XOMA Corporation (XOMA)

[Iron heart]

XOMA 6-May-2010 Quarterly Report

http://biz.yahoo.com/e/100506/xoma10-q.html

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

The accompanying discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements and the related disclosures, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and assumptions that affect the reported amounts in our consolidated financial statements and accompanying notes. On an on-going basis, we evaluate our estimates including, but not limited to, those related to terms of revenue recognition, long-lived assets, warrant liabilities and share-based compensation. We base our estimates on historical experience and on various other market-specific and other relevant assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ significantly from these estimates.

Overview

We are a leader in the discovery, development and manufacture of therapeutic antibodies designed to treat inflammatory, autoimmune, infectious and oncological diseases. Our proprietary development pipeline includes XOMA 052, an anti-interleukin-1 beta ("IL-1 beta") antibody, XOMA 3AB, a biodefense anti-botulism antibody candidate, and preclinical antibody discovery programs in several indications. We have a fully-integrated product development platform, extending from preclinical science to development and manufacturing. We have multiple revenue streams resulting from the licensing of our antibody technologies, biodefense contracts and discovery and development collaborations and product royalties. Our technologies have contributed to the success of marketed antibody products, including LUCENTIS? (ranibizumab injection) for wet age-related macular degeneration and CIMZIA? (certolizumab pegol) for rheumatoid arthritis and Crohn's disease.

We have established on-going technology licensing programs for certain of our proprietary technologies, which have attracted numerous significant licensees including Bayer Healthcare AG, Johnson & Johnson (formerly Centocor, Inc.), Merck & Co., Inc. ("Merck"), Pfizer Inc. and Takeda Pharmaceutical Company Limited ("Takeda"). We have a premier antibody discovery and development platform that includes multiple antibody discovery or phage display libraries that increase our ability and that of our collaboration partners to discover new therapeutic antibodies. Once an antibody is discovered, we use a number of proprietary technologies including our Human Engineering?, affinity maturation, bacterial cell expression and manufacturing technologies to enhance and improve the qualities of the antibodies for efficacy, safety, stability, productivity and cost. Some of XOMA's technologies are used widely across the industry and have generated significant revenues for the company. For example, bacterial cell expression technology is a key biotechnology for the discovery and manufacture of antibodies and other proteins. Thus far, more than 50 pharmaceutical and biotechnology companies have signed bacterial cell expression licenses with us, and a number of licensed product candidates are in clinical development.

Our biodefense initiatives currently include a $65 million multiple-year contract funded by the National Institute of Allergy and Infectious Diseases ("NIAID"), a part of the National Institutes of Health ("NIH"), to support our ongoing development of drug candidates toward clinical trials in the treatment of botulism poisoning. This contract is the third that NIAID has awarded us for the development of botulinum antitoxins and brings the program's total awards to nearly $100 million. We also develop products with premier pharmaceutical companies including Novartis AG ("Novartis"), Schering-Plough Research Institute, a division of Schering Corporation, which is now a subsidiary of Merck (referred to herein as "Merck/Schering-Plough"), and Takeda.

Significant Developments in 2010

Proprietary Pipeline

? In February of 2010, we announced that enrollment had begun in a 325-patient Phase 2b dose-ranging clinical trial of XOMA 052 in Type 2 diabetes patients. The clinical trials are designed to further evaluate the use of multiple dose regimens on the safety, pharmacodynamics and efficacy of XOMA 052 in cardiometabolic and other diseases, and based on positive results, to select doses for pivotal Phase 3 studies.

? In March of 2010, we announced the initiation of a Phase 2 clinical trial of XOMA 052 in Type 1 diabetes patients funded by the Juvenile Diabetes Research Foundation.

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? In April of 2010, we announced the issuance of two new U.S. patents, one covering methods of treating Type 2 diabetes with high affinity IL-1 beta antibodies and antibody fragments including XOMA 052, and one covering methods of treating IL-1 related inflammatory diseases including rheumatoid arthritis and osteoarthritis with XOMA 052 and other antibodies and antibody fragments with similar binding properties for human IL-1 beta.

Collaboration Revenue

? In the first quarter of 2010, we received a $1 million payment from Takeda for achieving a pre-established, pre-clinincal milestone under our collaboration agreement.

Financings

? In February of 2010, we completed an underwritten offering of 42 million units, with each unit consisting of one of our common shares and a warrant to purchase 0.45 of a common share, for gross proceeds of approximately $21 million.

? Also in February of 2010, the holders of the warrants issued in May and June of 2009 agreed to amend their warrants to remove the provisions that would have required a reduction of the warrant exercise price and an increase in the number of shares issuable on exercise of the warrants each time we sold common shares at a price less than the exercise price of such warrants (the "Eliminated Adjustment Provisions") and the exercise price of the warrants issued in May of 2009 was reduced from $1.02 per share to $0.001 per share and we made a $4.5 million payment to holders of the warrants issued in June of 2009. The exercise price of the warrants issued in June of 2009 remains unchanged at $1.30 per share. The holders of the warrants issued in May of 2009 subsequently exercised all their warrants, acquiring 5,882,353 common shares for an aggregate exercise price of $5,882.

? In the first quarter of 2010, we sold 8,940,225 common shares through Wm Smith & Co. ("Wm Smith"), under our At Market Issuance Sales Agreement dated July 14, 2009 (the "ATM Agreement"), for aggregate gross proceeds of $6.4 million.

Other

? In March of 2010, we received a Staff Determination letter from The NASDAQ Stock Market LLC ("NASDAQ") indicating that we have not regained compliance with the minimum $1.00 per share requirement for continued inclusion on The NASDAQ Global Market, pursuant to NASDAQ Listing Rule 5450(a)(1). As a result, our common shares would have been subject to delisting from The NASDAQ Global Market unless we requested a hearing before a NASDAQ Listing Qualifications Panel (the "Panel") to present our plan for regaining compliance, which we have done. The delisting of our common shares has therefore been stayed pending the issuance of the Panel's decision following the hearing.
Results of Operations

Revenues

Total revenues for the three months ended March 31, 2010, and 2009, were as
follows (in thousands):



Three Months Ended March 31,
2010 2009
License and collaborative fees $ 189 $ 27,700
Contract and other revenue 6,811 7,398
Royalties 202 4,606

Total revenues $ 7,202 $ 39,704



License and collaborative fee revenue includes fees and milestone payments related to the out-licensing of our products and technologies. The decrease in license and collaborative fee revenue for the three months ended March 31, 2010, as compared to the same period of 2009, was entirely due to $27.5 million in revenue recognized in the first quarter of 2009 related to the expansion of our collaboration agreement with Takeda to provide Takeda with access to multiple antibody technologies. The generation of future revenue related to license fees and other collaborative arrangements is dependent on our ability to attract new licensees to our antibody and bacterial cell expression technologies and new collaboration partners. Depending on whether and when we obtain new licensees and collaboration partners, we expect to experience a decline in these revenues for 2010 from 2009 levels.

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Contract and other revenue decreased by $0.6 million for the three months ended March 31, 2010, as compared to the same period of 2009. This revenue includes agreements where we provide contracted research and development and manufacturing services to our collaboration partners, including Takeda, Merck/Schering-Plough and NIAID. The decrease in contract and other revenue for the three months ended March 31, 2010 was primarily due to a decrease in revenue on our Merck/Schering-Plough contract of $2.1 million, as a result of the termination of certain programs in 2009, and a decrease in revenue on our Novartis contract of $2.1 million, due to the completion of work under this agreement in the third quarter of 2009.

These decreases were partially offset by increases in contract revenue related to work performed under our contract with NIAID Contract No. HHSN272200800028C ("NIAID 3") of $2.4 million. In addition, contract revenue from our collaboration with Takeda increased by $1.5 million in the first quarter of 2010, primarily related to a $1 million payment for achieving a pre-established, pre-clinical milestone under one of our discovery and development programs with Takeda. We also recognized the remaining unamortized balance of $1.1 million in deferred revenue pertaining to another discovery and development program with Takeda that was discontinued. These increases were partially offset by a decrease in other work performed under the Takeda collaboration.

Based on expected increases in revenue related to our NIAID 3 contract and our subcontract awards from SRI International, partially offset by decreases in contract revenue from other collaboration partners, we expect contract and other revenue in 2010 to remain comparable to 2009 levels or to slightly increase, depending on the timing and level of revenue generating activity.

Revenue from royalties decreased by $4.4 million for the three months ended March 31, 2010, compared to the same period of 2009, primarily due to the sale of our LUCENTIS? royalty interest to Genentech, Inc., a wholly-owned member of the Roche Group (referred to herein as "Genentech") in the third quarter of 2009. Royalties earned from sales of LUCENTIS? during the first quarter of 2009 were $2.4 million. Also contributing to the decrease in royalty revenue was the cessation of royalties earned from sales of RAPTIVA? in the second quarter of 2009. RAPTIVA? was withdrawn from the commercial drug markets in the first half of 2009. Royalties earned from sales of RAPTIVA? during the first quarter of 2009 were $2.2 million.

Royalties earned from sales of CIMZIA? were $0.2 million for the three months ended March 31, 2010. We receive royalties on U.S. sales of CIMZIA? for the treatment of Crohn's disease and on U.S. and Canadian sales of CIMZIA? for the treatment of moderate-to-severe rheumatoid arthritis in adults. Royalties earned from sales of CIMZIA? in the first quarter of 2009 were immaterial. We expect royalty revenue from sales of CIMZIA? to increase in 2010.

Research and Development Expenses

Biopharmaceutical development includes a series of steps, including in vitro and in vivo preclinical testing, and Phase 1, 2 and 3 clinical studies in humans. Each of these steps is typically more expensive than the previous step, but actual timing and the cost to us depends on the product being tested, the nature of the potential disease indication and the terms of any collaborative arrangements with other companies. After successful conclusion of all of these steps, regulatory filings for approval to market the products must be completed, including approval of manufacturing processes and facilities for the product. Our research and development expenses currently include costs of personnel, supplies, facilities and equipment, consultants, third party costs and other expenses related to preclinical and clinical testing.

Research and development expenses were $17.6 million for the three months ended March 31, 2010, compared with $16.5 million for the same period of 2009. The increase of $1.1 million for the three months ended March 31, 2010, as compared to the same period in 2009, was primarily due to increased spending on XOMA 052 related to the initiation of the Phase 2 clinical program. In addition, spending on NIAID 3 increased in the first quarter of 2010 due to increased activity under the contract. Partially offsetting these increases in spending were decreases in spending on Novartis-related contract activities, due to the completion of work under this agreement in the third quarter of 2009, and on Merck/Schering-Plough-related contract activities, due to the termination of certain programs in 2009.

Salaries and related personnel costs are a significant component of research and development expenses. We recorded $7.0 million in research and development salaries and employee-related expenses for the three months ended March 31, 2010, as compared with $7.6 million for the same period of 2009. The decrease of $0.6 million for the first quarter of 2010 was primarily due to a decrease in salaries and benefits of $0.6 million related to the workforce reduction in the first quarter of 2009. See Results of Operations: Share-Based Compensation for discussion of our share-based compensation expense.

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Our research and development activities can be divided into earlier stage programs and later stage programs. Earlier stage programs include molecular biology, process development, pilot-scale production and preclinical testing. Also included in earlier stage programs are costs related to excess manufacturing capacity, which we expect will decrease in 2010 due to the consolidation of facilities. Later stage programs include clinical testing, regulatory affairs and manufacturing clinical supplies. The costs associated with these programs approximate the following (in thousands):
Three Months Ended March 31,
2010 2009
Earlier stage programs $ 11,174 $ 12,603
Later stage programs 6,413 3,918

Total $ 17,587 $ 16,521



Our research and development activities can also be divided into those related to our internal projects and those projects related to collaborative and contract arrangements. The costs related to internal projects versus collaborative and contract arrangements approximate the following (in thousands):
Three Months Ended March 31,
2010 2009
Internal projects $ 13,686 $ 9,084
Collaborative and contract arrangements 3,901 7,437

Total $ 17,587 $ 16,521



For the three months ended March 31, 2010, our largest development program (XOMA 052) accounted for more than 30% but less than 40% of our total research and development expense, and one other development program (NIAID) accounted for more than 10% but less than 20% of our total research and development expense. All remaining development programs accounted for less than 10% of our total research and development expense for the three months ended March 31, 2010. For the three months ended March 31, 2009, our largest development program (XOMA 052) accounted for more than 20% but less than 30%, and two other development programs (NIAID and Novartis) each accounted for more than 10% but less than 20% of our total research and development expenses.

We expect our research and development spending in 2010 will increase due to the initiation of our Phase 2 clinical program for XOMA 052 in Type 2 diabetes and cardiovascular disease and in support of our biodefense contracts. We continue ongoing discussions with a number of companies for a corporate partnership to develop and commercialize XOMA 052.

Future research and development spending may be impacted by potential new licensing or collaboration arrangements, as well as the termination of existing agreements. Beyond this, the scope and magnitude of future research and development expenses are difficult to predict at this time.

Selling, General and Administrative Expenses

Selling, general and administrative expenses include salaries and related personnel costs, facilities costs and professional fees. Selling, general and administrative expenses were $5.6 million for the three months ended March 31, 2010, compared with $6.1 million for the same period of 2009. The $0.5 million decrease for the first quarter of 2010, as compared to the same period of 2009, relates to a decrease in salaries and related personnel costs of $0.2 million, primarily related to the workforce reduction in the first quarter of 2009, and other decreases due to our continued focus on cost control.

Restructuring Charges

On January 15, 2009, we announced a workforce reduction of approximately 42%. As part of this workforce reduction, we recorded a charge of $3.3 million related to severance, other termination benefits and outplacement services, which were fully paid in 2009. We do not expect to incur any additional employee-related restructuring charges in connection with this workforce reduction.

As a result of the workforce reduction, we temporarily vacated a building in order to optimize our facility usage. As manufacturing demand increases in the future, we plan to resume operations at this facility. As of March 31, 2010, we performed an analysis of the long-lived assets related to the vacant building, with an approximate net book value of $4.0 million. Based on estimated undiscounted future cash inflows, we have determined that there is no current impairment relating to these assets, and will continue to assess these assets for impairment at each future reporting period.

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Other Income (Expense)

Interest expense was $0.1 million and $1.8 million for the three months ended March 31, 2010 and 2009, respectively. The decrease in interest expense of $1.7 million for the three months ended March 31, 2010, as compared to the same period of 2009, was primarily due to the repayment in full of the term loan facility with Goldman Sachs Specialty Lending Holdings, Inc. ("Goldman Sachs") in September of 2009.

Other income (expense) was ($5.8 million) and $3,000 for the three months ended March 31, 2010 and 2009, respectively. The increase in other expense in 2010 primarily related to $4.5 million paid in the first quarter of 2010 to the holders of warrants issued in June of 2009, upon modification of the terms. In addition, other expense includes losses of $1.3 million recognized relating to the revaluation of our warrant liabilities during the period. See Results of Operations: Warrant Liabilities below for additional disclosure.

Warrant Liabilities

In February of 2010, we issued warrants to purchase XOMA's common shares in connection with an underwritten offering, as further discussed below in Liquidity and Capital Resources: Underwritten Offering. We have accounted for the warrants issued in February of 2010 as a liability at fair value as further discussed below in Critical Accounting Estimates: Warrant Liabilities. The fair value of the warrant liability at issuance date was estimated using the Black-Scholes Option Pricing Model (the "Black-Scholes Model") and we recorded a warrant liability of $4.4 million. We revalued the warrant liability at March 31, 2010 and recorded an increase in the fair value of the warrant liability of $2.0 million in other income (expense) in our condensed consolidated statement of operations.

In May of 2009, we issued warrants to an institutional investor as part of a registered direct offering. The warrants represented the right to acquire an aggregate of up to 5,882,353 common shares over a five year period beginning May 15, 2009 at an exercise price of $1.02 per share. In February of 2010, the holders of these warrants agreed to amend the terms of their warrants to remove the Eliminated Adjustment Provisions and the exercise price of these warrants was reduced from $1.02 per share to $0.001 per share.

Prior to amendment, we recorded the warrants issued in May of 2009 as a liability at fair value due to the Eliminated Adjustment Provisions and certain other provisions as further discussed below in Critical Accounting Estimates:
Warrant Liabilities, which was estimated using the Monte Carlo Simulation Model ("Simulation Model"). The fair value of the warrant liability was $2.9 million on February 1, 2010, prior to amendment of the warrants, resulting in an increase in the fair value of the warrant liability of $0.5 million which we recorded in other income (expense). Subsequent to amendment of the warrant terms, on February 2, 2010, the fair value of the warrant liability using the Black-Scholes Model was $2.6 million, resulting in a decrease in the fair value of the warrant liability of $0.3 million which we recorded in other income (expense). The holders of these warrants subsequently exercised all their warrants, acquiring 5,882,353 common shares for an aggregate exercise price of $5,882. As of March 31, 2010, none of the warrants issued in May of 2009 remained outstanding and the related liability was fully extinguished and reclassified to additional paid-in capital.

In June of 2009, we issued warrants to certain institutional investors as part of a separate registered direct offering. The warrants represent the right to acquire an aggregate of up to 5,217,391 common shares over a five year period beginning December 11, 2009 at an exercise price of $1.30 per share. In February of 2010, the holders of these warrants agreed to amend the terms of their warrants to remove the Eliminated Adjustment Provisions and we made a cash payment of $4.5 million to these warrant holders, which was recorded in other income (expense). The exercise price of these warrants remained unchanged at $1.30 per share.

Prior to amendment, we recorded the warrants issued in June of 2009 as a liability at fair value due to the Eliminated Adjustment Provisions and certain other provisions as further discussed below in Critical Accounting Estimates:
Warrant Liabilities, which was estimated using the Simulation Model. The fair value of the warrant liability was $3.3 million on February 1, 2010, prior to amendment of the warrants, resulting in an increase in the fair value of the warrant liability of $0.9 million which we recorded in other income (expense). We revalued the warrants at March 31, 2010 using the Black-Scholes Model and recorded a decrease in the fair value of the warrant liability of $1.9 million in other income (expense).

Income Taxes

No income tax expense was recognized for the three months ended March 31, 2010. We recognized $5.8 million in foreign income tax expense for the three months ended March 31, 2009, in connection with the expansion in February of 2009 of our existing collaboration with Takeda. We were paid a $29 million expansion fee, of which $5.8 million was withheld for payment to the Japanese taxing authority.

Accounting Standards Codification Topic 740, Income Taxes ("ASC 740") provides for the recognition of deferred tax assets if realization of such assets is more likely than not. Based upon the weight of available evidence, which includes our historical operating performance and carry-back potential, we have determined that total deferred tax assets should be fully offset by a valuation allowance.

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We did not have unrecognized tax benefits as of March 31, 2010 and do not expect this to change significantly over the next twelve months. In accordance with ASC 740, we will recognize interest and penalties accrued on any unrecognized tax benefits as a component of income tax expense. As of March 31, 2010, we have not accrued interest or penalties related to uncertain tax positions.

Share-Based Compensation

In March of 2010, our Board of Directors approved a company-wide grant of an aggregate of 12,987,100 share options. This grant included 12,840,100 options that were issued as part of our annual incentive compensation review, of which 8,950,000 options were granted subject to shareholder approval of an increase in the number of shares available under our existing share option plans. These options are not included in the options outstanding or granted disclosures or in share-based compensation expense as they are not deemed granted for accounting purposes until the foregoing shareholder approval is obtained. We will record a cumulative adjustment for share-based compensation expense based on the fair value of these options at the date of approval. The options granted as part of this annual incentive compensation review will vest monthly over four years.

For the three months ended March 31, 2010, we recognized $1.0 million in share-based compensation expense, compared with the same amount for the first quarter of 2009. As of March 31, 2010, there was $6.8 million of unrecognized share-based compensation expense related to unvested share options with a weighted average remaining recognition period of 2.7 years.

Liquidity and Capital Resources

Cash and cash equivalents at March 31, 2010 were $28.4 million compared with $23.9 million at December 31, 2009. Net cash used in operating activities was $16.4 million for the three months ended March 31, 2010, compared with net cash provided by operations of $15.3 million for the same period in 2009. The decrease in cash provided by operations for the three months ended March 31, 2010, as compared to same period of 2009, was primarily due to a decrease in revenue receipts for license and collaborative fees and royalties. In the first quarter of 2009, we received $23.2 million related to the expansion of our existing collaboration with Takeda, and recognized royalty revenue from sales of LUCENTIS?and RAPTIVA? of $4.6 million.

In addition, in the first quarter of 2010, net accounts payable and accrued liabilities decreased by $1.3 million primarily related to the payment in the period of employee bonuses for 2009, and deferred revenue decreased by $1.6 million primarily due to the accelerated recognition of the remaining $1.1 million of the unamortized balance in deferred revenue pertaining to a discontinued discovery and development program under our collaboration with Takeda. . . .