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SECURITIES AND EXCHANGE COMMISSION

Washington, DC

Form 10-Q

(Mark One)

For the quarterly period ended September 30, 2004

or

For the transition period from              to             

Commission File Number: 0-28748

CLOSURE MEDICAL CORPORATION

(Exact name of registrant as specified in its charter)

5250 Greens Dairy Road, Raleigh, North Carolina 27616

(Address of principal executive offices) (Zip Code)

(919) 876-7800

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

Indicate the number of shares outstanding of each of the issuer’s classes of common stock, as of the latest practicable date.

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CLOSURE MEDICAL CORPORATION

INDEX

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PART I- FINANCIAL INFORMATION

ITEM 1. CONDENSED FINANCIAL STATEMENTS

CLOSURE MEDICAL CORPORATION

BALANCE SHEETS

(In thousands, except per share data)

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

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CLOSURE MEDICAL CORPORATION

STATEMENTS OF OPERATIONS

(Unaudited)

(In thousands, except per share data)

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

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CLOSURE MEDICAL CORPORATION

STATEMENTS OF CASH FLOWS

(Unaudited)

(In thousands)

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

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Closure Medical Corporation

Notes to Condensed Financial Statements

(Unaudited)

1. Organization

Closure Medical Corporation (the “Company” or “Closure”) develops and manufactures innovative biomaterial-based medical devices that fulfill the needs of healthcare practitioners, patients and consumers.

2. Significant Accounting Policies

The significant accounting policies followed by the Company for interim financial reporting are consistent with the accounting policies followed for annual financial reporting. These unaudited financial statements have been prepared in accordance with Rule 10-01 of Regulation S-X, and in management’s opinion, all adjustments of a normal recurring nature necessary for a fair presentation have been included. They do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements and should be read in conjunction with the financial statements and notes thereto for the year ended December 31, 2003 included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2003.

The results of operations for the three and nine month periods ended September 30, 2004 are not necessarily indicative of the results to be expected for the entire fiscal year ending December 31, 2004.

Accounting for Stock-Based Compensation

The Company accounts for stock-based compensation based on the provisions of Accounting Principles Board Opinion No. 25, “Accounting for Stock Issued to Employees”. In December 2002, the FASB issued Statement No. 148, “Accounting for Stock-Based Compensation – Transition and Disclosure – an amendment of FASB Statement No. 123” (“SFAS 148”). This amendment of Statement No. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”) provides 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 effect of the method used on reported results. The effects of the Company adopting the disclosure requirements of SFAS 123 and SFAS 148 are included in the following table.

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Closure Medical Corporation

Notes to Condensed Financial Statements

(Unaudited)

2. Significant Accounting Policies (continued)

Had compensation expense, assuming it was recognized on a straight-line basis over the vesting period for awards under the Company’s Equity Compensation Plan and in the period of purchase for benefits received under the Employee Stock Purchase Plan, been determined based on the fair value at the grant date, consistent with the provisions of SFAS 123 and SFAS 148, the Company’s results of operations would have been reduced to the pro forma amounts indicated below:

The assumptions used to calculate the fair value of options granted are evaluated and revised, as necessary, to reflect market conditions and experience at the grant date.

3. Income Taxes

The Company’s effective tax rate for the nine months ended September 30, 2004 was 35 percent. The effective tax provision rate differed from the statutory federal income tax rate primarily due to the impact of state taxes and the estimated effect of research and development credits.

4. Inventories

Inventories included the following (in thousands):

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Closure Medical Corporation

Notes to Condensed Financial Statements

(Unaudited)

5. Net Income Per Common Share

Basic net income per common share is computed using the weighted-average number of shares of common stock outstanding during the period.

Diluted net income per common share is computed using the weighted-average number of shares of common and common equivalent shares outstanding during the period. Common equivalent shares consist of stock options using the treasury stock method and are excluded from the computation if their effect is antidilutive.

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ITEM 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

CAUTIONARY STATEMENT PURSUANT TO SAFE HARBOR PROVISIONS OF THE PRIVATE SECURITIES LITIGATION ACT OF 1995

The following discussion should be read in conjunction with the unaudited, condensed financial statements and notes thereto included in Part I—Item 1 of this Form 10-Q and the audited financial statements and notes thereto and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Annual Report on Form 10-K for the year ended December 31, 2003.

This report and the documents incorporated by reference herein contain “forward-looking statements” within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. When used in this report and the documents incorporated herein by reference, the words “expect,” “anticipate,” “believe,” “estimate,” and similar expressions are generally intended to identify forward-looking statements. These forward-looking statements are based on a number of factors concerning future events, and are subject to a number of uncertainties and other factors, many of which are outside of our control. These statements include, among others, the statements in Management’s Discussion and Analysis about the following:

There are important factors that could cause actual results to differ materially from those expressed or implied by such forward-looking statements including, but not limited to, the following:

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These and other risks and uncertainties affecting Closure are discussed in greater detail in this report and in other filings by Closure with the Securities and Exchange Commission. We undertake no obligation to update or revise forward-looking statements, whether as a result of new information, future events or otherwise.

OVERVIEW

Closure Medical Corporation develops and manufactures innovative biomaterial-based medical devices that fulfill the needs of healthcare practitioners, patients and consumers. Each of our products utilizes our proprietary medical grade cyanoacrylate technology. Our strategy is to focus our business around three primary platforms: topical wound care, surgical sealants and new technologies. Our main platform is topical wound care and to date we have commercialized products for wound care and closure for the professional healthcare, over-the-counter, or OTC, and veterinary markets. Under our surgical sealant platform we currently have a vascular product, OMNEX^™ surgical sealant, in a clinical study and have ongoing research into other devices to be used inside the body as internal sealants.

Our leading product, DERMABOND adhesive, is sold to healthcare professionals for the replacement of sutures and staples to rapidly close wounds and incisions while sealing and protecting them from infection. This product allows natural healing to proceed by closing and sealing injured tissue without the trauma caused by suturing or stapling. We believe that using DERMABOND adhesive results in enhanced patient and physician benefits such as lower overall procedure costs and is easier and quicker to use than sutures or staples.

We have other products that are marketed in the OTC adhesive bandage and the OTC oral pain relief markets. BAND-AID^® Brand Liquid Bandage, or Liquid Bandage, quickly seals, protects and stops bleeding from minor cuts and scrapes. SOOTHE-N-SEAL^® adhesive provides a protective barrier that shields oral ulcers and sores from irritation caused by eating and drinking while providing immediate and long-term pain relief.

In addition, we have two veterinary products in our NEXABAND^® product line that are used in cat declaw and spay and neuter procedures.

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We have entered into marketing partnerships with third parties that distribute and market our current products to professionals and consumers. Our partners include Ethicon, Inc., a Johnson & Johnson company; Johnson & Johnson Consumer Products Company, or J&J Consumer; Colgate Oral Pharmaceuticals, Inc.; and Abbott Laboratories, Inc.

We continue to pursue modifications and improvements to our existing products to enhance their effectiveness and expand their marketability. In January 2004, two new applicator systems, ProPen and ProPen XL, for the DERMABOND product line were launched by Ethicon. The applicators further enhance DERMABOND’s precision application and ease of use. The ProPen is a single-use device designed with interchangeable tips, which allows for fine-line delivery of adhesive for those wound closures requiring precise application. The XL version of ProPen delivers twice the express volume as the ProPen for closing longer surgical incisions. Also during January 2004, J&J Consumer launched BAND-AID^® Brand Liquid Bandage for Skin Cracks, the first line extension for the original Liquid Bandage. J&J Consumer also continues to introduce the Liquid Bandage product in markets outside the U.S., including Europe and Australia.

In addition, our research and development efforts are focused on developing internal surgical sealant products. The first such product is OMNEX^™ surgical sealant, to be used in peripheral vascular procedures such as arteriovenous bypass and access procedures. In March 2004, we received approval from the U.S. Food and Drug Administration and have initiated enrollment in a pivotal clinical study to support U.S. Premarket Approval for OMNEX^™ sealant, our first product to be used inside the body. The approval was based on the positive results of a ten-patient pilot study that completed enrollment in December 2003. As of November 5, 2004, 112 of the expected 150 patients had been treated with the product. The pivotal study protocol requires four- and twelve-week follow-up visits for participants at approximately 12 medical institutions in the U.S. and Europe. The study is assessing the ability of OMNEX^™ sealant to prevent leakage following reconstruction of vascular structures in patients receiving femoral bypass or arteriovenous shunt procedures for hemodialysis access. We expect to begin marketing OMNEX^™ sealant in Europe during the first half of 2005. We have applied for the European CE mark and expect a response around the end of 2004. In addition, we are in discussions with major multi-national medical device companies that have an interest in partnering with us to distribute OMNEX^™ sealant.

In addition to OMNEX^™ sealant, we are researching other indications for our internal sealant technology. These and other future products require further development and may be subject to clinical trials and regulatory clearance or approval before commercialization.

RESULTS OF OPERATIONS

Revenues. Total revenues for the three months ended September 30, 2004 were $9.2 million compared to $8.9 million for the corresponding period of 2003. For the 2004 quarter, DERMABOND adhesive revenue growth was supported by the continued penetration of ProPen products, which were approximately 24 percent of end-user sales in the U.S., and higher-than-normal royalty revenue. Liquid Bandage revenues were flat during the quarter, supported by shipments of the product internationally and sales of the skin crack gel product in the U.S. For the nine months ended September 30, 2004, total revenues increased 21 percent to $31.0 million from $25.5 million for the 2003 period. During the nine-month period of 2004, revenue growth was largely due to an increase in DERMABOND revenues, primarily resulting from ProPen’s premium pricing and favorable economics. Liquid Bandage also contributed to revenue growth during the nine-month period, primarily due to shipments of the product internationally and sales of the skin crack gel product in the U.S.

Expectations for 2004 DERMABOND revenues were reduced during the third quarter, reflecting lower unit growth at the end-user level and a reduction of our marketing partner’s inventories of the product. Depending on the level of end-user sales, we expect inventories to normalize at our marketing partner’s stated target of five to six weeks during the first half of 2005. In addition, as previously disclosed, Liquid Bandage revenues continue to be impacted by lower-priced competitive products in the U.S. As a result, in the near term, we believe a majority of the Liquid Bandage revenues could be generated from sales of the product internationally. In response to the competitive product in the U.S., during the fourth quarter, we plan to provide a lower-priced Liquid Bandage product for distribution. We will receive approximately 25 percent less revenue per unit from sales of this product, but we believe our gross margin per unit will be comparable with our existing Liquid Bandage products.

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Cost of products sold. Cost of products sold was $2.3 million for the three months ended September 30, 2004 compared to $2.1 million for the 2003 period. Cost of products sold as a percentage of revenues increased to 25 percent for the three months ended September 30, 2004 versus 24 percent for the corresponding 2003 period. The increase was the result of manufacturing inefficiencies related to in-house ProPen production and additional overhead related to our manufacturing expansion that took place at the beginning of 2004, offset by the impact of higher-than-normal royalty revenue of $373,000. For the nine months ended September 30, 2004 and 2003, cost of products sold was $8.1 million and $6.1 million, respectively. Cost of products sold as a percentage of revenues was 26 percent and 24 percent for the nine months ended September 30, 2004 and 2003, respectively. The increase relates to manufacturing inefficiencies attributed to the commencement of in-house ProPen production, incremental overhead costs associated with our facility expansion, and a reduction of product development revenues during the 2004 period. We expect that future costs of products sold will continue to fluctuate based on production volumes and the relative proportions of our various products in the manufacturing process.

Operating Expenses. Operating expenses were $4.1 million for the three months ended September 30, 2004 and $3.7 million for the same period of 2003. For the nine months ended September 30, 2004 and 2003, operating expenses were $12.3 million and $10.9 million, respectively. As a percentage of total revenues, research, development and regulatory affairs expenses were 29 percent and 23 percent for the three months ended September 30, 2004 and 2003, respectively. For the nine months ended September 30, 2004, research, development and regulatory affairs expenses as a percentage of total revenues were 25 percent compared to 24 percent in the comparable 2003 period. The increase in research, development and regulatory expenses was primarily due to expenses relating to the development of the OMNEX^™ sealant, including the pivotal clinical study as well as additional personnel costs to support those efforts. General and administrative expenses as a percentage of total revenues decreased to 15 percent for the three and nine month periods ended September 30, 2004 compared to 19 percent for both 2003 periods.

Net interest income. Net interest income was $195,000 for the three months ended September 30, 2004, compared to $69,000 for the three months ended September 30, 2003. For the nine months ended September 30, 2004 and 2003, net interest income was $428,000 and $216,000, respectively. These increases are primarily due to higher average investment balances coupled with higher interest rates during the 2004 periods.

Provision for income taxes. The provision for income taxes was $1.1 million for both the three months ended September 30, 2004 and 2003. For the nine months ended September 30, 2004 the provision for income taxes was $3.9 million compared to $3.2 million during the 2003 period. The effective tax rate for the nine months ended September 30, 2004 declined to approximately 35 percent from 36 percent in the 2003 period due to the effect of research and development credits. Although we record a provision for income taxes on our statement of operations, we are not required to actually pay federal income taxes, other than alternative minimum taxes, until such time as our net operating losses, approximately $1.8 million as of September 30, 2004, and tax credit carryforwards, approximately $3.0 million as of September 30, 2004, are exhausted.

LIQUIDITY AND CAPITAL RESOURCES

At September 30, 2004, we had net working capital of $40.0 million. Our principal sources of liquidity include cash, cash equivalents and marketable investments, which totaled $46.1 million at September 30, 2004. Additionally, Closure maintains a $3.0 million available line of credit for working capital purposes which is secured by trade accounts receivable, inventory and equipment. At September 30, 2004, there was no outstanding balance on the line of credit.

Capital Expenditures

There are no individually material capital expenditure commitments outstanding as of September 30, 2004. We estimate that capital expenditures for the remainder of 2004 may amount to approximately $500,000. We believe that our balances of cash, cash equivalents, and investments together with funds generated from operations and existing borrowing facilities will be sufficient to meet our operating cash requirements and fund required capital expenditures for the foreseeable future.

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Research and Development

Closure incurred approximately $8.1 million in research, development and regulatory affairs expenses during 2003. Through the first nine months of 2004, research, development and regulatory affairs expenses totaled $7.6 million. We anticipate that research and development expenses will continue to increase for the remainder of this year and for the next several years as we develop new products and line extensions for existing products. We also expect that clinical trials related to new products and line extensions will be costly and represent a significant part of future expenses. Research and development costs are expensed as incurred and include items related to personnel, costs of supplies, clinical trials and fees paid to consultants and outside contractors and providers. We have arrangements with certain marketing partners in which we share certain research, development and regulatory affairs expenses related to approved projects. Reimbursements from our marketing partners are recorded as a reduction in research, development and regulatory affairs expenses on a quarterly basis. During the first nine months of 2004, we recorded reimbursements of approximately $28,000 in accordance with these cost-sharing arrangements. We cannot estimate the costs of our research and development projects due to uncertainties regarding successful completion of projects, clinical trial outcomes and regulatory approvals. We believe that funds for future research and development needs can be obtained from existing cash and investment balances and from cash generated from operations. However, no assurance can be given that we may not require additional funds to support the completion of new product development, conduct clinical trials and obtain regulatory approvals.

Cash Flows

Net cash provided by operating activities was $10.2 million for the nine months ended September 30, 2004 compared to $7.3 million for the same period in 2003. Cash provided by operations during 2004 increased primarily due to the combination of an increase in net income and the continued utilization of net operating losses for tax purposes, as well as reduced investment in working capital accounts.

Net cash used by investing activities was $14.4 million for the nine months ended September 30, 2004 compared to $9.6 million during the 2003 period. The increase in net cash used during 2004 primarily related to a net increase in purchases of investments.

Net cash provided by financing activities was $3.7 million for the nine months ended September 30, 2004 compared to $2.5 million for same period in 2003. The increase in net cash provided by financing activities was due to an increase in net proceeds from the exercise of stock options during the 2004 period.

Based on our current plans, we believe that existing cash, cash equivalents and investments, which totaled $46.1 million as of September 30, 2004, will be sufficient to finance our operating and capital requirements for at least the next 12 to 24 months. We anticipate that our recurring operating expenses will increase for the next several years, as we expect research, development and regulatory affairs and general and administrative expenses will increase as we implement our strategic plan. We will also invest in long-term assets such as intangible assets and capital expenditures to expand our manufacturing capabilities.

Our future capital requirements, however, will depend on numerous factors, including but not limited to the following:

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We may be required to seek additional capital to finance our operations in the future. If our currently available funds and internally generated cash flow are not sufficient to satisfy our financing and operating needs, we will be required to seek additional funding through bank borrowings, additional public or private sales of our securities, including equity securities, or through other arrangements with marketing partners. Other than our available working capital line of credit, we have no credit facility or other committed sources of capital. There can be no assurance that additional funds, if required, will be available to us on favorable terms, if at all.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

There have been no material changes to our critical accounting policies and estimates since December 31, 2003. For detailed information on our critical accounting policies and estimates, see our Annual Report on Form 10-K for the year ended December 31, 2003.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK

INTEREST RATE SENSITIVITY

We are subject to interest rate risk on our investment portfolio which consists primarily of high quality short-term money market funds, commercial paper, corporate bonds and other investments with an average maturity of less than one year. We mitigate default risk by investing in what we believe are safe and high credit quality securities and by monitoring investment ratings. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity and there are limitations regarding average and individual duration of investments as established by the Board of Directors. These available-for-sale securities are subject to interest rate risk and will decrease in value if market interest rates increase. At September 30, 2004, our total portfolio consisted of approximately $46.1 million of cash, cash equivalents and investments, the majority of which had maturities within one year. Additionally, we generally have the ability to hold fixed income investments to maturity. Therefore, we do not expect our results of operations or cash flows to be materially affected due to a sudden change in interest rates.

FOREIGN CURRENCY EXCHANGE RISK

Our international sales and related royalties of DERMABOND adhesive and international sales of NEXABAND^® adhesives are based on sales in foreign currencies. All of our sales to customers are payable in U.S. dollars and we may be adversely affected by fluctuations in currency exchange rates. Additionally, fluctuations in currency exchange rates may adversely affect demand for our products by increasing the price of our products in the currency of the countries in which the products are sold.

ITEM 4. CONTROLS AND PROCEDURES

The Company’s management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, evaluated the effectiveness the Company’s disclosure controls and procedures as of the end of the period covered by this report. Based on that evaluation, the Chief Executive Officer and Chief Financial Officer concluded

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that the Company’s disclosure controls and procedures as of the end of the period covered by this report have been designed and are functioning effectively to provide reasonable assurance that the information required to be disclosed by the Company in reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms. The Company believes that a controls system, no matter how well designed and operated, cannot provide absolute assurance that the objectives of the controls system are met, and no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within a company have been detected.

No change in the Company’s internal control over financial reporting occurred during the Company’s most recent 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 6. EXHIBITS

Exhibit 31.1 – Certification of Chief Executive Officer.

Exhibit 31.2 – Certification of Chief Financial Officer.

Exhibit 32.1 – Certification of Chief Executive Officer pursuant to 18 U.S.C Section 1350.

Exhibit 32.2 – Certification of Chief Financial Officer pursuant to 18 U.S.C Section 1350.

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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