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XNPT > SEC Filings for XNPT > Form 10-K on 14-Mar-2013All Recent SEC Filings

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Form 10-K for XENOPORT INC


Annual Report

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


We are a biopharmaceutical company focused on developing and commercializing a portfolio of internally discovered product candidates with an initial focus on neurological disorders. Our innovative product and product candidates are prodrugs that are typically created by modifying the chemical structure of currently marketed drugs, referred to as parent drugs, and are designed to correct limitations in the oral absorption, distribution and/or metabolism of the parent drug. Our marketed product and each of our product candidates are orally-available, patented or patentable molecules that address potential markets with clear unmet medical needs. Our marketed product is approved in the United States, where it is known as Horizant® (gabapentin enacarbil) Extended-Release Tablets, and in Japan, where it is known as Regnite® (gabapentin enacarbil) Extended-Release Tablets. Horizant is approved by the U.S. Food and Drug Administration, or FDA, for the treatment of moderate-to-severe primary restless legs syndrome, or RLS, and for the management of postherpetic neuralgia, or PHN, in adults Regnite is approved by the Japanese Ministry of Health, Labor and Welfare, or MHLW, as a treatment for patients with RLS.

In addition to our marketed product, we have three product candidates in clinical development. Our lead product candidate, arbaclofen placarbil, or AP, is a potential treatment for patients with spasticity. We are conducting a pivotal Phase 3 clinical trial for AP as a potential treatment for spasticity in patients with multiple sclerosis, or MS, and we anticipate top-line results will be available early in the second quarter of 2013. Our second product candidate, XP21279, is a potential treatment for patients with advanced idiopathic Parkinson's disease, and we plan to continue development of XP21279 to the extent our resources permit or we enter into a collaboration with a third party. We are evaluating our third product candidate, XP23829, in Phase 1 studies with healthy subjects to determine its safety and pharmacokinetic profile. We believe that XP23829 could be a potential treatment for patients with relapsing-remitting MS, or RRMS, psoriasis and/or certain other disorders where the mechanism of action of XP23829 may be relevant.

On November 8, 2012, we executed a termination and transition agreement with Glaxo Group Limited, or GSK, that terminated our development and commercialization agreement with respect to Horizant, and also provided for a mutual release of claims and resolved all ongoing litigation between the parties. Pursuant to the termination and transition agreement, during a transition period that will end on April 30, 2013, GSK will continue to exclusively commercialize, promote, manufacture and distribute Horizant in the United States. We will not be responsible for any losses associated with the terminated collaboration agreement, are no longer eligible to receive any further milestone payments from GSK and will not receive any revenue or incur any losses from GSK's sales of Horizant during the transition period. In addition, prior to the end of the transition period, GSK will provide to us inventory of gabapentin enacarbil in GSK's possession that is not required for use by GSK in the manufacture of Horizant. In exchange for such inventory, we will make annual payments to GSK of $1.0 million for six years beginning in 2016. Following the transition period, we will assume all responsibilities for further development, manufacturing and commercialization of Horizantin the United States. We have elected to have GSK continue to supply Horizant tablets to us for up to six months following the transition period.

Pursuant to a separate stock purchase agreement, or SPA, entered into between us and GSK on November 8, 2012, GSK purchased $20.0 million of our common stock, or an aggregate of 1,841,112 shares at $10.863 per share, which per share price represented a 12.5 percent premium to the average of the closing prices of our common stock for the ten trading days prior to October 31, 2012. In addition, on November 9, 2012, we exercised a put option requiring GSK to purchase an additional 2,190,100 shares of our common stock at $9.132 per share, which per share price represented a 12.5 percent premium to the average of the closing prices of our common stock for the ten trading days prior to November 9, 2012.

Revenues recognized through December 31, 2012 have been primarily comprised of up-front, milestone and contingent event-based payments from our collaboration agreements. However, as a result of our termination and transition agreement with GSK and the return of the commercialization rights to Horizant to us, we expect the future composition of our revenues to consist primarily of revenues from Horizant product sales. However, we have no experience in commercializing products on our own, and have only limited management expertise in developing a commercial operation. To assume control of and to be prepared to commercialize Horizant on

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May 1, 2013, we will need to continue to expand our organization and infrastructure substantially. We expect that the expenses of establishing sales and marketing capabilities and a distribution and supply chain infrastructure will be substantial, and these costs may exceed any revenues that we are able to generate from Horizant product sales. If we are not able to build the appropriate capabilities and infrastructure prior to the Horizant transition scheduled for May 1, 2013, we may not be able to assume control of Horizant on May 1, 2013, sales of Horizant could suffer and our business will be harmed. In the six months ended December 31, 2011, GSK recorded net sales in the United States of Horizant of $2.0 million, and in the year ended December 31, 2012, GSK recorded net sales in the United States of Horizant of $6.5 million. Our future product sales of Horizant will be dependent upon the success of our strategies for commercialization, promotion, manufacturing and distribution as well as our ability to successfully execute on these activities and to comply with applicable laws, regulations and regulatory requirements. Specifically, our strategy includes contracting with a contract sales organization that will focus our promotion on specialty doctors in certain geographic territories. However, our commercialization strategy for Horizant is unproven and our commercialization efforts may not be successful. In addition, our lack of commercialization experience, as an organization and with respect to Horizant product sales, will make future operating results difficult to predict.

Gabapentin enacarbil is licensed to Astellas Pharma Inc. in Japan and five other Asian countries. In July 2012, Astellas initiated sales of Regnite in Japan. We are entitled to receive percentage-based high-teen royalties on net sales of Regnite in Japan, and the royalties will be recognized when royalty payments are received.

During the year ended December 31, 2012, royalty revenue from net sales of Regnite in Japan was only $0.1 million. We expect royalty revenues from our collaboration with Astellas to fluctuate based on the results of their commercialization, marketing and distribution efforts of Regnite in Japan. Additionally, we expect revenues to fluctuate to the extent we enter into new collaborative agreements for our marketed product or any of our product candidates.

We expect our research and development expenses to increase in 2013 primarily due to the AP Phase 3 spasticity and XP23829 development programs as well as regulatory costs related to the commercialization of Horizant. The timing and amount of research and development expenses incurred will primarily depend upon the extent of current or future clinical trials for AP and XP23829 and post-marketing requirements for Horizant as well as the related expenses associated with our development organization, regulatory requirements for our product candidates and Horizant, advancement of our preclinical program and product candidate manufacturing costs. Our future research and development expenses are subject to numerous assumptions that may prove to be wrong and also are subject to risks related to the difficulty and uncertainty of clinical success and regulatory approvals of our product candidates.

On July 30, 2012, we completed an underwritten public offering of 7,076,922 shares of our common stock at a price to the public of $6.50 per share, including 923,076 shares representing the exercise in full of the over-allotment option granted to the underwriters. Net cash proceeds from the public offering were $43.0 million, after deducting the underwriting discounts and commissions and offering expenses payable by us.

We believe that our existing capital resources, together with interest thereon, will be sufficient to meet our projected operating requirements into the second quarter of 2014. However, we have based our estimate of cash sufficiency on assumptions that may prove to be wrong, and we could utilize our available capital resources sooner than we expect. Further, our operating plan may change, and we may need additional funds to meet operational needs and capital requirements for product development and commercialization sooner than planned. We have no credit facility or committed sources of capital other than potential contingent event-based and royalty payments that we are eligible to receive under our collaboration agreement with Astellas. Pursuant to the termination and transition agreement with GSK, upon the expiration of the transition period, we will be responsible for all Horizant commercialization and development activities, including all post-marketing requirements and commitments. Such costs could be greater than we anticipate, and sales of Horizant may be less than we anticipate, which could accelerate our need for additional capital.

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Critical Accounting Policies and Significant Judgments and Estimates

Our management's discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenues and expenses during the reporting periods. On an ongoing basis, we evaluate our estimates and judgments related to each of our critical accounting areas. We base our estimates on historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

Revenue Recognition

Revenue arrangements entered into, or materially modified, through December 31, 2010 are accounted for in accordance with the provisions of the Revenue Recognition-Multiple-Element Arrangements topic of the Financial Accounting Standards Board Accounting Standards Codification, or the Codification. A variety of factors were considered in determining the appropriate method of revenue recognition under these arrangements, such as whether the various elements could be considered separate units of accounting, whether there was objective and reliable evidence of fair value for these elements and whether there was a separate earnings process associated with a particular element of an agreement.

The provisions of Accounting Standards Update, or ASU, 2009-13, Multiple-Deliverable Revenue Arrangements, or ASU 2009-13, which is included within the Codification as Revenue Recognition-Multiple-Element Arrangements, will be applied by us to revenue arrangements entered into, or materially modified, beginning January 1, 2011. Under the provisions of ASU 2009-13, we will use a selling price hierarchy for determining the selling price of a deliverable, which will be used to determine the allocation of consideration to each unit of accounting under an arrangement. The selling price used for each deliverable will be based on vendor-specific objective evidence if available, third-party evidence if vendor-specific objective evidence is not available or estimated selling price if neither vendor-specific objective evidence nor third-party evidence is available. As of December 31, 2012, we had not applied the provisions of ASU 2009-13 to any of our revenue arrangements as we had not entered into any new, or materially modified any current revenue arrangements in 2011 or 2012.

The provisions of ASU 2010-17, Milestone Method of Revenue Recognition, or ASU 2010-17, which is included within the Codification as Revenue Recognition-Milestone Method, are being applied by us on a prospective basis for milestones achieved starting in 2011.

Where there are multiple deliverables combined as a single unit of accounting, revenues are deferred and recognized over the period during which we remain obligated to perform services. The specific methodology for the recognition of the revenue (e.g., straight-line or according to specific performance criteria) is determined on a case-by-case basis according to the facts and circumstances applicable to a given agreement. For contracts with specific performance criteria, we utilize the performance-based expected revenue method of revenue recognition, which requires that we estimate the total amount of costs to be expended for a given unit of accounting and then recognize revenue equal to the portion of costs expended to date. The estimated total costs to be expended are subject to revision from time-to-time as the underlying facts and circumstances change.

Payments received in excess of revenues recognized are recorded as deferred revenue until such time as the revenue recognition criteria have been met.

Collaboration revenue includes revenue from our current collaboration agreement with Astellas. Net revenue from unconsolidated joint operating activities included all revenue that resulted solely from our terminated collaboration agreement with GSK. We account for the revenue-related activities of these collaboration agreements as follows:

• Up-front, licensing-type payments. Up-front, licensing-type payments are assessed to determine whether or not the licensee is able to obtain any stand-alone value from the license. Where this is not the case, we

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do not consider the license deliverable to be a separate unit of accounting, and the revenue is deferred with revenue recognition for the license fee being assessed in conjunction with the other deliverables that constitute the combined unit of accounting.

• Milestones. Under the provisions of ASU 2010-17, consideration that is contingent upon achievement of a milestone can be recognized in its entirety as revenue in the period in which the milestone is achieved. Recognition will occur only if the consideration earned from the achievement of a milestone meets all the criteria for the milestone to be considered substantive at the inception of the arrangement, such that it:
(i) is commensurate with either our performance to achieve the milestone or the enhancement of the value of the item delivered as a result of a specific outcome resulting from our performance to achieve the milestone;
(ii) relates solely to past performance; and (iii) is reasonable relative to all deliverables and payment terms in the arrangement.

The provisions of ASU 2010-17 do not apply to contingent payments for which payment is either contingent solely upon the passage of time or the result of a collaborative partner's performance. We will assess the nature of, and appropriate accounting for, these payments on a case-by-case basis in accordance with the provisions of the Revenue Recognition topic of the Codification.

• Profit and loss sharing. This represented our share of the profits and losses from the co-promotion of Horizantwith GSK until the termination of our collaboration agreement. Amounts were recognized in the period in which the related activities occurred, and their financial statement classification was based on our assessment that these activities constituted part of our ongoing central operations.

• Product royalties. We are entitled to receive royalties on net sales of Regnite in the Astellas territory. Astellas initiated sales of Regnite in Japan in July 2012, and we recognize the associated product royalties when they can be reliably measured and collectability is reasonably assured (generally upon receipt of the royalty payment).

Accrued Expenses

As part of the process of preparing financial statements, we are required to estimate accrued expenses. This process involves communicating with our applicable personnel to identify services that have been performed on our behalf and estimating the level of service performed and the associated cost incurred for the service when we have not yet been invoiced or otherwise notified of actual cost. The majority of our service providers invoice us monthly in arrears for services performed. We make estimates of our accrued expenses as of each balance sheet date in our financial statements based on facts and circumstances known to us. We periodically confirm the accuracy of our estimates with selected service providers and make adjustments, if necessary. To date, we have not adjusted our estimate at any particular balance sheet date by any material amount. Examples of estimated accrued expenses include:

• fees paid to contract research organizations in connection with preclinical and toxicology studies and clinical trials;

• fees paid to investigative sites in connection with clinical trials;

• fees paid to contract manufacturers in connection with the production of clinical trial materials; and

• professional service fees.

We base our expenses related to clinical trials on our estimates of the services received and efforts expended pursuant to contracts with multiple research institutions and clinical research organizations that conduct and manage clinical trials on our behalf. The financial terms of these agreements are subject to negotiation, vary from contract to contract and may result in uneven payment flows. Payments under some of these contracts depend on factors such as the successful enrollment of patients and the completion of clinical trial milestones. In accruing service fees, we estimate the time period over which services will be performed and the level of effort to be expended in each period. If we do not identify costs that we have begun to incur or if we underestimate or overestimate the level of services performed or the costs of these services, our actual expenses could differ from our estimates.

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Fair Value Measurements

The carrying amounts of certain of our financial instruments, including cash and cash equivalents and short-term investments, are stated at fair value. We account for the fair value of our financial instruments in accordance with the provisions of the Fair Value Measurement topic of the Codification.

Fair value is the price that would be received to sell an asset or paid to transfer a liability (an exit price) in an orderly transaction between market participants at the measurement date. We apply the market approach valuation technique for fair value measurements on a recurring basis and attempt to maximize the use of observable inputs and minimize the use of unobservable inputs. The fair value hierarchy prioritizes the inputs to valuation techniques used to measure fair value into three broad levels. All of our cash equivalents and short-term investments are measured using inputs classified at Level 1 or Level 2 within the fair value hierarchy. Level 1 inputs are quoted prices in active markets for identical assets. Level 2 inputs are based upon quoted prices for similar instruments in active markets, quoted prices for identical or similar instruments in markets that are not active and model-based valuation techniques for which all significant inputs are observable in the market or can be corroborated by observable market data for substantially the full term of the assets. Level 3 inputs are unobservable inputs that are supported by little or no market activity and are significant to the fair value of the assets or liabilities. Where applicable, these models project future cash flows and discount the future amounts to a present value using market-based observable inputs obtained from various third-party data providers, including but not limited to, benchmark yields, interest rate curves, reported trades, broker/dealer quotes and market reference data.

Stock-Based Compensation

The provisions of the Compensation - Stock Compensation topic of the Codification establish accounting for stock-based awards exchanged for employee services. In accordance with the topic, for stock options, awards and stock purchase rights granted under the 2005 Employee Stock Purchase Plan, stock-based compensation cost is measured on the grant date, based on the fair value of the award, and is recognized as expense over the requisite employee service period.

We estimate the fair value of stock options and stock purchase rights using a Black-Scholes valuation model. The fair value of each option grant is estimated on the date of grant using the Black-Scholes option valuation model, and the resulting charge is expensed using the straight-line attribution method over the vesting period. Restricted stock units are measured at the fair value of our common stock on the date of grant and expensed over the period of vesting using the straight-line attribution approach. The Compensation - Stock Compensation topic of the Codification requires the use of option-pricing models that were not developed for use in valuing employee stock options. The Black-Scholes option-pricing model was developed for use in estimating the fair value of short-lived, exchange-traded options that have no vesting restrictions and are fully transferable. In addition, option-pricing models require the input of highly subjective assumptions, including the option's expected life and the price volatility of the underlying stock. Historically, we derived both the expected life and the expected stock price volatility assumptions using data obtained from similar entities, taking into consideration factors such as industry, stage of life cycle, size and financial leverage. On a prospective basis, beginning in the first quarter of 2011, we have determined that our historical volatility can be used as a reasonable basis to derive the expected stock price volatility assumption and have applied our historical volatility when valuing employee stock options granted beginning in the first quarter of 2011.

We account for stock compensation arrangements to non-employees in accordance with the Equity-Based Payments to Non-Employees topic of the Codification, using a fair value approach. The compensation costs of these arrangements are subject to remeasurement over the vesting terms as earned.

Nonretirement Postemployment Benefits

On May 31, 2012, we adopted the XenoPort Amended and Restated 2012 Severance Plan, or the 2012 Severance Plan, for the benefit of our non-executive employees. Under the terms of the 2012 Severance Plan, a non-executive employee terminated by us because of elimination of his or her position is eligible to receive

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continuation of medical insurance under COBRA and specified severance payments based on the employee's level and years of service with us. We account for employee termination benefits in accordance with the provisions of the Compensation-Nonretirement Postemployment Benefits topic of the Codification and record employee termination liabilities once they are both probable and estimable for severance provided under our existing severance program.

Research and Development Expenses

Research and development expenses consisted of costs associated with both partnered and unpartnered research activities, as well as costs associated with our drug discovery efforts, conducting preclinical studies and clinical trials, manufacturing development efforts and activities related to regulatory filings. Research and development expenses are comprised of: external research and development expenses incurred under agreements with (i) third-party contract research organizations and investigative sites, where a substantial portion of our preclinical studies and all of our clinical trials are conducted,
(ii) third-party manufacturing organizations, where a substantial portion of our preclinical supplies and all of our clinical supplies are produced and
(iii) consultants; employee-related expenses, which include salaries and benefits; and facilities, depreciation and amortization and other allocated expenses, which include direct and allocated expenses for rent and maintenance of facilities, depreciation of leasehold improvements and equipment and laboratory and other supplies. We use our employee and infrastructure resources across multiple research projects, including our drug development programs. We do not allocate our employee and infrastructure costs on a project-by-project basis.

Our current portfolio of proprietary product candidates is summarized in the table below. The table summarizes development initiatives, including the related stages of development and the direct, third-party research and development expenses recognized in connection with each of our product candidates. The information in the column labeled "Estimated Completion of Current Phase" is our current estimate of the timing of completion of the current phase of development. The actual timing of completion could differ materially from the estimates provided in the table. For a discussion of the risks and uncertainties associated with the timing of completing a product development phase, see the "Our success also depends substantially on our product candidates that are still under development. If we are unable to bring any of these product candidates to market, or experience significant delays in doing so, our ability to generate product revenue and our likelihood of success will be reduced;" "If third parties do not manufacture Horizant, Regnite or our product candidates in sufficient quantities or at an acceptable cost, commercialization of Horizant and Regnite and clinical development and commercialization of our product candidates would be harmed or delayed;" "If we are required to obtain alternate third-party manufacturers, it could delay or prevent the clinical development and commercialization of our product candidates;" "Use of third-party manufacturers may increase the risk that we will not have adequate supplies of Horizant or our product candidates;" "If our preclinical studies do not produce successful results or our clinical trials do not demonstrate safety and efficacy in humans, we will not be able to commercialize our product candidates;" "Any failure or delay in commencing or completing clinical trials for our product candidates could severely harm our business;" "We rely on third parties to conduct our clinical trials. If these third parties do not perform as contractually required or expected, we may not be able to obtain regulatory approval for, or commercialize, our product candidates;" "If we or Astellas are not able to obtain or maintain required regulatory approvals, we or Astellas will not be able to commercialize Horizant, Regnite or our product candidates, our ability to generate revenue will be materially impaired and our business . . .

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