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SCLN > SEC Filings for SCLN > Form 10-K on 1-Apr-2013All Recent SEC Filings




Annual Report

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

This Management's Discussion and Analysis of Financial Condition and Results of Operations should be read in conjunction with the "Selected Financial Data" and our consolidated financial statements and related notes thereto included elsewhere in this Annual Report on Form 10-K. This Management's Discussion and Analysis of Financial Condition and Results of Operations and other parts of this Annual Report on Form 10-K contain forward-looking statements which involve risks and uncertainties. See "Note Regarding Forward-Looking Statements" and "Risk Factors" contained in this Annual Report on Form 10-K.


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 to grow our revenue and profitability through our strong sales and marketing efforts. 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 many years of experience marketing our lead product, ZADAXIN® (thymalfasin). In addition, we have an established product promotion business model with large pharmaceutical partners and we are focused on establishing profitability in all of these collaborations. We believe our sales and marketing strengths position us to benefit from the long-term expansion of the pharmaceutical market in China. This pharmaceutical market currently ranks third among the global pharmaceutical markets, and we believe China will rank second among global pharmaceutical markets by 2020. We seek to expand our presence in China and increase revenues by growing sales and profitability of our current product portfolio, launching new products from our development pipeline, adding new, profitable product services agreements and leveraging our strong cash position to in-license additional products.

We operate in two segments which are generally based on the nature and location of our customers: 1) China and 2) the rest of the world which includes our US and Hong Kong operations.

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. ("Pfizer") 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 the products we promote under services agreements and we anticipate 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, can increase the future revenues and profitability of our pharmaceutical business in China over the coming years. Our "promotion services revenues" result from fees we receive for exclusively promoting products under services agreements with certain pharmaceutical partners, including Sanofi Aventis S.A. ("Sanofi") and Baxter International, Inc. ("Baxter") in China. We refer to these agreements as promotion agreements, service agreements and distribution contract rights agreements. We recognize promotion services revenues as a percentage of our collaborators' product sales revenue for these 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. In January 2013, our promotion agreement with Sanofi was renewed until December 31, 2013 under the same terms as our previous agreement. As we seek renewals of our product services agreements, our strategy is to establish more favorable terms with the goal of achieving profitability under these agreements through improved margins as well as through managing expenses relating to our product services revenue.

ZADAXIN is approved in over 30 countries and may be used for the treatment of HBV, 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

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(issued by the Chinese Medical Association). Our sales force is focused on increasing sales to the country's largest hospitals (class 3 with over 500 beds) as well as mid-size 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 widening our market strategies by targeting numerous smaller hospitals as well as hospitals that are in more rural areas. We are also seeking to expand the indications for which ZADAXIN could be used, including sepsis.

Our market portfolio also includes the anti-epileptic drug Depakine, the hypnotic Stilnox (marketed as Ambien ® in the US), the ACE inhibitor Tritace, and Aggrastat, an intervention cardiology product launched in China in 2009.

We are also pursuing the registration of several other therapeutic products in China. These include: DC Bead®, an embolic acting bead with drug loading capabilities that can be used 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 continue to seek to establish profitable in-licensing arrangements for approved or late-stage branded, well-differentiated products which 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.

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 strengthen our sales and marketing infrastructure in China, with the goal of meeting the growing demand for pharmaceuticals in the China market. However, we believe that several developments in 2012 had, or may yet have, material impacts on the growth rate of our business in China and affected 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 include, but are not limited to: a reduction in the retail price for ZADAXIN and other products that occurred later in the year than expected; an increase in the channel inventory levels of ZADAXIN during the third quarter and particularly in September of 2012; matters relating to our NovaMed acquisition, including a non-cash impairment loss to fully write down the value of the licensing and product services agreement intangible assets recorded as part of the NovaMed acquisition; a remeasurement of the valuation of the contingent consideration expense recorded as part of the NovaMed acquisition; issues in internal control over financial reporting primarily within the NovaMed subsidiary; and changes in management.

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%. The reduction was announced in September 2012 and became effective October 8, 2012. Based on an agreement with our primary importer of ZADAXIN into China, this importer will take a larger share of the price reduction impact in exchange for certain exclusive importation rights into China. As a result, the actual impact on SciClone's revenue and margins is expected to be less than a 5% decrease in our sales price of ZADAXIN to this importer. In addition, the National Development and Reform Commission's ("NDRC") retail list prices (or the price at the hospital pharmacy level), for Aggrastat, as well as for several of our oncology products exclusively promoted in China for Pfizer and Baxter, were reduced ranging from 10 to 20%.

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ZADAXIN Inventory and Sales

China uses a tiered system to import and distribute products. The distributors make the sales in the country, but the product is imported for them by our exclusive ZADAXIN importer. Our product sales revenues result from the sale of our products to our customers, the importing agent. It takes approximately seven weeks for our customers to clear a shipment of ZADAXIN through the importation process for sale in China. Our China importation customer tends 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 and we believe that our sales to our customers exceeded the pace at which our customers were able to sell ZADAXIN through to other parties, primarily hospital pharmacies. ZADAXIN channel inventory levels decreased by approximately $5 million in the fourth quarter of 2012, and we expect them to continue to decrease over the next two quarters. As a result, we expect that ZADAXIN revenues will be lower in the first half of 2013, compared to the first half of 2012. We expect our 2013 sales revenue to be lower than or comparable to our 2012 revenues of $156 million. We continue to believe that we will grow demand for ZADAXIN through increased penetration in the market.

In addition, we believe that our sales organization's efforts relative to ZADAXIN may have been affected by changes to and turnover in management in China, particularly the departures of senior executives. Turnover among sales personnel in the China market generally, including among our own sales staff, is expected to continue, and we may experience additional departures in our China operations. During this transition period, if we are unable to achieve 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.

We have taken definitive steps to address the issues affecting product sales. We have revised and we are implementing changes in our strategy designed to increase 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 with the intent 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 the recent appointment of a Chief Executive Officer for our China operations, and we are aggressively recruiting additional management for our China operations. Our recent and continuing executive recruiting in China is intended to bring in additional pharmaceutical company experience in the China market to grow ZADAXIN sales, to increase profitability, to enhance our financial capabilities and internal controls, 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. Although revenues from the NovaMed business have grown since the acquisition, overall revenue growth and profitability have not met the expectations we forecast at the time of the acquisition. This condition was considered to be an impairment indicator with respect to the intangible assets related to our promotion and distribution contract rights. During the third quarter ended September 30, 2012, 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 for the third quarter and full year ended December 31, 2012 on our consolidated statements of operations.

In January 2013, our promotion agreement with Sanofi was renewed until December 31, 2013 under the same terms as the prior agreement. Certain of our other product services agreements with third parties will be

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expiring soon unless renewed, extended or renegotiated. We are actively negotiating renewals or extensions of these agreements. 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 renegotiate, renew or extend the agreements on terms acceptable to us, our revenues and profitability would be affected.

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 was remeasured each quarter and changes to the fair value were recorded to contingent consideration expense or gain. As of December 31, 2012, we determined the fair value of the contingent consideration was $0, resulting in a non-cash gain of $15.4 million for the year ended December 31, 2012. The significant reduction in the valuation of the contingent consideration expense during the year was related to revenue and EBITDA (earnings before interest, depreciation and taxes) targets not being achieved and to the reduced probability of renewal relating to NovaMed's product distribution agreements, including, in particular, the target of renewing the Depakine services agreement with Sanofi for a five-year term. The Depakine services agreement was extended through December 31, 2013, a term less than five years.

Restatement of Financial Results

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

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 our distributors of our subsidiary NovaMed. Our policy is that all customers' obligations to pay for product are final once product is delivered. However, we have 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). Effective as of the fourth quarter of 2012, we entered into a new agreement with that distributor which clarified the "sell-in" method of revenue recognition to provide consistency with our policy regarding revenue recognition on a prospective basis. As of December 31, 2012, we had received payment for all revenues recognized under the "sell-through" method.

• The recognition of previously unrecognized product return reserves for sales of Aggrastat sold by our subsidiary NovaMed prior to the date of 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 the 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

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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. The revisions for the year ended December 31, 2011 had an impact of decreasing our revenues by $1.1 million and decreasing our net income by $0.3 million. Basic and diluted earnings per share decreased by $0.01. As of December 31, 2011, accounts receivable decreased by $3.8 million, inventory increased by $2.3 million and goodwill related to the acquisition of NovaMed increased by $1.9 million.

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 related to our NovaMed subsidiary. Certain out of period adjustments and these deficiencies were identified through the performance of controls and processes recently implemented at our NovaMed subsidiary as part of our assessment of internal control over financial reporting in 2012. We concluded that the aggregation of these deficiencies is 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 related controls at our NovaMed subsidiary, and the corporate monitoring thereof. We concluded that these deficiencies identified in the fourth quarter of 2012 are an additional indicator of the material weakness that was identified in the third quarter of 2012.

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 recent 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 are not complete as of December 31, 2012.

China 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 who will begin April 1, 2013, and a Chief Financial Officer, China Operations who began August 2012.

Other 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 $1.1 million, of which approximately $0.1 million and $1.0 million were recognized to general and administrative and research and development expense, respectively, for the year ended December 31, 2012. We have substantially completed the restructuring.

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The US Securities and Exchange Commission ("SEC") and the US 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 substantially concluded its original 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.

In our Form 10-Q for the period ended September 30, 2012, filed with the SEC on November 9, 2012, we disclosed, among other things, a non-cash impairment loss to fully write down the value of intangible assets recorded as part of the NovaMed acquisition; a remeasurement of the valuation of the contingent consideration expense recorded as part of the NovaMed acquisition; a significant increase in ZADAXIN channel inventory levels; and internal control issues primarily within the NovaMed organization that was concluded to represent a material weakness in internal control over financial reporting. Following our disclosure of these items, we received a subpoena from the SEC requesting documents related to these and various other matters regarding the NovaMed acquisition and our operations in China. After review of the subpoena, and in order to respond to inquiries from the DOJ and SEC and to determine if any wrong-doing occurred, our Audit Committee determined to undertake an additional independent investigation as to additional matters including, but not limited to, matters related to our acquisition of NovaMed and FCPA matters.

We are unable to predict what consequences any investigation by any regulatory agency or by our Special Committee may have on us. Our cooperation with these investigations has resulted in substantial legal and accounting expenses, has diverted management's attention from other business concerns and could harm our business. The ongoing investigations and any other regulatory investigations that might be initiated in the future will result in similar substantial expenses, management diversion and harm to our business. If we fail to comply with regulations or to carry out controls on our Chinese or other foreign operations in a manner that satisfies all applicable laws, our business would be harmed. Any civil or criminal action commenced against us by a regulatory agency 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 certain of our officers, directors and/or employees. The investigations, results of the investigations, or remedial actions we have taken or may take as a result of such investigations may adversely affect our business in China. If we are subject to adverse findings resulting from the SEC and DOJ investigations, or from our own independent investigation, we could be required to pay damages or penalties or have other remedies imposed upon us. In addition, we will incur additional expenses related to remedial measures we are undertaking, and could incur fines or other penalties. The period of time necessary to resolve the investigations by the DOJ and the SEC is uncertain, and these matters could require significant management and financial resources which could otherwise be devoted to the operation of our business. We cannot predict what the outcome of those investigations will be, or the timing of any resolution.

On February 22, 2013, we announced that our reported financial results for each of the second and third quarters of 2011, the year ended December 31, 2011, and the first three quarters of fiscal 2012 could not be relied upon and that we would restate them. Subsequently, we received a purported derivative litigation naming certain of our officers and directors as defendants. We believe the claims lack merit and will vigorously defend against them.

Refer to Part II, Item 8 "Notes to Consolidated Financial Statements" Note 18 "Other Corporate Matters" and Part I, Item 3 "Legal Proceedings" in this Form 10-K for further information regarding the investigation and remedial measures, and related litigation.

We believe our cash and investments as of December 31, 2012 and ongoing revenue generating business operations will be sufficient to support our current . . .

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