrants exercised 852 1,675 3,167
Other long-term obligations 313 245 --
----------- ---------- ----------
Net cash provided by financing
activities 47,933 29,882 43,408
----------- ---------- ----------
Net increase (decrease) in cash and
cash equivalents 1,465 (12,821) 8,978
Cash and cash equivalents at beginning
of year 15,086 27,907 18,929
----------- ---------- ----------
Cash and cash equivalents at end
of year $ 16,551 $ 15,086 $ 27,907
=========== ========== ==========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-11
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY
(DOLLARS IN THOUSANDS)
<TABLE>
<CAPTION>
Additional
Preferred Stock Common Stock Paid-In
----------------------- ----------------------
Shares Amount Shares Amount Capital
---------- ---------- ---------- ---------- -------------
<S> <C> <C> <C> <C> <C>
Balance, December 31, 1995 33,885,928 $ 339 $ 143,161
Sale of Common Stock 3,223,800 32 39,595
Warrants issued as commitment
fee under equity line 875
Valuation adjustment of
Common Stock issued in
private placement 626
Warrants granted for services 500
Options and warrants exercised 364,949 4 3,249
Net loss
---------- -------- ----------
Balance, December 31, 1996 37,474,677 375 188,006
Options exercised 199,306 2 1,673
Net loss
---------- -------- ----------
Balance, December 31, 1997 37,673,983 377 189,679
Sale of Common Stock 1,533,115 15 19,985
Sale of Preferred Stock 400 $ -- 19,915
Conversion of Preferred Stock (50) -- 1,012,394 10 (10)
Preferred Stock dividends 16,957 -- (536)
Warrants granted for services 1,079
Options exercised 117,075 1 851
Net loss
---------- -------- ----------- -------- ----------
Balance, December 31, 1998 350 $ -- 40,353,524 $ 403 $ 230,963
========== ======== ========== ======== ===========
</TABLE>
<TABLE>
<CAPTION>
Accrued Total
Dividends/ Stock-
Accumulated Note Holders'
Deficit Receivable Equity
------------- ------------ ----------
<S> <C> <C> <C>
Balance, December 31, 1995 $ (116,681) $ (919) $ 25,900
Sale of Common Stock 39,627
Warrants issued as commitment
fee under equity line 875
Valuation adjustment of
Common Stock issued in
private placement 626
Warrants granted for services 500
Options and warrants exercised 3,253
Net loss (22,401) (22,401)
------------- ----------- ----------
Balance, December 31, 1996 (139,082) (919) 48,380
Options exercised 1,675
Net loss (36,089) (36,089)
------------- ----------- ----------
Balance, December 31, 1997 (175,171) (919) 13,966
Sale of Common Stock 20,000
Sale of Preferred Stock 19,915
Conversion of Preferred Stock --
Preferred Stock dividends 536 --
Warrants granted for services 1,079
Options exercised 852
Net loss (43,285) (43,285)
------------- ----------- ----------
Balance, December 31, 1998 $ (218,456) $ (383) $ 12,527
============= ============ ==========
</TABLE>
See accompanying notes to the consolidated financial statements.
F-12
<PAGE>
ADVANCED TISSUE SCIENCES, INC.
NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
Organization - Advanced Tissue Sciences, Inc. (the "Company") is a tissue
engineering company utilizing its proprietary technology to develop and
manufacture human-based tissue products for tissue repair and transplantation.
The Company is focusing on the worldwide commercialization of skin, cartilage
and cardiovascular products. The Company's leading therapeutic products are
tissue-engineered skin products for the temporary covering of severe and
partial-thickness burns, which is on the market in the United States, and for
the treatment of diabetic foot ulcers, which is in clinical trials in the United
States and on the market in Canada, the United Kingdom and several other
European countries through a joint venture with Smith & Nephew plc ("Smith &
Nephew").
Principles of Consolidation - The consolidated financial statements include the
accounts of the Company, its wholly owned subsidiaries and DermEquip, L.L.C.
("DermEquip"), a limited liability company owned jointly with Smith & Nephew.
All intercompany accounts and transactions have been eliminated. The Company's
other interests in joint ventures with Smith & Nephew are accounted for under
the equity method (see Note 3).
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 reported amounts of assets and liabilities and
related disclosures at the date of the financial statements, and the amounts of
revenues and expenses reported during the period. Actual results could differ
from those estimates.
Dependence on Certain Suppliers - The mesh frameworks used by the Company in its
therapeutic products are sourced from single manufacturers. Any significant
supply interruption would adversely affect the Company's product manufacturing.
In addition, an uncorrected impurity or supplier's variation in a raw material,
either unknown to the Company or incompatible with the Company's manufacturing
process, could have a material adverse effect on the Company's ability to
manufacture its products.
Reclassification - Certain reclassifications have been made to prior year
amounts to conform to the presentation for the year ended December 31, 1998.
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Cash Equivalents and Short-term Investments - In addition to investments in
money market funds, cash equivalents consist primarily of investments in
commercial paper and obligations issued or guaranteed by the United States
Government with maturities of three months or less at the date of acquisition.
Cash equivalents were approximately $14,509,000 and $15,064,000 as of December
31, 1998 and 1997, respectively. Short-term investments are valued on the basis
of quoted market value and consist primarily of investments in commercial paper
and obligations issued or guaranteed by the United States Government with
maturities of one year or less but more than three months at the date of
acquisition. Cash equivalents and short-term investments are stated at
amortized cost, which approximates market value. As of December 31, 1998 and
1997, the Company's cash equivalents and short-term investments were classified
as available-for-sale and consisted of (in thousands):
1998 1997
-------- --------
Debt securities of U.S. Government agencies $ 6,503 $ 2,002
United States treasury bills -- 1,984
Commercial paper 5,578 --
Money market funds 8,931 13,078
-------- --------
Total cash equivalents and short-term
investments $ 21,012 $ 17,064
======== ========
F-13
<PAGE>
These investments all mature in less than one year. There were no significant
unrealized or realized gains or losses related to such securities during the
years ended December 31, 1998 or 1997. Cash and cash equivalents include
$2,145,000 and $1,878,000, respectively, as of December 31, 1998 and 1997 held
by DermEquip. Such funds are available to support the operations of DermEquip.
In January 1999, the Company received $15 million from Smith & Nephew, through
the Dermagraft Joint Venture, in conjunction with the expansion of the
Dermagraft Joint Venture (see Note 18).
Inventory - Inventories are stated at the lower of cost, principally standard
costs which approximate actual costs on a first-in, first-out basis, or market.
Property is recorded at cost and is depreciated using estimated useful lives
which range from 3 to 10 years. For financial statement purposes, depreciation
is generally computed using the straight-line method. For tax purposes,
depreciation is generally computed by accelerated methods on allowable useful
lives. Amortization of capitalized leases is included with depreciation
expense. Costs related to the validation of new manufacturing facilities and
equipment are capitalized prior to the assets being placed in service. In
addition, interest is capitalized related to the construction of such assets.
Such costs and capitalized interest are amortized over the estimated useful
lives of the related assets. During 1997, $444,000 of interest expense was
capitalized. No interest was capitalized in 1998 or 1996. Depreciation expense
for the years ended December 31, 1998, 1997 and 1996 amounted to approximately
$4,710,000, $2,077,000 and $1,739,000, respectively.
Patents - The Company owns and has patents pending in the United States and
abroad to protect the processes and products being developed by the Company.
Direct patent application and maintenance costs related to patents issued are
amortized over the estimated useful life of the patent, approximately 17 years.
Such costs related to pending applications are deferred until the patent is
issued or charged to operations at the time a determination is made not to
pursue an application. Patents are presented net of accumulated amortization of
approximately $259,000 and $213,000 as of December 31, 1998 and 1997,
respectively. Patent application and maintenance costs related to licensing
agreements are expensed as incurred.
Industry Segment and Geographic Information - The Company operates in a single
industry segment - the development and commercialization of human-based tissue
products for tissue repair and transplantation. Export sales of the Company's
laboratory testing kits (see Note 4), principally to Europe and Asia, totaled
approximately $621,000 in the year ended December 31, 1996. During the years
ended December 31, 1997 and 1998, international sales have been through the
Dermagraft Joint Venture (see Note 3). The Company has no foreign operations.
Revenue Recognition - Revenues from product sales to third parties are
recognized when products are shipped. Revenues from product sales to related
parties (see Note 3) are recognized at such time as the related party is
contractually obligated to purchase the product, generally upon the completion
of manufacture. Such product sales to the Dermagraft Joint Venture are equal to
the Company's cost. Revenues under collaborative research agreements are
recognized as costs are incurred over the related period of the agreement.
Revenues from government grants are recognized based on the performance
requirements of the grant or as the grant expenditures are incurred. Expenses
related to such agreements and grants are classified as research and development
expenses.
Research and Development Costs are expensed as incurred. Such costs include
proprietary research and development activities and expenses associated with
collaborative research agreements.
Basic and Diluted Loss Per Common Share - Financial Accounting Standards Board
Statement No. 128, "Earnings Per Share," ("FAS No. 128") prescribes the method
used to calculate basic and diluted earnings per share. Basic earnings per
share are determined based on the weighted average number of shares outstanding
during the period. Diluted earnings per share include the weighted average
number of shares outstanding and give effect to potentially dilutive common
shares such as options and warrants outstanding.
F-14
<PAGE>
Both the basic and diluted loss per common share for the years ended December
31, 1998, 1997 and 1996 are based on the weighted average number of shares of
Common Stock outstanding during the periods. Potentially dilutive securities
include options and warrants outstanding (see Notes 12 and 14) and debt and
convertible preferred stock (see Notes 8, 12 and 13); however, such securities
have not been included in the calculation of the diluted loss per share as
their effect is antidilutive. Since such securities are antidilutive, there
is no difference between basic and diluted loss per share for any of the
periods presented. The net loss applicable to common shares used in the
calculation of basic and diluted loss per common share for the year ended
December 31, 1998 includes dividends of $578,000 accrued on the Company's
Convertible Series B Preferred Stock during such period.
Stock Options - As permitted under Financial Accounting Standards Board
Statement No. 123, "Accounting for Stock-Based Compensation" ("FAS No. 123"),
the Company follows Accounting Principles Board (APB) Opinion No. 25,
"Accounting for Stock Issued to Employees," in accounting for outstanding stock
options and warrants. Under APB Opinion No. 25, compensation expense relating
to employee stock options is determined based on the excess of the market price
of the Company's stock over the exercise price on the date of grant and does not
require the recognition of compensation expense for stock issued under plans
defined as noncompensatory. Adoption of FAS No. 123 requires recognition of
compensation expense for virtually all options based on their computed "fair
value" on the date of grant. See Note 14.
New Accounting Standards - In June 1997, the Financial Accounting Standards
Boards issued Financial Accounting Standards No. 130, "Reporting Comprehensive
Income" ("FAS No. 130") and No. 131, "Segment Information" ("FAS No. 131).
Both of these standards are effective for fiscal years beginning after
December 15, 1997 and have been adopted by the Company. FAS No. 130 requires
that all components of comprehensive income, including net income, be reported
in the financial statements in the period in which they are recognized.
Comprehensive income is defined as the change in equity during a period from
transactions and other events and circumstances from non-owner sources. Net
income and other comprehensive income, including foreign currency translation
adjustments, and unrealized gains and losses on investments, shall be reported,
net of their related tax effect, to arrive at comprehensive income. The
Company's comprehensive loss is not materially different than net loss for
the periods presented. FAS No. 131 amends the requirements for public
enterprises to report financial and descriptive information about its reportable
operating segments. Operating segments as defined in FAS No. 131, are
components of an enterprise for which separate financial information is
available and is evaluated regularly by the Company in deciding how to allocate
resources and in assessing performance. The financial information is required
to be reported on the basis that is used internally for evaluating the segment
performance. As stated above, the Company believes it currently operates in
one business and operating segment and that the adoption of this standard does
not have a material impact on the Company's financial statements.
NOTE 3 - STRATEGIC ALLIANCES
In April 1996, the Company entered into an agreement with Smith & Nephew to form
a joint venture for the worldwide commercialization of Dermagraft(R), the
Company's tissue-engineered dermal skin replacement, for the treatment of
diabetic foot ulcers (the "Dermagraft Joint Venture"). In January 1998, the
Company and Smith & Nephew expanded the Dermagraft Joint Venture to include
venous ulcers, pressure ulcers, burns and other skin tissue wounds. At that
time, the Company retained the exclusive right to market TransCyte(TM)
(formerly Dermagraft-TC(R)), a temporary covering for full and partial-
thickness burns, in the United States, while the Dermagraft Joint Venture was
granted the right to market TransCyte for other skin wounds in the United
States. In August 1998, the Company and Smith & Nephew further expanded the
Dermagraft Joint Venture to include exclusive rights to TransCyte for full
and partial-thickness burns in the United States effective October 1998.
Smith & Nephew is a worldwide healthcare company with extensive sales and
distribution capabilities. It manufactures a wide range of tissue repair
products, principally addressing the areas of bone, joints, skin and other
soft tissue.
As consideration for entering into the Dermagraft Joint Venture, Advanced Tissue
Sciences received a $10 million up front fee in 1996. In addition, as a part of
the agreement to expand the joint venture, Smith & Nephew purchased $20 million,
or 1,533,115 newly-issued shares, of the Company's Common Stock at approximately
$13.05 per share in January 1998 (see Note 12). The Company also received an
additional $15 million in January
F-15
<PAGE>
1999, and could receive, subject to the achievement of certain milestones
related to regulatory approvals, reimbursement and sales levels, further
payments of up to $136 million. In the expanded joint venture, the Company
and Smith & Nephew share equally in the expenses and revenues of the
Dermagraft Joint Venture, except the Company will fund the first $6 million
of expenses for conducting clinical trials and for regulatory support of
Dermagraft and TransCyte in the treatment of venous and pressure ulcers. In
addition, the Company will fund certain manufacturing and distribution costs and
certain costs related to post-market studies of TransCyte through December 1999.
However, such manufacturing and distribution costs are to be returned to the
Company out of future gross margin or net profits, if any, from sales of
TransCyte for burns in the United States.
During 1997, the Company and Smith & Nephew shared equally in the expenses
and revenues of the joint venture. See Note 17 with respect to related
party transactions with the Dermagraft Joint Venture. Under the expanded
joint venture, the Company will continue to manufacture and Smith & Nephew
will continue to market and sell the joint venture's products.
In 1994, Smith & Nephew and the Company entered into a separate joint venture
for the development of tissue-engineered cartilage for orthopedic applications
(the "Cartilage Joint Venture"). Under the Cartilage Joint Venture, Smith &
Nephew contributed the first $10 million in funding and the Company contributed
certain technology licenses. The Cartilage Joint Venture's total funding since
inception reached $10 million in January 1997 and, as provided in the joint
venture agreement, the Company and Smith & Nephew began sharing equally in
Cartilage Joint Venture revenues and expenditures. See Note 17 with respect
to related party transactions with the Cartilage Joint Venture.
The results of operations of the joint ventures for the years ended December 31,
1998, 1997 and 1996 are as follows (in thousands):
1998 1997 1996
-------- -------- --------
Dermagraft Joint Venture
- ------------------------
Net sales $ 632 $ 36 $ --
Cost of goods sold 10,054 824 --
Other costs and expenses 20,874 17,052 10,000
Net loss (30,296) (17,840) (10,000)
Current assets 3,296 373 --
Non-current assets 237 304 --
Current liabilities 2,767 3,737 --
Partners' capital 766 (3,060) --
Cartilage Joint Venture
- -----------------------
Costs and expenses $ 4,468 $ 7,150 $ 6,889
Net loss (4,468) (7,150) (6,889)
Current assets 55 79 82
Non-current assets 400 591 717
Current liabilities 338 535 1,554
Partners' capital 117 135 (755)
NOTE 4 - IN VITRO LABORATORY TESTING BUSINESS
In October 1996, the Company closed its In Vitro Laboratory Testing ("IVLT")
business to focus all of its resources on its therapeutic programs. Although
the Company was a leader in the in vitro testing business and continuously
broadened applications of it products, the market for in vitro laboratory
testing products was evolving too slowly for the Company to continue to devote
its resources to this business. The statement of operations for the year ended
December 31, 1996 includes charges of approximately $1.0 million for costs
associated with the closure of the IVLT business (substantially all of which are
reflected in selling, general and administrative expenses). Exclusive of these
charges, costs associated with operations of the IVLT business were $2,528,000
for the year ended December 31, 1996.
F-16
<PAGE>
NOTE 5 - INVENTORIES
Inventories consist of the following components as of December 31, 1998 and 1997
(in thousands):
1998 1997
-------- --------
Raw materials and supplies $ 2,965 $ 3,295
Work-in-process 399 347
Finished goods -- 1,001
-------- --------
$ 3,364 $ 4,643
======== ========
NOTE 6 - PROPERTY
The major classes of property as of December 31, 1998 and 1997 are as follows
(in thousands):
1998 1997
-------- --------
Equipment $ 20,992 $ 11,645
Furniture and fixtures 622 586
Leasehold improvements 10,754 6,254
Equipment under capital leases 110 110
Construction in progress 87 12,689
-------- --------
32,565 31,284
Less accumulated depreciation
and amortization (11,941) (8,094)
-------- --------
Net property $ 20,624 $ 23,190
======== ========
Construction in progress in 1997 primarily relates to an expansion of the
Company's manufacturing facilities and related process equipment that was placed
in service in January 1998.
NOTE 7 - ACCRUED EXPENSES
Accrued expenses as of December 31, 1998 and 1997 consisted of (in thousands):
1998 1997
-------- --------
Salaries and benefits $ 2,083 $ 2,606
Dermagraft Joint Venture 1,316 683
Sponsored research 401 1,562
Clinical studies 57 667
Other 948 1,493
-------- --------
$ 4,805 $ 7,011
======== ========
NOTE 8 - LONG-TERM DEBT
In August 1997, DermEquip entered into a term loan agreement with The Chase
Manhattan Bank to borrow up to $16 million (the "Chase Loan") through June 1998.
During the first half of 1998, DermEquip completed drawdowns under the loan
agreement to a total of $16 million. Principal is payable in equal quarterly
installments from June 1998 through June 2004. The Chase Loan bears interest
payable quarterly at the 90-day London Interbank Offered Rate ("LIBOR") plus
1/4 percent (5.56% at December 31, 1998). DermEquip's obligations with
respect to the Chase Loan are jointly and severally guaranteed by Smith &
Nephew and the Company. The guaranties are secured by DermEquip's assets,
having a carrying value of $14,485,000 as of December 31, 1998, and by each
company's interest in DermEquip.
F-17
<PAGE>
In March 1997, the Company borrowed $10 million from Smith & Nephew pursuant to
a commitment as a part of the agreement to form the Dermagraft Joint Venture
(see Note 3). The loan is unsecured and bears interest at 90-day LIBOR plus 4%
(9.31% at December 31, 1998)and is due on the earlier of (i) March 2000 or (ii)
the date on which the Company no longer has an ownership interest in the
Dermagraft Joint Venture. At the option of the Company, the loan may be paid in
cash or Common Stock valued at the then current fair market value.
Through December 1998, the Company has borrowed $5.7 million from Smith & Nephew
pursuant to a commitment as a part of the agreement to form the Cartilage Joint
Venture (see Note 3). Under the terms of that joint venture agreement, the
Company may borrow up to a total of $10 million. The loan is unsecured and
bears interest at 90-day LIBOR plus 4% (9.31% at December 31, 1998) and is due
on the earlier of (i) June 2000 or (ii) the date on which the Company no longer
has an ownership interest in the Cartilage Joint Venture.
Debt and capital lease obligations as of December 31, 1998 and 1997 were as
follows (in thousands):
1998 1997
-------- --------
Chase Loan $ 14,080 $ 14,600
Smith & Nephew notes:
Dermagraft Joint Venture 10,000 10,000
Cartilage Joint Venture 5,685 3,400
Obligations under capital leases
and other 184 96
Less current portion (2,689) (1,939)
-------- --------
$ 27,260 $ 26,157
======== ========
Maturities of long-term debt and capital lease obligations over the next five
years are $2,689,000 in 1999, $18,272,000 in 2000, $2,588,000 in 2001,
$2,560,000 in 2002, $2,560,000 in 2003 and $1,280,000 thereafter. As
substantially all of the Company's debt carries interest at variable rates, the
fair market value of such instruments is estimated to approximate their carrying
value.
NOTE 9 - LEASE COMMITMENTS
Operating lease commitments relate primarily to the Company's manufacturing,
research and administrative facilities. The leases for the Company's primary
facility, which include manufacturing, research and administrative facilities,
expire in September 2000; however, these leases include an option to extend the
term for an additional five years. These leases include the cost of some of the
utilities and certain services, and provide for annual rental increases ranging
from a minimum of 3% to a maximum of 7% based on changes in the Consumer Price
Index.
The Company also leases two other facilities for manufacturing, research and
administration. One lease has a two-year term which expired in July 1998;
however, the Company has exercised its option to extend the term of the lease
for six months and has been leasing the space on a month-to-month basis since
January 1999. The lease includes the operating costs for the facility and
provides for a 4% annual rent increase. The other lease has a five-year term
and expires in January 2002. The lease provides that the Company will pay rent,
which increases 4% annually, as well as the operating costs of the leased
facility.
In October 1997, the Company entered into a 15-year lease agreement for
additional research and administrative space. The facility was completed and
the lease began in the fourth quarter of 1998. The lease provides for a 4%
annual rent increase during the first five years, 3% during the second five
years and 2.5% during the final five years. Under the lease, the Company will
also be responsible for all operating costs. The Company also has options to
extend the term of the lease for two five-year periods. In December 1998, the
Company completed the financing of $1.5 million of office and laboratory
furniture and equipment for the new research and administrative facility under
three operating leases with terms ranging from three to four years.
F-18
<PAGE>
The following is a summary of the annual future minimum lease commitments as
of December 31, 1998 (in thousands):
CAPITAL OPERATING
LEASES LEASES
--------- -----------
Year Ending December 31:
1999 $ 36 $ 5,806
2000 36 5,615
2001 30 4,212
2002 -- 3,960
2003 -- 3,630
Thereafter -- 41,063
--------- ----------
Total minimum lease payments 102 $ 64,286
==========
Less amount representing interest (25)
---------
Present value of net minimum lease payments $ 77
=========
Rental expense charged to operations under operating leases for facilities and
equipment for the years ended December 31, 1998, 1997 and 1996 amounted to
approximately $4,219,000, $3,412,000 and $2,778,000, respectively.
NOTE 10 - COMMITMENTS AND CONTINGENCIES
Under agreements with several universities, the Company has entered into
commitments to sponsor research for a minimum of $1.0 million in 1999. In
addition, in 1997, the Company was awarded a $2 million grant by the
National Institute of Standards and Technology under their Advanced Technology
program to support the development of tissue-engineered vascular grafts over a
three-year period beginning in 1998. The grant requires the Company to meet
certain minimum levels of program funding in order to receive the grant
funding. In addition, the second and third years of funding will be
contingent on the availability of funds from Congress, subject to satisfactory
performance by the Company and at the sole discretion of the National
Institute of Standards and Technology.
The Company is also responsible for patent application costs and associated
maintenance fees related to inventions under certain licensing agreements. The
Company seeks to protect its proprietary technology through the use of various
aspects of United States and foreign patent law and contractual arrangements.
However, there can be no assurance that the Company's patents or patent
applications will afford protection against competitors with similar technology,
nor can there be any assurance that the Company's present patents will not be
infringed upon or designed around by others. Substantial costs could be
incurred to protect against infringement or defend the Company's patents and
licensed patents.
Under the terms of its joint venture agreements, the Company has agreed to fund
its share of the costs of the Dermagraft and Cartilage Joint Ventures. See Note
3.
NOTE 11 - LEGAL PROCEEDINGS
Since June 1998, several lawsuits have been filed in the United States District
Court for the Southern District of California against the Company and two of its
officers. The lawsuits allege violations of the federal securities laws arising
out of alleged misstatements and alleged failures to disclose certain material
facts concerning the clinical trials and obtaining United States Food and Drug
Administration approval of Dermagraft for the treatment of diabetic foot ulcers.
The lawsuits purport to seek damages on behalf of a class of shareholders who
purchased Advanced Tissue Sciences, Inc. Common Stock during the period
generally from January 13, 1997 through June 11, 1998. The complaints in the
lawsuits do not specify an amount of claimed damages. The Company believes
that the lawsuits are without merit and intends to defend against them
vigorously. In addition, the Company believes the ultimate resolution will
not have a material adverse effect on the Company's financial condition,
results of operations or liquidity. However, there can be no assurance that
an adverse result would not have a material adverse effect on the Company.
F-19
<PAGE>
NOTE 12 - CAPITAL STOCK
As of December 31, 1998, the Company had 49,973,115 shares of Common Stock
reserved for issuance under options and warrants, and for the conversion of and
the payment of dividends on the Company's Convertible Series B Preferred Stock.
In January 1995, the Company adopted a Shareholder Rights Plan and pursuant
thereto issued one preferred share purchase right ("Right") on each outstanding
share of Common Stock. The Rights are exercisable only if a person or group
acquires, or makes a tender offer to acquire, 15% or more of the Company's
Common Stock. In connection with the adoption of the Shareholder Rights Plan,
the Company's Board of Directors designated and reserved 500,000 shares of the
Company's authorized Preferred Stock as Series A Junior Participating Preferred
Stock, par value $.01 per share (the "Series A Preferred Stock"). The Rights
have no voting privileges and expire on January 6, 2005.
When exercisable, each Right entitles its holder to buy one-hundredth of a share
of the Series A Preferred Stock at an exercise price of $55, subject to certain
antidilution adjustments. In addition, if at any time after the Rights become
exercisable, should (i) the Company be acquired in a merger or other business
combination transaction, or sell 50% or more of its consolidated assets or
earnings power, each Right will entitle its holder to purchase a number of the
acquiring company's common shares having a market value at the time of twice the
Right's exercise price or (ii) a person or group acquire 15% or more of the
Company's outstanding Common Stock, each Right will entitle its holder, other
than the acquirer, to purchase, at the Right's then-current exercise price, a
number of shares of the Company's Common Stock having a market value of twice
the Right's exercise price. The rights are redeemable for one cent per Right at
any time up to and including ten days after the acquisition of 15% of the then
outstanding Common Stock.
In July 1998, the Company raised $25 million through a private placement of
Convertible Series B Preferred Stock (the "Series B Preferred Stock") to a group
of investors (the "Investors"). Subject to adjustment in certain events, the
Series B Preferred Stock is convertible into Common Stock of the Company at
$4.77 per share (the "Conversion Price"). The Conversion Price will be
increased by one-half the amount by which the market price of the Common Stock
on the date of conversion exceeds $7.96 per share, if any. Conversely, should
the average daily trading price (as defined in the agreements) prior to a
conversion be equal to or below $3.58 per share, the Conversion Price will be
equal to such average daily trading price. The Series B Preferred Stock accrues
dividends at 5% per annum. Dividends are payable quarterly in Common Stock or
cash at the option of the Company beginning in the first quarter of 1999. To
the extent not previously converted, the Series B Preferred Stock is, at the
election of the Company, redeemable at $50,000 per share plus accrued dividends
or convertible into Common Stock three years from the date of issuance subject
to extension in certain circumstances. Twenty percent of the Series B
Preferred Stock is redeemable at the option of the holders on the occurrence
of certain events (see Note 13). During 1998, fifty shares of the Series B
Preferred Stock were converted into 1,012,394 shares of Common Stock at an
average price of $2.47 per share. See Note 18 with respect to conversions of
Series B Preferred Stock subsequent to the end of 1998.
In connection with an expansion of the Dermagraft Joint Venture, Smith & Nephew
purchased $20 million, or 1,533,115 newly-issued shares, of the Company's Common
Stock in January 1998 at approximately $13.05 per share. Smith & Nephew has the
right to request registration of the shares.
In February 1998, the Company extended an investment agreement (the "Investment
Agreement") with an investment group for an equity line which allows the Company
to access up to $50 million through sales of its Common Stock. In connection
with the extension, the Company granted the investment group a warrant to
purchase 50,000 shares of Common Stock at an exercise price of $14.00 per share.
In July 1998, the Investment Agreement was further extended, subject to certain
minimum requirements, to February 2000 at no cost to the Company. Any decision
to draw any funds under the Investment Agreement and the timing of any such draw
are solely at the Company's discretion.
F-20
<PAGE>
The Investment Agreement provides that the Company can obtain up to $15 million
at any one time through the sale of Common Stock. Any sales against the equity
line will be at a five percent discount to the average low sales prices of the
Company's Common Stock over a specified period of time as determined by market
volume at the time of the draw. The Company's ability to draw under the
Investment Agreement is subject to certain conditions including, but not
limited to, registration of the shares, a minimum trading price of $2.00 per
share, and certain limitations on the number of shares of Common Stock held
by the investment group at any point in time.
NOTE 13 - REDEEMABLE PREFERRED STOCK
Twenty percent of the Series B Preferred Stock issued in the July 1998 private
placement of $25 million of series preferred stock is classified as redeemable.
These shares of the Series B Preferred Stock are redeemable at 125% of
liquidation value at the option of the holders upon the occurrence of certain
events such as a change in control or suspension or delisting from The Nasdaq
National Market, or at the Conversion Price plus accrued dividends on a
failure to have adequate shares authorized, registered and available for
conversion of such preferred stock. Accordingly, $5 million of the Series B
Preferred Stock has been reflected as redeemable preferred stock in the
accompanying balance sheet. See Note 12 for additional terms of the Series B
Preferred Stock.
NOTE 14 - EMPLOYEE BENEFIT PLANS
The Company's Stock Incentive Plan (the "1997 Plan") provides for the grant of
incentive stock options, non-qualified stock options and stock issuances to
employees and consultants and automatic 50,000-share grants to non-employee
directors, currently to a maximum of 7,450,000 shares of Common Stock. At
December 31, 1998, a total of 6,092,826 shares were outstanding under options or
available for grant under the 1997 Plan. The Company has elected to continue to
account for its employee stock option plans under APB Opinion No. 25 rather than
adopt FAS No. 123 (see Note 2).
Under the 1997 Plan, all employees are granted stock options on their date of
employment and on promotion. The number of shares granted is based on the
employee's position and responsibilities. The options granted generally become
exercisable in equal annual amounts over five years. The options generally have
a term of ten years as long as the employee remains in the service of the
Company. The Company also began to make annual grants to employees in 1997.
Non-employee directors receive an automatic grant of 50,000 shares upon joining
the Board and generally every third year thereafter. These options generally
are immediately exercisable, become vested in equal annual amounts over three
years and have a term of ten years assuming continued service on the Company's
Board of Directors.
In August 1998, the Board of Directors approved a plan whereby each employee
option holder under the 1997 Plan, excluding officers and directors of the
Company, could exchange all of their current vested and unvested options with an
exercise price in excess of $7.00 per share for new options priced at market
value as of August 6, 1998. Specifically, existing options with exercise prices
between $7.01 and $11.00 per share were exchangeable three shares for two and
existing options priced above $11.00 were exchangeable two shares for one. A
total of 649,210 existing option shares at an average price of $12.68 were
exchanged for 360,534 replacement option shares with an exercise price of $3.34.
These replacement options vest on the same basis as the replaced options but
require that the employee continue their employment with the Company for a
minimum of one year from the date of grant in order for any of the shares to
vest. The replacement options are included as both grants and cancellations in
the stock option activity table shown below.
In addition to the 1997 Plan, the Company has issued options and warrants to
directors, consultants, employees and others as compensation for services.
These options vest and are exercisable over a variety of periods as determined
by the Company's Board of Directors.
F-21
<PAGE>
The following table summarizes activity under the 1997 Plan and for other
options and warrants for Common Stock for the years ended December 31, 1998,
1997 and 1996:
<TABLE>
<CAPTION>
1997 Plan Other Options and Warrants
-------------------------- ----------------------------
Weighted Weighted
Number Average Price Number Average Price
of Shares Per Share of Shares Per Share
----------- -------------- ----------- ---------------
<S> <C> <C> <C> <C>
Outstanding, December 31, 1995 2,317,515 $6.28 1,460,299 $6.81
Granted 1,660,450 $14.05 275,000 $10.50
Exercised (99,290) $8.87 (265,659) $8.61
Canceled (104,974) $8.10 -- --
---------- ----------
Outstanding, December 31, 1996 3,773,701 $9.58 1,469,640 $7.18
Granted 691,885 $13.82 -- --
Exercised (189,306) $8.75 (10,000) $1.69
Canceled (161,130) $11.48 -- --
---------- ----------
Outstanding, December 31, 1997 4,115,150 $10.26 1,459,640 $7.21
Granted 1,075,529 $6.23 50,000 $14.00
Exercised (117,075) $7.28 -- --
Canceled (1,175,882) $12.31 -- --
---------- ----------
Outstanding, December 31, 1998 3,897,722 $8.62 1,509,640 $7.44
========== ==========
</TABLE>
The weighted average fair value of options granted was $4.47, $10.09, and $9.60
under the 1997 Plan in 1998, 1997, and 1996, respectively, and $9.71 and $5.00
for other options and warrants in 1998 and 1996, respectively. The number of
shares exercisable under the 1997 Plan at December 31, 1998, 1997 and 1996 were
2,104,429, 2,083,170 and 1,713,872, respectively, with a weighted average price
per share of $7.81, $7.09 and $5.52, respectively. All of the shares
reflected as outstanding under other options and warrants granted were
exercisable as of December 31, 1998, 1997 and 1996 at the weighted average
price per share shown above.
Included in other options and warrants granted are warrants issued to an
investment group during 1998 and 1996, which are exercisable for 50,000 and
175,000 shares of Common Stock at an exercise price of $14.00 and $10.50
per share, respectively. These warrants were issued as a commitment fee
on the equity line (see Note 12). During the years ended December 31, 1998,
1997 and 1996, $430,000, $438,000 and $390,000, respectively, were charged
to expense reflecting the amortization of the fair market value of these
warrants over the commitment period. In addition, the Company charged
$588,000 and $586,000 to expense in 1998 and 1996, respectively, in
connection with options or warrants granted to employees and consultants.
F-22
<PAGE>
The following table summarizes by price ranges the number of shares, weighted
average exercise price and weighted average remaining life (in years) of options
and warrants exercisable and outstanding as of December 31, 1998.
<TABLE>
<CAPTION>
Exercisable Total Outstanding
------------------------------- -----------------------------------
Number of Weighted Average Number of Weighted Average
----------------------
Price Range Shares Exercise Price Shares Exercise Price Life
- ----------------- ----------- ------------------ --------- ----------------- ----
<S> <C> <C> <C> <C> <C>
1997 Plan:
$1.69 775,000 $1.69 775,000 $1.69 0.5
$1.96 - 3.93 51,540 $3.55 643,242 $3.26 7.3
$3.94 - 5.89 103,690 $5.51 113,410 $5.52 4.7
$5.90 - 7.85 30,125 $7.54 119,400 $6.91 8.3
$7.86 - 9.81 245,535 $8.67 362,775 $8.66 5.7
$9.82 - 11.78 220,239 $10.89 259,900 $10.93 6.0
$11.79 - 13.74 506,427 $13.35 1,292,670 $13.36 7.2
$13.75 - 15.70 46,054 $14.76 78,275 $14.71 6.9
$15.71 - 17.66 125,819 $17.30 253,050 $17.11 7.7
---------- ---------
Total 1997 Plan 2,104,429 $7.81 3,897,722 $8.62 5.7
========== =========
Other Options and Warrants:
$1.47 - 1.67 300,000 $1.57 300,000 $1.57 4.5
$4.50 10,000 $4.50 10,000 $4.50 1.7
$8.11 - 10.50 1,149,640 $8.71 1,149,640 $8.71 2.7
$14.00 50,000 $14.00 50,000 $14.00 6.1
---------- ---------
Total Other 1,509,640 $7.44 1,509,640 $7.44 3.1
========== =========
</TABLE>
The following table reflects the Company's pro forma net loss applicable to
common stock and basic and diluted loss per common share for the years ended
December 31, 1998, 1997 and 1996 had the expense provisions of FAS No. 123 been
implemented (in thousands except per share amounts):
1998 1997 1996
---------- ---------- ----------
Net loss applicable to common stock:
As reported $ (43,863) $ (36,089) $ (22,401)
Pro forma (51,040) (43,224) (27,971)
Basic and diluted loss per share:
As reported $ (1.11) $ (.96) $ (.61)
Pro forma (1.30) (1.15) (.77)
Because the Statement 123 method of accounting has not been applied to options
granted prior to January 1, 1995, the above pro forma information may not be
representative of that to be expected in future years.
The fair value of each option grant has been estimated on the date of grant
using the Black-Scholes option pricing model. The following weighted average
assumptions were used for grants made under the 1997 Plan in 1998, 1997 and
1996: (i) risk-free interest rates of 3.97% to 5.60% for 1998, 6.1% to 6.7% for
1997 and 5.3% for 1996; (ii) expected lives of one year to eight years for 1998,
four to nine years for 1997 and seven years for 1996; and (iii) volatility of
69% to 100% for 1998, 63% to 64% for 1997 and 64% for 1996. It is assumed that
no dividends are paid on the stock in all the Black-Scholes option pricing model
estimates. The estimated value of warrants issued in 1998 and 1996 for services
were based on the value of the services rendered.
The Company has a 401(k) Plan (the "401(k) Plan") under which employees meeting
certain eligibility requirements may elect to participate and contribute to the
401(k) Plan. Under the 401(k) Plan, the Company may elect to match a
discretionary percentage of contributions. No such matching contributions have
been made to the 401(k) Plan since its inception.
F-23
<PAGE>
NOTE 15 - INCOME TAXES
The Company has federal and California net operating loss carryforwards of
approximately $200 million and $34 million, respectively, as of December 31,
1998. The difference between the federal and California operating tax loss
carryforwards principally results from a fifty percent limitation on California
loss carryforwards, the Company not having operations in California until late
1989 and the capitalization of certain research and development expenses for
California purposes. As of December 31, 1998, the Company also has federal and
California research and development tax credit carryforwards of approximately
$5.4 million and $2.1 million, respectively, and has California manufacturer's
investment tax credit carryforwards of approximately $559,000. The federal net
operating loss and research and development tax credit carryforwards will begin
expiring in 2000 and 2001, respectively, and the California research and
development tax credit carryforwards and the California manufacturer's
investment tax credit carryforwards will begin expiring in 2004, unless
previously utilized. California net operating loss carryforwards of
approximately $5 million expired in 1998, and $5 million and $4 million will
expire in 1999 and 2000, respectively, if not previously utilized.
Utilization of future net operating loss carryforwards could be limited if
certain cumulative changes in the Company's ownership were to occur. Included
in the federal net operating loss carryforwards, and subject to an annual
limitation, are approximately $5 million of losses related to an acquisition.
Net deferred tax assets have been completely offset by a valuation allowance as
realization of the deferred tax assets is uncertain. During the year ended
December 31, 1998, the valuation allowance increased by $12,609,000.
Significant components of the Company's net deferred tax assets as of December
31, 1998 and 1997 are as follows (in thousands):
1998 1997
---------- ----------
Deferred tax assets:
Net operating loss carryforwards $ 72,085 $ 60,920
Tax credit carryforwards 7,156 6,303
Capitalized research and development 4,905 4,472
Other 1,529 1,198
---------- ----------
Total deferred tax assets 85,675 72,893
---------- ----------
Deferred tax liabilities:
Patent expense (830) (657)
---------- ----------
Total deferred tax liability (830) (657)
---------- ----------
Net deferred tax assets before
valuation allowance 84,845 72,236
Valuation allowance (84,845) (72,236)
---------- ----------
Net deferred tax assets $ -- $ --
========== ==========
Approximately $7 million of the valuation allowance for deferred tax assets
relates to benefits of stock option deductions which, when and if recognized,
will be allocated directly to additional paid-in capital.
NOTE 16 - SUPPLEMENTAL CASH FLOW INFORMATION
The following summarizes the significant non-cash investing and financing
activities of the Company and provides other supplemental cash flow information.
During 1998, non-cash financing activities included the issuance of warrants
exercisable for Common Stock as a commitment fee with a value of $418,000
representing the amount of the fee as negotiated between the parties. Non-
cash financing and investing activities during the year ended December 31,
1997 included the financing of $50,000 of equipment through capital leases.
During the year ended December 31, 1996, non-cash financing and investing
activities included the issuance of warrants exercisable for Common Stock as
a commitment fee and for consulting services, and the financing of $60,000 of
equipment through a capital lease. The commitment fee of 1.75% of the equity
line (see Note 12), or $875,000, was negotiated between the Company and the
investment group providing the equity line and represents the estimated fair
value of the warrant. The warrant granted for consulting services has been
valued at an estimated fair market value of $500,000 representing the
estimated fair
F-24
<PAGE>
market value of the services to be provided as negotiated between the parties.
The value of the warrants was amortized over the commitment period and over
the period the services were provided. Other non-cash activities have
involved the issuance of compensatory stock options to employees and
consultants (see Note 14).
Net cash from operating activities reflects cash payments for interest expense
of approximately $1,368,000, $868,000, $6,000 for the years ended December 31,
1998, 1997 and 1996, respectively.
NOTE 17 - RELATED PARTY TRANSACTIONS
During the years ended December 31, 1998, 1997 and 1996, the Company has
performed services for its Dermagraft and Cartilage Joint Ventures and has
manufactured products for the Dermagraft Joint Venture to sell to customers
or for use in clinical trials as described below (see Note 3). The Company
has a fifty percent interest in each of the Dermagraft and Cartilage Joint
Ventures.
Dermagraft Joint Venture
- ------------------------
During the years ended December 31, 1998 and 1997, the Company recognized
$5,598,000 and $7,041,000, respectively, in contract revenues for research
and development, marketing and other activities performed for the Dermagraft
Joint Venture. In addition, during the years ended December 31, 1998 and
1997, product sales to related parties include products sold to the
Dermagraft Joint Venture of $10,927,000 and $1,190,000, respectively.
As a purpose of the Dermagraft Joint Venture is to share the costs of
manufacturing and commercializing the Company's Dermagraft and TransCyte
products between the joint venture's partners, product sales to the
Dermagraft Joint Venture are equal to the Company's cost of goods sold for
such products including period costs (except for the period from January 1,
1997 to September 30, 1998 when the Company also sold TransCyte in the
United States and, therefore, absorbed period costs related to TransCyte).
Period costs reflect overhead costs related to excess production capacity
and include rent, depreciation, and quality control, facilities, supplies and
other such costs to support or related to the excess production capacity. Due
to costs related to excess production capacity, the Dermagraft Joint Venture
immediately writes the inventory down to estimated market value at the date
of purchase, which is the net realizable value at which the joint venture
believes it will be able to sell the products to its customers. During the
years ended December 31, 1998 and 1997, such write downs by the Dermagraft
Joint Venture totaled $8,267,000 and $491,000, respectively. To the extent
the Company does not sell such products to the Dermagraft Joint Venture, it
will be required to write such inventories down to net realizable value.
Cartilage Joint Venture
- -----------------------
During the years ended December 31, 1998, 1997 and 1996, the Company recognized
$2,337,000, $3,934,000 and $3,564,000, respectively, in contract revenues for
research and development activities performed for the Cartilage Joint Venture.
The Company's share of the above costs incurred by the Company and charged to
the Dermagraft and Cartilage Joint Ventures are reflected in the equity in
losses of joint ventures in the accompanying statement of operations and
totaled $9,547,000, $5,899,000 and $1,782,000 in the years ended December 31,
1998, 1997 and 1996, respectively.
NOTE 18 - SUBSEQUENT EVENTS
Payment in Connection with Expansion of Strategic Alliance
In January 1999, the Company received a $15 million payment from Smith & Nephew,
through the Dermagraft Joint Venture, in connection with the 1998 expansion
of the Dermagraft Joint Venture to include venous ulcers, pressure ulcers,
burns and other skin wounds. See Note 3.
F-25
<PAGE>
Increase in Authorized Common Stock (Unaudited)
In February 1999, the Common Stockholders of Advanced Tissue Sciences, Inc,
approved an amendment to the Company's Restated Certificate of Incorporation to
increase the number of authorized shares of Common Stock from 100,000,000 shares
to 125,000,000.
Conversion of Convertible Series B Preferred Stock (Unaudited)
In February 1999, approximately 36 shares of the Company's Convertible Series
B Preferred Stock were converted into 743,005 shares of Common Stock at an
average price of $2.44 per share. See Note 12.
F-26
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Advanced Tissue Sciences, Inc.
We have audited the accompanying consolidated balance sheets of Advanced Tissue
Sciences, Inc. as of December 31, 1998 and 1997, and the related consolidated
statements of operations, stockholders' equity and cash flows for each of the
three years in the period ended December 31, 1998. These financial statements
are the responsibility of the Company's management. Our responsibility is to
express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of Advanced Tissue
Sciences, Inc. at December 31, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles.
ERNST & YOUNG LLP
San Diego, California
January 29, 1999
F-27
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED BALANCE SHEETS
(IN THOUSANDS)
<TABLE>
<CAPTION>
December 31,
----------------------
1998 1997
-------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash $ 72 $ 12
Accounts receivable from partners
and affiliates 1,538 --
Inventory 1,462 361
Other current assets 224 --
-------- --------
Total current assets 3,296 373
Property - net 237 160
Other assets -- 144
-------- --------
Total assets $ 3,533 $ 677
======== ========
LIABILITIES AND PARTNERS' CAPITAL
Current liabilities:
Payable to partners and affiliates $ 2,767 $ 3,609
Accounts payable -- 35
Accrued expenses -- 93
-------- --------
Total current liabilities 2,767 3,737
Partners' capital 766 (3,060)
-------- --------
Total liabilities and partners' capital $ 3,533 $ 677
======== ========
</TABLE>
See accompanying notes to the combined financial statements.
F-28
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED STATEMENTS OF OPERATIONS
(IN THOUSANDS)
<TABLE>
<CAPTION>
April 29, 1996
(inception) to
Year Ended December 31,
----------------------------- December 31,
1998 1997 1996
------------- -------------- ----------------
<S> <C> <C> <C>
Product sales $ 632 $ 36 $ --
------------- ------------- ---------------
Operating expenses:
Research and development 2,907 5,118 --
Selling, general and administrative 17,779 11,204 --
Cost of goods sold 10,054 824 --
------------- ------------- ---------------
Total operating expenses 30,740 17,146 --
------------- ------------- ---------------
Loss from operations (30,108) (17,110) --
Other income (expense):
Interest income 93 108 --
Interest charges from related parties (622) (454) --
License fee to related party -- -- (10,000)
Other income (expense) 341 (384) --
------------- ------------- ---------------
Net loss $ (30,296) $ (17,840) $ (10,000)
============= ============= ===============
</TABLE>
See accompanying notes to the combined financial statements.
F-29
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
<TABLE>
<CAPTION>
April 29, 1996
(inception) to
Year Ended December 31,
------------------------------ December 31,
1998 1997 1996
-------------- -------------- ----------------
<S> <C> <C> <C>
Operating activities:
Net loss $ (30,296) $ (17,840) $ (10,000)
Adjustments to reconcile net loss to cash
used in operating activities:
Depreciation 40 3 --
Other adjustments to net loss 144 6 --
Changes in assets and liabilities:
Accounts receivable from partners
and affiliates (1,538) -- --
Inventory (1,101) (361) --
Other current assets (224) -- --
Accounts payable (35) 35 --
Payable to partners and affiliates (842) 3,609 --
Accrued expenses (93) 93 --
------------- ------------- ---------------
Net cash used in operating activities (33,945) (14,455) (10,000)
------------- ------------- ---------------
Investing activities:
Acquisition of property (117) (163) --
------------- ------------- ---------------
Financing activities:
Contributions from partners 39,175 15,284 10,000
Distributions to partners (5,053) (654) --
------------- ------------- ---------------
Net cash provided by financing activities 34,122 14,630 10,000
------------- ------------- ---------------
Net increase in cash 60 12 --
Cash at beginning of period 12 -- --
------------- ------------- ---------------
Cash at end of period $ 72 $ 12 $ --
============= ============= ===============
</TABLE>
See accompanying notes to the combined financial statements.
F-30
<PAGE>
DERMAGRAFT JOINT VENTURE
COMBINED STATEMENTS OF PARTNERS' CAPITAL
(IN THOUSANDS)
<TABLE>
<CAPTION>
Advanced
Tissue Smith &
Sciences, Inc. Nephew plc Total
---------------- ------------ ---------
<S> <C> <C> <C>
From April 29, 1996 (inception)
to December 31, 1996
Capital contributions $ -- $ 10,000 $ 10,000
Net loss -- (10,000) (10,000)
------------- ----------- ---------
Balance, December 31, 1996 -- -- --
Capital contributions 7,780 7,746 15,526
Capital distributions (390) (356) (746)
Net loss (8,920) (8,920) (17,840)
------------- ----------- ---------
Balance, December 31, 1997 (1,530) (1,530) (3,060)
Capital contributions 20,111 19,336 39,447
Capital distributions (2,504) (2,821) (5,325)
Net loss (15,694) (14,602) (30,296)
------------- ----------- ---------
Balance, December 31, 1998 $ 383 $ 383 $ 766
============= =========== =========
</TABLE>
See accompanying notes to the combined financial statements.
F-31
<PAGE>
DERMAGRAFT JOINT VENTURE
NOTES TO THE COMBINED FINANCIAL STATEMENTS
NOTE 1 - BASIS OF PRESENTATION
Organization - Advanced Tissue Sciences, Inc. ("Advanced Tissue Sciences") and
Smith & Nephew plc ("Smith & Nephew") entered into a fifty-fifty joint venture
(the "Dermagraft Joint Venture") for the worldwide commercialization of
Dermagraft(R), a tissue-engineered dermal replacement, for the treatment of
diabetic foot ulcers in April 1996. Advanced Tissue Sciences is a tissue
engineering company utilizing its proprietary core technology to develop and
manufacture living human tissue products for tissue repair and transplantation.
Smith & Nephew is a worldwide healthcare company with extensive sales and
distribution capabilities. It develops, manufactures and markets a wide range
of tissue repair products, principally addressing the areas of bone, joints,
skin and other soft tissue.
The Dermagraft Joint Venture became responsible for the further development and
commercialization of Dermagraft for diabetic foot ulcers effective January 1997.
In January 1998, the Dermagraft Joint Venture was expanded to include venous
ulcers, pressure ulcers, burns and other skin tissue wounds. At that time,
Advanced Tissue Sciences retained the exclusive right to market TransCyte(TM)
(formerly Dermagraft-TC(R)), a temporary covering for full and partial-thickness
burns, in the United States, while the Dermagraft Joint Venture was granted the
right to market TransCyte for other skin wounds in the United States. In August
1998, the joint venture was further expanded to include exclusive rights to
TransCyte for full and partial-thickness burns in the United States effective
October 1998. TransCyte is currently being marketed in the United States for
burns, and Dermagraft for the treatment of diabetic foot ulcers is in clinical
trials in the United States and on the market in Canada, the United Kingdom
and several other European countries.
In the expanded joint venture, Advanced Tissue Sciences and Smith & Nephew will
continue to share equally in the expenses and revenues of the Dermagraft Joint
Venture, except Advanced Tissue Sciences has agreed to fund the first $6 million
of expenses for conducting clinical trials and for regulatory support of
Dermagraft and TransCyte in the treatment of venous ulcers and pressure sores.
In addition, Advanced Tissue Sciences will fund certain manufacturing and
distribution costs and certain costs related to post-market studies of TransCyte
through December 1999. Such manufacturing and distribution costs are to be
returned to Advanced Tissue Sciences out of future gross margin on net profits,
if any, from sales of TransCyte for burns in the United States.
References herein to Advanced Tissue Sciences and Smith & Nephew include their
subsidiaries and certain affiliates.
Principles of Combination - The combined financial statements include the
accounts of Dermagraft U.S. and Dermagraft International, which are Delaware
general partnerships formed between subsidiaries of Advanced Tissue Sciences and
Smith & Nephew, and the revenues and expenses of Advanced Tissue Sciences, Smith
& Nephew and their affiliates associated with the worldwide commercialization of
Dermagraft and TransCyte. All intercompany accounts and transactions have
been eliminated.
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 reported amounts of assets and liabilities and
related disclosures at the date of the financial statements, and the amounts of
revenues and expenses reported during the period. Actual results could differ
from those estimates.
Dependence on Certain Suppliers - The mesh frameworks used in the manufacture of
Dermagraft and TransCyte are sourced from single manufacturers. Any significant
supply interruption would adversely affect product manufacturing. In addition,
an uncorrected impurity or supplier's variation in raw material, either unknown
or incompatible with the manufacturing process, could have a material adverse
effect on the manufacture of the product.
F-32
<PAGE>
NOTE 2 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Inventories are valued at the lower of cost or market using the first-in,
first-out method. The Dermagraft Joint Venture, under contractual obligation,
purchases product at cost, which includes period costs, from Advanced Tissue
Sciences at the completion of manufacture. Period costs reflect overhead
costs related to excess production capacity and include rent, depreciation
and quality control, faciliites, supplies and other such costs to support or
related to the excess production capacity. As cost currently exceeds
market value due to excess production capacity, the Dermagraft Joint Venture
immediately writes the inventory down to estimated market value at the date
of purchase, which is the net realizable value at which the joint venture
believes it will be able to sell the products to its customers. During the
years ended December 31, 1998 and 1997, such write downs totaled $8,267,000
and $491,000, respectively.
Property is recorded at cost and depreciation is calculated on a straight-line
basis using an estimated useful life of five years.
Revenue/Expense Recognition - Revenues from product sales are recognized when
products are shipped to the customer. Research and development costs are
expensed as incurred.
New Accounting Standards - In June 1997, the Financial Accounting Standards
Board issued Financial Account Standard No. 130, "Reporting Comprehensive
Income" ("FAS No. 130"). This standard is effective for fiscal years
beginning after December 15, 1997 and has been adopted by the joint venture.
FAS No. 130 requires that all components of comprehensive income, including
net income, be reported in the financial statements in the period in which
they are recognized. Comprehensive income is defined as the change in equity
during a period from transactions and other events and circumstances from
non-owner sources. Net income and other comprehensive income, including
foreign currency translation adjustments, and unrealized gains and losses on
investments, shall be reported, net of their related tax effect to arrive at
comprehensive income. The joint venture's comprehensive loss is not
materially different than net loss for the periods presented.
NOTE 3 - INVENTORIES
Inventories consist of the following components as of December 31, 1998 and 1997
(in thousands):
1998 1997
-------- --------
Work-in-process $ 461 $ 288
Finished goods 1,001 73
-------- --------
$ 1,462 $ 361
======== ========
Inventories are net of reserves of $213,000 and zero as of December 31, 1998
and 1997, respectively. See Note 2 with respect to the carrying value of
the joint venture's inventory.
NOTE 4 - PROPERTY
The following is a summary of property and accumulated depreciation as of
December 31, 1998 and 1997 (in thousands):
1998 1997
-------- --------
Equipment, at cost $ 280 $ 163
Less accumulated depreciation (43) (3)
-------- -------
Net property $ 237 $ 160
======== =======
Depreciation expense charged to operations was $40,000 in 1998 and $3,000 in
1997.
F-33
<PAGE>
NOTE 5 - RELATED PARTY TRANSACTIONS
Under the joint venture agreements, Advanced Tissue Sciences is manufacturing
and Smith & Nephew is selling and marketing Dermagraft and TransCyte for the
Dermagraft Joint Venture (see Note 2). In addition, Advanced Tissue Sciences
and Smith & Nephew are providing research, development and administrative
services to the Dermagraft Joint Venture. All such expenses are reflected in
the combined financial statements at their estimated cost. The Dermagraft
Joint Venture also pays the partners interest on the use of their working
capital in support of the joint venture's operations. The following table
summarizes related party revenues and expenses for the years ended December
31, 1998 and 1997 (in thousands):
Advanced
Tissue Sciences Smith & Nephew
------------------- -------------------
1998 1997 1998 1997
-------- -------- -------- --------
Sales $ -- $ -- $ 632 $ 36
Cost of goods sold 10,054 824 -- --
Research and development 2,260 4,476 465 642
Selling, general and
administrative 2,979 2,750 14,161 7,101
Upon entering into the Dermagraft Joint Venture in April 1996, Smith & Nephew
agreed to pay Advanced Tissue Sciences an up front fee of $10 million. This fee
was funded through a capital contribution to the Dermagraft Joint Venture by
Smith & Nephew and paid by the joint venture to Advanced Tissue Sciences. Under
the joint venture agreements, the $10 million expense is allocated to Smith &
Nephew's capital account. As the Dermagraft Joint Venture did not begin
operations until January 1, 1997, the $10 million fee represents the only
activity in the Dermagraft Joint Venture from April 29, 1996 (inception) to
December 31, 1996 (see Note 1). Smith & Nephew has also agreed to pay up to an
additional $136 million on the achievement of certain milestones related to
product approval, gaining product reimbursement and on attaining specific sales
milestones. These milestones, if achieved, are to be funded and paid to
Advanced Tissue Sciences either directly by Smith & Nephew or through the
Dermagraft Joint Venture in the same manner as the up front fee.
NOTE 6 - SUPPLEMENTAL CASH FLOW INFORMATION
The Joint Venture's non-cash investing and financing activities for the year
ended December 31, 1998 included $325,000 in interest charges contributed as
capital by the partners.
NOTE 7 - SUBSEQUENT EVENT
In January 1999, the joint venture received a $15 million payment from Smith
& Nephew and then paid the same amount to Advanced Tissue Sciences in
connection with the 1998 expansion of the Dermagraft Joint Venture to include
venous ulcers, pressure ulcers, burns and other skin wounds. As discussed in
Note 5 above, the $15 million expense will be allocated to Smith & Nephew's
capital account.
NOTE 8 - YEAR 2000 COMPLIANCE (UNAUDITED)
The Year 2000 ("Y2K") issue results from computer systems and software products
being coded using two digits rather than four to define the applicable years.
Computer systems and software products utilize embedded technology that is time-
sensitive and may recognize a date as the year 1900 rather than the year 2000
which could cause computer system failures and errors leading to a disruption
in business operations. The Y2K issue could affect not only the joint
venture's operations but also the operations of its business partners,
customers, suppliers and regulatory agencies among others.
The joint venture purchases substantially all significant materials and
services from the joint venture's partners. In response to the risks
presented by the Y2K issue, the joint venture's partners have developed and
are currently implementing Y2K compliance plans. Although their assessment
of the Y2K issue is not complete, the partners believe their internal systems
are Y2K compliant or will be replaced or upgraded to comply with Y2K require-
ments. While a portion of the partners' Y2K compliance costs are being
charged to the joint venture, such costs are not expected to have a material
impact on the joint venture's financial condition or operating results.
F-34
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors
ATS Dermagraft, Inc. and Smith & Nephew SNATS, Inc.
We have audited the accompanying combined balance sheets of the Dermagraft Joint
Venture as of December 31, 1998 and 1997, and the related combined statements of
operations, partners' capital and cash flows for the years ended December 31,
1998 and 1997 and for the period April 29, 1996 (inception) through December 31,
1996. These financial statements are the responsibility of the joint venture's
management. Our responsibility is to express an opinion on these financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the combined financial position of the Dermagraft Joint
Venture at December 31, 1998 and 1997, and the combined results of its
operations and its cash flows for the years ended December 31, 1998 and 1997 and
for the period April 29, 1996 (inception) through December 31, 1996, in
conformity with generally accepted accounting principles.
ERNST & YOUNG LLP
San Diego, California
January 18, 1999
F-35
EXHIBIT 23
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements
(Form S-8 No. 33-39446) pertaining to the 1987 Incentive Stock Option and
Appreciation Plan, 1990 Stock Option Plan for Non-Employee Directors and Options
Granted to Certain Officers, Directors, Consultants and Scientific Advisory
Board Members under Written Compensation Agreements; (Form S-8 No. 33-48044)
pertaining to Options Granted Certain Officers, Directors, Consultants and
Scientific Advisory Board Members under Written Compensation Agreements; (Form
S-8 No. 33-50156 and No. 33-82310) pertaining to the 1992 Stock Option/Stock
Issuance Plan; (Form S-8 No. 333-36879) pertaining to the 1997 Stock Incentive
Plan; (Form S-3 No. 33-55520, No. 33-61935, No. 333-08659 and No. 333-62955)
pertaining to the registration of shares of Advanced Tissue Sciences, Inc.
Common Stock of our report dated January 29, 1999, with respect to the
consolidated financial statements of Advanced Tissue Sciences, Inc., and our
report dated January 18, 1999, with respect to the combined financial statements
of the Dermagraft Joint Venture included in the Annual Report (Form 10-K/A) of
Advanced Tissue Sciences, Inc. for the year ended December 31, 1998.
/s/ Ernst & Young LLP
ERNST & YOUNG LLP
San Diego, California
September 10, 1999
<TABLE> <S> <C>
<ARTICLE> 5
<LEGEND>
This schedule contains summary financial information extracted from
Amendment No. 1 on Form 10-K/A for the year ended December 31, 1998
and is qualified in its entirety by reference to such financial statements.
</LEGEND>
<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-END> DEC-31-1998
<CASH> 16,551
<SECURITIES> 6,503
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 3,364
<CURRENT-ASSETS> 28,830
<PP&E> 32,565
<DEPRECIATION> 11,941
<TOTAL-ASSETS> 53,985
<CURRENT-LIABILITIES> 8,388
<BONDS> 27,260
5,000
0
<COMMON> 403
<OTHER-SE> 11,588
<TOTAL-LIABILITY-AND-EQUITY> 53,985
<SALES> 11,962
<TOTAL-REVENUES> 20,481
<CGS> 15,045
<TOTAL-COSTS> 45,115
<OTHER-EXPENSES> 0
<LOSS-PROVISION> (17,628)
<INTEREST-EXPENSE> 2,343
<INCOME-PRETAX> (43,285)
<INCOME-TAX> 0
<INCOME-CONTINUING> (43,285)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (43,285)
<EPS-BASIC> (1.11)
<EPS-DILUTED> (1.11)
</TABLE>
