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SCLN > SEC Filings for SCLN > Form 10-Q/A on 1-Apr-2013All Recent SEC Filings

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Quarterly Report

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

Special Note Regarding Forward-Looking Statements

This Quarterly Report on Form 10-Q/A contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. These forward-looking statements are based on our current expectations, estimates and projections about our business, industry, management's beliefs and certain assumptions made by us. Words such as "anticipate," "expect," "intend," "plan," "believe" or similar expressions are intended to identify forward-looking statements including those statements we make regarding our future financial results; anticipated product sales of current or anticipated products; the sufficiency of our resources to complete clinical trials and other new product development initiatives; government regulatory actions that may affect product reimbursement, product pricing or otherwise affect the scope of our sales and marketing; the timing and outcome of clinical trials; prospects for ZADAXIN ® and our plans for its enhancement and commercialization as well as our expectations regarding other products; future size of the worldwide hepatitis B virus ("HBV") and hepatitis C virus ("HCV") and other markets; research and development and other expense levels; the ability of our suppliers to continue financially viable production of our products; cash and other asset levels; the allocation of financial resources to certain trials and programs, and expenses related to litigation and regulatory investigations. These statements are not guarantees of future performance and are subject to certain risks, uncertainties and assumptions that are difficult to predict. Therefore, our actual results could differ materially and adversely from those expressed in any forward-looking statements as a result of various factors including, but not limited to, those described under the caption "Risk Factors" in this Quarterly Report on Form 10-Q/A. We undertake no obligation to revise or update publicly any forward-looking statements for any reason.


SciClone Pharmaceuticals (NASDAQ: SCLN) is a revenue-generating, profitable, United States ("US")-based, China-focused, specialty pharmaceutical company with a substantial commercial business and a product portfolio of therapies for oncology, infectious diseases, cardiovascular, urological, respiratory, and central nervous system disorders. We are focused on continuing international sales growth through our strong sales and marketing efforts and growing our profitability. Our business and corporate strategy is focused primarily on the People's Republic of China ("China") where we have built a solid reputation and established a strong brand through our many years of experience marketing our lead product, ZADAXIN. We believe our strengths position us to benefit from the long-term expansion of the pharmaceutical market in China. We believe China will rank second among global pharmaceutical markets by 2016, with projected growth rates of 15% or more annually over the next several years. We seek to grow sales of our current product portfolio in the region while we leverage our strong cash position for product in-licensing.

We aim to expand our presence in China by increasing revenues from our key products, launching products in our pipeline, in-licensing additional products and adding new product services agreements. Our current portfolio spans major therapeutic areas including oncology, infectious diseases, cardiovascular, urological, respiratory and central nervous system disorders. We operate in two segments which are generally based on the nature and location of our customers:
1) China and 2) rest of the world, including the US.

We have two categories of revenues: "product sales revenues" and "promotion services revenues." Our product sales revenues result from our proprietary and in-licensed products, including our lead product, ZADAXIN, and products from Pfizer Inc. and Iroko Pharmaceuticals LLC. ZADAXIN has the highest margins in our portfolio as it is a premium proprietary product sold exclusively by SciClone. Aggrastat®, an in-licensed product, has higher margins than our products we promote under services agreements and we expect that revenues from this product will grow significantly as it further penetrates the China market. In addition, we anticipate that new marketed products, when and if introduced, such as DC Bead®, Tramadol®, and ondansetron RapidFilm®, can increase the future revenues and profitability of our pharmaceutical business in China over the coming years. In the first quarter of 2012, we received notification of the approval in China of Tramadol for use in the treatment of moderate to severe pain. See Part II, Item 1 "Legal Proceedings" regarding the status of our agreement with MEDA Pharma GmbH & Co. KG ("MEDA") regarding Tramadol and other products in development. Our "promotion services revenues" result from fees we receive for exclusively promoting products under services agreements with certain partners, including Sanofi and Baxter International, Inc. in China. We refer to these agreements as promotion agreements, service agreements and distribution contract rights. We recognize promotion services revenues as a percentage of our collaborators' product sales revenue for our exclusively promoted products, such as Depakine®, Stilnox®, and Tritace®. Over time, as additional proprietary or in-licensed products come to the market, we aim to shift our product mix towards those higher margin products. We are also attempting to improve margins under our product services agreements through changes in terms as we seek renewals of those agreements, as well as through managing expenses relating to generating our product services revenue.

SciClone's ZADAXIN (thymalfasin) is approved in over 30 countries and may be used for the treatment of HBV, hepatitis C ("HCV"), and certain cancers, and as a vaccine adjuvant according to the local regulatory approvals we have in these countries. In China, thymalfasin is included in the treatment guidelines issued by the Ministry of Health ("MOH") for liver cancer, as well as guidelines for treatment of chronic HBV (issued by both the Chinese Medical Association and the Asian-Pacific Association for the Study of the Liver) and invasive fungal infections of critically ill patients (issued by the Chinese Medical Association). To grow ZADAXIN sales to China, our sales force is focused on increasing sales to the country's largest hospitals (class 3 with over 500 beds) as well as midsize hospitals (class 2). These hospitals serve Tier 1 and Tier 2 cities located mostly in the eastern part of China which are the largest and generally have the most affluent populations. We are also seeking to expand the indications for which ZADAXIN is used, including sepsis.

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SciClone's marketed portfolio also includes Depakine, the most widely prescribed broad-spectrum anti-convulsant in China; Tritace, an ACE inhibitor for the treatment of hypertension; Stilnox, a fast-acting hypnotic for the short-term treatment of insomnia (marketed as Ambien ® in the US); and Aggrastat, an intervention cardiology product launched in 2009.

SciClone is also pursuing the registration of several other therapeutic products in China. These include: DC Bead, an embolic drug-eluting bead for targeted delivery of cancer chemotherapy drugs directly to the tumor; Loramyc®, a mucoadhesive tablet formulation of miconazole lauriad to treat oropharyngeal candidiasis; Rapinyl®, a sublingual tablet formulation of fentanyl to treat breakthrough cancer pain; and RapidFilm, an oral film formulation of ondansetron to treat nausea induced by chemotherapy.

We acquired NovaMed Pharmaceuticals, Inc. ("NovaMed") on April 18, 2011 and our results of operations include the operations of NovaMed as of that date forward. Since the acquisition of NovaMed, we have put strategies in place designed to expand and strengthen our sales and marketing infrastructure in China, with the goal of meeting the growing demand for pharmaceuticals in the China market. The expansion of our sales force with the addition of more than 130 sales, marketing, and sales support representatives since last year, and organization of the sales force into business units focusing on ZADAXIN, primary care and oncology, were consistent with this goal. We believe that these strategies had a positive effect on our business in the year following the acquisition. However, we believe that several developments in the third quarter of 2012 had, or may yet have, material impacts on the growth rate of our business in China and the Company's financial results in the second half of 2012. We are responding to these developments by taking actions to strengthen our business and improve our financial performance in subsequent quarters. These developments pertain to: a reduction in the retail price for ZADAXIN and other products that occurred later in the year than expected; the channel inventory of ZADAXIN; NovaMed acquisition matters, including our licensing and product services agreements with third parties and contingent consideration remeasurement; issues in internal control over financial reporting primarily within the NovaMed subsidiary; and management turnover.

Price Reduction for ZADAXIN and Other Products

ZADAXIN's national reimbursement retail list price in China was recently reviewed by regulatory authorities consistent with the China government's review of pharmaceutical prices once a product has been included into the Reimbursement Drug List ("RDL"). As a result of this review, the retail list price (or the price at the hospital pharmacy level) of ZADAXIN was reduced by approximately 18% in China. The reduction was announced September 2012 and became effective October 8, 2012. Based on an agreement with our primary importer of ZADAXIN into China, our importer will take a larger share of the price reduction impact, and the actual impact on SciClone's revenue and margins is expected to be less than a 5% decrease in our future sales price of ZADAXIN to the importer in China. In exchange for this favorable arrangement, we expanded exclusivity for the importer. In addition, the National Development and Reform Commission ("NDRC") price of Aggrastat, as well as several of our oncology products exclusively promoted in China for Pfizer and Baxter were reduced ranging from 10 to 20%.

We have not negotiated any particular arrangement regarding the sharing of these price reductions for products other than ZADAXIN with our partners, but generally, under our agreements, the effect on our per unit revenues would be approximately half of the reduction in price at the hospital retail level.

Over the long term, we anticipate that the price reductions may positively affect our sales volumes and result in broader penetration into Tier 3 and Tier 2 cities in target geographies, potentially increasing our total sales revenues from these products.

ZADAXIN Inventory and Sales

China uses a tiered method to import and distribute products. The distributors make the sales in the country, but the product is imported for them by licensed importers. Our product sales revenues result from the sale of our products to our customers, the importing agents and distributors. It takes approximately seven weeks for our customers to clear a shipment of ZADAXIN through the importation process for sale in China. Our customers tend to purchase infrequent large orders of ZADAXIN inventory to facilitate the distribution and sale to Chinese hospital pharmacies. The timing of infrequent large orders may significantly affect the ZADAXIN channel inventory levels and may cause fluctuations to our reported sales and profitability for each quarterly period.

During the third quarter and particularly in September 2012, we estimate that there was an increase of approximately $14 million in ZADAXIN channel inventory levels. We believe the overall market for thymalfasin has continued to grow, but that our strategy of increasing demand for ZADAXIN through various measures, including the expansion of our ZADAXIN sales force, has not led to the increased demand for ZADAXIN in the hospital pharmacies we anticipated in 2012. We continue to believe that we can increase penetration in the market and grow demand for ZADAXIN. During the nine months ended September 30, 2012, we believe that our sales to our customers have exceeded the pace at which our customers have been able to sell ZADAXIN through to other parties, primarily hospital pharmacies. During the six months ended June 30, 2012, we believe that the levels of ZADAXIN channel inventory grew moderately. During the three months ended September 30, 2012, we believe that the levels of ZADAXIN channel inventory grew significantly. We estimate that approximately $14 million of our revenue recognized in the three months ended September 30, 2012 related to the increase of ZADAXIN channel inventory levels at our customers in China. This increase in ZADAXIN channel inventory may adversely affect our revenue in future quarters.

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We have revised and we are implementing changes in our strategy for ZADAXIN market penetration. In addition, we believe that our sales organization's efforts may have been affected by changes to and turnover in senior management. We are recruiting experienced new senior-level sales and other management, particularly following the announced departures of two of our senior executives in China. We are also taking other measures which may address the channel build up, including working with one importer on an exclusive basis and implementing various programs to expand market demand. There may be additional departures among senior sales personnel in our ZADAXIN business unit. During this transition period, if we are unable to achieve our objectives for increased demand, we may experience declines in our quarterly sales revenue in the near term and our sales and profitability for the next few quarters may significantly decrease.

To expand market penetration and growth, particularly for ZADAXIN, we are widening our market strategies by targeting numerous smaller hospitals as well as hospitals that are in more rural areas. We are also piloting a program for "cross selling" ZADAXIN with our oncology sales force to further leverage their market reach. The implementation of these strategies has commenced in the fourth quarter. These additional strategies are intended to positively affect sales growth over the next several quarters. In addition, we have already been successful in making significant changes in our China organization with the recruitment of additional senior level management, and we are aggressively recruiting additional management for our China operations to address recent departures. Our recent and continuing executive recruiting is intended to bring added multi-national pharmaceutical company experience in the China market to grow ZADAXIN sales, to manage profitability and to improve and implement our sales strategies.

NovaMed: Intangible Asset Impairment; Contingent Consideration Remeasurement

We acquired NovaMed on April 18, 2011, and our results of operations include the operations of NovaMed as of that date forward. The acquisition increased our portfolio of commercial and development-stage products through exclusive licensing and product service agreements with a number of leading pharmaceutical companies. However, although revenues from the NovaMed business have grown since the acquisition, and are expected to continue to grow in the fourth quarter, overall revenue growth and profitability have not met our expectations as forecast at the time of the acquisition. This condition is considered to be an impairment indicator with respect to the intangible assets related to our promotion and distribution contract rights. We determined that the undiscounted cash flows estimated to be generated by the intangible assets were less than the carrying amounts. We further performed a discounted cash flow analysis related to the intangible assets and determined that a full impairment should be recorded. As a result, we recognized a non-cash impairment loss of approximately $42.7 million on our Condensed Consolidated Statement of Operations for the three- and nine-month periods ended September 30, 2012.

Certain of our product services agreements with third parties will be expiring over the next several months unless renewed, extended or re-negotiated; most importantly, our agreement with Sanofi to promote Depakine expires on June 30, 2013. We are actively negotiating renewals or extensions of these agreements. We are also in the process of assessing the financial performance of the products we promote under these agreements and their overall value within our entire portfolio of products. We are also assessing the terms and conditions of our agreements with the intent to secure more favorable terms to us relative to profitability. If any of these agreements are determined to no longer be beneficial to us and are allowed to expire, or if third parties will not re-negotiate, renew or extend the agreements on terms acceptable to us, our revenues and profitability would be adversely affected.

We continue to seek to establish profitable in-licensing arrangements for approved or late-stage branded, well-differentiated products that if not yet approved, have a clear regulatory approval pathway in China based on existing regulatory approval outside of China. Our objective is to in-license products with higher margins that can augment our product sales revenue, and we continue to explore opportunities to optimize our promotion services revenues. We are also working on the final stage of the regulatory approval in China for our in-licensed candidate DC Bead, and on the approval process for our other product candidates, all of which are in clinical trials or in other stages of the regulatory approval process in China.

The terms of our acquisition of NovaMed provided for the payment of an additional $43.0 million in earn-out payments upon the successful achievement of revenue and earnings targets for the 2011 and 2012 fiscal years (the "earn-out" or "contingent consideration"). We initially recorded $18.9 million as the estimated fair value of the contingent consideration. The fair value of the contingent consideration is remeasured each quarter, and changes to the fair value are recorded to contingent consideration expense or gain. As of September 30, 2012, we estimated the fair value of the contingent consideration will be $0.6 million, resulting in a non-cash gain of $12.8 million and $14.9 million for the three- and nine-month periods ended September 30, 2012, respectively. The significant reduction in the valuation of the contingent consideration expense during the third quarter was primarily related to the decrease in the estimated probability of achieving targets relating to NovaMed's product distribution agreements, including the renewal of the Depakine services agreement with Sanofi for a five-year term. The Depakine services agreement expires in June 2013. We currently are negotiating an extension of that agreement, but believe that any initial extension will be for less than a five-year term.

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Internal Control Issues - Material Weakness

During the quarter ended September 30, 2012, we identified deficiencies in the design and operating effectiveness of controls primarily associated with product return reserves related to our Aggrastat product line, and the override of certain controls in the financial statement close process each related to our NovaMed subsidiary. We concluded that the aggregation of these deficiencies was a material weakness. Furthermore, during the fourth quarter of 2012, we identified deficiencies related to the timing of revenue recognition for our Pfizer products, the override of controls related to our NovaMed subsidiary, and the corporate monitoring thereof. We concluded that these deficiencies identified in the fourth quarter of 2012 are indicative of the continuation of the material weakness that was identified in the third quarter of 2012. The misstatements related to this material weakness affected our financial reporting from the date of the NovaMed acquisition in the second quarter of 2011. We have discussed these matters with our independent registered public accounting firm and our Audit Committee.

With the oversight of management and our Audit Committee, we have initiated steps to address the material weakness. In the fourth quarter of 2012, we implemented additional controls related to our revenue recognition and product return reserve processes to strengthen our controls and provide that all available information is properly considered. We also re-evaluated the operation of our controls at our NovaMed subsidiary and made adjustments to strengthen these controls, including the hiring of our Chief Financial Officer, China Operations who joined the Company in the third quarter of 2012. We terminated personnel who were involved in the override of certain controls in the financial statement close process at our NovaMed subsidiary that resulted in the material weakness. While we have completed certain remediation efforts, our remediation activities were not complete as of December 31, 2012.

Management Turnover

We announced departures of key personnel from our China organization. These include the individual who was our Chief Executive Officer of SciClone's China operations and former Chief Executive Officer of NovaMed who resigned in December 2012, and our Chief Operating Officer in China who left the Company in October 2012. There may be additional departures within our China operations. We have and are continuing to recruit executives to address the departures and to expand and strengthen our China operations including the hiring of both a new Chief Executive Officer, China Operations and Chief Financial Officer, China Operations.

Other Ongoing Third Quarter Matters

We were developing SCV-07 in a phase 2b clinical trial for the prevention of oral mucositis ("OM"). On March 2, 2012, we announced the discontinuation of this trial based on the pre-planned interim analysis results that indicated the trial would not meet the pre-specified efficacy endpoints, and our intention to further curtail our US-based development efforts. In March 2012, we implemented a reduction in our workforce of 11 full-time employees, primarily in research and development, and recorded severance-related charges of approximately $1.0 million, of which approximately $0.1 million and $0.9 million were recognized to general and administrative and research and development expense, respectively, for the nine-month period ended September 30, 2012. We have substantially completed the restructuring.

The United States Securities and Exchange Commission ("SEC") and the United States Department of Justice ("DOJ") are each conducting formal investigations of SciClone regarding a range of matters including the possibility of violations of the Foreign Corrupt Practices Act ("FCPA"). We will continue to cooperate fully with the SEC and DOJ in the conduct of their investigations. In response to these matters, our Board appointed a Special Committee of independent directors (the "Special Committee") to oversee our response to the government inquiry. The Special Committee has substantially concluded its investigation and on May 4 and 5, 2011 reported its findings and recommendations to the Board of Directors. The Special Committee has also reported findings to the SEC and DOJ. The SEC's and DOJ's formal investigations are continuing. These continuing investigations could result in administrative orders against us, the imposition of significant penalties and/or fines against us, and/or the imposition of civil or criminal sanctions against us or certain of our officers, directors and/or employees. We cannot predict what the outcome of those investigations will be, or the timing of any resolution. Refer to Footnote 11 "Other Corporate Matters" and Part II, Item 1 "Legal Proceedings" in this Form 10-Q/A for further information regarding the investigation and remedial measures, and related litigation.

We believe our cash and investments as of September 30, 2012 and ongoing revenue generating business operations will be sufficient to support our current operating plan for at least the next 12 months. Our results may fluctuate from quarter to quarter and we may report quarterly losses in the future.

Restatement of Financial Results

We have revised our condensed consolidated financial statements for each of the third quarters and year to date periods of 2011 and 2012. Accordingly, the revised financial information included in this Form 10-Q/A has been identified as "restated". Concurrent with the filing of this Form 10-Q/A, we are also filing amended quarterly reports on Form 10-Q/A for each of the first and second quarters of 2012 to restate our consolidated financial statements therein, including the second and third quarters and year to date periods of 2011, and are filing a Form 10-K for the fiscal year ended December 31, 2012 which includes restated financial statements for the year ended December 31, 2011.

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The restatements relate to accounting errors originating with our subsidiary in China, NovaMed, which was acquired on April 18, 2011. The accounting errors relate primarily to the following:

• The timing of revenue recognition for certain Pfizer products sold by one of the distributors of our subsidiary, NovaMed. Our policy is that all customers' obligations to pay for product are final once product is delivered. However, we determined that there were various factors, including the override of certain controls, indicating that sales under NovaMed's distribution arrangement for Pfizer products with such distributor from the date of acquisition of NovaMed through the third quarter of 2012 ("the Relevant Periods") allowed for contingent payment terms dependent upon when that distributor sold the products. As a result of our review and evaluation of the matter, we believe that instead of recording revenue at the time of sale to that distributor ("sell-in" method), as previously reflected in the financial statements for the Relevant Periods, revenue under the arrangements in effect at our subsidiary NovaMed should have been recognized when we received payment for the products ("sell-through" or "cash receipts" method).

• The recognition of previously unrecognized product return reserves for sales of Aggrastat sold by our subsidiary NovaMed prior to the date of the acquisition. We have concluded a liability for expired product existed at the time of the NovaMed acquisition, related to pre-acquisition sales.

The revisions had an impact of increasing our revenues by $3.0 million for the nine-months ended September 30, 2012, and increasing our net income by $2.0 million for the same period. Basic and diluted earnings per share increased by $0.04 and $0.03, respectively, for the nine-months ended September 30, 2012. As of September 30, 2012, accounts receivable decreased by $1.5 million, inventory increased by $1.3 million, and goodwill related to the acquisition of NovaMed increased by $1.9 million.

Results of Operations


The following table summarizes the period over period changes in our product
sales and promotion services (in thousands):

                         Three Months Ended                        Nine Months Ended
                           September 30,                             September 30,
. . .
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