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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, DC 20549

 

 

Form 10-Q

 

(Mark One)

x       QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the Quarterly Period Ended June 30, 2013

 

OR

 

o          TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                 to                

 

Commission file number 0-19125

 

 

Isis Pharmaceuticals, Inc.

(Exact name of Registrant as specified in its charter)

 

 

2855 Gazelle Court, Carlsbad, CA 92010

(Address of principal executive offices, including zip code)

 

760-931-9200

(Registrant’s telephone number, including area code)

 

Securities registered pursuant to Section 12(b) of the Act: None

 

Securities registered pursuant to Section 12(g) of the Act:

Common Stock, $.001 Par Value

 

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  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes  x No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definition of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

Large accelerated filer  x		Accelerated filer  o
Non-accelerated filer  o		Smaller reporting company  o
(Do not check if a smaller reporting company)

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12(b)-2 of the Securities Exchange Act of 1934). Yes  o No  x

 

The number of shares of voting common stock outstanding as of August 1, 2013 was 115,307,756.

 

 

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ISIS PHARMACEUTICALS, INC.

FORM 10-Q

INDEX

 

PART I	FINANCIAL INFORMATION
ITEM 1:	Financial Statements:
	Condensed Consolidated Balance Sheets as of June 30, 2013 (unaudited) and December 31, 2012	3
	Condensed Consolidated Statements of Operations for the three and six months ended June 30, 2013  and 2012 (unaudited)	4
	Condensed Consolidated Statements of Comprehensive Income (Loss) for the three and six months ended June 30, 2013 and 2012 (unaudited)	5
	Condensed Consolidated Statements of Cash Flows for the six months ended June 30, 2013 and 2012 (unaudited)	6
	Notes to Condensed Consolidated Financial Statements (unaudited)	7
ITEM 2:	Management’s Discussion and Analysis of Financial Condition and Results of Operations	24
	Results of Operations	27
	Liquidity and Capital Resources	31
	Risk Factors	33
ITEM 3:	Quantitative and Qualitative Disclosures about Market Risk	42
ITEM 4:	Controls and Procedures	42
PART II	OTHER INFORMATION	43
ITEM 1:	Legal Proceedings	43
ITEM 2:	Unregistered Sales of Equity Securities and Use of Proceeds	43
ITEM 3:	Default upon Senior Securities	43
ITEM 4:	Mine Safety Disclosures	43
ITEM 5:	Other Information	43
ITEM 6:	Exhibits	44
SIGNATURES		45

 

TRADEMARKS

 

Isis Pharmaceuticals® is a registered trademark of Isis Pharmaceuticals, Inc.

 

Regulus Therapeutics™ is a trademark of Regulus Therapeutics Inc.

 

KYNAMRO™ is a trademark of Genzyme Corporation

 

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ISIS PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except share data)

 

		June 30, 2013			December 31, 2012
		(Unaudited)
ASSETS
Current assets:
Cash and cash equivalents		$	296,540		$	124,482
Short-term investments		294,212			249,964
Contracts receivable		2,024			522
Inventories		8,309			6,121
Investment in Regulus Therapeutics Inc.		62,190			33,622
Other current assets		5,786			8,727
Total current assets		669,061			423,438
Property, plant and equipment, net		88,312			91,084
Licenses, net		5,528			6,579
Patents, net		20,149			18,646
Deposits and other assets		5,601			5,939
Total assets		$	788,651		$	545,686
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable		$	9,461		$	10,239
Accrued compensation		7,031			7,878
Accrued liabilities		16,514			15,401
Accrued income taxes		8,727			—
Current portion of long-term obligations		4,853			4,879
Current portion of deferred contract revenue		40,409			35,925
Total current liabilities		86,995			74,322
Long-term deferred contract revenue		75,184			66,656
2 3 / 4  percent convertible senior notes		147,099			143,990
Long-term obligations, less current portion		7,382			7,402
Long-term financing liability for leased facility		70,910			70,550
Total liabilities		387,570			362,920
Stockholders’ equity:
Common stock, $0.001 par value; 200,000,000 shares authorized, 114,291,999 and 101,481,134 shares issued and outstanding at June 30, 2013 and December 31, 2012, respectively		114			102
Additional paid-in capital		1,292,745			1,077,150
Accumulated other comprehensive gain		26,986			12,480
Accumulated deficit		(918,764		)	(906,966		)
Total stockholders’ equity		401,081			182,766
Total liabilities and stockholders’ equity		$	788,651		$	545,686

 

See accompanying notes.

 

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ISIS PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except for per share amounts)

(Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2013			2012			2013			2012
Revenue:
Research and development revenue under collaborative agreements		$	37,615		$	47,140		$	79,535		$	68,957
Licensing and royalty revenue		477			200			1,916			1,618
Total revenue		38,092			47,340			81,451			70,575
Expenses:
Research and development		42,631			40,435			80,944			79,149
General and administrative		3,389			3,209			6,811			6,185
Total operating expenses		46,020			43,644			87,755			85,334
Income (loss) from operations		(7,928		)	3,696			(6,304		)	(14,759		)
Other income (expense):
Equity in net loss of Regulus Therapeutics Inc.		—			(163		)	—			(1,139		)
Investment income		589			477			967			1,077
Interest expense		(4,808		)	(5,219		)	(9,603		)	(10,398		)
Gain on investments, net		840			2			1,898			19
Loss before income tax benefit (expense)		(11,307		)	(1,207		)	(13,042		)	(25,200		)
Income tax benefit (expense)		1,181			—			1,244			(2		)
Net loss		$	(10,126	)	$	(1,207	)	$	(11,798	)	$	(25,202	)
Basic and diluted net loss per share		$	(0.09	)	$	(0.01	)	$	(0.11	)	$	(0.25	)
Shares used in computing basic and diluted net loss per share		108,539			100,213			105,225			100,185

 

See accompanying notes.

 

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ISIS PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME (LOSS)

(in thousands)

(Unaudited)

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2013			2012			2013			2012
Net loss		$	(10,126	)	$	( 1,207	)	$	(11,798	)	$	(25,202	)
Unrealized gains on securities, net of tax		9,202			1,210			15,669			1,738
Reclassification adjustment for realized gain on the sale of Sarepta shares included in net loss		—			—			(1,163		)	—
Comprehensive income (loss)		$	(924	)	$	3		$	2,708		$	( 23,464	)

 

See accompanying notes.

 

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ISIS PHARMACEUTICALS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

 

		Six Months Ended June 30,
		2013			2012
Net cash provided by (used in) operating activities		$	12,164		$	(9,288	)
Investing activities:
Purchases of short-term investments		(144,250		)	(116,653		)
Proceeds from the sale of short-term investments		96,926			142,681
Purchases of property, plant and equipment		(591		)	(864		)
Acquisition of licenses and other assets, net		(1,171		)	(1,592		)
Proceeds from sale of strategic investments		1,938			—
Net cash (used in) provided by investing activities		(47,148		)	23,572
Financing activities:
Proceeds from equity awards		36,879			1,617
Net proceeds from public common stock offering		173,223			—
Proceeds from equipment financing arrangement		2,513			9,100
Principal payments on debt and capital lease obligations		(5,573		)	(4,833		)
Net cash provided by financing activities		207,042			5,884
Net increase in cash and cash equivalents		172,058			20,168
Cash and cash equivalents at beginning of period		124,482			65,477
Cash and cash equivalents at end of period		$	296,540		$	85,645
Supplemental disclosures of cash flow information:
Interest paid		$	2,977		$	2,275
Income taxes paid		$	2		$	—
Supplemental disclosures of non-cash investing and financing activities:
Amounts accrued for capital and patent expenditures		$	1,055		$	679

 

See accompanying notes.

 

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ISIS PHARMACEUTICALS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2013

(Unaudited)

 

1.                                       Basis of Presentation

 

The unaudited interim condensed consolidated financial statements for the three and six month periods ended June 30, 2013 and 2012 have been prepared on the same basis as the audited financial statements for the year ended December 31, 2012. The financial statements include all normal recurring adjustments, which we consider necessary for a fair presentation of our financial position at such dates and our operating results and cash flows for those periods. Results for the interim periods are not necessarily indicative of the results for the entire year. For more complete financial information, these financial statements, and notes thereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2012 included in our Annual Report on Form 10-K filed with the Securities and Exchange Commission (“SEC”).

 

The condensed consolidated financial statements include the accounts of Isis Pharmaceuticals, Inc. (“we”, “us” or “our”) and our wholly owned subsidiary, Symphony GenIsis, Inc., which is currently inactive.  In addition to our wholly owned subsidiary, our condensed consolidated financial statements include our equity investment in Regulus Therapeutics Inc. In October 2012, Regulus completed an initial public offering (IPO).  We now own less than 20 percent of Regulus’ common stock and we no longer have significant influence over the operating and financial policies of Regulus.  As a result, in the fourth quarter of 2012, we stopped using the equity method of accounting for our equity investment in Regulus and we began accounting for our investment at fair value.

 

2.                                       Significant Accounting Policies

 

Revenue Recognition

 

We generally recognize revenue when we have satisfied all contractual obligations and are reasonably assured of collecting the resulting receivable. We are often entitled to bill our customers and receive payment from our customers in advance of recognizing the revenue. In those instances in which we have received payment from our customers in advance of recognizing revenue, we include the amounts in deferred revenue on our condensed consolidated balance sheet.

 

Research and development revenue under collaborative agreements

 

Our collaboration agreements typically contain multiple elements, or deliverables, including technology licenses or options to obtain technology licenses, research and development services, and in certain cases manufacturing services. Our collaborations may provide for various types of payments to us including upfront payments, funding of research and development, milestone payments, licensing fees, profit sharing and royalties on product sales. We evaluate the deliverables in our collaboration agreements to determine whether they meet the criteria to be accounted for as separate units of accounting or whether they should be combined with other deliverables and then accounted for as a single unit of accounting. When the delivered items in an arrangement have “stand-alone value” to our customer, we account for the deliverables as separate units of accounting and we allocate the consideration to each unit of accounting based on the relative selling price of each deliverable. Delivered items have stand-alone value if they are sold separately by any vendor or the customer could resell the delivered items on a standalone basis. We use the following hierarchy of values to estimate the selling price of each deliverable: (i) vendor-specific objective evidence of fair value; (ii) third-party evidence of selling price; and (iii) best estimate of selling price, or BESP. The BESP reflects our best estimate of what the selling price would be if we regularly sold the deliverable on a stand-alone basis. We recognize the revenue allocated to each unit of accounting as we deliver the related goods or services. If we determine that we should treat certain deliverables as a single unit of accounting, then we recognize the revenue ratably over our estimated period of performance.

 

In December 2012, we entered into a collaboration agreement with AstraZeneca to discover and develop antisense therapeutics against five cancer targets. As part of the collaboration, we received a $25 million upfront payment in December 2012 and a $6 million payment in June 2013 when AstraZeneca elected to continue the research collaboration.  We are also eligible to receive milestone payments, license fees for the research program targets and royalties on any product sales of drugs resulting from this collaboration. In exchange, we granted AstraZeneca an exclusive license to develop and commercialize ISIS-STAT3 Rx  and ISIS-AR Rx , which we previously referred to as ISIS-AZ1 Rx .   We also granted AstraZeneca options to license up to three drugs under the separate research program. We are responsible for completing an ongoing clinical study of ISIS-STAT3 Rx and IND-enabling studies for ISIS-AR Rx . AstraZeneca is responsible for all other global development, regulatory and commercialization activities for ISIS-STAT3 Rx  and ISIS-AR Rx . In addition, if AstraZeneca exercises its option for any drugs resulting from the research program, AstraZeneca will assume global development, regulatory and commercialization responsibilities for such drug.  Since this agreement has multiple elements, we evaluated the deliverables in this arrangement and determined that certain deliverables, either individually or in combination, have stand-alone value.  Below is a list of the four separate units of accounting under our agreement:

 

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·                   The exclusive license we granted to AstraZeneca to develop and commercialize ISIS-STAT3 Rx for the treatment of cancer;

·                   The development services we are performing for ISIS-STAT3 Rx ;

·                   The exclusive license we granted to AstraZeneca to develop and commercialize ISIS-AR Rx  and the research services we are performing for ISIS-AR Rx ; and

·                   The option to license up to three drugs under a research program and the research services we will perform for this program.

 

We determined that the ISIS-STAT3 Rx  license had stand-alone value because it is an exclusive license that gives AstraZeneca the right to develop ISIS-STAT3 Rx  or to sublicense its rights.  In addition, ISIS-STAT3 Rx  is currently in development and it is possible that AstraZeneca or another third party could conduct clinical trials without assistance from us.  As a result, we consider the ISIS-STAT3 Rx license and the development services for ISIS-STAT3 Rx  to be separate units of accounting. We recognized the portion of the consideration allocated to the ISIS-STAT3 Rx license immediately because we delivered the license and earned the revenue.  We are recognizing the amount allocated to the development services for ISIS-STAT3 Rx  as revenue over the period of time we perform services. The ISIS-AR Rx  license is also an exclusive license.  Because of the early stage of research for ISIS-AR Rx , we believe that our knowledge and expertise with antisense technology is essential for AstraZeneca or another third party to successfully develop ISIS-AR Rx .  As a result, we concluded that the ISIS-AR Rx  license does not have stand-alone value and we combined the ISIS-AR Rx  license and related research services into one unit of accounting.  We are recognizing revenue for the combined unit of accounting over the period of time we perform services. We determined that the options under the research program did not have stand-alone value because AstraZeneca cannot develop or commercialize drugs resulting from the research program until AstraZeneca exercises the respective option or options. As a result, we considered the research options and the related research services as a combined unit of accounting.  We are recognizing revenue for the combined unit of accounting over the period of our performance.

 

We determined that the initial allocable arrangement consideration was the $25 million upfront payment because it was the only payment that was fixed and determinable when we entered into the agreement.  In June 2013, we increased the allocable consideration to $31 million when we received the $6 million payment.   There was considerable uncertainty at the date of the agreement as to whether we would earn the milestone payments, royalty payments, payments for manufacturing clinical trial materials or payments for finished drug product.  As such, we did not include those payments in the allocable consideration.

 

We allocated the allocable consideration based on the relative BESP of each unit of accounting.  We engaged a third party, independent valuation expert to assist us with determining BESP. We estimated the selling price of the licenses granted for ISIS-STAT3 Rx  and ISIS-AR Rx  by using the relief from royalty method. Under this method, we estimated the amount of income, net of taxes, for each drug. We then discounted the projected income for each license to present value. The significant inputs we used to determine the projected income of the licenses included:

 

·                   Estimated future product sales;

·                   Estimated royalties on future product sales;

·                   Contractual milestone payments;

·                   Expenses we expect to incur;

·                   Income taxes; and

·                   An appropriate discount rate.

 

We estimated the selling price of the research and development services by using our internal estimates of the cost to perform the specific services, marked up to include a reasonable profit margin, and estimates of expected cash outflows to third parties for services and supplies over the expected period that we will perform research and development. The significant inputs we used to determine the selling price of the research and development services included:

 

·                   The number of internal hours we will spend performing these services;

·                   The estimated number and cost of studies we will perform;

·                   The estimated number and cost of studies that we will contract with third parties to perform; and

·                   The estimated cost of drug product we will use in the studies.

 

As a result of the allocation, we recognized $9.3 million of the $25 million upfront payment for the ISIS-STAT3 Rx  license in December 2012 and we recognized $2.2 million of the $6 million payment for the ISIS-STAT3 Rx  license in June 2013.  We are recognizing the remaining $19.5 million of the $31 million over the estimated period of our performance. Assuming a constant selling price for the other elements in the arrangement, if there was an assumed ten percent increase or decrease in the estimated selling price of the ISIS-STAT3 Rx  license, we determined that the revenue we would have allocated to the ISIS-STAT3 Rx  license would change by approximately seven percent, or $750,000, from the amount we recorded.

 

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Typically, we must estimate our period of performance when the agreements we enter into do not clearly define such information.  Our collaborative agreements typically include a research and/or development project plan that includes the activities the agreement requires each party to perform during the collaboration. We estimate the period of time over which we will complete the activities for which we are responsible and use that period of time as our period of performance for purposes of revenue recognition and amortize revenue over such period. If our collaborators ask us to continue performing work in a collaboration beyond the initial period of performance, we extend our amortization period to correspond to the new extended period of performance.  The revenue we recognize could be materially different if different estimates prevail.

 

From time to time, we may enter into separate agreements at or near the same time with the same customer.  We evaluate such agreements to determine whether they should be accounted for individually as distinct arrangements or whether the separate agreements are, in substance, a single multiple element arrangement.  We evaluate whether the negotiations are conducted jointly as part of a single negotiation, whether the deliverables are interrelated or interdependent, whether fees in one arrangement are tied to performance in another arrangement, and whether elements in one arrangement are essential to another arrangement. Our evaluation involves significant judgment to determine whether a group of agreements might be so closely related that they are, in effect, part of a single arrangement.

 

In January 2012, we entered into a collaboration agreement with Biogen Idec to develop and commercialize ISIS-SMN Rx  for Spinal Muscular Atrophy, or SMA. As part of the collaboration, we received a $29 million upfront payment and we are responsible for global development of ISIS-SMN Rx  through completion of Phase 2/3 clinical trials. In June 2012, we entered into a second and separate collaboration agreement with Biogen Idec to develop and commercialize a novel antisense drug targeting DMPK, or dystrophia myotonica-protein kinase. As part of the collaboration, we received a $12 million upfront payment and we are responsible for global development of the drug through the completion of a Phase 2 clinical trial. In December 2012, we entered into a third and separate collaboration agreement with Biogen Idec to discover and develop antisense drugs against three targets to treat neurological or neuromuscular disorders. As part of the collaboration, we received a $30 million upfront payment and we are responsible for the discovery of a lead antisense drug for each of three targets.  All three of these collaboration agreements give Biogen Idec the option or options to license one or more drugs resulting from the specific collaboration.  If Biogen Idec exercises an option, it will pay us a license fee and will assume future development, regulatory and commercialization responsibilities for the licensed drug. We are also eligible to receive milestone payments associated with the development of the drugs prior to licensing, milestone payments if Biogen Idec achieves pre-specified regulatory milestones, and royalties on any product sales of drugs resulting from these collaborations.

 

We evaluated the SMA, DMPK, and neurology agreements to determine whether we should account for them as separate agreements or as a single multiple element arrangement.  We determined that we should account for the agreements separately because we conducted the negotiations independently of one another, the first two agreements cover two different diseases while the targets for the third agreement were not defined at the inception of the agreement, there are no interrelated or interdependent deliverables, there are no provisions in any of these agreements that are essential to the other agreement, and the payment terms and fees under each agreement are independent of each other.  We also evaluated the deliverables in each of these agreements to determine whether they met the criteria to be accounted for as separate units of accounting or whether they should be combined with other deliverables and accounted for as a single unit of accounting.  For all three of these agreements, we determined that the options did not have stand-alone value because Biogen Idec cannot pursue the development or commercialization of the drugs resulting from these collaborations until it exercises the respective option or options.  As such, for each agreement we considered the deliverables to be a single unit of accounting and we are recognizing the upfront payment for each of the agreements over the respective research and development term, which is the estimated period of our performance.

 

Our collaborations often include contractual milestones, which typically relate to the achievement of pre-specified development, regulatory and commercialization events.  These three categories of milestone events reflect the three stages of the life-cycle of our drugs, which we describe in more detail in the following paragraph.

 

Prior to the first stage in the life-cycle of our drugs, we perform a significant amount of work using our proprietary antisense technology to design chemical compounds that interact with specific genes that are good targets for drug discovery.  From these research efforts, we hope to identify a development candidate.  The designation of a development candidate is the first stage in the life-cycle of our drugs.  A development candidate is a chemical compound that has demonstrated the necessary safety and efficacy in preclinical animal studies to warrant further study in humans.  During the first step of the development stage, we or our partners study our drugs in IND-enabling studies, which are animal studies intended to support an Investigational New Drug, or IND, application and/or the foreign equivalent.  An approved IND allows us or our partners to study our development candidate in humans.  If the regulatory agency approves the IND, we or our partners initiate Phase 1 clinical trials in which we typically enroll a small number of healthy volunteers to ensure the development candidate is safe for use in patients.  If we or our partners determine that a development

 

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candidate is safe based on the Phase 1 data, we or our partners initiate Phase 2 studies that are generally larger scale studies in patients with the primary intent of determining the efficacy of the development candidate.  The final step in the development stage is Phase 3 studies to gather the necessary safety and efficacy data to request marketing approval from the Food and Drug Administration, or FDA, and/or foreign equivalents.  The Phase 3 studies typically involve large numbers of patients and can take up to several years to complete.  If the data gathered during the trials demonstrates acceptable safety and efficacy results, we or our partner will submit an application to the FDA and/or its foreign equivalents for marketing approval.  This stage of the drug’s life-cycle is the regulatory stage.  If a drug achieves marketing approval, it moves into the commercialization stage, during which our partner will market and sell the drug to patients.  Although our partner will ultimately be responsible for marketing and selling the drug, our efforts to discover and develop a drug that is safe, effective and reliable contributes significantly to our partner’s ability to successfully sell the drug.  The FDA and its foreign equivalents have the authority to impose significant restrictions on an approved drug through the product label and on advertising, promotional and distribution activities.  Therefore, our efforts designing and executing the necessary animal and human studies are critical to obtaining claims in the product label from the regulatory agencies that would allow our partner to successfully commercialize our drug.  Further, the patent protection afforded our drugs as a result of our initial patent applications and related prosecution activities in the United States and foreign jurisdictions are critical to our partner’s ability to sell our drugs without competition from generic drugs.  The potential sales volume of an approved drug is dependent on several factors including the size of the patient population, market penetration of the drug, and the price charged for the drug.

 

Generally, the milestone events contained in our partnership agreements coincide with the progression of our drugs from development, to regulatory approval and then to commercialization.  The process of successfully discovering a new development candidate, having it approved and ultimately sold for a profit is highly uncertain.  As such, the milestone payments we may earn from our partners involve a significant degree of risk to achieve.  Therefore, as a drug progresses through the stages of its life-cycle, the value of the drug generally increases.

 

Development milestones in our partnerships may include the following types of events:

 

·                   Designation of a development candidate.  Following the designation of a development candidate, IND-enabling animal studies for a new development candidate generally take 12 to 18 months to complete;

·                   Initiation of a Phase 1 clinical trial.  Generally, Phase 1 clinical trials take one to two years to complete;

·                   Initiation or completion of a Phase 2 clinical trial.  Generally, Phase 2 clinical trials take one to three years to complete;

·                   Initiation or completion of a Phase 3 clinical trial.  Generally, Phase 3 clinical trials take two to four years to complete.

 

Regulatory milestones in our partnerships may include the following types of events:

 

·                   Filing of regulatory applications for marketing approval such as a New Drug Application, or NDA, in the United States or a Marketing Authorization Application, or MAA, in Europe.  Generally, it takes six to twelve months to prepare and submit regulatory filings.

·                   Marketing approval in a major market, such as the United States, Europe or Japan.  Generally it takes one to two years after an application is submitted to obtain approval from the applicable regulatory agency.

 

Commercialization milestones in our partnerships may include the following types of events:

 

·                   First commercial sale in a particular market, such as in the United States or Europe.

·                   Product sales in excess of a pre-specified threshold, such as annual sales exceeding $1 billion.  The amount of time to achieve this type of milestone depends on several factors including but not limited to the dollar amount of the threshold, the pricing of the product and the pace at which customers begin using the product.

 

We assess whether a substantive milestone exists at the inception of our agreements.  When a substantive milestone is achieved, we recognize revenue related to the milestone payment.  For our existing licensing and collaboration agreements in which we are involved in the discovery and/or development of the related drug or provide the partner with ongoing access to new technologies we discover, we have determined that all future development, regulatory and commercialization milestones are substantive. For example, for our strategic alliance with GlaxoSmithKline, or GSK, we are using our antisense drug discovery platform to seek out and develop new drugs against targets for rare and serious diseases. Alternatively, we provide on-going access to our technology to Alnylam Pharmaceuticals, Inc. to develop and commercialize RNA interference, or RNAi, therapeutics.  We consider milestones for both of these collaborations to be substantive.  For those agreements that do not meet the following criteria, we do not consider the future milestones to be substantive.  In evaluating if a milestone is substantive we consider whether:

 

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·                   Substantive uncertainty exists as to the achievement of the milestone event at the inception of the arrangement;

·                   The achievement of the milestone involves substantive effort and can only be achieved based in whole or part on our performance or the occurrence of a specific outcome resulting from our performance;

·                   The amount of the milestone payment appears reasonable either in relation to the effort expended or to the enhancement of the value of the delivered items;

·                   There is no future performance required to earn the milestone; and

·                   The consideration is reasonable relative to all deliverables and payment terms in the arrangement.

 

If any of these conditions are not met, we will defer recognition of the milestone payment and recognize it as revenue over the estimated period of performance, if any.  We earned $46 million in milestone payments in the first half of 2013, including a $25 million milestone payment from Genzyme we recognized in the first quarter of 2013 when the FDA approved the KYNAMRO NDA.  We consider milestone payments related to progression of a drug through the development and regulatory stages of its life cycle to be substantive milestones because the level of effort and inherent risk associated with these events is high. Therefore, we recognized the entire $46 million in milestone payments in the first half of 2013.  Further information about our collaborative arrangements can be found in Note 8, Collaborative Arrangements and Licensing Agreements, below and Note 7, Collaborative Arrangements and Licensing Agreements, of our audited financial statements for the year ended December 31, 2012 included in our Annual Report on Form 10-K filed with the SEC.

 

Licensing and royalty revenue

 

We often enter into agreements to license our proprietary patent rights on an exclusive or non-exclusive basis in exchange for license fees and/or royalties. We generally recognize as revenue immediately those licensing fees and royalties for which we have no significant future performance obligations and are reasonably assured of collecting the resulting receivable.

 

Cash, cash equivalents and short-term investments

 

We consider all liquid investments with maturities of 90 days or less when we purchase them to be cash equivalents. Our short-term investments have initial maturities of greater than 90 days from date of purchase. We classify our short-term investments as “available-for-sale” and carry them at fair market value based upon prices for identical or similar items on the last day of the fiscal period. We record unrealized gains and losses as a separate component of comprehensive income (loss) and include net realized gains and losses in gain (loss) on investments. We use the specific identification method to determine the cost of securities sold.

 

We have equity investments in privately- and publicly-held biotechnology companies that we have received as part of a technology license or collaboration agreement.  At June 30, 2013 we held ownership interests of less than 20 percent in each of the respective companies.

 

We account for our equity investments in publicly-held companies at fair value and record unrealized gains and losses related to temporary increases and decreases in the stock of these publicly-held companies as a separate component of comprehensive income (loss).  We account for equity investments in privately-held companies under the cost method of accounting because we own less than 20 percent and do not have significant influence over their operations. The cost method investments we hold are in early stage biotechnology companies and realization of our equity position in those companies is uncertain. In those circumstances we record a full valuation allowance. In determining if and when a decrease in market value below our cost in our equity positions is temporary or other-than-temporary, we examine historical trends in the stock price, the financial condition of the company, near term prospects of the company and our current need for cash. If we determine that a decline in value in either a public or private investment is other-than-temporary, we recognize an impairment loss in the period in which the other-than-temporary decline occurs.

 

Inventory valuation

 

We capitalize the costs of raw materials that we purchase for use in producing our drugs because until we use these raw materials they have alternative future uses. We include in inventory raw material costs for drugs that we manufacture for our partners under contractual terms and that we use primarily in our clinical development activities and drug products. We can use each of our raw materials in multiple products and, as a result, each raw material has future economic value independent of the development status of any single drug. For example, if one of our drugs failed, we could use the raw materials for that drug to manufacture our other drugs. We expense these costs when we deliver the drugs to our partners, or as we provide these drugs for our own clinical trials. We reflect our inventory on the balance sheet at the lower of cost or market value under the first-in, first-out method. We review inventory periodically and reduce the carrying value of items we consider to be slow moving or obsolete to their estimated net realizable value. We consider several factors in estimating the net realizable value, including shelf life of raw materials, alternative uses for our drugs and clinical trial materials and historical write-offs. We did not record any inventory write-offs for the first six months of 2013 and 2012. Total inventory, which consisted of raw materials, was $8.3 million and $6.1 million as of June 30, 2013 and December 31, 2012, respectively.

 

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Patents

 

We capitalize costs consisting principally of outside legal costs and filing fees related to obtaining patents. We review our capitalized patent costs regularly to ensure that they include costs for patents and patent applications that have future value. We evaluate patents and patent applications that we are not actively pursuing and write off any associated costs. We amortize patent costs over their useful lives, beginning with the date the United States Patent and Trademark Office, or foreign equivalent, issues the patent.  For the first six months of 2013 and 2012, we recorded non-cash charges of $275,000 and $288,000, respectively, which we included in research and development expenses, related to the write-down of our patent costs to their estimated net realizable values.

 

Long-lived assets

 

We evaluate long-lived assets, which include property, plant and equipment, patent costs, and exclusive licenses acquired from third parties, for impairment on at least a quarterly basis and whenever events or changes in circumstances indicate that we may not be able to recover the carrying amount of such assets.

 

Equity method of accounting

 

We accounted for our ownership interest in Regulus using the equity method of accounting until Regulus’ IPO in October 2012.  In the fourth quarter of 2012, we began accounting for our investment at fair value because we now own less than 20 percent of Regulus’ common stock and we no longer have significant influence over the operating and financial policies of Regulus. Under the equity method of accounting, we included our share of Regulus’ operating results on a separate line in our condensed consolidated statement of operations called “Equity in net loss of Regulus Therapeutics Inc.”

 

Use of estimates

 

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ from those estimates.

 

Basic and diluted net loss per share

 

We compute basic net loss per share by dividing the net loss by the weighted-average number of common shares outstanding during the period. As we incurred a net loss for the three and six months ended June 30, 2013 and 2012, we did not include dilutive common equivalent shares in the computation of diluted net loss per share because the effect would have been anti-dilutive.  The following would have had an anti-dilutive effect on net loss per share:

 

·                   2 3 / 4  percent convertible senior notes;

·                   2 5 / 8  percent convertible subordinated notes;

·                   GlaxoSmithKline convertible promissory notes issued by Regulus;

·                   Dilutive stock options; and

·                   Unvested restricted stock units.

 

We redeemed all of our 2 5 / 8  percent notes in September 2012 and in October 2012 Regulus completed an IPO, upon which we were no longer guarantors on the two convertible notes that Regulus issued to GSK.  As a result, the 2 5 / 8  percent notes and GSK convertible promissory notes are not common equivalent shares for the three and six months ended June 30, 2013.

 

Public Common Stock Offering

 

In June 2013, we completed the sale of 9,617,869 shares of our common stock through a public offering at a price of $19.00 per share, which included 617,869 additional shares sold pursuant to an option we granted to the underwriters. We received net proceeds of approximately $173.2 million from the sale of these shares net of underwriting discounts and commissions and other estimated offering expenses of $9.5 million.

 

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Consolidation of variable interest entities

 

We identify entities as variable interest entities either: (1) that do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) in which the equity investors lack an essential characteristic of a controlling financial interest.  We perform ongoing qualitative assessments of our variable interest entities to determine whether we have a controlling financial interest in the variable interest entity and therefore are the primary beneficiary.  As of June 30, 2013 and December 31, 2012, we had collaborative arrangements with five and six entities, respectively, that we considered to be variable interest entities.  We are not the primary beneficiary for any of these entities as we do not have both the power to direct the activities that most significantly impact the economic performance of our variable interest entities and the obligation to absorb losses or the right to receive benefits from our variable interest entities that could potentially be significant to the variable interest entities.  As of June 30, 2013, the total carrying value of our investments in variable interest entities was $63.6 million, and was primarily related to our investment in Regulus. Our maximum exposure to loss related to these variable interest entities is limited to the carrying value of our investments.

 

Accumulated other comprehensive income (loss)

 

Accumulated other comprehensive income (loss) is comprised of unrealized gains and losses on securities, net of taxes, and  adjustments we made to reclassify realized gains and losses on securities from other accumulated comprehensive income to our condensed consolidated statement of operations . The following table summarizes changes in accumulated other comprehensive income (loss) for the three and six months ended June 30, 2013 and 2012 (in thousands):

(1)          Other comprehensive income for the three and six months ended June 30, 2013 includes income tax expense of $6.3 million and $10.0 million, respectively.

 

(2)          Included in g ain on investments, net on our condensed consolidated statement of operations.

 

Convertible debt

 

In August 2012, we completed a $201.3 million offering of convertible senior notes, which mature in 2019 and bear interest at 2¾ percent.  In September 2012, we used a substantial portion of the net proceeds from the issuance of the 2¾ percent notes to redeem our 2 5 ¤ 8  percent convertible subordinated notes. Consistent with how we accounted for our 2 5 ¤ 8  percent notes, we account for our 2¾ percent notes by separating the liability and equity components of the instrument in a manner that reflects our nonconvertible debt borrowing rate. As a result, we assigned a value to the debt component of our 2¾ percent notes equal to the estimated fair value of similar debt instruments without the conversion feature, which resulted in us recording the debt instrument at a discount.  We are amortizing the debt discount over the life of these 2¾ percent notes as additional non-cash interest expense utilizing the effective interest method.

 

Segment information

 

We operate in a single segment, Drug Discovery and Development operations, because our chief decision maker reviews operating results on an aggregate basis and manages our operations as a single operating segment.

 

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Stock-based compensation expense

 

We measure stock-based compensation expense for equity-classified awards, principally related to stock options, restricted stock units, or RSUs, and stock purchase rights under our Employee Stock Purchase Plan, or ESPP, based on the estimated fair value of the award on the date of grant using an option-pricing model. We recognize the value of the portion of the award that we ultimately expect to vest as stock-based compensation expense over the requisite service period in our condensed consolidated statements of operations.  We reduce stock-based compensation expense for estimated forfeitures at the time of grant and revise in subsequent periods if actual forfeitures differ from those estimates.

 

We use the Black-Scholes model to estimate the fair value of stock options granted and stock purchase rights under the ESPP. The expected term of stock options granted represents the period of time that we expect them to be outstanding.  We estimate the expected term of options granted based on historical exercise patterns.  For the six months ended June 30, 2013 and 2012, we used the following weighted-average assumptions in our Black-Scholes calculations:

 

Employee Stock Options:

 

		Six Months Ended June 30,
		2013		2012
Risk-free interest rate		1.0	%	0.8	%
Dividend yield		0.0	%	0.0	%
Volatility		51.5	%	51.1	%
Expected life		5.1 years		5.1 years

 

ESPP:

 

		Six Months Ended June 30,
		2013		2012
Risk-free interest rate		0.1	%	0.1	%
Dividend yield		0.0	%	0.0	%
Volatility		61.4	%	42.3	%
Expected life		6 months		6 months

 

Board of Director Stock Options:

 

		Six Months Ended June 30,
		2013
Risk-free interest rate		2.3	%
Dividend yield		0.0	%
Volatility		52.4	%
Expected life		7.3 years

 

For the six months ended June 30, 2012, we did not grant stock options to our Board of Directors.

 

The fair value of RSUs is based on the market price of our common stock on the date of grant.  RSUs vest annually over a four year period.  The weighted-average grant date fair value of RSUs granted to employees for the six months ended June 30, 2013 and 2012 was $14.48 and $7.60, respectively.

 

The following table summarizes stock-based compensation expense for the three and six months ended June 30, 2013 and 2012 (in thousands), which was allocated as follows:

 

		Three Months Ended June 30,						Six Months Ended June 30,
		2013			2012			2013			2012
Research and development		$	2,252		$	2,073		$	4,798		$	4,008
General and administrative		384			387			707			719
Total		$	2,636		$	2,460		$	5,505		$	4,727

 

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As of June 30, 2013, total unrecognized estimated non-cash stock-based compensation expense related to non-vested stock options and RSUs was $9.7 million and $3.3 million, respectively. We will adjust total unrecognized compensation cost for future changes in estimated forfeitures.  We expect to recognize the cost of non-cash, stock-based compensation expense related to non-vested stock options and RSUs over a weighted average amortization period of 1.3 years and 1.9 years, respectively.

 

Impact of recently issued accounting standards

 

In February 2013, the FASB issued guidance requiring enhanced disclosures related to reclassifications out of accumulated other comprehensive income (loss).  Under the guidance, we must disclose the amounts we reclassified out of accumulated other comprehensive income (loss) by component. In addition, for significant amounts that we reclassified entirely from other comprehensive income (loss) to net loss, we must disclose the line item of net loss, either on the face of the statement of operations or in the notes to the financial statements. For amounts that we did not reclassify entirely to net loss, we must cross-reference to other disclosures that provide additional detail about those amounts. The guidance is effective retrospectively for fiscal years, and interim periods within those years, beginning after December 15, 2012 and was effective for our fiscal year beginning January 1, 2013. As this guidance relates to disclosure only, the adoption of this guidance did not have any effect on our financial statements.

 

3.                                       Investments

 

As of June 30, 2013, we have primarily invested our excess cash in debt instruments of the U.S. Treasury, financial institutions, corporations, and U.S. government agencies with strong credit ratings and an investment grade rating at or above A-1, P-1 or F-1 by Moody’s, Standard & Poor’s (S&P) or Fitch, respectively.  We have established guidelines relative to diversification and maturities that maintain safety and liquidity. We periodically review and modify these guidelines to maximize trends in yields and interest rates without compromising safety and liquidity.

 

The following table summarizes the contract maturity of the available-for-sale securities we held as of June 30, 2013:

 

One year or less		57	%
After one year but within two years		26	%
After two years but within three years		17	%
Total		100	%

 

As illustrated above, we primarily invest our excess cash in short-term instruments with 83 percent of our available-for-sale securities having a maturity of less than two years.

 

At June 30, 2013, we had an ownership interest of less than 20 percent in each of three private companies and three public companies with which we conduct business.  The privately-held companies are Santaris Pharma A/S (formerly Pantheco A/S), Achaogen Inc., and Atlantic Pharmaceuticals Limited.  The publicly-traded companies are Antisense Therapeutics Limited, iCo Therapeutics Inc., and Regulus. We account for equity investments in the privately-held companies under the cost method of accounting and we account for equity investments in the publicly-traded companies at fair value. We record unrealized gains and losses as a separate component of comprehensive income (loss) and include net realized gains and losses in gain (loss) on investments. In the first quarter of 2013, we sold all of the common stock of Sarepta Therapeutics, Inc. that we owned resulting in a realized gain of $1.1 million.

 

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The following is a summary of our investments (in thousands):

 

											Other-Than-
											Temporary
		Amortized			Unrealized						Impairment			Estimated
June 30, 2013		Cost			Gains			Losses			Loss			Fair Value
Available-for-sale securities:
Corporate debt securities (1)		$	134,045		$	60		$	(88	)	$	—		$	134,017
Debt securities issued by U.S. government agencies (1)		23,887			—			(85		)	—			23,802
Debt securities issued by the U.S. Treasury		5,023			4			—			—			5,027
Debt securities issued by states of the United States and political subdivisions of the states		11,989			35			—			—			12,024
Total securities with a maturity of one year or less		174,944			99			(173		)	—			174,870
Corporate debt securities		103,219			23			(546		)	—			102,696
Debt securities issued by U.S. government agencies		10,002			25			(3		)	—			10,024
Debt securities issued by the U.S. Treasury		8,340			14			—			—			8,354
Debt securities issued by states of the United States and political subdivisions of the states		8,771			5			(22		)	—			8,754
Total securities with a maturity of more than one year		130,332			67			(571		)	—			129,828
Total		$	305,276		$	166		$	(744	)	$	—		$	304,698

 

											Other-Than-
											Temporary
		Cost			Unrealized						Impairment			Estimated
June 30, 2013		Basis			Gains			Losses			Loss			Fair Value
Equity securities:
Regulus Therapeutics Inc.		$	15,525		$	46,665		$	—		$	—		$	62,190
Current portion (included in Other current assets)		1,538			776			—			(880		)	1,434
Long-term portion (included in Deposits and other assets)		625			—			—			—			625
Total		$	17,688		$	47,441		$	—		$	(880	)	$	64,249

 

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											Other-Than-
											Temporary
		Amortized			Unrealized						Impairment			Estimated
December 31, 2012		Cost			Gains			Losses			Loss			Fair Value
Available-for-sale securities:
Corporate debt securities (1)		$	115,249		$	81		$	(9	)	$	—		$	115,321
Debt securities issued by U.S. government agencies (1)		12,100			2			(66		)	—			12,036
Debt securities issued by the U.S. Treasury		1,000			1			—			—			1,001
Debt securities issued by states of the United States and political subdivisions of the states		16,560			18			(2		)	—			16,576
Total securities with a maturity of one year or less		144,909			102			(77		)	—			144,934
Corporate debt securities		80,166			112			(92		)	—			80,186
Debt securities issued by U.S. government agencies		8,034			38			—			—			8,072
Debt securities issued by the U.S. Treasury		12,424			27			—			—			12,451
Debt securities issued by states of the United States and political subdivisions of the states		8,306			31			(16		)	—			8,321
Total securities with a maturity of more than one year		108,930			208			(108		)	—			109,030
Total		$	253,839		$	310		$	(185	)	$	—		$	253,964

 

											Other-Than-
											Temporary
		Cost			Unrealized						Impairment			Estimated
December 31, 2012		Basis			Gains			Losses			Loss			Fair Value
Equity securities:
Regulus Therapeutics Inc.		$	15,526		$	18,096		$	—		$	—		$	33,622
Current portion (included in Other current assets)		1,579			4,175			—			(880		)	4,874
Long-term portion (included in Deposits and other assets)		625			—			—			—			625
Total		$	17,730		$	22,271		$	—		$	(880	)	$	39,121

 

(1)          Includes investments classified as cash equivalents on our condensed consolidated balance sheet.

 

Investments we considered to be temporarily impaired at June 30, 2013 were as follows (in thousands):

 

				Less than 12 months of temporary impairment
		Number of Investments		Estimated Fair Value			Unrealized Losses
Corporate debt securities		85		$	152,051		$	(634	)
Debt securities issued by U.S. government agencies		7		25,342			(88		)
Debt securities issued by states of the United States and political subdivisions of the states		6		7,823			(22		)
Total temporarily impaired securities		98		$	185,216		$	(744	)

 

We believe that the decline in value of these securities is temporary and primarily related to the change in market interest rates since purchase.  We believe it is more likely than not that we will be able to hold these securities to maturity.  Therefore, we anticipate full recovery of their amortized cost basis at maturity.

 

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4.                                     Fair Value Measurements

 

We use a three-tier fair value hierarchy to prioritize the inputs used in our fair value measurements.  These tiers include: Level 1, defined as observable inputs such as quoted prices in active markets for identical assets, which includes our money market funds and treasury securities classified as available-for-sale securities and an investment in equity securities in a publicly-held biotechnology company; Level 2, defined as inputs other than quoted prices in active markets that are either directly or indirectly observable, which includes our fixed income securities and commercial paper classified as available-for-sale securities; and Level 3, defined as unobservable inputs in which little or no market data exists, therefore requiring an entity to develop its own assumptions. Our Level 3 investments include investments in the equity securities of publicly-held biotechnology companies for which we calculated a lack of marketability discount because there are restrictions on when we can trade the securities. The majority of our securities have been classified as Level 2. We obtain the fair value of our Level 2 investments from our custodian banks or from a professional pricing service.  We validate the fair value of our Level 2 investments by understanding the pricing model used by the custodian bank or professional pricing service provider and comparing that fair value to the fair value based on observable market prices.  During the three and six months ended June 30, 2013 and 2012 there were no transfers between our Level 1 and Level 2 investments. We use the end of reporting period method for determining transfers between levels.

 

We measure the following major security types at fair value on a recurring basis. We break down the inputs used to measure fair value for these assets at June 30, 2013 and December 31, 2012 as follows (in thousands):

 

		At June 30, 2013			Quoted Prices in Active Markets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Cash equivalents (1)		$	287,759		$	277,272		$	10,487		$	—
Corporate debt securities (2)		231,216			—			231,216			—
Debt securities issued by U.S. government agencies (2)		28,837			—			28,837			—
Debt securities issued by the U.S. Treasury (2)		13,381			13,381			—			—
Debt securities issued by states of the United States and political subdivisions of the states (2)		20,778			—			20,778			—
Investment in Regulus Therapeutics Inc.		62,190			—			—			62,190
Equity securities (3)		1,434			1,434			—			—
Total		$	645,595		$	292,087		$	291,318		$	62,190

 

		At December 31, 2012			Quoted Prices in Active Markets (Level 1)			Significant Other Observable Inputs (Level 2)			Significant Unobservable Inputs (Level 3)
Cash equivalents (1)		$	105,496		$	101,496		$	4,000		$	—
Corporate debt securities (2)		193,507			—			193,507			—
Debt securities issued by U.S. government agencies (2)		18,108			—			18,108			—
Debt securities issued by the U.S. Treasury (2)		13,452			13,452			—			—
Debt securities issued by states of the United States and political subdivisions of the states (2)		24,897			—			24,897			—
Investment in Regulus Therapeutics Inc.		33,622			—			—			33,622
Equity securities (3)		4,874			4,146			—			728
Total		$	393,956		$	119,094		$	240,512		$	34,350

(1)          Included in cash and cash equivalents on our condensed consolidated balance sheet.

 

(2)          Included in short-term investments on our condensed consolidated balance sheet.

 

(3)          Included in other current assets on our condensed consolidated balance sheet.

 

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