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HYPERION THERAPEUTICS INC - 10-Q - Management's Discussion and Analysis of Financial Condition and Results of Operations(Edgar Glimpses Via Acquire Media NewsEdge) You should read the following management's discussion and analysis of our financial condition and results of operations in conjunction with our unaudited condensed consolidated financial statements and notes thereto included in Part I, Item 1 of this Quarterly Report on Form 10-Q and with our audited consolidated financial statements and related notes thereto for the year ended December 31, 2013, included in our Annual Report on Form 10-K, filed with the U.S. Securities and Exchange Commission ("SEC"). 23-------------------------------------------------------------------------------- Table of Contents Overview We are a commercial biopharmaceutical company focused on the development and commercialization of novel therapeutics to treat disorders in the area of orphan diseases. Our products, RAVICTI® (glycerol phenylbutyrate) Oral liquid, BUPHENYL® and AMMONAPS® (sodium phenylbutyrate) Tablets and Powder, are designed to lower ammonia in the blood. Ammonia is produced in the intestine after a person eats protein and is normally detoxified in the liver by conversion to urea. Elevated levels of ammonia are potentially toxic and can lead to severe medical complications which may include death. We have developed RAVICTI, which we launched during the first quarter of 2013, to treat most urea cycle disorders ("UCD") including 7 of the 8 most prevalent UCD subtypes, and are developing glycerol phenylbutyrate ("GPB"), the active pharmaceutical ingredient in RAVICTI, to treat hepatic encephalopathy ("HE"). HE may develop in some patients with liver scarring, known as cirrhosis, or acute liver failure and is a chronic complication of cirrhosis which fluctuates in severity and may lead to serious neurological damage. UCD and HE are diseases in which blood ammonia is elevated. UCD are inherited rare genetic diseases caused by a deficiency of one or more enzymes or transporters that constitute the urea cycle, which in a healthy individual removes ammonia through its conversion to urea. We estimate there are approximately 2,100 cases of UCD in the United States of which approximately 1,100 have been diagnosed. However, we estimate that only about 600 patients are currently treated with an FDA approved medication. In addition, we are developing DiaPep277 ®, a first-in-class immune intervention therapy for the potential treatment of Type 1 diabetes in patients with residual beta cell function. Type 1 (or insulin dependent) diabetes is an auto immune disease that results in the destruction of beta cells, the insulin secreting cells in the pancreas, resulting in loss of glycemic (glucose or blood sugar) control. On February 1, 2013, the U.S. Food and Drug Administration ("FDA") granted approval of RAVICTI for chronic management of 7 of the 8 subtypes of UCD in adult and pediatric patients greater than two years of age who cannot be managed by dietary protein restriction and/or amino acid supplementation alone. Limitations of use include treatment of patients with acute hyperammonemia ("HA") crises for whom urgent intervention is typically necessary, patients with N-acetylglutamate synthetase ("NAGS") deficiency for whom the safety and efficacy of RAVICTI has not been established, and UCD patients under two months of age for whom RAVICTI is contraindicated due to uncertainty as to whether newborns, who may have immature pancreatic function, can effectively digest RAVICTI. In May 2013, we acquired BUPHENYL, an FDA-approved therapy for treatment of 3 of the most prevalent UCD subtypes, from Ucyclyd Pharma Inc. ("Ucyclyd"), a subsidiary of Valeant Pharmaceuticals International, Inc. ("Valeant"). In Europe and the Middle East, BUPHENYL is sold under the brand name AMMONAPS®. The active pharmaceutical ingredient in BUPHENYL and AMMONAPS is sodium phenylbutyrate ("NaPBA"). References to BUPHENYL in this Form 10-Q include AMMONAPS when referring to the product in the Middle East and Europe. Subsequent to the acquisition, we began selling BUPHENYL within the United States to patients who have not transitioned to RAVICTI. In addition, we sell BUPHENYL through our distributors outside the United States. In 2011, an Abbreviated New Drug Application ("ANDA") for a generic tablet form of NaPBA was approved in the U.S., and in 2013, an ANDA for generic powder was approved. Both of these generic forms are owned by companies other than Hyperion. References to NaPBA in this Form 10-Q include the generically available tablet and powdered forms of the drug, as well as our branded products in both powdered and tablet forms. An average gross selling price per patient per year of RAVICTI therapy is currently approximately $350,000. The price of BUPHENYL per gram is approximately one quarter that of RAVICTI. Prices for both therapies vary among patients because doses are individualized based on a patient's weight and disease severity. We have launched a dedicated call center, which serves as an integrated resource for RAVICTI prescription intake and distribution, reimbursement adjudication, patient financial support, and ongoing compliance support for patients. In addition, the call center provides financial support assistance to BUPHENYL patients. Together with distribution via two specialty pharmacies, we believe these services provide important support to UCD patients and their physicians, and help them achieve more favorable outcomes in managing their disease. As part of our ongoing commitment to the patient community, we provide our UCD products at no cost to patients as we help them establish insurance coverage for our UCD products and donate to an independent foundation with an established track record of enabling patients to access medications affordably. RAVICTI was granted orphan drug exclusivity in the United States for the maintenance treatment of patients with UCD shortly after its FDA approval in 2013. This exclusivity extends through February 1, 2020. RAVICTI has also received orphan drug designation in the European Union ("EU"), although the right to marketing exclusivity cannot be determined until it is authorized to market in the EU. In March 2013, U.S. Patent No. 8,404,215 entitled "Methods of Therapeutic Monitoring of Nitrogen Scavenging Drugs" issued from U.S. Patent Appl. No. 13/417,137 with claims directed to methods of optimizing the dosage of nitrogen scavenging drugs based on target fasting ammonia levels. This patent will expire in March 2032, and is currently listed in the FDA publication "Approved Drug Products with Therapeutic Equivalence Evaluations," known as the Orange Book. In February 2014, U.S. Patent 8,642,012 entitled "Methods of Treatment Using Ammonia Scavenging Drugs" issued from U.S. Patent Appl. No. 12/350,111 with claims directed to methods of treating patients with UCD using phenylacetic acid ("PAA") prodrugs based on in part on target urinary phenylacetylglutamine ("PAGN") levels. This patent will expire in September 2030 with Patent Term Extension ("PTE")and is currently listed in the Orange Book. Both of these patents are currently the subject of litigation with Par Pharmaceutical, Inc. ("Par"). We believe GPB has potential in other indications; and therefore in 2012 we completed a Phase II trial assessing the safety and efficacy of GPB in the treatment of episodic overt HE. Episodic overt HE can be diagnosed clinically through a set of signs and 24 -------------------------------------------------------------------------------- Table of Contents symptoms. The Phase II trial met its primary endpoint, which was to demonstrate that the proportion of patients experiencing an HE event was significantly lower on GPB versus placebo, both administered in addition to standard of care, which included lactulose and/or rifaximin. The FDA has granted orphan drug designation to GPB for this indication, but whether a compound receives exclusivity for an indication is not determined by the FDA until the drug has been approved for marketing. HE is a serious but potentially reversible neurological disorder that can occur in patients with cirrhosis or acute liver failure. It comprises a spectrum of neuropsychiatric abnormalities and motor disturbances that are associated with varying degrees of disability, ranging from subtle to lethal. HE is believed to occur when the brain is exposed to ammonia that is normally removed from the blood by a healthy liver. We believe that ammonia plays a central role in this disease, and the most commonly utilized therapies for the treatment of HE are believed to act by reducing ammonia. Published epidemiological data suggest that there are approximately 140,000 patients in the United States who have episodic HE. We believe GPB, if approved for HE, would treat HE through a systemic reduction of ammonia. In June 2014, we completed the acquisition of Andromeda. Andromeda was incorporated in Israel in 2007 and is primarily focused on the development of DiaPep277, a first-in-class immune intervention therapy for Type 1 diabetes in patients with residual beta cell function, an orphan indication with approximately 35,000 adults diagnosed annually across the U.S. and Europe. DiaPep277 is currently being evaluated in a Phase 3 clinical study in adult patients (ages 20-45) with Type 1 diabetes diagnosed within the last six months. The Phase 3 study is fully enrolled and results are anticipated in the first quarter of 2015. If the data from the study is positive, we plan to file a New Drug Application ("NDA") and a Marketing Authorization Application ("MAA") in the second half of next year, with the US and EU, respectively. Andromeda is also conducting an open label extension study to gather an additional two years of safety data, to further support the safety of the drug. This study is expected to complete in 2017, and is not required for filing or approval. Financial Overview Revenues Our product revenues consist of the following: • Revenues from the sale of RAVICTI which was approved by the FDA on February 1, 2013 and was commercially launched in the U.S. during the period ended March 31, 2013; and • Revenues from the sale of BUPHENYL which we acquired from Ucyclyd on May 31, 2013, pursuant to the restated collaboration agreement. We currently distribute BUPHENYL in the U.S. and certain countries outside the U.S. See "Results of Operations" below for more detailed discussion on revenues. Cost of sales Our cost of sales includes third-party manufacturing costs, royalty fees payable under our restated collaboration agreement with Ucyclyd, and other indirect costs including compensation cost of personnel, shipping and supplies. The manufacturing costs we incurred prior to FDA approval of RAVICTI have been recorded as research and development expenses in our condensed consolidated statements of operations. For RAVICTI, we expect that cost of sales as a percentage of sales will increase in future periods as product manufactured prior to FDA approval is utilized, as these previously manufactured products have been fully expensed as research and development expenses in prior periods. As a result of the business combination related to the purchase of BUPHENYL, cost of sales is higher due to the recording of the step-up value on BUPHENYL inventories acquired from Ucyclyd which were expensed to cost of sales as that inventory was sold and is not indicative of cost of sales in future periods. Since the inventories we purchased were part of the business combination, the inventories were recorded at fair value on the acquisition date. Research and Development Expenses We recognize research and development expenses as they are incurred. Our research and development expenses consist primarily of: • salaries and related expenses for personnel, including expenses related to stock options or other stock-based compensation granted to personnel in development functions; • fees paid to clinical consultants, clinical trial sites and vendors, including clinical research organizations ("CROs"), in conjunction with implementing and monitoring our clinical trials and acquiring and evaluating clinical trial data, including all related fees, such as for investigator grants, patient screening fees, laboratory work and statistical compilation and analysis; 25 -------------------------------------------------------------------------------- Table of Contents • other consulting fees paid to third parties; • expenses related to production of clinical supplies, including fees paid to contract manufacturers; • expenses related to license fees and milestone payments under in-licensing agreements; • expenses related to compliance with drug development regulatory requirements in the United States, the European Union and other foreign jurisdictions; and • depreciation and other allocated expenses. We expense both internal and external research and development expenses as they are incurred. We have developed RAVICTI in UCD and GPB for HE in parallel, and we typically use our employees, consultants and infrastructure resources across our two programs. Thus, some of our research and development expenses are not attributable to an individual program, but rather are allocated across our programs and these costs are included in unallocated costs as detailed below. Allocated expenses include salaries, stock-based compensation and related benefit expenses for our employees, consulting fees and fees paid to clinical suppliers. The following table shows our research and development expenses for the three and six months ended June 30, 2014 and 2013 (in thousands): Three Months Ended Six Months Ended June 30, June 30, 2014 2013 2014 2013 (unaudited) (unaudited) UCD Program $ 2,379 $ 1,618 $ 4,731 $ 2,545 HE Program 892 235 1,552 549 DiaPep277 Program 574 - 574 - Unallocated 201 709 407 1,307 Total $ 4,046 $ 2,562 $ 7,264 $ 4,401 We expect our research and development expenses to increase when we initiate our Phase III trial of GPB for the treatment of patients with episodic HE. Additionally, we expect these costs to increase due to the acquisition of Andromeda and its ongoing Phase 3 trial of DiaPep277. Due to the inherently unpredictable nature of product development, we are currently unable to exactly predict the expenses we will incur or the duration of the trial. Based on our current discussions with FDA, our estimate of the cost of our Phase III trial of GPB in HE will be between $50.0 million to $55.0 million from initiation of the trial until submission of data to FDA. Our research and development expenditures are subject to numerous uncertainties in timing and cost to completion. Development timelines, the probability of success and development expenses can differ materially from expectations. Clinical trials in orphan diseases, such as UCD, HE and Type 1 diabetes in patients with residual beta cell function may be difficult to enroll given the small number of patients with these diseases. Completion of clinical trials may take several years or more, but the length of time generally varies according to the type, complexity, novelty and intended use of a product candidate. The cost of clinical trials may vary significantly over the life of a project as a result of differences arising during clinical development, including, among others: • the number of trials required for approval; • the number of sites included in the trials; • the length of time required to enroll suitable patients; • the number of patients that participate in the trials; • the drop-out or discontinuation rates of patients; • the duration of patient follow-up; • the number and complexity of analyses and tests performed during the trial; • the phase of development of the product candidate; and • the efficacy and safety profile of the product candidate. Our expenses related to clinical trials are based on estimates of patient enrollment and related expenses at clinical investigator sites as well as estimates for the services received and efforts expended pursuant to contracts with multiple research institutions and contract research organizations that conduct and manage clinical trials on our behalf. We generally accrue expenses related to clinical trials based on contracted amounts applied to the level of patient enrollment and activity according to the protocol. If timelines or contracts are modified based upon changes in the clinical trial protocol or scope of work to be performed, we modify our estimates of accrued expenses accordingly on a prospective basis. 26-------------------------------------------------------------------------------- Table of Contents Selling, General and Administrative Expenses Selling general and administrative expenses consist primarily of salaries, benefits and stock-based compensation for employees in administration, finance and business development, legal, investor relations, marketing, commercial and sales functions, including fees to third party vendors providing customer support services. Other significant expenses include consulting fees, allocated facilities expenses and professional fees for accounting and legal services, including legal services associated with obtaining and maintaining patents. We expect that our selling, general and administrative expenses will increase with the acquisition of Andromeda and continued commercialization of RAVICTI and marketing of BUPHENYL. We expect these increases will likely include increased expenses for insurance, expenses related to the hiring of additional personnel and payments to outside consultants, lawyers and accountants. On February 6, 2014, the Board of Directors of the Company approved performance RSU grants to sales individuals. These RSU's will become fully vested if both the performance and service conditions are met. If the performance and service conditions are met, the total expense recorded in the current year for these RSU's would be approximately $0.2 million. On March 17, 2014, we received notification of a Paragraph IV certification from the generic drug manufacturer Par Pharmaceutical, Inc. ("Par") that it had filed an Abbreviated New Drug Application with the FDA seeking approval for a generic version of RAVICTI Oral Liquid. The Paragraph IV certification alleges that certain our patents are invalid and/or will not be infringed by Par's manufacture, use or sale of the product for which the ANDA was submitted. We filed suit against Par on April 23, 2014 to protect our patents and to obtain a stay of the FDA's approval of Par's ANDA. On July 22, 2014, Par filed a motion to dismiss for lack of personal jurisdiction, or in the alternative, a motion to transfer the case to the Southern District of New York. As a result of this pending litigation and the expansion of our business, we expect our legal expenses to increase in the future. Amortization of intangible asset In 2014, the amortization of intangible asset pertains to the amortization expense of BUPHENYL product rights acquired on May 31, 2013. For additional information, see Note 9 to our unaudited condensed consolidated financial statements appearing elsewhere in this report. Change in acquisition-related contingencies In connection with the acquisition of Andromeda, we may be required to pay future consideration that is contingent upon the achievement of specified development, regulatory approval or sales-based milestone events. We estimated the fair value of the acquisition-related contingent consideration and contingent liabilities on the acquisition date and at the end of the reporting period thereafter. Any change in the fair value of contingent consideration on the reporting date and the acquisition date is recorded in this line item on the condensed consolidated statements of operations. Contingent liabilities are evaluated in accordance with ASC 450 at each reporting period with charges recorded in this line item on the condensed consolidated statements of operations. For additional information, see Note 6 to our unaudited condensed consolidated financial statements appearing elsewhere in this report. Interest Income Interest income consists of interest earned on our investments and cash and cash equivalents. Interest Expense Interest expense consists primarily of non-cash and cash interest costs related to our borrowings. Gain from settlement of retention option The amount of gain is comprised of (i) fair value of BUPHENYL of $20.4 million and (ii) net cash received from Ucyclyd of $10.9 million off-set by (iii) the $0.3 million carrying value of the option to purchase the rights to BUPHENYL and AMMONUL. Accordingly, we recorded the resulting net settlement of $31.1 million as gain from our settlement of the retention option on our condensed consolidated statements of operations. For additional information, see Note 3 to our unaudited condensed consolidated financial statements appearing elsewhere in this report. Other Income (Expense), net Other income (expense), net for the six months ended June 30, 2014 was $0.2 million expense and primarily includes amortization of discount on available-for-sale investments partially offset by the gain on foreign currency transactions. During the six months ended June 30, 2013 other income (expense), net consisted of a $0.5 million payment from Ucyclyd in accordance with the restated collaboration agreement. 27-------------------------------------------------------------------------------- Table of Contents Income Taxes We have been granted orphan drug designation by the FDA for our products currently under development. The orphan drug designation allowed us to claim increased federal tax credits for its research and development activities. We have $18.0 million of federal credit carryforwards of which $17.4 million relates to Orphan Drug Credit claims for 2009 through 2013. We have claimed tax credits for our research and development activities in Israel and have $3.0 million of credit carryforwards. We intend to continue maintaining a full valuation allowance on our deferred tax assets until there is sufficient evidence to support the reversal of all or some portion of these allowances. However, considering our current assessment of income from potential future sales, there is a reasonable possibility that, within the next year, sufficient positive evidence may become available to reach a conclusion that a significant portion of the valuation allowance will no longer be needed. As such, we may release a significant portion of our valuation allowance against our deferred tax assets within the next 12 months. This release would result in the recognition of certain deferred tax assets and a decrease to income tax expense for the period such release is recorded. For the three and six months ended June 30, 2014, we recorded an income tax benefit of $2.1 million and $2.0 million, respectively. Income before income taxes for the three and six months ended June 30, 2014 was $15.4 million and $16.7 million, respectively. The effective income tax benefit rate was 13.8% and 12.2% for the three and six months ended June 30, 2014, respectively. The difference between the effective rate and the U.S. statutory rate is primarily due to the valuation allowance on the U.S. deferred taxes and lower foreign tax rates. There was no income tax expense or benefit for the three and six months ended June 30, 2013. Our expected taxable income in 2014 will largely be offset by federal and state net operating losses and credits. Critical Accounting Policies and Estimates Our consolidated financial statements are prepared in accordance with United States generally accepted accounting principles. Application of these principles requires management to make estimates, assumptions, and judgments that affect the amounts reported in the financial statements and accompanying notes. These estimates, assumptions, and judgments are based on information available as of the date of the financial statements; accordingly, as this information changes, the financial statements could reflect different estimates, assumptions, and judgments. Actual results could differ from those estimates. Critical accounting estimates are necessary in the application of certain accounting policies and procedures, and are particularly susceptible to significant change. Critical accounting policies are defined as those that are reflective of significant judgments and uncertainties, and could potentially result in materially different results under different assumptions and conditions. For additional information on our critical accounting policies, please refer to the information contained in Note 2 of the accompanying unaudited condensed consolidated financial statements and the Critical Accounting Policies and Estimates section of our Management's Discussion and Analysis of Financial Condition and Results of Operations included in Annual Report on Form 10-K for the year ended December 31, 2013. Business Combinations We allocate the purchase price of an acquired business to the tangible and intangible assets acquired and liabilities assumed based upon their estimated fair values on the acquisition date. Any excess of the purchase price over the fair value of the net assets acquired is recorded as goodwill. The purchase price allocation process requires us to make significant estimates and assumptions, especially at the acquisition date with respect to intangible assets. Direct transaction costs associated with the business combination are expensed as incurred. Valuation of Acquisition-Related Contingencies Resulting from the Andromeda Business Combination In conjunction with the acquisition of Andromeda, we have recorded acquisition-related contingencies upon the achievement of specified development, regulatory approval or sales-based milestone events. The acquisition-related contingencies are measured at their respective fair values as of the acquisition date. The models used in valuing these acquisition-related contingencies require the use of significant estimates and assumptions including but not limited to: • estimates of revenues and operating profits related to the product candidate; • the probability of success for unapproved product candidate considering their stage of development; • the time and resources needed to complete the development and approval of product candidate; • the life of the potential commercialized products and associated risks, including the inherent difficulties and uncertainties in developing a product candidate such as obtaining FDA and other regulatory approvals; and • risks related to the viability of and potential alternative treatments in any future target markets. We revalue contingent consideration obligations each quarter following the acquisition and record increases or decreases in their fair value in our condensed consolidated statements of operations. 28-------------------------------------------------------------------------------- Table of Contents Increases or decreases in the fair value of our contingent consideration liabilities are recorded in our statements of operations and can result from updates to assumptions such as the expected timing or probability of achieving the specified milestones, changes in projected revenues or changes in discount rates. Significant judgment is employed in determining these assumptions as of the acquisition date and for each subsequent period. Updates to assumptions could have a significant impact on our results of operations in any given period. Actual results may differ from estimates. Valuation of Acquisition-Related Contingent Liability Acquisition-related contingent liability, which consists primarily of potential milestone payments and royalty obligations, and potential payments to certain employees of Andromeda is recorded in the condensed consolidated balance sheets at its acquisition date estimated fair value. We reassess the probability and estimates associated with the contingent liability at each reporting period. For liability payable to third parties, any increase in the liability is recorded in the condensed consolidated statements of operations. For liabilities payable to employees, we account for the liability in accordance with ASC 450 Contingencies. Accounts Receivable Our trade accounts receivable are recorded net of product sales allowances for prompt-payment discounts, chargebacks and doubtful accounts. We estimate chargebacks and prompt-payment discounts based on contractual terms, historical trends and our expectations regarding the utilization rates for these programs. Inventories Our inventories are stated at the lower of cost or market value with cost determined under the first-in-first-out (FIFO) cost method. Our inventories consist of raw materials, work in process and finished goods. Subsequent to the FDA approval of RAVICTI on February 1, 2013, we began capitalizing inventories as the related costs were expected to be recoverable through the commercialization of the product. Prior to the FDA approval of RAVICTI, we recorded the costs incurred as research and development expenses in the condensed consolidated statements of operations. If information becomes available that suggest that our inventories may not be realizable, we may be required to expense a portion or all of the previously capitalized inventories. The costs of our inventories consists mainly of third party manufacturing costs, associated compensation related costs of personnel indirectly involved in the manufacturing process and other overhead costs attributable to the manufacture of inventories. Products that have been approved by the FDA or other regulatory authorities, such as RAVICTI are also used in clinical programs, to assess the safety and efficacy of the products for usage in diseases that have not been approved by the FDA or other regulatory authorities. The form of RAVICTI utilized for both commercial and clinical programs is identical and, as a result, the inventory has an "alternative future use". Raw materials and purchased drug product associated with clinical development programs are included in inventory and charged to research and development expense when the product enters the research and development process and no longer can be used for commercial purposes and, therefore, does not have an "alternative future use". On May 31, 2013, we acquired BUPHENYL including inventory from Ucyclyd. We recorded these inventories at fair value in the amount of $3.9 million on the acquisition date. As of June 30, 2014, we sold the entire inventory acquired from the acquisition of BUPHENYL. We evaluate for potential excess inventory by analyzing current and future product demand relative to the remaining product shelf life. We develop demand forecasts by considering factors such as, but not limited to, overall market potential, market share, market acceptance and patient usage. During the quarter ended June 30, 2014, we recorded a provision for inventory obsolescence of $0.1 million which was recorded into cost of sales in our condensed consolidated statements of operations. Goodwill and Intangible Assets We record intangible assets at acquisition cost less accumulated amortization and impairment. Intangible asset with finite lives are amortized over their estimated useful life using the economic use method, which reflects the pattern that the economic benefits of the intangible asset are consumed as revenue is generated. The pattern of consumption of the economic benefits is estimated using the future projected cash flows of the intangible asset. The goodwill and indefinite lived intangible asset we acquired in a business combination is tested for impairment annually or more frequently if events or changes in circumstances indicate that the asset might be impaired. Impairment of Long-lived Assets We review our property and equipment and long-lived assets for impairment whenever events or changes in circumstances indicate that the carrying amount of an asset class may not be recoverable. Recoverability is measured by comparing the carrying amount to the future net undiscounted cash flows that the assets are expected to generate. If such assets are considered impaired, the impairment to be recognized is measured by the amount by which the carrying amount of the assets exceeds the fair value determined using projected discounted future net cash flows arising from the assets. 29-------------------------------------------------------------------------------- Table of Contents Fair Value of Financial Instruments We measure our financial assets and liabilities at fair value based on the exchange price that would be received for an asset or paid for to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants. The carrying amounts of our financial instruments, including cash equivalents, short-term investments, accounts payable, and accrued liabilities, approximate fair value due to their short maturities. The carrying amounts of long-term investments and the acquisition-related contingent consideration represent their estimated fair values. Income Taxes We are subject to income taxes in the U.S. and we use estimates in determining our provision for income taxes. We use the liability method of accounting for income taxes, whereby deferred income tax assets or liability account balances are calculated at the balance sheet date using current tax laws and rates in effect for the year in which the differences are expected to affect taxable income. Recognition of deferred income tax assets is appropriate when based on the weight of positive and negative evidence realization of such assets is more likely than not. We recognize a valuation allowance against our net deferred income tax assets if it is more likely than not that some portion of the deferred income tax assets will not be fully realizable. This assessment requires judgment as to the likelihood and amounts of future taxable income by tax jurisdiction. We apply the provisions of FASB's guidance on accounting for uncertainty in income taxes. We assess all material positions taken in any income tax return, including all significant uncertain positions, in all tax years that are still subject to assessment or challenge by relevant taxing authorities. Assessing an uncertain tax position begins with the initial determination of the position's sustainability and the tax benefit to be recognized is measured at the largest amount of benefit that is greater than 50 percent likely of being realized upon ultimate settlement. As of each balance sheet date, unresolved uncertain tax positions must be reassessed, and we will determine whether (i) the factors underlying the sustainability assertion have changed and (ii) the amount of the recognized tax benefit is still appropriate. The recognition and measurement of tax benefits requires significant judgment. Judgments concerning the recognition and measurement of a tax benefit might change as new information becomes available. Revenue Recognition We recognize revenue in accordance with the Financial Accounting Standards Board ("FASB") Accounting Standards Codification ("ASC") 605, Revenue Recognition, when the following criteria have been met: persuasive evidence of an arrangement exists; delivery has occurred and risk of loss has passed; and the seller's price to the buyer is fixed or determinable and collectability is reasonably assured. We determine that persuasive evidence of an arrangement exists based on written contracts that define the terms of our arrangements. In addition, we determine that services have been delivered in accordance with the arrangement. We assesses whether the fee is fixed or determinable based on the payment terms associated with the transaction and whether the sales price is subject to refund or adjustment. We assess collectability based primarily on the customer's payment history and on the creditworthiness of the customer. Product Revenue During the three and six months ended June 30, 2014, our product revenues represent sales of RAVICTI and BUPHENYL in the U. S. and outside the U.S. We recognized revenue once all four revenue recognition criteria described above are met. In 2013, we began distributing RAVICTI to two specialty pharmacies through a specialty distributor. The specialty pharmacies then in turn dispense RAVICTI to patients in fulfillment of prescriptions. As RAVICTI was our first commercial product, we could not reasonably assess potential product sales allowances at the time of sale to the specialty distributor. As a result, the price of RAVICTI was not deemed fixed or determinable. We deferred the recognition of revenues on product shipments of RAVICTI to the specialty distributor until the product was shipped to patients by the specialty pharmacies at which time our related product sales allowances could be reasonably estimated. Starting June 2014, we could reasonably estimate and determine sales allowances, therefore we began recognizing RAVICTI revenue at the point of sale to the specialty distributor, which resulted in the one-time non- recurring recognition of an additional $8.6 million in net revenues. We sell BUPHENYL in the United States to a specialty distributor, who in turn sells this product to retail pharmacies, hospitals and other dispensing organizations. We recognize revenue from BUPHENYL sales upon receipt by the specialty distributor. For product sales of BUPHENYL outside the United States, revenue is recognized once the product is accepted by the customer or once their acceptance period has expired whichever comes first. We recognize revenue net of product sales allowances, including estimated rebates, chargebacks, prompt-payment discounts, returns, distribution service fees and Medicare Part D coverage gap reimbursements. Product shipping and handling costs are included in cost of sales. 30-------------------------------------------------------------------------------- Table of Contents Product Sales Allowances We establish reserves for prompt-payment discounts, government and commercial rebates, product returns and chargebacks. Allowances relating to prompt-payment discounts and chargebacks are recorded at the time of revenue recognition, resulting in a reduction in product sales revenue and a decrease in trade accounts receivables. Accruals related to government rebates, product returns and other applicable allowances such as distributor fees are recognized at the time of revenue recognition, resulting in a reduction in product sales and an increase in accrued expenses or a reduction in the related accounts receivable depending on the nature of the sales deduction. Co-payment assistance We provide cash donation to an independent non-profit third party organization (which supports patients who have commercial insurance and meet certain financial eligibility requirements) with co-payment assistance and travel costs. We account for the amount of co-payment assistance as a reduction of product revenues. The following table summarizes the provisions, and credits/payments, for the gross to net sales deductions: Other Sales- Rebates & Prompt pay Related (in thousands) Chargebacks discounts Deductions TotalBalance as of December 31, 2013 $ 5,051 $ - $ 184 $ 5,235 Provision related to current period sales 8,203 2,350 997 11,550 Credits/payments (5,745 ) (2,350 ) (699 ) (8,794 ) Balance as of June 30, 2014 $ 7,509 $ - $ 482 $ 7,991 Stock-Based Compensation We recognize as compensation expense the fair value of stock options and other stock-based compensation issued to employees over the requisite service periods, which are typically the vesting periods. We determine the fair value of restricted stock units using the closing price of our common stock on the date of grant. We estimate the fair value of stock options using the Black-Scholes option valuation model. The fair value of employee stock options and restricted stock units is amortized on a straight-line basis over the requisite service period of the awards. Cost of Sales Our cost of sales during the quarter ended June 30, 2014 consist mainly of third party manufacturing cost of products sold, royalty fees and other indirect costs related to personnel compensation, shipping and supplies. 31-------------------------------------------------------------------------------- Table of Contents We recorded costs incurred prior to the FDA approval of RAVICTI as research and development expenses in our condensed consolidated statement of operations. We expect that cost of sales relating to RAVICTI as a percentage of revenue will increase in future periods as product manufactured prior to FDA approval, and therefore fully expensed, is utilized. The cost of BUPHENYL sales as a percentage of revenue was higher due to the recording of the step-value on BUPHENYL inventories acquired from Ucyclyd which was expensed to cost of sales as the inventory was sold and is not indicative of cost of sales in future periods. 32 -------------------------------------------------------------------------------- Table of Contents Results of Operations Comparison of the Three and Six Months Ended June 30, 2014 and 2013 Three Months Ended % Six Months Ended % June 30, Increase/ Increase/ June 30, Increase/ Increase/ (in thousands, except for percentages) 2014 2013 (Decrease) (Decrease) 2014 2013 (Decrease) (Decrease) (unaudited) (unaudited) Product revenue, net $ 37,095 $ 7,305 $ 29,790 408 % $ 56,577 $ 8,088 $ 48,489 600 % Cost of sales 4,473 875 3,598 411 6,856 943 5,913 627 Research and development 4,046 2,562 1,484 58 7,264 4,401 2,863 65 Selling general and administrative 11,365 9,220 2,145 23 22,536 17,164 5,372 31 Amortization of intangible asset 1,014 329 685 208 2,028 329 1,699 516 Change in acquisition-related contingencies 704 - 704 100 704 - 704 100 Interest income 140 11 129 1,173 278 12 266 2217 Interest expense (269 ) (387 ) (118 ) (30 ) (569 ) (795 ) (226 ) (28 ) Gain from settlement of retention option - 31,079 (31,079 ) (100 ) - 31,079 (31,079 ) (100 ) Other income (expense), net (4 ) - 4 100 (194 ) 500 694 139 Income tax benefit 2,119 - 2,119 100 2,031 - 2,031 100 Revenues During the three and six months ended June 30, 2014, we generated $37.1 million and $56.6 million of net product revenues. During the three and six months ended June 30, 2013, we generated $7.3 million and $8.1 million of net product revenues. Product revenues from the sale of RAVICTI and BUPHENYL are recorded net of sales returns and estimated product sales allowances including government rebates, chargebacks, prompt -payment discounts and distributor fees. For the three months period ended June 30, 2014 and 2013, net product revenues consisted of the following: • net U.S. sales from RAVICTI in the amount of $31.6 million and $6.2 million, respectively; and • net sales from BUPHENYL in the amount of $5.7 million (of which amount $3.0 million relates to sales outside the U.S. and $2.7 million sales in the U.S.) and $1.1 million (of which amount $0.1 million relates to sales outside the U.S. and $1.0 million sales in the U.S.), respectively. For the six months period ended June 30, 2014 and 2013, net product revenues consisted of the following: • net U.S. sales from RAVICTI in the amount of $47.1 million and $7.0 million, respectively; and • net sales from BUPHENYL in the amount of $9.7 million (of which amount $4.5 million relates to sales outside the U.S. and $5.2 million sales in the U.S.) and $1.1 million (of which amount $0.1 million relates to sales outside the U.S. and $1.0 million sales in the U.S.), respectively. The above amounts for the three and the six month periods ended June 30, 2014 were partially offset by $0.2 million of co-payment assistance. Prior to June 2014, revenue from the sale of RAVICTI was recognized based on the amount of product sold through to the end user consumer. Starting June 2014, we were able to reasonably estimate and determine sales allowances, therefore we began recognizing RAVICTI revenue at the point of sale to the specialty distributor, which resulted in the one-time non-recurring recognition of an additional $8.6 million in net revenues for the three and the six months ended June 30, 2014. Cost of Sales Cost of sales of $4.5 million for the three months ended June 30, 2014 consisted of BUPHENYL product costs of $1.8 million and RAVICTI product costs of $2.7 million. Cost of sales of $6.9 million for the six months ended June 30, 2014 consisted of BUPHENYL product costs of $2.8 million and RAVICTI product costs of $4.1 million. RAVICTI product costs included $2.5 million and $3.8 million for the three and six months ended June 30, 2014 for royalty expenses payable under our restated collaboration agreement with Ucyclyd Pharma, Inc. Cost of sales of $0.9 million for the three and six months ended June 30, 2013 consisted of BUPHENYL product costs of $0.3 million and RAVICTI product costs of $0.6 million. RAVICTI product costs for the three and six months ended June 30, 2013 primarily included royalty expenses payable under our restated collaboration agreement with Ucyclyd Pharma, Inc. We began capitalizing inventory costs after FDA approval of RAVICTI as the related costs were expected to be recoverable through the commercialization of the product. We recorded costs incurred prior to FDA approval of RAVICTI as research and development expenses in our 2012 consolidated statement of operations. 33 -------------------------------------------------------------------------------- Table of Contents For BUPHENYL, cost of sales was higher and not indicative of cost of sales in future periods due to the recording of the step-up value on BUPHENYL inventories acquired from Ucyclyd which will be expensed to cost of sales as the inventory is sold. Since the inventories were purchased as part of a business combination, they were recorded at fair value on the acquisition date. Research and Development Expenses Research and development expenses increased by $1.5 million, or 58%, to $4.0 million for the three months ended June 30, 2014, from $2.6 million for the three months ended June 30, 2013. This increase was primarily due to increases of $0.6 million in compensation related expenses, $0.7 million increase in EU and Canada regulatory preparation and filing fees related to RAVICTI and $0.6 million due to expenses incurred by Andromeda from the date of acquisition to the reporting date. This was partially offset by decreases of $0.2 million in consulting costs and $0.2 million in clinical development costs. Research and development expenses increased by $2.9 million, or 65%, to $7.3 million for the six months ended June 30, 2014, from $4.4 million for the six months ended June 30, 2013. This increase was primarily due to increases of $1.3 million in compensation related expenses, $0.1 million increase in consulting costs, $0.9 million increase in EU and Canada regulatory preparation and filing fees related to RAVICTI and $0.6 million due to expenses incurred by Andromeda from the date of acquisition to the reporting date. Selling, General and Administrative Expenses Selling, general and administrative expenses increased by $2.1 million, or 23%, to $11.4 million for the three months ended June 30, 2014, from $9.2 million for the three months ended June 30, 2013. This increase was primarily due to increases of $1.0 million in compensation expense as a result of hiring additional employees in the sales and marketing departments, $0.6 million related to the legal costs incurred for the Andromeda acquisition, $0.2 million related to information technology infrastructure expenses, $0.2 million in other office and administrative related expenses and $0.1 million due to expenses incurred by Andromeda from the date of acquisition to the reporting date. Selling, general and administrative expenses increased by $5.4 million, or 31%, to $22.5 million for the six months ended June 30, 2014, from $17.2 million for the six months ended June 30, 2013. This increase was primarily due to increases of $3.6 million in compensation expense as a result of hiring additional employees, $1.3 million related to the costs incurred for Andromeda acquisition, $0.3 million related to information technology infrastructure expenses, $0.1 million in other office and administrative related expenses, and $0.1 million due to expenses incurred by Andromeda from the date of acquisition to the reporting date. Amortization of intangible asset For the three and six months ended June 30, 2014, amortization of intangible asset in the amount of $1.0 million and $2.0 million pertains to the amortization expense for BUPHENYL product rights acquired as part of the BUPHENYL acquisition on May 31, 2013. For the three and six months ended June 30, 2013, amortization of intangible asset in the amount of $0.3 million pertains to the amortization expense for BUPHENYL product rights acquired as part of the BUPHENYL acquisition on May 31, 2013. Change in acquisition-related contingencies For the three and six month periods ended June 30, 2014, change in value of acquisition -related contingencies of $0.7 million pertains to the change in the fair value of the acquisition related contingent consideration and change in the acquisition related contingent liability between the acquisition date and the reporting date. Interest Income The changes in interest income were not significant for the three and six months ended June 30, 2014 and 2013. Interest Expense Interest expense were $0.3 million and $0.4 million for the three months ended June 30, 2014 and 2013, respectively. Interest expense were $0.6 million and $0.8 million for the six months ended June 30, 2014 and 2013, respectively. Interest expense decreased by $0.2 million, or 28% primarily due to the repayment of our notes. 34 -------------------------------------------------------------------------------- Table of Contents Gain from settlement of retention option The amount of gain is comprised of (i) fair value of BUPHENYL of $20.4 million and (ii) net cash received from Ucyclyd of $10.9 million off-set by (iii) the $0.3 million carrying value of the option to purchase the rights to BUPHENYL and AMMONUL. Accordingly, we recorded the resulting net settlement of $31.1 million as gain from our settlement of the retention option on our condensed consolidated statements of operations. For additional information, see Note 3 to our unaudited condensed consolidated financial statements appearing elsewhere in this report. Other Income (Expense), net Other income (expense), net for the six months ended June 30, 2014 was $0.2 million expense and primarily includes amortization of discount on available-for-sale investments partially offset by the gain on foreign currency transactions. During the six months ended June 30, 2013, we recorded $0.5 million in income related to Ucyclyd's payment to us in relation to our restated collaboration agreement. Income tax benefit Income tax benefit was $2.1 million and $2.0 million for the three and six months ended June 30, 2014, respectively. The effective income tax benefit rate was 13.8% and 12.2% for the three and six months ended June 30, 2014. The difference between the effective rate and the U.S. statutory rate is primarily due to the valuation allowance on the U.S. deferred taxes and lower foreign tax rates.There was no income tax expense or benefit for the three and six months ended June 30, 2013. Liquidity and Capital Resources During the six months ended June 30, 2014, we generated net revenues of $56.6 million. As of June 30, 2014 and December 31, 2013, our principal sources of liquidity were our cash provided by operating activities and our cash and cash equivalents and investments. Prior to our commercialization of RAVICTI our principal source of liquidity was sales of our equity securities. On March 13, 2013, we completed our follow-on offering. We received net proceeds from the offering of $63.7 million, after deducting underwriting discounts and commissions of $4.1 million and expenses of $0.8 million. On August 14, 2013, we filed a shelf registration statement on Form S-3, which was declared effective by the SEC on September 13, 2013. The shelf registration statement permits: (a) the offering, issuance and sale of up to a maximum aggregate offering price of $150.0 million of our common stock, preferred stock, debt securities, warrants and/or units; (b) the sale of up to 8,727,000 shares of common stock by certain selling stockholders; and (c) the offering, issuance and sale of up to a maximum aggregate offering price of $50.0 million of our common stock that may be issued and sold under a sales agreement with Cantor Fitzgerald & Co. As of June 30, 2014, there were no sales of any securities registered pursuant to the shelf registration statement. At June 30, 2014, we had an accumulated deficit of $103.6 million. We expect to incur increased research and development expenses when we initiate a Phase III trial of GPB for the treatment of patients with episodic HE and due to the acquisition of Andromeda and its ongoing Phase 3 trial of DiaPep277. In addition, we expect to continue to incur significant commercial, sales and marketing, and outsourced manufacturing expenses in connection with commercialization of RAVICTI and marketing of BUPHENYL in UCD. These increased expenses as compared to prior years include payroll related expenses due to hiring additional employees, costs related to operation of our distribution network and marketing costs and general infrastructure expenses as we expand our organization. Our plans with respect to these matters include utilizing a substantial portion of our capital resources and efforts in completing the development and obtaining regulatory approval of DiaPep 277 in Type 1 diabetes and of GPB in HE, expanding our organization, and commercialization of RAVICTI and marketing of BUPHENYL. We believe that our existing cash and cash equivalents as of June 30, 2014, and our future expected income will be sufficient to fund our operations for at least the next 12 months. 35 -------------------------------------------------------------------------------- Table of Contents Cash Flows The following table sets forth the major sources and uses of cash for the periods set forth below (in thousands): Six Months Ended June 30, (In thousands) 2014 2013 (unaudited) Net cash provided by (used in): Operating activities $ 23,459 $ (12,999 ) Investing activities (15,570 ) 10,529 Financing activities (1,484 ) 62,344 Net increase in cash and cash equivalents $ 6,405 $ 59,874 Cash provided by operating activities of $23.5 million for the six months ended June 30, 2014 included our net income of $18.7 million, adjusted for non-cash items such as $0.7 million of change in acquisition-related contingencies, $0.3 million of amortization of debt discount and debt issuance cost, $2.0 million of amortization of intangible asset, $3.2 million of stock-based compensation expense, $0.2 million of amortization of discount on available-for-sale investments, $0.2 million of depreciation expense, $0.1 million of provision for inventory obsolescence, a net cash inflow of $11.6 million related to changes in operating liabilities partially offset by a net cash outflow of $14.0 million related to changes in operating assets. Cash used in operating activities of $13.0 million for the six months ended June 30, 2013 included our net income of $16.0 million, adjusted for non-cash items such as $31.1 million of gain from the settlement of retention option, $0.3 million of amortization of debt discount, $0.3 million of amortization of intangible asset, $1.8 million of stock-based compensation expense, a net cash outflow of $2.4 million related to changes in operating assets partially offset by a net cash inflow of $2.1 million related to changes in operating liabilities. Net cash used in investing activities was $15.6 million for the six months ended June 30, 2014 and primarily consisted of the $14.0 million paid to acquire Andromeda and additions made to property, plant and equipment of $0.3 million. Net cash provided by investing activities was $10.5 million for the six months ended June 30, 2013 and includes a net payment of $11.0 million received from Ucyclyd partially offset by additions made to property and equipment of $0.4 million. Net cash used in financing activities was $1.5 million for the six months ended June 30, 2014 and primarily consisted of payments of notes payable of $2.8 million partially offset by proceeds from issuance of common stock due to exercise of stock options of $1.2 million. Net cash provided by financing activities was $62.3 million for the six months ended June 30, 2013 related primarily to the proceeds from our follow-on offering of $64.5 million (net of underwriting discounts and commissions) and proceeds from issuance of common stock due to exercise of stock options of $0.3 million partially offset by our payments of notes payable of $1.7 million and payments of deferred offering costs of $ 0.8 million. Future Funding Requirements We will likely need to obtain additional financing to fund our future operations, including supporting sales and marketing activities related to RAVICTI and BUPHENYL, funding a Phase III trial in HE, as well as funding the ongoing development of DiaPep277 and any additional product candidates we might acquire or develop on our own. Our future funding requirements will depend on many factors, including, but not limited to • our ability to successfully commercialize RAVICTI and market BUPHENYL; • the amount of sales and other revenues from products and product candidates that we may commercialize, if any, including the selling prices for such products and the availability of adequate third-party reimbursement; • selling and marketing costs associated with our UCD products, including the cost and timing of expanding our marketing and sales capabilities and establishing a network of specialty pharmacies; • the progress, timing, scope and costs of our nonclinical studies and clinical trials, including the ability to timely enroll patients in our planned and potential future clinical trials; • the time and cost necessary to obtain regulatory approvals and the costs of post-marketing studies that may be required by regulatory authorities; • the costs of obtaining clinical and commercial supplies of RAVICTI, BUPHENYL and DiaPep277 • payments of milestones and royalties to third parties; • cash requirements of any future acquisitions of product candidates; • the time and cost necessary to respond to technological and market developments: • the costs of filing, prosecuting, defending and enforcing any patent claims and other intellectual property rights; and • any new collaborative, licensing and other commercial relationships that we may establish. We believe that our current cash and cash equivalents will be sufficient to fund our operations for at least the next 12 months. 36-------------------------------------------------------------------------------- Table of Contents We have based these estimates on a number of assumptions that may prove to be wrong, and changing circumstances beyond our control may cause us to consume capital more rapidly than we currently anticipate. For example, we may not achieve the revenues we anticipated and our HE Phase III clinical trial may cost more than we expect. Because of the numerous risks and uncertainties associated with the development and commercialization of GPB and DiaPep277 or any other product candidates, we are unable to estimate with any certainty the amounts of increased capital outlays and operating expenditures associated with our current and anticipated clinical trials. Additional financing may not be available when we need it or may not be available on terms that are favorable to us. We may seek to raise additional capital through a combination of private and public equity offerings and debt financings. To the extent that we raise additional capital through the sale of equity or convertible debt securities, the ownership interest of existing stockholders will be diluted, and the terms may include liquidation or other preferences that adversely affect the rights of existing stockholders. Debt financing, if available, would result in increased fixed payment obligations and may involve agreements that include covenants limiting or restricting our ability to take specific actions such as incurring debt, making capital expenditures or declaring dividends. If adequate funds are not available to us on a timely basis, or at all, we may be required to terminate or delay clinical trials or other development activities for RAVICTI, GPB and DiaPep277, or delay our establishment of sales and marketing capabilities or other activities that may be necessary to successfully market BUPHENYL. We may elect to raise additional funds even before we need them if the conditions for raising capital are favorable. Off-Balance Sheet Arrangements We do not currently have, nor have we ever had, any relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which would have been established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. In addition, we do not engage in trading activities involving non-exchange traded contracts. Jumpstart Our Business Startups Act of 2012 The Jumpstart Our Business Startups Act of 2012 (the "JOBS Act") permits an "emerging growth company" such as us to take advantage of an extended transition period to comply with new or revised accounting standards applicable to public companies. We are choosing to "opt out" of this provision and, as a result, we will comply with new or revised accounting standards as required when they are adopted. This decision to opt out of the extended transition period under the JOBS Act is irrevocable. |