-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, L0qcXj6mhIMPghBFtXy7lrx+VguvPB+O1imqXbg/CVt2p9Ee9AftvQNWMjHByWue oREsA+jkVM843ZjjFrK1IQ== 0000912057-97-011202.txt : 19970401 0000912057-97-011202.hdr.sgml : 19970401 ACCESSION NUMBER: 0000912057-97-011202 CONFORMED SUBMISSION TYPE: 10-K PUBLIC DOCUMENT COUNT: 6 CONFORMED PERIOD OF REPORT: 19961231 FILED AS OF DATE: 19970331 SROS: NYSE FILER: COMPANY DATA: COMPANY CONFORMED NAME: ALZA CORP CENTRAL INDEX KEY: 0000004310 STANDARD INDUSTRIAL CLASSIFICATION: PHARMACEUTICAL PREPARATIONS [2834] IRS NUMBER: 770142070 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 10-K SEC ACT: 1934 Act SEC FILE NUMBER: 001-06247 FILM NUMBER: 97569551 BUSINESS ADDRESS: STREET 1: 950 PAGE MILL RD STREET 2: PO BOX 10950 CITY: PALO ALTO STATE: CA ZIP: 94303-0802 BUSINESS PHONE: 4154945000 10-K 1 10-K SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-K [X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 Commission File Number 1-6247 ALZA CORPORATION ----------------------------------------------------- (Exact name of registrant as specified in its charter) Delaware 77-0142070 ------------------------------- -------------------------- (State or other jurisdiction of (I.R.S. Employer incorporation of organization) Identification No.) 950 Page Mill Road, P.O. Box 10950, Palo Alto, CA 94303-0802 - -------------------------------------------------- ------------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (415) 494-5000 -------------------- Securities registered pursuant to Section 12(b) of the Act: Name of each exchange Title of each class on which registered - -------------------- ------------------------- Common Stock New York Stock Exchange 5 1/4% Liquid Yield Option-TM- Notes due 2014 New York Stock Exchange (Zero Coupon-Subordinated) 5% Convertible Subordinated Debentures due 2006 New York Stock Exchange Securities registered pursuant to Section 12(g) of the Act: ALZA Corporation Warrants (to purchase Common Stock at $65 per share) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes [X] No [ ] Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [ ] State the aggregate market value of the voting stock held by non-affiliates of the registrant, as of March 17, 1997: $2,410,274,299 Indicate the number of shares outstanding of each of the registrant's classes of common stock, as of March 17, 1997: Title of Class Number of Shares -------------- ----------------- Common Stock 84,912,721 DOCUMENTS INCORPORATED BY REFERENCE Part II, Items 5, 6, 7 and 8 are incorporated by reference to the registrant's Annual Report to Stockholders for the year ended December 31, 1996; Part III, Items 10, 11, 12 and 13 are incorporated by reference to the definitive proxy statement for the registrant's Annual Meeting of Stockholders to be held on May 8, 1997. ALZA CORPORATION FORM 10-K ANNUAL REPORT FOR THE FISCAL YEAR ENDED DECEMBER 31, 1996 TABLE OF CONTENTS Page PART I Item 1. BUSINESS. . . . . . . . . . . . . . . . . . . . . . . . . .3 Item 2. PROPERTIES. . . . . . . . . . . . . . . . . . . . . . . . 19 Item 3. LEGAL PROCEEDINGS . . . . . . . . . . . . . . . . . . . . 19 Item 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS . . . 20 EXECUTIVE OFFICERS OF THE REGISTRANT. . . . . . . . . . . 21 PART II Item 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS . . . . . . . . . . . . . . . . . . . 23 Item 6. SELECTED FINANCIAL DATA . . . . . . . . . . . . . . . . . 23 Item 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS . . . . . . . . . . . 23 Item 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA . . . . . . . 23 Item 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE . . . . . . . . . . . 23 PART III Item 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT . . . 24 Item 11. EXECUTIVE COMPENSATION . . . . . . . . . . . . . . . . . 24 Item 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT . . . . . . . . . . . . . . . . . . . . . 24 Item 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS . . . . . 24 PART IV Item 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K. . . . . . . . . . . . . . . . . . . . . . . 25 -2- PART I ITEM 1. BUSINESS INTRODUCTION ALZA Corporation ("ALZA") is a leader in the development and commercialization of innovative pharmaceutical products that incorporate drugs into advanced dosage forms designed to provide controlled, predetermined rates of drug release for extended time periods. By administering drugs in preset patterns and by alternative routes, ALZA's advanced dosage forms, called therapeutic systems, can add to the medical and economic value of drug therapies by minimizing their unpleasant or harmful side effects, optimizing their beneficial actions, simplifying drug therapy, and increasing patient compliance by decreasing the frequency with which medication must be administered. ALZA was incorporated under the laws of the State of California on June 11, 1968, and changed its legal domicile from California to Delaware in 1987. ALZA's mailing address is 950 Page Mill Road, P.O. Box 10950, Palo Alto, CA 94303-0802. Historically, most of ALZA's product development activities have been undertaken pursuant to joint development and commercialization agreements with large pharmaceutical companies. These agreements normally provide for the pharmaceutical company client to reimburse ALZA for costs incurred in product development and clinical evaluation of a specified product, including a portion of general and administrative expenses. The client receives marketing rights to the product, and ALZA receives royalties based on the client's sales of the product. In some cases ALZA manufactures all or a portion of the client's requirements of the product; in other cases the client manufactures the product. Among the ALZA-developed products commercialized to date by client companies are Procardia XL-Registered Trademark- (nifedipine) for the treatment of angina and hypertension, Duragesic-Registered Trademark- (fentanyl) CII for the management of severe chronic pain, Transderm-Nitro-Registered Trademark- (nitroglycerin) for the prevention and treatment of angina and NicoDerm-Registered Trademark- CQ-TM- (nicotine) for use as an aid in smoking cessation. The United States health care industry has changed dramatically in the last several years. Pharmaceutical companies have merged and reduced their combined sales forces, acquired pharmacy benefit companies, and built alliances in an effort to cut costs, ensure market share, and improve research and development productivity. In this environment, every new pharmaceutical product must add value to the health care marketplace. Beginning in the early 1990s and accelerating over the past several years, ALZA has embarked on a three-part strategy to capitalize on the opportunities created by the new health care marketplace. First, ALZA has continued its traditional product development arrangements with client companies. ALZA currently has products in development with -3- several of the world's largest pharmaceutical companies. Second, ALZA has expanded its commercialization capabilities and activities as described under "ALZA Pharmaceuticals" below. ALZA now has an approximately 60 person sales force which promotes Ethyol-Registered Trademark- (amifostine), Testoderm-Registered Trademark- (testosterone) CIII, Testoderm-Registered Trademark- with Adhesive and Mycelex-Registered Trademark- (clotrimazole) Troche, and co-promotes Duragesic-Registered Trademark- (fentanyl) CII, Glucotrol XL-Registered Trademark- (glipizide), the ENACT AirWatch-TM- system, Hexalen-Registered Trademark- (altretamine) and NeuTrexin-Registered Trademark- (trimetrexate glucuronate). As part of its strategy to expand its commercialization activities and in order to decrease ALZA's dependence on client companies, in 1993 ALZA formed Therapeutic Discovery Corporation ("TDC") to develop, with ALZA, a pipeline of products for commercialization by ALZA. At the end of 1996, ALZA submitted a New Drug Application for a second-generation transdermal testosterone product under development with TDC, and a number of additional products were in the ALZA/TDC pipeline, including several in clinical evaluation. (See "Therapeutic Discovery Corporation" below.) Third, in order to extend ALZA's leadership in drug delivery technology, ALZA formed the ALZA Technology Institute ("ATI") in 1994. ATI is increasing ALZA's investment in the research and development of therapeutic systems, including systems for the delivery of biotechnology compounds and for use in gene therapy. NOTICE CONCERNING FORWARD-LOOKING STATEMENTS Some of the statements made in this Form 10-K are forward-looking in nature, including but not limited to ALZA's product development activities and plans, plans concerning the commercialization of products, and other statements that are not historical facts. The occurrence of the events described, and the achievement of the intended results, are subject to the future occurrence of many events, some or all of which are not predictable or within ALZA's control; therefore, actual results may differ materially from those anticipated in any forward-looking statements. Many risks and uncertainties are inherent in the pharmaceutical industry; others are more specific to ALZA's business. Many of the significant risks related to ALZA's business are described in this Form 10-K, including risks associated with technology and product development, risks relating to clinical development, regulatory clearance to market products and medical acceptance of products, changes in the health care marketplace, patent and intellectual property matters, regulatory and manufacturing issues, and risks associated with competition from other companies. -4- ALZA TECHNOLOGIES AND PRODUCTS D-TRANS-TM- TRANSDERMAL SYSTEMS. ALZA's transdermal therapeutic systems provide for the controlled delivery of drugs directly into the bloodstream through intact skin. Transdermal systems are well suited for the delivery of potent drugs that are poorly absorbed and/or extensively metabolized when administered orally. ALZA's D-TRANS-TM- products are thin, multilayer systems, in the form of small adhesive patches, that combine a drug reservoir with a polymer membrane or other mechanism to control drug release to the surface of intact skin, and then through the skin into the bloodstream. The transdermal products developed by ALZA and marketed in the United States and/or other countries include: - CATAPRES-TTS-Registered Trademark- (clonidine) - Applied once-weekly for the treatment of hypertension, marketed by Boehringer Ingelheim Pharmaceutical, Inc. ("Boehringer"). - DURAGESIC-Registered Trademark- (fentanyl) CII - A 72-hour system for management of chronic pain in patients who require continuous opioid analgesia for pain that cannot be controlled by lesser means, marketed by Janssen Pharmaceutica, Inc. (together with its affiliates, "Janssen") and co-promoted in the United States by ALZA Pharmaceuticals. - NicoDerm-Registered Trademark- CQ-TM- / NICODERM-Registered Trademark- (nicotine) - Applied once-daily to aid in smoking cessation. NicoDerm-Registered Trademark- CQ-TM- is marketed for over-the-counter use by SmithKline Beecham as part of a joint venture with Hoechst Marion Roussel, Inc. ("HMR"), and Nicoderm-Registered Trademark- is marketed as a prescription product by HMR in Australia, Canada, South Korea, New Zealand and the United States. - TESTODERM-Registered Trademark- AND TESTODERM-Registered Trademark- WITH ADHESIVE (testosterone) CIII - A once-daily transdermal system for replacement therapy in males for conditions associated with a deficiency or absence of endogenous testosterone, marketed by ALZA Pharmaceuticals in the United States. In January 1997, Scitech Genetics Limited introduced Testoderm-Registered Trademark- and Testoderm-Registered Trademark- with Adhesive in Singapore under a distribution agreement with ALZA. ALZA has executed an agreement with Ferring N.V. ("Ferring") pursuant to which Ferring has the right to market Testoderm-Registered Trademark- and Testoderm-Registered Trademark- with Adhesive in 12 European countries. - TRANSDERM-NITRO-Registered Trademark- (nitroglycerin) - Applied once-daily for the prevention and treatment of angina pectoris, marketed by Novartis Pharmaceuticals Corporation (together with its affiliates, "Novartis"). -5- - TRANSDERM SCOP-Registered Trademark- (scopolamine) - Applied once every three days for prevention of nausea and vomiting associated with motion sickness, marketed by Novartis. A number of additional transdermal products are in various stages of development and clinical testing. ORAL SYSTEMS. ALZA has developed several therapeutic systems for oral administration. ALZA's OROS-Registered Trademark- products resemble conventional tablets or capsules in appearance, but use an osmotic mechanism to provide pre-programmed, controlled drug delivery to the gastrointestinal tract. An OROS-Registered Trademark- product comprises a polymer membrane with one or more laser-drilled holes surrounding a core containing the drug or drugs, with or without osmotic or other agents. Water from the gastrointestinal tract diffuses through the membrane at a controlled rate into the drug core, causing the drug to be released in solution or suspension at a predetermined controlled rate out of the laser-drilled hole(s). OROS-Registered Trademark- systems are well suited for delivering drug compounds throughout the gastrointestinal tract in programmed delivery for local treatment or systemic absorption. The OROS-Registered Trademark- products developed by ALZA and marketed in the United States and/or other countries include: - COVERA-HS-TM- (verapamil) - A once-daily Controlled-Onset-Extended-Release (COER-24-TM-) tablet for the treatment of hypertension and angina pectoris, marketed by G.D. Searle ("Searle"). - DynaCirc CR-Registered Trademark- (isradipine) - A once-daily system for the treatment of hypertension, marketed by Novartis, introduced in the United States in early 1997. - GLUCOTROL XL-Registered Trademark- (glipizide) - A once-daily treatment for Type II diabetes, marketed in the United States by Pfizer Inc. ("Pfizer") and co-promoted by ALZA Pharmaceuticals. - MINIPRESS XL-Registered Trademark- / ALPRESS-Registered Trademark- LP (prazosin) - A once-daily formulation for the treatment of hypertension, marketed in France and India by Pfizer. - PROCARDIA XL-Registered Trademark- / ADALAT CR-Registered Trademark- (nifedipine) - A once-daily formulation for the treatment of both angina and hypertension, marketed by Pfizer in the United States and Bayer AG ("Bayer") outside the United States. -6- - VOLMAX-Registered Trademark- (albuterol) - A twice-daily dosage form for the treatment of asthma, marketed by Muro Pharmaceutical, Inc. and Forest Laboratories, Inc. in the United States and by Glaxo Holdings p.l.c. outside the United States. An OROS-Registered Trademark- pseudoephedrine product, an OROS-Registered Trademark- chlorpheniramine product and an OROS-Registered Trademark- pseudoephedrine/brompheniramine product, all once-daily over-the-counter cold/allergy treatments, have been cleared for marketing in the United States by the United States Food and Drug Administration ("FDA"). The pseudoephedrine and chlorpheniramine products were marketed by Ciba Self Medication prior to the merger between Ciba Geigy Ltd. and Sandoz Ltd. (now Novartis). ALZA is in discussions with third parties for the commercialization of the OROS-Registered Trademark- cold/allergy products. Pharmagenesis, Inc. has the right to market the pseudoephedrine product in the People's Republic of China, Hong Kong, Macao and Taiwan. Pacific Pharmaceuticals has the right to market the pseudoephedrine product and/or the pseudoephedrine/brompheniramine product in South Korea. A number of additional OROS-Registered Trademark- products are in various stages of development and testing with TDC and other client companies. In addition to the OROS-Registered Trademark- systems described above, ALZA has developed other proprietary oral delivery technologies including: - CHRONSET-Registered Trademark- - ALZA's Chronset-Registered Trademark- therapeutic system, currently in development for the oral delivery of compounds including proteins and peptides, provides a predetermined delay in the release of active compounds from an orally administered capsule in order to target the location or the timing of a bolus delivery. - LIQUID OROS-Registered Trademark- - ALZA is developing a liquid OROS-Registered Trademark- system designed for the delivery of highly insoluble liquid drug formulations or polypeptides. A delivery orifice in the outer layers of a coated capsule allows controlled release of drug, while an internal osmotic layer pushes against the drug compartment, forcing the liquid drug formulation from the system. - RingCap-TM- - ALZA has developed its RingCap-TM- technology, a new oral controlled release technology designed to have a low manufacturing cost and broad applicability. By incorporating several insoluble polymeric rings around a tablet, the erosion of the tablet can be controlled, modulating the release of drug in the gastrointestinal tract. RingCap-TM- systems can deliver the total dose of the selected drug evenly over an extended period. PERIODONTAL PRODUCTS. The Actisite-Registered Trademark- (tetracycline hydrochloride) periodontal fiber was developed jointly with On-Site Therapeutics, Inc. The thread-like polymeric fibers are designed to treat adult periodontal disease by providing rate-controlled delivery of -7- tetracycline for ten days after placement in the periodontal pocket by a dental practitioner. The product was introduced in the United States in July 1994 by a partnership of ALZA and Procter & Gamble (the "ALZA/P&G Partnership"). ALZA has the right to market the Actisite-Registered Trademark- product in most countries outside of the United States, and is marketing the product, through distributors, in several European countries (see "ALZA Pharmaceuticals" below). The product is manufactured by ALZA. Procter and Gamble ("P&G"), pursuant to the ALZA/P&G Partnership, has licensed for sale in Europe a bioerodible product called the Perio-Chip-TM-, which delivers chlorhexidine for the treatment of periodontal disease. The product, licensed by P&G from Perio Products Ltd., an Israeli company, is awaiting regulatory approval in the United Kingdom and other Western European countries. P&G will market the product, and ALZA and P&G will share the profits from P&G's sales of the product. BAXTER INFUSOR-Registered Trademark- . The Baxter Infusor-Registered Trademark-, a lightweight, disposable device for intravenous therapy, resulted from a joint development arrangement between ALZA and Baxter International Inc. ("Baxter"). The product is manufactured and marketed by Baxter in the United States, Europe and Asia for the delivery of chemotherapeutic agents and analgesics. IVOMEC SR-Registered Trademark- BOLUS (ivermectin). Developed jointly with Merck & Co., Inc. ("Merck"), IVOMEC SR-Registered Trademark- is a product combining the antiparasitic agent ivermectin with ALZA's ruminal bolus technology. The product, which controls internal and external parasites in cattle for an entire grazing season following a single administration, was introduced by Merck in the United States in early 1997 and is marketed by Merck in a number of other countries. Merck has filed regulatory applications for clearance to market the product in other countries. OTHER ALZA PRODUCTS. Three product lines developed by ALZA in its earlier years are marketed directly by ALZA Pharmaceuticals in the United States, and in other countries under distribution agreements with third parties. Those products are: - OCUSERT-Registered Trademark- - Ocusert-Registered Trademark- (pilocarpine) Pilo-20 and Pilo-40 ocular therapeutic systems are used for the treatment of glaucoma. - PROGESTASERT-Registered Trademark- - The Progestasert-Registered Trademark- (progesterone) intrauterine contraceptive device provides contraception for one year by releasing the natural hormone progesterone. - ALZET-Registered Trademark- - ALZET-Registered Trademark- mini-osmotic pumps are implantable, capsule-shaped units that can deliver solutions containing a wide range of agents in laboratory animals at controlled rates for up to four weeks. -8- E-TRANS-TM- SYSTEMS. ALZA's E-TRANS-TM- electrotransport systems are designed to deliver drugs across intact skin through the use of an electrical potential gradient. ALZA's E-TRANS-TM- systems are small, easy-to-apply devices consisting of an adhesive, a drug reservoir, electrodes and a power source/controller. The systems are designed to deliver large molecules (including proteins and peptides) and potent drugs that are poorly absorbed or extensively metabolized in the gastrointestinal tract. ALZA has products utilizing this technology under development, including an E-TRANS-TM- fentanyl product under development with Janssen. DUROS-TM- SYSTEMS. ALZA's DUROS-TM- human implant technology is designed to enable the delivery of peptides, proteins and other bioactive macromolecules arising from the biotechnology industry. Products incorporating DUROS-TM- implant technology have the potential to deliver macromolecules to subcutaneous sites for systemic therapy or to specific tissues; a single miniature implant may be able to provide therapy for up to one year. In early 1997, ALZA filed an Investigational New Drug application ("IND") with the FDA for a DUROS-TM- leuprolide human implant product in development with TDC. SKIN INTERFACE TECHNOLOGY. ALZA is conducting research on a new skin interface technology designed to increase drug transport across the skin and enable delivery of larger molecular weight compounds, including proteins and peptides. This new technology may be used to enhance ALZA's existing D-TRANS-TM- transdermal and E-TRANS-TM- electrotransport technologies. ALZA's activities in this area include a research program with TDC related to the E-TRANS-TM- electrotransport delivery of insulin. THERAPEUTIC DISCOVERY CORPORATION FORMATION. In June 1993, ALZA distributed a special dividend of Units to ALZA stockholders. Each Unit consisted of one share of TDC Class A common stock and one warrant to purchase one-eighth of one share of ALZA common stock. On June 11, 1996, the component parts of the Units began trading separately on the Nasdaq Stock Market. The TDC Class A common stock trades under the symbol TDCA, and the ALZA warrants trade under the symbol ALZAW. The ALZA warrants are exercisable at a price of $65 per share, and will expire, if not previously exercised, on December 31, 1999. ALZA/TDC AGREEMENTS. TDC was formed by ALZA for the purpose of selecting and developing new human pharmaceutical products combining ALZA's proprietary drug delivery technologies with various drug compounds, and commercializing such products, most likely through licensing to ALZA. ALZA and TDC have a development agreement (the "Development Contract") pursuant to which ALZA conducts research and development activities on behalf of TDC. ALZA has granted to TDC a royalty-free, -9- exclusive, perpetual license to use ALZA's proprietary drug delivery technologies to develop and commercialize specified TDC products. ALZA has an option to license all of the products developed by TDC, on a product-by-product and country-by-country basis, providing ALZA with access to a potential pipeline of products for worldwide commercialization. If ALZA exercises its license option for any product, ALZA will make royalty payments to TDC (if the product is sold by ALZA) generally up to a maximum of 5% of ALZA's net sales of such a product, or if the product is sublicensed to a third party, ALZA will pay TDC generally up to 50% of ALZA's sublicensing revenues with respect to the product. The exact percentages of net sales and ALZA's sublicensing revenue payable to TDC will depend on the amount of TDC's funding of the product. ALZA has an option, exercisable on a product-by-product basis, to buy out its royalty obligation to TDC by making a one-time payment that is a multiple of royalties and sublicensing fees paid in specified periods. ALZA also has an option, exercisable at ALZA's sole discretion, to purchase, according to a predetermined formula, all (but not less than all) of the outstanding shares of TDC Class A common stock (the "Purchase Option"). The Purchase Option is exercisable at any time until December 31, 1999, or later under certain circumstances. The Purchase Option will expire, in any event, on the 60th day after TDC files a Form 10-K or Form 10-Q containing a balance sheet showing less than an aggregate of $5.0 million in cash, cash equivalents, short-term investments and long-term investments. At December 31, 1996 TDC reported cash, cash equivalents, short-term investments and long-term investments of $85.3 million. Based on TDC's current rate of expenditures, it can be expected that all TDC funds available for product development will be exhausted during the second half of 1997. Under the formula set forth in TDC's Restated Certificate of Incorporation, if ALZA exercises the Purchase Option, the exercise price will be the greatest of (a) $100 million; (b) the fair market value of one million shares of ALZA common stock; (c) the greater of (i) 25 times the worldwide royalties and sublicensing fees paid by ALZA to TDC during four specified calendar quarters or (ii) 100 times such royalties and sublicensing fees during a specified calendar quarter, in either case less any amounts previously paid by ALZA to exercise any buy-out option with respect to any product; or (d) $325 million less all amounts paid by TDC to ALZA under the Development Contract. Based on information available at the end of 1996, the Purchase Option exercise price is expected to be $100 million. The purchase price may be paid in cash, in ALZA common stock, or any combination of the two, at the option of ALZA. During any period when TDC no longer has funds available for product development, but ALZA has not yet made a determination whether or not to exercise its Purchase Option or its License Option for a particular product, ALZA will need to continue funding TDC product development at its own expense in order to keep the product development programs intact subject to ALZA's determination of the continued technical and commercial feasibility of the product and the compatibility of the product with ALZA's product portfolio and business objectives. ALZA performs certain administrative services for TDC under an administrative services agreement (terminable at the option of TDC) for which ALZA is reimbursed its direct costs, plus certain overhead expenses. For the years ended 1996, 1995 and 1994, reimbursement to ALZA under this agreement was approximately $0.2 million, $0.1 million and $0.2 million, respectively. -10- In order to choose appropriate product candidates for development, ALZA and TDC used a market-driven product discovery process under which they examined unmet medical needs in selected therapeutic areas and then targeted cost-effective products for development. The therapeutic areas on which ALZA and TDC focused were pain management, supportive therapies in oncology and AIDS, urology and endocrinology; however, ALZA and TDC have also pursued product opportunities outside these therapeutic areas where ALZA's drug delivery systems could add significant value to drug therapy. Included in the review of appropriate candidates for incorporation in an ALZA therapeutic system were compounds currently off-patent or soon to be off-patent, proprietary compounds available for license, compounds in biotechnology and pharmaceutical pipelines, and drugs that were abandoned early in their development due to side effects or poor efficacy in conventional dosage forms. By the end of 1996, these product discovery activities were essentially completed. TDC PRODUCTS IN DEVELOPMENT. ALZA and TDC have a number of products in various stages of development, including several in clinical evaluation. As is true throughout the pharmaceutical industry, products in development must overcome a number of technological, clinical, regulatory, proprietary and commercial hurdles in order to become successful products. Development of some TDC products has been terminated, and there can be no assurance that any or all of the products in development by ALZA and TDC will reach the marketplace or will become commercially successful products. In 1996 ALZA and TDC focused their product development activities on products having the greatest commercial potential, some of which are described below. In the pain management area, ALZA and TDC had in development at the end of 1996 an OROS-Registered Trademark- hydromorphone product intended to provide 24-hour pain management for chronic pain requiring potent opioid analgesia. In early 1997, ALZA licensed the product worldwide from TDC, and ALZA entered into an agreement with Knoll Pharmaceutical Company and its parent company Knoll AG for the continued clinical development and worldwide commercialization of the product. In the urology area, ALZA and TDC have under development an OROS-Registered Trademark- oxybutynin product, a once-a-day dosage form intended to provide treatment for urge urinary incontinence. At the end of 1996, the product was in Phase III clinical studies. In the area of oncology, ALZA and TDC have in development a DUROS-TM- leuprolide human implant product designed for the palliative treatment of prostate cancer for an extended period, with discontinuation of treatment possible at any time. The IND was submitted for this product in early 1997 and clinical studies are expected to begin during 1997. -11- In the endocrinology area, at the end of 1996 ALZA submitted a New Drug Application to the FDA for a second-generation transdermal testosterone product to follow Testoderm-Registered Trademark- and Testoderm-Registered Trademark- with Adhesive. This product is a single patch that can be worn on the arm or the torso and is designed to provide convenient physiologic testosterone replacement therapy. In addition, ALZA and TDC have in Phase III clinical trials an intrauterine therapeutic system for the delivery of progesterone as an adjunctive therapy to estrogen hormone replacement therapy in women. The product is designed to provide local delivery of progesterone to the uterus for 18 up to 24 months. PRODUCT DEVELOPMENT RISKS All pharmaceutical products require extensive development and clinical activities before an application can be filed for regulatory approval to market the product. There are many risks inherent in this process and it should be expected that many of the products for which development is initiated ultimately will not become commercial products. Substantial technical, financial and human resources are required to successfully complete the development of a product. The proper performance characteristics for the product must be defined, and the product must be designed and developed to meet those characteristics. Every product faces significant technological hurdles, and often one or more of these cannot be overcome. After a product is manufactured on a pilot scale, clinical safety and efficacy must be shown. Clinical studies are costly, and can take many years to complete. There can be no assurance that the desired outcomes will be shown in the clinical studies or that regulatory approval for the product will be obtained. Several years, and millions of dollars, may be spent before it can be known whether all technical and clinical requirements for a product can be met. There are further technology risks in converting a pilot scale manufacturing process to commercial scale. The regulatory clearance process can take many years, and may vary in different countries. Pricing and reimbursement approvals are also required in some countries, particularly in Europe. Finally, even once a product is developed, approved by regulatory authorities and manufactured, there can be no assurance of its commercial success. In order to provide added value and gain medical and commercial acceptance, a product generally must show some performance improvement or other benefits over products incorporating the same or similar drug compounds. In some cases, these benefits may be difficult to establish. Finally, the product must be accepted for reimbursement by third-party healthcare providers. ALZA TECHNOLOGY INSTITUTE ALZA Technology Institute ("ATI"), established by ALZA in 1994, continued its mission to extend and expand ALZA's drug delivery technologies in 1996. ATI has -12- further developed ALZA's E-TRANS-TM- electrotransport and DUROS-TM- implant technologies, as well as skin interface technology and the Chronset-Registered Trademark-, Liquid OROS-Registered Trademark- and RingCap-TM- systems. During 1996, ATI continued to apply ALZA's technology in the biotechnology area and in addressing the delivery problems of gene therapy. RESEARCH AND DEVELOPMENT EXPENDITURES ALZA spent $114.8 million on client-sponsored product development activities during 1996 ($85.8 million and $61.4 million in 1995 and 1994, respectively); such amounts exclude reimbursable general and administrative costs. ALZA spent $26.8 million on ALZA-sponsored research and development activities during 1996 ($17.6 million and $14.7 million in 1995 and 1994, respectively); such amounts exclude allocable general and administrative costs. Presentation of the 1995 and 1994 research and development activities have been reclassified to conform with the 1996 presentation. The ALZA-sponsored research and development activities include expenses of the ALZA Technology Institute of $20.3 million, $13.8 million and $9.2 million for 1996, 1995 and 1994, respectively. Research and development costs are expensed as incurred. ALZA had research and development revenue of $131.2 million during 1996, $104.0 million during 1995 and $68.7 million during 1994 from clients with which ALZA has joint product development agreements (including $100.7 million in 1996, $70.1 million in 1995 and $31.6 million in 1994 from TDC). ALZA's research and development revenue generally represents clients' reimbursement of costs, including a portion of general and administrative expenses. Therefore product development activities do not contribute significantly to current net income. MANUFACTURING ALZA manufactures some or all of the product requirements for certain client companies, including Duragesic-Registered Trademark- for Janssen, NicoDerm-Registered Trademark- CQ-TM- and Nicoderm-Registered Trademark- for HMR, Covera-HS-TM- for Searle, Procardia XL-Registered Trademark- and Adalat CR-Registered Trademark- for Pfizer and Catapres-TTS-Registered Trademark- for Boehringer. ALZA also manufactures the Progestasert-Registered Trademark-, ALZET-Registered Trademark-, Ocusert-Registered Trademark-, Testoderm-Registered Trademark-, Testoderm-Registered Trademark- with Adhesive and Actisite-Registered Trademark- products. ALZA's 255,000 square foot commercial manufacturing facility is in Vacaville, California. ALZA's products can be more complex to manufacture than more traditional dosage forms and can require a more labor-intensive manufacturing process. As a result, the cost of manufacturing may be higher than that of other pharmaceutical products, and the time required to develop an appropriate manufacturing process may be extensive. Converting a pilot scale manufacturing process to a robust commercial manufacturing process requires substantial investment of technical and financial resources. Some of the materials used in manufacturing ALZA-developed products are unique and may be available from only one or a limited number of suppliers. ALZA attempts, where appropriate, to negotiate long-term supply arrangements for some of these materials. With the increasing costs associated with product liability claims in the -13- pharmaceutical and medical device industries, particularly in the area of implantable materials, it may become increasingly difficult, more expensive, or in some cases impossible for ALZA to obtain some of the materials it may need for certain of its products. Scarcity or unavailability of materials could make products more costly, prevent the commercialization of some products, or cause delays in development due to the necessity to design products to incorporate available or obtainable materials. To the extent ALZA licenses-in products, or promotes products developed by third parties, ALZA will be dependent on third parties to manufacture those products. The Ethyol-Registered Trademark- (amifostine) product, a very important contributor to ALZA's net sales, is manufactured for U.S. Bioscience, Inc. ("U.S. Bioscience") by a third party contract manufacturer, and is expected to be manufactured by U.S. Bioscience at its facility in the Netherlands in the near future. A lack of supply of product from a third party could adversely affect ALZA's net sales revenues. ALZA PHARMACEUTICALS ALZA established its ALZA Pharmaceuticals division in 1993 to expand ALZA's marketing capabilities in order to commercialize ALZA-developed products, including those under development with TDC, as well as licensed-in products. ALZA Pharmaceuticals now has a sales force of approximately 60 people located throughout the United States. In 1996 ALZA Pharmaceuticals began marketing Ethyol-Registered Trademark- in the United States. Ethyol-Registered Trademark- is a unique cytoprotective agent developed by U.S. Bioscience, indicated for the reduction of cumulative renal toxicity associated with repeated administration of the chemotherapeutic drug cisplatin in patients with advanced ovarian or non-small cell lung cancer. U.S. Bioscience co-promotes the product with ALZA. ALZA has the right to market the product for five years, with an option for a sixth year, and will receive residual payments for a specified period after the end of ALZA's marketing term. In 1996 ALZA Pharmaceuticals also began promoting in the United States Bayer Corporation's Mycelex-Registered Trademark- (clotrimazole) Troche and co-promoting U.S. Bioscience's Hexalen-Registered Trademark- (altretamine) and NeuTrexin-Registered Trademark- (trimetrexate glucuronate) products in the United States. ALZA Pharmaceuticals also co-promotes Duragesic-Registered Trademark- with Janssen, Glucotrol XL-Registered Trademark- with Pfizer and the ENACT AirWatch-TM- system, all in the United States. ALZA Pharmaceuticals also markets ALZET-Registered Trademark- mini-osmotic pumps, Progestasert-Registered Trademark- and Ocusert-Registered Trademark-, and supports P&G in the marketing and promotion of Actisite-Registered Trademark-. ALZA Pharmaceuticals is establishing international commercialization capabilities by developing distribution arrangements to market several ALZA-developed products. Actisite-Registered Trademark- is distributed in Austria, Denmark, Germany, Italy, Spain, Sweden, Switzerland and the United Kingdom by distributors, and agreements were recently signed for the distribution of the product in Japan and South Korea, following regulatory approval. In 1997, ALZA signed an agreement with Ferring for the rights to market Testoderm-Registered Trademark- with -14- Adhesive, as well as the second-generation testosterone product under development with TDC, in 12 European countries. In order to enter into the agreement with Ferring, ALZA exercised its license option for the TDC testosterone product for those 12 countries. ALZA has also signed distribution agreements for 17 Asian countries for Testoderm-Registered Trademark- and for five Asian countries for OROS-Registered Trademark- pseudoephedrine. There can be no assurance that ALZA Pharmaceuticals will be successful in its marketing and sales efforts. There are numerous risks associated with the marketing and sales of pharmaceutical products, including the availability of products (whether through development by ALZA and TDC, in-licensing or otherwise) for ALZA Pharmaceuticals to market in specialty areas that match the expertise of the sales force, market acceptance of the products, and changes in the health care marketplace, including cost containment efforts and the concentration of providers of medical and pharmaceutical benefits through health maintenance organizations, formularies and other mechanisms. GOVERNMENTAL REGULATION Under the United States Food, Drug and Cosmetic Act, "new drugs" must obtain clearance from the FDA before they lawfully can be marketed in the United States. Applications for marketing clearance must be based on extensive clinical and other testing, the cost of which is very substantial. The packaging and labeling of all new drug products are also subject to FDA regulation. Approvals (sometimes including pricing approvals) are required from health regulatory authorities in foreign countries before marketing of pharmaceutical products may commence in those countries. Requirements for approval may differ from country to country, and can involve additional testing. There can be substantial delays in obtaining required clearances from both the FDA and foreign regulatory authorities after applications are filed. Even after clearances are obtained, further delays may be encountered before the products become commercially available. ALZA's manufacturing activities, and the products sold by ALZA and its client companies in the United States and/or exported to other countries, are subject to extensive regulation by the FDA and comparable agencies in other countries where the products are distributed. FDA regulations govern a range of activities including manufacturing, quality assurance, advertising and record-keeping. The continuing trend of stringent FDA oversight in product clearance and enforcement has caused more uncertainty, greater risks and higher costs of obtaining clearance to market a product, and sometimes longer clearance cycles. Failure to obtain, or delays in obtaining, FDA and other regulatory clearance to market new products, as well as other regulatory actions and recalls, could adversely affect ALZA's financial results. -15- Environmental regulations may also affect the manufacturing process. As a pharmaceutical company, ALZA uses in its business chemicals and materials which may be classified as hazardous or toxic which require special handling and disposal. In addition, ALZA undertakes to minimize releases to the environment and exposure of its employees and the public to such materials. The costs of these activities have increased substantially in recent years, and it is possible that such costs may continue to increase significantly in the future. PATENTS AND PATENT APPLICATIONS As of December 31, 1996, ALZA owned approximately 500 United States patents and had approximately 200 pending United States patent applications relating to its products and other technologies. ALZA has in excess of 2,400 foreign patents and pending patent applications covering its various technologies and products. Patents have been issued, or are expected to be issued, covering ALZA's current technologies and products, as well as products under development. Patent protection generally has been important in the pharmaceutical industry. ALZA believes that its current patents, and patents that may be obtained in the future, are important to current and future operations. There can be no assurance that ALZA's existing patents will cover future products, that additional patents will be issued, or that any patents now or hereafter issued will be of commercial benefit. In the United States, patents generally are granted for specified periods of time. Some of ALZA's earlier patents covering various aspects of certain OROS-Registered Trademark- and D-TRANS-TM- dosage forms have begun to expire, or will expire, over the next several years; however, ALZA technologies and products are generally covered by multiple patents. Although a patent has a statutory presumption of validity in the United States, the issuance of a patent is not conclusive as to such validity or as to the enforceable scope of the claims of the patent. There can be no assurance that patents of ALZA will not be successfully challenged in the future. In some cases, third parties have initiated reexamination by the Patent and Trademark Office of patents issued to ALZA, and have opposed ALZA patents in other jurisdictions. The validity or enforceability of ALZA patents after their issuance have also been challenged in litigation. If the outcome of such litigation is adverse to ALZA, third parties may then be able to use the invention covered by the patent, in some cases without payment. There can be no assurance that ALZA patents will not be infringed or successfully avoided through design innovation. It is also possible that third parties may obtain patent or other proprietary rights that may be necessary or useful to ALZA. With numerous other companies engaged in developing drug delivery technologies, it can be expected that other parties may in some circumstances file patent applications or obtain patents that compete in priority -16- with ALZA's patent applications. Such competition may result in adversarial proceedings such as patent interferences and oppositions, which can increase the uncertainty of patent coverage. In cases where third parties are first to invent a particular product or technology, it is possible that those parties will obtain patents that will be sufficiently broad so as to prevent ALZA from using certain technology or from further developing or commercializing certain products. As ALZA expands its direct marketing of products, ALZA may attempt to license-in products or compounds or technologies for use in products. In each of these cases, if licenses from third parties are necessary but cannot be obtained, commercialization of the products would be delayed or prevented. In addition, ALZA utilizes significant unpatented proprietary technology, and there can be no assurance that others will not develop similar technology. For a description of certain legal proceedings relating to patents, see "Legal Proceedings" below. COMPETITION All of ALZA's current and future drug delivery products will face competition both from traditional forms of drug delivery and from advanced delivery systems being developed by others. Licensed-in products will face competition from competing therapies for the same indications. ALZA's competition potentially includes all of the pharmaceutical companies in the world, including current ALZA clients. Many of these other pharmaceutical companies have greater financial resources, technical staff and manufacturing and marketing capabilities than ALZA. A number of companies are developing drug delivery technologies. To the extent that ALZA develops or markets products incorporating drugs that are off-patent, or are being developed by multiple companies, ALZA will face increased competition from other companies developing and marketing similar products. As the pharmaceutical industry continues to consolidate, and as pressures increase for cost-effective research and development, some pharmaceutical companies have reduced, and may continue to reduce, their funding of research and development. Competition for limited client dollars may therefore increase, and this competition could include the clients' internal research and development programs, other drug delivery programs and other technologies and products of third parties. Similarly, as pharmaceutical companies search to fill gaps in their product pipelines with licensed-in products, ALZA will be competing for product in-licensing opportunities with companies with far greater financial and other resources than ALZA. Competition in drug delivery systems is generally based on performance characteristics and price. Acceptance by hospitals, physicians and patients is crucial -17- to the success of a product. Health care reimbursement policies of managed care organizations, insurers and government agencies will continue to exert pressure on pricing, and various federal and state agencies have enacted regulations requiring rebates of a portion of the purchase price of many pharmaceutical products. Cost-effectiveness, although often difficult to measure, is becoming increasingly critical. The health care industry has continued to change rapidly as the public, government, medical practitioners and the pharmaceutical industry focus on ways to expand medical coverage while controlling the growth in health care costs. The growth of managed care organizations and the resulting pressures for cost-containment in the United States health care system are expected to continue to put pressures on the prices charged for pharmaceutical products. Prescription drug reimbursement practices and the growth of large managed care organizations, as well as generic and therapeutic substitution (substitution of a different product for the same indication), could significantly affect ALZA's business. While ALZA believes the changing health care environment may increase the value of ALZA's drug delivery products over the long term, it is impossible to predict the impact these changes may have on ALZA. REVENUES In 1996, ALZA received royalty revenue from 16 products in the marketplace. Sales of Procardia XL-Registered Trademark- in the United States by Pfizer accounted for approximately 40% of ALZA's royalties and fees in 1996 (more than 40% in 1995 and more than 50% in 1994). Because the basic patents covering the drug nifedipine expired several years ago, other companies are attempting to develop products similar to Procardia XL-Registered Trademark-. To date no product has been introduced which is bioequivalent to Procardia XL-Registered Trademark-. If such a product were to be developed and introduced, its marketing could have a significant impact on Procardia XL-Registered Trademark- pricing and sales, and therefore on ALZA's royalties. Information about ALZA's revenues is presented below: 1996 1995 1994 (in millions) ------- ------- ------- Royalties and fees $171.4 $145.4 $123.8 Research and development 131.2 104.0 68.7 Net sales 108.6 76.9 68.5 Interest and other 54.8 24.3 17.8 ------- ------- ------- Total revenues $466.0 $350.6 $278.8 ------- ------- ------- ------- ------- ------- TDC accounted for 22% of ALZA's total revenues in 1996, 20% in 1995 and 11% in 1994; Pfizer accounted for 20% of ALZA's total revenues in 1996, 23% in 1995 and -18- 30% in 1994; Janssen accounted for 13% of ALZA's total revenues in 1996 and 12% in each of 1995 and 1994; and HMR accounted for 10% of ALZA's total revenues in each of 1996 and 1995. The loss of revenues from one or more of these clients would have a material adverse effect on ALZA's profitability. INDUSTRY SEGMENTS; EXPORTS ALZA's business comprises one industry segment. Export sales were $23.0 million in 1996, $20.1 million in 1995 and $16.9 million in 1994, principally to distributors and client companies in Europe. EMPLOYEES On December 31, 1996, ALZA had 1,652 employees, of whom approximately 820 were engaged in research and development activities, approximately 491 were engaged in manufacturing activities and the remainder were working in general, administrative and marketing areas. ITEM 2. PROPERTIES ALZA's corporate offices are located in Palo Alto, California, and its two primary research and development campuses are in Palo Alto and Mountain View, California. ALZA also occupies a small research facility in Spring Lake Park, Minnesota. ALZA's large-scale commercial manufacturing facility is located in Vacaville, California. While ALZA believes that its facilities and equipment are sufficient to meet its current operating requirements, ALZA is actively planning to expand its facilities and equipment to support its long-term requirements. ITEM 3. LEGAL PROCEEDINGS In December 1991, a patent infringement suit was filed by Ciba-Geigy Inc. ("Ciba-Geigy"), now Novartis Pharmaceuticals Corporation, against Marion Merrell Dow Inc. (now HMR) and ALZA in connection with the commercialization of Nicoderm-Registered Trademark-. In October 1994, the Court granted a motion for summary judgment in favor of ALZA and HMR. During October 1995, the Court of Appeals for the Federal Circuit upheld the most significant portions of the summary judgment decision, and sent back to the District Court the issue of validity of certain other more limited claims of a patent licensed to Ciba-Geigy. During January 1995 ALZA and HMR filed a separate suit against Ciba-Geigy and LTS Lohmann Therapy Systems Corporation in the United States District Court for the Southern District of New York for infringement of two United States patents issued to ALZA in 1994 relating to the transdermal administration of nicotine. In June 1996, ALZA and HMR entered into a settlement agreement with Ciba-Geigy which resolved these disputes. Ciba-Geigy made a one-time settlement -19- payment to HMR and ALZA, and is paying ongoing royalties on its U.S. nicotine patch sales retroactive to January 1, 1996. ALZA and HMR share the royalty payments in accordance with the agreements between them. During January 1994, a suit was filed against ALZA by Cygnus Inc. ("Cygnus") in the United States District Court for the Northern District of California, seeking a declaration of unenforceability and invalidity of an ALZA patent relating to transdermal administration of fentanyl and alleging violation of antitrust laws. In April 1995 the District Court granted ALZA's motion to dismiss the lawsuit; Cygnus appealed that ruling. During 1996, the Court of Appeals of the Federal Circuit upheld the District Court's dismissal of Cygnus' claims against ALZA. Cygnus has no further right of appeal. Product liability suits have been filed against Janssen and ALZA from time to time relating to the Duragesic-Registered Trademark- product. Janssen is managing the defense of these suits in consultation with ALZA under an agreement between the parties. ALZA has been named as a potentially responsible party in connection with the cleanup and environmental remediation of the Hillview-Porter Regional Site Project near ALZA's Palo Alto facilities. ALZA believes that it did not discharge any of the chemicals of concern at this site. ALZA does not believe that its liability in this matter, if any, will be material. However, because the action involves many parties and multiple regulatory authorities, and the cleanup and allocation of financial responsibility may not be resolved for several years, it is impossible to predict the timing or amount of ALZA's potential liability. Historically, the cost of resolution of ALZA's liability (including product liability) claims has not been significant, and ALZA is not aware of any asserted or unasserted claims pending against it, including the suits mentioned above, the resolution of which would have a material adverse impact on the operations or financial position of ALZA. ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS None. -20- EXECUTIVE OFFICERS OF THE REGISTRANT
Principal Occupations for Name Age Past Five Years - ------------------- ------ --------------------------------------------------------- Dr. Ernest Mario 58 Co-Chairman of the Board and Chief Executive Officer of ALZA (since 1993); Chief Executive of Glaxo Holdings, p.l.c. (1989-1993). Dr. Felix Theeuwes 59 President, Research and Development of ALZA (since 1994); Executive Vice President, Research and Development (1991-1994) and Chief Scientist (since 1982). Bruce C. Cozadd 33 Senior Vice President and Chief Financial Officer of ALZA (since 1997); Vice President and Chief Financial Officer (1994-1996); Vice President, Corporate Planning and Analysis (1993); Manager, Strategic Projects (1991- 1993). Dr. Gary V. Fulscher 53 Senior Vice President, Operations of ALZA (since 1994); Vice President, Administration (1987-1994). Dr. Samuel R. Saks 42 Senior Vice President, Medical Affairs of ALZA (since 1994); Vice President, Medical Affairs (1992-1994); Vice President, Clinical Research, Oncology, Schering-Plough Corporation (1991-1992). Peter D. Staple 45 Senior Vice President and General Counsel of ALZA (since 1997); Vice President and General Counsel (1994-1996); Vice President and Associate General Counsel of Chiron Corporation (1992-1994); Vice President (from 1990-1992) and Associate General Counsel of Cetus Corporation (1983-1992).
-21- Dr. James W. Young 52 Senior Vice President, Commercial Development of ALZA (since October 1995); Vice President and Managing Director of ALZA Technology Institute (June 1995 - September 1995); President, Pharmaceuticals Division, Affymax N.V., (1992-1995); Senior Vice President and General Manager of Pharmaceuticals at Sepracor Inc. (1987-1992). James Butler 56 Vice President, Sales and Marketing of ALZA (since 1993); Vice President and General Manager of Glaxo, Inc.'s corporate division (1987-1993). Harold Fethe 52 Vice President, Human Resources of ALZA (since 1991).
-22- PART II ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS ALZA incorporates by reference the information concerning the market for its common stock and related stockholder matters set forth at page 38 in the Annual Report to Stockholders (the "Annual Report") attached as Exhibit 13. ITEM 6. SELECTED FINANCIAL DATA ALZA incorporates by reference the selected consolidated financial data set forth at page 39 in the Annual Report. ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS ALZA incorporates by reference Management's Discussion and Analysis of Financial Condition and Results of Operations set forth at pages 17 to 22 in the Annual Report. ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA ALZA incorporates by reference the consolidated financial statements and notes thereto set forth at pages 23 to 37 in the Annual Report and the Report of Ernst and Young LLP, Independent Auditors, at page 37 in the Annual Report. ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE Not applicable. -23- PART III ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT ALZA incorporates by reference the information concerning its directors set forth under the heading "Election of Directors" on pages 1 to 4 in ALZA's definitive proxy statement dated March 27, 1997, for its Annual Meeting of Stockholders to be held on May 8, 1997 (the "Proxy Statement"). Information concerning ALZA's executive officers appears at the end of Part I of this report on pages 21 and 22. ITEM 11. EXECUTIVE COMPENSATION ALZA incorporates by reference the information ("Summary Compensation Table", "1996 Option Grants", "1996 Aggregated Option Exercises and Fiscal Year-End Option Values" and "Certain Executive Agreements") set forth under the heading "Executive Compensation" on pages 5 to 10 in the Proxy Statement. ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT ALZA incorporates by reference the information set forth under the heading "Beneficial Stock Ownership" on page 13 in the Proxy Statement. ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS ALZA incorporates by reference the information set forth under the heading "Certain Transactions" on page 14 in the Proxy Statement. -24- PART IV ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K (a) Documents filed as part of this Annual Report on Form 10-K: 1. Consolidated Financial Statements: Incorporated by reference to the Annual Report (see accompanying Index to Consolidated Financial Statements). 2. Consolidated Financial Statement Schedule: (see accompanying Index to Consolidated Financial Statement Schedule). 3. Exhibits: 3.1 Restated Certificate of Incorporation of ALZA Corporation filed with the Delaware Secretary of State on February 14, 1994(1) 3.2 Composite Bylaws of ALZA Corporation as restated on February 10, 1994 and amended on August 11, 1994, February 16, 1995, February 15, 1996 and August 13, 1996(2) 4.1 Indenture dated July 7, 1994 between ALZA Corporation and the Chase Manhattan Bank, N.A. as Trustee, relating to ALZA's 5 1/4% Liquid Yield Option-TM- Notes(3) 4.2 Specimen of LYONs-TM- Certificate (included in Exhibit 4.1) 4.3 Form of Warrant Agreement between ALZA Corporation and the Chase Manhattan Bank (with attached Warrant Certificate)(4) 4.4 Indenture dated April 23, 1996 between ALZA Corporation and the Chase Manhattan Bank, N.A., as Trustee, relating to ALZA's 5% Convertible Subordinated Debentures(5) 4.5 Specimen of 5% Convertible Subordinated Debenture (included in Exhibit 4.4) 10.1 Technology License Agreement between ALZA Corporation and Therapeutic Discovery Corporation(6) 10.2 Development Agreement between ALZA Corporation and Therapeutic Discovery Corporation(6) 10.3 License Option Agreement between ALZA Corporation and Therapeutic Discovery Corporation(6) See footnotes on following page -25- 10.4 Restated Certificate of Incorporation of Therapeutic Discovery Corporation(6) 10.5 Agreement Regarding Certain Products and Activities and Amendment No. 1 to Development Agreement between ALZA Corporation and Therapeutic Discovery Corporation(7) 10.6 Executive Deferral Plans II(8)* 10.7 Executive Deferral Plan Amendments(9)* 10.8 Amendment Number 2 to Executive Deferral Plans II(10)* 10.9 ALZA Corporation Amended and Restated Stock Plan(11)* 10.10 Form of Executive Agreement between ALZA Corporation and Certain Executive Officers(7)* 11 Statement regarding computation of per share earnings 13 Portions of Annual Report to Stockholders expressly incorporated by reference herein 21 Subsidiaries 23 Consent of Ernst & Young LLP, Independent Auditors 27 Financial Data Schedule (b) No reports on Form 8-K were filed during the quarter ended December 31, 1996. ______________________________________________________________ 1 Incorporated by reference to ALZA's Form 10-K Annual Report for the year ended December 31, 1993. 2 Incorporated by reference to ALZA's Form 10-Q Quarterly Report for the period ended September 30, 1996. 3 Incorporated by reference to ALZA's Form 10-Q Quarterly Report for the period ended June 30, 1994. 4 Incorporated by reference to ALZA's Form 8-A Registration Statement (Commission File No. 0-11234) dated March 31, 1993, as amended. 5 Incorporated by reference to ALZA's Form S-3 Registration Statement (Commission File No. 333-2343) dated April 8, 1996, as amended. 6 Incorporated by reference to the Form 10 of Therapeutic Discovery Corporation (Commission File No. 0-21478) dated March 31, 1993, as amended. 7 Incorporated by reference to ALZA's Form 10-K Annual Report for the year ended December 31, 1995. 8 Incorporated by reference to ALZA's Form 10-K Annual Report for the year ended December 31, 1992, and ALZA's Form 10-Q Quarterly Report for the period ended September 30, 1993. 9 Incorporated by reference to ALZA's Form 10-K Annual Report for the year ended December 31, 1992. 10 Incorporated by reference to ALZA's Form 10-K Annual Report for the year ended December 31, 1994. 11 Incorporated by reference to ALZA's Form 10-Q Quarterly Report for the period ended June 30, 1995. * A management contract or compensatory plan or arrangement required to be filed as an Exhibit pursuant to Item 14(c) of Form 10-K. -26- ALZA CORPORATION INDEX TO CONSOLIDATED FINANCIAL STATEMENTS, REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS AND CONSOLIDATED FINANCIAL STATEMENT SCHEDULE (Item 14(a)) Page Number Reference ---------------------------- Annual Report Form to Stockholders 10-K --------------- ---- Consolidated statement of income for the years ended December 31, 1996, 1995 and 1994 23 Consolidated balance sheet at December 31, 1996 and 1995 24 Consolidated statement of stockholders' equity for the years ended December 31, 1996, 1995 and 1994 25 Consolidated statement of cash flows for the years ended December 31, 1996, 1995 and 1994 26 Notes to consolidated financial statements 27-37 Report of Ernst & Young LLP, Independent Auditors 37 The following consolidated financial statement schedule of ALZA Corporation is included: II- Consolidated valuation and qualifying 28 accounts All other schedules have been omitted because the required information is not present or is not present in amounts sufficient to require submission of the schedule, or because the information required is included in the consolidated financial statements, including the notes thereto. -27- SCHEDULE II ALZA CORPORATION CONSOLIDATED VALUATION AND QUALIFYING ACCOUNTS YEARS ENDED DECEMBER 31, 1996, 1995 AND 1994 Balance at Additions Beginning Charged to Deductions Balance at of Year Income (write-offs) End of Year ------------ ------------ ------------- ------------- (In millions) Allowance for doubtful receivables: 1996 $0.2 $0.4 $ - $0.6 ------------ ------------ ------------- ------------- ------------ ------------ ------------- ------------- 1995 $0.3 $ - $(0.1) $0.2 ------------ ------------ ------------- ------------- ------------ ------------ ------------- ------------- 1994 $0.2 $0.1 $ - $0.3 ------------ ------------ ------------- ------------- ------------ ------------ ------------- ------------- -28- SIGNATURES Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized. ALZA CORPORATION By /s/ [Ernest Mario] ------------------------------- Dr. Ernest Mario Chief Executive Officer Date: March 31, 1997 -29- Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrant and in the capacities and on the dates indicated. /s/ [Alejandro Zaffaroni] /s/ [Dean O. Morton] --------------------------- ------------------------ Dr. Alejandro Zaffaroni Dean O. Morton Co-Chairman of the Board of Director Directors and Director Date: March 31, 1997 Date: March 31, 1997 /s/ [Ernest Mario] /s/ [Denise M. O'Leary] --------------------------- ------------------------ Dr. Ernest Mario Denise M. O'Leary Co-Chairman of the Board of Director Directors, Director and Chief Date: March 31, 1997 Executive Officer Date: March 31, 1997 /s/ [William R. Brody] /s/ [Issac Stein] --------------------------- ------------------------ Dr. William R. Brody Isaac Stein Director Director Date: March 31, 1997 Date: March 31, 1997 /s/ [William G. Davis] /s/ [Julian N. Stern] --------------------------- ------------------------ William G. Davis Julian N. Stern Director Director Date: March 31, 1997 Date: March 31, 1997 /s/ [Robert J. Glaser] /s/ [Bruce C. Cozadd] --------------------------- ------------------------ Dr. Robert J. Glaser Bruce C. Cozadd Director Senior Vice President, Chief Date: March 31, 1997 Financial Officer and Principal Accounting Officer Date: March 31, 1997 -30- EXHIBIT INDEX Exhibit - ------- 11 Statement regarding computation of per share earnings 13 Portions of Annual Report to Stockholders expressly incorporated by reference into Annual Report on Form 10-K 21 Subsidiaries 23 Consent of Ernst & Young LLP, Independent Auditors 27 Financial Data Schedule -31- EX-11 2 EXHIBIT 11 EXHIBIT 11 Statement Regarding Computation of Per Share Earnings (In millions, except per share data) Year Ended December 31, 1996 1995 1994 --------- ---------- ---------- PRIMARY: Common stock 84.2 82.3 81.8 Stock options 0.8 0.3 0.5 $25 warrants - - - $65 warrants - - - 5 1/4% zero coupon convertible subordinated debentures 9.2 - - --------- ---------- ---------- Weighted average common and dilutive common equivalent shares 94.2 82.6 82.3 --------- ---------- ---------- --------- ---------- ---------- Net income available to common stockholders $ 92.4 $ 72.4 $ 58.1 Add after-tax interest on 5 1/4% zero coupon convertible subordinated debentures 9.2 - - --------- ---------- ---------- Adjusted net income $ 101.6 $ 72.4 $ 58.1 --------- ---------- ---------- --------- ---------- ---------- Net income per common and common equivalent share $ 1.08 $ 0.88 $ 0.71 --------- ---------- ---------- --------- ---------- ---------- Primary earnings per share is based on weighted average shares of common stock outstanding plus dilutive common equivalent shares. The 5 1/4% zero coupon convertible subordinated debentures (issued in July 1994) are considered common stock equivalents but were not included in the per share calculation for 1995 or 1994 as their inclusion would have had an antidilutive effect. Shares issuable upon an assumed conversion of the 5 1/4% zero coupon convertible subordinated debentures were dilutive for the last three quarters of 1996. Consequently, a total of 9.2 million shares are included in the weighted average common and dilutive common equivalent shares for the year ended December 31, 1996. -33- Year Ended December 31, 1996 1995 1994 ----------- ---------- ----------- FULLY DILUTED: Common stock 84.2 82.3 81.8 Stock options 0.8 0.4 0.5 $25 warrants - - - $65 warrants - - - 5 1/4% zero coupon convertible subordinated debentures 9.2 - - 5% convertible subordinated debentures - - - ----------- ---------- ----------- Weighted average common and dilutive common equivalent shares 94.2 82.7 82.3 ----------- ---------- ----------- ----------- ---------- ----------- Net income available to common stockholders $ 92.4 $ 72.4 $ 58.1 Add after-tax interest on 5 1/4% zero coupon convertible subordinated debentures 9.2 - - ----------- ---------- ----------- Adjusted net income $ 101.6 $ 72.4 $ 58.1 ----------- ---------- ----------- ----------- ---------- ----------- Net income per common and common equivalent share $ 1.08 $ 0.88 $ 0.71 ----------- ---------- ----------- ----------- ---------- ----------- Fully diluted earnings per share is based on weighted average shares of common stock outstanding plus dilutive common equivalent shares and dilutive convertible securities. The 5 1/4% zero coupon convertible subordinated debentures (issued in July 1994) are considered common stock equivalents but were not included in the per share calculation for 1995 or 1994 as their inclusion would have had an antidilutive effect. Shares issuable upon an assumed conversion of the 5 1/4% zero coupon convertible subordinated debentures were dilutive for the last three quarters of 1996. Consequently, a total of 9.2 million shares are included in the weighted average common and dilutive common equivalent shares for the year ended December 31, 1996. The 5% convertible subordinated debentures are not considered common stock equivalents and were not included in the fully diluted earnings per share calculation for 1996 as their inclusion would have had an antidilutive effect. Fully diluted earnings per share is not presented on the face of the Consolidated Statement of Income since dilution is less than 3% for each year presented. -34- EX-13 3 EXHIBIT 13 PAGE 17 OF PAPER FORMAT ANNUAL REPORT EXHIBIT 13 MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS OVERVIEW ALZA Corporation ("ALZA" or the "Company") reported net income of $92.4 million in 1996, compared to net income of $72.4 million in 1995 and $58.1 million in 1994. Included in the 1996 results is the net benefit of approximately $2.3 million in non-recurring items, which are discussed below. TOTAL REVENUES (PRESENTED GRAPHICALLY IN PAPER FORMAT ANNUAL REPORT) (In millions) 1996 1995 1994 1993 1992 ----- ----- ----- ----- ----- Royalties and fees $ 171 $ 145 $ 124 $ 113 $ 115 Research and development 131 104 69 47 39 Net sales 109 77 68 54 76 Interest & other 55 24 18 20 21 ----- ----- ----- ----- ----- TOTAL REVENUES $ 466 $ 351 $ 279 $ 234 $ 251 ROYALTIES AND FEES Royalties and fees, which are generally derived from sales by client companies of products developed jointly with ALZA, were $171.4 million in 1996 ($162.2 million before non-recurring items), compared to $145.4 million ($138.0 million before a non-recurring item) in 1995 and $123.8 million in 1994. Excluding the non-recurring items, the growth in royalties and fees in 1996 was due to increased sales of Adalat CR-Registered Trademark- (nifedipine), Catapres TTS-Registered Trademark- (clonidine), Duragesic-Registered Trademark- (fentanyl) and Glucotrol XL-Registered Trademark- (glipizide) and royalties from sales of NicoDerm-Registered Trademark- CQ-TM- (nicotine) following its introduction in the third quarter of 1996. In addition, despite lower sales of Procardia XL-Registered Trademark- (nifedipine), royalties from this product increased due to a higher effective royalty rate, as discussed below. Reducing royalties and fees in 1996 were lower royalties on sales of Transderm-Nitro-Registered Trademark- (nitroglycerin). -1- PAGE 17 OF PAPER FORMAT ANNUAL REPORT Royalties and fees for 1996 include a non-recurring benefit of $7.1 million from the reversal of a portion of the reserve accrued in 1994 and 1995 to account for a potential reduction in royalty revenue from Procardia XL-Registered Trademark-, marketed in the U.S. by Pfizer, Inc. ("Pfizer"), due to a U.S. patent issued to Bayer AG. Pfizer and ALZA entered into an agreement under which the remainder of the reserve was utilized to satisfy ALZA's potential obligations related to the resolution of this royalty issue. Under the agreement, the royalty payable by Pfizer to ALZA on sales of Procardia XL-Registered Trademark- was reset to 7%, retroactive to January 1, 1996. While ALZA's total royalties from Procardia XL-Registered Trademark- increased as a result of the higher effective royalty rate, sales of Procardia XL-Registered Trademark-, as reported by Pfizer, decreased by 11% during 1996 as compared to 1995. Royalties and fees for 1996 also include a $6.4 million non-recurring benefit in connection with the settlement of litigation relating to patent disputes concerning transdermal nicotine patches. Under the terms of the settlement announced in June 1996, Ciba-Geigy Corporation ("Ciba"), now Novartis Pharmaceuticals Corporation ("Novartis"), made a one-time payment to Hoechst Marion Roussel Inc. ("HMR") and ALZA, and will pay ongoing royalties on Novartis' U.S. nicotine patch sales, retroactive to January 1, 1996, to be shared by HMR and ALZA. Partially offsetting the additions to royalties and fees discussed above was a non-recurring charge to establish a reserve of $4 million representing the unamortized portion of a $5 million advance payment made in 1988 to the former limited partners of the ALZA OROS-Registered Trademark- Products Limited Partnership (the "Partnership"). The advance payment was made in connection with ALZA's exercise of its option to acquire all of the limited partners' interests in the Partnership. Under the terms of the partnership agreement, the advance payment is creditable by ALZA, within specified limits, against payments otherwise due to the former limited partners on sales of the OROS-Registered Trademark- cold/allergy products and Covera-HS-TM- (verapamil). The reserve was established due to uncertainties regarding ALZA's ability to utilize the prepayment within the time period specified in the partnership agreement. -2- PAGE 17-18 OF PAPER FORMAT ANNUAL REPORT Included in royalties and fees for 1995 is a benefit of $7.4 million resulting from the reversal of a portion of a reserve established after a patent infringement suit was filed in 1991 by Ciba against ALZA and HMR relating to the Nicoderm-Registered Trademark- transdermal nicotine product. In October 1995 a federal appeals court upheld the most significant portions of a summary judgment previously granted by a district court in which the broadest claims of the Ciba patent were held invalid. This suit was settled in 1996. Royalties and fees for 1995 and 1994 reflect reductions of $9 million and $8 million, respectively, resulting from additions to the reserve established in the third quarter of 1994 to account for the potential reduction in royalty revenue from Pfizer on sales of Procardia XL-Registered Trademark- discussed above. Including the $7.1 million benefit described above, royalties from Procardia XL-Registered Trademark- accounted for approximately 42% of ALZA's royalties and fees for 1996. Excluding non-recurring items, Procardia XL-Registered Trademark- accounted for approximately 40% of ALZA's royalties and fees for 1996. Excluding from total royalties and fees for 1995 the benefit of the $7.4 million reserve reversal discussed above, royalties from Procardia XL-Registered Trademark- accounted for more than 40% and 50% of ALZA's royalties and fees in 1995 and 1994, respectively. RESEARCH AND DEVELOPMENT Research and development expenses increased to $141.6 million in 1996 compared to $103.4 million in 1995 and $76.1 million in 1994. The year over year increases were due primarily to increased product development activities undertaken on behalf of Therapeutic Discovery Corporation ("TDC"). INVESTMENT IN RESEARCH AND DEVELOPMENT (PRESENTED GRAPHICALLY IN PAPER FORMAT ANNUAL REPORT) (In millions) 1996 1995 1994 1993 1992 Investment in Research and Development $ 142 $ 103 $ 76 $ 53 $ 52 Research and development revenue was $131.2 million in 1996, compared to $104.0 million and $68.7 million in 1995 and 1994, respectively. Reducing research and development revenue for 1996 were $2.1 million of non-recurring items consisting of a credit from ALZA to TDC for work that was previously billed and a charge for certain potentially uncollectable receivables. ALZA's research and development -3- PAGE 18 OF PAPER FORMAT ANNUAL REPORT revenue generally represents client reimbursement of costs, including a portion of general and administrative expenses. Therefore, product development activities do not contribute significantly to current net income. The increase in research and development revenue in 1996 was due to product development activities undertaken on behalf of TDC. TDC, which commenced operations in mid-1993, was formed by ALZA for the purpose of selecting and developing new human pharmaceutical products combining ALZA's proprietary drug delivery technologies with various drug compounds, and commercializing such products, most likely through licensing to ALZA. ALZA and TDC have a development agreement pursuant to which ALZA conducts product development activities on behalf of TDC. For the years ended 1996, 1995 and 1994, ALZA had product development revenue from TDC of $100.7 million, $70.1 million and $31.6 million, respectively. At the end of 1996 ALZA filed a New Drug Application for a second-generation transdermal testosterone product under development with TDC, and a number of additional TDC products were in the development pipeline, including several in clinical evaluation. NET SALES (PRESENTED GRAPHICALLY IN PAPER FORMAT ANNUAL REPORT) (In millions) 1996 1995 1994 1993 1992 ---- ---- ---- ---- ---- Contract manufacturing $ 86 $ 63 $ 58 $ 47 $ 68 ALZA-marketed products 23 14 11 7 7 ---- ---- ---- ---- ---- TOTAL NET SALES $ 109 $ 77 $ 69 $ 54 $ 75 NET SALES AND COSTS OF PRODUCTS SHIPPED ALZA's net sales increased by $31.7 million to $108.6 million in 1996 compared to 1995. Included in net sales are sales generated from contract manufacturing activities for ALZA's client companies, and sales of products marketed directly by ALZA and through distributors. -4- PAGE 18 OF PAPER FORMAT ANNUAL REPORT Net sales from ALZA's contract manufacturing activities were $85.4 million in 1996, compared to $63.3 million and $57.4 million in 1995 and 1994, respectively. The increase in net sales from contract manufacturing in 1996 is the result of shipments of launch quantities of NicoDerm-Registered Trademark- CQ-TM- and Covera-HS-TM-. Shipments of launch quantities are not indicative of the potential for future sales of a product. The increase in net sales from contract manufacturing in 1995 as compared to 1994 was due to larger orders by client companies in 1995, predominately for transdermal products . Because of variability in the mix and volume of clients' product requirements, the level of contract manufacturing sales fluctuates from period to period. ALZA manufactures and directly markets in the U.S. the Testoderm-Registered Trademark- testosterone transdermal system CIII, the Progestasert-Registered Trademark- intrauterine progesterone contraceptive system, ALZET-Registered Trademark- osmotic pumps and the Ocusert-Registered Trademark- pilocarpine ocular therapeutic system. In 1996, ALZA began promoting Ethyol-Registered Trademark- (amifostine) in the Unites States. Ethyol-Registered Trademark- is a unique cytoprotective agent developed by U.S. Bioscience, Inc. ("U.S. Bioscience"), indicated for the reduction of cumulative renal toxicity associated with repeated administration of the chemotherapeutic drug cisplatin in patients with advanced ovarian or non-small cell lung cancer. U.S. Bioscience co-promotes the product with ALZA. In 1994, ALZA launched Testoderm-Registered Trademark-, the first transdermal testosterone replacement therapy for testosterone deficient men. ALZA also manufactures the Actisite-Registered Trademark- (tetracycline hydrochloride) periodontal fiber, which is marketed in the U.S. by a partnership between ALZA and Procter & Gamble for adjunctive treatment of periodontitis. Progestasert - -Registered Trademark-, ALZET-Registered Trademark-, Ocusert-Registered Trademark- and Actisite-Registered Trademark- are sold internationally through other companies under distribution agreements. Net sales of ALZA-marketed products were $23.2 million in 1996, compared to $13.6 million in 1995 and $11.1 million in 1994. The increase in sales of ALZA-marketed products for 1996 from 1995 was due to Ethyol-Registered Trademark- net sales of $9.4 million from March 1996 through the end of the year. Sales of Testoderm-Registered Trademark- were $6.7 million, $6.8 million and $4.2 million for 1996, 1995 and 1994, respectively. -5- PAGE 18-19 OF PAPER FORMAT ANNUAL REPORT Costs of products shipped increased to $85.2 million in 1996 compared to $65.4 million in 1995. Included in costs of products shipped in 1996 are $2.4 million of non-recurring charges primarily related to costs associated with a limited recall of two lots of the Duragesic-Registered Trademark- product. Gross margin as a precent of net sales increased to 22% for 1996, primarily due to proportionately greater shipments of higher margin products and the manufacturing and shipment of launch quantities. Although net sales increased in 1995 over 1994, gross margin as a percent of net sales decreased during the same period due to higher manufacturing overhead costs, including costs associated with ALZA's ongoing quality assurance activities. GENERAL, ADMINISTRATIVE AND MARKETING General, administrative and marketing expenses increased to $47.1 million in 1996, compared to $41.1 million in 1995 and $33.4 million in 1994. The increase in 1996 was due primarily to sales and marketing expenses related to the launch of Ethyol-Registered Trademark-, the amortization of the upfront payment ALZA made in 1995 to U.S. Bioscience for Ethyol-Registered Trademark- and an increase in overall general and administrative expenses in support of increased corporate activities. The increase in 1995, as compared to 1994, was primarily due to a charge of approximately $7 million for a portion of the amount ALZA paid to U.S. Bioscience under the marketing and distribution agreement for Ethyol-Registered Trademark-. Without this charge, general, administrative and marketing expenses for 1995 were essentially flat with 1994. In 1994, general, administrative and marketing expenses included costs related to the formation of ALZA Pharmaceuticals (ALZA's sales and marketing division) and launch expenses related to Testoderm-Registered Trademark-. ALZA Pharmaceuticals was created for the purpose of expanding ALZA's marketing capabilities in order to commercialize ALZA-developed products, including those under development with TDC and licensed-in products. In 1994, ALZA Pharmaceuticals established a U.S. sales force of approximately 50 people and began actively promoting Testoderm-Registered Trademark-. In addition to promoting Ethyol-Registered Trademark- and Testoderm-Registered Trademark-, ALZA Pharmaceuticals co-promotes Glucotrol XL-Registered Trademark- with Pfizer and Duragesic-Registered Trademark- with Janssen Pharmaceutica, Inc. ("Janssen") and in 1996 began promoting Bayer Corporation's Mycelex-Registered Trademark- (clotrimazole) Troche and co-promoting U.S. Bioscience's Hexalen-Registered Trademark- (altretamine) and NeuTrexin-Registered Trademark- (trimetrexate glucuronate) products. At the end of 1996, ALZA's U.S. sales force had grown to approximately 60 people. -6- PAGE 19 OF PAPER FORMAT ANNUAL REPORT INTEREST AND OTHER REVENUE Interest and other revenue, which consists primarily of interest income, was $54.8 million in 1996, compared to $24.3 million and $17.8 million in 1995 and 1994, respectively. The increase in 1996 over 1995 was primarily due to higher average invested cash balances following ALZA's offering of $500 million of 5% convertible subordinated debentures due 2006 (the "5% Debentures") in April 1996, which resulted in $489 million in net proceeds to ALZA, and net realized gains of $8.4 million on sales of investments. Also included in interest and other revenue in 1996 was a $2.5 million non-recurring benefit resulting from the issuance to ALZA of shares of common stock of Vivus, Inc. in exchange for rights to use certain ALZA technology. Reducing interest and other revenue in 1996 was a non-recurring charge of $2.8 million related to ALZA's dental business activities and investments. Operating results of the ALZA and Procter & Gamble partnership have not met expectations primarily due to lower than expected sales of the Actisite - -Registered Trademark- periodontal fiber. The increase in interest and other revenue in 1995 over 1994 was due in large part to higher invested cash balances. INTEREST AND OTHER EXPENSE ALZA reported total interest expense of $43.0 million in 1996, compared to $23.9 million in 1995 and $19.4 million in 1994. The increase reflects the interest expense on the 5% Debentures and the higher outstanding balance on ALZA's 5 1/4% zero coupon convertible subordinated debentures due 2014 (the "5 1/4% Debentures"). In mid-1994, ALZA replaced its $250 million commercial paper program with approximately $337 million of 5 1/4% Debentures. The increase in 1995 interest expense as compared to 1994 was due to higher average outstanding debt as the 5 1/4% Debentures were outstanding for the full year and a higher average interest rate on such debt. LIQUIDITY AND CAPITAL RESOURCES Cash, cash equivalents and short-term investments at the end of 1996 increased 139% as compared to 1995. Unrealized losses on ALZA's investments at December 31, 1996 were $0.1 million, net of tax effect. At December 31, 1995, ALZA had unrealized gains on its investments of $1.9 million, net of tax effect. -7- PAGE 19-20 OF PAPER FORMAT ANNUAL REPORT ALZA invested approximately $48.6 million in 1996 and $46.3 million in 1995 in additions to property, plant and equipment to support its expanding research and development and manufacturing activities. NET CASH PROVIDED BY OPERATING ACTIVITIES (PRESENTED GRAPHICALLY IN PAPER FORMAT ANNUAL REPORT) (In millions) 1996 1995 1994 1993 1992 ----- ----- ---- ---- ---- Net Cash Provided by Operating Activities $ 135 $ 111 $ 74 $ 76 $ 97 NET CASH PROVIDED BY OPERATING ACTIVITIES In April 1996, ALZA completed a $500 million public offering of the 5% Debentures which resulted in $489 million of net proceeds to ALZA. The proceeds of the offering will be used for general corporate purposes, which may include expansion of ALZA's pharmaceutical business (including sales and marketing activities); expansion of its research and development and manufacturing facilities; expenditures under existing or future joint ventures, partnerships or other similar arrangements; the completion or continuation of the development of TDC products if ALZA exercises its right to license any or all of the TDC products or its purchase option with respect to TDC; the acquisition of assets, technologies, products and businesses to expand ALZA's operations; and working capital. In January 1997, ALZA entered into an agreement with U.S. Bioscience under which U.S. Bioscience will sell approximately 1.2 million of its common shares to ALZA (4.9% of the outstanding common shares of U.S. Bioscience) at a purchase price of $18.256 per share, for an aggregate investment of $21.5 million. U.S. Bioscience will spend a portion of the proceeds on programs supporting the Ethyol-Registered Trademark- product. In February 1997, ALZA entered into an agreement with Alkermes, Inc. ("Alkermes") under which Alkermes will sell 2.0 million of its common shares to ALZA (9.7% of the outstanding common shares of Alkermes) at a purchase price of $25 per share, for an aggregate investment of $50 million. Separately, ALZA and Alkermes agreed to collaborate on a program for the development and commercialization of a -8- PAGE 20 OF PAPER FORMAT ANNUAL REPORT product utilizing Alkermes' drug delivery technology. ALZA will fund the development costs of the program and will have worldwide commercialization rights to the product. Alkermes will receive royalties based on product sales and it is anticipated that Alkermes will manufacture the product. OUTLOOK The following is intended to provide an outlook for 1997 and beyond. To the extent any statements made in this Annual Report, including this section, deal with information that is not historical, these statements are necessarily forward-looking. As such, they are subject to the occurrence of many events outside ALZA's control and are subject to various risk factors that could cause ALZA's results to be materially different from those presented in the outlook. These factors are described in ALZA's reports on Forms 10-K and 10-Q filed with the Securities and Exchange Commission and include, without limitation, the inherent risk of product development failure, the risk of clinical outcomes, regulatory risks and risks related to proprietary rights, market acceptance (including third-party reimbursement) and competition. ROYALTIES AND FEES ALZA expects royalties and fees (exclusive of non-recurring items) to continue to increase in 1997 as a result of sales growth from products currently marketed by client companies and from the introduction of several products which have recently received marketing clearance and, to a lesser extent, products which are awaiting approval by regulatory authorities outside of the United States. Sales of Procardia XL -Registered Trademark- by Pfizer, which accounted for approximately 42% of ALZA's royalties and fees in 1996, decreased 11% from 1995, and are likely to continue to decline. ALZA cannot predict 1997 sales levels for this product. Sales of products from which ALZA derives royalties and fees are affected by the clients' marketing efforts and the introduction and marketing of competing products, among other factors. Most of the factors affecting royalties and fees are therefore not within ALZA's control. -9- PAGE 20-21 OF PAPER FORMAT ANNUAL REPORT RESEARCH AND DEVELOPMENT THERAPEUTIC DISCOVERY CORPORATION At the end of 1996, ALZA filed a New Drug Application for a second-generation transdermal testosterone product and ALZA and TDC had a number of products in development, including several in clinical evaluation. If 1996 TDC product development expenditure levels continue in 1997, it can be expected that all TDC funds available for product development will be exhausted during the second half of 1997. ALZA has an option, exercisable at ALZA's sole discretion, to purchase all (but not less than all) of the outstanding shares of TDC Class A common stock (the "Purchase Option"). The Purchase Option will expire, if not exercised, on the 60th day after TDC files a Form 10-K or Form 10-Q with the Securities and Exchange Commission containing a balance sheet showing less than an aggregate of $5 million in cash and cash equivalents, short-term investments and long-term investments. During any period when TDC no longer has funds available for product development, but ALZA has not yet made a determination whether or not to exercise its Purchase Option, ALZA will likely need to continue funding TDC product development at its own expense in order to keep the product development programs intact. Under the formula set forth in TDC's Restated Certificate of Incorporation, the Purchase Option exercise price is expected to be $100 million. The purchase price may be paid in cash, ALZA common stock or any combination of the two, at the option of ALZA. If ALZA were to exercise the Purchase Option, ALZA would incur a one-time charge for the acquisition of in-process technology and might realize certain tax benefits. If ALZA were to decide not to exercise the Purchase Option, ALZA would have the right, for an additional 90 days, to license any or all TDC products, on a product-by-product and country-by-country basis. ALZA would make payments to TDC, with respect to any licensed products, for countries as to which the license option is exercised, based on sales of the licensed products by ALZA in those countries and any up-front fees or sublicensing revenues received by ALZA from third parties marketing the licensed products in those countries. -10- PAGE 21 OF PAPER FORMAT ANNUAL REPORT If ALZA were to exercise the Purchase Option, ALZA would need to fund any continuing development expenses for TDC products. If ALZA were to choose not to exercise the Purchase Option, but to license some or all of the products, ALZA would need to fund the additional product development activities necessary to complete the licensed products. If ALZA were to use its own funds to cover these expenses, the product development activities would result in research and development expenses without the corresponding research and development revenues previously provided by TDC. ALZA could also choose to fund the expenses by partnering with third parties for the continued development and commercialization of some or all of the products, either on a worldwide basis or in specified markets. Alternatively, ALZA could determine to continue product development through other financing arrangements. ALZA has not made a decision as to whether it will exercise the Purchase Option or its license option for any TDC products (except with respect to the two products for which ALZA has already exercised the license option), and ALZA does not anticipate making this decision until TDC has exhausted its funds available for product development. PHARMACEUTICAL COMPANY CLIENTS To maintain or increase 1996 product development revenue levels, ALZA will need to enter into new arrangements with client companies to replace revenues lost when programs terminate or products are submitted for regulatory clearance or are cleared for marketing. Development agreements with client companies are generally terminable by the clients on short notice and may be terminated for many reasons, including technical issues, marketing concerns, reallocation of client resources, and changes in client priorities. In addition, revenues from any particular client program will decrease dramatically once the New Drug Application for the product has been filed, and could decrease earlier if the client, rather than ALZA, were to undertake the clinical development of the product. In addition, to the extent that TDC client revenues are no longer available, ALZA would need to significantly increase revenues under agreements with pharmaceutical company clients in order to maintain current research and development revenue levels. -11- PAGE 21-22 OF PAPER FORMAT ANNUAL REPORT ALZA TECHNOLOGY INSTITUTE ALZA expects to increase its internal research expenditures in 1997 through the ALZA Technology Institute in order to continue strengthening the Company's leadership in the drug delivery field. Areas of focus for 1997 include the further development of the E-TRANS-TM- electrotransport, DUROS-TM- implant, D-TRANS-TM- and E-TRANS-TM- skin interface, Liquid OROS-Registered Trademark- and RingCap-TM- technologies and the application of ALZA's technologies to the biotechnology and gene therapy fields. NET SALES ALZA expects that contract manufacturing revenues may decrease somewhat in 1997 compared to 1996 levels. In 1996, ALZA manufactured and shipped significant quantities of product in anticipation of product launches. Net sales of launch quantities are not necessarily indicative of future net sales and ALZA does not anticipate manufacturing such launch quantities in 1997. Because many factors affecting contract manufacturing activities are not within ALZA's control, revenues will fluctuate from period to period depending on the volume, mix and timing of orders received from client companies. However, net sales of ALZA-marketed products are expected to increase in 1997, primarily due to anticipated increasing sales of Ethyol - -Registered Trademark-. GENERAL, ADMINISTRATIVE AND MARKETING EXPENSES General, administrative and marketing expenses are expected to remain flat or slightly higher than 1996 levels based on currently planned operations. However, if ALZA were to in-license additional products, or to enter into additional collaborations, general, administrative and marketing expenses likely would increase as a result of both the costs involved in the transactions and the costs of the new activities. ALZA TTS RESEARCH PARTNERS, LTD. Duragesic-Registered Trademark- has been a very successful product for ALZA and Janssen, which markets the product under a distribution agreement with ALZA. ALZA developed Duragesic-Registered Trademark- on behalf of the ALZA TTS Research Partners, Ltd. (the "TTS Partnership"), a limited partnership from which ALZA licenses the product. The TTS Partnership receives payments from ALZA equal to 4% of Janssen's net sales of Duragesic-Registered Trademark-. -12- PAGE 22 OF PAPER FORMAT ANNUAL REPORT ALZA's license from the TTS Partnership for Duragesic-Registered Trademark- will become nonexclusive on December 4, 1998. Once ALZA's license becomes nonexclusive, the TTS Partnership will need to determine whether to grant nonexclusive licenses to third parties. Under ALZA's distribution agreement with Janssen for the Duragesic-Registered Trademark- product, if ALZA's license from the TTS Partnership becomes nonexclusive and if the TTS Partnership licenses the product to a third party and the third party introduces the product, Janssen's royalty payable to ALZA will drop significantly, however, ALZA will continue to owe the TTS Partnership 4% of Janssen's net sales. ALZA has an option to purchase all of the interests in the TTS Partnership for $120 million less amounts paid by ALZA to the TTS Partnership under its license to ALZA prior to the date the option is exercised. (As of December 31, 1996, ALZA has paid the Partnership $18.3 million under its license). The exercise price is payable in cash, ALZA common stock, or a combination of the two at ALZA's option. Because ALZA's licenses to the Duragesic - -Registered Trademark- (and Testoderm-Registered Trademark- products) will become nonexclusive in 1998, ALZA will need to consider, in 1997 or 1998, whether it wishes to exercise its purchase option or otherwise offer to purchase all of the limited partnership interests in the TTS Partnership. LIQUIDITY AND CAPITAL RESOURCES ALZA believes that its existing cash and investment balances are adequate to fund its cash needs for 1997 and beyond. In addition, should the need arise, ALZA believes it would be able to borrow additional funds or otherwise raise additional capital. ALZA may consider using its capital to make strategic investments or to acquire or license technology or products. ALZA may also enter into strategic alliances with third parties which could provide additional funding for research and product development and support for product marketing and sales. LOOKING BEYOND 1997 Over the longer term, ALZA intends to become less dependent on royalties and fees as ALZA's sales and marketing activities expand and as ALZA directly markets more products (including products developed with TDC); however, there can be no assurance that these expanded activities will be successful due to factors such as the risks of product -13- PAGE 22 OF PAPER FORMAT ANNUAL REPORT development, the length of the regulatory approval process and acceptance of products by the intended markets. ALZA also expects that gross margins, as a percent of net sales, will continue to increase over the longer term, although quarter-to-quarter fluctuations will continue to occur. Higher gross margins may be achieved through a proportionate increase in the sales of ALZA-marketed products, increased utilization of capacity and greater operating efficiencies. -14- PAGE 23 OF PAPER FORMAT ANNUAL REPORT CONSOLIDATED STATEMENT OF INCOME
Years ended December 31, (In millions, except per share amounts) 1996 1995 1994 ---- ---- ---- REVENUES: Royalties and fees $ 171.4 $ 145.4 $ 123.8 Research and development, including amounts from TDC (1996-$100.7; 1995-$70.1; 1994-$31.6) 131.2 104.0 68.7 Net sales 108.6 76.9 68.5 Interest and other 54.8 24.3 17.8 ------- ------- ------- Total revenues 466.0 350.6 278.8 COSTS AND EXPENSES: Research and development 141.6 103.4 76.1 Costs of products shipped 85.2 65.4 56.6 General, administrative and marketing 47.1 41.1 33.4 Interest and other 43.0 23.9 19.4 ------- ------- ------- Total costs and expenses 316.9 233.8 185.5 ------- ------- ------- Income before income taxes 149.1 116.8 93.3 Provision for income taxes 56.7 44.4 35.2 ------- ------- ------- Net income $ 92.4 $ 72.4 $ 58.1 ------- ------- ------- ------- ------- ------- Net income per common and common equivalent share $ 1.08* $ 0.88 $ 0.71 ------- ------- ------- ------- ------- ------- Weighted average common and dilutive common equivalent shares 94.2 82.6 82.3 ------- ------- ------- ------- ------- -------
See accompanying notes. * Earnings per share calculation uses adjusted net income of $101.6. See Note 1 of the Notes to Consolidated Financial Statements. -15- PAGE 24 OF PAPER FORMAT ANNUAL REPORT CONSOLIDATED BALANCE SHEET December 31, (In millions, except per share amounts) 1996 1995 ---- ---- ASSETS: CURRENT ASSETS: Cash and cash equivalents $ 187.7 $ 88.0 Short-term investments 812.1 331.1 Receivables, net of allowance for doubtful accounts (1996-$0.6; 1995-$0.2) 116.6 108.0 Inventories 39.2 34.5 Prepaid expenses and other current assets 19.2 16.5 --------- ------- Total current assets 1,174.8 578.1 PROPERTY, PLANT AND EQUIPMENT: Buildings and leasehold improvements 228.7 178.7 Equipment 144.2 130.0 Construction in progress 18.1 33.8 Land and prepaid land leases 17.1 17.0 --------- ------- 408.1 359.5 Less accumulated depreciation and amortization (100.3) (82.5) --------- ------- Net property, plant and equipment 307.8 277.0 Other assets 131.1 82.1 --------- ------- TOTAL ASSETS $ 1,613.7 $ 937.2 --------- ------- --------- ------- LIABILITIES AND STOCKHOLDERS' EQUITY: CURRENT LIABILITIES: Accounts payable $ 28.7 $ 20.0 Accrued liabilities 37.2 29.4 Deferred revenue 0.4 17.6 Current portion of long-term debt 0.9 0.9 --------- ------- Total current liabilities 67.2 67.9 5% convertible subordinated debentures 500.0 - 5 1/4% zero coupon convertible subordinated debentures 382.3 362.9 Other long-term liabilities 67.5 51.8 Commitments and contingencies STOCKHOLDERS' EQUITY: Common stock, $.01 par value, 300.0 shares authorized; 84.6 and 82.5 shares issued and outstanding at December 31, 1996 and 1995, respectively 0.8 0.8 Additional paid-in capital 362.2 310.5 Unrealized (losses) gains on available-for-sale securities, net of tax effect (0.1) 1.9 Retained earnings 233.8 141.4 --------- ------- Total stockholders' equity 596.7 454.6 --------- ------- TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 1,613.7 $ 937.2 --------- ------- --------- ------- See accompanying notes. -16- PAGE 25 OF PAPER FORMAT ANNUAL REPORT CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY Years ended December 31, 1996, 1995, and 1994 (In millions)
UNREALIZED GAINS (LOSSES) TOTAL ADDITIONAL ON AVAILABLE- STOCK- COMMON PAID-IN FOR-SALE RETAINED HOLDERS' STOCK CAPITAL SECURITIES EARNINGS EQUITY -------- ------------ ------------- ---------- --------- BALANCE, DECEMBER 31, 1993 $ 0.8 $ 295.0 $ - $ 10.9 $ 306.7 Common stock issued - 7.2 - - 7.2 Unrealized losses on available-for- sale securities, net of tax effect - - (7.5) - (7.5) Net income - - - 58.1 58.1 -------- ------------ ------------- ---------- --------- BALANCE, DECEMBER 31, 1994 0.8 302.2 (7.5) 69.0 364.5 Common stock issued - 8.3 - - 8.3 Unrealized gains on available-for- sale securities, net of tax effect - - 9.4 - 9.4 Net income - - - 72.4 72.4 -------- ------------ ------------- ---------- --------- BALANCE, DECEMBER 31, 1995 0.8 310.5 1.9 141.4 454.6 Common stock issued - 51.7 - - 51.7 Unrealized losses on available-for- sale securities, net of tax effect - - (2.0) - (2.0) Net income - - - 92.4 92.4 -------- ------------ ------------- ---------- --------- BALANCE, DECEMBER 31, 1996 $ 0.8 $ 362.2 $ (0.1) $ 233.8 $ 596.7 -------- ------------ ------------- ---------- --------- -------- ------------ ------------- ---------- ---------
See accompanying notes. -17- PAGE 26 OF PAPER FORMAT ANNUAL REPORT CONSOLIDATED STATEMENT OF CASH FLOWS Years ended December 31, (In millions) 1996 1995 1994 ---- ---- ---- CASH FLOWS FROM OPERATING ACTIVITIES: Net income $ 92.4 $ 72.4 $ 58.1 Non-cash adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization 22.0 15.3 13.7 Interest on 5 1/4% zero coupon convertible subordinated debentures 19.3 18.4 8.1 Decrease (increase) in assets: Receivables (8.6) (23.1) (28.3) Inventories (4.7) (1.1) (8.3) Prepaid expenses and other current assets (1.2) 6.2 (1.4) Increase (decrease) in liabilities: Accounts payable 8.7 - 8.3 Accrued liabilities 7.8 10.6 1.4 Deferred revenue (17.2) 1.3 9.6 Other long-term liabilities 16.7 11.4 13.1 --------- ------- ------- Total adjustments 42.8 39.0 16.2 --------- ------- ------- Net cash provided by operating activities 135.2 111.4 74.3 CASH FLOWS FROM INVESTING ACTIVITIES: Capital expenditures (48.6) (46.3) (37.2) Purchases of available-for-sale securities (1,125.2) (205.2) (328.9) Sales of available-for-sale securities 542.6 134.1 147.9 Maturities of available-for-sale securities 98.1 12.0 102.1 Increase in cash surrender value-life insurance and prepaid premiums (20.3) (4.1) (12.3) Decrease (increase) in other assets (21.5) (10.2) 4.4 --------- ------- ------- Net cash used in investing activities (574.9) (119.7) (124.0) CASH FLOWS FROM FINANCING ACTIVITIES: Net proceeds from 5% convertible subordinated debentures 488.8 - - Net proceeds from 5 1/4% zero coupon convertible subordinated debentures - - 328.1 Maturities of commercial paper, net - - (249.6) Principal payments on long-term debt (1.1) (0.8) (0.9) Issuances of common stock 51.7 8.3 7.2 --------- ------- ------- Net cash provided by financing activities 539.4 7.5 84.8 --------- ------- ------- Net increase (decrease) in cash and cash equivalents 99.7 (0.8) 35.1 Cash and cash equivalents at beginning of year 88.0 88.8 53.7 --------- ------- ------- Cash and cash equivalents at end of year $ 187.7 $ 88.0 $ 88.8 --------- ------- ------- --------- ------- ------- See accompanying notes. -18- PAGE 27 OF PAPER FORMAT ANNUAL REPORT NOTES TO CONSOLIDATED FINANCIAL STATEMENTS DECEMBER 31, 1996, 1995, AND 1994 NOTE 1: BASIS OF PRESENTATION AND SIGNIFICANT ACCOUNTING POLICIES ALZA Corporation ("ALZA" or the "Company") develops a broad range of pharmaceutical products based on ALZA's proprietary therapeutic systems technologies, primarily under joint development and commercialization agreements with ALZA's client companies, including Therapeutic Discovery Corporation ("TDC"). Royalties and fees include royalty revenue and other payments based on sales by ALZA's client companies of products developed under joint development and commercialization agreements, and certain one-time or infrequent fees or similar payments under such agreements. Fees for promotion and co-promotion of certain products which are generally contingent on sales performance are also included in royalties and fees. Revenues from development activities with client companies are reported as research and development revenue. ALZA's research and development revenue represents clients' reimbursement to ALZA of costs incurred in product development and clinical evaluation, including a portion of general and administrative expenses, and therefore does not contribute significantly to current net income. ALZA's policy is to expense all costs of research and product development related to both costs incurred on its own behalf and on behalf of its clients. ALZA manufactures all or a portion of the product requirements for certain of its client companies, including Duragesic-Registered Trademark- (fentanyl) for Janssen Pharmaceutica, Inc. ("Janssen"), NicoDerm-Registered Trademark- CQ-TM- and Nicoderm-Registered Trademark- (nicotine) for Hoechst Marion Roussel, Inc. ("HMR"), Covera-HS-TM- (verapamil) for G.D. Searle, Catapres-TTS-Registered Trademark- (clonidine) for Boehringer Ingelheim Pharmaceutical, Inc., Adalat CR-Registered Trademark- (nifedipine) for Bayer AG and Procardia XL-Registered Trademark- (nifedipine) for Pfizer Inc. ("Pfizer"). In addition, ALZA manufactures and markets directly in the U.S. its Progestasert-Registered Trademark- (progesterone) system, ALZET - -Registered Trademark- osmotic pumps, the Ocusert-Registered Trademark- -19- PAGE 27 OF PAPER FORMAT ANNUAL REPORT pilocarpine ocular therapeutic system and the Testoderm-Registered Trademark- testosterone transdermal system CIII. ALZA also manufactures the Actisite-Registered Trademark- (tetracycline hydrochloride) periodontal fiber, which is marketed in the U.S. by a partnership between ALZA and Procter & Gamble. Internationally, Progestasert-Registered Trademark-, ALZET-Registered Trademark-, Ocusert-Registered Trademark- and Actisite - -Registered Trademark- are marketed by ALZA through distributors. ALZA also markets Ethyol-Registered Trademark- (amifostine) in the United States. Revenues from all of these activities are reported as net sales. ALZA recognizes sales revenues at the time of product shipment; sales are net of discounts, rebates and allowances. Export sales, principally to distributors and client companies in Europe, were $23.0 million, $20.1 million, and $16.9 million in 1996, 1995 and 1994, respectively. Included in interest and other revenue are revenues from ALZA's co-promotion arrangements with client companies that are not contingent on sales and net losses from ALZA's partnership with Procter & Gamble. ALZA earned interest income, including realized gains and losses on sales of investments, of $54.6 million, $26.0 million, and $17.6 million in 1996, 1995 and 1994, respectively. TDC accounted for 22% of ALZA's total revenues in 1996, 20% in 1995 and 11% in 1994; Pfizer accounted for 20% of ALZA's total revenues in 1996, 23% in 1995 and 30% in 1994; Janssen accounted for 13% of ALZA's total revenues in 1996 and 12% in each of 1995 and 1994; and HMR accounted for 10% of ALZA's total revenues in each of 1996 and 1995. PRINCIPLES OF CONSOLIDATION The consolidated financial statements include the accounts of ALZA and its wholly-owned subsidiaries, ALZA Development Corporation, ALZA International, Inc. and ALZA Limited. All significant intercompany accounts and transactions have been eliminated. -20- PAGE 27-28 OF PAPER FORMAT ANNUAL REPORT USE OF ESTIMATES The preparation of financial statements in accordance with generally accepted accounting principles requires management to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates. CASH AND CASH EQUIVALENTS ALZA reports all highly liquid debt instruments purchased with a maturity of three months or less as cash equivalents. The carrying amount reported on the balance sheet for cash and cash equivalents approximates their fair value. SHORT-TERM INVESTMENTS ALZA has classified its entire investment portfolio, including cash equivalents of $185.2 million and $82.7 million at December 31, 1996 and 1995, respectively, as available-for-sale. Although ALZA may not dispose of all of the securities in its investment portfolio within one year, ALZA's investment portfolio is available for current operations and, therefore, has been classified as a current asset. Investments in the available-for-sale category are carried at fair value with unrealized gains and losses recorded as a separate component of stockholders' equity. At December 31, 1996, net unrealized losses on available-for-sale securities were $0.1 million, net of $0.1 million tax effect. At December 31, 1995, net unrealized gains on available-for-sale securities were $1.9 million, net of $1.3 million tax effect. The cost of securities when sold is based upon specific identification. Realized gains and losses for the year ended December 31, 1996 were $9.1 million and $0.7 million, respectively. Realized gains and losses were not material for the year ended December 31, 1995. -21- PAGE 28 OF PAPER FORMAT ANNUAL REPORT The following is a summary of ALZA's investment portfolio at December 31, 1996 and 1995:
(In millions) December 31, 1996 December 31, 1995 ------------------------------------------------ ------------------------------------------------- Estimated Estimated Amortized Unrealized Unrealized Fair Amortized Unrealized Unrealized Fair Cost Gains Losses Value Cost Gains Losses Value ----------- ---------- ----------- ---------- ---------- ----------- ----------- --------- U.S. Treasury securities and obligations of U.S. government agencies $ 434.1 $ 1.0 $ 1.8 $ 433.3 $ 150.9 $ 1.4 $ 0.6 $ 151.7 Collateralized mortgage obligations and asset backed securities 112.8 0.3 0.4 112.7 43.4 0.3 0.2 43.5 Corporate securities (primarily corporate notes and commercial paper) 450.6 1.9 1.2 451.3 216.3 2.3 - 218.6 ----------- ---------- ----------- ---------- ---------- ----------- ----------- --------- $ 997.5 $ 3.2 $ 3.4 $ 997.3 $ 410.6 $ 4.0 $ 0.8 $ 413.8 ----------- ---------- ----------- ---------- ---------- ----------- ----------- --------- ----------- ---------- ----------- ---------- ---------- ----------- ----------- ---------
The amortized cost and estimated fair value of debt securities at December 31, 1996 and 1995, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the issuers of the securities may have the right to prepay certain of the obligations without prepayment penalties.
(In millions) 1996 1995 ----------------------------- ---------------------------- Estimated Estimated Amortized Fair Amortized Fair Cost Value Cost Value ------------- ------------- ------------- ------------ Due in one year or less $ 384.5 $ 384.5 $ 176.7 $ 176.8 Due after one year through four years 428.1 427.8 138.2 139.6 Due after four years through eight years 184.9 185.0 95.7 97.4 ------------- ------------- ------------- ------------ $ 997.5 $ 997.3 $ 410.6 $ 413.8 ------------- ------------- ------------- ------------ ------------- ------------- ------------- ------------
CREDIT AND INVESTMENT RISK Most of ALZA's revenues, comprised primarily of royalties and fees, research and development revenue and net sales, are derived from agreements with major pharmaceutical company clients and TDC, all of which have significant cash resources. Therefore, ALZA considers its credit risk related to these transactions to be minimal. -22- PAGE 29 OF PAPER FORMAT ANNUAL REPORT ALZA invests excess cash in securities of banks and companies from a variety of industries with strong credit ratings, and in U.S. government obligations. These securities typically bear minimal risk and ALZA has not experienced any material losses on its investments due to institutional failure or bankruptcy. ALZA's investment policy is designed to limit exposure with any one institution. INVENTORIES Raw materials, work in process and finished goods inventories are stated at the lower of standard cost (which approximates actual costs on a first-in, first-out cost method) or market value. Inventories consist of the following: (In millions) 1996 1995 ------ ------ Raw materials $ 17.7 $ 15.8 Work in process 18.0 15.2 Finished goods 3.5 3.5 ------ ------ Total inventories $ 39.2 $ 34.5 ------ ------ ------ ------ PROPERTY, PLANT AND EQUIPMENT Property, plant and equipment are stated at cost, including capitalized interest additions of $2.2 million in 1996, $1.3 million in 1995 and $0.3 million in 1994. Additions and improvements are capitalized; maintenance and repairs are expensed as incurred. Except for certain manufacturing equipment that is depreciated on a per unit manufactured basis, depreciation and amortization are computed on the straight-line method, over estimated useful lives, as follows: Buildings 30 to 40 years Leasehold improvements Terms of the leases (1 to 5 years) Equipment 3 to 9 years Prepaid land leases Remaining terms of the leases (17 to 61 years) Depreciation and amortization expense was $17.8 million, $14.8 million and $13.4 milion for 1996, 1995 and 1994, respectively. Prepaid land leases represent ALZA's total cost, paid in advance, of leasehold -23- PAGE 29-30 OF PAPER FORMAT ANNUAL REPORT rights to land upon which certain of ALZA's buildings in Palo Alto, California are situated. Included in construction in progress are payments made in connection with facilities being constructed or modified, and the installation of related equipment in Mountain View, California (primarily research and development) and Vacaville, California (primarily commercial manufacturing). ACCRUED LIABILITIES The details of ALZA's accrued liabilities are as follows: (In millions) 1996 1995 ------ ------ Accrued compensation $ 15.4 $ 13.4 Accrued income taxes 7.3 2.1 Other accrued liabilities 14.5 13.9 ------ ------ Total accrued liabilities $ 37.2 $ 29.4 ------ ------ ------ ------ ADVERTISING COSTS Advertising costs are accounted for as expenses in the period in which they are incurred. Advertising expense for the years ended December 31, 1996, 1995 and 1994 was $4.4 million, $3.3 million and $3.7 million, respectively. PER SHARE INFORMATION Per share information is based on weighted average common and dilutive common equivalent shares, including ALZA common stock, warrants and options, for the period each was outstanding. The 5 1/4% zero coupon convertible subordinated debentures are considered common stock equivalent shares, but were not included in the per share calculation for 1995 or 1994 as their inclusion would have had an antidilutive effect. Shares issuable upon an assumed conversion of the 5 1/4% zero coupon convertible subordinated debentures were dilutive for the last three quarters of 1996. Consequently, a total of 9.2 million shares are included in weighted average common and dilutive common equivalent shares for the year ended December 31, 1996. The 5% convertible subordinated debentures are not considered common stock equivalents. Fully diluted earnings per share are not presented since dilution is less than 3% for each year presented. -24- PAGE 30 OF PAPER FORMAT ANNUAL REPORT NOTE 2: U.S. BIOSCIENCE, INC. In December 1995, ALZA entered into a marketing and distribution agreement with U.S. Bioscience, Inc. ("U.S. Bioscience") for Ethyol-Registered Trademark-. Under the terms of the agreement, ALZA has exclusive rights to market the product in the United States for five years, and is responsible for sales and marketing; the U.S. Bioscience sales force co-promotes the product with ALZA. ALZA launched the product in early 1996. After the five-year period, which ALZA has an option to extend for one year, marketing rights to Ethyol-Registered Trademark- will revert to U.S. Bioscience and ALZA will receive payments from U.S. Bioscience for ten years based on continued sales of the product. ALZA paid U.S. Bioscience an up-front payment and initial distribution fee totaling $20 million. Of this amount, approximately $13 million was capitalized and attributed to the product as originally cleared for marketing by the Food and Drug Administration. Approximately $7 million was charged to general, administrative and marketing expenses and was attributed to potential expanded product indications. ALZA expects to pay an additional $15 million in distribution fees through 1999 based on U.S. Bioscience clinical activities relating to Ethyol-Registered Trademark-. The up-front payment and initial distribution fee are being amortized on a straight-line basis over the term of the agreement and are included in general, administrative and marketing expenses. See Note 11 for additional information related to U.S. Bioscience. NOTE 3: DEBT OBLIGATIONS AND OTHER LONG-TERM LIABILITIES In April 1996, ALZA completed a $500 million public offering of 5% convertible subordinated debentures due 2006 (the "5% Debentures"). The offering resulted in approximately $489 million of net proceeds to ALZA. Interest is payable semiannually on May 1 and November 1 of each year, commencing November 1, 1996. Each 5% Debenture is convertible, at the option of the holder, at any time prior to maturity, unless previously redeemed or repurchased, into shares of ALZA common stock at a conversion price of $38.19 per share, subject to certain anti-dilution adjustments. In connection with the offering, ALZA incurred underwriting fees and other costs of $12.1 million, which are included in other assets and are being amortized over the term of the 5% Debentures. The 5% Debentures rank pari passu with ALZA's outstanding 5 1/4% zero coupon convertible subordinated debentures discussed below. The proceeds of the -25- PAGE 30-31 OF PAPER FORMAT ANNUAL REPORT offering will be used for general corporate purposes, which may include expansion of ALZA's pharmaceutical business (including its sales and marketing activities); expansion of its research and development and manufacturing facilities; expenditures under existing or future joint ventures, partnerships or other similar arrangements; the completion or continuation of the development of TDC products if ALZA exercises its right to license any or all of the TDC products or its purchase option with respect to TDC; the acquisition of assets, technologies, products and businesses to expand ALZA's operations; and working capital. The 5% Debentures are listed for trading on the New York Stock Exchange. At December 31, 1996 the fair value of the 5% Debentures was $490 million. In July 1994, ALZA completed a public offering of 5 1/4% zero coupon convertible subordinated debentures due 2014 (the "5 1/4% Debentures"). The 5 1/4% Debentures were issued at a price of $354.71 per $1,000 principal amount at maturity. The offering resulted in $328.1 million of net proceeds to ALZA. Approximately $250 million of the net proceeds were used to retire ALZA's outstanding commercial paper; the remainder was available for general corporate purposes. The 5 1/4% Debentures, due July 2014, have a principal amount at maturity of $948.8 million, with a yield to maturity of 5 1/4% per annum, computed on a semiannual bond equivalent basis. There are no periodic interest payments. At the option of the holder, each 5 1/4% Debenture is convertible into 12.987 shares of common stock at any time. At the option of the holder, the 5 1/4% Debentures will be purchased by ALZA on July 14, 1999, July 14, 2004 or July 14, 2009, at a purchase price equal to the issue price plus accreted original issue discount to such purchase date. ALZA, at its option, may elect to deliver either common stock or cash in the event of conversion or purchase of the 5 1/4% Debentures. ALZA, at its option, may redeem any or all of the 5 1/4% Debentures for cash after July 14, 1999 at a redemption price equal to the issue price plus accreted original issue discount. In connection with the offering, ALZA incurred underwriting fees and other costs of $9.0 million, which are included in other assets and are being amortized over the term of the 5 1/4% Debentures. The 5 1/4% Debentures are listed for trading on the New York Stock Exchange. At December 31, 1996 and 1995 the fair value of the 5 1/4% Debentures was $397.3 million and $387.8 million, respectively. -26- PAGE 31 OF PAPER FORMAT ANNUAL REPORT ALZA's other long-term liabilities are as follows: (In millions) 1996 1995 ------ ------ Deferred compensation $ 31.2 $ 26.0 Deferred income taxes 25.4 25.7 Long-term debt 10.9 0.1 ------ ------ Total other long-term liabilities $ 67.5 $ 51.8 ------ ------ ------ ------ ALZA has deferred compensation arrangements under which selected employees may defer a portion of their salaries. ALZA has purchased life insurance policies that it intends to use to partially finance amounts to be paid in the future to participants, based on their deferred salary amounts and interest. Included in long-term debt are $10.8 million in notes representing the required future payments under an $11.9 million investment (included in other assets) in low income housing partnerships. The aggregate annual maturities of long-term debt at December 31, 1996, payable in each of the years 1998 through 2002 and thereafter are $2.6 million, $1.7 million, $1.6 million, $1.6 million, $1.5 million and $1.9 million, respectively. NOTE 4: CAPITAL STOCK AND WARRANTS In January 1996, privately held warrants to purchase 1.0 million shares of ALZA common stock were exercised. Net proceeds to ALZA totaled $25 million. In connection with the formation of TDC, ALZA issued warrants to purchase approximately 1.0 million shares of common stock at an exercise price of $65 per share. The warrants, to the extent not exercised, will expire on December 31, 1999. ALZA is authorized to issue 100,000 shares of preferred stock, $.01 par value, none of which was outstanding at December 31, 1996 or 1995. The Board of Directors may determine the rights, preferences and privileges of any preferred stock issued in the future. -27- PAGE 32 OF PAPER FORMAT ANNUAL REPORT NOTE 5: ARRANGEMENTS WITH THERAPEUTIC DISCOVERY CORPORATION In June 1993, ALZA distributed a special dividend of Units to ALZA stockholders. Each Unit consisted of one share of Therapeutic Discovery Corporation Class A common stock and one warrant to purchase one-eighth of one share of ALZA common stock. On June 11, 1996, the component parts of the Units began trading separately on the Nasdaq Stock Market. The TDC Class A common stock trades under the symbol TDCA, and the ALZA warrants trade under the symbol ALZAW. TDC was formed by ALZA for the purpose of selecting and developing new human pharmaceutical products combining ALZA's proprietary drug delivery technology with various drug compounds, and commercializing such products, most likely through licensing to ALZA. ALZA and TDC have a development agreement (the "Development Contract") pursuant to which ALZA conducts research and development activities on behalf of TDC. Product development revenue from TDC during 1996, 1995 and 1994 under the contract was $100.7 million, $70.1 million and $31.6 million, respectively. ALZA has an option to license all of the products developed by TDC, on a product-by-product and country-by-country basis, providing ALZA with access to a potential pipeline of products for worldwide commercialization. If ALZA exercises its license option for any product, ALZA will make royalty payments to TDC (if the product is sold by ALZA) up to a maximum of 5% of ALZA's net sales of such product or, if the product is sublicensed to a third party, ALZA will pay TDC up to 50% of ALZA's sublicensing revenues with respect to the product. The exact percentages of net sales and ALZA's sublicensing revenue payable to TDC will depend on the amount of TDC's funding of the product. ALZA has an option, exercisable on a product-by-product basis, to buy out its royalty obligation to TDC by making a one-time payment that is a multiple of royalties and sublicensing fees paid in specified periods. ALZA also has an option, exercisable at ALZA's sole discretion, to purchase, according to a predetermined formula, all (but not less than all) of the outstanding shares of TDC Class A common stock (the "Purchase -28- PAGE 32 OF PAPER FORMAT ANNUAL REPORT Option"). The Purchase Option is exercisable at any time until December 31, 1999, or later under certain circumstances. The Purchase Option will expire, in any event, on the 60th day after TDC files a Form 10-K or Form 10-Q containing a balance sheet showing less than an aggregate of $5.0 million in cash and cash equivalents, short-term investments and long-term investments. At December 31, 1996, TDC reported cash and cash equivalents, short-term investments and long-term investments of $85.3 million. Based on TDC's current rate of expenditures, it can be expected that all TDC funds available for product development will be exhausted during the second half of 1997. Under the formula set forth in TDC's Restated Certificate of Incorporation, the Purchase Option exercise price is expected to be $100 million. The purchase price may be paid in cash, in ALZA common stock, or any combination of the two, at the option of ALZA. ALZA performs certain administrative services for TDC under an administrative services agreement (terminable at the option of TDC), for which ALZA is reimbursed its direct costs, plus certain overhead expenses. For the years ended 1996, 1995 and 1994, administrative service revenue under this agreement was $0.2 million, $0.1 million and $0.2 million, respectively, and is included in interest and other revenue. NOTE 6: EMPLOYEE COMPENSATION AND BENEFIT PROGRAMS In 1993, ALZA adopted a company-wide bonus program under which substantially all regular employees are eligible to receive a bonus. The annual bonus, if any, is determined by ALZA's Board of Directors, at its discretion, based on the Company's performance during the year. Bonus and award expenses under this program for 1996, 1995 and 1994 were $6.9 million, $5.3 million and $2.6 million, respectively. In 1986, ALZA adopted a company-funded, defined contribution retirement plan for its employees. This plan provides for an annual basic contribution and allows for additional discretionary contributions on a -29- PAGE 32-33 OF PAPER FORMAT ANNUAL REPORT year-by-year basis. Such contributions are allocated to participants based on the participant's salary and age. For 1996, 1995 and 1994, the total expense for such contributions to this plan was $2.9 million, $2.7 million and $2.2 million, respectively. ALZA has an employee savings plan which permits participants to make contributions by salary reductions pursuant to section 401(k) of the Internal Revenue Code. Beginning in 1996, the Company matched contributions up to a maximum of $1,000 per participant. ALZA's contribution to the plan was $0.7 million in 1996. The Company has elected to follow Accounting Principles Board Opinion No. 25, "Accounting for Stock Issued to Employees" ("APB 25") and related interpretations in accounting for its employee stock options and employee stock purchase plan because, as discussed below, the alternative fair value accounting provided for under Financial Accounting Standards Board Statement No. 123, "ACCOUNTING FOR STOCK-BASED COMPENSATION" ("SFAS 123"), requires use of option valuation models that were not developed for use in valuing employee stock options. Under APB 25, because the exercise price of the Company's employee stock options equals the market price of the underlying stock on the date of grant, no compensation expense is recognized. ALZA has a stock option plan, adopted in 1992 and amended in 1995, whereby incentive stock options to purchase shares of ALZA common stock at not less than the fair market value of the stock at the date of the grant, and nonstatutory stock options to purchase shares of ALZA common stock at not less than 85% of the fair market value of the stock at the date of grant, have been and may be granted to certain present and potential employees, directors and consultants. Options typically vest one to three years from date of grant and generally expire ten years after the date of grant. Grants of restricted stock also may be made under the plan; to date no restricted stock has been granted. A total of 5,637,621 shares of ALZA's common stock have been reserved for common shares issuable under its stock option plan which was adopted in 1992 and amended in 1995. To date, all options granted have had exercise prices equal to the -30- PAGE 33 OF PAPER FORMAT ANNUAL REPORT fair market value of common stock on the date of grant. Options granted under previous plans also remain outstanding, but no additional options may be granted under such plans. Pro forma information regarding net income and net income per share is required by SFAS 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of SFAS 123. The fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted average assumptions for 1996 and 1995: risk-free interest rates in the range of 4.78% to 7.48%; dividend yields of zero; an expected volatility factor of the market price of the Company's common stock of 0.30; and an expected life of the option in the range of 2.3 to 5.3 years. The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility and expected option life. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do not necessarily provide a reliable single measure of the fair value of its employee stock options. ALZA has an employee stock purchase plan under which essentially all ALZA's employees may participate and purchase stock at 85% of its fair market value at certain specified dates. Employee contributions are limited to 15% of compensation and no more than 300,000 shares may be purchased by all participants in any plan year. In 1996, 1995 and 1994 an aggregate of 237,950, 165,314 and 157,075 shares, respectively, of ALZA common stock were purchased by the participants under the terms of this plan. Since adoption of this plan in 1984, 1,405,398 shares have been issued under this plan and 644,602 shares are available for issuance. The fair value of the employees' purchase rights was estimated using the Black-Scholes option pricing model with the following weighted-average assumptions for 1996 and -31- PAGE 33-34 OF PAPER FORMAT ANNUAL REPORT 1995: risk free interest rate in the range of 4.78% to 5.87%; dividend yields of zero; an expected votality factor of the market price of the Company's common stock of 0.30; and an expected life of 6 months. The weighted-average fair value for shares issued under the employee stock purchase plan for 1996 and 1995 was $6.21 and $5.62, respectively. For purposes of pro forma disclosures, the estimated fair value of the options is amortized to expense over the option vesting periods. The Company's pro forma net income would have been $85.8 million and $70.0 million for 1996 and 1995, respectively. Pro forma net income per common and common equivalent share would have been $1.01 and $0.85 for 1996 and 1995, respectively. Because SFAS 123 is applicable only to options granted subsequent to December 31, 1994, its pro forma effect will not be fully realized until 1998. A summary of the Company's stock option activity, and related information for the years ended December 31 follows:
1996 1995 ------------------------------------ ------------------------------------- Options Weighted-Average Options Weighted-Average (in millions) Exercise Price (in millions) Exercise Price --------------- ------------------- ---------------- ------------------- Outstanding-beginning of year 5.7 $23 4.4 $21 Granted 0.9 27 1.8 23 Exercised (0.9) 20 (0.3) 14 Forfeited (0.2) 25 (0.2) 21 --------------- ---------------- Outstanding-end of year 5.5 24 5.7 23 --------------- ---------------- --------------- ---------------- Exercisable - end of year 2.2 23 1.8 23 Weighted-average fair value of options granted during the year $8.13 $7.75
-32- PAGE 34-35 OF PAPER FORMAT ANNUAL REPORT
OPTIONS OUTSTANDING OPTIONS EXERCISABLE ------------------------------------------------------ --------------------------------- Number Weighted-Average Number Range of Outstanding Remaining Weighted-Average Exercisable Weighted-Average Exercise at 12/31/96 Contractual life Exercise at 12/31/96 Exercise Prices (in millions) (in years) Price (in millions) Price - ------------------- ---------------- --------------- ----------------- --------------- --------------- $12.00-18.75 0.1 2.08 $ 13.01 0.1 $ 13.01 19.00-25.88 4.8 7.67 22.71 1.8 21.63 27.50-34.00 0.5 7.35 30.20 0.2 31.05 44.50-49.25 0.1 5.28 45.72 0.1 45.73
NOTE 7: COMMITMENTS AND CONTINGENCIES ALZA leases certain buildings and equipment under operating leases. Rent expense under these leases during the years ended 1996, 1995 and 1994 was $3.7 million, $1.7 million and $1.6 million, respectively. Aggregate minimum rental commitments under non-cancelable operating lease arrangements as of December 31, 1996 were $8.0 million and are payable as follows: $3.2 million in 1997, $2.3 million in 1998, $2.0 million in 1999, $0.4 million in 2000 and $0.1 million in 2001. NOTE 8: INCOME TAXES The provision for income taxes is as follows for each of the three years ended December 31: (In millions) 1996 1995 1994 ------ ------ ------ Federal: Current $ 47.9 $ 30.1 $ 23.4 Deferred (2.4) 5.6 4.1 ------ ------ ------ 45.5 35.7 27.5 State: Current 11.2 6.4 6.2 Deferred - 2.3 1.5 ------ ------ ------ 11.2 8.7 7.7 ------ ------ ------ Provision for income taxes $ 56.7 $ 44.4 $ 35.2 ------ ------ ------ ------ ------ ------ -33- PAGE 35 OF PAPER FORMAT ANNUAL REPORT Tax benefits associated with employee stock option transactions reduced accrued income taxes by $3.3 million for 1996 and $1.0 million for each of 1995 and 1994. The provision for income taxes differs from the amount computed by applying the statutory federal income tax rate to income before income taxes. The sources and tax effects of the differences are as follows: (In millions) 1996 1995 1994 ------ ------ ------ Expected federal tax at 35% $ 52.2 $ 40.9 $ 32.7 State income taxes, net of federal benefit 7.3 5.7 5.0 Investment and research tax credits (2.3) (1.3) (2.0) Other (0.5) (0.9) (0.5) ------ ------ ------ Provision for income taxes $ 56.7 $ 44.4 $ 35.2 ------ ------ ------ ------ ------ ------ Temporary differences which give rise to a significant portion of deferred tax assets and liabilities for 1996 and 1995 are as follows: (In millions) 1996 1995 ------ ------ Deferred tax assets: Inventories $ 5.7 $ 6.2 Compensation 14.5 13.0 Capitalized intangibles 6.1 5.8 Deferred revenue 0.1 7.2 State income taxes 4.8 2.4 Other 3.3 2.1 ------ ------ Total deferred tax assets 34.5 36.7 Deferred tax liabilities: Property, plant and equipment 39.8 38.2 Unrealized gains (losses) on available-for- sale securities (0.1) 1.3 Other 2.5 2.1 ------ ------ Total deferred tax liabilities 42.2 41.6 ------ ------ Net deferred tax liabilities $ 7.7 $ 4.9 ------ ------ ------ ------ -34- PAGE 36 OF PAPER FORMAT ANNUAL REPORT NOTE 9: LITIGATION In December 1991, a patent infringement suit was filed by Ciba-Geigy Inc. ("Ciba-Geigy"), now Novartis Pharmaceuticals Corportation, against Marion Merrell Dow Inc. (now Hoechst Marion Roussel, Inc.) and ALZA in connection with the commercialization of Nicoderm-Registered Trademark-. In October 1994, the Court granted a motion for summary judgment brought by ALZA and HMR, ruling the Ciba-Geigy patent invalid. During October 1995, the Court of Appeals for the Federal Circuit upheld the most significant portions of the summary judgment decision, and sent back to the District Court the issue of validity of certain other more limited claims. ALZA believed that these narrower claims were invalid and did not cover the Nicoderm-Registered Trademark- product; therefore, ALZA reversed a portion of a reserve that was established after the patent infringement suit was filed. The effect of the reversal increased royalties and fees by approximately $7.4 million during the fourth quarter of 1995. During January 1995, ALZA and HMR filed a separate suit against Ciba-Geigy and LTS Lohmann Therapy Systems Corporation for infringement of two U.S. patents issued to ALZA in 1994 relating to the transdermal administration of nicotine. In June 1996, ALZA and HMR entered into a settlement agreement with Ciba-Geigy which resolved these disputes. Ciba-Geigy made a one-time settlement payment to HMR and ALZA, and is paying ongoing royalties on its U.S. nicotine patch sales, retroactive to January 1, 1996. ALZA and HMR share the royalty payments in accordance with the agreements between them. During January 1994, a suit was filed against ALZA by Cygnus Therapeutic Systems ("Cygnus") seeking a declaration of unenforceability and invalidity of an ALZA patent relating to transdermal administration of fentanyl (which patent covers Duragesic-Registered Trademark-) and alleging violation of antitrust laws. In April 1995, the court granted ALZA's motion to dismiss the lawsuit; Cygnus appealed that ruling. During 1996, the Court of Appeals of the Federal Circuit upheld the District Court's dismissal of Cygnus' claims against ALZA. Cygnus has no further right of appeal. -35- PAGE 36-37 OF PAPER FORMAT ANNUAL REPORT Pharmaceutical companies are subject to product liability claims from time to time. Product liability suits have been filed against Janssen and ALZA from time to time relating to the Duragesic-Registered Trademark- product. Janssen is managing the defense of these suits in consultation with ALZA under an agreement between the parties. Historically, the cost of resolution of ALZA's liability (including product liability) claims has not been significant, and ALZA is not aware of any asserted or unasserted claims pending against it, including the suits mentioned above, the resolution of which would have a material adverse impact on the operations or financial position of the Company. NOTE 10: STATEMENT OF CASH FLOWS Supplemental disclosures of cash flow information: (In millions) 1996 1995 1994 ------ ------ ------ Cash paid during the year for: Income taxes $ 42.2 $ 37.0 $ 25.7 Interest 16.3 2.6 6.3 Supplemental schedule of noncash investing and financing activities: (In millions) 1996 1995 1994 ------ ----- ------- Net unrealized gains (losses) on available-for-sale securities, net of tax effect $ (2.0) $ 9.4 $ (7.5) Deferred issuance costs - 5 1/4% Debentures - - 8.4 Deferred issuance costs - 5% Debentures 11.2 - - NOTE 11: SUBSEQUENT EVENTS Subsequent to year end, ALZA entered into an agreement with U.S. Bioscience under which U.S. Bioscience will sell approximately 1.2 million of its common shares to ALZA (4.9% of the outstanding common shares of U.S. Bioscience) at a purchase price of $18.256 per share, for an aggregate investment -36- PAGE 37 OF PAPER FORMAT ANNUAL REPORT of $21.5 million. U.S. Bioscience will spend a portion of the proceeds on programs supporting the Ethyol-Registered Trademark- product. Also subsequent to year end, ALZA announced that it had entered into an agreement under which Alkermes, Inc. ("Alkermes") will sell 2.0 million of its common shares (9.7% of the outstanding common shares of Alkermes) to ALZA at a purchase price of $25 per share, for an aggregate investment of $50 million. Separately, ALZA and Alkermes agreed to collaborate on a program for the development and commercialization of a product utilizing Alkermes' drug delivery technology. ALZA will fund the development costs of the program and will have worldwide commercialization rights to the product. Alkermes will receive royalties based on product sales and it is anticipated that Alkermes will manufacture the product. -37- PAGE 37 OF PAPER FORMAT ANNUAL REPORT REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS THE BOARD OF DIRECTORS AND STOCKHOLDERS ALZA CORPORATION We have audited the accompanying consolidated balance sheet of ALZA Corporation as of December 31, 1996 and 1995, and the related consolidated statements of income, stockholders' equity and cash flows for each of the three years in the period ended December 31, 1996. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the consolidated financial position of ALZA Corporation at December 31, 1996 and 1995, and the consolidated results of its operations and its cash flows for each of the three years in the period ended December 31, 1996, in conformity with generally accepted accounting principles. Ernst & Young LLP Palo Alto, California February 14, 1997 -38- PAGE 38 OF PAPER FORMAT ANNUAL REPORT ALZA COMMON STOCK ALZA common stock is listed for trading (symbol AZA) on the New York Stock Exchange and ALZA warrants are listed for trading (symbol ALZAW) on the Nasdaq Stock Market ("Nasdaq"). Both securities are reported in the WALL STREET JOURNAL and other newspapers. As of December 31, 1996, there were 9,022 holders of record of ALZA common stock and 5,968 holders of record of ALZA warrants. ALZA has never paid cash dividends on its common stock and has no plan to do so in the foreseeable future. The quarterly high and low sales prices of ALZA common stock for the calendar years 1996 and 1995, as reported on the composite tape, and ALZA warrants from the date of initial trading (June 11, 1996) as quoted on Nasdaq, are shown below:
ALZA COMMON STOCK ALZA WARRANTS ------------------------------------------------- ------------------ 1996 1995 1996 ------------------------ ---------------------- ------------------ High Low High Low High Low First quarter $34 7/8 $24 3/8 $24 1/8 $18 1/8 $ - $ - Second quarter 32 1/2 26 3/8 24 5/8 18 3/8 3/16 1/8 Third quarter 27 3/4 24 27 22 1/8 3/16 1/16 Fourth quarter 29 25 1/8 25 1/8 20 1/4 1/8 1/16
-39- PAGE 38 OF PAPER FORMAT ANNUAL REPORT SELECTED CONSOLIDATED QUARTERLY FINANCIAL DATA (UNAUDITED) (In millions, except per share amounts)
1996 1995 ------------------------------------- ----------------------------------- Fourth Third Second First Forth Third Second First - --------------------------------------------------------------------------------------------------------------- Total revenues $126.2 $114.9 $128.1 $96.8 $101.8 $85.6 $83.0 $80.2 Operating income 36.2 33.2 36.7 31.2 31.5 30.0 27.6 27.3 Net income 25.7 23.1 23.2 20.4 19.7 18.2 17.5 17.0 Net income per share 0.30 0.27 0.27 0.24 0.24 0.22 0.21 0.21 - ---------------------------------------------------------------------------------------------------------------
-40- PAGE 39 OF PAPER FORMAT ANNUAL REPORT SELECTED CONSOLIDATED FINANCIAL DATA (In millions, except per share amounts)
1996 1995 1994 1993 1992 1991 1990 1989 1988 1987 - ------------------------------------------------------------------------------------------------------------------------ Total revenues $466.0 $350.6 $278.8 $234.2 $250.5 $162.3 $109.4 $92.7 $84.2 $70.8 Net income (loss) 92.4 72.4 58.1 45.6(1) 72.2 (62.1)(2) 24.7 18.8 17.0 14.0 Net income (loss) per share 1.08(3) 0.88 0.71 0.57 0.90 (0.88) 0.35 0.27 0.25 0.21 Cash, cash equivalents, short-term and long-term investments 999.8 419.1 344.9 257.5(4) 338.5 296.6 302.4 109.0 121.1 142.8 Total assets 1,613.7 937.2 806.3 621.8(4) 698.4 580.5 530.9 288.4 261.6 243.5 Convertible debentures 882.3 362.9 344.6 -(5) 229.0 213.2 273.2 75.0 75.0 75.0 Total stockholders' equity 596.7 454.6 364.5 306.7(4) 407.5 322.9 219.6 186.6 159.8 139.0 - ------------------------------------------------------------------------------------------------------------------------
(1) Includes pre-tax charges and allowances of $28.1 million ($0.23 per share on an after-tax basis) related primarily to manufacturing activities. Also includes $6.6 million ($0.08 per share) in one-time benefits resulting from the adoption of Statement of Financial Accounting Standards No. 109, "Accounting for Income Taxes", and a $3.8 million ($0.05 per share) extraordinary charge relating to the redemption of ALZA's 7 1/2% zero coupon convertible subordinated debentures. (2) Includes the effects of a one-time charge of $101.3 million ($1.38 per share) related to the purchase of in-process technology. (3) Net income per share calculation uses adjusted net income of $101.6 million. (4) Includes the effect of the $250 million contribution to Therapeutic Discovery Corporation and the related special dividend to ALZA stockholders. (5) Approximately $249.5 million of commercial paper (including accrued interest) was outstanding. -41- EX-21 4 EXHIBIT 21 Exhibit 21 SUBSIDIARIES ALZA Development Corporation (incorporated in California) ALZA International, Inc. (incorporated in Delaware) ALZA Limited (incorporated in the United Kingdom) -35- EX-23 5 EXHIBIT 23 Exhibit 23 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in this Annual Report (Form 10-K) of ALZA Corporation of our report dated February 14, 1997, included in the 1996 Annual Report to Stockholders of ALZA Corporation. Our audits also included the consolidated financial statement schedule of ALZA Corporation listed in Item 14(a). This schedule is the responsibility of ALZA's management. Our responsibility is to express an opinion based on our audits. In our opinion, the consolidated financial statement schedule referred to above, when considered in relation to the basic financial statements taken as a whole, presents fairly in all material respects the information set forth therein. We also consent to the incorporation by reference in the Registration Statements (Forms S-3 No. 33-53671 and No. 333-02765 and Forms S-8 No. 2-92629, No. 2-97422, No. 33-21810, No. 33-36141, No. 33-49824, No. 33-51890, and No. 333-21877) and in the related Prospectuses, of our report dated February 14, 1997 with respect to the consolidated financial statements incorporated herein by reference, and our report included in the preceding paragraph with respect to the consolidated financial statement schedule included in this Annual Report (Form 10-K) of ALZA Corporation. Ernst & Young LLP Palo Alto, California March 28, 1997 -36- EX-27 6 EXHIBIT 27
5 THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE FINANCIAL STATEMENTS INCLUDED IN PART II, ITEM 8 OF FORM 10-K DATED DECEMBER 31, 1996 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS. 1,000,000 12-MOS DEC-31-1996 DEC-31-1996 188 812 117 0 39 1,175 408 100 1,614 67 882 0 0 1 596 1,614 109 466 85 227 0 0 43 149 57 92 0 0 0 92 1.08 1.08
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