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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] QUARTERLY REPORT UNDER SECTION 13 OR 15(d) OF THE SECURITIES AND EXCHANGE
ACT OF 1934
For the quarterly period ended: June 30, 2002
Commission File Number: 0-23413
INTERLEUKIN GENETICS, INC.
(Exact name of registrant as specified in its Charter)
DELAWARE 94-3123681
(State or other jurisdiction of (I.R.S. Employer
incorporation or organization) Identification No.)
135 BEAVER STREET
WALTHAM, MA 02452
(Address of principal executive offices) (Zip Code)
(781) 398-0700
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 ( )
Title of Each Class Outstanding at July 31, 2002
------------------- -----------------------------
Common stock, $.001 Par value 21,436,200
INTERLEUKIN GENETICS, INC.
Form 10-Q
INDEX
PART I. FINANCIAL INFORMATION
Item 1.
Condensed Consolidated Balance Sheets at
June 30, 2002 and December 31, 2001................................... 1
Condensed Consolidated Statements of Operations for the
Three and six months ended June 30, 2002 and June 30, 2001............ 2
Condensed Consolidated Statements of Cash Flows for the
six months ended June 30, 2002 and June 30, 2001...................... 3
Notes to Condensed Consolidated Financial Statements.................. 4
Item 2.
Management's Discussion and Analysis of Financial Condition
And Results of Operations............................................. 9
Certain Factors That May Affect Future Results of Operations............... 16
Item 3.
Quantitative and Qualitative Disclosure About Market Risk............. 25
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.................................................. 26
Item 2. Changes in Securities and Use of Proceeds.......................... 26
Item 3. Default Upon Senior Securities..................................... 26
Item 4. Submission of Matters to a Vote of Security Holders................ 26
Item 5. Other Information.................................................. 26
Item 6. Exhibits and Reports on Form 8-K................................... 26
2
INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED BALANCE SHEETS
================================================================================
ASSETS
As of
June 30, 2002 December 31, 2001
------------- -----------------
Current assets:
Cash and cash equivalents $ 1,051,677 $ 3,922,736
Accounts receivable, net of allowance for doubtful accounts
of $13,000 and $14,000 at June 30, 2002 and December
31, 2001, respectively 4,873 75,982
Prepaid expenses and other current assets 96,263 103,436
----------- -----------
Total current assets 1,152,813 4,102,154
FIXED ASSETS, NET 358,099 178,904
OTHER ASSETS 92,225 112,068
----------- -----------
TOTAL ASSETS $ 1,603,137 $ 4,393,126
=========== ===========
LIABILITIES AND STOCKHOLDERS' EQUITY
CURRENT LIABILITIES:
Accounts payable $ 283,519 $ 181,554
Accrued expenses 490,068 477,368
Deferred revenue 68,108 142,349
Current portion of capital lease obligations 38,087 30,216
----------- -----------
Total current liabilities 879,782 831,487
CAPITAL LEASE OBLIGATIONS, LESS CURRENT PORTION 25,143 11,091
----------- -----------
Total liabilities 904,925 842,578
----------- -----------
STOCKHOLDERS' EQUITY:
Preferred stock, no par value - 5,000,000 shares
authorized; none issued or outstanding -- --
Common stock, $0.001 par value - 50,000,000 shares
authorized; 21,460,827 and 21,452,326 shares issued
and 21,436,200 and 21,427,699 outstanding at June 30,
2002 and December 31, 2001, respectively 21,461 21,452
Treasury stock - 24,627 shares at cost (250,119) (250,119)
Additional paid-in capital 39,294,091 39,292,936
Accumulated deficit (38,367,221) (35,513,721)
----------- -----------
Total stockholders' equity 698,212 3,550,548
----------- -----------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,603,137 $ 4,393,126
=========== ===========
The accompanying notes are an integral part of these condensed
consolidated financial statements
INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
================================================================================
FOR THE THREE MONTHS ENDED JUNE 30, FOR THE SIX MONTHS ENDED JUNE 30,
----------------------------------- ---------------------------------
2002 2001 2002 2001
------------ ------------ ------------ -----------
REVENUE $ 13,540 $ 118,654 $ 22,552 $ 158,945
COST OF REVENUE 185 19,845 335 34,944
------------ ------------ ----------- -----------
GROSS PROFIT 13,355 98,809 22,217 124,001
------------ ------------ ----------- -----------
OPERATING EXPENSES:
Research and development 850,179 702,271 1,778,195 1,415,946
Selling, general and administrative 569,240 620,223 1,111,707 1,176,121
------------ ------------ ----------- -----------
Total operating expenses 1,419,419 1,322,494 2,889,902 2,592,067
------------ ------------ ----------- -----------
LOSS FROM OPERATIONS (1,406,064) (1,223,685) (2,867,685) (2,468,066)
------------ ------------ ----------- -----------
OTHER INCOME (EXPENSE):
Interest income 6,751 79,589 19,755 187,591
Interest expense (3,013) (2,672) (6,267) (5,769)
Other income (expense) -- 619 697 52
------------ ------------ ----------- -----------
Total other income 3,738 77,536 14,185 181,874
------------ ------------ ----------- -----------
NET LOSS $ (1,402,326) $ (1,146,149) $(2,853,500) $(2,286,192)
============ ============ =========== ===========
BASIC AND DILUTED NET LOSS PER SHARE $ (0.07) $ (0.05) $ (0.13) $ (0.11)
============ ============ =========== ===========
Weighted average common shares
OUTSTANDING 21,434,403 21,249,232 21,431,380 20,667,551
============ ============ =========== ===========
The accompanying notes are an integral part of these condensed
consolidated financial statements
INTERLEUKIN GENETICS, INC. AND SUBSIDIARIES
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
================================================================================
FOR THE SIX MONTHS ENDED JUNE 30,
-----------------------------------
2002 2001
------------- -------------
CASH FLOWS FROM OPERATING ACTIVITIES
Net loss $ (2,853,500) $ (2,286,192)
Adjustments to reconcile net loss to net cash used in
operating activities:
Depreciation and amortization 42,530 21,206
Change in value of stock options issued as compensation
for services rendered (4,955) 117,336
Unrealized loss on marketable securities - (13,243)
Changes in assets and liabilities:
Accounts receivable, net 71,109 32,485
Prepaid expenses and other current assets 7,173 10,980
Accounts payable 101,965 (146,440)
Accrued expenses 12,700 137,408
Deferred revenue (74,241) (116,229)
------------ -----------
Net cash used in operating activities (2,697,219) (2,242,689)
------------ -----------
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of fixed assets (179,487) (22,416)
Decrease (increase) in other assets 19,843 (97,955)
Proceeds from maturity of investments -- 999,040
------------ -----------
Net cash (used in) provided by investing activities (159,644) 878,669
------------ -----------
CASH FLOW FROM FINANCING ACTIVITIES
Net proceeds from sales of common stock, net 6,119 3,373,844
Payments of capitalized lease obligations (20,315) (39,005)
------------ -----------
Net cash provided by financing activities (14,196) 3,334,839
------------ -----------
Net (decrease) increase in cash and equivalents (2,871,059) 1,970,819
CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD 3,922,736 2,391,561
------------ -----------
CASH AND CASH EQUIVALENTS, END OF PERIOD $ 1,051,677 $ 4,362,380
============ ===========
Supplemental disclosures of cash flow information:
Cash paid for interest $ 6,267 $ 5,769
============ ===========
Cash paid for income taxes $ -- $ --
============ ===========
SUPPLEMENTAL DISCLOSURES OF NONCASH INVESTING AND
FINANCING ACTIVITIES:
Acquisition of fixed assets under capital leases $ 42,238 $ --
============ ===========
The accompanying notes are an integral part of these condensed
consolidated financial statements
NOTE 1 - PRESENTATION OF INTERIM INFORMATION
Interleukin Genetics, Inc., a Delaware corporation is a functional genomics
company focused on personalized medicine. We believe that by identifying
individuals at risk for certain diseases and combining this knowledge with
specific therapeutic interventions, better healthcare decisions can be made,
reducing costs and greatly improving patient health outcomes. We have a growing
portfolio of patents covering the genetics of a number of common diseases and
conditions.
We have prepared the accompanying unaudited condensed consolidated financial
statements in accordance with generally accepted accounting principles for
interim financial reporting and with Securities Exchange Commission rules and
regulations for Form 10-Q. It is recommended that these interim condensed
consolidated financial statements be read in conjunction with the consolidated
financial statements and the notes in our Annual Report on Form 10-K for the
year ended December 31, 2001. The interim condensed consolidated financial
statements are unaudited; however, in the opinion of our management, include all
adjustments, consisting only of normal recurring adjustments, necessary to make
the interim financial information not misleading. All significant intercompany
transactions and accounts have been eliminated in consolidation. Results for
interim periods are not necessarily indicative of those to be expected for the
full year.
Since our inception, we have incurred accumulated deficits of approximately
$38.4 million, including a net loss of approximately $2.9 million during the six
months ended June 30, 2002. For the six months ended June 30, 2002, we have
incurred negative cash flows from operating activities of approximately $2.7
million.
We anticipate that our current cash resources, including cash received from the
recent sale of term promissory notes and warrants (See Note 7: "Term Promissory
Notes", beginning on page 7, for more details) are adequate to fund operations
only until approximately mid-October 2002. As a result, there is significant
doubt about our ability to continue as a going concern. Our future capital
requirements are anticipated to be substantial, and we do not have commitments
for additional capital at this time. Our capital requirements are expected to
arise from continued research and development efforts, the protection of our
intellectual property rights (including preparing and filing of patent
applications), payments to investors in our December 2000 and January 2001
financings if our common stock is delisted from the Nasdaq SmallCap Market (see
Note 6: "Stockholders' Equity") and repayment of the principal and interest on
our 15% term promissory notes due August 2003, the commercial launch of
additional genetic tests, as well as operational, administrative, legal and
accounting expenses. We are currently pursuing various sources of capital and
strategic partnerships in order to raise the capital necessary to continue
operations past mid-October 2002. WE CAN GIVE NO ASSURANCE THAT WE WILL BE ABLE
TO RAISE ANY ADDITIONAL CAPITAL, OR IF WE DO RAISE ADDITIONAL CAPITAL, THAT IT
WILL BE ON TERMS ACCEPTABLE TO OUR STOCKHOLDERS OR US. IF ADDITIONAL AMOUNTS
CANNOT BE RAISED, WE WOULD SUFFER MATERIAL ADVERSE CONSEQUENCES TO OUR BUSINESS,
FINANCIAL CONDITION AND RESULTS OF OPERATIONS AND WOULD LIKELY BE REQUIRED TO
SEEK OTHER ALTERNATIVES UP TO AND INCLUDING PROTECTION UNDER THE UNITED STATES
BANKRUPTCY LAWS.
NOTE 2 - RESEARCH ARRANGEMENTS
4
We have had a collaborative relationship with Sheffield University since 1994.
In July 1999, we entered into an arrangement with Sheffield whereby we acquired
the right to develop and commercialize Sheffield's past and future discoveries.
Pursuant to this Research and Technology Transfer Agreement, Sheffield agreed to
forego its rights to future royalties and granted us commercialization rights to
future discoveries in exchange for 275,000 shares of our common stock. This
common stock had a market value of $653,000 at the time of issuance and was
recorded as a research and development expense in the period of issuance. This
agreement also requires us to issue options on July 1st of each year to
Sheffield to purchase our common stock. Each option issued is exercisable at the
then current market price for a number of shares determined as follows: (i)
25,000 shares if this agreement is in effect and (ii) 10,000 shares for each
patent application related to Sheffield's discoveries that we filed during the
preceding 12 months. This agreement has a term of five years and may be canceled
by us if the principal collaborator at Sheffield, Dr. Gordon Duff, leaves
Sheffield or by either party upon six months' notice. Under the terms of this
agreement we have issued options to acquire 35,000 shares of our common stock in
both 2001 and 2002. In total we have issued options to acquire 105,000 shares of
our common stock. These options were fully vested upon issuance and expire five
years from the dates of issuance.
We also entered into a Research Support Agreement with Sheffield in July 1999
that requires us to pay the costs of all genetic research being conducted on our
behalf at Sheffield. Sheffield conducts this research according to an Annual
Research Plan that is determined by a Steering Committee made up equally of
members from Sheffield and us. This agreement automatically renews in one-year
increments, but may be canceled by us if Dr. Duff leaves Sheffield or by either
party upon six months' notice. In the event Sheffield terminated the agreement,
it is doubtful we could discover or commercialize new products without incurring
greater expense and increased utilization of our resources. We have made
payments of approximately $74,000 to Sheffield for the six months ended June 30,
2002 and an aggregate amount of $612,000 to Sheffield under the terms of this
agreement through June 30, 2002.
In September 1999, we entered into a five-year Consulting Agreement with Dr.
Gordon Duff, Sheffield's key collaborator. In accordance with the Consulting
Agreement, Dr. Duff received 200,000 shares of our common stock for
relinquishing interests in previous research agreements, the value of which was
$475,000 and was recorded as research and development expense in the period of
issuance. Under this agreement Dr. Duff will also receive a royalty equal to one
percent of the first $4 million of net sales under the PST technology and two
percent of net sales above $4 million. In July 2000, in consideration of future
services, Dr. Duff received an option to purchase 25,000 shares of our common
stock at the then current market price. In both July 2001 and July 2002, Dr.
Duff received an additional option to purchase 25,000 shares our common stock at
the market price as of that date in consideration of his ongoing consulting for
us. These options were fully vested upon issuance and expire five years from the
date of issuance. Dr. Duff also received cash payments of approximately $22,000
for the six months ended June 30, 2002 for services rendered under the terms of
this consulting agreement.
In December 2001, we entered into a research collaboration agreement with Kaiser
Permanente's Center for Health Research ("Kaiser"), to study genetic risk
factors for chronic diseases that are affected by inflammation. This
5
agreement requires us to fund clinical trials completed at Kaiser per specific
research study plans. The first study plan that we are funding is a study to
assess the genetic risk that diabetic patients have of developing cardiovascular
disease. We expect to announce additional studies with Kaiser during the
calendar year of 2002. It is hoped that knowledge resulting from this work will
enable us to develop new diagnostic tools that physicians and health care
organizations can use to assess their patients' genetic risk for many diseases.
In March 2002, we entered into a research collaboration agreement with
UnitedHealth Group's research arm, the Center for Healthcare Policy and
Evaluation, to study how commonly inherited gene variants affect the response of
patients with certain inflammatory diseases to specific drugs. Knowledge
resulting from this work will help us develop pharmacogenetic tests that
physicians and managed care organizations can use to assist in the selection of
the optimal drug for an individual patient.
NOTE 3 - REVENUE RECOGNITION
Revenue from genetic susceptibility tests is recognized when the tests have been
completed and the results reported to the doctors, provided that collection of
the related receivable is probable. To the extent test kits have been purchased
but not yet submitted for test results, revenue recognition is deferred. Amounts
received prior to meeting the above revenue recognition criteria are presented
as deferred revenue in the accompanying balance sheets. Contract revenues are
recognized ratably as services are provided. In accordance with Staff Accounting
Bulletin No. 101, up front non-refundable license fees are deferred and
recognized ratably over the license term.
NOTE 4 - USE OF ESTIMATES
The preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the financial
statements, as well as the reported amounts of revenues and expenses during the
reported periods. Actual results could differ from those estimates.
NOTE 5 - BASIC AND DILUTED NET LOSS PER COMMON SHARE
Statement of Financial Accounting Standards (SFAS) No. 128 (SFAS 128), "Earnings
per Share," outlines methods for computing and presenting earnings per share.
SFAS 128 requires a calculation of basic and diluted earnings per share for all
periods presented. We reported losses for the three and six month periods ended
June 30, 2002 and 2001 and accordingly, outstanding options and warrants have
been excluded from the calculation of the diluted weighted average shares
outstanding as they are antidilutive in loss periods. The calculation of diluted
net loss per share excludes 2,775,302 and 2,359,945 stock options outstanding at
June 30, 2002 and June 30, 2001, respectively and 1,345,952 warrants to purchase
common stock outstanding at both June 30, 2002 and June 30, 2001.
NOTE 6 - STOCKHOLDERS' EQUITY
6
In January 2001, we sold in a private placement 1.2 million shares of common
stock for $2.50 per share. The purchasers of the common stock also received
warrants to purchase up to 600,000 shares of common stock exercisable at $3.00
per share. We generated net proceeds of approximately $2.9 million from this
transaction. Under the terms of this private placement we are required to adjust
downward the price per share paid in the offering, by issuing additional shares
to match any lower price per share paid in subsequent offerings prior to May 23,
2003.
In December 2000, we sold in a private placement 542,373 shares of common stock
for $3.69 per share. The purchasers of the common stock also received warrants
to purchase up to 135,593 shares of common stock exercisable at $4.83 per share.
We generated net proceeds of approximately $2.0 million from this transaction.
Under the terms of this private placement we are required to adjust downward the
price per share paid in the offering, by issuing additional shares, to match any
lower price per share paid in subsequent offerings prior to February 9, 2003.
Following the January 2001 private placement described above, we issued an
additional 257,627 shares of common stock to the purchasers in the December 2000
private placement, and new warrants to purchase 264,407 shares of Common Stock
exercisable at a price of $3.13 per share to replace the previously issued
warrants to purchase 135,593 shares of Common Stock at a price of $4.83 per
share.
None of the warrants discussed in this section have been exercised.
On April 2, 2002 we received a notice from Nasdaq stating that we were not in
compliance with their continued listing requirements because our common stock
bid price had fallen below Nasdaq's $1.00 minimum bid price requirements for 30
consecutive trading days. We were given a 180-day grace period to regain
compliance with this rule. This grace period expires September 30, 2002. Since
April 1, 2002, our closing bid price had ranged from $0.50 to $1.02, but has
not closed above $1 for more than two consecutive days. To meet the bid price
requirement, the bid price of our common stock must close at or above $1.00 per
share for more than ten consecutive trading days prior to September 30, 2002.
Accordingly, we may not be able to maintain our continued listing on the Nasdaq
or the Boston Stock Exchange.
Pursuant to the terms of our December 2000 and January 2001 financings, if our
common stock is delisted from the Nasdaq SmallCap Market we must pay a maximum
of $100,000 per month to the investors in those financings indefinitely. Payment
amount is based upon the number of shares outstanding as of June 30, 2002. This
payment amount represents 2% of the total amount invested in the December 2000
and January 2001 private placements but would be reduced if the investors sell
some or all of their shares prior to our common stock being delisted. These
payments would make it more difficult for us to raise additional funds and to
operate our business.
NOTE 7 - TERM PROMISSORY NOTES
On August 9, 2002 we received approximately $475,000 in net proceeds from the
sale of term promissory notes with an original aggregate principal amount of
$525,000. These notes mature in one year and pay interest at a rate of 15%. The
outstanding principal amount and all interest is to be paid upon maturity. We
can prepay the principal and accrued interest without penalty. The purchasers of
the promissory notes received warrants to purchase one share of our common stock
for a purchase price of $2.50 for every dollar invested in the promissory notes.
In total warrants to purchase 525,000 shares of our common stock were issued.
These warrants expire in ten years.
NOTE 8 - SEGMENT INFORMATION
We follow the provisions of SFAS No. 131 (SFAS 131), "Disclosures about Segments
of an Enterprise and Related Information." SFAS 131 establishes standards for
reporting information about operating segments in annual and interim financial
statements, requiring that public business enterprises report financial and
descriptive information about reportable segments based on a management
approach. SFAS 131 also establishes standards for related disclosures about
products and services, geographic areas and major customers. In applying the
requirements of this statement, we continue to have one reportable segment,
which is the development of genetic susceptibility tests and therapeutic targets
for common diseases.
7
During 2000, we closed our foreign operations. Therefore, we no longer have any
assets outside of the United States. For the six-month periods ended June 30,
2002 and 2001 all assets were located, and all revenue was primarily generated
in the United States.
8
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
FORWARD LOOKING STATEMENTS
This quarterly report on Form 10-Q contains certain forward-looking statements
within the meaning of Section 27A of the Securities Act and Section 21E of the
Securities Exchange Act. Statements contained in this report that are not
statements of historical fact may be deemed to be forward-looking statements.
Words or phrases such as "will likely result", "will enable", "expect", "will
continue", "anticipate", "estimate", "intend", "plan", "project", "outlook", or
similar expressions are intended to identify forward-looking statements.
Forward-looking statements address or may address the following subjects:
- The sufficiency of our current cash resources to fund operations until
mid-October 2002; o Our continued listing on the Nasdaq SmallCap Market;
- Our expectation of the benefits that will result from ongoing research
programs that outside parties are conducting on our behalf;
- Our expectation of the benefits that will result from the ongoing
research we are funding at Sheffield University;
- Any expectation we may have regarding the success of developing
products, the timing of releasing products for sale or the success of
these products when they are released;
- Our expectation that total research and development costs, including
clinical costs, will be between approximately $3.5 and $4.0 million for
the year ended December 31, 2002; and
- Our expectation that we will continue to experience losses until our
genetic testing revenues grow substantially from current levels.
Actual results may vary materially from those expressed in forward-looking
statements. Factors that could cause actual results to differ from expectations
include but are not limited to: our ability to obtain adequate capital, risks
related to market acceptance of genetic risk assessment tests in general and our
products in particular, risk related to technology and product obsolescence,
delays in development of products, dependence on third parties, competitive
risks and those risks set forth within the section below titled "Certain Factors
That May Affect Future Results of Operations". We cannot be certain that our
results will not be adversely affected by one or more of those factors or by
other factors not currently anticipated. All information set forth in this Form
10-Q is as of the date of this Form 10-Q. Unless required by law we accept no
responsibility to update this information.
GENERAL OVERVIEW
We develop and sell genetic susceptibility tests, tests that identify which
individuals will respond to specific drug therapies and medical research tools.
We focus our efforts on discovering genetic factors that predict the
susceptibility of individuals to various diseases or determine which individuals
will respond to a specific drug therapy. We market PST(R) in the
9
United States and Europe. PST is our only genetic test currently on the market
and predicts the risk of periodontal disease. Products currently under
development include tests that predict the risk of osteoporosis, coronary artery
disease and complications from diabetes and a test that predicts which drug
treatment will be most effective for patients with advanced Rheumatoid
Arthritis.
Every living organism has a unique "genome," a master blueprint of all the
cellular structures and activities necessary to build and support life. A genome
is a map of the organism's DNA, which is in part comprised of segments called
"genes." Genes contain the specific sequences of information responsible for
particular physiological traits and processes. Each gene contains a sequence of
nucleotides, which provide precise genetic instructions to create, or "express"
a protein. Proteins are the primary building blocks of an organism's
physiological characteristics. A typical human cell contains thousands of
different proteins essential to its structure, growth and function. If even one
gene or single nucleotide is abnormal, it can severely alter the cell's function
and result in a disease condition. Throughout the past decade, researchers have
focused on discovering genes and sequencing the human genome to determine the
order of nucleotides in a specific gene, permitting identification of the gene
and the protein it produces using a variety of techniques. For example,
scientists have used cDNA libraries, which contain copies of DNA with only the
expressed portion of the gene, in conjunction with computer software to identify
locations of genes within the genome. Recent advances have allowed these
technologies to operate in a high-throughput manner, causing the discovery of
genes to become much more efficient and allowing researchers to focus on the
functional aspects of genes. Understanding the functional aspects of genes
permits the researchers to correlate those genes to medically relevant
conditions. The efforts to discover and understand these functional aspects of
the genes in the human genome are commonly referred to as "functional genomics."
Identifying genes that may predispose a person to a particular disease may allow
researchers to develop diagnostic tests for the disease permitting early
diagnosis and more successful treatment. We believe that combining genetic
susceptibility tests with specific therapeutic strategies results in improved
clinical outcomes and more cost-effective disease management.
We also develop and license our medical research tools to pharmaceutical and
biotech companies. For instance, BioFusion(R) is our proprietary computer
modeling system that simulates complex diseases and allows researchers to
identify useful information from the rapidly increasing genetic information
databases that companies and academic centers worldwide generate.
We distribute PST through third party distributors. Kimball Genetics markets PST
in the United States and Hain Diagnostika/ADA GmbH distributes PST in all
countries outside of North America and Japan. Hain has extensive experience in
commercializing genetic tests in several fields, as well as a specific
commitment to marketing products directly to dentists. Sales of PST have
generated minimal revenues to date, and we do not know if or when PST will
achieve commercial acceptance.
Commercial success of genetic susceptibility tests will depend upon their
acceptance as medically useful and cost-effective by patients, physicians,
dentists, other members of the medical and dental community, and third-party
payers. We are not certain whether we will be successful in developing and
10
bringing to market our current or future tests based on the genetic discoveries
made by our collaborators and us.
Our ability to successfully commercialize genetic susceptibility tests depends
partly on obtaining adequate reimbursement for such products and related
treatment from government and private health care insurers and other third-party
payers. Doctors' decisions to recommend genetic susceptibility tests may be
influenced by the scope and reimbursement for such tests by third-party payers.
If both third-party payers and individuals are unwilling to pay for the test,
then the number of tests performed will significantly decrease, therefore
resulting in a reduction of revenues.
Research in the field of disease predisposing genes and genetic markers is
intense and highly competitive. We have many competitors in the United States
and abroad that have considerably greater financial, technical, marketing, and
other resources available. If we do not discover disease predisposing genes or
genetic markers and develop susceptibility tests and launch such services or
products before our competitors, then revenues may be reduced or eliminated.
RESULTS OF OPERATIONS
COMPARISON OF THREE MONTHS ENDED JUNE 30, 2002 TO THREE MONTHS ENDED
JUNE 30, 2001
Revenue for the three months ended June 30, 2002 was $13,540 compared to
$118,654 for the three months ended June 30, 2001, a decrease of 89%. In the
three months ended June 30, 2002, we recorded revenue from 506 PST tests
compared to 1,729 tests in the same period in 2001. Cost of revenue was $185 for
the three months ended June 30, 2002 compared to $19,845 for the same period in
2001. Gross profit margin was 99% in the three months ended June 30, 2002
compared to 83% for the same period in 2001.
The decrease in revenue was the result of (i) the inclusion in last year's
revenue totals of $90,720 for the processing of 1,008 tests in association with
a single clinical trial that was conducted by Washington Delta Dental, (ii) a
decrease in the number of PST tests processed, exclusive of the clinical trial
mentioned above, and (iii) the replacement of our prior PST distributor,
Straumann Company, with our current distributor, Kimball Genetics, as our
primary distributor within the United States. We receive less revenue per test
from Kimball than we had from Straumann but we do not need to pay a processing
fee back to them. This change in distributors has reduced our revenue but
improved our gross margin percentage. The gross profit per test is approximately
the same per test for Kimball as it was for Straumann.
For the three months ended June 30, 2002, we had research and development
expenses of $850,179 as compared to $702,271 for the same quarter of 2001, an
increase of 21%. The increase was primarily the result of increases in personnel
costs associated with an increased number of ongoing clinical projects and with
staffing of our new research laboratory and the cost of supplying the
laboratory.
We are currently conducting several research and clinical projects both in-house
and through collaborative partners. The most significant projects are the
following:
11
CARDIOVASCULAR DISEASE: We are working with Kaiser Permanente's Center for
Health Research to investigate the value of testing for genetic differences
among people who have type 2 diabetes to determine their relative risk of
developing cardiovascular disease. It is hoped that this program will enable us
to develop new diagnostic tools for assessing diabetic patients' genetic risk
for heart disease. Enrollment on this study is complete and the analysis is
underway. If we are successful we expect to have a test predictive of
cardiovascular complications from diabetes on the market in 2003.
RHEUMATOID ARTHRITIS: In collaboration with United Health Group, we are
conducting a study to determine whether analysis of genotype will be useful to
predict responses to anti-cytokine therapy for individuals with rheumatoid
arthritis. Different anti-cytokine therapies act very differently on a patient's
biology. Two of the three anti-cytokine therapies used to treat rheumatoid
arthritis are anti TNFa drugs; the other acts upon the IL-1 gene. We believe
that depending upon the specific genetics of individual patients, we might be
able to predict which class of drugs would be most effective.
In collaboration with the University of Sheffield School of Health and Related
Research (ScHARR), we are conducting a study to determine if it is cost
effective to analyze patient genotypes prior to the use of Anakinra in the
treatment of Rheumatoid Arthritis.
ALZHEIMER'S DISEASE: We are working with the University of Arkansas for Medical
Sciences to study the genetic causes of inflammation in relation to Alzheimer's
Disease. This study will focus on how IL-1 genetic variations alter inflammation
in the brain leading to Alzheimer's Disease. This information, together with
other genetic data, might be used to develop new drug targets and help in the
development of therapeutics for individuals with genetic differences in their
inflammatory mechanisms.
SHEFFIELD STUDIES: We are funding research at Sheffield University in support of
several research projects including the following: A study to determine the
haplotypes, or sets of genetic variations that are inherited together, that
exist within the IL-1 cluster; A study to discover novel drug targets for
inflammatory diseases by discovering genes involved in the responses of cells
after they have been activated by IL-1; the development of a system that
measures the net IL-1 biologic activity of blood or any tissue fluid and the
discovery of the genetic variations that control patient to patient differences
in inflammatory mechanisms. We believe that the completion of these studies will
greatly enhance our understanding of the IL-1 gene cluster and the relationship
of this gene cluster to inflammatory responses and disease risk.
FUNCTIONAL GENETICS RESEARCH: We are currently conducting the following studies
at our research center in Waltham, Massachusetts:
- Identify functional SNPs: A project to determine which of the SNPs,
within the IL-1 gene cluster, leads to an alteration in the expression
of the IL-1 genes.
- Create IL-1 genotype and haplotype specific cell models that can be
used for studying drug responses. It is hoped that these models will be
critical to the analyses of genotype related drug response for use
12
in future partnerships and collaborative projects in support of the
development of new drugs.
- Investigate IL-1 genotype and haplotype influences on the expression of
inflammatory response genes derived from normal and disease tissues.
OSTEOPOROSIS: We anticipate conducting one or more clinical studies that we hope
will confirm our initial results of association between polymorphisms in the
IL-1 and TNFa and a woman's risk for vertebral fracture. Completion of these
studies will depend upon our ability to raise additional funds.
We expect total research and development costs, including clinical costs, to be
between approximately $3.5 and $4.0 million for the calendar year 2002. Actual
costs may vary from this estimate as a result of our ability to raise additional
new capital, changes in technology, the success of current and future research
projects, the success or failure of our current or future strategic alliances
and collaborations and the identification of new business opportunities.
We have not made an attempt to finalize an estimate of our research and
development expenses beyond 2002 due to the factors listed above.
Selling, general and administrative expenses were $569,240 during the three
months ended June 30, 2002 compared to $620,223 during the same quarter last
year, a decrease of 8%. The decrease was primarily the result of a reduction in
administrative, sales and marketing expense related to the sale and distribution
of PST and a decrease in travel, legal and recruiting expense. This was
partially offset by increases in rent and expenses related to our business
development efforts.
Interest income for the three months ended June 30, 2002 was $6,752 compared to
$79,589 for the same period in 2001. This decrease is due primarily to the lower
average cash and cash equivalent balances in 2002 in comparison to the same
period in 2001. Interest expense of $3,014 was incurred during the quarter ended
June 30, 2002, compared to $2,672 in the same period in 2001.
COMPARISON OF SIX MONTHS ENDED JUNE 30, 2002 TO SIX MONTHS ENDED JUNE 30, 2001
Revenue for the six months ended June 30, 2002 was $22,552 compared to $158,945
for the six months ended June 30, 2001, a decrease of 86%. In the six months
ended June 30, 2002, we recorded revenue from 993 PST tests compared to 2,458
tests in the same period in 2001. Cost of revenue was $335 for the three months
ended June 30, 2002 compared to $34,944 for the same period in 2001. Gross
profit margin was 99% in the six months ended June 30, 2002 compared to 78% for
the same period in 2001.
The decrease in revenue was the result of (i) the inclusion in last year's
revenue totals of $101,520 for the processing of 1,128 tests in association with
a single clinical trial that was conducted by Washington Delta Dental, (ii) a
decrease in the number of PST tests processed, exclusive of the clinical trial
mentioned above, and (iii) the replacement of our prior PST distributor,
Straumann Company, with our current distributor, Kimball Genetics, as our
primary distributor within the United States. We receive less revenue per test
from Kimball than we had from Straumann but we do not need to pay a processing
fee back to them. This change in distributors has reduced our revenue but
improved our gross margin percentage. The gross
13
profit per test is approximately the same per test for Kimball as it was for
Straumann.
For the six months ended June 30, 2002, we had research and development expenses
of $1,778,195 as compared to $1,415,946 for the same period of 2001, an increase
of 26%. The increase was primarily the result of increases in personnel costs
associated with an increased number of ongoing clinical projects and with
staffing of our new research laboratory and the cost of supplying the
laboratory.
Selling, general and administrative expenses were $1,111,707 during the six
months ended June 30, 2002 compared to $1,176,121 during the same period last
year, a decrease of 5%. The decrease was primarily the result of a reduction in
administrative, sales and marketing expense related to the sale and distribution
of PST. This was partially offset by increases in rent and expenses related to
our business development efforts.
Interest income for the six months ended June 30, 2002 was $19,755 compared to
$187,591 for the same period in 2001. This decrease is due primarily to the
lower average cash and cash equivalent balances in 2002 in comparison to the
same period in 2001. Interest expense of $6,267 was incurred during the six
months ended June 30, 2002, compared to $5,769 in the same period in 2001.
LIQUIDITY AND CAPITAL RESOURCES
To date, we have funded our operations primarily through public and private
sales of equity and private sales of debt. During 2001, we raised net proceeds
of approximately $2.9 million, from a private placement of common stock and
approximately $480,000 from the exercise of stock options and warrants.
Subsequent to the end of the fiscal quarter, on August 9, 2002, we received
approximately $475,000, net proceeds, from the sale of term promissory notes
with an aggregate original principal amount of $525,000. These notes mature in
one year and pay interest at a rate of 15%. The outstanding principal and all
interest is to be paid upon maturity. We can prepay the principal and accrued
interest without penalty. The purchasers of the promissory notes received
warrants to purchase one share of stock for a purchase price of $2.50 for every
dollar invested in the promissory notes. In total warrants to purchase 525,000
shares of stock were issued. These warrants expire in ten years. With the sale
of these notes we anticipate that we have sufficient cash and cash equivalents
to fund operations only until approximately mid-October 2002.
Since inception, we have incurred accumulated deficits of approximately $38.4
million, including losses of approximately $2.9 million during the six months
ended June 30, 2002. Net cash used in operating activities was $2.7 million
during the six months ended June 30, 2002 and $2.2 million during the same
period last year.
We anticipate that we will continue to experience losses until our genetic
testing revenues grow substantially from current levels. In addition, if we are
successful in reaching agreements with strategic partners, milestone payments,
if any, from these strategic partners would help fund our research and
development efforts. We cannot give any assurances that we will be able
14
to increase our revenues, either from genetic tests or licensing revenue, or
that we will be able to reach strategic partnering agreements.
We currently do not have any commitments for material capital expenditures. Our
obligation at June 30, 2002 for capitalized lease obligations totaled
approximately $63,000, of which $25,000 is classified as long-term and $38,000
is classified as current. We will be required to repay approximately $603,750 in
principal and interest on our recently issued 15% term promissory notes during
August 2003. Pursuant to the terms of our December 2000 and January 2001
financings, if our common stock is delisted from the Nasdaq SmallCap Market we
must pay $100,000 per month to the investors in those financings indefinitely
unless we are subsequently listed on the New York Stock Exchange, the American
Stock Exchange or the Nasdaq National Market or SmallCap Market. We presently do
not meet the criteria for initial inclusion on any of these exchanges or
markets.
As of June 30, 2002 we had cash and cash equivalents totaling $1.1 million
compared to $3.9 million as of December 31, 2001. We anticipate that existing
cash and cash equivalents, including funds received from the recent sale of
promissory notes (described above) will be sufficient to conduct operations only
until approximately mid-October 2002. As a result, there is significant doubt
about our ability to continue as a going concern. Our future capital
requirements are anticipated to be substantial, and we do not have commitments
for additional capital at this time. Capital requirements are expected to arise
from the commercial launch of additional genetic tests, continued research and
development efforts, the protection of intellectual property rights (including
preparing and filing of patent applications), payments to our investors in our
December 2000 and January 2001 financings if our common stock is delisted from
the Nasdaq SmallCap Market and repayment of the principal and interest on our
15% term promissory notes, as well as operational, administrative, legal and
accounting expenses. We are currently pursuing sources of capital and strategic
partnerships in order to raise the capital necessary to continue operations past
mid-October 2002 on terms favorable to us or stockholders, if at all. However,
we can not assure that we will be successful in these efforts. WE CAN GIVE NO
ASSURANCE THAT WE WILL BE ABLE TO RAISE ANY ADDITIONAL CAPITAL, OR IF WE DO
RAISE ADDITIONAL CAPITAL, THAT IT WILL BE ON TERMS ACCEPTABLE TO OUR
STOCKHOLDERS OR US. IF ADDITIONAL AMOUNTS CANNOT BE RAISED, WE WOULD SUFFER
MATERIAL ADVERSE CONSEQUENCES TO OUR BUSINESS, FINANCIAL CONDITION AND RESULTS
OF OPERATIONS AND WOULD LIKELY BE REQUIRED TO SEEK OTHER ALTERNATIVES UP TO AND
INCLUDING PROTECTION UNDER THE UNITED STATES BANKRUPTCY LAWS.
CRITICAL ACCOUNTING POLICIES
Our significant accounting policies are described in Note 2 to the
consolidated financial statements included in this report. We believe our most
critical accounting policies are in the areas of revenue recognition, cost
estimations of certain ongoing research contracts and our decision to expense
all patent related costs as incurred.
Revenue recognition:
Revenue from genetic susceptibility tests is recognized when the tests have
been completed and the results reported to the doctors. To the extent test kits
have been purchased but not yet submitted for test results, we defer recognition
of revenue. This amount is presented on our balance sheet as
15
deferred revenue. Contract revenues are recognized ratably as services are
provided based on a fixed contract price or on negotiated hourly rates. Fees for
the sale or licensing of product rights are recorded as deferred revenue upon
receipt and recognized as revenue on a straight-line basis over the period that
the related products or services are delivered or obligations as defined in the
agreement are performed.
Cost estimates:
Much of our research and development is done on contract by outside parties.
It is not unusual that at the end of an accounting period we need to estimate
both the total cost of these projects and the percent of that project which was
completed as of the accounting date. We then need to adjust those estimates when
final invoices are received. To date, these adjustments have not been material
to our financial statements, and we believe that the estimates that we made as
of June 30, 2002 are reflective of the actual expenses incurred as of that date.
However, readers should be cautioned that the possibility exists that certain
research projects might cost more than we have estimated and that these higher
costs will be reflected in future periods.
Patent expenses:
We have made the decision to expense patent expenses as incurred due to the
possibility that we will never be able to derive any benefits from our patents.
We have exclusive rights in nine issued U.S. patents and have twenty pending
U.S. patents applications. We have also been granted a number of corresponding
foreign patents and we have a number of foreign counterparts of our U.S. patents
and patent applications pending. Since inception we have expensed close to $2.2
million in the effort to obtain patent protection for our intellectual property
including approximately $250,000 during the six months ended June 2002. If we
had decided to record the costs of developing patent protection as an intangible
asset on the balance sheet it would have had a material effect on the
presentation of our financial statements. In future periods we may decide to
change this presentation as the realizability of return on this investment
becomes more certain.
CERTAIN FACTORS THAT MAY AFFECT FUTURE RESULTS OF OPERATIONS:
IF WE FAIL TO OBTAIN ADDITIONAL CAPITAL, OR OBTAIN IT ON UNFAVORABLE TERMS, THEN
WE MAY HAVE TO END OUR RESEARCH AND DEVELOPMENT PROGRAMS AND OTHER OPERATIONS
We anticipate that our current financial resources are adequate to maintain our
current and planned operations through mid-October 2002. If we cannot raise
additional capital prior to mid-October 2002, we will be unable to fund our
business operations and will be required to seek other strategic alternatives
and may be required to declare bankruptcy. Any future issuances of our equity
securities may require stockholder approval for an increase in authorized
shares. If we are unable to obtain such approval, we will be required to seek
other strategic alternatives and may be required to declare bankruptcy.
Our future capital needs depend on many factors. We will need capital for
continued research and development efforts, obtaining and protecting patents,
16
the commercial launch of additional genetic tests and administrative expenses.
Pursuant to the terms of our December 2000 and January 2001 financings, if our
common stock is delisted from the Nasdaq SmallCap Market we must pay $100,000
per month to the investors in those financings indefinitely. We also will be
required to repay approximately $603,750 in principal and interest on our
recently issued 15% term promissory notes in August 2003. Additional financing
may not be available when needed, or, if available, it may not be available on
favorable terms. If we cannot obtain additional funding on acceptable terms when
needed, we may have to discontinue operations, or, at a minimum, curtail one or
more of our research and development programs.
WE MAY BE DELISTED FROM NASDAQ RESULTING IN A LIMITED PUBLIC MARKET FOR OUR
COMMON STOCK AND VOLATILITY IN OUR STOCK PRICE
Our common stock is currently listed on the Nasdaq SmallCap Market and the
Boston Stock Exchange. On April 2, 2002 we received a notice from Nasdaq stating
that we were not in compliance with their continued listing requirements because
our common stock bid price had fallen below Nasdaq's $1.00 minimum bid price
requirement for 30 consecutive trading days. We were given a 180-day grace
period to regain compliance with this rule. This grace period expires September
30, 2002. Since April 1, 2002, our closing bid price has ranged from $0.50 to
$1.02, but has not closed above $1 for more than two consecutive days. To meet
the bid price requirement, the bid price of our common stock must close at or
above $1.00 per share for more than ten consecutive trading days prior to
September 30, 2002. Accordingly, we may not be able to maintain our continued
listing on the Nasdaq or the Boston Stock Exchange.
In addition, we do not currently satisfy the Nasdaq rule that we have
stockholders' equity of at least $2.5 million. If we receive a notice from
Nasdaq that we fail to meet the stockholders' equity requirement we will have
ten days to present a plan for achieving compliance to Nasdaq or face immediate
delisting of our common stock. Even if we present a plan, the Nasdaq may not
approve of it and may delist our common stock anyway. We will need to increase
stockholder's equity by a total of approximately $5 million in order to satisfy
the stockholders' equity requirements through December 31, 2002.
If we are unable to maintain our Nasdaq Smallcap Market listing, our common
stock would likely begin to trade on the NASD's OTC Bulletin Board and become a
"penny stock", as long as it trades below $5.00 per share. Broker-dealer
practices in connection with transactions in penny stocks are regulated by penny
stock rules adopted by the SEC. The penny stock rules require a broker-dealer,
prior to a transaction in a penny stock not otherwise exempt from the rules, to
deliver a standardized risk disclosure statement prepared by the SEC that
provides information about penny stocks and the nature and level of risks in the
penny stock market. The broker-dealer also must provide the customer with
current bid and offer quotations for the penny stock, the compensation of the
broker-dealer and its salesperson in the transaction, as well as the monthly
account statements showing the market value of each penny stock held in the
customer's account. In addition, the penny stock rules require that, prior to a
transaction in a penny
17
stock not otherwise exempt from such rules, the broker-dealer must make a
special written determination that the penny stock is a suitable investment for
the purchaser and receive the purchaser's written agreement to the transaction.
Selling our common stock will also be more difficult because of reduced trading
volume and transaction size. Transactions could also be delayed, and security
analysts' and news media's coverage, if any, of us will be reduced. These
factors may result in lower prices and larger spreads in the bid and ask prices
for our shares. The delisting of our shares would also greatly impair our
ability to raise additional necessary capital through equity or debt financing.
Historically, our common stock has experienced low trading volumes. The market
price of our common stock has been highly volatile, and it may continue to be
highly volatile, as has been the case with the securities of other public
biotechnology companies. Factors such as announcements by us or by our
competitors concerning technological innovations, new commercial products or
procedures, proposed government regulations and developments or disputes
relating to patents or proprietary rights are likely to affect the market price
of our common stock. Changes in the market price of our common stock may bear no
relation to our actual operational or financial results.
IF OUR COMMON STOCK IS DELISTED FROM NASDAQ, WE WILL NEED TO PAY PENALTIES OF
$100,000 PER MONTH.
Pursuant to the terms of our December 2000 and January 2001 financings, if our
common stock is delisted from the Nasdaq SmallCap Market we must pay $100,000
per month to the investors in those financings indefinitely. These payments
would make it more difficult for us to raise additional funds and to operate our
business.
WE HAVE A HISTORY OF OPERATING LOSSES AND EXPECT THESE LOSSES TO CONTINUE IN THE
FUTURE
We have experienced significant operating losses since our inception and expect
these losses to continue for the foreseeable future. We incurred losses from
operations of $6.2 million in 1999, $5.2 million in 2000 and $4.8 million in
2001. As of June 30, 2002, our accumulated deficit was more than $38 million.
Our losses result primarily from research and development and selling, general
and administrative expenses. We have not generated significant revenues from
product sales, and we do not know if we will ever generate significant revenues
from product sales. We will need to generate significant revenues to continue
our research and development programs and achieve profitability. We cannot
predict when, if ever, we will achieve profitability.
WE HAVE COMPLETED FINANCIAL TRANSACTIONS THAT MAY REQUIRE US TO ISSUE MORE
SHARES TO EXISTING SHAREHOLDERS WHICH WILL DILUTE THE VALUE OF THE STOCK
In December 2000 and January 2001 we sold in private placements a total of 2
million shares of our common stock for $2.50 per share and warrants to purchase
864,407 shares of common stock exercisable at $3.00 and $3.13. Under the terms
of these private placements we are required to adjust downward the price per
share in the offering, by issuing additional shares, to match any offering price
paid in subsequent offerings during a 24-month period following completion of
the private placements. The price of our common stock has been volatile and has
recently been trading at or below $1.00 per share.
18
This low share price will make it very difficult to raise additional capital at
a price matching that of the private placements. Therefore, it is likely that we
will need to issue additional shares to the purchasers in these offerings, if we
are to raise additional capital. This might significantly dilute the value of
the outstanding common stock. The 24-month period expires in February 2003 for
one transaction and May 2003 for the other.
THE MARKET FOR GENETIC SUSCEPTIBILITY TESTS IS UNPROVEN
The market for genetic susceptibility tests is at an early stage of development
and may not continue to grow. Both we and the general scientific community have
only a limited understanding of the role of genes in predicting disease. When we
identify a gene or genetic marker that may predict disease, we conduct clinical
trials to confirm the initial scientific discovery and to establish the
scientific discovery's clinical utility in the marketplace. The results of these
clinical trials could limit or delay our ability to bring the test to market,
reduce the test's acceptance by our customers or cause us to cancel the program,
any of which limit or delay sales and cause additional losses. The only genetic
susceptibility test we currently market is PST, and it has produced only minimal
revenues to date. The marketplace may never accept our products, and we may
never be able to sell our products at a profit. We may not complete development
of or commercialize our other genetic susceptibility tests.
The success of our genetic susceptibility tests will depend upon their
acceptance as medically useful and cost-effective by patients, physicians,
dentists, other members of the medical and dental community and by third-party
payors, such as insurance companies and the government. We can achieve broad
market acceptance only with substantial education about the benefits and
limitations of genetic susceptibility tests. Our tests may not gain market
acceptance on a timely basis, if at all. If patients, dentists and physicians do
not accept our tests, or take a longer time to accept them than we anticipate,
then it will reduce our sales, resulting in additional losses.
WE RELY HEAVILY ON THIRD PARTIES TO PERFORM SALES, MARKETING AND DISTRIBUTION
FUNCTIONS ON OUR BEHALF, WHICH COULD LIMIT OUR EFFORTS TO SUCCESSFULLY MARKET
PRODUCTS
We have limited experience and capabilities with respect to distributing,
marketing and selling genetic susceptibility tests. We have relied and plan to
continue to rely significantly on sales, marketing and distribution arrangements
with third parties, over which we have limited influence. If these third parties
do not successfully market our products, it will reduce our sales and increase
our losses. If we are unable to negotiate acceptable marketing and distribution
agreements with future third parties, or if in the future we elect to perform
sales, marketing and distribution functions ourselves, we will incur significant
costs and face a number of additional risks, including the need to recruit
experienced marketing and sales personnel.
WE RELY HEAVILY ON THIRD PARTIES TO PERFORM RESEARCH AND DEVELOPMENT ON OUR
BEHALF, WHICH COULD LIMIT OUR EFFORTS TO SUCCESSFULLY DEVELOP PRODUCTS
We have limited research and development capabilities. In July 1999, we entered
into a new contractual arrangement with the University of Sheffield, replacing
the research and development agreement that had been in place since
19
1996. Under our arrangement with Sheffield, we will undertake the business
development and commercialization of discoveries resulting from Sheffield's
research. The agreement is non-cancelable for those discoveries on which
Sheffield and we have reached a specific business development agreement, but
otherwise either party can end the arrangement upon six months' notice. This
agreement with Sheffield has a five-year term with an automatic yearly renewal.
As part of this arrangement, we issued an aggregate of 475,000 shares of our
common stock to Sheffield and its researchers in exchange for patent rights and
other interests held by Sheffield and its researchers under our previous project
agreements. Our agreement with Sheffield requires us to fund agreed upon
research and development activities at the University of Sheffield on our behalf
based upon annual budgets. We also entered into a five-year consulting agreement
with Sheffield's key collaborator, Dr. Gordon Duff.
Reliance on third-party research and development entails risks we would not be
subject to if we performed this function ourselves. These risks include reliance
on the third party for regulatory compliance and quality assurance, the
possibility of breach of agreements by third parties because of factors beyond
our control and the possibility of terminations or nonrenewals of agreements by
third parties, based on their own business priorities, at times that are costly
or inconvenient for us. We may in the future elect to perform all research and
development ourselves, which will require us to raise substantial additional
funds and recruit additional qualified personnel.
IF WE ARE UNSUCCESSFUL IN ESTABLISHING ADDITIONAL STRATEGIC ALLIANCES, OUR
ABILITY TO DEVELOP AND MARKET PRODUCTS AND SERVICES WILL BE DAMAGED
Entering into strategic alliances for the development and commercialization of
products and services based on our discoveries is an important element of our
business strategy. We anticipate entering into additional collaborative
arrangements with Sheffield and other parties in the future. We face significant
competition in seeking appropriate collaborators. In addition, these alliance
arrangements are complex to negotiate and time-consuming to document. If we fail
to maintain existing alliances or establish additional strategic alliances or
other alternative arrangements, then our ability to develop and market products
and services will be damaged. In addition, the terms of any future strategic
alliances may be unfavorable to us or these strategic alliances may be
unsuccessful.
IF WE FAIL TO OBTAIN AN ADEQUATE LEVEL OF REIMBURSEMENT FOR OUR PRODUCTS OR
SERVICES BY THIRD-PARTY PAYORS, THEN OUR PRODUCTS AND SERVICES WILL NOT BE
COMMERCIALLY VIABLE
The availability and levels of reimbursement by governmental and other
third-party payors affect the market for any healthcare service. These
third-party payors continually attempt to contain or reduce the costs of
healthcare by challenging the prices charged for medical products and services.
Our ability to successfully commercialize our existing genetic susceptibility
test and others that we may develop depends on obtaining adequate reimbursement
from third-party payors. The extent of third-party payor reimbursement will
likely heavily influence physicians' and dentists' decisions to recommend
genetic susceptibility tests, as well as patients' elections to pursue testing.
If reimbursement is unavailable or limited in scope or amount, then we cannot
sell our products and services profitably. In particular, third-party payors
tend to deny reimbursement for services which they determine to be
20
investigational in nature or which are not considered "reasonable and necessary"
for diagnosis or treatment. To date, few third-party payors have agreed to
reimburse patients for genetic susceptibility tests, and we do not know if
third-party payors will, in the future, provide full reimbursement coverage for
these genetic tests. If third-party payors do not provide adequate reimbursement
coverage, then individuals may choose to directly pay for the test. If both
third-party payors and individuals are unwilling to pay for the tests, then the
number of tests we can sell will be significantly decreased, resulting in
reduced revenues and additional losses.
IF WE FAIL TO OBTAIN PATENT PROTECTION FOR OUR PRODUCTS AND PRESERVE OUR TRADE
SECRETS, THEN COMPETITORS MAY DEVELOP COMPETING PRODUCTS AND SERVICES, WHICH
WILL DECREASE OUR SALES AND MARKET SHARE
Our success will partly depend on our ability to obtain patent protection, in
the United States and in other countries, for our products and services. In
addition, our success will also depend upon our ability to preserve our trade
secrets and to operate without infringing upon the proprietary rights of third
parties.
We own exclusive rights in nine issued U.S. patents and have 20 U.S. patent
applications pending. We have also been granted a number of corresponding
foreign patents and have a number of foreign counterparts of our U.S. patents
and patent applications pending. Our patent positions, and those of other
pharmaceutical and biotechnology companies, are generally uncertain and involve
complex legal, scientific and factual questions. Our ability to develop and
commercialize products and services depends on our ability to:
- Obtain patents;
- Obtain licenses to the proprietary rights of others;
- Prevent others from infringing on our proprietary rights; and
- Protect trade secrets.
Our pending patent applications may not result in issued patents or any
issued patents may never afford meaningful protection for our technology or
products. Further, others may develop competing products which avoid
legally infringing upon, or conflicting with, our patents. In addition,
competitors may challenge any patents issued to us, and these patents may
subsequently be narrowed, invalidated or circumvented.
We also rely on trade secrets and proprietary know-how that we seek to protect,
in part, by confidentiality agreements. The third parties we contract with may
breach these agreements, and we might not have adequate remedies for any breach.
Additionally, our competitors may discover or independently develop our trade
secrets.
THIRD PARTIES MAY OWN OR CONTROL PATENTS OR PATENT APPLICATIONS AND REQUIRE US
TO SEEK LICENSES, WHICH COULD INCREASE OUR COSTS OR PREVENT US FROM DEVELOPING
OR MARKETING OUR PRODUCTS OR SERVICES
We may not have rights under patents or patent applications which are related to
our current or proposed products. Third parties may own or control these patents
and patent applications in the United States and abroad. Therefore,
21
in some cases, to develop or sell any proposed products or services, with patent
rights controlled by third parties, our collaborators or we may seek, or may be
required to seek, licenses under third-party patents and patent applications. If
this occurs, we will pay license fees or royalties or both to the licensor. If
licenses are not available to us on acceptable terms, we or our collaborators
may be prohibited from developing or selling our products or services.
If third parties believe our products or services infringe upon their patents,
they could bring legal proceedings against us seeking damages or seeking to
enjoin us from testing, manufacturing or marketing our products or services. Any
litigation could result in substantial expenses to us and significant diversion
of attention by our technical and management personnel. Even if we prevail, the
time, cost and diversion of resources of patent litigation would likely damage
our business. If the other parties in any patent litigation brought against us
are successful, in addition to any liability for damages, we may have to cease
the infringing activity or obtain a license.
TECHNOLOGICAL CHANGES MAY CAUSE OUR PRODUCTS AND SERVICES TO BE OBSOLETE
Our competitors may develop susceptibility tests that are more effective than
our technologies or that make our technologies obsolete. Innovations in the
treatment of the diseases in which we have products or product candidates could
make our products obsolete. These innovations could prevent us from selling, and
significantly reduce or eliminate the markets for, our products.
WE ARE SUBJECT TO INTENSE COMPETITION FROM COMPANIES, WHICH MAY DAMAGE OUR
BUSINESS
Our industry is highly competitive. Our competitors in the United States and
abroad are numerous and include major pharmaceutical and diagnostic companies,
specialized biotechnology firms, universities and other research institutions,
including those receiving funding from the Human Genome Project. Many of our
competitors have considerably greater financial resources, research and
development staffs, facilities, technical personnel, marketing and other
resources than we do. Furthermore, many of these competitors are more
experienced than we are in discovering, commercializing and marketing products.
These greater resources may allow our competitors to discover important genes or
genetic markers before we do. If we, in conjunction with the University of
Sheffield, do not discover disease predisposing genes and commercialize these
discoveries before our competitors, then our ability to generate sales and
revenues will be reduced or eliminated, and could make our products obsolete. We
expect competition to intensify in our industry as technical advances are made
and become more widely known.
WE ARE SUBJECT TO GOVERNMENT REGULATION WHICH MAY SIGNIFICANTLY INCREASE OUR
COSTS AND DELAY INTRODUCTION OF FUTURE PRODUCTS
The sale, performance or analysis of our genetic tests do not currently require
FDA or other federal regulatory authority approval. Changes in existing
regulations could require advance regulatory approval of genetic susceptibility
tests, resulting in a substantial curtailment or even prohibition of our
activities without regulatory approval. If our genetic tests ever require
regulatory approval, on either a state or federal level,
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then the costs of introduction will increase and marketing and sales of products
may be significantly delayed.
WE MAY BE SUBJECT TO PRODUCT LIABILITY CLAIMS THAT ARE COSTLY TO DEFEND AND THAT
COULD LIMIT OUR ABILITY TO USE SOME TECHNOLOGIES IN THE FUTURE
The design, development, manufacture and use of our genetic susceptibility tests
involve an inherent risk of product liability claims and associated adverse
publicity. Producers of medical products face substantial liability for damages
in the event of product failure or allegations that the product caused harm. We
currently maintain product liability insurance, but it is expensive and
difficult to obtain, may not be available in the future on economically
acceptable terms and may not be adequate to fully protect us against all claims.
We may become subject to product liability claims that, even if they are without
merit, could result in significant legal defense costs. We could be held liable
for damages in excess of the limits of our insurance coverage, and any claim or
resulting product recall could create significant adverse publicity.
ETHICAL, LEGAL AND SOCIAL ISSUES RELATED TO GENETIC TESTING MAY REDUCE DEMAND
FOR OUR PRODUCTS
Genetic testing has raised issues regarding the appropriate utilization and the
confidentiality of information provided by genetic testing. Genetic tests for
assessing a person's likelihood of developing a chronic disease have focused
public attention on the need to protect the privacy of genetic assessment
medical information. For example, concerns have been expressed that insurance
carriers and employers may use these tests to discriminate on the basis of
genetic information, resulting in barriers to the acceptance of genetic tests by
consumers. This could lead to governmental authorities prohibiting genetic
testing or calling for limits on or regulating the use of genetic testing,
particularly for diseases for which there is no known cure. Any of these
scenarios would decrease demand for our products and result in substantial
losses.
OUR DEPENDENCE ON KEY EXECUTIVES AND SCIENTISTS COULD ADVERSELY IMPACT THE
DEVELOPMENT AND MANAGEMENT OF OUR BUSINESS
Our success substantially depends on the ability, experience and performance of
our senior management and other key personnel. If we lose one or more of the
members of our senior management or other key employees, it could damage our
development programs and our business. In addition, our success depends on our
ability to continue to hire, train, retain and motivate skilled managerial and
scientific personnel. The pool of personnel with the skill that we require is
limited. Competition to hire from this limited pool is intense. We compete with
numerous pharmaceutical and health care companies, as well as universities and
nonprofit research organizations in the highly competitive Boston, Massachusetts
business area. Loss of the services of Dr. Philip R. Reilly, our Chairman and
CEO, Dr. Kenneth Kornman, our President, or Dr. Paul M. Martha, our Chief
Medical Officer, could delay our research and development programs and damage
our business. We have entered into employment agreements with three to five year
terms with Drs. Reilly, Kornman and Martha. Any of these employees can terminate
his employment upon 30 days notice. We do not maintain key man life insurance on
any of our personnel.
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BECAUSE OUR PRINCIPAL SHAREHOLDERS, OFFICERS AND DIRECTORS CONTROL A LARGE
PERCENTAGE OF OUR VOTING POWER, OTHER STOCKHOLDERS' VOTING POWER MAY BE LIMITED
As of February 28, 2002, our directors, executive officers and certain of their
affiliates beneficially owned approximately 18% of our outstanding common stock.
Accordingly, these shareholders, individually and as a group, may be able to
influence the outcome of shareholder votes, including votes concerning the
election of directors, the adoption or amendment of provisions in our
Certificate of Incorporation or By-Laws and the approval of certain mergers and
other significant corporate transactions, including a sale of substantially all
of our assets. These shareholders may make decisions that are adverse to other
shareholders' interests. This ownership concentration may also adversely affect
the market price of our common stock.
WE DO NOT EXPECT TO PAY DIVIDENDS FOR THE FORESEEABLE FUTURE.
We have never declared or paid any cash dividends on our capital stock. We
currently intend to retain any earnings for use in the operation and expansion
of our business and do not anticipate paying any cash dividends on our common
stock in the foreseeable future.
ANTI-TAKEOVER PROVISIONS OF DELAWARE LAW AND OUR CHARTER COULD MAKE A
THIRD-PARTY ACQUISITION OF US DIFFICULT.
The anti-takeover provisions of Delaware law could make it more difficult for a
third party to acquire control of us, even if the change in control would be
beneficial to stockholders. We will be subject to the provisions of Section 203
of the General Corporation Law of Delaware. Section 203 will prohibit us from
engaging in certain business combinations, unless the business combination is
approved in a prescribed manner. Accordingly, Section 203 may discourage, delay
or prevent someone from acquiring or merging with us. In addition, our restated
certificate of incorporation and amended and restated by-laws contain certain
provisions that may make a third party acquisition of us difficult, including:
- a classified board of directors, with three classes of directors each
serving a staggered three-year term;
- the ability of the board of directors to issue preferred stock; and
- the inability of our stockholders to call a special meeting or act by
written consent.
WE MAY BE PROHIBITED FROM FULLY USING OUR NET OPERATING LOSS CARRYFORWARDS,
WHICH COULD AFFECT OUR FINANCIAL PERFORMANCE
As a result of the losses incurred since inception, we have not recorded a
federal income tax provision and have recorded a valuation allowance against all
future tax benefits. As of December 31, 2001, we had net operating loss
carryforwards of approximately $27.9 million for federal and state income tax
purposes, expiring in varying amounts through the year 2021. We also had a
research tax credit of approximately $397,000 at December 31, 2001, that expires
in varying amounts through the year 2021. Our ability to use these net operating
loss and credit carryforwards is subject to restrictions contained in the
Internal Revenue Code which provide for limitations on our utilization of our
net operating loss and credit carryforwards following a greater than 50%
ownership change during the prescribed testing period. We
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experienced a change in ownership interest in June 1999. As a result,
approximately $15.6 million of our net operating loss carryforwards are limited
in utilization to approximately $825,000 annually. The annual limitation may
result in the expiration of the carryforwards prior to utilization. In addition,
in order to realize the future tax benefits of our net operating loss and tax
credit carryforwards, we must generate taxable income, of which there is no
assurance.
Future issuances of preferred stock may dilute the rights of our common
stockholders.
Our board of directors has the authority to issue up to 5,000,000 shares of
preferred stock and to determine the price, rights, privileges and other terms
of these shares. The board of directors may exercise this authority without the
approval of the stockholders. The rights of the holders of any preferred stock
that we may issue in the future may adversely affect the rights of holders of
our common stock.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
As of June 30, 2002 the only financial instruments we carried were cash and cash
equivalents. We believe the market risk arising from holding these financial
instruments is not material.
Some of our sales occur outside the United States and are transacted in foreign
currencies. Accordingly, we are subject to exposure from adverse movements in
foreign currency exchange rates. At this time we do not believe this risk is
material and we do not currently use derivative financial instruments to manage
foreign currency fluctuation risk. However, if foreign sales increase and the
risk of foreign currency exchange rate fluctuation increases, we may in the
future consider utilizing derivative instruments to mitigate these risks.
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PART II
OTHER INFORMATION
ITEM 1. LEGAL PROCEEDINGS
The Company is not a party to, nor is its property the subject of, any pending
legal proceeding.
ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS
(a) Not applicable
(b) Not applicable
(c) Not applicable
(d) Not applicable
ITEM 3. DEFAULTS UPON SENIOR SECURITIES
None
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
The following matter was voted upon at the Annual Meeting of Shareholders held
on June 17, 2002, and received the votes stated below:
The following persons nominated were elected to serve as directors
until the 2005 Annual Meeting and received the number of votes stated
opposite their names:
Kenneth S. Kornman: For: 15,544,296 Withheld: 158,700
Thomas A. Moore: For: 15,677,282 Withheld: 25,714
ITEM 5. OTHER INFORMATION
None
ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K
On May 31, 2002 the Company filed a report on Form 8-K to disclose an
announcement of a clinical study with research at UnitedHealth Group's Center
for Health Care Policy & Evaluation to determine the influence of certain
genetic markers on individual's response to rheumatoid arthritis therapies.
On June 28, 2002 the Company filed a report on Form 8-K to announce the
dismissal of Arthur Andersen LLP as the Company's independent public
accountants.
Exhibits:
- ---------
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Exhibit 99: Certification Pursuant to Section 906 of the Sarbanes-Oxley Act of
2002.
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SIGNATURES
In accordance with the requirements of the Exchange Act, the registrant caused
this report to be signed on its behalf by the undersigned, thereunto duly
authorized.
INTERLEUKIN GENETICS, INC.
Date: August 16, 2002 By: /s/ Philip R. Reilly
------------------------------------
Philip R. Reilly
Chairman of the Board and
Chief Executive Officer
(Principal Executive Officer)
By: /s/ Fenel M. Eloi
------------------------------------
Fenel M. Eloi
Chief Financial Officer,
Secretary & Treasurer
(Principal Financial and
Accounting Officer)
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