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TNOX > SEC Filings for TNOX > Form 10-K on 16-Mar-2007All Recent SEC Filings

Show all filings for TANOX INC

Form 10-K for TANOX INC


16-Mar-2007

Annual Report


ITEM 7. Management's Discussion and Analysis of Financial Condition and Results of Operations

Overview

Tanox discovers and develops therapeutic monoclonal antibodies to address significant unmet medical needs in the areas of immune-mediated diseases, infectious disease, inflammation and cancer. Our products are genetically engineered antibodies that target a specific molecule or antigen.

On November 9, 2006, we entered into an agreement and plan of merger with Genentech and Green Acquisition Corporation, a wholly-owned subsidiary of Genentech, pursuant to which Genentech would acquire Tanox for approximately $919 million in cash. Under the terms of the agreement, Green Acquisition will merge with and into Tanox, and the stockholders of Tanox will receive $20.00 in cash for each share held, less any applicable withholding tax. In addition, each option to purchase Tanox common stock outstanding at the time of the merger will be canceled and the option holder entitled to receive a cash amount equal to the product of (i) the number of shares of Tanox common stock as to which the option remains unexercised, multiplied by (ii) the amount, if any, by which $20.00 exceeds the exercise price of the option, less any applicable withholding tax. The boards of directors of both companies and the stockholders of Tanox have approved the transaction, which remains subject to expiration of the waiting period under the Hart-Scott-Rodino Antitrust Improvements Act and the satisfaction of other customary closing conditions. On January 29, 2007, we and Genentech announced that we had received a Request for Additional Information and Documentary Materials, commonly referred to as a "second request," from the FTC in connection with the proposed acquisition, which extends the waiting period. Genentech continues to engage in active and productive discussions with the FTC, and we expect that the transaction will close within the first half of 2007, subject to expiration of the waiting period and the satisfaction of other customary closing conditions, including the absence of any material adverse effect having occurred in respect of Tanox.

Marketed Product - Xolair

Xolair was developed in collaboration with Genentech and Novartis. In the U.S., Xolair is labeled for treatment of adults and adolescents (12 years of age and above) with moderate-to-severe persistent asthma who have a positive skin test or in vitro reactivity to a perennial aeroallergen and whose symptoms are inadequately controlled with inhaled corticosteroids. In Europe, Xolair is licensed as add-on therapy to improve asthma control in adults and adolescents (12 years of age and above) with severe persistent allergic asthma. Xolair was approved for use in the U.S. by the Food and Drug Administration (FDA) in June 2003 and approved for use in Europe in October 2005. On February 21, 2007, the FDA announced it requested that Genentech strengthen the existing warning on the potential risk for anaphylaxis in patients receiving Xolair by adding a boxed warning to the product label and implementing a Risk Mitigation Action Plan, including providing a medication guide for patients and advice to health care providers to observe patients for at least two hours after dosing. Genentech and Novartis have advised that they will be working with the FDA on its request.

Under our collaboration agreements with Genentech and Novartis, we receive royalties on the net sales of Xolair and share in Novartis' net profits from sales of Xolair in the U.S. For the year 2006, we recorded net royalty revenue of $40.2 million from sales of Xolair versus $29.4 million for the year 2005. We recorded net profit sharing revenue of $6.7 million from Novartis for the fourth quarter of 2005 and the first three quarters of 2006, as the profit-sharing calculation is one quarter in arrears. We recorded net profit sharing revenue of $1.1 million in 2005, resulting from profits made in the first three quarters of 2005. Over the next several years, we expect that the net amount we will receive in royalties and profit-sharing payments from sales of Xolair, taking into account both credits and the amounts payable to our former attorneys, will be in the range of 8% to 12% of net sales, depending on the sales level achieved and geographic distribution of sales.


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Index to Financial Statements

For the year 2006, we recorded manufacturing rights revenue of $7.0 million, compared to manufacturing rights revenue of $1.1 million for the year 2005. Under the terms of the February 25, 2004 Tripartite Cooperation Agreement (TCA) among Tanox, Genentech and Novartis, Tanox relinquished any rights to manufacture Xolair and in exchange receives payments based on the quantity of Xolair produced. Manufacturing rights revenue is based on the quantity of Xolair produced each quarter, as defined in our collaboration agreement, and is calculated and recorded one quarter in arrears.

Novartis is conducting a Phase 3 clinical trial to study the effectiveness of Xolair in pediatric allergic asthma patients. Enrollment of the trial has been completed. In the second quarter of 2006, Novartis submitted an application for the approval of Xolair in Japan. Under our collaboration agreement with Novartis, the filing resulted in a $2.0 million milestone payment to Tanox, of which $1.0 million was recorded as development agreement revenue from a related party in the second quarter of 2006. The $1.0 million of the milestone recorded as deferred revenue is creditable to Novartis against future royalties owed Tanox.

Development agreement revenue in 2006 also includes $1.0 million earned as reimbursement by Novartis of a portion of Tanox's 2006 development costs for a high affinity anti-IgE program.

Clinical Development Programs

We have two products in clinical development.

TNX-355

TNX-355 is our monoclonal antibody in development to treat HIV/AIDS. In May 2006, we reported positive 48-week results from the Phase 2 clinical trial of TNX-355. The results showed that TNX-355, when given in combination with an optimized background regimen (OBR) of other antiviral therapies, produced a greater reduction in viral load in HIV-infected patients than did placebo in combination with OBR. These results, together with positive 24-week data reported in October 2005, demonstrate the long-term antiviral and immunologic impact of TNX-355. At both the 24-week and 48-week time points, TNX-355 was well tolerated, with no serious adverse events related to the drug as assessed by study investigators.

We have conducted a meeting with the FDA to discuss the clinical trial results and continued development of TNX-355. At the FDA's request, a dose-finding trial has been designed that explores different dosing strategies. The Agency concurred that the dose-finding trial, if appropriately designed and successful, could be considered pivotal as part of a registration program for TNX-355 in HIV treatment-experienced patients. We are in the process of evaluating the FDA's most recent feedback on the proposed trial design.

TNX-650

TNX-650 is a humanized anti-IL-13 antibody. A Phase 1 clinical trial was initiated in May 2006 to evaluate TNX-650 as a potential treatment of Hodgkin's lymphoma in patients who are refractory to chemotherapy or radiation treatment. Five patient cohorts have been enrolled to date.

In early October 2006, we also began enrolling patients in a Phase 1 clinical trial of TNX-650 as a potential treatment for moderate-to-severe asthma. The trial is a randomized, double-blind, placebo-controlled, dose-escalation study of the safety, tolerability and pharmacokinetics of single doses of TNX-650 in healthy volunteers. Enrollment of this Phase 1 study, which is taking place at a single site in the U.S., has been completed. Preclinical studies indicate that IL-13 is a key mediator of asthma responses, including airway inflammation, obstruction and hyper-reactivity.


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Index to Financial Statements

Preclinical Programs

TNX-234, a humanized antibody, is being developed as a potential treatment for wet and/or advanced dry age-related macular degeneration (AMD). TNX-558 is being evaluated as a potential inflammatory-disease therapy. In addition, we have generated a humanized high affinity anti-IgE antibody for the potential treatment of allergic diseases, and development activities are ongoing with Novartis under our two-party Amended and Restated Development and Licensing Agreement.

Manufacturing

Our San Diego, California manufacturing facility has received a Drug Manufacturing License from the State of California.

Critical Accounting Policies

Use of Estimates

The preparation of consolidated financial statements in conformity with U.S. generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and footnotes thereto. Actual results may differ from those estimates.

Revenue Recognition

Under our collaboration agreements with Genentech and Novartis, we receive a royalty on the net sales of Xolair worldwide and share in Novartis' net profits from Xolair sales in the U.S. Royalty revenue is recorded monthly based on contractual terms and information provided by Genentech and Novartis. Royalties are reconciled and adjusted if actual results differ from those previously reported to us and are subject to audit by Tanox. Our interest in Novartis' U.S. net profits is calculated and recorded one quarter in arrears. Manufacturing rights revenue represents amounts received from Genentech and Novartis in consideration of our relinquishment, under the collaboration agreements, of our rights to manufacture Xolair. Manufacturing rights revenue is based on the quantity of Xolair produced, as defined in our collaboration agreement, and is calculated and recorded one quarter in arrears. Revenues from development agreements include payments for milestone achievements and sponsored research and development costs. Milestone payments are received under best efforts contracts and are not refundable. They are recognized as revenue when the milestones are achieved and there are no remaining performance obligations. Revenues for sponsored research and development are recognized as revenue as we complete our obligations related to such activities. Any revenue contingent upon future performance is deferred and recognized as the performance is completed. Revenues recognized are net of certain credits and amounts due to our former attorneys under an arbitration award.

Research and Development

Research and development expenses consist of direct costs and indirect overhead costs, including facilities costs, salaries, related benefit costs and material and supply costs. Expenses may also include upfront fees and milestones paid to licensors and collaborative partners. Such amounts are expensed as incurred. Research and development costs also include estimates for clinical trial costs, which are based on patient enrollment and clinical trial progress. Actual costs may differ from estimates.


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Index to Financial Statements

Share-based Compensation

Tanox adopted FAS 123R, "Share-Based Payment" on January 1, 2006 using the modified prospective transition method, which requires that share-based compensation is recognized for all awards granted, modified or settled after the effective date as well as for all awards granted to employees prior to the effective date that remain unvested as of the effective date. Prior to the adoption of FAS 123R, we accounted for our share-based compensation expense under the recognition and measurement provisions of APB Opinion No. 25, "Accounting for Stock Issued to Employees." Under the intrinsic value method described in APB Opinion No. 25, no compensation expense was recognized if the exercise price of the employee stock option equaled the market price of the underlying stock on the date of grant.

Tanox estimates the fair value of stock options using the Black-Scholes-Merton option pricing model. The assumptions used under this model are as follows: 1) the expected term of the options is estimated using historical option exercise data; 2) the expected volatility is estimated based on historical stock price volatility; 3) the risk-free interest rate is based on the U.S. Treasury zero-coupon issues with a remaining term equal to the expected term of the option; and 4) a zero percent dividend yield. Under FAS 123R, the fair value of stock options granted is recognized as expense over the service period, net of estimated forfeitures, which we base on historical data. To the extent actual forfeitures differ from our current estimates, cumulative adjustments to share-based compensation expense will be recorded in the period that estimates are revised.

Recent Accounting Pronouncement

In June 2006, the Financial Accounting Standards Board (FASB) issued Interpretation No. 48, "Accounting for Uncertainty in Income Taxes - an Interpretation of FASB Statement No. 109," (FIN 48). This interpretation clarifies the accounting for uncertainty in income taxes recognized in an enterprise's financial statements in accordance with FASB Statement No. 109, "Accounting for Income Taxes." The interpretation prescribes a recognition threshold and measurement attribute for a tax position taken or expected to be taken in a tax return and also provides guidance on derecognition, classification, interest and penalties, accounting for interim periods, disclosure and transition. The provisions of FIN 48 are effective for fiscal years beginning after December 15, 2006. We are currently evaluating the impact, if any, this statement may have on our financial statements.


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Index to Financial Statements

Results of Operations

This discussion of our Results of Operations contains forward-looking statements regarding revenue, research and development expenses and general and administrative expenses. For a discussion of the risks and uncertainties associated with our forward looking statements, please see the "Item 1A. Risk Factors" section in this Form 10-K.

Years Ended December 31, 2006, 2005 and 2004

Revenues. For the years ended December 31, 2006, 2005 and 2004, revenues consist
of the following:



                                                               For the year ended December 31,
                                                               2006            2005          2004
                                                                        (in thousands)
Royalties, net                                             $     38,218    $     29,104    $ 13,240
Royalties from related party, net                                 1,942             258          71
Profit share from related party, net                              6,710           1,139          -
Development agreements, license fees and manufacturing
rights, net                                                       7,205          14,132       3,725
Development agreements from related party, net                    2,062              54       3,470

Total revenues                                             $     56,137    $     44,687    $ 20,506

Revenues are recorded net of credits and amounts payable to our former attorneys under an arbitration award.

Royalty revenue increased $10.8 million in 2006 from 2005, and $16.1 million in 2005 versus 2004, as a result of increased Xolair sales.

In addition to Xolair royalty revenue, Tanox recorded Xolair net profit sharing revenue of $6.7 million from Novartis for the fourth quarter of 2005 and the first three quarters of 2006, as the profit-sharing calculation is one quarter in arrears. We recorded net profit sharing revenue of $1.1 million in 2005, resulting from profits made in the first three quarters of 2005. Under our collaboration agreements, Tanox shares in Novartis' net profits from sales of Xolair in the U.S.

For the year 2006, we recorded manufacturing rights revenue of $7.0 million, compared to manufacturing rights revenue of $1.1 million for the year 2005. Under the terms of the TCA among Tanox, Genentech and Novartis, Tanox relinquished any rights to manufacture Xolair and in exchange receives payments based on the quantity of Xolair produced. Manufacturing rights revenue is based on the quantity of Xolair produced each quarter, as defined in our collaboration agreement, and is calculated and recorded one quarter in arrears.

In the second quarter of 2006, Novartis submitted an application for the approval of Xolair in Japan. Under our collaboration agreement with Novartis, the filing resulted in a $2.0 million milestone payment to Tanox, of which $1.0 million was recorded as development agreement revenue from a related party in the second quarter of 2006. The remaining $1.0 million of the milestone is creditable to Novartis against future royalties due Tanox and was recorded as deferred revenue.

Development agreement revenue in 2006 also includes $1.0 million earned as reimbursement by Novartis of a portion of Tanox's 2006 development costs for a high affinity anti-IgE program.


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Index to Financial Statements

Development agreement revenue in 2005 includes $12.8 million in milestone revenue associated with Xolair annual sales achieving $300 million in the U.S. The $20.0 million gross milestone was reduced by $7.2 million which was due to our former attorneys under an arbitration award. Development agreement revenue for 2004 includes a one-time reimbursement of $6.6 million received under the terms of our collaboration agreements, representing reimbursement by Genentech and Novartis of a portion of the TNX-901 development costs incurred by Tanox in previous years.

Research and Development Expenses. Research and development expense consists of costs incurred for product development and discovery research programs. Research and development expenses consist of direct costs and indirect overhead costs, including facilities costs, salaries, related benefit costs and material and supply costs. At December 31, 2006, our research and development clinical stage programs include TNX-355 for HIV/AIDS, TNX-650 for Hodgkin's lymphoma and TNX-650 for Asthma. Research and preclinical stage programs include TNX-234 for AMD, TNX-558 for inflammatory disease, the high affinity anti-IgE program and other discovery and exploratory research projects. For the years ended December 31, 2006, 2005 and 2004, costs associated with research and development programs, including allocated overhead, were:

                                                  For the year ended December 31,
                                                  2006            2005         2004
                                                          (in thousands)
    Clinical stage programs                   $     38,365    $     36,064   $ 18,698
    Research and preclinical stage programs         15,044          11,834      8,502

    Total research and development expenses   $     53,409    $     47,898   $ 27,200

Research and development expenses increased $5.5 million in 2006 from 2005. The increase in research and development costs was attributed primarily to expenses associated with manufacturing activities in preparation for planned clinical trials, the write-off of $1.4 million in prepaid expense related to future creditable amounts with a third party manufacturer, increased spending for preclinical programs and employee share-based compensation expense.

Research and development expenses increased $20.7 million in 2005 from 2004. Approximately $16.3 million of this increase was attributable to the costs associated with the re-commissioning of our San Diego manufacturing facility in 2005. The remainder of the 2005 increase relates primarily to increased clinical trial costs associated with the TNX-355 Phase 2 study and increased personnel costs.

Acquired in-process research and development. On March 31, 2005, we acquired a tissue factor antagonist program for the potential treatment of ALI/ARDS. We issued an aggregate of 800,000 shares of our common stock and paid $6.0 million in cash for the program, resulting in a fair value of $13.7 million. As of the acquisition date, the acquired program was still in early stage development and had not reached technological feasibility. We determined that no alternative future use existed for this program, and, accordingly, the $13.7 million acquisition price was recorded as acquired in-process research and development expense.


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Index to Financial Statements

General and Administrative Expenses. For the years ended December 31, 2006, 2005 and 2004, the cost associated with general and administrative activities were:

For the year ended December 31, 2006 2005 2004

(in thousands)

General and administrative expenses $ 13,465 $ 7,152 $ 7,033

General and administrative expenses increased $6.3 million in 2006 from 2005. The increase in general and administrative costs was attributed primarily to transaction related expenses in connection with the proposed merger with Genentech and employee share-based compensation expense.

Other Income. For the years ended December 31, 2006, 2005 and 2004, other income was:

For the year ended December 31, 2006 2005 2004

(in thousands)

Other Income $ 8,169 $ 4,619 $ 3,437

Other income for the year ended December 31, 2006 increased $3.6 million from 2005, and $1.2 million in 2005 versus 2004, primarily due to an increase in interest income resulting from higher average interest rates on investments.

Income Taxes. There was no provision for income taxes in 2006, 2005 or 2004, due to pre-tax losses of $2.6 million, $19.4 million and $10.3 million, respectively.

Share-Based Compensation. We adopted FAS 123R on January 1, 2006. Prior to the adoption, we disclosed such expenses on a pro forma basis in the notes to our financial statements. For the year ended December 31, 2006, we recorded approximately $3.7 million of share-based compensation expense, of which $1.6 million was included in research and development expense and $2.1 million was included in general and administrative expense. The adoption of FAS 123R resulted in an increase in net loss per share of $0.08 for the year ended December 31, 2006. (See Note 11 "Capital Stock" in our Notes to Consolidated Financial Statements.)

Net Loss. For the year ended December 31, 2006, we recorded a net loss of $2.6 million, or $0.06 net loss per share, compared to a net loss of $19.4 million, or $0.43 net loss per share for same period in 2005. The decrease in net loss in 2006 was due primarily to increased revenue associated with Xolair and the one-time acquired in-process research and development expense for the purchase of the tissue factor antagonist program in 2005. The net loss increased to $19.4 million in 2005 or $0.43 net loss per share, as compared to $10.3 million or $0.23 net loss per share in 2004. The increase in net loss in 2005 was due primarily to the acquired in-process research and development expense for the purchase of a tissue factor antagonist program, re-commissioning costs associated with our San Diego manufacturing facility and the increase in other research and development expenses. This was partially offset by increased revenue associated with Xolair.


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Index to Financial Statements

Liquidity and Capital Resources

We have financed our operations since inception primarily through sales of equity securities, development and licensing fee revenues, interest income and, beginning in 2003, revenue related to Xolair. During the year ended December 31, 2000, we sold approximately 8.6 million shares of common stock in an initial public offering for net proceeds of $225.8 million. As of December 31, 2006, we had $185.1 million in cash, cash equivalents and investments, of which $173.2 million were classified as current assets.

Cash, cash equivalents and investments increased by $20.6 million for the year ended December 31, 2006 to $185.1 million from $164.5 million at December 31, 2005. The net increase in funds was attributed primarily to the receipt of a one-time net milestone payment of $12.8 million based on Xolair achieving sales of more than $300 million for the first time, and Xolair royalty, profit sharing and manufacturing rights revenue received in 2006, partially offset by the funding of operating activities.

Net cash provided by operating activities was $17.5 million for the year ended December 31, 2006 compared to net cash used in operating activities of $17.3 million for 2005. The increase in cash during 2006 was due primarily to the receipt of the one-time Xolair net milestone payment of $12.8 million and Xolair royalty, profit sharing and manufacturing rights revenue received. The 2005 use of cash was comprised mainly of a net loss of $19.4 million and an increase in receivables and other assets of $22.8 million related to the Xolair milestone, offset by acquired in-process research and development of $13.7 million.

Net cash used in investing activities was $16.2 million for the year ended December 31, 2006 compared to net cash provided by investing activities of $62.3 million for 2005. In 2006, investment purchases exceeded maturities by $13.8 million, compared to an excess investment maturities over purchases of $74.0 million in 2005. In 2005, $6.0 million of cash was paid for acquired in-process research and development and $5.6 million was used to purchase manufacturing assets from Biogen Idec.

Net cash provided by financing activities was $6.2 million for the year ended December 31, 2006 compared to net cash used in financing activities of $3.6 million for 2005. The increase in net cash from financing activities during 2006 was due to stock option exercises, while the decrease in cash for 2005 was due to the repayment of a note to a bank of $5.0 million partially offset by an increase in cash of $1.4 million from stock option exercises.

Pursuant to a Lease Assignment and Asset Purchase Agreement dated December 9, 2004, between Biogen Idec and Tanox, on January 10, 2005, Tanox acquired from Biogen Idec certain manufacturing, process development and quality control equipment, related documentation and furniture and fixtures housed in a 76,000 square foot leased facility located in San Diego, California. The Company paid Biogen Idec approximately $5.6 million for the assets and allocated $4.6 million as property, plant and equipment and $1.0 million as an intangible asset for manufacturing equipment documentation, included in other assets on the balance sheet. Tanox also agreed to assume the obligations of Biogen Idec under a lease for the facility, which extends until September 30, 2011. The lease has two five-year extension options and escalating annual lease payments of approximately 4%. As partial consideration for our agreement to the extension of the lease term to September 30, 2011, Biogen Idec agreed to make two payments to us, each in the amount of $2.4 million, on September 30, 2007 and November 30, 2008. We expect the total lease obligation of Tanox for this lease assignment through 2011, net of the Biogen Idec payments, will be approximately $24.6 million.

On March 31, 2005, the Company acquired a tissue factor antagonist program for . . .

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