S-1/A 1 ds1a.htm AMENDMENT NO. 18 TO FORM S-1 Amendment No. 18 to Form S-1
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As filed with the Securities and Exchange Commission on February 25, 2011

Registration No. 333-148151

 

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

Amendment No. 18

to

FORM S-1

REGISTRATION STATEMENT

Under

The Securities Act of 1933

 

 

Prometheus RxDx Corp.

(Exact name of Registrant as

specified in its charter)

 

 

 

Delaware

  2834   27-1519134

(State or other jurisdiction of

incorporation or organization)

 

(Primary Standard Industrial

Classification Code Number)

 

(I.R.S. Employer

Identification Number)

9410 Carroll Park Drive

San Diego, CA 92121

(858) 824-0895

(Address, including zip code, and telephone number, including area code, of Registrant’s principal executive offices)

 

 

Joseph M. Limber

President and Chief Executive Officer

Prometheus RxDx Corp.

9410 Carroll Park Drive San Diego, CA 92121

(858) 824-0895

(Name, address, including zip code, and telephone number, including area code, of agent for service)

 

 

Copies to:

 

Michael W. Hall, Esq.

Cheston J. Larson, Esq.

Michael E. Sullivan, Esq.

Latham & Watkins LLP

12636 High Bluff Drive, Suite 400

San Diego, CA 92130

(858) 523-5400

 

William Franzblau, Esq.

Vice President, Legal Affairs

Prometheus RxDx Corp.

9410 Carroll Park Drive

San Diego, CA 92121

(858) 824-0895

 

Mark K. Hyland, Esq.

Shearman & Sterling LLP

525 Market Street

San Francisco, CA 94105

(415) 616-1100

 

 

Approximate date of commencement of proposed sale to the public: As soon as practicable after the effective date of this Registration Statement.

If any of the securities being registered on this Form are to be offered on a delayed or continuous basis pursuant to Rule 415 under the Securities Act of 1933, check the following box.  ¨

If this Form is filed to register additional securities for an offering pursuant to Rule 462(b) under the Securities Act, please check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(c) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

If this Form is a post-effective amendment filed pursuant to Rule 462(d) under the Securities Act, check the following box and list the Securities Act registration statement number of the earlier effective registration statement for the same offering.  ¨

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

 

Large accelerated filer ¨    Accelerated filer ¨
Non-accelerated filer x (Do not check if a smaller reporting company)    Smaller reporting company ¨

The Registrant hereby amends this Registration Statement on such date or dates as may be necessary to delay its effective date until the Registrant shall file a further amendment which specifically states that this Registration Statement shall thereafter become effective in accordance with Section 8(a) of the Securities Act of 1933 or until the Registration Statement shall become effective on such date as the Commission, acting pursuant to said Section 8(a), may determine.

 

 

 


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The information in this preliminary prospectus is not complete and may be changed. These securities may not be sold until the registration statement filed with the Securities and Exchange Commission is effective. This preliminary prospectus is not an offer to sell nor does it seek an offer to buy these securities in any jurisdiction where the offer or sale is not permitted.

 

Subject to Completion. Dated February 25, 2011.

             Shares

LOGO

Prometheus RxDx Corp.

Common Stock

 

 

This is an initial public offering of shares of common stock of Prometheus RxDx Corp.

Prometheus is offering              shares to be sold in the offering. The selling stockholders identified in this prospectus are offering an additional              shares. Prometheus will not receive any of the proceeds from the sale of the shares being sold by the selling stockholders.

Prior to this offering, there has been no public market for the common stock. It is currently estimated that the initial public offering price per share will be between $             and $            . Application has been made for the listing of the common stock on the Nasdaq Global Select Market under the symbol “RXDX.”

See “Risk Factors” on page 13 to read about factors you should consider before buying shares of the common stock.

 

 

Neither the Securities and Exchange Commission nor any other regulatory body has approved or disapproved of these securities or passed upon the accuracy or adequacy of this prospectus. Any representation to the contrary is a criminal offense.

 

 

 

     Per Share      Total  

Initial public offering price

   $                    $                

Underwriting discount

   $                    $                

Proceeds, before expenses, to Prometheus

   $                    $                

Proceeds, before expenses, to the selling stockholders

   $                    $                

To the extent that the underwriters sell more than              shares of common stock, the underwriters have the option to purchase up to an additional              shares from Prometheus at the initial public offering price less the underwriting discount.

 

 

The underwriters expect to deliver the shares against payment in New York, New York on                     , 2011.

 

Goldman, Sachs & Co.    Credit Suisse

 

SunTrust Robinson Humphrey

   Cowen and Company    Wedbush PacGrow Life Sciences

 

 

Prospectus dated                     , 2011.


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TABLE OF CONTENTS

Prospectus

 

     Page  

Prospectus Summary

     1   

The Offering

     8   

Summary Financial Data

     11   

Risk Factors

     13   

Special Note Regarding Forward-Looking Statements

     50   

Use of Proceeds

     52   

Dividend Policy

     52   

Capitalization

     53   

Dilution

     55   

Selected Financial Data

     57   

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     59   

Business

     83   

Management

     125   

Compensation Discussion and Analysis

     131   

Executive Compensation

     141   

Principal and Selling Stockholders

     156   

Certain Relationships and Related Party Transactions

     160   

Description of Capital Stock

     164   

Shares Eligible for Future Sale

     168   

Material U.S. Federal Income Tax Considerations to Non-U.S. Holders

     171   

Underwriting

     174   

Notice to Canadian Residents

     182   

Legal Matters

     183   

Experts

     183   

Where You Can Find Additional Information

     183   

Index to Consolidated Financial Statements

     F-1   

 

 

Through and including                     , 2011 (the 25th day after the date of this prospectus), all dealers effecting transactions in these securities, whether or not participating in this offering, may be required to deliver a prospectus. This is in addition to a dealer’s obligation to deliver a prospectus when acting as an underwriter and with respect to an unsold allotment or subscription.

 

 

We have not authorized anyone to provide any information or to make any representations other than those contained in this prospectus or in any free writing prospectuses we have prepared. We take no responsibility for, and can provide no assurance as to the reliability of, any other information that others may give you. This prospectus is an offer to sell only the shares offered hereby, but only under circumstances and in jurisdictions where it is lawful to do so. The information contained in this prospectus is current only as of its date.

 

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PROSPECTUS SUMMARY

This summary does not contain all of the information you should consider before buying shares of our common stock. You should carefully read the entire prospectus, including the consolidated financial statements of Prometheus Laboratories Inc. and the related notes included in this prospectus and the information set forth under the headings “Risk Factors” and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” before deciding to invest in shares of our common stock. Unless the context requires otherwise, references in this prospectus to “Prometheus,” “we,” “us” and “our” refer to Prometheus RxDx Corp. and its subsidiaries, including Prometheus Laboratories Inc., and references to “diagnostic tests” or “diagnostic testing” refer to laboratory tests developed by us and laboratory tests developed by third parties and acquired by us that have either been cleared for use by the U.S. Food and Drug Administration, or FDA, or that we have validated for such use. Unless otherwise indicated, the information contained in this prospectus assumes the completion of the IPO reorganization as described below.

Prometheus RxDx Corp.

Business Overview

Prometheus is committed to improving lives through the development and commercialization of novel pharmaceutical and diagnostic products that enable physicians to provide greater individualized patient care. We are primarily focused on the detection, diagnosis and treatment of disorders within the fields of gastroenterology and oncology. Our strategy includes the marketing and promotion of pharmaceutical products and complementary proprietary diagnostic testing services. By integrating therapeutics and diagnostics, we believe we can provide physicians with more targeted solutions to optimize care for their patients.

We believe our business model of offering pharmaceuticals combined with our diagnostic testing services differentiates us from other pharmaceutical, specialty pharmaceutical and diagnostic companies, and provides our sales force greater access to physicians. Leveraging this model, we believe we have established ourselves as a leader in the gastroenterology market, where our sales force, including approximately 125 sales representatives, sales managers and regional field trainers, has significant experience and technical knowledge of the market. The length of our average sales call with physicians was approximately 11 minutes in 2010, which we believe to be longer than the industry average. We principally market our gastroenterology pharmaceutical and diagnostic products and services to the approximately 12,000 gastroenterologists in the United States, of whom approximately 83% prescribed our ENTOCORT® EC (budesonide) Capsules, LOTRONEX® (alosetron hydrochloride) Tablets or ordered at least one of our diagnostic testing services during 2010. We believe our sales success, access to physicians and proprietary diagnostic testing services may also provide us with an advantage in gaining access to or acquiring additional pharmaceutical and diagnostic products.

We are also applying our integrated therapeutics and diagnostics business model to the field of oncology. In December 2009, we acquired exclusive rights from Novartis Vaccines and Diagnostics, Inc., or Novartis, to distribute, promote and sell PROLEUKIN® (aldesleukin) for injection in the United States for the treatment of adults with metastatic renal cell carcinoma and metastatic melanoma. We began selling Proleukin in February 2010. Net sales of Proleukin were approximately $64 million in the United States for the eleven months that we distributed the product in 2010. We have established a separate oncology sales force which includes approximately 45 sales representatives, sales managers and regional field trainers located throughout the United States. We have also developed a proprietary oncology platform, known as CEER, to help individualize oncology targeted therapies for cancer patients. We believe this technology will address an unmet need to guide the use of currently marketed and future oncology therapies, by enabling oncologists to better predict and monitor drug effectiveness in inhibiting specific disease pathways, which are believed to play a role in cancer progression.

We currently operate under two business segments: (1) the pharmaceutical products segment that markets and sells prescription drugs, and (2) the diagnostic testing services segment. Our total revenues have grown from

 

 

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$187.4 million in 2006 to $519.0 million in 2010, representing a compounded annual growth rate, or CAGR, of 29.0%. During this same period, our net sales of pharmaceutical products grew from $119.1 million to $434.7 million, representing a CAGR of 38.2%, and our aggregate net sales of diagnostic testing services grew from $68.3 million to $81.3 million, representing a CAGR of 4.5%. The overall growth since 2006 in our pharmaceutical and diagnostic segments is due principally to the addition of Entocort EC in 2005, the addition of Lotronex beginning in November 2007, the addition of Proleukin beginning in February 2010 and the introduction of new or improved diagnostic testing services. Collaboration and other revenues of $3.0 million in 2010 were primarily due to the recognition of revenue from the upfront payment and ongoing research services provided in connection with a collaboration agreement with Bayer Schering Pharma AG of approximately $2.8 million. For the year ended 2006, we had net income of $32.2 million. Our net income increased to $48.2 million for the year ended 2010. This growth in net income is due primarily to the growth in aggregate net sales as well as management of our overall operating expenditures.

We expect to continue to grow through increased sales of our existing pharmaceutical products and diagnostic testing services, the development, licensing and acquisition of additional pharmaceuticals and diagnostic testing services, and additional collaborations leveraging our CEER oncology diagnostic platform. As we grow, we also expect to expand into additional areas that are consistent with our business model of offering pharmaceuticals complemented by proprietary diagnostics.

Gastroenterology Pharmaceutical Products

We market and promote Entocort EC, a glucocorticosteroid, which is currently the only FDA-approved drug indicated for the induction and maintenance of clinical remission in mild to moderate active Crohn’s disease involving the ileum and/or the ascending colon. Crohn’s disease is a chronic disorder that causes inflammation of the digestive or gastrointestinal tract. In January 2005, our sales force began promoting Entocort EC in the United States under an exclusive distribution agreement with AstraZeneca LP, or AstraZeneca, that expires December 31, 2011. Entocort EC is designed to release primarily in the ileum and/or the ascending colon, so that as little as 10% of the drug enters systemic circulation. Entocort EC can benefit patients by reducing the frequency of glucocorticosteroid-related side effects, such as acne and puffiness of the face, as compared to those patients taking prednisolone. Entocort EC prescriptions have increased approximately 114% between 2004, the year before we began selling the product, and 2010. In 2010, net sales from Entocort EC were $316.5 million, an increase of approximately 55.2% from 2009 net sales of $203.9 million and 117.9% from 2008 net sales of $145.0 million.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. Lotronex is the only prescription drug approved by the FDA for use in female patients with severe diarrhea-predominant irritable bowel syndrome, or IBS, who have chronic IBS symptoms, have had abnormalities of the gastrointestinal tract excluded and have not responded adequately to conventional therapy. Prior to our acquisition of Lotronex, GlaxoSmithKline voluntarily withdrew Lotronex from the market in 2000. The FDA approved a supplemental New Drug Application for Lotronex in 2002 with a more limited indication and it was subsequently re-introduced to the market. In order to reduce the potential for harmful side effects of Lotronex, the drug is subject to a special prescribing program designed to ensure that only doctors who have enrolled in the Prescribing Program for Lotronex write prescriptions for the drug. In connection with their enrollment into the prescribing program, the physicians must have an understanding of IBS and be familiar with the side effects and risks of Lotronex. New data from a study of 29,072 patients who received 203,939 prescriptions showed the incidence of serious outcomes has remained rare and stable since the reintroduction of Lotronex under the prescribing program and cases are typically of short duration that resolve upon withdrawal of treatment. The data were published in the April 2010 issue of The American Journal of Gastroenterology. In 2010, net sales of Lotronex were $34.8 million, an increase of approximately 14.5% from 2009 net sales of $30.4 million.

We also sell but do not promote a number of other branded drugs, including Imuran® for use as an adjunct for the prevention of rejection in kidney transplantation and the management of active rheumatoid arthritis,

 

 

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Helidac® Therapy for use together with an H2 antagonist for the eradication of Helicobacter pylori bacteria, the leading cause of peptic ulcers, and Ridaura® for the management of rheumatoid arthritis for patients who have not responded adequately to one or more non-steroidal anti-inflammatory drugs. Through a third-party distributor, we also sell a generic formulation of mercaptopurine, which is approved as a maintenance therapy for acute lymphatic leukemia as part of a combination regimen. Although not approved or promoted for gastrointestinal diseases, Imuran and mercaptopurine are often prescribed by physicians for such use. Our aggregate net sales from our non-promoted pharmaceutical products were $19.4 million in 2010, a decrease from net sales of $25.8 million and $22.5 million in 2008 and 2009, respectively.

Gastroenterology Diagnostic Testing Services

Our diagnostic testing services include specific immunoassays to detect and differentiate diseases, pharmacogenetic testing and drug metabolite monitoring. Our tests can help physicians to detect and differentiate IBD from other bowel disorders and differentiate Crohn’s disease from ulcerative colitis, the two main types of IBD, and differentiate a patient’s future risks of complications from Crohn’s disease. In addition, we offer tests that assist physicians in using and monitoring thiopurine drugs and the detection, diagnosis or treatment of celiac disease, lactose intolerance and other related disorders. We currently perform all gastroenterology diagnostic testing services in our laboratory located in San Diego, California, which is certified for highly-complex testing under the Clinical Laboratory Improvement Amendments of 1988, or CLIA.

We believe our PROMETHEUS® IBD Serology 7 is the most comprehensive IBD diagnostic testing service available to help physicians detect and differentiate IBD from other disorders that have similar symptoms such as IBS, celiac disease and lactose intolerance. In addition, this product helps physicians differentiate Crohn’s disease from ulcerative colitis with an overall predictive accuracy of 76% based on validation studies. IBD Serology 7 includes seven tests, three of which are proprietary, and a proprietary algorithm. While there are other laboratories offering IBD tests, we do not believe they are as comprehensive as our IBD Serology 7 product. We provide a diagnostic prediction on every test and prognostic information that may help guide treatment decisions.

In the third quarter of 2010, we launched our PROMETHEUS® Crohn’s Prognostic, the first and only serogenetic prognostic test for Crohn’s disease. This test combines six serologic markers and three genetic mutation markers to provide a personalized serogenetic profile that quantifies a patient’s risk of developing disease complications over time. Quantifying risk of complications may assist physicians in optimizing treatment strategies for Crohn’s patients.

Our tests for thiopurine management provide information that helps physicians better manage therapeutic treatment, achieve better clinical outcomes and lower the potential for toxicity when prescribing thiopurine drugs, including azathioprine and mercaptopurine. As with many drugs, the effectiveness and side effects associated with thiopurines vary from person to person due to each person’s ability to metabolize or process thiopurines. For most, metabolizing thiopurines does not pose any health risk; however, a very small percentage of patients, approximately 0.3%, have almost no ability to metabolize these drugs. Failure to metabolize thiopurines can lead to drug accumulation in the body and result in liver toxicity and potentially death.

We offer three celiac diagnostic tests to physicians, including antibody tests, a celiac genetics test and a panel that combines both the antibody and genetic tests. Celiac disease is an autoimmune digestive disorder that damages the small intestine, interfering with the absorption of nutrients. We believe our Celiac Serology, a panel of celiac antibody tests, is one of the few five-analyte serology panels currently being offered. It is designed to help physicians make a more accurate diagnosis. Celiac Genetics, our genetics test, is the only test that provides risk stratification to identify the relative risk of developing celiac disease for those patients that test positive and also aids in lifelong celiac disease rule-out for those that do not carry the genes. Both the serology and genetics tests are also offered together in our Celiac PLUS test panel. In June 2009, we began offering MyCeliacID, a saliva-based, do it yourself genetic test based on the same technology as our Celiac Genetics test. MyCeliacID is available online. After a request is made online, a licensed physician orders the test and reviews the laboratory results prior to release to the patient.

 

 

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Oncology Pharmaceutical Products

In December 2009, we acquired exclusive rights from Novartis to distribute, promote and sell Proleukin in the United States for the treatment of adults with metastatic renal cell carcinoma and metastatic melanoma. In addition, we have an option to amend this distribution and promotion agreement to include the rest of the world upon meeting certain preconditions demonstrating our ability to distribute Proleukin in specified countries.

Proleukin is a recombinant human interleukin-2 for treatment in adults with metastatic melanoma and metastatic renal cell carcinoma. Proleukin therapy is a form of immunotherapy that uses the body’s natural immune system to fight cancer. Proleukin has been used for more than ten years in the treatment of metastatic melanoma, the most aggressive type of skin cancer, and more than 15 years in the treatment of metastatic renal cell carcinoma, the most common type of kidney cancer in adults. Studies have demonstrated that Proleukin therapy offers the possibility of a complete and long-lasting response in these diseases in a small percentage of patients.

Data from an independent, multicenter trial presented at the 2010 American Society of Clinical Oncology (ASCO) Genitourinary Cancers Symposium in March 2010 demonstrated that the overall response rate, which includes patients who have a complete or partial response to the treatment, for high-dose Proleukin in patients with metastatic renal cell carcinoma (28%) was significantly better than the historical overall response rate (14%).

Net sales for Proleukin were approximately $75.0 million in the United States in 2009. We began selling Proleukin in February 2010. Our net sales of Proleukin were approximately $64.0 million for the eleven months that we distributed the product in 2010.

Oncology Diagnostic Testing Services

We are developing diagnostic tests that may be used in conjunction with certain cancer therapies using our proprietary CEER platform. We expect that these diagnostics will be aimed at selecting and evaluating the efficacy of drugs both during their development and following approval during their use in the treatment of cancer. Specifically, we believe our technology may enable oncologists to monitor drug effectiveness in inhibiting specific disease pathways that are believed to play a role in cancer progression. To date, we have demonstrated that our technology can successfully detect the activation of certain key cancer pathways. We are conducting clinical studies with an initial focus on metastatic breast cancer and received New York State approval in October 2009 for our initial assay.

In March 2010, we entered into a non-exclusive collaboration with Bayer Schering Pharma AG, or Bayer, pursuant to which we will use our CEER platform to develop tests specifically tailored to oncology pharmaceutical compounds Bayer has under development. In December 2010, we also entered into a mutation analysis services agreement with Bayer. We believe the expanded information derived from this agreement has the potential to improve patient stratification in clinical studies and accelerate the development of novel diagnostic and therapeutic products.

In addition, we have entered into several small agreements with other large pharmaceutical companies which will utilize our CEER platform.

Our Competitive Strengths

We believe that we bring the following competitive advantages or strengths to the markets and customers we serve:

 

   

Differentiated, Physician-Focused Business Model - Our business model of offering pharmaceutical products combined with complementary diagnostic testing services differentiates us from most other pharmaceutical, specialty pharmaceutical and diagnostic companies. We believe it creates a different value proposition for the physician as compared to a traditional pharmaceutical sales call.

 

 

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A Leader in Commercializing Diagnostic Technologies - We believe we are a technological leader in helping to develop and commercialize diagnostic testing services. Since 2000, we have developed and commercialized 20 new diagnostic products designed to help gastroenterologists and believe we are well positioned to maintain and build a leading position in developing or acquiring access to new technologies related to gastroenterology and oncology, respectively.

 

   

Highly-Trained and Effective Sales Force - Unlike many pharmaceutical sales forces that are trained only to understand the mechanism of action, side effects and comparative benefits of the pharmaceutical products they market, our sales representatives are also trained to understand how our diagnostic testing services relate to diseases. We believe this creates a more collaborative and science-based interaction with physicians resulting in longer sales calls with, and greater access to, physicians.

 

   

Facilitating a More Individualized Approach to Patient Care - Individual patients may respond differently to medications and the same disease can vary significantly from patient to patient. Our diagnostic tests identify individual patient and disease differences at a molecular or genetic level, including tests for measuring or identifying variations in genes, proteins or metabolites. These diagnostics, in conjunction with a patient’s symptoms, medical history, lifestyle and other health conditions, allow physicians to more effectively tailor treatment to the individual patient. We believe our science-based approach enables more individualized patient care and can help physicians determine the optimal management and treatment of challenging diseases.

 

   

Management Team with Proven Track Record - Our senior management has an average of over 20 years experience in the healthcare industry. Under our current management, we have built a strong financial foundation. We believe our strong financial condition, coupled with the experience and proven track record of our senior management team, positions us well to capitalize on additional opportunities. In addition, our team has executed our product acquisition and in-licensing strategy by acquiring rights to Entocort EC, Lotronex, and Proleukin as well as entering into our collaboration with Bayer utilizing our proprietary CEER platform within the last six years.

Our Strategy for Growth

Our strategy for growth is focused on leveraging our differentiated business model to acquire, develop and commercialize proprietary pharmaceutical products and complementary highly complex diagnostic testing services in the United States. We intend to leverage our sales force and the relationships our sales force have created with physicians to market and sell these additional products and services. In addition to capitalizing on our current strengths, we intend to pursue growth by:

 

   

expanding our access to marketed proprietary pharmaceutical products or products in later-stage development through acquisitions, licensing or distribution agreements, co-promotion or co-marketing agreements or strategic mergers or acquisitions;

 

   

adding diagnostic testing services and new technologies through collaborations, internal development programs, in-licensing or acquisitions that complement our products and sales strategy;

 

   

increasing the market penetration of our existing products and services through product enhancements, targeted promotion and by educating physicians and payors as to the clinical and cost benefits of our products and services; and

 

   

carefully expanding into additional therapeutic areas that are consistent with our business model.

While our focus has been on gastroenterology products and diagnostic services in the United States, we are expanding into oncology and may carefully expand into other therapeutic areas as well. We may also consider expanding therapeutics and diagnostics services outside the United States in the future.

 

 

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Risk Factors

Our business and our ability to execute on our business strategy are subject to a number of risks that you should be aware of before you decide to buy our common stock. In particular, you should consider the following risks, which are discussed more fully in “Risk Factors” beginning on page 13:

 

   

Our revenues and financial results depend significantly on a limited product line, including our leading pharmaceutical product, Entocort EC, Lotronex, and Proleukin, and our three leading diagnostic product groups, IBD Serology 7, thiopurine management and celiac tests. Factors adversely affecting the pricing of, or demand for, these products would have a material adverse effect on our business.

 

   

Unless our distribution agreement with AstraZeneca is renewed or extended, we will lose all rights to market and sell Entocort EC at the end of 2011 or earlier if a generic equivalent is sold in the United States, and we do not currently expect such agreement to be renewed or extended. Entocort EC accounted for approximately 61% of our net sales for the year ended December 31, 2010.

 

   

In May 2010, AstraZeneca granted Teva Pharmaceutical Industries Ltd., or Teva, a license to market Teva’s generic version of Entocort EC in the United States beginning on February 15, 2012 (or earlier in certain circumstances), subject to regulatory approval. If a generic version of Entocort EC is launched while we have the right to distribute and market Entocort EC, it could adversely affect our ability to successfully execute our business strategy to maximize the value of Entocort EC and would likely negatively impact our financial condition and results of operations.

 

   

We may be unable to successfully integrate and commercialize Proleukin as planned and we may be unable to maintain a supply of Proleukin to meet market demand after our existing inventory of the product is sold or expires.

 

   

The inability to expand our business through strategic product, technology or company acquisitions or licenses, or the inability to integrate new products or technologies, may cause our competitive position in the specialty pharmaceutical and diagnostic industries to suffer.

 

   

Our future growth depends, in part, on our ability to develop proprietary diagnostic products and our ability to commercialize any of the products we develop, and these development or commercialization efforts may fail.

 

   

Continuing and increased regulation by the Department of Health and Human Services, including the FDA and the Centers for Medicare and Medicaid Services, or other government regulatory bodies regulating drugs and laboratory-developed tests, analyte-specific reagents or genetic testing could lead to increased costs and delays in introducing new products and may subject our currently available products to increased regulatory scrutiny, which may result in increased costs or withdrawal from the market.

 

   

If we lose or are unable to secure collaborators or partners, or if our collaborators or partners do not apply adequate resources to their relationships with us, our product development and potential for profitability will suffer.

Corporate Information

We are a Delaware corporation that was incorporated in June 2009 and currently a wholly owned subsidiary of Prometheus Laboratories Inc., which was incorporated in California in December 1995. We were formed to implement a holding company structure as a result of which we will become a holding company for Prometheus Laboratories Inc. after the completion of the IPO reorganization, as more fully described below. Our principal executive offices are located at 9410 Carroll Park Drive, San Diego, California 92121, and our telephone number is (858) 824-0895. Our website address is http://www.prometheusrxdx.com. The information on, or accessible through, our website is not part of this prospectus.

 

 

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Trademarks and Trade Names

We own or have rights to use certain trademarks or trade names in conjunction with the operation of our business including, without limitation, ENTOCORT®, LOTRONEX®, the Lotronex design mark, the Prescribing Program for Lotronex, PROLEUKIN®, PROLEUKIN and the swirl design, Helidac®, Imuran®, PROMETHEUS®, Ridaura®, Trandate®, Zyloprim®, LactoTYPE®, FIBROSpect®, BreathTek®, MyCeliacID, “for the person in every patient®,” “practice to practice®,” “get help going where you want to go with Lotronex,” “help your patients get where they want to go with Lotronex,” “From information to insight®,” CEER, the MyCeliacID design mark and our interlink logo design.

 

 

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THE OFFERING

Common stock offered by us

             shares (or              shares, if the underwriters exercise their option to purchase              additional shares in full)

 

Common stock offered by the selling stockholders

             shares

 

Total offering

             shares (or              shares, if the underwriters exercise their option to purchase              additional shares in full)

 

Common stock to be outstanding after the offering

             shares (or              shares, if the underwriters exercise their option to purchase              additional shares in full)

 

Proposed Nasdaq Global Select Market symbol

RXDX

 

Use of proceeds

As described in “Use of Proceeds,” we intend to use the net proceeds of this offering for working capital purposes and for other general corporate purposes, including to finance in-licensing and acquisition opportunities, research and development for new products, sales and marketing activities and capital expenditures. We will not receive any proceeds from the sale of shares by the selling stockholders.

 

Conflicts of interest

As described in “Use of Proceeds,” some of the net proceeds of this offering will be used to pay down borrowings under our credit agreement. Because more than 5% of the proceeds of this offering, not including underwriting compensation, will be received by SunTrust Robinson Humphrey, Inc., or SunTrust, and/or its affiliates in this offering, this offering is being conducted in compliance with NASD Rule 2720, as administered by the Financial Industry Regulatory Authority. Pursuant to that rule, the appointment of a qualified independent underwriter is not necessary in connection with this offering because SunTrust is not among the underwriters primarily responsible for managing this offering.

 

Dividend policy

Following the consummation of the offering, we do not expect to pay any dividends on our common stock for the foreseeable future.

 

Risk factors

You should carefully read and consider the information set forth under the heading “Risk Factors” and all other information set forth in this prospectus before deciding to invest in our common stock.

The number of shares of common stock shown to be outstanding after the offering is based on the number of shares of common stock outstanding as of December 31, 2010. This number does not include as of such date:

 

   

5,089,544 shares of common stock reserved for future issuance upon the exercise of stock options outstanding under our 2000 Equity Incentive Award Plan and our 2009 Equity Incentive Award Plan, at a weighted average exercise price of $8.21 per share;

 

   

342,857 shares of common stock initially reserved for future issuance under our 2009 Employee Stock Purchase Plan, which will become effective, subject to our Board of Directors’ discretion as to when and if to implement such plan, on the day prior to the date on which we become subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, or the Exchange Act; and

 

 

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251,069 shares of common stock reserved for future issuance upon the exercise of outstanding warrants, at a weighted average exercise price of $3.07 per share.

Except as otherwise indicated, all information in this prospectus assumes:

 

   

a 1-for-1.75 reverse stock split of Prometheus Laboratories Inc.’s common stock to be effected before the completion of this offering;

 

   

that our shares of common stock will be sold at $             per share, which is the midpoint of the range set forth on the cover of this prospectus;

 

   

no exercise by the underwriters of their option to purchase up to              additional shares from us;

 

   

the automatic conversion of all outstanding shares of the preferred stock of Prometheus Laboratories Inc. into 20,237,605 (on a post-split basis) shares of common stock at the close of business on the day immediately preceding the completion of this offering;

 

   

the consummation of the IPO reorganization described below;

 

   

no outstanding options have been exercised since December 31, 2010; and

 

   

no outstanding warrants have been exercised or repurchased since December 31, 2010.

IPO Reorganization

We were incorporated in Delaware in June 2009 and are a wholly owned subsidiary of Prometheus Laboratories Inc. We do not have any operations. Prometheus Laboratories Inc. is undertaking a reorganization in connection with this offering as a result of which we will become a holding company for Prometheus RxDx Holdings, Inc., which will in turn be a holding company for Prometheus Laboratories Inc. Following the automatic conversion of Prometheus Laboratories Inc.’s preferred stock into shares of its common stock at the close of business on the day immediately prior to the completion of this offering, Prometheus Laboratories Inc. will be merged with our recently formed subsidiary, Prometheus California Inc., with Prometheus Laboratories Inc. surviving the merger and continuing as our operating subsidiary. At the effective time of the merger, outstanding shares of the common stock of Prometheus Laboratories Inc. will be converted (on a post-split basis) into the right to receive shares of our common stock on a one-for-one basis. In addition, we will assume (on a post-split basis) the equity plans of Prometheus Laboratories Inc., the options and rights granted thereunder, as well as any outstanding warrants previously granted to purchase shares of the capital stock of Prometheus Laboratories Inc., all on a one-for-one basis and on the same terms and conditions. See “Certain Relationships and Related Party Transactions—IPO Reorganization.” Subsequent to the completion of the reorganization and this offering, Prometheus Laboratories Inc. plans to undergo a name change whereby it will change its name to Prometheus RxDx, Inc.

 

 

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Our ownership and corporate structure upon completion of the reorganization and this offering will be as set forth in the following chart:

LOGO

* Subsequent to the completion of the reorganization and this offering, Prometheus Laboratories Inc. plans to undergo a name change whereby it will change its name to Prometheus RxDx, Inc.

 

 

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SUMMARY FINANCIAL DATA

The following table provides a summary of our consolidated financial data for the periods indicated. The summary historical consolidated financial data for each of the fiscal years ended December 31, 2008, 2009 and 2010 have been derived from the audited consolidated statement of operations data and the consolidated balance sheet data as of December 31, 2009 and 2010 of Prometheus Laboratories Inc., which are included elsewhere in this prospectus. This prospectus does not include financial statements of Prometheus RxDx Corp. or Prometheus RxDx Holdings, Inc. because each has only been formed for the purpose of effecting the IPO reorganization and, until the consummation of the IPO reorganization, will hold no material assets and will not engage in any operations. You should read this information together with the consolidated financial statements of Prometheus Laboratories Inc. and related notes, “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and “Certain Relationships and Related Party Transactions—IPO Reorganization” included elsewhere in this prospectus.

 

     Years Ended December 31,  
     2008     2009     2010  
    (In thousands, except per share
data)
 

Consolidated Statement of Income:

     

Net sales and other revenues:

     

Pharmaceutical products(1)(2)

  $ 195,985      $ 256,777      $ 434,655   

Diagnostic testing services

    82,073        84,422        81,291   

Collaboration and other revenues

           304        3,026   
                       

Total revenues

    278,058        341,503        518,972   
                       

Operating expenses:

     

Cost of sales (excludes amortization of acquired product rights)

    113,601        155,691        250,683   

Selling, general and administrative

    81,626        87,419        108,077   

Research and development

    14,628        21,787        26,308   

Amortization of acquired product rights

    12,057        13,568        28,984   
                       

Total operating expenses

    221,912        278,465        414,052   
                       

Income from operations

    56,146        63,038        104,920   

Interest income

    1,655        480        263   

Interest income—warrants(3)

    5,602                 

Interest expense—discount accretion(4)

                  (3,871

Interest expense—other

    (3,691     (3,244     (12,123

Other income (expense), net

    553        (2,240     (2,454
                       

Income before income taxes

  $ 60,265      $ 58,034      $ 86,735   
                       

Net income

  $ 37,225      $ 32,092      $ 48,215   
                       

Net income per common share(5):

     

Basic

  $ 1.21      $ 1.06      $ 1.68   

Diluted

  $ 0.77      $ 0.77      $ 1.21   

Shares used to compute net income per common share(5):

     

Basic

    5,453        5,166        5,416   

Diluted

    8,541        7,138        7,486   

Pro forma net income per common share(5):

     

Basic

      $ 1.88   

Diluted

      $ 1.74   

Shares used to compute pro forma net income per common share(5):

     

Basic

        25,654   

Diluted

        27,724   

Other Data:

     

Depreciation and amortization

  $ 14,209      $ 16,560      $ 33,943   

Capital expenditures

  $ 1,432      $ 7,611      $ 4,868   

 

 

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The following table presents a summary of our balance sheet as of December 31, 2010 on an actual basis and on a pro forma as adjusted basis assuming:

 

   

the automatic conversion of all outstanding shares of the preferred stock of Prometheus Laboratories Inc. into 20,237,605 shares of common stock at the close of business on the day immediately preceding the completion of this offering;

 

   

the consummation of the IPO reorganization described elsewhere in this prospectus; and

 

   

the issuance and sale by us of              shares of common stock in this offering and our receipt of the estimated net proceeds from this offering, based on an assumed initial public offering price of $             per share, the midpoint of the range set forth on the cover of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us, and the application of 50% of the net proceeds of this offering as a mandatory prepayment on the outstanding principal balance of our borrowings under our credit agreement.

The pro forma as adjusted information below is illustrative only and our capitalization following the completion of this offering will be adjusted based on the actual initial public offering price and other terms of this offering determined at pricing. You should read this table together with the sections entitled “Capitalization,” “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Certain Relationships and Related Party Transactions—IPO Reorganization” and the consolidated financial statements of Prometheus Laboratories Inc. and the related notes appearing elsewhere in this prospectus.

 

     December 31, 2010  
     Actual      Pro
Forma as
Adjusted
 
     (In thousands)  

Balance Sheet Data:

     

Cash and cash equivalents and marketable securities

   $ 87,846       $                    

Working capital(6)

     74,855      

Total assets

     558,394      

Total long-term debt, less current portion

     134,077      

Total shareholders’ equity

     261,431      

 

(1)

In November 2007, we began selling LOTRONEX® (alosetron hydrochloride) Tablets in the United States under a distribution agreement with GlaxoSmithKline. In January 2008, we acquired Lotronex from GlaxoSmithKline and paid $80.0 million and issued 714,285 shares of Prometheus Laboratories Inc. common stock to GlaxoSmithKline. In February 2010, we began selling PROLEUKIN (aldesleukin) for injection in the United States under an exclusive distribution and promotion agreement with Novartis. See Notes 1 and 2 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(2) 2009 reflects $3.7 million of allowances for managed care rebates related to the Department of Defense Tricare Retail Pharmacy program pursuant to a final rule that became effective on May 26, 2009 ($1.8 million relates to sales made during 2008 and $1.9 million relates to sales made during 2009). See Note 1 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(3) Reflects the reversal of accretion of the redeemable warrants to their estimated fair value. See Note 9 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(4) Reflects the accretion of the present value discount of deferred license extension payments. See Note 2 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(5) See Note 1 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus for an explanation of the net income and shares used in computing net income per share.

 

(6) Working capital is calculated by subtracting total current liabilities from total current assets.

 

 

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RISK FACTORS

Investing in our common stock involves a high degree of risk. You should carefully consider the following risk factors, as well as the other information in this prospectus, before deciding whether to invest in shares of our common stock. The occurrence of any of the following risks could harm our business, financial condition, results of operations or growth prospects. In that case, the trading price of our common stock could decline, and you may lose all or part of your investment.

Risks Related to Our Business and Industry

Our revenues and financial results depend significantly on a limited product line.

ENTOCORT® EC (budesonide) Capsules, our leading pharmaceutical product, accounted for approximately 61% of our net sales in the year ended December 31, 2010. In addition, approximately 16% of our net sales in the year ended December 31, 2010, were derived from our three leading diagnostic product groups, PROMETHEUS® IBD Serology 7 for the diagnosis and stratification of inflammatory bowel disease, or IBD, and our thiopurine management and celiac disease testing products. Although we expect Lotronex and PROLEUKIN® (aldesleukin) for injection, to represent leading products in the future and although we have other products and intend to introduce additional products in the future, we expect sales of these key products other than Entocort EC to continue to account for a substantial portion of our near-term revenue following 2011. Because our business is highly dependent on these products and on the gastrointestinal disease and disorder market and the oncology market, factors adversely affecting the pricing of, or demand for, these products would have a material and adverse effect on our business and could cause the value of our stock to decline substantially. In addition, market acceptance of our products is dependent upon acceptance of our products by gastroenterologists and oncologists, who comprise a relatively small number of physicians within these medical fields. Further, we cannot ensure the continued availability of Entocort EC in commercial quantities at acceptable costs, nor can we assure the availability of our leading diagnostic tests at acceptable costs.

Our exclusive right to promote Entocort EC expires at the end of 2011.

Pursuant to our distribution agreement with AstraZeneca LP, or AstraZeneca, we have the exclusive right to promote, distribute, market and sell Entocort EC, our leading pharmaceutical product, in the United States until the earlier of December 31, 2011 or 30 days after the sale of a generic equivalent in the United States. Unless the distribution agreement is renewed or its term extended, we will lose all rights to market and sell Entocort EC after such date. We currently do not expect the agreement to be renewed or extended. In addition, we do not currently expect to try to distribute and market a generic version of Entocort EC when the relevant patents expire.

In addition, if we undergo a change in control with any of thirteen listed organizations prior to June 30, 2011, AstraZeneca has the option to terminate the distribution agreement.

If we cannot implement our strategy to expand our business through strategic product, technology or company acquisitions or licenses, our competitive position and our business may suffer.

We have historically increased our sales and net income through strategic acquisitions or licenses of pharmaceutical and diagnostic products and the development of proprietary diagnostic products. Our strategy is, in part, focused on increasing sales and enhancing our competitive standing through the acquisition of products, technologies or companies or in-licensing additional products or technologies in order to complement our business and enable us to promote and sell new products and services. Since we engage in limited proprietary research activity with respect to product development, we rely heavily on purchasing or in-licensing products from other companies.

Other companies, many of which have substantially greater financial, marketing and sales resources than we do, compete with us for the acquisition of products, technologies and companies and the in-license of products and technologies. We may not be able to in-license or acquire rights to additional pharmaceutical products,

 

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diagnostic technologies or companies on acceptable terms, or at all, or may not be able to obtain future financing for acquisitions or licenses on acceptable terms, or at all. For example, as a result of recent volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. Future turbulence in the U.S. and international markets and economic difficulties may adversely affect our ability to obtain additional financing on terms acceptable to us, or at all. If such market conditions exist, they may limit our ability to obtain financing for acquisitions or licenses. The inability to effect in-licenses or acquisitions of additional products, technologies or companies could limit the overall growth of our business and adversely affect our business, financial condition and results of operations.

Furthermore, even if we obtain additional rights to pharmaceutical products or diagnostic technologies, or if we acquire a company, we may not be able to generate sales sufficient to create a profit or otherwise avoid a loss. For example, our marketing strategy, distribution channels and levels of competition with respect to acquired products or technologies may be different than those of our current pharmaceutical products or diagnostic technologies, limiting our ability to compete favorably in those product categories.

Our future growth depends, in part, on our ability to develop proprietary diagnostic products and we may be unable to commercialize any of the products we develop internally.

Our future growth will depend, in part, on our ability to develop, obtain regulatory approval for and commercialize proprietary diagnostic products that we develop internally and through scientific collaborations, including through our non-exclusive collaboration with Bayer Schering Pharma AG, or Bayer. For example, we are developing diagnostic tests that may be used in conjunction with certain cancer therapies using our proprietary CEER diagnostic platform. The development process involves a high degree of risk and may take several years. We cannot be sure that we will be successful, especially as we enter into markets beyond gastroenterology. Internally-developed products or technologies may not result in commercial products and we may abandon development of a product candidate at any time. We may have to make significant investments in development, marketing and selling any diagnostic product candidate. Our diagnostic product development or commercialization efforts may fail for many reasons which would affect our results of operations and financial condition.

Risks associated with integrating acquisitions or internally developing products could disrupt our business.

As part of our business strategy, we will consider and, as appropriate, make acquisitions of technologies, products and businesses and, in addition, may internally develop proprietary diagnostic products. In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline and in 2009 we acquired the rights to sell Proleukin in the United States for the treatment of adults with metastatic renal cell carcinoma and metastatic melanoma. Acquisitions, and to a lesser extent, internally-developed products or technologies, typically entail many risks, and acquisitions could result in difficulties integrating the operations, personnel, technologies and products of the companies acquired, some of which may result in significant charges to earnings. Our ability to manage our acquisitions and internally-developed products or technologies will require us to continue to implement and improve our operational, financial and management information systems and to motivate and effectively manage an increasing number of employees. In connection with acquisitions, we could experience disruption in our business or employee base, or key employees of companies that we acquire may seek employment elsewhere, including with our competitors. Furthermore, the products of companies we acquire or products we develop internally may overlap with our existing products or those of our customers, creating conflicts with existing relationships or with other commitments that are detrimental to the integrated businesses. If we are unable to successfully integrate our acquisitions and internally-developed products or technologies with our existing business, we may not obtain the advantages that the acquisitions or developments were intended to create, which may materially adversely affect our business, results of operations, financial condition and cash flows, our ability to develop and introduce additional new products and the market price of our stock. We have never acquired a company before and therefore have no experience in integrating a company into our business.

 

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If we are unable to achieve the desired revenues from one or more of our acquisitions, we may consider the disposition of one or more product lines. We may not be able to consummate any divestiture at a fair market price. We may also be unable to reinvest the proceeds from any disposition to produce the same level of operating profit as the divested product lines or to generate a commensurate rate of return on the amount of our investment.

Lotronex was temporarily withdrawn from the market due to serious toxicity and has been the subject of substantial litigation. If additional litigation occurs with respect to Lotronex or if the U.S. Food and Drug Administration, or FDA, takes negative regulatory action against Lotronex, our reputation, financial position and results of operations may suffer.

Lotronex has been linked to reports of ischemic colitis and severe constipation. Ischemic colitis is a condition in which reduced blood flow to the intestines causes injury to the colon and can lead to hospitalization, and in rare cases, blood transfusions, surgery and death. GlaxoSmithKline voluntarily withdrew Lotronex from the market in 2000 after failing to reach agreement with the FDA on how to best manage risks associated with the product. The FDA approved a supplemental New Drug Application, or sNDA, for Lotronex in 2002 with a more limited indication, and Lotronex is now approved to treat only women with severe cases of irritable bowel syndrome, or IBS, involving diarrhea and whose symptoms have not been improved satisfactorily by other treatments. This approval is subject to limited distribution and the potential for expedited withdrawal by the FDA under Subpart H of the FDA’s New Drug Application, or NDA, regulations. In addition, Lotronex has been the subject of a number of lawsuits against GlaxoSmithKline, principally based on an alleged failure to adequately warn patients of potentially harmful side effects. GlaxoSmithKline has advised us that all of these lawsuits have been resolved with the exception of three which GSK believes will be dismissed. Although Lotronex was re-introduced to the market in 2002, it still carries the risk of harmful side effects. Although we are only liable for claims relating to Lotronex arising after our acquisition of the product, patients treated with Lotronex who suffer from side effects may resort to litigation against us, which may be costly and time-consuming and may result in damage to our reputation, financial position and results of operations. To date, no such claims relating to Lotronex have been filed against us.

We may be unable to secure an adequate supply of LOTRONEX®’s (alosetron hydrochloride) active pharmaceutical ingredient, or API, to meet manufacturing demand.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. GlaxoSmithKline agreed to supply us with Lotronex for a period of two years after the completion of the acquisition, subject to our right to renew the term for additional one-year periods upon advance notice given six months prior to the end of the then-current term, although the supply price would increase should we seek to renew the supply agreement for more than one additional one-year period. In the first half of 2010, a new manufacturer for Lotronex was qualified and validated and the first batch of Lotronex from this manufacturer was shipped in May 2010.

Under our supply agreement, GlaxoSmithKline has manufactured a sufficient amount of API for Lotronex to allow us to meet our anticipated needs through 2013. If the API is later determined to be defective for any reason, or is otherwise damaged, lost or destroyed, we may be unable to secure sufficient replacement API to be used in the manufacture of Lotronex. Despite its commitment to replace defective API, we cannot assure you that GlaxoSmithKline will have the capability to do so.

Failure to secure an adequate supply of Lotronex API for any of the foregoing reasons could adversely affect our business, financial condition and results of operations.

We may be unable to secure an adequate supply of Proleukin to meet market demand.

In December 2009, we entered into a distribution and promotion agreement with Novartis Vaccines and Diagnostics, Inc., or Novartis, pursuant to which we acquired the exclusive right to distribute, market and sell Proleukin for injection in the United States for the treatment of adults with metastatic renal cell carcinoma and metastatic melanoma. The agreement has an initial term of six years, extendable at our option for up to six

 

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additional one-year periods. In conjunction with such distribution and promotion agreement, we also entered into an exclusive supply agreement pursuant to which Novartis agreed to supply us with Proleukin for the term of the distribution and promotion agreement, including any extensions of the distribution and promotion agreement term. Notwithstanding our supply agreement with Novartis, Proleukin is manufactured on behalf of Novartis by Bayer HealthCare Pharmaceuticals, Inc., or Bayer HealthCare, under a separate manufacturing agreement between Novartis and Bayer HealthCare to which we are not a party. There is currently no alternative source of supply for Proleukin due to the significant length of time required to qualify an alternative manufacturer. In the event that Novartis is unable to supply us with Proleukin for any reason, including whether due to any problem with the manufacturing of Proleukin by Bayer HealthCare or as a result of any delivery issues encountered by Novartis, we will be unable to supply Proleukin to the market after our existing inventory of the product is sold or expires.

The risk of a supply failure in the case of Proleukin is especially acute give the length of the order process and the shelf life for the finished product in the United States. Under our supply agreement with Novartis, a specified time period of the forecasts for orders we provide to Novartis is binding on us and we must place such orders within a specified period of time prior to required delivery of finished products. Thus, disruption in the source of supply for any reason could lead to diminished product inventory for a substantial period of time. In addition, our remedies under the supply agreement in the event of a supply failure are limited to our right to obtain certain escalating discounts on the purchase price for late delivered products according to the number of days such delivery is delayed beyond the original delivery date, or in the event of an extended supply failure, to terminate both the distribution and promotion agreement and supply agreement and to seek certain other legal and contractual remedies.

If Novartis fails to meet its obligations under the supply agreement, our ability to obtain a sufficient supply of Proleukin will be impaired and we may be unable to meet commercial demand for the product. Consequently, an extended failure by Novartis to supply Proleukin for any reason could adversely affect our business, financial condition and results of operations.

Our ability to expand sales of Lotronex may be limited which may adversely impact our financial position and results of operations.

Our ability to expand sales of Lotronex is subject to risks associated with its limited indication on a subgroup of irritable bowel syndrome, or IBS, patients and potential for harmful side effects and related “black box” warnings in the product label containing expanded warning statements. In order to limit the potential for harmful side effects of Lotronex, it is subject to a special prescribing program designed to ensure that only doctors who have enrolled write prescriptions for it. In connection with enrolling in the Prescribing Program for Lotronex™, the physicians must demonstrate an understanding of IBS and be familiar with Lotronex and its potential side effects. The prescribing program instructs the prescribing physician to review the medication guide with the patient and sign a patient-physician agreement with the patient prior to prescribing Lotronex, which indicates that the patient has been advised of and understands the risks and benefits of Lotronex. The physician then places a blue sticker on the prescription, signifying to the pharmacist that he or she is an enrolled physician. Because the prescribing program for Lotronex restricts the physicians who may prescribe Lotronex to those who have enrolled in the prescribing program, it may limit the number of prescriptions written for Lotronex. As of February 1, 2011, there were approximately 12,614 physicians, physician assistants and nurse practitioners in the United States enrolled in the prescribing program. Moreover, physicians and patients may avoid Lotronex due to the administrative burdens of the prescribing program, concerns regarding physician liability, or due to concerns over side effects. In fact, only 23% of enrolled prescribers actually prescribed Lotronex in 2010. Limitations on the number of prescriptions written for Lotronex as a result of the prescribing program or concerns over side effects may limit our ability to expand sales of Lotronex and adversely impact our financial position and results of operations.

 

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We operate in a highly competitive business environment.

The pharmaceutical and diagnostic industries are highly competitive and require an ongoing, extensive search for technological innovation. They also require, among other things, the ability to effectively discover, develop, test, commercialize, market and promote products, including communicating the effectiveness, safety and value of products to actual and prospective customers and medical professionals.

Many of our competitors have greater resources than we have. This enables them, among other things, to spread their marketing and promotion costs over a broader revenue base. Other competitive factors in the pharmaceutical and diagnostic industries include quality and price, product technology, reputation, customer service and access to technical information.

Many large, well-capitalized companies offer products in the United States that compete with Entocort EC. Entocort EC currently competes with other therapies including aminosalicylates, such as sulfasalazine or mesalamine, and other corticosteroids, such as hydrocortisone, prednisone or prednisolone, none of which is currently approved for the treatment of Crohn’s disease but which are often prescribed by physicians for such use. A number of large, well-capitalized companies offer products in the United States that compete with Proleukin in both metastatic renal cell carcinoma and metastatic melanoma. Proleukin competes against targeted therapies such as Nexavar, Sutent and Torisel in metastatic renal cell carcinoma and against Temodar and DTIC (dacarbazine) in metastatic melanoma. To date, other than Lotronex, Zelnorm® (tegaserod maleate) and Amitiza® (lubiprostone) are the only other pharmaceutical products that have been approved to treat IBS. Zelnorm was withdrawn from the U.S. market in 2007 and is currently only available under investigational new drug protocols to patients whose condition is life-threatening and who require hospitalization. Amitiza was approved by the FDA in April 2008 for the treatment of IBS with constipation in women 18 years of age and older. In addition, our branded pharmaceutical products Imuran®, Trandate® and Zyloprim® face intense competition from generic products. Imuran also faces competition from newer products that have come to market, and Ridaura® faces competition from newer pharmaceutical products. Zyloprim also competes with other non-generic anti-gout agents, such as probenecid, sulfinpyrazone and colchicines. In addition, our Helidac® product faces competition from TAP Pharmaceutical’s PREVPAC® and Axcan Pharma Inc.’s three-in-one capsule for the eradication of Helicobacter pylori. Our generic mercaptopurine product competes with other generic mercaptopurine products, including a generic product launched by Teva Pharmaceuticals in April 2005. In addition to competing with these generic products, mercaptopurine also competes with Imuran and generic azathioprine products.

Our diagnostic testing services compete with several large, national laboratories including Quest Diagnostics Incorporated, or Quest, and Laboratory Corporation of America Holdings and also compete with regional and hospital laboratories. The larger competitors have substantially greater financial and human resources, as well as a much larger infrastructure than we do.

A third party, Specialty Laboratories, has a co-existing license to the intellectual property partly underlying our TPMT Genetics diagnostic test. Quest purchased Specialty Laboratories’ parent company, and its commercialization of the intellectual property may strengthen Quest’s competitive position against us with respect to this product.

It is possible that developments by our competitors could make our products or technologies less competitive or obsolete. Our future growth depends, in part, on our ability to provide products which are more effective than those of our competitors and to keep pace with rapid medical and scientific change.

Sales of our existing products may decline rapidly if a new product is introduced by a competitor, particularly if a new product represents a substantial improvement over any of our existing products. In addition, the high level of competition in our industry could force us to reduce the price at which we sell our products or require us to spend more to market our products.

Additionally, we compete to acquire the intellectual property assets that we require to continue to develop and broaden our product range. In addition to our in-house research and development efforts, we seek to acquire rights to new intellectual property through corporate acquisitions, asset acquisitions, licensing and joint venture

 

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arrangements. Competitors with greater resources may acquire assets that we seek, and even where we are successful, competition may increase the acquisition price of such assets or prevent us from capitalizing on such acquisitions or licensing opportunities. If we fail to compete successfully, our growth may be limited.

If we lose or are unable to secure collaborators or partners, or if our collaborators or partners do not apply adequate resources to their relationships with us, our product development and potential for profitability will suffer.

We have entered into, or may enter into, distribution, co-promotion, partnership and other arrangements for development, manufacturing, sales, marketing and other commercialization activities relating to our products. For example, we have entered into a distribution agreement with AstraZeneca for the right to promote, distribute, market and sell Entocort EC, a distribution and promotion agreement with Novartis for the right to promote, market and sell Proleukin, and a non-exclusive agreement with Bayer for the development of diagnostic tests specifically tailored to oncology pharmaceutical compounds which Bayer has under development. Furthermore, we have entered into agreements with Cedars-Sinai Medical Center and the University of California Los Angeles relating to the development and commercialization of diagnostic discoveries related to IBD. The amount and timing of resources applied by these or other potential collaborators are largely outside of our control.

If any of our current or future collaborators breaches or terminates our agreements, or fails to conduct our collaborative activities in a timely manner, our commercialization of products could be diminished or blocked completely. It is possible that collaborators will change their strategic focus, pursue alternative technologies or develop alternative products, either on their own or in collaboration with others. For example, the financial success of our non-exclusive collaboration agreement with Bayer is dependent in large part on whether Bayer will elect to designate any of its compounds for use with a complementary diagnostic test we develop and whether Bayer will be able to successfully advance any such compound through clinical trials to regulatory approval, none of which is within our control. The effectiveness of our partners, if any, in marketing our products will also affect our revenues and earnings.

We desire to enter into new collaborative agreements. However, we may not be able to successfully negotiate any additional collaborative arrangements and, if established, these relationships may not be scientifically or commercially successful. Our success in the future depends in part on our ability to enter into agreements with other highly-regarded organizations. This can be difficult due to internal and external constraints placed on these organizations. Some organizations may have insufficient administrative and related infrastructure to enable collaborations with many companies at once, which can extend the time it takes to develop, negotiate and implement a collaboration. Once news of discussions regarding possible collaborations are known in the medical community, regardless of whether the news is accurate, failure to announce a collaborative agreement or the entity’s announcement of a collaboration with another entity may result in adverse speculation about us, resulting in harm to our reputation and our business.

Disputes could also arise between us and our existing or future collaborators, as to a variety of matters, including financial and intellectual property matters or other obligations under our agreements. These disputes could be both expensive and time-consuming and may result in delays in the development and commercialization of our products or could damage our relationship with a collaborator. In November 2007, we entered into an exclusive license agreement with Alizyme Therapeutics Limited, or Alizyme, to develop and commercialize COLAL-PRED® (prednisolone sodium metazoate) in North America. On July 24, 2009, Alizyme, and its parent company, Alizyme plc, entered administration in England, in each case on the grounds that it was or was likely to become unable to pay its debts. We have a claim in damages against both Alizyme and Alizyme plc. On December 21, 2009, the administration transitioned to a liquidation, as a result of which (to the extent the license remains in force) the liquidator may seek to disclaim the license agreement and Alizyme’s obligations under it, on the grounds that it is an unprofitable contract. In the present circumstances, we may be unable to successfully commercialize Colal-Pred should we desire to do so. Pending resolution of the status of our license agreement through negotiation and Alizyme’s liquidation process, we are currently not investing in clinical or preclinical development activities associated with Colal-Pred. We will evaluate the commercial opportunity for Colal-Pred to determine if it is commercially feasible or desirable to continue with development activities if we are successful in obtaining appropriate rights to Colal-Pred.

 

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We do not currently have any manufacturing facilities and depend on others for the manufacture and supply of all of the pharmaceutical products we offer.

We have no manufacturing facilities, and we rely on third-party manufacturers to provide us with an adequate and reliable supply of our pharmaceutical products on a timely basis. AstraZeneca manufactures Entocort EC, Patheon Inc. manufactures Lotronex, and Proleukin is manufactured on behalf of Novartis by Bayer HealthCare under a separate manufacturing agreement between Novartis and Bayer HealthCare. For the manufacturers and suppliers of our non-promoted pharmaceutical products, see “Business—Manufacturing and Testing—Pharmaceutical Products.” Our manufacturers must comply with U.S. regulations, including current Good Manufacturing Practices, or cGMPs, of the FDA applicable to the manufacture of pharmaceutical products, and their facilities must be inspected by the FDA and other regulatory agencies as part of their business. cGMP requirements relate to the control and organization of personnel, buildings, facilities, equipment, components, drug product, containers and closure, production and process controls, packaging and labeling controls, holding and distribution, laboratory controls, records and reports, and returned and salvaged products. Ongoing compliance with cGMPs is monitored through periodic inspections and market surveillance by state and federal agencies, including the FDA. In addition, because some of our manufacturers are located outside of the United States, they must also comply with applicable foreign laws and regulations.

We have limited control over our third-party manufacturers, including with respect to regulatory compliance and quality assurance matters. Any delay or interruption of supply related to a third-party manufacturer’s failure to comply with regulatory or other requirements could limit our ability to make, or cause us to cease, sales of our pharmaceutical products. Any manufacturing defect or error discovered after products have been produced and distributed could result in even more significant consequences, including costly recall procedures, re-stocking costs, damage to our reputation and potential for product liability claims. In addition, the importation of pharmaceutical products into the United States is subject to regulation by the FDA, and the FDA can refuse to allow an imported product into the United States if it appears that the product fails to comply with applicable laws or regulations. Moreover, our third-party manufacturers and suppliers may experience difficulties related to their overall business and financial stability.

Each of our pharmaceutical products and many of the raw materials required to manufacture such products are sourced from single manufacturers. Many of our relationships with these suppliers are subject to short-term contracts or contracts that have expired and have not been renewed. We cannot assure you that we will be able to renew any such contracts at all or on terms that would be acceptable to us. We plan to continue outsourcing the manufacture of all of our pharmaceutical products in the foreseeable future. Although alternative sources of supply exist, the number of third-party manufacturers with the manufacturing and regulatory expertise and facilities to manufacture the finished forms of our pharmaceutical products or the raw materials incorporated in our products on a commercial scale is limited, and it could be expensive and take a significant amount of time to arrange for alternative manufacturers, which could have a material adverse effect on our business.

Any new manufacturer of products or active pharmaceutical ingredients would be required to qualify under applicable regulatory requirements and would need to have sufficient rights under applicable intellectual property laws to the method of manufacturing such products or ingredients. Any drug product manufactured by that manufacturer would also require FDA approval for the new manufacturer, manufacturing site and process. If any of our current third party manufacturers moves its manufacturing operations to another facility, it may be required to obtain FDA approval as well. The FDA may require us to conduct additional clinical trials, collect stability data and provide additional information concerning product made by any new supplier in order to obtain such approval. Obtaining the necessary FDA approvals or other qualifications under applicable regulatory requirements and ensuring non-infringement of third-party intellectual property rights could result in a significant interruption of supply and could require the new manufacturer to bear significant additional costs which may be passed on to us.

If advances in technology allow others to perform diagnostic tests which are similar to or better than ours or to perform such services in a more efficient or cost-effective manner than is currently possible, the demand for our diagnostic testing services may decrease.

The diagnostic industry is characterized by advancing technology that may enable clinical laboratories, hospitals, physicians or other medical providers to perform diagnostic testing services similar to or better than

 

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ours in a more efficient or cost-effective manner than is currently possible. If these or other advances in technology result in a decreased demand for our diagnostic testing services, our financial condition and results of operations would be harmed. In addition, in order for our business to be successful, we may need to develop new diagnostic tests or improve existing diagnostic tests. There is no assurance, however, that we will be able to develop or improve tests in the future or that we will be able to do so in a timely manner. Even if we successfully develop such tests in a timely manner, these new tests may not be utilized by our customers. If we fail to develop new tests or release new or improved tests on a timely basis, or if such tests do not obtain market acceptance, our financial condition and results of operations could also be harmed.

Failure to accurately disclose the performance of our diagnostic tests could result in legal actions as well as damage to our reputation with customers, which could have a material adverse effect upon our business.

Many of our diagnostic tests were developed and validated internally by us. If we fail to properly develop diagnostic tests or if we inaccurately measure the performance of the diagnostic tests we develop due to human error, deficiencies in our quality control process or otherwise, we may become subject to legal action as well as damage to our reputation with customers, which could have a material adverse effect upon our business.

In July 2008, we discovered that there was an overlap due to human error between the training and validation cohorts of our IBD Serology 7 diagnostic test. This overlap resulted in us overstating our performance specifications for adult patients. The difference in pediatric patients was not statistically significant. As a result, whereas we previously reported an overall predictive accuracy of 89%, we discovered that the test in fact exhibits an overall predictive accuracy of 76%. We did not change our diagnostic test, only the validation cohort and therefore there was no impact on previous or future test results. In other words, the actual predictions and test results reported by us using our IBD Serology 7 diagnostic test did not change as a result of the revisions to the validation cohort. We believe that this change was not material to patient care, however third parties could bring legal actions against us for having to restate the performance parameters which could damage our reputation and could have a material adverse effect upon our business. To date, there have been no legal actions relating to this matter.

If we are unable to maintain adequate levels of payment or reimbursement for our pharmaceutical products, their commercial success may be severely hindered.

Our ability to sell our pharmaceutical products may depend in large part on the extent to which payment or reimbursement for the costs of our products is available from private health insurers, managed care organizations, government entities and others. Third-party payors are increasingly attempting to contain their costs. We cannot predict actions third-party payors may take, or whether they will limit the coverage and level of payment or reimbursement for our pharmaceutical products or refuse to provide any coverage at all. Reduced or partial payment or reimbursement coverage could make our pharmaceutical products less attractive to patients, suppliers and prescribing physicians and may not be adequate for us to maintain price levels sufficient to realize an appropriate return on our investment in our products or compete on price.

In some cases, insurers and other healthcare payment organizations try to encourage the use of less expensive generic brands through their prescription benefits coverage and payment or reimbursement policies. Insurers and other healthcare payment organizations may make the generic alternatives more attractive to the patient by providing different amounts of coverage or out-of-pocket expenses so that the net cost of the generic product to the patient is less than the net cost of a branded product. The prescription benefit policies of insurers could also have a negative effect on our product revenues and profitability.

Many managed care organizations negotiate the price of medical services and products and develop formularies which establish pricing and reimbursement levels. Exclusion of a product from a formulary can lead to its sharply reduced usage in the managed care organization’s patient population. If our pharmaceutical products are not included within an adequate number of formularies or adequate payment or reimbursement levels are not provided, or if those policies increasingly favor generic products, our market share and gross margins could be negatively affected, which would have a material adverse effect on our overall business and financial condition. In addition, managed care initiatives to control costs may influence primary care physicians

 

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to refer fewer patients to gastroenterologists and other specialists. Reductions in these referrals could have a material adverse effect on the size of our potential market and increase costs to effectively promote our pharmaceutical products.

Our account managers contact private health insurers, managed care organizations, government entities and other third-party payors, seeking coverage for our products. The process for obtaining coverage can be lengthy and time-consuming, in some cases taking several months or years before a particular payor initially reviews our pharmaceutical product, and we may ultimately be unsuccessful in obtaining coverage. Our competitors generally have larger account management organizations, as well as existing business relationships with third-party payors relating to their products. If we fail to successfully secure and maintain coverage for our pharmaceutical products or are significantly delayed in doing so, we will have difficulty achieving market acceptance of our pharmaceutical products and our business will be materially adversely affected.

If third-party payors do not pay for or adequately reimburse our customers, market acceptance of our diagnostic testing services may be impaired, which may adversely affect our revenues and our operating results.

Market acceptance of our diagnostic testing services and the majority of our diagnostics sales depend, in large part, on the availability of adequate payment or reimbursement from insurance plans, including government plans such as Medicare, managed care organizations, private insurance plans and other third-party payors. Reimbursement by a third-party payor may depend on a number of factors, including a payor’s determination that a product is not experimental or investigational, and that it is medically necessary, appropriate for a specific patient, cost effective or supported by peer-reviewed publications. Because each third-party payor individually approves payment or reimbursement, obtaining these approvals can be a time-consuming and costly process that requires us to provide scientific and clinical support for the use of each of these products to each third-party payor separately with no assurance that approval will be obtained. This individualized process or any action by the government negatively affecting payment for or reimbursement of our products can delay the market acceptance of new products and may have a negative effect on our revenues and operating results. In addition, there are strict billing rules with respect to claims for diagnostic tests performed on stored specimens for Medicare beneficiaries who were hospital inpatients or outpatients that require us to bill individual hospitals for tests performed on Medicare beneficiaries during stipulated time frames. Because we generally do not have a written agreement in place with these hospitals, we may not be paid for our tests or may have to pursue payment from the hospital on a case-by-case basis. We believe these billing rules may lead to confusion regarding whether Medicare provides adequate reimbursement for our tests, and could discourage Medicare patients from using our tests. We also cannot ensure that hospitals will agree to arrangements to pay us for tests performed on patients falling under these rules.

We believe third-party payors are increasingly limiting coverage for diagnostic testing services, and in many instances are exerting pressure on product suppliers to reduce their prices. Consequently, third-party payment or reimbursement may not be consistently available or adequate to cover the cost of our products. Additionally, third-party payors who have previously approved a specific level of payment or reimbursement may reduce that level. Under prospective payment systems, in which healthcare providers may be paid or reimbursed a set amount based on the type of diagnostic procedure performed, such as those utilized by Medicare and in many private managed care systems, providers may not be willing to incur the cost of our diagnostic products. Any limitations on payment or reimbursement for our services could limit our ability to commercialize and sell new services or to continue to sell our existing services, or may cause the selling prices of our existing services to be reduced, which would adversely affect our revenues and operating results.

Adverse results in material litigation matters could have a material adverse effect upon our business.

We may become subject in the ordinary course of business to material legal action related to, among other things, intellectual property disputes, professional liability, contract disputes, false advertising, stockholder litigation and employee-related matters, as well as inquiries from governmental agencies and Medicare or Medicaid requesting comment on allegations of billing irregularities that are brought to their attention through billing audits or third parties. Legal actions could result in substantial monetary damages as well as damage to our reputation with customers, which could have a material adverse effect upon our business.

 

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In June 2004, we filed a complaint against Mayo Collaborative Services in the U.S. District Court for the Southern District of California for infringement of two patents, both of which relate to our Thiopurine Metabolites diagnostic testing services. We are an exclusive licensee of these patents pursuant to a license agreement with Sainte-Justine Hospital. In December 2005, Mayo Clinic Rochester was added to the case as a defendant. We believe that Mayo Collaborative Services and Mayo Clinic Rochester infringed these patents. Mayo Collaborative Services and Mayo Clinic Rochester answered our complaint and asserted affirmative defenses and counterclaims, including that our patents are invalid, not infringed and unenforceable. We denied these counterclaims and sought a court order that would prevent Mayo Collaborative Services or Mayo Clinic Rochester from commercializing products which infringe either of the two patents.

In November 2005, the court granted our motion for summary judgment of infringement, holding that Mayo Collaborative Services infringed one of the claims of one patent. The court also denied Mayo Collaborative Services’ motion for summary judgment that it had not infringed either patent. A consolidated hearing on a number of other motions for summary judgment, including a motion related to the validity of the patents, was held on May 10, 2007. In March 2008, the court granted the motion for summary judgment of Mayo Collaborative Services and Mayo Clinic Rochester for patent invalidity relating to the two patents mentioned above. We filed an appeal of the court’s decision with the U.S. Court of Appeals for the Federal Circuit. On September 16, 2009, the U.S. Court of Appeals for the Federal Circuit ruled in our favor by overturning the lower court’s ruling and directing the court to deny Mayo Collaborative Services’ summary judgment motion. On June 29, 2010, the U.S. Supreme Court granted the petition for a writ of certiorari filed by Mayo Collaborative Services and Mayo Clinic Rochester, vacated the judgment and remanded the case to the U.S. Court of Appeals for the Federal Circuit for further consideration in light of the U.S. Supreme Court’s decision in the case of Bilski v. Kappos. On July 26, 2010, Mayo Collaborative Services and Mayo Clinic Rochester filed a petition with the U.S. Court of Appeals for the Federal Circuit seeking en banc review. The Federal Circuit denied Mayo Collaborative Services’ petition and as directed by the Federal Circuit, each party has filed a supplemental brief with the Federal Circuit addressing the effect of the Supreme Court’s Bilski v. Kappos decision. On remand, the Federal Circuit once again held the methods patentable. We are awaiting Mayo’s decision regarding whether to seek certiorari again or return to the district court to address the remaining issues in the lawsuit. Should we be unsuccessful in our action against Mayo and should Mayo introduce and commercialize a competing product, our revenues from this product may be adversely impacted.

Product or professional liability claims and product recalls could limit our ability to sell products.

We may be exposed to product or professional liability claims in the event that the development or use of our pharmaceutical products or diagnostic testing services is alleged to have resulted in adverse effects or inaccurate diagnosis. Side effects of our pharmaceutical products or marketing or manufacturing problems pertaining to any of our products or services, errors in reporting the results of our diagnostic tests or errors in reporting the performance parameters of our diagnostic tests could harm our business by, among other things, reducing demand for our products, injuring our reputation and creating significant adverse media attention or litigation. Product or professional liability claims could also be expensive or could delay or prevent the completion of our development programs or result in withdrawal of approval to market a product or the recall of a product. These problems often occur with little or no notice in connection with the sale of pharmaceutical products. Such risks will exist even with respect to those pharmaceutical products or diagnostic tests that receive regulatory approval for commercial sale. While we have taken, and will continue to take, what we believe are appropriate precautions, there can be no assurance that we will avoid significant product or professional liability exposure. If we do not have sufficient capital resources to pay a judgment our creditors could levy against our assets, including our intellectual property, which could have a material adverse effect on our business.

We currently maintain both product and professional liability insurance coverage. However, such insurance coverage might not be sufficient to fully cover any potential claims. Such insurance can be expensive and difficult to obtain. Adequate insurance coverage may not be available in the future at an acceptable cost, if at all, or in sufficient amounts to protect us against any such liability. Any product or professional liability claim in excess of insurance coverage would have to be paid out of our cash reserves which would have a detrimental effect on our

 

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financial condition. If we do not have sufficient capital resources to pay a judgment our creditors could levy against our assets, including our intellectual property, which could have a material adverse effect on our business.

In addition, the manufacturers of our pharmaceutical products may be exposed to product liability claims in the event that the use of our pharmaceutical products is alleged to have resulted in adverse effects. Product liability claims against any of the manufacturers of our pharmaceutical products could be expensive for the manufacturers and, as a result, they may be unable or unwilling to continue manufacturing our products.

We cannot assure you that a product liability claim or series of claims brought against us would not have an adverse effect on our business, financial condition, and results of operations. If any claim is brought against us, regardless of the success or failure of the claim, we cannot assure you that we will be able to obtain or maintain product liability insurance in the future on acceptable terms or with adequate coverage against potential liabilities or the cost of a recall.

We may not be able to maintain our current insurance policies covering our business, assets, directors and officers and product liability claims and we may not be able to obtain new policies in the future.

We currently maintain property, product liability, business interruption, directors’ and officers’ and general liability insurance. Due to recent concerns over corporate governance in the United States, corporate accounting scandals and product liability lawsuits related to pharmaceuticals, liability and other types of insurance can be more difficult and costly to obtain. Unanticipated additional insurance costs could have a material adverse effect on our results of operations and cash flows. We expect that our insurance costs will increase upon completion of this offering and due to changes that often occur in the insurance markets from time to time. There can be no assurance that we will be able to maintain our existing insurance policies or obtain new policies in meaningful amounts or at a reasonable cost. Any failure to obtain or maintain any necessary insurance coverage could have a material adverse effect on our business, financial condition and results of operations.

All of our gastroenterological diagnostic testing services are performed at a single laboratory and, in the event this facility was to be affected by man-made or natural disasters, our operations could be severely impaired.

We currently perform all our gastroenterological diagnostic testing services in our laboratory located in San Diego, California. Despite precautions taken by us, any future natural or man-made disaster at our laboratory, such as a fire, earthquake or terrorist activity, could cause substantial delays in our operations, damage or destroy our equipment and biological samples or cause us to incur additional expenses. In the event of an extended shutdown of our laboratory, we may be unable to perform our diagnostic testing services in a timely manner or at all and therefore would be unable to operate our business in a commercially competitive manner. Despite carrying business interruption insurance, there is no assurance that we could recover quickly from a serious natural or man-made disaster or that we would not permanently lose customers as a result of any such business interruption. This could harm our operating results and financial condition.

In order to rely on a third party to perform our diagnostic testing services, we could only use another facility with established state licensure and accreditation under The Clinical Laboratory Improvement Amendments of 1988, or CLIA. We cannot assure you that we would be able to find another CLIA-certified facility and comply with applicable procedures, or that any such laboratory would be willing to perform the tests for us on commercially reasonable terms. In order to establish a redundant laboratory facility, we would have to spend considerable time and money securing adequate space, constructing the facility, recruiting and training employees and establishing the infrastructure necessary to support a second facility. Additionally, any new laboratory opened by us would be subject to certification under CLIA and licensure by various states, which would take a significant amount of time and result in delays in our ability to begin operations.

Failure to timely or accurately bill for our diagnostic testing services could have a material adverse effect on our net revenues and bad debt expense.

Billing for diagnostic testing can be extremely complicated. Depending on the billing arrangement and applicable law, we must bill various payors, such as insurance companies, Medicare, Medicaid, physicians,

 

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hospitals, employer groups and patients, all of which have different billing requirements. Additionally, compliance with applicable laws and regulations as well as internal compliance policies and procedures adds further complexity to the billing process. Changes in laws and regulations could negatively impact our ability to bill our clients or increase our costs. The Centers for Medicare and Medicaid Services, or CMS, also establishes procedures and continuously evaluates and implements changes to the reimbursement process for billing government programs.

Missing or incorrect information on test requisitions adds complexity to and slows the billing process, creates backlogs of unbilled tests, and generally increases the aging of accounts receivable and bad debt expense. Failure to timely or correctly bill may lead to our not being reimbursed for our services or an increase in the aging of our accounts receivable, which could adversely affect our results of operations and cash flows. Failure to comply with applicable laws relating to billing federal healthcare programs could also lead to various penalties, including:

 

   

exclusion from participation in Medicare/Medicaid programs;

 

   

asset forfeitures;

 

   

civil and criminal fines and penalties; and

 

   

the loss of various licenses, certificates and authorizations necessary to operate our business.

Any of these penalties or sanctions could have a material adverse effect on our results of operations or cash flows.

Failures in our information technology systems could disrupt our operations, which could reduce our customer base and result in lost revenues.

Information technology, or IT, systems are used extensively in virtually all aspects of our business, including laboratory testing, billing, customer service, logistics and management of medical data. Our success depends, in part, on the continued and uninterrupted performance of our IT systems. IT systems are vulnerable to damage from a variety of sources, including telecommunications or network failures, software malfunctions, equipment failures, malicious human acts and natural disasters. Moreover, despite network security measures, some of our servers are potentially vulnerable to physical or electronic break-ins, computer viruses and similar disruptive problems. Despite the precautionary measures we have taken to prevent unanticipated problems that could affect our IT systems, system failures could still occur and sustained or repeated system failures could adversely affect our reputation and result in a loss of customers and net revenues.

In addition, public and private initiatives to create Health Information Technology, or HIT, standards and to mandate standardized clinical coding systems for the electronic exchange of clinical information, including laboratory results, could require costly modifications to our existing IT systems. While we do not expect HIT standards to be adopted or implemented without adequate time to comply, failure or delay in implementing HIT or clinical coding standards, interoperability standards, or in adopting and incorporating standardized clinical coding systems in our IT systems, could result in a loss of customers, a loss of business opportunities, and could adversely affect our reputation and operating results.

If we are unable to attract and retain key personnel, our business will suffer.

As of February 1, 2011, we had 478 employees. Our success depends on our continued ability to attract, retain and motivate highly-qualified management, business development, sales and marketing, laboratory, product development and other personnel. We may not be able to recruit and retain qualified personnel, particularly for senior sales and marketing, laboratory and research and development positions, in the future due to intense competition for personnel among businesses like ours, and the failure to do so could have a significant negative impact on our future product revenues and business results. A loss of key research personnel or their work product could hamper or prevent our ability to market existing or new products, which could severely harm our business.

Our success depends on a number of key management and technical personnel, including Joseph M. Limber, our President and Chief Executive Officer. Although we have entered into an employment agreement with

 

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Mr. Limber, this agreement provides for at-will employment and is terminable at any time, with or without notice, subject to severance payments under certain conditions. Therefore, we may not be able to retain his services. In addition, we do not have “key person” insurance policies on any of our executive officers that would compensate us for the loss of their services. If we lose the services of one or more of these individuals, replacement could be difficult and may take an extended period of time, while significantly impeding the achievement of our business objectives.

We have highly-focused sales forces and the acquisition or development of additional products or technologies for fields beyond gastroenterology and oncology may require us to hire additional sales representatives, who may be costly and difficult to integrate.

Our gastrointestinal sales force is focused on the gastrointestinal disease and disorder market and its over 12,000 gastroenterologists in the United States. As of February 1, 2011, we had an approximately 125 person gastrointestinal sales force, including sales representatives, sales managers and regional field trainers located throughout the United States and an approximately 45 person oncology sales force, including sales representatives, sales managers and regional field trainers located throughout the United States. Our sales representatives complete comprehensive, disease-level sales training programs and are required to participate in regular, ongoing training activities. This training is in addition to training on the mechanism of action, side effects and comparative benefits of pharmaceuticals typically given to pharmaceutical representatives.

Additional product acquisitions or other developments may require us to expand our sales force. Training of additional sales representatives can be costly and time consuming, particularly given the level of experience and sophistication we seek in our sales force. In addition, as we continue to acquire and develop products outside the field of gastroenterology, the difficulty of integrating and training new sales representatives will increase. If we are unable to effectively retain, train and integrate additional sales representatives, it may adversely affect our ability to effectively market and sell our products.

We depend on wholesale pharmaceutical distributors for retail distribution of our branded pharmaceutical products, and if we lose any of our significant wholesale pharmaceutical distributors, our business could be harmed.

We sell a majority of our pharmaceutical products to wholesale pharmaceutical distributors who, in turn, sell the products to hospitals, pharmacies and other customers. Three wholesale pharmaceutical distributors, Cardinal Health, Inc., McKesson Corporation and AmerisourceBergen Corporation, individually comprised 42%, 34% and 20%, respectively, of our branded pharmaceutical product sales for the year ended December 31, 2010. Collectively, these three wholesalers comprised 95%, 96%, and 96% of our branded pharmaceutical product sales for the years ended December 31, 2008, 2009 and 2010, respectively. The loss of any of these wholesale pharmaceutical distributors’ accounts or a material reduction in their purchases could harm our business, financial condition or results of operations.

In addition, these wholesale customers comprise a significant part of the distribution network for pharmaceutical products in the United States. This distribution network has undergone, and may continue to undergo, significant consolidation marked by mergers and acquisitions. As a result, a smaller number of large wholesale distributors control a significant share of the market. Consolidation of drug wholesalers has increased, and may continue to increase, competitive and pricing pressures on pharmaceutical products. In addition, at times, wholesaler purchases may exceed customer demand, resulting in reduced wholesaler purchases in later quarters. We cannot assure you that we can manage these pricing pressures or that wholesaler purchases will not decrease as a result of this potential excess buying.

Our sales can be greatly affected by the inventory levels our wholesalers carry. We monitor wholesaler inventory of our products using a combination of methods. Pursuant to distribution service agreements with our two largest wholesale customers, we receive inventory level reports. For most other wholesalers where we do not receive inventory level reports, however, our estimates of wholesaler inventories may differ significantly from actual inventory levels. Significant differences between actual and estimated inventory levels may result in excessive inventory production, inadequate supplies of products in distribution channels, insufficient product available at the retail level,

 

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and unexpected increases or decreases in orders from our wholesalers. Forward buying by wholesalers, for example, may result in significant and unexpected changes in customer orders from quarter to quarter. These changes may cause our revenues to fluctuate significantly from quarter to quarter, and in some cases may cause our operating results for a particular quarter to be below our expectations or internal projections. If our financial results are below expectations for a particular period, the market price of our securities may drop significantly.

We rely on third parties to perform many necessary services for our commercial products, including services related to the distribution, storage and transportation of our products.

We have retained third-party service providers to perform a variety of functions related to the sale and distribution of our products as well as certain diagnostic testing, key aspects of which are out of our direct control. For example, we rely on one third-party service provider, Integrated Commercialization Solutions, Inc., or ICS, to provide services related to warehousing and inventory management, distribution, contract administration and chargeback processing, accounts receivable management and call center management, and, as a result, most of our inventory is stored at a single warehouse maintained by ICS. We rely on ICS as well as other third-party providers that perform services for us, including draw site collection and transportation of pharmaceuticals and patient samples. If these third-party service providers fail to comply with applicable laws and regulations, fail to meet expected deadlines, or otherwise do not carry out their contractual duties to us, or encounter damage at their facilitates, our ability to deliver products and services to meet commercial demand would be significantly impaired. In addition, we utilize third parties to perform various other services for us relating to the return and destruction of nonsaleable pharmaceutical products. We do not currently have the internal capacity to perform these important commercial functions, and although there are other service providers who can perform these functions, we may not be able to maintain commercial arrangements for these services on reasonable terms.

The process of qualifying and validating a new pharmaceutical manufacturer generally takes between 12 and 24 months but may take significantly longer. During that process, the products for which we are seeking a new manufacturer are not being manufactured, and we instead rely on sales from inventories stockpiled at the time we begin the process. It is possible that our inventories of any of these products could be entirely depleted prior to FDA approval of the new manufacturer, which would result in our inability to continue to sell such product pending completion of the qualification process. Our inability to continue our sales of any product would likely permanently damage that product’s market position and our financial condition or results of operations would be harmed.

Our success also depends, in part, on our branded non-promoted, pharmaceutical products, which face competition from generic products.

In addition to our proprietary pharmaceutical products Entocort EC and Lotronex, we sell a number of branded pharmaceutical products that we do not actively promote, which, in the aggregate, accounted for approximately 4.5% of our net sales from pharmaceutical products, or 3.8% and of our total net sales, in the year ended December 31, 2010. Many of our branded pharmaceutical products, including Imuran, face competition from less expensive generic products. Even if physicians prescribe our products, third-party payors and pharmacists can substitute generic products. Government agencies and third-party payors put pressure on patients to purchase generic products instead of brand-name products as a way to reduce healthcare costs. An increase in the amount of generic competition against our branded products would lower our unit sales and revenues.

Risks Related to Regulatory Matters

We are subject to ongoing regulatory review of our pharmaceutical products, and compliance with applicable regulations can be costly and time-consuming. Failure to comply with applicable regulations may result in fines, penalties, removal of our products from the market or criminal prosecution.

Like all pharmaceutical companies, we are subject to extensive, complex, costly and evolving regulation by the federal government, principally the U.S. Department of Health and Human Services, or HHS, which includes

 

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the FDA and CMS, and similar state government agencies, as well as by varying regulatory agencies in foreign countries where our products are being manufactured. The Federal Food, Drug, and Cosmetic Act, the Prescription Drug Marketing Act, the Federal Anti-Kickback Statute, the False Claims Act, the Controlled Substances Act and other federal and state statutes and regulations govern or influence the development, testing, manufacturing, packing, labeling, storing, record keeping, safety, approval, advertising, promotion, sale and distribution of our products and require, among other things, ongoing compliance with the FDA’s cGMP regulations. In addition, Lotronex has been deemed to have in effect a Risk Evaluation and Mitigation Strategy, or REMS, and we are subject to additional requirements and the risk of civil penalties for failure to comply with the REMS. On September 2, 2010, the FDA issued an approval letter for the REMS program. The approval included a modification for the removal of the requirement for the prescriber to sign the patient agreement form and to include all prescribers such as physicians, nurse practitioners and physician assistants. Furthermore, under California law we must also comply with the Pharmaceutical Research and Manufacturers of America Code on Interactions with Healthcare Professionals and the Office of the Inspector General, or OIG, Compliance Program Guidance for Pharmaceutical Manufacturers. Other states have similar requirements for pharmaceutical marketing.

Under certain of these regulations, the FDA requires post-marketing testing and surveillance to monitor the effects of approved pharmaceutical products or places conditions on any approvals, which restrict the commercial applications of such products. In addition, the subsequent discovery of previously unknown problems with any pharmaceutical product may result in restrictions on the product, including withdrawal of the product from the market. If we fail to comply with applicable regulatory requirements, we may be subject to warning letters, product recall, restrictions on marketing, product seizure, injunction, civil penalties, and criminal prosecution.

In regard to Entocort EC, AstraZeneca is responsible for a post-marketing pediatric study for the product in accordance with the FDA’s requirements imposed at the time of NDA approval for the product. AstraZeneca is required to consult with us concerning any proposed material changes in the label for Entocort EC. We are entitled to have a representative participate in any substantive meeting with the FDA for the pediatric study accompanying a representative from the AstraZeneca team. AstraZeneca is required to fund any post-marketing obligations required for the product. AstraZeneca has requested that the FDA waive the post-marketing pediatric study requirement as AstraZeneca has been unable to successfully engage an adequate number of patients to perform the study. In regard to Proleukin, Novartis will continue to be responsible for conducting and completing the final outstanding post-marketing study, which is designed to obtain additional clinical data to determine the effects of antibodies and elevated creatinine on the pharmacokinetics of Proleukin. We are also responsible for continuing certain investigator-initiated trials for Proleukin commenced by Novartis. In addition, we are responsible to continue the conduct of ongoing GlaxoSmithKline initiated post-marketing studies with respect to monitoring the occurrence of serious adverse events associated with Lotronex, compliance with the Prescribing Program for Lotronex, and the effectiveness of such program. Of such studies, all have been completed except a patient survey program. The patient survey program is ongoing and is currently being managed for us by a third party service provider.

Moreover, as part of the sales and marketing process, pharmaceutical companies frequently provide samples of approved drugs to physicians. This practice is regulated by the FDA and other governmental authorities, including, in particular, requirements concerning record keeping and control procedures. Any failure to comply with the regulations may result in significant criminal and civil penalties as well as damage to our credibility in the marketplace. Further, President Obama recently signed into law the Patient Protection and Affordable Health Care Act, as amended by the Health Care and Education Affordability Reconciliation Act, or collectively the PPACA, which, among other things, requires pharmaceutical manufacturers and distributors to provide HHS with an annual report on the drug samples they provide to physicians, effective April 1, 2012.

 

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We have not obtained all relevant state manufacturer and/or wholesale distributor licenses necessary to ship or sell prescription drugs that we distribute into several states, and our ability to ship or sell prescription drugs in these states may be affected if these states require us to cease further marketing and distribution activities until such licenses are obtained.

To date, we have not obtained all relevant state manufacturer and/or wholesale distributor licenses necessary to ship or sell prescription drugs into several states. In addition, as a result of the IPO reorganization and the planned name change of Prometheus Laboratories Inc. we will have to reapply for certain of these licenses. Our ability to ship into or sell prescription drugs in these states may be affected if these states require us to cease further marketing and distribution activities until such licenses are obtained. Further, these states may seek monetary penalties for failure to maintain appropriate licenses. Any disciplinary action taken by a state may adversely affect to obtain necessary state licenses in the future.

Our diagnostics business could be harmed from the loss or suspension of a license or imposition of a fine or penalties under, or future changes in, federal or state laws and regulations.

The clinical laboratory testing industry is subject to extensive regulation, and many of these statutes and regulations have not been interpreted by the courts. CLIA, which is implemented and enforced by CMS, extends federal oversight to virtually all clinical laboratories by requiring that they be certified by the federal government or by a federally-approved accreditation agency. CLIA is intended to ensure the quality and reliability of non-research laboratory testing performed on the patient samples collected in the United States and its territories by mandating specific standards in the areas of personnel qualifications, administration, participation in proficiency testing, patient test management, quality and inspections. While our laboratory is currently CLIA certified, the sanction for failure to comply with CLIA requirements may be suspension, revocation or limitation of a laboratory’s CLIA certificate, which is necessary to conduct business, as well as significant fines and/or criminal penalties.

In addition, we are subject to regulation under state law. State laws may require that laboratories and/or laboratory personnel meet certain qualifications, specify certain quality controls or require maintenance of certain records. For example, New York State requires us to obtain approval for any diagnostic test prior to offering it for sale or soliciting patient samples from New York. We cannot assure you that these licenses will be obtained. Failure to obtain these licenses could jeopardize our ability to launch and commercialize diagnostic tests in these states. Compliance with CLIA standards is verified by periodic inspections and may require participation in proficiency testing programs. No assurances can be given that our facility will pass all future inspections conducted to ensure compliance with federal or any other applicable licensing or certification laws. Substantial expenditures may be required on an ongoing basis to ensure that we comply with existing regulations and to bring us into compliance with newly-instituted regulations or requirements.

We cannot assure you that applicable statutes and regulations will not be interpreted or applied by a prosecutorial, regulatory or judicial authority in a manner that would adversely affect our business. Potential sanctions for violation of these statutes and regulations include significant fines and the suspension or loss of various licenses, certificates and authorizations, which could have a material adverse effect on our business. In addition, compliance with future legislation or regulations could impose additional requirements on us which may be costly and difficult to implement.

Proposed FDA regulation of laboratory-developed tests or genetic testing or a determination that any of our tests are not laboratory-developed tests could lead to increased costs and delays in introducing new diagnostic tests.

The FDA regulates instruments, test kits, reagents and other devices used to perform diagnostic testing by clinical laboratories. In the past, the FDA also claimed regulatory authority over laboratory-developed tests, but had stated that it was exercising enforcement discretion in not regulating laboratory-developed tests. However, in September 2006, the FDA published a draft guidance document pertaining to its regulation of laboratory-developed tests. In addition, bills proposing various regulatory schemes may be introduced in Congress which, if passed into law, could also materially change the regulation of laboratory-developed tests.

 

 

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The draft guidance document described certain laboratory-developed tests that the FDA intends to regulate as in vitro diagnostic test systems (i.e., as medical devices). The FDA calls this category of laboratory-developed tests “In Vitro Diagnostic Multivariate Index Assays,” or IVDMIAs. A draft of the guidance pertaining to IVDMIAs was issued by the FDA in September 2006 and revised in July 2007. In June 2010, the FDA announced that it would not move forward with the July 2007 IVDMIA guidance. On July 19 and 20, 2010, the FDA sponsored a public meeting in College Park, Maryland, seeking input on the regulation of laboratory-developed tests. According to remarks from the FDA, the FDA plans on issuing regulatory framework and guidance. These initiatives supersede the previous IVDMIA initiative. Any final guidance document may contain no grandfather clause or other restrictions, which could affect our ability to provide tests that are already on the market.

FDA regulation of laboratory-developed tests or increased regulation of the various medical devices used in laboratory-developed testing would lead to an increased regulatory burden and additional costs and delays in introducing new tests, including genetic tests. For example, the new diagnostic tests that we are currently developing in the United States could require either pre-market notification, also known as 510(k) clearance, or pre-market approval, from the FDA prior to marketing. Laboratory tests already being offered may also be subject to the requirement to submit an application to obtain FDA clearance or approval. The 510(k) clearance process usually takes from three to 12 months from the time of submission to the time that the manufacturer or laboratory can obtain 510(k) clearance to market a product in the United States, but can take significantly longer and such clearance may never be obtained. The pre-market approval process, often referred to as the PMA process, is much more costly, lengthy and uncertain and generally takes between one and three years from submission to PMA approval, but may take significantly longer and such approval may never be obtained. In addition, generating the clinical data to support a 510(k) or PMA can take six months or longer. In addition, a new 510(k) or PMA Supplement may need to be cleared or approved by the FDA before the device or its labeling can be modified.

We believe FDA regulation of laboratory-developed tests will lead to a substantially increased regulatory burden, additional costs and delays in introducing new diagnostic tests. Laboratories under FDA regulation will also have to operate in compliance with the Quality System Regulation and comply with other FDA regulations governing devices including limitations on advertising and promotion. It is not possible to predict when or if the FDA might issue final guidance, what changes might be made, or what the impact of such a final guidance document would be on our currently marketed diagnostic tests or our diagnostic tests currently under development. The failure to comply with FDA requirements can result in enforcement actions including seizures, injunctions, prosecution, civil penalties, recalls and warning letters.

Compliance with the HIPAA security and privacy regulations and other laws pertaining to privacy, security and identity theft may increase our costs.

We are subject to regulation under the federal Health Insurance Portability and Accountability Act of 1996, or HIPAA and rules promulgated by the Department of Health and Human Services thereunder. The HIPAA privacy and security regulations establish comprehensive federal standards with respect to the uses and disclosures of protected health information by health plans, healthcare providers and healthcare clearinghouses, in addition to setting standards to protect the confidentiality, integrity and availability of protected health information. Generally, protected health information is any individually identifiable information, including demographic information, related to the past, present or future physical or mental health condition, the provision of healthcare to an individual, or the past, present or future payment for such healthcare, which is created or received by a healthcare entity. The regulations establish a complex regulatory framework on a variety of subjects, including:

 

   

the circumstances under which uses and disclosures of protected health information are permitted or required without a specific authorization by the patient, including but not limited to treatment purposes, activities to obtain payments for services and healthcare operations activities;

 

   

a patient’s rights to access, amend and receive an accounting of certain disclosures of protected health information;

 

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the content of notices of privacy practices for protected health information; and

 

   

administrative, technical and physical safeguards required of entities that use or receive protected health information.

We have implemented policies and procedures related to compliance with the HIPAA privacy and security regulations, as required by law. The privacy regulations establish a “floor” and do not supersede state laws that are more stringent. Therefore, we are required to comply with both federal privacy regulations and varying state privacy laws.

The privacy and security regulations provide for significant fines and other penalties for wrongful use or disclosure of protected health information, including potential civil and criminal fines and penalties. Although the HIPAA statute and regulations do not expressly provide for a private right of damages, we also could incur damages under state laws to private parties for the wrongful use or disclosure of confidential health information or other private personal information. Our failure to maintain compliance with, or a change in, state or federal laws regarding privacy could result in civil or criminal penalties and could have a material effect on our business.

In February 2009, President Obama signed into law economic stimulus legislation known as the “American Recovery and Reinvestment Act of 2009, or the ARRA. Title XIII of the ARRA, also known as the Health Information Technology for Economic and Clinical Health, or HITECH, Act, contains extensive revisions to HIPAA. The changes to HIPAA include new restrictions on the use of protected health information, or PHI, without an individual’s written authorization, a new requirement to account for routine disclosures of PHI held in an electronic health record, a requirement to notify individuals of breaches to their PHI, new rights of a state attorney general to enforce HIPAA violations, extension of certain HIPAA privacy and security law provisions and penalties to business associates of covered entities, and significantly increased penalties for violations of the law. Since several of the provisions contemplate future adoption of implementing regulations, we cannot at this time determine the extent to which these changes will impact our business, or how much it will cost us to comply.

In addition, the Federal Trade Commission has instituted new requirements, called the “Red Flags Rule,” to protect consumers against identity theft and to impose obligations on certain institutions to curb identity theft. The Red Flags Rule applies to any entity that regularly defers payments for goods or services or arranges for the extension of credit, and for which there is reasonably foreseeable risk of identity theft. Entities subject to the Red Flags Rule must implement an identity theft prevention program, which must include written policies and procedures to identify and detect “red flags” of identity theft. The program must also indicate what actions will be taken when red flags are identified, and must be re-evaluated periodically to reflect new risks from identity theft. Although enforcement of the Red Flags Rule has been postponed several times, and is not expected until mid-2010, our billing and collection practices could make us subject to the Red Flags Rule. The FTC has been under pressure to postpone enforcement from several trade associations and professional organizations who are either (i) taking the position that the Red Flag Rules do not apply to them, or (ii) seeking a more restrictive interpretation of the rules in order narrow the definition of which entities must comply. To the extent we are subject to the Red Flags Rule, we do not know how much it will cost us to comply. If applicable, any failure to comply may subject us to financial penalties once enforcement of the Red Flags Rule commences.

Regulations requiring the use of “standard transactions” for healthcare services issued under HIPAA may negatively impact our profitability and cash flows.

Pursuant to HIPAA, the Secretary of HHS, has issued final regulations designed to improve the efficiency and effectiveness of the healthcare system by facilitating the electronic exchange of information in certain financial and administrative transactions while protecting the privacy and security of the information exchanged.

The HIPAA transaction standards are complex, and subject to differences in interpretation by third-party payors. For instance, some third-party payors may interpret the standards to require us to provide certain types of information, including demographic information not usually provided to us by physicians. As a result of inconsistent application of transaction standards by third-party payors or our inability to obtain certain billing information not usually provided to us by physicians, we could face increased costs and complexity, a temporary disruption in accounts receivable and ongoing reductions in reimbursements and net revenues. In addition,

 

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requirements for additional standard transactions, such as claims attachments or use of a national provider identifier, could prove technically difficult, time-consuming or expensive to implement, all of which could harm our business.

We may incur significant liability if it is determined that we are promoting the “off-label” use of drugs.

Although not approved or promoted for gastrointestinal diseases, several of our non-promoted pharmaceutical products, including Imuran and mercaptopurine, are often prescribed by physicians for such use. Companies may not promote drugs for “off-label” uses, which are uses that are not described in the product’s labeling and that differ from those approved by the FDA. Physicians may prescribe drug products for off-label uses, and such off-label uses are common across medical specialties. Although the FDA and other regulatory agencies do not regulate a physician’s choice of treatments, the Federal Food, Drug, and Cosmetic Act and FDA regulations restrict communications on the subject of off-label uses of drug products by pharmaceutical companies. The OIG and FDA both actively enforce laws and regulations prohibiting promotion of off-label uses and the promotion of products for which marketing clearance has not been obtained. A company that is found to have improperly promoted off-label uses may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions.

Although we believe that all of our communications regarding all of our products are in compliance with the relevant legal requirements, the OIG or the FDA may disagree, and we may be subject to significant liability, including civil and administrative remedies, as well as criminal sanctions. In addition, management’s attention could be diverted from our business operations and our reputation could be damaged.

We may incur liability if our continuing medical or health education programs and/or product promotions are determined, or are perceived, to be inconsistent with regulatory guidelines.

The FDA provides guidelines with respect to appropriate promotion and continuing medical and health education activities. Although we endeavor to follow these guidelines, the FDA or OIG may disagree, and we may be subject to significant liability, including civil and administrative remedies as well as criminal sanctions. In addition, management’s attention could be diverted and our reputation could be damaged.

If we fail to comply with healthcare laws and regulations, we could face substantial penalties and our business, operations and financial condition could be adversely affected.

In addition to FDA rules and regulations on marketing of pharmaceutical products, several other types of state and federal laws have been applied to restrict and govern certain marketing practices in the pharmaceutical and clinical laboratory industries in recent years. These laws include anti-kickback, false claims and Stark Act statutes.

The federal healthcare program anti-kickback statute prohibits, among other things, knowingly and willfully offering, paying, soliciting or receiving remuneration to induce or in return for purchasing, leasing, ordering or arranging for the purchase, lease or order of any healthcare item or service reimbursable under Medicare, Medicaid or other federally financed healthcare programs. This statute applies to laboratory services and has also been interpreted to apply to arrangements between pharmaceutical manufacturers on one hand and prescribers, purchasers and formulary managers on the other. Although there are a number of statutory exemptions and regulatory safe harbors protecting certain common activities from prosecution, the exemptions and safe harbors are drawn narrowly, and any remuneration to or from a prescriber or purchaser of healthcare services may be subject to scrutiny if they do not qualify for an exemption or safe harbor. Our practices may not in all cases meet all of the criteria for safe harbor protection from anti-kickback liability. Further, the PPACA amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes. A person or entity no longer needs to have actual knowledge of this statute or specific intent to violate it. In addition, the government may assert that a claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims laws.

Federal false claims laws prohibit any person from knowingly presenting or causing to be presented a false claim for payment to the federal government, or knowingly making or causing to be made a false statement to get

 

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a false claim paid. Pharmaceutical and other healthcare companies have been prosecuted under these laws for allegedly providing free product to customers with the expectation that the customers would bill federal programs for the product. Other companies have been prosecuted for causing false claims to be submitted because of the company’s marketing of the product for unapproved, and thus non-reimbursable, uses. The majority of states also have statutes or regulations similar to the federal anti-kickback law and false claims laws, which apply to items and services reimbursed under Medicaid and other state programs, or, in several states, apply regardless of the payor. These false claims statutes allow any person to bring suit in the name of the government alleging false and fraudulent claims presented to or paid by the government (or other violations of the statutes) and to share in any amounts paid by the entity to the government in fines or settlement. Such suits, known as qui tam actions, have increased significantly in the healthcare industry in recent years. Sanctions under these federal and state laws may include civil monetary penalties, exclusion of a manufacturer’s products from reimbursement under government programs, criminal fines and imprisonment.

Under another federal statute, known as the Stark Act or “self-referral” prohibition, physicians who have an investment or compensation relationship with an entity may not refer Medicare patients for designated health services, which include clinical laboratory services, regardless of the intent of the parties, unless an exception applies. Similarly, entities may not bill Medicare or any other party for services furnished pursuant to a prohibited referral. Unlike the federal anti-kickback statute, the Stark Act is strict liability, meaning that all of the requirements of a Stark Act exception must be met in order to take advantage of the exception. Many states have their own self-referral laws as well, which in some cases apply to all patient referrals, not just Medicare.

Because of the breadth of these laws and the narrowness of the safe harbors and exceptions, it is possible that some of our business activities could be subject to challenge under one or more of such laws. Such a challenge, regardless of the outcome, could have a material adverse effect on our business, business relationships, reputation, financial condition and results of operations.

If our operations are found to be in violation of any of the laws described above or any other governmental regulations that apply to us, we may be subject to penalties, including civil and criminal penalties, damages, fines and the curtailment or restructuring of our operations. Any penalties, damages, fines, curtailment or restructuring of our operations could harm our ability to operate our business and our financial results. Any action against us for violation of these laws, even if we successfully defend against it, could cause us to incur significant legal expenses and divert our management’s attention from the operation of our business. Moreover, achieving and sustaining compliance with applicable federal and state privacy, security and fraud laws may prove costly.

Our reporting and payment obligations under the Medicaid drug rebate program and other governmental purchasing and rebate programs are complex and may involve subjective decisions, and any determination of failure to comply with those obligations could subject us to penalties and sanctions, which could have a material adverse effect on our business.

The regulations regarding reporting and payment obligations with respect to the Medicaid drug rebate program and other governmental pricing programs are complex. Our calculations and methodologies are subject to review and challenge by the applicable governmental agencies, and it is possible that such reviews could result in material changes. In addition, because our processes for these calculations and the judgments involved in making these calculations involve, and will continue to involve, subjective decisions and complex methodologies, these calculations are subject to the risk of errors.

A number of pharmaceutical companies have been and currently are defendants in lawsuits filed by state attorneys general based on alleged price reporting violations and are subject to an investigation by the U.S. Department of Justice. Although we believe we are in compliance with pricing laws, if a governmental agency commences an investigation of us, based on a claim of violation of fraud and false claims laws or otherwise, we may be subject to civil and/or criminal sanctions, including fines, penalties and possible exclusion from federal healthcare programs (including Medicare and Medicaid). Some of the applicable laws may impose liability even in the absence of specific intent to defraud. For example, the PPACA amends the intent requirement of the federal anti-kickback and criminal health care fraud statutes so that a person or entity no longer needs to have actual knowledge of the statutes or specific intent to violate them. In addition, the government may assert that a

 

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claim including items or services resulting from a violation of the federal anti-kickback statute constitutes a false or fraudulent claim for purposes of the false claims laws. Furthermore, should there be ambiguity with regard to how to properly calculate and report payments, and even in the absence of any such ambiguity, a governmental authority may take a position contrary to a position that we have taken, and may impose civil and/or criminal sanctions. Any such penalties or sanctions could have a material adverse effect on our business, financial position and results of operations and could cause the market value of our stock to decline.

Healthcare cost control initiatives could cause us to sell our products at lower prices, resulting in decreased revenues.

Government payors, such as Medicare and Medicaid, as well as insurers, including managed care organizations, have increased their efforts to control the cost, utilization and delivery of healthcare services. From time to time, Congress has considered and implemented changes in the Medicare reimbursement methodologies in conjunction with budgetary legislation. Further reductions of reimbursement for Medicare services or changes in policy regarding coverage of laboratory tests may be implemented from time to time. Changes in federal, state, local and third-party payor regulations or policies may have a material adverse impact on our business. Actions by agencies regulating insurance or changes in other laws, regulations, or policies may also have a material adverse effect upon our business.

Furthermore, there have been and continue to be a number of initiatives at the federal and state levels that seek to reduce healthcare costs. Most recently, the PPACA was enacted, which includes measures to significantly change the way health care is financed by both governmental and private insurers. These changes include, among other things:

 

   

increases in Medicaid rebates owed by manufacturers under the Medicaid Drug Rebate Program for both branded and generic drugs;

 

   

annual, non-deductible fees on any entity that manufactures or imports certain prescription drugs and biologics;

 

   

a deductible excise tax on any entity that manufactures, produces or imports medical devices offered for sale in the United States;

 

   

new requirements for manufacturers to discount drug prices to eligible patients by 50% at the pharmacy level and mail order services for their outpatient drugs to be covered under Medicare Part D;

 

   

an increase in the number of entities eligible for discounts under the Public Health Service pharmaceutical pricing program;

 

   

an approval pathway for “follow-on” biologics; and

 

   

a new Patient-Centered Outcomes Research Institute to oversee, identify priorities in and conduct comparative clinical effectiveness research.

At this time, it remains unclear the full effect that the PPACA would have on our business.

Additionally, individual states have become increasingly aggressive in passing legislation and implementing regulations designed to control pharmaceutical and diagnostic product pricing, including price or patient reimbursement constraints, discounts, restrictions on certain product access, and to encourage importation from other countries and bulk purchasing. Legally-mandated price controls on payment amounts by third-party payors or other restrictions could harm our results of operations and financial condition.

We expect there will continue to be federal and state laws and/or regulations, proposed and implemented, that could limit the amounts that federal, state and foreign governments will pay for healthcare products and services. The extent to which future legislation or regulations, if any, relating to the healthcare industry or third-party coverage and reimbursement may be enacted or what effect such legislation or regulation would have on our business remains uncertain. Such measures or other healthcare system reforms that are adopted could have a material adverse effect on our ability to successfully commercialize our products or could limit or eliminate our spending on development projects and affect our ultimate profitability.

 

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In addition, regional healthcare authorities and individual hospitals are increasingly using bidding procedures to determine what pharmaceutical and diagnostic products and which suppliers will be included in their prescription drug and other healthcare programs. This can reduce demand for our products or put pressure on our product pricing, which could negatively affect our revenues and profitability.

The regulatory approval process is expensive, time consuming and uncertain and may prevent us from obtaining approvals for pharmaceutical products we may attempt to commercialize.

The research, testing, manufacturing, labeling, approval, selling, marketing and distribution of pharmaceutical products are subject to extensive regulation by the FDA and other regulatory authorities in the United States. We will not be permitted to market any drug product we may develop in the United States unless we receive approval of an NDA from the FDA. Submitting and obtaining approval of an NDA can be a lengthy, expensive and uncertain process.

Prior to receiving approval to commercialize a pharmaceutical product in the United States, we must demonstrate with substantial evidence from adequate and well-controlled clinical trials, and to the satisfaction of the FDA, that it is safe and effective for its intended use. We may also be required to conduct preclinical studies, including carcinogenicity studies. Results from preclinical studies and clinical trials can be interpreted in different ways. Even if we believe the preclinical or clinical data are promising, such data may not be sufficient to support approval by the FDA and other regulatory authorities. Administering a pharmaceutical product to humans may produce undesirable side effects, which could interrupt, delay or halt clinical trials for such products and result in the FDA or other regulatory authorities denying approval of the product.

Regulatory approval of an NDA is uncertain, and the approval process is expensive and may take several years. The FDA also has substantial discretion in the approval process. Despite the time and expense exerted, failure can occur at any stage, and we could encounter problems that cause us to abandon clinical trials, repeat clinical trials or perform additional preclinical studies and clinical trials. The number of preclinical studies and clinical trials that will be required for FDA approval varies depending on the drug candidate, the disease or condition that the product candidate is designed to address. The FDA can delay, limit or deny approval of a product candidate for many reasons, including, but not limited to, the following:

 

   

a drug candidate may not be deemed safe or effective;

 

   

the FDA may not find the data from preclinical studies and clinical trials sufficient;

 

   

the FDA might not approve our or our third-party manufacturers’ processes or facilities; or

 

   

the FDA may change its approval policies or adopt new regulations.

If pharmaceutical products we attempt to commercialize fail to demonstrate safety and efficacy in clinical trials or do not gain regulatory approval, our potential for growth will be limited.

Our business involves the use of hazardous materials and we and our third-party manufacturers must comply with environmental laws and regulations, which can be expensive and restrict how we do business.

Our third-party manufacturers’ activities and our own activities involve the controlled storage, use and disposal of hazardous materials, including the components of our pharmaceutical products, test samples and reagents, biological materials and other hazardous compounds. We and our manufacturers are subject to federal, state and local laws and regulations governing the use, manufacture, storage, handling and disposal of these hazardous materials. Although we believe that the safety procedures for handling and disposing of these materials comply with the standards prescribed by these laws and regulations, we cannot eliminate the risk of accidental contamination or injury from these materials. In the event of an accident, state or federal authorities may curtail our use of these materials and/or interrupt our business operations. In addition, if an accident or environmental discharge occurs, or if we discover contamination caused by prior operations, including by prior owners and operators of properties we acquire, we could be liable for cleanup obligations, damages and fines. Although we maintain hazardous material insurance coverage under our general insurance policy, it is limited in

 

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both the scope and amount of coverage. We cannot assure you that our policy would be sufficient to cover any claims. Any substantial unexpected costs we may incur could significantly harm our financial condition and results of operations.

Failure to comply with environmental, health and safety laws and regulations, including the federal Occupational Safety and Health Administration Act and the Needlestick Safety and Prevention Act, may result in fines and penalties and loss of licensure, and have a material adverse effect upon our business.

We are subject to licensing and regulation under federal, state and local laws and regulations relating to the protection of the environment and human health and safety, including laws and regulations relating to the handling, transportation and disposal of medical specimens, infectious and hazardous waste and radioactive materials as well as regulations relating to the safety and health of laboratory employees. Our laboratory is subject to applicable federal and state laws and regulations relating to biohazard disposal of all laboratory specimens, and we utilize outside vendors for disposal of such specimens. In addition, the federal Occupational Safety and Health Administration has established extensive requirements relating to workplace safety for healthcare employers, including clinical laboratories, whose workers may be exposed to blood-borne pathogens such as HIV and the hepatitis B virus. These requirements, among other things, require work practice controls, protective clothing and equipment, training, medical follow-up, vaccinations and other measures designed to minimize exposure to, and transmission of, blood-borne pathogens. In addition, the Needlestick Safety and Prevention Act requires, among other things, that we include in our safety programs the evaluation and use of engineering controls such as safety needles if found to be effective at reducing the risk of needlestick injuries in the workplace.

Failure to comply with federal, state and local laws and regulations could subject us to denial of the right to conduct business, fines, criminal penalties and/or other enforcement actions which would have a material adverse effect on its business. In addition, compliance with future legislation could impose additional requirements on us, which may be costly.

Risks Related to Intellectual Property

Our ability to protect our proprietary technology, which is vital to our business, is uncertain, and if we are unable to obtain or enforce our intellectual property rights, our competitors may develop and market products or services with similar features to ours.

Our commercial success, competitive position and amount of future income will depend in part on obtaining and maintaining patent, trademark and trade secret protection for our branded pharmaceuticals, our diagnostic tests and our other proprietary products, technologies and/or services that we are developing or may develop, in-license or otherwise acquire in the future. Our success will also depend on whether we are able to successfully assert or use these intellectual property rights against infringing competitors. We will only be able to protect our products, technologies and services from unauthorized use by third parties to the extent that valid and enforceable patents, trademarks or trade secrets cover them.

Our policy is to seek patent protection and enforce the intellectual property rights we own and license. We cannot assure you that patent applications we file and have filed will result in patents being issued. If a patent application is filed that qualifies as a joint invention, the joint inventor or his or her employer may have rights in the invention. We cannot assure you that a third party will not infringe upon, design around or develop uses covered by any patent issued or licensed to us or that these patents will provide any measure of commercial exclusivity. Even issued patents may later be modified or revoked by the U.S. Patent and Trademark Office, or the USPTO, or invalidated or made unenforeceable in legal proceedings.

Moreover, we believe that obtaining foreign patents may be more difficult than obtaining domestic patents because of differences in patent laws and, accordingly, our patent position may be stronger in the United States than abroad. Foreign patents may be more difficult and/or expensive to enforce or defend and/or the remedies available may be less extensive than in the United States. Various countries limit the subject matter that can be

 

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patented and limit the ability of a patent owner to enforce patents in the medical and other related fields. This may limit our ability to obtain or utilize those patents internationally.

Patent applications in the United States are maintained in secrecy until at least 18 months after the filing of the application with the USPTO and, since publication of discoveries in the scientific or patent literature tends to lag behind actual discoveries, we cannot be certain that we were the first creator of the inventions covered by pending patent applications or the first to file patent applications on those inventions. We cannot assure you that any of the pending patents for which we have filed applications will be issued, or, if issued, whether the scope of the claims allowed will be sufficient to protect our products, technologies and services.

Several pharmaceutical and diagnostic companies and research and academic institutions have developed technologies, filed patent applications or received patents for technologies that may be related or competitive to our business. Others may file patent applications and may receive patents that may overlap or conflict with patents or patent applications we have obtained or licensed for our use, either by claiming the same methods, assays or compounds or by claiming methods, assays or compounds that could dominate those owned by or licensed to us. Litigation or other patent office proceedings to establish the validity of patents, to defend against patent infringement claims of others and to assert patent infringement claims against others can be expensive and time-consuming even if the outcome is favorable to us. If the outcome is unfavorable to us, this could have a material adverse effect on our business. We have taken and may, in the future, take steps to enhance our patent protection, but we cannot assure you that these steps will be sufficient or that, even if successful, our patent protection will be adequate.

The patent positions of pharmaceutical and diagnostic companies can be highly uncertain and involve complex legal and factual questions for which important legal principles remain unresolved. Key questions of patent law underlying pharmaceutical and diagnostic patents remain unresolved or are in flux in the United States and even more so outside the United States. Changes in either the patent laws or in interpretations of patent laws in the United States and other countries may diminish the value of our intellectual property. Accordingly, we cannot predict the validity or scope of enforceability of claims that may be allowed in our patents or in third-party patents.

The degree of future protection afforded by our proprietary rights is uncertain, because legal means provide only limited protection that may not be adequate to protect our rights or permit us to gain or keep our competitive advantage. For example:

 

   

we, or the parties from whom we have acquired or licensed patent rights, may not have been the first to file the underlying patent applications or the first to make the inventions covered by such patents;

 

   

the named inventors or co-inventors of patents or patent applications that we have licensed or acquired may be incorrect or incomplete, which may give rise to inventorship disputes or invalidate the patents;

 

   

others may independently develop similar or alternative technologies or duplicate any of our products, technologies or services or design around our patents;

 

   

it is possible that none of the pending patent applications licensed to us will result in issued patents;

 

   

the issued patents covering our products, technologies or services may not provide us with any competitive advantages;

 

   

the issued patents may be challenged, invalidated, circumvented or rendered unenforceable;

 

   

issued patents covering our products, technologies or services may ultimately be deemed or adjudicated as obvious, anticipated, patent subject ineligible, non-enabled and/or otherwise invalid;

 

   

the issued patents may be subject to re-examination which could result in a narrowing of the scope of claims or cancellation of claims found unpatentable;

 

   

we may not develop or acquire additional proprietary technologies that are patentable;

 

   

our trademarks may be invalid or subject to a third party’s prior use; or

 

   

our ability to enforce our patent rights will depend on our ability to detect infringement, and litigation to enforce patent rights is costly and time-consuming.

 

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The terms of exclusivity for the two U.S. patents covering Entocort EC expire in May 2011 and January 2015. Therefore, even if we are able to extend our exclusive contractual right with AstraZeneca to promote Entocort EC beyond 2011, Entocort EC may face increased competition from generic products upon the expiration of either of the patents. Additionally, the U.S. patents covering Helidac expire in October 2010, April 2012 and February 2014; and the five U.S. patents covering Lotronex expire in May 2011, January 2013, January 2018, October 2018 and October 2018. In August 2009, we submitted one of the Lotronex method of use patents for reexamination in view of references that raised a new question of patentability. In October 2010, the certificate of reexamination confirming patentability was issued. The reexamined patent has amended claims that make it eligible for listing in the Orange Book. This may provide additional exclusivity until October 2018. Only the compound patent is currently listed in the FDA’s Orange Book. In January 2011, after receiving a letter from Roxane Laboratories, Inc. or Roxane, stating that Roxane filed an Abbreviated New Drug Application with the Food and Drug Administration for a generic form of LOTRONEX® (alosetron hydrochloride), we sued Roxane in the United States District Court for District of New Jersey for infringement of a method of treatment patent that protects the use of Lotronex according to the label as set forth in U.S. Patent 6,284,770, or the ‘770 Patent. In August 2009, we submitted this patent for reexamination, and in October 2010, the United States Patent and Trademark Office issued a reexamination certificate for the ‘770 patent. The reexamination procedure reconfirmed the validity of the patent. Following our receipt of the reexamination certificate, we listed the ‘770 patent in the Orange Book. Roxane’s notice letter only references the ‘770 patents and does not reference our composition of matter patent for Lotronex as set forth in U.S. Patent 5,360,800 (which expires in January 2013). Proleukin is covered by two key U.S. patents which expire in November 2012 and October 2015. The initial term of the distribution and promotion agreement with Novartis granting us exclusive rights to commercialize Proleukin expires at the end of January 2016, but may be extended at our option for up to six additional one-year periods subject to the payment of an annual renewal fee. In the event that we elect to extend the term of the distribution and promotion agreement beyond January 2016, Proleukin may face increased competition from generic products upon expiration of either of the above U.S. patents.

We also rely on trade secrets to protect our products, technology and services, particularly where we do not believe patent protection is appropriate or obtainable. However, trade secrets can be difficult to maintain and protect. While we use commercially reasonable efforts to protect our trade secrets, our licensors, employees, consultants, contractors, outside scientific collaborators and other advisors may unintentionally or willfully disclose such trade secret information to third parties and competitors. We attempt to protect our confidential and proprietary technology in large part by entering into confidentiality and non-disclosure agreements with our employees, consultants and other contractors. We cannot assure you, however, that these agreements will not be breached, that we will have adequate remedies for any breach or that competitors will not know of, or independently discover, our trade secrets. We cannot assure you that others will not independently develop substantially equivalent proprietary information or be issued patents that may prevent the sale of our products, technologies, services or know-how or require licensing and the payment of significant fees or royalties by us in order to produce our products, technologies or services. Moreover, we cannot assure you that our technology does not infringe upon any valid claims of patents that other parties own. Enforcing a claim that a third party illegally obtained and is using our trade secrets is expensive and time consuming, and the outcome is unpredictable. In addition, courts outside the United States are sometimes less willing to protect trade secrets. Moreover, our competitors may independently develop or acquire equivalent knowledge, methods or know-how.

If our licensors or we fail to obtain or maintain patent protection or trade secret protection for our products, assays, methods, technologies, services or any other product candidate we may in-license or acquire, third parties could use our proprietary information, which could impair our ability to compete in the market and adversely affect our ability to generate revenues and maintain profitability.

 

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Two companies each submitted an Abbreviated New Drug Application, or ANDA, to the FDA containing a Paragraph IV patent certification for Entocort EC in the first half of 2008, indicating that each company intends to market a generic version of Entocort EC prior to the expiration of one or both patents covering the product and one such company has entered into a settlement agreement pursuant to which it will launch its generic version in February 2012 (or earlier in certain circumstances, subject to regulatory approval).

In the first half of 2008, Barr Laboratories, Inc., or Barr, which was acquired by Teva Pharmaceutical Industries Ltd., or Teva, in December 2008, and Mylan Pharmaceuticals, Inc., or Mylan, each submitted an ANDA containing a Paragraph IV patent certification for Entocort EC pursuant to the Hatch-Waxman Act. We have the exclusive right to distribute, market and sell Entocort EC in the United States under an agreement with AstraZeneca which currently runs through the earlier of December 31, 2011 or 30 days after the sale of a generic equivalent in the United States. In the United States, Entocort EC is protected by two patents, the terms of exclusivity for which expire in May 2011 and January 2015. The submission of the ANDAs containing the Paragraph IV certification indicates that each party intends to market a “generic equivalent” of Entocort EC prior to the expiration of one or both patents covering the product. Under the Hatch-Waxman Act, an ANDA applicant who files a Paragraph IV certification is required to notify the owner of the patent and the holder of the NDA for the listed drug, which notice must include a detailed statement of the factual and legal basis for the ANDA applicant’s opinion that the patent is not valid or will not be infringed by introduction into the market of the proposed generic product. Both of the patents covering Entocort EC are owned by an affiliate of AstraZeneca.

The submission of an ANDA for a drug product claimed in a patent is an act of infringement, and therefore the ANDA applicant may be sued for patent infringement upon the NDA holder or patent holder’s receipt of notification that the ANDA with the Paragraph IV certification has been submitted to the FDA. A lawsuit for patent infringement filed within 45 days of receipt of notice of the Paragraph IV certification automatically triggers a 30-month stay (commencing the date of receipt of notice), during which the FDA may not give final approval of the ANDA application, unless there is a judicial determination or settlement of the patent dispute prior to the expiration of such 30 month period.

Under our agreement with AstraZeneca, AstraZeneca has the exclusive right to determine what action, if any, will be taken in the event of any infringement or threatened infringement on the patents covering Entocort EC. AstraZeneca received a notification from each ANDA applicant and AstraZeneca filed separate suits against Barr and Mylan for patent infringement. Subject to receiving an earlier issued judicial determination or settlement of the patent dispute, we believe that the 30-month stay for Barr would have expired in October 2010 and the 30-month stay for Mylan would have expired in December 2010. Pursuant to FDA rules and regulations, the first ANDA filer will generally have a 180-day period of exclusivity from the date it launches its generic product during which all other ANDA filers will not be allowed to market or sell their generic product. On May 18, 2010, AstraZeneca and Teva entered into a settlement agreement pursuant to which AstraZeneca granted Teva a license to market Teva’s generic version of Entocort EC in the United States beginning on February 15, 2012 (or earlier in certain circumstances), subject to regulatory approval, and Teva stipulated that the patents covering Entocort EC are valid and enforceable. In addition, on that same day the U.S. District Court for the District of Delaware entered an order for judgment for AstraZeneca based on a stipulation between Mylan and AstraZeneca that Mylan was infringing the patent covering Entocort EC that expires in May 2011 and that all of the patents are not invalid. As such, Mylan may not be able to begin marketing its generic version until at least May 2011 when the patent covering Entocort EC has expired (or pursuant to the terms of any settlement or license agreement between Mylan and AstraZeneca).

If a generic version of Entocort EC is launched while we have the right to distribute and market Entocort EC, it would terminate our ability to market and sell Entocort EC and would negatively impact our financial condition and results of operations. In addition, we would need to obtain approval from the FDA before we could begin to distribute and market a generic version of Entocort. Moreover, any application to market a generic version of Entocort filed by us during the term of the AstraZeneca patents would be an act of infringement and a lawsuit filed by AstraZeneca within 45 days of notice would result in a 30-month stay of approval for our application. In addition, while AstraZeneca has the exclusive right to determine what action, if any, will be taken

 

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in the event of an infringement or threatened infringement of the patents, we are required during the term of our agreement with AstraZeneca, upon AstraZeneca’s reasonable request and at AstraZeneca’s cost, to use diligent efforts to assist AstraZeneca in its actions, in which case any litigation may prove to be time-consuming and distracting to management, which could have a material adverse effect on our business. We have limited, if any, control over the amount or timing of resources that AstraZeneca devotes on our behalf or the priority they place on defending and maintaining Entocort’s patent rights. Our business may suffer if AstraZeneca fails to prevent infringement by the ANDA applicant, or if the subject patents are found to be invalid.

We also rely on our licensors to protect our patent rights, and if our licensors fail to adequately protect and enforce such rights or if we do not have exclusivity for the marketing of our products or services, our ability to gain exclusivity for our products or services could suffer.

Our distribution agreement with AstraZeneca grants us the exclusive right for the promotion and sale in the United States of Entocort EC, our leading pharmaceutical product. In addition, we have licensed a number of patents, including patents related to Proleukin and our IBD Serology 7, thiopurine management and oncology diagnostic tests, with respect to which we depend substantially on third parties to protect and enforce the proprietary rights covering these patents and diagnostic tests. With regard to some of these proprietary rights, we have limited, if any, control over the amount or timing of resources that such parties devote on our behalf or the priority they place on obtaining and maintaining these patent rights, prosecuting these patent applications to our advantage and enforcing any issued patents against infringement by third parties. Our business may significantly suffer if one or more of these agreements terminates or expires, if we or any of our licensors fail to abide by the terms of such agreements or fail to prevent infringement by third parties, or if the subject patents are found to be invalid or unenforceable. Without the protection of the intellectual property we license, other companies might be able to offer substantially identical products for sale, which could adversely affect our competitive business position and harm our business prospects. We license Colal-Pred from Alizyme which is located outside of the United States, and we may seek agreements in the future with other companies located outside of the United States. In the event of the insolvency of one of these companies, foreign insolvency law may not protect our proprietary rights under these agreements in the same manner as United States law. Failure to take appropriate steps to protect against infringement of intellectual property rights could jeopardize our ongoing efforts to promote them and could adversely affect our ability to generate revenues and maintain profitability.

If our licenses are terminated for any of our products, product candidates or diagnostic testing services, we may not be able to continue developing or offering such products or services. In addition, if we breach the terms of the distribution agreements with AstraZeneca or Novartis, or any of our other licenses, or otherwise lose our rights under these agreements (including as a result of the liquidation of Alizyme discussed above), we may be unable to continue developing and selling our products, including, without limitation, Entocort EC and Proleukin. AstraZeneca or others may dispute the scope of our rights under the distribution agreement, and our licensors or others may dispute the scope of our rights under our licenses. AstraZeneca may breach the terms of the distribution agreement or, similarly, the licensors under our licenses may breach the terms of their respective licenses. Any such breach could materially and adversely affect our ability to generate revenues and profitability and, if not cured, may result in the termination of the applicable agreement. In addition, under the distribution agreement, AstraZeneca has the right to require us to discontinue promoting Entocort EC in the event of a claim by a third party that the sale of the product infringes a third party’s patent in the United States.

If the use or sale of our technologies or the manufacture or sale of certain products or services infringe the intellectual property rights of third parties, we may incur substantial liabilities and be unable to commercialize products or services based on these technologies in a profitable manner, if at all.

Other companies may have or may acquire patent rights that they could enforce against us. If they do so, we may be required to modify our technologies, pay licensing fees or cease activities. If our products, technologies or services infringe the patent rights of others, they could bring legal action against us or our licensees, suppliers, vendors, resellers, distributors, customers or collaborators, claiming damages and seeking to enjoin manufacturing and marketing of the affected products, technologies or services.

 

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Because patent applications can take many years to issue and eighteen months to publish, there may be currently pending applications unknown to us or reissue applications that may later result in issued patents upon which our products, technologies or services may infringe. There could also be existing patents of which we are unaware that our products, technologies or services may infringe. In addition, if third parties file patent applications or obtain patents claiming products, technologies or services also claimed by us in pending applications or issued patents, we may have to participate in interference proceedings in the U.S. Patent and Trademark Office to determine priority of invention. If third parties file oppositions in foreign countries, we may also have to participate in opposition proceedings in foreign tribunals to defend the patentability of our filed foreign patent applications.

If a third party claims that we infringe its proprietary or intellectual property rights, it could cause our business to suffer in a number of ways, including:

 

   

we may become involved in time-consuming and expensive litigation, even if the claim is without merit, the third party’s patent is ultimately invalid or unenforceable or we are ultimately found to have not infringed;

 

   

we may become liable for substantial damages for past infringement if a court decides that our technologies infringe upon a third party’s patent;

 

   

we may be ordered by a court to stop making, selling or licensing our products or services without a license from the patent holder, which may not be available on commercially acceptable terms, if at all, or which may require us to pay substantial royalties or grant cross-licenses to our patents; and

 

   

we may have to redesign our product so that it does not infringe upon others’ patent rights, which may not be possible or could require substantial investment or time.

If any of these events occur, our business could suffer and the market price of our common stock may decline.

Because of the expense and uncertainty of litigation, we may not be in a position to enforce our intellectual property rights against third parties.

Because of the expense and uncertainty of litigation, we may conclude that even if a third party is infringing our patents or other intellectual property rights, the risk-adjusted cost of bringing and enforcing such a claim or action may be too high or not in the best interest of our company or our stockholders. In such cases, we may decide that the more prudent course of action is to simply monitor the situation or initiate or seek some other non-litigious action or solution.

If we are involved in intellectual property claims and litigation, the proceedings may divert and consume our resources and subject us to significant liability for damages, substantial litigation expense and/or the loss of our proprietary rights.

Litigation may be necessary to assert or defend against infringement claims, enforce our issued and licensed patents, protect our trade secrets or know-how or determine the enforceability, scope and validity of the proprietary rights of others. Our involvement in intellectual property claims and litigation could:

 

   

divert and consume existing management, legal, scientific and financial resources;

 

   

subject us to significant liabilities;

 

   

allow our competitors to market competitive products or services without obtaining a license from us;

 

   

cause product shipment delays and lost sales;

 

   

require us to enter into royalty or licensing agreements, which may not be available on terms acceptable to us, if at all; or

 

   

force us to discontinue selling or to modify our products, to discontinue providing services, or to cease developing new products or services.

 

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There can be no assurance that any such litigation will result in a favorable outcome to us. Additionally, at times, other commercial laboratories that are also our customers have used assays that we believe infringe the patents underlying our licenses. When this occurs, commencing litigation, or otherwise accusing our customers of infringement, may cause them to reduce or eliminate the number of assays that they refer to us.

For a description of current litigation involving our intellectual property, see “Business—Legal Proceedings.”

We may be subject to damages resulting from claims that we or our employees have wrongfully used or disclosed alleged trade secrets of their former employers.

Many of our employees or consultants were previously employed at universities or other diagnostic or biotechnology or pharmaceutical companies, including our current and potential competitors. Although we are not aware of any claims currently pending against us, we may be subject to claims that these employees, consultants or we have inadvertently or otherwise used or disclosed trade secrets or other proprietary information of their former employers. Litigation may be necessary to defend against these claims. Even if we are successful in defending against these claims, litigation could result in substantial costs and be a distraction to management. If we fail in defending such claims, in addition to paying monetary damages, we may lose valuable intellectual property rights or personnel or both.

If we cannot obtain intellectual property owned by third parties that we desire to use or incorporate into new products we plan to develop, we may not be able to develop or commercialize these future products.

As part of our business strategy, we regularly consider and, as appropriate, may make acquisitions or purchases of intellectual property, technologies, products, assets and businesses that we believe are strategically desirable or complementary to our business. As part of this strategy, we may develop additional diagnostic tests or acquire the rights to additional pharmaceutical products. The technology that we ultimately may use in the development and commercialization of these future products may be protected by patent and other intellectual property rights owned by third parties. If we are unable to obtain rights to use necessary third-party intellectual property under commercially reasonable terms, or at all, we may be unable to develop these products, and this could harm our ability to expand our commercial product offerings and to generate additional revenue from these products.

Under our distribution agreement with AstraZeneca, we do not have the right to determine what action will be taken in the event of any infringement of the ENTOCORT® trademark.

We have the exclusive right to distribute, market and sell Entocort EC in the United States and to use the trademark, ENTOCORT®, under our distribution agreement with AstraZeneca. We believe the protection of the ENTOCORT® trademark is critical to the commercial success of Entocort EC and to our competitive position. Under the distribution agreement, AstraZeneca has the exclusive right to determine what action, if any, will be taken in the event of any infringement or threatened infringement on the above patents or the trademark. We cannot be certain that AstraZeneca will take any action in the event of an infringement or a threatened infringement of the trademark. If AstraZeneca does not adequately protect the ENTOCORT® trademark from infringement, any goodwill that has been developed in that mark may be lost or impaired.

Many of our diagnostic products and services depend upon third-party computer software.

Many of our diagnostic products and services use, are based upon or incorporate third-party or “open source” computer software. If we are unable to maintain or obtain a license to such software or keep any “open source” proprietary or if software is found to contain errors that cannot be fixed, then we may be unable to offer these diagnostic products and services, which could materially and adversely affect our business, financial condition, results of operations and growth prospects.

 

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Risks Related to Our Finances and Capital Requirements

Our quarterly operating results may fluctuate significantly.

We expect our operating results to be subject to quarterly fluctuations. Our operating results will be affected by numerous factors, including:

 

   

termination or expiration of, or the outcome of disputes relating to, patents, license agreements, trademarks and other rights;

 

   

acquisitions and sales of new products, technologies or businesses;

 

   

expenditures incurred to acquire and promote additional products, technologies or businesses;

 

   

changes in our relationships with any collaborators;

 

   

competitive pricing pressures and general economic and industry conditions which affect customer demand;

 

   

the introduction of new products by us or our competitors;

 

   

a changing customer base;

 

   

changes in sales and marketing expenditures;

 

   

the mix of products that we sell during any time period;

 

   

changes in treatment practices of physicians that currently prescribe our products;

 

   

changes in third-party insurance coverage and reimbursement policies;

 

   

supply interruptions;

 

   

varying levels of research and development expenditures due to the timing of validation studies and clinical trials and related costs, among other factors;

 

   

expenditures as a result of legal actions and the outcome of any such legal action;

 

   

the impairment and write-down of intangibles or other assets;

 

   

federal, state or international regulatory actions;

 

   

additions or departures of key personnel;

 

   

implementation of new or revised accounting or tax rules or policies;

 

   

the timing and amount of milestone payments by us;

 

   

increases in insurance rates for existing products and the cost of insurance for new products; and

 

   

timing of revenue recognition related to licensing agreements.

If our quarterly operating results fall below the expectations of investors or securities analysts, the price of our common stock could decline substantially. Furthermore, any quarterly fluctuations in our operating results may, in turn, cause the price of our stock to fluctuate substantially. We believe that quarterly comparisons of our financial results are not necessarily meaningful and should not be relied upon as an indication of our future performance.

We may require additional funding, and our future access to capital is uncertain. Insufficient funds could cause us to delay, scale back or choose not to pursue some or all of our potential product acquisitions and licensing opportunities.

We believe that our available cash balances, existing borrowing capacity under our revolving line of credit, anticipated cash flows from operations and the proceeds we receive from the exercise of stock options and this offering will be sufficient to support our current operating needs for the foreseeable future. However, our business can change unpredictably due to a variety of factors, including competition, regulation, legal proceedings or other events, which could impact our funding needs or our cash flow from operations. In addition,

 

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our estimates of the funds necessary to develop and commercialize new diagnostic tests or therapeutic products may be inaccurate or we may acquire products or other assets in the future, in each case which could require additional funds. Furthermore, we may seek additional capital due to favorable market conditions or strategic considerations even if we believe we have sufficient funds for our current or future operating plans. Accordingly, we could seek additional funding through public or private financing, including equity and debt offerings. Adequate funds, whether through the financial markets or from other sources, may not be available when we need them or on terms acceptable to us. For example, domestic and international capital markets have experienced and may continue to experience heightened volatility and turmoil, based on domestic and international economic conditions and concerns. These factors potentially make it more difficult to raise capital through the issuance of equity securities. Furthermore, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. Insufficient funds could cause us to delay, scale back or choose not to pursue some or all of our potential product acquisitions and licensing opportunities.

Raising additional capital may cause dilution to existing stockholders, restrict our operations or require us to relinquish rights.

We may seek the additional capital necessary to fund our operations through public or private equity offerings, debt financings, and collaborative and licensing arrangements. To the extent that we raise additional capital through the sale of equity or convertible debt securities, your ownership interest may be diluted and the terms may include liquidation or other preferences or rights that adversely affect your rights as a stockholder. Debt financing, if available, may involve agreements that include covenants limiting or restricting our ability to take specific actions such as incurring additional debt, making capital expenditures, or declaring dividends. If we raise additional funds through collaboration and licensing arrangements with third parties, we may have to relinquish valuable rights to our technologies or products, or grant licenses on terms that are not favorable to us.

We are a holding company with no business operations of our own and depend on our subsidiaries for cash.

We are a holding company with no significant business operations of our own. Our business operations are conducted through our subsidiaries. Dividends from, and cash generated by, our subsidiaries will be our principal sources of cash to repay indebtedness, fund operations and pay dividends, if any. Accordingly, our ability to repay our indebtedness, fund operations and pay dividends, if any, to our stockholders is dependent on the earnings and the distributions of funds from our subsidiaries. Our credit agreement significantly restricts our subsidiaries from paying dividends and otherwise transferring cash or other assets to us. In addition, our subsidiaries are permitted under our credit agreement to incur additional indebtedness that may severely restrict or prohibit the making of distributions, the payment of dividends or the making of loans by our subsidiaries to us.

Our indebtedness could adversely affect our financial health.

As of December 31, 2010, we had $178.5 million of indebtedness. Our existing indebtedness could:

 

   

impair our ability to obtain additional financing in the future for working capital needs, capital expenditures and general corporate purposes;

 

   

increase our vulnerability to general adverse economic and industry conditions;

 

   

make it more difficult for us to satisfy other debt obligations we may incur in the future;

 

   

require us to dedicate a substantial portion of our cash flows from operations to the payment of principal and interest on our indebtedness, thereby reducing the availability of our cash flows to fund working capital needs, capital expenditures and other general corporate purposes;

 

   

limit our flexibility in planning for, or reacting to, changes in our business and the industry in which we operate;

 

   

place us at a disadvantage compared to our competitors that have less indebtedness; and

 

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expose us to higher interest expense in the event of increases in interest rates because our indebtedness under our credit agreement bears, and future borrowings may bear, interest at a variable rate.

For a description of our credit agreement, see “Management’s Discussion and Analysis of Financial Condition and Results of Operations—Contractual Obligations and Commercial Commitments.”

Covenants in our credit agreement may limit our ability to operate our business.

Under the credit agreement we entered into on December 21, 2009, we are subject to certain affirmative and negative covenants, including limitations on our ability: to grant liens; to make investments; to create, incur, assume, guarantee or be liable with respect to certain indebtedness; to merge, dissolve, liquidate or consolidate our business; to convey, sell, transfer, license, lease or otherwise dispose of assets; to pay dividends and make certain other restricted payments; or to enter into any sale lease-back transactions. We are also subject to certain covenants that require us to maintain certain financial ratios and are required under certain conditions to make mandatory prepayments of outstanding principal.

As a result of these covenants and ratios, we have certain limitations on the manner in which we can conduct our business, and we may be restricted from engaging in favorable business activities or financing future operations or capital needs. In addition, if we default under the credit agreement because of a covenant breach or otherwise, all outstanding amounts could become immediately due and payable, which would negatively impact our liquidity and reduce the availability of our cash flows to fund working capital needs, capital expenditures and other general corporate purposes.

Our failure to comply with covenants under our indebtedness could lead to a breach of our distribution and promotion agreement with Novartis relating to Proleukin.

Our distribution and promotion agreement with Novartis relating to our right to distribute, market and sell Proleukin in the United States contains cross default provisions that specify that the occurrence of certain types of financing defaults by us with respect to certain types of indebtedness will be deemed to be a material breach of that agreement by us. Generally, these financing defaults may arise if (1) we fail to make payments on that indebtedness when due, including payments of deferred purchase price of property or services, lease obligations and guarantees but excluding accounts payable arising in the ordinary course of business, (2) events or conditions arise and remain uncured by us on indebtedness for borrowed money for more than a specified period of time that would accelerate, or permit the acceleration of, the maturity date of that indebtedness or (3) indebtedness for borrowed money is declared to be due and payable or is required to be repaid prior to its maturity date, excluding required prepayments not due to a breach or default under such debt agreements. Novartis has the right to terminate the distribution and promotion agreement immediately upon the occurrence of a financing default and for a period of 30 days thereafter. This termination will be effective irrespective of whether the financing default is subsequently cured or waived. If the agreement is terminated by Novartis due to our material breach, we will be subject to a restriction which would prevent us from distributing, marketing or selling any pharmaceutical product for the treatment of renal cell carcinoma and/or melanoma in the licensed territory for a specified period of time following the date of termination. Termination by Novartis due to our breach could have a material adverse effect on our results of operations and cash flows and in turn would be a separate default under our current credit agreement.

Impairment of our significant long-lived assets may reduce our profitability.

Our long-lived assets consist of property, equipment, acquired and licensed product rights, patents and trademarks. We regularly review the carrying amount of our long-lived assets. Some factors we consider important in assessing whether or not impairment exists include performance relative to expected historical or projected future operating results, significant changes in the manner of our use of the assets or the strategy for our overall business and significant negative industry or economic trends. If the carrying value of the asset exceeds projected undiscounted cash flows, the asset will be written down to its fair value, which could result in an impairment of our long-lived assets. Any impairment of our long-lived assets in the future may reduce our profitability and have a material adverse effect on our results of operations and financial condition. Our net long-lived assets were $323.2 million at December 31, 2010.

 

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Our results of operations and liquidity needs could be materially affected by market fluctuations and economic downturn.

Our results of operations could be materially affected by economic conditions generally, both in the U.S. and elsewhere around the world. Domestic and international capital markets have experienced and may continue to experience heightened volatility and turmoil based on domestic and international economic conditions and concerns. In the event these economic conditions and concerns continue or a market downturn occurs, our results of operations could be adversely affected by those factors in many negative ways, including making it more difficult for us to raise funds if necessary, and our stock price may decline. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. If economic instability continues, we cannot be assured that we will not experience losses on these deposits.

In addition, the weakening of the national economy and the recent reduced availability of credit may have decreased the financial stability of our customers. As a result, it may become more difficult for us to collect our accounts receivable or it may take us longer for us to collect our accounts receivable. If these conditions continue, our operating cash flow and results of operations could be adversely affected.

Risks Relating to Securities Markets and Investment in Our Stock

There may not be a viable public market for our common stock.

Prior to this offering, there has been no public market for our common stock, and there can be no assurance that a regular trading market will develop and continue after this offering or that the market price of our common stock will not decline below the initial public offering price. The initial public offering price will be determined through negotiations between us, the selling stockholders and the underwriters and may not be indicative of the market price of our common stock following this offering. Among the factors considered in such negotiations are the history and prospects for the industry in which we compete, market valuations of other companies that we and the representative of the underwriters believe to be comparable to us, prospects for our future earnings, the present state of our development and other factors deemed relevant. See “Underwriting” for additional information.

As a new investor, you will experience immediate and substantial dilution in the net tangible book value of your shares.

The initial public offering price of our common stock in this offering will be considerably more than the net tangible book value per share of our outstanding common stock following the completion of the IPO reorganization. Investors purchasing shares of common stock in this offering will pay a price that substantially exceeds the value of our tangible assets after subtracting liabilities. As a result, investors will:

 

   

incur immediate dilution of $             per share, based on an assumed initial public offering price of $             per share, the midpoint of the price range set forth on the cover page of this prospectus, assuming the automatic conversion of the convertible preferred stock of Prometheus Laboratories Inc. and the IPO reorganization; and

 

   

contribute     % of the total amount invested to date to fund our company based on an assumed initial offering price to the public of $             per share, the midpoint of the price range set forth on the cover page of this prospectus, but will own only     % of the shares of common stock outstanding after the offering.

To the extent outstanding stock options or warrants are exercised, there will be further dilution to new investors.

We believe that our existing cash, cash equivalents and marketable securities, together with the borrowing capacity under our credit agreement will be sufficient to meet our projected operating requirements for the foreseeable future. However, because we may need to raise additional capital in the future, we may conduct substantial additional equity offerings. These future equity issuances, together with the exercise of outstanding options or warrants and any additional shares issued in connection with acquisitions, will result in further dilution to investors.

 

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We expect that the price of our common stock will fluctuate substantially.

The initial public offering price for the shares of our common stock sold in this offering has been determined by negotiation between the representative of the underwriters and us. This price may not reflect the market price of our common stock following this offering. The price of our common stock may decline. In addition, the market price of our common stock is likely to be highly volatile and may fluctuate substantially due to many factors, including:

 

   

fluctuations in our operating results;

 

   

acquisitions and sales of new products, technologies or businesses;

 

   

regulatory developments affecting any development-stage product candidates;

 

   

the outcome of legal actions to which we are party;

 

   

additions or departures of key personnel;

 

   

announcements concerning product development results or intellectual property rights of others;

 

   

approvals or disapprovals of regulatory filings we have submitted;

 

   

changes in regulatory laws and regulations in the United States or announcements relating to these matters;

 

   

new legislation in the United States relating to the sale or pricing of pharmaceuticals;

 

   

deviations in our operating results from the estimates of securities analysts or other analyst comments;

 

   

discussion of us or our stock price by the financial and scientific press and in online investor communities; and

 

   

economic and other external factors, including disasters and other crises.

The realization of these or any of the risks described in these “Risk Factors” could have a dramatic and material adverse impact on the market price of our common stock.

Fluctuations in the value of the Euro could negatively affect the amount of any potential revenues under our non-exclusive research and collaboration agreement with Bayer.

Payments that Bayer is obligated to pay us under our research and collaboration agreement are denominated in Euros. Our reporting currency is the U.S. dollar. As a result, we are exposed to foreign exchange risk, and any future revenues we report as a result of these payments may be negatively affected by fluctuations in the exchange rate between the U.S. dollar and the Euro based upon the exact timing of when such payments become due, if at all. An appreciation in the U.S. dollar relative to the Euro will result in lower revenues under this agreement. We have entered into foreign currency hedging contracts for certain of the payments due from Bayer to potentially reduce the effect of any adverse changes in foreign currency exchange rates.

Approximately    % of our outstanding common stock has been deposited into a voting trust, which could affect the outcome of stockholder actions.

Before completion of this offering, approximately            shares of our common stock owned by affiliates of Credit Suisse Securities (USA) LLC, representing approximately    % of our common stock then outstanding, will become subject to a voting trust agreement pursuant to which the shares will be voted by an independent voting trustee.

The voting trust agreement requires that the trustee cause the shares subject to the voting trust to be represented at all stockholder meetings for purposes of determining a quorum, but the trustee is not required to vote the shares on any matter. The voting trust agreement does not provide any criteria that the trustee must use in determining whether or not to vote on a matter. If the trustee votes the shares on any matter subject to a stockholder vote, including proposals involving the election of directors, changes of control and other significant

 

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corporate transactions, the shares will be voted in the same proportion as votes cast “for” or “against” those proposals by our other stockholders. As long as these shares continue to be held in the voting trust, if the trustee determines to vote the shares on a particular matter, the voting power of all other stockholders will be magnified by the operation of the voting trust. With respect to matters such as the election of directors, Delaware law provides that the requisite stockholder vote is based on the shares actually voted. Accordingly, with respect to these matters, the voting trust will make it possible to control the “majority” vote of our stockholders with only     % of our outstanding common stock. In addition, with respect to other matters, including the approval of a merger or acquisition of us or substantially all of our assets, a majority or other specified percentage of our outstanding shares of common stock must be voted in favor of the matter in order for it to be adopted. If the trustee does not vote the shares subject to the voting trust on these matters, the effect of the non-vote would be equivalent to a vote “against” the matter, making it substantially more difficult to achieve stockholder approval of the matter. See “Description of Capital Stock—Voting Trust Agreement” for more information regarding the voting trust agreement.

Our management team may invest or spend the proceeds of this offering in ways with which you may not agree or in ways which may not yield a return.

The net proceeds from this offering will in part be used to repay debt and may be used for working capital purposes and for other general corporate purposes, including to finance in-licensing or acquisition opportunities, the research and development of new products, sales and marketing activities and other capital expenditures. Although we may also use a portion of the net proceeds to in-license or acquire complementary products or to acquire or to enter into collaborations with complementary businesses, we have no current binding commitments or agreements to do so. Our management will have considerable discretion in the application of the net proceeds, and you will not have the opportunity, as part of your investment decision, to assess whether the proceeds are being used appropriately. The net proceeds may be used for corporate purposes that do not increase our operating results or market value. Until the net proceeds are used, they may be placed in investments that do not produce significant income or that may lose value.

Future sales of our common stock may depress our stock price.

Sales of a substantial number of shares of our common stock in the public market could occur at any time. These sales, or the perception in the market that the holders of a large number of shares intend to sell shares, could reduce the market price of our common stock. After this offering, we will have            outstanding shares of common stock based on the number of shares outstanding as of February 1, 2011, after giving effect to the 1-for-1.75 reverse stock split and the automatic conversion of all of the shares of the preferred stock of Prometheus Laboratories Inc. outstanding as of February 1, 2011 into shares of its common stock in connection with this offering and the conversion of all shares of Prometheus Laboratories Inc. common stock into shares of our common stock in connection with the IPO reorganization. See “Certain Relationships and Related Party Transactions—IPO Reorganization.” This also includes the shares that we are selling in this offering, which may be resold in the public market immediately, unless the shares are held by any of our affiliates as such term is defined in Rule 144 of the Securities Act. Of the remaining shares,            shares are currently restricted as a result of securities laws or lock-up agreements but will be available for resale in the public market (subject in some cases to applicable volume limitations under Rule 144) upon the expiration of the lock-up agreements 180 days after the date of this prospectus (or longer if the lock-up period is extended) as described in the “Shares Eligible for Future Sale” section of this prospectus. In addition, as of February 1, 2011, we had outstanding options to purchase a total of 5,033,085 shares of our common stock, of which 3,895,147 were exercisable, and outstanding warrants that will be exercisable to purchase a total of 251,069 shares of our common stock following completion of this offering, which in each case if exercised, will result in these additional shares becoming available for sale upon expiration of the lock-up agreements.

Moreover, after this offering, holders of approximately            shares of common stock will have rights, subject to some conditions, to require us to file registration statements covering their shares or to include their shares in registration statements that we may file for ourselves or other stockholders. These rights will continue following this offering and will terminate on April 30, 2011, or for any particular holder with registration rights

 

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who holds less than 1% of our outstanding capital stock and less than 57,142 shares of our capital stock. We also intend to register all shares of common stock that we may issue under our equity compensation plans. Once we register these shares, they can be freely sold in the public market upon issuance, subject to the lock-up agreements described in the “Shares Eligible for Future Sale” section of this prospectus. In addition to the foregoing, certain of our stockholders, including our executive officers, intend to enter into Rule 10b5-1 plans to sell shares of our common stock during the term of the lock-up agreements, but no sales may take place until the expiration of the lock-up agreements.

Our executive officers and directors and their affiliates will exercise control over stockholder voting matters in a manner that may not be in the best interests of all of our stockholders.

Immediately following this offering, our executive officers and directors and their affiliates will together control approximately    % of our outstanding common stock. As a result, these stockholders will collectively be able to significantly influence all matters requiring approval of our stockholders, including the election of directors and approval of significant corporate transactions. The concentration of ownership may delay, prevent or deter a change in control of our company even when such a change may be in the best interests of some stockholders, could deprive our stockholders of an opportunity to receive a premium for their common stock as part of a sale of our company or our assets and might affect the prevailing market price of our common stock.

Anti-takeover provisions under our charter documents and Delaware law could delay or prevent a change in control which could limit the market price of our common stock and may prevent or frustrate attempts by our stockholders to replace or remove our current management.

Our certificate of incorporation and bylaws contain provisions that could delay or prevent a change in control of our company or changes in our Board of Directors that our stockholders might consider favorable. Some of these provisions include:

 

   

a Board of Directors divided into three classes serving staggered three-year terms, such that not all members of the Board of Directors will be elected at one time;

 

   

a prohibition on stockholder action through written consent;

 

   

a requirement that special meetings of stockholders be called only by the chairman of our Board of Directors, our president or by a majority of the members of our Board of Directors;

 

   

advance notice requirements for stockholder proposals and nominations;

 

   

a requirement of approval of not less than 662/3% of all outstanding shares of our capital stock entitled to vote to amend any bylaws by stockholder action, or to amend specific provisions of our certificate of incorporation; and

 

   

the authority of the Board of Directors to issue preferred stock on terms determined by the Board of Directors without stockholder approval.

In addition, we are governed by the provisions of Section 203 of the Delaware General Corporation Law, which may prohibit certain business combinations with stockholders owning 15% or more of our outstanding voting stock. These and other provisions in our certificate of incorporation, bylaws and Delaware law could make it more difficult for stockholders or potential acquirers to obtain control of our Board of Directors or initiate actions that are opposed by the then-current Board of Directors, including to delay or impede a merger, tender offer or proxy contest involving our company. Any delay or prevention of a change in control transaction or changes in our Board of Directors could cause the market price of our common stock to decline.

We have never paid dividends on our capital stock, and because we do not anticipate paying any cash dividends in the foreseeable future, capital appreciation, if any, of our common stock will be your sole source of gain on an investment in our stock.

We have paid no cash dividends on any of our classes of capital stock to date and we currently intend to retain our future earnings, if any, to fund the development and growth of our business. We do not anticipate

 

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paying any cash dividends on our common stock in the foreseeable future. Furthermore, our credit agreement restricts our ability to pay dividends. As a result, capital appreciation, if any, of our common stock will be your sole source of gain for the foreseeable future.

We may become involved in securities class action litigation that could divert management’s attention and harm our business.

The stock markets have from time to time experienced significant price and volume fluctuations that have affected the market prices for the common stock of pharmaceutical companies. These broad market fluctuations may cause the market price of our common stock to decline. In the past, securities class action litigation has often been brought against a company following a decline in the market price of its securities. This risk is especially relevant for us because pharmaceutical companies have experienced significant stock price volatility in recent years. We may become involved in this type of litigation in the future. Litigation often is expensive and diverts management’s attention and resources, which could adversely affect our business.

 

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SPECIAL NOTE REGARDING FORWARD-LOOKING STATEMENTS

This prospectus contains forward-looking statements. These forward-looking statements are contained in the sections entitled “Prospectus Summary,” “Risk Factors,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Business” and elsewhere in this prospectus. These statements relate to future events or our future financial performance and involve known and unknown risks, uncertainties and other factors that could cause our actual results, levels of activity, performance or achievement to differ materially from those expressed or implied by these forward-looking statements. These risks and uncertainties include, among others:

 

   

our dependence on a highly-concentrated product line and a single market;

 

   

changes in the price of, or demand for, our leading pharmaceutical products or our leading diagnostic products;

 

   

the expiration of our exclusive right to promote Entocort EC;

 

   

our ability to achieve expected sales of PROLEUKIN® (aldesleukin) for injection and maintain a reliable supply of the product;

 

   

our ability to successfully expand our business through increased strategic product or technology in-licensings or acquisitions or through development of proprietary diagnostic products;

 

   

the timing or likelihood of regulatory filings and approvals;

 

   

the potential for a change in control event under our distribution agreement with AstraZeneca LP which may result in termination of our exclusive right to promote Entocort EC;

 

   

the risk of side effects of Lotronex or any other product candidates;

 

   

the competitive environment in which we operate;

 

   

the effect of government regulations and changes in laws, regulations and policies governing the pharmaceutical and diagnostic industries, including the recently enacted PPACA;

 

   

our ability to continue to secure collaborators or partners;

 

   

competition from generic products for our branded pharmaceutical products;

 

   

our reliance on third parties for the manufacture and supply of all of the pharmaceutical products we offer;

 

   

our ability to secure alternative manufacturers of our pharmaceutical products or active pharmaceutical ingredients in the event that our agreement with any single source manufacturer is terminated;

 

   

our ability to maintain coverage and reimbursement for any of our pharmaceutical or diagnostic products;

 

   

our reliance on a limited number of wholesale pharmaceutical distributors for a majority of our pharmaceutical sales;

 

   

our ability to protect the intellectual property covering our products and the outcome of existing litigation to enforce the intellectual property covering our products; and

 

   

the prospect of acquiring other pharmaceutical product candidates in clinical development.

Forward-looking statements include all statements that are not historical facts. In some cases, you can identify forward-looking statements by terms such as “may,” “will,” “should,” “could,” “would,” “expect,” “plan,” “anticipate,” “believe,” “estimate,” “project,” “predict,” “potential,” or the negative of those terms, and similar expressions and comparable terminology 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

 

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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 prospectus and, except as required by law, we undertake no obligation to update or revise publicly any forward-looking statements, whether as a result of new information, future events or otherwise after the date of this prospectus.

The forward-looking statements contained in this prospectus are excluded from the safe harbor protection provided by the Private Securities Litigation Reform Act of 1995 and Section 27A of the Securities Act.

 

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USE OF PROCEEDS

We estimate that we will receive net proceeds of approximately $             million from the sale of the shares of common stock offered by us in this offering, or appropriately $             million if the option to purchase additional shares is exercised in full, in each case based on an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover of this prospectus, and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us. Each $1.00 increase or decrease in the assumed public offering price of $             per share would increase or decrease the net proceeds to us from this offering by approximately $             million, or approximately $             million if the option to purchase additional shares is exercised in full, in each case assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

The principal purposes for this offering are to create a public market for our common stock and to increase our ability to access the capital markets in the future. In addition, under our current credit agreement, we are required to use 50% of the net proceeds of this offering as a prepayment on the outstanding principal balance of our loan. As of December 31, 2010, we had $178.5 million in outstanding borrowings under this credit agreement, with a weighted average interest rate of 4.84%. Of the original $210.0 million loan balance, $185.0 million of these borrowings were used to fund an upfront payment of the acquisition of our rights to Proleukin and the remainder will be used for working capital and other general corporate purposes. The loans mature and the credit agreement terminates in December 2013. We intend to use the remaining net proceeds of this offering after such repayment for working capital purposes and other general corporate purposes, including to finance in-licensing and acquisition opportunities, the research and development of new products, sales and marketing activities, and capital expenditures. However, the use of net proceeds for such purposes is uncertain at this time, and the amounts and timing of our actual expenditures may vary significantly from our expectations depending on numerous factors, including our results of operations, financial condition and capital requirements. We may find it necessary or advisable to use the net proceeds for other purposes, and we will have broad discretion in the application of the net proceeds. Pending their use, we intend to invest the net proceeds in short-term, interest-bearing, investment-grade securities.

Although we may also use a portion of the net proceeds to in-license or acquire complementary products or to acquire or to enter into collaborations with complementary businesses, we have no current binding commitments or agreements to do so.

We will not receive any of the proceeds from the sale of shares by the selling stockholders.

DIVIDEND POLICY

We currently intend to retain all future earnings, if any, for use in the operation and expansion of our business and do not anticipate paying any cash dividends in the foreseeable future. Our credit agreement restricts us from paying any cash dividends to our stockholders. Any future determination related to dividend policy will be made at the discretion of our Board of Directors and will depend upon, among other factors, our results of operations, financial condition, capital requirements, contractual restrictions and such other factors as our Board of Directors deems relevant.

 

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CAPITALIZATION

The following table presents a summary of our capitalization per our balance sheet as of December 31, 2010 on an actual basis and on a pro forma as adjusted basis assuming:

 

   

a 1-for-1.75 reverse stock split of Prometheus Laboratories Inc.’s common stock to be effected prior to the completion of this offering;

 

   

the automatic conversion of all outstanding shares of the preferred stock of Prometheus Laboratories Inc. into 20,237,605 (on a post-split basis) shares of common stock at the close of business on the day immediately preceding the completion of this offering;

 

   

the consummation of the IPO reorganization described elsewhere in this prospectus; and

 

   

the issuance and sale by us of              shares of common stock in this offering and our receipt of the estimated net proceeds from this offering, based on an assumed initial public offering price of $             per share, the midpoint of the range set forth on the cover of this prospectus, after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us, and the application of 50% of the net proceeds of this offering as a mandatory prepayment on the outstanding principal balance of our borrowings under our credit agreement.

The pro forma information below is illustrative only and our capitalization following the completion of this offering will be adjusted based on the actual initial public offering price and other terms of this offering determined at pricing. You should read this table together with the sections entitled “Capitalization,” “Selected Financial Data,” “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Certain Relationships and Related Party Transactions—IPO Reorganization” and the consolidated financial statements of Prometheus Laboratories Inc. and the related notes appearing elsewhere in this prospectus.

 

     As of December 31, 2010  
     Actual     Pro Forma
as Adjusted(1)
 
     (In thousands, except
share amounts and
par values)
 

Long-term debt(2)

   $ 134,077      $                

Stockholders’ Equity:

    

Prometheus Laboratories Inc.

    

Preferred stock, $0.001 par value: 36,000,000 shares authorized, 35,415,856 convertible preferred shares issued and outstanding; no shares authorized, issued or outstanding, pro forma as adjusted

     35          

Common stock, $0.001 par value; 60,000,000 shares authorized, 5,437,650 shares issued and outstanding; 1,000 shares authorized, issued and outstanding, pro forma as adjusted

     10          

Prometheus RxDx Holdings, Inc.

    

Common stock $0.001 par value; 1,000 shares authorized issued and outstanding; 1,000 shares authorized, issued and outstanding, pro forma as adjusted

              

Prometheus RxDx Corp.

    

Preferred stock, $0.001 par value: 10,000,000 shares authorized, no preferred shares issued and outstanding; 10,000,000 shares authorized, no shares issued or outstanding, pro forma as adjusted

              

Common stock, $0.001 par value; 200,000,000 shares authorized, 1,000 shares issued and outstanding; 200,000,000 shares authorized,              shares issued and outstanding, pro forma as adjusted

         

Additional paid-in capital

     120,990     

Accumulated other comprehensive loss

     (60  

Retained earnings

     140,456     
                

Total stockholders’ equity

     261,431     
                

Total capitalization

   $ 395,508     
                

 

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(1) Each $1.00 increase or decrease in the assumed public offering price of $             per share, the midpoint of the range set forth on the cover of this prospectus, would increase or decrease, respectively, the amount of additional paid-in capital and total stockholders’ equity by approximately $             million and $             million, respectively, assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

 

(2) We have $50.0 million in revolving loans available to us under a credit agreement. No revolving loans were outstanding as of December 31, 2010.

The number of shares of common stock shown in the table above to be outstanding after the offering is based on the number of shares of Prometheus Laboratories Inc. common and preferred stock outstanding as of December 31, 2010. This number does not include as of such date:

 

   

5,089,544 shares of common stock reserved for future issuance upon the exercise of stock options outstanding under our 2000 Equity Incentive Award Plan and our 2009 Equity Incentive Award Plan, at a weighted average exercise price of $8.21 per share;

 

   

342,857 shares of common stock initially reserved for future issuance under our 2009 Employee Stock Purchase Plan, which will become effective, subject to our Board of Directors’ discretion as to when and if to implement such plan, on the day prior to the date on which we become subject to the reporting requirements of the Exchange Act; and

 

   

251,069 shares of common stock reserved for future issuance upon the exercise of outstanding warrants, at a weighted average exercise price of $3.07 per share.

 

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DILUTION

If you invest in our common stock, your interest will be diluted to the extent the initial public offering price per share of our common stock exceeds the historical net tangible book value per share of our common stock. As of December 31, 2010, our historical net tangible book value was $(49.5) million, or $(1.93) per share of common stock, based on 5,437,650 shares of our common stock outstanding, the assumed conversion of all outstanding shares of Prometheus Laboratories Inc. preferred stock into 20,237,605 shares of common stock and the consummation of the IPO reorganization. Our historical net tangible book value represents the amount of our total tangible assets reduced by the amount of our total liabilities.

After giving pro forma effect to our sale in this offering of shares of our common stock at an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover of this prospectus, and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us, and the application of 50% of the net proceeds of this offering as a mandatory prepayment on the outstanding principal balance of our borrowings under our credit agreement, our pro forma, as adjusted, net tangible book value as of December 31, 2010 would have been $             million, or $             per share of our common stock. This represents an immediate increase of net tangible book value of $             per share to our existing stockholders and an immediate dilution of $             per share to investors purchasing shares in this offering. The following table illustrates this per share dilution:

 

Assumed initial public offering price per share

     $     

Historical net tangible book value per share as of December 31, 2010

   $ (1.93  

Increase per share attributable to investors purchasing shares in this offering

    
          

Pro forma net tangible book value per share, as adjusted to give effect to this offering

    
          

Dilution to investors in this offering

     $                
          

Each $1.00 increase or decrease in the assumed public offering price of $             per share would increase or decrease our pro forma as adjusted, net tangible book value by approximately $             million, our pro forma as adjusted net tangible book value per share by approximately $             per share and the dilution to investors in this offering by approximately $             per share, assuming the number of shares offered by us, as set forth on the cover of this prospectus, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

If the underwriters exercise their option to purchase              additional shares in full, the pro forma as adjusted, net tangible book value per share after giving effect to this offering would be $             per share, and the dilution to investors in this offering would be $             per share.

 

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The following table summarizes, as of December 31, 2010 , on a pro forma as adjusted basis, the number of shares of common stock purchased from us, the total effective cash consideration paid to us, and the average price per share paid by our existing stockholders and by our new investors purchasing stock in this offering at an assumed initial public offering price of $             per share, which is the midpoint of the price range set forth on the cover of this prospectus, before deducting the estimated underwriting discounts and commissions and estimated offering expenses payable by us. The following table is illustrative only and the total consideration paid and the average price per share are subject to adjustment based on the actual initial public offering price and other terms of this offering determined at pricing. The following table does not reflect the impact of the sale of shares by the selling stockholders.

 

     Shares Purchased      Total Consideration      Average Price
Per Share
 
     Number      Percent      Amount      Percent     
     (In thousands)         

Existing stockholders before this offering

            %       $               %       $     

New investors participating in this offering(1)

               $     
                                      

Total

        %       $                      %       $                
                                      

 

(1) Excludes              shares to be sold by the selling stockholders to the new investors in this offering and for which we will not receive any proceeds.

Taking into account the sales by the selling stockholders of              shares, the number of shares held by existing stockholders, upon completion of this offering, will be             or approximately     % of the total shares of common stock outstanding, and the number of shares held by new investors participating in this offering, upon completion of this offering, will be              or approximately     % of the total shares of common stock outstanding.

Each $1.00 increase or decrease in the assumed public offering price of $             per share would increase or decrease total gross consideration paid by new investors, total gross consideration paid by all stockholders and the average price per share paid by all stockholders by $             million, $             million and $             per share, respectively, assuming the number of shares offered by us, as set forth on the cover of this prospectus exclusive of the additional shares subject to the underwriters’ option to purchase, remains the same and after deducting the estimated underwriting discounts and commissions and estimated offering costs payable by us.

If the underwriters exercise their option to purchase additional shares in full, our existing stockholders would own     % and our new investors would own     % of the total number of shares of our common stock outstanding after this offering.

The discussions and tables above assume no exercise of the outstanding options or warrants with exercise prices that are below the assumed initial public offering price. To the extent any of these options or warrants are exercised, there will be further dilution to investors in the offering.

 

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SELECTED FINANCIAL DATA

The following table summarizes certain of our selected consolidated financial data. The selected consolidated financial data as of and for each of the fiscal years ended December 31, 2006, 2007, 2008, 2009 and 2010 have been derived from the audited consolidated financial statements of Prometheus Laboratories Inc., of which the 2008, 2009 and 2010 consolidated statement of operations data and the consolidated balance sheet data as of December 31, 2009 and 2010 are included elsewhere in this prospectus. This prospectus does not include financial statements of Prometheus RxDx Corp. or Prometheus RxDx Holdings, Inc. because each has only been formed recently for the purpose of effecting the IPO reorganization and, until the consummation of the IPO reorganization, will hold no material assets and will not engage in any operations. The selected consolidated financial data should be read in conjunction with “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” “Certain Relationships and Related Party Transactions—IPO Reorganization” and the consolidated financial statements of Prometheus Laboratories Inc. and related notes included elsewhere in this prospectus.

 

    Years Ended December 31,  
    2006     2007     2008     2009     2010  
    (In thousands, except per share amounts)  

Consolidated Statement of Operations:

         

Net sales and other revenues:

         

Pharmaceutical products(1)(2)

  $ 119,150      $ 143,655      $ 195,985      $ 256,777      $ 434,655   

Diagnostic testing services(3)

    68,261        77,285        82,073        84,422        81,291   

Collaboration and other revenues

                         304        3,026   
                                       

Total revenues

    187,411        220,940        278,058        341,503        518,972   
                                       

Operating expenses:

         

Cost of sales (excludes amortization of acquired product rights)

    66,688        87,306        113,601        155,691        250,683   

Selling, general and administrative

    57,075        60,985        81,626        87,419        108,077   

Research and development

    4,622        13,024        14,628        21,787        26,308   

Amortization of acquired product rights

    3,255        3,255        12,057        13,568        28,984   
                                       

Total operating expenses

    131,640        164,570        221,912        278,465        414,052   
                                       

Income from operations

    55,771        56,370        56,146        63,038        104,920   

Interest income

    2,514        4,316        1,655        480        263   

Interest income (expense)—warrants(4)

    (2,015     (31,085     5,602                 

Interest expense—discount accretion(5)

                                (3,871

Interest expense—other

    (1,993     (3,120     (3,691     (3,244     (12,123

Other income (expense), net

    236        130        553        (2,240     (2,454
                                       

Income before income taxes

    54,513        26,611        60,265        58,034        86,735   

Provision (benefit) for income taxes

    22,274        22,293        23,040        25,942        38,520   
                                       

Net income

    32,239        4,318        37,225        32,092        48,215   

(Accretion to) reversal of redemption value of redeemable convertible preferred stock

    (5,161     35,176                        
                                       

Net income attributable to common shareholders

  $ 27,078      $ 39,494      $ 37,225      $ 32,092      $ 48,215   
                                       

Net income per common share(6)

         

Basic

  $ 1.05      $      $ 1.21      $ 1.06      $ 1.68   

Diluted

  $ 0.88      $      $ 0.77      $ 0.77      $ 1.21   

Shares used to compute net income per common share(6)

         

Basic

    5,538        5,717        5,453        5,166        5,416   

Diluted

    6,631        5,717        8,541        7,138        7,486   

Pro forma net income per common share(6):

         

Basic

          $ 1.88   

Diluted

          $ 1.74   

Shares used to compute pro forma net income per common share(6):

         

Basic

            25,654   

Diluted

            27,724   

 

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     As of December 31,  
     2006     2007      2008      2009      2010  
     (In thousands)  

Balance Sheet Data:

             

Cash, cash equivalents and marketable securities

   $ 78,291      $ 81,915       $ 96,686       $ 61,904       $ 87,846   

Working capital(7)

     72,751        51,186         107,746         49,039         74,855   

Total assets

     167,331        261,025         284,837         504,863         558,394   

Total long-term debt, less current portion

     22,700        71,250         63,750         178,500         134,077   

Redeemable preferred stock(8)

     102,405                                  

Total shareholders’ equity (deficit)(8)

     (6,987     104,970         170,928         208,144         261,431   

 

(1)

We entered into an exclusive agreement with AstraZeneca LP for the marketing, sale and distribution of ENTOCORT® EC (budesonide) Capsules in the United States beginning January 1, 2005. Entocort EC sales are included in our operations since that date. In November 2007, we began selling LOTRONEX® (alosetron hydrochloride) Tablets in the United States under a distribution agreement with GlaxoSmithKline. In January 2008, we acquired Lotronex from GlaxoSmithKline and paid $80.0 million and issued 714,285 shares of Prometheus Laboratories Inc. common stock to GlaxoSmithKline. In February 2010, we began selling PROLEUKIN (aldesleukin) for injection in the United States under an exclusive distribution agreement with Novartis Vaccines and Diagnostics, Inc. We also launched a generic mercaptopurine product through a third-party distributor in February 2004. See Notes 1 and 2 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(2) The year ended December 31, 2009 reflects $3.7 million of allowances for managed care rebates related to the Department of Defense Tricare Retail Pharmacy program pursuant to a final rule that became effective on May 26, 2009 ($1.8 million relates to sales made during 2008 and $1.9 million relates to sales in 2009). See Note 1 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(3) The year ended December 31, 2006 includes a $3.6 million increase in net sales as a result of a change in estimate.

 

(4) Reflects the accretion or reversal of accretion of the redeemable warrants to their estimated fair value. See Note 9 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(5) Reflects the accretion of the present value discount of deferred license extension payments. See Note 2 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

 

(6) See Note 1 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus for an explanation of the net income and shares used in computing net income per share.

 

(7) Working capital is calculated by subtracting total current liabilities from total current assets.

 

(8) Prior to April 10, 2007, the holders of each series of the Series C, Series D and Series E Preferred Stock of Prometheus Laboratories Inc. could have also elected to have their shares redeemed for the applicable liquidation value. However, the holders of the Series C, Series D and Series E Preferred Stock did not exercise the redemption right during the election period which ended on April 10, 2007 and, as a result, there are no further redemption rights with respect to the Series C, Series D and Series E Preferred Stock. Accordingly, the Series C, Series D and Series E Preferred Stock were reclassified to shareholders’ equity as of that date.

 

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MANAGEMENT’S DISCUSSION AND ANALYSIS OF

FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with “Selected Financial Data” and the consolidated financial statements of Prometheus Laboratories Inc. and related notes appearing elsewhere in this prospectus and assumes the consummation of the IPO reorganization. This prospectus does not include financial statements of Prometheus RxDx Corp. or Prometheus RxDx Holdings, Inc. because each has only been formed recently for the purpose of effecting the IPO reorganization and, until the consummation of the IPO reorganization, will hold no material assets and will not engage in any operations. In addition to historical information, this discussion and analysis contains forward-looking statements that involve risks, uncertainties and assumptions. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of certain factors, including but not limited to those set forth under “Risk Factors” and elsewhere in this prospectus.

Overview

We are a specialty pharmaceutical and diagnostic company committed to developing and commercializing novel pharmaceutical and diagnostic products to help physicians individualize patient care. We sell both pharmaceutical products and complementary diagnostic testing services. Historically, our products and services have focused on the detection, diagnosis and treatment of gastrointestinal diseases and disorders in the United States. We have experienced significant sales growth in our pharmaceutical products segment in 2008, 2009 and 2010, through the addition of new products and through the growth of existing products. We expanded our sales force and began selling ENTOCORT® EC (budesonide) Capsules in 2005 under a distribution agreement with AstraZeneca LP, or AstraZeneca, significantly increasing our net sales and selling, general and administrative costs to support the product. In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline. Lotronex is a pharmaceutical product for the treatment of severe diarrhea-predominant irritable bowel syndrome, or IBS, in female patients who meet the conditions stated in the product label. We sold Lotronex under an exclusive distribution agreement from November 1, 2007 until the acquisition was completed on January 4, 2008. In December 2009, we acquired exclusive rights from Novartis Vaccines and Diagnostics, Inc., or Novartis, distribute, promote and sell PROLEUKIN® (aldesleukin) for injection in the United States for the treatment of adults with metastatic renal cell carcinoma and metastatic melanoma. We expanded our sales force and expect to incur additional costs for marketing and other supporting costs as a result of this acquisition from Novartis. We began selling Proleukin in February 2010 with a newly established oncology sales force. Prior to 2005, our gastroenterology sales force principally promoted our diagnostic testing services.

Growth in our pharmaceuticals segment reflects the addition of Entocort EC in January 2005, Lotronex in 2007 and Proleukin, with sales beginning in February 2010. Our other pharmaceutical products principally consist of branded products that we do not promote as they no longer have adequate patent protection. Consistent with our expectations, sales of these products have and are expected to continue to decline as market share is lost to generics and other competitive products. We also launched a generic pharmaceutical product, mercaptopurine, in February 2004 through a third-party distributor. As with other generic products, sales of mercaptopurine have declined each year since its introduction as additional generics have entered the market. Future declines in our pharmaceuticals could be further attributable to the expiration of our distribution agreement with AstraZeneca. In November 2010, the distribution agreement was extended for a period of up to one year, expiring upon the earlier of December 31, 2011 or 30 days after the sale of a generic equivalent in the United States. Unless the distribution agreement is renewed or its term extended, we will lose all rights to market and sell Entocort EC after such date. We currently do not expect the agreement to be renewed or extended.

Since 2005, growth in our diagnostics segment has been principally driven by product improvements and the growth of our existing products. We introduced improvements to our testing services for both IBD and celiac disease in 2006 and launched our new Crohn’s disease prognostic test in the third quarter of 2010. For the year ended December 31, 2010, our diagnostic testing services revenues decreased approximately $3.1 million from the year ended December 31, 2009, due primarily to lower unit volumes that resulted from an overall reduction in physician office visits by patients and decreased sales force promotion, in addition to decreased payor reimbursement. The decreased sales force promotion on diagnostics resulted from a shift to increased promotional effort on Lotronex.

 

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In March 2010, we entered into a non-exclusive collaboration agreement with Bayer Schering Pharma AG, or Bayer, pursuant to which we will develop diagnostic tests specifically tailored to oncology pharmaceutical compounds which Bayer has under development. In December 2010, we also entered into a mutation analysis services agreement with Bayer. The expanded information derived from this agreement has the potential to improve patient stratification in clinical studies and accelerate the development of novel diagnostic and therapeutic products.

Collaboration and other revenues for the years ended December 31, 2009 and 2010 included revenue recognized from the upfront payment and research funding in connection with the Bayer and other collaborations, in addition to royalties and other non-recurring milestone payments from an exclusive out-license agreement.

Our results of operations could be materially affected by economic conditions generally, both in the U.S. and elsewhere around the world. Issues related to the availability and cost of credit, concerns of the U.S. deficit and debt level, the U.S. mortgage market, a declining residential real estate market in the U.S., inflation, energy costs and geopolitical issues have contributed to declining business and consumer activity and increased unemployment. The global economy experienced a significant economic recession during 2008 and 2009; economic recovery began in 2010 but at weak levels. Domestic and international capital markets have also experienced heightened volatility and turmoil. In the event of an additional market downturn, our results of operations could be adversely affected by those factors in many negative ways, including making it more difficult for us to raise funds if necessary, and our stock price may decline. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. We cannot be assured that we will not experience losses on these deposits.

As a result of volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by tighter credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers. While improving, such conditions in the U.S. and international markets and economies may adversely affect our ability to obtain additional financing on terms acceptable to us, or at all. If these market conditions continue, they may limit our ability to timely replace maturing liabilities and to access the capital markets to meet liquidity needs.

IPO Reorganization

We were incorporated in Delaware in June 2009 and are a wholly owned subsidiary of Prometheus Laboratories Inc. Prometheus Laboratories Inc. is undertaking a reorganization in connection with this offering as a result of which we will become a holding company for Prometheus RxDx Holdings, Inc., which will in turn be a holding company for Prometheus Laboratories Inc. Following the automatic conversion of Prometheus Laboratories Inc.’s preferred stock into shares of its common stock at the close of business on the day immediately prior to the completion of this offering, Prometheus Laboratories Inc. will be merged with our recently formed subsidiary, Prometheus California Inc., with Prometheus Laboratories Inc. surviving the merger and continuing as our operating subsidiary. At the time of the merger, outstanding shares of the common stock of Prometheus Laboratories Inc. will be converted (on a post-split basis) into the right to receive shares of our common stock on a one-for-one basis. In addition, we will assume (on a post-split basis) the equity plans of Prometheus Laboratories Inc., the options and rights granted thereunder, as well as any outstanding warrants previously granted to purchase shares of capital stock of Prometheus Laboratories Inc., all on a one-for-one basis and on the same terms and conditions. See “Certain Relationships and Related Party Transactions—IPO Reorganization.” Subsequent to the completion of the reorganization and this offering, Prometheus Laboratories Inc. plans to undergo a name change whereby it will change its name to Prometheus RxDx, Inc.

Critical Accounting Policies, Estimates and Assumptions

The preparation and presentation of financial statements in conformity with U.S. generally accepted accounting principles, or GAAP, requires us to establish policies and to make estimates and assumptions that affect the amounts reported in our consolidated financial statements. Accounting assumptions and estimates are inherently

 

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uncertain and actual results may differ materially from our estimates. Our significant accounting policies are more fully described in Note 1 to the consolidated financial statements included elsewhere in this prospectus.

Revenue Recognition—Pharmaceutical Products

Revenues from pharmaceutical product sales are generally recognized upon delivery and passage of title to customers and are presented net of amounts estimated for cash discounts, returns, rebates, chargebacks and other allowances. These reductions are estimated based on contractual requirements, historical experience, trends in physicians’ prescribing patterns, analysis of the estimated inventory levels in the distribution channel and product lot expiration dates.

We utilize wholesalers as the principal means of distributing our products to healthcare providers such as hospitals and pharmacies. We monitor sales and estimate the inventory levels held by the wholesalers using data obtained from wholesalers who currently make up approximately 96% of our gross pharmaceutical product sales. We have agreements with three of our largest wholesalers which provide us with data on inventory levels and demand. In addition, our two largest wholesalers have agreed to manage their inventory levels within certain limits based on demand in conjunction with inventory management agreements. We regularly review the inventory data as compared to prescription trends, lot expirations and expected market changes in estimating allowances for returns, rebates and chargebacks. We believe wholesaler inventory levels are being maintained at reasonable levels given demand.

Accruals for sales allowances are recorded in the same period that the related sales are recognized, as a reduction to product sales. Pharmaceutical product sales are net of the following sales allowances in the years ended December 31, 2008, 2009 and 2010:

 

     Years Ended December 31,  
     2008      2009      2010  
    

(In thousands)

 

Sales returns

   $ 4,808       $ 7,450       $ 8,466   

Medicaid rebates

     5,162         9,545         15,734   

Chargebacks

     7,534         15,697         28,683   

Discounts and other allowances

     7,581         16,739         29,335   
                          

Total sales allowances

   $ 25,085       $ 49,431       $ 82,218   
                          

% of gross sales

     11%         16%         16%   

Pharmaceutical sales allowances were $25.1 million, $49.4 million and $82.2 million for the years ended December 31, 2008, 2009 and 2010, respectively. For the year ended December 31, 2008, pharmaceutical sales allowances reflect the first full year effect of Lotronex, which we acquired in January 2008. For all periods presented, pharmaceutical sales allowances reflect substantial growth in sales of Entocort EC. Pharmaceutical sales allowances further reflect the addition of Proleukin in February 2010. Relative to sales, Entocort EC has a proportionately lower level of returns due to its high volume and turnover compared to our other pharmaceutical products. Increases in Medicaid rebates, chargebacks and other discounts and allowances for the years ended December 31, 2009 and 2010 are attributable primarily to increases in product pricing and pharmaceutical revenues in the periods. In addition, the increase in chargebacks in 2009 and 2010 reflects incremental allowances of $3.7 million and $4.5 million, respectively, related to the U.S. Department of Defense, or DOD, Tricare Retail Pharmacy program pursuant to a final rule that became effective on May 26, 2009. The final rule implements the DOD’s revised interpretation of the National Defense Authorization Act of 2008, or NDAA, that was signed into law on January 28, 2008. The final rule changed the process by which managed care rebate obligations for the Tricare Retail Pharmacy program are created such that a contractual agreement is no longer required and the obligation to pay such rebates emanates from the NDAA itself. In consideration of this final rule, of the $3.7 million incremental allowances recorded in 2009, approximately $1.8 million represents a retroactive rebate assessment for pharmaceutical product sales made during 2008. We are in the process of requesting a waiver to appeal the 2008 retroactive rebate assessment, the outcome of which is uncertain.

 

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In March 2010, the Patient Protection and Affordable Care Act healthcare legislation, as amended by the Health Care and Education Affordability Reconciliation Act, or collectively the PPACA, was enacted in the U.S. This legislation contains several provisions that affect our business. Although many provisions of the new legislation do not take effect immediately, several provisions became effective in the first quarter of 2010. These include (1) an increase in the minimum Medicaid rebate to states participating in the Medicaid program from 15.1% to 23.1% on our branded pharmaceutical products; (2) the extension of the Medicaid rebate to Managed Care Organizations that dispense drugs to Medicaid beneficiaries; (3) the expansion of the 340(B) Public Health Services drug pricing program, which provides outpatient drugs at reduced rates, to include additional hospitals, clinics and healthcare centers; and (4) a directive issued by the Center for Medicaid Services indicating changes to the calculation of the unit rebate amount to be no greater than average manufacturing price.

Beginning in 2011, the new law requires drug manufacturers to provide a 50% discount to Medicare beneficiaries whose prescription drug costs cause them to be subject to the Medicare Part D coverage gap. Also, beginning in 2011, we will be assessed our share of a new fee payable by all branded prescription drug manufacturers and importers. This fee will be calculated based upon each organization’s percentage share of total branded prescription drug sales to U.S. government programs (such as Medicare, Medicaid and Veteran’s Administration and Public Health Service discount programs) made during the previous year. This fee is expected to be included in operating expenses. Based upon our branded prescription drugs sold through U.S. government programs and the applicable fee structure, our 2011 fee estimate is between $0.4 million to $0.8 million.

The manner in which this new legislation will be implemented is still being formulated. For example, the Health Resources and Services Administration, or HRSA, is developing policy and implementation plans and building system capacity necessary to enroll new covered entities that are impacted by the new legislation. This will allow HRSA to begin working directly with new eligible entities and enrolling them in the 340(B) program. As a result, we do not yet know when and how discounts will be provided to the additional entities eligible to participate under the 340(B) program. In addition, the operation of the Medicare Part D coverage gap and the calculation and allocation of the annual fee on branded prescription drugs remains unclear.

We take a proactive approach to monitoring and evaluating new laws and regulations that impact our industry, including the NDAA and the PPACA. The financial impact of these newly issued laws and regulations are included in our results of operations for the year ended December 31, 2010, to the extent applicable.

The following table provides a summary of activity with respect to our pharmaceutical allowances:

 

    Sales Returns     Managed Care,
Medicare
and Medicaid
Rebates
    Chargebacks     Discounts
and Other
Allowances
 
    (In thousands)  

Balance December 31, 2007

    7,188        1,259        1,362        465   

Current Provision(1)

    4,533        5,162        7,534        7,581   

Credits Issued(2)

    (2,046     (4,495     (7,471     (6,849

Changes in Prior Year Estimate(3)

    275                        
                               

Balance December 31, 2008

    9,950        1,926        1,425        1,197   

Current Provision(1)

    7,125        9,649        14,060        16,739   

Credits Issued(2)

    (5,104     (6,853     (12,066     (14,790

Changes in Prior Year Estimate(3)(4)

    325        (104     1,637          
                               

Balance December 31, 2009

    12,296        4,618        5,056        3,146   

Current Provision(1)

    9,306        15,734        28,732        29,335   

Credits Issued(2)

    (6,171     (10,442     (26,772     (27,633

Changes in Prior Year Estimate(3)

    (840     —          (49     —     
                               

Balance December 31, 2010

  $ 14,591      $ 9,910      $ 6,967      $ 4,848   
                               

 

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(1) Represents increases in the allowances for sales returns, managed care, Medicare and Medicaid rebates, chargebacks, discounts and other allowances related to sales in the applicable year.

 

(2) Credits are reported in the year that they are issued. In general, sales returns are received in years subsequent to the year of sale while credits for the other allowances relate to sales in both the current year and the immediately preceding year.

 

(3) Changes in estimate represent adjustments to allowances related to prior years’ sales.

 

(4) Changes in prior year estimate relating to chargebacks includes a retroactive rebate assessment of $1.8 million related to the Tricare Retail Pharmacy program.

Sales Returns

In general, our wholesale and retail customers can return our pharmaceutical products for up to six months following the date of expiration. We have inventory agreements with two of our largest wholesalers that provide for returns of our pharmaceutical products for up to 12 months following the date of expiration. We base our sales returns allowance on our actual returns history, known or expected market events, trend experience, lot expiration dates and estimated inventory levels in the distribution channel. We also consider product demand and the impact of product price increases. In addition, we consider external factors such as competitive pricing pressure, known or expected introductions of new products or possible generic encroachment that may impact our estimates for sales returns. We monitor this activity and re-evaluate returns allowance rates and balances on a periodic basis.

Pharmaceutical products that are returned to us are evaluated on an individual basis to determine eligibility for the issuance of credit, in accordance with our corresponding wholesaler or retail customer returned goods policy. If eligible, credit is issued at the time of the pharmaceutical product return in the form of a credit memo. No returned product is exchanged for saleable product from inventory in conjunction with any returns transaction.

Accrued sales returns were $10.0 million, $12.3 million and $14.6 million as of December 31, 2008, 2009 and 2010, respectively. The increase in accrued sales returns from 2008 to 2010 principally reflects increased sales of Entocort EC in 2009 and 2010, and the addition of Proleukin in February 2010. Returns as a percentage of sales decreased from 2.2% in 2008 to 1.6% in 2010, due primarily to increased sales of Entocort EC. As Entocort EC sales and product demand increases, product turns over more rapidly in the retail channel reducing the overall returns rate. Products with declining sales generally experience higher returns as a percentage of sales. As reflected in the table above, we have not experienced significant or material changes in estimates related to returns in the periods presented.

Managed Care, Medicare and Medicaid Rebates

Managed Care, Medicare and Medicaid rebates are amounts we are required to refund or issue credit for, to the extent we participate in certain federal and state Managed Care programs. These allowances are recorded based on historical trends, projected changes in pricing and our level of participation in such programs, as well as any expected changes in product sales into such programs. We monitor our rebate activity, allowance rates and balances on a periodic basis.

Accrued rebate allowances were $1.9 million, $4.6 million and $9.9 million as of December 31, 2008, 2009 and 2010, respectively. Rebates as a percentage of sales increased from 2.3% in 2008 to 3.1% in 2009 and 3.0% in 2010. Rebates have increased as a percentage of sales in 2009 and 2010, due primarily to the impact of price increases for Entocort EC and Lotronex exceeding the annual allowable CPI-U inflationary index. Further, effective January 1, 2010, Medicaid rebates were increased by the recently enacted PPACA.

Chargebacks

Chargebacks are generated from contractual agreements with wholesalers or other managed care organizations that we have entered into to sell our pharmaceutical products at the prices specified in such agreements. These customers purchase our products through wholesalers at contracted prices. We are then charged for the incremental difference between the selling price and the contracted price at which the product

 

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was sold. These chargebacks are generally processed by the wholesaler, reported to us and netted against amounts due to us from the wholesalers. We base our allowance for chargebacks on contract discount rates and historical chargeback realization, adjusting for the addition of new or terminated contracts, and changes in buying patterns or pricing. Most of our contracts are for discounts off list price and therefore move in a manner consistent with price increases. We monitor chargeback activity and evaluate allowance rates and balances on a periodic basis.

Accrued chargebacks were $1.4 million, $5.1 million and $7.0 million as of December 31, 2008, 2009 and 2010, respectively. The increase in chargebacks as a percentage of sales from 3.4% in 2008 to 5.5% in 2010 is primarily attributable to the impact of the legislative ruling for the DOD’s Tricare Retail Pharmacy program, which changed the process by which managed care rebate obligations for the Tricare Retail Pharmacy program are created. Since the inception of this ruling, total chargebacks of $8.2 million have been recorded over 2009 and 2010, or approximately 1% of sales over such period, of which $1.8 million represents a retroactive rebate assessment for pharmaceutical product sales made during 2008. Additionally, the increase in chargebacks as a percentage of sales is attributable to the addition of Proleukin in February 2010, growth of Lotronex, and the price and volume growth of Entocort EC.

Discounts and Other Allowances

We record allowances for prompt payment discounts, inventory management agreement fees, patient assistance programs and other allowances, if any, based on payment and other contractual terms extended to customers. These discounts and allowances move in tandem with sales.

Other than increases in allowances recorded as a result of increased pharmaceutical product sales and the net effect of previously noted changes in legislation, we have not experienced any material changes in estimates or market conditions in the year ended December 31, 2010 that would significantly differ from prior years presented.

Revenue Recognition—Diagnostic Testing Services

Revenues from diagnostic testing services are recognized once the services have been performed and the results have been reported to the customer. For diagnostic testing services, we typically invoice laboratories or hospitals with which we have a direct bill agreement, or commercial and governmental insurance providers on behalf of patients, as the primary payors of amounts due for the services we perform. We recognize sales to our direct bill accounts based on their negotiated fee schedule, if applicable, while sales billed to commercial and governmental insurance providers are invoiced at list price. We provide for estimated contractual allowances as a reduction in gross revenues at the time of sale based upon contracts, past payment experience and consideration of other payor-specific factors such as test-specific coverage policies. Contractual allowances as a percentage of gross diagnostic revenues were approximately 7%, 7% and 8% for 2008, 2009 and 2010, respectively. In general, the increase in contractual allowances as a percentage of gross diagnostic revenues from 2008 to 2010 is attributable to an anticipated decrease in contractual payments due to the current economic environment resulting in continued competitive pricing pressure and an overall reduction in managed care reimbursement, offset by improvements in the commercial payor billing and collections process, including increased billing frequency and claims appeal follow-up.

We invoice patients for amounts uncollected from third parties, when allowed by law and not restricted by contract, and for those amounts directly owed by patients. A bad debt allowance is also recorded at the time of sale for estimated losses on amounts estimated to be ultimately due from patients or direct bill customers. The collection of receivables due from patients is subject to credit risk and the ability of the patients to pay. Charges for bad debts are charged to general and administrative expense. Bad debts as a percentage of gross diagnostic revenues were approximately 4%, 4% and 3% in 2008, 2009 and 2010, respectively. The decrease in bad debt allowances as a percentage of gross diagnostic revenues from 2008 to 2010 is attributable to improvements made in the billing and collections process, including increased billing frequency and dispute resolution.

We estimate contractual and bad debt allowances based on a number of factors, including our collection history and trends, payor reimbursement levels, and market events. We review our estimates at least quarterly

 

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and regularly meet with our billing and trade groups to identify collection issues and contract changes or new pricing agreements which may impact our receivables and allowances. In addition, over the past several years, we have increased the number of “direct bill” accounts. These accounts include hospitals and other commercial laboratories which are billed based on a negotiated fee schedule. Our direct bill accounts pay us directly and then bill and collect from insurance companies and other payors without recourse to us, reducing our exposure to contractual allowances and collection risks. We have not experienced material changes in diagnostic testing services contractual allowances, payor/customer mix or bad debt allowances in the year ended December 31, 2010 that would significantly differ from prior years presented.

The majority of direct billings are paid within contractual terms. Any accounts past due will be contacted by collections personnel as needed to resolve any issues. Amounts billed to, but not paid by, commercial insurance providers are billed to patients; however, unpaid insurance claims might not be transferred to patients for several months depending on the reasons for the denial of the claims and the timing of the appeals process, if any. Other receivables due from insurance providers are written-off as uncollectible against the allowance for doubtful accounts after reasonable collection efforts have been exhausted. Patients are invoiced on at least a monthly basis until collected. Patient accounts that are significantly past due are written-off and transferred to a third-party collection agency, generally no sooner than six months from the date of service. At the end of each calendar year, any remaining diagnostic accounts receivable with a date of service of over 16 months prior to such year end are written-off unless subject to current collection activities or unexpired Medicare statutes.

The following table sets forth our accounts receivable balances for diagnostic testing services outstanding by aging category for each major payor source as of December 31, 2010:

 

     Days Outstanding  
     <60 Days      61-120 Days      >120 Days      Total  

Direct bill

   $ 9,261       $ 1,917       $ 173       $ 11,351   

Commercial payors

     1,833         227         62         2,122   

Patient

     1,411         920         1,534         3,865   

Medicare/Medicaid and other

     152         45         26         223   
                                   

Total accounts receivable

   $ 12,657       $ 3,109       $ 1,795         17,561   
                             

Less: Allowances for doubtful accounts

              (2,096
                 

Accounts receivable, net

            $ 15,465   
                 

The following table sets forth our accounts receivable balances for diagnostic testing services outstanding by aging category for each major payor source as of December 31, 2009:

 

     Days Outstanding  
     <60      61-120      >120      Total  
     (In thousands)  

Direct bill

   $ 9,450       $ 1,218       $ 449       $ 11,117   

Commercial payors

     1,824         151         110         2,085   

Patient

     1,775         1,039         1,627         4,441   

Medicare/Medicaid and other

     164                 26         190   
                                   

Total accounts receivable

   $ 13,213       $ 2,408       $ 2,212       $ 17,833   
                             

Less: Allowances for doubtful accounts

              (1,960
                 

Accounts receivable, net

            $ 15,873   
                 

Our day’s sales outstanding, which is computed on net accounts receivable, was 69 days as of December 31, 2009 and December 31, 2010, respectively. The allowance for doubtful accounts as a percentage of gross accounts receivable related to our diagnostic testing services was materially consistent at 11% and 12% as of December 31, 2009 and December 31, 2010, respectively.

 

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Revenue Recognition—Collaboration and Other Revenues

We analyze each element of our collaborative or license arrangements to determine the appropriate revenue recognition.

Upfront Payments

We recognize revenue from non-refundable upfront payments over the related performance period or at the time we have satisfied all performance obligations. In accordance with authoritative guidance for revenue arrangements with multiple deliverables, those deliverables are divided into separate units of accounting if the delivered item has stand-alone value, the customer has a general right of return relative to the delivered item and delivery or performance of the undelivered item(s) is probable and substantially within the vendor’s control. These criteria must be met in order for a delivered item to be accounted for as a separate unit.

Research Service Fees

We recognize research service fees, or collaborative research revenues, as revenue over the contractual research term in accordance with the collaboration agreements as negotiated contractual amounts are earned. If we cannot separate ongoing research services from upfront payments received, as defined by relevant guidance for revenue arrangements with multiple deliverables, these elements of the collaboration agreement are considered a combined unit of accounting and recognized ratably over the term of the contractual obligation.

Milestones

Milestone payments are recognized as revenue using the milestone method. Under the milestone method, consideration earned from achievement of the milestone is indicative of the value provided to the partner through either (1) the efforts performed by the vendor or (2) a specific outcome resulting from the partner’s performance to achieve a specific milestone. Revenue from a milestone achievement is recognized when earned, provided that the milestone event is substantive, the achievability of the underlying event was not reasonably assured at the inception of the agreement, the milestone event represents the culmination of an earnings process and the milestone payment is non-refundable.

Royalty Revenue

Royalty revenue is recognized related to the sale or use of our products or technologies under license agreements with third parties. For those arrangements where royalties are reasonably estimable, we recognize revenue based on estimates of royalties earned during the applicable period and adjust for differences between the estimated and actual royalties in the following period. Historically, these adjustments have not been material.

Intangibles and Long-Lived Assets

Intangibles and long-lived assets, including fixed assets, are continually monitored and are reviewed for impairment whenever events or changes in circumstances indicate that the carrying amount of any such asset may not be recoverable. The determination of recoverability is based on an estimate of undiscounted cash flows expected to result from the use of an asset and its eventual disposition. The estimate of cash flows is based upon, among other things, certain assumptions about expected future operating performance, growth rates and other factors. Our estimates of undiscounted cash flows may differ from actual cash flows due to, among other things, technological changes, economic conditions, changes to our business model or changes in our operating performance. If the sum of the undiscounted cash flows is less than the carrying value of the asset, we recognize an impairment charge, measured as the amount by which the carrying value exceeds the fair value of the asset. We estimate fair value by discounting the projected cash flows expected to be generated by the applicable asset over their remaining useful life.

We believe the fair values and the useful lives of our intangible and long-lived assets are appropriate based upon the current and future cash flows expected from such assets, and our estimates and assumptions used in projecting such cash flows to be reasonable given available facts and circumstances as of December 31, 2009 and 2010.

 

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We record amortization for intangible assets based upon the straight-line method unless another method better reflects the manner in which the asset will be consumed. For acquired product rights for which we can reliably estimate associated future revenues, we amortize the acquired intangible assets based upon the current period revenue for the related product as a percentage of the total undiscounted revenue projected for the product, over the expected life of the acquired intangible asset. If actual net revenues or the plans and estimates used in future revenue forecasts materially differ from estimates used to calculate amortization, we will adjust prospective amortization as necessary. We assess our ability to reliably estimate future revenue based upon a number of factors, including the history and stability of past product revenues at the time that the product right is acquired. In cases where historical product revenues do not exist or are not indicative of anticipated future revenues for an acquired product right, the straight-line method of amortization is used.

Stock-Based Compensation

Prometheus Laboratories Inc. applies the respective authoritative guidance for Stock Compensation, which requires the measurement and recognition of compensation expense for all share-based payments made to employees and directors. The guidance establishes that the fair value of share-based awards is estimated at the grant date using an option-pricing model, and the portion that is ultimately expected to vest is recognized as compensation expense over the requisite service period. Prometheus Laboratories Inc. recognized stock-based compensation expense of approximately $2.9 million, $4.5 million and $4.6 million for the years ended December 31, 2008, 2009 and 2010, respectively. Stock-based compensation may fluctuate significantly based on changes in fair market value due to changes in stock prices, volatility, exercise patterns and the other factors as discussed below used to value stock-based compensation.

The process of estimating the fair value of share-based compensation awards and recognizing share-based compensation expense over the related requisite service period involves significant estimates and assumptions. Prometheus Laboratories Inc. estimated the fair value of share-based awards on the date of grant using a Black-Scholes option-pricing model, which requires management to make certain assumptions including (1) the expected volatility in the market price of our common stock; (2) a risk-free rate of interest; (3) an estimated dividend yield; (4) the period of time employees are expected to hold the award prior to exercise; (5) a rate of forfeiture, including option expiration and cancellations, that will occur prior to or during the vesting term; and (6) the fair value of the underlying common stock.

To estimate the expected volatility under the Black-Scholes option pricing model, Prometheus Laboratories Inc. utilized the disclosed stock price volatility of industry peers of a similar size whose shares are publicly-traded, due to its lack of a trading history, and calculated an even blend of their historical and implied volatility. The risk-free interest rate assumption was based on zero coupon U.S. Treasury instruments whose term was consistent with the expected term of its share-based grants. There was no assumed dividend yield as it did not expect to pay dividends for the foreseeable future. Prometheus Laboratories Inc. estimated the expected term of the options using the “simplified” method. Under this method, the expected term is calculated as the average of the time-to-vesting and the contractual life of the option. The FASB revised authoritative guidance for Stock Compensation also requires the issuer to estimate the expected impact of forfeited awards and to recognize stock-based compensation expense only for those awards expected to vest. Prometheus Laboratories Inc. used historical experience to estimate its projected rate of forfeitures. If actual forfeiture rates are materially different from the estimates, stock-based compensation expense could be significantly different from what was recorded. We will periodically review actual forfeiture rates and revise our estimates as considered necessary. The cumulative effect on current and prior periods of a change in the estimated forfeiture rate will be recognized as compensation expense in the period of the revision.

 

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The following table summarizes by grant date the number of shares of common stock subject to options granted in the years ended December 31, 2008, 2009 and 2010, the associated per share exercise price and the per share estimated fair value of the common stock. The exercise prices were set by the Board of Directors of Prometheus Laboratories Inc. at prices believed to equal or exceed the fair value of our common stock at each of the grant dates. The estimated per share fair values are based on the contemporaneous valuations as described below.

 

Grant Date

   Number of
Options Granted
     Per Share
Exercise Price
     Estimated
Per Share
Fair Value
 

March 20, 2008

     247,809       $ 15.89       $ 15.89   

July 10, 2008

     450,755       $ 14.49       $ 14.49   

September 11, 2008

     207,073       $ 15.54       $ 15.54   

November 13, 2008

     65,850       $ 12.20       $ 12.20   

March 12, 2009

     98,405       $ 10.26       $ 10.26   

June 18, 2009

     458,307       $ 10.47       $ 10.47   

July 1, 2009

     71,425       $ 10.47       $ 10.47   

September 17, 2009

     72,557       $ 9.49       $ 9.49   

November 19, 2009

     405,738       $ 9.33       $ 9.33   

December 14, 2009

     1,284       $ 9.33       $ 9.33   

December 18, 2009

     37,142       $ 9.33       $ 9.33   

February 25, 2010

     128,314       $ 14.49       $ 14.49   

July 1, 2010

     108,266       $ 13.06       $ 13.06   

September 16, 2010

     282,134       $ 13.06       $ 13.06   

November 17, 2010

     23,137       $ 14.11       $ 14.11   

Beginning in March 2006, the Board of Directors of Prometheus Laboratories Inc. considered contemporaneous valuations provided by management in determining the fair value of our common stock. Such valuations valued the common stock as described below:

 

Valuation Date

   Valuation
Per Share
 

March 2008

   $ 15.89   

June 2008

   $ 14.49   

August 2008

   $ 15.54   

October 2008

   $ 12.20   

February 2009

   $ 10.26   

May 2009

   $ 10.47   

August 2009

   $ 9.49   

October 2009

   $ 9.33   

January 2010

   $ 14.49   

June 2010

   $ 13.06   

October 2010

   $ 14.11   

The contemporaneous valuations were prepared consistent with the American Institute of Certified Public Accountants Practice Aid, “Valuation of Privately-Held Company Equity Securities Issued as Compensation,” or the Practice Aid. Prometheus Laboratories Inc. used both market approaches, which compare it to similar publicly-traded companies or transactions, and an income approach, which looks at projected future cash flows, to value the company from among the alternatives discussed in the Practice Aid. In addition, as Prometheus Laboratories Inc. had several series of preferred stock outstanding, it was also necessary to allocate our company’s value to the various classes of stock, including warrants and stock options. As provided in the Practice Aid, there are several approaches for allocating enterprise value of a privately-held company among the securities held in a complex capital structure. The possible methodologies include the probability-weighted expected return method, the option-pricing method and the current value method. The current value method is more applicable to an early stage company and was therefore not used.

 

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The common stock valuations for March, June, August and October 2008, February, May, August and October 2009 and January, June and October 2010 used the probability-weighted expected return method. Under the probability-weighted expected return method, shares are valued based upon the probability-weighted present value of expected future returns, considering various future outcomes available to the company, as well as the rights of each share class. The valuations also reflect a marketability discount ranging from 11% to 22% for the differences in market value of a publicly-traded stock versus privately-held stock, which has additional risk related to a lack of liquidity. The market discounts were calculated using a Black-Scholes option pricing model.

Prometheus Laboratories Inc. began using the probability-weighted expected return method in August 2007, when its Board of Directors and management determined it was probable that an acquisition of a substantial pharmaceutical product would be completed before the end of 2007 and, therefore, an initial public offering or sale of the company was substantially more likely to be pursued and completed in 2008, 2009 or 2010. Due to the distressed market conditions during 2008, 2009 and 2010, neither of these events have occurred. Under the probability-weighted expected return method, the common shares were valued by weighting the estimated enterprise values of likely future outcomes, including an initial public offering or the sale of the company.

The table below summarizes discounted per share value of the company (assuming conversion of the preferred stock of Prometheus Laboratories Inc. to common and the exercise of vested, in the money warrants and options), the discounted average per share value allocated to the preferred stock, the discounted per share value allocated to the common stock and the marketability discount applied at each valuation date from March 2008 to October 2010.

 

Valuation Date

   As Converted
Stock Value(1)
     Average
Preferred
Stock Value
     Estimated
Fair Value of
Common Stock
     Marketability
Discount
 

March 2008

   $ 15.89       $ 15.89       $ 15.89         13%   

June 2008

   $ 14.49       $ 14.49       $ 14.49         12%   

August 2008

   $ 15.54       $ 15.54       $ 15.54         11%   

October 2008

   $ 12.20       $ 12.20       $ 12.20         14%   

February 2009

   $ 10.26       $ 10.26       $ 10.26         22%   

May 2009

   $ 10.47       $ 10.47       $ 10.47         19%   

August 2009

   $ 9.49       $ 9.49       $ 9.49         18%   

October 2009

   $ 9.33       $ 9.33       $ 9.33         14%   

January 2010

   $ 14.49       $ 14.49       $ 14.49         12%   

June 2010

   $ 13.06       $ 13.06       $ 13.06         11%   

October 2010

   $ 14.11       $ 14.11       $ 14.11         12%   

 

(1) Represents the estimated enterprise values divided by the total common shares outstanding, assuming conversion of the preferred stock to common shares and the exercise of vested, in-the-money warrants and options.

The decrease in estimated fair value from March 2008 to June 2008 reflects a downturn in general financial market conditions and was determined by an analysis of changes in the market multiples of publicly-held specialty pharmaceutical and diagnostic companies. The increase in estimated fair value from June 2008 to August 2008 reflects a minor increase in these same market multiples during the period. In addition, $9.08 was the price at which Prometheus Laboratories Inc. repurchased redeemable warrants which were put to it in April 2008. See Note 9 to the consolidated financial statements of Prometheus Laboratories Inc. located elsewhere in this prospectus. The decrease in estimated market value from August 2008 to February 2009 in part reflects a downturn in general financial market conditions and also reflects the impact of valuing separately the estimated future cash flows from Entocort EC through the end of the distribution agreement which was December 31, 2010 at the time of such estimation. The slight increase in estimated fair value from February 2009 to May 2009 primarily reflects changes in the market multiples of publicly-held specialty pharmaceutical and diagnostic companies. The decrease from May 2009 to October 2009 primarily reflects decreases in these same multiples as well as a decrease in the indicated fair value of the Entocort EC business. The value of the Entocort EC business

 

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continued to decline as the expiration of the distribution agreement on December 31, 2010 became closer. In November 2010, we extended our agreement with AstraZeneca until the earlier of December 31, 2011 or 30 days after the first sale of a generic equivalent in the United States.

The increase in estimated fair value from October 2009 to January 2010 reflects the December 2009 acquisition of exclusive rights from Novartis to distribute, promote and sell Proleukin for injection in the United States as well as a general increase in market multiples during this period. The changes in estimated fair value from January 2010 to October 2010 reflects the continued market volatility and changes in the market multiples of publicly-held specialty pharmaceutical and diagnostic companies.

The other quantitative and qualitative factors considered by the Board of Directors of Prometheus Laboratories Inc. in determining the fair value of its common stock have included:

 

   

the rights, preferences and privileges of its convertible preferred stock relative to those of its common stock (including Series C, Series D and Series E redemption rights, preferences held by the preferred stock with respect to dividend payments, and preference payments and participation of the preferred stock with the common stock on a voluntary or involuntary dissolution, liquidation or winding up of the affairs of the company, including a sale of the company, which factors were particularly significant until such time as the Board of Directors of Prometheus Laboratories Inc. approved proceeding with an initial public offering concurrent with entering into the agreements to distribute and acquire Lotronex);

 

   

the current and projected operating and financial performance of Prometheus Laboratories Inc.;

 

   

the status of new product development or acquisitions;

 

   

general financial market conditions and the market prices of similar publicly-held specialty pharmaceutical and diagnostic companies;

 

   

the fact that the option grants involved illiquid securities in a private company; and

 

   

the likelihood of achieving a liquidity event, such as an initial public offering or the sale of Prometheus Laboratories Inc., given its performance, the need for additional capital or liquidity for investors and prevailing market conditions.

There are significant judgments and estimates inherent in the determination of these valuations. These judgments and estimates include assumptions regarding the future performance of Prometheus Laboratories Inc., the time to completing an initial public offering or other liquidity event, and the timing of and probability of launching additional products as well as determinations of the appropriate valuation methods. If Prometheus Laboratories Inc. had made different assumptions, our deferred stock-based compensation amount, our stock-based compensation expense, net income and net income per share could have been significantly different.

Prometheus Laboratories Inc. has also granted performance-based stock options with terms that allow the recipients to vest in a specific number of shares based upon the achievement of performance goals as specified in the awards. Share-based compensation expense associated with these performance-based stock options is recognized using management’s best estimates of the time to vesting for the achievement of the performance milestones. If the actual achievement of the performance milestones varies from the estimates, share-based compensation expense could be materially different than what was recorded in the period. The cumulative effect on current and prior periods of a change in the estimated time to vesting for performance-based stock options will be recognized as compensation cost in the period of the revision, and recorded as a change in estimate.

While the assumptions used to calculate and account for share-based compensation awards represents management’s best estimates, these estimates involve inherent uncertainties and the application of management’s judgment. As a result, if revisions are made to the underlying assumptions and estimates, our share-based compensation expense could vary significantly from period to period.

The total estimated compensation cost related to non-vested awards not yet recognized was $10.9 million and $6.7 million as of December 31, 2009 and 2010, respectively. The weighted-average period over which this expense in expected to be recognized is approximately 1.7 years. See Notes 1 and 9 to the consolidated financial statements located in this prospectus for further discussion of share-based compensation.

 

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All outstanding options to purchase shares of Prometheus Laboratories Inc. common stock will be converted into options to purchase shares of our common stock in connection with this offering. See “Certain Relationships and Related Party Transactions—IPO Reorganization.”

Results of Operations

We have two reportable business segments: pharmaceutical products and diagnostic testing services. The pharmaceutical products segment includes Entocort EC for the treatment of mild to moderate active Crohn’s disease involving the ileum and/or ascending colon, Proleukin for the treatment of adults with metastatic renal cell carcinoma and metastatic melanoma, Lotronex for the treatment of severe diarrhea-predominant IBS in women and non-promoted pharmaceutical products including, but not limited to, Imuran® for use as an adjunct for the prevention of rejection in kidney transplantation and the management of active rheumatoid arthritis, Helidac® Therapy, or Helidac, for the eradication of Helicobacter pylori, the leading cause of peptic ulcers, and Ridaura® for the management of rheumatoid arthritis for patients who have not responded adequately to one or more non-steroidal anti-inflammatory drugs. The diagnostics segment includes specialized diagnostic tests including specific immunoassays to detect and differentiate certain diseases, drug metabolite monitoring and pharmacogenetic testing. Collaboration and other revenues represent revenue recognized from various collaboration and other licensing arrangements. These revenues also contribute to gross margin. We have no inter-segment revenues.

As both pharmaceutical products and diagnostics testing services are sold through the same commercial organization and managed by the same personnel, we report, manage and evaluate our business segment performance on net revenues and gross margin. We do not allocate selling, general and administrative, research and development, or other indirect costs to our business segments for performance assessment. Accordingly, our segment discussion and analysis for the years ended December 31, 2008, 2009 and 2010 only addresses net sales and the related gross margin.

Comparison of the Years Ended 2009 and 2010

Total Revenues

The following table sets forth the net sales of our pharmaceutical products and diagnostic testing services segments and collaboration and other revenues for the years ended December 31, 2009 and 2010 and the changes between these periods.

 

     2009      2010      Increase/
(Decrease)
     % Increase/
(Decrease)
 
     (Unaudited; in thousands)         

Pharmaceutical Products:

           

Entocort EC

   $ 203,872       $ 316,475       $ 112,603         55%   

Proleukin

             63,978         63,978           

Lotronex

     30,378         34,769         4,391         14%   

Non-Promoted

     22,527         19,433         (3,094)         (14%)   
                             

Total

     256,777         434,655         177,878         69%   

Diagnostic Testing Services

     84,422         81,291         (3,131)         (4%)   
                             

Net Sales

     341,199         515,946         174,747         51%   

Collaboration and Other Revenues

     304         3,026         2,722         895%   
                             

Total Revenues

   $ 341,503       $ 518,972       $ 177,469         52%   
                             

Total revenues increased to $519.0 million for the year ended December 31, 2010 from $341.5 million for the year ended December 31, 2009. The increase was the result of increased pharmaceutical product sales due to higher unit sales volumes of Entocort and Lotronex, price increases on our branded products and the addition of Proleukin in February 2010. In addition, increases in collaboration and other revenues were attributable to revenue associated with the collaboration agreement with Bayer Schering Pharma AG, or Bayer. These increases were partially offset by a decrease in our diagnostic testing services due primarily to a decrease in unit sales

 

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volumes and by a decrease in non-promoted pharmaceutical product sales due to continued generic encroachment.

Pharmaceutical Products

Pharmaceutical product sales increased to $434.7 million for the year ended December 31, 2010 from $256.8 million for the year ended December 31, 2009. The increase of $177.9 million, or 69%, was due in part to increases in Entocort EC pricing and unit volumes, which resulted in increased net sales of $92.6 million and $20.0 million, respectively, over the same period in 2009. Beginning February 1, 2010, we also began selling Proleukin under an exclusive distribution and promotion agreement. Sales of Proleukin were $64.0 million for the eleven months ended December 31, 2010. In addition, increases in Lotronex price and unit volume increased net sales by $1.9 million and $2.5 million, respectively, over the same period in 2009. Sales of our non-promoted pharmaceutical products decreased by $3.1 million for the year ended December 31, 2010 compared to the same period in 2009 due to continued volume erosion caused by generic competition.

Diagnostic Testing Services

Net sales of diagnostic testing services decreased to $81.3 million for the year ended December 31, 2010 from $84.4 million for the year ended December 31, 2009. The decrease of approximately $3.1 million, or 4%, was due primarily to lower unit volumes that resulted from an overall reduction in physician office visits by patients and decreased sales force promotion. In addition, decreased payor reimbursement negatively impacted net sales by $1.0 million. Decreased contractual reimbursement was attributable to continued competitive pricing pressure and an overall reduction in managed care reimbursement. We believe the decline in physician office visits by patients was attributable to the challenging economic environment and continued high unemployment in 2010. Decreased sales force promotion was a result of the consolidation of two gastroenterology sales forces into a single and smaller sales force in the second quarter of 2009, and a shift towards increased promotional effort on Lotronex.

Collaboration and Other Revenues

Collaboration and other revenues increased to $3.0 million for the year ended December 31, 2010 from $0.3 million for the year ended December 31, 2009. The year ended December 31, 2010 included the recognition of revenue from the upfront payment and ongoing research funding in connection with the collaboration agreement with Bayer of approximately $2.8 million, in addition to revenues associated with contractual milestones and royalties from separate collaboration and license agreements of approximately $0.2 million. The year ended December 31, 2009 also included revenue of $0.3 million from the achievement of a commercial milestone related to an exclusive out-licensing arrangement for certain patented diagnostic technologies, entered into in 2007.

Gross Margin (including amortization of acquired product rights and intangibles)

The following table sets forth the gross margin on sales for our pharmaceutical products and diagnostic testing services segments and collaboration and other revenues for the years ended December 31, 2009 and 2010 and the changes between these periods.

 

     2009      2010      Increase/
(Decrease)
    % Increase/
(Decrease)
 
     (Unaudited; in thousands)        

Pharmaceutical Products

   $ 106,300       $ 175,202       $ 68,902        65%   

Diagnostic Testing Services

     65,640         61,077         (4,563     (7%
                            

Gross Margin from Net Sales

     171,940         236,279         64,339        37%   

Collaboration and Other Revenues

     304         3,026         2,722        895%   
                            

Gross Margin from Net Sales and Collaboration and Other Revenues

   $ 172,244       $ 239,305       $ 67,061        39%   
                            

Gross Margin Percentage

     50%         46%        

 

 

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Our gross margin increased to $239.3 million for the year ended December 31, 2010 from $172.2 million for the year ended December 31, 2009. The increase of $67.1 million was primarily a result of an increase in pharmaceutical product sales, including the addition of Proleukin in February 2010, offset partially by a decline in diagnostic testing services. The overall gross margin percentage declined to 46% for the year ended December 31, 2010 from 50% for the year ended December 31, 2009, reflecting the increased proportion of total gross margin contributed by our pharmaceutical product segment. Pharmaceutical products gross margin includes the amortization of acquired product rights and intangibles of $29.0 million and $13.6 million for the years ended December 31, 2010 and 2009, respectively.

Pharmaceutical Products

Pharmaceutical product gross margin increased to $236.3 million for the year ended December 31, 2010 from $171.9 million for the year ended December 31, 2009. The increase in gross margin was primarily a result of increased pharmaceutical net sales of $177.9 million for the year ended December 31, 2010 over the same period in 2009. Our pharmaceutical product gross margin percentage was 40% and 41% for the years ended December 31, 2010 and December 31, 2009.

Diagnostic Testing Services

Diagnostic testing services gross margin decreased to $61.1 million for the year ended December 31, 2010 from $65.6 million for the year ended December 31, 2009. The decrease was primarily a result of decreased net sales for diagnostic testing services of $3.1 million and increased investment in laboratory automation and quality control initiatives. Diagnostic testing services gross margin percentage was 75% and 78% for the years ended December 31, 2010 and 2009, respectively.

Collaboration and Other Revenues

Collaboration and other revenues represented incremental gross margin of $3.0 million and $0.3 million for the years ended December 31, 2010 and 2009, respectively, and were derived from various license and collaboration agreements, as previously noted. In general, expenses related to these revenues, if any, were recorded in research and development expense.

Operating Expenses

The following table sets forth our operating expenses for the years ended December 31, 2009 and 2010.

 

     2009      2010      Increase/
(Decrease)
     % Increase/
(Decrease)
 
     Operating
Expense
     % of Net
Sales
     Operating
Expense
     % of Net
Sales and
Collaboration
and Other
Revenues
       
     (Unaudited; in thousands)                

Sales and Marketing

   $ 53,201         16%       $ 64,858         12%       $ 11,657         22%   

General and Administrative

     34,218         10%         43,219         8%         9,001         26%   

Research and Development

     21,787         6%         26,308         5%         4,521         21%   

Sales and Marketing

Sales and marketing expense increased to $64.9 million for the year ended December 31, 2010 from $53.2 million for the year ended December 31, 2009. The increase was primarily a result of an increase in sales force and employee related expenses of $7.1 million and promotional and other commercial operating costs of $4.5 million. Increased sales and marketing expenses are attributable to the oncology commercial and sales force expansion in early 2010, subsequent to the completion of the Proleukin promotion and distribution agreement in December 2009. Sales and marketing expenses as a percentage of net sales and collaboration and other revenues decreased to 12% for the year ended December 31, 2010 from 16% for the same period in 2009. This percentage decrease was as a result of the 22% increase in total sales and marketing expenses compared to the 52% increase in net sales and collaboration and other revenues for the year ended December 31, 2010 compared to December 31, 2009.

 

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General and Administrative

General and administrative expense increased to $43.2 million for the year ended December 31, 2010 from $34.2 million for the year ended December 31, 2009. The increase was primarily a result of increases in salaries and related employee expenses of $1.4 million and general operating expenses of $3.7 million. Due to sustained unfavorable market conditions and the resulting delay of an initial public offering, previously deferred costs of approximately of $2.5 million were charged to general and administrative expense in the year ending December 31, 2010. Additionally, $2.3 million in consulting fees were incurred associated with the execution of collaboration agreements. Increases in general and administrative expense were offset by improvements in estimated diagnostic accounts receivable collectability, which reduced bad debt expense by $0.8 million from the same period in 2009. General and administrative expense as a percentage of net sales and collaboration and other revenues decreased to 8% for the year ended December 31, 2010 from 10% for the same period in 2009 as a result of the 26% increase in total general and administrative expenses compared to the 52% increase in net sales and collaboration and other revenues over the same period in 2009.

Research and development

Research and development expense increased to $26.3 million for the year ended December 31, 2010 from $21.8 million for the year ended December 31, 2009. The increase was primarily a result of a $4.3 million increase in salaries, benefits, travel and other employee expenses due to an increase in headcount and clinical development infrastructure and $2.8 million in increased costs for the development and validation of new diagnostic products, including costs incurred in connection with research collaboration agreements. Increases in research and development expense were offset by decreases in clinical study activity of $2.5 million from the same period in 2009. Research and development expense as a percentage of net sales and collaboration and other revenues decreased to 5% for the year ended December 31, 2010 from 6% for the same period in 2009 as a result of the 21% increase in total research and development expenses compared to the 52% increase in net sales and collaboration and other revenues over the same period in 2009. We expect to incur significant research and development expenses in 2011 related to diagnostic development activities in both gastroenterology and oncology. However, these development activities involve a high degree of uncertainty, and we may abandon development of any product candidate at any time.

Interest Expense—Other

Interest expense related to our bank credit agreement increased to $12.1 million for the year ended December 31, 2010 from $3.2 million for the same period in 2009. The increase was primarily a result of an increase in the principal balance outstanding and an increase in interest rates during the year ended December 31, 2010 compared to the same period in 2009 due to the refinancing of our term loan in December 2009. See—Liquidity and Capital Resources for further discussion of our bank credit agreement.

Interest Expense—Discount Accretion

Interest expense related to the accretion of discounted future license payments to face value was $3.9 million for the year ended December 31, 2010. See Note 2 to the consolidated financial statements of Prometheus Laboratories Inc. included elsewhere in this prospectus.

Other Expense

Other expenses increased to $2.5 million in 2010 from $2.2 million in 2009. In November 2010, our diagnostic license and collaboration agreement with Rosetta Genomics Ltd. was terminated, resulting in an impairment of the remaining unamortized acquired license rights and development fund assets of $2.1 million. In addition, other-than-temporary impairments of the stock acquired in a related stock purchase agreement were recorded in 2010 and 2009 totaling $2.1 million and $2.3 million, respectively. These expenses were offset by consideration received in 2010 in conjunction with a settlement agreement and mutual release associated with the termination of $1.2 million.

 

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Provision for Income Taxes

Income tax expense increased to $38.5 million, or 44.4% of pre-tax income, for the year ended December 31, 2010, compared to $25.9 million, or 44.7% of pre-tax income, for the year ended December 31, 2009. The lower tax rate for the year ended December 31, 2010 compared to the year ended December 31, 2009 was primarily due to a March 2009 write-down of deferred tax assets of $1.0 million due to changes in California tax laws which become effective in 2011. In February 2009, the California Legislature enacted 2009-2010 budget legislation containing various California tax law changes including an election to apply a single sales factor apportionment formula for taxable years beginning on or after January 1, 2011. Such a change in apportionment will reduce our California effective tax rate. We anticipate making the election in connection with filing our California 2010 tax return and, as a result, the state and federal deferred tax assets have been adjusted to reflect a reduction in the future tax rate. This adjustment was recorded as a discrete item and increased the effective tax rate in the year ended December 31, 2009 by 1.8%.

Comparison of the Years Ended December 31, 2008 and 2009

Total Revenues

The following table sets forth the net sales of our pharmaceutical products and diagnostic testing services segments and collaboration and other revenues for the years ended December 31, 2008 and 2009 and the changes between these periods.

 

     2008      2009      Increase/
(Decrease)
     %  Increase/
(Decrease)
 

Pharmaceutical Products:

           

Entocort EC

   $ 145,028       $ 203,872       $ 58,844         41%   

Lotronex

     25,154         30,378         5,224         21%   

Non-Promoted

     25,803         22,527         (3,276)         (13)%   
                             

Total

     195,985         256,777         60,792         31%   

Diagnostic Testing Services

     82,073         84,422         2,349         3%   
                             

Net Sales

     278,058         341,199         63,141         23%   

Collaboration and Other Revenues

             304         304           
                             

Total Revenues

   $ 278,058       $ 341,503       $ 63,445         23%   
                             

Total revenues increased to $341.5 million in 2009 from $278.1 million in 2008. The increase was the result of increased pharmaceutical product sales due to price increases and higher volume and increased diagnostic testing services due to higher volume from existing products, offset by a decrease in non-promoted pharmaceutical products due to continued generic encroachment.

Pharmaceutical Products

Pharmaceutical product sales increased to $256.8 million in 2009 from $196.0 million in 2008. The increase of $60.8 million, or 31%, was due to increases in Entocort EC price and unit volume, which resulted in increased net sales of $58.7 million and $0.1 million, respectively, over 2008. Increases in Lotronex price and unit volume increased net sales by $4.6 million and $0.6 million, respectively, over 2008. Sales of our non-promoted pharmaceutical products decreased by $3.3 million in 2009 compared to 2008 due to continued volume erosion caused by generic competition.

In 2009, the growth of our pharmaceutical products sales was offset by a $3.7 million provision for rebates related to the DOD’s Tricare Retail Pharmacy program, of which $1.8 million related to a retroactive rebate assessment for sales made during 2008.

Diagnostic Testing Services

Net sales of diagnostic testing services increased to $84.4 million in 2009 from $82.1 million in 2008. The increase was primarily due to increased volume of our celiac and IBS diagnostic testing services of $2.0 million

 

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and $1.1 million, respectively, offset by amounts including a $0.5 million decrease in our IBD Serology 7 testing service.

Collaboration and Other Revenues

Collaboration and other revenues were $0.3 million in 2009, primarily derived from a milestone payment received upon achievement of a commercial milestone related to a 2007 out-licensing arrangement for certain patented diagnostic technologies.

Gross Margin (including amortization of acquired product rights and intangibles)

The following table sets forth the gross margin on sales for our pharmaceutical products and diagnostic testing services segments and collaboration and other revenues for the years ended December 31, 2008 and 2009 and the changes between these periods.

 

     2008      2009      Increase/
(Decrease)
    %  Increase/
(Decrease)
 

Pharmaceutical Products

   $ 86,339       $ 106,300       $ 19,961        23%   

Diagnostic Testing Services

     66,061         65,640         (421     (1%
                            

Gross Margin from Net Sales

     152,400         171,940         19,540        13%   

Collaboration and Other Revenues

             304         304        100%   
                            

Gross Margin from Net Sales and Collaboration and Other Revenues

   $ 152,400       $ 172,244       $ 19,844        13%   
                            

Gross Margin Percentage

     55%         50%        

Our gross margin increased to $172.2 million in 2009 from $152.4 million in 2008. The increase of $19.8 million was primarily a result of an increase in sales, partially offset by a change in the pharmaceutical product mix as discussed below. The overall gross margin percentage declined to 50% in 2009 from 55% in 2008, reflecting a lower overall gross margin in our pharmaceuticals segment. Pharmaceutical gross profit includes the amortization of acquired product rights and intangibles of $13.6 million and $12.1 million in 2009 and 2008, respectively.

Pharmaceutical Products

Pharmaceutical product gross margin increased to $106.3 million in 2009 from $86.3 million in 2008. The increase in gross margin was primarily a result of increased pharmaceutical net sales of $60.8 million in 2009 over 2008. Our pharmaceutical product gross margin percentage decreased to 41% in 2009 from 44% in 2008 as sales of Entocort EC were proportionately larger in 2009 as compared to 2008. Due to the product cost and royalty structure under the distribution agreement with AstraZeneca, Entocort EC has a significantly lower gross margin than for most of our other pharmaceutical products. Additionally, the decrease in pharmaceutical gross margin was impacted by the amortization of acquired product rights and intangibles increasing to $13.6 million in 2009 compared to $12.1 million in 2008. The increase of $1.5 million was due to the amortization of product rights and intangible assets relating to the acquisition of Lotronex in January 2008, including a $20.0 million sales-based milestone paid in May 2009.

Diagnostic Testing Services

Diagnostic testing services gross margin decreased to $65.6 million in 2009 from $66.1 million in 2008. The nominal decrease was a result of product mix and increased laboratory operations quality control initiatives, offset by an increase in net revenues of $2.3 million. Diagnostic testing services gross margin percentage was 78% and 80% in 2009 and 2008, respectively.

Collaboration and Other Revenues

Collaboration and other revenues represented incremental gross margin of $0.3 million in 2009, and were derived from an out-licensing arrangement, as previously noted.

 

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Operating Expenses

The following table sets forth our operating expenses for the years ended December 31, 2008 and 2009.

 

     2008      2009      Increase/
(Decrease)
    %
Increase/
(Decrease)
 
     Operating
Expense
     % of Net
Sales
     Operating
Expense
     % of Net
Sales
      

Sales and Marketing

   $ 54,932         20%       $ 53,201         16%       $ (1,731     (3)%   

General and Administrative

     26,694         10%         34,218         10%         7,524        28 %   

Research and Development

     14,628         5%         21,787         6%         7,159        49 %   

Sales and Marketing

Sales and marketing expense decreased to $53.2 million in 2009 from $54.9 million in 2008. The decrease of $1.7 million was a result of decreased sales force and employee related expenses of approximately $1.9 million, offset by an increase in promotion, consulting and other commercial operating costs of $0.2 million. Sales and marketing expenses as a percentage of net sales decreased to 16% in 2009 from 20% in 2008 as a result of the 3% decrease in total sales and marketing expenses compared to the 23% increase in net sales in 2009 over 2008.

General and Administrative

General and administrative expense increased to $34.2 million in 2009 from $26.7 million in 2008. The increase was primarily a result of increases in employee related expenses of $5.2 million due to increased stock-based compensation and headcount, $0.4 million in legal expenses relating to general legal, business development and ongoing patent litigation matters and $1.2 million in other general operating expenses. Additionally, declines in estimated diagnostic accounts receivable collectability resulted in incremental bad debt expense of $0.7 million over the same period in 2008. General and administrative expense as a percentage of net sales was 10% in 2009 and 2008.

Research and development

Research and development expense increased to $21.8 million in 2009 from $14.6 million in 2008. The increase was primarily a result of a $3.7 million increase in salaries, benefits, travel and other employee expenses due to an increase in headcount and $3.5 million in increased costs for the development and validation of new diagnostic products. Research and development expense as a percentage of net sales increased to 6% in 2009 from 5% in 2008 as a result of the 49% increase in research and development expense compared to the 23% increase in net sales in 2009 over 2008. We expect to incur significant research and development expenses related to diagnostic development activities in both the gastrointestinal and oncology areas. However, these development activities involve a high degree of risk and uncertainty, and we may abandon development of any product candidate at any time.

Interest Expense

Interest expense related to our bank credit agreements decreased to $3.2 million in 2009 from $3.7 million in 2008. The decrease was primarily a result of decreases in interest rates as well as a lower principal balance outstanding through 2009 compared to 2008, offset by a $0.7 million write-off of unamortized debt issuance costs associated with the refinancing of our 2007 credit agreement in 2009. See Liquidity and Capital Resources for further discussion of our bank credit agreements.

In conjunction with a loan agreement entered into in June 2000 and the issuance of the senior notes in April 2001, we issued warrants to purchase Series D Redeemable Preferred Stock and common stock, respectively, collectively referred to as the redeemable warrants. As the holders of the redeemable warrants have certain rights that may require us to repurchase the warrants or the related shares, subsequent to June 20, 2005, increases or decreases in the fair value of the redeemable warrants have been recorded as interest expense in the statement of income through April 30, 2008. Redemption rights related to the warrants to purchase the Series D Redeemable

 

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Preferred Stock expired in April 2007. Redemption rights with respect to the warrants to purchase common stock issued in connection with our senior notes expired in April 2008. Interest expense for 2008 also included the reversal of interest expense of $5.6 million related to a reduction in the fair value of the redeemable warrants.

Interest and Other Income or Expense

Interest income decreased to $0.5 million in 2009 from $1.7 million in 2008. The decrease of $1.2 million was primarily related to a substantial reduction in yield on investments. This decrease in yield was due to lower interest rates and a conservative cash management strategy to protect and conserve our principal cash and cash equivalent balances in light of the current economic environment.

Other income and other expenses decreased to $2.2 million of expense in 2009 from $0.6 million of income in 2008. In 2009, in conjunction with a license agreement, we acquired 2.0 million shares of stock in Rosetta Genomics, Ltd., or Rosetta Genomics, recorded at the time of acquisition at a fair market value of $3.15 per share. On January 13, 2010, Rosetta Genomics finalized a registered direct offering for approximately 2,530,000 shares of common stock and warrants to purchase up to 1,265,000 shares of common stock. This offering created approximately 18% dilution for existing shareholders, with the potential for an additional 9% dilution if warrants issued in conjunction with the registered direct offering are exercised. The purchase price in the registered direct offering was $2.00 per share. As a result, we recorded an other-than-temporary impairment of the stock acquired in the stock purchase agreement of $2.3 million, or $1.15 per share, as of December 31, 2009. This impairment, charged to earnings, reduced our basis in the stock from $3.15 to $2.00 per share. Other income also included proceeds related to the sale of equity obtained through the license of patented diagnostic technologies of $0.5 million in 2008.

Provision for Income Taxes

Income tax expense increased to $25.9 million, or 44.7% of pre-tax income, in 2009 from $23.0 million, or 38.2% of pre-tax income, in 2008. The higher tax rate for 2009 compared to 2008 was primarily due to a $5.6 million non-taxable reversal of accretion to the fair value of the redeemable warrants in March 2008 (see Note 9 to the consolidated financial statements of Prometheus Laboratories Inc. located elsewhere in this prospectus). In February 2009, the California Legislature enacted 2009-2010 budget legislation containing various California tax law changes including an election to apply a single sales factor apportionment formula for taxable years beginning on or after January 1, 2011. Such a change in apportionment will reduce our California effective tax rate. We anticipate making the election and as a result, the state and federal deferred tax assets have been adjusted to reflect a reduction in the future tax rate. Adjustments related to this law change increased the effective tax rate for 2009 by approximately 2.0%.

Liquidity and Capital Resources

Since our inception, we have financed our operations primarily through private placements of the preferred stock of Prometheus Laboratories Inc., debt financings and sales of our pharmaceutical products and diagnostic testing services. At December 31, 2010, we had $87.8 million in cash and cash equivalents, compared to cash, cash equivalents and marketable securities of $61.9 million and $96.7 million at December 31, 2009 and 2008, respectively. We believe that our existing funds, cash expected to be generated from operations and our access to financing should be adequate to satisfy the working capital, capital expenditure and debt repayment requirements of our present business for the foreseeable future.

Cash Flows

The following table summarizes our cash flow activity for the periods indicated:

 

     For the Years Ended December 31,  
     2008     2009     2010  
    

(In thousands)

 

Net cash provided by operating activities

   $ 45,311      $ 49,676      $ 82,827   

Net cash provided by (used in) investing activities

     33,009        (218,509     (22,293

Net cash provided by (used in) financing activities

     (26,429     130,945        (31,486

 

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Operating Activities

Cash provided by operating activities has been and is expected to continue to be our primary recurring source of funds. Cash flows from operations have increased to $82.8 million in 2010, from $49.7 million and $45.3 million in 2009 and 2008, respectively. Increases in operating cash flows are attributable to growth in net income in 2010 over the preceding years, in addition to increased non-cash adjustments to net income from depreciation and amortization of $33.9 million, $16.6 million and $14.2 million in 2010, 2009 and 2008, respectively, due to incremental amortization of acquired intangibles from purchased or licensed assets. Additionally, non-cash adjustments to net income in 2010 included $3.9 million accretion of discounted future license payments related to the Proleukin distribution and promotion agreement. Further non-recurring, non-cash adjustments to net income included $3.5 million and $2.3 million related to the impairment of investments and write-off of intangible assets in 2010 and 2009, respectively. Net cash provided by operations was reduced in 2008 by a reversal of non-cash warrant accretion of $5.6 million related to adjustments to fair market value of the redeemable warrants of Prometheus Laboratories Inc. Net cash outflows from changes in working capital were $17.5 million, $10.5 million and $8.4 million in 2010, 2009 and 2008, respectively. This increase is attributable to growth in our pharmaceutical net sales and the addition of Proleukin in 2010, resulting in higher accounts receivable balances and necessitating increased inventory on-hand, offset by the related increases in sales based royalties and sales allowances.

Investing Activities

Cash used by investing activities was $22.3 million and $218.5 million in 2010 and 2009, respectively, compared with cash provided by investing activities of $33.0 million in 2008. Investing activities included the net sales and maturities of marketable securities of $3.1 million and $37.1 million in 2010 and 2008, respectively. Investing activities included the net investment of cash and cash equivalents in excess of our operating requirements of $3.1 million in 2009. In 2008, $80.0 million in restricted cash was used for an upfront payment to acquire Lotronex. No restricted cash was held at December 31, 2010 or 2009.

Purchases of product rights and intangible assets were $20.5 million, $207.8 million and $82.7 million in 2010, 2009 and 2008, respectively. Such investing activities primarily related to commercial milestones achieved related to Lotronex product sales in 2010 and 2009, the Proleukin commercial agreement in 2009 and the Lotronex asset purchase in 2008, as discussed elsewhere in this prospectus. We are continuing to pursue the acquisition of pharmaceutical products and diagnostic technologies and expect to continue to invest in acquiring access to such products and technologies in the future. Such investments could be substantial.

Capital expenditures were $4.9 million, $7.6 million and $1.4 million in 2010, 2009 and 2008, respectively, principally reflecting acquisitions of equipment for our laboratory operations and leasehold improvements to support our growth, including an 11,000 square foot expansion to our current facility in 2009.

Financing Activities

Cash used in financing activities was $31.5 and $26.4 million in 2010 and 2008, respectively. Cash provided by financing activities was $130.9 million in 2009. Most of our financing activities have related to borrowings and the repayment of debt. Payments of debt include principal payments under bank credit agreements of $31.5 million, $71.3 million and $3.8 million in the years ended 2010, 2009, and 2008, respectively. In December 2009, we repaid the $65.6 million balance outstanding and terminated our then-existing credit agreement. Concurrently, we borrowed $210.0 million ($201.5 million net of fees and costs) pursuant to a new term loan entered into under a new bank credit agreement. Net cash outflows for financing activities in 2010, 2009 and 2008 were offset by proceeds from the exercise of stock options by $0.2 million, $0.8 million and $0.3 million, respectively.

In April 2008, holders of senior note warrants to purchase 1,467,473 shares of Prometheus Laboratories Inc. common stock put their warrants to the company for an aggregate purchase price of $23.3 million in cash and Prometheus Laboratories Inc. issued a net of 786,038 shares of common stock pursuant to the automatic cashless exercise of the remaining senior note warrants to purchase 786,906 shares of its common stock.

 

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Future Financing Requirements

We believe that our available cash balances and anticipated cash flows from operations will be sufficient to satisfy our operating needs for the foreseeable future. However, our business and its financing needs can change unpredictably due to a variety of factors including product acquisition opportunities, competition, regulation, legal proceedings and other events.

In December 2009, we acquired exclusive rights from Novartis to distribute, promote and sell Proleukin for injection in the United States. Under the terms of the agreement, Novartis received a $185.0 million upfront payment and will receive royalties based on net sales of Proleukin, which royalty amounts increase as a percentage of net sales from the low single digits to the low double digits as net sales increase, and we may also be required to make payments of up to $123.3 million in the aggregate on the achievement of certain sales-based milestones associated with third party products which are approved for use with Proleukin. Prometheus Laboratories Inc. has the option to extend the initial six-year term on an annual basis for up to an additional six years. In addition, the companies had the option to amend the agreement to include worldwide distribution rights upon the completion of certain conditions, which was not exercised. Each of these options requires us to make specified payments at the time of exercise.

In January 2008, we acquired exclusive rights to Lotronex in the United States from GlaxoSmithKline for $80.0 million in cash and 714,285 shares of Prometheus Laboratories Inc. common stock. In addition to the upfront fee, we will pay royalties to GlaxoSmithKline based on net sales of Lotronex and may also make payments of up to $100.0 million on the achievement of certain sales-based milestones. In April 2009 and June 2010, we attained sales-based milestones upon the achievement of $35.0 million and $70.0 million, respectively, in cumulative net sales of Lotronex since the completion of the asset acquisition in January 2008. These achievements resulted in two milestone payments of $20.0 million each, which occurred in May 2009 and July 2010, respectively.

Pursuant to our distribution agreement with AstraZeneca, we have the exclusive right to promote, distribute, market and sell Entocort EC, our leading pharmaceutical product, in the United States until the earlier of December 31, 2011 or 30 days after the sale of a generic equivalent in the United States. Entocort EC accounted for approximately 61% of our net sales in the year ended December 31, 2010. Unless the distribution agreement is renewed or its term extended, we will lose all rights to market and sell Entocort EC after such date. We currently do not expect the agreement to be renewed or extended. As such, the expiration of the distribution agreement will result in significant declines in our results of operations and cash flows provided by operating activities to the extent such declines are not offset by increases in sales in our other existing products and any new products.

As a result of the above, in the future we could need additional funds to support our existing operations, to acquire new products or technologies, to commercialize new products and services, to develop and perform clinical trials related to these technologies or to expand our infrastructure. Accordingly, we may need to raise additional funds through the sale of equity or debt securities or from credit facilities; however, additional funds, if needed, may not be available on satisfactory terms, if at all.

For example, domestic and international capital markets have experienced and may continue to experience heightened volatility and turmoil, based on domestic and international economic conditions and concerns. These factors potentially make it more difficult to raise capital through the issuance of equity securities. Furthermore, as a result of the recent volatility in the capital markets, the cost and availability of credit has been and may continue to be adversely affected by illiquid credit markets and wider credit spreads. Concern about the stability of the markets generally and the strength of counterparties specifically has led many lenders and institutional investors to reduce, and in some cases, cease to provide funding to borrowers.

 

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Contractual Obligations and Commercial Commitments

Contractual obligations and commercial commitments represent future cash commitments and liabilities under agreements with third parties, and exclude contingent liabilities for which we cannot reasonably predict future payment.

Bank Credit Agreement

In December 2009, Prometheus Laboratories Inc. entered into a new credit agreement with a group of financial institutions under which we borrowed $210.0 million pursuant to a term loan and obtained a $50.0 million revolving credit line. Concurrently, we terminated our existing credit agreement and paid off the $65.6 million balance outstanding. As of December 31, 2010, we had $178.5 million of borrowings outstanding under the term loan and no outstanding borrowings under the revolving loans. The loans mature and the credit agreement terminates in December 2013. Under the credit agreement, we pay a commitment fee of 0.50% to 0.75% per annum on amounts available under the revolving loans, based upon our consolidated leverage ratio. The term loan and any borrowings under revolving loans bear interest, at our election, either at (1) LIBOR plus an increment of 3.50% to 5.00% or (2) the bank’s prime rate (or the federal funds rate plus 0.5%, or the Eurodollar rate plus 1% whichever is higher) plus an increment of 2.50% to 4.00%, such increments being based on our consolidated leverage ratio. Repayment of the outstanding principal of the term loan is based on minimum amortization of 15%, 15%, 20% and 50% in 2010, 2011, 2012 and 2013, respectively. The agreement also provides for certain mandatory prepayments including a portion of any equity or debt proceeds, extraordinary receipts, as defined, and excess cash flow, as defined. As of December 31, 2010, we calculated the amount of the 2010 excess cash flow prepayment to be $15.0 million, payable in the first quarter of 2011. In entering into the credit agreement, we incurred loan fees of approximately $8.5 million, which are included in other assets and are being amortized as a component of interest expense over the term of the credit agreement. The credit agreement requires us to comply with various financial and restrictive covenants. As of December 31, 2010, we were in compliance with all covenants.

Commercial Commitments

The following table summarizes our contractual obligations as of December 31, 2010. The expected timing of payment of the obligations presented below is estimated based upon current information or contractual terms. Timing of payments and actual amounts paid may be different depending on the timing of receipt of goods or services or changes to agreed-upon terms or amounts for some obligations. The table does not include any milestones, or other contingent payments.

 

     Total      2011
<1 year
     2012-2013
2-3 years
     2014-2015
4-5 years
 

Term loan principal payments(1)

   $  178,500       $  44,423       $ 134,077       $ —     

Term loan interest payments(2)

     14,553         7,023         7,530         —     

Credit agreement commitment fees(3)

     750         250         500         —     

Operating lease obligations(4)

     2,650         1,307         1,343         —     

Minimum royalty obligation(5)

     160,736         160,736         —           —     

Licensing obligations(6)

     30,000         10,000         14,000         6,000   

Purchasing and other obligations

     2,681         2,681         —           —     
                                   

Total

   $ 389,870       $ 226,420       $  157,450       $ 6,000   
                                   

 

(1) Includes the mandatory prepayment of $15.0 million based on contractual excess cash flow calculation in 2011.

 

(2) Assumes the December 31, 2010 interest rate of approximately 4.46% for all periods, scheduled debt payments and no borrowings under revolving loans.

 

(3) Assumes a 0.50% commitment fee on $50.0 million in revolving loans for all periods. Assumes there are no borrowings during the term of the credit agreement.

 

 

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(4) Reflects the future minimum lease payments due under the operating lease for our laboratory, research and administrative facility.

 

(5) Reflects aggregate minimum royalties payable on net sales of Entocort EC in 2011.

 

(6) Amounts represent the estimated minimum levels of promotional spending required in each period under certain licensing agreements.

Off-Balance Sheet Arrangements

Since inception, we have not engaged in any off-balance sheet arrangements, including the use of structured finance, special purpose entities or variable interest entities.

Quantitative and Qualitative Disclosures about Market Risk

Interest Rate Risk

We are exposed to changes in interest rates, primarily from our variable-rate term and revolving loans, if any.

Our term and revolving loans bear interest, at our election, at LIBOR, or the applicable bank’s prime rate (or the federal funds rate plus 0.5%, whichever is higher), plus an increment based on our consolidated leverage ratio. We do not believe that the interest rate risk represented by our floating rate debt is material as of December 31, 2010.

Under our current policies, we do not use interest rate derivatives instruments to manage our exposure to interest rate changes. A hypothetical 1.0% adverse move in interest rates would not materially affect the fair value of our financial instruments or variable rate debt that is exposed to changes in interest rates.

We do not believe our cash, cash equivalents and marketable securities have significant risk of default or illiquidity. While we believe our cash, cash equivalents and marketable securities are well diversified and do not contain excessive risk, we cannot provide absolute assurance that in the future our investments will not be subject to adverse changes in market value. In addition, we maintain significant amounts of cash and cash equivalents at one or more financial institutions that are in excess of federally insured limits. Given the current instability of financial institutions, we cannot be assured that we will not experience losses on these deposits.

We have no operations outside the United States and do not have any foreign currency or other derivative financial instruments.

Foreign Exchange Risk

We manage our exposure to foreign exchange market risks, when deemed appropriate, through the use of derivative financial instruments, including foreign currency forward contracts with major financial institutions. Such derivative financial instruments are viewed as hedging or risk management tools and are not used for speculative or trading purposes. See “Notes to Consolidated Financial Statements, Note 1—Fair Value of Financial Instruments” for a description of our foreign currency hedging transactions.

 

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BUSINESS

Overview

Prometheus is committed to improving lives through the development and commercialization of novel pharmaceutical and diagnostic products that enable physicians to provide greater individualized patient care. We are primarily focused on the detection, diagnosis and treatment of disorders within the fields of gastroenterology and oncology. Our strategy includes the marketing and promotion of pharmaceutical products and complementary proprietary diagnostic testing services. By integrating therapeutics and diagnostics, we believe we can provide physicians with more targeted solutions to optimize care for their patients. We believe we are a leader in applying diagnostic testing capabilities for the identification, stratification and monitoring of patients for the treatment of gastrointestinal diseases and are also applying these principles to oncology.

Our portfolio of pharmaceutical products for gastrointestinal diseases and disorders includes ENTOCORT® EC (budesonide) Capsules, which is indicated for the treatment of mild to moderate active Crohn’s disease involving the ileum and/or the ascending colon, and LOTRONEX® (alosetron hydrochloride) Tablets, the only prescription drug approved for use in female patients with severe diarrhea-predominant irritable bowel syndrome, or IBS, who have chronic irritable bowel syndrome, or IBS, symptoms, have had abnormalities of the gastrointestinal tract excluded and have not responded adequately to conventional therapy.

Our diagnostic testing services in gastroenterology include specific immunoassays to detect and differentiate diseases, pharmacogenetic testing and drug metabolite monitoring. Our highly specific tests can help physicians to detect and differentiate inflammatory bowel disease from other bowel disorders and to differentiate Crohn’s disease from ulcerative colitis. In addition, we offer tests that assist physicians in the detection, diagnosis or treatment of celiac disease, lactose intolerance and other related disorders.

We believe our business model of offering pharmaceuticals combined with diagnostic testing services provides our sales force greater access to physicians and differentiates us from other pharmaceutical, specialty pharmaceutical and diagnostic companies. Leveraging this model, we believe we have established ourselves as a leader in the gastroenterology market, where our sales force, including approximately 125 sales representatives, sales managers and regional field trainers, has significant experience and technical knowledge of the market. The length of our average sales call with physicians was approximately 11 minutes in 2010, which we believe to be longer than the industry average. We principally market our gastroenterology pharmaceutical and diagnostic products and services to the approximately 12,000 gastroenterologists in the United States, of whom approximately 83% prescribed Entocort EC, Lotronex or ordered at least one of our diagnostic testing services during 2010. We believe our sales success, access to physicians and proprietary diagnostic testing services may also provide us an advantage in gaining access to or acquiring additional pharmaceutical and diagnostic products.

We are also applying our integrated therapeutics and diagnostics business model to the field of oncology. In December 2009, we acquired exclusive rights from Novartis Vaccines and Diagnostics, Inc., or Novartis, to distribute, promote and sell PROLEUKIN® (aldesleukin) for injection in the United States for the treatment of adults with metastatic renal cell carcinoma and metastatic melanoma. We began selling Proleukin in February 2010. Net sales of Proleukin were approximately $64 million in the United States for the eleven months that we distributed the product during 2010.

In March 2010, we also entered into a non-exclusive collaboration agreement with Bayer Schering Pharma AG, or Bayer, pursuant to which we will develop diagnostic tests specifically tailored to oncology pharmaceutical compounds which Bayer has under development using our proprietary CEERTM platform. With the addition of Proleukin, our collaboration with Bayer and our several small services collaborations with large pharmaceutical companies which also utilize our CEER platform, we believe we are now well positioned to succeed in the oncology market. We have established a separate oncology sales force which includes approximately 45 sales representatives, sales managers and regional field trainers located throughout the United States.

We currently operate under two business segments: (1) the pharmaceutical products segment that markets and sells prescription drugs, and (2) the diagnostic testing services segment. Our total revenues have grown from $187.4 million in 2006 to $519.0 million in 2010 (a compounded annual growth rate, or CAGR, of 29.0%), with

 

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aggregate net sales of pharmaceutical products growing from $119.1 million to $434.7 million (a CAGR of 38.2%) and aggregate net sales of diagnostic testing services growing from $68.3 million to $81.3 million (a CAGR of 4.5%) across the same period. Collaboration and other revenues increased from $0.3 million for the year ended December 31, 2009 to $3.0 million for the year ended December 31, 2010, primarily due to the recognition of revenue from the upfront payment and ongoing research funding in connection with the collaboration agreement with Bayer.

Prometheus Laboratories Inc. was founded and incorporated in California in December 1995 initially to license, develop and commercialize diagnostic discoveries related to inflammatory bowel disease originally made by Cedars-Sinai Medical Center, or Cedars-Sinai, and the University of California, Los Angeles, or UCLA. We have grown, and expect to continue to grow, through the development, licensing and acquisition of pharmaceuticals and diagnostic technologies. We have expanded into the field of oncology and may expand into additional therapeutic areas that are consistent with our business model of offering proprietary pharmaceuticals complemented by proprietary diagnostics.

IPO Reorganization

We were incorporated in Delaware in June 2009 and are a wholly-owned subsidiary of Prometheus Laboratories Inc. We do not have any operations. Prometheus Laboratories Inc. is undertaking a reorganization in connection with this offering as a result of which we will become a holding company for Prometheus RxDx Holdings, Inc., which in turn will be a holding company for Prometheus Laboratories Inc. Following the automatic conversion of Prometheus Laboratories Inc.’s preferred stock into shares of its common stock at the close of business on the day immediately prior to the completion of this offering, Prometheus Laboratories Inc. will be merged with our recently formed subsidiary, Prometheus California Inc., with Prometheus Laboratories Inc. surviving the merger and continuing as our operating subsidiary. At the effective time of the merger, outstanding shares of the common stock of Prometheus Laboratories Inc. will be converted (on a post-split basis) into the right to receive shares of our common stock on a one-for-one basis. In addition, we will assume (on a post-split basis) the equity plans of Prometheus Laboratories Inc., the options and rights granted thereunder, as well as any outstanding warrants previously granted to purchase shares of the capital stock of Prometheus Laboratories Inc., all on a one-for-one basis and on the same terms and conditions. See “Certain Relationships and Related Party Transactions—IPO Reorganization.”

 

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Our ownership and corporate structure upon completion of the reorganization and this offering will be as set forth in the following chart:

LOGO

* Subsequent to the completion of the reorganization and this offering, Prometheus Laboratories Inc. plans to undergo a name change whereby it will change the name to Prometheus RxDx, Inc.

Gastrointestinal Diseases

In 2008, gastrointestinal anti-inflammatory prescription drugs accounted for sales of over $4.3 billion in the United States, according to IMS Health. Despite the relatively high number of patients suffering from gastrointestinal diseases and disorders, there are only approximately 12,000 gastroenterologists in the United States. Currently, our commercial gastroenterology products focus primarily on the diagnosis and treatment of inflammatory bowel disease, or IBD, IBS and celiac disease.

Inflammatory Bowel Disease

IBD represents a group of chronic, progressive, recurring and debilitating inflammatory disorders of the gastrointestinal tract. The immune system normally protects the body from infection. In people with IBD, however, the immune system reacts inappropriately by launching an attack on the body’s own tissues. In the process, the body sends white blood cells into the lining of the intestines, where they produce chronic inflammation. These cells then generate harmful products that ultimately lead to ulcerations and bowel injury. IBD typically has an onset before 30 years of age and is a lifelong illness that can be potentially life-threatening. Although IBD has no known cause, there is a presumed genetic component to susceptibility. IBD may be triggered by environmental factors and although IBD is not thought to be caused by dietary factors, dietary modification may reduce discomfort.

According to the Crohn’s & Colitis Foundation of America, an estimated 1.4 million Americans suffer from IBD. Crohn’s disease and ulcerative colitis are the two main types of IBD diseases. The main difference between Crohn’s disease and ulcerative colitis is the location and nature of the inflammation. Because the symptoms of Crohn’s disease and ulcerative colitis are so similar, it is sometimes difficult to establish a definite diagnosis. However, differentiating between the two diseases is extremely important as treatment may be very different. Historically, accurate diagnosis could only be done invasively by endoscopy with biopsy of lesions. In the past

 

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ten years, non-invasive diagnostic tests have been introduced that provide information to aid physicians in diagnosing IBD.

Crohn’s Disease

Crohn’s disease is a chronic disorder that causes inflammation of the digestive or gastrointestinal tract. Crohn’s disease most commonly affects the end of the small intestine, or the ileum, and the beginning of the large intestine, or the colon, although it may involve any part of the gastrointestinal tract. Crohn’s disease may involve all layers of the intestine, and there can be normal healthy bowel in between patches of diseased bowel. The inflammation extends deep into the lining of the affected area and primarily causes ulcerations, or breaks in the lining, of the small and large intestines. Flare-ups of the disease can range from mild to severe and typically involve symptoms such as diarrhea, abdominal pain, fever and sometimes rectal bleeding.

Treatment for Crohn’s disease depends on the location and severity of the disease, complications and response to previous treatment. Mild symptoms may be treated with an antidiarrhea medication. For mild to moderate symptoms, the only medication approved by the U.S. Food and Drug Administration, or FDA, is Entocort EC; however, although not approved for such use, physicians also prescribe aminosalicylates, such as sulfasalazine or mesalamine. Corticosteroids, such as hydrocortisone or prednisone, although also not approved for such use, are also given orally to control inflammation. However, corticosteroids are not generally used for prolonged treatment due to serious side effects including acne and puffiness of the face, among others. Depending on the severity of the disease, physicians may also prescribe medications that suppress the immune system, such as azathioprine, mercaptopurine or methotrexate although these are also not approved to treat Crohn’s disease.

Moderate to severe disease may be treated with biologics, such as infliximab and adalimumab, which inhibit the action of certain factors that lead to inflammation. When a pharmaceutical does not control the disease, or when the side effects of steroids or other drugs threaten a person’s health, surgery may be required. However, inflammation may return next to the area of the bowel that was removed.

Crohn’s disease is often expensive to treat because many patients may require long-term medical care, including multiple hospitalizations, surgeries and expensive therapeutics. The condition can be difficult to manage clinically and consumes a substantial amount of healthcare resources in terms of physician time, procedures and medications. More than 600,000 Americans had Crohn’s disease in 2007, according to Datamonitor.

Ulcerative Colitis

Ulcerative colitis is a chronic disease of the colon and rectum. The disease is marked by inflammation and ulceration of the innermost lining of the colon, whereas Crohn’s disease can affect all layers of the intestine. Ulcerative colitis involves inflammation of the entire rectum and extends up the colon in a continuous manner. There are no areas of normal intestine between the areas of diseased intestine. Because the inflammation makes the colon empty frequently, symptoms typically include diarrhea (sometimes bloody) and often crampy abdominal pain. Ulcerative colitis may, however, also affect parts of the body outside the intestine, producing symptoms resembling arthritis in other parts of the body.

Ulcerative colitis can be painful and debilitating, and at times it can lead to life-threatening complications. The goal of medical treatment is to reduce the inflammation and to induce remission initially with medication, followed by the administration of maintenance medication to prevent a relapse of the disease. Treatment for ulcerative colitis depends on the severity of the disease, complications and response to previous treatment. Most patients with mild to moderate ulcerative colitis will first be treated with aminosalicylates, such as sulfasalazine or mesalamine, which are used to help control inflammation. Patients with moderate to severe disease who do not respond to aminosalicylates may take corticosteroids such as prednisone, methylprednisone and hydrocortisone, which are also used to reduce inflammation. These drugs are not recommended for long-term use due to their side effects, but they can be effective for short-term use. Depending on the severity of the disease, patients may also take medications that suppress the immune system, such as azathioprine and mercaptopurine. These drugs

 

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are used for patients who have not responded to aminosalicylates or corticosteroids or who are dependent on corticosteroids.

Severe symptoms can often result in hospitalization and surgery. In the best cases, treatment may lead not only to symptom relief, but also to long-term remission. More than 700,000 Americans had ulcerative colitis in 2007, according to Datamonitor.

Irritable Bowel Syndrome

IBS is a disorder characterized most commonly by cramping, abdominal pain, bloating, constipation and diarrhea. Patients diagnosed with IBS are commonly classified as having one of three forms: IBS with constipation, IBS with diarrhea, or mixed-pattern IBS alternating between constipation and diarrhea. IBS causes substantial discomfort and distress, but, unlike IBD, it is not characterized by intestinal inflammation or permanent intestinal damage. Researchers have yet to discover any specific cause for IBS. No cure has been found for IBS, but symptoms can often be controlled with diet, stress management and prescription and over-the-counter medications, including fiber supplements, laxatives, anti-diarrhea medication, antispasmodics and antidepressants. For severe cases, however, IBS can be disabling. People suffering from severe cases of IBS may be unable to work, attend social events or even travel short distances. Thus far, only three drugs have been approved for the treatment of IBS. The first, Lotronex (alosetron hydrochloride), is the only prescription drug approved for use in female patients with severe diarrhea-predominant IBS who have chronic IBS symptoms, have had abnormalities of the GI tract excluded, and have not responded adequately to conventional therapy. The second, Zelnorm® (tegaserod maleate), was withdrawn from the United States market in 2007 and is currently only available under investigational new drug protocols for patients whose condition is life-threatening and require hospitalization. Amitiza® (lubiprostone) was approved by the FDA in April 2008 for the treatment of IBS with constipation in women 18 years of age and older.

According to the NIDDK, in 2007, almost 60 million, or 20%, of the U.S. population had symptoms of IBS, making it one of the most common disorders diagnosed by physicians. Of these patients, less than 5% meet the criteria for prescription of Lotronex. IBS occurs more often in women than in men, and it generally begins in late adolescence or early adult life and rarely appears for the first time after the age of 50. Unfortunately, many people suffer from IBS for a long time before seeking medical treatment. Up to 75% of people suffering from IBS are believed not to be receiving medical care for their symptoms, due in part to the current difficulties of diagnosing IBS.

Celiac Disease

Celiac disease is an autoimmune digestive disease that damages the small intestine, interfering with the absorption of nutrients from food. People with celiac disease cannot tolerate a protein called gluten, which is found in wheat, barley and rye. With celiac disease, eating foods or using products containing gluten causes an immune response that damages the villi in the small intestine. Villi are small, fingerlike protrusions that line the small intestine and allow nutrients from food to be absorbed into the bloodstream.

Although the cause of celiac disease is unknown, research has shown that it is strongly associated with certain genes involved in the regulation of the body’s immune response to gluten. It is also believed that celiac disease is generally triggered the first time by an environmental factor such as a viral infection or severe stress. The disease can appear at any time during a person’s life. Symptoms of celiac disease will vary significantly from person to person and include, but are not limited to, diarrhea, abdominal pain, skin rash, and weight loss. According to a Columbia University led survey of over 1,600 celiac patients published in the American Journal of Gastroenterology in 2001, the average length of time between the first symptoms and a diagnosis of celiac disease is 11 years. The only treatment for people with celiac disease is lifetime avoidance of gluten. In most cases, a diet avoiding gluten prevents any further damage and allows existing intestinal damage to heal.

According to the NIDDK, as many as three million Americans live with celiac disease but it remains greatly underdiagnosed. The number of diagnosed patients is expected to increase significantly over the next several

 

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years, driven by broad-based educational campaigns, NIH research funding and widely available genetic and blood tests for highly-specific antibodies.

Oncology

Cancer is a group of diseases in which abnormal cells divide without control and are able to invade and sometimes spread, or metastasize, to other tissues in the body. According to the National Cancer Institute, or NCI, more than 11 million people are living with cancer in the United States. The NCI also estimates that approximately 1.5 million individuals are diagnosed with, and 500,000 patients die of, cancer each year. However, there are only approximately 10,500 oncologists practicing in the United States.

There are more than 100 different types of cancer; each grows at different rates and responds to different treatments. Currently, our commercial oncology pharmaceutical product focuses on metastatic renal cell carcinoma and metastatic melanoma. Our CEER oncology diagnostic platform is focused on a number of cancer pathways including breast cancer.

Metastatic Renal Cell Carcinoma

Kidney cancer currently affects more than 58,000 people each year in the United States and nearly 13,000 Americans are expected to die from the disease in 2010. Renal cell carcinoma, the most common type of kidney cancer in adults, begins in the renal cortex, the part of the body that filters blood and produces urine. Metastatic kidney cancer refers to cancer that has spread outside its original location, often first to the lymph nodes and then to another part of the body, such as the lungs, bone, or liver. While surgery is the most common treatment for early disease, metastatic kidney cancer cannot be treated effectively by surgery alone and often requires the addition of drug therapy. Proleukin has been approved by the FDA for the treatment of adults with metastatic renal cell carcinoma for more than 15 years. Complete and long-lasting responses have been observed for a small percentage of patients.

Metastatic Melanoma

Melanoma is a type of skin cancer that begins in specialized skin cells called melanocytes, which are responsible for providing pigment to the skin. Melanoma is the most aggressive type of skin cancer. It is estimated that 68,130 people will be diagnosed with and 8,700 people will die of melanoma in 2010. Metastatic melanoma refers to disease that has spread from its original site to other parts of the body. Various chemotherapy agents are used to treat metastatic melanoma, however their overall success in metastatic melanoma is limited. Proleukin has been approved by the FDA for the treatment of adults with metastatic melanoma for more than ten years. Studies have demonstrated that Proleukin offers the possibility of a complete and long-lasting remission in this disease, although only in a small percentage of patients.

Metastatic Breast Cancer

According to the National Cancer Institute, one in eight women will be diagnosed with cancer of the breast during her lifetime. Although it occurs in both men and women, less than 1% of all new breast cancer cases occur in men. More than 40,000 women died from breast cancer in 2009, though death rates have been decreasing since 1990 due in part to treatment advances, earlier detection through screening and increased awareness. Metastatic breast cancer occurs when cells from the original tumor spread beyond the breast to other parts of the body. It is estimated that nearly 155,000 women in the United States are currently living with metastatic breast cancer. While there is no cure for metastatic breast cancer, treatment options are available. If metastasis has occurred, diagnosis and monitoring of the cancer remains critical to ensure optimal treatment and response to treatment.

Our Competitive Strengths

We believe that we bring the following competitive advantages or strengths to the markets and customers we serve.

 

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Differentiated, Physician-Focused Business Model

We believe our business model of offering pharmaceuticals combined with complementary diagnostic testing services differentiates us from most other pharmaceutical, specialty pharmaceutical and diagnostic companies and provides us with several benefits and advantages. We focus on specialist physicians and provide them with diagnostic testing services that can be used for early disease detection, diagnosis and differentiation; for selecting pharmaceuticals and avoiding therapeutic side effects; and for therapy monitoring.

We also believe selling both proprietary pharmaceuticals and diagnostics in the same sales call creates a different dynamic as compared to a traditional pharmaceutical sales call, resulting in longer sales calls and greater physician access. In addition, as the use of targeted therapeutics in stratified patient populations becomes more prevalent in the treatment of complex diseases, we believe our business model may provide us with a competitive advantage in acquiring or licensing additional pharmaceutical products and in obtaining, developing and commercializing additional diagnostics.

A Leader in Commercializing Diagnostic Technologies

We believe we are a technological leader in helping to develop and commercialize diagnostic testing services. For example, we believe our IBD Serology 7 diagnostic is the most comprehensive IBD test available to help physicians detect and differentiate IBD from other disorders that have similar symptoms. This product also helps physicians differentiate Crohn’s disease from ulcerative colitis. Since 2000, we have developed and commercialized 20 new diagnostic products designed to help gastroenterologists. Our diagnostic development group has successfully developed, scaled up and validated both our own technologies and those discovered and licensed in from academic institutions and others. We believe we are well positioned to maintain and build a leading position in developing and acquiring access to new technologies related to gastroenterology and oncology, respectively, based on our experience and past successes in commercializing new technologies and, when combined with the strength of our existing product portfolio, our differentiated business model and our effective sales force.

Highly-Trained and Effective Sales Force

We believe we have a leading sales force in the gastroenterology market. Unlike many pharmaceutical sales forces that are trained only to understand the mechanism of action, side effects and comparative benefits of their pharmaceuticals, our sales representatives are also trained to understand how our diagnostics relate to diseases. We feel this knowledge in conjunction with the marketing of our diagnostic products creates a more collaborative and science-based interaction with physicians in a sales call and, as a result, we believe our sales representatives generally experience longer sales calls with and greater access to physicians than most other pharmaceutical sales representatives. In addition to making our sales force more effective with respect to promoting existing products, we believe the nature of our interactions with physicians can help to build a lasting sales channel through which additional, high-value products and services can be brought to the physician community.

Facilitating a More Individualized Approach to Patient Care

Individual patients may respond differently to medications and the same disease can vary significantly from patient to patient. Our diagnostic tests identify individual patient and disease differences at a molecular or genetic level, including tests for measuring or identifying variations in genes, proteins or metabolites. These diagnostics, in conjunction with a patient’s symptoms, medical history, lifestyle and other health conditions, allow physicians to more effectively tailor treatment to the individual patient. We believe our science-based approach enables more individualized patient care and can help physicians determine the optimal management and treatment of challenging diseases.

Management Team with Proven Track Record

We have an experienced management team that is focused on the daily execution of our business plan and the future growth of our company. Our senior management has an average of over 20 years experience in the

 

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healthcare industry. Under our current management, we have built a strong record of commercial success. Our net sales have increased from $278.1 million in 2008 to $519.0 million in 2010, representing a CAGR of 36.6%. We believe our strong financial condition, coupled with the experience and proven track record of our senior management team, positions us well to capitalize on additional opportunities. In addition, our team has executed our product acquisition and in-licensing strategy by acquiring rights to Entocort EC, Lotronex and Proleukin within the last six years from three different pharmaceutical companies and entering into our collaboration agreement with Bayer.

Our Strategy for Growth

Capitalizing on our current strengths, our strategy for growth is focused on leveraging our differentiated business model to acquire, develop and commercialize proprietary pharmaceutical products and complementary, highly complex diagnostic testing services in the United States. We intend to leverage our sales force and the relationships our sales force has created with physicians to market and sell these additional products and services. Specifically, we intend to pursue growth by:

 

   

Expanding our access to marketed proprietary pharmaceutical products or products in later-stage development through acquisitions, licensing or distribution agreements, co-promotion or co-marketing agreements or strategic mergers or acquisitions;

 

   

Adding diagnostic testing services and new technologies through collaborations, internal development programs, in-licensing or acquisitions that complement our products and sales strategy;

 

   

Increasing the market penetration of our existing products and services through product enhancements, targeted promotion and by educating physicians and payors as to the clinical and cost benefits of our products and services; and

 

   

Carefully expanding into additional therapeutic areas that are consistent with our business model.

While our focus has been on gastroenterology products and diagnostic testing services in the United States, we are expanding into oncology and may carefully expand into other therapeutic areas as well. In June 2009 we began offering MyCeliacID in the United States, Mexico and Canada via the internet. We may also consider expanding full therapeutic and diagnostics services outside the United States in the future for our other products.

Acquire Additional Pharmaceutical Products

We are selectively pursuing additional proprietary pharmaceutical products through acquisitions, licensing or distribution agreements, co-promotion or co-marketing agreements and we may also consider strategic mergers or acquisitions to access products. We are seeking products we believe are promotion sensitive, can generate a meaningful level of sales and can benefit from complementary diagnostics. Generally, these products require a more complex sales call than other pharmaceuticals. We believe there are a number of such products in the larger pharmaceutical companies which do not fit well into their sales models, and in earlier stage companies bringing products through registration, but who do not have the capacity or capabilities to sell these products. We also believe that interest in our internally developed oncology diagnostic technology may afford us additional opportunities to gain access to pharmaceutical products.

Besides acquiring or licensing currently marketed products, we may also pursue the acquisition of compounds in the later stages of development having evidence of safety and efficacy, and that are expected to have a reasonable time horizon to potential market approval. Another potential source of products for us includes acquiring access to products already approved and marketed outside the United States that we believe may have a reasonably straightforward path to registration in the United States.

Expand Our Diagnostic Testing Services

Since launching our first diagnostic test, we have helped to build the market for our highly complex clinical diagnostic testing services in gastroenterology. Our strategy has been and is to be a technological leader by developing and introducing new and improved diagnostic testing services in our chosen markets, including

 

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oncology. We have acquired and expect to continue to acquire proprietary diagnostic technologies through licenses and collaborations, generally with academic institutions. In addition, we will continue to develop new diagnostic testing services, to enhance our existing diagnostics and to scale up, validate and commercialize licensed technologies, through our internal research and development capabilities and collaborations with pharmaceutical companies.

In many cases, we may acquire diagnostic tests that support our pharmaceutical products. However, we may acquire or develop diagnostic tests without complementary pharmaceutical products.

Increase Market Penetration

We believe there will be continuing opportunities to increase the market penetration of our existing products and services through product enhancements, targeted promotion and by educating physicians and payors as to the clinical and cost benefits of our products and services. For example, we believe that some of the increases in the sales of our diagnostic testing services for IBD and celiac disease are directly attributable to enhancements made to those products in the last several years.

Diagnostic tests, in conjunction with a patient’s symptoms, medical history, lifestyle and other health conditions, can help physicians to more effectively tailor treatment to the individual patient. Potential benefits could be substantial, including improvements in diagnosis, more effective treatment and reductions in side effects, benefiting patients and thereby generating cost savings to the healthcare system. To the extent such cost savings can be achieved and documented, payors may be more willing to provide expanding coverage for diagnostic testing services and to use appropriate pharmaceuticals.

Application to Other Therapeutic Areas

With the appropriate opportunity, we may carefully expand into additional therapeutic areas that are consistent with our business model of marketing proprietary pharmaceuticals complemented by diagnostics. In addition to the relationship between pharmaceuticals and diagnostics, we will be looking for specialties in which we believe there is a high probability that we will be able to acquire or gain access to multiple products, both marketed and in development.

Based on our experience in the gastroenterology market, we believe there are several market attributes that help make our business model of integrating pharmaceuticals and diagnostics successful. These attributes include:

 

   

complex disease states that are difficult to diagnose and treat;

 

   

diseases that must be treated with drugs which often carry issues related to both safety and efficacy; and

 

   

focused markets represented by a reasonably concentrated number of physicians.

There are other therapeutic areas that we believe have these attributes, and therefore should be good candidates for us. We are currently expanding into the field of oncology, which we believe to be one such therapeutic area. We also believe urology, neurology and endocrinology represent potential markets for our business model.

Our Products

Gastroenterology Pharmaceutical Products

Our promoted pharmaceutical products for gastrointestinal diseases and disorders include Entocort EC for the treatment of mild to moderate active Crohn’s disease involving the ileum and/or ascending colon and Lotronex for treatment of a subset of women with severe diarrhea-predominant IBS. We sell, but do not actively market, several other pharmaceuticals including Imuran, Helidac Therapy, and Ridaura, in addition to a number of other diagnostic tests. We also manufacture a generic mercaptopurine product which is sold through a third-party distributor. We currently only offer our pharmaceutical products in the United States.

 

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The following table sets forth our key pharmaceutical products that are currently sold, the indications they are approved for and our net sales from each product for calendar years 2008, 2009 and 2010.

 

         Net Sales  
         Years Ended
December 31,
 

Product

  

Disease/Uses

  2008     2009     2010  
         (In millions)  

Promoted:

        

Entocort EC

   Mild to moderate active Crohn’s disease involving the ileum and/or ascending colon   $ 145.0      $ 203.9      $ 316.5   

Lotronex(1)

   Certain cases of severe diarrhea-predominant irritable bowel syndrome in women     25.2        30.4        34.8   

Proleukin(2)

   Metastatic renal cell carcinoma and metastatic melanoma                   64.0   

Non-promoted:

        

Imuran

   Kidney transplantation and rheumatoid arthritis     6.4        5.4        4.9   

Helidac Therapy

   H. pylori eradication     8.0        7.2        5.7   

Ridaura

   Rheumatoid arthritis for patients who have not responded adequately to one or more non-steroidal anti-inflammatory drugs     3.9        3.6        3.3   

Mercaptopurine

   Lymphatic leukemia     5.9        4.8        4.4   

Other(3)

       1.6        1.5        1.1   
                          

Total Pharmaceutical

Product Sales

     $ 196.0      $ 256.8      $ 434.7   
                          

 

(1) We began marketing and selling Lotronex in November 2007 under an exclusive distribution agreement with GlaxoSmithKline. In January 2008, we acquired exclusive rights to Lotronex from GlaxoSmithKline.

 

(2) We began selling Proleukin in February 2010 under an exclusive distribution and promotion agreement with Novartis.

 

(3) Includes Trandate tablets and Zyloprim tablets. In December 2010, we signed an agreement with ThePharmaNetwork, LLC, to sell Trandate and Zyloprim. The transaction will not close until the technology transfer has successfully been completed, which we anticipate will be later in 2011.

We do not market our non-promoted pharmaceutical products since they no longer have patent protection and either compete with generic products or newer compounds often preferred by physicians.

We sell the majority of our branded pharmaceutical products to wholesalers who, in turn, sell the products to hospitals, pharmacies and other customers. All these customers have a right to return the product if it expires before use. Cardinal Health, Inc., McKesson Corporation and Amerisource Bergen Corporation individually comprised 42%, 34% and 20%, respectively, of our branded pharmaceutical product sales in 2010. Collectively they comprised 95%, 96% and 96% of our branded pharmaceutical product sales in the years ended December 31, 2008, 2009 and 2010, respectively.

ENTOCORT® EC (budesonide) Capsules

Entocort EC is the only FDA-approved drug indicated for the induction and maintenance of clinical remission in mild to moderate active Crohn’s disease involving the ileum and/or the ascending colon. The ileum and/or the ascending colon are affected in approximately 70% of Crohn’s disease patients. Entocort EC consists of an encapsulated formulation of budesonide granules, a glucocorticosteroid. Entocort EC is designed to release primarily in the ileum and/or the ascending colon, so that as little as 10% of the drug enters systemic circulation. Entocort EC may benefit patients by reducing glucocorticosteroid-related side effects. In addition, one of two studies has shown that Entocort EC demonstrated symptom control for flares that is not statistically different from prednisolone (a steroid used to treat Crohn’s disease) at eight weeks. Entocort EC is also approved for up to three months maintenance therapy for many people with mild to moderate Crohn’s disease.

Many large, well-capitalized companies offer products in the United States that compete with Entocort EC. Entocort EC currently competes with other therapies including aminosalicylates, or 5-ASAs, such as sulfasalazine or mesalamine, and other corticosteroids, such as hydrocortisone, prednisone or prednisolone, none

 

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of which are currently approved for the treatment of Crohn’s disease but which are often prescribed by physicians for such use. 5-ASAs are generally prescribed for both ulcerative colitis and Crohn’s disease. 5-ASAs have been tested in clinical trials for Crohn’s disease, but have failed to demonstrate statistically significant effectiveness versus placebo. We are also aware of a number of products being tested in later-stage clinical trials for the treatment of mild to moderate Crohn’s disease.

Entocort EC has been shown to help more patients achieve clinical remission of Crohn’s disease as compared to mesalamine. As compared to prednisolone, Entocort EC also has been shown to have a lower incidence of glucocorticosteroid-related side effects, such as acne and puffiness of the face, among others, as compared to those patients taking prednisolone.

We believe Entocort EC competes on perceived value based on relative cost, product efficacy and safety. Entocort EC prescriptions have increased approximately 114% in 2010 over 2004, the year before we began selling the product, in a relatively flat market during the same period. Since we acquired promotion and distribution rights to Entocort EC, we have increased Entocort EC’s share of the prescription market defined to include Entocort EC and the 5-ASAs from 6.1% in January 2005 to 11.8% in December 2010. We have priced Entocort EC treatment based on its value as the only approved product for the treatment of mild to moderate Crohn’s disease, and its value relative to competing therapies.

We have the exclusive right to distribute, market and sell Entocort EC in the United States and to use the trademark, ENTOCORT® under an agreement with AstraZeneca which currently runs through December 31, 2011 unless terminated earlier due to the introduction of a generic equivalent. In the United States, Entocort EC is protected by two patents, the terms of exclusivity for which expire in May 2011 and January 2015. Both of the patents are owned by an affiliate of AstraZeneca. Under the agreement, AstraZeneca has the exclusive right to determine what action, if any, will be taken in the event of any infringement or threatened infringement on the above patents or the trademark. AstraZeneca manufactures Entocort EC according to the terms of our agreement.

AstraZeneca is responsible for a post-marketing pediatric study for Entocort EC in accordance with the FDA’s requirements imposed at the time of NDA approval for the product. AstraZeneca is required to consult with us concerning any proposed material changes in the label for Entocort EC. We are entitled to have a representative participate in any substantive meeting with the FDA for the pediatric study accompanying a representative from the AstraZeneca team. AstraZeneca is required to fund any post-marketing obligations required for the product. AstraZeneca has requested that the FDA waive the post-marketing pediatric study requirement as AstraZeneca has been unable to successfully engage an adequate number of patients to perform the study.

LOTRONEX® (alosetron hydrochloride) Tablets

In January 2008, we acquired exclusive rights to LOTRONEX® (alosetron hydrochloride) Tablets in the United States from GlaxoSmithKline. Lotronex is the only prescription drug approved by the FDA for use in a specific subset of female patients with severe diarrhea-predominant IBS, as more fully described in the label. Patients with severe diarrhea-predominant IBS constitute less than 5% of all people suffering from IBS. From November 1, 2007 until we completed the acquisition, we marketed and sold Lotronex under an exclusive distribution agreement. There are five U.S. patents covering Lotronex, including a compound patent which expires in January 2013 and method of use patents which expire in October 2018. See “Risk Factors—Risks Related to Intellectual Property.”

Lotronex is indicated for use only in women with severe diarrhea-predominant IBS who have not responded adequately to conventional therapy, whose IBS symptoms are chronic, and who have had other gastrointestinal medical conditions ruled out. Diarrhea-predominant IBS is severe if, in addition to diarrhea, the patient experiences at least one of the following symptoms: frequent and severe abdominal pain/discomfort; frequent bowel urgency/fecal incontinence; or disability/restriction of daily activities because of IBS. Clinical studies with Lotronex have not been performed to assess the benefits of Lotronex in men or patients under the age of 18.

Lotronex may reduce pain or discomfort in the lower abdominal area, bowel urgency, or the sudden need to have a bowel movement, and diarrhea resulting from IBS. Because of the potential for serious side effects associated with Lotronex, its use is restricted to patients with severe IBS who have not responded adequately to

 

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conventional therapy and for whom the benefits outweigh the risks. Serious side effects associated with Lotronex include ischemic colitis and severe constipation. Ischemic colitis is a condition in which reduced blood flow to the intestines usually causes injury to the colon. These conditions can lead to hospitalization, and in rare cases, blood transfusions, surgery and death. Lotronex should be discontinued immediately in patients who develop constipation or symptoms of ischemic colitis. Physicians should instruct patients who report constipation to immediately contact the physician if the constipation does not resolve after discontinuation of Lotronex.

Prior to our acquisition of the exclusive rights to Lotronex in the United States, GlaxoSmithKline voluntarily withdrew Lotronex from the market in 2000 after failing to reach agreement with the FDA on how to best manage risks associated with the product. The FDA approved a supplemental NDA for Lotronex in 2002 with a more limited indication and a special warning referred to as a “black box” warning and Lotronex was subsequently re-introduced to the market. In order to reduce the potential for serious side effects of Lotronex, it is subject to a special prescribing program designed to minimize the risks of serious complications of constipation and ischemic colitis. Under this program, only physicians who have enrolled in the Prescribing Program for Lotronex™ may write prescriptions for it. As of February 1, 2011, approximately 12,614 physicians, physician assistants and nurse practitioners in the United States were enrolled in the prescribing program. However, only 23% of enrolled physicians actively prescribed Lotronex in 2010. In connection with their enrollment into the prescribing program, the physicians must demonstrate an understanding of IBS and be familiar with the side effects and risks of Lotronex. The program instructs the prescribing physician to review the medication guide with the patient and to sign a patient-physician agreement with the patient prior to prescribing Lotronex, which indicates that the patient has been advised of and understands the risks and benefits of Lotronex. The physician then places a blue sticker on the prescription, signifying to the pharmacist that he or she is an enrolled physician.

New data from a study of 29,072 patients who received 203,939 prescriptions showed the incidence of ischemic colitis and severe constipation have remained rare and stable since the reintroduction of Lotronex under the prescribing program and cases are typically of short duration that resolve upon withdrawal of treatment. In clinical trials conducted since reintroduction, incidence rates for ischemic colitis and severe constipation in patients with severe diarrhea-predominant IBS receiving Lotronex were four and two cases per 1,000 patients, respectively, compared to two and zero cases per 1,000 in the placebo group. The data were published in the April 2010 issue of The American Journal of Gastroenterology.

In addition, Lotronex has been the subject of a number of lawsuits against GlaxoSmithKline, primarily based on an alleged failure to inform patients of the potentially severe side effects. GlaxoSmithKline has advised us that all of these lawsuits have been resolved with the exception of three, which GSK believes will be dismissed. Since reintroduction of Lotronex in 2002, no lawsuits involving Lotronex have been filed against GlaxoSmithKline relating to adverse side effects of the product. Under our agreement to purchase Lotronex, we are not liable for claims related to Lotronex that arose prior to the date of the acquisition.

We are responsible for continuing ongoing GlaxoSmithKline-initiated post-marketing studies with respect to monitoring the occurrence of serious adverse events and risk factors associated with Lotronex, compliance and prescriber enrollment with the Prescribing Program for Lotronex, evaluation of the appropriate use, survey of patients, the effectiveness of such program and submitting periodic reports to the FDA. Of the post-marketing studies, all have been completed except a patient survey program. The patient survey program is ongoing and is currently being managed for us by GlaxoSmithKline through a third party service provider. We intend to utilize the same service provider to assist us with managing this program.

Non-Promoted Pharmaceutical Products

For the last several years, we have not marketed any of our non-promoted pharmaceutical products.

Imuran® (azathioprine)

Imuran is indicated for adjunctive use in the prevention of rejection in kidney transplants and in the management of active rheumatoid arthritis. Although Imuran is not indicated for the treatment of IBD and we do not promote it for that indication, physicians often prescribe it for various forms of IBD, including Crohn’s

 

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disease and ulcerative colitis, as well as other autoimmune disorders. Imuran is prescribed primarily by gastroenterologists, transplant surgeons, nephrologists, rheumatologists and internal medicine specialists. Imuran has intense competition, both from generics and newer products that have come to market.

Helidac® Therapy (bismuth subsalicylate/metronidazole/tetracycline hydrochloride)

Helidac Therapy, or Helidac, when taken with an H2 antagonist, is indicated for the eradication of Helicobacter pylori, or H. pylori, bacteria, which causes peptic ulcers, and for patients with duodenal ulcer disease. Helidac was the first product to combine all the drug components necessary for H. pylori eradication into one easy-to-use kit. Helidac is a compliance package made up of metronidazole, tetracycline hydrochloride and bismuth subsalicylate. Each of the products contained in the compliance package are available as separate tablets or capsules and are available as generics. Helidac competes principally with TAP Pharmaceutical’s PREVPAC®. In addition, Axcan Pharma Inc. has introduced a three-in-one capsule for the eradication of H. pylori.

Ridaura® (auranofin)

Ridaura is approved for the treatment of active classical or definite rheumatoid arthritis in adults. Ridaura is the only oral formulation of a gold salt available for the treatment of rheumatoid arthritis for patients who have not responded adequately to one or more non-steroidal anti-inflammatory drugs. It should be used in treating rheumatoid arthritis only when other non-steroidal, anti-inflammatory drugs are not effective. Ridaura faces intense competition from newer pharmaceuticals.

Mercaptopurine

Mercaptopurine is approved for maintenance for acute lymphatic leukemia as part of a combination regimen and, although it is not indicated for the treatment of certain gastrointestinal diseases and we do not promote it for those indications, physicians often prescribe it for various forms of IBD, including Crohn’s disease and ulcerative colitis. Mercaptopurine is a generic version of the branded product Purinethol®, currently owned by Teva Pharmaceuticals. Our distribution partner, Par Pharmaceutical, Inc., or Par, launched mercaptopurine as the first generic on the market in February 2004. Subsequently, three additional generics have been approved and launched, including a generic launched by Teva Pharmaceuticals in April 2005. In addition to these generics, mercaptopurine competes with Imuran and generic azathiopurine products.

Trandate® (labetalol hydrochloride)

Trandate is approved for the management of high blood pressure, or hypertension. Trandate can be used alone or in combination with other anti-hypertensive agents, particularly thiazide and loop diuretics. Trandate is typically prescribed by cardiologists, family practitioners and internists. Trandate competes both with generics and many other drugs used to treat hypertension. In December 2010, we signed an agreement with ThePharmaNetwork, LLC, to sell Trandate. The transaction will not close until the technology transfer has successfully been completed, which we anticipate will be later in 2011.

Zyloprim® (allopurinol)

Zyloprim reduces serum and uric acid levels and is approved for the management of patients with gout, patients receiving certain types of chemotherapy to leukemia, lymphoma and other cancers, and patients with kidney or urinary stones. Zyloprim is typically prescribed by orthopedic specialists, rheumatologists, podiatrists, nephrologists and family practitioners. In addition to generic competition, Zyloprim also competes with other non-generic anti-gout agents, such as probenecid, sulfinpyrazone and colchicines. In December 2010, we signed an agreement with ThePharmaNetwork, LLC, to sell Zyloprim. The transaction will not close until the technology transfer has successfully been completed, which we anticipate will be later in 2011.

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