ARROWHEAD RESEARCH CORP - 10-Q - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

(Edgar Glimpses Via Acquire Media NewsEdge) This Quarterly Report on Form 10-Q contains certain 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, and we intend that such forward-looking statements be subject to the safe harbors created thereby. For this purpose, any statements contained in this Quarterly Report on Form 10-Q except for historical information may be deemed to be forward-looking statements. Without limiting the generality of the foregoing, words such as "may," "will," "expect," "believe," "anticipate," "intend," "could," "estimate," or "continue" or the negative or other variations thereof or comparable terminology are intended to identify forward-looking statements. In addition, any statements that refer to projections of our future financial performance, trends in our businesses, or other characterizations of future events or circumstances are forward-looking statements.

The forward-looking statements included herein are based on current expectations of our management based on available information and involve a number of risks and uncertainties, all of which are difficult or impossible to predict accurately and many of which are beyond our control. As such, our actual results may differ significantly from those expressed in any forward-looking statements.

Readers should carefully review the factors identified in this report under the caption "Risk Factors" as well as the additional risks described in other documents we file from time to time with the Securities and Exchange Commission ("SEC"), including our most recent Annual Report on Form 10-K. In light of the significant risks and uncertainties inherent in the forward-looking information included herein, the inclusion of such information should not be regarded as a representation by us or any other person that such results will be achieved, and readers are cautioned not to place undue reliance on such forward-looking information. Except as may be required by law, we disclaim any intent to revise the forward-looking statements contained herein to reflect events or circumstances after the date hereof or to reflect the occurrence of unanticipated events.

Overview Arrowhead Research Corporation is a nanomedicine company developing innovative therapies at the interface of biology and nanoengineering to cure disease and improve human health. Arrowhead has one of the most advanced and broadest technology 19 -------------------------------------------------------------------------------- platforms for therapeutics based on RNA interference (RNAi), including access to several different RNAi delivery systems and small interfering RNA (siRNA) structures in commercial development for RNAi therapeutics. This broad technology platform enables optimization of siRNA therapeutic candidates for delivery based on siRNA chemistry, tissue type, disease state, target gene and siRNA type and chemistry on a target-by-target basis. Through its acquisition of Alvos Therapeutics, Arrowhead has access to a large platform of proprietary human-derived homing peptides and the method for their discovery. These targeting peptide sequences can be linked to our siRNA delivery vehicles as well as to traditional small molecule drugs to preferentially shuttle them into target cells. Arrowhead is leveraging its in-house R&D expertise and capabilities, as well as a broad intellectual property portfolio for RNAi therapeutics, and RNAi and peptide delivery vehicles and targeting methods to seek development partnerships with other pharmaceutical and biotech companies committed to bringing RNAi therapeutics to market, as well as continuing the preclinical and clinical development of its own clinical candidates. Arrowhead's non-RNAi development programs include a unique therapeutic candidate that shows promise in pre-clinical studies for the potential treatment of obesity and advanced bioactive materials for the regeneration of injured tissues.

Arrowhead's wholly-owned subsidiary, Arrowhead Madison Inc., operates a lab facility in Madison, Wisconsin, supporting the company's initiatives including the development of RNAi therapeutics. In addition to its wholly owned subsidiaries, Arrowhead Madison and Alvos Therapeutics, Arrowhead operates two majority owned subsidiaries, Calando, a leader in delivering small interfering RNAs for gene silencing, and Ablaris, an anti-obesity therapeutics company, and has minority investments in Nanotope, a regenerative medicine company and Leonardo, a multistage drug delivery company.

The Company's principal executive offices are located at 225 South Lake Avenue, Suite 1050, Pasadena, California 91101, and its telephone number is (626) 304-3400.

Liquidity and Capital Resources As a development stage company, Arrowhead has historically financed its operations through the sale of securities of Arrowhead and its subsidiaries.

Research and development activities have required significant capital investment since the Company's inception, and are expected to continue to require significant cash investment for the foreseeable future.

At December 31, 2012, the Company had cash on hand of approximately $2.9 million. Cash and cash equivalents decreased during the first three months of fiscal 2013 by $446,000 from $3.4 million at September 30, 2012.

During the three months ended December 31, 2012, cash used in operating activities was $3.8 million, which represents the on-going expenses for research and development activities, business development, and corporate overhead. Cash expenses were partially offset by cash received from revenues and other inflows of $0.3 million.

Cash provided by investing activities was $0.1 million, primarily related to proceeds from the disposition of fixed assets.

Cash provided by financing activities was $3.3 million, primarily related to cash received from the sale of Common Stock.

Recent Financing Activity: On January 25, 2013, the Company sold 1.7 million units at a price of $2.12 per unit in a public offering. Each unit consisted of one share of Common Stock and a warrant to purchase 0.5 share of Common Stock, exercisable at $2.14. Gross proceeds from the offering were $3.5 million; net proceeds were $3.3 million after deducting commissions and other offering expenses.

On December 6, 2012, the Company sold 1.8 million units at a price of $2.26 per unit in a public offering. Each unit consisted of one share of Common Stock and a warrant to purchase 0.5 share of Common Stock. The exercise price of these warrants is $2.12. Gross proceeds from the offering were $4.1 million, including a $500,000 promissory note due February 1, 2013. Net proceeds were approximately $3.6 million after deducting commissions and other offering expenses.

On August 10, 2012, the Company sold 2.3 million units at a price of $2.76 per unit in a registered offering to institutional and individual investors. Each unit consisted of one share of Common Stock and a warrant to purchase 0.75 share of Common Stock exercisable at $3.25 per share. Gross proceeds from the offering were approximately $6.2 million, with net proceeds of approximately $5.8 million after deducting commissions and other offering expenses.

On October 20, 2011, the Company and Lincoln Park Capital Fund, LLC, an Illinois limited liability company ("LPC") entered into a $15 million purchase agreement, together with a registration rights agreement, whereby LPC agreed to purchase up to $15 million of Common Stock, subject to certain limitations, from time to time during the three-year term of the agreement. Additionally, the Company filed a registration statement with the U.S. Securities & Exchange Commission covering the resale of the shares that may be issued to LPC under the agreement.

On January 30, 2012, the SEC declared the registration statement effective for the resale of such shares. The Company has the right, in its sole discretion, over a 36-month period to sell up to $15 million of Common Stock (subject to certain limitations) to LPC, depending on certain conditions as set forth in the agreement. As of December 31, 2012, the Company had drawn $1 million from the facility. The use of this facility requires a minimum share price of $2.00, as defined in the agreement.

20 -------------------------------------------------------------------------------- Although the Company has sources of liquidity, as described above, the Company anticipates that further equity financings, and/or asset sales and license agreements will be necessary to continue to fund operations in the future.

Critical Accounting Policies and Estimates Management makes certain judgments and uses certain estimates and assumptions when applying accounting principles generally accepted in the United States in the preparation of our Consolidated Financial Statements. We evaluate our estimates and judgments on an ongoing basis and base our estimates on historical experience and on assumptions that we believe to be reasonable under the circumstances. Our experience and assumptions form the basis for our judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may vary from what we anticipate and different assumptions or estimates about the future could change our reported results. We believe the following accounting policies are the most critical to us, in that they are important to the portrayal of our consolidated financial statements and require our most difficult, subjective or complex judgments in the preparation of our consolidated financial statements. For further information, see Note 1, Organization and Basis of Presentation, to our Consolidated Financial Statements which outlines our application of significant accounting policies and new accounting standards.

Stock Compensation Expense We recognize stock-based compensation expense based on the grant date fair value using the Black-Scholes options pricing model, which requires us to make assumptions regarding certain variables including the risk-free interest rate, expected stock price volatility, and the expected life of the award. The assumptions used in calculating stock-based compensation expense represent management's best estimates, but these estimates involve inherent uncertainties, and if factors change or the Company used different assumptions, its stock-based compensation expense could be materially different in the future.

Derivative Financial Instruments During the normal course of business, and associated with certain equity financings, the Company may issue warrants or become party to other agreements which require the use of derivative accounting treatment under GAAP. The company does not enter into derivative contracts for speculative purposes. We account for derivatives under the provisions of ASC Topic 815, which generally requires that derivative assets and liabilities be measured at fair value each reporting period with changes in fair value reflected as a current period income or loss, unless the derivatives qualify for hedge accounting treatment. The valuation of such derivatives are made using option pricing models which require various assumptions, some of which may be subjective, including but not limited to the Company's stock price, the expected life of the instrument, a risk-free interest rate, and expected stock price volatility. Subjective assumptions are estimated by management, but other reasonable assumptions could provide differing results.

Revenue Recognition Revenue from product sales are recorded when persuasive evidence of an arrangement exists, title has passed and delivery has occurred, a price is fixed and determinable, and collection is reasonably assured.

We may generate revenue from technology licenses, collaborative research and development arrangements, research grants and product sales. Revenue under technology licenses and collaborative agreements typically consists of nonrefundable and/or guaranteed technology license fees, collaborative research funding, and various milestone and future product royalty or profit-sharing payments.

Revenue associated with research and development funding payments under collaborative agreements is recognized ratably over the relevant periods specified in the agreement, generally the research and development period.

Revenue from up-front license fees, milestones and product royalties are recognized as earned based on the completion of the milestones and product sales, as defined in the respective agreements. Payments received in advance of recognition as revenue are recorded as deferred revenue.

Overview for the three months ended December 31, 2012 During the three months ended December 31, 2012, the Company continued its research and development efforts, in particular, its focus on advancing ARC-520, its next clinical candidate for treatment of hepatitis B virus (HBV). The Company has completed internal preclinical requirements and has initiated final IND-enabling steps, including GMP manufacturing and GLP toxicology.

Results of Operations The Company had consolidated loss attributable to Arrowhead of $4,592,284 for the three months ended December 31, 2012, compared to a consolidated loss attributable to Arrowhead of $2,485,505 for the three months ended December 31, 2011. Details of the results of operations are presented below.

Revenue 21 -------------------------------------------------------------------------------- The Company recorded revenue of $159,016 during the three months ended December 31, 2012, as compared to $23,958 during the quarter ended December 31, 2011. The revenue in 2012 was related to three license agreements related to technology acquired in conjunction with the acquisition of Roche Madison, Inc., totaling $44,000, as well as $115,000 in non-recurring services revenue. The revenue in 2011 was related to the two license agreements acquired in conjunction with the acquisition of Roche Madison, Inc. recognized for a partial period.

Operating Expenses The analysis below details the operating expenses and discusses the expenditures of the Company within the major expense categories. The following tables provide details of operating expenses for the three months ended December 31, 2012 and 2011.

Salaries-Three months ended December 31, 2012 compared to the three months ended December 31, 2011 The Company employs management, administrative, and scientific and technical staff at its corporate offices and its research facility. Salaries expense consists of salary and related benefits. Salary and benefits include two major categories: general and administrative compensation expense, and research and development compensation expense, depending on the primary activities of each employee. Arrowhead also manages certain general and administrative functions for Nanotope and Leonardo and charges fees for those services. The following table provides detail of salary and wage expenses for the three months ended December 31, 2012 as compared to the three months ended December 31, 2011.

(in thousands) Three months % of Three months % of Increase (Decrease) Ended Expense Ended Expense December 31, 2012 Category December 31, 2011 Category $ % G&A-compensation-related $ 717 44 % $ 593 45 % $ 124 21 % R&D-compensation-related 912 56 % 728 55 % 184 25 % Total $ 1,629 100 % $ 1,321 100 % $ 308 23 % During the three months ended December 31, 2012, G&A compensation expense increased from $593,000 to $717,000. The Company added two management positions in 2012, a Vice President of Program Management and a Director of Finance/Investor Relations. R&D compensation expense increased from $728,000 to $912,000 due to employees hired in connection with our acquisition of the Madison research facility. The acquisition closed on October 21, 2011, accordingly, the prior period did not include a full quarter of R&D operations.

General & Administrative Expenses-Three months ended December 31, 2012 compared to the three months ended December 31, 2011 The following table provides detail of G&A expenses for the three months ended December 31, 2012 as compared to the three months ended December 31, 2011.

(in thousands) Three months % of Three months % of Increase (Decrease) Ended Expense Ended Expense December 31, 2012 Category December 31, 2011 Category $ % Professional/outside services $ 366 40 % $ 802 63 % $ (436 ) -54 % Patent expense 250 27 % 221 17 % 29 13 % Facilities and related 42 5 % 26 2 % 16 62 % Travel 99 11 % 63 5 % 36 57 % Business insurance 49 5 % 50 4 % (1 ) -2 % Communication and Technology 36 4 % 46 4 % (10 ) -22 % Office expenses 41 4 % 32 3 % 9 28 % Other 35 4 % 27 2 % 8 30 % Total $ 918 100 % $ 1,267 100 % $ (349 ) -28 % Professional/outside services include legal, accounting, consulting and other outside services retained by the Company. All periods include normally recurring legal and audit expenses related to SEC compliance and other corporate matters.

Professional/outside services expense was $366,000 during the three months ended December 31, 2012, compared to $802,000 in the comparable prior period. The decrease primarily relates to certain fees and expenses associated with the acquisition of Roche Madison, Inc. incurred in the first quarter of fiscal 2011 which were not repeated in the current quarter.

22 -------------------------------------------------------------------------------- Patent expense was $250,000 during the three months ended December 31, 2012, compared to $221,000 in the comparable prior period. Patent expense increased due to the increasing foreign patent applications associated with the patent portfolio of Arrowhead Madison. Other patent expenses include attorney fees for services related to the Company's other intellectual property. The Company expects to continue to invest in patent protection as the Company extends and maintains protection for its current portfolios and files new patent applications as its product applications are improved. The cost will vary depending on the needs of the Company.

Facilities-related expense was $42,000 during the three months ended December 31, 2012, compared to $26,000 in the comparable prior period.

Facilities expense increased due to the increase of lease costs as the Company moved from a temporary lower cost location to a new corporate office in August of 2012.

Travel expense was $99,000 during the three months ended December 31, 2012, compared to $63,000 in the comparable prior period. Travel expense increased due to travel related to fund raising efforts, investor relations meetings and business development by Company personnel. Travel expense includes expenses related to travel by Company personnel for operational business meetings at other company locations for other business initiatives and collaborations with other companies, and for marketing, investor relations, fund raising and public relations purposes. Travel expenses can fluctuate from quarter to quarter and from year to year depending on current projects and activities.

Business insurance expense was $49,000 during the three months ended December 31, 2012, compared to $50,000 in the comparable prior period, essentially unchanged.

Communication and technology expense was $36,000 during the three months ended December 31, 2012 compared to $46,000 in the comparable prior period. The decrease was related to software maintenance costs at our Madison facility, primarily end-user software and software maintenance on laboratory computer software.

Office expense was $41,000 during the three months ended December 31, 2012 compared to $32,000 in the comparable prior period. The increase was related to higher costs associated with the new corporate headquarters, as well as increased costs at the Madison facility.

Research and Development Expenses - Three months ended December 31, 2012 compared to the three months ended December 31, 2011 R&D expenses are related to the Company's on-going research and development efforts, primarily related to its laboratory research facility in Madison, Wisconsin, and also include outsourced R&D services. The following table provides detail of research and development expenses for the three months ended December 31, 2012, as compared to the three months ended December 31, 2011.

(in thousands) Three months % of Three months % of Increase (Decrease) Ended Expense Ended Expense December 31, 2012 Category December 31, 2011 Category $ % Outside labs & contract services $ 284 18 % $ 245 32 % $ 39 16 % In vivo studies 362 23 % 13 2 % 349 NM Drug Manufacturing 217 14 % 80 10 % 137 171 % Consulting 177 11 % 154 20 % 23 15 % License, royalty & milestones 28 1 % 15 2 % 13 87 % Laboratory supplies & services 235 15 % 83 11 % 152 183 % Facilities and related 191 12 % 132 17 % 59 45 % Sponsored research 72 5 % 45 6 % 27 60 % Other research expenses 11 1 % 2 0 % 9 450 % Total $ 1,577 100 % $ 769 100 % $ 808 105 % NM = Not Meaningful Outside labs and contract services expense was $284,000 during the three months ended December 31, 2012, compared to $245,000 in the comparable prior period.

The increase was primarily related to study and analytic development costs for HBV candidate.

In vivo studies expense was $362,000 during the three months ended December 31, 2012, compared to $13,000 in the comparable prior year period. The current period expense relates to preclinical GLP toxicology program costs related to our HBV program.

Drug manufacturing expense was $217,000 during the three months ended December 31, 2012, compared to $80,000 in the comparable prior year period. Drug manufacturing costs during the current quarter related to manufacturing costs for clinical supplies 23 -------------------------------------------------------------------------------- for the HBV program. These costs are expected to accelerate over the next two quarters as the Company completes its manufacturing campaign related to supplies for the HBV clinical trial expected to begin by the end of 2013.

Consulting expense was $177,000 during the three months ended December 31, 2012, compared to $154,000 in the comparable prior period. The majority of consulting expense during the current quarter relates to clinical and regulatory consulting related to the Company's HBV program. The costs in the prior period related to clinical consulting for our Cancer candidate, CALAA01. The Company expects consulting costs related to the HBV program to continue.

Licensing fees, royalty and milestones expense was $28,000 during the three months ended December 31, 2012, compared to $15,000 in the comparable prior period. Licensing fees, royalty and milestones expenses during the three months ended December 31, 2012 were primarily related to fees owed from existing contracts assumed as a result of our acquisition of our Madison facility, other expenses were related to fees owed to the University of Texas MD Anderson Cancer Center (UT-MDACC) related to the Company's acquisition of Alvos Therapeutics in April 2012. During the three months ended December 31, 2011, a quarterly license fee of $15,000 was paid by Ablaris to UT-MDACC under a license agreement signed in December 2010. In fiscal 2012, Ablaris paid a milestone payment of $300,000, which payment was applied to the quarterly license payment due in the current quarter. The milestone payment will continue to be applied to quarterly license payments until such milestone payment has been fully applied.

Laboratory supplies and services expense was $235,000 during the three months ended December 31, 2012, compared to $83,000 in the comparable prior period.

Laboratory supplies are used at our Madison research facility which was acquired on October 21, 2011. During the three months ended December 31, 2011, the Madison research facility was acquired and did not include a full three months of activity, and the facility was utilizing laboratory supplies on-hand at the time of the acquisition.

Facilities expense was $191,000 during the three months ended December 31, 2012, compared to $132,000 in the comparable prior period. Costs for rent, utilities and repairs and maintenance increased as the current quarter reflects a full three months of costs, while the prior period was a partial quarter as the acquisition of the Madison facility occurred on October 21, 2011.

Sponsored research expense was $72,000 during the three months ended December 31, 2012, compared to $45,000 in the comparable prior period. Sponsored research expense in both periods relates solely to work at the University of Cincinnati related to our obesity program. Such research expense is dependent upon studies undertaken, and vary based on needs of the program.

Stock-based compensation expense-Three months ended December 31, 2012 compared to the three months ended December 31, 2011 Stock-based compensation expense, a noncash expense, was $396,000 during the three months ended December 31, 2012, compared to $252,000 during the comparable prior period. Stock-based compensation expense is based upon the valuation of stock options granted to employees, directors, and certain consultants. Many variables affect the amount expensed, including the Company's stock price on the date of the grant, as well as other assumptions. Based on the completion of vesting of a number of stock options during the second half of fiscal 2012, compensation expense related to those awards ended. This was mostly offset by additional options granted to new and existing employees in fiscal 2012.

Depreciation and amortization expense-Three months ended December 31, 2012 compared to the three months ended December 31, 2011 Depreciation and amortization expense, a noncash expense, was $450,000 during the three months ended December 31, 2012, compared to $454,000 during the comparable prior period. The majority of depreciation and amortization expense relates to depreciation on lab equipment and leasehold improvement in Madison.

The decrease in depreciation expense relates to lab equipment in Madison that became fully depreciated during fiscal 2012.

Other income (expense)-Three months ended December 31, 2012 compared to the three months ended December 31, 2011 Other income was $29,000 during the three months ended December 31, 2012, compared to other income of $1,352,000 in the comparable prior period. The primary component of other income in the three months ended December 31, 2012 was the equity in loss of our unconsolidated affiliates, Nanotope and Leonardo in the amount of $64,000, representing on-going charges related to corporate services provided from Arrowhead, mostly offset by a noncash gain from the change in the value of derivative assets and liabilities. The primary component of other income during the three months ended December 31, 2011, was a noncash gain recorded upon the acquisition of Roche Madison, Inc. This gain was somewhat offset by a noncash loss from the equity investment in Nanotope of $107,000, the change in the value of derivatives, and realized and unrealized gains of marketable securities.

Off-Balance Sheet Arrangements We do not have and have not had any off-balance sheet arrangements or relationships.

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