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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
(X) Annual report pursuant to Section 13 or 15(d) of the Securities Act of 1934 for the
fiscal year ended December 31, 1998 or
( ) Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of
1934.
COMMISSION FILE NO. 0-18962
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CYGNUS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 94-2978092
(State or other (I.R.S. Employer
jurisdiction of
incorporation or Identification
organization) No.)
400 PENOBSCOT DRIVE, REDWOOD CITY, CALIFORNIA 94063
(Address of principal executive offices and zip code)
(650) 369-4300
(Registrant's telephone number, including area code)
Securities registered pursuant to Section 12(b) of the Act: NONE
Securities registered pursuant to Section 12(g) of the Act: COMMON STOCK, $
0.001 PAR VALUE
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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 ___
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405
of Regulation S-K is not contained herein, and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]
The aggregate market value of voting stock held by non-affiliates of the
registrant, based upon the closing price of Common Stock on MARCH 18, 1999 as
reported on the Nasdaq National Market was APPROXIMATELY $153,328,872.
Determination of affiliate status for this purpose is not a determination of
affiliate status for any other purpose.
22,101,459
(Number of shares of common stock outstanding as of MARCH 18, 1999)
DOCUMENTS INCORPORATED BY REFERENCE
Registrant's Consolidated financial statements for the fiscal year ended
December 31, 1998 and definitive Proxy Statement to be filed pursuant to
Regulation 14A for its 1999 Annual Meeting of Stockholders is incorporated by
reference into Part III hereof.
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CYGNUS, INC.
1998 ANNUAL REPORT ON FORM 10-K
TABLE OF CONTENTS
PAGE
----
PART I
Item 1. Business .................................................................................... 2
Item 2. Properties .................................................................................. 13
Item 3. Legal Proceedings ........................................................................... 14
Item 4. Submission of Matters to a Vote of Security Holders ......................................... 14
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters ....................... 17
Item 6. Selected Financial Data ..................................................................... 18
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations ....... 19
Item 7A. Quantitative and Qualitative Disclosures About Market Risk .................................. 30
Item 8. Financial Statements and Supplementary Data ................................................. 31
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure ........ 31
PART III
Item 10. Directors and Executive Officers of the Registrant .......................................... 32
Item 11. Executive Compensation ...................................................................... 32
Item 12. Security Ownership of Certain Beneficial Owners and Management .............................. 32
Item 13. Certain Relationships and Related Transactions .............................................. 32
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K ............................. 33
SIGNATURES ............................................................................................ 38
1
PART I
ITEM 1. BUSINESS
OVERVIEW
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES RELATING TO THE FUTURE FINANCIAL PERFORMANCE OF CYGNUS, INC.
("CYGNUS" OR THE "COMPANY"), AND ACTUAL EVENTS OR RESULTS MAY DIFFER
MATERIALLY. IN EVALUATING SUCH STATEMENTS, STOCKHOLDERS AND INVESTORS SHOULD
SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED UNDER THE CAPTION "RISK
FACTORS" CONTAINED IN THE MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS WHICH COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS.
THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY
REVISIONS TO THESE FORWARD-LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT
EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCES
OF UNANTICIPATED EVENTS.
Cygnus, Inc. ("Cygnus" or the "Company") is engaged in the development
and manufacture of diagnostic and drug delivery systems, utilizing
proprietary technologies to satisfy unmet medical needs cost effectively. The
Company's current efforts are primarily focused on two core areas: an
automatic and continuous glucose monitoring device (the GlucoWatch-Registered
Trademark- monitor) and transdermal drug delivery systems.
The Company was incorporated in California in 1985 and was merged into a
Delaware corporation in September 1995. The Company's principal executive
offices are located at 400 Penobscot Drive, Redwood City, California 94063,
and its telephone number at that address is (650) 369-4300.
On August 11, 1998, John Hodgman was appointed President, Chief Executive
Officer and Director by Cygnus' Board of Directors following the resignation
of Gregory B. Lawless. In addition, Andre Marion, who is a Cygnus Director,
was named Vice Chairman of the Board of Directors. Gary Cleary continues his
duties as Chairman of the Board of Directors and Chief Technical Officer.
THE GLUCOWATCH -Registered Trademark- SYSTEM.
The Company's GlucoWatch monitor represents a potential advance in
diabetes care technology as compared to the currently prevailing "finger
stick" blood monitoring method. The GlucoWatch monitor is designed to measure
glucose automatically and continuously through the ease and convenience of a
device worn like a wristwatch. Worldwide sales of blood glucose
self-monitoring products were approximately $2.5 billion in 1997 (Boston
Biomedical Consultants, Inc.). It is estimated that more than 40 million
people in North America, Europe, Japan and Korea have diabetes. In the United
States ("U.S.") alone, more than ten million people have been diagnosed,
with another five million believed to have the condition. The number of
people with diabetes is expected to continue to grow with the aging of the
population, while the number of diagnosed cases is also expected to increase
with changes in diagnostic standards and new diagnostic technologies.
Clinical studies sponsored by the National Institutes of Health ("NIH")
indicate that better management of glucose levels through more frequent
testing would enable people with diabetes to reduce or significantly delay
many serious diabetes-related health complications. However, largely due to
the pain of repetitive finger sticking and the associated disruption of
daily life, the Company believes most people with diabetes currently test
their glucose levels less than half as often as recommended. As a result of
the drawbacks of the finger stick method, the Company believes that there is
a significant unmet demand for an automatic and continuous glucose-monitoring
device.
To address this unmet demand, the Company is developing the GlucoWatch
monitor, which is expected to reduce or eliminate significant drawbacks of
the finger stick testing technique. The device, which is worn like a
wristwatch, is designed to automatically extract and measure glucose levels
through intact skin up to three times per hour. The extracted glucose is
collected in a consumable component called the AutoSensor, which is attached
to the back of the device and replaced approximately every twelve hours. The
GlucoWatch monitor potentially offers a combination of features not available
in currently marketed devices, such as an electronic memory to store and
display glucose levels; the ability to download stored information to
personal computers to analyze glucose data and trends;
2
alerts indicating hypo- and hyperglycemic conditions; and event markers which
record factors that affect glucose levels. The GlucoWatch monitor can be worn
during the day and night for continuous glucose monitoring. The Company
believes the GlucoWatch monitor will provide the frequent testing and trend
analysis of glucose levels necessary to enable people with diabetes to better
manage their condition and eliminate the repetitive pain and inconvenience
associated with the finger stick monitoring method. The Company believes this
unique combination of features will result in better control of glucose
levels, improved quality of life and more cost-effective healthcare.
In developing the GlucoWatch monitor, the Company has sought to design a
device that would offer the above features and be safe and effective for
home use by patients with diabetes. In December 1998, Cygnus completed
extensive development clinical studies using a version of the GlucoWatch
monitor designed for commercial sale. These studies were conducted on people
with diabetes by independent clinical investigators across the U.S. The
results of these studies demonstrated that the GlucoWatch monitor is able to
measure glucose levels with accuracy and precision. The results of the most
controlled testing portion of the development clinical studies exceeded
Cygnus' internal performance accuracy target values. The protocols for the
development clinical studies were designed to be the same as the protocols
used in its registration clinical studies which, if successfully completed,
will lead to its completed United States Food and Drug Administration ("FDA")
submission for clearance to market the device. Although the Company believes
its clinical results to date are encouraging, no assurance can be given that
data generated in the registration clinical studies will be as favorable as
data generated in clinical trials to date or that, even if such data are as
favorable, such data will provide a sufficient basis for the approval of the
GlucoWatch monitor by the FDA.
On January 25, 1999 the Company submitted the first part of the
Pre-Market Approval Application ("PMA") to the FDA. This submission included
a variety of information, including manufacturing documentation. The Company
intends to submit the remainder of the PMA by the end of June 1999. The
product PMA will include analysis of a series of clinical studies totaling
more than 500 people which were completed in December 1998, as well as at
least two additional studies.
In 1996, the Company entered into collaboration agreements with Becton
Dickinson & Company ("Becton Dickinson") and Yamanouchi Pharmaceutical Co.,
Ltd. ("Yamanouchi") for the commercialization of the GlucoWatch monitor.
Under the Yamanouchi agreement, Cygnus granted Yamanouchi the marketing and
distribution rights of the GlucoWatch monitor in Japan and Korea. Cygnus is
eligible to receive up-front and milestone payments prior to
commercialization and to receive a percentage of the product's future
commercial success. Under the Becton Dickinson agreement, the Company had
granted Becton Dickinson exclusive worldwide marketing and distribution
rights, with the exception of Japan and Korea. On March 31, 1998, the Company
announced the termination of its agreement with Becton Dickinson.
Consequently, the Company will not receive any future milestone payments
under the Becton Dickinson agreement and will not be obligated to share
future revenue, if any, associated with commercialization of the GlucoWatch
monitor. The Company is currently in discussions with a number of companies
to establish an alliance for the commercialization of the GlucoWatch monitor
to provide for distribution, sales, marketing, and customer service support
in North America and Europe. There can be no assurance that the Company will
be able to enter into new collaborative arrangements.
In 1998, the Company entered into long term agreements with E.I. du Pont
de Nemours & Company ("DuPont") for the development and supply of thick film
materials for Cygnus' GlucoWatch monitor. A key component of the GlucoWatch
monitor is the sensor, which Cygnus developed with DuPont's materials. The
agreements call for continued cooperation for future sensor technology
developments and continued supply of materials.
TRANSDERMAL DRUG DELIVERY SYSTEMS.
Transdermal drug delivery systems provide for the controlled release of
drugs directly into the bloodstream through intact skin. The Company's
transdermal drug delivery products are thin multilayer systems, in the form
of small adhesive patches. Transdermal delivery can provide a number of
advantages over conventional methods of drug administration, including
enhanced efficacy, increased safety, greater convenience and improved patient
compliance. By delivering a steady flow of drugs into the bloodstream over an
extended period of time, transdermal systems can avoid the "peak and valley"
effect of traditional oral or injectable therapy and can enable more
controlled, effective treatment. By avoiding first pass metabolism through
the gastrointestinal tract and the liver, the therapeutically
3
equivalent dosage for the transdermal delivery of certain compounds can be
significantly less than the corresponding oral dosage, potentially reducing
dosage-related side-effects.
The Company's transdermal product line is focused on contraception,
hormone replacement therapy and smoking cessation. The Company has received
FDA approval for two products, one of which is currently marketed, the
Nicotrol-Registered Trademark- (Pharmacia AB, Stockholm, Sweden) nicotine
patch. The Company has strategic collaborations for its transdermal products
with Ortho-McNeil Pharmaceutical, Inc. ("Ortho"), a subsidiary of Johnson &
Johnson (contraception), American Home Products ("AHP") Corporation and
Sanofi S.A. ("Sanofi") (hormone replacement therapy), and Pharmacia & Upjohn
("Pharmacia") (smoking cessation).
The FemPatch-Registered Trademark- (Warner-Lambert Co., Morris Plains,
NJ) system, commercially launched in 1997, is a low-dose, 7-day estrogen
replacement transdermal patch for the treatment of menopausal symptoms.
Sanofi, the Company's worldwide licensee, had sublicensed U.S. marketing
rights to Warner-Lambert. In November 1998, Warner-Lambert terminated its
agreement with Sanofi, which also terminated the Supply Agreement between
Warner-Lambert and the Company. Consequently, the Company does not expect
product revenue related to the FemPatch system in 1999.
In July 1998, the Company was notified by AHP, the licensee for two of
the Company's transdermal hormone replacement products, that AHP wanted to
discuss the status of their agreement with the Company. In November 1998, the
Company and AHP entered into an Amendment to their Agreement. (For more on
the AHP amendment, see "Contract Revenue," under Management's Discussion and
Analysis of Financial Condition and Results of Operations.)
PORTFOLIO OF PRODUCTS
The data in the following table summarize Cygnus' current product
portfolio, the potential indications, development status and licensees of
marketing and distribution rights. The data in the table are qualified by
reference to the more detailed descriptions set forth herein. Development of
the various products listed is being funded by the designated licensee or
distributor, the Company, or both. The Company has additional products in
early development, which are not listed below, and is conducting a number of
new product feasibility studies.
4
PRODUCT PORTFOLIO
PRODUCT INDICATIONS STATUS (1) MARKETING
RIGHTS
DIAGNOSTIC SYSTEMS:
CONTINUOUS, AUTOMATIC GLUCOSE MONITORING:
GlucoWatch Monitor Diabetes Registration clinicals Yamanouchi
Cygnus
DRUG DELIVERY SYSTEMS:
TRANSDERMAL DRUG DELIVERY:
SMOKING CESSATION:
Nicotrol Patch Smoking cessation Commercialized in North Pharmacia & Upjohn, Inc.;
America and certain European Johnson & Johnson (2)
countries
Nicotine Patch Smoking cessation Pre-clinical Undisclosed
HORMONE REPLACEMENT:
Low-Dose Estrogen
7-Day:
FemPatch System Menopausal symptoms Commercialized in North Sanofi (3)
America
Estrogen 7-Day Menopausal symptoms Submitted New Drug American Home Products
Application ("NDA") and
European Dossier
Estrogen/Progestin:
Combination 3.5-Day Menopausal symptoms Phase 3 clinicals American Home Products
CONTRACEPTION:
Estrogen/Progestin:
Combination 7-Day Contraception Phase 3 clinicals Johnson & Johnson (4)
OTHER PRODUCTS:
Clonazepam Anti-epileptic Pre-clinical National Institutes of
Health ("NIH") (5)
Mucosal Disk Breath freshening Marketing Authorization Filed Undisclosed
Mucosal Disk Sore throat Marketing Authorization Filed Undisclosed
(1) The Company's drug delivery products are generally developed in the
following stages: development, prototype, pre-clinical studies in
preparation to file an Investigational New Drug Application ("IND"),
clinical trials, and regulatory submission.
(2) Pharmacia has worldwide rights and has sublicensed rights in North
America to Johnson & Johnson.
(3) In November 1998, Warner-Lambert terminated its agreement with Sanofi,
which also terminated the Supply Agreement between Warner-Lambert and
the Company.
(4) The Company's agreement with Johnson & Johnson grants Johnson & Johnson
exclusive rights to the estrogen/progestin combination 7-day contraception
product.
(5) Product being funded through the first clinical trial by an NIH grant.
5
AUTOMATIC AND CONTINUOUS GLUCOSE MONITORING
MARKET OPPORTUNITY
People with diabetes measure blood glucose levels to adjust their diet
and insulin use to better control their glucose levels in order to prevent
diabetes-related complications. Currently, to measure their glucose levels,
people with diabetes must stick their fingers with a lancet, draw blood and
place a drop of blood on a glucose reagent strip inserted in an instrument
which provides a glucose reading. Each day of testing can involve numerous
sticks and the complete procedure is not only painful but disruptive to daily
life. As a result of this pain and disruption, the Company believes most
people with diabetes monitor their blood glucose levels less than twice per
day, instead of the recommended four to seven times per day. Even at this
level of testing, the market for products for self-monitoring of glucose
levels by people with diabetes is quite substantial.
Worldwide sales of products for the self-monitoring of blood glucose
levels were approximately $2.5 billion in 1997. The Company believes that
approximately 80% to 90% of the sales were related to disposable glucose
reagent strips for finger stick monitoring (Boston Biomedical Consultants,
Inc.). In the U.S., a relatively small segment of people with diabetes who
measure their glucose level account for the majority of testing; for example,
of these people, just 19% (about 1.6 million) account for 52% of the tests
performed. It is estimated that more than 40 million people in North America,
Europe, Japan and Korea have diabetes. In the U.S. alone, more than ten
million people have been diagnosed with diabetes, with another five million
believed to be undiagnosed. The number of people diagnosed with diabetes has
been growing and is expected to continue to grow due to the aging of the
population, changes in diagnostic standards and new diagnostic technologies.
Specifically, the diagnostic standards in the U.S. have been changed such
that a fasting plasma glucose value of greater than or equal to 126 mg/dL now
indicates a diagnosis of diabetes, whereas such diagnosis previously required
a value of greater than or equal to 140 mg/dL. Diabetes can lead to severe
complications over time, including blindness, loss of kidney function and
peripheral neuropathy, causing circulation problems to the arms and legs and
pain and potential amputation. The American Diabetes Association ("ADA")
estimated that the complications arising from diabetes cost the U.S.
healthcare system in excess of $45 billion in 1992. These complications are
largely a consequence of years of poor management of glucose levels by people
with diabetes. Results of the Diabetes Control and Complication Trial, a
major clinical trial sponsored by the National Institutes of Health ("NIH")
and published in 1993, showed that more frequently monitored blood glucose
levels and rigid adherence to a program of diet, exercise and insulin
injections could prevent or significantly delay the onset of many of the
long-term complications of diabetes.
THE GLUCOWATCH MONITOR
The Company believes that there is an unmet demand for automatic and
continuous glucose monitoring. To address this unmet demand, the Company has
developed the GlucoWatch monitor, which is worn like a wristwatch and, after
calibrating each new AutoSensor with a standard blood glucose monitor,
automatically extracts and measures glucose levels painlessly through intact
skin every twenty or thirty minutes. The GlucoWatch monitor then displays and
stores current and past glucose levels and trend data. The extracted glucose
is collected in a consumable component called the AutoSensor, which is
attached to the back of the device and replaced approximately every twelve
hours. The GlucoWatch monitor potentially offers, in a portable and discreet
device, a combination of features not available in currently marketed
devices. These include frequent data collection, electronic memory to store
and display glucose levels, personal computer downloading for trend analysis,
alerts indicating hypo- and hyperglycemic conditions and event markers which
record factors that affect glucose levels. The GlucoWatch monitor is designed
to be worn day and night for continuous glucose monitoring. The GlucoWatch
monitor is expected to reduce or eliminate significant drawbacks of the
finger stick technique, such as the pain of repetitive sticking and the
disruption of normal activities caused by indiscreet, cumbersome procedures.
The Company believes the GlucoWatch monitor can lead to improved disease
management, enabling people with diabetes to prevent or delay severe
complications associated with the condition.
The GlucoWatch monitor extracts glucose molecules through intact skin
utilizing a patented sampling process called electroosmosis (or "reverse
iontophoresis"). The extracted glucose is collected and measured by an
AutoSensor, a replaceable component which includes an enzyme-containing
hydrogel and electrodes for electroosmotic extraction and biosensing. The
glucose collected in the AutoSensor triggers an electro-chemical reaction in
the AutoSensor, generating
6
electrons. The biosensor measures the electrons and an application specific
integrated circuit ("ASIC") in the GlucoWatch monitor equates the number of
electrons to a concentration of glucose in the blood. The GlucoWatch monitor
automatically measures glucose levels at twenty minute intervals. The
GlucoWatch monitor displays the most recent readings and trends at the push
of a button. Its electronic memory capabilities permit the retrieval and
downloading of data, allowing longer-term trend analysis for better disease
management.
The GlucoWatch monitor system was designed to be simple and easy to use.
Each day the rechargeable battery is replaced. In addition, an AutoSensor is
attached on the back of the GlucoWatch monitor, which will provide twelve
hours of glucose measurements after a three-hour warm-up period. A finger
stick blood glucose measurement is input into the GlucoWatch monitor for
calibration. Measurements will then be generated painlessly, bloodlessly and
automatically by the GlucoWatch monitor, providing up to thirty-six glucose
measurements over a twelve-hour period.
The Company believes approximately 80% to 90% of current sales in the
glucose monitoring market come from the consumable test strips on which a
drop of blood is placed and inserted into a meter. The GlucoWatch monitor
uses a similar approach. The "monitoring device" is designed to function for
a number of years, while the consumable AutoSensor is designed to provide
twelve hours of measurements.
REGULATORY APPROVAL
For FDA approval of the GlucoWatch monitor, the Company is currently
conducting registration clinical studies. In response to conversations with
the FDA, the Company intends to complete the submission of a Pre-Market
Approval Application ("PMA") by June 1999 for the GlucoWatch monitor for
adults with diabetes. On January 25, 1999 the Company submitted the first
part of the PMA to the FDA. This submission included a variety of
information, including manufacturing documentation.
Although the Company believes its clinical results to date are
encouraging, no assurance can be given that data generated in the
registration clinical studies will be as favorable as data generated in
clinical trials to date or that, even if such data are as favorable, such
data will provide a sufficient basis for the approval of the GlucoWatch
monitor by the FDA. In addition, there can be no assurance that if the
product is cleared for marketing by the FDA that all of the potential
features of the GlucoWatch monitor would be approved for use or that the
intended usage described above would be approved.
COMPETITION
The glucose monitoring market is highly competitive. Currently the
market is dominated by finger stick blood glucose monitoring products. This
monitoring technique presents a number of barriers to generating more
frequent blood glucose measurements, including the pain of repetitive finger
lancing and the disruption of normal activities, as people with diabetes
typically do not want to go through the finger stick process in public.
Several companies are attempting to develop non-invasive or less invasive
methods to monitor glucose levels. One technology that a number of companies
are pursuing is the use of infrared spectroscopy, which uses radiation to
measure glucose levels. Other companies are attempting to develop a variety
of methods to extract interstitial fluid and measure the glucose
concentration therein. The Company believes that none of the currently
marketed finger stick products nor other products in development have the
range of features and benefits offered by the GlucoWatch monitor to address
the unmet needs.
TRANSDERMAL DRUG DELIVERY SYSTEMS
Transdermal drug delivery systems provide for the controlled release of
drugs directly into the bloodstream through intact skin. The Company's
transdermal drug delivery products are thin multilayer systems, in the form
of small adhesive patches. Transdermal delivery can provide a number of
advantages over conventional methods of drug administration, including
enhanced efficacy, increased safety, greater convenience and improved patient
compliance. By delivering a steady flow of drugs into the bloodstream over an
extended period of time, transdermal systems can avoid the "peak and valley"
effect of traditional oral or injectable therapy and can enable more
controlled, effective treatment. By avoiding first pass metabolism through
the gastrointestinal tract and the liver, the therapeutically
7
equivalent dosage for the transdermal delivery of certain compounds can be
significantly less than the corresponding oral dosage, potentially reducing
dosage-related side-effects.
Cygnus has established a comprehensive, integrated approach to the
development of transdermal delivery systems. Cygnus develops a unique product
profile for each transdermal product based on an evaluation of several key
variables that change with each drug and therapeutic indication. Based on its
assessment of the product profile and the interrelationship between the drug
and the physical and biological characteristics of the skin, Cygnus
formulates the appropriate materials and designs the structure of the
transdermal system to achieve desired product characteristics such as
comfort, extended wear, delayed or enhanced onset and controlled release.
CONTRACEPTION
The contraceptive market is estimated, by industry sources, to have had
1997 worldwide sales of $2.9 billion. The market is dominated by oral
contraceptive pills. There are no transdermal patches currently marketed for
contraception. The Company believes a seven-day contraceptive patch could
lead to improved dosing compliance and is developing such a product under an
agreement with Ortho-McNeil Pharmaceutical, Inc. ("Ortho"), a subsidiary of
Johnson & Johnson. Ortho has exclusive worldwide marketing rights to the
product. Cygnus has received up-front payments and will receive milestone
payments as well as a percentage of net sales, if and when the product is
commercialized, and is responsible for the development and manufacture of the
product. This product is currently in Phase 3 clinical trials.
HORMONE REPLACEMENT
The hormone replacement market is large, with $1.33 billion in sales
worldwide in 1997, and is expected to grow as more women reach the age of
menopause (Med Ad News, May 1998). The Company believes that its transdermal
hormone replacement products have a competitive advantage over certain
transdermal hormone replacement products as a result of superior patient
comfort profile as well as applicable seven-day extended delivery systems.
Cygnus has two hormone replacement products in development: a 7-day
estrogen patch, for which the New Drug Application ("NDA") has been submitted
to the FDA, and the European Dossier has been submitted to the European
authorities; and a 3.5-day estrogen/progestin combination patch, which is
currently in Phase 3 clinical trials. These products are being developed
under an agreement with American Home Products. Under the terms of the
agreement, American Home Products has worldwide marketing rights with respect
to the products resulting from the collaboration. Cygnus received up-front
fees and is entitled to receive milestone payments as well as a percentage of
net sales on all products to be manufactured by Cygnus for the worldwide
market. In addition, AHP pays for all clinical trial expenses. Cygnus is
otherwise responsible for financing the development and manufacture of the
products. Cygnus will pay Sanofi a percentage of net sales on the two
products licensed to American Home Products subject to certain minimums. In
July 1998, the Company was notified by AHP that AHP wanted to discuss the
status of their agreement with the Company. In November 1998, the Company and
AHP entered into an Amendment to their Agreement. (For more on the AHP
amendment see "Contract Revenue," under Management's Discussion and Analysis
of Financial Condition and Results of Operations.)
The FemPatch system, commercially launched in 1997, is a low-dose, 7-day
estrogen replacement transdermal patch for the treatment of menopausal
symptoms. Sanofi, the Company's worldwide licensee, has sublicensed U.S.
marketing rights to Warner-Lambert. In November 1998, Warner-Lambert
terminated its agreement with Sanofi, which also terminated the Supply
Agreement between Warner-Lambert and the Company.
SMOKING CESSATION
The smoking cessation market is estimated to have had 1997 worldwide
sales of $555.0 million (Drug Store News, September 7, 1998). The Company's
Nicotrol product was initially introduced in the U.S. as a prescription
product in 1992 and subsequently approved for over-the-counter sale in the
U.S. in 1996. The Nicotrol patch is currently marketed in North America by
Johnson & Johnson and in many European countries by Pharmacia. Cygnus
receives royalties on the worldwide sales of the Nicotrol patch. Cygnus is
also collaborating with an undisclosed partner for a different
over-the-counter nicotine transdermal system. This product is currently in
the pre-clinical stage.
8
DEPENDENCE ON NEW PRODUCTS; UNCERTAINTY OF MARKET ACCEPTANCE
For the Company to be successful, it will need to develop, license, or
acquire new products. Several products based on the Company's technologies
are currently under development by Cygnus and its licensees. Many of these
products (including the GlucoWatch monitor) will require significant
additional development and investment, including preclinical and clinical
testing, prior to their commercialization. From time to time the Company has
experienced delays or setbacks in the development of certain of its products.
For example, the Company experienced development delays in the
miniaturization of the GlucoWatch monitor. There can be no assurance that the
Company will be able to successfully address problems that may arise during
the development and commercialization process. In addition, there can be no
assurance that such products or future products (including the GlucoWatch
monitor) can or will be successfully developed, prove to be safe and
effective in clinical trials, meet applicable regulatory standards, be
capable of being manufactured in commercial quantities at reasonable cost, be
marketed successfully or achieve market acceptance. Product development
efforts can be terminated by the Company or its licensees and there can be no
assurance that initial product development efforts or third party
collaborations will be successful. If any of the Company's development
programs are not successfully completed, required regulatory approvals or
clearances are not obtained, or products for which approvals or clearances
are obtained are not commercially successful, the Company's business,
financial condition and results of operations could be materially and
adversely affected.
The Company's business is subject to the risks inherent in the
development of new products using new technologies and approaches. There can
be no assurance that unforeseen problems will not develop with these
technologies or applications, that the Company will be able to successfully
address technological challenges it encounters in its research and
development programs or that commercially feasible products will ultimately
be developed by the Company.
Before the Company can market the GlucoWatch monitor, it must first
conduct registration clinical trials using a version of the product designed
for commercial sale, prepare a submission to the FDA and obtain clearance or
approval from the FDA. Approval from other U.S. or foreign government
regulatory agencies may also be required. Each of these stages will involve
certain risks and challenges. The Company has completed research clinical
studies using a commercial version of the product and is conducting
registration clinical trials for submission to the FDA. There can be no
assurance that the commercial product will produce results that support the
necessary regulatory filings and approvals. In addition, if the Company
receives the necessary regulatory approvals for the GlucoWatch monitor, there
can be no assurance that unforeseen problems will not occur in product
manufacturing and commercial scale-up or marketing or product distribution.
Any such occurrence could significantly delay the commercialization of the
GlucoWatch monitor or prevent its market introduction entirely. Furthermore,
if the GlucoWatch monitor is successfully developed, the commercial success
of the GlucoWatch monitor will depend on its acceptance in the market.
GOVERNMENT REGULATION; NO ASSURANCE OF REGULATORY APPROVALS
The design, manufacturing, labeling, distribution and marketing of the
Company's products are subject to extensive and rigorous government regulation
in the U.S. and certain other countries where the process of obtaining and
maintaining required regulatory clearance or approvals is lengthy, expensive
and uncertain. In order for the Company to market its products in the U.S.,
the Company must obtain clearance or approval from the FDA. To date, the
Company has two products which have received FDA approval, the Nicotrol patch
and the FemPatch system. Before a regulatory submission can be filed with the
FDA, a product must undergo extensive clinical trials. The Company's drug
delivery systems require the filing of a NDA or an Abbreviated New Drug
Application ("ANDA") with the FDA and the FDA's approval of the NDA or ANDA.
Devices such as the GlucoWatch monitor under development by the Company will
require the filing and FDA clearance or approval of a medical device
submission. The time required for regulatory approval of the Company's
products after a filing is uncertain. There can be no assurance that problems
will not arise that could delay or prevent the commercialization of the
Company's products or that the FDA and foreign regulatory agencies will be
satisfied with the results of clinical trials or approve the marketing of any
products. Moreover, even if regulatory approval is granted, such approval may
include significant limitations on indicated uses for which any such products
could be marketed.
9
On January 25, 1999 the Company submitted the first part of the PMA to
the FDA for the GlucoWatch monitor. This submission included a variety of
information, including manufacturing documentation. The Company intends to
submit the remainder of the PMA by the end of June 1999. The product PMA will
include analysis of a series of clinical studies totaling more than 500
people which were completed in December 1998, as well as at least two
additional studies.
A drug or medical device and its manufacturer are subject to continual
review after approval, and later discovery of previously unknown problems
with a product or the manufacturing process may result in restrictions on
such product or the manufacturer, including withdrawal of the product or
products from the market. Failure to comply with applicable regulatory
requirements may, among other things, result in fines, suspensions of
regulatory approvals, product recalls, operating restrictions and criminal
prosecution. In addition, new government regulations may be established that
could delay or prevent regulatory approval of the Company's potential
products. Cygnus is also subject to federal, state and local regulations
regarding work place safety, environmental protection and hazardous and
controlled substance controls, among others.
In order for the Company to market its products in Europe and certain
other foreign jurisdictions, the Company and its distributors and agents must
obtain required regulatory registrations or approvals and otherwise comply
with extensive regulations regarding safety, efficacy and quality in those
jurisdictions. Specifically, certain foreign regulatory bodies have adopted
various regulations governing product standards, packaging requirements,
labeling requirements, import restrictions, tariff regulations, duties and
tax requirements. These regulations vary from country to country. In order to
commence sales of the GlucoWatch monitor in Europe, the Company must receive
CE mark certification, which is an international symbol of quality and
compliance with applicable European medical device directives. To obtain CE
certification, the Company must pass a review of the GlucoWatch monitor
technical file by a European Community notified body. Failure to receive CE
mark certification or other foreign regulatory approvals could have a
material adverse effect on the Company's business, financial condition and
results of operations. There can be no assurance that the Company will obtain
any other required regulatory registrations or approvals in such countries or
that it will not be required to incur significant costs in obtaining or
maintaining such regulatory registrations or approvals. Delays in obtaining
any registrations or approvals required to market the Company's products,
failure to receive these registrations or approvals, or future loss of
previously obtained registrations or approvals could have a material adverse
effect on the Company's business, financial condition and results of
operations.
COMPETING PRODUCTS AND CHANGES IN TECHNOLOGY
A large number of companies are involved or are becoming involved in the
development and commercialization of products incorporating diagnostic and
drug delivery systems. This field is highly competitive, and Cygnus believes
that competition will substantially increase in the future. A number of
companies have invested, and are continuing to invest, significant resources
in the development of diagnostic and drug delivery systems. Many of these
companies have greater financial, research and development and other
resources than Cygnus, as well as more experience than Cygnus in
commercializing diagnostic and transdermal drug delivery products. Such
companies may improve existing drug formulations and products more
efficiently than Cygnus or may design and develop new diagnostic and
transdermal drug delivery products which are more accepted in the marketplace
than the Company's products.
The Company's primary competitors in the glucose monitoring industry are
expected to be companies that currently market finger stick method products.
These companies have established products and distribution channels. In
addition, a number of companies are engaged in the development of products
using technology that is different than that used by Cygnus, but that are
also intended to permit less painful or painless glucose monitoring. These
technologies include infrared spectroscopy, which uses radiation to measure
glucose levels, and a variety of methods (including, in one case, transdermal
technology) to extract interstitial fluid and measure the glucose
concentration therein. The Company is not aware of any products under
development that potentially offer the range of benefits of the GlucoWatch
monitor. However, there can be no assurance that these products will not be
more accepted in the marketplace than the GlucoWatch monitor or will not
render the Company's glucose monitor uncompetitive or obsolete. A number of
companies have developed or are seeking to develop new drugs to treat
diabetes that could reduce demand for glucose monitoring systems. In
addition, many of the Company's competitors and potential competitors have
substantially greater resources, research and development staffs and
facilities than the Company and have significantly greater experience than
the Company in developing, manufacturing and marketing glucose
10
monitoring devices. Competition within the glucose monitoring industry could
also result in price reductions for glucose monitoring devices such that the
Company may not be able to sell the GlucoWatch monitor at a price level
adequate for the Company to realize a return on its investment.
The drug delivery industry is a rapidly evolving field. A number of
other companies, including major pharmaceutical companies, are also
developing and marketing transdermal and other similar systems for the
controlled delivery of drugs. Products currently on the market or under
development by competitors deliver the same drugs or other drugs to treat the
same indications as many of the products under development by the Company.
The first pharmaceutical product to reach the market in a therapeutic area
often obtains and maintains significant market share relative to later
entrants to the market. The Company's transdermal products will also compete
with drugs marketed not only in similar drug delivery systems but also in
traditional dosage forms such as oral administration, bolus injection and
continuous infusion. New drugs, new therapeutic approaches or future
developments in alternative drug delivery technologies, such as time-release
capsules, liposomes, inhalants, and implants, may provide therapeutic or cost
advantages over the drug delivery systems being developed by the Company.
MANUFACTURING; DEPENDENCE ON THIRD PARTY SUPPLIERS
Any manufacture of the Company's products is subject to current good
manufacturing practices ("cGMP") requirements prescribed by the FDA and other
standards prescribed by the appropriate regulatory agency in the country of
use. Additionally, the Company's agreements with licensees either specify
pricing formulas for products manufactured and sold by Cygnus to its
licensees or specify that prices will be negotiated in the future. There can
be no assurance that prices for the Company's products will cover the
manufacturing costs for these products in light of the Company's limited
manufacturing experience and general supply and demand conditions in the
marketplace.
The Company's GlucoWatch monitor has not yet been manufactured for
commercial sale, and the Company has no experience manufacturing the
GlucoWatch monitor in the volumes that would be necessary for the Company to
achieve significant commercial sales. To successfully commercialize the
GlucoWatch monitor, the device will have to be manufactured in compliance
with regulatory requirements, in a timely manner and in sufficient quantities
while maintaining product performance, quality and acceptable manufacturing
costs. There can be no assurance that the Company will be able to establish
and maintain reliable, full scale manufacturing of the GlucoWatch monitor at
commercially reasonable prices. Manufacturers often encounter difficulties in
scaling up production of new products, including problems involving product
performance, production yields, quality control and assurance and shortages
of personnel. In addition, manufacturing facilities will be subject to cGMP
regulations, including possible preapproval inspection, international quality
standards and other regulatory requirements. Difficulties encountered by the
Company in manufacturing scale-up or failure by the Company to implement and
maintain manufacturing facilities in accordance with cGMP regulations,
international quality standards or other regulatory requirements could result
in a delay or termination of production, which could have a material adverse
effect on the Company's business, financial condition and results of
operations.
In the past, the Company has experienced these problems in scaling up
its products for commercial launch. There can be no assurance that similar
problems will not be encountered in the future. In addition, there can be no
assurance that the Company will be able to achieve and maintain product
performance quality and reliability if and when producing the GlucoWatch
monitor in the quantities required for commercialization, nor that the
GlucoWatch monitor can be assembled and manufactured at an acceptable cost.
The GlucoWatch monitor will be manufactured from components purchased
from outside suppliers, most of which are the Company's single source for
such components. In the event the Company is unable to obtain these
components from its suppliers, the Company would be required to obtain
components from alternate suppliers. Any interruption in the supply of
GlucoWatch monitor components could have a material adverse effect on the
Company's business, financial condition and results of operations.
The Company received ISO 9002 certification in 1997. Consequently, the
Company expects to receive approval for the use of the "CE" mark for sales of
its products in Europe in 1999.
Several materials used in the Company's transdermal products are
currently obtained from single sources. Although the Company has not
experienced difficulty acquiring these materials for the manufacture of its
products for
11
sale or clinical trials, there can be no assurance that supply interruptions
will not occur or that the Company will not have to obtain substitute
vendors, if such vendors are available, which could require additional
regulatory submissions and approvals. Any such interruption of supplies could
have a material adverse effect on the Company's ability to develop,
manufacture and sell its transdermal products.
The Company leases a 21,000 square foot manufacturing facility which has
been used in both commercial and clinical supply production. The Company
believes it has sufficient capacity to support the planned market
introduction of its current drug delivery products for the next 3-5 years.
The Company is currently establishing its commercial AutoSensor manufacturing
operations in an existing third-party facility. Each of the foregoing
facilities complies with applicable regulatory requirements.
THIRD-PARTY REIMBURSEMENT
Successful commercialization of certain of the Company's products may
depend in part on the availability of reimbursement from third-party health
care payors, such as private insurance plans and the government. There can be
no assurance that such reimbursement will be available. Third-party payors
are increasingly attempting to contain health care costs by limiting both
coverage and the level of reimbursement for new therapeutic and diagnostic
products. There can be no assurance that adequate levels of reimbursement
will be available to enable the Company to achieve market acceptance of the
GlucoWatch monitor or other new products under development or to maintain
price levels sufficient to realize an appropriate return on its investment.
In certain international countries, the period of time needed to obtain such
reimbursement can be lengthy. The Company may delay the launch of its
products into certain countries until eligibility for reimbursement is
established. This could potentially have an adverse effect on the Company.
SENIOR CONVERTIBLE NOTES
In February 1998, the Company entered into Note Purchase Agreements with
certain institutional investors to issue and sell approximately $43 million
of 4% Senior Subordinated Convertible Notes due in 2005 (the "Notes"). On
October 28, 1998, the Company restructured the Notes. Key provisions in the
restructured Notes include the repayment of $18.5 million in principal
(reducing the principal balance from $43 million to $24.5 million) in October
1998, a delay in the convertibility of the majority of the Notes to June 30,
1999 or after, modification of conversion prices of the Notes, the ability of
the Company to redeem at par at any time all or part of the new principal
amount of the Notes, an increase in the interest rate to 5.5% paid annually
on the new principal balance and the change in the final maturity of the
Notes to October 1, 2000.
Under the terms of the restructured Notes, all of the remaining $24.5
million principal amount of the Notes are redeemable by the Company at par
including accrued interest. In addition, $18.5 million of the Notes will not
be able to be converted into Common Stock by the Note Holders until June 30,
1999 or later, effectively a five-month delay from the original terms of the
Notes. The restructured Notes were divided into three tranches. The first
tranche had an original principal amount of $6 million and was convertible
in whole or in part into Common Stock at any time, at a price that was fixed
until June 30, 1999 ($3.54), and was subject to a potential upward adjustment
on February 1, 1999 based on certain market formulas. As of December 31,
1998, $1.9 million of the first tranche had been converted into Common Stock.
The balance of the first tranche was fully converted in January 1999. The
second tranche also has an original principal amount of $6 million and cannot
be converted into Common Stock until June 30, 1999, at which time it becomes
convertible in whole or in part. On June 30, 1999, the conversion price of
the second tranche will be $6.89, which was established on February 1, 1999,
based on certain market formulas. Subsequent to June 30, 1999, the conversion
price of the second tranche will be determined based on other market
formulas. The third tranche of the restructured Notes has an original
principal amount of $12.5 million and cannot be converted into Common Stock
until July 1, 1999. Beginning July 1, 1999, no more than 15% of the second
and third tranches may be converted per calendar month at a conversion
price formulated from market prices. Any portions of the 15% monthly amounts
of the second and third tranches that are not converted in the relevant month
may be rolled over for conversion in future months. If the Company called the
second tranche of Notes ($6 million) for redemption before February 1, 1999,
the Note Holders would have been entitled to convert not more than 50% of
such Notes called before the redemption occurs. No such call was made by the
Company prior to February 1, 1999. If the Company calls the third tranche of
Notes ($12.5 million) for redemption before July 1, 1999, the Note Holders
will not be entitled to convert any portion of such tranche so called. The
Note Holders will otherwise be entitled to convert Notes called for
redemption before the redemption occurs, at conversion prices based on market
formulas.
12
The terms of the restructured Notes contained beneficial conversion
features relative to the first tranche which resulted in a non-cash charge to
earnings of $4.2 million. Future tranches of the restructured Notes may also
have similar beneficial conversion features. Such beneficial features, if
any, are contingent upon future events including timing of conversion and
market prices at the time of conversion and accordingly the Company is not
able to estimate any potential charges at this time.
PATENTS AND PROPRIETARY RIGHTS
It is the Company's policy to aggressively protect its investments in
technology and marketing by filing patent and trademark applications in the
U.S. and key foreign countries. The Company also relies on trade secrets,
know-how, licensing opportunities, and collaborative relationships to develop
and maintain its competitive position.
As of December 1998, the Company had approximately 45 issued U.S.
patents and about 94 foreign patents issued or allowed. These patents cover
various aspects of transdermal technology, including transdermal patch
formulations (such as those used in hormone replacement therapy,
contraception, and nicotine dependence therapy) and glucose monitoring
systems. The Company has more than 100 patent applications pending worldwide,
including the U.S. The Company has 3 U.S. trademark registrations, with 5
trademark applications pending; and 19 foreign trademark registrations, with
52 trademark applications pending.
The Company's GlucoWatch system incorporates technology developed
in-house as well as technology licensed exclusively to the Company by the
Regents of the University of California ("Regents"). Regents holds several
U.S. patents covering technology for transdermal extraction of glucose and
other analytes. Corresponding foreign patent applications are also pending or
granted. The Company has an exclusive license worldwide under these patents.
EMPLOYEES
As of December 31, 1998, the Company had 143 full time employees. Of
this total number of employees, 59 were engaged in research and development,
including process development, 34 in scientific affairs and quality
assurance, 29 in general administrative, and 21 in operations. None of the
Company's employees is represented by a labor union. Cygnus has experienced
no work stoppages and it believes its employee relations are good.
The Company's success will depend in large part on the continued
services of its scientific, managerial and manufacturing personnel. The loss
of a significant group of key personnel could have a material adverse effect
on the Company. The Company's success also depends upon its ability to
continue to attract and retain other highly qualified scientific, managerial
and manufacturing personnel. Competition for such personnel is intense. In
this respect, the Company competes with numerous pharmaceutical and health
care companies, as well as universities and nonprofit research organizations.
There can be no assurance that the Company will continue to be able to
attract and retain sufficient qualified personnel.
ITEM 2. PROPERTIES
Cygnus leases approximately 92,000 square feet in four buildings. Three
are located in Redwood City, California and the fourth is located in Menlo
Park, California. The first, approximately 38,000 square feet, is the
headquarters building, used for laboratories and administrative offices. The
second, approximately 21,000 square feet, is used for manufacturing,
laboratories and support offices. The third facility, also in Redwood City,
California, has approximately 11,000 square feet, of which approximately
8,000 square feet are utilized for additional administrative offices. The
fourth facility, which is located in Menlo Park, has approximately 22,000
square feet, and is used for storage of manufacturing materials and final
products.
The three facilities in Redwood City are leased through 2003 with an
option to renew at the then-prevailing market rent through 2008. The facility
in Menlo Park is leased over a three year period ending in October 1999.
The manufacturing facility was designed and constructed to comply with
ISO 9002 and cGMP standards. Cygnus holds drug and medical device
manufacturing licenses from the California Department of Health Services, has
an application on file with the U.S. Drug Enforcement Agency for the
manufacture of controlled drug products in this
13
facility, and is registered with the FDA as a drug establishment. The Company
believes it has sufficient capacity to meet current operating requirements
and satisfy foreseeable future demands for its current drug delivery
products. The Company is currently establishing its commercial AutoSensor
manufacturing operations in an existing third-party facility which complies
with applicable regulatory requirements.
As the Company completes the development of its products, it will begin
evaluating its existing manufacturing plans, under which a new manufacturing
site may become necessary.
ITEM 3. LEGAL PROCEEDINGS
On November 20, 1998, the American Arbitration Association issued the
final award on the arbitration proceedings between Cygnus and Pharmacia &
Upjohn ("Pharmacia") relating to the Nicotrol patch, Cygnus' smoking
cessation patch. Pursuant to the findings from the arbitration proceedings,
Cygnus was awarded $4.3 million for prevailing in some of its claims and
Pharmacia was awarded $1.6 million for prevailing in some of its claims.
Accordingly, Cygnus realized a net amount of $2.7 million. By way of
background, Cygnus initiated these proceedings in May 1997 based on an
agreement between Cygnus and Pharmacia, which provided that Pharmacia would
be obligated to pay Cygnus for, among other things, existing inventory costs
and certain purchase order commitments. Pharmacia disputed their obligations
regarding certain of the inventory costs and certain purchase order
commitments. In March 1998, Pharmacia added a counterclaim against Cygnus in
the arbitration, seeking approximately $1.5 million in reimbursement for an
alleged overpayment in royalties for Nicotrol units shipped in 1996 and 1997.
Cygnus' claim and Pharmacia's counterclaim commenced on June 15, 1998 before
a panel of the American Arbitration Association. This final and unappealable
decision settles all claims and counterclaims submitted to this Arbitration
by the Parties. See the Company's quarterly reports on Form 10-Q for the
quarter ended March 31, 1998, June 30, 1998 and September 30, 1998, filed
with the Securities and Exchange Commission ("SEC") on May 15, 1998,
August 4, 1998 and November 16, 1998, respectively, and the Company's annual
report on Form 10-K for the year ended December 31,1997, filed with the SEC
on February 6, 1998.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
A Special Meeting of Stockholders of Cygnus, Inc. was held on
December 1, 1998. The following item was voted upon by the stockholders:
Votes
----------------------------------------------------------
Broker
Affirmative Negative Abstain Non-Votes
------------ -------- -------- ----------
To approve the Company's amendment of
the Restated Certificate of Incorporation to
effect a one-for-three reverse stock split
Proposal of the Company's outstanding
Common Stock as set forth in the Cygnus, 16,773,772 547,427 91,601 0
Inc. Proxy Statement for Special Meeting of
Stockholders, dated November 10, 1998.
(For further details, see "Management's
Discussion and Analysis of Financial
Condition and Results of Operation".)
14
EXECUTIVE OFFICERS
The executive officers of the Company, who serve at the discretion of
the Board of Directors, are as follows, in alphabetical order:
NAME AGE TITLE
Neil R. Ackerman, Ph.D. 55 Senior Vice President, Research & Development
Craig W. Carlson 51 Appointed Chief Financial Officer and Senior
Vice President, Finance effective December 8,
1998
Gary W. Cleary, Ph.D. 56 Chairman of the Board of Directors and Chief
Technical Officer
James F. Grady, Jr., Ph.D. 50 Senior Vice President, Human Resources &
Administration
John C. Hodgman 45 Appointed President, Chief Executive Officer and
Director effective August 11, 1998
Stephen N. Kirnon 36 President, Drug Delivery Division
Andre S. Marion 63 Appointed Vice Chairman of the Board of
Directors effective August 11, 1998
Barbara G. McClung 44 Vice President, General Counsel and appointed
Secretary effective December 8, 1998
DR. ACKERMAN joined Cygnus in May of 1994 as Vice President, Research &
Development. In January 1997, Dr. Ackerman was promoted to Senior Vice
President, Research & Development. From 1990 to May 1994, Dr. Ackerman served
as Vice President of Research and Development for Glycomed, leading its
discovery efforts focused on cardiovascular and inflammatory diseases. From
1982 to 1990, he was Research Director, Cancer and Inflammatory Diseases with
DuPont Pharmaceuticals, responsible for leading a 100-person staff that had
the objective of discovering therapeutics for cancer, inflammatory and
immune-based diseases. Prior to that he was employed by Syntex Corporation
and Pfizer, Inc. in research and management capacities. Dr. Ackerman received
B.S. and Ph.D. degrees from the University of Maryland and completed a
post-doctoral fellowship at Stanford University.
MR. CARLSON was appointed Chief Financial Officer and Senior Vice
President, Finance effective December 8, 1998. He joined Cygnus in July 1993
as Vice President, Corporate Communications, then became Vice President,
Strategic Planning and Corporate Marketing. Mr. Carlson most recently served
as Senior Vice President, Finance, with responsibilities for the finance,
information technology and corporate communications functions at
15
Cygnus. From 1988 to July 1993, he was Vice President and Group Director at
Young & Rubicam Advertising in San Francisco. Prior to that, Mr. Carlson was
Vice President of Campbell-Mithun Advertising. He holds a B.A. from Union
College and an M.B.A. from Stanford University.
DR. CLEARY, the Company's founder and Chairman of the Board of
Directors, also served as the Company's President and Chief Executive Officer
from its inception until July 1986. Since 1986, Dr. Cleary has served as
Chief Technical Officer of the Company. During his professional career, Dr.
Cleary has served as an investigator with the U.S. Food and Drug
Administration and held research and management positions at Cutter Labs,
Alza Corporation, Key Pharmaceuticals, Inc. and Genentech Inc. Dr. Cleary
holds an M.B.A. in Health Sciences from the University of Miami, a Ph.D. in
Pharmaceutical Sciences from Rutgers University and a Pharm.D. in Pharmacy
from the University of California, San Francisco.
DR. GRADY joined the Company in May 1993 as Vice President, Human
Resources. From June 1995 to September 1997, Dr. Grady also served as Vice
President of Operations at the Company. In September 1997, he was appointed
Senior Vice President, Human Resources and Administration. From January 1989
to May 1993, Dr. Grady led the human resources department for a division of
Beckman Instruments. From 1986 to January 1989, Dr. Grady held various
positions with SmithKline Beckman (now SmithKline Beecham), including
Director of Compensation & Organizational Development for its worldwide
research and development business unit. He received a B.S. in Psychology and
a Ph.D. in Education from the University of Pittsburgh.
MR. HODGMAN was appointed President, Chief Executive Officer and
Director in August 1998. From May 1995 to August 1998, Mr. Hodgman served as
President, Cygnus Diagnostics, for which he was responsible for all
commercialization efforts for the GlucoWatch monitor, and Chief Financial
Officer. Mr. Hodgman joined Cygnus in August 1994 as Vice President, Finance
and Chief Financial Officer. Prior to joining Cygnus, Mr. Hodgman served as
Vice President of Operations and Finance and Chief Financial Officer for
Central Point Software, a personal computer and networking software company.
Prior to that, he was the Vice President of Finance and Administration and
Chief Financial Officer of Ateq Corporation. Mr. Hodgman holds a B.S. degree
from Brigham Young University and an M.B.A. from the University of Utah.
MR. KIRNON joined Cygnus in April 1993 as Director, Business Development
and, subsequently, he was promoted to Vice President, Business Development.
In September 1997, Mr. Kirnon was promoted to President, Drug Delivery
Division, and he is responsible for all efforts of the Drug Delivery
Division. Prior to joining Cygnus, Mr. Kirnon served as the National Sales &
Marketing Manager for BioGenex, Inc. Prior to that, he held various positions
in sales, marketing, and operations as part of the fast track management
program for SmithKline Beecham. Mr. Kirnon holds a B.A. in Biochemical
Sciences from Harvard University and an M.B.A. from Pepperdine University in
General Management.
MR. MARION, a Cygnus Director, was named Vice Chairman of Cygnus in
August 1998. Mr. Marion founded Applied Biosystems, Inc., a supplier of
instruments for biotechnology research, and served as President, Chief
Executive Officer and Chairman of the Board prior to its merger with The
Perkin-Elmer Corporation in 1993. He then served as Vice President, The
Perkin-Elmer Corporation and President of the Applied Biosystems Division
until his retirement in February 1995. Mr. Marion is also a director of
Molecular Devices Corp., Applied Imaging and a private company.
MS. McCLUNG joined the Company in January 1998 as Vice President,
Intellectual Property. In August 1998, Ms. McClung was promoted to Vice
President and General Counsel. Ms. McClung was also appointed Secretary,
effective December 8, 1998. From August 1990 to January 1998, she was
Corporate Patent Counsel at Chiron Corporation. Prior to that she was Patent
Counsel at DuPont. She is a member of the California, Delaware, and
Pennsylvania bars as well as being a registered patent attorney before the US
Patent and Trademark Office. Ms. McClung received a JD from the University of
Pennsylvania Law School, as well as a B.A. from the University of California,
San Diego, and an M.A. from the University of Pennsylvania.
16
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED SHAREHOLDER MATTERS
The market price for shares of the Company's Common Stock has been
highly volatile. Factors such as the results of preclinical studies and
clinical trials for Cygnus' products or products of its competitors,
announcements of technological innovations, strategic relationships, new
product introductions by the Company or its competitors, governmental
regulation, regulatory approvals or delays or developments relating to patent
or proprietary rights, as well as period-to-period fluctuations in financial
results, may have a significant impact on the market price of the Common
Stock. Additionally, in recent years, the stock market has experienced
extreme price and volume fluctuations.
The Company's Common Stock trades on the Nasdaq National Market tier of
the Nasdaq Stock Market -SM- under the symbol "CYGN." The following table sets
forth, for the periods indicated, the high and low closing sale prices per
share of the Common Stock as reported by the national market.
1998: High Low
---- ---
First Quarter $20 5/8 $16
Second Quarter 13 1/2 5 25/32
Third Quarter 10 1/4 3 1/16
Fourth Quarter 6 7/8 2 5/8
1997: High Low
---- ----
First Quarter $16 5/8 $13 3/8
Second Quarter 17 1/4 10 5/8
Third Quarter 19 3/4 16
Fourth Quarter 24 5/8 18 3/4
As of December 31, 1998, there were approximately 557 record holders of
the Company's Common Stock. Cygnus has not paid any cash dividends since its
inception and does not expect to pay any cash dividends on its Common Stock
in the foreseeable future. In addition, the Company is precluded from paying
any dividends under certain of its financing arrangements.
17
ITEM 6. SELECTED FINANCIAL DATA
The selected consolidated financial data presented below are derived
from the audited consolidated financial statements of Cygnus, Inc. The
financial consolidated statements as of December 31, 1998, 1997 and for each
of the three years in the three-year period ended December 31, 1998 are
included elsewhere herein. The selected financial data as of December 31,
1996, 1995, and 1994 and for each of the years in the two-year period ended
December 31, 1995, are derived from audited consolidated financial statements
not included herein. The data should be read in conjunction with the
consolidated financial statements and related notes, the information set
forth under "Management's Discussion and Analysis of Financial Conditions
and Results of Operations" and other financial information included herein.
No dividends have been paid for any of the periods presented.
Year Ended December 31,
---------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(In thousands, except per share data)
CONSOLIDATED STATEMENT OF OPERATIONS DATA:
Product revenues $ 587 $ 4,212 $ 17,211 $ 3,704 $ 1,917
Contract revenues 10,178 14,106 13,085 12,579 14,533
Royalty and other revenues 890 11,184 5,907 2,723 4,820
------- ------ ------- ------ ------
Total revenues 11,655 29,502 36,203 19,006 21,270
Costs and expenses:
Costs of products sold 3,478 10,413 16,659 4,746 3,293
Research and development 32,149 22,328 23,165 20,029 21,605
Marketing, General and
Administrative 11,730 8,695 9,296 7,369 5,491
Arbitration settlement -- 39,666 -- -- --
Purchase of in-process research
and development -- -- -- -- 9,000
------- ------ ------- ------ ------
Total costs and expenses 47,357 81,102 49,120 32,144 39,389
------- ------ ------- ------ ------
Loss from operations (35,702) (51,600) (12,917) (13,138) (18,119)
Other income and expense (3,726) 1,140 1,865 296 759
------- ------ ------- ------ ------
Net loss $(39,428) $(50,460) $(11,052) $(12,842) $(17,360)
------- ------ ------- ------ ------
------- ------ ------- ------ ------
Basic and diluted net loss per share $ (1.95) $ (2.67) $ (0.60) $ (0.79) $ (1.24)
------- ------ ------- ------ ------
------- ------ ------- ------ ------
Shares used in computation of basic and
diluted net loss per share 20,226 18,928 18,544 16,265 13,947
------- ------ ------- ------ ------
------- ------ ------- ------ ------
Year Ended December 31,
---------------------------------------------------------
1998 1997 1996 1995 1994
---- ---- ---- ---- ----
(In thousands)
CONSOLIDATED BALANCE SHEET DATA:
Working capital $ 11,542 $ 9,941 $ 36,386 $ 38,555 $ 18,041
Total assets 43,454 49,277 68,798 57,854 38,116
Long-term obligations 60,220 33,234 13,437 8,331 7,398
Accumulated deficit (175,955) (136,527) (86,067) (75,015) (62,174)
Stockholders' equity (net capital deficiency) (32,767) (13,800) 31,213 38,252 18,117
18
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
THIS REPORT CONTAINS FORWARD-LOOKING STATEMENTS THAT INVOLVE RISKS AND
UNCERTAINTIES RELATING TO THE FUTURE FINANCIAL PERFORMANCE OF CYGNUS, INC.
("CYGNUS" OR THE "COMPANY), AND ACTUAL EVENTS OR RESULTS MAY DIFFER
MATERIALLY. IN EVALUATING SUCH STATEMENTS, STOCKHOLDERS AND INVESTORS SHOULD
SPECIFICALLY CONSIDER THE VARIOUS FACTORS IDENTIFIED UNDER THE CAPTION "RISK
FACTORS" CONTAINED IN THE MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS WHICH COULD CAUSE ACTUAL RESULTS TO
DIFFER MATERIALLY FROM THOSE INDICATED BY SUCH FORWARD-LOOKING STATEMENTS.
THE COMPANY UNDERTAKES NO OBLIGATION TO PUBLICLY RELEASE THE RESULTS OF ANY
REVISIONS TO THESE FORWARD-LOOKING STATEMENTS WHICH MAY BE MADE TO REFLECT
EVENTS OR CIRCUMSTANCES AFTER THE DATE HEREOF OR TO REFLECT THE OCCURRENCES
OF UNANTICIPATED EVENTS.
GENERAL
Cygnus is engaged in the development and manufacture of diagnostic and
drug delivery systems, utilizing its proprietary technologies to satisfy
unmet medical needs cost-effectively. The Company's current efforts are
primarily focused on two core areas: a continuous and automatic glucose
monitoring device (the GlucoWatch system) and transdermal drug delivery
systems.
The Company's product development efforts have been and are expected to
continue to be either self-funded, funded by licensees or distributors, or
both. In general, the Company's agreements provide that Cygnus will
manufacture its products and receive manufacturing revenues from sales of
these products to its licensees or distributors. Cygnus may also receive
royalties based on certain of its licensees' or distributors' product sales.
In certain circumstances, the Company may elect to license manufacturing
rights for a product to its licensee in exchange for a technology transfer
fee and/or a higher royalty rate.
Cygnus' licensees and distributors generally have the right to abandon a
product development effort at any time for any reason without significant
penalty. Such cancellations may result in delays, suspension or abandonment
of clinical testing, the preparation and processing of regulatory filings and
product development and commercialization efforts. Licensees have exercised
this right in the past, and there can be no assurance that current and future
licensees or distributors will not exercise this right in the future. If a
licensee or distributor were to cease funding one of the Company's products,
Cygnus would either self-fund development efforts, identify and enter into an
agreement with an alternative licensee or distributor or suspend further
development work on the product. There can be no assurance that, if
necessary, the Company would be able to negotiate an agreement with an
alternative licensee or distributor on acceptable terms. Since all payments
to the Company under its agreements following their execution are contingent
on the occurrence of future events or sales levels, and the agreements are
terminable by the licensee or distributor, no assurance can be given as to
whether the Company will receive any particular payment thereunder or as to
the amount or timing of any such payment. The Company may choose to self-fund
certain research and development projects in order to exploit its
technologies. Any increase in Company-sponsored research and development
activities will have an immediate adverse effect on the Company's results of
operations. However, should such Company-sponsored research and development
activities result in a commercial product, the long-term effect on the
Company's results of operations could be favorable. In the past some of the
Company's licensees, distributors and collaborators have approached the
Company requesting modification of the terms of existing agreements. The
Company is currently involved in discussions with several companies with
regard to a collaboration for the marketing and distribution of the
GlucoWatch monitor in the U.S. and Europe. There can be no assurance that the
Company will be able to enter into new collaborative arrangements.
For the Company to remain competitive, it will need to develop,
in-license or acquire new diagnostic and drug delivery products. Furthermore,
the Company's ability to develop and commercialize products in the future
will depend on its ability to enter into collaborative arrangements with
additional licensees on favorable terms. There can be no assurance that the
Company will be able to enter into new collaborative arrangements on such
terms, if at all.
The Company's results of operations vary significantly from year to year
and depend on, among other factors, the signing of new product development
agreements and the timing of recognizing payment amounts specified
thereunder, the timing of recognizing license or distribution fees and cost
reimbursement payments made by pharmaceutical licensees, and the demand for
its products. Up-front and interim milestone payments from contracts are
generally earned and recognized based on the percentage of actual efforts
expended compared to total expected efforts
19
during the development period for each contract. However, contract revenues
are not always aligned with the timing of related expenses. To date, research
and development expenses have generally exceeded contract revenue in any
particular period and the Company expects the same situation to continue for
the next few years. In addition, the level of revenues in any given period is
not necessarily indicative of expected revenues in future periods. In 1998
seventy six percent of revenues recognized by the Company were attributable
to four customers. The Company has incurred net losses each year since its
inception and does not believe it will achieve profitability in 1999. At
December 31, 1998, the Company's accumulated deficit and net capital
deficiency were approximately $175.9 million and $32.8 million, respectively.
RESULTS OF OPERATIONS:
COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1998 AND 1997
PRODUCT REVENUES for the year ended December 31, 1998 were $0.6 million
compared to $4.2 million for the year ended December 31, 1997. Product
revenue for the year ended December 31, 1998 resulted from the shipments of
the FemPatch system. Included in product revenue for the year ended December
31, 1997 are the initial shipments of the FemPatch system and the final
shipments of the Nicotrol patch. The reduction in total product revenue is
primarily due to the discontinuation of shipments of the FemPatch system.
Due to the discontinuation of Nicotrol patch manufacturing and the
termination of the FemPatch system supply agreement, the Company does not
expect any further product revenues until new products are commercialized.
The Company does, however, expect to continue to receive royalty revenues
from the manufacture and sale of the Nicotrol patch by the Company's
licensee. There can be no assurance that the Company will be successful in
its efforts to commercialize any future products.
Due to the above factors and the uncertainty regarding when and if
additional products will obtain approval from the FDA and when and if
licensees will sell and market such products, the Company believes that the
level of product revenues experienced to date is not indicative of future
results and may fluctuate from year to year.
CONTRACT REVENUES for the year ended December 31, 1998 were $10.2
million compared to the $14.1 million for the year ended December 31, 1997.
Contract revenues primarily reflect labor and material cost reimbursements
associated with the development of certain transdermal delivery systems and
the amortization of milestone payments relating to certain transdermal
delivery systems and the glucose monitoring device. The decrease in contract
revenues is primarily due to a one-time payment of $1.0 million received
from Pharmacia & Upjohn in June 1997 for the exercise of its option to
purchase the U.S. manufacturing rights for the Nicotrol patch, a reduction in
clinical billings related to one of the Company's hormone replacement
products and reduced milestone amortization related to the GlucoWatch monitor.
In February 1996, the Company entered into an agreement with Becton
Dickinson & Company for the marketing and distribution of the GlucoWatch
monitor, a continuous and automatic glucose monitoring device being developed
by Cygnus. Under the terms of the agreement, Becton Dickinson had exclusive
worldwide marketing and distribution rights, with the exception of Japan and
Korea. The agreement was amended in June 1997 to grant Becton Dickinson
worldwide marketing rights, with the exception of Japan and Korea, for the
Company's second generation glucose monitor. Cygnus retained primary
responsibility for completing product development, obtaining regulatory
approvals and manufacturing. In the first half of 1996, Cygnus received an
up-front, non-refundable payment from Becton Dickinson. On March 31, 1998,
the Company announced that the agreement it had with Becton Dickinson had
been terminated. Consequently, the Company will not receive any future
milestone payments under the Becton Dickinson agreement and will not be
obligated to share future revenue, if any, associated with commercialization
of the GlucoWatch monitor. The Company is currently involved in discussions
with several companies with regard to collaboration for the sales and
distribution of the GlucoWatch monitor in the U.S. and Europe. There can be
no assurance that the Company will be able to enter into new collaborative
arrangements.
In July 1996, the Company entered into an agreement with Tokyo-based
Yamanouchi for the marketing and distribution of the GlucoWatch monitor.
Under the terms of this agreement, Yamanouchi has exclusive marketing and
distribution rights in Japan and Korea. Cygnus will have primary
responsibility for completing product development and for manufacturing. In
the third quarter of 1996, Cygnus received an up-front, non-refundable
payment from
20
Yamanouchi and is eligible to receive milestone payments as well as a
percentage of the product's future commercial sales. In July 1996, the
Company also entered into a development and marketing agreement with
Yamanouchi for a 7-day transdermal product to deliver a proprietary
Yamanouchi compound. In July 1998, Yamanouchi discontinued the agreement
related to the 7-day transdermal product.
In 1998, the Company entered into an agreement with Undisclosed company,
for the development, supply and commercialization of a nicotine transdermal
system, a smoking cessation patch being developed by Cygnus. Under the terms
of the agreement, the Undisclosed company has marketing and distribution
rights in certain territories. Cygnus has exclusive manufacturing and supply
rights. The Undisclosed company has primary responsibility for obtaining
regulatory approval and commercialization. Cygnus has received payment for
1998 manufacturing and development costs and will receive similar future
payments. The Company is also eligible to receive future milestone payments
as well as a percentage of the product's future commercial success.
In December 1998, a NDA was submitted to the FDA and the European
Dossier has been submitted to the European authorities for the Company's
7-day estrogen patch. In July 1998, the Company was notified by AHP, the
licensee for two of the Company's transdermal hormone replacement products,
that AHP wanted to discuss the status of its agreement with the Company.
Cygnus was notified by AHP that it intended to exercise its right under the
agreement to seek a sublicensee for these products and is now actively
involved in doing so. AHP and Cygnus have negotiated an amendment to the
agreement that provides Cygnus immediate ownership of the regulatory filing
packages for the two products and the right to co-promote the two products as
well. The amendment also provides that if AHP is unable to sign an agreement
with a sublicensee within six months, the rights to the two products will
revert to Cygnus and AHP will be obligated to continue development
activities for the two products for an additional six months. There can be no
assurance that AHP will find a sublicensee. Furthermore, if AHP is
unsuccessful in finding a sublicensee, it is uncertain what course of action
the Company will take with regard to these two products, although it is
expected the Company will seek a new collaboration for the distribution and
marketing of the products.
Contract revenues are expected to fluctuate from quarter to quarter and
from year to year, and future contract revenues cannot be reasonably
predicted. The contributing factors to achieving contract revenues include,
but are not limited to, future successes in finalizing new collaborative
agreements, timely achievement of milestones under current contracts, and
strategic decisions on self-funding certain projects. The Company is unable
to predict to what extent the termination of existing contracts by current
partners, or new collaborative agreements, if any, will impact overall
contract revenues in 1999 and subsequent future periods.
ROYALTY AND OTHER REVENUES for the year ended December 31, 1998 were
$0.9 million, compared to $11.2 million for the year ended December 31, 1997.
The amounts include royalties from sales by Pharmacia of the Company's
nicotine transdermal product in Europe and Canada, and by Pharmacia's
marketing partner in the U.S. The net decrease in royalty and other revenues
for the year ended December 31, 1998 compared to the year ended December 31,
1997 is primarily due to the 1996 launch in the U.S. of the non-prescription
Nicotrol patch. The year ended December 31, 1997 included the recognition of
previously deferred royalty payments associated with this launch, and a
reimbursement payment from Pharmacia relating to inventory and purchase
commitments, whereas no such revenue was included in the period ended
December 31, 1998.
Royalty revenue will fluctuate from period to period, since it is
primarily based upon sales by the Company's licensees. The level of royalty
income for a product also depends on various external factors, including the
size of the market for the product, product pricing levels and the ability of
the Company's licensee to market the product. Therefore, the level of royalty
revenue for any given period is not indicative of the expected royalty
revenue for future periods.
COSTS OF PRODUCTS SOLD for the year ended December 31, 1998, were $3.5
million compared to $10.4 million for the year ended December 31, 1997. Costs
of products sold primarily include direct and indirect production, facility
and personnel costs required to meet current and future anticipated
production levels. Costs of products sold for the period ended December 31,
1998 include shipments of the FemPatch system. The decrease in costs of
products sold for the period ended December 31, 1998 is primarily due to the
reduced shipments of the FemPatch system. The Company experienced negative
product margins for the periods ended December 31, 1998 and December 31, 1997
due to low production volumes that prevented the Company from absorbing all
of its fixed manufacturing costs. Because
21
the Company is not currently manufacturing any commercial products, the
Company expects that fixed manufacturing costs will continue to result in
negative product margins for the foreseeable future.
RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1998
were $32.1 million compared to $22.3 million for the year ended December 31,
1997. The increase in research and development expenses for the year ended
December 31, 1998 is primarily due to the increased costs associated with the
GlucoWatch monitor and the Autosensor in the following areas: material,
design and scale up for development efforts, and material and outside charges
for the accelerated level of clinical activities. Research and development and
clinical activities primarily include support and development for the glucose
monitoring program, the Company's hormone replacement therapy products and a
contraception product. Cygnus does not anticipate an increase in its overall
research and development expenses in 1999.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended
December 31, 1998 were $11.7 million, compared to $8.7 million for the year
ended December 31, 1997. The increase is primarily due to increased sales
and marketing expenses related to the GlucoWatch monitor, in particular
marketing research expenses. The Company does not expect that marketing,
general and administrative expenses will increase in 1999.
ARBITRATION SETTLEMENT EXPENSE for the year ended December 31, 1997 of
$39.7 million represents a non-recurring arbitration settlement expense with
Sanofi. As of December 31, 1998, the Company had accrued liabilities related
to the arbitration settlement of $24.2 million. Of the total accrued
liability of $24.2 million, $24.1 million is long-term. Under the terms of
the settlement, Cygnus (i) paid Sanofi $14.0 million in cash in January 1998,
(ii) will make royalty payments of between 6.5% and 8.5% of any and all net
sales on its two hormone replacement products, which are subject to minimum
payments in an aggregate amount equal to $17.0 million, commencing in 2001
and ending in 2005, whether or not any net sales of the two products have
occurred, and (iii) issued, in December 1997, a convertible promissory note
in the principal amount of $6.0 million, payable in full at the end of four
years and bearing interest at 6.5% per annum. The note will be convertible
into the Company's Common Stock at Sanofi's option, exercisable at any time
during the four year term, at a conversion rate of $21.725 per share.
INTEREST INCOME (EXPENSE), NET OF INTEREST AND OTHER EXPENSE for the
year ended December 31, 1998, was ($3.7) million as compared to $1.1 million
for the year ended December 31, 1997. The decrease is due primarily to the
$4.2 million non-cash costs of the beneficial conversion feature associated
with the October 1998 restructuring of the 4% Senior Subordinated Convertible
Notes, the interest expense associated with the subordinated convertible
debt, the amortization of the financing fees related to this debt and the
interest related to the additional long-term debt incurred in the second
quarter of 1998. These costs were offset by a net arbitration settlement with
Pharmacia & Upjohn from which Cygnus received $2.7 million.
COMPARISON FOR THE YEARS ENDED DECEMBER 31, 1997 AND 1996
PRODUCT REVENUES for the year ended December 31, 1997 were $4.2 million
compared to $17.2 million for the year ended December 31, 1996. Included in
product revenue, for the year ended December 31, 1997, are initial shipments
of the FemPatch system. The reduction in total product revenue resulted from
the discontinuation of the Nicotrol patch manufacturing in the first quarter
of 1997.
CONTRACT REVENUES for the year ended December 31, 1997 were $14.1
million compared to the $13.1 million for the year ended December 31, 1996.
Contract revenues primarily reflect labor and material cost reimbursements
associated with certain transdermal delivery systems and the amortization of
milestone payments relating to certain transdermal delivery systems and the
glucose monitoring device. The increase in contract revenues is primarily due
to a one time $1.0 million payment from Pharmacia for the exercise of its
option to purchase the U.S. manufacturing rights for the Nicotrol patch.
ROYALTY AND OTHER REVENUES for the year ended December 31, 1997 were
$11.2 million, compared to $5.9 million for the year ended December 31, 1996.
The amounts include royalties from sales by Pharmacia of the Company's
nicotine transdermal product in Europe and Canada and by Pharmacia's
marketing partner in the U.S. The net increase in royalty and other revenues
is primarily due to the recognition of previously deferred royalty payments
associated with the U.S. over-the-counter sales of the Nicotrol patch during
the second half of 1996 and a $2.5 million reimbursement payment from
Pharmacia relating to inventory and purchase commitments previously expensed
by the Company in 1996.
22
COSTS OF PRODUCTS SOLD for the year ended December 31, 1997 were $10.4
million compared to $16.7 million for the year ended December 31, 1996. Costs
of products sold primarily include direct and indirect production, facility
and personnel costs required to meet the production levels. The decrease in
costs of products sold largely reflects the reduction of direct expenses
related to the Nicotrol patch production as a result of Pharmacia exercising
its option to purchase the manufacturing rights of the Nicotrol patch. Cost
of products sold for the year ended December 31, 1997 include the initial
shipments of the FemPatch system, the Company's second commercialized
product. The Company experienced negative product margins for the year ended
December 31, 1997 due to low production volumes which prevented the Company
from absorbing all of its fixed manufacturing costs.
RESEARCH AND DEVELOPMENT EXPENSES for the year ended December 31, 1997
were $22.3 million compared to $23.2 million for the year ended December 31,
1996. Research and development and clinical activities primarily include the
glucose monitoring development program, the support of the Company's hormone
replacement therapy products and a contraception product.
MARKETING, GENERAL AND ADMINISTRATIVE EXPENSES for the year ended
December 31, 1997 were $8.7 million, compared to $9.3 million for the year
ended December 31, 1996. The decrease resulted primarily from decreased
professional fees associated with the Company's legal proceedings involving
Sanofi.
INTEREST INCOME, NET OF INTEREST AND OTHER EXPENSE for the year ended
December 31, 1997 was $1.1 million as compared to $1.9 million for the year
ended December 31, 1996. The decrease is due primarily to higher interest
expense associated with the Company's June 1996, $8.0 million bank loan
agreement for short-term working capital. In addition, interest income earned
has decreased in conjunction with the decrease in the cash and cash
equivalents balance.
LIQUIDITY AND CAPITAL RESOURCES
Overall, the cash, cash equivalents and investment balances as of
December 31, 1998 totaled $28.8 million, representing a decrease of $6.0
million from the total as of December 31, 1997. At December 31, 1998, the
Company had a negative net worth of $32.8 million.
Through December 1997, the Company received net proceeds of
approximately $82.1 million from public offerings of its Common Stock. In
February 1998, the Company received net proceeds of approximately $13.3
million (net of issuance costs of approximately $0.5 million) from a direct
public offering of its Common Stock.
Through 1997, the Company financed approximately $9.7 million of
manufacturing and research equipment under capital loan and lease
arrangements. In the second quarter of 1998, the Company entered into a new
loan agreement for $1.4 million to finance additional capital equipment.
Borrowings under this agreement are secured by specific Company assets.
In April of 1998, the Company consolidated its two outstanding bank
loans into an expanded credit facility with the same bank. An additional $4.7
million was borrowed, increasing the total outstanding under the new
agreement to $10.0 million. In November of 1998, the April agreement was
further amended to modify the covenants. This balance will be repaid through
November 2001, with monthly interest-only payments through November 1998 and
monthly principal-and-interest installments thereafter. As of December 31,
1998 there is $9.8 million outstanding under this agreement. Borrowings under
this agreement are secured by specific Company assets.
In February 1998, the Company entered into Note Purchase Agreements with
certain institutional investors to issue and sell approximately $43 million
of 4% Senior Subordinated Convertible Notes due 2005 (the "Notes"). On
October 28, 1998, the Company restructured the Notes. Key provisions in the
restructured Notes include the October 1998 repayment of $18.5 million in
principal (reducing the principal balance from $43 million to $24.5 million),
a delay in the convertibility of the majority of the Notes to June 30, 1999,
modification of conversion prices of the Notes, the ability of the Company to
redeem at par at any time all or part of the new principal amount of the
Notes, an increase in the interest rate to 5.5% paid annually on the new
principal balance and the change in the final maturity of the Notes to
October 1, 2000 (see "Senior Convertible Notes" Part 1, Item I). Through
December 31, 1998, $1.9 million of the first tranche of $6.0 million was
converted into equity. In January 1999, the remaining balance of $4.1
million of the original first tranche of $6.0 million was converted into
equity.
23
In addition to the cash received from the public offerings, issuance of
the Notes, equipment lease and short-term working capital financing, the
Company has been financing its operations primarily through revenues and
interest income.
Net cash used in operating activities for the year ended December 31,
1998 was $42.5 million, compared with net cash used of $14.6 million for year
ended December 31, 1997. Cash used in operating activities during the year
ended December 31, 1998 was primarily due to the Company's net loss of $39.4
million and a $14.0 million cash payment made in January 1998 to Sanofi under
the terms of the arbitration settlement, offset by the non-cash beneficial
conversion costs of $4.2 million associated with the October 1998
restructuring of the Notes, an increase in accounts payable and other accrued
liabilities of $2.8 million, depreciation and amortization of $1.9 million
and amortization of debt issuance cost of $1.6 million. Cash used in
operating activities during the year ended December 31, 1997 was primarily
due to the Company's net loss of $50.5 million, a decrease of $10.4 million
in deferred revenue, a decrease of $2.1 million in accounts payable and other
accrued liabilities and an increase of $3.2 million in prepaid expenses and
other current assets. This was offset by the $39.2 million increase in Sanofi
obligations, decrease of $5.7 million in accounts receivable, $2.7 million of
depreciation and amortization and an increase of $1.5 million in deferred
compensation and other long-term liabilities.
The current level of cash used in operating activities is not
necessarily indicative of the level of future cash usage. The Company expects
a decrease in operating cash usage for 1999 primarily because the $14.0
million payment in 1998 of the Sanofi arbitration liability will not recur in
1999.
Net cash used in investing activities of $7.6 million for the year ended
December 31, 1998 resulted primarily from net purchases of investments of
$4.2 million and capital expenditures of $3.4 million. Net cash used in
investing activities of $0.8 million for the year ended December 31, 1997
resulted primarily from $3.1 million in capital expenditures, offset by $2.3
million in net maturity and sales of investments.
Net cash provided by financing activities of $39.7 million for the year
ended December 31, 1998 includes, as mentioned above, net proceeds of $40.4
million and $13.3 million from the Company's February 1998 issuance of Senior
Subordinated Convertible Notes and from a direct public offering of its
Common Stock, respectively; additional stock proceeds of $0.9 million and
$6.1 million from the issuance of long-term debt, offset by a subordinated
debt principal repayment of $18.5 million; and long-term debt and capital
lease repayments of $2.0 million and $0.5 million, respectively. Net cash
provided by financing activities of $3.0 million for the year ended December
31, 1997 included $2.5 million from the exercise of warrants to purchase
common stock, $2.9 million of common stock issuance proceeds and $1.3 million
received from the Company's capital equipment loan, offset by $3.8 million in
long-term debt and capital lease repayments.
The Company's long-term capital expenditure requirements will depend
upon numerous factors, including the progress of the Company's research and
development programs; the time required to obtain regulatory approvals; the
resources that the Company devotes to the development of self-funded
products, proprietary manufacturing methods and advanced technologies; the
ability of the Company to obtain additional licensing arrangements and to
manufacture products under those arrangements; the additional expenditures to
support the manufacture of new products, if and when approved; and possible
acquisitions of products, technologies and companies. As the Company
evaluates the progress of its development projects, in particular the
GlucoWatch system, its commercialization plans and the lead time to set up
manufacturing capabilities, Cygnus may commence long-term planning for
another manufacturing site. Nevertheless, the Company believes that such
long-term planning will not result in any material impact on cash flows and
liquidity for 1999.
Based upon current expectations for operating losses and projected
short-term capital expenditures, the Company believes that its existing cash,
cash equivalents and investments of $28.8 million as of December 31, 1998,
when coupled with cash from revenues and earnings from investments, will be
sufficient to meet its operating expenses and capital expenditure
requirements at least through the end of 1999. However, there can be no
assurance that the Company will not require additional financing, depending
upon future business strategies, results of clinical trials and management
decisions to accelerate certain research and development programs and other
factors.
24
INCOME TAXES. At December 31, 1998, the Company had federal net
operating loss and research and development tax credit carryforwards of
approximately $131.0 million and $2.4 million, respectively. The Company had
state net operating loss and tax credit carryforwards of approximately $19.8
million and $1.9 million, respectively. These carryforwards will expire at
various dates beginning in 1999. Because of the "change in ownership"
provisions of the Internal Revenue Code, a substantial portion of the
Company's net operating loss and tax credit carryforwards may be subject to
annual limitations. The annual limitations may result in the expiration of
net operating losses and tax credits before utilization.
YEAR 2000 COMPLIANCE
The Company is preparing for the impact of the arrival of the Year 2000
("Y2K")on its business, as well as on the businesses of its customers,
suppliers and business partners. The "Y2K Issue" is a term used to describe
the problems created by systems that are unable to accurately interpret dates
after December 31, 1999. These problems are derived predominantly from the
fact that many software programs have historically categorized the "year" in
a two-digit format. The Year 2000 Issue creates potential risks for the
Company, including potential problems in the Company's products as well as in
the Information Technology ("IT") and non-IT systems that the Company uses in
its business operations. The Company may also be exposed to risks from third
parties with whom the Company interacts who fail to adequately address their
own Y2K Issues.
The Company began its Y2K efforts early in 1998 by forming a Project
office chaired by the Company's Senior Vice President of Finance. The Board
of Directors is advised periodically on the status of the Company's Y2K
compliance program.
The project team developed a five phase approach to identifying and
remediating Y2K Issues. These phases are:
1. Awareness
2. Inventory
3. Assessment
4. Correction and Testing
5. Implementation
The Company completed the awareness phase of the project in the third
quarter of 1998. This phase consisted of meetings with company personnel
educating them on the issues related to Y2K. The meetings focused on internal
systems, both IT and non-IT, as well as external systems and relationships.
The Company engaged the services of an outside Y2K consulting service to
perform a comprehensive inventory of internal IT and non-IT systems and
applications. The inventory was completed during the fourth quarter of 1998.
Concurrent with the inventory, the Company's consultant performed an
assessment of the systems and applications documented in the inventory. The
result of this independent assessment showed that the majority of the
Company's internal IT systems were compliant. This is due to the fact that
the Company does not rely on in-house developed applications for its core
business applications and therefore does not have legacy code to review and
test. The Company's core business applications, Accounts Payable, Accounts
Receivable, Sales Orders, and Inventory Control are supported by an
application that has been certified by the supplier to be fully Y2K
compliant and the compliance has been tested by the company. The assessment
did determine that the payroll application in use was non-compliant. This was
upgraded to a compliant version in the first quarter of 1999.
Due to the regulatory requirements placed on the pharmaceutical and
medical device industry by the FDA, the Company has placed appropriate
attention on the non-IT systems. For the Company, this specifically covers
all areas governed by current Good Manufacturing Practice ("cGMP") guidelines
and include but are not limited to environmental monitoring/control systems,
laboratory instrumentation and their sub-systems, production equipment, and
materials handling equipment. The assessment identified several of these
non-IT systems to be non-compliant. The majority of these non-compliant
systems are laboratory instrumentation and their sub-systems. These systems
are assessed to be non-mission critical. The Company fully expects that these
systems will be upgraded, replaced or have a contingency plan in place by
January 1, 2000.
Concurrent with the inventory and assessment of internal systems and
applications, the Company identified several providers of products and
services that are critical to its operations. The Company is working with
these providers to ensure that these critical products and services are
available for continued operations after January 1, 2000. At this time the
Company is not aware of any issues relating to these providers.
The correction and testing, as well as the implementation, phases of the
Company's Y2K compliance program are currently under way and are expected to
be completed prior to January 1, 2000.
The total cost associated with the Company's Y2K remediation is not
expected to be material to the Company's financial condition or results of
operations. The estimated total cost of the Company's Year 2000 remediation
is not expected to exceed $500,000. Through December, 1998, the Company has
spent approximately $100,000 in connection with Y2K Issues. The cost of
implementing the replacement for the Company's core business applications has
not been included in this figure since the replacement of the previous
applications was not accelerated due to Y2K Issues. All Y2K expenditures are
made from the respective departments' budgets.
Although the Company assesses its Y2K issue to be moderate to low, there
can be no assurance that the Company will be completely successful in its
efforts to address Y2K Issues.
Having reasonably determined that the Company's own hardware and
software systems will be substantially Y2K compliant, management believes
that the worst case scenarios would most likely involve simultaneous
Y2K-related disruptions from the Company's key customers, suppliers, service
providers and/or other business partners. For these worst case scenarios to
have maximum adverse impact on the Company, the vendors in question would
either need to be sole-source providers, or their peer companies, who would
otherwise be potential second-source suppliers, would also need to undergo
similar Y2K-related disruption. The Company believes that such simultaneous
disruptions of the supply of basic goods and services due to Y2K-related
issues are unlikely to occur.
Although the Company has not yet developed a comprehensive contingency
plan to address situations that may result if the Company or any of the third
parties upon which the Company is dependent is unable to achieve Y2K
readiness, the Company's Y2K compliance program is ongoing and its ultimate
scope, as well as the consideration of contingency plans, will continue to be
evaluated as new information becomes available.
The foregoing Y2K discussion contains "forward-looking statements"
within the meaning of the Private Securities Litigation Reform Act of 1995.
Such statements, including without limitation, anticipated costs and the
dates by which the Company expects to complete certain actions, are based on
management's best current estimates, which were derived utilizing numerous
assumptions about future events, including the continued availability of
certain resources, representations received from third parties and other
factors. However, there can be no guarantee that these estimates will be
achieved, and actual results could differ materially from those anticipated.
Specific factors that might cause such material differences include, but are
not limited to, the ability to identify and remediate all relevant IT and
non-IT systems, results of Year 2000 testing, adequate resolution of Y2K
Issues by businesses and other third parties who are service providers,
suppliers or customers of the Company, unanticipated system costs, the
adequacy of and ability to develop and implement contingency plans and
similar uncertainties. The "forward-looking statements" made in the foregoing
Y2K discussion speak only as of the date on which such statements are made,
and the Company undertakes no obligation to update any forward-looking
statement to reflect events or circumstances after the date on which such
statement is made or to reflect the occurrence of unanticipated events.
RISK FACTORS
Cygnus wishes to caution stockholders and investors that the following
important factors, among others, in some cases have affected, and in the
future could affect, Cygnus' actual results and could cause Cygnus' actual
consolidated results for 1999, and beyond, to differ materially from those
expressed in any forward-looking statements made by or on behalf of Cygnus.
The statements under this caption are intended to serve as cautionary
statements within the meaning of the Private Securities Litigation Reform Act
of 1995. The following information is not intended to limit in any way the
characterization of other statements or information under other captions as
cautionary statements for such purpose.
HISTORY OF OPERATING LOSSES; FUTURE CAPITAL REQUIREMENTS
The Company has a limited operating history upon which its prospects can
be evaluated. Such prospects must be considered in light of the substantial
risks, expenses and difficulties encountered by entrants into the medical
device and drug delivery industry. The Company reported a net loss of $14.6
million for the fourth quarter of 1998 and has experienced annual operating
losses since inception. The Company expects to continue to incur operating
losses at least until significant sales, if any, of the GlucoWatch monitor or
the contraceptive patch (which is in phase III clinical trails and is
currently in development with Johnson & Johnson) commence. There can be no
assurance that the Company will generate significant revenues or achieve
profitability. The Company has, and expects to have, fluctuations in
quarterly results based on recognition of collaborative and contract revenues
and expenses. Some of these fluctuations could be significant.
To date the Company has generated limited revenues from product sales
and does not have significant experience in manufacturing, marketing or
selling its products. There can be no assurance that the Company's future
development efforts will result in commercially viable products, that the
Company will be successful in introducing its products, or that required
regulatory clearances or approvals will be obtained in a timely manner, or at
all. There can be no assurance that the Company's products will ever gain
market acceptance or that the Company will continue to generate revenues or
achieve profitability.
The Company's revenues to date have been derived primarily from product
development and licensing fees related to its products under development, as
well as from manufacturing and royalty revenues from the Nicotrol patch and
the FemPatch system. The Company will no longer receive manufacturing revenue
from the Nicotrol patch or the FemPatch system. The Company will, however,
continue to receive royalty payments for the Nicotrol patch. The Company
expects that a substantial portion of its future revenues will be derived, if
regulatory approvals are obtained, from sales of the GlucoWatch monitor and
other products currently under development.
The continued development of the Company's products will require the
commitment of substantial resources to conduct the research, preclinical
development and clinical trials necessary to bring such products to market
and to establish production and marketing capabilities. The Company may seek
additional funding through public or private financings, including debt or
equity financings, and through other arrangements, including collaborative
arrangements. Any additional equity financings may be dilutive to
stockholders and debt financing, if available, may involve restrictions on
dividends and other restrictions on the Company. Adequate funds, whether
through financial markets or collaborative or other arrangements with
corporate partners or from other sources, may not be available when needed
or, if available, on terms acceptable to the Company. Lack of sufficient
additional funds may require the Company to delay, scale back or eliminate
some or all of its research and product development programs or to license
others to commercialize products or technologies that the Company would
otherwise seek to develop itself.
25
The Company believes that its existing cash, cash equivalents and
investments, when coupled with cash from revenues and earnings from
investments, will be sufficient to meet its operating expenses, dept
repayment and capital expenditure requirements at least through 1999. The
amounts and timing of expenditures will depend on the progress of ongoing
research and development, the results of preclinical testing and clinical
trials, the rate at which operating losses are incurred, the execution of any
development and licensing agreements with corporate partners, the Company's
development of products, the FDA regulatory process and other factors, many
of which are beyond the Company's control.
DEPENDENCE ON LICENSEES, DISTRIBUTORS AND COLLABORATIVE ARRANGEMENTS
The Company's business strategy for the development, clinical testing,
regulatory approval, manufacturing and commercialization of its products
depends, in large part, upon the Company's ability to selectively enter into
and maintain collaborative arrangements with licensees and distributors. If
the GlucoWatch monitor is commercialized, the Company will be dependent upon
Yamanouchi Pharmaceutical Co., Ltd. for marketing and distribution of the
GlucoWatch monitor in Japan and Korea. The Company does not currently have
any marketing or distribution agreements for the GlucoWatch monitor other
than the Yamanouchi collaboration. However, the Company is currently involved
in discussions with several companies with regard to the collaboration for
the sales and distribution of the GlucoWatch monitor in the U.S. and Europe.
The Company's licensees and distributors generally have the right to
terminate a product development effort at any time prior to regulatory
approval for any reason without significant penalty. Such cancellations may
result in delays, suspension or abandonment of clinical testing, the
preparation and processing of regulatory filings and product development and
commercialization efforts. Licensees have exercised this right in the past,
and there can be no assurance that current and future licensees or
distributors will not exercise this right in the future.
Since all payments to the Company under its licensing and distribution
agreements following their execution are contingent on the occurrence of
future events or sales levels, and the agreements are terminable by the
licensee or distributor, no assurance can be given as to whether the Company
will receive any particular payment thereunder or as to the amount or timing
of any such payment. In the past some of the Company's licensees,
distributors and collaborators have approached the Company requesting
modification of the terms of existing agreements. If a licensee or
distributor were to cease funding one of the Company's products, Cygnus would
either self-fund development efforts, identify and enter into an agreement
with an alternative licensee or distributor, or suspend further development
work on the product. Additionally, the Company may choose to self-fund
certain research and development projects in order to exploit its
technologies. However, should such Company-sponsored research and development
activities result in a commercial product, the long-term effect on the
Company's results of operations could be favorable. There can be no assurance
that, if necessary, the Company would be able to negotiate an agreement with
an alternative licensee or distributor on acceptable terms. Any increase in
Company-sponsored research and development or sales and marketing activities
will have an immediate adverse effect on the Company's results of operations.
Furthermore, the resources and attention a licensee or distributor
devotes to a product are not within the Company's control. As a result,
there may be delays in clinical testing, the preparation and processing of
regulatory filings and commercialization efforts conducted by the Company's
licensees or distributors. There can be no assurance that one or more of the
Company's licensees or distributors will not, for competitive reasons,
support, directly or indirectly, a company or product that competes with the
Company's product that is the subject of its license or distributor agreement
with the Company. Furthermore, any dispute between the Company and one of
its licensees or distributors might require the Company to initiate or defend
against expensive litigation or arbitration proceedings.
Any termination of any license or distributor arrangement by one of the
Company's licensees or distributors, any inability of a licensee or
distributor to fund or otherwise satisfy its obligations under its
arrangements with the Company and any significant dispute with or breach of a
contractual commitment by a licensee or distributor would likely require the
Company to seek and reach agreement with another licensee or distributor or
to assume, to the extent possible and at its own expense, all the
responsibilities being undertaken by the licensee or distributor. There can
be no assurance that the Company would be able to reach agreement with a
replacement licensee or distributor. If the Company were not able to find a
replacement licensee or distributor, there can be no assurance that the
Company would be able to perform or fund the activities for which such
licensee or distributor is currently responsible. Even if the Company were
able to perform and fund these activities, the Company's capital requirements
would increase substantially. In addition, the further development and the
clinical testing, regulatory approval process, marketing,
26
distribution and sale of the product covered by such licensee or distributor
would be significantly delayed. (See "Risk Factors -- Limited Marketing and
Sales Experience.")
For the Company to be competitive, it will need to develop, in-license
or acquire new diagnostic and drug delivery products. Furthermore, the
Company's ability to develop and commercialize products in the future will
depend, in part, on its ability to enter into collaborative arrangements with
additional licensees on favorable terms. There can be no assurance that the
Company will be able to enter into new collaborative arrangements on such
terms, if at all. Additionally, there can be no assurance that existing or
future collaborative arrangements will be successful.
Any of the foregoing circumstances could have a material adverse effect
upon the Company's business, financial condition, and results of operations.
DEPENDENCE ON LICENSED PATENT APPLICATIONS AND PROPRIETARY TECHNOLOGY
The Company's success depends in large part on its ability to obtain
patent protection for its products, preserve its trade secrets and operate
without infringing the proprietary rights of others, both in the U.S. and in
other countries. Patent applications in the U.S. are maintained in secrecy
until patents are issued, and since publication of discoveries in the
scientific or patent literature tends to lag behind actual discovery by
several months, Cygnus cannot be certain that it was the first to file patent
applications on such inventions or that it will not infringe third party
patents once issued. No assurance can be made that patents will be issued
with respect to any of the Company's patent applications or that any patents
will provide competitive advantages for its products or will not be
challenged or circumvented by competitors. Cygnus also relies on trade
secrets and proprietary know-how that it seeks to protect, in part, by
confidentiality agreements with its licensees, employees and consultants.
There can be no assurance that these agreements will not be breached, that
the Company would have adequate remedies for any breach or that the Company's
trade secrets will not otherwise become known or be independently developed
by its competitors.
Any litigation, in the U.S. or abroad, as well as foreign opposition
and/or domestic interference proceedings, could result in substantial expense
to the Company and significant diversion of effort by the Company's technical
and management personnel. Litigation may be necessary to enforce patents
issued to the Company or to protect trade secrets or know-how owned by the
Company as well at to defend against infringement charges. A negative
determination in such proceedings in which the Company is a party could
subject the Company to significant liabilities to third parties or require
the Company to seek licenses from third parties. Although patent and
intellectual property disputes in the pharmaceutical product area have often
been settled through licensing or similar arrangements, costs associated with
such arrangements may be substantial and could include ongoing royalties.
Furthermore, there can be no assurance that necessary licenses would be
available to the Company on satisfactory terms, if at all. Accordingly, an
adverse determination in a judicial or administrative proceeding or failure
to obtain necessary licenses could prevent the Company from manufacturing and
selling certain of its products, which would have a material adverse effect
on the Company.
HIGHLY LEVERAGED; ABILITY TO SERVICE DEBT
As of December 31, 1998, the Company had indebtedness of $59.5 million,
including a balance of $22.6 million remaining on its Notes. Through December
31, 1998 $1.9 million of the first tranche of $6.0 million was converted into
equity. In January 1999, the remaining balance of $4.1 million of the
original first tranche of $6.0 million was converted into equity. The degree
to which the Company is leveraged could materially and adversely affect the
Company's ability to obtain financing for working capital, acquisitions or
other purposes and could make it more vulnerable to industry downturns and
competitive pressures. The Company's ability to meet its debt service
obligations will be dependent upon the Company's future performance, which
will be subject to financial, business and other factors affecting the
operations of the Company, many of which are beyond its control. Although the
Company believes its cash flows will be adequate to meet its interest
payments, there can be no assurance that the Company will continue to
generate cash flows in the future sufficient to cover its fixed charges or to
permit the Company to satisfy any redemption obligations pursuant to the
Notes (see below). If the Company is unable to generate cash flows in the
future sufficient to cover its fixed charges or to permit the Company to
satisfy any redemption obligations pursuant to the Notes, and the Company is
unable to borrow sufficient funds either under its credit facilities or from
other sources, it may be required to refinance all or a portion of its
existing debt, to sell all or a portion of its assets, or to sell equity
27
securities. There can be no assurance that a refinancing would be possible,
nor can there be any assurance as to the timing of any asset sales or sales
of equity securities or the proceeds which the Company could realize
therefrom.
The Notes are subordinate in right of payment to all existing and future
Senior Debt (as defined in the First Supplemental Indenture). By reason of
such subordination of the Notes, in the event of insolvency, bankruptcy,
liquidation, reorganization, dissolution or winding up of the business of the
Company or upon default in payment with respect to any Senior Debt of the
Company or an event of default with respect to such indebtedness resulting in
the acceleration thereof, the assets of the Company will be available to pay
the amounts due on the Notes only after all Senior Debt of the Company has
been paid in full. Moreover, holders of Common Stock would only receive the
assets remaining after payment of all indebtedness and preferred stock, if
any.
The Notes are obligations exclusively of the Company. Although the
Company does not currently conduct operations through subsidiaries, it may
elect to do so as products become commercialized. In such event, the cash
flow and the consequent ability to service debt, including the Notes, of the
Company, will be partially dependent upon the earnings of its subsidiaries
and the distribution of those earnings to, or upon loans or other payments of
funds by those subsidiaries to, the Company. The payment of dividends and the
making of loans and advances to the Company by its subsidiaries would be
subject to statutory or contractual restrictions, would be dependent upon the
earnings of those subsidiaries and would be subject to various business
considerations. Any right of the Company to receive assets of any of its
subsidiaries upon their liquidation or reorganization (and the consequent
right of the holders of the Notes [the "Holder(s)"] to participate in those
assets) would be effectively subordinated to the claims of that subsidiary's
creditors (including trade creditors), except to the extent that the Company
is itself recognized as a creditor of such subsidiary, in which case the
claims of the Company would still be subordinate to any security interests in
the assets of such subsidiary and any indebtedness of such subsidiary senior
to that held by the Company. Under certain circumstances, including the
delisting of the Company's securities from the Nasdaq National Market, each
holder of Notes will have the right, at the Holder's option, to require the
Company to repurchase all or a portion of such Holder's Notes at a purchase
price equal to 110% of the principal amount thereof plus accrued interest
thereon to the repurchase date.
LIMITED MARKETING AND SALES EXPERIENCE
The Company has limited experience in marketing or selling medical
device products. In order to successfully market and sell the GlucoWatch
monitor or the Company's other products under development, the Company must
either develop a more extensive marketing and sales force or enter into
arrangements with third parties to market and sell such products. There can
be no assurance that the Company will be able to successfully develop a more
extensive marketing and sales force or that it will be able to enter into
marketing and sales agreements with third parties on acceptable terms, if at
all. If the Company maintains its own marketing and sales capabilities, it
will compete with other companies that have experienced and well-funded
marketing and sales operations. If the Company enters into a marketing
arrangement with a third party for the marketing and sales of the Company's
products, any revenues to be received by the Company from such products will
be dependent on the third party, and the Company will likely be required to a
pay a sales commission or similar amount to such party.
PRODUCT LIABILITY
The design, development, manufacture and use of the Company's products
involve an inherent risk of product liability claims and associated adverse
publicity. Producers of medical products may face substantial liability for
damages in the event of product failure or if it is alleged that the product
caused harm. The Company currently maintains product liability insurance.
Such insurance is expensive and difficult to obtain and may not be available
in the future on acceptable terms or at all. There can be no assurance that
the Company will not be subject to product liability claims, that the
Company's current insurance would cover such claims, or that adequate
insurance will continue to be available on acceptable terms to the Company in
the future. In the event the Company is held liable for damages in excess of
the limits of its insurance coverage, or if any claim or product recall
results in significant adverse publicity against the Company, the Company's
business, financial condition and results of operations could be materially
and adversely affected.
ATTRACTING AND RETAINING KEY EMPLOYEES
28
The Company's ability to operate successfully and manage its potential
future growth depends in significant part upon the continued service of
certain key scientific, technical, managerial and finance personnel, and its
ability to attract and retain additional highly qualified scientific,
technical, managerial and finance personnel. The Company faces intense
competition for qualified personnel in these areas, many of whom are often
subject to competing employment offers, and there can be no assurance that
the Company will be able to attract and retain such personnel. The loss of
key personnel or inability to hire and retain additional qualified personnel
in the future could have a material adverse effect on the Company's business,
financial condition and results of operations.
VOLATILITY OF STOCK PRICE
The trading price of the Company's Common Stock is subject to
substantial fluctuations in response to factors such as announcements by the
Company or its competitors of results of regulatory approval filings or
clinical trials or testing, developments or disputes governing proprietary
rights, technological innovations or new commercial products, government
regulatory action, general conditions in the medical technology industry,
changes in securities analysts' recommendations, or other events or factors,
many of which are beyond the Company's control. In addition, the stock market
in general has experienced extreme price and volume fluctuations in recent
years which have particularly affected the market prices of many medical
technology companies and which have been unrelated to the operating
performance of such companies. Fluctuations or decreases in the trading
price of the Company's Common Stock may adversely affect the market for the
Company's Common Stock. In the past, following periods of volatility in the
market price for a company's securities, securities class action litigation
often has been instituted. Such litigation could result in substantial costs
and a diversion of management attention and resources, which could have a
material adverse effect on the Company's business, financial condition and
operating results.
ABSENCE OF DIVIDENDS
The Company has never declared or paid cash dividends on its Common
Stock. The Company's current bank term loan precludes it from paying
dividends to stockholders. The Company currently intends to retain any
earnings for use in its business and therefore does not anticipate paying any
dividends in the future.
NO REVERSE STOCK SPLIT FOR THE COMPANY; NASDAQ CONTINUED LISTING REQUIREMENTS
ACHIEVED
On September 30, 1998, the Company received correspondence from Nasdaq
stating that the Company was not in compliance with the minimum bid price
requirement for continued listing on the Nasdaq National Market. The Company
subsequently demonstrated compliance with the New Nasdaq Listing Requirements
by maintaining a $5.00 minimum closing bid price for the required number of
consecutive trading days.
In January 1999, the Company announced that there will be no reverse
stock split of the Company's common stock. Nasdaq notified the Company on
January 27, 1999 that it had been found to be in compliance with the bid
price requirement as well as all other requirements necessary for continued
listing on the Nasdaq National Market. The Company had received approval from
shareholders, in December 1998, for a three-for-one reverse stock split as a
solution if there was no other recourse in complying with the continued
listing requirements for the Nasdaq National Market; however, the Company has
no current plans to implement the stock split at this time.
29
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK.
INTEREST RATE RISK
The Company's exposure to market risk for changes in interest rates
relates primarily to the Company's investment portfolio and long-term debt
obligations. The Company does not use derivative financial instruments in its
investment portfolio. The Company places its investments with high credit
quality issuers and, by policy, limits the amount of credit exposure to any
one issuer. As stated in its policy, the Company is averse to principal loss
and ensures the safety and preservation of its invested funds by limiting
default risk, market risk and reinvestment risk.
The Company mitigates default risk by investing in only the highest
credit quality securities. The portfolio includes only marketable securities
with active secondary or resale markets to ensure portfolio liquidity.
The Company has no cash flow exposure due to rate changes for its $22.6
million Notes or for the $8.9 million of other liabilities with fixed rates.
The Company also has no cash flow exposure due to the rate change for certain
long-term portions of Company's arbitration obligations as such obligations
are not interest bearing. The Company does have cash flow exposure on its
$9.8 million bank term loan due to its variable pricing. The Company
primarily enters into debt obligations to support general corporate purposes
including capital expenditures and working capital needs.
The table below presents principal amounts and related weighted-average
interest rates by year of maturity for the Company's investment portfolio and
debt obligations.
(dollars in thousands) 1999 2000 2001 Total Fair Value
---- ---- ---- ----- ----------
ASSETS:
Cash & Cash equivalents
Fixed $ 5,305 --- --- $ 5,305 $ 5,305
Average rate 4.49% --- --- 4.49% ---
30
Variable rate $ 3,961 --- --- $ 3,961 $ 3,961
Average rate 4.92% --- --- 4.92% ---
Short-term investments
Fixed $ 14,979 --- --- $ 14,979 $ 14,982
Average rate 5.44% --- --- 5.44% ---
Long-term investments
Fixed --- $ 3,613 --- $ 3,613 $ 3,622
Average rate --- 5.7% --- 5.7% ---
Total investments
Securities $ 24,245 $ 3,613 --- $ 27,858 $ 27,870
Average rate 5.15% 5.7% --- 5.63% ---
LIABILITIES:
Total long-term debt, including
current portion
Senior Subordinated
Convertible Notes --- $ 22,563 --- $ 22,563 $ 22,563
Fixed --- 5.5% --- 5.5% ---
Other
Fixed $ 1,357 $ 1,183 $ 6,358 $ 8,898 $ 8,898
Average rate 11.05% 11.27% 6.77% 8.02% ---
Variable rate $ 2,500 $ 2,708 $ 4,583 $ 9,791 $ 9,791
Average rate 8.75% 8.75% 8.75% 8.75% ---
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The consolidated financial statements for the years ended December 31,
1998, 1997 and 1996 are incorporated herein by reference and submitted as a
separate section of this Form 10-K. (See Item 14.)
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
Not Applicable.
31
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Cygnus incorporates by reference the information concerning its
directors set forth under the heading "Proposal One -- Re-Election of
Directors" in the Company's definitive Proxy Statement with respect to
Cygnus' 1999 Annual Meeting of Stock Holders to be filed with the Securities
and Exchange Commission within 120 days of December 31, 1998 (the "Proxy
Statement").
Information concerning Cygnus' executive officers appears at the end of
Part I of this report.
ITEM 11. EXECUTIVE COMPENSATION
Cygnus incorporates by reference the information set forth under the
heading "Executive Compensation and Other Information" in the Company's
definitive Proxy Statement to be filed pursuant to Regulation 14A for its
1999 Annual Meeting of Stockholders.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Cygnus incorporates by reference the information set forth under the
heading "Security Ownership of Certain Beneficial Owners and Management" in
the Company's definitive Proxy Statement to be filed pursuant to Regulation
14A for its 1999 Annual Meeting of Stockholders.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Cygnus incorporates by reference the information set forth under the
headings "Proposal One -- Re-Election of Directors" and "Executive
Compensation and Other Information" in the Company's definitive Proxy
Statement to be filed pursuant to Regulation 14A for its 1999 Annual Meeting
of Stockholders.
32
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
a.1) FINANCIAL STATEMENTS AND REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS Page
-----
Report of Ernst & Young LLP, Independent Auditors ................................................. F-3
Consolidated Balance Sheets as of December 31, 1998 and 1997 ...................................... F-4
Consolidated Statements of Operations for the years ended
December 31, 1998, 1997 and 1996 .......................................................... F-5
Consolidated Statement of Stockholders' Equity/(net capital deficiency) for the years ended
December 31, 1998, 1997 and 1996 .......................................................... F-6
Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996 .......................................................... F-7
Notes to Consolidated Financial Statements ........................................................ F-8
a.2) FINANCIAL STATEMENT SCHEDULE
II. Valuation and Qualifying Accounts ............................................................ S-1
All other schedules have been omitted since the required information
is not present or is not present in amounts sufficient to require
submission of the schedule, or because the information required is
included in the consolidated financial statements, including the notes
thereto.
b) REPORTS ON FORM 8-K
The Company has recently filed three Current Reports on Form 8-K.
On October 28, 1998, the Company filed a Current Report on Form 8-K
reporting under Item 5 that the Company publicly announced its
earnings for the quarter ended September 30, 1998.
On October 30, 1998, the Company filed a Current Report on Form 8-K
reporting under Item 5 the restructuring of the Company's 4% Senior
Subordinated Convertible Notes due 2005.
On December 3, 1998, the Company filed a Current Report on Form 8-K
reporting under Item 5 that it is to receive $2.726 million from
arbitration proceedings against Pharmacia & Upjohn.
c) EXHIBITS
The following exhibits are filed herewith or incorporated by reference:
3.1 Bylaws of the Registrant, as amended, incorporated by reference to
Exhibit 3.3 of the Registrant's Registration Statement Form S-1
No. 33-38363.
3.2 Restated Articles of Incorporation of the Registrant, as amended to
date, incorporated by reference to Exhibit 3.4 of the Registrant's
Registration Statement Form S-1 No. 33-38363.
4.1 Specimen of Common Stock certificate of the Registrant, incorporated by
reference to Exhibit 4.1 of the Registrant's Registration Statement
Form S-1 No. 33-38363.
4.2 Rights Agreement dated September 21, 1993 between the Company and
Chemical Trust Bank of California (the "Transfer Agent"), which
includes the Certificate of Determination for the Series A Junior
Participating Preferred Stock as Exhibit A, the form of Right
Certificate as Exhibit B and the Summary of Rights to purchase
Preferred Shares as Exhibit C, incorporated by reference to Exhibit I
of the Registrant's Form 8-A filed on October 21, 1993, Registration
No. 0-18962.
33
4.3 Form of Senior Indenture incorporated herein by reference to
Exhibit 4.1 filed with the Company's Registration Statement on Form S-3
(File No. 33-39275) declared effective by the Securities and Exchange
Commission on November 12, 1997 (the "November 1997 Form S-3").
4.4 Form of Subordinated indenture incorporated herein by reference to
Exhibit 4.2 filed with the Company's November 1997 Form S-3.
4.5 Form of Senior Debt Security (included in Exhibit 4.1) incorporated
herein by reference to Exhibit 4.3 filed with the Company's November
1997 Form S-3.
4.6 Form of Subordinated Debt Security (included in Exhibit 4.2)
incorporated herein by reference to Exhibit 4.4 filed with the
Company's November 1997 Form S-3.
4.7 First Supplemental Indenture dated as of February 2, 1998 by and
between Cygnus, Inc. and State Street Bank and Trust Company of
California, N.A. Incorporated by reference to Exhibit 4.5 of the
Company's Form 8-K dated February 4, 1998.
4.8 Second Supplemental Indenture, dated as of October 28, 1998, by and
between Cygnus, Inc. and State Street Bank and Trust Company of
California, N.A., to the Indenture dated as of February 3, 1998 and
the First Supplemental Indenture dated as of February 3, 1998,
incorporated by reference to Exhibit 4.8 of the Company's Form 8-K
filed on October 30, 1998.
4.9 First Amendment to the Rights Agreement dated October 26, 1998 between
the Company and ChaseMellon Shareholder Services, L.L.C. (the "Rights
Agent" successor to Chemical Trust), incorporated by reference to
Exhibit 99.1 of the Registrant's Form 8-A/A filed on December 14, 1998,
Registration No. 0-18962.
4.10 Amended and Restated Rights Agreement dated October 27, 1998 between
the Company and ChaseMellon Shareholder Services, L.L.C. (the "Rights
Agent" successor to Chemical Trust), which includes the Certificate of
Determination for the Series A Junior Participating Preferred Stock as
Exhibit A, the form of Right Certificate as Exhibit B and the Summary
of Rights to purchase Preferred Shares as Exhibit C, incorporated by
reference to Exhibit 99.2 of the Registrant's Form 8A/A filed on
December 14, 1998, Registration No. 0-19962.
10.1 Warrant dated September 28, 1990 issued by the Registrant to Paine
Webber R&D Partners II, L.P., incorporated by reference to Exhibit 10.5
of the Registrant's Registration Statement Form S-1 No. 33-38363.
10.2 Agreement dated October 1, 1992 between the Registrant and Kabi
Pharmacia, incorporated by reference to Exhibit 19.1 of the
Registrant's Form 10-Q for the quarter ended September 30, 1992,
Registration No. 0-18962.
10.3 Amended August 29, 1986 Agreement dated as of May 30, 1988 between the
Registrant and Sanofi S.A. ("Sanofi"), incorporated by reference to
Exhibit 10.9A of the Registrant's Registration Statement Form S-1
No. 33-38363.
10.4 Amendment No. 1 made as of May 4, 1990 to the Amended August 29, 1986
Agreement between the Registrant and Sanofi, incorporated by reference
to Exhibit 10.9B of the Registrant's Form S-1 Registration Statement
No. 33-38363.
10.5 Amendment No. 2 made as of August 31, 1990 to the Amended August 29,
1986 Agreement between the Registrant and Sanofi, incorporated by
reference to Exhibit 10.9C of the Registrant's Form S-1 Registration
Statement No. 33-38363.
10.6 Supply Agreement dated September 28, 1990 between the Registrant and
Warner-Lambert Company, incorporated by reference to Exhibit 10.12 of
the Registrant's Form S-1 Registration Statement No. 33-38363.
10.7 Agreement dated November 29, 1990 between the Registrant and
Warner-Lambert Company, incorporated by reference to Exhibit 10.13 of
the Registrant's Form S-1 Registration Statement No. 33-38363.
10.8 Ten-year Industrial Net Lease Agreement (Building No. 2) dated
September 27, 1988 between the Registrant and Seaport Centre Venture
Phase I, incorporated by reference to Exhibit 10.26 of the Registrant's
Form S-1 Registration Statement No. 33-38363.
10.9 Ten-year Industrial Net Lease Agreement (Building No. 8) dated
September 27, 1988 between the Registrant and Seaport Centre Venture
Phase I, incorporated by reference to Exhibit 10.27 of the Registrant's
Form S-1 Registration Statement No. 33-38363.
10.10 Sublease Agreement dated June 12, 1990 between the Registrant and M&T
Publishing, Inc., incorporated by reference to Exhibit 10.28 of the
Registrant's Form S-1 Registration Statement No. 33-38363.
10.11 Letter Agreement dated December 18, 1991 between the Registrant and
Menlo Capital Corporation, incorporated by reference to Exhibit 10.33
of the Registrant's Form S-1 Registration Statement No. 33-45180.
34
10.12 Lease Agreement dated as of October 15, 1991 between the Registrant
and Lincoln Menlo Associates Limited, a California Limited Partnership,
incorporated by reference to Exhibit 10.34 of the Registrant's Form S-1
Registration Statement No. 33-45180.
10.13 Services Agreement made as of April 6, 1990 between the Registrant and
DepoMed Systems, Inc., incorporated by reference to Exhibit 10.35 of
the Registrant's Form S-1 Registration Statement No. 33-45180. 10.14
10.14 Loan and Security Agreement dated June 26, 1992 between the Registrant
and AT&T Commercial Finance Corporation. Incorporated by reference to
Exhibit 10.30 of the Registrant's Form 10-K for the fiscal year ended
December 31, 1993.
*10.15 Distributorship Agreement dated as of February 9, 1996 between the
Registrant and Becton Dickinson. Incorporated by reference to
exhibit 10.1 of the Company's Form 10-Q for the quarter ended
March 31, 1996.
*10.16 Agreement dated November 11, 1993 between the Registrant and Kabi
Pharmacia (the "Kabi Agreement") Incorporated in reference to
exhibit 10.33 of the Company's Form 10-K for the fiscal year ended
December 31, 1993.
*10.17 Development, Supply and License Agreement dated December 28, 1993
between the Registrant and Wyeth-Ayerst, a division of American Home
Products (the "U.S. Agreement") Incorporated by reference to
exhibit 10.34 of the Company's Form 10-K for the fiscal year ended
December 31, 1993.
*10.18 Development, Supply and License Agreement dated December 28, 1993
between the Registrant and Wyeth-Ayerst, a division of American Home
Products (the "International Agreement") Incorporated by reference to
exhibit 10.35 of the Company's Form 10-K for the fiscal year ended
December 31, 1993.
*10.19 Loan and Security Agreement between the Registrant and Silicon Valley
Bank entered into as of June 24, 1996. Incorporated by reference to
exhibit 10.1 of the Company's Form 10-Q for the quarter ended
June 30, 1996.
10.20 Product Development, Supply and License Agreement dated June 8, 1994
between the Registrant and Ortho Pharmaceutical Corporation, a division
of Johnson & Johnson. Incorporated by reference to exhibit 10.35 of the
Company's Form 10-Q for the quarter ended June 30, 1994.
10.21 Agreement dated November 22, 1994, between the Registrant and Kabi
Pharmacia (the "Kabi" Agreement). Incorporated by reference to
exhibit 10.39 of the Company's Form 10-K for the fiscal year ended
December 31, 1994.
10.22 Loan and Security Agreement between Silicon Valley Bank and Registrant
entered into as of December 21, 1994. Incorporated by reference to
exhibit 10.40 of the Company's Form 10-K for the fiscal year ended
December 31, 1994.
10.23 GMS Technology Purchase Agreement dated December 30, 1994, between the
Registrant and Paine Webber. Incorporated by reference to exhibit 10.41
of the Company's Form 10-K for the fiscal year ended December 31, 1994.
10.24 Lease Agreement dated January 18, 1995, between the Registrant and
Comdisco for $4.5 million. Incorporated by reference to exhibit 10.42
of the Company's Form 10-K for the fiscal year ended December 31, 1994.
*10.25 Product Supply and Distribution Agreement between the Registrant and
Yamanouchi Pharmaceutical Co., LTD. dated as of July 14, 1996.
Incorporated by reference to exhibit 10.1 of the Company's Form 10-Q
for the quarter ended June 30, 1996.
10.26 Loan and Security Agreement dated June 27, 1997 between Heller
Financing and Registrant.
10.27 Form of Note Purchase Agreement dated as of February 2, 1998 between
Cygnus, Inc. and certain institutional investors. Incorporated by
reference to Exhibit 10.28 of the Company's Form 8-K dated
February 4, 1998.
10.28 Form Common Stock Purchase Agreement dated February 2, 1998 between
Cygnus, Inc. and certain institutional investors. Incorporated by
reverence to exhibit 10.29 of the Company's Form 8-K dated
February 4, 1998.
10.29 First Amendment to Ten Year Industrial Net Lease Agreement
(Building No. 2) dated June 9, 1998 between the Registrant and
Metropolitan Life Insurance Company, a New York corporation
(predecessor in interest to Seaport Centre Venture Phase I).
10.30 Third Amendment to Ten Year Industrial Net Lease Agreement
(Building No. 8) dated June 9, 1998 between the Registrant and
Metropolitan Life Insurance Company, a New York corporation
(predecessor in interest to Seaport Centre Venture Phase I).
*10.31 Amendment Agreement to Development, Supply and License Agreement dated
November 17, 1998 between the Registrant and Wyeth-Ayerst, a division
of American Home Products Corporation, a Delaware corporation.
*10.32 Supply and Development Agreement dated May 21, 1998 between the
Registrant and Undisclosed.
35
*10.33 Amendment No. 1 to Supply and Development Agreement dated August 21,
1998 between the Registrant and Undisclosed
*10.34 Supply Agreement dated June 19, 1998 between the Registrant and E.I.
du Pont de Nemours & Co., a Delaware corporation.
*10.35 Detection of Analytes Product Development and License Agreement dated
June 19, 1998 between the Registrant and E.I. du Pont de Nemours & Co.,
a Delaware corporation.
10.36 Amended and Restated Loan and Security Agreement between the Registrant
and Silicon Valley Bank entered into as of April 30, 1998, incorporated
by reference to exhibit 10.45 of the Company's Form 10-Q for the
quarter ended September 30, 1998.
10.37 Press Release, dated November 25, 1997, issued by Cygnus, Inc.
announcing the results of research clinical studies. Incorporated by
reference to exhibit 99.1 of the Company's Form 8-K dated December 25,
1997.
10.38 Press Release, dated November 25, 1997, issued by Cygnus, Inc.
announcing a proposed public offering of convertible subordinated
notes. Incorporated by reference to exhibit 99.2 of the Company's
Form 8-K dated December 25, 1997.
EXECUTIVE COMPENSATION PLANS AND ARRANGEMENTS
10.39 1994 Stock Option / Award Plan, incorporated by reference to
Exhibit 99.1 of the Registrant's Form S-8 Registration Statement
No. 333-18357, filed December 20, 1996.
10.40 Amended 1991 Employee Stock Purchase Plan incorporated by reference
to Exhibit 99.2 of the Registrant's Form S-8 Registration Statement
No. 333-18357, filed December 20, 1996.
10.41 Form of Indemnification Agreement for Directors and Officers,
incorporated by reference to Exhibit 10.29 of the Registrant's
Form S-1 Registration Statement No. 33-38363.
10.42 1991 Bonus Plan for Director-Level Employees and Officers incorporated
by reference to Exhibit 10.36 of the Registrant's Form S-1
Registration Statement No. 33-45180.
10.43 Amended and Restated Employment Agreement dated January 29, 1996
between the Registrant and Gregory B. Lawless. Incorporated by
reference to exhibit 10.30 of the Company's Form 10-K for the fiscal
year ended December 31, 1996.
10.44 Form of Agreement with Executive Officers relating to change in
control . incorporated by reference to exhibit 10.31 of the Company's
Form 10-K for the fiscal year ended December 31, 1996.
10.45 Employment Agreement dated May 30, 1992 between the Registrant and
Alan F. Russell.
10.46 1994 Stock Option/Award Plan (As Amended and Restated as of February 24,
1998), incorporated by reference to Exhibit 99.1 o the Company's
Form S-8 Registration Statement No. 333-67331, filed November 16, 1998.
10.47 Amended 1991 Employee Stock Purchase Plan (As Amended and Restated as of
February 24, 1998), incorporated by reference to Exhibit 99.6 of the
Company's Form S-8 Registration Statement No. 333-67331, filed
November 16.1998.
10.48 Plan Amendment Cygnus, Inc. 1994 Stock Option/Award Plan, Incorporated
by reference to Exhibit 99.2 of the Company's Form S-8 Registration
Statement No. 333-67331, filed November 16.1998.
10.49 Form of Special Addendum to Stock Option Agreement (Change in Control),
incorporated by reference to Exhibit 99.3 of the Company's Form S-8
Registration Statement No. 333-67331, filed November 16.1998.
10.50 Form of Special Addendum to Stock Option Agreement (Termination of
Employment Without Cause -- Officers), incorporated by reference to
Exhibit 99.4 of the Company's Form S-8 Registration Statement
No. 333-67331, filed November 16.1998.
10.51 Form of Special Addendum to Stock Option Agreement (Termination of
Employment Without Cause -- Key Employee), incorporated by reference to
Exhibit 99.5 of the Company's Form S-8 Registration Statement
No. 333-67331, filed November 16.1998.
10.52 Written Compensation Agreement between Registrar and Mr. Marion,
incorporated by reference to Exhibit 99.7 of the Company's Form S-8
Registration Statement No. 333-67331, filed November 16.1998.
10.53 Stock Option Agreement between Registrant and Mr. Marion, incorporated
by reference to Exhibit 99.8 of the Company's Form S-8 Registration
Statement No. 333-67331, filed November 16.1998.
10.54 Form of Agreement dated August 28, 1998 between the Company and each of
the Executive officers with respect to post-employment benefits
incorporated by reference to Exhibit 10.46 of the Company's form 10-Q
for the period ended September 30, 1998.
36
10.55 Form of Agreement between the Company and each of the Executive
officers with respect to post-employment benefits relating to change
of control incorporated by reference to Exhibit 10.46 of the Company's
Form 10-Q for the period ended September 30, 1998.
- ------------
23.1 Consent of Ernst & Young LLP, Independent Auditors (see page 40)
25.1 Power of Attorney (see page 39)
27.0 Financial Data Schedule
- ------------
* A confidential treatment request has been applied for or granted with respect
to a portion of this document.
37
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, Registrant has duly caused this Report to be signed on
its behalf by the undersigned, thereunto duly authorized, on the 30th day of
March, 1999.
CYGNUS, INC.
By: /s/ JOHN C. HODGMAN
-------------------------------------
John C. Hodgman
President and Chief Executive Officer
(Principal Executive Officer)
38
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints John C. Hodgman, attorney-in-fact for
the undersigned, with the power of substitution, for the undersigned in any
and all capacities, to sign any and all amendments to this Report on Form
10-K, and to file the same, with exhibits thereto and other documents in
connection therewith, with the Securities and Exchange Commission, hereby
ratifying and confirming all that said attorney-in-fact, or his substitute or
substitutes, may do or cause to be done by virtue hereof.
IN WITNESS WHEREOF, each of the undersigned has executed this Power of
Attorney as of the date indicated opposite his/her name.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Signature Title Date
/s/ GARY W. CLEARY, Ph.D. Chairman of the Board of Directors and Chief March 30, 1999
- ------------------------------ Technical Officer
Gary W. Cleary, Ph.D.
/s/ JOHN C. HODGMAN President and Chief Executive Officer March 30, 1999
- ------------------------------ (Principal Executive Officer)
John C. Hodgman
/s/ CRAIG W. CARLSON Chief Financial Officer and Senior Vice March 30, 1999
- ------------------------------ President, Finance (Principal Accounting
Craig W. Carlson Officer)
/s/ FRANK T. CARY Director March 30, 1999
- ------------------------------
Frank T. Cary
/s/ ANDRE F. MARION Vice Chairman of the Board of Directors March 30, 1999
- ------------------------------
Andre F. Marion
/s/ RICHARD G. ROGERS Director March 30, 1999
- ------------------------------
Richard G. Rogers
/s/ WALTER B. WRISTON Director March 30, 1999
- ------------------------------
Walter B. Wriston
39
EXHIBIT 23.1
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the use of our report dated January 19, 1999, except for
the Note 14, as to which the date is February 23, 1999 in this Annual Report
(Form 10-K) of Cygnus, Inc.
We consent to the incorporation by reference in the Registration
Statements (Form S-8 Nos. 33-41502, 33-43710, 33-59774, 33-86038 and
333-18357) pertaining to the Amended 1986 Stock Option Plan, the 1991 Amended
Employee Stock Purchase Plan, the Amended 1986 Incentive Stock Plan and the
1994 Stock Option/Award Plan of Cygnus, Inc. of our report dated January 19,
1999, except for the Note 14, as to which the date is February 23, 1999 with
respect to the consolidated financial statements and schedule of Cygnus, Inc.
included in the Annual Report (Form 10-K) for the year ended December 31,
1998.
Palo Alto, California /s/ ERNST & YOUNG LLP
March 30, 1999
40
Cygnus, Inc.
Consolidated Financial Statements
For the Years ended December 31, 1998, 1997 and 1996
with
Report of Independent Auditors
F-1
Cygnus, Inc.
CONSOLIDATED FINANCIAL STATEMENTS
For the Years ended December 31, 1998, 1997 and 1996
Contents
Report of Ernst & Young LLP, Independent Auditors ....................................... F-3
Audited Consolidated Financial Statements:
Consolidated Balance Sheets ............................................................. F-4
Consolidated Statements of Operations ................................................... F-5
Consolidated Statement of Shareholders' Equity/(net capital deficiency) ................. F-6
Consolidated Statements of Cash Flows ................................................... F-7
Notes to Consolidated Financial Statements .............................................. F-8
F-2
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
Cygnus, Inc.
We have audited the accompanying consolidated balance sheets of Cygnus,
Inc. as of December 31, 1998 and 1997, and the related consolidated
statements of operations, stockholders' equity (net capital deficiency) and
cash flows for each of the three years in the period ended December 31, 1998.
Our audits also included the financial statement schedule listed in the Index
at Item 14(a). These financial statements and schedule are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these financial statements and schedule based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to
obtain reasonable assurance about whether the financial statements are free
of material misstatement. An audit includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements.
An audit also includes assessing the accounting principles used and
significant estimates made by management, as well as evaluating the overall
financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the financial statements referred to above present
fairly, in all material respects, the consolidated financial position of
Cygnus, Inc. at December 31, 1998 and 1997, and the consolidated results of
its operations and its cash flows for each of the three years in the period
ended December 31, 1998, in conformity with generally accepted accounting
principles. Also, in our opinion, the related financial statement schedule,
when considered in relation to the basic financial statements taken as a
whole, presents fairly in all material respects the information set forth
therein.
Palo Alto, California January 19, 1999, except for the Note 14, as to which
the date is February 23, 1999
/s/ Ernst & Young LLP
F-3
Cygnus, Inc.
CONSOLIDATED BALANCE SHEETS
(In thousands)
DECEMBER 31,
1998 1997
-------------------------------------
ASSETS:
CURRENT ASSETS:
Cash and cash equivalents $ 10,219 $ 20,669
Short-term investments 14,982 14,163
Trade accounts receivable, net of allowance (1998 -- $123;
1997 -- $123) 876 2,040
Inventories 771 924
Prepaid expenses and other current assets 510 1,834
Current portion of employee notes receivable 185 154
-------------------------------------
Total current assets
27,543 39,784
EQUIPMENT AND IMPROVEMENTS:
Office and laboratory equipment 18,237 14,856
Leasehold improvements 1,304 885
-------------------------------------
19,541 15,741
Less accumulated depreciation and amortization (13,077) (11,145)
-------------------------------------
Net equipment and improvements 6,464 4,596
Long-term investments 3,622 --
Long-term portion of employee notes receivable 286 301
Deferred compensation and other assets 4,451 4,596
Unamortized portion of the issuance costs of the Senior
Subordinated Convertible Notes 1,088 --
-------------------------------------
Total Assets $ 43,454 $ 49,277
-------------------------------------
-------------------------------------
LIABILITIES AND NET CAPITAL DEFICIENCY:
CURRENT LIABILITIES:
Accounts payable $ 2,585 $ 1,070
Amounts payable to related parties 1,043 224
Accrued clinical trials 831 --
Accrued compensation 4,593 3,298
Accrued professional services 729 842
Other accrued liabilities 943 1,263
Customer advances 207 624
Current portion of arbitration obligation 60 16,223
Current portion of deferred revenue 1,153 1,846
Current portion of long-term debt 3,415 3,767
Current portion of capital lease obligations 442 686
-------------------------------------
Total current liabilities 16,001 29,843
Long-term portion of arbitration obligation 24,158 23,000
Long-term portion of deferred revenue -- 1,188
Long-term portion of debt 8,252 3,812
Long-term portion of capital lease obligations 581 390
Senior Subordinated Convertible Notes 22,563 --
Deferred compensation and other long-term liabilities 4,666 4,844
STOCKHOLDERS' NET CAPITAL DEFICIENCY:
Preferred stock, $0.001 par value: 5,000 shares authorized;
no shares issued and outstanding -- --
Common stock, $0.001 par value: 40,000 shares authorized;
issued and outstanding: 20,886 and 19,273 shares at
December 31, 1998 and 1997, respectively 21 19
Additional paid-in-capital 143,155 122,709
Accumulated deficit (175,955) (136,527)
Accumulated other comprehensive income / (loss) 12 (1)
-------------------------------------
Net capital deficiency (32,767) (13,800)
-------------------------------------
Total liabilities and stockholders' net capital deficiency $ 43,454 $ 49,277
-------------------------------------
-------------------------------------
SEE ACCOMPANYING NOTES.
F-4
Cygnus, Inc.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except per share data)
YEARS ENDED DECEMBER 31,
1998 1997 1996
-------------------------------------
REVENUES:
Product revenues $ 587 $ 4,212 $ 17,211
Contract revenues 10,178 14,106 13,085
Royalty and other revenues 890 11,184 5,907
--------------------------------------
TOTAL REVENUES 11,655 29,502 36,203
COSTS AND EXPENSES:
Costs of products sold 3,478 10,413 16,659
Research and development 32,149 22,328 23,165
Marketing, general and administrative 11,730 8,695 9,296
Arbitration settlement --- 39,666 ---
--------------------------------------
TOTAL COSTS AND EXPENSES 47,357 81,102 49,120
Loss from operations (35,702) (51,600) (12,917)
Interest and other income 6,009 2,989 2,851
Interest and other expense (9,735) (1,849) (986)
--------------------------------------
NET LOSS $(39,428) $(50,460) $(11,052)
--------------------------------------
--------------------------------------
BASIC AND DILUTED NET LOSS PER SHARE $ (1.95) $ (2.67) $ (0.60)
--------------------------------------
--------------------------------------
Shares used in computation of basic and diluted
net loss per share 20,226 18,928 18,544
--------------------------------------
--------------------------------------
SEE ACCOMPANYING NOTES.
F-5
Cygnus, Inc.
CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY/(NET CAPTIAL DEFICIENCY)
For the Years Ended December 31, 1998, 1997 and 1996
(In thousands)
Accumulated Total
Other Stockholders'
Additional Compre- Equity (net
Common paid-in- Accumulated hensive capital
Stock capital Deficit Income/(loss) deficiency)
---------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1995 $ 18 $ 113,248 $ (75,015) $ 1 38,252
Issuance of 333 shares of common stock -- 2,749 -- -- 2,749
Issuance of 90 shares of common stock under
the Employee Stock Purchase Plan -- 823 -- -- 823
Issuance of 45 shares of common stock
through exercise of warrant -- 446 -- -- 446
Change in unrealized loss on investments -- -- -- (5) (5)
Net loss -- -- (11,052) -- (11,052)
---------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1996 $ 18 $ 117,266 $ (86,067) $ (4) $ 31,213
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Issuance of 258 shares of common stock 1 2,211 -- -- 2,212
Issuance of 64 shares of common stock under
the Employee Stock Purchase Plan -- 707 -- -- 707
Issuance of 255 shares of common stock
through exercise of warrant -- 2,525 -- -- 2,525
Change in unrealized loss on investments -- -- -- 3 3
Net loss -- -- (50,460) -- (50,460)
---------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1997 $ 19 $ 122,709 $ (136,527) $ (1) $ (13,800)
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Issuance of 3 shares of common stock -- 20 -- -- 20
Issuance of 141 shares of common stock under
the Employee Stock Purchase Plan -- 872 -- -- 872
Issuance of 906 shares of common stock in
fourth public offering, net of issuance
costs of $486 1 13,326 -- -- 13,327
Issuance of 565 shares arising from the
conversion of the Senior Subordinated
Note 1 1,998 -- -- 1,999
Additional paid-in capital arising from the
beneficial conversion feature of the
restructure of the Senior Subordinated
Notes -- 4,230 -- -- 4,230
Change in unrealized gain / (loss) on
investments -- -- -- 13 13
Net loss -- -- (39,428) -- (39,428)
---------------------------------------------------------------------------
BALANCE, DECEMBER 31, 1998 $ 21 $ 143,155 $ (175,955) $12 $(32,767)
---------------------------------------------------------------------------
---------------------------------------------------------------------------
SEE ACCOMPANYING NOTES
F-6
Cygnus, Inc.
CONSOLIDATED STATEMENTS OF CASH FLOWS
Increase/(Decrease) in Cash and Cash Equivalents
(In thousands)
YEARS ENDED DECEMBER 31,
1998 1997 1996
------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (39,428) $ (50,460) $ (11,052)
Adjustments to reconcile net loss to net cash (used in)/provided by
operating activities:
Depreciation 1,684 1,971 1,861
Amortization 256 768 941
(Gain)/loss on write-down and disposals of equipment (19) 1,350 --
Beneficial conversion feature of restructured Notes 4,230 -- --
Amortization of debt issuance costs 1,561
Other (125) (133) (280)
(Increase)/decrease in assets:
Trade accounts receivables 1,163 5,719 (5,449)
Inventories 153 1,407 (1,953)
Prepaid expenses and other assets 1,454 (3,201) (1,888)
Increase/(decrease) in liabilities:
Accounts payable and other accrued liabilities 2,848 (2,061) 2,325
Accrued compensation 1,295 121 986
Accrued professional services (114) 151 (35)
Customer advances (418) (522) 300
Deferred revenue (1,881) (10,445) 6,646
Arbitration liability (15,005) 39,223 --
Deferred compensation and other liabilities (178) 1,494 1,261
--------- --------- ----------
Net cash used in operating activities (42,524) (14,618) (6,337)
--------- --------- ----------
CASH FLOWS FROM INVESTING ACTIVITIES
Capital expenditures (3,365) (3,095) (1,515)
Purchases of investments (48,314) (30,148) (31,565)
Maturity and sale of investments 44,073 32,408 31,602
--------- --------- ----------
Net cash used in investing activities (7,606) (835) (1,478)
--------- --------- ----------
CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from sale and leaseback of assets -- -- 464
Issuance of common stock 14,219 5,444 4,018
Net proceeds from the issuance of Senior Subordinated Convertible Notes 40,351
Proceeds from issuance of long-term debt 6,110 1,331 8,000
Principal payments of Senior Subordinated Convertible Notes (18,500)
Principal payments of long-term debt (2,023) (2,486) (490)
Payment of capital lease obligations (477) (1,315) (1,474)
--------- --------- ----------
Net cash provided by financing activities 39,680 2,974 10,518
--------- --------- ----------
Net increase/(decrease) in cash and cash equivalents (10,450) (12,479) 2,703
Cash and cash equivalents at beginning of year 20,669 33,148 30,445
--------- --------- ----------
Cash and cash equivalents at end of year $10,219 $20,669 $33,148
--------- --------- ----------
--------- --------- ----------
SEE ACCOMPANYING NOTES.
F-7
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
DESCRIPTION OF BUSINESS
The Company was incorporated in California in 1985 and was merged into a
Delaware corporation in September 1995. The Company is engaged in the
development and manufacture of diagnostic and drug delivery systems,
utilizing proprietary technologies to satisfy unmet medical needs cost
effectively. The Company's current efforts are primarily focused on two core
areas: an automatic and continuous glucose monitoring device (the GlucoWatch
monitor) and transdermal drug delivery systems.
CONSOLIDATION
The consolidated financial statements include the accounts of the Company
and its wholly-owned subsidiaries after elimination of all material
inter-company balances and transactions. Cygnus' subsidiaries were inactive
in 1998, 1997 and 1996.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally
accepted accounting principles requires management to make estimates and
assumptions that affect the amounts reported in the financial statements and
accompanying notes. Actual results could differ from those estimates.
REVENUE RECOGNITION
Product sales are recorded when FemPatch or Nicotrol products are
shipped. Nicotrol product shipments were discontinued in the first quarter of
1997 upon Pharmacia's exercise of its option to purchase the U.S.
manufacturing rights for the Nicotrol patch from Cygnus. FemPatch product
shipments were discontinued in the second quarter of 1998 and in November
1998 the agreement between Warner-Lambert and Sanofi was terminated, which
also terminated the supply agreement between the Company and Warner-Lambert.
Up-front and interim milestone payments from feasibility and development
contracts are generally earned and recognized based on percentage of actual
efforts expended compared to total expected efforts during the development
period for each contract. The total expected efforts under each contract are
estimated by management and updated periodically in light of the current
conditions and expected development timeline. Milestone payments received at
the end of the development period of an agreement are generally recognized
upon receipt. Deferred revenue includes the portion of up-front and interim
milestone payments received on research, development and distribution
agreements which have been deferred and will be recognized over the related
development period in relation to efforts expended under the agreement.
Two customers provided 60% and 40% of the 1998 product sales and royalty
and other income. In 1997, these two customers provided 84% and 16% of this
revenue, and in 1995 and 1996 one of these customers provided 100% of product
sales and royalty and other income.
Five customers provided 47%, 17%, 11%, 9% and 6% of the 1998 contract
revenues. In 1997, four of these customers provided 33%, 14%, 10% and 10% of
this revenue, and in 1996, three of these customers provided 28%, 25% and 5%
of this revenue.
COSTS OF PRODUCTS SOLD
Direct and indirect costs associated with manufacturing FemPatch and
Nicotrol products are included in costs of products sold.
RESEARCH AND DEVELOPMENT
The Company has entered into license, collaboration and distribution agreements
with certain companies. In general, these agreements provide that Cygnus will
create and/or manufacture the drug delivery or diagnostic system and receive
F-8
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
reimbursements for costs incurred, payment for product shipped to licensees
or distributors and royalties based on product sales by its licensees and
distributors. Additionally, under such agreements, Cygnus may receive one or
more up-front payments and milestone payments (which are made upon the
occurrence of certain events, such as the filing of the NDA or an ANDA for a
product), as well as reimbursements of certain research and development
expenses. Research and development expenses consist of process development
costs, costs associated with work performed under development agreements and
self-funded research, and costs incurred in clinical studies and
regulatory/scientific affairs. Research and development expenses covered
under contracts partially funded by the Company's licensees and distributors
for the years ended December 31, 1998, 1997 and 1996 were approximately
$24,374, $19,242 and $17,657, respectively. Revenues recorded under
arrangements amounted to $10,178, $11,206 and $10,827, respectively. Cygnus'
pharmaceutical company licensees and distributors generally have the right to
abandon the rights to a product and the obligation to make related payments.
Since all payments to the Company under these agreements are contingent on
the occurrence of future events or sales levels, and the agreements are
terminable by the licensee or distributor, no assurance can be given as to
whether the Company will receive any particular payment thereunder or as to
the amount or timing of any such payment.
INVENTORIES
Inventories are stated at the lower of cost (first-in, first-out method) or
market, after appropriate consideration was given to obsolescence and
inventories in excess of anticipated future demand. Net inventories consist of
the following:
DECEMBER 31,
1998 1997
------------
Raw materials $771 $787
Work in process ---- 86
Finished goods ---- 51
------------
$771 $924
------------
------------
Inventories at December 31, 1998 and 1997 relate to the Company's estrogen
(FemPatch) transdermal product.
F-9
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
EQUIPMENT AND IMPROVEMENTS
Equipment and improvements are recorded at the lower of cost or net
realizable value. Depreciation of equipment is computed on a straight-line
basis over the estimated useful lives of eighteen months to sixty months.
Leasehold improvements and assets recorded under capital leases are amortized
using the straight-line method over the shorter of the estimated useful life
of the assets or the term of the leases. In 1997, the Company incurred
charges of $1.3 million to write down the cost of Nicotrol patch equipment to
its net realizable value. This write-down was due to the termination of
Nicotrol patch manufacturing by the Company.
DEFERRED COMPENSATION
In 1995, the Company adopted a non-qualified deferred compensation plan.
The Plan was intended to be unfunded and was maintained by the Company
primarily for the purpose of providing deferred compensation for a select
group of management. As of December 31, 1998 and 1997, the Company recorded
$4.3 million and $4.4 million, respectively, as other long-term assets and as
other long-term liabilities related to the plan which included both
contributions and net investment earnings. These investments were directed by
the participants. In January 1999, the Company terminated the plan and the
plan assets will be distributed to participants in the first quarter of 1999.
NET LOSS PER SHARE
Basic and diluted net loss per share is computed using the weighted
average number of shares of Common Stock outstanding. Shares issuable from
stock options and warrants outstanding are excluded from the diluted earnings
per share computation, as their effect is anti-dilutive.
ACCOUNTING FOR STOCK-BASED COMPENSATION
Under Statement 123, "Accounting for Stock-Based Compensation,"
stock-based compensation expense to employees is measured using either the
intrinsic value method as prescribed by Accounting Principle Board Opinion
No. 25, "Accounting for Stock Issued to Employees" (APB 25), or the
fair-value method described in FAS 123. Cygnus has elected to follow APB 25
and related interpretations in accounting for its employee stock options and
disclose only the pro-forma impact of the fair-value method on net income and
earnings per share. (See Note 4 "Stockholders' Equity.")
NEW ACCOUNTING PRONOUNCEMENTS
Effective January 1, 1998 the Company adopted the Financial Accounting
Standard Board's Statements of Financial Accounting Standards No. 130,
Reporting Comprehensive Income ("FAS 130") and Financial Accounting Standard
No. 131, Disclosure about Segment of an Enterprise and Related Information
("FAS 131") and restated prior years' financial statements to conform to the
above reporting standards.
FAS 130 establishes standards for reporting and displaying comprehensive
income and its components in a full set of general purpose financial
statements. Comprehensive income includes all changes in stockholders' equity
during a period except those resulting from investments by owners and
distributions to owners. The adoption of FAS 130 resulted in revised and
additional disclosure but had no effect on the financial position, results of
operations or liquidity of the Company.
FAS 131 establishes standards for the way that public business
enterprises report information about operating segments in annual financial
statements and requires that those enterprises report selected information
about operating segments in interim financial reports. It also establishes
standards for related disclosures about products and services, geographic
areas, and major customers. Effective December 31, 1998, the Company adopted
FAS 131. On this basis, the Company has two principal businesses and,
therefore, two reportable business segments: diagnostics and drug delivery.
Segment results are presented on this basis in 1998, as well as retroactively
(see Note 7, "Business Segments"). This new pronouncement does not alter
reported net income.
F-10
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 1: BASIS OF PRESENTATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
(CONTINUED)
In June 1998, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standard No. 133, Accounting for Derivative
Instruments and Hedging Activities ("FAS 133"). FAS 133 requires all
derivatives to be recorded on the balance sheet at fair value and establishes
special accounting rules for different types of hedges. Adoption of this
statement is required in the year ending December 31, 2000 and is not
expected to have a material impact on Company's results of operations or
financial condition.
SECURITIES AVAILABLE-FOR-SALE
Securities available-for-sale are carried at fair value, based on quoted
market prices, and the unrealized gains and losses have been combined with
the accumulated deficit due to immateriality. Realized gains and losses and
declines in value judged to be other-than-temporary on available-for-sale
securities are included in investment income. The cost of securities sold is
based on the specific identification method. Interest and dividends on
securities classified as available-for-sale are included in investment income.
The Company considers all highly liquid investments with a maturity from
the date of purchase of three months or less to be cash equivalents. The
Company invests its excess (to current demands) cash in high credit quality,
highly liquid instruments. These investments have included, but are not
limited to, Treasury Notes, Federal Agency Securities, Auction Rate
Certificates, Auction Rate Preferred Stock, and Commercial Paper.
F-11
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 2: FAIR VALUE OF FINANCIAL INSTRUMENTS
For the years ended December 31, 1998 and 1997 the net realized gains and
losses on available-for-sale securities were immaterial.
As of December 31, 1998 and 1997 all debt securities are classified as
available-for-sale. The following is a summary of available-for-sale
securities as of December 31, 1998 and 1997:
AVAILABLE-FOR-SALE SECURITIES
--------------------------------------------
GROSS GROSS ESTIMATED
UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
--------------------------------------------
AS OF DECEMBER 31, 1998:
Cash Equivalents:
Money Market Fund $ 3,961 $ -- $ -- $ 3,961
Certificate of Deposit 4,000 -- -- 4,000
Federal Agency Security, due in less
than ninety days 1,305 -- -- 1,305
------- ---- ---- -------
Total Cash Equivalents $ 9,266 $ -- $ -- $ 9,266
------- ---- ---- -------
------- ---- ---- -------
Short-Term Investments:
Federal Agency Securities 2,290 3 -- 2,293
Auction Rate Certificates 11,049 -- -- 11,049
Corporate Notes 1,640 -- -- 1,640
------- ---- ---- -------
Total Short-Term Investments $14,979 $ 3 $ -- $14,982
------- ---- ---- -------
------- ---- ---- -------
Long-Term Investments:
Federal Agency Securities 3,613 11 (2) 3,622
------- ---- ---- -------
Total Long-Term Investments $ 3,613 $ 11 $ (2) $ 3,622
------- ---- ---- -------
------- ---- ---- -------
AS OF DECEMBER 31, 1997:
Cash Equivalents:
Money Market Fund $18,925 $ -- $ -- $18,925
------- ---- ---- -------
Total Cash Equivalents $18,925 $ -- $ -- $18,925
------- ---- ---- -------
------- ---- ---- -------
Short-Term Investments:
Treasury Bills $ 1,900 $ 1 $ -- $ 1,901
Federal Agency Securities 3,023 -- -- 3,023
Auction Rate Certificates 6,216 -- -- 6,216
Auction Rate Preferred 1,012 -- -- 1,012
Corporate Notes 2,013 -- (2) 2,011
------- ---- ---- -------
Total Short-Term Investments $14,164 $ 1 $ (2) $14,163
------- ---- ---- -------
------- ---- ---- -------
All cash equivalents and investments as of December 31, 1998 and 1997 have
maturity dates of less than twenty-one months and one year, respectively.
F-12
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3: CREDIT LINE AND LEASES
In December 1994, the Company borrowed $1.7 million under a bank line of
credit to finance the purchase of manufacturing and research equipment. In
June of 1996, the Company received $8.0 million under a bank loan agreement
for short-term working capital. In April of 1998, the Company consolidated
its two outstanding bank loans into an expanded credit facility with the same
bank. An additional $4.7 million was borrowed, increasing the total
outstanding under the new agreement to $10.0 million. In November of 1998,
the April agreement was further amended to modify the covenants. This balance
will be repaid through November 2001, with monthly interest-only payments
through November 1998, and monthly principal-and-interest installments
thereafter. As of December 31, 1998 there is $9.8 million outstanding under
this agreement. The line bears interest at one percentage point above the
prime rate (8.75% in total as of December 31, 1998). In June 1997, the
Company entered into a loan agreement for $1.3 million to finance additional
capital equipment. The line bears interest at a fixed rate of 9.39% per year.
Borrowings under this agreement are secured by specific Company assets. This
loan is being repaid monthly through June 2000. As of December 31, 1998,
there was $0.7 million outstanding. In the second quarter of 1998, the
Company entered into a new loan agreement for $1.4 million to finance
additional capital equipment. Borrowings under this agreement are also
secured by specific Company assets. As of December 31, 1998, there was $1.2
million outstanding. All loan agreements are subject to certain financial
covenants, including minimum cash balances and tangible net worth. If certain
of these covenants are not met, the lenders may require collateral of the
amounts outstanding. In the event of default, the lenders may, at their
option, exercise their rights to remedies specified in the loan agreements
which include, among other things, the acceleration of amounts due under the
agreements.
Assets leased under capital leases are included in equipment with a cost
of $5,490 and $5,065 on December 31, 1998 and 1997, respectively, with
related accumulated amortization of approximately $4,806 and $4,275 on
December 31, 1998 and 1997, respectively. Upon the expiration of the lease,
the Company has purchase options for the leased equipment at market value. As
of December 31, 1998, there was $1,023 outstanding. This lease agreement has
certain financial covenants, including minimum cash balance. If certain of
these covenants are not met, the leasing company may require collateral of
the amounts outstanding. In the event of default, the leasing company can
accelerate all amounts due.
The future aggregate principal payments of long-term debt and minimum
lease payments under capital leases, together with the present value of the
net minimum lease payments as of December 31, 1998, are as follows:
LONG-TERM DEBT CAPITAL LEASES
-------------- --------------
Years ending December 31,
1999 $ 3,415 $ 555
2000 3,450 495
2001 4,802 145
------- ------
Total principal and minimum lease payments, respectively $11,667 1,195
-------
-------
Less amount representing interest 172
------
Present value of net minimum lease payments 1,023
Current portion 442
------
Amounts due after one year $ 581
------
------
The fair market value of the long-term debt approximates its carrying
value of $11,667.
The Company leases its facilities under a non-cancelable operating lease
for three of its four buildings expiring in 2003. The terms of the lease
provide for rental payments on a graduated scale. The Company is recognizing
rent expense on a straight-line method over the lease period and therefore
has accrued for the rent expense incurred but not paid. Additionally, the
Company leases an off-site warehouse with a three-year lease term ending in
October 1999.
F-13
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 3: CREDIT LINE AND LEASES (CONTINUED)
Minimum future rental commitments under the operating leases on December
31, 1998 amount to $1,941 in 1999, $1,904 in 2000, $1,954 in 2001, $2,015 in
2002, and $2,078 in 2003. Rent expense amounted to $1,064, $1,020, and
$1,013, for the years ended December 31, 1998, 1997, and 1996, respectively.
NOTE 4: STOCKHOLDERS' EQUITY
PREFERRED SHARE PURCHASE RIGHTS PLAN
Pursuant to the Company's Stockholder Rights Plan, the Board declared a
dividend distribution of one Preferred Share Purchase Right ("Right") for
each outstanding share of Common Stock, issuable on October 18, 1993 to
stockholders of record on that date. These rights will remain outstanding
until September 21, 2003.
WARRANTS
In September 1990, in connection with the PaineWebber product development
program, a warrant to purchase 300 shares of common stock at $9.90 per share
was issued to the development partner. All warrants have been exercised as of
December 31, 1997.
EMPLOYEE STOCK PURCHASE PLAN
As part of an employee retention program, the Company established the
1991 Employee Stock Purchase Plan, as Amended and Restated as of February 24,
1998 (the "Stock Purchase Plan") to provide employees with an opportunity to
purchase Common Stock of the Company through payroll deductions. A total of
925 shares of Common Stock were reserved for issuance to eligible employees
under the amended Stock Purchase Plan. The amended Stock Purchase Plan will
terminate in 2023 unless sooner terminated by the Board of Directors. Under
this Stock Purchase Plan, the Company's employees, subject to certain
restrictions, may purchase shares of Common Stock at 85 percent of the lesser
of the fair market value at either the date of enrollment or the date of
purchase. During 1998 and 1997, 116 and 64 shares, respectively, were issued
under the Stock Purchase Plan, and at December 31, 1998, 362 shares were
available for issuance.
STOCK OPTION PLAN
The Company has elected to follow Accounting Principles Board Opinion
No.25, "Accounting for Stock Issued to Employees" (APB 25), and related
Interpretations in accounting for its employee stock options because, as
discussed below, the alternative fair value accounting provided for under
FASB Statement No. 123, "Accounting for Stock-Based Compensation," requires
use of option valuation models that were not developed for use in valuing
employee stock options. Under APB 25, because the exercise price of the
Company's employee stock options equals the market price of the underlying
stock on the date of grant, no compensation expense is recognized.
The Company has a 1994 Stock Option/Award Plan, as Amended and Restated
as of February 24, 1998 (the "Stock Plan") which authorizes the Board of
Directors to grant incentive stock options, nonstatutory stock options, stock
purchase rights and stock bonuses to employees and consultants. The Stock
Plan, as amended, authorizes the issuance of up to 7,916 Common Shares, of
which 1,402 are available for grant at December 31, 1998. Under the Stock
Plan, incentive stock options must be granted at fair market value at the
date of grant as determined by the Board of Directors or committee thereof.
Options generally vest over a four-year period and are exercisable for a term
of ten years after issuance, unless otherwise determined by the Board of
Directors or committee thereof.
Pro forma information regarding net income and earnings per share is
required by Statement 123, which also requires that the information be
determined as if the Company has accounted for its employee stock options
granted subsequent to December 31, 1994 under the fair value method of that
Statement. The fair value for these options and the fair value for the stocks
issued under the Stock Purchase Plan were estimated at the date of grant
using a Black-Scholes option pricing model with the following
weighted-average assumptions for 1998, 1997 and 1996: risk-free interest rate
of 4.25%, 5.41% and 6.125%, respectively; a dividend yield of 0.0%;
volatility factors of the expected market price of the Company's common stock
of .78, .66, and .68, respectively; and a weighted-average expected life of
the option of 5 years.
F-14
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 4: STOCKHOLDERS' EQUITY (CONTINUED)
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options which have no vesting
restrictions and are fully transferable. In addition, option valuation models
require the input of highly subjective assumptions, including the expected
stock price volatility. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion the existing models do not
necessarily provide a reliable single measure of the fair value of its
employee stock options.
For purposes of pro forma disclosures, the estimated fair value of the
options issued under the Stock Plan is amortized to expense over the options'
vesting period. The estimated fair value of the compensation benefit
received under the Stock Purchase Plan is expensed in the year of purchase.
The Company's pro forma information follows:
1998 1997 1996
---- ---- ----
Pro forma net loss $(44,898) $(54,691) $(13,653)
Pro forma loss per share $ (2.22) $ (2.89) $ (0.74)
The effects on pro forma disclosures of applying FAS 123 are not likely
to be representative of effects on pro forma disclosures of future years
because FAS123 is applicable only to options granted subsequent to
December 31, 1994.
F-15
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 4: STOCKHOLDERS' EQUITY (CONTINUED)
A summary of the Company's stock option activity, including the number,
weighted-average exercise price, and weighted-average remaining contractual
life for options outstanding and the number and weighted-average exercise
price of options exercisable for the year ended December 31, 1998, is as
follows:
OPTIONS OUTSTANDING EXERCISABLE
- ----------------- ------------------------------------- -------------------------
Number Weighted Weighted Number Weighted
Outstanding Average Average Exercisable Average
Range of Exercise at Year-end Remaining Exercise at Year-end Exercise
Prices (000) Contractual Price (000) Price
Life
- ----------------- ------------------------------------- -------------------------
$ 3.25 - $ 3.25 881 6.31 $3.25 0 0
$ 4.25 - $ 7.000 588 6.11 $6.7695 539 $ 6.8934
$ 7.25 - $10.75 606 5.53 $9.1055 541 $ 9.0473
$11.00 - $14.375 442 8.04 $13.8119 229 $14.1384
$14.500 - $14.500 594 8.44 $14.5000 338 $14.5000
$14.750 - $15.625 454 4.27 $15.5668 428 $15.5940
$15.84 - $18.000 449 7.74 $16.9533 168 $16.4855
$18.1250 - $22.625 413 7.56 $20.4436 269 $20.7817
------- -------
$ 3.25 - $22.625 4,427 6.69 $11.3393 2,512 $12.6510
OPTION ACTIVITY SUMMARY FOR THE YEAR ENDED DECEMBER 31:
---------------------------------------------------------------------
1998 1997 1996
--------------------- ---------------------- ---------------------
Weighted - Weighted - Weighted -
Average Average Average
Options Exercise Options Exercise Options Exercise
(000) Price (000) Price (000) Price
--------------------- ---------------------- ---------------------
Outstanding-beginning of year 3,277 $13.2569 2,432 $11.81 2,372 $ 9.66
Granted 1,458 $ 7.717 1,346 $14.96 486 $19.78
Granted outside Plan 20 $ 3.25 ---- ---- ---- ----
Exercised (25) $ 8.5055 (258) $ 8.35 (333) $ 8.41
Forfeited (303) $14.356 (243) $13.24 (93) $10.75
----- ----- -----
Outstanding at end of year 4,427 $11.3393 3,277 $13.27 2,432 $11.81
----- -------- ----- ------ ----- ------
----- -------- ----- ------ ----- ------
Exercisable at end of year 2,512 $12.6510 1,627 $11.89 1,350 $10.90
----- -------- ----- ------ ----- ------
----- -------- ----- ------ ----- ------
Weighted-average fair value of
Options granted during the year $7.717 $7.13 $9.54
Under the Stock Plan, stock may be sold and stock bonuses or rights to
purchase common stock may be granted by the Board of Directors or a committee
thereof (the "Board") for past services at the fair market value at the date
of grant. The Board may impose certain repurchase rights, in favor of the
Company, in the event that an employee is terminated prior to certain
predetermined vesting dates. As of December 31, 1998, 1997 and 1996, no
shares were subject to repurchase.
F-16
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 4: STOCKHOLDERS' EQUITY (CONTINUED)
COMMON STOCK RESERVED FOR FUTURE ISSUANCE
At December 31, 1998, the total number of shares of Common Stock reserved
for issuance under all stock plans was 6,190.
F-17
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 5: INCOME TAXES
An income tax benefit has not been accrued on net losses due to the
uncertainty regarding the Company's future profitability.
Significant components of the Company's deferred tax assets for federal
and state income taxes as of December 31, 1998 and 1997 are as follows:
YEAR ENDED DECEMBER 31,
1998 1997
---- ----
Net operating loss carryforwards $ 46,000 $ 25,900
Research and development credits 3,600 2,400
Reserves and accruals 4,500 4,100
Capitalized R&D 7,900 5,700
Arbitration obligation 10,000 15,800
Other -- net 2,700 3,400
----------------------
Total deferred tax assets $ 74,700 $ 57,300
Valuation allowance for deferred tax assets (74,700) (57,300)
----------------------
Net deferred tax assets $ 0 $ 0
----------------------
----------------------
The valuation allowance for the deferred tax assets increased by $17.4
million and $19.8 million during the years ended December 31, 1998 and
December 31, 1997, respectively. Approximately $3.2 million of the valuation
allowance results from tax deductions under the stock option plans and will
be credited to Common Stock when recognized.
At December 31, 1998, the Company had federal net operating loss and
research and development tax credit carryforwards of approximately $131
million and $2.4 million, respectively. The Company had state net operating
loss and tax credit carryforwards of approximately $19.8 million and $1.9
million, respectively. These carryforwards will expire at various dates
beginning in 1999.
Because of the "change in ownership" provisions of the Internal Revenue
Code, a substantial portion of the Company's net operating loss and tax
credit carryforwards may be subject to annual limitations. The annual
limitation may result in the expiration of net operating losses and tax
credits before utilization.
NOTE 6: STATEMENTS OF CASH FLOWS DATA
1998 1997 1996
--------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOWS INFORMATION
Interest paid $ 2,834 $ 1,631 $ 844
SUPPLEMENTAL SCHEDULE OF NON-CASH INVESTING AND
FINANCING ACTIVITIES
Equipment purchased under capital leases $ --- $ --- $ 464
Unrealized gain/(loss) on investments $ 12 $ 3 $ (5)
F-18
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 7: BUSINESS SEGMENTS
The Company operates in two business segments: diagnostics and drug
delivery. Both segments are engaged in development and manufacture, utilizing
proprietary technologies to satisfy unmet medical needs cost effectively. The
segments are strategic business units managed separately based on the
differences in the technologies of their respective product lines.
The diagnostics division's efforts are primarily focused on an automatic
and continuous glucose monitoring device, the GlucoWatch automatic glucose
monitor. The GlucoWatch monitor is designed to take frequent measurements,
thus providing an abundance of glucose data to potentially better control
fluctuating glucose levels. The Company believes its proprietary extraction
and sensing technologies provide the potential to develop unique products for
glucose monitoring which could lead to improved treatment for people with
diabetes.
The drug delivery division's efforts are focused primarily on transdermal
drug delivery systems, which provide for the controlled release of drugs
directly into the bloodstream through intact skin. Cygnus' transdermal
technology is based on the objective of making transdermal products less
irritating, more comfortable and longer to wear for the patient. The Company
has received FDA approval for two products and has a number of others in
late-stage development, including two hormone replacement therapy products
and a contraceptive product.
The accounting policies of the business segments are the same as those
describe in the summary of significant accounting policies. The Company does
not currently have a measure of interest income or interest expense by
business segment. There are no reconciling items between total segment
revenues and profit and (loss) and consolidated results. The Company utilizes
the following information for the purpose of making decisions and assessing
segments' performance.
BUSINESS SEGMENTS
---------------------------------------------
1998 DIAGNOSTICS DRUG DELIVERY CORPORATE TOTAL
---- ----------- ------------- ---------------
Revenue $ 457 $ 11,198 $ 11,655
Profit/(loss) (40,030) 602 (39,428)
Depreciation and amortization 969 971 1,940
Other significant items:
Beneficial conversion costs 4,230 ---- 4,230
Identifiable assets 39,130 4,324 43,454
Expenditure for long lived assets $ 2,834 $ 531 $ 3,365
1997
----
Revenue $ 2,146 $ 27,356 $ 29,502
Profit/(loss) (15,083) (35,377) (50,460)
Depreciation and amortization 1,230 1,509 2,739
Other significant items:
Arbitration settlement ---- (39,666) (39,666)
Writedown of assets 15 1,275 1,290
Identifiable assets 42,955 6,322 49,277
Expenditure for long lived assets $ 2,577 $ 518 $ 3,095
1996
----
Revenue $ 2,712 $ 33,491 $ 36,203
Profit/(loss) (8,405) (2,647) (11,052)
Depreciation and amortization 757 2,045 2,802
Identifiable assets 53,750 15,048 68,798
Expenditure for long lived assets $ 791 $ 724 $ 1,515
F-19
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 7: BUSINESS SEGMENTS (CONTINUED)
All segmental revenues have been generated in the U.S. and the Company
currently does not have any long lived assets outside the U.S.
NOTE 8: SENIOR CONVERTIBLE NOTES
In February 1998, the Company entered into Note Purchase Agreements with
certain institutional investors to issue and sell approximately $43 million
of 4% Senior Subordinated Convertible Notes due 2005 (the "Notes"). On
October 28, 1998, the Company restructured the Notes. Key provisions in the
restructured Notes include the October 1998 repayment of $18.5 million in
principal (reducing the principal balance from $43 million to $24.5 million),
a delay in the convertibility of the majority of the Notes to June 30, 1999
or after, modification of conversion prices of the Notes, the ability of the
Company to redeem at par at any time all or part of the new principal amount
of the Notes, an increase in the interest rate to 5.5% paid annually on the
new principal balance and the change in the final maturity of the Notes to
October 1, 2000.
Under the terms of the restructured Notes, all of the remaining $24.5
million principal amount of the Notes are redeemable by the Company at par
including accrued interest. $18.5 million of the Notes will not be
convertible into Common Stock by the Note Holders until June 30, 1999. The
restructured Notes are divided into three tranches. The first tranche had a
original principal amount of $6 million and was convertible in whole or in
part into Common Stock at any time, at a price that was fixed until June 30,
1999 ($3.54), and was subject to a potential upward adjustment on February 1,
1999 based on certain market formulas. As of December 31, 1998, $1.9 million
of the first tranche had been converted into Common Stock. The balance of the
first tranche was fully converted in January 1999. The second tranche also
has an original principal amount of $6 million and cannot be converted into
Common Stock until June 30, 1999, at which time it becomes convertible in
whole or in part. On June 30, 1999, the conversion price of the second
tranche will be $6.89, which was established on February 1, 1999, based on
the average of closing bid prices using a fifteen trading days look-back from
February 1, 1999. Subsequent to June 30, 1999, the conversion price of the
second tranche will be determined based on other market formulas containing
certain look-back provisions. The third tranche of the restructured notes has
an original principal amount of $12.5 million and cannot be converted into
Common Stock until July 1, 1999 at a conversion price that will be determined
based on market based pricing formulas which contain look-back provisions.
Beginning July 1, 1999, no more than 15% of the second and third tranches
may be converted per calendar month at conversion prices which reflect
market based formulas. Such formulas contain components based on various
averages of closing bid prices and low trading prices during fifteen or ten,
as the case may be, trading days look-back periods from various dates. Any
portions of the 15% monthly amounts of the second and third tranches that are
not converted in the relevant month may be rolled over for conversion in
future months. If the Company calls the second tranche of Notes ($6 million)
for redemption before February 1, 1999, the Note Holders will be entitled to
convert not more than 50% of such notes called before the redemption occurs.
No such call was made by the Company prior to February 1, 1999. If the
Company calls the third tranche of Notes ($12.5 million) for redemption
before July 1, 1999, the Note Holders will not be entitled to convert any
portion of such tranche so called. The Note Holders will otherwise be
entitled to convert Notes called for redemption before the redemption occurs,
at conversion prices based on market formulas.
The terms of the restructured Notes contained beneficial conversion
features relative to the first tranche which resulted in a non-cash charge to
earnings of $4.2 million. Future tranches of the restructured Notes may also
have similar beneficial conversion features. Such beneficial features, if
any, are contingent upon future events including timing of conversion and
market prices at the time of conversion and accordingly the Company is not
able to estimate any potential charges at this time.
F-20
CYGNUS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
FOR THE YEAR ENDED DECEMBER 31, 1998 (CONTINUED)
(IN THOUSANDS, EXCEPT PER SHARE DATA)
NOTE 9: RELATED PARTY TRANSACTIONS
The Company currently does business with two companies that are
principally owned by a non-officer Vice President of the Company. These
companies are primarily engaged to design and build manufacturing equipment
for the GlucoWatch system, and to manufacture components of the GlucoWatch
system. The Company spent approximately $4.0 million with these companies in
1998, and this amount is expected to increase in 1999. As of December 31,
1998, $1.0 million was payable to these companies, and the Company had
outstanding purchase commitments to one of these companies totaling $0.9
million.
NOTE 10: COMMITMENTS
As of December 31, 1998, the Company had non-cancelable purchase orders
totaling $0.9 million with a single vendor for the construction of
manufacturing equipment to be used to produce components of the GlucoWatch
system.
NOTE 11: CONCENTRATION OF CREDIT RISK
The Company maintains its cash, cash equivalents and investments
primarily with a bank and two brokerage houses. This practice is consistent
with the Company's policy to maintain high liquidity and ensure safety of
principal.
As of December 31, 1998, approximately 97% of the trade accounts
receivable are due from three customers. The remaining balance of the trade
accounts receivable are due from two customers, all of which are large
pharmaceutical companies. As of December 31, 1997, approximately 90% of the
trade accounts receivable were due from two customers. The remaining balance
of the trade accounts receivable were due from four customers, all of which
were large pharmaceutical companies. Generally, the Company does not require
any collateral on receivable balances.
NOTE 12: EMPLOYEE BENEFIT PLAN
The Company has a defined contribution benefit plan (the "Plan") covering
substantially all employees. The Plan provides for employee contributions up
to 15 percent of their annual pre-tax compensation or to a maximum of 17
percent of the combined pre-tax and after-tax compensation, as defined in the
Plan. The Plan provides for the Company to match a portion of the
contributions. For the years ended December 31, 1998 and 1997, the Company
incurred defined contribution expense of $0.1 million and $0.08 million,
respectively.
NOTE 13: LEGAL PROCEEDINGS
On November 20, 1998, the American Arbitration Association issued the
final award on the arbitration proceedings between Cygnus and Pharmacia &
Upjohn ("Pharmacia") relating to the Nicotrol patch, Cygnus' smoking
cessation patch. Pursuant to the findings from the arbitration proceedings,
Cygnus was awarded $4.3 million for prevailing in some of its claims and
Pharmacia was awarded $1.6 million for prevailing in some of its claims.
Accordingly, Cygnus realized a net amount of $2.7 million. By way of
background, Cygnus initiated these proceedings in May 1997 based on the
agreement between Cygnus and Pharmacia, which provided that Pharmacia would
be obligated to pay Cygnus for, among other things, existing inventory costs
and certain purchase order commitments. Pharmacia disputed their obligations
regarding certain of the inventory costs and certain purchase order
commitments. In March 1998, Pharmacia added a counterclaim against Cygnus in
the arbitration, seeking approximately $1.5 million in reimbursement for an
alleged overpayment in royalties for Nicotrol units shipped in 1996 and 1997.
Cygnus' claim and Pharmacia's counterclaim commenced on June 15, 1998 before
a panel of the American Arbitration Association. This final and unappealable
decision settles all claims and counterclaims submitted to this Arbitration
by the Parties.
NOTE 14: SUBSEQUENT EVENTS
On February 23, 1999 a warrant to purchase 120 shares of Common Stock was
issued to Petkevich and Partners, LLC for services rendered in providing
financing advice. Sixty (60) shares can be purchased at $0.01 (one cent) per
share prior to March 2, 1999 by Petkevich and Partners, LLC and 60 shares at
$3.25 per share prior to November 1, 1999. The warrant and shares have not
been registered under the Securities Act of 1933. On February 26, 1999,
Petkevich and Partners, LLC exercised the warrant to purchase 60 shares at
the exercise price of $0.01 (one cent) per share of the outstanding warrant.
F-21
SCHEDULE II
CYGNUS, INC.
VALUATION AND QUALIFYING ACCOUNTS
YEARS ENDED DECEMBER 31, 1998, 1997, AND 1996
(DOLLARS IN THOUSANDS)
BALANCE AT CHARGED TO CHARGED TO
BEGINNING OF COSTS AND OTHER BALANCE AT
YEAR EXPENSES ACCOUNTS DEDUCTIONS END OF YEAR
-------------------------------------------------------------------------
Year ended December 31, 1998:
Deducted from asset accounts:
Allowance for doubtful accounts $ 123 $ -- $ -- $ -- $ 123
Warranty reserve 435 -- -- -- 435
---------------------------------------------------------------------
$ 558 $ -- $ -- $ -- $ 558
---------------------------------------------------------------------
---------------------------------------------------------------------
Year ended December 31, 1997:
Deducted from asset accounts:
Allowance for doubtful accounts $1,137 $ -- $ -- $(1,014) $ 123
Warranty reserve 435 -- -- -- 435
---------------------------------------------------------------------
$1,572 $ -- $ -- $(1,014) $ 558
---------------------------------------------------------------------
---------------------------------------------------------------------
Year ended December 31, 1996:
Deducted from asset accounts:
Allowance for doubtful accounts $1,137 $ -- $ -- $ -- $ 1,137
Warranty reserve 435 -- -- -- 435
---------------------------------------------------------------------
$1,572 $ -- $ -- $ -- $ 1,572
---------------------------------------------------------------------
---------------------------------------------------------------------
S-1