Innoviva, Inc. - Quarter Report: 2014 March (Form 10-Q)

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

 

FORM 10-Q

 

(Mark One)

 

x      QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the quarterly period ended March 31, 2014

 

OR

 

o         TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

 

For the transition period from                    to                   

 

Commission File Number: 0-30319

 

THERAVANCE, INC.

(Exact Name of Registrant as Specified in its Charter)

 

 

901 Gateway Boulevard

South San Francisco, CA 94080

(Address of Principal Executive Offices)

 

(650) 808-6000

(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  o

 

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x  No  o

 

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer,” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 

 

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).  Yes  o  No  x

 

The number of shares of registrant’s common stock outstanding on April 30, 2014 was 112,633,882.

 

 

Table of Contents

 

TABLE OF CONTENTS

 

PART I — FINANCIAL INFORMATION
Item 1. Financial Statements
Condensed Consolidated Balance Sheets as of March 31, 2014 and December 31, 2013	3
Condensed Consolidated Statements of Operations for the three months ended March 31, 2014 and 2013	4
Condensed Consolidated Statements of Comprehensive Loss for the three months ended March 31, 2014 and 2013	5
Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2014 and 2013	6
Notes to Condensed Consolidated Financial Statements	7
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations	19
Item 3. Quantitative and Qualitative Disclosures About Market Risk	32
Item 4. Controls and Procedures	33
PART II. OTHER INFORMATION
Item 1A. Risk Factors	34
Item 2. Unregistered Sales of Equity Securities and Use of Proceeds	55
Item 6. Exhibits	56
Signatures	57

 

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PART I — FINANCIAL INFORMATION

 

Item 1. Financial Statements

 

THERAVANCE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

 

 

		March 31, 2014			December 31, 2013
		(Unaudited)			*
Assets
Current assets:
Cash and cash equivalents		$	125,275		$	143,510
Short-term investments		245,648			321,615
Accounts receivable, net of allowances of $209 and $89 at March 31, 2014 and December 31, 2013		3			199
Receivables from collaborative arrangements (including amounts from a related party of $775 and $2,247 at March 31, 2014 and December 31, 2013)		865			3,181
Prepaid expenses and other current assets		6,391			4,287
Inventories		11,014			10,406
Total current assets		389,196			483,198
Marketable securities		59,831			55,374
Restricted cash		833			833
Property and equipment, net		9,734			10,238
Intangible assets, net		137,477			124,257
Other assets		7,963			7,355
Total assets		$	605,034		$	681,255
Liabilities and stockholders’ equity
Current liabilities:
Accounts payable		$	5,546		$	7,583
Payable to a related party		—			40,000
Accrued personnel-related expenses		13,829			10,881
Accrued clinical and development expenses		9,890			9,714
Accrued interest on convertible subordinated notes		1,273			2,800
Other accrued liabilities		4,792			4,137
Deferred revenue, current		8,814			9,289
Total current liabilities		44,144			84,404
Convertible subordinated notes		287,500			287,500
Deferred rent		4,891			4,774
Deferred revenue		5,247			5,455
Commitments and contingencies (Notes 3, 8 and 10)
Stockholders’ equity:
Common stock, $0.01 par value; authorized: 200,000 shares; outstanding: 112,519 and 111,516 at March 31, 2014 and December 31, 2013		1,125			1,115
Additional paid-in capital		1,834,862			1,803,048
Accumulated other comprehensive income		171			162
Accumulated deficit		(1,572,906		)	(1,505,203		)
Total stockholders’ equity		263,252			299,122
Total liabilities and stockholders’ equity		$	605,034		$	681,255

*                    Condensed consolidated balance sheet at December 31, 2013 has been derived from audited consolidated financial statements.

 

See accompanying notes to condensed consolidated financial statements.

 

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THERAVANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)

 

		Three Months Ended March 31,
		2014			2013
Revenue:
Product sales		$	945		$	—
Royalty revenue from a related party, net of intangible assets amortization of $1,780 and $0 for the three months ended March 31, 2014 and 2013 (Note 3)		(1,050		)	—
Net revenue from collaborative arrangements (including amounts from a related party of $270 and $1,322 for the three months ended March 31, 2014 and 2013)		270			1,344
Total net revenue		165			1,344
Costs and expenses:
Cost of goods sold		188			—
Research and development		43,387			26,416
Selling, general and administrative		22,834			8,315
Total costs and expenses		66,409			34,731
Loss from operations		(66,244		)	(33,387		)
Other income (expense), net		(3		)	(1,422		)
Interest income		188			185
Interest expense		(1,644		)	(2,736		)
Net loss		$	(67,703	)	$	(37,360	)
Basic and diluted net loss per share		$	(0.62	)	$	(0.39	)
Shares used to compute basic and diluted net loss share		109,859			96,379

 

See accompanying notes to condensed consolidated financial statements.

 

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THERAVANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS

(In thousands, except per share data)

(Unaudited)

 

		Three Months Ended March 31,
		2014			2013
Net loss		$	(67,703	)	$	(37,360	)
Other comprehensive income (loss):
Net unrealized gain (loss) on available-for-sale securities, net of tax		9			(7		)
Comprehensive loss		$	(67,694	)	$	(37,367	)

 

See accompanying notes to condensed consolidated financial statements.

 

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THERAVANCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)

 

		Three Months Ended March 31,
		2014			2013
Cash flows from operating activities
Net loss		$	(67,703	)	$	(37,360	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization		3,400			1,898
Stock-based compensation		13,535			6,095
Change in fair value of capped-call derivative assets		—			1,422
Other non-cash items		(2		)	(1		)
Changes in operating assets and liabilities:
Accounts receivable		(178		)	—
Receivables from collaborative arrangements		2,316			(1,153		)
Prepaid expenses and other current assets		(2,132		)	(1,224		)
Inventories		(430		)	(2,481		)
Other assets		(998		)	—
Accounts payable		(1,174		)	(221		)
Accrued personnel-related expenses, accrued clinical and development expenses, and other accrued liabilities		4,448			(3,176		)
Accrued interest on convertible subordinated notes		(1,527		)	(174		)
Deferred rent expense		116			(202		)
Deferred revenue		(308		)	4,946
Net cash used in operating activities		(50,637		)	(31,631		)
Cash flows from investing activities
Purchases of property and equipment		(1,620		)	(740		)
Purchases of available-for-sale securities		(56,649		)	(104,125		)
Maturities of available-for-sale securities		122,399			54,753
Sales of available-for-sale securities		5,000			5,000
Increase in intangible assets		(55,000		)	—
Payments received on notes receivable		—			100
Net cash provided by (used in) investing activities		14,130			(45,012		)
Cash flows from financing activities
Proceeds from issuances of common stock, net		18,272			2,991
Purchase of capped-call options		—			(36,800		)
Proceeds from issuances of convertible subordinated notes, net of debt issuance costs		—			281,673
Net cash provided by financing activities		18,272			247,864
Net increase (decrease) in cash and cash equivalents		(18,235		)	171,221
Cash and cash equivalents at beginning of period		143,510			94,849
Cash and cash equivalents at end of period		$	125,275		$	266,070

 

See accompanying notes to condensed consolidated financial statements.

 

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THERAVANCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

 

1. Description of Operations and Summary of Significant Accounting Policies

 

Description of Operations

 

Theravance, Inc. (Theravance, the Company, the Registrant or we and other similar pronouns) is a biopharmaceutical company with a pipeline of internally discovered product candidates and strategic collaborations with pharmaceutical companies. Theravance is focused on the discovery, development and commercialization of small molecule medicines across a number of therapeutic areas including respiratory disease, bacterial infections, and central nervous system (CNS)/pain.

 

Basis of Presentation

 

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) for interim financial information and the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and notes required by GAAP for complete financial statements. In our opinion, the unaudited condensed consolidated financial statements have been prepared on the same basis as audited consolidated financial statements and include all adjustments, consisting of only normal recurring adjustments, necessary for the fair presentation of our financial position, results of operations, comprehensive loss and cash flows. The interim results are not necessarily indicative of the results of operations to be expected for the year ending December 31, 2014 or any other period.

 

The accompanying unaudited condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2013 filed with the Securities and Exchange Commission (SEC) on March 3, 2014.

 

Business Separation

 

In April 2013, Theravance announced that its Board of Directors approved plans to separate its businesses into two independent publicly traded companies. The company to be spun-off, Theravance Biopharma, Inc. (Theravance Biopharma), filed an initial Form 10 with the SEC on August 1, 2013 and filed amendments of its Form 10 with the SEC on September 27, 2013, October 29, 2013, November 22, 2013, April 8, 2014, April 30, 2014 and May 7, 2014. After the spin-off, Theravance will be responsible for all development and commercial activities under the LABA collaboration and the Strategic Alliance agreements with Glaxo Group Limited (GSK). Theravance will be eligible to receive the associated potential royalty revenues from RELVAR®/BREO® ELLIPTA® (fluticasone furoate/vilanterol, “FF/VI”), ANORO™ ELLIPTA™ (umeclidinium bromide/vilanterol, “UMEC/VI”) and potentially VI monotherapy and 15% of the potential royalty revenues from UMEC/VI/FF, MABA (Bifunctional Muscarinic Antagonist-Beta2 Agonist), and MABA/FF and other products that may be developed under the LABA collaboration and Strategic Alliance agreements. Theravance Biopharma will be a biopharmaceutical company focused on discovery, development and commercialization of small-molecule medicines in areas of significant unmet medical need. The result will be two independent, publicly traded companies with different business models enabling investors to align their investment philosophies with the strategic opportunities and financial objectives of the two independent companies. The condensed consolidated financial statements do not reflect any adjustments resulting from the planned business separation.

 

Inventories

 

Inventories consist of raw materials, work-in-process and finished goods related to the production of VIBATIV® (telavancin). Raw materials include VIBATIV® active pharmaceutical ingredient (API) and other raw materials. Work-in-process and finished goods include third party manufacturing costs and labor and indirect costs we incur in the production process. Included in inventories are raw materials and work-in-process that may be used as clinical products, which are charged to research and development (R&D) expense when consumed. In addition, under certain commercialization agreements, we may sell VIBATIV® packaged in unlabeled vials that are recorded in work-in-process. Inventories are stated at the lower of cost or market value. We determine the cost of inventory using the average-cost method for validation batches. We analyze our inventory levels quarterly and write down any inventory that is expected to become obsolete, that has a cost basis in excess of its expected net realizable value or for inventory quantities in excess of expected requirements.

 

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Revenue Recognition

 

Revenue is recognized when the four basic criteria of revenue recognition are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed or determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the nature of the fee charged for products or services delivered and the collectability of those fees. Where the revenue recognition criteria are not met, we defer the recognition of revenue by recording deferred revenue until such time that all criteria are met.

 

Collaborative Arrangements and Multiple-Element Arrangements

 

Revenue from nonrefundable, up-front license or technology access payments under license and collaborative arrangements that are not dependent on any future performance by us is recognized when such amounts are earned. If we have continuing obligations to perform under the arrangement, such fees are recognized over the estimated period of continuing performance obligation.

 

We account for multiple element arrangements, such as license and development agreements in which a customer may purchase several deliverables, in accordance with FASB ASC Subtopic 605-25, “Multiple Element Arrangements.” For new or materially amended multiple element arrangements, we identify the deliverables at the inception of the arrangement and each deliverable within a multiple deliverable revenue arrangement is accounted for as a separate unit of accounting if both of the following criteria are met: (1) the delivered item or items have value to the customer on a standalone basis and (2) for an arrangement that includes a general right of return relative to the delivered item(s), delivery or performance of the undelivered item(s) is considered probable and substantially in our control. We allocate revenue to each non-contingent element based on the relative selling price of each element. When applying the relative selling price method, we determine the selling price for each deliverable using vendor-specific objective evidence (“VSOE”) of selling price, if it exists, or third-party evidence (“TPE”) of selling price, if it exists. If neither VSOE nor TPE of selling price exist for a deliverable, we use the best estimated selling price for that deliverable. Revenue allocated to each element is then recognized based on when the basic four revenue recognition criteria are met for each element.

 

For multiple-element arrangements entered into prior to January 1, 2011, we determined the delivered items under our collaborative arrangements did not meet the criteria to be considered separate accounting units for the purposes of revenue recognition. As a result, we recognized revenue from non-refundable, upfront fees and development contingent payments in the same manner as the final deliverable, which is ratably over the expected term of our performance of R&D services under the agreements. These upfront or contingent payments received, pending recognition as revenue, are recorded as deferred revenue and are classified as a short-term or long-term liability on the consolidated balance sheets and recognized over the estimated period of performance. We periodically review the estimated performance periods of our contracts based on the progress of our programs.

 

Where a portion of non-refundable upfront fees or other payments received are allocated to continuing performance obligations under the terms of a collaborative arrangement, they are recorded as deferred revenue and recognized as revenue or as an accrued liability and recognized as a reduction of research and development expenses ratably over the term of our estimated performance period under the agreement. We determine the estimated performance periods, and they are periodically reviewed based on the progress of the related program. The effect of any change made to an estimated performance period and, therefore revenue recognized, would occur on a prospective basis in the period that the change was made.

 

Under certain collaborative arrangements, we have been reimbursed for a portion of our research and development expenses. These reimbursements have been reflected as a reduction of research and development expense in our consolidated statements of operations, as we do not consider performing research and development services to be a part of our ongoing and central operations. Therefore, the reimbursement of research and developmental services and any amounts allocated to our research and development services are recorded as a reduction of research and development expense.

 

Amounts deferred under a collaborative arrangement in which the performance obligations are terminated will result in an immediate recognition of any remaining deferred revenue and accrued liability in the period that termination occurred, provided that there are no remaining performance obligations.

 

We account for contingent payments in accordance with FASB Subtopic ASC 605-28 “Revenue Recognition—Milestone Method.” We recognize revenue from milestone payments when (i) the milestone event is substantive and its achievability was not reasonably assured at the inception of the agreement and (ii) we do not have ongoing performance obligations related to the achievement of the milestone. Milestone payments are considered substantive if all of the following conditions are met: the milestone payment (a) is commensurate with either our performance to achieve the milestone or the enhancement of the value of the delivered item or items as a result of a specific outcome resulting from our performance to achieve the milestone, (b) relates solely to past

 

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performance, and (c) is reasonable relative to all of the deliverables and payment terms (including other potential milestone consideration) within the arrangement.

 

Under our collaborative arrangements with GSK, and in accordance with FASB Subtopic ASC 808-10, “Collaborative Arrangements,” royalty revenue earned is reduced by amortization expense resulting from the fees paid to GSK, which were capitalized as finite-lived intangible assets. When amortization expense exceeds amounts recognized for royalty revenues from GSK, negative revenue would be reported in our consolidated statements of operations.

 

Product Revenues

 

We sell VIBATIV® in the U.S. through a limited number of distributors, and title and risk of loss transfer upon receipt by these distributors. Healthcare providers order VIBATIV® through these distributors. Commencing in the first quarter of 2014, we record revenue on the sale of VIBATIV® on a sell-through basis, once the distributors sell the product to healthcare providers.

 

Product sales are recorded net of estimated government-mandated rebates and chargebacks, distribution fees, estimated product returns and other deductions. We reflect such reductions in revenue as either an allowance to the related account receivable from the distributor, or as an accrued liability, depending on the nature of the sales deduction. Sales deductions are based on management’s estimates that consider payer mix in target markets, industry benchmarks and experience to date. We monitor inventory levels in the distribution channel, as well as sales of VIBATIV® by distributors to healthcare providers, using product-specific data provided by the distributors. Product return allowances are based on amounts owed or to be claimed on related sales. These estimates take into consideration the terms of our agreements with customers, historical product returns of VIBATIV® experienced by our former collaborative partner, Astellas, rebates or discounts taken, estimated levels of inventory in the distribution channel, the shelf life of the product, and specific known market events, such as competitive pricing and new product introductions. We update our estimates and assumptions each quarter and if actual future results vary from our estimates, we may adjust these estimates, which could have an effect on product sales and earnings in the period of adjustment.

 

Sales Discounts:  We offer cash discounts to our customers, generally 2% of the sales price, as an incentive for prompt payment. We expect our customers to comply with the prompt payment terms to earn the cash discount. We account for cash discounts by reducing accounts receivable by the full amount and recognizing the discount as a reduction of revenue in the same period the related revenue is recognized.

 

Chargebacks and Government Rebates:  For VIBATIV® sales in the U.S., we estimate reductions to product sales for qualifying federal and state government programs including discounted pricing offered to Public Health Service (PHS) as well as government-managed Medicaid programs. Our reduction for PHS is based on actual chargebacks that distributors have claimed for reduced pricing offered to such health care providers. Our accrual for Medicaid is based upon statutorily-defined discounts, estimated payer mix, expected sales to qualified healthcare providers, and our expectation about future utilization. The Medicaid accrual and government rebates that are invoiced directly to us are recorded in other accrued liabilities on the consolidated balance sheet. For qualified programs that can purchase our products through distributors at a lower contractual government price, the distributors charge back to us the difference between their acquisition cost and the lower contractual government price, which we record as an allowance against accounts receivable.

 

Distribution Fees and Product Returns:  We have written contracts with our distributors that include terms for distribution-related fees. We record distribution-related fees based on a percentage of the product sales price. We offer our distributors a right to return product purchased directly from us, which is principally based upon the product’s expiration date. Additionally, we have granted more expansive return rights to our distributors following our product launch of VIBATIV®. We will generally accept returns for expired product during the six months prior to and twelve months after the product expiration date on product that had been sold to our distributors. Product returned is generally not resalable given the nature of our products and method of administration. We have developed estimates for VIBATIV® product returns based upon historical VIBATIV® sales from our former collaborative partner, Astellas. We record distribution fees and product returns as an allowance against accounts receivable.

 

Allowance for Doubtful Accounts:  We maintain a policy to record allowances for potentially doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. As of March 31, 2014 and December 31, 2013, there was no allowance for doubtful accounts.

 

Royalties

 

We recognize royalty revenue on licensee net sales of our products in the period in which the royalties are earned and reported to us and collectability is reasonably assured.

 

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Intangible Assets

 

We capitalize fees paid to licensors related to agreements for approved products or commercialized products. We capitalize these fees as finite-lived intangible assets and amortize these intangible assets on a straight-line basis over their estimated useful lives upon the commercial launch of the product, which is expected to be shortly after regulatory approval of such product. The estimated useful lives of these intangible assets are based on a country-by-country and product-by-product basis, as the later of the expiration or termination of the last patent right covering the compound in such product in such country and 15 years from first commercial sale of such product in such country, unless the agreement is terminated earlier. Consistent with our policy for classification of costs under the research and development collaborative arrangements, the amortization of these intangible assets will be recognized as a reduction of royalty revenue. We review our intangible assets for impairment when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The recoverability of finite-lived intangible assets is measured by comparing the asset’s carrying amount to the expected undiscounted future cash flows that the asset is expected to generate. The determination of recoverability typically requires various estimates and assumptions, including estimating the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. We derive the required cash flow estimates from near-term forecasted product sales and long-term projected sales in the corresponding market.

 

2. Net Loss per Share

 

Basic net loss per share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding, less RSAs subject to forfeiture. Diluted net loss per share is computed by dividing net loss by the weighted-average number of shares of common stock outstanding, less RSAs subject to forfeiture, plus all additional common shares that would have been outstanding, assuming dilutive potential common shares had been issued for other dilutive securities.

 

For the three months ended March 31, 2014 and 2013, diluted and basic net loss per share were identical since potential common shares were excluded from the calculation, as their effect was anti-dilutive.

 

The computations for basic and diluted net loss per share were as follows:

 

		Three Months Ended March 31,
(In thousands, except per share data)		2014			2013
Numerator:
Net loss		$	(67,703	)	$	(37,360	)
Denominator:
Weighted-average shares of stock outstanding		112,052			99,181
Less: unvested RSAs		(2,193		)	(2,802		)
Weighted-average shares used to compute basic and diluted net loss per share		109,859			96,379
Net loss per share:
Basic and diluted net loss per share		$	(0.62	)	$	(0.39	)

 

Anti-Dilutive Securities

 

The following common equivalent shares were not included in the computation of diluted net loss per share because their effect was anti-dilutive:

 

		Three Months Ended March 31,
(In thousands)		2014		2013
Shares issuable under equity incentive plans and ESPP		3,211		5,469
Shares issuable upon the conversion of convertible subordinated notes		2,780		14,256
Total anti-dilutive securities		5,991		19,725

 

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3. Collaborative Arrangements

 

Net Revenue from Collaborative Arrangements

 

We recognized net revenue from collaborative arrangements as follows:

 

		Three Months Ended March 31,
(In thousands)		2014			2013
GSK		$	(780	)	$	1,322
Other		—			22
Net revenue from collaborative arrangements		$	(780	)	$	1,344

 

GSK

 

LABA Collaboration

 

In November 2002, we entered into our long-acting beta2 agonist (LABA) collaboration with GSK to develop and commercialize once-daily LABA products for the treatment of chronic obstructive pulmonary disease (COPD) and asthma. For the treatment of COPD, the collaboration has developed two combination products: (1) RELVAR®/BREO® ELLIPTA® (FF/VI), a once-daily combination medicine consisting of a LABA, vilanterol (VI), and an inhaled corticosteroid (ICS), fluticasone furoate (FF) and (2) ANORO™ ELLIPTA™ (UMEC/VI), a once-daily medicine combining a long-acting muscarinic antagonist (LAMA), umeclidinium bromide (UMEC), with a LABA, VI. For the treatment of asthma, RELVAR® ELLIPTA® is approved in multiple regions outside of North America and the collaboration is further developing FF/VI for the U.S.

 

In the event that a product containing VI is successfully developed and commercialized, we will be obligated to make milestone payments to GSK, which could total as much as $220.0 million if both a single-agent and a combination product or two different combination products are launched in multiple regions of the world. Of these potential payments to GSK for registrational and launch-related milestone fees, we paid a total of $140.0 million as of March 31, 2014 and recorded an additional $30.0 million liability in April 2014. These milestone fees paid or owed to GSK were capitalized as finite-lived intangible assets, which are being amortized over their estimated useful lives commencing upon the commercial launch of the product. We estimate the remaining potential milestone payments of $50.0 million could be payable by the end of 2014.

 

Total milestone fees paid of $140.0 million as of March 31, 2014 resulted from the following:

 

·                  In May 2013, the U.S. Food and Drug Administration (FDA) approved BREO® ELLIPTA® as an inhaled long-term, once-daily maintenance treatment of airflow obstruction in patients with COPD, including chronic bronchitis and/or emphysema. It is also indicated to reduce exacerbations of COPD in patients with a history of exacerbations.

·                  In September 2013, the Japanese Ministry of Health, Labour and Welfare (MHLW) approved RELVAR® ELLIPTA® for the treatment of bronchial asthma in cases where concurrent use of inhaled corticosteroid and long-acting inhaled beta2 agonist is required.

·                  In October 2013, BREO® ELLIPTA® was launched in the U.S. for the treatment of COPD.

·                  In November 2013, the European Commission granted marketing authorization for RELVAR® ELLIPTA® for the regular treatment of asthma and the systematic treatment of COPD.

·                  In December 2013, RELVAR® ELLIPTA® was launched in Japan for the treatment of bronchial asthma.

·                  In December 2013, the U.S. FDA approved ANORO™ ELLIPTA™ as a combination anticholinergic/long-acting beta2-adrenergic agonist (LABA) indicated for the long-term, once-daily, maintenance treatment of airflow obstruction in patients with COPD, including chronic bronchitis and/or emphysema.

·                  In January 2014, RELVAR® ELLIPTA® was launched in the European Union.

 

Total milestone fees recorded of $30.0 million in April 2014 resulted from the following:

 

·                  In April 2014, ANORO™ ELLIPTA™ was launched in the U.S. for the treatment of COPD.

 

We are entitled to receive annual royalties from GSK on sales of RELVAR®/BREO® ELLIPTA® as follows: 15% on the first $3.0 billion of annual global net sales and 5% for all annual global net sales above $3.0 billion. Sales of single-agent LABA medicines and combination medicines would be combined for the purposes of this royalty calculation. For other products combined with a LABA from the LABA collaboration, such as ANORO™ ELLIPTA™, royalties are upward tiering and range from 6.5% to 10%.

 

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Amortization expense resulting from the milestone fees paid to GSK, which are capitalized as finite-lived intangible assets, is a reduction to royalty revenue. When amortization expense exceeds amounts recognized for royalty revenue, negative revenue would be reported in our consolidated statements of operations.

 

2004 Strategic Alliance

 

In March 2004, we entered into our strategic alliance with GSK (the Strategic Alliance agreement and the LABA collaboration are together referred to herein as the GSK Agreements). Under this alliance, GSK received an option to license exclusive development and commercialization rights to product candidates from certain of our discovery programs on pre-determined terms and on an exclusive, worldwide basis. Upon GSK’s decision to license a program, GSK is responsible for funding all future development, manufacturing and commercialization activities for product candidates in that program. In addition, GSK is obligated to use diligent efforts to develop and commercialize product candidates from any program that it licenses. If the program is successfully advanced through development by GSK, we are entitled to receive clinical, regulatory and commercial milestone payments and royalties on any sales of medicines developed from the program. If GSK chooses not to license a program, we retain all rights to the program and may continue the program alone or with a third party. GSK has no further option rights on any of our research or development programs under the strategic alliance.

 

In 2005, GSK licensed our bifunctional muscarinic antagonist-beta2 agonist (MABA) program for the treatment of COPD, and in October 2011, we and GSK expanded the MABA program by adding six additional Theravance-discovered preclinical MABA compounds (the “Additional MABAs”). GSK’s development, commercialization, milestone and royalty obligations under the strategic alliance remain the same with respect to GSK961081 (‘081), the lead compound in the MABA program. GSK is obligated to use diligent efforts to develop and commercialize at least one MABA within the MABA program, but may terminate progression of any or all Additional MABAs at any time and return them to us, at which point we may develop and commercialize such Additional MABAs alone or with a third party. Both GSK and we have agreed not to conduct any MABA clinical studies outside of the strategic alliance so long as GSK is in possession of the Additional MABAs. If a single-agent MABA medicine containing ‘081 is successfully developed and commercialized, we are entitled to receive royalties from GSK of between 10% and 20% of annual global net sales up to $3.5 billion, and 7.5% for all annual global net sales above $3.5 billion. If a MABA medicine containing ‘081 is commercialized as a combination product, such as ‘081/FF, the royalty rate is 70% of the rate applicable to sales of the single-agent MABA medicine. For single-agent MABA medicines containing an Additional MABA, we are entitled to receive royalties from GSK of between 10% and 15% of annual global net sales up to $3.5 billion, and 10% for all annual global net sales above $3.5 billion. For combination products containing an Additional MABA, such as a MABA/ICS combination, the royalty rate is 50% of the rate applicable to sales of the single-agent MABA medicine. If a MABA medicine containing ‘081 is successfully developed and commercialized in multiple regions of the world, we could earn total contingent payments of up to $125.0 million for a single-agent medicine and up to $250.0 million for both a single-agent and a combination medicine. If a MABA medicine containing an Additional MABA is successfully developed and commercialized in multiple regions of the world, we could earn total contingent payments of up to $129.0 million.

 

Agreements Entered into with GSK in Connection with the Spin-Off

 

In conjunction with the planned spin-off of Theravance Biopharma, on March 3, 2014, we, Theravance Biopharma and GSK entered into a series of agreements clarifying how the companies will implement the spin-off and operate following the spin-off. We, Theravance Biopharma and GSK entered into a three-way master agreement providing for GSK’s consent to the spin-off provided certain conditions are met. In addition, we and GSK also entered into amendments of our LABA collaboration and Strategic Alliance agreements, and Theravance Biopharma and GSK entered into a governance agreement, a registration rights agreement and an extension agreement. The three-way master agreement is currently effective, but will terminate if the spin-off is not effected by June 30, 2014, and the other agreements will become effective upon the spin-off, provided that the spin-off is effected on or before June 30, 2014.

 

The amendments to the GSK Agreements do not change the economics or royalty rates. The amendments to the GSK Agreements do provide that GSK’s diligent efforts obligations regarding commercialization matters under both agreements will change upon regulatory approval in either the United States or the European Union of UMEC/VI/FF or a MABA in combination with FF. Upon such regulatory approval, GSK’s diligent efforts obligations as to commercialization matters under the GSK Agreements will have the objective of focusing on the best interests of patients and maximizing the net value of the overall portfolio of products under the collaboration agreement and strategic alliance agreement. Since GSK’s commercialization efforts following such regulatory approval will be guided by a portfolio approach across products in which we will retain our full interests upon the spin-off and also products in which we will have retained only a portion of our interests upon the planned spin-off transaction, GSK’s

 

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commercialization efforts may have the effect of reducing the overall value of our remaining interests in the GSK Agreements after the spin-off.

 

Purchases of Common Stock under the Company’s Governance Agreement and Common Stock Purchase Agreements with GSK

 

During the first quarter of 2014, GSK purchased 342,229 shares of our common stock pursuant to its periodic “top-up” rights under our Amended and Restated Governance Agreement, dated as of June 4, 2004, as amended, among us, GSK and certain GSK affiliates, for an aggregate purchase price of approximately $12.9 million.

 

GSK Contingent Payments and Revenue

 

The potential future contingent payments receivable related to the MABA program of $363.0 million are not deemed substantive milestones due to the fact that the achievement of the event underlying the payment predominantly relates to GSK’s performance of future development, manufacturing and commercialization activities for product candidates after licensing the program.

 

Net revenue recognized from GSK under the LABA collaboration and strategic alliance agreements was as follows:

 

		Three Months Ended March 31,
(In thousands)		2014			2013
Royalty revenue		$	730		$	—
Amortization of intangible assets		(1,780		)	—
Net royalty revenue		(1,050		)	—
LABA collaboration		—			907
Strategic alliance—MABA program license		270			415
Total net revenue from GSK		$	(780	)	$	1,322

 

Amortization expense for intangible assets, which is a reduction to royalty revenue, exceeded amounts recognized for royalty revenues under the LABA Collaboration with GSK, resulting in negative revenue in the first quarter of 2014.

 

Clinigen Group

 

Commercialization Agreement

 

In March 2013, we entered into a commercialization agreement (the “Clinigen Commercialization Agreement”) with Clinigen Group plc (Clinigen) to commercialize VIBATIV® for the treatment of hospital acquired nosocomial pneumonia, including ventilator-associated pneumonia, known or suspected to be caused by methicillin resistant Staphylococcus aureus (MRSA) when other alternatives are not suitable. Under the agreement, we granted Clinigen exclusive commercialization rights in the European Union and certain other European countries (including Switzerland and Norway). We received a $5.0 million upfront payment in March 2013. Also, we are eligible to receive tiered royalty payments on net sales of VIBATIV®, ranging from 20% to 30% during the term of the agreement, and from a low double digit percentage to a mid-teen percentage if Clinigen exercises its post-term option. We are responsible, either directly or through our vendors or contractors, for supplying at Clinigen’s expense both API and finished drug product for Clinigen’s commercialization activities. The agreement has a term of at least 15 years, with an option to extend exercisable by Clinigen. However, Clinigen may terminate the agreement at any time after it has initiated commercialization upon twelve months’ advance notice.

 

Under the Clinigen Commercialization Agreement, the significant deliverables were determined to be the license, committee participation and manufacturing supply. We determined that the license represents a separate unit of accounting as the license, which includes rights to our underlying technologies for VIBATIV®, has standalone value because the rights conveyed permit Clinigen to perform all efforts necessary to use our technologies to bring the compound through commercialization. We based the best estimate of selling price for the license on potential future cash flows under the arrangement over the estimated commercialization period. We determined that the committee participation represents a separate unit of accounting as Clinigen could negotiate for and/or acquire these services from other third parties, and we based the best estimate of selling price on the nature and timing of the services to be performed. We based the best estimate of selling price for the manufacturing supply on a fully burdened cost to purchase and transfer the underlying API and finished goods from our third party contract manufacturer.

 

The $5.0 million upfront payment received in 2013 was allocated to two units of accounting based on the relative selling price method as follows: $4.9 million to the license and $0.1 million to the committee participation. We did not recognize any revenue

 

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from the license and committee participation as the technical transfer activities were not completed as of March 31, 2014 and the associated units of accounting were not delivered. The amount of the upfront payment allocated to the committee participation was deferred and will be recognized as revenue over the estimated performance period. Amounts received under a future separate supply agreement for API and finished goods, which will be manufactured by our third party contract manufacturers, will be recognized as revenue to the extent of future API and finished goods inventory sales.

 

Reimbursement of R&D Costs

 

Under certain collaborative arrangements, we are entitled to reimbursement of certain R&D costs. Our policy is to account for the reimbursement payments by our collaboration partners as reductions to R&D expense.

 

The following table summarizes the reductions to R&D expenses related to the reimbursement payments:

 

		Three Months Ended March 31,
(In thousands)		2014			2013
GSK		$	43		$	171
Merck		—			1,429
Alfa Wassermann		72			208
R-Pharm		18			326
Total reduction to R&D expense		$	133		$	2,134

 

4. Available-for-Sale Securities

 

The classification of available-for-sale securities in the consolidated balance sheets is as follows:

 

(In thousands)		March 31, 2014			December 31, 2013
Cash and cash equivalents		$	119,160		$	125,009
Short-term investments		245,648			321,615
Marketable securities		59,831			55,374
Restricted cash		833			833
Total		$	425,472		$	502,831

 

The estimated fair value of available-for-sales securities is based on quoted market prices for these or similar investments that were based on prices obtained from a commercial pricing service. Available-for-sale securities are summarized below:

 

		March 31, 2014
(In thousands)		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Estimated Fair Value
U.S. government securities		$	37,042		$	74		$	—		$	37,116
U.S. government agencies		110,171			59			—			110,230
U.S. corporate notes		88,607			48			(10		)	88,645
U.S. commercial paper		74,487			—			—			74,487
Money market funds		114,994			—			—			114,994
Total		$	425,301		$	181		$	(10	)	$	425,472

 

		December 31, 2013
(In thousands)		Amortized Cost			Gross Unrealized Gains			Gross Unrealized Losses			Estimated Fair Value
U.S. government securities		$	42,104		$	55		$	(1	)	$	42,158
U.S. government agencies		141,278			61			(8		)	141,331
U.S. corporate notes		94,923			54			—			94,977
U.S. commercial paper		102,021			2			(1		)	102,022
Money market funds		122,343			—			—			122,343
Total		$	502,669		$	172		$	(10	)	$	502,831

 

At March 31, 2014, all of the available-for-sale securities had contractual maturities within two years and the average duration of marketable securities was approximately seven months. We do not intend to sell the investments that are in an unrealized

 

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loss position, and it is unlikely that we will be required to sell the investments before recovery of their amortized cost basis, which may be maturity. We have determined that the gross unrealized losses on our marketable securities at March 31, 2104 were temporary in nature. All marketable securities with unrealized losses at March 31, 2014 have been in a loss position for less than twelve months.

 

During each of the three months ended March 31, 2014 and 2013, we sold available-for-sale securities totaling $5.0 million, and the related realized gains and losses were not significant in any of these periods.

 

5. Fair Value Measurements

 

We define fair value as the exchange price that would be received for an asset or paid to transfer a liability (an exit price) in the principal or most advantageous market for the asset or liability in an orderly transaction between market participants on the measurement date.

 

Our valuation techniques are based on observable and unobservable inputs. Observable inputs reflect readily obtainable data from independent sources, while unobservable inputs reflect our market assumptions. We classify these inputs into the following hierarchy:

 

Level 1—Quoted prices for identical instruments in active markets.

 

Level 2—Quoted prices for similar instruments in active markets; quoted prices for identical or similar instruments in markets that are not active; and model-derived valuations whose inputs are observable or whose significant value drivers are observable.

 

Level 3—Unobservable inputs and little, if any, market activity for the assets.

 

Our available-for-sale securities are measured at fair value on a recurring basis and our convertible subordinated notes are not measured at fair value on a recurring basis. The estimated fair values were as follows:

 

		Estimated Fair Value Measurements at Reporting Date Using:
Types of Instruments		Quoted Prices in Active Markets for Identical Assets			Significant Other Observable Inputs			Significant Unobservable Inputs
(In thousands)		Level 1			Level 2			Level 3			Total
Assets at March 31, 2014:
U.S. government securities		$	37,116		$	—		$	—		$	37,116
U.S. government agency securities		82,895			27,335			—			110,230
U.S. corporate notes		69,497			19,148			—			88,645
U.S. commercial paper		74,487			—			—			74,487
Money market funds		114,994			—			—			114,994
Total assets measured at estimated fair value		$	378,989		$	46,483		$	—		$	425,472
Liabilities at March 31, 2014:
Convertible subordinated notes due 2023		$	—		$	369,685		$	—		$	369,685

 

		Estimated Fair Value Measurements at Reporting Date Using
Types of Instruments		Quoted Prices in Active Markets for Identical Assets			Significant Other Observable Inputs			Significant Unobservable Inputs
(In thousands)		Level 1			Level 2			Level 3			Total
Assets at December 31, 2013:
U.S. government securities		$	42,158		$	—		$	—		$	42,158
U.S. government agency securities		98,236			43,095			—			141,331
U.S. corporate notes		61,591			33,386			—			94,977
U.S. commercial paper		3,499			98,523			—			102,022
Money market funds		122,343			—			—			122,343
Total assets measured at estimated fair value		$	327,827		$	175,004		$	—		$	502,831
Liabilities at December 31, 2013:
Convertible subordinated notes due 2023		$	—		$	408,250		$	—		$	408,250

 

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At March 31, 2014, securities with a total fair value of $2.8 million were measured using Level 1 inputs in comparison to December 31, 2013, at which time the securities had a fair value of $2.9 million and were measured using Level 2 inputs. The transfer to Level 1 from Level 2 was primarily the result of increased trading volume of the securities at and around March 31, 2014, compared to December 31, 2013.

 

At March 31, 2014, securities with a total fair value of $1.0 million were measured using Level 2 inputs in comparison to December 31, 2013, at which time the securities had a fair value of $1.0 million and were measured using Level 1 inputs. The transfer to Level 2 from Level 1 was primarily the result of decreased trading volume of the securities at and around March 31, 2014, compared to December 31, 2013.

 

Due to their short-term maturities, we believe that the fair value of our bank deposits, receivables from collaborative arrangements, accounts payable and accrued expenses approximate their carrying value.

 

6. Inventories

 

Inventories were as follows:

 

		March 31,			December 31,
(In thousands)		2014			2013
Raw materials		$	3,997		$	5,138
Work-in-process		2,225			360
Finished goods		4,792			4,908
Total inventories		$	11,014		$	10,406

 

7. Intangible Assets

 

Intangible assets, which consist of registrational and launch-related milestone fees paid or owed to GSK, were as follows:

 

		March 31, 2014
(In thousands)		Weighted Average Remaining Amortization Period (Years)		Gross Carrying Value			Accumulated Amortization			Net Carrying Value
FDA approval and launch of BREO® ELLIPTA® in the U.S.		15.4		$	60,000		$	(1,579	)	$	58,421
MHLW approval and launch of RELVAR® ELLIPTA® in Japan		14.7		20,000			(444		)	19,556
European Commission approval and launch of RELVAR® ELLIPTA®		14.8		30,000			(500		)	29,500
FDA approval of ANOROTM ELLIPTATM in the U.S.		15.2		30,000			—			30,000
Total intangible assets				$	140,000		$	(2,523	)	$	137,477

 

		December 31, 2013
(In thousands)		Weighted Average Remaining Amortization Period (Years)		Gross Carrying Value			Accumulated Amortization			Net Carrying Value
FDA approval and launch of BREO® ELLIPTA® in the U.S.		15.7		$	60,000		$	(632	)	$	59,368
MHLW approval and launch of RELVAR® ELLIPTA® in Japan		14.9		20,000			(111		)	19,889
European Commission approval of RELVAR® ELLIPTA®		15		15,000			—			15,000
FDA approval of ANOROTM ELLIPTATM in the U.S.		15.2		30,000			—			30,000
Total intangible assets				$	125,000		$	(743	)	$	124,257

 

Additional information regarding these milestone fees is included in Note 3 “Collaborative Arrangements.” Amortization expense for the BREO® ELLIPTA® intangible asset for the U.S. region and the RELVAR® ELLIPTA® intangible asset for the Japan region began in the fourth quarter of 2013 and for the RELVAR® ELLIPTA® intangible asset for the European Union region began in the first quarter of 2014.  Amortization expense is recorded as a reduction in revenue from collaborative arrangements. Amortization

 

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expense in the first quarter of 2014 was $1.8 million. Estimated annual amortization expense of intangible assets is $8.1 million for 2014, $9.1 million for each of the years from 2015 to 2018 and $94.7 million thereafter.

 

8. Stock-Based Compensation

 

Equity Incentive Plan

 

The 2012 Equity Incentive Plan (2012 Plan) provides for the grant of stock options, time-based and performance-contingent RSUs, time-based and performance-contingent RSAs, and stock appreciation rights to employees, non-employee directors and consultants. As of March 31, 2014, total shares remaining available for issuance under the 2012 Plan were 2,925,115.

 

Performance-Contingent RSAs

 

Over the past three years, the Compensation Committee of the Company’s Board of Directors (the “Compensation Committee”) has approved grants of performance-contingent RSAs to senior management and a non-executive officer. Generally, these awards have dual triggers of vesting based upon the achievement of certain performance goals by a pre-specified date, as well as a requirement for continued employment. When the performance goals are probable of achievement for these types of awards, time-based vesting and, as a result, recognition of stock-based compensation expense commence.

 

Included in these performance-contingent RSAs is the grant of 1,290,000 special long-term retention and incentive performance-contingent RSAs to senior management in 2011. The awards have dual triggers of vesting based upon the achievement of certain performance conditions over a six-year timeframe from 2011 through December 31, 2016 and require continued employment. The maximum potential expense associated with this program, net of forfeitures, is $28.2 million related to stock-based compensation expense, which would be recognized in increments based on achievement of the performance conditions.

 

As of March 31, 2014, we determined that the achievement of the requisite performance conditions for vesting of the first tranche of these awards was probable and, as a result, $6.8 million of the total stock-based compensation expense of $7.0 million related to this grant was recognized in the first quarter of 2014.

 

In May 2014, the Compensation Committee approved the modification of certain performance conditions for the second tranche of awards related to this grant. The modification permitted recognition of partial achievement of the original performance conditions that were met prior to the business separation. Therefore, we determined that the achievement of the modified performance conditions for this tranche was probable. As a result an additional $4.3 million of stock-based compensation expense will be recognized over a one year vesting period commencing in May 2014. In addition, the remaining unvested equity award was restructured to reflect the change in our Company and to address potential retention concerns following the business separation.

 

Stock-Based Compensation Expense

 

The allocation of stock-based compensation expense included in the condensed consolidated statements of operations was as follows:

 

		Three Months Ended March 31,
(In thousands)		2014			2013
Research and development		$	5,439		$	3,797
Selling, general and administrative		8,096			2,298
Total stock-based compensation expense		$	13,535		$	6,095

 

Total stock-based compensation expense capitalized to inventory was not material for the first quarter of 2014 and was $0.1 million for first quarter of 2013.

 

As of March 31, 2014, unrecognized compensation expense, net of expected forfeitures, was as follows: $19.8 million related to unvested stock options; $12.7 million related to unvested RSUs; and $21.9 million related to unvested RSAs (excludes performance-contingent RSAs).

 

Valuation Assumptions

 

The range of weighted-average assumptions used to estimate the fair value of stock options granted was as follows:

 

		Three Months Ended March 31,
		2014			2013
Employee stock options
Risk-free interest rate		1.78-1.95		%	1.01%-1.14		%
Expected term (in years)		6			6
Volatility		60		%	58		%
Dividend yield		—		%	—		%
Weighted-average estimated fair value of stock options granted		$	21.29		$	12.32

 

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Stockholders’ Equity

 

For the three months ended March 31, 2014, approximately 433,000 shares were exercised at a weighted-average exercise price of $15.34 per share, for total cash proceeds of approximately $6,636,000.

 

9. Income Taxes

 

We did not record a provision for income taxes for the three months ended March 31, 2014 and 2013, because we expect to and did generate a taxable net operating loss for the fiscal years ended December 31, 2014 and 2013. In addition, the deferred tax assets remain fully offset by a valuation allowance or uncertain tax position liabilities.

 

10. Commitments and Contingencies

 

Special Long-Term Retention and Incentive Cash Awards Program

 

In 2011, we granted special long-term retention and incentive cash bonus awards to certain employees. The awards have dual triggers of vesting based upon the achievement of certain performance conditions over a six-year timeframe from 2011 through December 31, 2016 and continued employment. The maximum potential cash bonus expense associated with this program is $38.2 million, which would be recognized in increments based on the probable achievement of the performance conditions.

 

As of March 31, 2014, we determined that the achievement of the requisite performance conditions for the first tranche of these awards was probable and, as a result, $9.1 million of the total cash bonus expense of $9.5 million related to this grant was recognized in the first quarter of 2014.

 

In May 2014, the Compensation Committee approved the modification of certain performance conditions for the second tranche of awards related to this grant. The modification permitted recognition of partial achievement of the original performance conditions that were met prior to the business separation. Therefore, we determined that the achievement of the requisite performance conditions for this tranche was probable. As a result an additional $5.0 million of cash bonus expense will be recognized over a one year vesting period commencing in May 2014. In addition, a portion of the remaining cash award was restructured to address potential retention concerns following the business separation.

 

11. Subsequent Event

 

Private Placement of $450 Million of 9% Non-Recourse Notes

 

In April 2014, we entered into certain note purchase agreements relating to the private placement of $450.0 million aggregate principal amount of non-recourse 9% fixed rate term notes due 2029 (the “2029 Notes”) issued by our wholly-owned subsidiary.

 

The 2029 Notes are secured by a security interest in a segregated bank account established to receive 40% of royalties from global net sales occurring on or after April 1, 2014 and ending upon the earlier of full repayment of principal or May 15, 2029 due to us under the LABA Collaboration with GSK. The 2029 Notes bear an annual interest rate of 9%, with interest and principal paid quarterly beginning November 15, 2014.  The 2029 Notes may be redeemed at any time prior to maturity, in whole or in part, at specified redemption premiums. Prior to May 15, 2016, in the event that the specified portion of royalties received in a quarter is less than the interest accrued for the quarter, the principal amount of the 2029 Notes will increase by the interest shortfall amount for that period.  Since the principal and interest payments on the 2029 Notes are based on royalties from product sales, which will vary from quarter to quarter, the 2029 Notes may be repaid prior to the final maturity date in 2029.

 

From the net proceeds of the offering of approximately $434.3 million, we established a $32.0 million milestone payment reserve account to fund 40% of any future milestone payments that could become payable under the LABA Collaboration with GSK. This milestone reserve account is a segregated bank account in which the $32.0 million is retained. As part of this sale, we incurred approximately $15.7 million in transaction costs, which will be amortized to interest expense over the estimated life of the 2029 Notes.

 

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

 

Forward-Looking Statements

 

The information in this discussion contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended (Securities Act), and Section 21E of the Securities Exchange Act of 1934, as amended. Such forward-looking statements involve substantial risks, uncertainties and assumptions. All statements contained herein that are not of historical fact, including, without limitation, statements regarding our strategy, future operations, future financial position, future revenue, projected costs, prospects, plans, intentions, expectations, goals and objectives, may be forward-looking statements. The words “anticipates,” “believes,” “could,” “designed,” “estimates,” “expects,” “goal,” “intends,” “may,” “objective,” “plans,” “projects,” “pursue,” “will,” “would” and similar expressions (including the negatives thereof) are intended to identify forward-looking statements, although not all forward-looking statements contain these identifying words. We may not actually achieve the plans, intentions, expectations or objectives disclosed in our forward-looking statements and the assumptions underlying our forward-looking statements may prove incorrect. Therefore, you should not place undue reliance on our forward-looking statements. Actual results or events could materially differ from the plans, intentions, expectations and objectives disclosed in the forward-looking statements that we make. Factors that we believe could cause actual results or events to differ materially from our forward-looking statements include, but are not limited, to those discussed below in “Risk Factors” in Item 1A of Part II and in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” in this Item 2 of Part I. All forward-looking statements in this document are based on information available to us as of the date hereof and we assume no obligation to update any such forward-looking statements.

 

OVERVIEW

 

Executive Summary

 

Theravance is a biopharmaceutical company with a pipeline of internally discovered product candidates and strategic collaborations with pharmaceutical companies. We are focused on the discovery, development and commercialization of small molecule medicines across a number of therapeutic areas including respiratory disease, bacterial infections, and central nervous system (CNS)/pain. Theravance’s key programs include: RELVAR®/BREO® ELLIPTA® (fluticasone furoate/vilanterol, “FF/VI”), ANORO™ ELLIPTA™ (umeclidinium bromide/vilanterol, “UMEC/VI”) and MABA (Bifunctional Muscarinic Antagonist-Beta2 Agonist), each partnered with Glaxo Group Limited (GSK), and our Long-Acting Muscarinic Antagonist program. By leveraging our proprietary insight of multivalency to drug discovery, we are pursuing a best-in-class strategy designed to discover superior medicines in areas of significant unmet medical need.

 

In the first quarter of 2014, our net loss was $67.7 million, an increase of $30.3 million from $37.4 million in the first quarter of 2013 primarily due to an increase in our costs and expenses. In the first quarter of 2014, our costs and expenses were $66.4 million, an increase of $31.7 million from $34.7 million in the first quarter of 2013 primarily due to higher employee-related expenses, including stock-based compensation expense, external-related costs for key Phase 2 clinical trials, expansion of commercial activities related to VIBATIV and external legal and accounting fees incurred in connection with our separation strategy. Cash, cash equivalents, and marketable securities totaled $430.8 million on March 31, 2014, a decrease of $89.7 million from December 31, 2013 primarily due to registrational and launch-related milestone payments to GSK of $55.0 million and cash used in operations, partially offset by net proceeds of $18.3 million received from issuances of our common stock.

 

Recent Developments

 

Private Placement of $450 Million of 9% Non-Recourse Notes

 

In April 2014, we entered into certain note purchase agreements relating to the private placement of $450.0 million aggregate principal amount of non-recourse 9% fixed rate term notes due 2029 (the “2029 Notes”) issued by our wholly-owned subsidiary. The 2029 Notes are secured by a security interest in a segregated bank account established to receive 40% of royalties from global net sales occurring on or after April 1, 2014 and ending upon the earlier of full repayment of principal or May 15, 2029 due to us under the LABA Collaboration with GSK.

 

Business Separation Announcement

 

In April 2013, Theravance announced that its Board of Directors approved plans to separate its businesses into two independent publicly traded companies. The company to be spun-off, Theravance Biopharma, Inc. (Theravance Biopharma), filed an initial Form 10 with the SEC on August 1, 2013 and filed amendments of its Form 10 with the SEC on September 27, 2013, October 29, 2013, November 22, 2013, April 8, 2014, April 30, 2014 and May 7, 2014. After the spin-off, Theravance will be responsible for all

 

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development and commercial activities under the LABA collaboration and the Strategic Alliance agreements with GSK. Theravance will be eligible to receive the associated potential royalty revenues from FF/VI (RELVAR®/BREO® ELLIPTA®), UMEC/VI (ANORO™ ELLIPTA™) and potentially VI monotherapy and 15% of the potential royalty revenues from UMEC/VI/FF, MABA, and MABA/FF and other products that may be developed under the LABA collaboration and Strategic Alliance agreements. Theravance Biopharma will be a biopharmaceutical company focused on discovery, development and commercialization of small-molecule medicines in areas of significant unmet medical need. The result will be two independent, publicly traded companies with different business models enabling investors to align their investment philosophies with the strategic opportunities and financial objectives of the two independent companies.

 

Program Highlights

 

Respiratory Programs with GlaxoSmithKline plc (GSK)

 

RELVAR®/BREO® ELLIPTA® (fluticasone furoate/vilanterol “FF/VI”)

 

RELVAR®/BREO® ELLIPTA® has been approved in 42 countries for marketing and has been launched in 12 countries, including the U.S., Canada, Japan, and U.K., as of April 25, 2014. In April 2014, GSK and Theravance announced that the Therapeutic Goods Administration (TGA) has approved BREO™ ELLIPTA® for the treatment of patients with asthma or COPD in Australia. In April 2014, GSK announced its intention to file BREO® for asthma in the U.S. in 2014.

 

BREO® ELLIPTA® is the proprietary name in the U.S., Canada and Australia for the once-daily combination medicine of an inhaled corticosteroid (ICS), fluticasone furoate “FF”, and a long-acting beta2-agonist (LABA), vilanterol “VI” (FF/VI) administered using the ELLIPTA®, a dry powder inhaler (DPI). RELVAR® ELLIPTA® is the proprietary name for FF/VI outside of the U.S., Canada and Australia. BREO® ELLIPTA® is not indicated for the relief of acute bronchospasm or for the treatment of asthma in the U.S. or Canada.

 

In April 2014, GSK and Theravance announced the start of a Phase 3 efficacy and safety study of FF/VI evaluating the contribution of the ICS component on lung function, in patients with COPD. Positive results from this study will help support a potential filing of FF/VI for the treatment of patients with COPD in Japan.

 

In March 2014, GSK and Theravance announced that recruitment of patients into the “Study to Understand Mortality and MorbidITy”, known as SUMMIT, has completed enrollment of 16,000 patients. The aim of this study is to determine the impact of RELVAR®/BREO® ELLIPTA® (FF/VI) on all-cause mortality amongst patients with moderate COPD who have cardiovascular disease (CVD) or are at increased risk for CVD. As an event-driven study, the exact duration of the treatment phase will depend on the mortality rate within the study. However, it is anticipated that each patient will participate in the study in the range of 16-53 months.

 

In February 2014, GSK submitted a regulatory application to the China Food and Drug Administration (CFDA) for FF/VI, administered using the ELLIPTA® inhaler, for asthma and COPD.

 

ANORO™ ELLIPTA® (umeclidinium bromide/vilanterol, UMEC/VI)

 

On April 28, 2014, GSK and Theravance announced that ANORO™ ELLIPTA®, the first once-daily product approved in the U.S. that combines two long-acting bronchodilators in a single inhaler for the maintenance treatment of COPD, is now available in U.S. retail pharmacies. The FDA-approved strength of ANORO™ ELLIPTA® is UMEC/VI 62.5 mcg/25 mcg.

 

In February 2014, the European Medicines Agency’s (EMA) Committee for Medicinal Products for Human Use (CHMP) issued a positive opinion recommending marketing authorization for UMEC/VI under the proposed brand name ANORO® as a once-daily, maintenance bronchodilator treatment to relieve symptoms in adult patients with COPD. The proposed strength is UMEC/VI 55 mcg / 22 mcg.

 

UMEC/VI is also under regulatory review by a number of other regulatory authorities, including Japanese Ministry of Health, Labour and Welfare.

 

In March 2014, GSK and Theravance announced positive results from three Phase 3 studies. Two studies comparing the efficacy and safety of ANORO™ ELLIPTA® with inhaled corticosteroid/long-acting beta2-adrenergic agonist combination, ADVAIR® DISKUS® (fluticasone propionate/salmeterol ‘FSC 250/50’) and the third comparing the efficacy and safety of ANORO™ ELLIPTA® with SERETIDE® DISKUS® ‘FSC 500/50’ in patients with COPD and no history of moderate to severe COPD exacerbations in the last year. In each of the studies UMEC/VI achieved a

 

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statistically significant improvement in lung function, measured as weighted mean forced expiratory volume in one second (wm FEV1) over 0-24 hours at the end of the 12 week study (Day 84), compared to either dose of FSC.

 

Inhaled Bifunctional Muscarinic Antagonist-Beta2 Agonist (MABA) — GSK961081

 

GSK961081 (‘081) is an investigational, single molecule bifunctional bronchodilator discovered by Theravance with both muscarinic antagonist and beta2 receptor agonist activities. Preclinical Phase 3-enabling studies and a Phase 1 study with healthy volunteers of the combination ‘081/FF are ongoing to explore its potential as a once-daily medicine delivered in the ELLIPTA® inhaler.

 

Theravance Respiratory Program

 

Long-Acting Muscarinic Antagonist (LAMA) — TD-4208

 

In April 2014, Theravance initiated a dose-ranging Phase 2b study with TD-4208 as a nebulized aqueous solution in patients with moderate to severe COPD. TD-4208 is an investigational inhaled LAMA discovered using Theravance’s multivalent approach to drug design. The Phase 2b study will evaluate the bronchodilator effect, safety and tolerability of four doses of TD-4208 and placebo in patients with moderate to severe COPD. Approximately 350 patients will be randomized to receive one of four doses of TD-4208 inhalation solution (44 mcg, 88 mcg, 175 mcg, 350 mcg) or placebo once daily via a jet nebulizer for 28 days in a double-blind, parallel group study. The primary endpoint of the study is trough forced expiratory volume in one second (FEV1) after the 28-day treatment period. Secondary endpoints include measurements of serial FEV1 on Day 28 and Day 1 and safety and tolerability assessments.

 

Bacterial Infections Program

 

VIBATIV® (telavancin)

 

In March 2014, Theravance was informed by its partner, Clinigen Group plc (“Clinigen”) that it had received a notification that the European Commission (EC) lifted the Europe-wide suspension of the Marketing Authorization for VIBATIV® (telavancin) for the treatment of adults with nosocomial pneumonia (hospital-acquired), including ventilator-associated pneumonia, known or suspected to be caused by methicillin resistant Staphylococcus aureus (MRSA) when other alternatives are not suitable. Theravance and Clinigen have an exclusive commercialization agreement in the European Union and certain other European countries (including Switzerland and Norway) for VIBATIV®.

 

Central Nervous System (CNS)/Pain Program

 

Norepinephrine and Serotonin Reuptake Inhibitor — TD-9855

 

In April 2014, Theravance announced positive results from a Phase 2 study of TD-9855, an investigational norepinephrine and serotonin reuptake inhibitor (NSRI), in patients with fibromyalgia (FM). The Phase 2 randomized, double-blind, parallel-group, placebo-controlled study evaluated the safety and efficacy of two doses of TD-9855 (5 mg and 20 mg) in 392 patients. Study medication was administered once-daily for up to 6 weeks. The primary endpoint of the study was improvement in pain. Secondary endpoints assessed improvement in core symptoms of fibromyalgia using established fibromyalgia measures, the Fibromyalgia Impact Questionnaire (FIQ) and the Patient Global Impression of Change scale (PGIC). Impact on common symptoms of fibromyalgia was also evaluated as exploratory endpoints. The study demonstrated statistically significant and clinically meaningful improvements in the primary and secondary endpoints at the 20 mg dose of TD-9855 compared to placebo. The 5 mg dose did not meet statistical significance for the primary endpoint. Both doses were generally well tolerated. The five most common treatment-emergent adverse events reported were headache, nausea, dizziness, insomnia and constipation. Changes in heart rate and blood pressure with TD-9855 were within the range of those seen in approved drugs in this class. Two serious adverse events were reported in TD-9855 treatment groups, with one assessed as possibly treatment related in the 5 mg group.  Topline results support further development of TD-9855.

 

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GI Motility Dysfunction Programs

 

Velusetrag

 

In April 2014, Theravance announced the positive topline results from a Phase 2 study with velusetrag for the treatment of patients with diabetic or idiopathic gastroparesis. Velusetrag is an oral, once-daily, investigational 5-HT4 selective agonist discovered by Theravance and partnered with Alfa Wassermann S.p.A. (Alfa Wassermann). Improvement in gastric emptying time was observed with all doses of velusetrag (5, 15, 30 mg). The primary endpoint of the study was the proportion of patients with at least a 20 percent improvement in gastric emptying (GE) as measured by half-time (t1/2), the time to half-emptying of the stomach of the biomarker, on Day 7 of each treatment period. Forty-seven percent more of the patients in the 30 mg velusetrag group demonstrated at least a 20% improvement in gastric emptying (GE t1/2) compared to patients in the placebo group (velusetrag 30 mg 52%, placebo 5%; p<0.001), which is a statistically significant increase. All doses of velusetrag improved gastric emptying t1/2 by 34-52 minutes versus 13 minutes for placebo. The 30 mg dose demonstrated statistically significant differences relative to placebo in percentage change and absolute change in minutes. Similar treatment effects were observed in both diabetic and idiopathic gastroparetic patients treated with velusetrag. All doses of velusetrag were generally well tolerated. The two most common adverse events were diarrhea and headache. One serious adverse event of pyelonephritis was observed during post-treatment follow-up on velusetrag 30 mg and was assessed as not related to study drug by the investigator. Based on these results, Theravance and Alfa Wassermann have agreed to advance velusetrag into a Phase 2b study later this year.

 

TD-8954

 

TD-8954 is a selective 5-HT4 receptor agonist. Theravance recently initiated a Phase 2a study to evaluate the safety, tolerability and pharmacodynamics of a single-dose of TD-8954 administered intravenously compared to metoclopramide in critically ill patients with enteral feeding intolerance. The objective of the study is assessment of adverse events and the ability to tolerate feeding.

 

Collaborative Arrangement with GSK

 

LABA Collaboration

 

In November 2002, we entered into our long-acting beta2 agonist (LABA) collaboration with GSK to develop and commercialize once-daily LABA products for the treatment of COPD and asthma. For the treatment of COPD, the collaboration has developed two combination products: (1) RELVAR®/BREO® ELLIPTA® (FF/VI) (BREO® ELLIPTA® is the proprietary name in the U.S. and Canada and RELVAR® ELLIPTA® is the proprietary name outside the U.S. and Canada), a once-daily combination medicine consisting of a LABA, vilanterol (VI), and an inhaled corticosteroid (ICS), fluticasone furoate (FF) and (2) ANORO™ ELLIPTA™ (UMEC/VI), a once-daily medicine combining a long-acting muscarinic antagonist (LAMA), umeclidinium bromide (UMEC), with a LABA, VI. Under the collaboration agreements between the parties, GSK and Theravance are exploring various paths to create triple therapy medications. The use of triple therapy is supported by the GOLD (Global initiative for chronic Obstructive Lung Disease) guidelines in high-risk patients with severe COPD and a high risk of exacerbations. One potential triple therapy path is the combination of UMEC/VI (two bronchodilators) and FF (an inhaled corticosteroid), to be administered via the ELLIPTA® investigational dry powder inhaler, which triple therapy program GSK has referred to as Diamond. GSK recently announced its goal of advancing Diamond into Phase 3 in either 2014 or 2015. For the treatment of asthma, RELVAR® ELLIPTA® is approved in multiple regions outside of North America and the collaboration is further developing FF/VI for the U.S. The FF/VI program is aimed at developing a once-daily combination LABA/ICS to succeed GSK’s Advair ® /Seretide™ (salmeterol and fluticasone as a combination) franchise, which had reported 2013 sales of approximately $8.3 billion, and to compete with Symbicort ® (formoterol and budesonide as a combination), which had reported 2013 sales of approximately $3.5 billion. ANORO™ ELLIPTA™, which is also a combination product, is targeted as an alternative treatment option to Spiriva® (tiotropium), a once-daily, single-mechanism bronchodilator, which had reported 2013 sales of approximately $4.7 billion.

 

In the event that a product containing VI is successfully developed and commercialized, we will be obligated to make milestone payments to GSK, which could total as much as $220.0 million if both a single-agent and a combination product or two different combination products are launched in multiple regions of the world. Of these potential payments to GSK for registrational and launch-related milestone fees, we paid a total of $140.0 million as of March 31, 2014 and recorded an additional $30.0 million liability in April 2014. These milestone fees paid or owed to GSK were capitalized as finite-lived intangible assets, which are being amortized over their estimated useful lives commencing upon the commercial launch of the product. We estimate the remaining potential milestone payments of $50.0 million could be payable by the end of 2014.

 

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Total milestone fees paid of $140.0 million as of March 31, 2014 resulted from the following:

 

·                  In May 2013, the U.S. Food and Drug Administration (FDA) approved BREO® ELLIPTA® as an inhaled long-term, once-daily maintenance treatment of airflow obstruction in patients with COPD, including chronic bronchitis and/or emphysema. It is also indicated to reduce exacerbations of COPD in patients with a history of exacerbations.

·                  In September 2013, the Japanese Ministry of Health, Labour and Welfare (MHLW) approved RELVAR® ELLIPTA® for the treatment of bronchial asthma in cases where concurrent use of inhaled corticosteroid and long-acting inhaled beta2 agonist is required.

·                  In October 2013, BREO® ELLIPTA® was launched in the U.S. for the treatment of COPD.

·                  In November 2013, the European Commission granted marketing authorization for RELVAR® ELLIPTA® for the regular treatment of asthma and the systematic treatment of COPD.

·                  In December 2013, RELVAR® ELLIPTA® was launched in Japan for the treatment of bronchial asthma.

·                  In December 2013, the U.S. FDA approved ANORO™ ELLIPTA™ as a combination anticholinergic/long-acting beta2-adrenergic agonist (LABA) indicated for the long-term, once-daily, maintenance treatment of airflow obstruction in patients with COPD, including chronic bronchitis and/or emphysema.

·                  In January 2014, RELVAR® ELLIPTA® was launched in the European Union.

 

Total milestone fees recorded of $30.0 million in April 2014 resulted from the following:

 

·                  In April 2014, ANORO™ ELLIPTA™ was launched in the U.S. for the treatment of COPD.

 

We are entitled to receive annual royalties from GSK on sales of RELVAR®/BREO® ELLIPTA® as follows: 15% on the first $3.0 billion of annual global net sales and 5% for all annual global net sales above $3.0 billion. Sales of single-agent LABA medicines and combination medicines would be combined for the purposes of this royalty calculation. For other products combined with a LABA from the LABA collaboration, such as ANORO™ ELLIPTA™, royalties are upward tiering and range from 6.5% to 10%.

 

Amortization expense resulting from the milestone fees paid to GSK, which are capitalized as finite-lived intangible assets, is a reduction to royalty revenue. When amortization expense exceeds amounts recognized for royalty revenue, negative revenue would be reported in our consolidated statements of operations.

 

2004 Strategic Alliance

 

In March 2004, we entered into our strategic alliance with GSK (the Strategic Alliance agreement and the LABA collaboration are together referred to herein as the GSK Agreements). Under this alliance, GSK received an option to license exclusive development and commercialization rights to product candidates from certain of our discovery programs on pre-determined terms and on an exclusive, worldwide basis. Upon GSK’s decision to license a program, GSK is responsible for funding all future development, manufacturing and commercialization activities for product candidates in that program. In addition, GSK is obligated to use diligent efforts to develop and commercialize product candidates from any program that it licenses. If the program is successfully advanced through development by GSK, we are entitled to receive clinical, regulatory and commercial milestone payments and royalties on any sales of medicines developed from the program. If GSK chooses not to license a program, we retain all rights to the program and may continue the program alone or with a third party. GSK has no further option rights on any of our research or development programs under the strategic alliance.

 

In 2005, GSK licensed our MABA program for the treatment of COPD, and in October 2011, we and GSK expanded the MABA program by adding six additional Theravance-discovered preclinical MABA compounds (the “Additional MABAs”). GSK’s development, commercialization, milestone and royalty obligations under the strategic alliance remain the same with respect to GSK961081 (‘081), the lead compound in the MABA program. GSK is obligated to use diligent efforts to develop and commercialize at least one MABA within the MABA program, but may terminate progression of any or all Additional MABAs at any time and return them to us, at which point we may develop and commercialize such Additional MABAs alone or with a third party. Both GSK and we have agreed not to conduct any MABA clinical studies outside of the strategic alliance so long as GSK is in possession of the Additional MABAs. If a single-agent MABA medicine containing ‘081 is successfully developed and commercialized, we are entitled to receive royalties from GSK of between 10% and 20% of annual global net sales up to $3.5 billion, and 7.5% for all annual global net sales above $3.5 billion. If a MABA medicine containing ‘081 is commercialized as a combination product, such as a ‘081/FF, the royalty rate is 70% of the rate applicable to sales of the single-agent MABA medicine. For single-agent MABA medicines containing an Additional MABA, we are entitled to receive royalties from GSK of between 10% and 15% of annual global net sales up to $3.5 billion, and 10% for all annual global net sales above $3.5 billion. For combination products containing an Additional MABA, such as a MABA/ICS combination, the royalty rate is 50% of the rate applicable to sales of the single-agent MABA medicine. If a MABA medicine containing ‘081 is successfully developed and commercialized in multiple regions of the world, we could earn total contingent payments of up to $125.0 million for a single-agent medicine and up to $250.0 million for both a single-agent and a

 

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combination medicine. If a MABA medicine containing an Additional MABA is successfully developed and commercialized in multiple regions of the world, we could earn total contingent payments of up to $129.0 million.

 

Agreements Entered into with GSK in Connection with the Spin- Off

 

In conjunction with the planned spin-off of Theravance Biopharma, on March 3, 2014, we, Theravance Biopharma and GSK entered into a series of agreements clarifying how the companies will implement the spin-off and operate following the spin-off. We, Theravance Biopharma and GSK entered into a three-way master agreement providing for GSK’s consent to the spin-off provided certain conditions are met. In addition, we and GSK also entered into amendments of our LABA collaboration and Strategic Alliance agreements (GSK Agreements), and Theravance Biopharma and GSK entered into a governance agreement, a registration rights agreement and an extension agreement. The three-way master agreement is currently effective, but will terminate if the spin-off is not effected by June 30, 2014, and the other agreements will become effective upon the spin-off, provided that the spin-off is effected on or before June 30, 2014.

 

The amendments to the GSK Agreements do not change the economics or royalty rates. The amendments to the GSK Agreements do provide that GSK’s diligent efforts obligations regarding commercialization matters under both agreements will change upon regulatory approval in either the United States or the European Union of UMEC/VI/FF or a MABA in combination with FF. Upon such regulatory approval, GSK’s diligent efforts obligations as to commercialization matters under the GSK Agreements will have the objective of focusing on the best interests of patients and maximizing the net value of the overall portfolio of products under the collaboration agreement and strategic alliance agreement. Since GSK’s commercialization efforts following such regulatory approval will be guided by a portfolio approach across products in which we will retain our full interests upon the spin-off and also products in which we will have retained only a portion of our interests upon the planned spin-off transaction, GSK’s commercialization efforts may have the effect of reducing the overall value of our remaining interests in the GSK Agreements after the spin-off.

 

Purchases of Common Stock by GSK

 

During the first quarter of 2014, GSK purchased 342,229 shares of our common stock pursuant to its periodic “top-up” rights under our Amended and Restated Governance Agreement, dated as of June 4, 2004, as amended, among us, GSK and certain GSK affiliates, for an aggregate purchase price of $12.9 million.

 

GSK Contingent Payments and Revenue

 

The potential future contingent payments receivable related to the MABA program of $363.0 million are not deemed substantive milestones due to the fact that the achievement of the event underlying the payment predominantly relates to GSK’s performance of future development, manufacturing and commercialization activities for product candidates after licensing the program.

 

Net revenue recognized from GSK under the LABA collaboration and strategic alliance agreements was as follows:

 

		Three Months Ended March 31,
(In thousands)		2014			2013
Royalty revenue		$	730		$	—
Amortization of intangible assets		(1,780		)	—
Net royalty revenue		(1,050		)	—
LABA collaboration		—			907
Strategic alliance—MABA program license		270			415
Total net revenue from GSK		$	(780	)	$	1,322

 

Amortization expense for intangible assets, which is a reduction to royalty revenue, exceeded amounts recognized for royalty revenues under the LABA Collaboration with GSK, resulting in negative revenue in the first quarter of 2014. Estimated annual amortization expense of intangible assets is $8.1 million for 2014.

 

Under the GSK collaboration arrangements, we are reimbursed for research and development expenses. These reimbursements have been reflected as a reduction of research and development expense and were not material in the first quarter of 2014 and were $0.2 million for the first quarter of 2013.

 

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Critical Accounting Policies and Estimates

 

Our management’s discussion and analysis of our financial condition and results of operations is based on our financial statements, which have been prepared in accordance with U.S. generally accepted accounting principles (“GAAP”). The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the financial statements, as well as the reported revenue generated and expenses incurred during the reporting periods. Our estimates are based on our historical experience and on various other factors that we believe are reasonable under the circumstances, the results of which form the basis for making judgments about the carrying value of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions. We believe that the accounting policies discussed below are critical to understanding our historical and future performance, as these policies relate to the more significant areas involving management’s judgments and estimates.

 

Revenue Recognition

 

Revenue is recognized when the four basic criteria of revenue recognition are met: (1) persuasive evidence of an arrangement exists; (2) delivery has occurred or services have been rendered; (3) the fee is fixed or determinable; and (4) collectability is reasonably assured. Determination of criteria (3) and (4) are based on management’s judgments regarding the nature of the fee charged for products or services delivered and the collectability of those fees. Where the revenue recognition criteria are not met, we defer the recognition of revenue by recording deferred revenue until such time that all criteria are met.

 

Product Revenues

 

We sell VIBATIV® in the U.S. through a limited number of distributors, and title and risk of loss transfer upon receipt by these distributors. Healthcare providers order VIBATIV® through these distributors. Commencing in the first quarter of 2014, we record revenue on the sale of VIBATIV® on a sell-through basis, once the distributors sell the product to healthcare providers.

 

Product sales are recorded net of estimated government-mandated rebates and chargebacks, distribution fees, estimated product returns and other deductions. We reflect such reductions in revenue as either an allowance to the related account receivable from the distributor, or as an accrued liability, depending on the nature of the sales deduction. Sales deductions are based on management’s estimates that consider payer mix in target markets, industry benchmarks and experience to date. We monitor inventory levels in the distribution channel, as well as sales of VIBATIV® by distributors to healthcare providers, using product-specific data provided by the distributors. Product return allowances are based on amounts owed or to be claimed on related sales. These estimates take into consideration the terms of our agreements with customers, historical product returns of VIBATIV® experienced by our former collaborative partner, Astellas, rebates or discounts taken, estimated levels of inventory in the distribution channel, the shelf life of the product, and specific known market events, such as competitive pricing and new product introductions. We update our estimates and assumptions each quarter and if actual future results vary from our estimates, we may adjust these estimates, which could have an effect on product sales and earnings in the period of adjustment.

 

Sales Discounts:  We offer cash discounts to our customers, generally 2% of the sales price, as an incentive for prompt payment. We expect our customers to comply with the prompt payment terms to earn the cash discount. We account for cash discounts by reducing accounts receivable by the full amount and recognizing the discount as a reduction of revenue in the same period the related revenue is recognized.

 

Chargebacks and Government Rebates:  For VIBATIV® sales in the U.S., we estimate reductions to product sales for qualifying federal and state government programs including discounted pricing offered to Public Health Service (PHS) as well as government-managed Medicaid programs. Our reduction for PHS is based on actual chargebacks that distributors have claimed for reduced pricing offered to such health care providers. Our accrual for Medicaid is based upon statutorily-defined discounts, estimated payer mix, expected sales to qualified healthcare providers, and our expectation about future utilization. The Medicaid accrual and government rebates that are invoiced directly to us are recorded in other accrued liabilities on the consolidated balance sheet. For qualified programs that can purchase our products through distributors at a lower contractual government price, the distributors charge back to us the difference between their acquisition cost and the lower contractual government price, which we record as an allowance against accounts receivable.

 

Distribution Fees and Product Returns:  We have written contracts with our distributors that include terms for distribution-related fees. We record distribution-related fees based on a percentage of the product sales price. We offer our distributors a right to return product purchased directly us, which is principally based upon the product’s expiration date. Additionally, we have granted more expansive return rights to our distributors following our product launch of VIBATIV®. We will generally accept returns

 

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for expired product during the six months prior to and twelve months after the product expiration date on product that had been sold to the distributors. Product returned is generally not resalable given the nature of our products and method of administration. We have developed estimates for VIBATIV® product returns based upon historical VIBATIV® sales from our former collaborative partner, Astellas. We record distribution fees and product returns as an allowance against accounts receivable.

 

Allowance for Doubtful Accounts:  We maintain a policy to record allowances for potentially doubtful accounts for estimated losses resulting from the inability of our customers to make required payments. As of March 31, 2014 and December 31, 2013, there was no allowance for doubtful accounts.

 

Royalties

 

We recognize royalty revenue on licensee net sales of our products in the period in which the royalties are earned and reported to us and collectability is reasonably assured.

 

Collaborative Arrangements and Multiple Element Arrangements

 

We generate revenue from collaboration and license agreements for the development and commercialization of our product candidates. Collaboration and license agreements may include non-refundable upfront payments, partial or complete reimbursement of research and development costs, supply arrangement, contingent payments based on the occurrence of specified events under our collaborative arrangements, license fees and royalties on sales of product candidates if they are successfully approved and commercialized. Our performance obligations under the collaborations may include the transfer of intellectual property rights in the form of licenses, obligations to provide research and development services and related materials, supply of active pharmaceutical ingredient (API) and/or drug product, and obligations to participate on certain development and/or commercialization committees with the collaborative partners. We make judgments that affect the periods over which we recognize revenue. We periodically review our estimated periods of performance based on the progress under each arrangement and account for the impact of any changes in estimated periods of performance on a prospective basis.

 

On January 1, 2011, we adopted an accounting standards update that amends the guidance on accounting for new or materially modified multiple-element arrangements that we enter into subsequent to January 1, 2011. This guidance removed the requirement for objective and reliable evidence of fair value of the undelivered items in order to consider a deliverable a separate unit of accounting. It also changed the allocation method such that the relative-selling-price method must be used to allocate arrangement consideration to all the units of accounting in an arrangement. This guidance established the following hierarchy that must be used in estimating selling price under the relative-selling-price method: (1) vendor-specific objective evidence of fair value of the deliverable, if it exists, (2) third-party evidence of selling price, if vendor-specific objective evidence is not available or (3) vendor’s best estimate of selling price (BESP) if neither vendor-specific nor third-party evidence is available.

 

We may determine that the selling price for the deliverables within collaboration and license arrangements should be determined using BESP. The process for determining BESP involves significant judgment on our part and includes consideration of multiple factors such as estimated direct expenses and other costs, and available data. We have determined BESP for license units of accounting based on market conditions, similar arrangements entered into by third parties and entity-specific factors such as the terms of previous collaborative agreements, our pricing practices and pricing objectives, the likelihood that clinical trials will be successful, the likelihood that regulatory approval will be received and that the products will become commercialized. We have also determined BESP for services-related deliverables based on the nature of the services to be performed and estimates of the associated effort as well as estimated market rates for similar services.

 

For each unit of accounting identified within an arrangement, we determine the period over which the performance obligation occurs. Revenue is then recognized using either a proportional performance or straight-line method. We recognize revenue using the proportional performance method when the level of effort to complete our performance obligations under an arrangement can be reasonably estimated. Direct labor hours or full time equivalents are typically used as the measurement of performance. The total amount of deferred revenue based on BESP at March 31, 2014 was $7.1 million. Any changes in the remaining estimated performance obligation periods under these collaborative arrangements will not have a significant impact on the results of operations, except for a change in estimated performance period resulting from the termination of a collaborative arrangement, which would result in immediate recognition of the related deferred revenue.

 

Our collaborative agreements with GSK and our former collaborative arrangement with Astellas were entered into prior to January 1, 2011. The delivered items under these collaborative agreements did not meet the criteria required to be accounted for as separate accounting units for the purposes of revenue recognition. As a result, revenue from non-refundable, upfront fees and development contingent payments were recognized ratably over the expected term of our performance of R&D services under the

 

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agreements. These upfront or contingent payments received, pending recognition as revenue, were recorded as deferred revenue and recognized over the estimated performance periods.

 

Under our GSK collaborative arrangements we recognized negative revenue of $0.8 million and revenue of $1.3 million for the three months ended March 31, 2014 and 2013. The remaining deferred revenue under the GSK strategic alliance agreement is $5.7 million at March 31, 2014. Any change in the estimated performance period, which is predominantly based on GSK’s development timeline, will not have a significant impact on the results of operations, except for a change in estimated performance period resulting from the termination of the MABA program that would result in immediate recognition of the deferred revenue.

 

On January 1, 2011, we also adopted an accounting standards update that provides guidance on revenue recognition using the milestone method. Payments that are contingent upon achievement of a substantive milestone are recognized in their entirety in the period in which the milestone is achieved. Milestones are defined as events that can be achieved based only on our performance and as to which, at the inception of the arrangement, there is substantive uncertainty about whether the milestone will be achieved. Events that are contingent only on the passage of time or only on third-party performance are not considered milestones subject to this guidance. Further, the amounts received must relate solely to prior performance, be reasonable relative to all of the deliverables and payment terms in the agreement and commensurate with our performance to achieve the milestone after commencement of the agreement. Total contingent payments that may become payable to us under our collaborative agreements were up to $429.5 million at March 31, 2014 and are considered non-substantive.

 

Under our collaborative arrangements with GSK, and in accordance with FASB Subtopic ASC 808-10, “Collaborative Arrangements,” royalty revenue earned is reduced by amortization expense resulting from the fees paid to GSK, which were capitalized as finite-lived intangible assets. When amortization expense exceeds amounts recognized for royalty revenues from GSK, negative revenue would be reported in our consolidated statements of operations.

 

Amounts related to research and development funding is recognized as the related services or activities are performed, in accordance with the contract terms. Payments may be made to us based on the number of full-time equivalent researchers assigned to the collaborative project and the related research and development expenses incurred. Accordingly, reimbursement of research and development expenses pursuant to the cost-sharing provisions of our agreements with certain collaborative partners are recognized as a reduction of research and development expenses. For the first quarter of 2014, we recorded a reduction in our research and development expenses of $0.1 million for reimbursement of research and development expenses related to these collaborative arrangements.

 

Intangible Assets

 

We capitalize fees paid to licensors related to agreements for approved products or commercialized products. We capitalize these fees as finite-lived intangible assets and amortize these intangible assets on a straight-line basis over their estimated useful lives upon the commercial launch of the product, which is expected to be shortly after regulatory approval of such product. The estimated useful lives of these intangible assets are based on a country-by-country and product-by-product basis, as the later of the expiration or termination of the last patent right covering the compound in such product in such country and 15 years from first commercial sale of such product in such country, unless the agreement is terminated earlier. Consistent with our policy for classification of costs under the research and development collaborative arrangements, the amortization of these intangible assets will be recognized as a reduction of royalty revenue.

 

We review our intangible assets for impairment when events or changes in circumstances indicate that the carrying amount of such assets may not be recoverable. The recoverability of finite-lived intangible assets is measured by comparing the asset’s carrying amount to the expected undiscounted future cash flows that the asset is expected to generate. The determination of recoverability typically requires various estimates and assumptions, including estimating the useful life over which cash flows will occur, their amount, and the asset’s residual value, if any. We derive the required cash flow estimates from near-term forecasted product sales and long-term projected sales in the corresponding market.

 

Our gross intangible assets of $140.0 million at March 31, 2014 consist of registrational and launch-related to milestone fees paid or owed to GSK (see “Collaborative Arrangements with GSK” above for more information). These intangible assets are considered finite-lived intangible assets, which will be amortized over their estimated useful lives using the straight-line method commencing upon commercial launch.

 

Inventories

 

Inventories of $11.0 million and $10.4 million at March 31, 2014 and December 31, 2013 are stated at the lower of cost or market value. Raw materials include VIBATIV® active pharmaceutical ingredient (API) and other raw materials. Work-in-process and

 

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finished goods include third party manufacturing costs and labor and indirect costs we incur in the production process. Included in inventories are raw materials and work- in-process that may be used as clinical products, which are charged to research and development (R&D) expense when consumed. We have recently commenced commercial sales of VIBATIV®.  The realization of the carrying value of our VIBATIV® inventory is dependent upon significant increases in sales volumes of VIBATIV®. If information becomes available that suggests the inventories may not be realizable, we may be required to expense a portion or all of the previously capitalized inventories.

 

Results of Operations

 

Net Revenue

 

Total net revenue, as compared to the prior year period, was as follows:

 

		Three Months Ended March 31,
(In thousands)		2014			2013			Change
Product sales		$	945		$	—		$	945		—	%
Royalty revenue		730			—			730			—
Amortization of intangible assets		(1,780		)	—			(1,780		)	—
Net royalty revenue		(1,050		)	—			(1,050		)	—
Net revenue from collaborative arrangements		270			1,344			(1,074		)	(80	)
Total net revenue		$	165		$	1,344		$	(1,179	)	(88	)%

 

Total net revenue decreased in the first quarter of 2014 compared to the same period a year ago. Revenue for the first quarter of 2014 includes product sales, net royalty revenue and revenue from collaborative arrangements compared to the same period in 2013, which only includes revenue from collaborative arrangements. Product sales in the first quarter of 2014 resulted from the recognition of VIBATIV® product sales, which includes amounts that were previously deferred due to inherent uncertainties in estimating normal channel inventory at the distributors. Royalty revenue earned in the first quarter of 2014 of $0.7 million is related to net sales of RELVAR®/BREO® ELLIPTA® from GSK. Royalty revenue is reduced by amortization expense for intangible assets, which in the first quarter of 2014 exceeded amounts recognized for royalty revenues under the LABA Collaboration with GSK. Revenue from collaborative arrangements decreased in the first quarter of 2014 compared to the same period in 2013 as a result of deferred revenue under the LABA Collaboration Agreement with GSK being fully recognized in 2013.

 

A portion of our upfront fees and certain contingent payments received from our collaborative arrangements have been deferred and are being amortized ratably into revenue or R&D expense over the estimated performance period. Future revenue will include the ongoing amortization of upfront and contingent payments earned. We periodically review and, if necessary, revise the estimated periods of performance pursuant to these contracts.

 

Cost of Goods Sold

 

Cost of goods sold, as compared to the prior year period, was as follows:

 

		Three Months Ended March 31,
(In thousands)		2014			2013			Change
Cost of goods sold		$	188		$	—		$	188		—	%

 

Cost of goods sold was $0.2 million in the first quarter of 2014 compared to $0 in the same period a year ago as a result of recognizing VIBATIV® product sales in the first quarter of 2014.

 

Research & Development

 

Our R&D expenses consist primarily of employee-related costs, external costs, and various allocable expenses. We budget total R&D expenses on an internal department level basis, we do not have project or program level reporting capabilities. We manage and report our R&D activities across the following four cost categories:

 

1)             Employee-related costs, which include salaries, wages and benefits;

2)             Stock-based compensation, which includes expenses associated with our stock option and other award plans;

3)             External costs, which include clinical trial related expenses, other contract research fees, consulting fees, and contract manufacturing fees; and

4)             Facilities and other, which include laboratory and office supplies, depreciation and other allocated expenses, which include general and administrative support functions, insurance and general supplies.

 

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