10-Q 1 0001.txt FORM 10-Q 2ND QUARTER UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] Quarterly Report Pursuant to Section 13 or 15(d) of the Securities and Exchange Act of 1934 For the quarterly period ended June 30, 2000 or [ ] Transition Report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934 For the transition period from ________ to __________ Commission File Number: 0-016607 ADVANCED TISSUE SCIENCES, INC. (Exact name of registrant as specified in charter) Delaware 14-1701513 ------------------------------- ------------------- (State or other jurisdiction of (I.R.S. Employer incorporation or organization Identification No.) 10933 North Torrey Pines Road, La Jolla, California 92037 --------------------------------------------------- ---------- (Address of principal executive offices) (Zip Code) Registrant's telephone number, including area code: (858) 713-7300 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 --- --- The number of shares of the Registrant's Common Stock, par value $.01 per share, outstanding at August 1, 2000 was 59,867,752. ADVANCED TISSUE SCIENCES, INC. FORM 10-Q FOR THE QUARTER ENDED JUNE 30, 2000 INDEX Part I - Financial Information Page Item 1 - Financial Statements Introduction to the Financial Statements................... 1 Consolidated Balance Sheets - June 30, 2000 and December 31, 1999...................... 2 Consolidated Statements of Operations - Three and Six Months Ended June 30, 2000 and 1999........ 3 Consolidated Statements of Cash Flows - Six Months Ended June 30, 2000 and 1999.................. 4 Consolidated Statement of Stockholders' Equity - Six Months Ended June 30, 2000........................... 5 Notes to the Consolidated Financial Statements............. 6-10 Item 2 - Management's Discussion and Analysis of Financial Condition and Results of Operations........................ 11-15 Item 3 - Quantitative and Qualitative Disclosures About Market Risk... 15 Part II - Other Information Item 4 - Submission of Matters to a Vote of Security Holders.......... 16 Item 5 - Other Information............................................ 16-22 Item 6 - Exhibits and Reports on Form 8-K............................. 23 Signatures.............................................................. 24 PART I - FINANCIAL INFORMATION ------------------------------ ITEM 1 - Financial Statements INTRODUCTION TO THE FINANCIAL STATEMENTS The financial statements have been prepared by Advanced Tissue Sciences, Inc. (the "Company"), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. The Company believes that the disclosures are adequate to make the information presented not misleading when read in conjunction with the financial statements and the notes thereto included in the Company's Annual Report on Form 10-K for the year ended December 31, 1999 and the Quarterly Report on Form 10-Q for the three months ended March 31, 2000. The financial information presented in this Quarterly Report on Form 10-Q reflects all adjustments, consisting only of normal recurring adjustments, which are, in the opinion of management, necessary for a fair statement of the results for the interim periods presented. The results for the interim periods are not necessarily indicative of results to be expected for the full year. -1- ADVANCED TISSUE SCIENCES, INC. CONSOLIDATED BALANCE SHEETS (Dollars in Thousands, Except Per Share Amounts) June 30, December 31, 2000 1999 ----------- ------------ (Unaudited) ASSETS Current assets: Cash and cash equivalents $ 17,878 $ 16,091 Short-term investments 4,992 9,988 Receivable from joint ventures 6,698 2,185 Inventory 183 4,295 Other current assets 1,412 1,664 ---------- ---------- Total current assets 31,163 34,223 Property - net 15,288 16,627 Patent costs - net 2,175 2,075 Restricted cash -- 5,000 Other assets 878 1,461 ---------- ---------- Total assets $ 49,504 $ 59,386 ========== ========== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Accounts payable $ 551 $ 755 Payable to joint ventures 427 3,550 Accrued expenses 5,306 5,560 Deferred revenue 1,797 3,595 Current portion of long-term debt and capital lease obligations 12,115 10,112 ---------- ---------- Total current liabilities 20,196 23,572 Long-term debt and capital lease obligations 7,692 8,987 Other long-term liabilities 339 364 ---------- ---------- Total liabilities 28,227 32,923 ---------- ---------- Redeemable Convertible Series B Preferred Stock, $.01 par value; 1,000 shares authorized; issued and outstanding, no shares at June 30, 2000 and 100.8 shares at December 31, 1999 (aggregate redemption and liquidation value of $5,104 at December 31, 1999) -- 5,040 ---------- ---------- Stockholders' equity: Accrued cumulative preferred stock dividends -- 64 Common Stock, $.01 par value; 125,000,000 shares authorized; issued and outstanding, 59,849,162 shares at June 30, 2000 and 56,600,544 shares at December 31, 1999 598 566 Additional paid-in capital 277,929 262,588 Note received in connection with sale of Common Stock and deferred compensation applicable to Common Stock (1,758) (2,033) Accumulated deficit (255,489) (239,762) Accumulated other comprehensive income (3) -- ---------- ---------- Total stockholders' equity 21,277 21,423 ---------- ---------- Total liabilities and stockholders' equity $ 49,504 $ 59,386 ========== ========== See accompanying notes to the consolidated financial statements. -2- ADVANCED TISSUE SCIENCES, INC. CONSOLIDATED STATEMENTS OF OPERATIONS) (In Thousands, Except Per Share Amounts)
Three Months Ended June 30, Six Months Ended June 30, --------------------------- -------------------------- 2000 1999 2000 1999 ---------- ----------- ---------- ---------- (Unaudited) Revenues: Product sales - Related parties $ 2,996 $ 3,617 $ 6,618 $ 6,688 Contracts and fees - Related parties 2,134 7,324 4,888 14,961 Others 1,133 181 2,167 343 --------- --------- --------- --------- Total revenues 6,263 11,122 13,673 21,992 --------- --------- --------- --------- Costs and expenses: Research and development 3,699 3,958 7,600 8,127 Cost of goods sold 2,996 3,617 6,618 6,688 Selling, general and administrative 2,860 2,791 5,484 6,171 Compensation related to variable stock option 704 -- 2,695 -- --------- --------- --------- --------- Total costs and expenses 10,259 10,366 22,397 20,986 --------- --------- --------- --------- Income (loss) from operations before equity in losses of joint ventures (3,996) 756 (8,724) 1,006 Equity in losses of joint ventures (3,542) (4,998) (7,255) (10,455) --------- --------- --------- --------- Loss from operations (7,538) (4,242) (15,979) (9,449) Other income (expense): Interest income and other 574 (151) 1,176 304 Interest expense (464) (533) (924) (1,087) --------- --------- --------- --------- Net loss (7,428) (4,926) (15,727) (10,232) Dividends on preferred stock -- (176) (48) (431) --------- --------- --------- --------- Net loss applicable to common stock $ (7,428) $ (5,102) $ (15,775) $ (10,663) ========= ========= ========= ========= Basic and diluted loss per common share $ (0.12) $ (0.11) $ (0.27) $ (0.25) ========= ========= ========= ========= Weighted average number of common shares used in computation of basic and diluted loss per share 59,845 45,522 59,014 43,252 ========= ========= ========= =========
See accompanying notes to the consolidated financial statements. -3- ADVANCED TISSUE SCIENCES, INC. CONSOLIDATED STATEMENTS OF CASH FLOWS (In Thousands)
Six Months Ended June 30, ----------------------------------- 2000 1999 -------------- -------------- (Unaudited) Operating activities: Net loss $ (15,727) $ (10,232) Adjustments to reconcile net loss to cash used in operating activities: Depreciation and amortization 1,969 2,390 Compensation for services paid in stock, options or warrants 2,973 79 Equity in losses of joint ventures 7,255 10,455 Other adjustments to net loss (13) 516 Deferred revenue (1,798) 6,633 Change in assets and liabilities: Receivables from joint ventures (4,513) 466 Inventory 4,112 (1,285) Other current assets 262 (571) Accounts payable (204) 1,316 Payable to joint ventures (3,123) 569 Accrued expenses (242) (266) -------------- -------------- Net cash (used in) provided by operating activities (9,049) 10,070 -------------- -------------- Investing activities: Purchases of short-term investments (3,000) (6,000) Maturities and sales of short-term investments 7,999 6,003 Acquisition of property (588) (570) Investment in joint ventures (8,411) (13,770) Distribution from joint ventures 1,364 3,325 Patent application costs (177) (210) Other long-term assets 391 28 -------------- -------------- Net cash used in investing activities (2,422) (11,194) -------------- -------------- Financing activities: Proceeds from borrowings 2,000 840 Payments of borrowings (1,292) (1,397) Restricted cash 5,000 -- Net proceeds from sale of Common Stock -- 1,003 Repurchase of Common Stock -- (457) Options and warrants exercised 7,598 5 Long-term obligations and other (48) 45 -------------- -------------- Net cash provided by financing activities 13,258 39 -------------- -------------- Net increase/(decrease) in cash and cash equivalents 1,787 (1,085) Cash and cash equivalents at beginning of period 16,091 16,551 -------------- -------------- Cash and cash equivalents at end of period $ 17,878 $ 15,466 ============== ==============
See accompanying notes to the consolidated financial statements. -4- ADVANCED TISSUE SCIENCES, INC. CONSOLIDATED STATEMENT OF STOCKHOLDERS' EQUITY (Dollars In Thousands) (Unaudited)
Accrued Dividends/ Note Common Stock Additional Receivable/ -------------------------- Paid-In Deferred Shares Amount Capital Compensation ---------- ---------- ------------ ------------ Balance, December 31, 1999 56,600,544 $ 566 $ 262,588 $ (1,969) Warrants exercised 1,750,000 17 6,983 Conversion of Preferred Stock 1,354,539 14 5,026 Compensation related to variable stock option 2,695 Options exercised 106,153 1 597 Amortization of compensation on restricted stock award 265 Preferred Stock dividends 37,926 -- 63 (63) Net loss Comprehensive income (loss) - unrealized loss on securities Other (23) 9 ---------- --------- ----------- ---------- Balance, June 30, 2000 59,849,162 $ 598 $ 277,929 $ (1,758) ========== ========= =========== ==========
Accumulated Total Other Stock- Accumulated Comprehensive holders' Deficit Income (Loss) Equity ----------- ------------- ---------- Balance, December 31, 1999 $ (239,762) $ 21,423 Warrants exercised 7,000 Conversion of Preferred Stock 5,040 Compensation related to variable stock option 2,695 Options exercised 598 Amortization of compensation on restricted stock award 265 Preferred Stock dividends -- Net loss (15,727) (15,727) Comprehensive income (loss) - unrealized loss on securities $ (3) (3) Other (14) ----------- ----------- ---------- Balance, June 30, 2000 $ (255,489) $ (3) $ 21,277 =========== =========== ==========
See accompanying notes to the consolidated financial statements. -5- ADVANCED TISSUE SCIENCES, INC. NOTES TO THE CONSOLIDATED FINANCIAL STATEMENTS (Unaudited) NOTE 1 - BASIS OF PRESENTATION Organization - Advanced Tissue Sciences, Inc. (the "Company") is a leading tissue engineering company utilizing its proprietary technology to develop and manufacture human-based tissue products for tissue repair and transplantation. The Company is focusing on the worldwide commercialization of tissue engineered products for wound care, orthopedics, aesthetic, reconstructive and cardiovascular applications. The Company's leading therapeutic products are tissue engineered skin products for the temporary covering of severe and partial-thickness burns, which is on the market in the United States, and for the treatment of diabetic foot ulcers, which is in clinical trials in the United States and on the market in the United Kingdom and several other European countries, Canada, Australia and New Zealand. Both products are being commercialized through a joint venture with Smith & Nephew plc ("Smith & Nephew"). The Company also has a strategic alliance with Inamed Corporation ("Inamed") for the development of tissue-engineered products for the aesthetic and reconstructive markets. Principles of Consolidation - The consolidated financial statements include the accounts of the Company, its wholly owned subsidiaries and DermEquip, L.L.C. ("DermEquip"), a limited liability company owned jointly with Smith & Nephew. DermEquip is a special purpose entity established to finance an expansion of the Company's manufacturing facility. All intercompany accounts and transactions have been eliminated. The Company's other interests in joint ventures with Smith & Nephew are accounted for under the equity method (see Notes 2 and 9). Use of Estimates - The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and related disclosures at the date of the financial statements, and the amounts of revenues and expenses reported during the period. Actual results could differ from those estimates. Dependence on Certain Suppliers - Certain materials, such as the mesh frameworks used by the Company in its therapeutic products, are sourced from single manufacturers. Any significant supply interruption would adversely affect the Company's product manufacturing. In addition, an uncorrected impurity or supplier's variation in a raw material, either unknown to the Company or incompatible with the Company's manufacturing process, could have a material adverse effect on the Company's ability to manufacture its products. Reclassification - Certain reclassifications have been made to prior year amounts to conform to the presentation for the three months and six months ended June 30, 2000. NOTE 2 - STRATEGIC ALLIANCES Smith & Nephew Joint Ventures ----------------------------- In 1996, the Company entered into an agreement with Smith & Nephew to form a joint venture for the worldwide commercialization of Dermagraft(R), the Company's tissue engineered dermal skin replacement, for the treatment of diabetic foot ulcers (the "Dermagraft Joint Venture"). In 1998, the Company and Smith & Nephew expanded the Dermagraft Joint Venture to include products to treat venous ulcers, pressure ulcers, burns and other skin tissue wounds. Smith & Nephew is a global medical device company with established sales in 90 countries. Smith & Nephew markets technically innovative products principally in the areas of wound management, orthopedics and endoscopy. As consideration for entering into the Dermagraft Joint Venture, Advanced Tissue Sciences received a $10 million up front fee in 1996. In addition, as a part of the agreement to expand the joint venture, Smith & Nephew purchased $20 million, or 1,533,115 newly-issued shares, of the Company's Common Stock at approximately $13.05 per share in 1998. The Company also received an additional $15 million as consideration for the expansion of the joint venture in January 1999, and could receive, subject to the achievement of certain milestones related to regulatory approvals, reimbursement and sales levels, further payments of up to $136 million. The $15 million payment was recognized into contract revenues in 1999 as related financial commitments were met. -6- In February 2000, the Company and Smith & Nephew agreed in principle to restructure certain payments associated with their Dermagraft Joint Venture as a result of delays in the commercial introduction of Dermagraft in the United States. The requirement for an additional clinical trial by the U.S. Food and Drug Administration substantially increased the partners' investments necessitating the restructuring. The objective of the restructuring is to defer the potential payment of certain milestones by Smith & Nephew while providing the Company a royalty stream and an opportunity to increase its long-term return from the venture. Specifically, except for $10 million in regulatory approval and reimbursement milestones related to Dermagraft in the treatment of diabetic foot ulcers, the Company agreed to make all other approval, reimbursement and sales milestones subject to, and payable from, joint venture earnings exceeding certain minimum levels. In return, the Dermagraft Joint Venture will pay the Company royalties on joint venture product sales. In addition, as a part of the agreement, the Company sold the Dermagraft manufacturing assets that it owned to DermEquip (see Note 1), and sold its raw material inventories to the Dermagraft Joint Venture. Under the joint venture, the Company and Smith & Nephew are sharing equally in the expenses and revenues of the Dermagraft Joint Venture, except the Company will fund the first $6 million of expenses for conducting clinical trials and for regulatory support of Dermagraft and TransCyte in the treatment of venous and pressure ulcers. In addition, the Company funded certain manufacturing and distribution costs and certain costs related to post-market studies of TransCyte through December 1999. However, such manufacturing and distribution costs are to be returned to the Company out of future gross margin or net profits, if any, from sales of TransCyte for burns in the United States. See Note 9 with respect to related party transactions with the Dermagraft Joint Venture. The Company and Smith & Nephew also agreed that certain of the proceeds from the sale of the Company's manufacturing plant assets and raw material inventory discussed above will be used to pay down a portion of the outstanding balance of the loan from Smith & Nephew related to the NeoCyte Joint Venture. The remaining outstanding principal and interest due at the June 30, 2000 maturity is to be paid in the Company's Common Stock at the then current market price for the Common Stock. The June 30, 2000 maturity date has been extended to August 30, 2000 (see Note 4). In 1994, Smith & Nephew and the Company entered into a separate joint venture for the development of tissue-engineered cartilage for orthopedic applications (the "NeoCyte Joint Venture"). Under the NeoCyte Joint Venture, Smith & Nephew contributed the first $10 million in funding and the Company contributed certain technology licenses. The NeoCyte Joint Venture's total funding since inception reached $10 million in January 1997 and, as provided in the joint venture agreement, the Company and Smith & Nephew are sharing equally in NeoCyte Joint Venture revenues and expenditures. See Note 9 with respect to related party transactions with the NeoCyte Joint Venture. The results of operations of the joint ventures for the three and six months ended June 30, 2000 and 1999 are as follows (in thousands):
Three Months Ended June 30, Six Months Ended June 30, ----------------------------- --------------------------- 2000 1999 2000 1999 ------------ ------------ ---------- ----------- Dermagraft Joint Venture ------------------------ Net sales $ 996 $ 561 $ 1,728 $ 1,028 Cost of goods sold 3,431 3,095 6,355 7,569 Other costs and expenses 3,228 4,644 6,777 9,424 Net loss (5,663) (7,178) (11,404) (15,965) NeoCyte Joint Venture --------------------- Costs and expenses $ 1,238 $ 1,310 $ 2,681 $ 2,475 Net loss (1,238) (1,310) (2,681) (2,475)
Inamed Agreements ----------------- In May 1999, the Company and Inamed entered into a strategic alliance for the development and marketing of several of the Company's human-based, tissue- engineered products for certain aesthetic and reconstructive applications. Specifically, Inamed licensed rights to further develop, manufacture and sell tissue engineered products for use in cosmetic surgery as a temporary covering after laser resurfacing or chemical peels, cartilage for -7- plastic and reconstructive surgery, and extracellular matrix for use in breast reconstruction. In addition, in September 1999, Inamed also received license rights to use extracellular matrix, including human collagen, from the Company's three-dimensional culture system for soft tissue augmentation (wrinkles and cosmetic correction) and as a bulking agent for the treatment of urinary incontinence. Inamed is a global surgical and medical device company engaged in the development, manufacturing and marketing of medical products for aesthetic medicine, plastic and reconstructive surgery and the treatment of obesity. In total, under the agreements between the parties, in exchange for worldwide licensing rights, Inamed has made a series of payments to the Company totaling $10 million, including $5 million to purchase Advanced Tissue Sciences' Common Stock. Inamed also received five-year warrants to purchase up to 500,000 shares of Common Stock. In addition to royalties on product sales, the Company may potentially receive up to a total of $10 million in milestones based on product approvals in the United States. The Company will be responsible for the funding and development of the products and the related manufacturing processes while Inamed will be responsible for clinical and regulatory activities. Advanced Tissue Sciences, or an affiliate, may elect to manufacture the products developed under the agreement. Fees for licensing rights and milestone payments will be recognized into revenues as the related financial commitments for product development and manufacturing processes are incurred. NOTE 3 - INVENTORIES Inventories consist of the following components as of June 30, 2000 and December 31, 1999 (in thousands): June 30, December 31, 2000 1999 ---------- ------------ Raw materials and supplies $ 183 $ 3,618 Work-in-process -- 677 -------- --------- $ 183 $ 4,295 ======== ========= As part of the restructuring of certain payments of the Dermagraft Joint Venture by the Company and Smith & Nephew (see Note 2), the Company sold its raw material inventories to the Dermagraft Joint Venture earlier in the year. NOTE 4 - LONG-TERM DEBT During the six-months ended June 30, 2000, the Company borrowed $2 million from Smith & Nephew pursuant to a commitment under the agreement forming the NeoCyte Joint Venture. Under the terms of that joint venture agreement, the Company may borrow up to a total of $10 million of which $9.5 million had been drawn as of June 30, 2000. In February 2000, the Company and Smith & Nephew agreed that the proceeds from the sale of the Company's manufacturing plant assets and raw material inventory would be used to pay a portion of this note, with the remaining outstanding principal and interest due at the June 30, 2000 maturity paid in the Company's Common Stock at the then current market price for the Common Stock. The June 30, 2000 maturity date has been extended to August 30, 2000 (see Note 2). Debt and capital lease obligations as of June 30, 2000 and December 31, 1999 were as follows (in thousands): June 30, December 31, 2000 1999 --------- ------------ Chase loan $ 10,240 $ 11,520 Smith & Nephew note - NeoCyte Joint Venture 9,525 7,525 Obligations under capital leases and other 42 54 Less current portion (12,115) (10,112) --------- --------- $ 7,692 $ 8,987 ========= ========= -8- NOTE 5 - CAPITAL STOCK In March 2000, 100.8 shares, representing all of the Company's Convertible Series B Preferred Stock (the "Series B Preferred Stock") as of December 31, 1999, were converted into 1,354,539 shares of the Common Stock at $3.72 per share. All of the Company's Convertible Series B Preferred Stock has been converted and no preferred stock remains outstanding as of June 30, 2000. Further, in conjunction with a public offering in November 1999, the Company had agreed that $5 million of the proceeds would be reserved for the redemption of any of its Series B Preferred Stock submitted for conversion at or below $3.58 per share. As a result of the March conversion, the $5 million became available to support the Company's operations and was reclassed from restricted cash to cash and cash equivalents. In November 1999, the Company completed a public offering of 3,750,000 units at $4.00 per unit, resulting in proceeds to the Company of $15 million. Upon issuance, the units separated into 3,750,000 shares of the Company's Common Stock and warrants to purchase an additional 1,750,000 shares of Common Stock at $4.00 per share. In January 2000, the Company received an additional $7.0 million from the exercise of warrants to purchase all 1,750,000 shares of Common Stock. NOTE 6 - BASIC AND DILUTED LOSS PER SHARE Basic earnings per common share are determined based on the weighted average number of shares outstanding during the period. Diluted earnings per common share include the weighted average number of shares outstanding and give effect to potentially dilutive common shares such as options and warrants outstanding. Both the basic and diluted loss per common share for the three and six months ended June 30, 2000 and 1999 are based on the weighted average number of shares of common stock outstanding during the periods. Potentially dilutive securities include options and warrants outstanding and debt and preferred stock convertible into Common Stock; however, such securities have not been included in the calculation of the diluted loss per share as their effect is antidilutive. Since such securities are antidilutive, there is no difference between basic and diluted loss per common share for the periods presented. The net loss applicable to common shares used in the calculation of basic and diluted loss per common share for the three months ended June 30, 1999 includes dividends of $176,000, and for the six months ended June 30, 2000 and 1999 includes dividends of $48,000 and $431,000, respectively, accrued or paid on the Company's Convertible Series B Preferred Stock during such periods. NOTE 7 - STOCK PLAN The following table summarizes activity under the Company's 1997 Stock Incentive Plan (the "1997 Plan") and for other options and warrants for common stock for the six months ended June 30, 2000
1997 Plan Other Options and Warrants --------------------------- ---------------------------- Weighted Weighted Number Average Price Number Average Price of Shares Per Share of Shares Per Share --------- -------------- ----------- -------------- Outstanding, December 31, 1999 4,044,640 $8.64 3,759,640 $6.55 Granted 829,500 $7.34 -- -- Exercised (61,153) $3.54 (1,795,000) $4.11 Canceled (184,473) $6.63 -- -- --------- ---------- Outstanding, June 30, 2000 4,628,514 $8.56 1,964,640 $8.78 ========= ==========
Stock options exercised by the Company's Chairman and Chief Executive Officer in 1995 through the issuance of a note are being accounted for as variable stock options which can result in significant increases and decreases in compensation expense subject to the variability of the Company's stock price. During the three and six months ended June 30, 2000, the Company charged $704,000 and $2,695,000, respectively, to expense for such variable stock options. -9- NOTE 8 - SUPPLEMENTAL CASH FLOW INFORMATION During the six months ended June 30, 2000, non-cash financing activities have included the conversion of $5 million of the Company's Series B Preferred Stock into 1,354,539 shares of Common Stock (see Note 5). During the six-month period ended June 30, 1999, non-cash financing transactions included (i) the repayment of a $10 million loan and accrued interest payable through the issuance of 2,800,595 shares of the Company's Common Stock and (ii) the exercise of stock options for 775,000 shares of Common Stock wherein the purchase price and withholding taxes of approximately $1.8 million were paid by the delivery of 463,154 shares of Common Stock. In addition, compensation expense of $2,973,000 and $79,000, has been recognized related to compensatory and variable stock options and a restricted stock award in the six-month periods ended June 30, 2000 and 1999, respectively. Net cash from operating activities reflects cash payments for interest expense of approximately $596,000 and $318,000 for the three-month periods and $786,000 and $799,000 for the six-month periods ended June 30, 2000 and 1999, respectively. NOTE 9 - RELATED PARTY TRANSACTIONS During the three and six months ended June 30, 2000 and 1999, the Company performed services for its Dermagraft and NeoCyte Joint Ventures and has manufactured products for the Dermagraft Joint Venture to sell to customers or for use in clinical trials as described below (see Note 2). The Company has a fifty percent interest in each of the Dermagraft and NeoCyte Joint Ventures. Dermagraft Joint Venture ------------------------ During the three and six-month periods ended June 30, 2000 and 1999, the Company recognized $1,282,000 and $6,650,000 in the three-month periods and $3,074,000 and $13,664,000 in the six-month periods, respectively, in royalties and contract revenues for research and development, marketing and other activities performed for the Dermagraft Joint Venture. These amounts also include $4,417,000 and $9,367,000 for the three and six-month periods ended June 30, 1999, respectively, related to the recognition of a $15 million milestone payment (see Note 2). In addition, product sales to related parties include products sold to the Dermagraft Joint Venture of $2,996,000 and $3,617,000 in the three-month periods and $6,618,000 and $6,688,000 in the six-month periods ended June 30, 2000 and 1999, respectively. As a purpose of the Dermagraft Joint Venture is to share the costs of manufacturing and commercializing the Company's Dermagraft and TransCyte products between the joint venture's partners, product sales to the Dermagraft Joint Venture are equal to the Company's cost of goods sold for such products including period costs. Period costs reflect overhead costs related to excess production capacity and include rent, depreciation and quality control, facilities, supplies and other such costs to support or related to the excess production capacity. Due to the excess production capacity, the Dermagraft Joint Venture immediately writes the inventory down to estimated market value at the date of purchase, which is the net realizable value at which the joint venture believes it will be able to sell the products to its customers. For the three-month periods ended June 30, 2000 and 1999 such write downs totaled $3,005,000 and $3,342,000, respectively, and were $5,133,000 and $5,747,000 for the six-month periods ended June 30, 2000 and 1999, respectively. As a result of restructuring the Dermagraft Joint Venture Agreement with Smith & Nephew in February 2000, the Company also receives certain royalty payments from the joint venture on product sales made by the joint venture (see Note 2). For the three and six months ended June 30, 2000, these royalty payments were not material. NeoCyte Joint Venture --------------------- During the three and six months ended June 30, 2000, the Company recognized $852,000 and $1,814,000, respectively, in contract revenues for research and development activities performed for the NeoCyte Joint Venture compared with $674,000 and $1,297,000 during the corresponding periods of 1999. The Company's share of the above costs incurred by the Company and charged to the Dermagraft and NeoCyte Joint Ventures are reflected in the equity in losses of joint ventures in the accompanying statement of operations and totaled $2,825,000 and $3,943,000 in the three months ended June 30, 2000 and 1999, respectively, and $5,709,000 and $7,848,000 for the six months ended June 30, 2000 and 1999, respectively. -10- ITEM 2 - MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q may contain predictions, estimates and other forward-looking statements that involve a number of risks and uncertainties, including those discussed under Item 5 below. This outlook represents our current judgment on the future direction of our business. Such risks and uncertainties could cause actual results to differ materially from any future performance suggested below. We undertake no obligation to release publicly the results of any revisions to these forward-looking statements to reflect events or circumstances arising after the date of this Quarterly Report. Advanced Tissue Sciences, Inc. (the "Company" or "Advanced Tissue Sciences") is engaged in the development and manufacture of human-based tissue products for tissue repair and transplantation using its proprietary tissue engineering technology. The Company's leading therapeutic products are tissue engineered skin products, TransCyte(TM) for the temporary covering of severe and partial-thickness burns and Dermagraft(R) for the treatment of severe skin ulcers. In addition to its TransCyte and Dermagraft skin products, the Company is focusing its resources on the development of tissue-engineered products for other wound care, orthopedic, aesthetic, reconstructive and cardiovascular applications. In 1997, the Company received marketing approval in the United States from the U.S. Food and Drug Administration (the "FDA") for its first therapeutic product, TransCyte, as a temporary covering for severe, full-thickness, or third degree, burns and for partial-thickness, or second degree, burns. Through September 1998, TransCyte was marketed for burns by Advanced Tissue Sciences through a direct sales force in the United States. Since October 1998, TransCyte has been or will be marketed in the United States and throughout the rest of the world consistent with regulatory approvals for burn and wound care applications under a joint venture with Smith & Nephew plc ("Smith & Nephew"). Dermagraft for the treatment of diabetic foot ulcers was approved for sale in Canada and was introduced in the United Kingdom and several other European countries in 1997 through the joint venture with Smith & Nephew. The Company also submitted a Premarket Approval (PMA) application to the FDA for approval to market Dermagraft for the treatment of diabetic foot ulcers in the United States. In January 1998, an FDA advisory panel recommended approval of Dermagraft with the condition that the Company perform a post-marketing study to confirm efficacy and provide physician training. However, the FDA decided the PMA application was not approvable without supportive data from an additional controlled clinical trial. The additional clinical trial began in late 1998 and the results of a planned interim analysis of data from this trial were announced in December 1999. These data showed that, although statistical significance was not achieved at the interim analysis, Dermagraft was healing more ulcers than the control treatment in those diabetic foot ulcers having a duration of greater than six weeks. In February 2000, the FDA approved an application for an amendment to the Investigational Device Exemption (IDE) for the ongoing clinical trial of Dermagraft in the treatment of diabetic foot ulcers. Based on the data from the interim analysis, the IDE was amended to revise the enrollment criteria and the statistical plan for data analysis. The amended IDE allowed for the modification of the study inclusion criteria to limit future enrollment to patients with ulcers of greater than six weeks duration. In addition, the amended statistical plan allows the Company to integrate the interim analysis data with additional data generated since that time from patients with ulcer duration of greater than six weeks. Enrollment in this additional clinical trial has been completed and the Company expects to submit its PMA applicatin for approval of Dermagraft for the treatment of diabetic foot ulcers to the FDA by the end of the summer. In October 1998, the FDA approved the Company's application for a Treatment Investigational Device Exemption (the "Treatment IDE") for Dermagraft, allowing the Company to make Dermagraft for the treatment of diabetic foot ulcers available to selected centers in the United States under an approved clinical protocol. The Treatment IDE is a regulatory provision that (1) permits companies to make available promising new products to patients with serious diseases for which there is no satisfactory alternative, and (2) allows companies to recover the costs of manufacturing and distributing the product. The Treatment IDE is being conducted concurrently with the ongoing clinical trial of Dermagraft in the treatment of diabetic foot ulcers in the United States. -11- In May 1999, the Company and Inamed Corporation ("Inamed") entered into a strategic alliance for the development and marketing of several of the Company's human-based, tissue-engineered products for aesthetic and certain reconstructive applications. Specifically, Inamed licensed rights to further develop, manufacture and sell certain of the Company's tissue-engineered products for use in cosmetic surgery, cartilage for plastic and reconstructive surgery, and extracellular matrix for use in breast reconstruction, and extracellular matrix, including human collagen, for soft tissue augmentation (wrinkle and cosmetic corrections) and as a bulking agent for the treatment of urinary incontinence. As part of this alliance, the Company received certain payments in 1999 and will be entitled to royalties on the future sales of the Company's tissue-engineered products by Inamed. Under the related agreements, Advanced Tissue Sciences will be responsible for the development of the products and the related manufacturing processes while Inamed will be responsible for clinical and regulatory activities. Advanced Tissue Sciences, or an affiliate, has the right to manufacture the products developed for Inamed. See Note 2 to the consolidated financial statements. In 1996, the Company entered into an agreement with Smith & Nephew to form a joint venture (the "Dermagraft Joint Venture") for the worldwide commercialization of Dermagraft in the treatment of diabetic foot ulcers. In 1998, Advanced Tissue Sciences and Smith & Nephew expanded the Dermagraft Joint Venture to include additional technology for the treatment of skin tissue wounds and applications such as venous ulcers, pressure ulcers, and TransCyte for full and partial-thickness burns. In connection with the expanded joint venture, the Company received a $15 million milestone payment in January 1999 which was recognized in contract revenues in 1999 as related financial commitments were met. In February 2000, the Company and Smith & Nephew agreed in principle to restructure certain milestone payments associated with the Dermagraft Joint Venture as a result of delays in the commercial introduction of Dermagraft in the United States. The requirement for an additional clinical trial by the FDA substantially increased the partners' investments necessitating the restructuring. The objective of the restructuring is to defer the potential payment of certain milestones by Smith & Nephew while providing the Company a royalty stream and an opportunity for an increase in its long-term return from the venture. Specifically, except for $10 million in regulatory approval and reimbursement milestones related to Dermagraft in the treatment of diabetic foot ulcers, the Company agreed to make all other approval, reimbursement and sales milestones subject to, and payable from, joint venture earnings exceeding certain minimum levels. In return, the Dermagraft Joint Venture will pay the Company royalties on joint venture product sales. In addition, as part of the agreement, the Company sold the Dermagraft manufacturing assets that it owned to a company jointly owned with Smith & Nephew, and also sold its raw material inventories to the Dermagraft Joint Venture. The proceeds of these sales will be used to pay down a portion of the outstanding balance of a loan from Smith & Nephew, with the remaining outstanding principal and interest due at the June 30, 2000 maturity to be paid in the Company's Common Stock at the then current market price. The June 30, 2000 maturity date has been extended to August 30, 2000. See Notes 2 and 4 to the consolidated financial statements. Under the joint venture, Advanced Tissue Sciences and Smith & Nephew are sharing equally in the expenses and revenues of the Dermagraft Joint Venture, except the Company is funding the first $6 million in expense for conducting clinical trials and regulatory support of Dermagraft and TransCyte in the treatment of venous ulcers and pressure ulcers. In addition, the Company funded certain manufacturing and distribution costs and certain costs related to post-market studies of TransCyte through December 1999. See Note 2 to the consolidated financial statements. In 1994, the Company and Smith & Nephew entered into a separate joint venture (the "NeoCyte Joint Venture") for the worldwide development, manufacture and marketing of human tissue-engineered cartilage for orthopedic applications. The joint venture partners are sharing equally in the NeoCyte Joint Venture's expenses. See Note 2 to the consolidated financial statements. In October 1997, the Company was awarded a $2 million Advanced Technology Program grant from the National Institute of Standards and Technology to fund collaborative cardiovascular research with the University of California, San Diego over a three-year period. Funding under the grant began in 1998 and continues into 2000. The Company has incurred, and expects to continue to incur, substantial expenditures in support of the commercialization, development and clinical trials of its TransCyte and Dermagraft products for burn and skin ulcer applications, for manufacturing systems and in advancing other applications of the Company's core technology. In particular, the Company will incur, either directly or through the Dermagraft Joint Venture, substantial costs for the -12- additional clinical trials of Dermagraft for skin ulcers and in support of clinical trials and post-market studies of TransCyte in the treatment of skin ulcers and for full and partial-thickness burns. The Company also expects to incur additional costs for the development of products and manufacturing processes under its strategic alliance with Inamed and, through the NeoCyte Joint Venture, for the development and clinical trials of tissue-engineered cartilage products; however, such costs are expected to be partially offset by the recognition of licensing fees and milestone payments from Inamed and by sharing such costs with partners. Results of Operations --------------------- Product sales totaled $2,996,000 and $6,618,000 for the three months and six months ended June 30, 2000, respectively, as compared to sales of $3,617,000 and $6,688,000 in the corresponding periods of 1999. Product sales to related parties reflect sales of Dermagraft and TransCyte to the Dermagraft Joint Venture at cost (see Notes 2 and 9 to the consolidated financial statements). The Company manufactures Dermagraft and TransCyte to meet the Dermagraft Joint Venture's forecasted requirements. The level of sales will continue to be sensitive to the Dermagraft Joint Venture's success in obtaining regulatory approvals and product reimbursement from both national healthcare systems and private insurers. Revenues from contracts and fees were $3,267,000 and $7,055,000 for the three and six months ended June 30, 2000, respectively, compared to $7,505,000 and $15,304,000 for the corresponding periods of 1999. The decrease in 2000 over the prior year periods primarily reflects the recognition of $4,417,000 and $9,367,000, respectively, in the three and six-month periods ended June 30, 1999 in revenue related to a $15 million payment received in January 1999 associated with the expansion of the Dermagraft Joint Venture. This decrease in 2000 is partially offset by the recognition of $899,000 and $1,798,000 in the three and six-month periods ended June 30, 2000 in licensing payments previously received from Inamed in 1999. Contract and fee revenues are principally for research and development activities performed for the Dermagraft and NeoCyte Joint Ventures. See Notes 2 and 9 to the consolidated financial statements. Research and development expenditures decreased to $3,699,000 and $7,600,000 in the three and six months ended June 30, 2000, respectively, as compared to $3,958,000 and $8,127,000 in the corresponding periods of 1999. The lower research and development costs in the three-month and six-month periods ended June 30, 2000 reflect decreases of $225,000 and $957,000, respectively in facility costs resulting from the Company terminating two building leases in the first half of 1999 and consolidating its operations into its two remaining buildings. The facility cost reduction was partially offset by increases of $109,000 in outside services and $145,000 in salaries and benefits, respectively, in the six months ended June 30, 2000 mainly related to increased clinical trial activity in the first six months of 2000 as compared to the same period in 1999. Cost of goods sold of $2,996,000 and $6,618,000, respectively, for the three and six months ended June 30, 2000 compares to $3,617,000 and $6,688,000 in the corresponding periods in 1999. Cost of goods sold represents the cost of TransCyte and Dermagraft sold to the Dermagraft Joint Venture. As a result of the FDA's decision to require additional clinical data for Dermagraft in the treatment of diabetic foot ulcers, the Company is continuing to incur significant costs associated with excess production capacity within its manufacturing facility. Due to costs related to excess production capacity, the Dermagraft Joint Venture immediately writes the inventory down to estimated market value at the date of purchase, which is the net realizable value at which the joint venture believes it will be able to sell the products to its customers. For the three-month periods ended June 30, 2000 and 1999 such write downs totaled $3,005,000 and $3,342,000, respectively, and were $5,133,000 and $5,747,000 for the six-month periods ended June 30, 2000 and 1999, respectively. To the extent the Company does not sell such products to the Dermagraft Joint Venture, it will be required to write such inventories down to net realizable value. Selling, general and administrative costs were $2,860,000 and $5,484,000 for the three and six months ended June 30, 2000, respectively, as compared to $2,791,000 and $6,171,000 in the corresponding periods of the prior year. As discussed above, the Company consolidated its operations into two facilities during the second quarter of 1999 with a resulting decrease in facilities costs of $242,000 and $968,000 in the three and six-month periods ended June 30,2000, respectively, as compared to the same periods in 1999. In the three and six months ended June 30, 2000, decreases in legal fees and the cost of other outside services of $194,000 and $585,000, respectively, were offset by increases in compensation costs of $493,000 and $843,000, respectively, as compared to the same periods during the prior year. -13- Compensation expense related to a variable stock option was $704,000 and $2,695,000 for the three months and six months ended June 30, 2000. Stock options exercised by the Company's Chairman and Chief Executive Officer in 1995 through the issuance of a note are being accounted for as variable stock options which can result in significant increases and decreases in compensation expense subject to the variability of the Company's stock price. Equity in losses of joint ventures were $3,542,000 and $7,255,000 for the three and six months ended June 30, 2000, respectively, compared to $4,998,000 and $10,455,000 for the corresponding periods of 1999. These amounts represent the Company's share of losses of the Dermagraft and NeoCyte Joint Ventures. During 1999, the Company funded certain manufacturing and distribution costs associated with the transfer of sales and marketing of TransCyte in the United States to the Dermagraft Joint Venture. No such costs were included in the equity in losses during the three and six-month periods ended June 30, 2000 as compared to $1,266,000 and $2,133,000, respectively during the same periods in 1999. In addition, the decrease in the 2000 loss reflects increased sales and reductions in the Dermagraft Joint Venture's cost structure. Net sales increased by 78% and 68% over the same periods in the prior year to $996,000 and $1,728,000 for the three months and six months ended June 30, 2000, respectively. Manufacturing costs decreased by $1,214,000 resulting in a $1,914,000 increase in the Dermagraft Joint Venture's gross margin for the six-month period ending June 30, 2000 as compared to the same period in 1999. Manufacturing costs for the second quarter 2000 were $336,000 higher than the prior year period. Selling, general and administrative expenses were reduced by $741,000 and $1,883,000 for the three and six-month periods ended June 30, 2000 as such costs have been reduced to reflect current sales volumes. The equity in losses of joint ventures includes costs incurred by the Company and charged to the Dermagraft and NeoCyte Joint Ventures totaling $2,825,000 and $3,943,000 for the three-month periods ended June 30, 2000 and 1999, respectively, and $5,709,000 and $7,848,000 for the six-month periods ended June 30, 2000 and 1999, respectively (see Note 9 to the consolidated financial statements). Interest income and other was a net income of $574,000 and $1,176,000 in the three and six months ended June 30, 2000, respectively, as compared to a net expense of $151,000 and a net income of $304,000 in the corresponding periods of 1999. The increases reflect higher interest income in the three-month and six-month periods ended June 30, 2000, whereas the second quarter of 1999 included one-time costs of $541,000 associated with the consolidation of the Company's operations into two facilities. Interest expense was $464,000 and $924,000 in the three months and six months ended June 30, 2000 as compared to $533,000 and $1,087,000 in the corresponding period of 1999. The decrease primarily reflects the repayment of a $10 million loan from Smith & Nephew in June 1999 partially offset by interest on $3 million in additional borrowings from Smith & Nephew related to the NeoCyte Joint Venture. Liquidity and Capital Resources ------------------------------- As of June 30, 2000, the Company had available working capital of $11.0 million, an increase of $316,000 from December 31, 1999. The increase reflects an additional $7.6 million received from the exercise of warrants and options, the availability of $5 million previously restricted for the redemption of outstanding shares of Convertible Series B Preferred Stock (see Note 5 to the consolidated financial statements) and $708,000 net increase in borrowings, partially offset by the use of $5.3 million of working capital to support operations and the net investment in the Company's joint ventures with Smith & Nephew of $7 million. Capital expenditures and patent application costs were $588,000 and $177,000, respectively, during the first half of 2000. The Company expects to continue to use working capital as it incurs substantial research and development expenses; additional costs in support of clinical trials; general and administrative costs in support of product commercialization; expenditures for capital equipment and patents, and in support of the Dermagraft and NeoCyte Joint Ventures and its strategic alliance with Inamed. These uses of working capital are expected to be only partially offset by revenues received from the Dermagraft and NeoCyte Joint Ventures with Smith & Nephew and from the Inamed alliance. If, for any reason, Smith & Nephew were to terminate the Dermagraft Joint Venture or, to a lesser extent, the NeoCyte Joint Venture, the Company would experience a substantial increase in the need for and use of its working capital to support the commercialization and manufacture of its Dermagraft and TransCyte products or the development of its orthopedic cartilage products. The Company's working capital and capital requirements are dependent upon a number of factors, including the timing and expense of the Company's preclinical and clinical studies, the achievement and timing of regulatory approvals and third-party reimbursement, sales and marketing efforts by the Company's strategic partners, new -14- technological innovations, market acceptance of the Company's products and the establishment of new strategic alliances. The Company currently believes it has sufficient funds to support its operations to the end of fiscal 2000. The further development of the Company's technology and commercialization of its products, as well as any further development of manufacturing capabilities or the establishment of any additional sales, marketing and distribution capabilities, will require the commitment of substantial funds. In addition, the Company believes it will need to raise additional funds to continue operations in 2001. Sources of funds may include payments from alliances with Smith & Nephew and Inamed. The Company may also pursue additional public or private offerings of debt or equity securities. Additional funding could potentially be obtained through new strategic alliances or other collaborative arrangements, or through the extension of existing strategic alliances. However, there can be no assurance that funds from the sources outlined above will be available when needed or on terms favorable to the Company, under existing arrangements or otherwise, or that the Company will be successful in entering into any other strategic alliances or collaborative arrangements. The Company continually reviews its product development activities in an effort to allocate its resources to those products the Company believes have the greatest commercial potential. Factors considered by the Company in determining the products to pursue include projected markets and need, potential for regulatory approval and reimbursement under the existing healthcare system as well as anticipated healthcare reforms, technical feasibility, expected and known product attributes and estimated costs to bring the product to market. Based on these and other factors, which the Company considers relevant, the Company may from time to time reallocate its resources among its product development activities. Additions to products under development or changes in products being pursued can substantially and rapidly change the Company's funding requirements. Financial Condition ------------------- Cash, cash equivalents and short-term investments as of June 30, 2000 decreased by $3.2 million to $22.9 million as compared to December 31, 1999 principally reflecting the use of $9 million to fund operations, a net investment of $7 million to support the Dermagraft and NeoCyte Joint Ventures, $588,000 for capital expenditures and $1.3 million for payment of debt, partially offset by $7.6 million received from the exercise of warrants and options, the availability of $5 million previously restricted for the redemption of outstanding shares of Convertible Series B Preferred Stock (see Note 5 to the consolidated financial statements) and $2.0 million in additional borrowings. Receivables from joint ventures from December 31, 1999 to June 30, 2000 increased by $4.5 million and inventory decreased by $4.1 million principally reflecting the sale of inventories by the Company to, and the timing of payments from, the Dermagraft Joint Venture (see Note 2 to the consolidated financial statements). The current portion of long-term debt at June 30, 2000 has increased by $2 million from December 31, 1999 reflecting additional borrowings from Smith & Nephew (see Note 4 to the consolidated financial statements). Payables to joint ventures decreased by $3.1 million over the same period based on the timing of payments made to the Dermagraft Joint Venture. ITEM 3 - QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to changes in interest rates primarily from its long-term debt arrangements and, secondarily, from its investments in certain securities. Although the Company's short-term investments are available for sale, the Company generally holds such investments until maturity. The Company does not utilize derivative instruments or other market risk sensitive instruments to manage exposure to interest rate changes. The Company believes that a hypothetical 100 basis point adverse move in interest rates along the entire interest rate yield curve would not materially affect the fair value of the Company's interest sensitive financial instruments at June 30, 2000. -15- PART II - OTHER INFORMATIO -------------------------- ITEM 4 - SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS The Company's Annual Meeting of Stockholders was held on May 23, 2000. During the Annual Meeting, the stockholders elected the following nominees to the Company's Board of Directors to serve for the term of one year or until their successors have been elected and qualified. The votes of the stockholders for each of the director nominees was as follows: Nominee In Favor Withheld ------------------------- ---------- --------- Arthur J. Benvenuto 53,521,778 995,045 Dr. Gail K. Naughton 53,606,038 910,785 Jerome E. Groopman, M.D. 54,113,035 403,788 Jack L. Heckel 54,087,245 429,578 Ronald L. Nelson 54,113,320 403,503 Dayton Ogden 54,113,320 403,503 David S. Tappan, Jr. 54,085,665 431,158 Dr. Gail R. Wilensky 54,100,305 416,518 In addition, the stockholders approved and adopted the amended and restated Bylaws of the Company with 52,845,936 shares in favor of the proposal, 1,061,722 shares opposed, 139,778 shares abstaining and 469,387 broker non-votes. The stockholders also approved the appointment of Ernst & Young LLP as independent auditors for the fiscal year ending December 31, 2000 with 54,261,370 shares in favor of the proposal, 178,603 shares opposed and 76,850 shares abstaining. Broker non-voting did not occur with regard to the election of directors or the appointment of Ernst & Young. ITEM 5 - FACTORS THAT MAY AFFECT FUTURE RESULTS The following is a summary description of some of the many risks we face in our business. You should carefully review these risks in evaluating our business and the businesses of our subsidiaries. You should also consider the other information described in this report. RISKS RELATED TO OUR BUSINESS ----------------------------- IF OUR PRODUCTS FAIL IN CLINICAL STUDIES, WE WILL BE UNABLE TO OBTAIN FDA APPROVAL AND WILL NOT BE ABLE TO SELL THOSE PRODUCTS. In order to sell our products that are under development, and our existing products for additional applications, we must receive regulatory approval for our products. To obtain those approvals, we must conduct clinical studies demonstrating that our products are safe and effective. No assurances can be given that we will obtain FDA approval, if any, on a timely basis. If we cannot obtain FDA approval for a product or any additional application of a product, that product cannot be sold and revenues will suffer. Early in 1998, an FDA Advisory Panel recommended the FDA approve Dermagraft for marketing in the United States for the treatment of diabetic foot ulcers. The Advisory Panel's recommendation included certain conditions we would have needed to satisfy after the commercial introduction of Dermagraft. However, in June 1998, the FDA requested we complete an additional controlled clinical trial to support our application for approval to market Dermagraft for the treatment of diabetic foot ulcers. The clinical trial began in late 1998 and the results of a planned interim analysis of data from this trial were announced in December 1999. These data showed that, although statistical significance was not achieved at the interim analysis, Dermagraft was healing more ulcers than the control treatment in those diabetic foot ulcers having a duration of greater than six weeks. In February 2000, the FDA approved an application for an amendment to the Investigational Device Exemption (IDE) for the ongoing clinical trial of Dermagraft in the treatment of diabetic foot ulcers. Based on the data presented to the FDA in December, the IDE has been amended to revise the enrollment criteria and the statistical plan for data analysis. Enrollment in this additional clinical trial has been completed and we expect to submit our PMA application for approval of Dermagraft for the treatment of diabetic foot ulcers to the FDA by the end of the summer. Commercial introduction within the United States is subject to FDA approval. We cannot predict with any certainty that the FDA will accept our PMA application filing or that the FDA will ever approve any such application. -16- Although Dermagraft appears promising based on clinical studies to date, it may not be successful in this additional clinical trial or other future clinical trials. Our ongoing clinical study of Dermagraft, and clinical studies of our other products, may be delayed or halted for various reasons, including: o the product is not effective, or physicians think that it is not effective; o patients experience severe side effects during treatment; o patients do not enroll in the study at the rate we expect; or o product supplies are not sufficient to treat the patients in the study. In addition, the FDA and foreign regulatory authorities have substantial discretion in the approval process. The FDA and foreign regulatory authorities may not agree that we have demonstrated that Dermagraft, or any of our other products, are safe and effective after we complete clinical trials. WE WILL NEED ADDITIONAL FUNDS TO SUPPORT OPERATIONS. IF WE ARE UNABLE TO OBTAIN THEM, WE WOULD BE UNABLE TO COMPLETE OUR PRODUCT DEVELOPMENT PROGRAMS AND WOULD HAVE TO REDUCE OR CEASE OUR OPERATIONS, OR ATTEMPT TO SELL SOME OR ALL OF OUR OPERATIONS OR TO MERGE WITH ANOTHER ENTITY. The further development of our technology and products as well as any further development of manufacturing capabilities or the establishment of additional sales, marketing and distribution capabilities will require the commitment of substantial funds. Our existing working capital will not be sufficient to meet our needs. We believe we will need to raise additional funds to continue operations in 2001. Potential sources of additional funds include payments from our alliances with Smith & Nephew and Inamed Corporation. If, for any reason, Smith & Nephew were to terminate the Dermagraft Joint Venture or, to a lesser extent, the NeoCyte Joint Venture, we would experience a substantial increase in the need for and use of our working capital to support the commercialization and manufacture of our Dermagraft and TransCyte products or the development of our orthopedic cartilage products. We may pursue additional public or private offerings of debt or equity securities or other means to obtain funds. We could also acquire additional funding through collaborative arrangements or the extension of existing arrangements, which could require the issuance of additional equity interests in us. We may not satisfy the milestones for additional funds under the joint ventures with Smith & Nephew or the Inamed alliance. We also may not be able to obtain adequate funds under other existing or future arrangements when such funds are needed or, if available, on terms acceptable to us. Insufficient funds may require us to delay, scale back or eliminate certain of our research and product development programs, or that we license third parties the right to commercialize products or technologies that we would otherwise commercialize ourselves or that we attempt to merge with another entity or otherwise reduce or cease operations. WE HAVE A HISTORY OF LOSSES AND MAY NOT BECOME PROFITABLE. To date, we have experienced significant operating losses in funding the research, development, testing and marketing of our products and expect to continue to incur substantial operating losses. To June 30, 2000, we had incurred cumulative net operating losses of $255.5 million. Our ability to achieve profitability depends in part upon our ability to successfully manufacture and market Dermagraft and TransCyte for skin ulcers and burns. We may never achieve a profitable level of operations or even if we achieve profitability, we may not be able to sustain it on an ongoing basis. OUR PRODUCTS MAY NOT BE ACCEPTED BY THE MARKET AND MAY NOT BE SUCCESSFULLY COMMERCIALIZED BECAUSE PHYSICIANS AND PATIENTS MAY NOT PURCHASE OR USE THEM. Our products are based on new and innovative technologies and the medical community or the general population may not broadly purchase or use our products as alternatives to existing methods of treatment. Sales of our products may be adversely affected by: o their respective cost; o concerns related to efficacy; o the effectiveness of alternative methods of treatment; and o the insufficiency of third-party reimbursement. Any future negative events or other unfavorable publicity involving the use of our products could also adversely affect the acceptance of our products. Both we and Smith & Nephew have limited direct experience marketing or obtaining third-party reimbursement for these types of products. -17- Additionally, TransCyte, which has been marketed and sold in the United States since 1997, may not achieve widespread commercial acceptance in the United States. Similarly, Dermagraft has only been sold internationally and may never achieve commercial acceptance in the United States even if it receives FDA approval. WE RELY ON THIRD PARTIES TO MARKET, DEVELOP AND SELL OUR PRODUCTS AND THOSE THIRD PARTIES MAY NOT PERFORM SUCCESSFULLY. OUR DEPENDENCE ON THIRD PARTIES AND OUR LACK OF SALES AND MARKETING PERSONNEL COULD LIMIT OUR ABILITY TO DEVELOP OUR PRODUCTS OR TO GENERATE REVENUES FROM PRODUCT SALES. We are particularly dependent on Smith & Nephew with respect to the Dermagraft Joint Venture and NeoCyte Joint Venture. The amount and timing of resources to be devoted by Smith & Nephew is not within our control. In addition, the Dermagraft and NeoCyte Joint Venture agreements provide that they may be terminated prior to their expiration under certain circumstances that are outside our control. If Smith & Nephew does not perform its obligations as expected or if Smith & Nephew has a strategic shift in its business focus, it would be difficult for us to successfully complete the development efforts of the Dermagraft Joint Venture and NeoCyte Joint Venture. We are relying on Smith & Nephew and others to market our products both domestically and internationally. Our success in generating market acceptance of Dermagraft and TransCyte will depend on the marketing efforts of Smith & Nephew. We cannot control the amount and timing of resources that Smith & Nephew or others may devote to marketing and selling our products. Smith & Nephew may not perform its obligations under the Dermagraft Joint Venture as expected. Our failure to achieve broad use of Dermagraft for the treatment of diabetic foot ulcers and, to a lesser extent, TransCyte for burn care, would hurt our ability to generate revenues and any future profits. To the extent that we choose not to or are unable to establish such arrangements, we would experience increased capital requirements to undertake research, development and marketing of our proposed products at our own expense. If we are not able to meet these expenses we may be unable to continue our operations. IF WE ARE UNABLE TO PROTECT OUR INTELLECTUAL PROPERTY, WE MAY BE UNABLE TO PREVENT OTHER COMPANIES FROM USING OUR TECHNOLOGY IN COMPETITIVE PRODUCTS. IF WE INFRINGE THE INTELLECTUAL PROPERTY RIGHTS OF OTHERS, WE MAY BE PREVENTED FROM DEVELOPING OR MARKETING OUR PRODUCTS. Our ability to compete effectively will depend, in part, on our ability to maintain the proprietary nature of our technology and manufacturing processes. Our competitors may develop similar products that are the same as our products and market those products after our patents expire, or may design around our existing patents. If this happens, sales of our products would suffer and our ability to generate revenues will be severely impacted. Furthermore, patents may be issued to others that prevent the manufacture or sale of our products. We may have to pay significant fees or royalties to license those patents in order to continue marketing our products. This would cause any future profits on sales of our products to decline. Our dependence upon having exclusive rights to the technology covered under our owned or licensed patents and patent applications is subject to the following risks: o applications may not result in issued patents; o current or future issued or licensed patents, trade secrets or know-how may not afford protection against competitors with similar technologies or processes; o any patents issued may be infringed upon or designed around by others; or o others may independently develop technologies or processes that are the same as or substantially equivalent to ours. In addition to patent protection, we also rely on trade secrets, know-how and technology advances. We enter into confidentiality agreements with our employees and others, but these agreements may not be effective in protecting our proprietary information. Others may independently develop substantially equivalent information or obtain access to our know-how. Litigation, which is very expensive, may be necessary to enforce or defend our patents or rights and may not end favorably for us. Any of our licenses, patents or other intellectual property may be challenged, invalidated, canceled, infringed or circumvented and may not provide any competitive advantage to us. -18- IF THE THIRD-PARTY SUPPLIERS THAT SUPPLY THE MATERIALS NECESSARY TO MANUFACTURE OUR PRODUCTS DO NOT SUPPLY QUALITY MATERIALS IN A TIMELY MANNER, IT MAY DELAY OR IMPAIR OUR ABILITY TO DEVELOP AND COMMERCIALIZE PRODUCTS ON A TIMELY AND COMPETITIVE BASIS OR ADVERSELY AFFECT OUR POTENTIAL FUTURE PROFITABILITY. Although most of the raw materials used in the manufacture of our Dermagraft and TransCyte products are available from more than one supplier, changes in certain critical components could cause the FDA to require us to prove equivalency of the materials or potentially to modify or perform additional clinical trials for our Dermagraft and TransCyte products, which could have the effect of restricting our ability to commercialize our products. The mesh framework used by us in the manufacture of Dermagraft is available from only one FDA-approved manufacturing source. Similarly, the synthetic mesh framework used by us in the manufacture of TransCyte is only available from a different FDA-approved manufacturing source. Because the FDA approval process requires manufacturers to specify their proposed suppliers of active ingredients and certain component parts and packaging materials in their applications, FDA approval of a new supplier would be required if these materials become unavailable from the current suppliers. Interruptions in supplies for the manufacture of our Dermagraft and TransCyte products may occur in the future and we may have to obtain substitute vendors for these materials. Any significant supply interruption would delay our clinical trials as well as our product development and marketing programs. In addition, an uncorrected impurity or supplier's variation in a raw material, either unknown to us or incompatible with our manufacturing process, could prevent or delay our ability to manufacture products. IF OUR PRODUCTS THAT ARE IN AN EARLY STAGE OF DEVELOPMENT ARE NEVER SUCCESSFULLY COMMERCIALIZED WE MAY NOT HAVE REVENUES TO CONTINUE OPERATIONS. We have products that are in an early stage of development. To date, only TransCyte has been approved for commercial sale and only Dermagraft has advanced to clinical trials in the United States. However, Dermagraft will still require further marketing approvals from the FDA, and all of our other products are at earlier stages of research, development and testing. These products, including additional indications for Dermagraft and TransCyte, will require significant additional research and development, as well as extensive preclinical and clinical testing. Since our products are based on innovative technologies, there are many reasons why our products may not advance beyond their early stage of development. These reasons include the possibilities that: o any or all of these products will be found to be unsafe or ineffective or otherwise fail to receive necessary regulatory approvals; o our products are uneconomical to market; o third parties may hold legal rights that preclude us from marketing such products; or o our products fail to achieve market acceptance in light of competing technologies and products. RISKS RELATED TO OUR INDUSTRY ----------------------------- IF WE FAIL TO OBTAIN REGULATORY APPROVAL TO COMMERCIALLY MANUFACTURE OR SELL ANY OF OUR PRODUCTS, OR IF APPROVAL IS DELAYED, IT COULD INCREASE THE COST OF PRODUCT DEVELOPMENT, OR ULTIMATELY PREVENT OR DELAY OUR ABILITY TO SELL OUR PRODUCTS AND GENERATE REVENUES. We and our collaborators are subject to extensive government regulation. The FDA and other state and foreign regulatory authorities require rigorous preclinical testing, clinical trials and other product approval procedures for our products. Numerous regulations also govern the manufacturing, safety, labeling, storage, record keeping, reporting and marketing of our products. The process of obtaining these approvals and complying with applicable government regulations is time consuming and expensive. The FDA and other state or foreign regulatory authorities have limited experience with our technology and products. As a result, our products are susceptible to requests for clinical modifications or additional supportive data, or changes in regulatory policy, which could substantially extend the test period for our products resulting in delays or rejections. Even after substantial time and expense, we may not be able to obtain regulatory product approval by the FDA or any equivalent state or foreign authorities. If we obtain regulatory product approval, the approval may limit the uses for which we may market the product. For example, in June 1998, the FDA indicated that our marketing application for Dermagraft for the treatment of diabetic foot ulcers was not approvable without supportive data from an additional clinical trial. We are currently -19- conducting the additional clinical trial as requested by the FDA. If the trial is not successful or if we do not receive FDA approval at the conclusion of the clinical trial it will prevent or at least delay sales of Dermagraft. In addition, although the FDA has classified TransCyte as a medical device, the state of California and the state of New York have notified us that we must register as a tissue bank in order to manufacture or distribute TransCyte in those states. Although some states do not regulate tissue banks, there are certain other states besides California and New York that do. Such states could take a position similar to California and New York with regard to the regulatory status of TransCyte. In June 1997, we submitted a petition to the FDA requesting an advisory opinion that the FDA's federal regulation of this product as a medical device preempts conflicting New York statutes (laws) from regulating the product as banked human tissue. In January 2000, the FDA denied our petition to pre-empt applicable New York statutes. In view of the FDA's decision, the Company has initiated discussions at the individual state level, beginning with the state of California in an attempt to resolve this matter. Subject to the outcome of these discussions, we and our customers could be subjected to a costly new layer of regulation. In addition, under the laws of some states that regulate tissue, including New York and Florida, the sale of human tissues for valuable consideration is prohibited. We are currently distributing TransCyte in California and New York under a provisional tissue banking license. Due to the similarities of our products, regulations applicable to TransCyte are also expected to apply to our Dermagraft product and potentially to our NeoCyte product as well. After regulatory approval is obtained, our product, its manufacture and related manufacturing facilities will be subject to continual review and periodic inspections. Any subsequent discovery of previously unknown problems with a product, manufacturer or facility may result in restrictions on the product or manufacturer, including withdrawal of the product from the market. For example, after inspecting our manufacturing facility early in 1998 in conjunction with our application for the approval of Dermagraft for the treatment of diabetic foot ulcers, the FDA notified us of numerous objectionable conditions under a Form FDA 483 list of observations. These observations concerned our manufacturing processes and systems for Dermagraft and TransCyte. In March 1998, the FDA issued a warning letter requiring us to investigate and correct the conditions identified by the FDA. In September 1998, we successfully completed a reinspection by the FDA of our manufacturing facility and quality systems. However, we must continue to pass future facility inspections by the FDA and foreign regulatory authorities. Our research and development activities and operations involve the controlled use of small quantities of radioactive compounds, chemical solvents and other hazardous materials. In addition, our business involves the growth of human tissues. In the event of an accident, we could be held liable for any damages that result. In addition, these research activities and operations are subject to continual review under the Occupational Safety and Health Act, the Environmental Protection Act, the Toxic Substances Control Act, the Resource Conservation and Recovery Act and other federal, state or local laws and regulations which impact our ability to develop and market our products. HEALTHCARE REFORM MEASURES AND REIMBURSEMENT PROCEDURES MAY PREVENT US FROM OBTAINING AN ADEQUATE LEVEL OF REIMBURSEMENT FOR OUR PRODUCTS THAT IN TURN WOULD DECREASE OUR ABILITY TO GENERATE REVENUES. Our ability to commercialize products successfully will depend in part on the extent to which reimbursement for the costs of such products and related treatments will be available from government health administration authorities, private health insurers and other organizations. In the United States, government and other third-party payors are increasingly attempting to contain healthcare costs by limiting both coverage and the level of reimbursement for new products approved for marketing by the FDA. In some cases, such payors may refuse to provide any coverage for uses of approved products for indications that the FDA has not granted marketing approval. Initiatives to reform healthcare delivery are increasing these cost containment efforts. As managed care organizations continue to expand as a means of containing healthcare costs, we believe there may be attempts by such organizations to restrict the use of, delay authorization to use, or limit coverage and the level of reimbursement for, new products, such as those being developed and commercialized by us, pending completion of cost/benefit analyses of such products by those managed care organizations. Internationally, where national healthcare systems are prevalent, little if any funding may be available for new products, and cost containment and cost reduction efforts can be more pronounced than in the United States. We have supported health economics studies and research and have developed cost offset or cost-effectiveness models with respect to our TransCyte and Dermagraft products in an effort to help obtain appropriate and adequate third party coverage and reimbursement for these products. However, these products are novel and as such are -20- subject to inherent uncertainty in the area of reimbursement. Adequate government or private payor coverage or levels of reimbursement may not be available for any of our products and we may not be able to maintain price levels sufficient for the realization of an appropriate return on our investment in such products. Failure to obtain sufficient coverage and reimbursement levels for uses of our products could decrease the market acceptance of such products. DISCOVERIES OR DEVELOPMENT OF NEW TECHNOLOGIES BY OUR COMPETITORS OR OTHERS MAY MAKE OUR PRODUCTS LESS COMPETITIVE OR MAKE OUR PRODUCTS OBSOLETE. The biomedical technology industry is subject to rapid, unpredictable and significant technological change. Competition from universities, research institutions and pharmaceutical, chemical and biotechnology companies is intense. Many competitors or potential competitors have greater financial resources, research and development capabilities and manufacturing and marketing experience than we do. In general, the first biomedical product to be commercialized for a particular therapeutic indication is often at a significant competitive advantage relative to later entrants to the market. Accordingly, the relative speed with which we can develop products, complete clinical trials, obtain regulatory approvals and develop commercial manufacturing capability may affect our competitive position. Other factors such as our ability to secure regulatory approval for our products, to implement production and marketing plans, and to secure adequate capital resources will also impact our competitive position. We may not have the resources to compete successfully. IF WE ARE NOT ABLE TO ATTRACT KEY PERSONNEL AND ADVISORS OR IF OUR CURRENT MANAGEMENT AND TECHNICAL PERSONNEL LEAVE THE COMPANY, IT MAY ADVERSELY AFFECT OUR ABILITY TO OBTAIN FINANCING OR TO DEVELOP OUR PRODUCTS. Our success will depend in large part upon our ability to attract and retain qualified scientific, administrative and management personnel as well as the continued contributions of our existing senior management and scientific and technical personnel. We face strong competition for such personnel and we cannot give any assurance that we will be able to attract or retain such individuals. In particular, if we lose the services of either Arthur J. Benvenuto, our Chairman and Chief Executive Officer, or Dr. Gail K. Naughton, our President and Chief Operating Officer, it will limit our ability to achieve our business objectives and could make it difficult to raise additional funds or to attract partners. WE MAY NOT HAVE ADEQUATE INSURANCE AND IF WE BECOME SUBJECT TO PRODUCT LIABILITY CLAIMS, IT MAY RESULT IN REDUCED DEMAND FOR OUR PRODUCTS OR DAMAGES THAT EXCEED OUR INSURANCE LIMITATIONS. The use of any of our products, whether for commercial applications or during clinical trials, exposes us to an inherent risk of product liability claims in the event such products cause injury, disease or result in adverse effects. Such liability might result from claims made directly by healthcare institutions, contract laboratories or others selling or using such products. We currently maintain product liability insurance coverage; however, such insurance coverage might not be sufficient to fully cover any potential claims. Such insurance can be expensive and difficult to obtain. Adequate insurance coverage may not be available in the future at an acceptable cost, if at all, or in sufficient amounts to protect us against any such liability. Any product liability claim in excess of insurance coverage would have to be paid out of our cash reserves which would have a detrimental effect on our financial condition. DISCOVERY OF PREVIOUSLY UNKNOWN PROBLEMS WITH A PRODUCT, MANUFACTURER, OR FACILITY, COULD RESULT IN PRODUCT RECALLS OR WITHDRAWALS AND SIGNIFICANTLY REDUCE OUR RESOURCES. Our tissue repair and transplantation products are complex and must be manufactured under well-controlled and sterile conditions, in addition to meeting strict product release criteria. Any manufacturing errors or defects, or uncorrected impurity or variation in a raw material, either unknown or undetected by us, could affect the quality and safety of our products. If any of the defects were material, we could be required to undertake a market withdrawal or recall of the affected products. The cost of a market withdrawal or product recall could significantly reduce our resources. -21- RISKS RELATED TO FINANCING -------------------------- OUR STOCK PRICE COULD CONTINUE TO BE VOLATILE AND ANY INVESTMENT COULD SUFFER A DECLINE IN VALUE, ADVERSELY AFFECTING OUR ABILITY TO RAISE ADDITIONAL CAPITAL WHICH COULD IN TURN DELAY COMMERCIALIZATION OF OUR PRODUCTS. The market price of our Common Stock has fluctuated significantly in recent years and is likely to fluctuate in the future. For example, from April 1998 to July 2000, our Common Stock has closed as high as $12.13 per share and as low as $1.97 per share. Factors contributing to this volatility have included: o the results of research or scientific discoveries by us or others; o progress or the results of preclinical and clinical trials; o new technological innovations; o the approval and commercialization of products; o developments concerning technology rights; o litigation and related developments; and o public perception regarding the safety and efficacy of our products. Fluctuations in our financial performance from period to period, the issuance of analysts' reports and general industry and market conditions also tend to have a significant impact on the market price of our Common Stock. FUTURE SALES OF OUR SECURITIES IN THE PUBLIC MARKET COULD LOWER OUR STOCK PRICE AND IMPAIR OUR ABILITY IN NEW STOCK OFFERINGS TO RAISE FUNDS TO CONTINUE OPERATIONS. The market price of our securities could drop due to sales of a large number of our securities or the perception that these sales could occur. Such sales also might make it more difficult for us to sell equity securities in the future at a price that we deem appropriate. OUR CHARTER DOCUMENTS AND STOCKHOLDER RIGHTS PLAN MAY PREVENT US FROM PARTICIPATING IN TRANSACTIONS THAT COULD BE BENEFICIAL TO STOCKHOLDERS. Our stockholder rights plan and provisions in our certificate of incorporation and bylaws may discourage transactions involving an actual or potential change in our ownership, including transactions in which you might otherwise receive a premium for your shares over the then-current market prices. These provisions also may limit our stockholder's ability to approve transactions that they deem to be in their best interest. In addition, our Board of Directors may issue shares of preferred stock without any further action by stockholders. Such issuances may have the effect of delaying or preventing a change in our ownership. -22- ITEM 6 - EXHIBITS AND REPORTS ON FORM 8-K (a) Exhibits
Exhibit No. Title Method of Filing ------- ----- ---------------- 3.1 Amended and Restated Certificate of Filed Herewith Incorporation of Advanced Tissue Sciences, Inc. as in effect on February 16, 1999 3.2 Amended and Restated By-Laws of the Filed Herewith Registrant Dated May 23, 2000 4.1 Rights Agreement, Dated as of January 6, Incorporated by Reference to Exhibit 1 to the 1995, between the Company and Chemical Registrant's Current Report on Form 8-K Dated Trust Company of California, including the January 5, 1995 Certificate of Determination for the Series A Junior Participating Preferred Stock as Exhibit A, the Form of Summary of Rights to Right Certificate as Exhibit B and the Purchase Preferred Shares as Exhibit C 4.2 First Amendment to Rights Agreement entered Incorporated by Reference to Exhibit 1 to the into as of November 8, 1999, between Registrant's Form 8-A, as amended, dated ChaseMellon Shareholder Services, L.L.C. November 10, 1999 and Advanced Tissue Sciences, Inc. 4.3 Second Amendment to Rights Agreement Incorporated by Reference to Exhibit 1 to the entered into as of December 13, 1999, Registrant's Form 8-A, as amended, dated March between ChaseMellon Shareholder Services, 28, 2000 L.L.C. and Advanced Tissue Sciences, Inc. 27 Financial Data Schedule Filed With Electronic Copy Only
(b) Reports on Form 8-K - The Company did not file any reports on Form 8-K during the three months ended June 30, 2000. -23- SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized. ADVANCED TISSUE SCIENCES, INC. Date: August 9, 2000 /s/ Arthur J. Benvenuto -------------------- ------------------------------ Arthur J. Benvenuto Chairman of the Board, Chief Executive Officer and Chief Accounting Officer -24-