SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
[X] Quarterly Report Under Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the quarterly period ended September 30, 2004
[ ] Transition Report Pursuant to Section 13 or 15(d)
of the Securities Exchange Act of 1934
For the transition period from to
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Commission file Number 0-16109
A.P. PHARMA, INC.
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(Exact name of registrant as specified in its charter)
Delaware 94-2875566
- ------------------------------- ------------------------
(State or other jurisdiction of (IRS Employer
incorporation or organization) Identification No.)
123 Saginaw Drive, Redwood City, CA 94063
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(Address of principal executive offices)
(650) 366-2626
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(Registrant's telephone number, including area code)
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15 (d) of the Securities Exchange
Act of 1934 during the preceding 12 months (or for such shorter period
that the registrant was required to file such reports), and (2) has
been subject to such filing requirements for the past 90 days.
Yes X No
--- ---
Indicate by check mark whether the registrant is an accelerated
filer (as defined in Rule 12b-2 of the Act).
Yes [ ] No [X ]
---- ----
At October 29, 2004, the number of outstanding shares of the Company's
common stock, par value $.01, was 25,010,215.
INDEX
PART I. FINANCIAL INFORMATION
ITEM 1. Financial Statements (unaudited):
Condensed Consolidated Balance Sheets
September 30, 2004 and December 31, 2003
Condensed Consolidated Statements of Operations
for the three and nine months ended September 30, 2004 and 2003
Condensed Consolidated Statements of Cash Flows
for the nine months ended September 30, 2004 and 2003
Notes to Condensed Consolidated Financial Statements
ITEM 2. Management's Discussion and Analysis of Financial
Condition and Results of Operations
ITEM 3. Quantitative and Qualitative Disclosure About Market Risk
ITEM 4. Controls and Procedures
PART II. OTHER INFORMATION
ITEM 1. Legal Proceedings
ITEM 6. Exhibits and Reports on Form 8-K
Signatures
PART I. FINANCIAL INFORMATION
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ITEM 1. Financial Statements:
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A.P. PHARMA, INC.
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CONDENSED CONSOLIDATED BALANCE SHEETS (in thousands)
- ----------------------------------------------------
September 30, December 31,
2004 2003
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(Unaudited) (Note 1)
ASSETS
Current assets:
Cash and cash equivalents $ 673 $ 97
Marketable securities 14,574 9,387
Accounts receivable, net 1,238 1,340
Prepaid expenses and other 500 434
------ ------
Total current assets 16,985 11,258
Property and equipment, net 1,313 1,430
Other long-term assets 281 467
------ ------
Total assets $ 18,579 $ 13,155
====== ======
LIABILITIES & STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable $ 701 $ 476
Accrued expenses 1,387 1,173
Accrued disposition costs 164 53
Deferred revenue -- 190
------ ------
Total current liabilities 2,252 1,892
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Stockholders' equity:
Common stock 98,895 86,844
Accumulated deficit (82,562) (75,598)
Accumulated other comprehensive
income (6) 17
------ ------
Total stockholders' equity 16,327 11,263
------ ------
Total liabilities and stockholders'
equity $ 18,579 $ 13,155
====== ======
See accompanying notes to condensed consolidated financial
statements.
A.P. PHARMA, INC.
- -----------------
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (UNAUDITED)
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(in thousands, except per share amounts)
- ---------------------------------------
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
2004 2003 2004 2003
------ ------ ------ ------
Royalties $ 1,258 $ 1,149 $ 3,515 $ 3,211
Contract revenues 200 119 407 279
------ ------ ------ ------
Total revenues 1,458 1,268 3,922 3,490
Operating expenses:
Research & development 2,656 1,854 8,655 6,391
General & administrative 760 649 2,245 2,193
------ ------ ------ ------
Total operating expenses 3,416 2,503 10,900 8,584
------ ------ ------ ------
Operating loss (1,958) (1,235) (6,978) (5,094)
Interest income, net 70 55 126 197
Other income (expense), net 1 165 23 153
------ ------ ------ ------
Loss from continuing operations (1,887) (1,015) (6,829) (4,744)
Gain (loss) from discontinued
operations (34) (43) (135) 1,759
------ ------ ------ ------
Net loss $(1,921) $(1,058) $(6,964) $(2,985)
====== ====== ====== ======
Basic and diluted loss
per share:
Loss from continuing operations $ (0.08) $ (0.05) $ (0.31) $ (0.23)
====== ====== ====== ======
Net loss $ (0.08) $ (0.05) $ (0.31) $ (0.15)
====== ====== ====== ======
Weighted average common shares
outstanding-basic and diluted 24,936 20,571 22,212 20,527
====== ====== ====== ======
See accompanying notes to condensed consolidated financial statements.
A.P. PHARMA, INC.
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CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (UNAUDITED)
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(in thousands, except for share amounts)
- ----------------------------------------
For the nine months ended
September 30,
-------------------------
2004 2003
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Cash flows from operating activities:
Net loss $(6,964) $(2,985)
Adjustments to reconcile net loss
to net cash used in operating
activities:
Gain (loss) from discontinued
operations 135 (1,759)
Gain on sale of marketable
securities (2) --
Depreciation and amortization 283 341
Recovery of doubtful accounts and
note receivable (10) (16)
Stock-based compensation
to non-employees 99 119
Accretion of premium/discount
to marketable securities (65) 44
Loss on retirements of property
and equipment 7 15
Changes in operating assets and
liabilities:
Accounts receivable 8 --
Prepaid expenses and other
current assets (56) (97)
Other long-term assets 186 (283)
Accounts payable 224 27
Accrued expenses 214 197
Deferred revenue (190) (193)
------ ------
Net cash used in continuing
operating activities (6,131) (4,590)
Net cash received from (used in)
discontinued operations 70 (333)
Cash flows from investing activities:
Proceeds from discontinued operations -- 2,139
Purchases of property and equipment (173) (185)
Purchases of marketable securities (15,922) (5,649)
Sales of marketable securities 10,779 6,784
------ ------
Net cash (used in) provided by
investing activities (5,316) 3,089
Cash flows from financing activities:
Proceeds on issuance of common
stock, net of issuance costs 11,756 --
Proceeds from the exercise of stock
options 151 --
Proceeds from issuance of shares under
the Employee Stock Purchase Plan 46 25
------ ------
Net cash proceeds provided by
financing activities 11,953 25
Net increase (decrease) in cash and
cash equivalents 576 (1,809)
Cash and cash equivalents, beginning
of the period 97 3,282
----- ------
Cash and cash equivalents, end
of the period $ 673 $ 1,473
===== ======
See accompanying notes to condensed consolidated financial statements.
A.P. PHARMA, INC.
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NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
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SEPTEMBER 30, 2004 and 2003 (UNAUDITED)
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(1) Basis of Presentation
---------------------
A.P. Pharma, Inc. (the "Company", "we", "our", or "us") is
developing patented polymer-based delivery systems to enhance
the safety and effectiveness of pharmaceutical compounds.
Projects are currently conducted for our own product portfolio
as well as under feasibility and development arrangements with
pharmaceutical and biotechnology companies. New products and
technologies under development include bioerodible polymers for
injectable and implantable drug delivery.
In the opinion of management, the accompanying unaudited
condensed consolidated financial statements have been prepared
in accordance with accounting principles generally accepted in
the United States for interim financial information and with
the instructions to Form 10-Q and Article 10 of Regulation S-X.
Accordingly, they do not include all of the information and
footnotes required by accounting principles generally accepted
in the United States for complete financial statements. In the
opinion of management, all adjustments of a normal recurring
nature considered necessary for a fair presentation have been
included. Operating results for the three and nine months
ended September 30, 2004 are not necessarily indicative of the
results that may be expected for the year ending December 31,
2004 or any future operating periods. The condensed
consolidated balance sheet as of December 31, 2003 has been
derived from the audited financial statements as of that date.
For further information, refer to the consolidated financial
statements and notes thereto included in our Annual Report on
Form 10-K for the year ended December 31, 2003.
The condensed consolidated financial statements include the
financial statements of the Company and its subsidiary, APS
Analytical Standards, Inc through the date of sale (February
13, 2003). All significant intercompany balances and
transactions have been eliminated in consolidation.
Critical Accounting Policies
- ----------------------------
We believe there have been no significant changes in our
critical accounting policies during the nine months ended
September 30, 2004 compared to those previously disclosed in
our Annual Report on Form 10-K for the year ended December 31,
2003 filed with the SEC on March 26, 2004.
Use of Estimates
- ----------------
The preparation of our financial statements in conformity with
accounting principles generally accepted in the United States
requires management to make estimates and assumptions that
affect the amounts reported in our financial statements and
accompanying notes. Estimates were made relating to useful
lives of fixed assets, valuation allowances, impairment of
assets and accruals. Actual results could differ materially
from those estimates.
Revenue Recognition
- -------------------
Our revenue arrangements with multiple deliverables are divided
into separate units of accounting if certain criteria are met,
including whether the delivered element has stand-alone value
to the customer and whether there is objective and reliable
evidence of the fair value of the undelivered elements. The
consideration we receive is allocated among the separate units
based on their respective fair values, and the applicable
revenue recognition criteria are considered separately for each
of the separate units. Advance payments received in excess of
amounts earned are classified as deferred revenue until earned.
* Royalties
Royalties from licensees are based on third-party sales of
licensed products or technologies and recorded as earned in
accordance with contract terms when third-party results can
be reliably determined and collectibility is reasonably
assured.
Generally, contractually required minimum royalties are
recorded ratably throughout the contract period. Royalties
in excess of minimum royalties are recognized as earned when
the related product is shipped to the end customer by our
licensees based on information provided to us by our
licensees.
* License Fees
We have licensing agreements that generally provide for
periodic minimum payments, royalties, and/or non-refundable
license fees. These licensing agreements typically require
a non-refundable license fee and allow our partners to sell
our proprietary products in a defined field or territory for
a defined period. The license agreements provide for the
Company to earn future revenue through royalty payments.
These non-refundable license fees are initially reported as
deferred revenues and recognized as revenues over the
estimated life of the product to which they relate as we
have continuing involvement with licensees until the related
product is discontinued or the related patents expire,
whichever is earlier. Revenue recognized from deferred
license fees is classified as license fees in the
accompanying consolidated statements of operations. License
fees received in connection with arrangements where we have
no continuing involvement are recognized as license fees
when the amounts are received or when collectibility is
assured, whichever is earlier. No such fees were recorded
during the three or nine months ended September 30, 2004.
A milestone payment is a payment made by a third party or
corporate partner to us upon the achievement of a
predetermined milestone as defined in a legally binding
contract. Milestone payments are recognized as license fees
when the milestone event has occurred and we have completed
all milestone related services such that the milestone
payment is currently due and is non-refundable. No such
fees were recorded during the three or nine months ended
September 30, 2004.
* Contract Revenues
Contract revenues relate to research and development
arrangements that generally provide for the company to
invoice research and development fees based on full-time
equivalent hours for each project. Revenues from these
arrangements are recognized as the related development costs
are incurred. These revenues approximate the costs
incurred.
Cash Equivalents and Short-term Investments
- -------------------------------------------
We consider all short-term investments in debt securities which
have original maturities of less than three months at date of
purchase to be cash equivalents. Investments which have
original maturities of three months or longer are classified as
marketable securities in the accompanying balance sheets.
Accrued Disposition Costs
- -------------------------
Costs relating to disposal of discontinued operations are
reported as accrued disposition costs in the accompanying
balance sheets. Accrued disposition costs include severance
costs and gross profit guarantees (see note 5).
Concentrations of Credit Risk
- -----------------------------
Financial instruments that potentially subject us to
concentrations of credit risk consist primarily of cash
equivalents, short-term investments and trade accounts
receivable. We invest excess cash in a variety of high grade
short-term, interest-bearing securities. This diversification
of risk is consistent with our policy to ensure safety of
principal and to maintain liquidity.
Approximately 87% of the receivables were concentrated with two
customers in the pharmaceutical industry as of September 30,
2004. To reduce credit risk, we perform ongoing credit
evaluations of our customers' financial conditions. We do not
generally require collateral for customers with accounts
receivable balances.
Segment and Geographic Information
- ----------------------------------
Our operations are confined to a single business segment, the
design and commercialization of polymer technologies for
pharmaceutical and other applications. Substantially all of
our revenues are derived from domestic customers.
Stock-Based Compensation
- ------------------------
We have elected to account for stock-based compensation related
to employees using the intrinsic value method. Accordingly,
except for stock options issued to non-employees and restricted
stock awards to employees and directors, no compensation cost
has been recognized for our stock option plans and stock
purchase plan. Compensation related to options granted to non-
employees is periodically remeasured as earned.
In accordance with FAS No. 123, "Accounting for Stock-Based
Compensation," as amended by FAS No. 148, "Accounting for
Stock-Based Compensation-Transition and Disclosure," we have
provided below the pro forma disclosures of the effect on net
loss and net loss per share as if FAS No. 123 had been applied
in measuring compensation expense for all periods presented (in
thousands, except per share amounts).
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ ----------------
2004 2003 2004 2003
---- ---- ---- ----
Net loss, as reported $(1,921) $(1,058) $(6,964) $(2,985)
Deduct:
Stock-based employee
compensation expense
determined under FAS No. 123 (102) (99) (308) (326)
------ ------ ------ ------
Pro forma net loss $(2,023) $(1,157) $(7,272) $(3,311)
====== ====== ====== ======
Basic and diluted loss per
share as reported $ (0.08) $ (0.05) $ (0.31) $ (0.15)
====== ====== ====== ======
Basic and diluted pro forma
loss per share $ (0.08) $ (0.06) $ (0.33) $ (0.16)
====== ====== ====== ======
Fair values of awards granted under the stock option plans and
employee stock purchase plan were estimated at grant or
purchase dates using the Black-Scholes option pricing model.
For pro forma disclosure, the estimated fair value of the
options is amortized to expense over the vesting period of the
options using the straight line method. The multiple option
approach is used to value the purchase rights granted under the
employee stock purchase plan. We used the following
assumptions:
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ ----------------
2004 2003 2004 2003
---- ---- ---- ----
Expected life in years (from
vesting date):
Stock options 5 5 5 5
Employee stock purchase plan 1.5 - 2 1.5 - 2 1.5 - 2 1.5 - 2
Interest rate:
Stock options 3.4% 2.8% 3.2% 2.8%
Employee stock purchase plan 1.47%-2.32% 1.20%-3.26% 1.20%-2.32% 1.20%-4.22%
Volatility:
Stock options 75% 66% 69% 66%
Employee stock purchase plan 65% - 68% 68 65 - 69% 65 - 68%
Expected dividend yield: 0% 0% 0% 0%
In March 2004 the Financial Accounting Standard Board ("FASB")
issued an exposure draft entitled "Share-Based Payment, an amendment
of FASB Statements No. 123 and 95" (proposed FAS 123R). The
proposed FAS 123R would require stock-based compensation to
employees to be recognized as a cost in the financial statements and
that such cost be measured according to the fair value of the stock
options. In the absence of an observable market price for the stock
awards, the fair value of the stock options would be based upon a
valuation methodology that takes into consideration various factors,
including the exercise price of the option, the expected term of the
option, the current price of the underlying shares, the expected
volatility of the underlying share price, the expected dividends on
the underlying shares and the risk-free interest rate. The proposed
requirements in the exposure draft would be effective for interim or
annual periods beginning after June 15, 2005. The cumulative effect
of adoption, if any, applied on a modified prospective basis, would
be measured and recognized on the date of implementation, July 1,
2005. The FASB expects to issue a final standard by December 31,
2004. A.P. Pharma is currently evaluating option valuation
methodologies and assumptions in light of the proposed FAS 123R.
Current estimates of option values using the Black-Scholes method
(as shown above) may not be indicative of results from valuation
methodologies ultimately adopted in the final rules.
Reclassifications
- -----------------
Certain immaterial amounts in the prior year financial
statements have been reclassified to conform with the current
year presentation.
(2) Loss Per Share Information
--------------------------
Basic loss per share is computed by dividing net loss by the
weighted-average number of common shares outstanding. Because
the Company is in a net loss position for the three and nine
months ended September 30, 2004 and 2003, diluted earnings per
share is also calculated using the weighted average number of
common shares outstanding and excludes the effects of options
which are antidilutive.
(3) Comprehensive Loss
------------------
Comprehensive loss for the three and nine months ended
September 30, 2004 and 2003 consists of the following (in
thousands):
Three Months Ended Nine Months Ended
September 30, September 30,
------------------ -----------------
2004 2003 2004 2003
---- ---- ---- ----
Net loss $(1,921) $(1,058) $(6,964) $(2,985)
Unrealized losses on
available-for-sale securities (5) (19) (23) (41)
------ ------ ------ ------
Comprehensive loss $(1,926) $(1,077) $(6,987) $(3,026)
====== ====== ====== ======
(4) Stockholders' Equity
--------------------
In June 2004, we sold 4,153,335 shares of common stock at a
price of $3.00 per share, for net proceeds of approximately
$11.8 million after deducting placement agent fees and costs
associated with the offering. The shares were offered under
our shelf registration statement on Form S-3, as amended.
During the nine months ended September 30, 2004, 68,448 and
50,750 shares of common stock were issued through the exercise
of stock options and purchased under the Employee Stock
Purchase Plan, respectively. Additionally, in May 2004,
shareholders approved the increase in shares reserved for
issuance under the 2002 Stock Incentive Plan and 1997 Employee
Stock Purchase Plan by 400,000 and 100,000, respectively.
(5) Discontinued Operations
-----------------------
We completed the sale of certain assets of our Analytical
Standards division as well as certain technology rights for our
topical pharmaceutical and cosmeceutical product lines and
other assets ("cosmeceutical and toiletry business") in
February 2003 and July 2000, respectively.
The Analytical Standards division and cosmeceutical and
toiletry business are reported as discontinued operations for
all periods presented in the accompanying Condensed
Consolidated Statements of Operations.
Gain (loss) from discontinued operations represents the gain on
sale of the Analytical Standards division to GFS Chemicals on
February 13, 2003, income attributable to the Analytical
Standards division and changes in estimates for our
cosmeceutical and toiletry business that was sold to RP Scherer
on July 25, 2000, as follows (in thousands):
For the Nine Months Ended
September 30,
-------------------------
2004 2003
---- ----
Analytical Standards Division
- -----------------------------
Gain on sale of Analytical
Standards division $ 3 $1,870
Income from Analytical Standards
division $ -- $ 7
---- -----
3 1,877
Cosmeceutical and Toiletry Business
- -----------------------------------
Recovery of doubtful accounts
receivable -- 4
Change in estimates for gross
profit guarantees (138) (132)
Change in estimate of provision
for income taxes and tax refunds -- 10
----- ----
(138) (118)
----- ----
Total gain (loss) from
discontinued operations $ (135) $1,759
===== =====
Basic and diluted loss per common share from discontinued
operations excluding the gain on sale of the Analytical
Standards and cosmeceutical product lines were less than
($0.01) per share for the nine months ended September 30, 2004
and 2003, respectively.
Liabilities related to the discontinued operations as of
September 30, 2004 in the amount of $164,000 include severance
costs and accruals for gross profit guarantees compared to
$53,000 as of December 31, 2003. These liabilities are
reported as accrued disposition costs in the accompanying
consolidated balance sheets.
Net cash received from (used in) discontinued operations of
$70,000 and $(333,000) for the nine months ended September 30,
2004 and 2003, respectively, relates to royalties received from
GFS offset by payments of severance costs to former employees
who were terminated as a result of the sale of the Analytical
Standards division.
Analytical Standards Division
- -----------------------------
On February 13, 2003, we completed the sale of our Analytical
Standards division to GFS Chemicals, Inc. ("GFS"), a privately
held company based in Columbus, Ohio. In this transaction, we
received $2.1 million on closing and are entitled to receive
royalties on sales of Analytical Standards products for a
period of five years at rates ranging from 5% to 15%. The net
present value of the guaranteed minimum royalties is included
in the gain (loss) from discontinued operations. Royalties in
excess of the guaranteed minimum royalties are included in the
gain (loss) from discontinued operations when they are realized
in accordance with our revenue recognition policy. We recorded
additional royalties of $20,000 as income for the nine months
ended September 30, 2004.
As a result of the sale of the Analytical Standards division,
we recorded severance charges of $210,000 for the year ended
December 31, 2003 as a partial offset to the gain on
disposition of the Analytical Standards division. In the nine
months ended September 30, 2004, a reduction to the estimated
severance charges of $19,000 was recorded. Approximately
$184,000 of these severance charges has been paid through
September 30, 2004 and approximately $7,000 is included in
accrued disposition costs.
Cosmeceutical and Toiletry Business
- -----------------------------------
On July 25, 2000, we completed the sale of certain technology
rights for our topical pharmaceuticals and cosmeceutical
product lines and other assets ("cosmeceutical and toiletry
business") to RP Scherer Corporation, a subsidiary of Cardinal
Health, Inc. We received $25 million at closing and were
entitled to receive further earnout amounts for the subsequent
three years up to a maximum of $26.5 million, the amounts of
which were dependent on the performance of the business sold.
During the first two years of the earnout period, we received
an aggregate of $3.8 million. No earnout income was received
or reported for the third and final earnout year.
Under the terms of the agreement with RP Scherer, we guaranteed
a minimum gross profit percentage on RP Scherer's combined
sales of products to Ortho Neutrogena and Dermik ("Gross Profit
Guaranty"). The guaranty period commenced on July 1, 2000 and
ends on the earlier of July 1, 2010 or the end of two
consecutive guaranty periods where the combined gross profit on
sales to Ortho and Dermik equals or exceeds the guaranteed
gross profit percentage. The Gross Profit Guaranty aggregated
$527,000 for the first four guaranty years. We expect the
annual Gross Profit Guaranty payments to range from
approximately $100,000 to $150,000 for the remainder of the
guaranty period. As there is no minimum amount of Gross Profit
Guaranty due, no accrual for the guaranty is estimable for
future years.
ITEM 2. Management's Discussion and Analysis of Financial Condition
-----------------------------------------------------------
and Results of Operations (all dollar amounts rounded to the
------------------------------------------------------------
nearest thousand)
-----------------
Overview
- --------
We are a specialty pharmaceutical company focused on the development
of ethical (prescription) pharmaceuticals utilizing our proprietary
polymer-based drug delivery systems. Our primary focus is the
development and commercialization of our bioerodible injectable and
implantable systems under the trade name Biochronomer(TM). Initial
target areas of application for our drug delivery technology include
pain management, anti-nausea, inflammation, vaccines and
ophthalmology applications. Our product development programs are
funded by the sale of common stock in June 2004, royalties from
topical products currently marketed by pharmaceutical partners,
proceeds from the divestitures of our cosmeceutical and analytical
standards product lines and by fees we receive from collaborative
partners.
Except for statements of historical fact, the statements herein are
forward-looking and are subject to a number of risks and
uncertainties that could cause actual results to differ materially
from the statements made. These include, among others, uncertainty
associated with timely development, approval, launch and acceptance
of new products, establishment of new corporate alliances, progress
in research and development programs, and other risks described
below or identified from time to time in our Securities and Exchange
Commission filings.
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of our financial statements in conformity with
accounting principles generally accepted in the United States
requires management to make estimates and assumptions that affect
the amounts reported in our financial statements and accompanying
notes. On an ongoing basis, we evaluate our estimates including
those related to the useful lives of fixed assets, valuation
allowances, impairment of assets, accrued clinical and preclinical
expenses and contingencies. Actual results could differ materially
from those estimates.
We believe there have been no significant changes in our critical
accounting policies during the nine months ended September 30, 2004
as compared to what was previously disclosed in our Annual Report on
Form 10-K for the year ended December 31, 2003 filed with the SEC on
March 26, 2004. For a description of our critical accounting
policies, please refer to our 2003 Annual Report on Form 10-K.
In March 2004 the Financial Accounting Standard Board ("FASB")
issued an exposure draft entitled "Share-Based Payment, an amendment
of FASB Statements No. 123 and 95" (proposed FAS 123R). The
proposed FAS 123R would require stock-based compensation to
employees to be recognized as a cost in the financial statements and
that such cost be measured according to the fair value of the stock
options. In the absence of an observable market price for the stock
awards, the fair value of the stock options would be based upon a
valuation methodology that takes into consideration various factors,
including the exercise price of the option, the expected term of the
option, the current price of the underlying shares, the expected
volatility of the underlying share price, the expected dividends on
the underlying shares and the risk-free interest rate. The proposed
requirements in the exposure draft would be effective for interim or
annual periods beginning after June 15, 2005. The cumulative effect
of adoption, if any, applied on a modified prospective basis, would
be measured and recognized on the date of implementation, July 1,
2005. The FASB expects to issue a final standard by December 31,
2004. A.P. Pharma is currently evaluating option valuation
methodologies and assumptions in light of the proposed FAS 123R.
Current estimates of option values using the Black-Scholes method
(as shown above) may not be indicative of results from valuation
methodologies ultimately adopted in the final rules.
Results of Operations for the Three and Nine Months Ended September
- -------------------------------------------------------------------
30, 2004 and 2003
- -----------------
Our revenues are derived principally from royalties and contract
revenues. Under strategic alliance arrangements entered into with
certain corporations, we can receive non-refundable upfront fees,
milestone payments and royalties based on third party product sales.
Royalties for the three and nine months ended September 30, 2004
were $1,258,000 and $3,515,000, respectively, compared to $1,149,000
and $3,211,000, respectively, in the same periods in 2003. These
increases were due mainly to growth in sales of Retin-A Micro(R) and
Carac. We expect royalty revenue to continue to increase in the
fourth quarter of 2004.
Contract revenues for the three and nine months September 30, 2004
were $200,000 and $407,000, respectively, compared to $119,000 and
$279,000, respectively, in the same periods in 2003. The increase
is mainly due to the initiation of a new collaborative research and
development arrangement in 2004.
Research and development expense increased by approximately $802,000
and $2,264,000 during the three and nine months ended September 30,
2004, respectively, from $1,854,000 and $6,391,000, respectively,
for the same periods in 2003. These increases were due mainly to
the cost of Phase 2 clinical trials with APF112 for the treatment of
post-surgical pain as well as the initiation of a Phase 1 clinical
trial using APF530 for the prevention of acute and delayed
chemotherapy-induced nausea and vomiting. The Phase 1 clinical
trial using APF530 for the treatment of acute and delayed
chemotherapy-induced nausea and vomiting and our pre-clinical
toxicology studies have now been completed. A U.S. regulatory
submission is planned for early in 2005 and we expect to initiate
pivotal studies later in 2005. We and our consultants have
considered a variety of alternatives regarding the future
development of APF112, and a Phase 2b clinical study is in the
advanced stages of planning. However, due to the current and
anticipated demands on our resources for the planned clinical
program for APF530, we will delay the start of the Phase 2b study
with APF112 until a partner or additional resources have been
secured.
General and administrative expense increased by approximately
$111,000 and $52,000 during the three and nine months ended
September 30, 2004 respectively, from $649,000 and $2,193,000,
respectively, due primarily to additional costs associated with the
requirements of Section 404 of the Sarbanes-Oxley Act of 2002.
Net interest income for the three months ended September 30, 2004
increased by $15,000 to $70,000 and decreased for the nine months
ended September 30, 2004 by $71,000 to $126,000. These changes were
due to lower interest rates earned on lower average cash balances in
the first half of the year and higher cash balances in the third
quarter of 2004 as a result of the stock issuance in June 2004. We
expect interest income to increase in the fourth quarter of 2004 due
to the receipt of approximately $11.8 million from the common stock
sale in June 2004 under our shelf registration statement.
Gain (loss) from discontinued operations represents the gain on sale
of the Analytical Standards division in February 2003, partially
offset by the loss from discontinued operations attributable to the
Analytical Standards division and the cosmeceutical and toiletries
product lines. The loss from discontinued operations totaled
$34,000 for the three months ended September 30, 2004, compared to
$43,000 for the three months ended September 30, 2003. The loss
from discontinued operations totaled $135,000 for the nine months
ended September 30, 2004, compared with the gain on the disposition
of the Analytical Standards division of $1,759,000 in the nine
months ended September 30, 2003.
Capital Resources and Liquidity
- -------------------------------
Cash, cash equivalents and marketable securities increased by
$5,763,000 to $15,247,000 at September 30, 2004 from $9,484,000 at
December 31, 2003 due primarily to the sale of 4,153,335 shares of
common stock in June 2004 at a price of $3.00 per share for net
proceeds of approximately $11.8 million.
Net cash used in continuing operating activities for the nine months
ended September 30, 2004 and 2003 was $6,131,000 and $4,590,000,
respectively. The increase in net cash used in operating activities
was mainly due to increased clinical and preclinical study costs.
Net cash used in investing activities for the nine months ended
September 30, 2004 was $5,316,000 compared to net cash provided by
investing activities of $3,089,000 for the nine months ended
September 30, 2003. The increase in the cash used in investing
activities was primarily due to the purchase of $15,922,000 of
marketable securities, partially offset by the sale of $10,779,000
of marketable securities.
In June 2004, we sold 4,153,335 shares of common stock in a public
offering at a price of $3.00 per share which yielded net proceeds of
approximately $11.8 million.
We have funded our operations, including technology and product
research and development, primarily through royalties received on
sales of Retin-A Micro and Carac, fees received in connection with
collaborative research and development arrangements, the proceeds
received from the sales of our Analytical Standards division and our
cosmeceutical and toiletry business, sale of common stock in June
2004 and interest earned on short-term investments. Our existing
cash and cash equivalents, marketable securities, collections of
accounts receivable, together with interest income and other
revenue-producing activities including royalties, license and option
fees and research and development fees are sufficient to meet our
cash needs through at least the first half of 2006.
Our future capital requirements will depend on numerous factors
including, among others, royalties from sales of products of third
party licensees; our ability to enter into collaborative research
and development and licensing agreements; progress of product
candidates in preclinical and clinical trials; investment in new
research and development programs; time required to gain regulatory
approvals; resources that we devote to self-funded products;
potential acquisitions of technology, product candidates or
businesses; and the costs of defending or prosecuting any patent
opposition or litigation necessary to protect our proprietary
technology.
In March 2004, we renegotiated the lease for our facilities. The
following is a summary of fixed payments related to certain
contractual obligations as of September 30, 2004 (in thousands):
Less More
than 2 to 3 4 to 5 than
Total 1 year years years 5 years
----- ------ ------ ------ -------
Operating Leases $3,068 $425 $943 $951 $749
----- --- --- --- ---
Total $3,068 $425 $943 $951 $749
===== === === === ===
Under the terms of the agreement with RP Scherer, we guaranteed a
minimum gross profit percentage on RP Scherer's combined sales of
products to Ortho Neutrogena and Dermik ("Gross Profit Guaranty").
The guaranty period commenced on July 1, 2000 and ends on the
earlier of July 1, 2010 or the end of two consecutive guaranty
periods where the combined gross profit on sales to Ortho and Dermik
equals or exceeds the guaranteed gross profit percentage. The Gross
Profit Guaranty aggregated $527,000 for the first four guaranty
years. We expect the annual Gross Profit Guaranty payments to range
from approximately $100,000 to $150,000 for the remainder of the
guaranty period. As there is no minimum amount of Gross Profit
Guaranty due, no accrual for the guaranty is estimable for future
years.
ITEM 3. Quantitative and Qualitative Disclosure about Market Risk
----------------------------------------------------------
Since December 31, 2003, there have been no material changes in the
Company's market risk exposure.
ITEM 4. Controls and Procedures
-----------------------
(a) Evaluation of disclosure controls and procedures: We carried
out an evaluation, under the supervision and with the participation
of our management, including the Chief Executive Officer and Chief
Financial Officer, of the effectiveness of the design and operations
of our disclosure controls and procedures pursuant to Rule 13a-15(e)
and 15(d)-15(e) of the Exchange Act. Based upon that evaluation,
the Chief Executive Officer and Chief Financial Officer concluded
that as of September 30, 2004, the end of period covered by this
report, our disclosure controls and procedures were sufficiently
effective to ensure that the information required to be disclosed by
us in this Quarterly Report on Form 10-Q was recorded, processed,
summarized and reported within the time periods specified in the
SEC's rules and Form 10-Q.
(b) Changes in internal controls: During the quarter ended
September 30, 2004, there have been no significant changes in our
internal control over financial reporting that materially affected,
or are reasonable likely to materially affect, our internal control
over financial reporting.
PART II. OTHER INFORMATION
-----------------
ITEM 1. Legal Proceedings
On October 22, 2003, Tristrata Technology, Inc. (Tristrata)
filed an amended complaint joining A.P. Pharma, Inc. and other
companies as defendants in Tristrata's action first filed July 12,
2002 against Cardinal Health, Inc. and others in the Federal
District Court of Delaware. Tristrata's complaint alleges
infringement of patents pertaining to alpha-hydroxy acids used in
cosmetics. A.P. Pharma answered Tristrata's amended complaint on
December 22, 2003. A.P. Pharma is vigorously defending this action.
At this early stage of the proceedings we cannot state the amount,
if any, which might be recovered by Tristrata from A.P. Pharma. In
our opinion, this litigation should not have a material effect on
our results of operations or financial condition.
ITEM 6. Exhibits and Reports on Form 8-K
(a) Exhibits
Exhibit 31.1 Certification of Chief Executive Officer pursuant to
Rules 13A-15(e) Promulgated under the Securities Exchange Act of 1934
as amended.
Exhibit 31.2 Certification of Chief Financial Officer pursuant to
Rules 13A-15(e) Promulgated under the Securities Exchange Act of 1934
as amended.
Exhibit 32 Certifications of Chief Executive Officer and Chief
Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted
pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934,
the registrant has duly caused this report to be signed on its
behalf by the undersigned thereunto duly authorized.
A.P. PHARMA, INC.
Date: November 15, 2004 By: /S/ Michael O'Connell
------------------ ----------------------------
Michael O'Connell
President and Chief
Executive Officer
Date: November 15, 2004 By: /S/ Gordon Sangster
------------------ ----------------------------
Gordon Sangster
Chief Financial Officer
Exhibit 31.1 SECTION 302 CERTIFICATIONS -------------------------- Certifications: I, Michael O'Connell, certify that: 1. I have reviewed this quarterly report on Form 10-Q of A.P. Pharma, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which could be reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 15, 2004 /s/ Michael O'Connell - --------------------- Michael O'Connell President and Chief Executive Officer
Exhibit 31.2 SECTION 302 CERTIFICATIONS -------------------------- Certifications: I, Gordon Sangster, certify that: 1. I have reviewed this quarterly report on Form 10-Q of A.P. Pharma, Inc.; 2. Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report; 3. Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report; 4. The registrant's other certifying officers and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) for the registrant and have: a) Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant is made known to us by others within those entities, particularly during the period in which this report is being prepared; b) Evaluated the effectiveness of the registrant's disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and c) Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financial reporting; and 5. The registrant's other certifying officers and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of registrant's board of directors: a) All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which could be reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and b) Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting. Date: November 15, 2004 /s/ Gordon Sangster - ------------------- Gordon Sangster Chief Financial Officer
Exhibit 32 CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED - ------------------------------------------------------------ PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 - --------------------------------------------------------- In connection with the Quarterly Report of A.P. Pharma, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Michael O'Connell, Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Michael O'Connell - --------------------- Michael O'Connell, Chief Executive Officer CERTIFICATION PURSUANT TO 18 U.S.C. SECTION 1350, AS ADOPTED - ------------------------------------------------------------ PURSUANT TO SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002 - --------------------------------------------------------- In connection with the Quarterly Report of A.P. Pharma, Inc. (the "Company") on Form 10-Q for the period ending September 30, 2004 as filed with the Securities and Exchange Commission on the date hereof (the "Report"), I, Gordon Sangster, Chief Financial Officer of the Company, certify, pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that: (1) The Report fully complies with the requirements of section 13(a) or 15(d) of the Securities Exchange Act of 1934; and (2) The information contained in the Report fairly presents, in all material respects, the financial condition and result of operations of the Company. /s/ Gordon Sangster - ------------------- Gordon Sangster, Chief Financial Officer