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SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q

Commission file number 0-19125

Isis Pharmaceuticals, Inc.
(Exact name of registrant as specified in its charter)

        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.

        Indicate the number of shares outstanding of each of the issuer's classes of common stock, as of the latest practicable date.

ISIS PHARMACEUTICALS, INC.
FORM 10-Q

INDEX

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ISIS PHARMACEUTICALS, INC.
CONDENSED BALANCE SHEETS
(in thousands, except share data)

See accompanying notes.

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ISIS PHARMACEUTICALS, INC.
CONDENSED STATEMENTS OF OPERATIONS
(in thousands, except for per share amounts)
(Unaudited)

See accompany notes.

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ISIS PHARMACEUTICALS, INC.
CONDENSED STATEMENTS OF CASH FLOWS
(in thousands)
(Unaudited)

See accompanying notes.

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ISIS PHARMACEUTICALS, INC.
NOTES TO CONDENSED FINANCIAL STATEMENTS
September 30, 2002
(Unaudited)

1. Basis of Presentation

        The unaudited interim financial statements for the three and nine month periods ended September 30, 2002 and 2001 have been prepared on the same basis as the Company's audited financial statements for the year ended December 31, 2001. The financial statements include all adjustments (consisting only of normal recurring adjustments) which the Company considers necessary for a fair presentation of the financial position at such dates and the operating results and cash flows for those periods. Results for the interim periods are not necessarily indicative of the results for the entire year. For more complete financial information, these financial statements, and notes thereto, should be read in conjunction with the audited financial statements for the year ended December 31, 2001 included in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission.

Revenue Recognition

        Revenue is generally recognized when all contractual obligations have been satisfied and collection of the resulting receivable is reasonably assured.

Research and development revenue under collaborative agreements

        Research and development revenue under collaborative agreements is recognized as the related expenses are incurred, up to contractual limits. Payments received under these agreements that relate to future performance are deferred and recorded as revenue earned over their specified future performance period. Revenue that relates to nonrefundable, up-front fees is recognized over the period of the contractual arrangements as performance obligations related to the services to be provided have been satisfied. Revenue that relates to milestones is recognized upon completion of the milestone's performance requirement. Isis recognizes revenue from federal research grants during the period in which the related expenditures are incurred. Revenue from our Vitravene product sales is recognized as the product is shipped. Revenue associated with our clinical product sales is recognized as product is delivered.

        As part of the Company's alliance with Eli Lilly and Company, Lilly provided a $100.0 million interest-free loan to fund the research collaboration. As of September 30, 2002, Isis had drawn down $40.0 million on the $100.0 million loan. Isis discounted the $40.0 million that had been drawn on the loan as of September 30, 2002, to its net present value by imputing interest on the amount at 20%, which represented market conditions in place at the time Isis entered into the loan. Isis is accreting the loan up to its face value over its term by recording interest expense. The difference between the cash received and the present value of the loan, represents value given to Isis by Lilly to help fund the research collaboration, and Isis is accounting for the difference as deferred revenue related to the collaboration, which is recognized as revenue over the period of performance.

Research and development revenue from affiliates

        Research and development revenue from affiliates is recognized as the related expenses are incurred, up to contractual limits. Revenue related to milestones is recognized upon completion of the milestone's performance requirement, unless consideration for achievement of the milestone is in cash in exchange for the Company's common stock.

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Licensing and royalty revenue

        Licensing and royalty revenue for which no services are required to be performed in the future is recognized immediately, if collectibility is reasonably assured.

Inventory

        Inventory is stated at the lower of cost or market. Inventory consists of raw materials, work in process and finished goods.

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 financial statements and accompanying notes. Actual results could differ from those estimates.

Accounting Pronouncements

        In April 2002 the FASB, issued SFAS No. 145, "Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections." FASB No. 4 required all gains or losses from extinguishment of debt to be classified as extraordinary items net of income taxes. SFAS No. 145 requires that gains and losses from extinguishment of debt be evaluated under the provisions of Accounting Principles Board Opinion No. 30, and be classified as ordinary items unless they meet the specific criteria for treatment as an extraordinary item. The Company adopted the provisions of SFAS 145 effective January 1, 2002, and applied them to its prepayment in May 2002 of the Company's 14% Senior Subordinated Notes and in July 2002 of the Company's 12% convertible debt. The prepayment of both of the 14% and 12% debt did not meet the specific criteria prescribed by SFAS No. 145 to be considered an extraordinary item and as such was recorded as a component of net loss. The Company does not anticipate that the adoption of this statement will have a material effect on its financial position or results of operations.

        In June 2002 the Financial Accounting Standards Board (FASB), issued Statement of Financial Accounting Standards (SFAS) No. 146, "Accounting for Costs Associated with Exit or Disposal Activities." SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies Emerging Issues Task Force Issues No. 94-3, "Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including Certain Costs Incurred in a Restructuring)." SFAS No. 146 is effective for exit or disposal activities initiated after December 31, 2002. Isis does not expect the adoption of SFAS No. 146 to have a material effect on its financial condition or results of operations.

2. Inventory

        Inventory includes the following categories, net of reserves (in thousands):

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3. Strategic Alliances

Affiliates

        In April 1999, Orasense Ltd. (Orasense) was formed to develop technology for the oral formulation of oligonucleotide drugs. In January 2000, a second joint venture, HepaSense Ltd. (HepaSense), was formed to treat patients chronically infected with the Hepatitis C virus. Both affiliates are Bermuda limited companies. Each entity's outstanding common stock is owned 80.1% by Isis and 19.9% by Elan International Services. In November 2002, Isis and Elan agreed to extend the Orasense collaboration through December 2002. Additionally, in November 2002, Isis and Elan terminated the HepaSense collaboration. The original HepaSense collaboration was scheduled to end in July 2002. As part of the termination, Elan's funding obligation ended in June 2002. As a result of the termination of the HepaSense collaboration, Isis has regained rights to its antisense drug for Hepatitis C, ISIS 14803.

        Elan and its subsidiaries have retained significant minority investor rights that are considered "participating rights' as defined in EITF 96-16 in each entity. Therefore, Isis does not consolidate the financial statements of Orasense or HepaSense, but instead accounts for the investments in each under the equity method of accounting. For the nine months ended September 30, 2002 and 2001, Isis recognized $8.4 million and $6.5 million, respectively, in revenue for research and development activities performed for these joint ventures. For the three months ended September 30, 2002, Isis reported $3.3 million in revenue primarily associated with Orasense with approximately $267,000 related to final services for HepaSense recognized in the third quarter of 2002. For the three months ended September 30, 2001, Isis reported $2.4 million in revenue for research and development activities performed for both Orasense and HepaSense. These amounts are included as research and development revenue from affiliates for the respective periods.

        In April 2002, Isis achieved a development milestone in its HepaSense Ltd. joint venture with Elan triggering a $3.75 million equity purchase by Elan of Isis common stock at a price of $29.74. Elan also received a warrant to purchase 6,304 shares of Isis common stock at an exercise price of $59.48 per share. The result of this transaction increased the Company's cash balance and was not recorded as revenue.

        In July 2002, Isis prepaid $19.7 million of 12% convertible debt held by Elan with $14.7 million in cash. The prepayment resulted in a gain of approximately $5 million which was recorded in the third quarter of 2002 as a gain from prepayment of debt.

        The results of operations of Orasense for the quarter and nine month periods ended September 30, 2002 and 2001 are as follows (in thousands):

        The research and development expense for HepaSense for the three months ended September 30, 2002 was associated with close out expenses incurred in the third quarter. The results of operations of

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HepaSense for the quarter and nine month periods ended September 30, 2002 and 2001 are as follows (in thousands):

Amgen, Inc.

        In August 2002, Isis achieved a research milestone in the Company's drug discovery collaboration with Amgen and received an associated milestone payment. The milestone is related to research progress in a three year antisense drug discovery collaboration initiated in December 2001. The milestone was recorded as research and development revenue under collaborative agreements as the milestone performance requirement was completed.

Hybridon, Inc.

        In August 2002, Isis and Hybridon cancelled the remaining reciprocal financial obligations related to their Collaboration and License Agreement entered into in May 2001. Under the original terms, Hybridon owed Isis an additional four million shares of Hybridon common stock, payable immediately. Isis owed Hybridon $4.5 million in cash or stock, due in May 2003. The cancellation of the obligations resulted in a decrease to the license carrying value in the amount of $500,000.

Eli Lilly and Company

        In September 2002, Isis agreed to manufacture Affinitac during the product launch period for Lilly. The agreement requires Lilly to provide Isis with a loan of up to $21 million to fund the construction of a new manufacturing suite dedicated to Affinitac. Isis will repay the loan from Affinitac success milestones due from Lilly or other product-related cash flows. The loan is secured with the movable equipment purchased for the manufacturing suite. The facility is under construction on Isis' Carlsbad campus in an existing building and is substantially complete.

4. Comprehensive Loss

        SFAS No. 130, Reporting Comprehensive Income, requires the Company to report, in addition to net loss, comprehensive loss and its components. A summary follows:

Statements of Comprehensive Loss

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5. Debt Issuance and Debt Prepayment

        In May 2002, Isis issued in a private placement $125 million of 5¹/2% convertible subordinated notes due May 2009. The Company received approximately $121 million of proceeds net of offering costs.

        In May 2002, Isis prepaid its 14% Senior Subordinated Notes totaling approximately $74 million with proceeds the Company received from the above mentioned debt offering. The transaction resulted in a payment of $40.1 million in principal, $32.6 million in accrued interest, and a $2.3 million loss on prepayment of debt which consisted of unamortized issuance costs, unamortized warrants and prepaid interest.

        In July 2002, Isis prepaid $19.7 million of 12% convertible debt held by Elan with $14.7 million in cash. The prepayment resulted in a gain of approximately $5 million that was recorded in the third quarter of 2002 as a gain from prepayment of debt.

6. Stockholders' Equity

Conversion of Series A Convertible Exchangeable 5% Preferred Stock

        At December 31, 2001, Isis had 120,150 shares authorized, issued and outstanding of Series A Convertible Exchangeable 5% Preferred Stock. The shares had a term of six years and were convertible into Isis' common stock on or after March 31, 2002. These also carry a mandatory pay-in-kind dividend of 5.0% per year on the original issue price per share, compounded semi-annually payable only upon conversion into Isis' common stock or cash.

        On August 7, 2002, the holder of our Series A Convertible Preferred Stock exercised its option to convert the Series A shares into Isis common stock. The transaction converted the outstanding 120,150 shares of Series A Convertible Preferred Stock into 656,674 shares of Isis common stock using a conversion price of $21.54 per share. Included in the conversion was approximately $2.1 million in preferred stock dividends, which were accrued in prior periods.

7. Subsequent Events

        In November 2002, the Company announced the termination of its GeneTrove database product offering and a resulting reorganization of the GeneTrove division. As a result, the Company will reduce its workforce by approximately 25 people. The restructuring plan also provides for the write-down of certain intellectual property related to the GeneTrove database product. The Company will incur a one-time charge of approximately $1.2 million associated with the restructuring in the fourth quarter of 2002. GeneTrove will continue to market its custom target validation services and intellectual property licenses to pharmaceutical industry partners.

        In November 2002, Isis and Elan agreed to extend the Orasense collaboration through December 2002. Additionally, in November 2002, Isis and Elan terminated the HepaSense collaboration. The original HepaSense collaboration was scheduled to end in July 2002. As part of the termination, Elan's funding obligation ended in June 2002. As a result of the termination of the HepaSense collaboration, Isis has regained rights to its antisense drug for Hepatitis C, ISIS 14803.

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ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

        In addition to historical information contained in this Report, this Report contains forward-looking statements regarding our business and the therapeutic and commercial potential of our technologies and products in development. Any statement describing our goals, expectations, intentions or beliefs is a forward-looking statement and should be considered an at-risk statement. Such statements are subject to certain risks and uncertainties, particularly those risks and uncertainties inherent in the process of discovering, developing and commercializing drugs that can be proven to be safe and effective for use as human therapeutics, in the process of conducting gene functionalization and target validation services, and in the endeavor of building a business around such products and services. Actual results could differ materially from those discussed in this Form 10-Q. Factors that could cause or contribute to such differences include, but are not limited to, those discussed in our Annual Report on Form 10-K for the year ended December 31, 2001, which is on file with the U.S. Securities and Exchange Commission and those identified in the section of Item 2 entitled "Risk Factors" beginning on page 20 of this Report. As a result, you are cautioned not to rely on these forward-looking statements.

        Since our inception in 1989, we have worked to advance the science of antisense for the development of a new class of drugs. We can design antisense drugs to treat a wide variety of diseases. Due to their gene selectivity, antisense drugs have the potential to be highly effective and less toxic than traditional drugs. We have made significant progress in understanding the capabilities of antisense drugs in treating disease. We have developed new chemistries and novel formulations to enhance the potency and utility of antisense drugs, and we have successfully turned our expertise into a broad pipeline of 13 antisense products currently in all phases of clinical development. Our drugs in development treat a variety of health conditions, including cancer and inflammatory, viral, metabolic and dermatological diseases, and are being studied in intravenous, subcutaneous, topical cream, enema and oral formulations. We achieved marketing clearance for the world's first antisense drug Vitravene® (fomivirsen) in 1998.

        Established in 2000, GeneTrove is our functional genomics division, which commercializes the first step of our antisense drug discovery program. GeneTrove capitalizes on the specificity of antisense, using it as a tool to identify what a gene does, which is called gene functionalization, and whether a specific gene is a good target for drug discovery, which is called target validation. GeneTrove provides valuable functional genomics services to the pharmaceutical and biotechnology industry, potentially enhancing and expediting drug discovery and development decisions, and generating near-term revenue for us in the process. We have collaborations with nine major pharmaceutical partners for these services, including Abbott Laboratories, Inc., Aventis (formerly Rhone-Poulenc Rorer), Amgen Inc., Celera Genomics Group, Chiron Corporation, Eli Lilly and Company, Johnson & Johnson Pharmaceutical Research & Development, LLC, Merck & Co., Inc. and Pharmacia Corporation. We expect these collaborations to fund the functionalization of approximately 1,400 new genes through the timeframe of these agreements, which conclude within the next two to three years. In August 2001 we supplemented our GeneTrove service business with the introduction of a subscription database product. However, GeneTrove was unsuccessful in generating customers for its database product. As a result, in November 2002, we decided to terminate the GeneTrove database product and reduced our workforce accordingly. GeneTrove will continue to market its custom target validation services and intellectual property licenses to pharmaceutical industry partners, as these components of the GeneTrove business are both financially and strategically valuable to us.

        Our Ibis Therapeutics division is taking advantage of the investment we have made in RNA-based drug discovery. The division is using its proprietary technology to create small molecule drugs that bind to structured regions of RNA—areas that are not available to antisense drug discovery. RNA is an optimal target as it is universal, simple in structure and predictable. Historically, the division has focused primarily on the research and development of anti-bacterials, anti-virals and anti-fungals, Ibis

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has since expanded its program to include a diagnostic application of its technology. Since its inception, Ibis has received significant financial support from various federal government agencies to use its technology for the development of RNA-based countermeasures to biological warfare. In October 2001, Ibis received a two-year contract with the Defense Advanced Research Projects Agency, or DARPA, to develop a sensor to detect infectious agents used in biological warfare attacks. Additionally, in March 2002, Ibis transitioned its government-sponsored research program to discover novel antibacterial drugs for biological warfare defense to the U.S. Army Medical Research Institute of Infectious Diseases, or USAMRIID. Ibis received a new three-year contract from USAMRIID to advance Ibis' work in developing therapeutic countermeasures to biological warfare and expects to receive funding of up to $2.4 million under this contract.

Critical Accounting Policies

        We prepare our financial statements in conformity with accounting principles generally accepted in the United States of America. As such, we are required to make certain estimates, judgments and assumptions that we believe are reasonable, based upon the information available to us. These estimates and assumptions affect the reported balances and amounts within our financial statements and supporting notes thereto. The significant accounting policies, which we believe are the most critical to aid in fully understanding and evaluating our reported financial results, include the following:

Revenue Recognition

        We generally recognize revenue when all contractual obligations have been satisfied and we are reasonably assured of collecting the resulting receivable. We often enter into collaborations where we receive nonrefundable up-front payments for prior or future expenditures. In compliance with current accounting rules, we recognize revenue related to up-front payments over the period of the contractual arrangements as we satisfy our performance obligations. Occasionally, we are required to estimate the period of a contractual arrangement or our performance obligation when the information is not clearly defined in the agreements we enter into. Should different estimates prevail, revenue recognized could be materially different. Agreements where we have made estimates of our continuing obligations include our collaborations with Lilly, Agouron Pharmaceuticals, Inc., a Pfizer company, Amgen, Antisense Therapeutics Limited, Chiron and Merck. The collaboration with Agouron ended in June 2002.

        Revenue related to milestones is recognized upon completion of the milestone's performance requirement. During fiscal 2002, we have earned milestones through our research collaborations with Amgen and Merck. In addition, in April 2002, we achieved a non-revenue development milestone in our HepaSense joint venture with Elan, which triggered a $3.75 million equity purchase by Elan of our common stock.

        As part of our Lilly alliance, Lilly provided a $100.0 million interest-free loan to fund the research collaboration. As of September 30, 2002 we had drawn down $40.0 million on the $100.0 million loan. We discounted the $40.0 million that had been drawn on the loan as of September 30, 2002 to its net present value by imputing interest on the amount at 20%, which represented market conditions in place at the time we entered into the loan. We are accreting the loan up to its face value over its term by recording interest expense. The difference between the cash received and the present value of the loan, represents value given to us by Lilly to help fund the research collaboration, and is accounted for as deferred revenue related to the collaboration, and is recognized as revenue over the period of performance.

        Additionally, licensing and royalty agreements we enter into for which we have no future performance obligations and are reasonably assured of collecting the resulting receivable are recognized

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as revenue immediately. Licensing and royalty agreements where we have no future obligations include Eyetech Pharmaceuticals in 2001.

Valuation of Intellectual Property

        We evaluate our licenses and patent assets for impairment on a quarterly basis, or whenever indicators of impairment exist. During this process, we review our portfolio of pending domestic and international patent applications, domestic and international issued patents, and licenses we have acquired from other parties. To determine if any impairment is present we consider challenges or potential challenges to our existing patents, the likelihood of applications being issued, the scope of our issued patents and our experience. In the event that we determine an impairment exists where we had previously determined that one did not exist, it may result in a material adjustment to our financial statements.

        In November 2002, we terminated our GeneTrove database product offering. As a result, we reviewed for impairment the intellectual property related to the database product offering. Our review resulted in a write-down of the intellectual property to reflect no value. The amount of the write-down will be reflected as a restructuring charge in the fourth quarter of 2002.

Valuation of Short-Term Investments

        We invest our excess cash in U.S. Government securities and debt instruments of financial institutions and corporations with strong credit ratings. We have established guidelines relative to diversification and maturities that maintain safety and liquidity. These guidelines are periodically reviewed and modified to take advantage of trends and interest rates. In determining if and when a decline in market value below amortized cost is other-than-temporary, we, together with our external portfolio managers, evaluate the market conditions, offering prices, trends of earnings, price multiples, and other key measures for our investments in debt instruments. When we deem such a decline in value is other than temporary, we recognize an impairment loss in the period operating results to the extent of the decline. To date, we have not had any material losses related to our cash or short-term investments.

Use of Estimates

        In preparing our financial statements to conform with accounting principles generally accepted in the United States, we make estimates and assumptions that affect the amounts reported in our financial statements and accompanying notes. These estimates include useful lives for fixed assets for depreciation calculations, useful lives for intellectual property for amortization calculations, estimated lives for license agreements related to deferred revenue, valuation of inventory, and assumptions for valuing stock options. Actual results could differ from these estimates.

Results of Operations

Revenue

        Our total revenue for the quarter and nine months ended September 30, 2002, was $20.3 million and $58.3 million, respectively, compared to $19.3 million and $31.5 million, respectively, for the same periods in 2001. The $26.8 million increase in revenue for the nine months ended September 30, 2002, was primarily related to the licensing of our Phase III non-small cell lung cancer compound, Affinitac (formerly known as LY900003 or ISIS 3521) to Eli Lilly and Company in August 2001 and to the company's success in attracting a variety of new partners and technology licensees.

        Under the category of research and development revenue under collaborative agreements, for the quarter and nine months ended September 30, 2002, we earned $17.0 million and $49.6 million,

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respectively, compared to $16.9 million and $24.8 million, respectively, for the same periods in 2001. The increase of $24.8 million for the nine months ended September 30, 2002 was a result of several collaborations in place during the nine months ended September 30, 2002 which were in effect for only a part of the same period in 2001 or non-existent for the same period of 2001. Our August 2001 Lilly alliance significantly contributed to the increase in 2002 over 2001. Other sources of revenue present in 2002 but not in 2001 included: our GeneTrove partnerships with Amgen, Celera, Chiron, Merck and Pharmacia which were entered into in late 2001 or in 2002; and our Ibis divisions' October 2001 and March 2002 biological warfare defense research program with DARPA and USAMRIID, respectively. The increase in revenue was partially offset by the June 2002 termination of our Pfizer collaboration and the decrease in earned milestones in 2002 compared to 2001.

        Research and development revenue from affiliates consisted of revenue associated with our two joint ventures with Elan, Orasense and HepaSense. In November 2002, we and Elan agreed to extend the Orasense collaboration through December 2002. Additionally, in November 2002, we and Elan terminated the Hepa