PENWEST PHARMACEUTICALS CO - 10-Q - 20041109 - NOTES_TO_FINANCIAL_STATEMENT
PENWEST PHARMACEUTICALS CO.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)
1. Business
Penwest Pharmaceuticals Co. (the “Company”) develops pharmaceutical
products based on innovative oral drug delivery technologies. The foundation of
Penwest’s technology platform is TIMERx®, an extended release delivery system
that is adaptable to soluble and insoluble drugs and that is flexible for a
variety of controlled release profiles. The Company has also developed two
additional oral drug delivery systems, Geminex® and SyncroDose™. Geminex is a
dual drug delivery system that is designed to provide independent release of
different active ingredients contained in a drug. SyncroDose is a drug delivery
system that is designed to release the active ingredient of a drug at the
desired site and time in the digestive tract.
Prior to February 27, 2003, Penwest also developed, manufactured and
distributed branded pharmaceutical excipients, which are the inactive
ingredients in tablets and capsules, primarily consisting of binders,
disintegrants and lubricants. On February 27, 2003, Penwest sold substantially
all of the assets used in the Company’s excipient business to subsidiaries and
affiliates of Josef Rettenmaier Holding GmbH & Co. KG (the “Asset Sale”). The
Company received $39.5 million in cash and a promissory note for $2.25 million
in consideration for the excipient business. In April 2003, the Company
received $1.0 million under the promissory note, and received the balance of
$1.25 million in May 2004. The Company used approximately $5.5 million of
proceeds of the Asset Sale to repay debt. As a result of the Asset Sale, the
accompanying condensed consolidated financial statements present Penwest’s
excipient business as discontinued operations for all periods presented.
The Company is subject to the risks and uncertainties associated with a
drug delivery company actively engaged in research and development. These risks
and uncertainties include, but are not limited to, a history of net losses,
technological changes, dependence on collaborators and key personnel, the
successful completion of development efforts and of obtaining regulatory
approval, the successful commercialization of TIMERx extended release products,
compliance with government regulations, patent infringement litigation,
competition from current and potential competitors, some with greater resources
than the Company, dependence on third party manufacturers and a requirement for
additional funding.
2. Basis of Presentation
The accompanying unaudited condensed consolidated financial statements
have been prepared in accordance with U.S. generally accepted accounting
principles for interim financial information and with the instructions to Form
10-Q and Rule 10-01 of Regulation S-X. Accordingly, they do not include all of
the information and footnotes required by U.S. generally accepted accounting
principles for complete financial statements. In the opinion of management, all
adjustments considered necessary for a fair presentation for the interim
periods presented have been included. All such adjustments are of a normal
recurring nature. Operating results for the three and nine month periods ended
September 30, 2004 are not necessarily indicative of the results that may be
expected for the year ending December 31, 2004. For further information, refer
to the consolidated financial statements and footnotes thereto included in the
Company’s Annual Report on Form 10-K for the year ended December 31, 2003.
As a result of the Asset Sale, the operating results of the excipient
business have been presented as discontinued operations in the condensed
consolidated statements of operations for the nine month period ended September
30, 2003, (see Note 9).
The balance sheet at December 31, 2003, has been derived from the audited
financial statements at that date but does not include all of the information
and footnotes required by U.S. generally accepted accounting principles for
complete financial statements.
3. Summary of Significant Accounting Policies
Revenue Recognition
Royalties and licensing fees — Revenues from non-refundable upfront
licensing fees received under collaboration agreements are recognized ratably
over the development period of the related collaboration agreement when this
period involves development risk associated with the incomplete stage of a
product’s development or over the estimated or contractual licensing and supply
term when there exists an obligation to supply inventory for manufacture.
Non-refundable milestone fees received for the development funding of a product
are partially recognized upon receipt based on the Company’s proportionate
development efforts achieved to date relative to the total expected development
efforts and the remainder is generally recognized ratably over the remaining
expected development
period. The proportionate development efforts achieved are measured by
estimating the percentage of work completed that is required of the Company in
the development effort for the product. This estimate is primarily derived from
the underlying project plans and timelines, developed by qualified personnel
who work closely on such projects. In particular, the Company reviews output
measures such as job specifications and tasks completed, compared to all such
job specifications and tasks outlined for a particular project. Job
specifications vary with each project and primarily include development
activities regarding initial formulation work, manufacturing scale-up,
proof-of-principle biostudies, clinical development and regulatory matters.
Other contractual fees received in connection with a collaborator’s launch of a
product are also recognized ratably over the estimated or contractual licensing
and supply term. Product royalty fees are recognized when earned.
Product sales — Revenues from product sales are recognized when title
transfers and customer acceptance provisions have lapsed, provided that
collections of the related accounts receivable are probable. Shipping and
handling costs are included in cost of revenues.
Research and Development Expenses
Research and development expenses consist of costs associated with
products being developed internally as well as products being developed under
collaboration agreements and include related salaries, benefits and other
personnel related expenses, clinical trial costs, and contract and other
outside service fees. Research and development costs are expensed as incurred.
A significant portion of the Company’s development activities are outsourced to
third parties including contract research organizations, and contract
manufacturers in connection with the production of clinical materials, or may
be performed by the Company’s collaborators. These arrangements may require
estimates be made of related service fees or the Company’s share of development
costs, in which actual results could materially differ from the estimates and
affect the reported amounts in the Company’s financial statements.
Stock-Based Compensation
The Company adopted the disclosure provisions of Statement of Financial
Accounting Standards (“SFAS”) No. 148, “Accounting for Stock-Based Compensation
— Transition and Disclosure,” which amends SFAS No. 123, “Accounting for
Stock-Based Compensation,” in 2002. SFAS No. 148 provides alternative methods
of transition for a voluntary change to the fair value based method of
accounting for stock-based employee compensation, which was originally provided
under SFAS No. 123. SFAS No. 148 also improves the timeliness of disclosures by
requiring the information to be included in interim as well as annual financial
statements. The adoption of these disclosure provisions had no impact on the
Company’s condensed consolidated results of operations, financial position or
cash flows. On October 13, 2004, the Financial Accounting Standards Board
concluded that SFAS 123R, “Share-Based Payment,” which would require all
companies to measure compensation cost for all share-based payments (including
employee stock options) at fair value, would be effective for public companies
for interim or annual periods beginning after June 15, 2005. The Company has
not yet determined the impact that SFAS 123R will have on its financial
statements.
At September 30, 2004, the Company maintained two stock-based employee
compensation plans. The Company accounts for these employee stock compensation
plans in accordance with the intrinsic value-based method prescribed by
Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to
Employees.” During the three and nine month periods ended September 30, 2004,
in connection with retainer and meeting fees earned by members of the Company’s
board of directors and scientific advisory board in 2004, the Company recorded
$20,000 and $60,000, respectively, of expense associated with the issuance of
discounted stock options and $58,000 and $151,000, respectively, of expense
associated with restricted stock grants. No other stock-based employee
compensation expense is reflected in net loss as all other options granted
under these plans had an exercise price equal to the fair market value of the
underlying common stock on the date of grant.
The following table reflects pro forma net loss and loss per share had the
Company elected to adopt the fair value approach of SFAS No. 123:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2004
2003
2004
2003
(Unaudited)
(Unaudited)
(in thousands, except
(in thousands, except
per share data)
per share data)
Net loss — as reported
$
(5,008
)
$
(5,537
)
$
(17,295
)
$
(8,172
)
Stock-based compensation expense included in reported net loss
78
55
211
146
Stock-based compensation under fair value method
(946
)
(806
)
(2,709
)
(2,482
)
Net loss — pro forma after stock–based compensation under fair value
method
$
(5,876
)
$
(6,288
)
$
(19,793
)
$
(10,508
)
Net loss per share, basic and diluted — as reported
$
(0.27
)
$
(0.32
)
$
(0.94
)
$
(0.51
)
Net loss per share, basic and diluted — pro forma after stock-based
compensation under fair value method
$
(0.32
)
$
(0.36
)
$
(1.07
)
$
(0.65
)
4. Issuance of Common Stock
On August 5 and August 6, 2003, the Company completed the sale of a total
of 2,507,762 shares of common stock through a private placement to selected
institutional investors (the “Private Placement”), resulting in net proceeds to
the Company, after fees and expenses, of approximately $49.3 million. As part
of the Private Placement, the Company granted the institutional investors
additional rights to purchase up to an additional 501,552 shares of common
stock at a price of $26.00 per share. These additional investment rights became
exercisable on September 12, 2003, and expired on December 9, 2003. None of
these additional investment rights were exercised.
5. Patents
Patents include costs to secure patents on technology and products
developed by the Company. Patents are amortized on a straight-line basis over
their estimated useful lives of from 17 to 20 years. Patents are evaluated for
potential impairment whenever events or circumstance indicate that future
undiscounted cash flows may not be sufficient to recover their carrying
amounts. An impairment loss is recorded to the extent the patent’s carrying
value is in excess of its fair value. When fair values are not readily
available, the Company estimates fair values using expected discounted future
cash flows.
During the second quarter of 2004, the Company recorded a write-down of
$410,000, net of accumulated amortization, related to the impairment of certain
patents covering its inhalation technology which the Company determined to no
longer have value. Such write-down is reflected in research and product
development expense in the condensed consolidated statements of operations.
6. Income Taxes
For continuing operations, the effective tax rates for the three and nine
month periods ended September 30, 2004 and 2003 were less than 1%. The
effective tax rates are higher than the federal statutory rate of a 34% benefit
primarily due to valuation allowances recorded to offset deferred tax assets
relating to the Company’s net operating losses.
The gain on sale of discontinued operations of approximately $9.5 million,
recorded in the nine months ended September 30, 2003, is net of tax expense of
$51,000, or less than 1% of the pretax gain. The tax expense is lower than the
federal statutory rate of 34% primarily due to net operating losses which
offset the gain. In addition, earnings from discontinued operations of $177,000
for the nine months ended September 30, 2003 is net of tax expense of $26,000,
or 13% of pretax earnings. This tax expense, which includes foreign taxes, is
lower than the federal statutory rate of 34% primarily due to overall U.S. net
operating losses that offset the U.S. earnings of the discontinued operation
(see Note 9).
The Company has a Supplemental Executive Retirement Plan (“SERP”), a
nonqualified plan, which covers the Chairman and Chief Executive Officer of
Penwest. The Company does not fund this liability and no assets are held by the
SERP. The Company uses a measurement date of December 31 for its SERP. The
following disclosures summarize information relating to the SERP:
Components of net periodic benefit cost:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2004
2003
2004
2003
(in thousands)
(in thousands)
Service cost
$
(8
)
$
(7
)
$
(24
)
$
(20
)
Interest cost
32
31
94
92
Amortization of net obligation at transition
10
15
30
45
Amortization of prior service cost
—
4
1
10
Amortization of net gain
—
(7
)
—
(20
)
Net periodic benefit cost
$
34
$
36
$
101
$
107
8. Comprehensive Loss
The components of comprehensive loss for the three and nine month periods
ended September 30, 2004 and 2003 are as follows:
Three Months Ended
Nine Months Ended
September 30,
September 30,
2004
2003
2004
2003
(Unaudited)
(Unaudited)
(in thousands)
(in thousands)
Net loss
$
(5,008
)
$
(5,537
)
$
(17,295
)
$
(8,172
)
Foreign currency translation adjustments
—
—
—
109
Change in unrealized net gains and losses on marketable securities
43
55
(102
)
49
Comprehensive loss
$
(4,965
)
$
(5,482
)
$
(17,397
)
$
(8,014
)
Accumulated other comprehensive income (loss) equals the cumulative
translation adjustment and unrealized net gains and losses on marketable
securities, which are the only components of other comprehensive income (loss)
included in the Company’s financial statements. Effective on the date of the
Asset Sale, accumulated other comprehensive income (loss) is comprised solely
of unrealized net gains and losses on marketable securities.
9. Discontinued Operations
On February 27, 2003, Penwest sold substantially all of the assets (the
“Assets”) used in the Company’s excipient business to subsidiaries and
affiliates of Josef Rettenmaier Holding GmbH & Co. KG (“Rettenmaier”) for
$41.75 million, plus the assumption of specified liabilities, subject to a
working capital adjustment. The Assets of the excipient business were sold to
Rettenmaier, either directly or through the sale of the outstanding capital
stock of the three subsidiaries of Penwest that did business in the UK, Germany
and Finland. The purchase price included $39.5 million in cash and a
non-interest bearing promissory note of $2.25 million, with $1.0 million paid
to Penwest in April 2003 and $1.25 million paid to Penwest in May 2004.
In the first quarter of 2003, the Company recorded a gain on the Asset
Sale of approximately $9.6 million, net of taxes of $62,000, and has reported
the operating results of the excipient business as a discontinued operation in
accordance with SFAS No. 144, “Accounting for the Impairment or Disposal of
Long-Lived Assets.” In the second quarter of 2003, the Company recorded an
expense of $83,000 for the working capital adjustment, net of a tax benefit of
$11,000 for a total gain of $9.5 million, net of tax expense of $51,000 for the
nine months ended September 30, 2003. The net carrying amount of the assets and
liabilities on the date of the Asset Sale was approximately $29.5 million. The
approximate carrying values of the major classes were: property, plant and
equipment of $11.4 million; inventory of $8.3 million; receivables of $6.0
million; and intangible assets of $4.3 million offset by other net liabilities.
The gain on the Asset Sale was net of transaction related costs totaling $3.1
million, primarily consisting of professional and advisory fees.
Revenues and pretax profits for the excipient business approximated $6.1
million and $203,000, respectively, for the period January 1, 2003 through the
Asset Sale date of February 27, 2003.
Prior to the sale of the excipient business, the Company owned an office,
laboratory and warehouse facility in Patterson, New York, as well as a facility
in Cedar Rapids, Iowa, where it manufactured pharmaceutical excipients. As part
of the Asset Sale, the Company transferred these properties and assigned its
lease of a pharmaceutical excipient manufacturing facility in Nastola, Finland
to Rettenmaier. Under a lease agreement signed with Rettenmaier on February 27,
2003, the Company has the right to occupy approximately 14,000 square feet of
office and research and development space in the Patterson facility until
February 2008, initially on a rent-free basis (plus operating expenses) for two
years and then pursuant to three successive one-year options at monthly rent
payments approximating $14,000, plus operating expenses.
10. Licensing Agreements
The Company enters into collaborative arrangements with pharmaceutical
companies to develop, manufacture or market products formulated with the
Company’s drug delivery technologies.
Endo Pharmaceuticals, Inc.
In September 1997, the Company entered into a strategic alliance agreement
with Endo Pharmaceuticals, Inc. with respect to the development of oxymorphone
ER, an extended release formulation of oxymorphone, a narcotic analgesic for
the treatment of moderate to severe pain, based on the Company’s TIMERx
technology. This agreement was amended and restated in April 2002. Endo has a
broad product line including established brands such as Percodan®, Percocet®,
and Lidoderm®. Endo is registered with the U.S. Drug Enforcement Administration
as a developer, manufacturer and marketer of controlled narcotic substances.
Under the strategic alliance agreement, the responsibilities of the
Company and Endo with respect to the oxymorphone product are determined by a
committee comprised of an equal number of members from each of the Company and
Endo (the “Alliance Committee”). During the development of the product, the
Company formulated oxymorphone ER, and Endo conducted all clinical studies and
prepared and filed all regulatory applications. The Company has agreed to
supply TIMERx material to Endo, and Endo has agreed to manufacture and market
oxymorphone ER in the United States. The manufacture and marketing outside of
the United States may be conducted by the Company, Endo or a third party, as
determined by the Alliance Committee.
Prior to April 17, 2003, the Company and Endo shared the costs involved in
the development of oxymorphone ER. On March 17, 2003, the Company notified Endo
that it was discontinuing its participation in the funding of the development
and marketing of oxymorphone ER effective April 17, 2003. As a result of this
termination of funding, Endo has the right to complete the development of
oxymorphone ER and recoup the portion of development costs incurred by Endo
that otherwise would have been funded by Penwest (“Unfunded Development Costs”)
through a temporary adjustment in the royalty rate payable to Penwest that will
return to its pre-adjustment level once Endo has recovered such costs. Endo may
also allow the Company to reimburse Endo directly for the Unfunded Development
Costs and, as a result, to receive the full royalty rate from Endo without
adjustment. The Company estimates that through July 31, 2004, Unfunded
Development Costs approximated $11.5 million.
The parties have agreed that the party marketing oxymorphone ER will pay the
other party royalties initially equal to 50% of the net realization (as defined
in the agreement) subject to adjustment for the Unfunded Development Costs.
This percentage will decrease if the aggregate U.S. net realization exceeds
pre-determined thresholds. In general, the royalty payable by the marketing
party to the other party will not drop below 40%. However, the royalty will be
reduced by one-third in limited circumstances, including termination of the
agreement based on uncured material breaches of the agreement by the royalty
receiving party and certain bankruptcy and insolvency events involving the
royalty receiving party. Under the agreement, Endo will purchase formulated
TIMERx material for use in oxymorphone ER exclusively from the Company at
specified prices, and include these purchases in cost of goods sold of the
product prior to determining net realization.
On March 2, 2000, Mylan Pharmaceuticals Inc. announced that it had signed
a supply and distribution agreement with Pfizer, Inc to market a generic
version of all three strengths (30 mg, 60 mg, 90 mg) of Pfizer’s Procardia XL.
In connection with that agreement, Mylan decided not to market Nifedipine XL, a
product the Company had developed in collaboration with Mylan, and agreed to
pay Penwest a royalty on all future net sales of the 30 mg strength of Pfizer’s
generic Procardia XL. The royalty percentage was comparable to the percentage
called for in Penwest’s original agreement with Mylan for Nifedipine XL. Mylan
has retained the marketing rights to the 30 mg strength of Nifedipine XL.
Mylan’s sales in the United States in 2003 of the 30 mg dosage strength version
of Pfizer’s generic Procardia XL totaled approximately $36.8 million. The term
of this agreement continues until such time as Mylan permanently ceases to
market generic Procardia XL.
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