Our common stock has been traded on The Nasdaq National Market under the symbol AVNC since October 17, 2003. The following table sets forth the quarterly high and low sales prices per share of our common stock as reported by Nasdaq for each quarter during the last two fiscal years, commencing on January 1, 2004:

 

 

As of February 28, 2006, there were 132 holders of record of our common stock. This figure does not represent the actual number of beneficial owners of our common stock because shares are generally held in “street name” by securities dealers and others for the benefit of individual owners who may vote the shares.

 

We have never declared or paid any cash dividends on our common stock. We currently intend to retain our future earnings, if any, to finance the further development and expansion of our business and do not intend to pay cash dividends for the foreseeable future. Any future determination to pay dividends will be at the discretion of our board of directors and will depend on our financial condition, results of operations, capital requirements, restrictions contained in current or future financing instruments and such other factors as our board of directors deems relevant.

 

From October 15, 2003, the effective date of our Registration Statement on Form S-1 (File No. 333-107599), to December 31, 2005, we have used the entire $54.3 million of the net offering proceeds from our initial public offering, as follows:

 

 

The following selected financial information has been derived from the audited financial statements. The information below is not necessarily indicative of results of future operations and should be read in conjunction with Item 7, “Management’s Discussion and Analysis of Financial Condition and Results of Operations” of this Form 10-K and the financial statements and related notes thereto included in Item 8 of this Form 10-K in order to fully understand factors that may affect the comparability of the information presented below.

 

 

The following discussion of our financial condition and results of operations should be read in conjunction with the financial statements and the notes to those statements included elsewhere in this annual report on Form 10-K. This discussion may contain forward-looking statements that involve risks and uncertainties. As a result of many factors, such as those set forth under the “Forward-Looking Statements” and “Factors that May Affect our Business ” sections in Part 1, Item 1 and elsewhere in this annual report on Form 10-K, our actual results may differ materially from those anticipated in these forward-looking statements.

 

Our Business

 

Advancis Pharmaceutical Corporation was incorporated in Delaware in December 1999 and commenced operations on January 1, 2000. We are a pharmaceutical company focused on developing and commercializing anti-infective drug products that fulfill unmet medical needs in the treatment of infectious disease. We are developing a portfolio of drugs based on the novel biological finding that bacteria exposed to antibiotics in front-loaded, sequential bursts, or pulses, are killed more efficiently than those exposed to standard antibiotic treatment regimens. We currently have 19 issued U.S. patents covering our proprietary once-a-day pulsatile delivery technology called PULSYS. We have initially focused on developing PULSYS product candidates utilizing approved and marketed drugs that no longer have patent protection or that have patents expiring in the next several years. Our lead pulsatile product candidate, based on the antibiotic amoxicillin, is currently under evaluation in a Phase III clinical trial and our Keflex PULSYS product candidate, based on the antibiotic cephalexin, is currently under evaluation in a Phase I clinical trial. We also have a number of additional PULSYS product candidates in preclinical development. We acquired the U.S. rights to Keflex (cephalexin) from Eli Lilly in 2004. We currently employ a small sales and marketing staff that is supporting the sale of Keflex products to national accounts. In anticipation of the possible introduction of our first pulsatile product, Amoxicillin PULSYS, as well as the possible introduction of Keflex line extension products, we plan to expand our sales and marketing capabilities by working with contract sales organizations or collaborative marketing partners. We have entered into agreements with third-party contract manufacturers for the commercial supply of our products.

 

Management Overview of Key Developments in 2005

 

The following is a summary of key events that occurred in 2005.

 

  PULSYS product development and collaborations

 

 

 

Marketed Products — Keflex

 

 

Other Events

 

 

Focus for 2006

 

Our primary focus for 2006 will be on the conduct of our Amoxicillin PULSYS Phase III clinical trial for adults and adolescents and, if we receive FDA approval of our Keflex line extension products, the commercial launch of these products in the second half of 2006. We will also continue clinical development of a once-daily version of Keflex PULSYS.

 

Critical Accounting Policies and Estimates

 

Our discussion and analysis of our financial condition and results of operations are based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities and expenses. On an ongoing basis, we evaluate our estimates and judgments, including those related to accrued expenses, fair valuation of stock related to stock-based compensation and income taxes. We based our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

 

We believe the following critical accounting policies affect our more significant judgments and estimates used in the preparation of our financial statements.

Revenue Recognition

 

We recognize revenue for the sale of pharmaceutical products and for payments received under collaboration agreements for licensing, milestones, and reimbursement of development costs.

 

Product Sales.   Revenue from product sales, net of estimated provisions, is recognized when there is persuasive evidence that an arrangement exists, delivery has occurred, the selling price is fixed or determinable, and collectibility is reasonably assured. Our customers consist primarily of large pharmaceutical wholesalers who sell directly into the retail channel. Provisions for sales discounts, and estimates for chargebacks, rebates, and product returns are established as a reduction of product sales revenue at the time revenues are recognized, based on historical experience adjusted to reflect known changes in the factors that impact these reserves. These revenue reductions are generally reflected either as a direct reduction to accounts receivable through an allowance, or as an addition to accrued expenses for estimated returns or if the payment is due to a party other than the wholesaler.

 

Chargebacks and rebates.   These are based on the difference between the prices at which we sell our products to wholesalers and the sales price ultimately paid under fixed price contracts by third party payers, including governmental agencies. We record an estimate at the time of sale to the wholesaler of the amount to be charged back to us or rebated to the end user. We have recorded reserves for chargebacks and rebates based upon various factors, including current contract prices, historical trends, and our future expectations. The amount of actual chargebacks and rebates claimed could be either higher or lower than the amounts we accrued. Changes in our estimates would be recorded in the income statement in the period of the change.

 

Product returns.   In the pharmaceutical industry, customers are normally granted the right to return product for a refund if the product has not been used prior to its expiration date, which for our Keflex products is typically three years from the date of manufacture for capsules, and two years for oral suspension products. Our return policy typically allows product returns for products within an eighteen-month window from six months prior to the expiration date and up to twelve months after the expiration date. We estimate the level of sales which will ultimately be returned pursuant to our return policy, and record a related reserve at the time of sale. These amounts are deducted from our gross sales to determine our net revenues. Our estimates take into consideration historical returns of our products and our future expectations. We periodically review the reserves established for returns and adjust them based on actual experience. The amount of actual product return could be either higher or lower than the amounts we accrued. Changes in our estimates would be recorded in the income statement in the period of the change. If we over or under estimate the quantity of product which will ultimately be returned, there may be a material impact to our financial statements.

 

Contract Revenue.   We use the milestone payment method of revenue recognition when all milestones in respect of payments to be received under contractual arrangements are determined to be substantive, at-risk and the culmination of an earnings process. Substantive milestones are payments that are conditioned upon events requiring substantive effort, when the amounts of the milestones are reasonable relative to the time, effort and risk involved in achieving them and when the milestones are reasonable relative to each other and the amount of any up-front payment. If these criteria are not met, the timing of the recognition of revenue from the milestone payment may vary. Up-front payments are recorded as deferred revenue. We estimate the length of the remaining development period and amortize an up-front payment over that development period.

 

Reimbursement of Development Costs.   We record revenue for reimbursement of development costs as the actual costs to perform the work are incurred. We are required to use judgment in recognizing reimbursement revenue in cases where the agreement provides for funding to us that is not dependent on actual costs we incur within a specific fiscal period. For our collaboration with Par Pharmaceutical for Amoxicillin PULSYS, for example, we were entitled to quarterly payments in pre-established amounts that funded our development work. Our policy is to limit revenue recognized to the minimum amounts expected under a specific collaboration agreement and to exclude amounts contingent on future events, such as successful commercialization and future profit-sharing, and amounts that are contingently refundable. Revenue recognized is limited to cumulative amounts under each contract such that, at any time, if a termination of the agreement were to occur, revenue previously recognized would not need to be reversed. Cash received in excess of revenue recognized is recorded as deferred revenue, with the deferred revenue recognized as revenue at the time future events occur that remove the contingencies.

 

Inventories

 

Inventory is stated at the lower of cost or market with cost determined under the first-in, first-out method. Inventory consists of Keflex finished capsules and finished oral suspension powder. We purchase our Keflex products from third-party manufacturers only at the completion of the manufacturing process, and accordingly have no raw material or work-in-process inventories. At least on a quarterly basis, we review our inventory levels and write down inventory that has become obsolete or has a cost basis in excess of its expected net realizable value or is in excess of expected requirements. During 2005, we recorded an inventory reserve provision of approximately $154,000 to cost of product sales related to slow-moving and obsolete inventory.

 

Intangible Assets

 

Acquired Intangible Assets.   We acquired the U.S. rights to the Keflex brand of cephalexin in 2004. We may acquire additional pharmaceutical products in the future that include license agreements, product rights and other identifiable intangible assets. When intangible assets are acquired, we review and identify the individual intangible assets acquired and record them based on relative fair values. Each identifiable intangible asset is then reviewed to determine if it has a definite life or indefinite life, and definite-lived intangible assets are amortized over their estimated useful lives.

 

Impairment.   We assess the impairment of our identifiable definite-lived intangible assets on at least an annual basis or when events or changes in circumstances indicate that the carrying value may not be recoverable. Some factors we consider important which could trigger an impairment review include significant underperformance compared to historical or projected future operating results, significant changes in our use of the acquired assets or the strategy for our overall business, or significant negative industry or economic trends. If we determine that the carrying value of intangible assets may not be recoverable based upon the existence of one or more of these factors, we first perform an assessment of the asset’s recoverability based on expected undiscounted future net cash flow, and if the amount is less than the asset’s value, we measure any impairment based on a projected discounted cash flow method using a discount rate determined by our management to be commensurate with the risk inherent in our current business model.

 

Accrued Expenses

 

As part of the process of preparing financial statements, we are required to estimate accrued expenses for services performed and liabilities incurred. This process involves identifying services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for such service as of each balance sheet date in our financial statements. Examples of estimated accrued expenses for services include professional service fees, such as lawyers and accountants, contract service fees, such as amounts paid to clinical monitors, data management organizations and investigators in conjunction with clinical trials, and fees paid to contract manufacturers in conjunction with the production of clinical materials. In connection with such service fees, our estimates are most affected by our understanding of the status and timing of services provided relative to the actual levels of services incurred by such service providers. The majority of our service providers invoice us monthly in arrears for services performed. In the event that we do not identify certain costs that have begun to be incurred or we under- or over-estimate the level of services performed or the costs of such services, our reported expenses for such period would be too low or too high. The date on which certain services commence, the level of services performed on or before a given date and the cost of such services are often judgmental. We make these judgments based upon the facts and circumstances known to us in accordance with generally accepted accounting principles. We also make estimates for other liabilities incurred, including health insurance costs for our employees. We are self-insured for claims made under our health insurance program and record an estimate at the end of a period for claims not yet reported. Our risk exposure is limited, as claims over a maximum amount are covered by an aggregate stop loss insurance policy.

 

Stock-Based Compensation

 

We have elected to follow APB Opinion No. 25, Accounting for Stock Issued to Employees, and related interpretations, in accounting for our stock-based compensation plans, rather than the alternative fair value accounting

method provided for under SFAS No. 123, “Accounting for Stock-Based Compensation.” In the notes to our financial statements we provide pro forma disclosures in accordance with SFAS No. 148 and related pronouncements. We account for transactions in which services are received in exchange for equity instruments based on the fair value of such services received from non-employees or of the equity instruments issued, whichever is more reliably measured, in accordance with SFAS No. 123 and EITF Issue No. 96-18. The factors which are most likely to affect charges or credits to operations related to stock-based compensation are the fair value of the common stock underlying stock options for which stock-based compensation is recorded and the volatility of such fair value. Since the Company’s initial public offering in October 2003, we have used the quoted market price of our common stock as the fair value, and we have established an estimate for volatility by considering the volatility of the stock of other comparable public companies. We expect to adopt SFAS 123R, “Share-Based Payment,” in the first quarter of 2006.

 

Income Taxes

 

As part of the process of preparing our financial statements we are required to estimate our income taxes in each of the jurisdictions in which we operate. We account for income taxes by the liability method. Under this method, deferred income taxes are recognized for tax consequences in future years of differences between the tax bases of assets and liabilities and their financial reporting amounts at each year-end, based on enacted laws and statutory tax rates applicable to the periods in which the differences are expected to affect taxable income. Valuation allowances are provided if, based upon the weight of available evidence, it is more likely than not that some or all of the deferred tax assets will not be realized. We have not recorded any tax provision or benefit for the years ended December 31, 2005, 2004 and 2003. We have provided a valuation allowance for the full amount of our net deferred tax assets since realization of any future benefit from deductible temporary differences and net operating loss carry forwards cannot presently be sufficiently assured. At December 31, 2005 and 2004, we had federal and state net operating loss carryforwards of approximately $78.3 million and $51.9 million, respectively, available to reduce future taxable income, which will begin to expire in 2020. Under the provisions of Section 382 of the Internal Revenue Code, certain substantial changes in our ownership may result in a limitation on the amount of net operating loss and research and experimentation tax credit carry forwards which can be used in future years. During 2005 and prior years, we may have experienced such ownership changes. When we complete the necessary studies, the amount of net operating loss carryovers may be reduced. However, since the valuation allowance fully reserves for all available carryovers, the effect of the reduction would be offset by a reduction in the valuation allowance. Thus, the resolution of this matter would have no effect on our reported assets, liabilities, revenues and expenses for the periods presented.

 

Recent Accounting Pronouncements

 

In December 2004, the FASB issued SFAS 123R, “Share-Based Payment,” a revision of SFAS 123, “Accounting for Stock-based Compensation.” SFAS 123R requires public companies to recognize expense associated with share-based compensation arrangements, including employee stock options, using a fair value-based option pricing model, and eliminates the alternative to use APB 25’s intrinsic value method of accounting for share-based payments. Accordingly, we plan to begin recognizing the expense associated with our share-based payments, as determined using a fair value-based method, in our statement of operations beginning on January 1, 2006. Adoption of the expense provisions of SFAS 123R is expected to have a material, noncash impact on our results of operations. The standard allows alternative transition methods for public companies. We expect to adopt the modified prospective application method as our transition method. Under this method, prior periods will not be restated. Compensation cost for the unvested portion of awards that are outstanding as of January 1, 2006 will be recognized as the requisite service is rendered on or after the effective date. The compensation cost for the unvested portion of those earlier awards will be based on the fair value at date of grant as previously calculated in our pro forma disclosure under SFAS 123, net of estimated forfeitures.

 

In February 2005, the EITF added to its agenda Issue No. 05-4, “The Effect of a Liquidated Damages Clause on a Freestanding Financial Instrument Subject to EITF Issue No. 00-19, ’Accounting for Derivative Financial Instruments Indexed to, and Potentially Settled in, a Company’s Own Stock.”’ The issue addresses liquidated damages provisions associated with registration rights agreements and the diversity in practice that exists in accounting for such provisions. In June 2005 and September 2005, the EITF discussed the Issue but did not reach a

consensus. Further deliberations by the EITF have been postponed until the FASB addresses whether a registration rights agreement is a derivative. The Company is monitoring the progress of the FASB and EITF on this Issue.

 

In May 2005, the FASB issued SFAS 154, “Accounting Changes and Error Corrections — a Replacement of APB Opinion No. 20 and FASB Statement No. 3.” SFAS 154 generally requires retrospective application to prior periods’ financial statements of voluntary changes in accounting principles. Under the prior rules, changes in accounting principles were generally recognized by including in net income of the period of the change the cumulative effect of changing to the new accounting principle. This statement does not change the previous requirements for reporting the correction of an error in previously issued financial statements, change in accounting estimate, or justification of a change in accounting principle on the basis of preferability. SFAS 154 is effective for accounting changes made in fiscal years beginning after December 31, 2005. Adoption of the provisions of this statement is not expected to have a material effect on our results of operations or financial position.

 

In November 2005, the FASB Staff issued FASB Staff Position (“FSP”) FAS 115-1, “The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments.” FSP FAS 115-1 addresses the determination as to when an investment is considered impaired, whether that impairment is other than temporary, and the measurement of an impairment loss. It also includes accounting considerations subsequent to the recognition of an other-than-temporary impairment and requires certain disclosures about unrealized losses that have not been recognized as other-than-temporary impairments. The guidance in this FSP is effective for reporting periods beginning after December 15, 2005. FSP FAS 115-1 is not expected to have a material effect on our financial statements.

 

Research and Development Expenses

 

We expect our research and development expenses to be significant we continue to develop our product candidates. These expenses consist primarily of salaries and related expenses for personnel, fees paid to professional service providers in conjunction with independently monitoring our clinical trials and acquiring and evaluating data in conjunction with our clinical trials, costs of contract manufacturing services, costs of materials used in clinical trials and research and development, depreciation of capital resources used to develop our products, and costs of facilities. We expense research and development costs as incurred. We believe that significant investment in product development is a competitive necessity and plan to continue these investments in order to be in a position to realize the potential of our product candidates and proprietary technologies.

 

The following table summarizes research and development expense for our product development initiatives for the fiscal years ended December 31, 2005, 2004 and 2003. See “Our Product Pipeline” above for our current priority product candidates.

 

 

 

Net Losses

 

We have a limited history of operations. We anticipate that our results of operations will fluctuate for the foreseeable future due to several factors, including payments made or received pursuant to licensing or collaboration agreements, progress of our research and development efforts, approval and commercial launch of new products, and the timing and outcome of regulatory approvals. Our limited operating history makes predictions of future operations difficult or impossible. Since our inception, we have incurred significant losses. As of December 31, 2005, we had an accumulated deficit of approximately $111.1 million. We anticipate incurring additional annual losses, perhaps at higher levels, for the foreseeable future.

 

received from GSK in May, 2004, with no comparable amount in 2005 due to the termination of the GSK collaboration in December 2004.

 

Reimbursement of development costs under the Par amoxicillin PULSYS collaboration agreement was recognized as revenue based on the related costs incurred. As a result of the termination of the collaboration on August 3, 2005, we accelerated the revenue recognition of $2.4 million, which represented the remaining deferred revenue balance in excess of the amount retained for future contingent liability to Par.

 

Cost of Product Sales.   Cost of product sales represents the purchase cost of the Keflex products sold, together with royalties due on the sale of certain Keflex products. Cost of product sales was $0.6 million in 2005 and $0.2 million in 2004.

 

Research and Development Expenses.   Research and development expenses increased $6.1 million, or 18%, to $39.7 million for the fiscal year ended December 31, 2005 from $33.6 million for the fiscal year ended December 31, 2004. Research and development expenses consist of direct costs which include salaries and related costs of research and development personnel, and the costs of consultants, materials and supplies associated with research and development projects, as well as clinical studies. Indirect research and development costs include facilities, depreciation, and other indirect overhead costs.

 

The following table discloses the components of research and development expenses reflecting our project expenses.

 

 

Personnel, benefits and related costs increased $1.2 million in 2005 primarily due to severance charges of $2.9 million versus $0.4 million in 2004, partly offset by a benefit of $1.3 million due to lower staffing levels throughout 2005 attributable to reductions in staff in November 2004 and July 2005. Stock-based compensation costs declined $1.0 million, of which $0.9 million results from use of the FIN 28 accelerated method of amortization, and the remaining decrease is due to cancellation of options for which expense had previously been recognized.

Contract R&D, consultants, materials and other costs decreased $0.7 million, due to a reduction in costs of $1.9 million on the generic clarithromycin project that was discontinued in 2004, and reductions in other projects of $1.9 million. Partly offsetting the decreases were increased costs of $1.8 million for Keflex product development, $1.0 million for pediatric and adult amoxicillin trials, and other projects of $0.3 million. Clinical trials expense increased $5.8 million overall, due to $7.6 million increased expense in 2005 for Phase III clinical trials of adult and pediatric amoxicillin, partly offset by lower expenses for generic clarithromycin of $1.3 million and other projects of $0.5 million.

 

Indirect project costs also increased by $0.8 million, primarily due to an increase in facility-related costs of $0.8 million and equipment depreciation of $0.7 million, resulting from the acquisition of product manufacturing equipment used to produce amoxicillin for clinical trials, offset by changes in all other indirect expenses of $0.7 million.

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses decreased $1.7 million, or 14%, to $10.5 million for the year ended December 31, 2005 from $12.2 million for the year ended December 31, 2004.

 

 

Salaries, benefits and related costs in 2005 increased $0.7 million, which was primarily attributable to severance costs of $1.1 million. Stock-based compensation costs decreased a total of $2.1 million, due to a decrease of $1.1 million attributable to the use of an accelerated method of amortization to recognize employee-based option expense recognized under APB 25, a decrease of $0.5 million due to reversal of prior period expense for the forfeiture of options that resulted from the termination of employees in 2005, and a decrease of $0.5 million due to a one-time charge in 2004 for stock-based compensation related to retirement of a director.

 

Legal and consulting costs decreased $1.4 million due primarily to a higher level of legal activity in 2004 in support of collaboration agreement negotiations. Other expenses increased $1.0 million, which included amortization of the Keflex intangible assets of $0.6 million, and increased facilities costs of $0.4 million.

 

Net Interest Income (Expense).   Net interest income was $1.0 million for the year ended December 31, 2005 compared to net interest income of $0.7 million for the year ended December 31, 2004. The increase is primarily attributable to higher short term interest rates in 2005 versus 2004.

 

Fiscal Year Ended December 31, 2004 Compared to Fiscal Year Ended December 31, 2003

 

Revenues.   We recorded revenues of $11.4 million during the fiscal year ended December 31, 2004 compared to $3.6 million during the fiscal year ended December 31, 2003, as follows:

 

 

Product sales of Keflex commenced in July 2004, subsequent to the purchase of the brand rights in the U.S. market from Eli Lilly. There were no product sales in 2003.

 

Revenues recognized in 2004 and 2003 from the amortization of upfront licensing fees include the amortization of a $5.0 million upfront payment received from GlaxoSmithKline (GSK) in July 2003, of which the unamortized portion of $3.2 million was recognized in 2004 due to the termination of the collaboration agreement, and the amortization of a $5.0 million upfront payment received from Par Pharmaceutical in May 2004, which was being amortized into revenue on a straight-line basis over a 36-month period.

 

Reimbursement of development costs revenue of $3.6 million related to the Par amoxicillin agreement was recognized based on the related costs incurred.

 

Cost of Product Sales.   Cost of product sales represents the purchase cost of the Keflex products sold. Cost of product sales was $170,000 in 2004. There were no product sales in 2003.

 

Research and Development Expenses.   Research and development expenses increased $17.0 million, or 103%, to $33.6 million for the fiscal year ended December 31, 2004 from $16.6 million for the fiscal year ended December 31, 2003. Research and development expenses consist of direct costs which include salaries and related costs of research and development personnel, and the costs of consultants, materials and supplies associated with research and development projects, as well as clinical studies. Indirect research and development costs include facilities, depreciation, and other indirect overhead costs.

 

The following table shows the aggregate changes in research and development expenses reflecting all of our project expenses.

 

 

Direct costs increased $12.3 million primarily as a result of increases of $11.1 million relating to the development of our pulsatile amoxicillin product candidate, plus increases of an aggregate of $2.4 million relating

to the evaluation of new preclinical product candidates, partially offset by decreases of an aggregate of $1.4 million relating to the development of our pulsatile clarithromycin and generic clarithromycin product candidates.

 

Increased project staffing levels in 2004 versus 2003 resulted in an increase of $3.7 million related to personnel, benefits and related costs. Contract research and development, consulting, materials and other direct costs increased $4.9 million in preparation for our clinical trials, and clinical trials expense increased $4.5 million from 2003 as we initiated two Phase III studies in 2004 (adult and pediatric amoxicillin PULSYS) as well as conducted 13 Phase I/II studies compared to nine Phase I/II studies in 2003.

 

Indirect project costs also increased by $4.7 million, primarily due to an increase in facility-related costs of $1.8 million, depreciation of $1.3 million, and overhead of $1.6 million due to increased insurance, Scientific Advisory Board expenses, and other expenses.

 

Selling, General and Administrative Expenses.   Selling, general and administrative expenses increased $5.8 million, or 90%, to $12.2 million for the fiscal year ended December 31, 2004 from $6.4 million for the fiscal year ended December 31, 2003.

 

 

Selling, general and administrative expenses consist of salaries and related costs for executive and other administrative personnel, as well as professional fees and facility costs. Salaries, benefits and related costs for personnel increased $0.8 million in 2004 due to higher compensation and benefits expenses related to new hires. Approximately $0.9 million of the total $5.8 million increase in general and administrative expenses is attributable to increased stock-based compensation charges, primarily due to the effect of certain 2003 grants being amortized for a full year in 2004. Legal and consulting costs increased $0.9 million in 2004 due to increased support activities attributable to the Company’s first full year of being a publicly-traded corporation, assistance in business development activities, litigation support and Sarbanes-Oxley compliance. Other expenses increased $3.1 million, principally due to higher costs for building and equipment operating expenses and depreciation of $0.5 million, amortization of $0.6 million of Keflex intangibles, increased audit fees and investor communications costs of $0.3 million related to the Company’s first full-year status as a public company, and increased business development marketing costs of $0.7 million related to identification and development of new market opportunities, including Keflex brand enhancement.

 

Net Interest Income (Expense).   Net interest income was $669,000 for the fiscal year ended December 31, 2004 compared to net interest expense of $1.6 million for the fiscal year ended December 31, 2003.

 

 

The increase in net interest income in 2004 of $2.2 million is primarily due to the beneficial conversion feature of deemed interest expense of $1.7 million incurred in 2003 (no similar item in 2004), plus increased interest income in 2004 of $540,000 resulting from the Company’s investment in marketable securities subsequent to its initial public offering of common stock in the second half of 2003. The deemed interest expense related to the

beneficial conversion feature was a one-time charge that related to the issuance of the Company’s convertible notes in March 2003 at a favorable conversion ratio for the noteholders.

 

Interest expense (net of capitalized interest) decreased $40,000 compared to the prior year. The Company has paid down in 2004 older fixed rate borrowings that were at higher interest rates than its newer, variable rate borrowings.

 

 

Cash received from product sales in 2005 of $5.2 million significantly exceeded product sales cash receipts in 2004 of $2.2 million, as the 2004 amount reflects only about a half year of activity. Cash received from collaboration partners relates to our previous collaboration agreements with Par Pharmaceutical for amoxicillin PULSYS and with GlaxoSmithKline for amoxicillin/clavulanate development. We received $14.25 million and $14.0 million in 2005 and 2004, respectively, from Par and $3.0 million and $5.0 million in 2004 and 2003, respectively, from GSK. The increase in cash disbursements from 2003 to 2005 reflects the growth in the Company’s average headcount and the significant costs involved in the Company’s Phase III clinical trials in 2004 and 2005.

 

 

The most significant investing activities in 2005 included net purchases and sales of marketable securities of $8.2 million, receipt of a $1.0 million advance payment pursuant to the potential sale of Keflex assets (which we

retained, as the agreement-in-principle expired without the sale of the business), and purchases of and deposits on property and equipment of $1.9 million.

 

Net cash used in investing activities during the year ended December 31, 2004 was $11.7 million. The most significant investing activities included the acquisition of Keflex intangibles for $11.2 million, and purchases of and deposits on property and equipment of $7.0 million. Net purchases and sales of marketable securities provided $6.6 million during the period.

 

Net cash used in investing activities during fiscal 2003 was $36.4 million. The Company invested $27.9 million of its IPO proceeds in marketable securities, representing securities with maturities exceeding 90 days. The Company also spent $9.0 million (excluding $1.6 million of accrued construction costs) on the acquisition of property and equipment, primarily for the fit-out of its new corporate, research and development facility in Germantown, Maryland. An additional $338,000 of cash was required by the Company’s equipment financing terms to be placed in financial institutions on a restricted basis as additional loan collateral. Partially offsetting these cash outflows was the receipt of $830,000 in cash as part of the tenant improvement allowance for our corporate, research and development facility; this amount will be amortized as a reduction in rent expense over the term of the lease.

 

 

The major financing activity in 2005 was the private placement of common stock, which provided $25.8 million net of issuance costs. Additionally, repayments on lines of credit totaled $1.0 million during the period.

 

Net cash provided by financing activities in 2004 was $0.2 million. The major financing activities included loan draws of $1.4 million for equipment financing in connection with the fit-out of the Company’s new corporate, research and development facility and repayments of $1.2 million on the Company’s existing borrowings.

 

Net cash from financing activities for fiscal 2003 was $80.9 million. The major financing activities included $5.0 million from the issue of convertible notes in March 2003, $20.8 million from the closing of the Series E preferred stock financing round in July 2003, and $54.3 million from the closing of Company’s initial public offering of its common stock in October 2003. The Company also obtained $1.3 million from draws under its lines of credit for equipment financing.

 

Borrowings

 

We are a party to four credit facilities for an aggregate amount of $5.9 million used to finance the purchase of equipment and to one loan agreement for $75,000 with a local government development fund. The credit facilities

have no amounts available for new borrowings. Of the total $5.9 million amount, $1.6 million was outstanding as of December 31, 2005, as summarized in the following table:

 

 

We do not currently hedge variable rate borrowings.

 

Stock Issuances

 

In April 2005, we completed a private placement of 6,846,735 shares of our common stock at a price of $3.98 per share and warrants to purchase a total of 2,396,357 shares of common stock at an exercise price of $4.78 per share, resulting in net proceeds, after commissions and expenses, of $25.8 million. The warrants are exercisable for five years.

 

Contractual Obligations

 

The following table summarizes our contractual obligations at December 31, 2005 and the effects such obligations are expected to have on our liquidity and cash flows in future periods.

 

 

 

 

In addition to the contractual obligations in the above table, the Company may incur funding liabilities for obligations which it enters into on a discretionary basis. These discretionary obligations could include additional facilities or equipment, investments in new technologies or products, acquisitions, funding of clinical trials, or similar events. As of December 31, 2005, we are not committed to fund any further pre-production development work at the Clonmel facility; however, should our Amoxicillin PULSYS Phase III trial be successful, our intention would be to fund approximately $2.8 million of additional development work at Clonmel, primarily in late 2006 and early 2007, to prepare for commercial production of Amoxicillin PULSYS.

 

During fiscal 2005 we spent approximately $1.4 million for capital expenditures, primarily for equipment purchased for use at third-party manufacturing facilities, as well as for use in our research and development facility in Germantown, Maryland.

 

Off-Balance Sheet Arrangements

 

We have not entered into any transactions, agreements or other contractual arrangements that meet the definition of off-balance sheet arrangements, with the exception of our private placement of common stock and warrants in April 2005. Warrants are instruments that meet the definition of a derivative under SFAS 133, although they qualify for the scope exception under paragraph 11 of SFAS 133. In the private placement, warrants were issued to purchase a total of 2,396,357 shares of common stock at an exercise price of $4.78 per share.

 

Prospective Information

 

We expect to incur losses from operations for the foreseeable future. We expect to continue to incur substantial research and development expenses in 2006, including expenses related to preclinical testing and clinical trials. We expect that our selling and marketing expenses will increase in 2006, assuming FDA approval of our Keflex line extension products and commercial launch of the new products. If the launch is successful, we will collect cash on these incremental sales which would offset some or all of our increased selling and marketing expenses in 2006. We believe the Keflex line extension products have the potential to generate significant cash in excess of selling costs in 2007. We also expect a limited window of opportunity for these products, approximating 18 to 24 months, should generic pharmaceutical companies decide to compete with our line extension products.

 

Our future capital requirements will depend on a number of factors, including the continued progress of our research and development of product candidates, the timing and outcome of regulatory approvals, payments received or made under any future collaborative agreements, the costs involved in preparing, filing, prosecuting, maintaining, defending and enforcing patent claims and other intellectual property rights, the acquisition of licenses to new products or compounds, the status of competitive products, the availability of financing and our or our partners’ success in developing markets for our product candidates.

 

After receiving the results in June and July 2005 of our unsuccessful pediatric and adult Phase III trials, we conducted an intensive analysis of the data with the intent to reach a conclusion regarding the future of our Amoxicillin PULSYS development program. We also considered how to maximize the future value of our Keflex franchise. Each of these outstanding matters has significant implications for our anticipated level of future spending and our capital available to fund future operations. In September 2005, we announced our decisions regarding these outstanding matters. We decided to continue our Amoxicillin PULSYS development program and to conduct a new Phase III clinical trial. We also decided to investigate the potential sale of the Keflex brand in order to increase our level of unrestricted cash on hand.

 

In July and September 2005, we reduced our workforce by approximately 38% as part of an initiative to reduce operating expenses. The cost reduction will enhance our ability to rely on our existing resources to fund our operations over the next year. We believe that our cash, cash equivalents and marketable securities of $29.4 million on hand as of December 31, 2005, together with the effect of the reduction in our workforce in the third quarter of 2005 and product revenue collections in 2006 from sales of our currently-marketed Keflex products, provide us with enough capital resources to finance our ongoing operations, including our new Phase III clinical trial, until at least

the first quarter of 2007. We will continue to balance our pace of development with our funding position, and we anticipate the resources described above will be sufficient to fund our planned operating expenses, debt repayments and capital equipment requirements for at least the next 12 months, barring unforeseen developments. This forecast is a forward-looking statement that involves risks and uncertainties, and actual results could vary.

 

We have no unused credit facility or other committed sources of capital. To the extent our capital resources are insufficient to meet future capital requirements, we will need to raise additional capital, incur indebtedness, or consider the sale of company assets in order to fund our operations. There can be no assurance that additional debt or equity financing will be available on acceptable terms, if at all. If adequate funds are not available, we may be required to delay, reduce the scope of or eliminate our research and development programs, reduce our commercialization efforts, effect changes to our facilities or personnel, or obtain funds through arrangements with collaborative partners or others that may require us to relinquish rights to certain product candidates that we might otherwise seek to develop or commercialize independently. Any future funding may dilute the ownership of our equity investors.

 

Safe Harbor Statement under the Private Securities Litigation Reform Act of 1995

 

Certain statements contained in “Business” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. The forward-looking statements are based on our current intent, belief and expectations. These statements are not guarantees of future performance and are subject to certain risks and uncertainties that are difficult to predict. Actual results may differ materially from these forward-looking statements because of our unproven business model, our dependence on new technologies, the uncertainty and timing of clinical trials, our ability to develop and commercialize products, our dependence on collaborators for services and revenue, our substantial indebtedness and lease obligations, our changing requirements and costs associated with planned facilities, intense competition, the uncertainty of patent and intellectual property protection, our dependence on key management and key suppliers, the uncertainty of regulation of products, the impact of future alliances or transactions and other risks described in this filing and our other filings with the Securities and Exchange Commission. Existing and prospective investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of today’s date. We undertake no obligation to update or revise the information contained in this announcement whether as a result of new information, future events or circumstances or otherwise.

 

Our exposure to market risk is currently confined to our cash and cash equivalents, marketable securities, and restricted cash that generally have maturities of less than one year. We currently do not hedge interest rate exposure. We have not used derivative financial instruments for speculation or trading purposes. Because of the short-term maturities of our cash, cash equivalents and marketable securities, we do not believe that an increase in market rates would have any significant impact on the realized value of our investments, but may increase the interest expense associated with our debt.

 

Our most liquid assets are cash, cash equivalents and marketable securities. Because of their liquidity, these assets are not directly affected by inflation. We also believe that we have intangible assets in the value of our intellectual property. In accordance with generally accepted accounting principles, we have not capitalized the value of this intellectual property on our balance sheet. Due to the nature of this intellectual property, we believe that these intangible assets are not affected by inflation. Because we intend to retain and continue to use our equipment, furniture and fixtures and leasehold improvements, we believe that the incremental inflation related to replacement costs of such items will not materially affect our operations. However, the rate of inflation affects our expenses, such as those for employee compensation and contract services, which could increase our level of expenses and the rate at which we use our resources.

 

The information required by this item is set forth on pages F-1 to F-30.

 

None.

 

Evaluation of Disclosure Controls and Procedures

 

Our management, including our principal executive and principal financial officers, has evaluated the effectiveness of our disclosure controls and procedures as of December 31, 2005. Our disclosure controls and procedures are designed to provide reasonable assurance that the information required to be disclosed in this annual report on Form 10-K has been appropriately recorded, processed, summarized and reported. Based on that evaluation, our principal executive and principal financial officers have concluded that our disclosure controls and procedures are effective at the reasonable assurance level.

 

Changes in Internal Control over Financial Reporting during the Quarter

 

Our management, including our principal executive and principal financial officers, has evaluated any changes in our internal control over financial reporting that occurred during the quarter ended December 31, 2005, and has concluded that there was no change that occurred during the quarter ended December 31, 2005 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

 

Management’s Report on Internal Controls over Financial Reporting

 

The Company’s management is responsible for establishing and maintaining adequate internal controls over financial reporting, as defined in Rule 13a-15(f) under the Securities Exchange Act of 1934. The Company’s system of internal controls over financial reporting was designed to provide reasonable assurance to the Company’s management and Board of Directors regarding the preparation and fair presentation of published financial statements.

 

All internal control systems, no matter how well designed, have inherent limitations. Therefore, even those systems determined to be effective can provide only reasonable assurance with respect to financial statement preparation and presentation and may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.

 

Management, including the chief executive officer and chief financial officer, assessed the effectiveness of the Company’s internal control over financial reporting as of December 31, 2005. In making this assessment, management used the criteria set forth by the Committee of Sponsoring Organizations of the Treadway Commission (COSO) in Internal Control — Integrated Framework. Based on our assessment, management concluded that the Company maintained effective internal control over financial reporting as of December 31, 2005.

 

The Company’s independent registered public accounting firm have issued an audit report on management’s assessment of the Company’s internal control over financial reporting. Their report appears on page F-2 and F-3.

 

None.