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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended June 30, 2004

or

For the transition period from              to             .

Commission file number: 000-23265

SALIX PHARMACEUTICALS, LTD.

(Exact name of Registrant as specified in its charter)

8540 Colonnade Center Drive, Suite 501

Raleigh, North Carolina 27615

(Address of principal executive offices, including zip code)

(919) 862-1000

(Registrant’s telephone number, including area code)

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 whether registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    YES  x    NO  ¨

The number of shares of the Registrant’s Common Stock outstanding as of August 4, 2004 was 36,167,588.

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SALIX PHARMACEUTICALS, LTD.

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PART I. FINANCIAL INFORMATION.

Item 1. Financial Statements

SALIX PHARMACEUTICALS, LTD. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCE SHEETS

(U.S. dollars, in thousands, except share amounts)

The accompanying notes are an integral part of these financial statements.

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SALIX PHARMACEUTICALS, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(unaudited)

(U.S. Dollars, in thousands, except per share data)

The accompanying notes are an integral part of these financial statements.

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SALIX PHARMACEUTICALS, LTD.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(unaudited)

(U.S. dollars, in thousands)

The accompanying notes are an integral part of these financial statements.

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SALIX PHARMACEUTICALS, LTD.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

June 30, 2004

(Unaudited)

Salix Pharmaceuticals, Ltd., a Delaware corporation (“Salix” or the “Company), is a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract.

These financial statements are stated in United States dollars and are prepared under accounting principles generally accepted in the United States. The accompanying condensed consolidated financial statements include the accounts of the Company and its subsidiaries. All significant intercompany balances and transactions have been eliminated.

The accompanying condensed consolidated financial statements include all adjustments (consisting only of normal recurring items), that, in the opinion of management, are necessary for a fair presentation of financial position, results of operations and cash flows. These financial statements should be read in conjunction with Management’s Discussion and Analysis of Financial Condition and Results of Operations included elsewhere in this Quarterly Report and with the audited consolidated financial statements included in the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2003 filed with the Securities and Exchange Commission. The results of operations for interim periods are not necessarily indicative of results to be expected for a full year or any future period.

At June 30, 2004, the Company had binding purchase order commitments for inventory purchases aggregating approximately $18.6 million over nine months.

The Company considers all investments that have a maturity of greater than three months and less than one year to be short-term investments. All securities with maturities beyond one year are considered long-term investments. The Company’s short-term and long-term investments consist of government agency and high-grade corporate bonds. The Company has the intent and ability to hold these investments until maturity; therefore, the investments are classified as held-to-maturity and are reported at amortized cost.

Inventory at June 30, 2004 consisted of $17.5 million of raw materials and $4.3 million of finished goods. Inventory at December 31, 2003 consisted of $12.2 million of raw materials and $3.9 million of finished goods.

When the Company makes product acquisitions that include license agreements, product rights and other identifiable intangible assets, it records the aggregate purchase price, along with the value of the product related liabilities that it assumes, as intangible assets. The Company allocates the purchase price to the fair value of the various intangible assets in order to amortize their cost as an expense in our statement of operations over the estimated economic useful life of the related assets. The Company assesses the impairment of identifiable intangible assets whenever events or changes in circumstances indicate that the carrying value might not be recoverable. Factors the Company considers important that could trigger an impairment review include significant underperformance relative to expected historical or projected future operating results, significant changes in the manner of the Company’s use of the acquired assets or the strategy for the Company’s overall business, and significant negative industry or economic trends.

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In assessing the recoverability of the Company’s intangible assets, it must make assumptions regarding estimated future cash flows and other factors. If the estimated undiscounted future cash flows do not exceed the carrying value of the intangible assets, the Company must determine the fair value of the intangible assets. If the fair value of the intangible assets is less than the carrying value, an impairment loss will be recognized in an amount equal to the difference. The Company reviews intangible assets for impairment at least annually and whenever events or changes in circumstances indicate that the carrying amount of an asset might not be recoverable.

In June 2004, the Company acquired the exclusive U.S. rights to Anusol-HC^® 2.5% (hydrocortisone Cream USP), Anusol-HC^® 25 mg Suppository (Hydrocortisone Acetate), Proctocort^® Cream (Hydrocortisone Cream USP) 1% and Proctocort^® Suppositories (Hydrocortisone Acetate Rectal Suppositores, 30 mg) from King Pharmaceuticals, Inc. for $13.0 million. At June 30, 2004, other assets consisted primarily of intangible assets related to the Anusol, Proctocort and Azasan product acquisitions.

On June 21, 2004, the Board of Directors approved a three-for-two stock split of the Company’s common stock, in the form of a stock dividend. As a result, stockholders received one additional common share for every two shares held on the record date of June 30, 2004. Statements or certificates were issued on or about July 12, 2004. All share and per share amounts have been retroactively adjusted to reflect the split for all periods presented.

Product sales are recorded upon shipment of order and transfer of title.

In December 1999, the SEC issued Staff Accounting Bulletin No. 101, “Revenue Recognition in Financial Statements”, as amended by SAB 104, “Revenue Recognition”, which clarifies conditions to be met in order to recognize revenue. SAB 101 requires companies to recognize up-front non-refundable fees over the term of the related agreement unless the fee is in exchange for products delivered or services performed that represent the culmination of a separate earnings process.

Due to the uniqueness of each of the Company’s licensing arrangements, the Company analyzes each element of each contract, including milestone payments, to determine the appropriate revenue recognition. In accordance with SAB 101, the Company recognizes revenue upon achievement of contractual milestones only when and to the extent that it concludes that a separate earnings process has been culminated or the milestone is representative of the level of effort and progress toward completion of a long-term contract.

Revenues from collaborative agreements for the three-month and six-month periods ended June 30, 2004 were $3.8 million. These revenues were primarily related to the Company’s agreement with Shire Pharmaceuticals Group plc under which Shire purchased from us the intellectual property related to balsalazide for Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Republic of Ireland, Luxembourg, Norway, the Netherlands, Switzerland and the United Kingdom.

Research and development costs, both internal and externally contracted, are expensed as incurred. These costs include direct expenditures for goods and services, as well as indirect expenditures such as salaries, administrative expenses and various allocated costs.

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Comprehensive loss is comprised of net loss and other comprehensive loss. Other comprehensive loss includes certain changes in the stockholders’ equity of the Company that are excluded from net loss. Specifically, other comprehensive loss includes foreign currency translation adjustments.

Comprehensive loss for the three and six months ended June 30, 2004 and 2003 was as follows:

The Company accounts for stock-based awards to employees under the intrinsic value method in accordance with Accounting Principles Board Opinion, or APB, No. 25, “Accounting for Stock Issued to Employees”, and has adopted the disclosure-only alternative of SFAS No. 123, “Accounting for Stock-Based Compensation”. Under APB 25, the Company generally recognizes no compensation expense with respect to such awards.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock Based Compensation-Transition and Disclosure and amendment of FASB Statement No. 123”. This statement amends SFAS No. 123, “Accounting for Stock Based Compensation”, to provide alternative methods of transition for a voluntary change to the fair value based method of accounting for stock based employee compensation. In addition, this statement amends the disclosure requirements of SFAS 123 to require prominent disclosures in both annual and interim financial statements about the method of accounting for stock based employee compensation and the effects of the method used on reported results.

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Had compensation cost for the Company’s stock-based compensation plan been determined based on fair value at the grant dates for awards under those plans consistent with the method of SFAS No. 123, the Company’s net loss and loss per share would have been increased to the pro forma amounts indicated below for the periods ended June 30, 2004 and 2003, respectively.

Future pro forma net income (loss) and earnings (loss) per share results might be materially different from actual amounts reported.

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

This report contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These forward-looking statements are subject to risks and uncertainties, including those set forth under “Cautionary Statement” included in this “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and elsewhere in this report, that could cause actual results to differ materially from historical results or anticipated results. The following discussion should be read in conjunction with our Condensed Consolidated Financial Statements and notes thereto included elsewhere in this report.

Overview

We are a specialty pharmaceutical company dedicated to acquiring, developing and commercializing prescription drugs used in the treatment of a variety of gastrointestinal diseases, which are those affecting the digestive tract. Our strategy is to identify and acquire rights to products that we believe have potential for near-term regulatory approval or are already approved; apply our regulatory, product development, and sales and marketing expertise to commercialize these products; and use our 100-member specialty sales and marketing team focused on high-prescribing U.S. gastroenterologists to sell our products. We rely on distribution relationships with third parties to sell our products outside the United States.

We generate revenue primarily by selling our products, prescription drugs, to pharmaceutical wholesalers. These direct customers of ours resell and distribute our products to and through pharmacies to patients who have had our products prescribed by doctors. Because demand for our products originates with doctors, our sales force calls on high-prescribing specialists, primarily gastroenterologists, and we monitor new and total prescriptions for our products as key performance indicators for our business.

Prescriptions result in our products being used by patients, requiring our direct customers to purchase more products to replenish their inventory. However, our revenue might fluctuate from quarter to quarter due to other factors, such as increased buying by wholesalers in anticipation of a price increase. Revenue could be less than anticipated in subsequent quarters as wholesalers’ increased inventory is used up. We believe such increased buying occurred in late 2003 and early 2004, and it could again.

In July 2000, the FDA approved Colazal^® for marketing in the United States for the treatment of mildly to

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moderately active ulcerative colitis. In December 2000, we established our own field sales force to market Colazal in the United States. Currently, this sales force has approximately 70 sales representatives in the field. Although the creation of an independent sales organization involved substantial costs, we believe that the financial returns from current and future products, if acquired and approved, will be more favorable to us than those from the indirect sale of product through marketing partners.

In November 2003, we acquired from aaiPharma LLC the exclusive right to sell three dosage strengths of Azasan (azathioprine tablets) in North America. In February 2004, we launched two dosage strengths of Azasan in the United States.

In May 2004, the FDA approved Xifaxan (rifaximin tablets) for marketing in the United States for the treatment of travelers’ diarrhea caused by noninvasive strains of E. coli in patients 12 years of age or older. We intend to market Xifaxan to gastroenterologists, hepatologists and infectious disease physicians in the United States through our own direct sales force. We are exploring other potential indications, formulations, clinical trials and co-promotion arrangements to capitalize on the potential for Xifaxan.

In June 2004, we acquired the exclusive U.S. rights to Anusol-HC^® 2.5% (hydrocortisone Cream USP), Anusol-HC^® 25 mg Suppository (Hydrocortisone Acetate), Proctocort^® Cream (Hydrocortisone Cream USP) 1% and Proctocort^® Suppositories (Hydrocortisone Acetate Rectal Suppositories, 30 mg) from King Pharmaceuticals, Inc. The two cream products are topical corticosteroids indicated for relief of the inflammatory and pruritic, or itching, manifestations of corticosteroid-responsive dermatoses. The two suppository products are indicated for use in inflamed hemorrhoids and postirradiation proctitis, as well as an adjunct in the treatment of chronic ulcerative colitis and other inflammatory conditions. We intend to market these products to gastroenterologists in the United States through our direct sales force.

In July 2002, we in-licensed exclusive development and marketing rights in the United States to a granulated formulation of mesalamine from Dr. Falk Pharma. We intend to complete the development work required to secure regulatory approval for the product in the United States.

We have made significant investments over the past few years to develop our commercialization infrastructure. As a result, we have sustained continuing operating losses and had an accumulated deficit of $95.0 million as of June 30, 2004. However, we currently expect that we will be profitable for the year ending December 31, 2004.

Critical Accounting Policies

In our Annual Report on Form 10-K for the fiscal year ended December 31, 2003, we identified our most critical accounting policies and estimates upon which our financial status depends as those relating to revenue recognition, investments, inventory, intangible assets, allowance for uncollectible accounts, and allowance for rebates and coupons. We reviewed our policies and determined that those policies remained our most critical accounting policies for the three and six months ended June 30, 2004. We did not make any changes in those policies during the quarter.

Results of Operations

Three-Month and Six-Month Periods Ended June 30, 2004 and 2003

Total product revenues for the three-month and six-month periods ended June 30, 2004 were $19.4 million and $39.3 million, respectively. Colazal product revenues for the three-month and six-month periods ended June 30, 2004 were $18.9 million and $38.3 million, respectively, compared to $12.9 million and $24.5 million, respectively, for the corresponding periods in 2003. In February 2004, we launched two dosage strengths of Azasan in the United States. Azasan product revenues for the three-month and six-month periods ended June 30, 2004 were $0.5 million and $1.0 million respectively.

Revenues from collaborative agreements for the three-month and six-month periods ended June 30, 2004 were $3.8 million. These revenues were primarily related to our agreement with Shire Pharmaceuticals Group plc under which Shire purchased from us the intellectual property related to balsalazide for Austria, Belgium, Denmark, Finland, France, Germany, Iceland, Republic of Ireland, Luxembourg, Norway, the Netherlands, Switzerland and the United Kingdom. We do not expect any future revenues under this agreement.

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Costs and expenses for the three-month and six-month periods ended June 30, 2004 were $25.3 million and $47.7 million, respectively, compared to $18.9 million and $36.5 million for the corresponding three-month and six-month periods in 2003. Higher operating expenses in absolute terms were due primarily to on-going clinical studies and development work on rifaximin and the granulated mesalamine product, Xifaxan market research and market development activities, and the marketing campaign for Colazal. However, as expected, as we increase revenue using the commercialization infrastructure built with significant investment over the past few years, costs and expenses in 2004 were less, as a percentage of revenue, than in 2003. We expect this trend to continue.

Cost of products sold for the three-month and six-month periods ended June 30, 2004 was $4.7 million and $9.4 million respectively, compared with $3.1 million and $5.8 million for the corresponding three-month and six-month periods in 2003. Gross margins for the three-month and six-month periods ended June 30, 2004 were $14.8 million and $29.9 million, respectively, compared to $9.9 million and $18.6 million for the corresponding three-month and six-month periods of 2003. Gross margins were approximately 76% for each of the three-month and six-month periods ended June 30, 2004 and June 30, 2003.

License fees and costs related to collaborative agreements for the three-month and six-month periods ended June 30, 2004 were constant at $1.8 million, compared with $31,000 and $63,000 in the corresponding three-month and six-month periods ended June 30, 2003. The $1.8 million of expense recognized in the period ended June 30, 2004 was primarily the result of royalty expense associated with the recognition of revenue under our agreement with Shire.

Research and development expenses were $4.6 million and $9.5 million for the three-month and six-month periods ended June 30, 2004, compared to $6.5 million and $11.6 million for the comparable periods in 2003. Our current major research and development projects are rifaximin and the granulated mesalamine product. The decrease in research and development expenses for the three-month and six-month periods ended June 30, 2004 was due primarily to the reduction of research and development expenditures for seeking FDA approval of rifaximin, which we received in May 2004. To date, we have incurred research and development expenditures of approximately $19.2 million for balsalazide, $28.2 million for rifaximin and $6.7 million for granulated mesalamine. Due to the risks and uncertainties of the drug development and regulatory approval process, research and development expenditures are difficult to forecast and subject to unexpected increases. We expect research and development costs to increase in absolute terms as we pursue additional indications for balsalazide and rifaximin, pursue development of the granulated mesalamine product, and if and when we acquire new products.

Selling, general and administrative expenses were $14.2 million and $27.0 million for the three-month and six-month periods ended June 30, 2004, compared to $9.4 million and $19.0 million in the corresponding three-month and six-month periods in 2003. This increase was primarily due to Xifaxan market research and market development activities and the marketing campaign for Colazal.

Interest and other income (expense), net was $0.2 million and $0.3 million for the three-month and six-month periods ended June 30, 2004, compared to ($1.0) million and ($0.4) million in the corresponding three-month and six-month periods in 2003. The 2003 amounts were negatively affected by expenses related to the attempted hostile takeover of our company via a tender offer and related proxy contest by Axcan Pharma, Inc. during the first six months of 2003.

We experienced net losses of $1.9 million and $4.3 million for the three-month and six-month periods ended June 30, 2004, compared with net losses of $7.0 million and $12.5 million in the corresponding three-month and six-month periods in the prior year.

Liquidity and Capital Resources

Since inception, we have financed product development, operations and capital expenditures primarily from funding arrangements with collaborative partners and from public and private sales of equity securities. Since launching Colazal in January 2001, product revenue has been a growing source of cash, a trend that we expect to continue. As of June 30, 2004, we had approximately $42.3 million in cash, cash equivalents and investments, compared to $64.8 million as of December 31, 2003.

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Cash used in our operations was $12.7 million for the six-month period ended June 30, 2004, compared with $13.5 million in the corresponding six-month period in 2003. Negative operating cash flows during these periods were primarily attributable to operating losses, increased inventory levels in 2004 associated with the commercial launch of Xifaxan and other working capital changes. To date, we have not experienced any material accounts receivable collection issues. Based on a review of specific customer balances, industry experience and the current economic environment, we currently reserve for specific accounts plus 1% of the outstanding accounts receivable balance as an allowance for uncollectible accounts, which at June 30, 2004 was approximately $413,000.

Cash used in investing activities for the six-month period ended June 30, 2004 was $11.1 million primarily related to the acquisition of the Anusol and Proctocort products. Cash provided by investing activities for the six-month period ended June 30, 2003 was $15.6 million primarily related to the maturity of investments. Our capital expenditures were $125,000 for the six-month period ended June 30, 2004, compared with $556,000 in the corresponding six-month period in 2003, with the expenditures in both periods primarily attributable to the purchase of office furniture and equipment.

Cash provided by financing activities during the six-month period ended June 30, 2004 was $3.3 million compared to $1.1 million in the corresponding six-month period in 2003. Cash provided by financing activities for both periods was primarily related to the exercise of stock options.

During the third quarter of 2002, we entered into a $7.0 million revolving working capital line of credit, with borrowing capacity of up to 75% of our eligible accounts receivable under 90 days old from the date of invoice. As amended, the facility expires in January 2005. We had no outstanding balance under this line as of June 30, 2004.

As of June 30, 2004, we had non-cancelable purchase order commitments for inventory purchases of approximately $18.6 million over nine months. We anticipate significant expenditures in 2004 related to our continued sales, marketing, product launch and development efforts associated with Colazal, Xifaxan and the granulated mesalamine product. To the extent we acquire rights to additional products, we will incur additional expenditures.

We have sustained continuing operating losses and had an accumulated deficit of $95.0 million as of June 30, 2004. We currently expect that we will become profitable for the year ending December 31, 2004. We believe our cash, cash equivalent and investments balances at June 30, 2004 should be sufficient to satisfy our cash requirements for the foreseeable future. However, our actual cash needs might vary materially from those now planned because of a number of factors, including our success selling products, the results of research and development activities, FDA and foreign regulatory processes, establishment of and change in relationships with strategic partners, technological advances by us and other pharmaceutical companies, the terms of our collaborative arrangements with strategic corporate partners, the status of competitive products and whether we acquire rights to additional products. We might seek additional debt or equity financing or both to fund our operations or acquisitions. If we increase our debt levels, we might be restricted in our ability to raise additional capital and might be subject to financial and restrictive covenants. If we issued additional equity, our stockholders could suffer dilution. We might also enter into additional collaborative arrangements with corporate partners that could provide us with additional funding in the form of equity, debt, licensing, milestone and/or royalty payments. We might not be able to enter into such arrangements or raise any additional funds on terms favorable to us or at all.

Cautionary Statement

We operate in a highly competitive environment that involves a number of risks, some of which are beyond our control. The following statement highlights some of these risks.

Statements contained in this Form 10-Q which are not historical facts are or might constitute forward-looking statements under the safe harbor provisions of the Private Securities Litigation Reform Act of 1995. Although we believe the expectations reflected in such forward-looking statements are based on reasonable

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assumptions, we can give no assurance that our expectations will be attained. Forward-looking statements involve known and unknown risks that could cause actual results to differ materially from expected results. Factors that could cause actual results to differ materially from our expectations expressed in the report include, among others: our dependence on our first three pharmaceutical products, balsalazide, rifaximin and granulated mesalamine, and the uncertainty of market acceptance of those products; the unpredictability of the duration and results of regulatory review of New Drug Applications and Investigational New Drug Applications; the high cost and uncertainty of the research, clinical trials and other development activities involving pharmaceutical products; our limited sales and marketing experience; the uncertainty of obtaining, and our dependence on, third parties to manufacture and sell our products; intense competition; the possible impairment of, or inability to obtain, intellectual property rights and the costs of obtaining such rights from third parties; and results of future litigation and other risk factors detailed from time to time in our other SEC filings.

Item 3. Quantitative and Qualitative Disclosures About Market Risk

Our purchases of raw materials and product sales to European distribution partners are denominated in Euros. Translation into our reporting currency, the United States dollar, has not historically had a material impact on our financial position. Additionally, our net assets denominated in currencies other than the functional currency have not exposed us to material risk associated with fluctuations in currency rates. Given these facts, we have not considered it necessary to use foreign currency contracts or other derivative instruments to manage changes in currency rates.

Pursuant to our investment policy, we have invested a portion of our available cash in government agency and high-grade corporate bonds. Due to the nature and maturity terms of these investments, we do not believe these investments present significant market risk.

Item 4. Controls and Procedures

(a) Disclosure controls and procedures (as defined in Exchange Act Rule 13a-15(e)) are designed only to provide reasonable assurance that information to be disclosed in our Exchange Act reports is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. As of the end of the period covered by this report, the Company carried out an evaluation, under the supervision and with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the Company’s disclosure controls and procedures pursuant to Exchange Act Rule 13a-15. Based upon that evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that the Company’s disclosure controls and procedures are effective to provide the reasonable assurance discussed above.

(b) No change in the Company’s internal control over financial reporting occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

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PART II. OTHER INFORMATION

Item 4. Submission of Matters to a Vote of Security Holders

Our 2004 Annual Meeting of Shareholders was held on June 17, 2004. The following is a brief description of each matter voted upon at the meeting and a statement of the number of votes cast for, against or withheld and the number of abstentions with respect to each matter.

Item 6. Exhibits and Reports on Form 8-K

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We furnished or filed the following Current Reports on Form 8-K during the quarter ended June 30, 2004:

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this Report to be signed on its behalf by the undersigned, thereunto duly authorized.

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