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

Form 10-Q

For the quarterly period ended September 30, 2002

OR

Commission File Number 0-27264

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

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.

The number of shares of the Common Stock of the registrant outstanding as of November 11, 2002, was 24,020,584.

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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
September 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.  To date, the Company's research and development efforts, utilizing advanced gene therapy technologies have focused on hemophilia, cancer and vaccines. In the future, the Company plans to concentrate its research and development efforts on the later-stage cardiovascular VEGF-2 products, which will be the focus of the Company following the planned merger with Vascular Genetics Inc. (VGI). The company has research agreements with Baxter Healthcare and with Centocor, a Johnson & Johnson company. GenStar's hemophilia, prostate cancer and HIV/AIDS product development programs are supported, in part, by grants from the National Cancer Institute and the National Institutes of Health.

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.

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 (“the Regents”).  In September 2002, the Regents approved the issuance of the additional 12,000 shares of common stock, and the shares were issued.  Allegro’s sole asset was a license to certain technologies for the treatment and prevention of AIDS and for lentiviral gene therapy.  Allegro had 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.

In September 2002, the Company entered into a definitive merger agreement with Vascular Genetics Inc.  The agreement is expected to result in the shareholders of each company owning approximately 50% of the fully-diluted ownership of the combined organization, which plans to change its name to CorAutus Genetics Inc.  Under the terms of the merger agreement, Vascular Genetics stockholders will receive, in exchange for all of the outstanding capital stock of Vascular Genetics, newly issued shares of GenStar common stock equal to the fully-diluted outstanding capitalization of GenStar, which is expected to be approximately 38

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million shares.  The transaction is subject to approval by the GenStar and Vascular Genetics shareholders, as well as other closing conditions.  The merger is expected to close in early 2003.

Upon completion of the merger, the combined company’s development efforts will focus on the development of Vascular Genetics' VEGF-2, a gene-based therapy for the treatment of severe cardiovascular disease.  In order to conserve resources and concentrate remaining resources on the VEGF-2 product, during November 2002, we introduced several cost reduction initiatives including the reduction of research and administrative staff by approximately 30 percent. We also have plans to combine all of our current operations into our Barnes Canyon facility, which includes our manufacturing operations, and then sublet our executive administrative and laboratory space, as well as implement certain other cost containment initiatives. 

Although we will be reducing our expenditures in the near term, we expect to incur increasing costs related to conducting late-stage clinical trials for the VEGF-2 product.  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. Also, there can be no assurance that the merger will be successfully completed, or that the combined organization will realize the expected synergies of the merger.

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.

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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.

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 $2,285,000 from contract research agreements and grants.   Total revenues for the nine months ended September 30, 2002 and 2001 were $863,000 and $162,000, respectively, and for the three months ended September 30, 2002 and 2001 were $423,000 and $90,000, respectively.  Revenues for the three and nine months ended September 30, 2002 include $24,000 and $23,000 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 nine months ended September 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 $329,000 to $7,017,000 during the nine months ended September 30, 2002 compared to $6,688,000 for the nine months ended September 30, 2001.  During the three months ended September 30, 2002, research and development expenses decreased $120,000 to $2,282,000 compared to $2,402,000 for the three months ended September 30, 2001.  Research and development expenses increased in the nine-month period ended September 30, 2002 compared to the same periods of 2001 due to higher occupancy costs which are the result of an upgrade in the capacity of our manufacturing capabilities.  This increase is offset by a decline in employee related expenses, which is the result of fewer research and development employees in the current year compared to the same period

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of last year.  Research and development expenses for the three months ended September 30, 2002 declined compared to the same period of 2001 due to lower employee related expenses which is the result of fewer research and development employees in the current year compared to same three month period of the prior year.  This decline is offset by an increase in occupancy costs due to an upgrade in the capacity of our manufacturing capabilities.  We anticipate research and development expenditures to decline in the near term due to cost-containment measures, but to increase in the future as we conduct pre-clinical 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 $110,000 during the nine months ended September 30, 2002, to $2,394,000 compared to $2,504,000 for the nine months ended September 30, 2001.  During the three months ended September 30, 2002 general and administrative expense decreased $26,000 to $777,000 compared to $803,000 for the three months ended September 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.

Interest income and expense

Interest income decreased $346,000 during the nine months ended September 30, 2002 to $513,000 compared to $859,000 for the nine months ended September 30, 2001.  During the three months ended September 30, 2002, interest income decreased $182,000 to $68,000 compared to $250,000 for the three months ended September 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 $14,000 for the nine months ended September 30, 2002 to $350,000 compared to $364,000 for the nine months ended September 30, 2001.  During the three months ended September 30, 2002, interest expense increased $8,000 to $119,000 compared to $111,000 for the three months ended September 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 nine months ended September 30, 2001 and 2002 was $7,922,000 and $6,998,000, 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 nine months ended September 30, 2001 and September 30, 2002 was $2,990,000 and $6,448,000, 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 nine months ended September 30, 2001 of $6,681,000 consists primarily of $3,873,000 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 and proceeds from the issuance of common stock upon exercise of options and warrants for common stock of $420,000, offset by repayments of the capital lease facility and notes payable of $386,000. Net cash used in financing activities of $141,000 for the nine months ended September 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 $615,000.

Over the course of the next year, we plan to focus our activities on later stage cardiovascular products following the completion of the planned merger with Vascular Genetics Inc., which will require significant capital resources.  GenStar’s future capital requirements will depend on many factors, including and the time and costs involved in obtaining regulatory approvals and effective

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commercialization activities, our ability to establish collaborative arrangements with others for drug development and scientific progress in our research and development programs.

As of September 30, 2002, the Company had cash, cash equivalents and short-term investments totaling $7,604,000 and working capital of $5,921,000.  GenStar has incurred net losses of $45.3 million since its inception through September 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 clinical trials progress and 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. GenStar does not have any commitments or arrangements assuring it of any additional funds in the future, and there can be no assurance that it will be able to obtain additional capital on acceptable terms, or at all.

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 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, the last milestone was achieved 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.  Failure to successfully address ongoing liquidity requirements will have a material adverse effect upon the business of GenStar. In the event that GenStar is unable to obtain additional capital, it will be required to take actions that may harm its business and its ability to achieve positive cash flow in the future, including potentially ceasing certain or all of our operations. To the extent that GenStar raises additional cash by issuing equity securities, existing stockholders of GenStar will be diluted. If additional funds are raised through issuance of debt securities, these securities are likely to have rights, preferences and privileges senior to holders of common stock and preferred stock.

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Item 3.     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.

Item 4.     CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

Within the 90-day period prior to the date of this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures pursuant to Rule 13a-14 of the Securities Exchange Act of 1934 (the “Exchange Act”).  Based upon that evaluation, the Chief Executive Officer and Chief Finanical Officer concluded that the Company’s disclosure controls and procedures are effective in timely alerting them to material information relating to the Company required to be included in the Company’s Exchange Act filings.

Changes in Internal Controls

There have been no significant changes in the Company’s internal controls or in other factors that could significantly affect internal controls subsequent to the date the Company carried out its evaluation.

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PART II.  OTHER INFORMATION

Item 1.   LEGAL PROCEEDINGS
         None.

Item 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS
         None.

Item 3.   DEFAULTS UPON SENIOR SECURITIES
         None.

Item 4.   SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
         None.

Item 5.   OTHER INFORMATION
         None.

Item 6.   EXHIBITS AND REPORTS ON FORM 8-K

       (a)  Exhibits

       (b)  Reports on Form 8-K

         On September 16, 2002, GenStar filed a Current Report on Form 8-K dated September 12, 2002 regarding the execution of an Agreement and Plan of Reorganization, dated September 12, 2002, by and among the Company, Genesis Acquisition Corporation ("Merger Sub"), a wholly-owned subsidiary of the Company, and Vascular Genetics Inc. pursuant to Item 5 of Form 8-K.

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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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CERTIFICATION OF CHIEF EXECUTIVE OFFICER

I, Robert E. Sobol, M.D., certify that: 

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CERTIFICATION OF CHIEF FINANCIAL OFFICER

I, Paul D. Quadros., certify that: 

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