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U. S. SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549

Form 10-Q

For the quarterly period ended June 30, 2002

OR

Commission File Number 0-27264

GenStar Therapeutics Corporation
(Exact name of registrant as specified in its charter)

DELAWARE
(State or other jurisdiction of
incorporation or organization)

33-0687976
(I.R.S. Employer
Identification no.)

Registrant’s Telephone Number, including area code:  (858) 450-5949

Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.  Yes x No o

The number of shares of the Common Stock of the registrant outstanding as of August 9, 2002, was 23,927,806.

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GenStar Therapeutics Corporation
(A development stage enterprise)

INDEX TO FORM 10-Q

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GENSTAR THERAPEUTICS CORPORATION
(A development stage enterprise)
CONDENSED CONSOLIDATED BALANCE SHEETS

See accompanying notes.

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GENSTAR THERAPEUTICS CORPORATION
(A development stage enterprise)
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)

See accompanying notes.

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GENSTAR THERAPEUTICS CORPORATION
(A development stage enterprise)
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)

See accompanying notes.

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GENSTAR THERAPEUTICS CORPORATION
(A development stage enterprise)

NOTES TO UNAUDITED CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
June 30, 2002

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Item 2.        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 contains forward-looking statements that are subject to a variety of risks and uncertainties including those set forth in our Annual Report on Form 10-KSB for the year ended December 31, 2001 under “Risks and Uncertainties”. The statements that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including without limitation statements regarding the Company’s expectations, beliefs, intentions or strategies regarding the future. All forward-looking statements included in this document are based on information available to the Company on the date hereof, and the Company assumes no obligation to update any such forward-looking statements. The Company’s actual results could differ materially from those anticipated in these forward-looking statements. The following information should be read in conjunction with the condensed consolidated financial statements and the notes thereto included in Item 1 of this quarterly report.  We also urge readers to review and consider our disclosures describing various factors that affect our business in our Annual Report on Form 10-KSB for the year ended December 31, 2001, including the disclosures under the captions “Management’s Discussion and Analysis of Financial Condition and Results of Operations”, “Cautionary Factors that May Affect Future Results” and “Risks and Uncertainties”, as well as the audited financial statements and notes thereto contained in such report.

OVERVIEW

GenStar Therapeutics Corporation is a biotechnology company dedicated to the development of innovative gene therapy products utilizing advanced gene delivery technologies for the treatment of serious medical disorders.  The primary focus of our research and development efforts is in the generation of products for the treatment of hemophilia, cancer and vaccines.

GenStar commenced operations as a stand-alone entity in January 1996 and has been in the development stage since inception.  Our original mission was to develop products to treat diseases in urology, with a particular interest in prostate cancer. We had licensed technology that uses the IL-3 gene to treat several types of cancer, but did not have technology to deliver the gene.  On July 8, 1998, we entered into an agreement with Baxter Healthcare Corporation in which we acquired the exclusive rights to certain gene delivery technologies and laboratory equipment.  The gene delivery technology will be used to enhance our existing technology and to develop products to deliver other genes.  We believe that the gene delivery technology provides a higher level of expression of the gene being delivered compared to other gene therapy approaches. Prior to our license of the technology, Baxter had been developing this technology for the treatment of hemophilia and cancer and had continued to fund the development of our MAX-AD FVIII product for hemophilia through the date of treatment of the first patient in a clinical trial for that product.

In May 2000, we acquired all of the outstanding shares of Allegro Cell Systems, Inc. (Allegro) in exchange for 288,000 shares of GenStar Common stock and an obligation to issue an additional 12,000 shares of common stock once approved by the University of California Regents.  Allegro’s sole asset was a license to certain technologies for the treatment and prevention of AIDS and for lentiviral gene therapy.  Allegro has no products, revenues, employees, facilities or other assets.  Based upon the very early stage of development of the technology and the lack of alternative future uses for it, the value of the technology was charged to acquired in-process technology.

GenStar’s current activities consist of the development of the MAXIMUM-AD gene transfer system for our MAX-AD FVIII product, our DUAL-AD vector product for prostate cancer, and the MAX-AD and HIV vector systems for the treatment of HIV/AIDS.  We anticipate defining additional uses for our vector technologies and potentially acquiring other technologies.  We expect to incur increasing research and development expenditures as we focus our efforts on further development of these products.  We expect that GenStar will have no product revenues and will incur significant losses for at least the next five years.  We may never be profitable.

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CRITICAL ACCOUNTING POLICIES AND ESTIMATES

    Our discussion and analysis of our financial condition and results of operations are based upon the Company’s consolidated 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 judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, patent costs and income taxes. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

    We believe the following critical accounting policies affect the significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue recognition

    We recognize revenue when all four of the following criteria are met:  (i) persuasive evidence that an arrangement exists; (ii) delivery of services has occurred; (iii) the selling price is fixed or determinable; and (iv) collectibility is reasonably assured.  In addition, we follow the provisions of the Securities and Exchange Commission’s Staff Accounting Bulletin No. 101 (“SAB 101”), Revenue Recognition in Financial Statements, which sets forth guidelines in the timing of revenue recognition.  Amounts received for upfront product and technology license fees under multiple-element arrangements are deferred and recognized over the period of such services or performance if such arrangements require ongoing services or performance.  Amounts received for milestones are recognized upon achievement of the milestone, unless the amounts received are creditable against royalties or we have ongoing performance obligations.  Royalty revenue will be recognized upon sale of the related products, provided the royalty amounts are fixed and determinable and collection of the related receivable is probable.  Grant revenue is recognized as the research expenses related to the grants are incurred. All amounts received under the collaborative research agreements or research grants are not refundable, regardless of the success of the underlying research.  Any amounts received prior to satisfying our revenue recognition criteria will be recorded as deferred revenue in the accompanying balance sheets.

Patent costs

    We expense the costs related to filing and pursuing patent applications as the costs are incurred because the recoverability of such expenditures is uncertain.

Income taxes

    We record a valuation allowance to reduce our deferred tax assets to the amount that is more likely than not to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.  The Company’s policy is record a valuation allowance equal to the net deferred tax asset.

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Stock based compensation

The Company grants stock options for a fixed number of shares to employees in accordance with Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, and accordingly, recognizes no compensation expense for the stock option grants to employees provided that the option exercise price is not less than the fair market value of the underlying stock on the date of the grant.  The value of options, warrants, or stock awards issued to non-employees have been determined in accordance with SFAS No. 123, Accounting for Stock Based Compensation, and Emerging Issues Task Force No. 96-18, Accounting for Equity Instruments that are Issued to Other than Employees for Acquiring, or in Conjunction with Selling Goods and Services, and are periodically remeasured as the options vest.  Warrants for Common Stock are valued at the date of issuance and are recorded to the expense category related to the services provided.

RESULTS OF OPERATIONS

Revenues

GenStar has generated revenues to date of $1,862,000 from contract research agreements and grants.   Total revenues for the six months ended June 30, 2002 and 2001 were $440,000 and $72,000, respectively, and for the three months ended June 30, 2002 and 2001 were $172,000 and $40,000, respectively.  Revenues for both the three and six months ended June 30, 2002 include $24,000 related to a research agreement with a corporate partner whereby the two companies will collaborate on certain research projects (see Note 6 to the Financial Statements).  There were no such research agreement revenues during the three and six months ended June 30, 2001.  We anticipate seeking additional research agreements and grants to help fund research and development efforts.  We do not anticipate revenues from products for at least five years.

Research and development

Research and development expenses increased $460,000 to $4,735,000 during the six months ended June 30, 2002 compared to $4,275,000 for the six months ended June 30, 2001.  During the three months ended June 30, 2002 research and development expenses increased $75,000 to $2,407,000 compared to $2,332,000 for the three months ended June 30, 2001.  Research and development expenses increased in both the six month and three month periods ended June 30, 2002 compared to the same periods of 2001 due to an upgrade in the capacity of our manufacturing capabilities.  We anticipate increasing research and development expenditures in the future as we conduct preclinical and clinical testing necessary to bring our products to market and to establish additional manufacturing capabilities.

General and administrative expense

General and administrative expense decreased $94,000 during the six months ended June 30, 2002 to $1,617,000 compared to $1,711,000 for the six months ended June 30, 2001.  During the three months ended June 30, 2002 general and administrative expense decreased $72,000 to $808,000 compared to $880,000 for the three months ended June 30, 2001.  General and administrative expenses include the costs of our administrative personnel and consultants, office lease expenses and other overhead costs, including legal and accounting costs. General and administrative expenses have decreased due to management’s efforts to reduce expenses in this area

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Interest income and expense

Interest income decreased $163,000 during the six months ended June 30, 2002 to $446,000 compared to $609,000 for the six months ended June 30, 2001.  During the three months ended June 30, 2002 interest income decreased $64,000 to $248,000 compared to $312,000 for the three months ended June 30, 2001.  Interest income is a result of the investment of excess cash in money market accounts, corporate bonds and certificates of deposit.  Interest expense decreased $22,000 for the six months ended June 30, 2002 to $231,000 compared to $253,000 for the six months ended June 30, 2001.  During the three months ended June 30, 2002 interest expense decreased $16,000 to $114,000 compared to $130,000 for the three months ended June 30, 2001.  Interest expense in both 2001 and 2002 relates to equipment financing and interest accrued on the deferred compensation liability.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used by operating activities during the six months ended June 30, 2001 and 2002 was $5,707,000 and $4,185,000, respectively. Net cash used by operating activities consists of expenditures for research and development and general and administrative expenses. Net cash provided by investing activities during the six months ended June 30, 2001 and June 30, 2002 was $235,000 and $2,384,000, respectively, and consists of net sales of short-term investments further reduced by purchases of furniture and equipment.  Net cash provided by financing activities during the six months ended June 30, 2001 of $4,766,000 consists primarily of $2,173,000 paid by Baxter under the credit agreement, proceeds from the sale of Series C Preferred Stock to Baxter of  $2,000,000, proceeds from our capital lease facility of $653,000, offset by repayments of the capital lease facility and notes payable of $242,000. Net cash provided by financing activities of $61,000 for the six months ended June 30, 2002 consists primarily of proceeds from our capital lease facility of $429,000, offset by repayments of the capital lease facility and notes payable of $383,000.

GenStar’s future capital requirements will depend on many factors, including scientific progress in our research and development programs, our ability to establish collaborative arrangements with others for drug development, progress with preclinical and clinical trials, the time and costs involved in obtaining regulatory approvals and effective commercialization activities.  As of June 30, 2002, the Company had cash, cash equivalents and short-term investments totaling $10,403,000 and working capital of $8,796,000.  GenStar has incurred net losses of $42.6 million since its inception through June 30, 2002 and has never been profitable during its existence. We expect to incur significant additional operating losses over the next several years as our research and development efforts expand. Our ability to achieve profitability depends upon our ability, alone or with others, to successfully complete development of products, obtain required regulatory approvals and manufacture and market products. We may not be successful and we may never attain significant revenues or profitability. Our operations to date have consumed substantial amounts of cash. The negative cash flow from operations is expected to continue and to accelerate for at least the next five years. The development of our products will require a commitment of substantial funds to conduct the costly and time-consuming research, preclinical and clinical testing necessary to bring our products to market and to establish manufacturing and marketing capabilities.

Under the terms of our Developmental Collaboration Agreement and Credit Agreements with Baxter, Baxter was required to provide funding for development of the MAX-AD FVIII hemophilia product.  Total funding received from Baxter under the agreement was $12,890,000, which was converted into 12,890 Shares of Series B Preferred Stock.  When we treated the first patient in a Phase I clinical trial for the hemophilia product, a milestone payment of $2,000,000 was due from Baxter. In June 2001, the first patient was treated using the hemophilia product and Baxter paid the $2,000,000 milestone payment in exchange for 2,000 shares of Series C Preferred Stock.  The Series B Preferred Stock is convertible into 2,010,920 shares of common stock.  The Series C Preferred Stock is convertible at Baxter’s option upon

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the earlier of (i) the first business day following the approval by the FDA of the right to market, sell or distribute any product using the MAXIMUM-AD Vector Technology for treatment of blood clotting disorders in humans relating to Hemophilia A, which product has been developed pursuant to the Developmental Collaboration Agreement between Baxter and the Company and (ii) the date seven years after the achievement of the most recently achieved Series C Milestone, currently in June 2001.

We anticipate our existing capital resources will enable us to maintain our current and planned operations through the middle of 2003.  However, no assurance can be given that we will not need additional funds prior to the middle of 2003.  We will need to raise substantial additional capital to fund future operations. We intend to seek additional funding either through collaborative arrangements or through public or private equity or debt financings. Additional financing may not be available on acceptable terms or at all.  If adequate funds are not available, we may be required to delay or reduce the scope of our operations or to obtain funds through arrangements with collaborative partners or others that may require us to relinquish rights we may otherwise have.

QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

The primary objective of our investment activities is to preserve principal while at the same time maximizing the income we receive from our investments without significantly increasing risk. Some of the securities that we invest in may have market risk. This means that a change in prevailing interest rates may cause the fair value of the principal amount of the investment to fluctuate. For example, if we hold a security that was issued with a fixed interest rate at the then-prevailing rate and the prevailing interest rate later rises, the fair value of the principal amount of our investment will probably decline. To minimize this risk, we maintain our portfolio of cash equivalents and short-term investments in a variety of securities, including commercial paper, money market funds, government and non-government debt securities. The average duration of all of our investments has generally been less than one year. Due to the short-term nature of these investments, we believe we have no material exposure to interest rate risk arising from our investments. Therefore, no quantitative tabular disclosure is required.

The Company does not conduct business with foreign entities, and does not have any foreign exchange risk.

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GENSTAR THERAPEUTICS CORPORATION
(A development stage enterprise)

PART II.  OTHER INFORMATION

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SIGNATURES

In accordance with the requirements of the Exchange Act, the Registrant has caused this Report to be signed on its behalf by the undersigned, hereunto duly authorized.

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