Management's Discussion and Analysis of Financial Conditions and Results of Operations
REGARDING FORWARD-LOOKING STATEMENTS
This report contains forward-looking statements. These statements involve known and unknown
risks, uncertainties and other factors which may cause our actual results,
performance or achievements to be materially different from any future results,
performances or achievements expressed or implied by the forward-looking
statements. Forward-looking statements include, but are not limited to,
and sales of our products and services;
declaration and distribution of any future dividends;
our ability to sustain licensing and other contract-based revenues;
of our contracts with the NIH and The Wellcome Trust on future business;
of, and expenses associated with, our intellectual property;
revenues and profitability, including any revenues from milestone payments and
access extension fees, under our DeltaBase collaboration agreements;
requirements of pharmaceutical and biotechnology companies;
benefits of knockout mice programs and, in particular, our technologies and
products, to the pharmaceutical industry;
increasing competition we face in the field of knockout mice from both
commercial and government organizations;
in the drug discovery, development and approval processes by our partners and
ability to successfully execute our business plan and to meet contractual
obligations, in view of the Company's limited staff; and
and capital resources.
In some cases, you can identify
forward-looking statements by terms such as "may," "will," "should," "could,"
"would," "expects," "plans," "anticipates," "believes," "estimates,"
"projects," "predicts," "potential" and similar expressions intended to
identify forward-looking statements. These statements reflect our current views
with respect to future events and are based on assumptions and subject to risks
and uncertainties. Given these uncertainties, you should not place undue
reliance on these forward-looking statements.
These forward-looking statements represent our estimates and assumptions
only as of the date of this report.
You should read this report completely
and with the understanding that our actual future results may be materially
different from what we expect. We qualify all of our forward-looking statements
by these cautionary statements.
YOU SHOULD READ THE FOLLOWING DISCUSSION AND ANALYSIS IN
CONJUNCTION WITH OUR FINANCIAL STATEMENTS AND THE NOTES ACCOMPANYING THE
Deltagen (or the
"Company") is a provider of research tools to the biopharmaceutical industry
and to the academic research community.
Deltagen has generated an inventory of "knockout mice" in which a single
gene has been deleted ("knocked out").
The knockout mice have been analyzed to determine the phenotypic changes
associated with that gene deletion. This
phenotypic data has been organized in an integrated database known as
DeltaBase. DeltaBase contains phenotypic
data on 750 different knockout mouse lines.
In addition to those 750 knockout mouse lines, Deltagen has
approximately 150 additional knockout mouse lines that have not been
characterized phenotypically. Deltagen
also has approximately 450 knockout lines at the embryonic stem (ES) cell
Our customers and partners/collaborators
have included some of the world's largest pharmaceutical companies, including
GlaxoSmithKline plc, Merck & Co., Inc., Pfizer Inc., Eli Lilly and Company
and Schering-Plough Research Institute.
We generate revenue from our DeltaBase
and DeltaOne products and programs.
DeltaBase is our proprietary database
that provides information, based on knockout mouse studies, on gene function
and validated gene targets for drug discovery.
Each knockout mouse underwent a standardized, detailed and extensive
analysis in order to determine the function and role that a particular gene
plays in the mouse and that gene's suitability as a drug target.
DeltaOne offers access to our portfolio
of knockout mice and/or accompanying phenotypic data, as well as any
corresponding intellectual property, on a gene-by-gene basis.
The Company has a three-year contract,
expiring September 2008, with the United States Government through the National
Institutes of Health ("NIH"). Under this
contract, potentially worth up to about $25 million, the NIH is eligible to
order any of the approximately 750 knockout mouse lines (and related phenotypic
data) that populate DeltaBase. The NIH
is permitted to publish the phenotypic data and make the knockout mouse materials
available for licensing to academic institutions. In September 2005, the NIH placed an initial
delivery order for 129 knockout lines ($5.16 million). A delivery order for four knockout mouse
lines ($0.160 million) was placed by the NIH in the third quarter of 2006. However, there are no assurances that the NIH
will place any additional delivery orders during the three-year term of the NIH
contract, which expires on September 30, 2008.
We derive substantially all of our
revenues from a narrow and limited range of sources. Substantially all of our revenues are derived
from the provision of knockout mouse lines and related phenotypic data to the
biopharmaceutical industry and pursuant to government contracts. Because of continuing consolidation in the
biopharmaceutical industry and the finite number of knockout lines in the
Company's inventory, significant uncertainty exists with respect to the
Company's future revenues.
Our operating results have fluctuated in
the past and are likely to do so in the future, and we do not believe that period-to-period
comparisons of our operating results are a good indication of our future
2. Critical Accounting
Policies and Estimates
The consolidated financial statements of
Deltagen for the three-month period ended September 30, 2006 are unaudited, but
have been prepared in accordance with accounting principles generally accepted
in the United States of America ("GAAP") for interim financial
information. These consolidated
financial statements have been prepared so that they present fairly, in the
opinion of management, the Company's financial position and its results of
operations and its cash flows for the period presented.
Under our revenue recognition policy,
revenues are recognized when a definitive agreement with a determinable price
exists, product delivery and/or invoicing (in each case where there is
reasonable assurance of meeting customer-specified criteria) have occurred, and
collectibility is reasonably assured. A
change in our revenue recognition policy or changes in the terms of contracts
under which we recognize revenues could have an impact on the amount and timing
of our recognition of revenues.
The preparation of consolidated
financial statements in conformity with GAAP requires the Company to make
estimates and assumptions that affect the amounts that are reported in the
consolidated financial statements and accompanying disclosures. Although these estimates are based on the
Company's best knowledge of current events and actions that the Company may
undertake in the future, actual results may differ materially from the
3. Results of Operations
The Company's consolidated revenues for
the three months ended September 30, 2006 totaled $0.970 million. The
third quarter revenues were attributable primarily to license fees associated
with the provision of knockout mice and related phenotypic data under the
Company's DeltaOneTM program. A delivery
order for four knockout mouse lines was placed by the NIH in the third quarter
of 2006. The revenues relating to this
delivery order ($0.160 million) will be recognized starting in the fourth
quarter of 2006 and through the first two quarters of 2007. However, there are no assurances that the NIH
will place any additional delivery orders during the three-year term of the NIH
contract, which expires on September 30, 2008.
The Company had interest income of
$0.126 million for the three months ended September 30, 2006.
Total consolidated expenses for the
three months ended September 30, 2006 were $0.959 million, of which $0.246
million were attributable to third-party royalty and commission obligations and
$0.123 million were attributable to a non-cash stock-based compensation expense
relating to stock options granted by the Company on March 30, 2006 in
accordance with Statement of Financial Standards (SFAS 123R). Other operating expenses, which totaled
$0.590 million for the three months ended September 30, 2006, were attributable
primarily to salaries and other general and administrative expenses. Legal and administrative fees associated with
prosecution of the Company's patent portfolio for the three months ended
September 30, 2006 were $0.083 million, compared to $0.201 million for the
second quarter of 2006 and $0.373 million in the first quarter of 2006. The decrease in patent-related expenses is
due to the Company reducing or discontinuing in the third quarter of 2006 its
efforts on the prosecution of certain of its patent applications in an effort
to reduce such expenses and after consideration of the factors set forth below.
Net income before provision for income
taxes for the three months ended September 30, 2006 was $0.137 million.
As of September 30, 2006, the Company
had $11.993 million in consolidated cash and cash equivalents and $1.808
million in accounts receivable.
4. Subsequent Events
a. Completion of Strategic Review: In July 2006, the Company engaged the
services of an investment banking firm to assist the Company in identifying and
evaluating various strategic alternatives and opportunities, including possible
sale of the Company. After thoroughly
reviewing the alternatives, the Board of Directors of the Company decided in
November 2006 not to pursue any such opportunities and terminated its agreement
with the investment banking firm. As a
result, the Company currently intends to maximize revenue generation from
continued licensing of its existing assets.
However, there is no guarantee that the Company will be successful in
maintaining its revenues or that the Company will declare any future dividends.
b. DeltaBase Milestone Buyouts: During the strategic review of the Company's
alternatives, the Board of Directors of the Company decided it was in the best
interest of the Company's shareholders to attempt to negotiate buyouts with its
major DeltaBase subscribers. In October
2006, the Company entered into an agreement with one of its DeltaBase
collaborators under which the Company received a one-time buyout payment in
exchange for the elimination of any future access extension fees and potential
milestone payments that may become due or payable under the DeltaBase agreement
with such collaborator. This buyout does
not affect any fees due Deltagen associated with the provision of knockout
mouse materials in the future. The
Company received the buyout payment in early December 2006. The Company is also currently negotiating
with another of its DeltaBase collaborators for a buyout of that collaborator's
access extension fees and potential milestone payments. Assuming the Company will be successful in
reaching agreement with such collaborator, the Company may discontinue
prosecution of a significant portion or all of its patent applications relating
to individual knockout mouse lines relating to those DeltaBase collaborations. Cessation of patent prosecution efforts would
significantly reduce operating expenses.
The patent prosecution expenses totaled $1.138 million during 2005 and
$0.657 million during the first nine months of 2006. In determining whether to discontinue
prosecution of its patent applications, the Company may take into consideration
many factors including, but not limited to, the following factors: the expense
of continued patent prosecution; the likelihood of obtaining issued patents;
the scope and breadth of any patent claims were such patents to issue; the
likelihood that any such patent claims would be valid, enforceable and have
commercial value; the likelihood that any such patent claims would recite the
same phenotypes or disease indications as those for which our drug collaborators
develop and commercialize drugs; the likelihood that drug development and
approval milestones will be reached by our DeltaBase collaborators; the likely
timing of any such milestone payments; the likelihood that our DeltaBase
collaborators would dispute whether milestone payments have been triggered and
the expense of litigating with such collaborators, if necessary; and the
probability of successfully enforcing any issued patents against potential
infringers, together with the expense of such litigation and an estimation of
any damages that may be awarded were the Company to prevail.
c. Contracts with The Wellcome Trust and GSF: In November 2006, the Company entered into
agreements with The Wellcome Trust and GSF - National Research
Center for Environment
and Health GmbH ("GSF") for the provision by the Company of knockout mouse
lines for distribution to academic researchers.
The terms of these agreements are generally consistent with those of the
NIH contract, under which The Wellcome Trust, as a "partner" of the NIH, was
eligible for financial terms no less favorable than those under the NIH
contract. The Wellcome Trust and GSF are
not obligated to place any orders under these contracts and, to date, have not
placed any orders. However, the Company
expects to receive an initial order in the first quarter of 2007.
d. New Facilities Lease: In November 2006, the Company signed a lease
for new office space located at The Atrium, 1900 South Norfolk Street, Suite 105, San
Mateo, CA 94403. The new address will become effective in
e. Dividend Declaration: After careful consideration of its various
strategic alternatives and opportunities, with the assistance of an investment
banking firm, the Company determined that declaration of a dividend would serve
best the interests of the Company's shareholders. The Company will distribute on December
28, 2006 a dividend of $0.20 per share.
The Company's shareholders of record as of the close of business on
December 18, 2008 will receive this dividend. The Company has approximately 38.5 million
shares outstanding that are eligible for the dividend. As a result, the total dividend distribution
would be approximately $7.7 million.
Risk Factors Affecting Future Operating Results
There are numerous risks and
uncertainties related to both our business and our industry that could cause
actual results or events to differ materially from those indicated by
We have DeltaBase agreements with
GlaxoSmithKline, Pfizer and Merck ("DeltaBase Agreements"). The milestone payments under the DeltaBase
Agreements are triggered only when all of the following conditions are
satisfied: (i) issuance of patents claiming knockout mice; (ii) such patents
having claims with specified language relating to certain recited phenotypes
and/or diseases; and (iii) the progression of a drug candidate relating to use
of DeltaBase data and/or mouse lines to certain specified drug development and
approval milestones. As of September 30, 2006, the Company
had been issued ten patents claiming knockout mice. There is significant uncertainty as to how
many additional patents, if any, the Company will be successful in obtaining in
the future, what the total cost associated with such patent prosecution efforts
would be, and whether and to what extent the Company will continue to pursue
such patents in the future. In addition,
satisfaction of the drug development and approval milestones under our DeltaBase
Agreements depends solely upon the efforts and success of our pharmaceutical
collaborators, which are not controlled by Deltagen. We may never know whether our DeltaBase
collaborators have been successful in their drug development efforts relating to
DeltaBase. Our collaborators may also
dispute whether milestone triggers have been satisfied and may resist or refuse
to pay milestone payments. Furthermore,
the more significant milestone payment amounts are associated with drug
approval, which is a rare event and takes many years to achieve. Accordingly, there is significant uncertainty
as to whether the Company will receive any milestone payments and, if so, how
many milestone payments the Company may ultimately receive from its DeltaBase
Agreements and what the value of any such payments may be. As a result, the Board of Directors of the Company decided it was in the
best interests of the Company's shareholders to attempt to negotiate buyouts
with its major DeltaBase subscribers, as described above in the "Subsequent
Events" section. In addition,
there are no royalty obligations under the DeltaBase Agreements. The Company is a party to a few DeltaOne
agreements that specify royalty payments based on sales of approved drugs by
such customers. However, these agreements generally involve a relatively small
fraction of the targets involved in the DeltaBase Agreements. Therefore, given the relatively few targets
involved in these deals and the low probability of approval and significant
sales for any given drug compound, we currently do not expect that such royalty
payments, if any, would be significant.
For a list of additional risk factors
that may affect our future operating results, refer to the "Risk Factors"
section of "Management's Discussion and Analysis of Financial Conditions and Results
of Operations" for the year ended December 31, 2005, as posted on the Company's
website (www.deltagen.com). The risk factors listed there are not the
only ones we face and additional risks and uncertainties not presently known to
us or that we currently deem immaterial also may impair or otherwise affect our