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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended March 31, 2004

or

For the transition period from              to             .

Commission file number: 000-23265

SALIX PHARMACEUTICALS, LTD.

(Exact name of Registrant as specified in its charter)

8540 Colonnade Center Drive, Suite 501

Raleigh, North Carolina 27615

(Address of principal executive offices, including zip code)

(919) 862-1000

(Registrant’s telephone number, including area code)

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  ¨

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    YES  x    NO  ¨

The number of shares of the Registrant’s Common Stock outstanding as of May 6, 2004 was 23,999,518.

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SALIX PHARMACEUTICALS, LTD.

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PART I. FINANCIAL INFORMATION

Item 1. Condensed Consolidated Financial Statements

SALIX PHARMACEUTICALS, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(U.S. dollars, in thousands, except share amounts)

The accompanying notes are an integral part of these financial statements.

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SALIX PHARMACEUTICALS, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(U.S. dollars, in thousands, except per share data)

The accompanying notes are an integral part of these financial statements.

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SALIX PHARMACEUTICALS, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(U.S. dollars, in thousands)

The accompanying notes are an integral part of these financial statements.

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SALIX PHARMACEUTICALS, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

March 31, 2004

(Unaudited)

Salix Pharmaceuticals, Ltd., a Delaware corporation (“Salix” or the “Company), is a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract.

These financial statements are stated in United States dollars and are prepared under accounting principles generally accepted in the United States. The accompanying condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated.

The accompanying condensed consolidated financial statements include all adjustments (consisting only of normal recurring items), that, in the opinion of management, are necessary for a fair presentation of financial position, results of operations and cash flows. These financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Report and with the audited consolidated financial statements for the fiscal year ended December 31, 2003 included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission. The results of operations for interim periods are not necessarily indicative of results to be expected for a full year or any future period.

At March 31, 2004, the Company had binding purchase order commitments for inventory purchases aggregating approximately $15.4 million over nine months.

The Company considers all investments that have a maturity of greater than three months and less than one year to be short-term investments. All securities with maturities beyond one year are considered long-term investments. The Company’s short-term and long-term investments consist of government agency and high-grade corporate bonds. The Company has the intent and ability to hold these investments until maturity; therefore, the investments are classified as held-to-maturity and are reported at amortized cost.

Inventory at March 31, 2004 consisted of $13.6 million of raw materials and $4.4 million of finished goods. Inventory at December 31, 2003 consisted of $12.2 million of raw materials and $3.9 million of finished goods. As of March 31, 2004, the Company had approximately $8.6 million in raw material inventories relating to products that had not been approved by the U.S. Food and Drug Administration.

When the Company makes product acquisitions that include license agreements, product rights and other identifiable intangible assets, it records the aggregate purchase price, along with the value of the product related liabilities that it assumes, as intangible assets. The Company allocates the purchase price to the fair value of the various intangible assets in order to amortize their cost as an expense in our statement of operations over the estimated economic useful life of the related assets. The Company assesses the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value might not be recoverable. Some factors that the Company considers important which could

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trigger an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of the Company’s use of the acquired assets or the strategy for the Company’s overall business, and significant negative industry or economic trends.

In assessing the recoverability of the Company’s intangible assets, it must make assumptions regarding estimated future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the carrying value of the intangible assets, the Company must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than the carrying value, an impairment loss will be recognized in an amount equal to the difference. The Company reviews intangible assets for impairment at least annually and whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable.

Product sales are recorded upon shipment of order and transfer of title.

In December 1999, the SEC issued Staff Accounting Bulletin No. 101, “SAB 101” “Revenue Recognition in Financial Statements”, as amended by SAB 104, “Revenue Recognition”, which, among other guidance, clarifies certain conditions to be met in order to recognize revenue. SAB 101 requires companies to recognize up-front non-refundable fees over the term of the related agreement unless the fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process.

Due to the uniqueness of each of our licensing arrangements, we analyze each element of each contract, including milestone payments, to determine the appropriate revenue recognition. In accordance with SAB 101, we recognize revenue upon achievement of contractual milestones only when and to the extent we conclude that a separate earnings process has been culminated or the milestone is representative of the level of effort and progress toward completion of a long-term contract.

Research and development costs, both internal and externally contracted, are expensed as incurred. These costs include direct expenditures for goods and services, as well as indirect expenditures such as salaries, administrative expenses and various allocated costs.

In January 2003, the FASB issued FIN 46, “Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51”, which requires a new approach in determining if a reporting entity should consolidate certain legal entities, or VIE’s. A legal entity is considered a VIE if it does not have sufficient equity at risk to finance its own activities without relying on financial support from other parties. If the legal entity is a VIE, then the reporting entity that is the primary beneficiary must consolidate it. Even if a reporting entity is not obligated to consolidate a VIE, then disclosure must be made about the VIE if the reporting entity has a significant variable interest. FIN 46 is effective immediately for VIEs created after January 31, 2003 and in the first interim period ending after March 15, 2004 for VIEs created prior to February 1, 2003. The adoption of FIN 46 has not and the Company does not expect it in the future to have a material impact on its results of operations or financial position.

Comprehensive loss is comprised of net loss and other comprehensive loss. Other comprehensive loss includes certain changes in the stockholders’ equity of the Company that are excluded from net loss. Specifically, other comprehensive loss includes foreign currency translation adjustments.

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Comprehensive loss for the three months ended March 31, 2004 and 2003 was as follows:

The Company accounts for stock-based awards to employees under the intrinsic value method in accordance with Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees”, and has adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-Based Compensation”. Under APB 25, the Company generally recognizes no compensation expense with respect to such awards.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock Based Compensation-Transition and Disclosure and amendment of FASB Statement No. 123”. This statement amends SFAS No. 123 “Accounting for Stock Based Compensation”, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock based employee compensation. In addition, this statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock based employee compensation and the effects of the method used on reported results (see below). The provisions of SFAS 148 have been adopted herein.

Had compensation cost for the Company’s stock-based compensation plan been determined based on fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, the Company’s net loss and loss per share would have been increased to the pro forma amounts indicated below for the periods ended March 31, 2004 and 2003, respectively.

Future pro forma net income (loss) and earnings (loss) per share results might be materially different from actual amounts reported.

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Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are subject to risks and uncertainties, including those set forth under “Cautionary Statement” included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report, that could cause actual results to differ materially from historical results or anticipated results. The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included elsewhere in this report.

Overview

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Our strategy is to identify and acquire rights to products that we believe have potential for near-term regulatory approval or are already approved; apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and use our 100-member specialty sales and marketing team focused on high-prescribing U.S. gastroenterologists to sell our products. We rely on distribution relationships with third parties to sell our products outside the United States.

We generate revenue primarily by selling our products, prescription drugs, to pharmaceutical wholesalers. These direct customers of ours resell and distribute our products to and through pharmacies to patients who have had our products prescribed by doctors. Because demand for our products originates with doctors, our sales force calls on high-prescribing specialists, primarily gastroenterologists, and we monitor new and total prescriptions for our products as key performance indicators for our business.

Prescriptions result in our products being used by patients, requiring our direct customers to purchase more products to replenish their inventory. However, our revenue might fluctuate from quarter to quarter due to other factors, such as increased buying by wholesalers in anticipation of a price increase. Revenue could be less than anticipated in subsequent quarters as wholesalers’ increased inventory is used up. We believe such increased buying occurred in late 2003 and early 2004, and it could again.

In July 2000, the FDA approved Colazal for marketing in the United States for the treatment of mildly to moderately active ulcerative colitis. In December 2000, we established our own field sales force to market Colazal in the United States. Currently, this sales force has approximately 70 sales representatives in the field. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from Colazal, as well as for Azasan and rifaximin and other future products, if acquired and approved, will be more favorable to us than those from the indirect sale of product through marketing partners.

In November 2003, we acquired from aaiPharma LLC the exclusive right to sell three dosage strengths of Azasan (azathioprine tablets) in North America. In February 2004, we launched two dosage strengths of Azasan in the United States.

In December 2001, we submitted a New Drug Application, or NDA, to the FDA for rifaximin as a treatment for travelers’ diarrhea. In October 2002, we received an approvable letter from the FDA in response to our application, in which the FDA requested additional clinical data necessary to gain approval for rifaximin. In November 2003, we submitted to the FDA an amendment to our NDA to report the results of the additional clinical study and to respond to the other items outlined in the FDA’s 2002 approvable letter. The FDA considered our amendment to be a complete response and has assigned a goal date of May 26, 2004 to review and act upon the application. If FDA approval is obtained, we intend to market rifaximin to gastroenterologists and infectious disease physicians in the United States through our own direct sales force. We are exploring other potential indications, formulations, clinical trials and co-promotion arrangements to capitalize on the potential for rifaximin.

In July 2002, we in-licensed exclusive development and marketing rights in the United States to a granulated formulation of mesalamine from Dr. Falk Pharma. We intend to complete the development work required to secure regulatory approval for the product in the United States.

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We have made significant investments over the past few years to develop our commercialization infrastructure. As a result, we have sustained continuing operating losses and had an accumulated deficit of $93.2 million as of March 31, 2004. We currently expect to become profitable in the second half of 2004 excluding any effects of a potential rifaximin launch. We further believe that we will be profitable for the year ending December 31, 2004 if rifaximin is approved and launched in 2004 as expected.

Critical Accounting Policies

In our Annual Report on Form 10-K for the fiscal year ended December 31, 2003, we identified our most critical accounting policies and estimates upon which our financial status depends as those relating to revenue recognition, investments, inventory, intangible assets, allowance for uncollectable accounts, and allowance for rebates and coupons. We reviewed our policies and determined that those policies remained our most critical accounting policies for the three months ended March 31, 2004. We did not make any changes in those policies during the quarter.

Results of Operations

Three-Month Periods Ended March 31, 2004 and 2003

Product revenues for the three-month period ended March 31, 2004 were $19.9 million, compared to $11.5 million for the corresponding three-month period in 2003. Product revenues for the three-month period ended March 31, 2004 for Colazal were $19.4 million, compared to $11.5 million for the corresponding three-month period in 2003. In February 2004, we launched two dosage strengths of Azasan in the United States. Product revenues for Azasan were $0.5 million during the three-month period ended March 31, 2004.

Costs and expenses for the three-month period ended March 31, 2004 were $22.5, compared to $17.6 million for the corresponding three-month period in 2003. Higher operating expenses in absolute terms were primarily the result of rifaximin market research and market development activities and the marketing campaign for Colazal. However, as expected, as we increase revenue using the commercialization infrastructure built with significant investment over the past few years, costs and expenses in 2004 were less, as a percentage of revenue, than in 2003. We expect this trend to continue.

Cost of products sold for the three-month period ended March 31, 2004 was $4.7 million, compared with $2.8 million for the three-month period in 2003. Cost of products sold for the three-month period ended March 31, 2004 for Colazal were $4.6 million, compared to $2.8 million for the corresponding three-month period in 2003. Costs of products sold for the