SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
FOR ANNUAL & TRANSITION REPORTS PURSUANT TO
SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
(Mark One)
[X] Annual report pursuant to Section 13 or 15(d) of the Securities
Exchange Act of 1934
For the fiscal year ended December 31, 2004 or
[ ] Transition report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the transition period from to
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Commission File Number: 0-16109
A.P. PHARMA, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-2875566
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(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification Number)
123 Saginaw Drive, Redwood City, California 94063
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(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (650) 366-2626
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Securities registered pursuant to Section 12 (b) of the Act: None
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Securities registered pursuant to Section 12 (g) of the Act:
Common Stock ($.01 par value)
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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 [ ]
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Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [X]
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Indicate by check mark whether the registrant is an accelerated filer (as
defined in Rule 12b-2 of the Act).
Yes [X ] No [ ]
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The aggregate market value of the voting stock of the registrant held by non-
affiliates of the registrant as of June 30, 2004, was $59,317,227. (1)
As of February 28, 2005, 25,040,392 shares of registrant's Common Stock, $.01
par value, were outstanding.
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(1)Excludes 7,227,200 shares held by directors, officers and shareholders
whose ownership exceeds 5% of the outstanding shares at June 30, 2004.
Exclusion of such shares should not be construed as indicating that the
holders thereof possess the power, directly or indirectly, to direct the
management or policies of the registrant, or that such person is controlled
by or under common control with the registrant.
DOCUMENTS INCORPORATED BY REFERENCE
Form
10-K
Document Part
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Definitive Proxy Statement to be used
in connection with the 2005 Annual Meeting
of Stockholders. III
TABLE OF CONTENTS
PART I
ITEM 1. Business
ITEM 2. Properties
ITEM 3. Legal Proceedings
ITEM 4. Submission of Matters to a Vote of Security Holders
PART II
ITEM 5. Market for the Registrant's Common Stock, Related
Stockholder Matters and Issuer Purchases of Equity Securities
ITEM 6. Selected Financial Data
ITEM 7. Management's Discussion and Analysis of Financial
Condition and Results of Operations
ITEM 7A. Quantitative and Qualitative Disclosure About Market Risk
ITEM 8. Financial Statements and Supplementary Data
ITEM 9. Changes in and Disagreements with Accountants on
Accounting and Financial Disclosure
ITEM 9A. Controls and Procedures
ITEM 9B. Other Information
PART III
ITEM 10. Directors and Executive Officers of the Registrant
ITEM 11. Executive Compensation
ITEM 12. Security Ownership of Certain Beneficial Owners
and Management and Related Stockholder Matters
ITEM 13. Certain Relationships and Related Transactions
ITEM 14. Principal Accountant Fees and Services
PART IV
ITEM 15. Exhibits, Financial Statement Schedules, and
Reports on Form 8-K
Signatures
Certifications
PART I
Item 1. BUSINESS
INTRODUCTION-FORWARD LOOKING STATEMENTS
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Except for statements of historical fact, the statements herein are forward-
looking and are subject to a number of risks and uncertainties that could
cause actual results to differ materially from the statements made. These
include, among others, uncertainty associated with progress in research and
development programs, timely development, approval, launch and acceptance of
new products, establishment of new corporate alliances and other factors
described below under the headings "APP Technology", "Products", "Marketing",
"Government Regulation", "Patents and Trade Secrets" and "Competition". In
addition, such risks and uncertainties also include the matters discussed
under Management's Discussion and Analysis of Financial Condition and Results
of Operations in Item 7 below.
COMPANY OVERVIEW
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In this Annual Report on Form 10-K, the "Company", "A.P. Pharma", "APP",
"we", "us", and "our", refer to A.P. Pharma, Inc.
We are a specialty pharmaceutical company focused on the development of
pharmaceutical products utilizing our proprietary polymer-based drug delivery
systems. Our focus is the development and commercialization of bioerodible
injectable and implantable systems under the trade name Biochronomer(TM).
Our business strategy is twofold:
- - to develop selected proprietary products, funding them through the
preliminary phases of regulatory review before entering into partnerships to
share costs and to earn a share of future profits; and
- - to license our proprietary technologies to corporate partners after the
successful completion of reimbursed feasibility studies to earn research and
development fees, licensing fees, milestone payments and royalties.
Initial targeted areas of application for our drug delivery technologies
include acute and delayed chemotherapy-induced nausea and vomiting; post-
surgical pain management; anti-inflammatory and ophthalmology applications;
device coatings and vaccines. Product development programs are primarily
funded by the sale of common stock in June 2004, royalties from topical
prescription products currently marketed by our pharmaceutical partners,
Johnson & Johnson and Sanofi-Aventis, proceeds from the divestiture of our
cosmeceutical and toiletry product lines in July 2000, fees we receive from
collaborative partners, and proceeds from the sale of our Analytical
Standards business in February 2003.
Bioerodible polymers are of increasing interest within the pharmaceutical and
biotechnology community for use in both drug delivery applications and as
devices. We have made substantial progress in developing bioerodible
polymers that potentially represent a significant improvement over existing
drug delivery systems. A major point of difference with other delivery
systems is that our polymers have been specifically designed as drug delivery
systems and are versatile. Over one hundred in vivo and in vitro studies
have been completed to advance understanding of this innovative drug delivery
technology. We have also completed Phase 2 human clinical trials using
APF112, our product-candidate for the treatment of post-surgical pain, and
Phase 1 human clinical trials using APF530, our product candidate for the
prevention of acute and delayed chemotherapy-induced nausea and vomiting.
Importantly, toxicology and clinical data indicate that the technology is
safe for use in humans. Studies demonstrate complete and controlled
bioerosion of the polymers. Erosion times can be varied from hours to days,
weeks or months and mechanical properties can be adjusted to produce
materials as diverse as injectable gels, coatings, strands, wafers, films or
microspheres. In addition, the manufacturing is reproducible and the
polymers are stable, provided they are stored under appropriate anhydrous
conditions. In studies, the polymers were observed to erode to completion
and, once the drug was released, no polymer remained. In addition, the
polymers bioerode with low acidity, thus potentially allowing the delivery of
sensitive proteins and DNA.
APF530 is our lead product candidate and is intended for the prevention of
acute and delayed chemotherapy-induced nausea and vomiting. We have
completed a Phase 1 trial which evaluated 2.5 mg, 5 mg, 10 mg and 20 mg doses
of granisetron. Preliminary results indicate that APF530 met its target
kinetic profile in healthy volunteers. At the highest dose, the product
showed meaningful plasma levels within one hour post dosing and these were
maintained for up to five days. We believe that meeting target plasma levels
is a critical step prior to establishing efficacy in the treatment of acute
and delayed chemotherapy-induced nausea and vomiting. In addition, the
escalating doses led to predicted increases in plasma levels of granisetron.
A regulatory submission was filed with the Food and Drug Administration (FDA)
early in 2005. We expect to initiate a Phase 2 clinical trial to assess
pharmacokinetics, safety and tolerability in patients receiving a single dose
of APF530 while undergoing moderately emetogenic chemotherapy in the first
half of 2005 and to enter pivotal studies towards the end of 2005.
Our second Biochronomer product candidate is APF112 for the treatment of
post-surgical pain. APF112 incorporates the well-known analgesic mepivacaine
in our Biochronomer system. It is designed to provide 24 to 36 hours of
post-surgical pain relief and to minimize the use of morphine-like drugs
(opioids) which are used extensively in post-surgical pain management.
Opioids are associated with a wide range of side effects, such as nausea,
sedation, dizziness, constipation, vomiting, urinary retention, and in some
situations, life-threatening respiratory depression. We completed Phase 2
human clinical trials for APF112 in 2004, involving a total of approximately
100 patients undergoing surgery for repair of inguinal hernia. The first
part of the trial was an open-label study in 12 patients. Results of this
study indicate that the pharmacokinetic measurements demonstrated measurable
blood levels of mepivacaine over a three-day period consistent with
observations made in preclinical studies with APF112. No severe or serious
adverse events were reported and wound healing in all patients was observed
to be normal over a 30-day follow-up period. The second part of the Phase 2
trial was a blinded study involving 96 patients and compared two doses of
APF112 with bupivacaine, the current standard treatment for post-surgical
pain. The primary endpoint of the study was safety. Additional endpoints
for the trial included a visual analog score of pain intensity, the standard
means of measuring pain, and patient reduction in opioid pain medication.
The safety and tolerability of APF112 as evaluated in both parts of the study
were very good. The efficacy results were equivocal because no significant
difference was shown between the two doses of APF112 and the standard of care
in terms of pain scores as well as amount of rescue pain medication used.
The mean Visual Analog Scale (VAS) pain scores in the standard of care group
were unusually low at approximately 3, compared with previously published
data of approximately 5, within the first 24 hours post surgery. A further
Phase 2 trial using APF112 is being developed, and we are exploring corporate
partnering opportunities before proceeding with this in order to focus our
limited resources on APF530.
We have also entered into client-funded feasibility studies with several
companies to develop a variety of products using our Biochronomer(TM)
delivery systems. These products are being developed in the areas of
ophthalmology, animal health care and device coatings. In general, these
research and development arrangements provide for us to receive research and
development fees from our collaborators. If they are concluded successfully,
they could lead to licensing agreements under which a partner would pay for
development costs and we would receive a license fee, research and
development fees, milestone payments and a royalty upon a product's marketing
clearance and commercialization.
In February 1997, we received FDA marketing clearance for our first
pharmaceutical product, Retin-A Micro(R), which was based on the original
patented Microsponge(R) technology, and which was licensed to Ortho
Neutrogena, a member of the Johnson & Johnson family of companies. This
product was launched in the United States in March 1997. Retin-A Micro was
also launched in Canada in the third quarter of 2001. In May 2002, the FDA
granted marketing clearance for a new low-dose 0.04% formulation of Retin-A
Micro, which was launched in the U.S. in July 2002. We are entitled to
receive royalties on the sales of these products over the life of the
applicable patents which expire in 2016.
We licensed to Dermik Laboratories, a Sanofi-Aventis company, a Microsponge-
based formulation incorporating 5-fluorouracil (5-FU) for the treatment of
actinic keratoses, a precancerous skin condition. The product was launched
in the first quarter of 2001 under the brand name Carac(TM). This product
has a number of advantages over other topical therapies, including less
irritation with shorter duration of therapy and reduced dosage frequency.
Until July 2000, we engaged in the development, manufacturing, and out-
licensing of the aforementioned topical pharmaceutical products as well as a
variety of cosmeceutical and toiletry products. In July 2000, we sold our
cosmeceutical and toiletry product lines, together with certain technology
rights to topical pharmaceuticals, to RP Scherer, a subsidiary of Cardinal
Health. Under the sale agreement, we retained the rights to our topical
prescription products, which are marketed by our corporate partners, Johnson
& Johnson and Sanofi-Aventis, and on which we continue to receive royalties.
In February 2003, we sold the assets of our wholly-owned subsidiary, APS
Analytical Standards, Inc., to GFS Chemicals of Columbus, Ohio, for $2.1
million in cash and the right to receive royalties for the next five years.
The Company, founded in February 1983 as a California corporation under the
name AMCO Polymerics, Inc., changed its name to Advanced Polymer Systems,
Inc. in 1984 and was reincorporated in Delaware in 1987. Our name was
changed to A.P. Pharma, Inc. in May 2001 to reflect the new pharmaceutical
focus of the company.
APP TECHNOLOGY
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We have made significant investment and progress in the development of
bioerodible drug delivery systems. Specifically, we have developed two
families of polymers, each with unique attributes. The first family is known
collectively as poly(ortho esters) under the trade name Biochronomer(TM);
polymers in the second family are known collectively as block copolymers of
poly(ortho esters) and poly(ethylene glycol) under the trade name
Bioerodimer(TM). The two polymer families are covered by US patent
5,968,543, issued October 19, 1999 and US patent 5,939,453, issued August 17,
1999. Both are broad composition of matter patents. A number of other
patent applications have been filed.
The Biochronomer polymer is a poly(ortho ester) whose production is highly
reproducible and kilo quantities of polymer have been produced according to
Good Manufacturing Practices (GMP).
Current product development work takes advantage of the versatility of these
materials, and is exemplified by forms that range from injectable gels into
which drugs can be incorporated by a simple mixing procedure, to solid
devices that can be fabricated at temperatures low enough to allow the
incorporation of materials such as proteins that require mild fabrication
conditions.
Our primary focus has been on advancing our Biochronomer technology, which is
designed to release drugs at selected implantation sites such as at the site
of a surgical procedure, under the skin, in joints, in the eye, or in muscle
tissue. Key benefits of this technology include the ability to fabricate the
poly(ortho ester) polymers into a variety of drug delivery forms as diverse
as wafers, strands, microspheres and injectable gels to enable various means
of administration into the body.
PRODUCTS
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Ethical Pharmaceutical Products
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We define ethical pharmaceutical products as prescription products that are
promoted primarily through the medical profession. We are developing
pharmaceutical product candidates that will require marketing clearance from
the FDA before they can be sold in the United States. We believe that the
benefits offered by our delivery systems will create valuable product
differentiation and commercial advantages in large, profitable markets.
Results from various preclinical and clinical studies confirm that this
technology offers the potential to maintain or improve therapeutic efficacy
and to reduce adverse drug side effects.
The following ethical dermatological products incorporating the Microsponge
technology have already been developed and commercialized:
Retin-A Micro: In February 1997, we received FDA marketing clearance for
Microsponge-entrapped tretinoin for improved acne treatment. Tretinoin has
been marketed in the United States by Ortho Neutrogena (formerly Ortho
Dermatological), a Johnson & Johnson ("J&J") subsidiary, under the brand name
RETIN-A(R) since 1971. It has proven to be a highly effective topical acne
medication. However, skin irritation among sensitive individuals can limit
patient compliance with the prescribed therapy. We developed a new
formulation of Retin-A containing Microsponge-entrapped tretinoin for acne
treatment which was licensed to J&J. This patent-protected approach to drug
delivery reduces the potentially irritating side effects of tretinoin. Ortho
Dermatological began marketing this product in March 1997 under the brand
name Retin-A Micro (R). Additionally, Ortho received FDA marketing clearance
in the United States for a second Retin-A Micro formulation, a low-dose
version, and launched the product in July 2002. Our formulation patents on
these products continue until 2016.
Ortho launched this product in Canada during 2001 and has completed Phase 3
clinical trials in Europe.
Carac: In the fourth quarter of 2000, Dermik Laboratories, a Sanofi-Aventis
company, received U.S. marketing clearance for an APP-developed formulation
containing Microsponge-entrapped 5-fluorouracil (5-FU) for the treatment of
actinic keratoses. This product was launched under the trade name Carac(TM)
in the first quarter of 2001. We receive royalties based on the sales of
this product over the life of the applicable patents. In September 2003, a
new formulation patent was issued by the U.S. Patent and Trademark office
(USPTO) extending patent coverage for this use of our Microsponge formulation
until 2021.
Products Under Development
- --------------------------
Our efforts in pharmaceutical markets include applications using our
Biochronomer technology that are under development, as noted below.
Our lead product candidate, APF530, is designed to prevent acute and delayed
chemotherapy-induced nausea and vomiting. A Phase 1 study has been
successfully completed in the U.K. in which we evaluated 2.5 mg, 5 mg, 10 mg
and 20 mg doses of granisetron. Preliminary results indicate that APF530 met
its target kinetic profile in healthy volunteers. At the highest dose, the
product showed meaningful plasma levels within one hour post dosing and these
were maintained for up to five days. This mirrors the period for this
condition during which patient relief is most required. A regulatory
submission was filed with the Food and Drug Administration (FDA) early in
2005 and we expect to initiate a Phase 2 clinical trial in the first half of
2005 and to enter pivotal studies towards the end of 2005.
The first product candidate to incorporate the Biochronomer(TM) delivery
system is APF112 which targets the management of pain in patients following
surgery. The treatment goal is to provide 24 to 36 hours of localized post-
surgical pain relief by delivering the drug mepivacaine directly to the
surgical site. Mepivacaine is a well-known drug for localized pain relief,
and it has an extensive safety protocol. APF112 is designed to prolong the
anesthetic effect of mepivacaine and thus to minimize or eliminate the use of
opioids (morphine-like drugs) which are currently used in the majority of
surgical procedures as a means of managing post-operative pain despite
unpleasant side effects - nausea, disorientation, sedation, constipation,
vomiting, urinary retention and, in some situations, life-threatening
respiratory depression. If efficacy in treating post-surgical pain can be
demonstrated, we believe that there will be substantial potential for this
product, as there are approximately 20 million surgical procedures performed
annually in the U.S. for which the product could potentially be utilized.
Phase 2 clinical studies were conducted in surgeries for inguinal hernia
repair during 2004 and although the safety and tolerability of APF112 were
very good the efficacy results were equivocal with no significant difference
between the two formulations of APF112 and the current standard of care. A
second Phase 2 study is being developed which, with the financial support of
a corporate partner, would evaluate a combination therapy using bupivacaine
for immediate pain relief following surgery and APF112 for longer-term pain
relief.
Other Products
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Analytical Standards. We initially developed microspheres (precursors to the
Microsponge system) for use as a testing standard for gauging the purity of
municipal drinking water.
In February 2003, we announced the sale of the assets of this subsidiary to
GFS Chemicals, Inc. of Columbus, Ohio for $2.1 million in cash and the right
to receive royalties for five years at rates ranging from 5% to 15% of sales
of analytical standards products.
MARKETING
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A key part of our business strategy is to form collaborations with
pharmaceutical partners. We have therefore negotiated fee-paying feasibility
agreements with several pharmaceutical and biotechnology companies for the
development of prescription products incorporating the Biochronomer delivery
system. If they are concluded successfully, they could lead to licensing
agreements.
In general, we grant limited marketing exclusivity in defined markets for
defined periods to our partners. However, after development is completed and
a partner commercializes a formulated product utilizing our delivery systems,
we can exert only limited influence over the manner and extent of our
partner's marketing efforts.
Our key marketing relationships currently involve only the Microsponge
delivery system for prescription products and are as follows:
Johnson & Johnson Inc. In May 1992, we entered into a development and
license agreement with Ortho-McNeil Pharmaceutical Corporation, (a subsidiary
of J&J ("Ortho")) related to tretinoin-based products incorporating our
Microsponge technology. As part of the agreement, certain license fees and
milestone payments were paid to us by Ortho. The license fees provided Ortho
with exclusive distribution or license rights for all Ortho tretinoin
products utilizing our Microsponge system. Ortho's exclusivity will continue
as long as annual minimum royalty payments are made, governed by the life of
the applicable patents owned by us through 2016.
In February 1997, we received FDA marketing clearance for the first product
covered by this agreement, Microsponge-entrapped tretinoin. This product has
been marketed by Ortho since March 1997 as Retin-A(R) Micro. We received a
payment of $3,000,000 from Ortho upon receipt of the FDA approval, of which
half is a milestone payment that was recognized as revenue in 1997 and half
as prepaid royalties which were recorded as deferred revenues. Ortho pays us
a royalty on product sales. In accordance with the licensing agreement, 25%
of the royalties we earned was applied against deferred revenues after
certain annual minimum royalty payments were met. The remaining balance of
these deferred revenues was extinguished during 2004. Should certain minimum
royalties not be achieved or paid, Ortho would lose its exclusivity and we
would regain marketing rights to the retinoid products.
Dermik. In March 1992, we restructured our 1989 joint venture agreement with
Dermik, a Sanfoi-Aventis company. As part of the agreement Sanofi-Aventis
received certain exclusive marketing rights for the U.S. Product
applications include a 5-FU treatment for actinic keratoses (precancerous
skin lesions). In the fourth quarter of 1999, Dermik filed an NDA for this
product and expanded its agreement with us to cover two additional
indications, in return for milestone payments and royalties upon successful
development. We received $500,000 on execution of this amendment
representing a milestone payment of $250,000 and prepaid royalties of
$250,000. In the fourth quarter of 2000 Dermik received FDA marketing
clearance for the product, which was launched under the trade name Carac(TM)
in the first quarter of 2001. In 2002, we recognized the prepaid royalties
as revenues because Dermik decided not to pursue the two additional
applications covered by the 1999 amendment and the rights reverted to us.
Dermik's exclusivity relating to Carac will continue as long as annual
minimum royalty payments are made, governed by the life of the applicable
patents. In December 2003, a patent was issued by the USPTO extending patent
coverage for this use of our Microsponge formulation until 2021.
GOVERNMENT REGULATION
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Ethical Products
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In order to clinically test, produce and sell products for human therapeutic
use, mandatory procedures and safety evaluations established by the FDA and
comparable agencies in foreign countries must be followed. The procedure for
seeking and obtaining the required governmental clearances for a new
therapeutic product includes preclinical animal testing to determine safety
and efficacy, followed by human clinical testing. This can take many years
and require substantial expenditures. In the case of third party agreements,
we expect that our corporate partners will partially fund the testing and the
approval process with guidance from us. We intend to seek the necessary
regulatory approvals for our proprietary products as they are being
developed.
PATENTS AND TRADE SECRETS
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As part of our strategy to protect our current products and to provide a
foundation for future products, we have filed a number of United States
patent applications on inventions relating to the composition of a variety of
polymers, specific products, product groups, and processing technology. We
have also filed foreign patent applications on our polymer technology with
the European Union, Japan, Australia, South Africa, Canada, Korea and Taiwan.
We have a total of 17 issued United States patents and an additional 88
issued foreign patents. Currently, we have 33 pending patent applications
worldwide. The patents on the Microsponge(R) system expire between October
2009 and September 2021. The patents on the bioerodible systems expire
between January 2016 and November 2021.
Although we believe the bases for these patents and patent applications are
sound, they are untested, and there is no assurance that they will not be
successfully challenged. There can be no assurance that any patent
previously issued will be of commercial value, that any patent applications
will result in issued patents of commercial value, or that our technology
will not be held to infringe patents held by others.
We rely on unpatented trade secrets and know-how to protect certain aspects
of our production technologies. Our employees, consultants, advisors and
corporate partners have entered into confidentiality agreements with us.
These agreements, however, may not necessarily provide meaningful protection
for our trade secrets or proprietary know-how in the event of unauthorized
use or disclosure. In addition, others may obtain access to, or
independently develop, these trade secrets or know-how.
COMPETITION
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In the development of bioerodible poly(ortho esters) for implantation
applications, there is competition from a number of other bioerodible
systems, especially polymers based on lactic and glycolic acid and to a
lesser extent, polyanhydrides. We believe that our proprietary bioerodible
Biochronomer(TM) polymers have a number of important advantages. Among these
are ease of manufacturing, ability to control both erosion times and
mechanical properties, the simultaneous drug delivery and erosion process,
resulting in complete polymer disappearance when all the drug has been
delivered. Also, the polymer bioerodes with low acidity, thus potentially
allowing the delivery of sensitive proteins and DNA.
The attribute of the second family of bioerodible polymers, the block
copolymers of poly(ortho esters) and poly(ethylene glycols), named
Bioerodimer, is that a hydrophobic (water-repelling) bioerodible segment can
be connected to a water-soluble segment. There are other such polymers, but
we believe that our proprietary material is superior because the hydrophobic
poly(ortho ester) segment can greatly increase the efficiency of drug
entrapment making transport to tumors much more effective.
HUMAN RESOURCES
- ---------------
As of February 28, 2005, we had 38 full-time employees, 6 of whom hold PhDs.
There were 30 employees engaged in research and development and quality
control, and 8 working in finance, business development, human resources and
administration.
We consider our relations with employees to be satisfactory. None of our
employees is covered by a collective bargaining agreement.
AVAILABLE INFORMATION
- ---------------------
We make available free of charge on or through our Internet website our
annual reports on Form 10-K, quarterly reports on Form 10-Q, current reports
on Form 8-K and all amendments to those reports as soon as reasonably
practicable after they are electronically filed with, or furnished to, the
Securities and Exchange Commission. Our Internet website address is
"www.appharma.com".
Item 2. PROPERTIES
We lease 26,067 square feet of laboratory, office and warehouse space in
Redwood City, California. The annual rent expense for the Redwood City
facility is approximately $463,000.
We occupied a production facility and warehouse in Lafayette, Louisiana that
was sold to RP Scherer in July 2000. The construction of the facility in
1986 was financed primarily by 15-year, tax-exempt industrial development
bonds. In 1995, we extinguished the bond liability through an "in-substance
defeasance" transaction by placing United States government securities in an
irrevocable trust to fund all future interest and principal payments. The
defeased debt balance outstanding of $2,500,000 as of December 31, 2004 was
repaid on January 25, 2005 using the proceeds from the maturities of the
United States government securities held in the irrevocable trust.
Our existing research and development and administrative facilities are not
yet being used at full capacity and management believes that these facilities
are adequate and suitable for current and anticipated needs.
Item 3. LEGAL PROCEEDINGS
On October 22, 2003, Tristrata Technology, Inc. (Tristrata) filed an amended
complaint joining A.P. Pharma, Inc. and other companies as defendants in
Tristrata's action first filed July 12, 2002 against Cardinal Health, Inc.
and others in the Federal District Court of Delaware. Tristrata's complaint
alleged infringment of patents pertaining to alpha-hydroxyacids used in
cosmetics. On January 19, 2005 the parties agreed to final dismissal of all
claims and counterclaims in the lawsuit resulting in no judgment against A.P.
Pharma.
Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
Item 5. MARKET FOR REGISTRANT'S COMMON STOCK RELATED STOCKHOLDER
MATTERS AND ISSUER PURCHASES OF EQUITY SECURITIES
Shares of the Company's common stock trade on the NASDAQ National Market,
under the symbol APPA. As of February 28, 2005, there were 437 holders of
record of the Company's common stock.
The Company has never paid cash dividends and does not anticipate paying cash
dividends in the foreseeable future. The following table sets forth for the
fiscal periods indicated, the range of high and low intra day sales prices
for the Company's common stock on the NASDAQ National Market System.
2004 High Low 2003 High Low
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First Quarter $3.79 $2.15 First Quarter $1.18 $0.84
Second Quarter 4.45 2.85 Second Quarter 1.96 1.00
Third Quarter 3.50 1.11 Third Quarter 2.45 1.38
Fourth Quarter 2.35 1.15 Fourth Quarter 3.15 2.02
See Note 8 "Stockholders' Equity" in the Notes to Consolidated Financial
Statements contained in part II Item 8 of this Form 10-K concerning A.P.
Pharma's equity compensation plans.
Item 6. SELECTED FINANCIAL DATA
(in thousands, except per share data)
For the Years Ended and as of
December 31, 2004 2003 2002 2001 2000
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Consolidated Statement of Operations Data
- -----------------------------------------
Royalties $ 4,972 $ 4,502 $ 4,026 $ 3,227 $ 2,081
Contract revenues 432 346 407 38 122
License fees -- -- 237 -- --
------ ------ ----- ------ ------
Total revenues 5,404 4,848 4,670 3,265 2,203
Expenses
Research and development 11,495 8,421 6,414 7,107 3,432
General and administrative 3,225 3,039 3,309 3,488 3,150
Interest and other income and
expense, net 224 404 658 1,192 546
------ ----- ------ ------ ------
Loss from continuing
operations (9,092) (6,208) (4,395) (6,138) (3,833)
Income (loss) from
discontinued operations(1) (133) (57) 401 624 1,238
Gain on disposition of
discontinued operations(2) 4 1,902 216 3,000 11,147
------ ------ ------ ------ ------
Net income (loss) $(9,221) $(4,363) $(3,778) $(2,514) $ 8,552
====== ====== ====== ====== ======
Basic income (loss) per
common share:
Loss from continuing
operations $ (0.40) $ (0.30) $ (0.22) $ (0.30) $ (0.19)
Net income (loss) $ (0.40) $ (0.21) $ (0.19) $ (0.12) $ 0.42
Diluted income (loss) per
common share:
Loss from continuing
operations $ (0.40) (0.30) $ (0.22) $ (0.30) $ (0.19)
Net income (loss) $ (0.40) $ (0.21) $ (0.19) $ (0.12) $ 0.42
Weighted average common
shares outstanding - basic 22,909 20,553 20,409 20,276 20,179
Weighted average common
shares outstanding - diluted 22,909 20,553 20,409 20,276 20,213
(1) Income (loss) from discontinued operations represents the income (loss)
attributable to our Analytical Standards division that was sold to GFS
Chemicals on February 13, 2003, and the income (loss) attributable to our
cosmeceutical and toiletries business that was sold to RP Scherer on July 25,
2000. See Note 10 "Discontinued Operations" in the Notes to Consolidated
Financial Statements of Part II, Item 8 of this Form 10-K.
(2) Gain on disposition of discontinued operations in 2000 represents the
gain on the sale of our cosmeceutical and toiletries business to RP Scherer
on July 25, 2000, and in 2001 and 2002 represents the annual earnout income
received from RP Scherer based on the performance of the business sold. The
gain on disposition of discontinued operations in 2003 represents the gain on
sale of our Analytical Standards division to GFS Chemicals on February 13,
2003. See Note 10 "Discontinued Operations" in the Notes to Consolidated
Financial Statements of Part II, Item 8 of this Form 10-K.
Consolidated Balance Sheet Data
- -------------------------------
December 31,
----------------------------------------------
2004 2003 2002 2001 2000
------- ------- ------ ----- ------
Working capital $12,636 $ 9,366 $13,989 $18,092 $20,111
Total assets 17,014 13,155 17,781 23,483 26,964
Long-term debt, excluding
current portion -- -- -- -- --
Stockholders' equity 14,154 11,263 15,459 19,173 21,159
Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION
AND RESULTS OF OPERATIONS
Overview
- --------
We are a specialty pharmaceutical company focused on the development of
ethical (prescription) pharmaceuticals utilizing our proprietary polymer-
based drug delivery systems. Our primary focus is the development and
commercialization of our bioerodible injectable and implantable systems under
the trade name Biochronomer(TM). Initial target areas of application for our
drug delivery technology include anti-nausea, pain management, inflammation,
vaccines and ophthalmology applications. Our product development programs
are funded by the sale of common stock in June 2004, royalties from topical
products currently marketed by pharmaceutical partners, proceeds from the
divestitures of our cosmeceutical and analytical standards product lines and
be fees we receive from collaborative partners.
Except for statements of historical fact, the statements herein are forward-
looking and are subject to a number of risks and uncertainties that could
cause actual results to differ materially from the statements made. These
include, among others, uncertainty associated with timely development,
approval, launch and acceptance of new products, establishment of new
corporate alliances, progress in research and development programs, and other
risks described below or identified from time to time in our Securities and
Exchange Commission filings.
Critical Accounting Policies and Estimates
- ------------------------------------------
The preparation of our 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 our
financial statements and accompanying notes. On an ongoing basis, we
evaluate our estimates including those related to the useful lives of fixed
assets, valuation allowances, impairment of assets, accrued clinical and
preclinical expenses and contingencies. Actual results could differ
materially from those estimates. The items in our financial statements
requiring significant estimates and judgments are as follows:
Revenue Recognition
- -------------------
Our revenue arrangements with multiple deliverables are divided into separate
units of accounting if certain criteria are met, including whether the
delivered item has stand-alone value to the customer and whether there is
objective and reliable evidence of the fair value of the undelivered items.
The consideration we receive is allocated among the separate units based on
their respective fair values, and the applicable revenue recognition criteria
are considered separately for each of the separate units. Advance payments
received in excess of amounts earned are classified as deferred revenue until
earned.
* Royalties
---------
Contractually required minimum royalties are recorded ratably throughout the
contractual period. Royalties in excess of minimum royalties are recognized
as earned when the related product is shipped to the customer by our
licensees based on information that we receive from our licensees.
* Contract Revenues
-----------------
Generally, contract revenues relate to research and development arrangements
that generally provide for our company to invoice research and development
fees based on full-time equivalent hours for each project. Revenues from
these arrangements are recognized as the related development costs are
incurred. These revenues approximate the costs incurred.
* License Fees
------------
We have licensing agreements that generally provide for us to receive
periodic minimum payments, royalties, and/or non-refundable license fees.
These licensing agreements typically require a non-refundable license fee and
allow partners to sell our proprietary products in a defined field or
territory for a defined period. The license agreements provide for us to
earn future revenue through royalty payments. These non-refundable license
fees are initially reported as deferred revenues and recognized as revenues
over the estimated life of the product to which they relate as we have
continuing involvement with licensees until the related product is
discontinued or the related patents expire, whichever is earlier. Revenue
recognized from deferred license fees is classified as license fees in the
accompanying consolidated statements of operations. License fees received in
connection with arrangements where we have no continuing involvement are
recognized when the amounts are received or when collectibility is assured,
whichever is earlier.
A milestone payment is a payment made to us by a third party or corporate
partner upon the achievement of a predetermined milestone as defined in a
legally binding contract. Milestone payments are recognized as license fees
when the milestone event has occurred and we have completed all milestone
related services such that the milestone payment is currently due and is non-
refundable.
Clinical Trial Accruals
- -----------------------
Our expenses related to clinical trials are based on estimates of the
services received and efforts expended pursuant to contracts with multiple
research institutions and clinical research organizations that conduct and
manage clinical trials on our behalf. Since the invoicing related to these
services does not always coincide with our financial statement close process,
we must estimate the level of services performed and fees incurred in
determining the accrued clinical trial costs. The financial terms of these
agreements are subject to negotiation and variation from contract to contract
and may result in uneven payment flows. Payments under the contracts depend
on factors such as the successful enrollment of patients or achievement of
certain events or the completion of portions of the clinical trial or similar
conditions. Expenses related to clinical trials generally are accrued based
on the level of patient enrollment and activity according to the protocol.
We monitor patient enrollment levels and related activity to the extent
possible and adjust our estimates accordingly. Historically these estimates
have been accurate and no material adjustments have had to be made.
Stock Based Compensation
- ------------------------
The preparation of the financial statement footnotes requires us to estimate
the fair value of stock options granted to employees. While fair value may
be readily determinable for awards of stock, market quotes are not available
for long-term, nontransferable stock options because these instruments are
not traded. We currently use the Black-Scholes option-pricing model to
estimate the fair value of employee stock options. However, the Black-
Scholes model was developed for use in estimating the fair value of traded
options, which have no vesting restrictions and are fully transferable.
Option valuation models require the input of highly subjective assumptions,
including but not limited to stock price volatility. Because our stock
options have characteristics significantly different from those of traded
options and changes to the subjective assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
provide a reliable single measure of the fair value of our employee stock
options. We are currenly evaluating our option valuation methodologies and
assumptions in light of the new accounting standard related to stock based
compensation.
Results of Operations for the years ended December 31, 2004, 2003 and
- ---------------------------------------------------------------------
2002
- ----
The following sets forth the consolidated statement of operations data and
percentage changes as compared to the prior year (dollar amounts are
presented in thousands):
For the Year Ended December 31, Annual % Change
------------------------------- ---------------
2004 2003 2002 04/03 03/02
---- ---- ---- ----- -----
Royalties $ 4,972 $4,502 $4,026 10% 12%
Contract revenues 432 346 407 25% (15%)
License fees -- -- 237 -- (100%)
------ ----- -----
Total revenues 5,404 4,848 4,670 11% 4%
Expenses
Research and development 11,495 8,421 6,414 37% 31%
General and
administrative 3,225 3,039 3,309 6% (8%)
Our revenues are derived principally from royalties, contract revenues and to
a lesser extent, license fees. Under strategic alliance arrangements entered
into with certain corporations, we may receive non-refundable upfront fees,
milestone payments and royalties based on third party product sales.
The increase in royalties in 2004 from 2003 of $470,000 or 10%, to $4,972,000
related to a 10% increase in royalties earned on sales of Retin-A(R) Micro by
Ortho Neutrogena, a Johnson and Johnson company, as well as a 12% increase in
royalties earned on sales of Carac(TM), a topical prescription treatment for
actinic keratoses that was launched in the first quarter of 2001 by our
marketing partner, Dermik Laboratories, a Sanofi-Aventis company. The
increase in royalties in 2003 from 2002 of $476,000 or 12%, to $4,502,000
related to a 21% increase in royalties earned on sales of Retin-A(R) Micro
partially offset by a decrease in royalties earned on sales of Carac(TM).
The increase in sales of Retin-A Micro was due primarily to the launch of a
new low-dose formulation in July 2002 after FDA marketing clearance. Royalty
income is expected to increase in 2005 assuming that sales for both
underlying product lines increase and that prices are not eroded.
Contract revenues increased by $86,000 or 25% in 2004 compared with 2003
mainly due to the initiation of a new collaborative research and development
arrangement in 2004. Contract revenues decreased in 2003 by $61,000 from
2002 as a result of fewer collaborative research and development
arrangements.
License fees recognized in 2002 are attributed to the forfeiture by a partner
of certain rights to proprietary Microsponge(R) formulation which resulted in
the full recognition of the related unamortized deferred revenue balance of
$237,000. No license fees were recognized in either 2004 or 2003.
Research and development expense increased in 2004 compared to 2003 by
$3,074,000, or 37% to $11,495,000 due mainly to the completion in 2004 of
Phase 2 clinical trials of APF112, our product candidate for post-surgical
pain management which incorporates our Biochronomer(TM) drug delivery system.
Additionally the phase 1 clinical study for APF530, our product candidate for
the prevention of acute and delayed chemotherapy-induced nausea and vomiting,
was conducted in 2004. Research and development expense increased in 2003
compared to 2002 by $2,007,000, or 31% to $8,421,000 due mainly to the
initiation of the Phase 2 clinical trials of APF112 as well as costs
associated with the manufacturing of GMP product for human clinical trials in
2003. Research and development expenses are expected to decrease in 2005 as
we focus our limited resources solely on APF530.
The scope and magnitude of future research and development expenses are
difficult to predict at this time given the number of studies that will need
to be conducted for any of our potential products. In general,
biopharmaceutical development involves a series of steps, beginning with
identification of a potential target, and includes proof of concept in
animals and Phase 1, 2 and 3 clinical studies in humans. Each step of this
process is typically more expensive than the previous one, so success in
development results in increasing expenditures. Our research and development
expenses currently include costs for scientific personnel, animal studies,
human clinical trials, supplies, equipment, consultants, overhead allocation
and sponsored research at academic and research institutions.
Products in Development
- -----------------------
We have a number of product candidates in various stages of development. The
following table sets forth the current opportunities for our own portfolio of
product candidates, the compound selected, the delivery time and the status.
CURRENT OPPORTUNITIES
Product Market Delivery
Portfolio Drug Size Duration Status
- --------- ---- ------ -------- ------
APF112 - Acute Mepivacaine $2 billion Short-term Phase 2
pain relief
(surgical/
orthopedic)
APF530 - Anti- Granisetron $2 billion Short-term Phase 2
nausea (chemo-
therapy)
APF328 - Anti- Meloxicam $1.5 billion Medium-term Pre-IND
inflammatory
(surgical/
orthopedic)
APF505 - Anti- Meloxicam $3.5 billion Long-term Pre-IND
inflammatory
(osteoarthritis)
In addition, several feasibility studies are ongoing with corporate
collaborators in the areas of ophthalmology, animal health care and device
coatings.
The major components of research and development expenses for 2004, 2003 and
2002 were as follows (in thousands):
2004 2003 2002
------ ------ ------
Internal research and
development costs $ 5,315 $ 4,869 $ 4,542
External polymer
development, clinical
and preclinical
programs 6,180 3,552 1,872
------ ------ ------
$11,495 $ 8,421 $ 6,414
====== ====== ======
Internal general research and development costs include employee salaries and
benefits, laboratory supplies, depreciation, and allocation of overhead.
External polymer development on clinical and preclinical programs includes
expenditures on technology and product development, preclinical and clinical
evaluations, regulatory and toxicology consultants, and polymer
manufacturing, all of which are performed on our behalf by third parties.
General and administrative expense increased in 2004 by $186,000 or 6% from
2003 due to an increase in professional fees primarily as a result of the new
audit requirements under Sarbanes Oxley. General and administrative expense
decreased in 2003 by $270,000 or 8% from 2002 due mainly to decreased
investor relations, depreciation and travel and entertainment expense,
partially offset by higher professional fees. General and administrative
expense includes salaries and related expenses, professional fees, directors'
fees, investor relations costs, insurance expense and overhead allocation.
General and administrative expense is expected to remain constant in 2005.
Interest and other income and expense consist primarily of income earned on
cash, cash equivalents and marketable securities. Interest income and other
income and expense decreased in 2004 by $180,000 compared to 2003 due to a
tax refund received in 2003 as well as lower interest rates on investments in
2004. The decrease in 2003 of $254,000 compared to 2002 was due mainly to
reduced interest rates on reduced cash balances.
On February 13, 2003, we completed the sale of certain assets of our
Analytical Standards division to GFS Chemicals, Inc. ("GFS"), a privately
held company based in Columbus, Ohio. In this transaction, we received $2.1
million on closing, and are entitled to receive royalties on sales of
Analytical Standards products for a period of five years at rates ranging
from 15% to 5%. The net present value of the guaranteed minimum royalties is
included in the gain on disposition of discontinued operations.
On July 25, 2000, we completed the sale of certain technology rights for our
topical pharmaceutical and cosmeceutical product lines and associated assets
("cosmeceutical and toiletry business") to RP Scherer Corporation, a
subsidiary of Cardinal Health, Inc. We received $25 million on closing and
were entitled to receive further earnout amounts for the subsequent three
years, the amounts of which were dependent on the performance of the business
sold.
Under the terms of the agreement with RP Scherer, we guaranteed a minimum
gross profit percentage on RP Scherer's combined sales of products to Ortho
Neutrogena and Dermik ("Gross Profit Guaranty"). The guaranty period
commenced on July 1, 2000 and ends on the earlier of July 1, 2010 or the end
of two consecutive guaranty periods where the combined gross profit on sales
to Ortho and Dermik equals or exceeds the guaranteed gross profit.
Income (loss) from discontinued operations represents the income (loss)
attributable to our Analytical Standards division through the date of sale
and the income (loss) attributable to our Analytical Standards division and
our cosmeceutical and toiletries business. For the year 2004, the net loss
from discontinued operations of $133,000 primarily related to the gross
profit guarantee owed under the RP Scherer agreement compared to $57,000 in
2003 which related to the gross profit guarantee offset by a recovery of bad
debt and tax refund received. The income from discontinued operations in
2002 of $401,000 primarily consisted of the operations of the Analytical
Standards division and other changes in reserves, offset by the gross profit
guarantee.
The gain on disposition of discontinued operations recorded in 2003 of
$1,902,000 relates to the gain on the sale of our Analytical Standards
division compared with $216,000 in 2002 which primarily related to the net
earnout income resulting from the sale of our cosmeceutical product lines in
2000.
Capital Resources and Liquidity
- -------------------------------
Cash, cash equivalents and marketable securities increased by $4,112,000 to
$13,596,000 at December 31, 2004 from $9,484,000 at December 31, 2003.
Net cash used in continuing operating activities for the years ended December
31, 2004, 2003 and 2002 was $7,842,000, $6,112,000 and $4,580,000,
respectively. Net cash used in continuing operating activities relates
primarily to funding net losses excluding the gain on disposition of
discontinued operations and changes in deferred revenue offset by
depreciation. The increase in net cash used in continuing operating
activities for 2004 and 2003 was primarily due to increased research and
development expenses resulting from the completion of the Phase 2 human
clinical studies for APF112, our product candidate for the treatment of post-
surgical pain as well as the completion of the Phase 1 clinical trial of
APF530, our product candidate for the prevention of acute and delayed
chemotherapy-induced nausea and vomiting.
The cash provided by discontinued operations of $99,000 in 2004 relates to
the royalties received from GFS for sales of Analytical Standards products
offset by severance payments made to former employees who were terminated as
a result of the sale of the Analytical Standards division. The cash used in
discontinued operations in 2003 and 2002 of $413,000 and $554,000,
respectively, relates to cash used in Analytical Standards division
operations, severance payments and payments of the gross profit guarantee to
RP Scherer, partially offset by royalties received from GFS.
Net cash used in investing activities for the year ended December 31, 2004,
was $1,256,000, compared with net cash provided by investing activities of
$3,257,000 and $4,723,000 in the years ended December 31, 2003 and 2002. The
proceeds received in 2003 of $2,142,000 related to the sale of our Analytical
Standards division. The proceeds received in 2002 of $216,000 related to the
earn-out received on the performance of the cosmeceutical business sold to RP
Scherer.
Our financing activities provided us with $12,012,000, $83,000 and $75,000
for the years ended December 31, 2004, 2003 and 2002, respectively. The net
cash provided by financing activities in 2004 primarily relates to the
issuance of 4,153,335 shares of common stock at 3.00 per share in June 2004.
The net cash provided by financing activities in 2003 and 2002 was primarily
related to proceeds from issuances of shares under the Employee Stock
Purchase Plan and stock option plans.
To date, we have financed our operations including technology and product
research and development, primarily through royalties received on sales of
Retin-A Micro and Carac, income from collaborative research and development
fees, the proceeds received from the sales of our Analytical Standards
division and our cosmeceutical and toiletry business, the sale of common
stock in June 2004, and interest earned on short-term investments. Our
existing cash and cash equivalents, marketable securities, collections of
accounts receivable, together with interest income and other revenue-
producing activities including royalties, license and option fees and
research and development fees, are expected to be sufficient to meet our cash
needs for at least the next year. It is possible that we will seek additional
financing within this timeline through debt or equity financing, the sale of
certain assets and technology rights, collaborative agreements or other
arrangements.
Our future capital requirements will depend on numerous factors including,
among others, royalties from sales of products of third party licensees; our
ability to enter into collaborative research and development and licensing
agreements; progress of product candidates in preclinical and clinical
trials; investment in new research and development programs; time required to
gain regulatory approvals; resources that we devote to self-funded products;
potential acquisitions of technology, product candidates or businesses; and
the costs of defending or prosecuting any patent opposition or litigation
necessary to protect our proprietary technology.
If our capital resources are unable to meet our capital requirements, we will
have to raise additional funds. We may be unable to raise sufficient
additional capital when we need it or to raise capital on favorable terms.
The sale of equity or convertible debt securities in the future may be
dilutive to our stockholders, and debt financing arrangements may require us
to pledge certain assets and enter into covenants that could restrict certain
business activities or our ability to incur further indebtedness and may
contain other terms that are not favorable to us or our stockholders. If we
are unable to obtain adequate funds on reasonable terms, we may be required
to curtail operations significantly or to obtain funds by entering into
financing, supply or collaboration agreements on unattractive terms.
Below is a summary of fixed payments related to certain contractual
obligations (in thousands). This table excludes amounts already recorded on
our balance sheet as current liabilities at December 31, 2004.
Less More
Than 1-3 3-5 Than
Total 1 year years years 5 years
----- ------ ----- ----- -------
Operating Leases(1) $2,954 $ 428 $ 940 $ 959 $ 627
----- ----- ----- ----- -----
Total $2,954 $ 428 $ 940 $ 959 627
===== ===== ===== ===== =====
(1) See Note 7 "Commitments" in the Notes to Consolidated Financial
Statements of Part II, Item 8 of this Form 10-K for more information.
Under the terms of the agreement with RP Scherer, we guaranteed a minimum
gross profit percentage on RP Scherer's combined sales of products to Ortho
Neutrogena and Dermik ("Gross Profit Guaranty"). The guaranty period
commenced on July 1, 2000 and ends on the earlier of July 1, 2010 or the end
of two consecutive guaranty periods where the combined gross profit on sales
to Ortho and Dermik equals or exceeds the guaranteed gross profit. Combined
payments for the Gross Profit Guaranty totaled $527,000 for the first four
guaranty years. We expect the annual Gross Profit Guaranty payments to range
from approximately $100,000 to $150,000 for the remainder of the guaranty
period.
Reclassifications
- -----------------
Certain reclassifications have been made to the prior year financial
statements to conform with the presentation in 2004. Patent legal expenses
in the prior years have been reclassified from research and development
expense to general and administrative expense.
Off-Balance-Sheet Arrangements
- ------------------------------
As of December 31, 2004, we did not have any off-balance-sheet arrangements,
as defined in Item 303(a)(4)(ii) of SEC Regulation S-K.
Recent Accounting Pronouncements
- --------------------------------
In December 2004, the Financial Accounting Standard Board ("FASB") issued
SFAS 123R, Statement No. 123R "Share-Based Payment", which is a revision of
FASB Statements No. 123 and 95". SFAS 123R requires all share-based payments
to employees, including employee stock options, to be recognized as a cost in
the financial statements based on their fair values. SFAS 123R must be
adopted no later than July 1, 2005. This statement allows for two methods of
adoption; (i) modified prospective or (ii) modified-retrospective. We will
adopt SFAS 123R on July 1, 2005 using the modified-prospective method which
requires the compensation cost for share-based payments to employees to be
recognized based on their grant-date fair value beginning July 1, 2005. We
are currently evaluating option valuation methodologies and assumptions in
light of the new requirements under FAS 123R and do not yet know the impact
that the adoption of SFAS 123R will have on the financial position or results
of operations. Current estimates of option values using the Black-Scholes
method may not be indicative of results from valuation methodologies
ultimately adopted.
FACTORS THAT MAY AFFECT FUTURE RESULTS
- --------------------------------------
Our business is subject to various risks, including those described below.
You should carefully consider these risk factors, together with all of the
other information included in this Form 10-K. Any of these risks could
materially adversely affect our business, operating results and financial
condition.
OUR BIOERODIBLE DRUG DELIVERY SYSTEM BUSINESS IS AT AN EARLY STAGE OF
DEVELOPMENT.
Our bioerodible drug delivery system business is at an early stage of
development. Our ability to produce bioerodible drug delivery systems that
progress to and through clinical trials is subject to, among other things:
- success with our research and development efforts;
- selection of appropriate therapeutic compounds for delivery;
- the required regulatory approval.
Successful development of delivery systems will require significant
preclinical and clinical testing prior to regulatory approval in the United
States and elsewhere. In addition, we will need to determine whether any
potential products can be manufactured in commercial quantities at an
acceptable cost. Our efforts may not result in a product that can be
marketed. Because of the significant scientific, regulatory and commercial
milestones that must be reached for any of our research programs to be
successful, any program may be abandoned, even after significant resources
have been expended.
WE WILL NEED ADDITIONAL CAPITAL TO CONDUCT OUR OPERATIONS AND TO DEVELOP OUR
PRODUCTS AND OUR ABILITY TO OBTAIN THE NECESSARY FUNDING ON FAVORABLE TERMS
IN THE FUTURE IS UNCERTAIN.
We will require additional capital resources in order to conduct our
operations and develop our products. While we estimate that our existing
capital resources, royalty income and interest income will be sufficient to
fund our current level of operations for at least the next year based on
current business plans, we cannot guarantee that this will be the case. The
timing and degree of any future capital requirements will depend on many
factors, including:
- scientific progress in our research and development programs;
- the magnitude and scope of our research and development programs;
- our ability to establish and maintain strategic collaborations or
partnerships for research, development, clinical testing, manufacturing and
marketing;
- our progress with preclinical and clinical trials;
- the time and costs involved in obtaining regulatory approvals;
- the costs involved in preparing, filing, prosecuting, maintaining,
defending and enforcing patent claims.
We intend to acquire additional funding through strategic collaborations, in
the form of license fees, research and development fees and milestone
payments. In the event that additional funds are obtained through
arrangements with collaborative partners, these arrangements may require us
to relinquish rights to some of our technologies, product candidates or
products that we would otherwise seek to develop and commercialize ourselves.
If sufficient funding is not available, we may be required to delay, reduce
the scope of or eliminate one or more of our research or development
programs, each of which could have a material adverse effect on our business.
IF WE ARE UNABLE TO RECRUIT AND RETAIN SKILLED EMPLOYEES, WE MAY NOT BE ABLE
TO ACHIEVE OUR OBJECTIVES.
Retaining our current employees and recruiting qualified scientific personnel
to perform future research and development work will be critical to our
success. Competition is intense for experienced scientists, and we may not
be able to recruit or retain sufficient skilled personnel to allow us to
pursue collaborations and develop our products and core technologies to the
extent otherwise possible.
WE ARE RELIANT ON SINGLE SOURCE THIRD PARTY CONTRACTORS FOR THE MANUFACTURE
AND PRODUCTION OF RAW MATERIALS AND PRODUCT CANDIDATES.
We currently, and for the foreseeable future will, rely upon outside
contractors to manufacture, supply and package for us key intermediates,
active pharmaceutical ingredients and formulated drug product for our product
candidates. Our current dependence upon others for the manufacture of our
raw materials and product candidates and our anticipated dependence upon
others for the manufacture of any products that we may develop, may adversely
affect our ability to develop our product candidates in a timely manner and
may adversely affect future profit margins and our ability to commercialize
any products that we may develop on a timely and competitive basis.
ENTRY INTO CLINICAL TRIALS WITH ONE OR MORE PRODUCTS MAY NOT RESULT IN ANY
COMMERCIALLY VIABLE PRODUCTS.
We do not expect to generate any significant revenues from product sales for
a period of several years. We may never generate revenues from product sales
or become profitable because of a variety of risks inherent in our business,
including risks that:
- clinical trials may not demonstrate the safety and efficacy of our
products;
- completion of clinical trials may be delayed, or costs of clinical trials
may exceed anticipated amounts;
- we may not be able to obtain regulatory approval of our products, or may
experience delays in obtaining such approvals;
- we and our licensees may not be able to successfully market our products.
BECAUSE WE OR OUR COLLABORATORS MUST OBTAIN REGULATORY APPROVAL TO MARKET OUR
PRODUCTS IN THE UNITED STATES AND FOREIGN JURISDICTIONS, WE CANNOT PREDICT
WHETHER OR WHEN WE WILL BE PERMITTED TO COMMERCIALIZE OUR PRODUCTS.
Federal, state and local governments in the United States and governments in
other countries have significant regulations in place that govern many of our
activities. The preclinical testing and clinical trials of the products that
we develop ourselves or that our collaborators develop are subject to
government regulation and may prevent us from creating commercially viable
products from our discoveries. In addition, the sale by us or our
collaborators of any commercially viable product will be subject to
government regulation from several standpoints, including the processes of:
- manufacturing;
- - labeling;
- distributing;
- advertising and promoting; and
- selling and marketing.
We may not obtain regulatory approval for the products we develop and our
collaborators may not obtain regulatory approval for the products they
develop. Regulatory approval may also entail limitations on the indicated
uses of a proposed product.
The regulatory process, particularly for biopharmaceutical products like
ours, is uncertain, can take many years and requires the expenditure of
substantial resources. Any product that we or our collaborative partners
develop must receive all relevant regulatory agency approvals or clearances,
if any, before it may be marketed in the United States or other countries.
In particular, human pharmaceutical therapeutic products are subject to
rigorous preclinical and clinical testing and other requirements by the Food
and Drug Administration in the United States and similar health authorities
in foreign countries. The regulatory process, which includes extensive
preclinical testing and clinical trials of each product in order to establish
its safety and efficacy, is uncertain, can take many years and requires the
expenditure of substantial resources.
Data obtained from preclinical and clinical activities is susceptible to
varying interpretations that could delay, limit or prevent regulatory agency
approvals or clearances. In addition, delays or rejections may be
encountered as a result of changes in regulatory agency policy during the
period of product development and/or the period of review of any application
for regulatory agency approval or clearance for a product. Delays in
obtaining regulatory agency approvals or clearances could:
- significantly harm the marketing of any products that we or our
collaborators develop;
- impose costly procedures upon our activities or the activities of our
collaborators;
- diminish any competitive advantages that we or our collaborative partners
may attain; or
- adversely affect our ability to receive royalties and generate revenues
and profits.
In addition, the marketing and manufacturing of drugs and biological products
are subject to continuing FDA review, and later discovery of previously
unknown problems with a product, its manufacture or its marketing may result
in the FDA requiring further clinical research or restrictions on the product
or the manufacturer, including withdrawal of the product from the market.
WE DEPEND ON OUR COLLABORATORS TO HELP US COMPLETE THE PROCESS OF DEVELOPING
AND TESTING OUR PRODUCTS AND OUR ABILITY TO DEVELOP AND COMMERCIALIZE
PRODUCTS MAY BE IMPAIRED OR DELAYED IF OUR COLLABORATIVE PARTNERSHIPS ARE
UNSUCCESSFUL.
Our strategy for the development, clinical testing and commercialization of
our products requires entering into collaborations with corporate partners,
licensors, licensees and others. We are dependent upon the subsequent
success of these other parties in performing their respective
responsibilities and the cooperation of our partners. Our collaborators may
not cooperate with us or perform their obligations under our agreements with
them. We cannot control the amount and timing of our collaborators'
resources that will be devoted to our research activities related to our
collaborative agreements with them. Our collaborators may choose to pursue
existing or alternative technologies in preference to those being developed
in collaboration with us.
Under agreements with collaborators, we may rely significantly on them, among
other activities, to:
- fund research and development activities with us;
- pay us fees upon the achievement of milestones; and
- market with us any commercial products that result from our
collaborations.
OUR RELIANCE ON THE RESEARCH ACTIVITIES OF OUR NON-EMPLOYEE SCIENTIFIC
ADVISORS AND OTHER RESEARCH INSTITUTIONS, WHOSE ACTIVITIES ARE NOT WHOLLY
WITHIN OUR CONTROL, MAY LEAD TO DELAYS IN TECHNOLOGICAL DEVELOPMENTS.
We have relationships with scientific advisors at academic and other
institutions, some of whom conduct research at our request. These scientific
advisors are not our employees and may have commitments to, or consulting or
advisory contracts with, other entities that may limit their availability to
us. We have limited control over the activities of these advisors and,
except as otherwise required by our collaboration and consulting agreements,
can expect only limited amounts of their time to be dedicated to our
activities. If our scientific advisors are unable or refuse to contribute to
the development of any of our potential discoveries, our ability to generate
significant advances in our technologies will be significantly harmed.
THE LOSS OF KEY PERSONNEL COULD SLOW OUR ABILITY TO CONDUCT RESEARCH AND
DEVELOP PRODUCTS.
Our future success depends to a significant extent on the skills, experience
and efforts of our executive officers and key members of our scientific
staff. We may be unable to retain our current personnel or attract or
assimilate other highly qualified management and scientific personnel in the
future. The loss of any or all of these individuals could harm our business
and might significantly delay or prevent the achievement of research,
development or business objectives.
WE FACE INTENSE COMPETITION FROM OTHER COMPANIES.
Most or all of the products we could develop or commercialize will face
competition from different therapeutic agents intended for treatment of the
same indications or from other products incorporating drug delivery
technologies. The competition potentially includes all of the pharmaceutical
and drug delivery companies in the world. Many of these pharmaceutical
companies have more financial resources, technical staff and manufacturing
and marketing capabilities than we do. To the extent that we develop or
market products incorporating drugs that are off-patent, or are being
developed by multiple companies, we will face competition from other
companies developing and marketing similar products.
Pharmaceutical companies are increasingly using advertising, including
direct-to-consumer advertising, in marketing their products. The costs of
such advertising are very high and are increasing. It may be difficult for
our company to compete with larger companies investing greater resources in
these marketing activities.
Other pharmaceutical companies are aggressively seeking to obtain new
products by licensing products or technology from other companies. We will
be competing to license or acquire products or technology with companies with
far greater financial and other resources.
INABILITY TO OBTAIN SPECIAL MATERIALS COULD SLOW DOWN OUR RESEARCH AND
DEVELOPMENT PROCESS.
Some of the critical materials and components used in our developed products
are sourced from a single supplier. An interruption in supply of a key
material could significantly delay our research and development process.
Special materials must often be manufactured for the first time for use in
drug delivery systems, or materials may be used in the systems in a manner
different from their customary commercial uses. The quality of materials can
be critical to the performance of a drug delivery system, so a reliable
source of a consistent supply of materials is important. Materials or
components needed for our drug delivery systems may be difficult to obtain on
commercially reasonable terms, particularly when relatively small quantities
are required, or if the materials traditionally have not been used in
pharmaceutical products.
PATENTS AND OTHER INTELLECTUAL PROPERTY PROTECTION MAY BE DIFFICULT TO OBTAIN
OR INEFFECTIVE.
Patent protection generally has been important in the pharmaceutical
industry. Our existing patents may not cover future products, additional
patents may not be issued, and current patents or patents issued in the
future may not provide meaningful protection or prove to be of commercial
benefit.
In the United States, patents are granted for specified periods of time.
Some of our earlier patents have expired, or will expire, over the next
several years.
Other companies may successfully challenge our patents in the future. Others
may also challenge the validity or enforceability of our patents in
litigation. If any challenge is successful, other companies may then be able
to use the invention covered by the patent without payment. In addition, if
other companies are able to obtain patents that cover any of our technologies
or products, we may be subject to liability for damages and our activities
could be blocked by legal action unless we can obtain licenses to those
patents.
In addition, we utilize significant unpatented proprietary technology and
rely on unpatented trade secrets and proprietary know-how to protect certain
aspects of our products and technologies and the methods used to manufacture
them. Other companies have or may develop similar technology which will
compete with our technology.
OUR ROYALTY REVENUES COULD DECLINE.
Our royalty revenues in future periods could vary significantly. Major
factors which could have an effect on our royalty revenues include, but are
not limited to:
- our partners' decisions about amounts and timing of advertising support
for Retin-A Micro and Carac.
- our partners' decisions about other promotion and marketing support for
Retin-A Micro and Carac.
- the timing of approvals for new product applications both in the United
States and abroad.
- the expiration or invalidation of patents.
- decreases in licensees' sales of product due to competition, manufacturing
difficulties or other factors that affect sales of product, including
regulatory restrictions on the advertising of pharmaceutical products.
Item 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
Our exposure to market rate risk for changes in interest rates relates
primarily to our investment portfolio. We do not use derivative financial
instruments. We manage our interest rate risk by maintaining an investment
portfolio primarily consisting of debt instruments of high credit quality and
relatively short average maturities. We also manage our interest rate risk
by maintaining sufficient cash and cash equivalents such that we are
typically able to hold our investments to maturity. At December 31, 2004 and
2003, respectively, our cash equivalents and marketable securities include
corporate and other debt securities as follows: (in thousands)
December 31,
-------------------------
2004 2003
---- ----
Available-for-sale:
Effective maturity of less than
3 months $ 2,228 $ 14
Due after 3 months and less than
1 year 10,486 8,665
Due after 1 year and less than
2 years -- 721
------ ------
Total Available for Sale $12,714 $ 9,400
====== ======
Notwithstanding our efforts to manage interest rate risks, there can be no
assurances that we will be adequately protected against the risks associated
with interest rate fluctuations.
Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
A.P. Pharma, Inc.
We have audited the accompanying consolidated balance sheets of A.P. Pharma,
Inc. as of December 31, 2004 and 2003, and the related consolidated
statements of operations, stockholders' equity, and cash flows for each of
the three years in the period ended December 31, 2004. Our audits also
included the financial statement schedule listed in the Index at Item 15(a)2.
These financial statements and schedule are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
financial statements and schedule based on our audits.
We conducted our audits in accordance with the standards of the Public
Company Accounting Oversight Board(United States). Those standards require
that we plan and perform the audit to obtain reasonable assurance about
whether the financial statements are free of material misstatement. An audit
includes examining, on a test basis, evidence supporting the amounts and
disclosures in the financial statements. An audit also includes assessing
the accounting principles used and significant estimates made by management,
as well as evaluating the overall financial statement presentation. We
believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of A.P. Pharma,
Inc. at December 31, 2004 and 2003, and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2004, in conformity with U.S. generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.
We also have audited, in accordance with the standards of the Public Company
Accounting Oversight Board (United States), the effectiveness of A.P. Pharma,
Inc's. internal control over financial reporting as of December 31, 2004,
based on criteria established in Internal Control - Integrated Framework
issued by the Committee of Sponsoring Organizations of the Treadway
Commission and our report dated March 11, 2005 expressed an unqualified
opinion theron.
/s/ERNST & YOUNG LLP
Palo Alto, California
March 11, 2005
A.P. Pharma, Inc.
Consolidated Balance Sheets
(in thousands except par value and shares)
- ------------------------------------------
December 31,
-------------------------
2004 2003
---- ----
Assets
Current Assets:
Cash and cash equivalents $ 3,110 $ 97
Marketable securities 10,486 9,387
Accounts receivable less allowance
for doubtful accounts of $0 at
December 31, 2004 and 2003 1,506 1,340
Prepaid expenses and other current
assets, less allowance for doubtful
note receivable of $394 and $413 at
December 31, 2004 and 2003,
respectively 394 434
------- -------
Total current assets 15,496 11,258
Property and equipment, net 1,235 1,430
Other long-term assets 283 467
------- -------
Total Assets $ 17,014 $ 13,155
======= =======
Liabilities and Stockholders' Equity
Current Liabilities:
Accounts payable $ 697 $ 476
Accrued expenses 2,003 1,173
Accrued disposition costs 160 53
Deferred revenue -- 190
------- -------
Total current liabilities 2,860 1,892
Commitments and Contingencies
(Note 7)
Stockholders' Equity:
Preferred stock, 2,500,000 shares
authorized; none issued or
outstanding at December 31,
2004 and 2003 -- --
Common stock, $.01 par value,
50,000,000 shares authorized;
25,033,919 and 20,641,924 issued
and outstanding at December 31,
2004 and 2003, respectively 250 206
Additional paid-in capital 98,739 86,638
Accumulated deficit (84,819) (75,598)
Accumulated other comprehensive
income (loss) (16) 17
------- -------
Total Stockholders' Equity 14,154 11,263
------- -------
Total Liabilities and Stockholders'
Equity $ 17,014 $ 13,155
======= =======
See accompanying notes to consolidated financial statements.
A.P. Pharma, Inc.
Consolidated Statements of Operations
(in thousands except per share data)
- -------------------------------------
Year Ended December 31,
-----------------------
2004 2003 2002
---- ---- ----
Revenues
Royalties $ 4,972 $ 4,502 $ 4,026
Contract revenues 432 346 407
License fees -- -- 237
------ ------ ------
Total revenues 5,404 4,848 4,670
Expenses
Research and development 11,495 8,421 6,414
General and administrative 3,225 3,039 3,309
------ ------ ------
Operating loss (9,316) (6,612) (5,053)
------ ------ ------
Interest income 202 251 590
Other income, net 22 153 68
------ ----- ------
Loss from continuing operations (9,092) (6,208) (4,395)
Income (loss) from discontinued
operations (133) (57) 401
Gain on disposition of discontinued
operations, net of taxes 4 1,902 216
------ ------ ------
Net loss $(9,221) $(4,363) $(3,778)
====== ====== ======
Basic and diluted loss per share:
Loss from continuing operations $ (0.40) $ (0.30) $ (0.22)
====== ====== ======
Net loss $ (0.40) $ (0.21) $ (0.19)
====== ====== ======
Weighted average common shares
outstanding - basic and diluted 22,909 20,553 20,409
====== ====== ======
See accompanying notes to consolidated financial statements.
A.P. Pharma, Inc.
Consolidated Statements of Stockholders' Equity and Comprehensive Loss
(in thousands)
- -------------------------------------------------------------------------------
For the Years Ended December 31, 2004, 2003 and 2002
Accumulated
Other
Additional Compre-
Common Stock Paid-In Accumulated hensive Stockholders'
Shares Amount Capital Deficit Income(Loss) Equity
---------- -------- ----------- ----------- ------------ ------------
Balance, December
31, 2001 20,357 $203 $86,188 $(67,457) $ 238 $19,172
Comprehensive
loss:
Net loss -- -- -- (3,778) -- (3,778)
Net unrealized
loss on
marketable
securities -- -- -- -- (162) (162)
------
Comprehensive
loss (3,940)
------
Fair value of
common stock
issued to
directors
for services and
restricted stock
awards 47 1 129 -- -- 130
Expenses associated
with stock options
granted to
non-employees -- -- 22 -- -- 22
Common stock issued
to employees under
the Employee Stock
Purchase Plan 63 1 74 -- -- 75
------ --- ------ ------- ---- ------
Balance, December
31, 2002 20,467 $205 $86,413 $(71,235) $ 76 $15,459
====== === ====== ======= ==== ======
Comprehensive
loss:
Net loss -- -- -- (4,363) -- (4,363)
Net unrealized
loss on
marketable
securities -- -- -- -- (59) (59)
------
Comprehensive
loss (4,422)
------
Common stock
issued upon
exercise of
stock options 14 -- 22 -- -- 22
Fair value of
common stock
issued to
directors
for services 86 1 112 -- -- 113
Expenses associated
with stock options
granted to
non-employees -- -- 30 -- -- 30
Common stock issued
to employees under
the Employee Stock
Purchase Plan 75 -- 61 -- -- 61
------ --- ------ ------- ---- ------
Balance, December
31, 2003 20,642 $206 $86,638 $(75,598) $ 17 $11,263
====== === ====== ======= ==== ======
Comprehensive
loss:
Net loss (9,221) (9,221)
Net unrealized
loss on
marketable
securities -- -- -- -- (33) (33)
------
Comprehensive
loss (9,254)
------
Common stock
issuance, net of
issuance costs 4,153 41 11,715 -- -- 11,756
Common stock
issued upon
exercise of
stock options 69 1 150 -- -- 151
Fair value of
common stock
issued to
directors
for services 52 1 116 -- -- 117
Expenses associated
with stock options
granted to
non-employees -- -- 16 -- -- 16
Common stock issued
to employees under
the Employee Stock
Purchase Plan 118 1 104 -- -- 105
------ --- ------ ------- ---- ------
Balance, December
31, 2004 25,034 $250 $98,739 $(84,819) $ (16) $14,154
====== === ====== ======= ==== ======
See accompanying notes to consolidated financial statements.
A.P. Pharma, Inc.
Consolidated Statements of Cash Flows (in thousands)
- ----------------------------------------------------
For the Year Ended December 31,
-------------------------------------
2004 2003 2002
--------- --------- ---------
Cash flows from operating activities:
Net loss $ (9,221) $ (4,363) $ (3,778)
Adjustments to reconcile net loss to net
cash used in operating activities:
Loss (income) from discontinued operations 133 57 (401)
Gain on disposition of discontinued
operations (4) (1,902) (216)
Gain on sale of marketable securities (2) (1) (81)
Depreciation and amortization 381 432 449
Provision for (recovery of) note receivable (18) (24) 66
Stock-based compensation 133 143 152
Amortization of premium/discount and
accretion of marketable securities (67) 28 22
Loss on retirements and disposals of fixed
assets 7 16 3
Changes in operating assets and liabilities:
Accounts receivable (287) (122) (53)
Prepaid expenses and other 58 (130) 254
Other long-term assets 184 (277) 26
Accounts payable 221 209 (54)
Accrued expenses 830 227 (464)
Deferred revenue (190) (405) (505)
------ ------- ------
Net cash used in continuing operating
activities (7,842) (6,112) (4,580)
Cash provided by (used in) used in
discontinued operations 99 (413) (554)
------ ------- -------
Net cash used in operating activities (7,743) (6,525) (5,134)
------ ------- -------
Cash flows from investing activities:
Proceeds from disposition of discontinued
operations -- 2,142 216
Purchases of property and equipment (193) (251) (428)
Purchases of marketable securities (17,318) (6,712) (12,563)
Maturities of marketable securities 14,065 6,832 8,039
Sales of marketable securities 2,190 1,246 9,459
------ ------- -------
Net cash (used in) provided by investing
activities (1,256) 3,257 4,723
------ ------- -------
Cash flows from financing activities:
Proceeds from the issuance of common
stock, net of issuance costs 11,756 -- --
Proceeds from the exercise of common
stock options 151 22 --
Proceeds from issuance of shares under
the Employee Stock Purchase Plan 105 61 75
------ ------- -------
Net cash provided by financing activities 12,012 83 75
------ ------- -------
Net decrease in cash and cash
equivalents 3,013 (3,185) (336)
Cash and cash equivalents at the beginning
of the year 97 3,282 3,618
------ ------ -------
Cash and cash equivalents at the end of
the year $ 3,110 $ 97 $ 3,282
====== ====== ======
Supplemental Cash Flow Data:
Cash paid for interest $ 5 $ 4 $ --
====== ====== ======
See accompanying notes to consolidated financial statements.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
- ------------------------------------------
DECEMBER 31, 2004, 2003 AND 2002
- --------------------------------
Note 1 Business
A.P. Pharma, Inc. (APP, the Company, we, our, or us) is developing patented
polymer-based delivery systems to enhance the safety and effectiveness of
pharmaceutical compounds. New products and technologies under development
include bioerodible polymers for injectable and implantable drug delivery.
Projects are also conducted under feasibility and development arrangements
with pharmaceutical and biotechnology companies.
On July 25, 2000, we completed the sale of certain technology rights for our
topical pharmaceutical and cosmeceutical product lines and other assets
("cosmeceutical and toiletry business") to RP Scherer Corporation, a
subsidiary of Cardinal Health, Inc. As a result of this transaction, our
Consolidated Statements of Operations reflect the receipt of certain earnout
payments and the payment of certain contractual obligations in the gain from
disposition of discontinued operations (see Note 10).
On February 13, 2003, we completed the sale of our Analytical Standard
division to GFS Chemicals, Inc. ("GFS"), a privately held company based in
Columbus, Ohio. In this transaction, we received $2.1 million and are
entitled to receive royalties on sales of Analytical Standards products of
15% for the first year, 10% for the second through fourth years, and 5% for
the fifth year. The net present value of the guaranteed minimum royalties is
included in the gain on disposition of discontinued operations (see Note 10).
Note 2 Summary of Significant Accounting Policies
Basis of Presentation
- ---------------------
The consolidated financial statements include the financial statements of the
Company and its wholly-owned subsidiary, APS Analytical Standards, Inc.
(Analytical Standards) through the date of sale (February 13, 2003). All
significant intercompany balances and transactions have been eliminated in
consolidation.
Cash Equivalents and Marketable Securities
- ------------------------------------------
We consider all short-term investments that have original maturities of less
than three months to be cash equivalents. Investments with effective
maturities of three months and longer are classified as marketable
securities. Investments consist primarily of commercial paper, bankers'
acceptances, master notes and corporate debt securities. We have classified
all our investments in certain debt and equity securities as "available-for-
sale", and, therefore, they are recorded at fair value with unrealized gains
and losses reported as a separate component of stockholders' equity. If the
fair value of a security is below its carrying value for each trading day for
six consecutive months or if its decline is due to a significant adverse
event, the impairment is considered to be other-than-temporary. Realized
gains and losses and declines in fair value that are deemed to be other-than-
temporary are reflected in the statement of operations. The cost of
securities sold is based on the specific identification method.
Financial Instruments
- ---------------------
The carrying values of the Company's financial instruments, including
marketable securities, accounts receivable and accrued liabilities,
approximate their respective fair values.
Allowance for Note Receivable
- -----------------------------
An allowance was recorded for a note receivable at such time as management
determined that collection was not reasonably assured. Interest income under
the terms of note receivable agreement is recorded when cash is received or
collectibility is reasonably assured. The note receivable, net of the
related allowance, is included in prepaid expenses and other current assets
in the accompanying balance sheet.
Property and Equipment
- ----------------------
Property and equipment are stated at cost less accumulated depreciation.
Depreciation is computed using the straight-line method over the estimated
useful lives of the assets as follows: equipment and machinery, 3 to 5 years;
furniture and fixtures, 5 years; and leasehold improvements, over the shorter
of the respective lease terms or the respective useful lives of the leasehold
improvements.
Long-Lived Assets
- -----------------
As circumstances dictate, we evaluate whether changes have occurred that
would require revision of the remaining estimated lives of recorded long-
lived assets or that render those assets impaired. Recoverability of assets
to be held and used is determined by comparing the undiscounted net cash
flows of long-lived assets to their respective carrying values. If such
assets are considered to be impaired, the amount of impairment to be
recognized is measured based on the projected discounted cash flows using an
appropriate discount rate.
Stock-Based Compensation
- ------------------------
We have elected to account for stock-based compensation related to employees
using the intrinsic value method. Accordingly, except for stock options
issued to non-employees and restricted stock awards to employees and
directors, no compensation cost has been recognized for our stock option
plans and stock purchase plan. Compensation related to options granted to
non-employees is periodically remeasured as earned.
In accordance with FAS No. 123, "Accounting for Stock-Based Compensation," as
amended by FAS No. 148, "Accounting for Stock-Based Compensation-Transition
and Disclosure," we have provided, below, the pro forma disclosures of the
effect on net loss and net loss per share as if FAS No. 123 had been applied
in measuring compensation expense for all periods presented (in thousands)
(see Note 8 "Stockholders' Equity"):
2004 2003 2002
----------- ----------- ---------
Net loss - as reported $(9,221) $(4,363) $(3,778)
Deduct:
Stock-based employee
compensation expense
determined under FAS 123 (400) (397) (601)
------- ------ ------
Net loss - pro-forma $(9,621) $(4,760) $(4,379)
====== ====== ======
Basic and diluted net
loss per common share
- as reported $ (0.40) $ (0.21) $ (0.19)
Basic and diluted net
loss per common share
- pro-forma $ (0.42) $ (0.23) $ (0.21)
Recent Accounting Pronouncements
- --------------------------------
In December 2004, the Financial Accounting Standard Board ("FASB") issued
SFAS 123R, Statement No. 123R "Share-Based Payment", which is a revision of
FASB Statements No. 123 and 95". SFAS 123R requires all share-based payments
to employees, including employee stock options, to be recognized as a cost in
the financial statements based on their fair values. SFAS 123R must be
adopted no later than July 1, 2005. This statement allows for two methods of
adoption; (i) modified prospective or (ii) modified-retrospective. We will
adopt SFAS 123R on July 1, 2005 using the modified-prospective method which
requires the compensation cost for share-based payments to employees to be
recognized based on their grant-date fair value beginning July 1, 2005. We
are currently evaluating option valuation methodologies and assumptions in
light of the new requirements under FAS 123R and do not yet know the impact
that the adoption of SFAS 123R will have on the financial position or results
of operations. Current estimates of option values using the Black-Scholes
method may not be indicative of results from valuation methodologies
ultimately adopted.
Use of Estimates
- ----------------
The preparation of 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
consolidated financial statements and accompanying notes. Estimates were
made relating to useful lives of fixed assets, valuation allowances,
impairment of assets and accruals. Actual results could differ materially
from those estimates.
Revenue Recognition
- -------------------
Our revenue arrangements with multiple deliverables are divided into separate
units of accounting if certain criteria are met, including whether the
delivered item has stand-alone value to the customer and whether there is
objective and reliable evidence of the fair value of the undelivered items.
The consideration we receive is allocated among the separate units based on
their respective fair values, and the applicable revenue recognition criteria
are considered separately for each of the separate units. Advance payments
received in excess of amounts earned are classified as deferred revenue until
earned.
Royalties
- ---------
Royalties from licenses are based on third-party sales of licensed products
or technologies and recorded as earned in accordance with contract terms when
third-party results can be reliably determined and collectibility is
reasonably assured.
Generally, contractually required minimum royalties are recorded ratably
throughout the contractual period. Royalties in excess of minimum royalties
are recognized as earned when the related product is shipped to the end
customer by our licensees based on information provided to us by our
licensees.
Contract Revenues
- -----------------
Contract revenues also relate to research and development arrangements that
generally provide for the company to invoice research and development fees
based on full-time equivalent hours for each project. Revenues from these
arrangements are recognized as the related development costs are incurred.
These revenues approximate the costs incurred.
License Fees
- ------------
We have licensing agreements that generally provide for periodic minimum
payments, royalties, and/or non-refundable license fees. These licensing
agreements typically require a non-refundable license fee and allow our
partners to sell our proprietary products in a defined field or territory for
a defined period. The license agreements provide for APP to earn future
revenue through royalty payments. These non-refundable license fees are
initially reported as deferred revenues and recognized as revenues over the
estimated life of the product to which they relate as we have continuing
involvement with licensees until the related product is discontinued or the
related patents expire, whichever is earlier. Revenue recognized from
deferred license fees is classified as license fees in the accompanying
consolidated statements of operations. License fees received in connection
with arrangements where we have no continuing involvement are recognized as
license fees when the amounts are received or when collectibility is assured,
whichever is earlier. No such fees were recorded during the years ended
December 31, 2004 and 2003.
A milestone payment is a payment made by a third party or corporate partner
to us upon the achievement of a predetermined milestone as defined in a
legally binding contract. Milestone payments are recognized as license fees
when the milestone event has occurred and we have completed all milestone
related services such that the milestone payment is currently due and is non-
refundable. No such fees were recorded during the years ended December 31,
2004 and 2003.
Research and Development
- ------------------------
Research and development consists of costs incurred for Company-sponsored and
collaborative research and development expenses. These costs consist
primarily of employee salaries and other personnel-related expenses,
facility-related expenses, lab consumables, polymer development
manufacturing, clinical and pre-clinical related services performed by
clinical research organizations, research institutions and other outside
service providers.
The filing of an IND and additional clinical trials of APF530 will have a
significant effect on the Company's research and development expenses.
Expenses related to clinical trials generally are accrued based on the level
of patient enrollment and activity according to the protocol. The Company
monitors patient enrollment levels and related activity to the extent
possible and adjusts estimates accordingly.
Research and development expenses under collaborative agreements approximate
the revenue recognized, excluding milestone and up-front payments received
under such arrangements.
Net Loss Per Share
- -------------------------
Basic and diluted net loss per share is computed based on the weighted-
average number of common shares outstanding. Diluted net loss per share is
not presented separately as the Company is in a net loss position and
including potentially dilutive securities in the net loss per share
computation would be anti-dilutive. See Note 9 "Net Loss Per Share".
Concentrations of Credit Risk
- -----------------------------
Financial instruments that potentially subject us to concentrations of credit
risk consist primarily of cash equivalents, short-term investments and trade
accounts receivable. We invest excess cash in a variety of high grade short-
term, interest-bearing securities. This diversification of risk is
consistent with our policy to ensure safety of principal and maintain
liquidity.
Approximately 96% and 80% of the receivables were concentrated with two
customers in the pharmaceutical industry as of December 31, 2004 and 2003,
respectively. Approximately 92%, 93% and 91% of total revenue were
concentrated with two customers for the years ended December 31, 2004, 2003
and 2002. To reduce credit risk, we perform ongoing credit evaluations of
our customers' financial condition. We do not generally require collateral
for customers with accounts receivable balances.
Segment and Geographic Information
- ----------------------------------
Our operations are confined to a single business segment, the design and
commercialization of polymer technologies for pharmaceutical and other
applications. Substantially all of our revenues are derived from customers
within the United States.
Reclassifications
- -----------------
Certain reclassifications have been made to the prior year financial
statements to conform with the presentation in 2004. Patent legal expenses
in the prior years have been reclassified from research and development
expense to general and administrative expense.
Note 3 Cash Equivalents and Marketable Securities
We consider all of our investments in debt and equity securities as
available-for-sale and, accordingly, we have recorded these investments at
fair value. Realized gains totaled $2,000, $1,000 and $81,000 for the years
ended December 31, 2004, 2003 and 2002, respectively. There were no realized
losses for the years ended December 31, 2004, 2003 and 2002.
At December 31, 2004 and 2003, the amortized cost and estimated market value
of investments in debt securities and cash are set forth in the tables below:
December 31, 2004
(in thousands)
------------------------------------------------
Unrealized Unrealized Estimated
Cost Gains Losses Market Value
------ ---------- ---------- ------------
Available-for-sale:
Corporate debt
securities $ 2,955 $ -- $ (7) $ 2,948
Asset-backed
securities 94 -- -- 94
Government debt
securities 7,750 -- (9) 7,741
Other debt securities 1,931 -- -- 1,931
------ --- --- ------
Total available-for-
sale 12,730 -- (16) 12,714
Cash 882 -- -- 882
------ --- --- ------
Totals $13,612 $ -- $(16) $13,596
====== === === ======
December 31, 2003
(in thousands)
------------------------------------------------
Unrealized Unrealized Estimated
Cost Gains Losses Market Value
------ ---------- ---------- ------------
Available-for-sale:
Corporate debt
securities $3,354 $10 $-- $3,364
Asset-backed
securities 2,006 6 -- 2,012
Government debt
securities 2,015 2 (1) 2,016
Other debt securities 2,008 -- -- 2,008
-----